kbank multi asset strategies jan 2011 eng

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.Mean S

Strategic Thesis The New Year is a period of high hopes. It looked like things were really getting better in the world’s largest economy as manufacturing data was on the up and up. To get the economists and markets even more exuberant, jobs data from ADP gave a surprising tease, well exceeding expectations. Unfortunately, the optimism faded when the Bureau of Labor Statistics told their sad story. Non-farm payrolls remained weak, while investors were trying to make heads or tails about the declining unemployment rate from 9.8% to 9.4%. The decline was for the wrong reasons as it turned out, since the labor force was declining, attributed to discourage job seekers. The immediate read from Asia was negative, possibly on concerns of stagflation…a combination of decelerating growth and accelerating inflation. This will gave the US dollar a temporary boost for its safe haven’s sakes…but how long. Inflation risk for the West will still be to the downside. Fed Chairman – Ben Bernanke reiterated that it could take 4-5 years before the US job market normalizes and hence suggests to us that it would the considerable same amount of time before US monetary policy also normalizes. So there will be more need for paper and green ink to print more US dollars. Local catalysts for USD/THB remain the current account surpluses. The year of the rabbit is likely to see smaller surpluses whereby KResearch has penciled in about USD 8.3bn to 11.3bn. Given that this will be an election year, chances are rising that domestic demand can fall on the way side which means imports would decelerate. We hold onto our 4Q11 USD/THB target of 28.00 given these considerations. On equities, we have become more bullish this month and abandoned our earlier view for investors to reduce their portfolio. We now expect the SET index to hit 1220 during the first half of the year instead of the second half. The downside risk of the SET index is not expected to be lower than 980 in the short-term.

Kobsidthi Silpachai, CFA –Kasikornbank [email protected] Susheel Narula – KSecurities [email protected] Kavee Chukitkasem – KSecurities [email protected] KResearch [email protected]

Holiday mood hangover had been putting a positive spin on sentiment for the time being

Bullish ADP reading suggest Friday’s non-farm payrolls added more fuel to the optimism…only to be disappointed by the figure from the Bureau of Labor Statistics showing that non-farm payrolls fell short of expectations

Hence the US will keep QE while Asia goes QT, that is quantitative tightening

Election year syndrome reinforces the sustained probability of current account surpluses and hence we retain our 4Q11 USD/THB target of 28.00

We have become more bullish this month and abandoned our earlier view for investors to reduce their portfolio. We now expect the SET index to hit 1220 during the first half of the year instead of the second half. The downside risk of the SET index is not expected to be lower than 980 in the short-term

KBank Multi Asset Strategies Not such a Happy New Year after all

Strategies Macro / Multi Asset January 2011 Volume 44

WWW.KASIKORNBANKGROUP.COM

“KBank Multi Asset Strategies” can now be accessed on Bloomberg: KBCM <GO>

Disclaimer: This report must be read with the Disclaimer on page 41 that forms part of it

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Key Parameters & Forecasts at Year-end 2003 2004 2005 2006 2007 2008 2009 2010E 2011EGDP, % YoY 7.1 6.3 4.6 5.2 4.9 2.5 -2.3 7.6 4.0 Consumption, % YoY 6.5 6.2 4.6 3.0 1.6 2.7 -1.1 4.0 3.3 Investment Spending, % YoY 12.1 13.2 10.5 3.9 1.3 1.2 -9.2 9.5 8.0 Govt Budget / GDP % -0.2 -0.2 0.3 -0.7 -1.5 -1.0 -5.6 -3.2 -4.4 Export, % YoY 18.2 21.6 15.2 17.0 17.3 15.9 -14.0 27.0 8.0 Import, % YoY 17.4 25.7 25.8 7.9 9.1 26.5 -25.2 35.0 11.0 Current Account (USD bn) 4.78 2.77 -7.6 2.3 14.1 1.6 21.9 14.2 10.0 CPI % YoY, average 1.8 2.8 4.5 4.6 2.3 5.5 -0.9 3.3 3.25 USD/THB 39.6 38.9 41.0 36.1 33.7 34.8 33.3 29.0 28.0 Fed Funds, % year-end 1.00 2.25 4.25 5.25 4.25 0.25 0.25 0.25 0.25 BOT repo, % year-end 1.25 2.00 4.00 5.00 3.25 2.75 1.25 2.00 2.75 Bond Yields

2yr, % year-end 1.73 2.78 4.94 5.02 3.91 1.98 2.17 2.35 3.00 5yr, % year-end 2.8 4.0 5.3 5.1 4.5 2.2 3.6 2.75 3.75 10yr, % year-end 4.9 4.9 5.5 5.4 4.9 2.7 4.3 3.25 4.50

USD/JPY 107.5 102.5 118.0 119.1 111.8 90.7 93.0 82.0 90.0 EUR/USD 1.26 1.36 1.18 1.32 1.46 1.40 1.43 1.40 1.31 SET Index 772.2 668.1 713.7 679.8 858.1 450.0 734.5 1040 1220 Source: Bloomberg, CEIC, KBank, KResearch, KSecurities

KBank Thai Government Bond Rich / Cheap model

-30.00

-20.00

-10.00

0.00

10.00

20.00

30.00

LB11

3A

LB11

6A

LB11

NA

LB12

3A

LB13

3A

LB13

7A

LB14

5B

LB14

DA

LB15

5A

LB15

DA

LB16

7A

LB16

NA

LB17

5A

LB18

3B

LB19

1A

LB19

6A

LB19

8A

LB19

DA

LB21

3A

LB24

DA

LB26

7A

LB28

3A

LB29

6A

LB39

6A

3 mth avgNow

Source: Bloomberg, KBank

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KBank THB NEER Index KBank USD/THB – FX Reserves / USD Majors model

KBank THB Trade Weighted Index

70

80

90

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110

00 01 02 03 04 05 06 07 08 09 10 11

Jan 1995 = 100

+ 1 std dev

-1 std dev

average

2830323436384042444648

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actual model

KBank USD/THB model

Source: Bloomberg, KBank Source: Bloomberg, KBank

FX reserves – USD/THB model DXY – USD/THB model

y = -7.6528Ln(x) + 69.973R2 = 0.8655

262830323436384042444648

25 75 125 175 225FX reserves to USD/THB mappingcurrent2011 forecast

USD/THB

FX reserves, USD bn

y = 27.699Ln(x) - 86.289R2 = 0.756

25

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50

70 80 90 100 110 120 130

DXY to USD/THB mapping current

USD/THB

DXY

since 2001


KBank BOT repo model SET forward dividend yield vs. 10yr bond yield

0.00.51.01.52.02.53.03.54.04.55.05.5

01 02 03 04 05 06 07 08 09 10 11 12

actual model

%

0123456789

00 01 02 03 04 05 06 07 08 09 10 11

10yr yields SET forward dividend yields

%


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Thai inflation parameters Thai contribution to GDP growth

-15%-10%

-5%0%5%

10%15%20%25%

01 02 03 04 05 06 07 08 09 10

CPI Core CPI PPI

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10

Priv ate consumption Gov ernment consumption Gross fix ed capital

Change in inv entories Net ex ports GDP

% y oy Contribution to growth

Source: CEIC, KBank Source: NESDB, KBank

Implied forward curve: swaps Implied forward curve: TGBs

0.501.001.502.002.503.003.504.004.505.00

0 1 2 3 4 5 6 7 8 9 10Jan-11 Apr-11 Jul-11 Jan-12

%

tenor (yrs)

Implied forward rate shifts (IRS)

1.50

2.00

2.50

3.00

3.50

4.00

4.50

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15Jan-11 Apr-11 Jul-11 Jan-12

%

tenor (yrs)

Implied bond yield curve shifts


US 2yr yields and implied forward US 5yr yields and implied forward

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

2yr yields, % implied forwards

1

2

3

4

5

6

7

8

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

5yr yields, % implied forwards


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5

KBank EUR/THB model KBank JPY/THB model

34.036.038.040.042.044.046.048.050.052.054.056.0

01 02 03 04 05 06 07 08 09 10 11 12

actual model

EUR/THB

25.027.029.031.033.035.037.039.041.043.0

01 02 03 04 05 06 07 08 09 10 11 12

actual model

JPY/THB


KBank GBP/THB model KBank CNY/THB model

43.0

48.0

53.0

58.0

63.0

68.0

73.0

78.0

01 02 03 04 05 06 07 08 09 10 11 12

actual model

GBP/THB

4.04.24.44.64.85.05.25.45.65.8

01 02 03 04 05 06 07 08 09 10 11 12

actual model

CNY/THB


KBank THB/VND model KBank AUD/THB model

300350400450500550600650700750

01 02 03 04 05 06 07 08 09 10 11 12

actual model

THB/VND

21.0

23.0

25.0

27.0

29.0

31.0

33.0

35.0

01 02 03 04 05 06 07 08 09 10 11 12

actual model

AUD/THB


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Not such a Happy New Year after all

Holiday mood hangover had been putting a positive spin on

sentiment for the time being

Bullish ADP reading suggest Friday’s non-farm payrolls added more fuel to the optimism

…only to be disappointed by the figure from the Bureau of Labor Statistics showing that non-farm payrolls fell short of expectations

Right for the wrong reasons: US unemployment eased from 9.8% to 9.4% but the labor force reduced as job seekers are discouraged

Based on the Taylor rule, low inflation and high unemployment means that the Fed Funds rate should be a negative 2.2% under the assertion that the central bank has only one monetary tool

Hence the US will keep QE while Asia goes QT, that is quantitative tightening

Election year syndrome reinforces the sustained probability of current account surpluses and hence we retain our 4Q11 USD/THB target of 28.00

Unfortunately we ponder that the continued current account surpluses is good for the Thai baht, but it is not good for the Thai citizen

Sufficient liquidity in the hands of investors to absorb the new bonds in the remaining three quarters of FY2011

Inflation rates would climb gradually but the market has yet to fully price in price pressure from higher world commodity prices

BoT’s forecast shows more of price risks lie in the year 2011 than in 2012 – slowdown in 2012 and completion of policy rate hikes are likely to result in milder core inflation rate next year

Given substantial uncertainties to the pace of the US recovery and differing views in the market, US treasuries are to continue seeing substantial fluctuations throughout the year 2011

Kobsidthi Silpachai, CFA - Kasikornbank [email protected] Warunee Sithithaworn – Kasikornbank [email protected] Nalin Chutchotitham – Kasikornbank [email protected]

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Fig 1. The wild ride for US jobs ….and recovery in 2011

Source: Cagle.com

The irrational exuberant optimism from the New Year festivities? Economic data points of late spurred hopes that the business sector is recovering. Seems that the New Year might be bringing new hope with the US ISM Manufacturing index (Institute of Supply Management’s purchasing manager’s index) has continued to hover about the 50 boom / bust line for 17 consecutive months. The index helps to measure how the manufacturing sector is performing. If it is reported to be more than 50, it generally means that the sector is expanding and if the reading is less than 50, the sector is contracting. But does an expanding manufacturing sector automatically mean an expanding job market? Fig 3 seems to suggest a good probability. Since 2000, the correlation between ISM manufacturing and monthly changes in non-farm payrolls is around 75%, which supports a good case for such an argument. Fig 2. ISM manufacturing has been over 50pts for the past 17 consecutive months

Fig 3. ISM manufacturing & BLS non-farm payrolls

303540455055606570

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

ISM manufacturing

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00 01 02 03 04 05 06 07 08 09 10-1000-800-600-400-2000200400600800

ISM manufacturing, left axis non-farm payrolls, right axis

ρ = 75%

Source: Bloomberg, CEIC, KBank Source: Bloomberg, CEIC, KBank

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The recent upside surprise to the markets was the Advance Data Processing (ADP) – employment change for the month of December 2010 which printed at 297k against the consensus of 100k. This is helping to boost the dollar’s appeal for the time being and makes the bulls on the US economic recovery look good. Fig 4 adds to the argument, which shows that ADP might explain about 88% of the variance of the Bureau of Labor Statistic’s (BLS) version of the non-farm payrolls. The regression equation would suggest that if December’s reading for ADP was 297k, the BLS reading should have been about 323k. Fig 4. ADP & BLS non-farm payrolls mapping Fig 5. KBank DXY model

297, 103

y = 1.0184x + 16.132R2 = 0.8819

-1000

-800

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0

200

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600

-1000 -800 -600 -400 -200 0 200 400

ADP employment change, k

Bureau of Labor Statistics, non-farm payrolls, k

latest data point mapping

7072747678808284868890

Jan-07

Jul-07

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Jul-08

Jan-09

Jul-09

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Jul-12

actual model


Release of Jobs Friday (first Friday of each month) sees the BLS highly influential data non-farm payrolls as well as the unemployment, which confounded the markets again. The BLS non-farm payrolls posted on 103k against expectations of 150k while the unemployment rate eased from 9.8% to 9.4%. Data snorkeling (i.e. looking into the water from only the surface) might show a pretty nice view as the unemployment rate fell. Data diving with scuba tanks (for more in-depth analysis) shows the reason why the unemployment rate fell. In the unemployment rate, the numerator is the number of total number of people actively looking for work but can not find work. The denominator is the size of the total labor force, the sum of those who are currently working and those who are not. The reason for a fall in the ratio can be due to: the numerator reduced while the denominator was unchanged the denominator increased while the numerator was unchanged the numerator reduced while the denominator increased …or the numerator reduce while the denominator declined but at a slower rate than

the numerator The last appears to be the case. In December, the number of unemployed workers fell by 556k or 4% against the prior month, while the total labor force also declined but at a slower rate of 3.5% or 259k against the prior month. The move in the direction of the unemployment rate appears positive, but it is for the wrong reasons. A decline in the total labor force is symptomatic that the labor force has given up hope. In Ben Bernanke’s recent testimony to Congress, he expressed concerns that the longer people are out of work, their skills become more obsolete, which makes it even more difficult to return back to the labor force. This is like the saying, “Use it or lose it”. Imagine a person going for a job interview and that person’s CV has been idle for the past two years. It becomes a stigma and suspected attestation that the person is not in demand by the jobs market.

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The other issue that looks to hold back the consumption variable (and Asia’s exports) in the US economy is that, given the large slack in the labor market, the balance of power is with the employer rather than the existing employee, which means that negotiating power for wage increases is very weak. To substantiate this case, fig 6 shows the relationship between the level of non-farm payrolls and the non-farm payrolls cost index (the employer’s cost is the proxy for the employee’s revenue, wages). Rising non-farm payrolls is reflective of a recovering jobs market and tips the scale for higher non-farm cost, which means higher wages. Higher wages means higher consumption. But if the case is not this i.e. weak non-farm payrolls weak non-farm payroll cost weak wages

low consumption low demand side inflation. To further add to the pessimism, the US labor participation rate has been consistently declining, fig 7. The participation rate is the percentage of the general population that is in the labor force. Such a trend seems more structural than cyclical, possibly reflective of the rise in the aging population as the baby boomers enter retirement. Fig 6. non-farm payrolls & non-farm cost index Fig 7. US labor participation rate

y = 0.001x - 34.097R2 = 0.9701

0

20

40

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40,000 60,000 80,000 100,000 120,000 140,000nonfarm payrolls, k

nonfarm cost index

5859606162636465666768

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10participation rate, % of total US population


It seems that for the time being, the markets’ bias is for US dollar upside for either good or bad data. Prior to this release, dollar bulls were arguing that the Fed might not spend all of Quantitative Easing part 2.0 program of USD 600bn citing improved economic conditions. Following the non-farm payrolls disappointment, the US dollar continues to benefit from the risk aversion. A slower growing than expected US economy can only be bad news for Asia coupled with inflation to stagflation fears for the region, investors are opting to take some money off the table. Unless the consensus is totally convinced that the recovery from manufacturing continues to transmit to the jobs market, the DXY – US dollar index might not go far. Our DXY model based on consensus inputs for EUR/USD, USD/JPY, GBP/USD, USD/CAD, USD/SEK, USD/CHF would indicate that DXY target for 1Q11 is around 80.53. The “glass half empty” view would argue that the unemployment rate is not somewhere near 5% but near 10%. Try telling those who have been out of a job for the past two years that the economy is recovering…and chances are, the optimist will get a vulgar gesture. Psychologically, pain has a higher magnitude than gain. Ever wonder why bear markets tend to last longer than bull markets?

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Fig 8. Bloomberg’s Taylor Rule Function

Source: Bloomberg, CEIC, KBank, Cagle.com

Again, we would like to present the Taylor rule as a guide and as a reminder the severity of the need for continued accommodative US monetary policy. Based on the rule and assertion of conducting monetary policy with only one tool i.e. the Fed Funds rate, the appropriate Fed Funds rates should be a negative 2.2% based on a 0.80% core PCE (proxy for inflation) and unemployment of 9.4% (proxy for being above or below trend economic growth). This reinforces the fact that other forms of easing monetary policy is needed to supplement a low policy rate since policy rates can not fall below 0%.

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The local catalysts for USD/THB November’s data points for Thailand continued to show more of the same i.e. current account surpluses. The month printed a current account surplus of USD1019 mn, bringing the 2010 YTD surplus to USD12.8bn vs. the same period in 2009 of USD18.6bn or down about 30.8%. The year of the rabbit is likely to see smaller surpluses whereby KResearch has penciled in about USD 8.3bn to 11.3bn. Given that this will be an election year, chances are rising that domestic demand (the sum of consumption, private sector spending a.k.a. investments and government spending) can fall on the way side which means imports would decelerate. Once house dissolution is announced, the government becomes a care taker government which equates to lackluster spending. Post the elections, the political jockeying for key ministerial and cabinet posts are hotly contested, especially in a coalition government. And if history is any guide, coalition governments are hardly stable, which will be reflected in both policies and their implementations i.e. from the sales of dreams to tangible reality. Need a reminder? How long did it take for Thailand to get its new airport, sky-train, underground mass transit system. We are still eagerly awaiting a formal 3G telecommunication system whereas other countries are already heading towards 4G. Taking this into consideration, it could be a period of one to two quarters before the political dust settles between the death and rebirth of a new government. In such uncertain circumstances, the private sector is likely to shift its investment gear to “neutral” until the political roadmap is clearer. This again reiterates a low import environment. As such, fig 9 and 10 show the implications for USD/THB as exporters outnumber importers. Hint…higher current account surpluses generally mean lower USD/THB levels.

Fig 9. Yes, the current account does matter Fig 10. …sliced in another way…cumulative current account vs. USD/THB

-30,000-20,000-10,000

010,00020,00030,00040,000

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293133353739414345

TH current account cumulative, Jan 91 = base, USD mn, left axisUSD/THB, right axis, inverted

34455, 30.2

y = -0.0003x + 37.339R2 = 0.7158

2830323436384042444648

-30,000 -20,000 -10,000 0 10,000 20,000 30,000 40,000

latest data point

USD/THB

cumulative current account balance, Jan 91 = base, USD mn


Portfolio flows are unlikely to incur material changes as the West is still looking into the face of deflation rather than inflation. The US Treasury Inflation Protection Securities or TIPS market might say different as the spread between the yield of the regular issues and TIPS issues widens. While one might argue that the rise in yields is due to fears of a blow out budget deficit, this probably is not the case since, it would require that both the yields on both types of securities to rise in tandem and hence keep the spreads relatively constant. But we view that the deck remains stacked against higher inflation expectations since there are still 15 million Americans out of work. The most recent minutes of the December 14th FOMC (Federal Open Market Committee) suggests caution is warranted:

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In their discussion of the economic situation and outlook, meeting participants saw the information received during the intermeeting period as pointing to some improvement in the near-term outlook, and they expected that economic growth, which had been moderate, would pick up somewhat going forward. Indicators of production and household spending had strengthened, and the tone of the labor market was a little better on balance. The new fiscal package was generally expected to support the pace of recovery next year. However, a number of factors were seen as likely to continue restraining growth, including the depressed housing market, employers' continued reluctance to add to payrolls, and ongoing efforts by some households and businesses to delever. Moreover, the recovery remained subject to some downside risks, such as the possibility of a more extended period of weak activity and lower prices in the housing sector and potential financial and economic spillovers if the banking and sovereign debt problems in Europe were to worsen. In light of recent readings on consumer inflation, participants noted that underlying inflation had continued trending downward, but several saw the risk of deflation as having receded somewhat.

Fig 11. Yields on 5yr UST less 5yr TIPS Fig 12. …but there is 15 million Americans out of work

-1.0-0.50.00.51.01.52.02.53.0

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

5yr UST - TIPS

%

higher inflation

lower inflation

02000400060008000

1000012000140001600018000

48 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08

unemployed, k


So, the message is that the US and much of the Western world will be careful before even contemplating cutting back on quantitative easing (QE). On the other side of the world, Asia is trying to undo the West’s quantitative easing by quantitative tightening (QT) for fear that easy money will reduce the quality of growth and result in economic cancer or asset bubbles. China is feverishly working to keep its inflation genie in the bottle, but that might be too late since there comes a point where the pursuit of growth will lead to inflation unless productivity gains are made. So, China has again executed more QT, by jacking the reserve requirement a 50bps further in hope for slowing money circulation and too much money chasing too few goods. While in Thailand, the central bank stepped up FX intervention in an endeavor to break the trend whereby the increase in foreign investors’ position in Thai fixed income leads to lower USD/THB level in a linear fashion. But will Thai authorities get tougher? Election year politics should discourage the government from prescribing tough medicine against the spread of the QE virus with harsh capital controls. The capital markets, primarily the stock market are one of the best money making machines to finance political campaigns.

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Fig 13. China’s reserve requirements Fig 14. Foreign positions in Thai fixed income

02468

101214161820

00 01 02 03 04 05 06 07 08 09 10 11

major banks small banks

259, 30.37

y = -0.0158x + 32.678R2 = 0.8631

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USD/THB

stepped up FX intervention to break the trend


Given the dichotomy of growth between the West and Asia, money will continue to flow to places where the risk / reward ratio is most optimal. The market’s mind is still leaning towards lower USD/CNY 12 months down the road by about 2.58%. As long as China continues to postpone a more liberal FX regime, regional currencies will remain the recipients of residual flows. We hold onto our 4Q11 USD/THB target of 28.00. Fig 15. USD/CNY 12mth NDF Fig 16. KBank USD/THB model

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2830323436384042444648

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actual model

KBank USD/THB model


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Continued current account surpluses: good for the Thai baht, bad for the Thai citizens The current account surplus is a main pillar of our call for the USD/THB. But what needs to be discussed is that it is a negative indicator of a severe imbalance between the external and internal economy. While it is a good sign for the Thai baht, it might be bad for the Thai citizens, primarily present and future taxpayers. Economists have an alias for the current account balance, that is, the investment / savings gap. The higher the current account surplus, the more Thailand is saving than investing. Pre 1997, it was the reverse position whereby the current account was in deficit as Thailand was investing (rather squandering) than saving. Today’s situation is symptomatic of either lack of confidence, lack of a national strategy, political instability, antiquated tax regimes…or all of the previous. Fig 17. Current account & outstanding public debt Fig 18. BOT FX reserves & bonds outstanding

010,00020,00030,00040,00050,00060,00070,00080,000

00 01 02 03 04 05 06 07 08 09 102,5002,7503,0003,2503,5003,7504,0004,2504,500

cumulative current account, USD mn, April 2000 is base, left axisoutstanding public debt,THB bn, right axis

ρ = 94%

excessive diesel subsidies led toboth a budget and current

account deficit

0200400600800

10001200140016001800200022002400

01 02 03 04 05 06 07 08 09 102030405060708090100110120130140150160170

BOT Bonds O/S (left axis) FX reserves (right axis)

ρ = 97%


This is then reflected in weak imports. In a futile endeavor to breathe life into the local economy, fiscal expansionary policy becomes more aggressive, equating to more borrowings from the future tax revenues to fund the short fall from the present income and hence rising public debt. Fig 17 clearly shows that between Sept 2006, whereby the coup marked the start of Thailand political and social struggle, to today, the amount of public debt had risen from THB 3.2 trillion to THB 4.2 trillion. To our understanding, this amount of public debt excludes debt issued by the central bank. But as history has shown, the central bank’s debt can become the public debt and serves as a reminder that the pain of 1997 has not disappeared as many would like to believe. The losses incurred from preventing the collapse of Thailand’s financial system resulting in loss by the Financial Institution Development Fund (FIDF) was initially THB 1.4 trillion. Today, that FIDF debt was fiscalized about a decade ago, but the outstanding is still about THB 1.1 trillion (please see http://www.pdmo.mof.go.th/?q=th/jakkdownload/138 for more details). No matter how these figures are spun i.e. as a percent of GDP it is still low…about 42%, the absolute levels in fig 17 tells us that political will is lacking as authorities are reluctant to pay it down since it would be politically unpopular as seen in European nations undergoing austerity measures e.g. strikes in Greece, France, Ireland, Portugal. The next worry on the wall is fig 18. While the outstanding BOT bonds are not included yet in public debt, the trend is worrisome. As part of FX intervention and sterilization, a positive balance of payments requires that the central bank buys USD/THB funded by the issuance of BOT bonds. The USD bought are then recycled to “perceived to be safe” investments such as US Treasuries and bonds of the Eurozone nations. The likes of Greece and other peripheral EU sovereigns have already seen a barrage of downgrades, a collapse in prices and a rise in yields. Investments in these assets have revealed their flaws since they are denominated in currencies which the baht has been appreciating

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against, leading to both realized and unrealized translation losses. The credit downgrade story has partly been played but the main attraction has not…the impending fear of a US credit downgrade from its AAA credit rating. This was the highlight of PIMCO founder / co –CIO, William Gross’s recent piece…”Off With Our Heads” which made these key points: American politicians and citizens alike have no clear vision of the costs of a

seemingly perpetual trillion-dollar annual deficit. Policy stimulus is focused on maintaining current consumption as opposed to making

the United States more competitive in the global marketplace. Dollar depreciation will sap the purchasing power of U.S. consumers, as well as the

global valuation of dollar denominated assets. So while on a US dollar bill, the words “In God we trust” is printed, the question for Asian central bankers need to ask is: “In the US dollar we trust”? Fig 19. Breakdown of foreign holdings in UST Fig 20. US credit default swaps

Japan20.4%

Others36.6%

UK11.1%

China21.0%

Taiwan3.0%

Germany1.4%

OPEC5.0%

Thailand1.5%

UST holdings

20253035404550556065

Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11

US credit default swaps, bps


Fig 21. Thailand's balance of payments

USD mn Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 BoP: Exports fob 17,876.5 15,475.1 16,291.6 17,954.9 17,045.5 17,584.0 BoP: Imports cif -15,334.2 -16,266.3 -15,439.8 -14,712.2 -14,772.9 -17,093.8 BoP: Trade Balance 2,542.4 -791.3 851.7 3,242.7 2,272.7 490.2 BoP: Current Account Balance 820.9 -1,000.8 280.5 2,767.0 2,739.6 1,019.0 BoP: Capital and Financial Account Balance 741.2 2,979.8 3,205.9 1,125.8 2,404.6 n.a. BoP: Overall Balance 2,166.4 1,412.2 3,589.4 4,269.8 5,821.7 820.3 FX Reserves 146,759.2 151,524.7 155,186.8 163,235.3 171,061.6 167,973.9 Change in FX Reserves 3,240.6 4,765.5 3,662.1 8,048.5 7,826.3 -3,087.7 Estimated intervention 1,074.2 3,353.3 72.7 3,778.7 2,004.6 -3,908.0

Source: Bloomberg, CEIC, KBank

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17

Ongoing inflationary concerns and unfinished rate hikes

Sufficient liquidity in the hands of investors to absorb the new

bonds in the remaining three quarters of FY2011

Inflation rates are expected to climb gradually but the danger is that the market has yet to fully price in price pressure from higher world commodity prices

BoT’s forecast shows more of price risks lie in the year 2011 than in 2012 – slowdown in 2012 and completion of policy rate hikes are likely to result in milder core inflation rate next year

Given substantial uncertainties to the pace of the U.S. recovery and differing views in the market, U.S. treasuries are to continue seeing substantial fluctuations throughout the year 2011

Local bond market update Supply news from year-end – The Public Debt Management Office (PDMO) released its bond auction plan for the January-March 2011 period (Q2 of fiscal year 2011) towards the end of December 2010. The table below summarizes the key changes to the tentative plan announced back in September. In general, we expect that there would be sufficient liquidity in the hands of investors to absorb the new bonds in the remaining three quarters of FY2011. This is especially so as Bt160bn of government bonds mature during the course of the year, indicating a net issuance for FY2011 of about Bt290bn. Hence, the supply side factors are unlikely to be an issue for the bond market.

Issuance framework for Q2/FY2011 Coming up in the next few months

Total supply for Q2 is Bt94.5bn (Bt90bn in Q1)

Introduction of Bt3.5bn of the new 50-year bond issue.

No auctions of T-bills for two months. There’s ample

government’s treasury cash (around Bt250bn at end Dec).

Auction size of 5-10 year bonds reduced to Bt10bn from last year’s Bt12.5bn.

Auction size of 30-year bonds is raised from Bt3bn to Bt5bn

Bt40bn of 12- and 18-year fixed-rate P/N to supplement bond issuance for long-term investors e.g. insurance companies and pension funds

Authorities said to expect new inflation-linked bonds in

May

Savings bonds of tenor 7-12 year may be added to bond issuance of FY2011 (expected in April). Total size may be t100bn. Coupon may be fixed rate or step-up

Changes to Primary Dealers’ roles (PDs) as part of ongoing development of the bond market

Source: PMDO, KBank

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18

Fig 22.Preference over mid-curve bonds in recent trade Fig 23. Changes to bond supply Q1 vs. Q2

01020304050607080

May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11

LB155A - LB196A spread LB133A - LB155A spread

bps Mid-curve government bond yield spread

0

5

10

15

20

25

30

5Y 7Y 10Y 12Y 15Y 20Y 30Y 50Y 4Y FRN CPIlinked

Q1 Q2

Bt bn

Tenor/type

Source: Bloomberg, KBank Source: PDMO, KBank

Fig 24. Preference over mid-curve bonds in recent trade Fig 25. Government bond and IRS yields change

Maturing Government loan bonds

40

89

03

70

88

0

20

40

60

80

100

Q4/2010 Q1/2011 Q2/2011 Q3/2011 Q4/2011 Q1/2012

bn baht

Principal

01020304050607080

0.3 0.5 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 15.0 20.0

IRS change Bond change

bp Yield change before and after Dec 1st rate hike

tenor (yrs)

Source: , Bloomberg, KBank Source: PDMO, KBank

Early reaction to the bond supply – Notice below that the amount of 5-year bonds lessened by about half while those of the 7- and 10-year bonds had increased. Overall, the changes in both quarters’ supply are not significant. However, we feel that the demand for 5-year bonds should remain strong among investors – it is neither too short nor too long and it remains one of the more liquid issues. Hence, since end-Dec, we had been seeing a strong preference for the mid-curve tenor – observe how yield spread widened between the 5- and 9-year issues and declined between the 2- and 5-year issues. This trend had recently slowed as investors thought there are limits to gains in the 5-year. The more important factors for this year are the inflationary trends and policy rate actions. Inflation rates are expected to climb gradually but the danger is that the market has yet to fully price in price pressure from higher world commodity prices. As for policy rate hikes that are lined up at the Bank of Thailand’s (BoT), we think they could be announced as soon as January 12th. Based on BoT’s inflation rates forecast, more of price risks lie in the year 2011 than in 2012. The slowdown in economic activities in the year 2012 and completion of policy rate hikes this year are likely to result in milder core inflation rate increased next year. At the same time, global liquidity is likely to start reducing into the year 2012. In short, we expect the BoT to react in a pre-emptive way by raising the policy rate three times during the first three meetings of the year (January, March, April). However, we do expect each hike to be 25 bp, due to the concerns for capital inflows and substantial liquidity in the local market. Currently, the market is pricing a bear-flattening trend of the sovereign yield curve going forward.

1919

19

Fig 26. Implied forward sovereign yield curves Fig 27. 6mx6m forward change

1.50

2.00

2.50

3.00

3.50

4.00

4.50

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15Jan-11 Apr-11 Jul-11 Jan-12

%

tenor (yrs)

Implied bond yield curve shifts

0

20

40

60

80

100

120

Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11

6m6m bond change 6m6m IRS change

%bp


We think that there would be plenty of reasons for inflation to continue rising this year. The sources of price pressure are several, from the demand side of supply side. From the supply side, commodity prices remained on an uptrend, especially after the year 2010 saw a number of occasions of severe weather. At the same time, the NYMEX WTI crude oil price futures curve is also seeing a parallel shift upwards from three months ago. Although the curve is not very steep, given that uncertainties to global growth remain, the shifting of the curve does indicate that the market is more convinced that oil prices would maintain its higher trend from here. From the demand side, we expect the up trend in private consumption and investment to continue, helping to close the output gap in the economy i.e. absorbing some of the excess capacity. In light of all of the development in the medium term, we continue to prefer bonds in the belly of the curve and recommend investors to reduce duration. However, the BoT’s latest economic forecast due for releases at end January would be a key factor in the determination of future policy rate hikes as well. Fig 28. Crude oil (NYMEX WTI) futures curves Fig 29.CRB index vs. Thai producer price index

80

82

84

86

88

90

92

94

1 2 3 4 5 6 7 8 9 10 11 12WTI futures current 1M ago 3M ago 12M ago

$/barrel

100

150

200

250

300

350

400

450

500

98 99 00 01 02 03 04 05 06 07 08 09 1070

90

110

130

150

170

190CRB Index ( Reuters/Jefferies world commodities index)Thai producer price index, PPI (right axis)


2020

20

Argument for <=50bp rate hike in 2011 Argument for > 50bp rate hike in 2011

Although global economic recovery is likely to

continue, the pace at which this happens would be more gradual as compared to that observed in 2010

BoT have started to normalize interest since July last

year. Impact from its early move is likely to be felt in H1/2011

Domestic demand is on an up trend but the pace of its

acceleration is not threatening

Too fast + too much interest rate increase may induce speculative capital inflows

Increased costs of liquidity absorption and FX

sterilization of BoT

As a rule, interest rate pass through is slow in creating

a real impact on the economy

Prevention of expectation of higher inflation taking its own course

Interest rates still do not reflect the costs of capital –

monetary policy stance remained loose

There are several risk factors which are out of BoT/MOF’s control e.g. severe weather impact on global commodity prices (supply side), energy prices

Early prevention of any form of asset bubble building

up – the stock market and the bond market had been driven by liquidity during the past year

Update on U.S. Treasury - yields may see a roller-coaster ride for another year For the past one month, the U.S. treasury yields had risen substantially, led by the optimism of the market with regards to positive economic data coming out from both the U.S. and other parts of the world. A revisit to the implied expectation concerning the Fed fund rate, the market still expects no change in the Fed’s target policy rate until the year ends. However, the change in the market’s sentiment with regards to the continued recovery in the U.S. economy had led to sell-off in the bond market, sustained rising of the major U.S. stock indices, and even some early short-cover of the U.S. dollar. Nevertheless, if we take a look at the market’s forecast of the 2- and 10-year U.S. treasury yields for the next four quarters, we would find that there are substantial differences between different houses’ views. Yet, this observation should not be a surprise as well. There remain arguments concerning the impacts of government borrowing and QE 2.0 on U.S. economic recovery and the inflationary pressure going forward. While economic recovery remained weak and unemployment situation helps to keep inflation under control, the corporate sector had seen better improvement and the liquidity that bolstered increase in stock prices might stoke asset price bubbles and inflationary pressure. Given substantial uncertainties to the pace of the U.S. recovery and the impacts of government’s policies, coupled with differing views in the market, we expect the U.S. treasury to continue seeing substantial fluctuations throughout the year 2011. The recent optimism in the stock market led the 2-10 spread to increase to about 273bp, nearing February 2010’s high of 291 bp. We think that there would definitely be corrections ahead, especially as the Federal Reserve still has about 6 more months to go for its QE 2.0 program.

2121

21

Fig 30. Interpolated yield curves Fig 31. S&P 500 vs 2-10 spread (U.S. Treasury)

-10-50510152025303540

30.010.07.05.03.02.01.00.50.30.10.0

1.0

2.0

3.0

4.0

5.0

Spread (right axis) 10-Jan-11 1-Dec-10yrs

% bpU.S. Treasury Active Curve

600700800900

10001100120013001400

Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10

S&P Index

100

150

200

250

300

350(% )

S&P Index 2-10 Spread (bps, RHS)


Fig 32. Bloomberg survey – 2Y UST forecast Fig 33. Bloomberg survey – 10Y UST forecast

0

1

2

3

4

5

6

Q1 11 Q2 11 Q3 11 Q4 11 Q1 12

Bloomberg Wgt Avg Median ForecastHigh Forecast Low Forecast

Bloom berg survey of 2-Y UST%

01234567

Q1 11 Q2 11 Q3 11 Q4 11 Q1 12

Bloomberg Wgt Avg Median ForecastHigh Forecast Low Forecast

Bloom berg survey of 10-Y UST%


2222

22

Economic Update

Key economic indicators for Nov-10 mitigated negative notes seen

in Oct-10. Exports recovered, but a strong surge in imports curbed trade and

current account surpluses. Private sector confidence was mixed, though private consumption

and investment had improved after being hurt by flooding in Oct-10. The Headline CPI continued upward, along with an upside surprise

in the Core CPI. Positive economic sentiment that was seen in Nov-10, amid

manageable impact of the flooding, suggests a possibility of better-than-expected 4Q10 and 2010 GDP.

Recent positive development in the U.S. – including a tax package – plus the Thai government’s additional spending through various measures and ahead of a possible arrangement of general elections, leads us to revise our 2011 GDP projection slightly upward to 4.0-5.0% YoY, from the 3.5-4.5% range estimated previously.

Table 1. Thailand Key Economic Indicators Units: YoY %, or indicated otherwise 2009 2010

YTD 2Q10 3Q10 Oct Nov DecComposite Private Consumption Index -2.5 6.1 7.5 5.0 2.3 4.1

• Sales Volume of Benzine and Gasohol 5.7 -1.7 -3.7 0.8 -1.2 7.6 • Value-added Tax at 1995 prices -10.2 16.0 20.1 13.0 4.6 9.7 • Imports of Consumer Goods at 1995 prices -6.2 23.6 34.9 16.3 11.3 16.9 • Passenger Car Sales 4.2 58.8 75.9 58.6 43.2 40.9 • Motorcycle Sales -13.0 23.3 30.5 21.1 2.0 9.3

Private Investment Index (PII) -11.2 17.8 21.8 20.1 17.3 15.5 • Sales Volume of Domestic Cement -2.4 4.6 12.2 0.8 -7.2 -1.8 • Sales Volume of Commercial Cars -19.2 40.6 37.3 39.5 28.9 36.3 • Imports of Capital Goods at 1995 prices -15.9 26.1 35.2 27.1 11.6 20.5 • Value of BOI Applications 59.4 6.2 36.9 -17.7 82.6 29.5

Manufacturing Production Index -7.2 16.3 17.6 9.8 6.0 5.6 • Industrial Capacity Utilization 56.1 63.4 62.6 64.2 63.9 63.6

Agriculture Production Index -0.3 -3.5 1.3 -5.0 -5.5 -4.2 • Agriculture Price Index -10.5 26.1 25.3 30.2 29.1 27.5

Exports (in $) -14.0 29.5 41.8 22.2 16.6 28.7 • Unit Value 0.3 9.4 10.0 7.4 7.5 7.5 • Volume -14.3 18.6 29.0 13.8 8.5 19.6

Imports (in $) -25.2 40.3 44.9 30.7 14.3 35.0 • Unit Value -2.5 8.2 9.0 6.0 6.5 6.1 • Volume -23.4 30.1 33.0 23.3 7.4 27.3

Trade Balance ($ millions) 19,388 12,722 4,633 3,303 2,273 490 Current Account ($ millions) 21,866 13,034 1,686 2,047 2,740 1,019 Broad Money 6.8 11.1 7.0 9.9 11.2 11.1 Headline CPI -0.9 3.3 3.3 3.3 2.8 2.8 3.0$/THB (Reference Rate) 34.335 31.727 32.385 31.634 29.970 29.886 30.118Source: BOT, MOC and the Office of Agricultural Economics

Thanyalak Vacharachaisurapol - KResearch [email protected] Kevalin Wangpichayasuk - KResearch [email protected] Kangana Chockpisansin - KResearch [email protected]

2323

23

Exports recorded better-than-expected performance For Nov-10, exports managed to surpass analysts’ expectations by not only erasing the previous month’s losses to reach $17.6 billion versus the $17.0 billion in Oct-10, but also enjoying strong growth of 28.7% YoY, compared to the 16.6% growth YoY (due in part to a base effect). Excluding gold, the adjusted export growth suggests a similar trend, with 25.7% YoY growth, which beat the 14.9% YoY seen in Oct-10. This might be explained by the fact that the Baht seems to have paused its appreciating trend, and some G3 economies are seeing positive momentum. Fig 1. Nov-10 exports beat most analysts’ expectations Fig 2. MoM gains were seen in agricultural and high-tech

products

0

5,000

10,000

15,000

20,000

May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10

Expo

rt Va

lue (U

SD M

illion

)

-40%

-20%

0%

20%

40%

60%

% Y

oY

Exports Exports (excluding gold)% YoY for Exports % YoY for Exports exclud. Gold

0

500

1,000

1,500

2,000

Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10

US

D M

illio

n

Gold Vehicles & Parts Computer & PartsPetroleum Products Electrical Appliances RiceIC and Parts Base Metal Products

Source: BOT, MOC, KResearch Source: BOT, CEIC, KResearch

Classified by key export products, gains were seen in agricultural products – including rice (growing 53.2% YoY, up over the 6.8% YoY in Oct-10), rubber (expanding 49.3% YoY, slower than the 63.5% YoY in Oct-10 due to a base effect), and tapioca products (growing 7.4% YoY, compared to the 17.3% YoY contraction in Oct-10) that received support from high prices. Other products that also supported the overall export growth were vehicles, parts and accessories (expanding 33.5% YoY, against the 33.0% YoY in Oct-10), computers and parts (rising 4.6% YoY, compared to the 4.4% YoY in Oct-10), chemical products (surging 52.0% YoY, bettering the 16.9% YoY in Oct-10), as well as canned food (growing 19.1% YoY, compared to the 6.2% contraction YoY in Oct-10). Classified by export markets, almost all major export markets reported MoM gains, although a base effect sent the YoY growth of exports to China lower (expanding 20.9% YoY, compared to the 26.9% YoY in Oct-10). Export markets that led growth in Nov-10 included ASEAN (growing 25.9% YoY, bettering the 14.6% YoY in Oct-10), Japan (expanding 25.1% YoY, against the 18.1% YoY in Oct-10), Middle East (rising 14.7% YoY, bettering the 7.9% YoY in Oct-10), India (surging 26.3% YoY, compared to the 8.2% YoY in Oct-10), U.S. (growing 19.9% YoY, compared to the 4.9% YoY in Oct-10) and the EU (rising 20.0% YoY, versus the 9.6% YoY in Oct-10).

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24

Fig 3. Excepting China, major export markets all helped the overall export gains in Nov-10

Fig 4. In addition to accelerated oil imports, other major import categories showed broad-based gains

0

10

20

30

40

50

U.S. China Japan EU (27) ASEAN (9) India Middle East

% Y

OY

2Q10 3Q10 Oct-10 Nov-10

(20)

0

20

40

60

80

100

Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10

% Y

oY

Consumer Goods Raw & Intermediate GoodsCapital Goods

Source: BOT, MOC, KResearch Source: BOT, KResearch

Imports gained markedly in Nov-10, with YoY growth accelerating to 35.0%YoY, compared to 14.4%YoY in Oct-10. However, around 60% of that MoM surge stemmed from higher oil imports, leaving the rest distributed among imports of raw materials & intermediate goods (rising 27.9%YoY, versus the 18.1%YoY in Oct-10), capital goods (gaining 24.6%YoY, compared to the 13.8%YoY in Oct-10), and consumer goods (increasing 20.4%YoY, compared to the 15.1%YoY in Oct-10). Due to accelerating MoM gains in imports outpacing export growth, the Nov-10 trade surplus edged downward for the second consecutive month to $490 million, compared to the $2,273 million in Oct-10. The current account surplus slid to $1,019 million from $2,740 million in Oct-10, despite a higher service, income and transfer account to $529 million, from $467 million in Oct-10, in tandem with healthier tourism revenue. Fig 5. Tourism revenue saw support from higher inbound tourist arrivals

Fig 6. Hotel occupancy rates continued to report MoM gains, excepting the South that was hurt by flooding

-20

-10

0

10

20

30

40

50

Nov-09 Feb-10 May-10 Aug-10 Nov-10

Fore

ign

Tour

ist A

rriv

als

(% Y

oY)

33

38

43

48

53

58

63

68

Hot

el O

ccup

ancy

Rat

e (%

)

Foreign Tourist Arrivals (lhs) Hotel Occupancy Rate (rhs)

0

10

20

30

40

50

60

70

Total Central South North Northeast

%

1Q10 2Q10 3Q10 Oct-10 Nov-10

Source: TAT, BOT, KResearch Source: TAT, BOT, KResearch

The tourism sector was little affected by the flooding Despite the widespread flooding starting in the middle of Oct-10 and proceeding into Nov-10, the number of foreign tourist arrivals for Nov-10 continued to report MoM gains for the second straight month, reaching 1.47 million, from 1.31 million in Oct-10. Meanwhile, a base effect pressured the growth of arrivals to 8.2% YoY, compared to the 8.6% YoY seen in Oct-10.

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25

The hotel occupancy rate rose to 55.12%, against the 49.05% in Oct-10, due to strong seasonal gains in the hotel occupancy rate in almost all regions, with the exception of the South where the accommodation take-up rate was hurt by flooding. Manufacturing production slid, dampened somewhat by the flooding According to data released by the Office of Industrial Economics (OIE) of the Ministry of Industry, the Manufacturing Production Index (MPI) for Nov-10 staged its second consecutive MoM drop for the month, wherein YoY growth had decelerated to 5.6% YoY, compared to 6.0% YoY in Oct-10. When looking into the details, the MPI for exports greater than 60% of their total production had cooled (rising 2.3% YoY, against 4.4% YoY in Oct-10), as the result of flooding that caused logistical problems – particularly for the case of garments and textiles – as well as causing some raw material shortage needed for production. However, the MPI for exports between 30%-60% of their total productions (rising 19.8% YoY, versus the 16.7% YoY in Oct-10) and for exports lower than 30% of their total production (expanding 5.3% YoY, compared to the 4.0% YoY in Oct-10) managed to reap additional gains, due to accelerated production of some products ahead of the high spending season, and in response to high consumer orders, particularly for eco-cars. In the same direction, the OIE’s capacity utilization rate for Nov-10 had decelerated to 63.6%, down slightly from the 63.9% in Oct-10. Fig 7. Flooding slowed manufacturing production somewhat

Fig 8. Private sector confidence was mixed

40

60

80


CPU

(%)

-20

-10

0

10

20

30

40

MP

I (%

YoY

)

CPU MPI

25.030.035.040.045.050.055.060.0


BSI

60.0

70.0

80.0

90.0

100.0

110.0

120.0CCI & TISI

BSI BSI (Expected for the next 3 mths) CCI TISI

Source: OIE, KResearch Source: BOT, University of the Thai Chamber of Commerce, KResearch

Private sector confidence was mixed In Nov-10, private sector confidence suggested weaker sentiment at the consumer-end, echoing lingering concerns toward possible impact from the flooding and political problems seen early in Nov-10. Apparently, the Consumer Confidence Index (CCI) had fallen for the second consecutive month, approaching 79.0% versus the 80.2% seen in Oct-10. However, the Business Sentiment Index (BSI) managed to swing back into expansion territory, by rising from the 50.0 level to 52.5%, although respondents continued to show some wariness about lingering economic and political uncertainty, high production costs, as well as their limited ability to increase prices for goods and services. To the same end, the Thai Industries Sentiment Index (TISI) increased to 99.7, from the 98.7 in Oct-10, suggesting another step closer to expansion (above the 100-threshold.)

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26

Fig 9. Private investment recovered from flooding Fig 10. Private consumption also reported better growth momentum

-5.00.05.0

10.015.020.0

1Q10 2Q10 3Q10 Oct-10 Nov-10

%Mo

M, %

QoQ,

SA

Private Investment Cement SalesCommercial Cars Imports of Capital Goods

-5.0

0.0

5.0

10.0

15.0

1Q10 2Q10 3Q10 Oct-10 Nov-10

%Mo

M, %

QoQ,

SA

Private Consumption Passenger Car Sales VAT

Source: BOT, KResearch Source: BOT, KResearch

Private investment and consumption reported healthier growth momentum As flooding began to ease in many parts of the country, both private investment and consumption managed to see some MoM gains in Nov-10. The seasonally-adjusted Private Investment Index (PII) rose into the black with growth of 0.3% MoM, compared to the 1.1% contraction MoM recorded in Oct-10, with support from all major components including commercial car sales, real imports of capital goods and cement sales. Also, the seasonally-adjusted Private Consumption Index (PCI) had accelerated 3.5% MoM, versus the 1.2% contraction MoM reported in Oct-10. Broad-based gains were seen across the key PCI components, including real VAT collections, passenger car and motorcycle sales, as well as real imports of consumer goods. On YoY, the PCI also saw its growth accelerating from 2.3% YoY in Oct-10 to 4.1% YoY, although a base effect resulted in cooling growth momentum in the PII to reach 15.5% YoY, compared to the 17.3% YoY.

The Core CPI picked up faster-than-expected in Dec-10 In Dec-10, the Headline CPI continued with upward momentum for growth of 3.0% YoY, beating the 2.8% recorded in Nov-10. However, this was due to a base effect, as their MoM gain had slowed from 0.21% in Nov-10 to 0.16% in Dec-10, reflecting downward price adjustments in fresh vegetables post-harvest, despite increases in the retail prices of fuel, meat, poultry, fresh fruit, prepared foods and housing rents.

Fig 11. PCI reported improving YoY growth Fig 12. Core CPI rose faster-than-expected in Dec-10

-20-15-10-505

10152025

1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 Aug-10 Sep-10 Oct-10 Nov-10

% Y

oY of

PII a

nd P

CI

Private Consumption Index (PCI) Private Investment Index (PII)

0.00.51.01.52.02.53.03.54.04.5

Dec-09 Apr-10 Aug-10 Dec-10

% Y

oY o

f CP

I and

Cor

e C

PI

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

% Y

oY o

f PP

I

PPI Headline CPI Core CPI

Source: MOC, KResearch Source: MOC, KResearch

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However, the Core CPI managed to show an upside surprise by reporting faster-than-expected growth of 0.35% MoM (versus the 0.11% MoM shown in Nov-10), which was the healthiest rate since Mar-09. This pushed up the over-year growth in the Core CPI from 1.1% YoY in Nov-10 to 1.4% YoY in Dec-10. Although the Dec-10 Core CPI remained quite tame and within the BOT’s Inflation Targeting zone, the trend is expected to continue, which would support further BOT policy rate tightening. At the producer end, the Producer Price Index (PPI) had contracted 1.1% MoM, compared to 0.7% growth MoM reported in Nov-10, due to falling prices for agricultural products that outweighed increased prices in manufactured and energy-related products. However, a base effect sent the PPI up to 6.7% YoY, compared to the 5.9% YoY in Nov-10. As for the 2010 overall figures, the Headline and Core CPI had averaged 3.3% and 1.0% over-year, respectively increasing over the 0.9% contraction and 0.3% growth YoY seen in 2009. Meanwhile, the PPI averaged as high as 9.4% YoY, against a 3.8% contraction YoY in 2009. The difference between the PPI and Headline CPI in 2010 suggests that greater price pressure is coming at the consumer-end, albeit at a gradual pace in light of government price controls and subsidies on some products. Healthy growth momentum in Nov-10 suggests a possibility of better-than-expected 4Q10 and 2010 GDP As both external and internal key economic indicators seemed to show upside surprises in Nov-10, amid a manageable impacts from the flooding, we therefore are more convinced that the 4Q10 GDP will possibly report a QoQ contraction of only 0.2% (seasonally-adjusted), against the previously projected figure of around 1.0%. Therein, 4Q10 GDP growth will likely see some upside, probably reaching 3.0% YoY, bettering our previous month’s projection of below 2.0% YoY. As a result, the 2010 GDP will likely grow 7.6% YoY, better than the 7.0% estimated earlier. Amid lingering uncertainty, growing U.S. economic optimism and the Thai government’s additional stimulus efforts could lend support to the 2011 GDP Over the past month, there were some positive developments in key U.S. economic indicators – including consumer spending, as well as service and manufacturing activities – suggesting that the recovery is still on course there, although still not broad-based or firm, as evidenced by disappointing signs and laggard movements in labor and housing markets. Another notable development worth mentioning is Congress’s passage of an $858 billion bill to extend all Bush-era tax cuts for two years, which is widely hoped to help boost the U.S. GDP by 0.5-1.0% and add over one million jobs. Such positive forces, coupled with assistance from the Fed’s QE2 initiative, will likely limit any downside to the U.S. economy, though there remains some lingering uncertainty – particularly from debt-laden countries in the EU where we still do not rule out more negative surprises from countries, such as Portugal, Spain, Belgium and Italy. As for China, softening growth momentum has become more evidently through a cooling Purchasing Managers’ Index (PMI) in Dec-10 and decelerating property prices seen over

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the past several months, but an uptick in the Headline CPI (reaching 5.1% in Nov-10) suggests that more tightening will still be needed. Despite the likelihood of additional policy rate hikes by the PBOC during 2011, plus other measures to control inflationary and asset price risks, we believe that China will be able to manage a soft landing with the 2011 GDP growth of around 8.0% or higher. We have thus become slightly more optimistic toward the near-term outlook for major trading partners’ economies, which would lend support to exports, although a base effect will still send YoY growth of exports down quite significantly after comparison with 2010. Also, we see additional economic contributions from the government, particularly from their extended measures to subsidy energy prices and increase consumers’ purchasing power until Feb-11, as well as the ‘Prachawiwat’ (People’s Agenda) welfare program and extra spending to prepare for general elections that could take place in 2H11. Such measures should help lessen negative forces from surrounding uncertainty pressuring domestic spending and investment. Consequently, we have revised our 2011 GDP forecast slightly upward to 4.0-5.0% YoY, from the 3.5-4.5% range estimated previously. Table 2. KResearch’s Indicative Forecasts Units: %YoY or otherwise indicated 2009 2010 2011GDP Growth -2.3 7.6 4.0-5.0Avg. Brent Crude (USD/barrel) 61.6 79.5 88.0-98.0

Private Consumption -1.1 4.3 3.4-4.1Investment -9.2 9.3 8.3-9.8

Gov. Budget (% of GDP) -5.6 -3.2 -5.0 to -3.8Export Growth -14.0 27.0 8.0-12.0Import Growth -25.2 35.0 12.0-16.0

Trade Balance (USD bn) 19.4 14.0 7.0-9.7Current Account (USD bn) 21.9 14.9 8.0-11.3

Headline CPI -0.9 3.3 2.5-4.0Core CPI 0.3 1.0 1.8-2.6

Avg. Unemployment (Thousands) 571 420.0 390-420Unemployment Rate (% of Labor Force) 1.5 1.1 1.0-1.1

Source: KResearch, Preliminary as of January 10, 2010.

However, we continue to maintain a cautious stance toward the possibility of heightened inflation, both at home and in other Asian nations, amid uptrend in prices of oil and soft commodities. We thus foresee that the Headline CPI should maintain YoY growth of around 2.8%, or higher, as recorded in 4Q10. Meanwhile, the Core CPI should gradually edge upward too, approaching 2.0% YoY by Jun-11. The Outlook for Next Month In Dec-10, export growth will likely dip below 10.0% YoY, due mostly to a base effect. The same reason seems to be applied to the MPI, resulting in a possible YoY contraction. The Headline CPI for Jan-11 is expected to continue upward momentum MoM, following higher prices of energy and some agricultural products, although a high base of comparison will possibly send YoY growth down below the 3.0% growth YoY recorded in Dec-10. A similar pattern is also projected for the Core CPI, with Jan-11 growth staying below 1.4% YoY, as seen in Dec-10.

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Strategy: Side effects from inflationary

Investment theme: ► We have become more bullish this month and abandoned our earlier

view for investors to reduce their portfolio. We now expect the SET index to hit 1220 during the first half of the year instead of the second half. The downside risk of the SET index is not expected to be lower than 980 in the short-term.

► A fast rise in inflation is the main reason for our change of view. KResearch forecasts the Thai headline inflation to increase through the second quarter and potentially reaching 4% for the year. This will prompt the local monetary authority to raise policy rate to 2.75% by mid-2011, 25bps higher than our previous view. Such rapid rise would be the most aggressive in Asia, except for the Philippines.

► While Thailand raises rates, we expect the US and EU will keep their rates at low levels for a foreseeable future. This will widen the spread between the US and Thai Baht short term rates to almost the highest level in the last 10 years, thus encouraging flows of liquidity in the Thai market.

► We advise using market dips on fears of inflation in Asia or the EU debt crisis as buying opportunities. Emphasis is on commodities companies, which are the causes of inflation, which we are still Overweight.

► We also remain Overweight on domestic plays. We expect Thai GDP growth in the first half to be mainly driven by private and public consumption and investment.

► Our top picks are BANPU PTT PTTCH TOP KTB STA TVO CPALL MINT BGH STEC and AMATA.

Inflation drives our view change

Last year, we were focused on what the Fed was doing as quantitative easing did move stock and commodities markets significantly. We were also earlier worried that a US economic recovery would bring about threats of liquidity withdrawal or exit which could pull down the market in the short term as funds return to hold US assets. However, it is now clear that the US Fed will maintain its low-interest-rate policy despite current US economic data showing a stronger-than-expected recovery. From the latest FOMC minutes released, the Fed was still concerned about downside risks to the US economy, particularly related to the housing market. That is providing the basis for the market to expect that the Fed will not raise the policy rate this year, which is also our assumption.

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In the European Union, inflation rate picked up a 2.2% YOY gain in December. That was well above the European Central Bank’s soft-stated target of "close but below" 2%. But the ECB cannot do much about it as it is fighting to keep debt crises in Greece, Ireland, Portugal and Spain from spreading out. It is very unlikely that the ECB will raise interest rates to fight inflation at the risk of slowing the economy when growth is already so anemic. Any drop in growth could provoke an even deeper crisis. All this points an outlook of weak Euro, meaning that we will a stronger USD index in the medium term of at least a quarter.

In our previous MAS reports, we noted that if the US economy were to stage a U-shape recovery then the USD index would appreciate, triggering a consolidation of the SET index back to 900 during the 1Q11 from profit taking and funds switching out. However, now we believe that despite the expected strengthening of the USD index, Asia markets will still be able to draw liquidity in on the basis of higher shorter rates. As the result, we currently expect the SET index to reach our target of 1220 during 1H11 instead of the 2H11 as noted earlier with downside risk not below 980.

China leads inflation in Thailand

The fact that China’s has adjusted up its target for consumer price inflation this year to 4%, from 3% in 2010 is a positive to Asia, in our view. The increase in target implicitly means that measures to control inflation should be less severe from the originally prepared for. Beijing suggested it will set the 2011 quota for new bank lending at Yuan7.5 trillion. That's the same quota as it set for 2010 but is likely to be exceeded as total new credit for during 11M10 has already reached Yuan7.44 trillion. However, Beijing also announced it would raise the minimum wage by 20.8% in 2011 from the current Yuan960/month to Yuan1160/month - the biggest increase ever. So why is the People's Bank not fighting inflation harder and seeming to fuel inflation? There are two main reasons.

First, there's a belief in Beijing that inflation will peak in mid-2011 with the new vegetable harvest. Food inflation was a major contributor to the 5.1% YoY rise in consumer inflation in November. Food prices climbed 11.7% YoY that month. Apparently, influential voices among Beijing's economic planners believe that a bad harvest of summer vegetables is to blame for that spike in food prices and inflation. The situation is expected to normalize with the next harvest. This is backed up from the historical price trends in commodities. According to figure 2-3, soft commodity index and the CRB index normally peak during in 1-2Q and soften in the second half of the year. Moreover, the high base of the CPI index in the second half last year will cool inflationary pressure in the second half of this year. Note that the consensus forecast for Chinese inflation this year is only 3.4%.

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Figure1: The CPI index in China and CRB Food Index

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Figure 2: Prices of RBS-soft commodities index and CRB Index

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Second, there's the constant worry in China about keeping the economy growing fast enough to produce jobs for everyone entering the workforce. That has led to a steady national goal of 8% GDP growth. China has encouraged a massive increase in college enrollment and now one-third of the 5.6 million 2009 graduates failed to find work in their first year out of school. Generating jobs in value-added, up-the-technology-ladder

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industries is one of Beijing's most important goals. Weigh this against the fight on inflation in the context of the survival of the Communist Party and see which comes out on top.

However, if China’s central bank decides to aggressively increase the policy rate, its economy would be able to maintain a healthy pace of growth. As shown in figures 4-5, China increased its policy rate from 5.58% to 7.47% during 2006-2007 and also raised the bank reserve ratio from 7.5% to 14.5% to fight inflation. However, during this period China still managed to GDP growth at 9.9 – 14.0%. Thus, we do not expect China to choose to fight inflation too hard. The rise in target inflation is already an admission that CPI would be allowed to climb higher, at least during 1H11.

Figure 4: China’s Real GDP growth vs its policy rate

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Thai inflation is on a rising trend Why did we discuss China inflation? Because it leads the Thai inflation. Rising food prices fuel Chinese inflation more than most places because its food accounts for 34% of its CPI basket compared to only 17% in the EU and 15% in the US (see figure 6). As such there is 85% correlation between food prices and China CPI. Thailand also has a high food component at 33% in the CPI basket but the correlation is 41% partly due to the government’s price controls. With the steady rise in food prices, Thai CPI will have to rise further: last week, the government allowed retail palm oil price to increase by Bt9 to maximum of Bt47/liter.

China inflation index is a good leading indicator for Thai inflation. KResearch forecasts Thai core inflation to reach 2% in 2Q11, from 1.4% in December last year. In order to test how high inflation can rise this year, we assume future MoM rise in 2011 equal to average MoM rise in the past 5 years. The 5-year period is chosen because it averages out the swings seen since 2006. At this rate, CPI would reach its highest level at 4.2% in June-11 before softening in 2H11 (figure 8). However, the objective of this assumption is to test the inflation level in 2011 which is not the KResearch view.

Figure 6: Relationship correlation of CPI and CRB food index with proportion of food in CPI basket

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Figure 7: Thailand CPI VS China CPI

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Figure 8: Based on a scenario, Thai headline CPI will peak in June-11

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Climbing inflation in the first half will pressure the BOT to increase its policy rate, especially from the current ‘accommodative’ state. KBANK forecasts the Thai policy rate will increase 0.75% in the first half of this year to 2.75% while consensus expects it to increase 0.75% this year. This is the fastest rate of increase in the region except for the Philippines (figure 9). If our policy rate reaches 2.75% as expected, the spread between the Thai and US rates will be 2.5%, close to the highest level in the last 10 yrs (figure 10).

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This will encourage more funds to flow into Thailand and provide support to our currency to appreciate further against the USD. It is important to highlight that during Nov-08 to Jan-09 when the short-term spread between Thai Baht and USD was the maximum and despite bleak market conditions following the collapse of Lehman Brother, the SET rose 19% in less than 2 months before falling back.

Figure 9: Consensus outlook on policy rates in Asia

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Figure10: Spread between Thai and US policy rates

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Go with the inflation story

All this has prompted us to change our view on the direction of the SET index. We expect the SET index to reach 1220 in 1H11 instead of 2H11. Any consolidation is not expected to get the index below 980. Foreign funds are expected to flow into the Thai market sooner than previously expected. Our strategy is to go with the inflation story. Use the dips on fears over Asia inflation or the EU debt crisis as buying opportunities. Increase exposure in companies with commodities exposure. We believe that oil prices will continue to rise despite the USD index appreciating. At present, unlike during 2007-2009, there is no correlation between oil prices and the USD index (see figure 11). The oil price is more likely to trend along with global economic growth. Maintain our Overweight position on the energy-related sector. Our top picks are PTT PTTCH TOP BANPU STA and TVO.

Figure11: Correlation between USD index and oil prices

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Despite our Neutral weighting on the banking sector, we see positive sentiments in the short term. The rising trend of domestic interest rates will benefit banks. Their net interest margin is expected to increase as lending rates increase faster than deposit rates while figure 12 shows net interest margins increasing with policy rate. Current loan-to-deposit ratio is also on the uptrend (figure 13), rising from 78% in 2007 to 90% in Oct-10, providing another support to net interest margin. We recommend KTB BBL and SCB. However, the residential sector will continue to underperform for the next several months.

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Figure12: Net interest margin vs Thai policy rate

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Besides the Energy sector, we like domestic plays and are Overweight on Commerce, Media, Contractors and Industrial Estates. Although we forecast that Thai GDP growth to slow from 7.6% in 2010 to 4% this year due to slowing export growth, private investment and consumption continue to growth pace. We also forecast higher growth in government spending.

Our top picks are BANPU PTT PTTCH TOP KTB STA TVO CPALL MINT BGH STEC and AMATA.

Figure 14: KS’s Portfolio Sector Current Weight Previous Wt Recom. Top

Recommended from Oct 10 / Sector Wt. Picks

Banking Neutral Overweight 23.7% KTB

Insurance Underweight Underweight 0.0% BLA

Food & Agro Overweight Overweight 5.9% TVO STA

Automotive Overweight Overweight 0.2% SAT

Petrochemical + SCC Neutral Neutral 10.1% PTTCH

Energy Overweight Neutral 38.2%

Coal Overweight Overweight 4.1% BANPU

E&P Neutral Neutral 8.9% PTTEP

Integrated Overweight Overweight 17.2% PTT

Refinery Neutral Underweight 5.6% TOP

Utilities Underweight Underweight 2.4% GLOW

Construction - SCC Underweight Underweight 0.0%

Property Underweight Underweight 4.5%

Contractor Overweight Overweight 0.9% STEC

Industrial Estate Overweight Overweight 1.0% AMATA

Residential Underweight Underweight 2.1% PS

Commercial Underweight Underweight 0.5% CPN

Commerce Overweight Overweight 6.8% CPALL

Healthcare Overweight Overweight 1.6% BGH

Media Overweight Overweight 2.1% MCOT

Securities Overweight Overweight 0.5% KEST

Tourism + MINT Overweight Overweight 1.1% MINT

Transport & Shipping Underweight Underweight 0.5%

Shipping Neutral Neutral 0.5% PSL

Transportation Underweight Underweight 0.0%

Electronics Neutral Neutral 1.1% SMT

ICT Underweight Neutral 3.2% ADVANC

Total 100%

Source: KS

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Figure 15: KS sector valuations

Source: KS U – Underweight, O – Overweight, N – Neutral As of 10th January 2011

Figure 16: 2011 sector valuation Figure 17: 2011 Consensus earnings changes

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Figure 18: 2011 country valuations Figure 19: SET PER discount to region

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HongKong 12/16%

India 17/26%

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Malaysia 13/23%

Philippines 14/11%

Singapore 16/15%

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Disclaimer For private circulation only. The foregoing is for informational purposes only and not to be considered as an offer to buy or sell, or a solicitation of an offer to buy or sell any security. Although the information herein was obtained from sources we believe to be reliable, we do not guarantee its accuracy nor do we assume responsibility for any error or mistake contained herein. Further information on the securities referred to herein may be obtained upon request.

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