KBank Multi Asset Strategies oct 2011 (English)

.Mean S

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Strategic Thesis The experience of Japan during the 1990s when the economy remained stagnant is one of the major examples the US and the Eurozone might try to avoid. Still, consensus wishes for a recovery but the markets might be saying something else. Of late, calling the direction of the USD/THB is likened to a coin toss. Analyzing the economics is already an arduous task in it of itself. Now the political and social dynamics complicate the direction even further: will Greece be the Achilles’’ heel of the euro? Will Troika withhold the next tranche of financial infusion? In light of lack of direction signals, USD/THB options seem to be the best bet amidst a dearth of clarity. We provide thoughts why USD/THB could cut both ways: up or down. We revised down our target for the policy rate to 3.50% for the end of this year, noting the BoT’s proposed change of inflation target as well as the worsening global conditions due to Europe’s debt crisis. The yield curve should continue to stay flat but the uncertainties in global financial markets could lead to lower appetite for duration in emerging market bonds: stay short duration prior to MPC meeting on Oct 19th. As with other asset classes, volatility in the equity markets will continue. We have set ourselves a one-month window ending in early November before considering the need to change fundamental macro assumptions which will change market outlook. There is a downside risk to our view presently, but we see SET index at 812 to provide strong support. This is based on PBV at 1.5x (fundamentally) and peak-to-trough correction of 30% (technically) – both historically well-tested. Our worst-case has SET index at 730, arrived through stress-testing assumptions on 2012 GDP growth at 1.9% from 5% with increased required risk premium. This worst-case scenario is comparatively better than the worst-case saw in the US sub prime crisis of 2008-9 when the SET went below 400.

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

Consensus appears to be hoping for the best and not preparing for the worst. It seems that the bitter lessons of 2008/9 have all been but forgotten

Calling the USD/THB direction has now become analogous to a coin toss…and here we provide two sides of the arguments

USD/THB options are probably the best bet for the next 1 to 2 months amidst lack of economic clarity compounded by external political and social abnormality

We revised down our target for the policy rate to 3.50% for the end of this year, noting the BoT’s proposed change of inflation target as well as the worsening global conditions due to Europe’s debt crisis

On equities we advise reducing portfolio at current levels. Aim to accumulate shares as we get below 850 but stick to sectors with business oriented towards domestic consumption

KBank Multi Asset Strategies Are we falling into the lull of optimism?

Strategies Macro / Multi Asset October 2011 Volume 42

WWW.KASIKORNBANKGROUP.COM

“KBank Multi Asset Strategies”

Disclaimer: This report must be read with the Disclaimer on page 44 that forms part of it

can now be accessed on Bloomberg: KBCM <GO>

Key Parameters & Forecasts at Year-end 2004 2005 2006 2007 2008 2009 2010 2011E 2012E GDP, % YoY 6.3 4.6 5.2 4.9 2.5 -2.3 7.8 3.8 4.5 Consumption, % YoY 6.2 4.6 3.0 1.6 2.7 -1.1 4.8 3.6 3.8 Investment Spending, % YoY 13.2 10.5 3.9 1.3 1.2 -9.2 9.4 6.3 5.8 Govt Budget / GDP % -0.2 0.3 -0.7 -1.5 -1.0 -5.6 -3.2 -4.0 -4.5 Export, % YoY 21.6 15.2 17.0 17.3 15.9 -14.0 28.5 20.0 10.0 Import, % YoY 25.7 25.8 7.9 9.1 26.5 -25.2 36.8 24.0 12.0 Current Account (USD bn) 2.77 -7.6 2.3 14.1 1.6 21.9 14.8 12.9 8.1 CPI % YoY, average 2.8 4.5 4.6 2.3 5.5 -0.9 3.3 3.8 3.7 USD/THB 38.9 41.0 36.1 33.7 34.8 33.3 31.4 29.0 28.0 Fed Funds, % year-end 2.25 4.25 5.25 4.25 0.25 0.25 0.25 0.25 0.25 BOT repo, % year-end 2.00 4.00 5.00 3.25 2.75 1.25 2.00 3.50 3.50 Bond Yields

2yr, % year-end 2.78 4.94 5.02 3.91 1.98 2.17 2.35 3.60 3.60 5yr, % year-end 4.0 5.3 5.1 4.5 2.2 3.6 2.75 3.65 3.65 10yr, % year-end 4.9 5.5 5.4 4.9 2.7 4.3 3.25 3.80 3.80

USD/JPY 102.5 118.0 119.1 111.8 90.7 93.0 82.0 77 81 EUR/USD 1.36 1.18 1.32 1.46 1.40 1.43 1.40 1.35 1.40 SET Index 668.1 713.7 679.8 858.1 450.0 734.5 1040 812 1320 Source: Bloomberg, CEIC, KBank, KResearch, KSecurities

KBank Thai Government Bond Rich / Cheap model

-20.00

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

20.00

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

Bps (actual YTM vs. model)

Source: Bloomberg, KBank

22

2

33

3

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

KBank THB Trade Weighted Index

75

80

85

90

95

100

105

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

Jan 1995 = 100

+ 1 std d

-1 std dev

average

2830323436384042444648

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

actual model

KBank USD/THB model

Source: Bloomberg, KBank Source: Bloomberg, KBank

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

y = -7.4157Ln(x) + 69.035R2 = 0.8878

262830323436384042444648

25 50 75 100 125 150 175 200 225 250FX reserves to USD/THB mapping current 2011 forecast

USD/THB

FX reserves, USD bn

y = 29.695Ln(x) - 95.504R2 = 0.7685

25

30

35

40

45

50

70 75 80 85 90 95 100 105 110 115 120 125

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 13actual model

%

0123456789

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

10yr yields SET forward dividend yields

%


44

4

Thai inflation parameters Thai contribution to GDP growth

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

05 06 07 08 09 10 11

CPI yoy PPI yoy Core CPI yoy

-15

-10

-5

0

5

10

15

1Q09 3Q09 1Q10 3Q10 1Q11Private consumption Government Consumption Gross fixed capital formation

Inventory change Net exports GDP yoy

% yoy

Source: CEIC, KBank Source: NESDB, KBank

Implied forward curve: swaps Implied forward curve: TGBs

2.50

2.70

2.90

3.10

3.30

3.50

3.70

3.90

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

%

tenor (yrs)

Implied forward rate shifts (IRS)

3.25

3.50

3.75

4.00

4.25

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Oct-11 Jan-12 Apr-12 Oct-12

%

tenor (yrs)

Bond yields implied 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

012345678

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

5yr yields, % implied forwards


55

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

300350400450500550600650700750800

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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Are we falling into the lull of optimism?

If we look at consensus forecasts for 2011 and especially 2012, economists are not paying heed to Michel de Notradamus’s prediction that the world as we know it will no longer exist post December 21st, 2012. According to the IMF’s latest forecasts, the global economy is to expand close to 4% for 2012 while Thailand is see a 4.8% pick up in economic activities. An argument against such optimism is gaining momentum as financial market conditions looks and feels more and more of a de javu of 2008. Prior to 2008, the US yield curve was flat and or inverted most of 2006 and 2007. In early 2008, Bear Stearns a global investment bank which had a peak market capitalization of USD 24.88bn collapsed and was bought by JP Morgan. On the macro front, non-farm payrolls had peaked in January 2008 (138 million) and were on a substantial decline leading to a surge on mortgage delinquencies.

Kobsidthi Silpachai, CFA - Kasikornbank [email protected] Nalin Chutchotitham – Kasikornbank [email protected] Amonthep Chawla, Ph.D. – Kasikornbank [email protected]

Fig 1. IMF forecast for global economic growth... Fig 2. IMF forecast for Thai economic growth

-1

0

1

2

3

4

5

6

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

World economic growth, % IMF projections, %

-3-2-10123456789

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Thai economic growth, % IMF projections, %

Source: IMF Source: IMF

Beside these ominous sign posts, one barometer of a prelude towards a full blown financial crisis is proxies of credit spreads. Here we are referring to LIBOR OIS spreads. These LIBOR OIS spreads (short for Overnight Index Swaps) are the difference between inter-bank funding benchmarks such as 3mth LIBOR minus a geometric estimate of central bank funding rates. The rule of thumb is, the higher the spread, the tighter the credit conditions in the inter-bank market Fig 3. US Libor OIS Fig 4. EU Libor OIS

050

100150200

250300

350400

02 03 04 05 06 07 08 09 10 11

US LIBOR OIS (Overnight Index Swap), bps

020406080

100120140160180200

02 03 04 05 06 07 08 09 10 11

Euro LIBOR OIS (Overnight Index Swap), bps

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

77

7

USD/THB, it cuts both ways In the following, we ponder both cases for further USD/THB downside and upside and summarized in fig 5. Fig 5. USD/THB, it cuts both ways

The case for lower USD/THB The case for higher USD/THB The US economy is still floundering. With unemployment very

elevated at 9%+, economic stimulus no doubt is needed Fiscal constraints means that stimulus in the form of

expansionary fiscal policy is not an option …hence QE3, 4, …. is still needed…..meaning the Fed will

printing more US dollars to monetize and reduce their indebtedness

The European authorities, despite having demonstrated shortcoming of leadership, solidarity and efficiency in dealing with the sovereign debt / banking crisis, is able to prevent or postpone a full blown crisis

Thailand is seen to post current account surpluses, meaning sellers of USD/THB outnumber buyers of USD/THB at the current level

China proceeds with CNY appreciation. This allows regional currencies including the Thai baht to appreciate as well without significant implications on competitiveness

Thai baht remains undervalued e.g. the Economist Big Mac index estimates Thai baht is 42.3% undervalued relative to the US dollar.

Bureaucracy of the EU system limits the speed of how

European authorities can effectively respond and resolve the crisis and allows the Eurozone to implode into a full fledge sovereign domino defaults and bank runs / closures

Risk aversion kicks in and investors further reduced investment positions in all sorts of risk asset classes including emerging markets equities and bonds

Higher risk perception of the EUR will prompt a shift of reserves away from the 17 nation currency (market share of 27%) and towards the US dollar (market share of 60%)

The Fed is contented with just the 2011 version of “Operation Twist”. This means that the Fed will not expand its balance sheet and slows down the pace of US dollar printing i.e. M1 money supply

The Bank of Thailand adopts a wait and see stance on monetary policy amidst lack clarity on the global economic front. This reduces support for the baht as policy rates stay at 3.50%

Source: KBank Source: KBank

USD/THB elevating higher… because?

In May 2010 and onwards, Greece, Ireland and Portugal sought financial bailout packages from other Eurozone countries and the International Monetary Fund (IMF). More than a year afterwards, much of the pledges of austerity, especially for the case of Greece were empty promises. With cross holdings of various Eurozone government bonds by various Eurozone commercial banks, the deterioration in fiscal health of government inadvertently meant the demise of commercial banks. If one was to make an analogy what CDOs (collateralized debt obligations) did to American and other banks worldwide post 2008 to now, it would be the toxic bonds of the weaker links (such as the PIIGS group) in the EU. Fig 6 shows that as Greek bond prices fall, it will take the Euro Stoxx bank index with it. The Euro Stoxx bank index comprises of 32 European banks with a cumulative total asset of EUR 5 trillion versus the Eurozone GDP of EUR 2.9 trillion. As the market value of these banks equity falls below their book value, it provides a estimate of how much recapitalization is needed. On figure 7, the implied recapitalization needs of these 32 banks are about EUR 367bn, currently. This is a moving target, as market expectations changes. Another point that can be taken from this is that, investors of banks have more or less have withdrawn their money in the form of equity. The question now is whether other sources of funds will withdraw their deposits i.e. bank runs.

88

8

Fig 6. Greece 10yr bond price, Euro Stoxx bank index Fig 7. Implied recapitalization of Euro Stoxx banks

2030405060708090

100110

Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11100120140160180200220240260

Greece 10yr bond, % of par (left) Euro Stoxx Bank index (right)

-600,000

-400,000

-200,000

0

200,000

400,000

600,000

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

Euro Stoxx bank index, market cap less book value implied recapitalization, EUR mn


What is the European immediate response, attempting to contain the crisis? Four little letters: EFSF with a big task. EFSF is short for “European Financial Stability Facility”. EFSF is similar in concept to our FIDF (Financial Institution Development Fund). During the 1997 crisis, the FIDF attempt to assuage bank runs on deposits. But when the dust settled, some 56 finance companies had to close and a handful of banks had to be nationalized to avert calamity. Recently, the EU authorities are pushing to expand the war chest of the EFSF, from EUR440bn to around EUR780bn, which represents the guaranteed commitments by countries within the Eurozone. The idea being, the EFSF would raise funding in the market, which it has so far sold 3 tranches for a total of EUR13bn, and on-lend to entities it deems needed financial assistance. However in the event that the EFSF could not honor its own financial obligations, the countries as shown in fig 8, would have to honor the EFSF on its behalf. Imagine a case where if the EFSF lent money to France. France was unable to pay back the EFSF and causing the EFSF to be unable to pay back its creditors. The creditors can then demand payments from say, Germany. The unfortunate thing is that most of these countries pledging to back the EFSF are not in a healthy fiscal position to back up their commitments in the first place. Even the market perceived mighty economy of Germany already has a debt / GDP ratio of 83%, well above the Maastricht Treaty limit of 60%. This questions the viability of the EFSF as it is really the weak nations trying to save themselves. It would stand a higher probability of success if Asian investors / central banks / sovereign wealth funds are lured into buying the EFSF bonds despite the fact that it is backed by near bankrupt nations.

99

9

Fig 8. EFSF guarantors and their budget / GDP & debt / GDP ratios

Country Guarantee commitments, EUR mn budget / GDP, % public debt/ GDP, % Kingdom of Belgium 27,032 -4.1 96.8 Federal Republic of Germany 211,046 -3.3 83.2 Ireland 12,378 -32.4 96.2 Kingdom of Spain 92,544 -9.2 60.1 French Republic 158,488 -7.0 81.7 Italian Republic 139,268 -4.6 119.0 Republic of Cyprus 1,526 -5.3 60.8 Grand Duchy of Luxembourg 1,947 -1.7 18.4 Republic of Malta 704 -3.6 68.0 Kingdom of the Netherlands 44,446 -5.4 62.7 Republic of Austria 21,639 -4.6 72.3 Portuguese Republic 19,507 -9.1 93.0 Republic of Slovenia 3,664 -5.6 38.0 Slovak Republic 7,728 -7.9 41.0 Republic of Finland 13,974 -2.5 48.4 Hellenic Republic 21,898 -10.5 142.8 Republic of Estonia 1,995 0.1 6.6 Total Guarantee Commitments 779,783

Source: http://www.efsf.europa.eu/about/index.htm

This hence leads to the lingering-in- the-back-of- market’s mind, will the euro survive. In his last ECB meeting, Jean Claude Trichet said that the euro will still be around in 10 years time. But what if it isn’t and the market has to go back to the US dollar, despite all of its imperfections? As the EUR arrived on the FX scene Asian central banks which had the Deutschemark as one of its reserve currency had to trade it in for the Euro. At the time of fixing, it was 1.95583 DEM to 1 EUR. Fig 10 shows that EUR’s market share rose from 18% to 26%+ at the expense of a lower USD market share slipping from 72% to 60%. Fig 9. Market share of fiat FX currency reserves Fig 10. USD, EUR market share in FX reserves

USD60.2%

EUR26.7%

JPY3.9%

CHF0.1%

GBP4.2%

Other4.9%

60

62

64

66

68

70

72

74

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201116

18

20

22

24

26

28

30

% holding in USD (left axis) % holding in EUR (right axis)

World's breakdown of reserve currency


1010

10

Operation Twist is another factor which had reversed the bearishness of the USD towards a bullish swing. The September 21st FOMC statement was US dollar bullish as:

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

The buying and selling of equal amounts equates to no significant expansion in the Fed’s balance sheet. Hence the exercise is merely a sector rotation, from the short end of the curve to the long end of the curve. This is a means of reducing the gapping as to force commercial banks to switch from making money from taking duration risk and toward taking credit risk. Operation Twist is to crowd out the non-private sector simulative activities i.e. borrowing from the Fed and lending to the US Treasury instead of lending to the private sector. Fig 11 shows that Fed Funds rate and the shape of the yield curve move in opposite directions, that is, as Fed Funds rises, the yield curve steepens. Whereas when the Fed Funds falls, the curve flattens. The Fed has flagged its intention to keep short rates where they are i.e. low. Hence to flatten the yield curve to encourage banks to take credit risk, the Fed has to buy longer dated maturity treasuries. Fig 11. Fed Funds rate, shape of the US yield curve Fig 12. US bank’s loans and leases, stagnating

-100-50

050

100150200250300350

00 01 02 03 04 05 06 07 08 09 10 110

1

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US 10yr yield less 2yr yield, left Fed Funds, right

correlation is -93%

%bps

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73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11Loans and leases, USD bn


1111

11

This, in it of itself, highlight that the Fed is in no urgency to print more money. Hence it reduces the bearish cue for USD/THB. Fig 13. y = f(x), USD M1 money supply as a function of Fed’s balance sheet

Fig 14. y = f(x), USD/THB as a function of USD M1 money supply

y = 0.0002x2 - 0.4615x + 1711.7R2 = 0.8832

1400

1500

1600

1700

1800

1900

2000

2100

2200

800 1000 1200 1400 1600 1800 2000 2200 2400 2600 2800 3000

USD M1 money supply, USD bn

Fed's balance sheet, USD bn

2108.8

y = -0.0188x + 65.37R2 = 0.9398

262830323436384042444648

1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 2000 2100 2200

without Sept 2006 to Dec 2008 period

USD/THB

USD M1, bn


Thailand’s Katrina / 3-11 or our 10-11 The current unfolding events regarding the floods that have devastated about 59 provinces out of 77 province is similar to how Katrina impacted the US Gulf coast areas or what Japan faced following the 3-11 earthquake / tsunami. Economic and social losses are at the moment are difficult to estimate. Finance Minister Thirachai Phuvanatnaranubala has put losses at about THB 60bn while the National Economic and Social Development Board (NESDB) have estimates the losses at THB80-90 bn. As the Bank of Thailand is located at the banks of the Chao Prahya river, the Central Bank is to have a great sense of urgency to adopt a wait and see stance as both internal and external environment are in an extreme state of flux. This means that carry trades by shorting the US dollar and a long position in Thai baht is less attractive in comparison to expectations of a hawkish Bank of Thailand and a dovish Fed. The Venice of the East (Bangkok is to face the most critical periods of flooding during October 16th to 18th) given the convergence of a high tide, more run off from the dams up North and possibly more rainfall from new depression systems.

1212

12

Fig 15. The BOT is located on the banks of the Chao Phraya river

Fig 16. Chao Phraya River System, highlighting impacted areas

Source: Google Maps Source: wikipedia

Fig 17. Policy rates, TH vs. US Fig 18. Implied forward rates, 1yr rate, 1yr from now

0

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

BOT repo Fed Funds

% change : 1yr rate, 1yr from now

-0.30-0.20-0.100.000.100.200.300.400.50

US CH ID MY UK KR EU SG TH

% change : 1yr rate, 1yr from now


1313

13

USD/THB is declining… because? The first Friday is one that is most followed by the markets since it is Jobs Friday. The US labor department reported that September created about 103k jobs which were higher than what economists had penciled in at 60k. The market seems to be contented with the report with 10yr bond yields climbing about 2% post the Fed’s announcement of Operation Twist. Still this is hardly something to celebrate about since while the US economy might have recovered, but the jobs market (one of the two Fed mandates) is hardly in equilibrium. At the peak of the US economic boom, the total number of Americans working excluding the agricultural sector was 137,996k whilst September’s reading is 131,334k. Fig 19. US non-farm payrolls change vs. consensus Fig 20. Total non-farm payrolls

-1000-800-600-400-200

0200400600800

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

non farm payroll - actual survey

'000

128,000

130,000

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138,000

140,000

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

non-farm payrolls, k


Hence, there is no double dip for the US jobs market, since it had never recovered. Many considered that this recent recovery was a “jobless” recovery, which is rather unsustainable since the US economy is largely driven by consumption. No jobs = no wages = no income = no spending = no growth. Therefore, it can not be stressed enough that the economy has to grow in order to accommodate the jobs market. Fig 21 maps the change in non-farm payrolls as a function of change in nominal GDP, which suggests that the US economy needs to grow at least 1% just to keep non-farm payrolls at a zero change. Unfortunately, stimulus via expansionary fiscal policy is no longer an option as the Eurozone crisis will attest to or else we will hear about the US sovereign debt crisis…again. Fig 21. y= f(x), change in non-farm payrolls as a function of change in US nominal GDP

Fig 22. US debt to GDP ratio, IMF estimates

y = 0.5025x - 0.0048R2 = 0.6318

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

-2.5% -2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0%

change in non-farm payrolls

change in nominal GDP

since 2000

0102030405060708090

100110120

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

US GDP % IMF projections

Source: Bloomberg, CEIC, KBank Source: IMF

1414

14

Beside cheap money with respect to time i.e. interest rates, one way the US can hope to recover is with cheap money with respect to other currencies i.e. foreign exchange rate. Fig 23 states our case, mapping the US dollar on a trade weighted basis versus the US GDP (chain weighted, real). The map suggests that as dollar weakens it will be supportive of US economic growth. For every point reduction in the US dollar, it should generate real economic growth of USD 54 bn, vice versa. This is why the legislative branch of the US government is looking towards a very precarious maneuver by drafting the “anti China currency bill” which is likely to spark a trade war. One bitter lesson from the Great Depression was that protectionism and trade barriers made matters worse and sank the global economy ever further. Fig 24 states the case for the currency bill, which shows that as the US sinks further into a trade deficit with China, the number of non-farm payrolls in the manufacturing also falls. Fig 23. y= f(x), US GDP as a function of trade weight dollar

Fig 24. US trade balance with China & US non-farm payrolls – manufacturing sector

74, 13,272 y = -49.137x + 16851R2 = 0.8366

10500

11000

11500

12000

12500

13000

13500

60 70 80 90 100 110 120 130

US chain weighted real GDP, US bn

DXY, US dollar index

-350-300-250-200-150-100

-500

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 1111.012.013.014.015.016.017.018.019.0

US trade balance with China, 12mth moving sum, USD bn (left axis)US non-farm payrolls, manufacturing, mn (right axis)

ρ = 92%


The market expectation is for further downside for the USD/CNY is still tepid since the spot and the 12mth NDF (non-deliverable forward) is about the same levels. Therefore if this bill truly picks up momentum, such expectations are likely to change for further downside for USD/CNY as well as USD/THB as shown by the mappings on fig.26 Fig 25. USD/CNY 12mth NDF, USD/THB Fig 26. USD/CNY 12mth NDF, USD/THB mapping

6.0

6.2

6.4

6.6

6.8

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7.2

7.4

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11293031323334353637

USD/CNY 12mth NDF (left axis) USD/THB spot (right axis)

correlation coefficient = 0.93

6.348, 30.88

y = 6.3239x - 9.664R2 = 0.9411

2830323436384042444648

6.0 6.5 7.0 7.5 8.0 8.5 9.0USD/CNY NDF

USD/THB spot


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A Japanization: are we going to see a lost decade in US/EU?

The experience of Japan during the 1990s when the economy remained stagnant is one of the major examples the US and the eurozone might try to avoid

The US and the eurozone had better take a serious measure to solve their economies unless they will end up like Japan which its government was reluctant to do anything except printing more money

The US could employ fiscal policy and reform its economy to lean toward more exports; meanwhile, debasing the dollar is also an important tool to lower its debt obligation

The tangible solution for the eurozone is to take a painful but meaningful step; default is already out of the question as Greece is seen unable to pay off debt without restructuring the payments with its creditors

The conflict between the US and China over the yuan appreciation will remain on-going and will be a part of the global economic volatility for the following year

Don’t learn from the Japanese model

The experience of Japan during the 1990s when the economy remained stagnant, called lost decade, is one of the major examples the US and the eurozone might try to avoid. The cause of the economic crisis in the US and Japan was similar: the burst of asset prices. The stock market clashed in 1990 in Japan while the housing prices burst in 2008 in the US. Both the events led to banking crises. The governments took part in stabilizing the financial market by injecting a great deal of money to keep banks alive. However, loosening monetary policy led to an increase in money supply and a lower interest rate. Liquidity trap was a major challenge in economic recovery as borrowers were reluctant to invest depite low interest rate. Bond issuance caused an increase in public debt, which led to a question on fiscal sustainability. Consequently, both the US and Japan’s governments were downgraded. How about the eurozone? The cause of the upcoming crisis was from an increase in public participation in solving financial crisis in 2008 when banks were unwilling to lend to another bank for fear of bankrupcy as seen in Lehman Brothers. Governments in the eurozone stimulated the economies by injecting money to the system, which subsequently was developed into another form of crisis: sovereign debt crisis. When the public becomes the problem the economies have no one left to rescue them. Japan, US and the eurozone have something in common which is the problem of huge public debt. How can the US and the eurozone avoid following the Japan’s foot step that caused the economy to stay stagnant for a decade? Actually, the way the US and the eurozone have been solving their economies is resemble to what Japan did two decades ago, which is by procrastinating the problem. No one has been taking a problem seriously. We have not yet seen a critical reform in any of these economies. Economic structure has remained the same prior to the crises. American consumers still enjoy incuring consumer’s debt while exports are discouraged

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by recent rise of the dollar. Greece and other PIIGS were reluctant to take a painful way of the austerity measures. They could not meet the target that they promised earlier. German and France have kept bailing out these countries for fear if these governments declare default. German and French banks would be in trouble as they hold a great deal of sovereign bonds. Therefore, the solution in the past is very simple: let’s hope there will be a mirable! Of course, there is no economic miracle to solve the sovereign debt problem in PIIGS. The longer they wait, the more painful creditors will encounter when facing with hair cut as the size of the loan has grown bigger due to series of bail-out. The US and the eurozone had better take a serious measure to solve their economies unless they will end up like Japan which its government was reluctant to do anything except printing more money. Don’t forget that Japan was in a better position than the US and perhaps the eurozone on the ground that Japanese are net savers and exports from Japan are more competitive. Fig 27. Growth of money supply in Japan Fig 28. Growth of money supply in the US

Japan money supply

-505

101520253035

May-01 May-02 May-03 May-04 May-05 May-06 May-07 May-08

Growth of M1 (% yoy)

% yoy

US money supply

-5

0

5

10

15

20

25

Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11Growth of M1 (% yoy)

% yoy


Is there a way out? Yes, of course. There are solutions to solve economic problems in the US and the eurozone. For the US, monetary policy is doomed. Liquidity trap of low interest rate is apparent. Therefore, the remaining tool is the fiscal policy. It is still hard to imagine that this is a solution, especially after the political tension between the Democrats and the Republicans over raising the debt ceiling and cutting budget deficit. However, the US still has room to increase government spending to create jobs and private consumption. Without political competition, the US government still has one powerful tool left. By doing so, it is important that the US continue reforming its economy to lean toward more exports. Meanwhile, debasing the dollar is also an important tool to lower its debt obligation. How about the eurozone? Politicians in the eurozone have been denying the truth that they cannot rescue PIIGS. If they continue injecting more money to rescue Greece and others, they will end up transfering money to PIIGS or bailing out their own banks. Even they continue pumping more money, it will end up hurting PIIGS more. It is noted that a country with larger debt obligation is likely to grow at a slower pace than before. There is a negative relationship between debt burden and growth. When public debt rises sharply, investors are likely to be worried about fiscal sustainability, which eventually leads to banking crisis. Banks can be punished from buying government bonds. Higher public debt leads to higher bond payments, which take a bigger portion of government budget. The government is seen to have fewer resources to invest. Consequently, a slow growth of capital stock is unable to induce higher labor productivity, which leads to slower pace of economic production. The tangible solution for the eurozone is to take a painful but meaningful step. Default is already out of the question as Greece is seen unable to

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pay off debt without restructuring the payments with its creditors. Creditors, including taxpayers, will need to accept losses. The remaining questions are whether other members of PIIGS will default and how much banks will need to recapitalize. Answers for these questions remain unknown as it depends on how much investors would continue selling stocks and depositors could be panic and start to withdraw money from banks that have high exposure to PIIGS’s debt. It is unavoidable that banks in the eurozone will end up being downgraded if they fail to recapitalize or prevent the bank run. Fig 29. Japanization in the US and the eurozone

Fig 30. Claims on PIIGS’s public debt by French and German banks

0

50,000

100,000

150,000

200,000

250,000

Dec-11French banks

Mar-11 Dec-11German banks

Mar-11 Dec-11Other banks

Mar-11

Portugal Ireland Italy Greece Spain

USD bn Foreign claims on public debt by nationality of reporting banks

Source: The Economist, July 30, 2011 Source: Bloomberg, KBank

Dexia and more to come Dexia could be viewed as a sign of an early stage of banking crisis in the eurozone. Dexia is a Franco-Belgian bank that is being in trouble for its high exposure to Greece’s debt. Dexia used short-term funding to finance long-term lending; hence, credit dried up during the eurozone debt crisis. Investors are concerned about the bank’s financial health that has led to a sharp decline in bank’s capital. French-Belgian governments tried to rescue Dexia either by injecting capital through the EFSF and ECB similarly to the US’ TARP in 2008, yet the plan was dropped as it would deplete resources from EFSF which should be used as the last resort. France and Belgium helped bail out Dexia, yet failed to separate bad bank. Subsequently, Dexia was agreed to the nationalization of its Belgian banking division, which was followed by a warning by Moody’s that the Belgium’s Aa1 government bond ratings could fall with this bail out plan. Based on this example, we will see larger public intervention on bailing out troubled banks, either by nationalizing banks or injecting more capital to prevent bank run. If banks collapse, financial turmoil in the eurozone will prevail. It is likely to see slower growth in the eurozone for the next few years until banks have successfully recapitalized to gain financial health. In addition, fiscal reform is necessary to allow the governments to reduce public debt for fear of disrupting economic growth in the future. BRICS and world economic recovery BRICS, namely Brazil, Russia, India, China and South Africa, are emerging economies that have been enjoying high economic growth. During the economic crisis in 2008, BRICS’s economies grew remarkably despite a fall of the global demand. Major factors are that they relied on their domestic consumption and investment to generate growth. Can they revive the ailing global economy again if we all fall into trouble? This time the answer is full of uncertainty. After the sub-prime crisis, the Fed introduced QE1 and QE2, which caused rapid capital flows to BRICS and other regions. Capital flows has led to an increase in the demand for local currencies, causing stronger exchange rate versus the US dollar. In order to maintain competitiveness in exports, several central banks

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intervened the market by accumulating more foreign reserve so as to slow down the pace of local currency appreciation. This attempt has drawn attention to currency war where one country has tried to make its exchange rate under-valued so as to gain greater competitiveness against others. The US is seen hostile to China for making the yuan artificially under-valued, threatening to pass a currency bill to punish China. The US claimed that it could generate more jobs if the yuan has been more appreciated. However, China warned the US that the currency war could lead to a trade war. This conflict will remain on-going and will be a part of the global economic volatility for the following year.

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20

Pricing in economic slowdown and policy rate pause

We revised down our target for the policy rate to 3.50% for the end of this year, noting the BoT’s proposed change of inflation target as well as the worsening global conditions due to Europe’s debt crisis

Given the new policy target and the BoT’s forecast of decelerating headline inflation rate, there should be less pressure to call for further hikes

Bond yields had a volatile third quarter but basically the yield curve remained flat

Foreign investors turned net-sellers of Thai bonds for the first time in months and risks of further sell-offs continue although we do not expect such an outcome unless European debt crisis turned into a global financial crisis of similar impact as the crisis in 2008

Q1 bond supply capped by delays in fiscal budget, high treasury cash balance, and P/N substitution

FY2012 bond supply plan changed slightly : more long-term bonds, lower 3-year bonds

We continue to see a flat yield curve going forward but the uncertainties in global financial markets could lead to lower appetite for duration in emerging market bonds: stay short duration

Market update – September and October interest rate movements During the past 3 weeks or so, the situation in Europe with regards to Greece’s debt crisis had worsened drastically, driving local bond yields and the IRS rates into different directions. The government yield curve shifted upwards as a result of foreign investors’ sell-off in emerging market assets while the IRS rates fell, following the short-dated THBFIX rates on the back of USD liquidity concern in the global markets. During the first week of October, such trends started to revert: bond yields started to fall slightly while IRS rates saw less downward pressure from the declines in swap points.

Fig 1. Government bond yield curve rebounded Fig 2. Movements of IRS rates

3.55 3.55 3.533.48

3.53 3.533.64 3.67 3.69

3.64

3.453.36 3.32 3.31 3.33 3.35 3.38 3.41 3.41 3.4

3.563.63 3.61 3.58 3.62

3.693.77 3.81 3.82 3.83

3.00

3.20

3.40

3.60

3.80

4.00

1y 2y 3y 4y 5y 6y 7y 8y 9y 10yTTM

%

07-Oct-11 22-Aug-11 26-Sep-11

Government bond yield curve

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11

IRS 2Y IRS 5Y IRS 10Y repo

%


2121

21

In any case, we expect that the short-term swap rates would remain capped at low levels (way below policy rate) for up to the end of December, given the market’s expectation that the Bank of Thailand (BoT) would not increase the policy rate further and the ongoing concerns about USD liquidity amid the tightness of USD funding conditions in Europe. Hence, we iterated our view last month that it is still a good time for the corporate sector to hedge borrowing costs but there is no hurry in doing so.

Fig 3. 6m swap points and 6m THBFIX rate Fig 4. Bond-swap spreads picked up slightly

20

25

30

35

40

45

50

Jun-11 Jul-11 Aug-11 Sep-11 Oct-112.25

2.50

2.75

3.00

3.25

3.50

3.75

USD/THB 6m forward point 6M THBFIX

%satangs

-80-60-40-20

020406080

Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11

2Y bond-swap spread 5Y bond-swap spread 10Y bond-swap spread

bps


Foreign investors had turned net-sellers of local THB fixed income securities for the first time in more than a year during September. During the same month, foreigners also pulled out of the local stock market (net-sell USD 541.5mn) and the USD/THB turned 4.01% weaker in the month of September before rebounding by nearly 1.0% in October. Expectations that the Thai baht would not perform in the near-term also reduce foreigners’ reinvestment into short-dated debt. As a result, foreign investors’ net holding of THB fixed income securities fell from THB 438.6bn at end August to THB 434.2bn at end September and further to THB 425.6bn as of October 7th. Furthermore, we note as well that foreigners’ holding of THB bonds had climbed by THB 300bn in a short 12 month period from THB 150bn back in September 2010. This reflects substantial risk of sudden capital outflow should foreign funds liquidate THB bonds in the face of another outbreak of global financial crisis. If that worst case scenario does not happen, we expect that emerging market bonds would continued to see positive demand, given their rising significance in the global markets and the stronger fiscal positions of emerging market economies.

Fig 5. Foreign holding position declined Fig 6. Foreign outright trade (net-purchase, monthly)

-50

100150200250300350400450500

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

foreign holding in Thai fixed income, THB bn

Bt bn

73

4016

71

127

84 79

163

19 28

128

45

3.7

-1.5-200

20406080

100120140160180

Sep Nov Jan Mar May Jul Sepforeign net-buy in THB bonds (billion baht)

THB bn

up till Oct 7th

Source: PDMO, KBank Source: PDMO, KBank

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22

During the sell-off, we did notice two factors. First of all, the yield curve had not steepened very much, which could be implying that demand for the long-term bonds remained and could be similar to the mid-curve bonds. In fact the flattening of the yield curve at the end of August, with 2-10 spread at 1bp, had been too abrupt and somewhat an overreaction of the market to the flattening of the U.S. yield curve. The sell-off in September thus helped to correct this spread back to around 20bp before declining towards 9bp on October 7th. This is in line with our expectation that insurance companies and pension funds continued to have high demand of bonds going forward. At the same time, the government’s bond supply plan does not overweight long-term bonds, as the PDMO is careful to push up long-term borrowing costs. Secondly, Fig 8. shows that local asset management companies continued to buy into the bond market, with the outright net-purchase position increasing for second straight month in September.

Fig 7. Foreigners continued to trade in securities with maturities <1Yr

Fig 8. Asset management (net-purchase, monthly)

Composition of bond traded by Non-resident

0

20

40

60

80

100

Jul-10

Aug Sep Oct Nov Dec Jan-11

Feb Mar Apr May Jun Jul Aug Sep

%

0-1 Y 1-3 Y 3-5 Y 5-10 Y > 10 Y

0

100

200

300

400

500

600

Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct

Mutual fund net-buy in THB bonds (billion baht)

THB bn

up till Oct 7th


BoT’s to pause in the face of worsening global conditions We have revised down our target for the policy rate this year to 3.50%, from earlier expectation of two more rate hikes that could bring the policy rate to 4.00% at year-end. For the year 2012, we think that that BoT will continue to stay pat, given that inflationary pressure would be reduced by the decelerating growth momentum. As for the MLR (minimum lending rate), we do expect it to stay at current level of 7.25% (average of 4 large banks) following the pausing of the policy rate. At the same time, we do expect that the fixed deposit rates would likely pause as well, or edge up very slightly due to banks’ competition to amass deposits. As a result, we expect that the real policy rate and real 1-year deposit rate would remain in the negative zone for the next two quarters, with the assumption that headline consumer price index climbs by an average of 0.23% each month the next three quarters (average monthly change since 2011). Such a condition means that monetary conditions remained somewhat accommodative to growth should the Thai economy decelerate in accordance to the slowdown in the advanced economies.

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Fig 9. MLR and policy rate Fig 10. Headline inflation rate (rough estimate)

0.0

1.0

2.0

3.04.0

5.0

6.0

7.0

8.0

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

MLR Repo rate%

461bp

375 bp

444bp

-6-4-202468

10

Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12Headline CPI yoy

%


Our reasons for the revised call are as follows:

1. Global economic outlook worsened significantly during the past couple of months: indicators from both the U.S. and Europe showed weak activities in various sectors. Manufacturing production that had been the core of the post-Lehman recovery begun to see several months of slowdown. Meanwhile, job market in the U.S. remained sluggish and fiscal austerity measures in Europe are likely to induce slower growth in industrial production as well as intra-regional trade.

2. European debt problems continued to worsen in a more rapid pace and the

European governments continued to have problem reaching a solution for the region’s debt problems, especially for Greece. This has led to continued worsening of investment sentiment globally and increased risks to the European financial sector's overall stability. In light of such uncertainties, the BoT may stay pat for the next few months and assess their impacts on Thailand.

3. BoT is planning to replace the core inflation rate with the headline inflation

rate for its policy target. The proposed target is 3.00% with allowance of 150bp on either side. The MoF has agreed with the proposal in principle but to make this change effective, the Cabinet would have to endorse it. Also, an annual average may be used instead of quarterly average. This means that the BoT is not under pressure to raise policy rate further this year, according to its forecast of headline inflation rate in July’s issue of Inflation Report.

4. Fiscal policies remained incomplete and thus it would be a challenge for the central

bank to try to assess the overall impact on inflation, even though several policies are likely to be add to price pressure e.g. minimum wage increase, paddy price floor scheme, first-time car-buyers and home-buyers’ schemes. At the same time, the BoT still have other "macro-prudential" regulations that they could enact should risks in specific sectors begin to increase e.g. increasing down-payment for home loans (announced last year).

Update on changes to bond supply Government’s financing requirements would total about THB 690-710bn* in FY2012. This comes from an estimate of THB 350bn budget deficit (earlier projected to be near THB 400bn) and refinancing of the maturing FIDF bonds (total THB340bn). In addition, the PDMO may require another THB149bn of financing to prepay some of the existing bank loans (from the 2009-2010 TKK fiscal stimulus program). The danger to this amount is that the government’s budget deficit may be larger than initially estimated. There are

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factors pointing to such a possibility, including global economic slowdown, reduction in oil tax and other government subsidies, as well as a higher-than-expected government expenditure for stimulus policies and expenditure following worse-than-expected flooding conditions this year. For the current quarter, the bond market should get a positive support from the low level of issuance. The PDMO reported that the Finance Ministry maintained a relatively high level of treasury cash balance, reducing the need to find much funding for the first quarter of FY2012. At the same time, the final draft of the FY2012 budget would be signed into law around early next year, thus the PDMO have limited capacity to seek funding for the purpose of financing deficits. Hence, the supply of government bonds for the present quarter is THB 32bn, with zero issuance in October and December. Issuance in November is separated into THB 15bn of new 5-year benchmark bonds, THB 9bn of new 7-year benchmark bond and another THB 8bn of a new floating-rate bond issue. Much of the refinancing of maturing FIDF bonds would be done via the issuance of about THB 3.9bn of promissory notes. Furthermore, the budget for maturing treasury bills would be reallocated into new retail savings bonds (sold via ATMs) mentioned in our previous report. In addition, the PDMO is reducing the planned issuance of 3-year bonds (new benchmark) to THB 50bn from earlier announced THB 100bn. The main reason for this is that short-term rates remained relatively high while the yield curve remained flat, thus issuing long-term bonds remained advantageous. It would thus increase the supply of 30-year and 50-year bonds by THB 10bn each for the year.

Fig 11. Government bond issuance comparison Fig 12. Changes of financing tools in FY2012

178 207

365 340 35046

154

29 24 5047 46

504060

22

0

100

200

300

400

500

600

FY2008 FY2009 FY2010 FY2011 FY2012

Benchmark bonds (LBs) Non-benchmark bonds (LBs)Floating-rate bonds (4Y) Inflation-linked bonds

Bt bn

0

20

40

60

80

100

120

140

5Y 7Y 10Y 15Y 20Y 30Y 50Y

FY2008 FY2009 FY2010 FY2011 FY2012Bt bn


Table 1. Government bond auction calendar for Oct - Dec 2011 unit : million baht

Auction Date LB176A LB193A LB157B (Float-rate) Total

Oct-11 - - - - 02-Nov-11 - 9,000 - 9,000 09-Nov-11 15,000 - - 15,000 16-Nov-11 - - 8,000 8,000 23-Nov-11 - - - - 30-Nov-11 - - - -

Dec-11 - - - - Total 15,000 9,000 8,000 32,000

Table 2. Issuance plan

Unit : in billions of baht

Auction frequency Month no. Per auction size

(THB bn) Total end FY2012 outstanding

Benchmark bonds (LBs)

New LB176A 5Y 6x even 15.0 - 20.0 100.0 100

New LB193A 7Y 6x odd 9.0 - 15.0 65.0 65

LB21DA 10Y 6x odd 9.0 - 15.0 60.0 100 - 120

New 15Y 6x even 5.0 - 9.0 35.0 35

new 20Y 6x odd 5.0 - 9.0 35.0 35

LB416A 30Y 6x even 3.0 - 5.0 30.0 57

LB616A 50Y 6x odd 2.0 - 2.5 25.0 28

Non-benchmark bonds

New FRB LB157B 4Y 6x odd 8.0 - 11.0 50.0 50.0

ILB217A 10Y 4x every quarter 10.0 - 15.0 60.0 100.0

new LB 3Y 6x odd 15.0 - 20.0 (may be

subjected to changes) 50.0 50.0

source: PDMO Market outlook We continue to see a flat yield curve going forward but the uncertainties in global financial markets could lead to lower appetite for duration in emerging market bonds. At the same time, we expect that demand concentration from both local and foreign investors would stay with the mid-curve issues; hence we foresee only a 5bp spread between the 2- and 5-year yields. As for investment strategy, we continue to recommend shortening of duration prior to MPC meeting on October 19th. Should the next statement shows a more dovish MPC, we would take that as a good sign to extend duration. Table 4. KBank’s new targets

Actual rates 2011 forecasts

Aug 30th Oct 5th Old New

Policy rate 3.50 3.50 4.00 3.50

2Y 3.50 3.57 4.20 3.60

5Y 3.42 3.56 4.30 3.65

10Y 3.51 3.69 4.40 3.80

Source: KBank, Bloomberg

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Table 3. Government’s financing plan for each fiscal year Unit : in billions of baht

FY2008 FY2009 FY2010 FY2011 FY2012* Treasury bills 0.0 134.0 -127.0 26.0 30.0 Benchmark bonds (LBs) 177.6 207.3 364.8 339.9 350.0 5Y 72.0 74.4 121.6 93.0 100.0 7Y - - 55.0 63.0 65.0 10Y 52.6 62.7 71.3 59.0 60.0 15Y 24.1 26.7 47.0 43.0 35.0 20Y 24.0 38.0 50.0 41.9 35.0 30Y 5.0 5.5 20.0 27.0 30.0 50Y - - - 13.0 25.0 Non-benchmark bonds (LBs) 45.7 154.0 29.0 24.0 50.0 2Y - 88.0 - - - 3Y (new benchmark in 2012) 12.7 50.0 - - 50.0 8Y 10.0 - 12.0 - - 12Y 8.0 16.0 17.0 24.0 - 14Y 15.0 - - - - Floating-rate bonds (4Y) - 22.0 47.0 46.0 50.0 Inflation-linked bonds - - - 40.0 60.0

Total Bonds (LBs) 223.4 383.3 440.8 449.9 510.0

Saving (SBs) and "retail investor" bonds 18.0 80.0 82.2 50.6 100.0 P/N 31.0 50.7 61.2 88.6 170.1 (4Y and above) 31.0 50.7 61.2 54.0 125.1 Restructuring (12 and above) - - - 34.6 45.0 Net bank loans 0.0 30.0 177.8 -58.7 -149.1 2-4Y - 30.0 260.0 58.9 - Restructuring (prepayment) - - -82.2 -117.6 -149.1 Others - - - - 49.1

Total financing requirement 272.3 678.0 635.0 556.5 710.1*

Source: PDMO * According the PDMO’s comments given to Reuters News on 26th September, the total funding needs should be around THB 690bn. Due to the lack of further information (other than presented here and PDMO’s document given in early September), our number currently does not tally with the news report.

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Economic Update

Key economic indicators for Aug-11 were mostly positive. Exports, excluding gold, remained robust, but sharply accelerating

imports narrowed the Aug-11 trade surplus and pushed the current account into the red.

Manufacturing production output gained ground, in line with recovering exports.

Although private sector confidence for Aug-11 turned out mixed – partly pressured by growing global economic uncertainty and domestic flooding wariness – private consumption and investment accelerated both MoM and YoY.

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

Reduced fuel prices helped ease the Sep-11 Headline CPI, but the Core CPI continued to head further north. Meanwhile, the BoT’s newly proposed Inflation Target and range should increase flexibility in monetary policy maneuvers, amid growing economic uncertainty at home and abroad.

In light of worsening situation among the debt-laden countries in EU, KResearch has preliminary estimated these impacts, thereby lying our 2012 GDP between 1.0-4.5% YoY for the case of limited and widespread impacts from the crisis.

Table 1. Thailand Key Economic Indicators

Units: YoY %, or indicated otherwise 2010 2011 YTD. 1Q 2Q Jul Aug Sep

Composite Private Consumption Index 5.9 4.2 4.3 4.3 2.1 5.4 • Sales Volume of Benzine and Gasohol -1.4 0.5 1.4 0.4 -3.8 2.3 • Value-added Tax at 1995 prices 15.5 11.3 10.6 13.3 4.6 13.8 • Imports of Consumer Goods at 1995 prices 22.6 13.9 16.7 11.6 9.5 17.1 • Passenger Car Sales 50.7 25.6 60.3 0.3 12.2 26.4 • Motorcycle Sales 22.9 15.4 14.6 18.2 0.4 26.1

Private Investment Index (PII) 18.5 11.0 14.8 7.7 6.5 8.3 • Sales Volume of Domestic Cement 8.8 3.8 3.6 1.4 6.6 11.7 • Sales Volume of Commercial Cars 42.3 18.4 31.7 3.1 10.1 15.7 • Imports of Capital Goods at 1995 prices 24.9 17.4 24.5 12.7 10.4 17.0 • Value of BOI Applications -33.9 41.8 8.1 63.2 154.3 24.2

Manufacturing Production Index 14.4 -1.0 -2.1 -2.5 -0.7 7.0 • Industrial Capacity Utilization 63.2 61.6 62.6 59.1 63.1 64.7

Agriculture Production Index -2.1 7.9 14.8 7.0 -7.1 3.5 • Agriculture Price Index 24.3 17.6 25.4 17.6 4.8 9.0

Exports (in $) 28.5 25.5 27.3 19.2 36.4 28.5 • Unit Value 9.1 6.8 6.7 7.0 7.1 6.7 • Volume 18.0 17.4 19.3 11.5 27.4 20.3

Imports (in $) 36.7 27.9 27.0 28.0 13.1 45.8 • Unit Value 8.1 10.7 8.9 11.5 12.1 11.8 • Volume 27.1 15.5 16.6 14.7 0.9 30.4

Trade Balance ($ millions) 32,212 20,516 7,963 7,296 4,552 705 Current Account ($ millions) 13,661 10,047 5,909 1,396 3,438 -697 Broad Money 10.9 17.5 13.2 16.3 17.6 17.5 Headline CPI 3.3 3.8 3.0 4.1 4.1 4.3 4.0 USD/THB (Reference Rate) 1.0 2.2 1.5 2.4 2.6 2.9 2.9 Source: BOT, MOC, OAE, and OIE

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28

Aug-11 exports – excluding gold – remained robust, while imports rallied to a historic high Although Aug-11 exports saw quite a significant slowdown to 28.4% YoY (from 36.4% YoY in Jul-11), this did not surprise us, as it was due to a base effect and plummeting gold exports (down from $994.9 million in Jul-11 to $385.5 million in Aug-11). Excluding gold, Aug-11 exports managed to report a MoM gain, reaching $20.6 billion, from $20.1 billion in Jul-11. As such, adjusted exports edged downward to a lesser extent (than the non-adjusted series) to 26.7% growth YoY, versus the 30.2% in Jul-11. Fig 1. A base effect forced export growth YoY downward in Aug-11

Fig 2. The same effect explained a slowdown in export volume

0

5,000

10,000

15,000

20,000

25,000

Feb-10 May -10 Aug-10 Nov -10 Feb-11 May -11 Aug-11

Expo

rt Va

lue (U

SD M

illion

)

0%

10%

20%

30%

40%

50%

% Y

oY

Ex ports Ex ports (ex cluding gold)% YoY for Ex ports % YoY for Ex ports ex clud. Gold

-30-20-10

010203040

Oct-09 Feb-11 Apr-11 Jun-11 Aug-11%

YoY

Export Price Import PriceExport Quantity Import Quantity

Sources: BOT, MOC, KResearch Sources: BOT, KResearch

This positive MoM performance of adjusted exports mirrored a continuing recovery in exports of vehicles & parts (despite a sharply deteriorating YoY figure, in light of a base effect wherein new eco-car models were largely exported in Aug-10) following an ongoing economic rebound in Japan. Meanwhile, MoM gains were seen in Thailand’s agricultural and food exports – particularly rubber, tapioca and sugar. Other hi-tech products, e.g., including computers & parts, electrical appliances and chemical products, also managed to recover from previous dips. In the area of Thailand’s key trade partners, exports to Japan accelerated to 25.5% growth YoY, from 22.9% YoY in Jul-11. Exports to ASEAN edged up to 36.8% growth YoY, from 34.7% YoY in Jul-11, though exports to EU slowed both MoM and YoY – the latter retreating to 26.7% growth for Aug-11, from 35.5% YoY in Jul-11. Fig 3. Many hi-tech products recovered from previous losses, and exports of some agricultural products remained healthy

Fig 4. Exports to ASEAN continued to show strong YoY growth, while improving exports to Japan mirrored the recovery there

(60)(40)(20)

020406080

100120140

Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11

% Y

oY

Vehicles & Parts Rubber Computer & PartsElectrical Appliances Rice IC and PartsTapioca Products

0102030405060708090

U.S. China Japan EU (15) ASEAN (9) India Middle East

% Y

OY

4Q10 1Q11 2Q11 Jul-11 Aug-11

Sources: BOT, KResearch Sources BOT, MOC, KResearch

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According to the BOT’s revised series, imports for Aug-11 rallied to a historic high of $20.2 billion, from $16.5 billion in Jul-11, thereby rising to 45.9% growth YoY, from 13.2% YoY in Jul-11. This robust performance was derived from higher imports of non-monetary gold, vehicles & parts (amid the ongoing recovery in automotive exports), crude oil (prior to a refinery plant shutdown for maintenance in the coming months), and petroleum ector machinery imports. If excluding gold, adjusted imports recorded 41.2% growth

addition to a significant improvement in capital goods imports, consumer goods, raw ng g in

sYoY in Aug-11, versus 22.2% YoY in Jul-11. Inmaterials and intermediate goods also reported stro

a s.

Fig 5. Imports jumped to a historic high, with broad-based gains across key categories

Fig 6. The current account narrowed markedly

(60)(40)(20)

020406080

100120140

Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11

% Y

oY

Imports Consumer GoodsRaw & Intermediate Goods Capital GoodsCrude Oil Vehicles & Parts

(4,000)(3,000)(2,000)(1,000)

01,0002,0003,0004,0005,0006,000

Aug-10 Nov-10 Feb-11 May-11 Aug-11

Ext

erna

l Bal

ance

s (U

SD

mill

ion)

Trade Service Current Account Balance

urces: BOT, MOC, KResearch Sources: BOT, MOC, KResearch So

As imports outperformed exports, the trade surplus for Aug-11 narrowed sharply to $704.8 million, versus the $4.6 billion in Jul-11. However, if excluding gold, the adjusted trade surplus would have improved to $1.9 billion, against the $4.3 billion in Jul-11. Net services, primary and secondary income for Aug-11 showed a deepening deficit of $1.4 billion, worsening from the $1.1 billion deficit in Jul-11, due to growing profit

patriations. In a nutshell, the current account fell from a $3.4 billion surplus in Jul-11

ages the tourism sector in ep-11 and Oct-11, not to mention the negative impact on crops and manufacturing utput – following disruptions at many key industrial estates.

reto a $697 billion deficit in Aug-11. Tourism enjoyed healthier momentum, but more evident impact of severe flooding will likely be seen in coming months In Aug-11, the number of foreign tourist arrivals increased for the third consecutive month, reaching 1.72 million, up over 1.52 million in Jul-11. Over-year growth also accelerated to 35.4% YoY, versus the 18.8% YoY in Jul-11. Meanwhile, the hotel occupancy rate for Aug-11 remained steady at around 57.7%. Nevertheless, it is expected that widespread flooding could produce more damSo

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30

Fig 7. Foreign tourists rallied further Fig 8. Hotel take-up rates improved

0

500

1000

1500

2000


No.

of F

orei

gn T

ouris

t Arr

ival

s (M

illion

)

0

10

20

30

40

50

60

70

% Y

oY

Foreign Tourist Arrivals (lhs) % YoY (rhs)

01020304050607080

Total Central South North Northeast

%

4Q10 1Q11 2Q11 Jul-11 Aug-11

TAT, BOT, KResearch Sources: TAT, BOT, KResearch Sources:

Manufacturing production gained ground After showing both MoM and YoY contractions in Jul-11, the Manufacturing Production Index (MPI), compiled by the Office of Industrial Economics (OIE), had risen 3.9% MoM in Aug-11. Its YoY change improved to 7.0% growth in Aug-11, from the 0.7% contraction

m 2.9% YoY to 15.1% YoY, due mainly to automotive production to clear order

lthier pattern, by gistering accelerated 64.7% growth YoY, up over the 63.1% in Jul-11.

in Jul-11, with broad-based gains being seen across all major MPI categories. Apparently, the export-oriented MPI reversed from a 2.1% contraction YoY in Jul-11 to 6.6% growth YoY in Aug-11, with support from hard-disk drives and rubber that were bolstered by high demand in China. Meanwhile, the domestic consumption-oriented MPI accelerated to 3.3% YoY in Aug-11, from 0.3% growth YoY in Jul-11, in light of accelerating production of petroleum products (ahead of a refinery plant shutdown for quality standard improvements, plus higher domestic demand after an exemption was instituted on Oil Fund levies for some types of retail fuels, effective late in Aug-11). As for the MPI of products that serve both domestic and international consumption, it jumped frobacklogs. The OIE’s capacity utilization rate for Aug-11 suggested the same heare Fig 9. Manufacturing production and capacity utilization recovered from the previous month

Fig 10. Broad-based gains were seen across all MPI categories

-10-8-6-4-202468

10


% Y

oY of

MPI

50525456586062646668

% C

apac

ity U

tiliza

tion R

ate

% Capacity Utilization (rhs) MPI (lhs)

-30-20-10

0102030405060

May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11

% Y

oY of

MPI

exports < 30% 30% < exports < 60% exports > 60%

ces: OIE, KResearch Sources: OIE, KResearch Sour

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Private sector confidence mixed Reversing the previous month’s direction, the Consumer Confidence Index (CCI) for Aug-11 showed a MoM decline, while the Thai Industries Sentiment Index (TISI) fell for the third consecutive month. This worsening sentiment reflected rising concern about the impact of widespread flooding, global economic uncertainty and fading hope toward

be short-lived, amid a more negative economic environment oth at home and abroad.

implementation of the government’s income-enhancement policies. On the other hand, the Aug-11 Business Sentiment Index (BSI) managed a MoM gain, bracing for lower production costs (due to falling fuel prices following the exemption of some Oil Fund levies), as well as better investment and production. However, it is highly likely that this uptick couldb Fig 11. Private sector confidence was mixed in Aug-11 Fig 12. Private consumption and investment regained

strength

40

45

50

55

60

Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11

BSI

60

70

80

90

100

110

120CCI & TISI

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

-20-10

010203040506070

PCI PII PassengerCar Sales

CementSales

CommercialCar Sales

Imports ofCapitalGoods

Imports ofConsumer

Goods

% Y

oY

4Q10 1Q11 2Q11 Jul-11 Aug-11

Sources: BOT, UTCC, FTI, KResearch KResearch ures for PCI and PII component compiled from non-seasonally adjusted series by

the BOT

Sources: BOT, Note: Fig

Private spending regained strength After switching between marginal MoM gains and contractions over the past 4 months, private sector spending seemed to enjoy a more solid improvement in Aug-11. The Private Consumption Index (PCI) increased 3.6% MoM, rising over the 2.3% MoM contraction in Jul-11. This brought its over-year growth upward to 5.4%, rising over 2.1% in Jul-11. In the same direction, the Private Investment Index (PII) for Aug-11 edged up 1.9% MoM (compared to 0.4% MoM seen in Jul-11), thereby resulting in accelerated YoY

ll as gasoline and diesel fuel consumption (boosted by n exemption on Oil Fund levies).

-11 Headline CPI, but the

easures to subsidize public transportation res (registering a 0.99% MoM decrease).

growth of 8.3% from 6.5% in Jul-11. Key components leading the increase included real VAT collections, imports of capital goods (serving the needs of expanded production in the automotive, electronics, and electrical appliance manufacturing sectors), auto sales (as intermediate auto-part shortage problems subside), as wea Reduced fuel prices helped ease the SepCore CPI continued to head further north The Headline CPI for Sep-11 saw easing pressure, by reporting a 0.33% MoM decline, versus the 0.43% growth in Aug-11. Consequently, its YoY growth decelerated to 4.03% from 4.29% in Aug-11. This subsiding pressure on the Headline CPI traced a 8.02% MoM drop in domestic retail fuel prices – particularly diesel and gasoline motor fuels – as a result of cooling global oil prices and the full benefit of the government’s Oil Fund levy cuts (effective late in Aug-11), as well as mfa

Lower fuel prices helped cushion a 4.14% MoM jump in vegetable and fruit prices, in light of the ‘Kin Jae’ Vegetarian festival and flooding in many areas. The Core CPI for Sep-11 continued to report a MoM increase of 0.1% (versus 0.27% MoM in Aug-11), thereby pushing it up to a new 3-year high at 2.92%, from 2.85% YoY in Aug-11. When looking out further into the remaining months of 2011, although the Core CPI could continue to accelerate MoM, a sharp decrease in fuel prices (particularly in Sep-11) helps lower a chance that the Core CPI will breach the existing Inflation Targeting range of 0.5-3.0%. This is not to mention the new BoT’s Inflation Target range of 3.0% (+/- 1.5%) with the yearly Headline CPI working as a new policy target (effective in 2012), that could impose greater flexibility for the monetary policy maneuver next year. Fig 13. Sep-11 core inflation headed further north

-0.5

0.0

0.5

1.0

1.5

Sep-10 Jan-11 May-11 Sep-11

% M

oM

0.0

1.0

2.0

3.0

4.0

5.0

% Y

oY

Headline CPI (MoM-lhs) Core CPI (MoM-lhs)Headline CPI (YoY-rhs) Core CPI (YoY-rhs)

Sources: MOC, KResearch

The EU debt crisis: A Big Threat to the Thai Economy over the next 6-12 months Over the past two months, financial market sentiment has been hurt by growing wariness toward the EU debt crisis, especially with the Greece’s diminishing ability to service their huge public debt and a postponement until Nov-11 of a ‘Troika’ (EU, IMF and ECB leaders) meeting to decide on the 6th financial support plan for Greece. In addition, there is widespread concern about more sovereign rating downgrades, and subsequent banking crises, with a looming collapse of Belgian-French Dexia Bank. At this juncture, two differing KResearch estimates on the impact of the EU debt crisis toward the Thai macroeconomic situation appear below:

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Table 2. KResearch’s Preliminary Assessment, the EU Debt Crisis: Impact on the Thai Economy 2011F 2012F

Scenario 1: Limited Impact

from the EU Debt Crisis

Scenario 2: Widespread Impact

from the EU Debt Crisis Key Assumptions

• EU officials use the EFSF and other

safety net packages to effectively contain the problem from spreading to other countries beyond PIG countries (Portugal, Ireland and Greece).

• Orderly, managed default of some PIG countries is possible.

• The 2012 EU economy is projected to remain in the black, while the US and Chinese economies will likely underperform their potential.

• EU officials are unable to push

forward effective measures with sufficient size in a timely manner. An uncontrollable event becomes possible.

• Larger countries in the EU – e.g., Italy, Spain and France – become exposed to contagion risks, with unusually high funding costs.

KResearch Macroeconomic Forecasts (Units: % YoY) GDP (Base Case)

3.5-4.2% (3.8%)

4.5%

1.0%

Exports

17.0-22.0%

(20.0%)

10.0%

-7.0%

Headline CPI

3.7-4.0% (3.8%)

3.7%

2.8%

Sources: KResearch, as of September 16, 2011

• Scenario 1: Limited Impact

If EU officials successfully use quantitative and qualitative measures to effectively restore market confidence, KResearch estimates that Thai exports will likely see a limited downside risk, with YoY growth reaching at least 10.0%, or so. Coupled with the Thai government’s stimulus efforts that could shore up the GDP by 1.5%, this would result in 2012 GDP growth of up to 4.5%.

• Scenario 2: Uncontrollable Impact In this case, assistance from the EU officials would fail to completely restore market confidence, thereby heightening risks to countries with larger economies – e.g., Italy, Spain and France. As such, the need to urgently overhaul the EFSF (in size, flexibility and/or scope of responsibility) would likely become necessary, which might include expediting the European Stability Mechanism (ESM), ahead of its previous timeline for readiness in mid-2013. Thai exports in 2012 might then report a 7.0% contraction YoY, causing GDP growth to drop to only 1.0% only. Dismal domestic demand would likely lessen inflationary pressure, lowering the Headline CPI to 2.8% YoY, versus the 3.7% YoY estimated in Scenario 1.

However, as there remain a number of triggers that could alter the direction and development of this EU debt crisis later on – e.g., results of the EU Summit to be held during October 17-18, as well as ECB, G-20 and EU Finance Minister meeting lined up during the first two weeks of Nov-11, in addition to a Troika meeting with Greek officials on whether to approve the 6th funding assistance plan at around that period – we will closely monitor this situation, prior to revisiting our assessment toward this event (if needed) in the future.

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33

Back to the remainder of 2011, aside from growing global economic risks, severe flooding at home that has damaged agricultural output, tourism and many industrial estates will likely hit the 4Q11 GDP, thereby increasing the likelihood that the full-year GDP will be lower than our current estimate of 3.8% YoY in the base-case scenario. The Outlook for Next Month Due to bearish global economic sentiment, Sep-11 exports might not be able to keep the Aug-11 gain. This direction, coupled with a base effect, could impose a downside risk to export growth YoY, possibly falling below the 28.4% growth YoY in Aug-11. The same explanation applies to the Sep-11 MPI, with YoY growth decelerating from the 7.0% in Aug-11. Meanwhile, the Oct-11 Headline CPI is expected to remain higher than 4.0% YoY, due to upside pressure from high food prices amid widespread flooding. Meanwhile, the Core CPI for Oct-11 could stay close to the 2.92% YoY reported for Sep-11.

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Strategy: Stay cautious, volatility remains

Investment theme:

► Markets are being driven by events in the EU and although there

appears to be progress, market will no longer be satisfied with half-solutions. Comprehensive plans including Greece debt haircut, EU banks ring-fencing and recapitalizations will now be needed to calm market. These decisions require political considerations and further setbacks are expected as talks progress.

► Volatility will continue. We have set ourselves a one-month window ending in early November before considering the need to change fundamental macro assumptions which will change market outlook.

► There is a downside risk to our view presently, but we see SET index at 812 to provide strong support. This is based on PBV at 1.5x (fundamentally) and peak-to-trough correction of 30% (technically) – both historically well-tested. Our worst-case has SET index at 730, arrived through stress-testing assumptions on 2012 GDP growth at 1.9% from 5% with increased required risk premium.

► This worst-case scenario is comparatively better than the worst-case saw in the US subprime crisis of 2008-9 when the SET went below 400. As presented in this report, we see damage from the EU crisis much less severe than that of the US sub-prime including Thailand crisis of 1997.

► We advise reducing portfolio at current levels. Aim to accumulate shares as we get below 850 but stick to sectors with business oriented towards domestic consumption. We have been recommending these sectors for a while and they have shown high degree of outperformance over the SET.

► The above consideration along with the impact from local floodings have made us increased our emphasis towards domestic/defensive sectors and we upgrade Utilities sector to Neutral. Our stock selections have also been made to anticipate companies that are expected to see quick recovery once normalcy returns. The stocks include: BBL ADVANC CPF MAJOR HMPRO CENTEL BGH LPN STEC and AMATA. We replaced PS with LPN as its stronger earnings outlook.

Kavee Chukitkasem - KSecurities [email protected]

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Changing environment Despite falling by over 10% since the last peak on 10 July, the SET continued to outperform the regional indices while USD/THB rate also depreciated less. In general, smaller markets have suffered less in this last downturn than bigger markets (figure 1). This pattern may have to do with availability of liquidity to foreign investors as bigger markets have greater liquidity and suffered more from selling, reflecting a panicky behavior. This sudden increase in risk aversion has been caused by concerns on systemic risks in the EU financial system. This overshadowed the 3 positive catalysts that we expected to provide support to the Thai market which were listed last month. Although these catalysts (easing of policy stance by Asian central banks, move towards launch a new fiscal stimulus the US and cut in Thailand corporate tax rate next year), did make some progress in varying degrees, the risks associated with the EU are now overwhelming. More detailed discussion of the EU debt situation can be found in the earlier sections of this report. Fig 1. Equity and foreign exchange rate performance since last peak on 10 July

Thailand

Indonesia

Philippines

Malaysia

Hong Kong

South Korea

China

India

Taiwan

Singapores

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

-30% -25% -20% -15% -10% -5% 0%

FX Performance

Equity Performance

Source: Bloomberg

As the EU problems worsen, their leaders and authorities are coming under greater pressures from the market to act in such a way that a complete solution can be presented. This would include at least a comprehensive plan to restructure Greece’s sovereign debt, recapitalize its banks and ring-fence financial institutions in the region. A decision to provide another bail-out package to Greece will not do as it simply delays the inevitable. As discussions among EU leaders progress (or lack of), markets are responding positively (or negatively) depending of the implications of details released. Before making the case for our view on the SET, it is important that we state the external market environment that we are assuming to understand our risks and catalysts factors. We are taking a view that between now and early November, EU leaders will have come up with comprehensive plan for orderly default of Greece debts, recapitalization and ring-fencing measures of EU banks with sources of funds and implementation steps clearly identified. We believe this one-month window is important because it will see at least two summit meetings among EU members: i) the EU leaders meeting on 17 October and ii) the G20 Cannes meeting on 3-4 November. We hope that a market-friendly solution will be worked out by then. Should the timeline be deferred, there would be significant downside risk to the market.

Short term strategy At the time of writing this report, the market mood is positive but we expect near-term volatility to remain high and sentiments can reverse quickly. Accordingly, we formulate short-term investment strategy based on the possible outcome during the period when the market waits for a comprehensive plan from Europe. At current levels of the SET (909), we advise reducing portfolio for short-term traders. The level of support for the SET is estimated at 812, equivalent to P/BV at 1.5x although we would begin accumulating below 850. Sectors that we would recommend entry here are mainly those focusing on domestic plays. In the worst case that the market goes into a free-fall during its panicky moments, we would enter SET at 730. This worst-case level is arrived through ‘stress-testing’ our assumptions for much weaker economic outlook including raising the equity risk premium. Note that such worst-case assumptions pretty much reflect outlook for prolonged problems in the EU as well as much weaker global economic growth. Fig 2. Short-term SET range and trading strategy

SET level Rationale and trading strategy

900 Rationale: Current levels Strategy: Reduce portfolio

812 Rationale: Derived from P/BV = 1.5x. The SET could fall to this level in the near because of volatility as the market waits for a clarity on EU. Strategy: On the way down, we would accumulate defensive stocks with strong exposure to domestic consumption theme (Power, ICT, Media, Commerce and Hospitals). We would add Banks and Property as bets for positive near-term outcome.

730 Rationale: This is the worst-case scenario and arrived from stress-testing valuation assumptions. This includes reducing 2012 Thai GDP growth from 5.0% to 1.9%, consumption growth from 4% to 2.3% and average Dubai crude oil price from USD107/bbl to USD90/bbl. We also raised our equity risk premium from 5.7% to 8.1% on the outlook of much weaker global economic growth from 3.8% to 1.4%. The set of assumption pretty much captures the scenario of prolonged EU problems Strategy: The market will take less time to get from 812 to 730 than from 900 to 812. Accordingly, high beta stocks are recommended namely Energy and Commodity.

Source: KS

Assessing downside Our worst-case assessment on the downside of the SET is 730. Compared to the previous correction of over 50% during 2008 US sub-prime crisis, the correction under the worst-case estimate is only 36%. Our worst-case of 730 appears to be relatively high compared to our peers. Reasons are as follow: 1. Less damage: Financial damage from the EU crisis is estimated to be much less

severe compared to that US sub-prime crisis. According to the IMF, financial damage from the EU problem is estimated to be Euro200billion (USD260billion) but market estimates total damage could reach Euro400billion (USD520billion) compared to USD1.4trillion during the US sub-prime crisis in 2008: on this estimate, the scale of the US problem is 3.5x larger. Some of the reasons may have to do with the fact that

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current financial leverage for financial institutions today are ‘less bad’ compared to levels in 2Q08, just before the sub-prime problems blew out (figures 3 and 4). Also the cause for the current problem lies in public debt sector where sovereign bonds holdings are concentrated among EU financial institutions whose global networks are far less extensive than those of US, thus less potential impact globally. On the other hand, the US sub-prime problem was caused by excessive consumer/commercial lending that spread out across the financial industry, making its fall-out much more severe.

Fig 3. Financial damage between subprime crisis and estimated EU crisis (PLEASE USE US SUB-PRIME IN THE CHART AND TAKE OUT WORD LEHMAN). Change everything to USD bn

Fig 4. Financial leverage between US and EU banks

0

5

10

15

20

25

30

EU US

2Q08

2Q11

Financial Leverage of Banks

Source: IMF, Bloomberg Source: IMF, Bloomberg

2. Much has been discounted: While authorities discuss about the level of haircut on Greece debts and recapitalizing banks, the market is already pricing in consequences of haircut and re-capitalization. For this reason, banks PBV is a fairly good early indicator of how much ‘bad news’ is in the market. Figure 5 shows the changes in PBV of banking sector before and after the climax in the crisis for Thailand (Tom Yam Kung - 1997), USA (Hamburger – 2008) and now EU (Spaghetti - 2011). At their worst points, Thailand PBV bottomed at 0.36x, US at 0.35x. Currently, EU banks are trading at PBV of 0.6x. From 0.6x to 0.35x is still another 40% down. But as mentioned above, the extent of the EU problem is not as severe as that of the sub-prime. Theoretically therefore, the PBV of EU banks do not have to go down as deep as that of US. But by how much?

Fig 5. PBV of banks before and after crisis: Thailand, USA and EU

Source: Bloomberg

To assess the worst point of the PBV for EU banks, we revert back to estimates on the expected financial damages and compare them with nominal size of GDP, the strength of banking system, including Thailand. Figure 6 shows that potential financial impact on EU economy is relatively marginal at 2.9% compared to 9.8% for the US. Meanwhile, EU banks have much lower leverage to begin with, so capital needs would be less severe. Although we could arithmetically estimate the fair PBV for EU banks based on the previous two crisis, we are inclined to view that PBV’s bottom would be closer to current 0.6x than 0.35x. But the longer the delay in resolving problems, the larger the size of damage will expand beyond USD520bn.

Fig 6. PBV comparison at the bottom for Thailand, USA and EU Country Thailand USA EU Crisis year 1997 2008 2011 Financial damage (USD bn) * 1,140 1,400 520 Nominal GDP (USD bn) * 4,700 14,291 17,960 Damage / GDP 24% 9.8% 2.9% Banks Asset/Equity 12.4% 12.1% 20.3% Bottom of Banks PBV (x) 0.36 0.35 0.35 - 0.6 Note: Except for Thailand in Baht currency. Source: IMF, BOT

3. Fundamentally, historically tested: In the past 10 years or since 2002 after the SET fully recovered from the balance of payment crisis in 1997, the SET has mostly traded within the PBV band of 1.5x to 2.5x (figure 7). The only time it traded below 1.5x PBV was during the 2008-2009 sub-prime crisis but we have discussed above that the severity of this crisis is expected to be much less now. We believe the 1.5x PBV level or equivalent to 812, provides fundamental support to the SET.

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40

Fig 7. SET trades mostly within 1.5x to 2.5x PBV

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

SET Index

Source: SET, KS

4. Quantitatively, historically tested: In the last 30 years of SET trading history, the index recorded bullish run of more than 100% in only 5 periods (figure 8). After such run, the average correction is 30% occurring over a period of less than 4 months. Using historical average as a guide, the correction phase should run until the end of October with low level to be tested at near 800.

Fig 8. A 30% correction after 100%+ run

0

200

400

600

800

1000

1200

1400

1600

1800

Jul-

87

Jul-

88

Jul-

89

Jul-

90

Jul-

91

Jul-

92

Jul-

93

Jul-

94

Jul-

95

Jul-

96

Jul-

97

Jul-

98

Jul-

99

Jul-

00

Jul-

01

Jul-

02

Jul-

03

Jul-

04

Jul-

05

Jul-

06

Jul-

07

Jul-

08

Jul-

09

Jul-

10

Jul-

11

SET Index

Up 368.35%, 959 Days

Up 233.31%, 1,134 Days

Up 169.73%, 294 Days

Up 140.87%, 455 Days

Up 202.14%, 980 Days

Down 53.03%, 126 Days

Down 33.67%, 77 Days

Down 33.75%, 119 Days

Down 25.92%, 126 Days

Down 24.87%, 65 Days

Correction's days = 25 days

Source: Bloomberg, KS

5. Brokers’ portfolio has been halved: The increased in SET volatility has also been

contributed by action from brokers’ trading desks. Total size of brokers’ portfolio (including only those that are listed which would account for most of proprietary trades anyway) is estimated to be Bt9bn as of the end of 2Q11. Based on the trading history since then, we expect that total value of trading position on their books would have declined to about Bt4bn. This is still significant and can provide strong downward pressures on bad days. Nonetheless, they also indicate the level of appetite when the market turns more positive.

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Fig 9. Less room to sell from brokers’ portfolio

0

2000

4000

6000

8000

10000

12000

14000

800

850

900

950

1000

1050

1100

1150

1200

30-J

un-1

1

07-J

ul-1

1

14-J

ul-1

1

21-J

ul-1

1

28-J

ul-1

1

04-A

u g-1

1

11-A

u g-1

1

18-A

u g-1

1

25-A

ug-1

1

01-S

e p-1

1

08-S

e p-1

1

15-S

e p-1

1

22-S

ep-1

1

29-S

e p-1

1

SET Port value (RHS)

Source: SET, KS

Selective on sector We are revisiting our worst-case scenario discussion to explore potential downside risks and opportunities for the different sectors with results shown in figure 10. As we believe the market will see days of panic in the coming weeks and some of the strong sectors whose business have limited impact will provide window to accumulate shares. We re-iterate our preference for the defensive, consumer related stocks including utilities and ICT. Their downside risks in terms of share prices and earnings impact are much less limited compared to others. Fig 10. Impact on 2012 earnings forecasts and fair price

Agribusiness

Automotive

Banking

CommerceCommercial

Construction Materials

Electronics

Energy

Coal

E&P

Oil&Gas

Refinery

UtilitiesHealth Care

ICT

Insurance

Media

Petrochemical

Industrial Estate

Residential

Securities

Shipping

Tourism

Transportation

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

-70% -60% -50% -40% -30% -20% -10%

EPS Change (%)

Fair Price Change (%)

Source: KS

KS’ Portfolio We Upgrade Utilities to Neutral and downgrade shipping sector to Underweight from Neutral. We believe defensive stocks will perform better in uncertain market conditions. Our top picks have also been selected to avoid companies that are expected to suffer from the floods. Note that in the near term, none of the company will be able to avoid the consequences from floods, but consumer related stocks are expected to see rebound in business once normalcy returns. We will be following up on the impact from floods later in our daily reports.

We are dropping PS from our stock pick list this month and adding LPN because of the latter’s stronger growth prospects. Other stocks include: BBL ADVANC CPF MAJOR HMPRO CENTEL BGH LPN STEC and AMATA.

Fig 11. KS’s portfolio Sector Current Weight Previous Wt Recom. Top Recommended from Aug 8 / Sector Wt. Picks Banking Neutral Neutral 22.1% BBL Insurance Neutral Neutral 0.9% BLA Food & Agro Overweight Overweight 6.1% CPF Automotive Neutral Neutral 0.1% SAT Petrochemical + SCC Underweight Underweight 5.8% PTTCH Energy Neutral Neutral 31.8% Coal Neutral Neutral 2.5% BANPU E&P Neutral Neutral 8.0% PTTEP Integrated Neutral Neutral 13.3% PTT Refinery Neutral Neutral 4.7% TOP Utilities Neutral Underweight 3.4% GLOW Property Overweight Overweight 6.1% Contractor Overweight Overweight 0.6% STEC Industrial Estate Overweight Overweight 0.9% AMATA Residential Overweight Overweight 3.7% LPN Commercial Underweight Underweight 0.9% CPN Commerce Overweight Overweight 8.8% MAKRO, BIGC Healthcare Overweight Overweight 2.8% BGH Media Overweight Overweight 2.3% RS Securities Underweight Underweight 0.2% KEST Tourism + MINT Neutral Neutral 0.8% CENTEL Transport & Shipping Underweight Underweight 0.2% Shipping Underweight Neutral 0.2% PSL Transportation Underweight Underweight 0.0% Electronics Underweight Underweight 0.4% SVI ICT Overweight Overweight 11.7% ADVANC Total 100%

Source: KS

4242

42

4343

43

Fig 12. KS sector valuations Rating

2010 earnings 10 11E 12E 10 11E 12E 10 11E 12E 10 11E 12E 10 11E 12EAgribusiness & Food 307 O 4.1 46.5 19.2 19.6 8.3 16.7 11.7 10.3 2.9 2.3 2.0 3.7 4.3 4.7 18.9 21.8 20.6Banking 1,058 N 14.2 66.8 10.5 23.0 15.8 12.0 9.1 7.8 1.4 1.3 1.2 3.2 3.9 4.4 12.6 15.0 15.7Construction Materials 318 U 4.3 67.9 53.5 -0.6 6.3 11.9 8.6 8.0 2.0 1.7 1.5 4.7 5.1 5.5 18.4 21.4 19.5Petrochemicals & Chemicals 174 U 2.3 95.6 39.4 103.9 6.4 17.0 7.0 6.7 1.4 1.3 1.1 3.4 7.4 8.5 8.8 19.3 17.9Contractors 33 O 0.4 43.2 127.7 254.0 -98.0 n.m. n.m. n.m. 1.5 1.5 1.5 1.3 2.2 1.0 -9.9 -4.1 0.1Commerce 435 O 5.9 24.6 20.3 8.4 21.2 30.1 23.8 19.7 7.1 6.2 5.5 2.5 2.8 3.5 24.1 27.8 29.6Commercial 72 O 1.0 26.3 -77.2 89.3 53.1 46.5 33.8 22.1 3.8 3.5 3.1 0.8 1.2 1.8 8.2 10.8 15.0ICT 591 U 7.9 20.8 30.3 -26.5 19.9 19.4 16.2 14.3 4.3 3.8 3.8 8.0 7.3 9.1 20.4 24.8 26.6Insurance 51 N 0.7 75.4 135.8 64.2 24.4 18.3 11.2 9.0 4.8 3.5 2.7 1.4 2.2 2.8 31.2 36.3 33.8Electronic 47 U 0.6 59.5 50.3 -18.4 8.9 6.1 7.1 6.4 1.2 1.1 1.0 8.5 7.6 8.3 21.0 16.4 16.5Energy & Utilities 1,897 N 25.5 59.6 29.5 25.4 8.0 11.9 8.0 7.2 1.7 1.6 1.4 3.9 5.1 5.6 15.3 20.4 20.4Media & Publishing 116 O 1.6 35.9 27.8 10.1 11.1 18.7 16.1 14.5 4.6 4.4 4.3 5.0 5.8 6.4 25.3 28.1 30.0Securities 23 U 0.7 58.3 85.9 -18.0 -16.8 5.9 7.1 7.7 1.2 1.2 1.1 14.1 12.3 11.7 20.5 16.3 14.9Health Care Services 139 O 1.9 16.9 -8.5 23.6 20.1 33.4 23.4 18.4 5.6 3.4 3.1 1.3 2.1 2.8 17.5 18.1 17.5Tourism 48 U 0.6 29.9 27.1 255.6 -4.9 52.2 18.7 15.5 2.2 1.8 1.8 1.2 2.6 2.6 4.4 10.4 11.4Residential 183 O 2.5 49.8 10.2 12.1 9.7 10.6 9.6 8.1 2.0 1.7 1.6 5.5 5.5 6.2 19.6 19.2 20.3Industrial Estate 45 O 0.6 77.0 65.1 -8.8 58.0 11.5 11.4 7.3 1.5 1.4 1.2 5.0 5.4 8.0 13.7 12.7 17.6Transportation 108 N 1.5 46.6 69.2 -83.9 351.9 16.5 13.2 8.0 0.6 0.6 0.6 4.2 3.0 5.3 4.1 4.7 7.5Shipping 25 U 0.3 50.7 -65.0 -15.5 82.7 46.8 60.6 11.8 0.6 0.6 0.6 4.3 3.8 5.5 1.2 1.0 4.9Automotive 6 N 0.1 89.2 116.4 0.6 25.5 8.3 8.1 6.5 1.5 1.3 1.2 4.9 3.7 4.6 21.4 17.5 19.4SET KS 5,676 76.4 52.8 24.9 12.5 12.9 14.1 10.2 8.9 1.9 1.7 1.6 4.1 4.8 5.5 14.3 17.9 18.4SET KS Ex - Financials 4,567 61.4 49.3 28.7 10.0 12.2 14.8 10.5 9.2 2.1 1.9 1.7 4.3 5.0 5.8 14.7 18.8 19.3

SET KS Ex - Energy 3,780 50.8 49.4 23.3 7.6 16.8 15.6 11.7 10.0 2.0 1.8 1.7 4.2 4.7 5.5 13.7 16.4 17.3SET 7,435

ROE (%) Mkt Cap (Btbn)

% Wt / SET

PBV (X)% Up / Down

MoM chg.Sector

EPS Growth PER (X) Yields (%)

Source: KS U – Underweight, O – Overweight, N – Neutral As of 7th October 2011

Fig 13. 2011 sector valuation Fig 14. 2011 Consensus earnings changes

Agri&Foods

Banking

Const.Materials

PetrochemicalsCommerce

Commercial

ICTInsuranceElectronic

Energy

SecuritiesTourism

Residential

Shipping

Automotive

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

10 15 20 25 30 35 40

PER / EPS Growth

ROE (%)

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Bank Energy Fin & Sec ICT Petrochem Property

-1 M -3 M( % )

Source: KS Source: Bloomberg

Fig 15. 2011 country valuations Fig 16. SET PER discount to region

HongKong 8/11%

Indonesia 11/19%

Malaysia 11/15%

Philippines 11/13%

S. Korea 8/15%

Taiwan 11/19%

Thailand 9/14%

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

10 12 14 16 18 20 22

PER / net Income Growth (%)

ROE (%)

0

10

20

30

40

Jan‐07

Apr‐07

Jul‐0

7

Oct‐07

Jan‐08

Apr‐08

Jul‐0

8

Oct‐08

Jan‐09

Apr‐09

Jul‐0

9

Oct‐09

Jan‐10

Apr‐10

Jul‐1

0

Oct‐10

Jan‐11

Apr‐11

Jul‐1

1

Oct‐11

SET PER

Regional PER

‐60%

‐40%

‐20%

0%

20%

Jan‐07

Apr‐07

Jul‐0

7

Oct‐07

Jan‐08

Apr‐08

Jul‐0

8

Oct‐08

Jan‐09

Apr‐09

Jul‐0

9

Oct‐09

Jan‐10

Apr‐10

Jul‐1

0

Oct‐10

Jan‐11

Apr‐11

Jul‐1

1

Oct‐11

Source: Bloomberg consensus Note: Country PER, EPS Growth, As of 7th October 2011

Source: Bloomberg

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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44

KBank Multi Asset Strategies oct 2011 (English)

Business

oil fund levies

libor ois

refinery plant

overnight

huge public

private sector

expansionary

equity risk