Monday, 14 May 2018

Macro and Credit - The Superposition principle

"The highest ecstasy is the attention at its fullest." - Simone Weil, French philosopher

Watching with interest the Wilson cycle playing in earnest on some various Emerging Markets, leading to additional significant fund outflows in the process, with effectively our previously discussed reverse osmosis theory playing out on some weaker EM players, when it came to selecting our title analogy, we reminded ourselves the "Superposition principle" from physics and systems theory. It states that, for all linear systems, the net response caused by two or more stimuli is the sum of the responses that would have been caused by each stimulus individually. So that if input A produces response X and input B produces response Y then input (A + B) produces response (X + Y). The homogeneity and additivity properties together are called the "Superposition principle". Also, wave interference is based on this principle.  When two or more waves traverse the same space, the net amplitude at each point is the sum of the amplitudes of the individual waves. In some cases, such as in noise-cancelling headphones, the summed variation has a smaller amplitude than the component variations; this is called destructive interference. In other cases, such as in Line Array, the summed variation will have a bigger amplitude than any of the components individually; this is called constructive interference, which one could imply it could be the situation for some specific Emerging Markets countries currently facing tremendous pressure from rising US interest rates and in conjunction with the recent surge of the US dollar but we ramble again...

In this week's conversation, we would like to continue to look at the outflows from some Emerging Markets and the consequences of the global tightening financial conditions we are seeing thanks to the Fed's rate hikes in conjunction with its Quantitative Tightening (QT) process.

Synopsis:
  • Macro and Credit - Balance of Payments pressures in some EMs are building up
  • Final charts - Flatter for longer 


  • Macro and Credit - Balance of Payments pressures in some EMs are building up
In our previous conversation we touched on the fact that for some macro tourists which had extended their stay in the carry trade that, the tourist trap was closing. QT to some extent is leading to the weaker leveraged hands being blown apart it seems. After the explosion of the house of straw of the short-vol pigs, it seems to us that next on the line, given the intensity in fund outflows and pressure on some EM currencies will be some of the "usual suspects" such as Turkey, Argentina to name a few. The global tightening of financial conditions has indeed been induced by the Fed with its hiking process in conjunction with QT. In similar fashion to the "Superposition principle", this process seems to be homogeneous and additive. As the noose of financial conditions is slowly tightening, the pressure is showing up in earnest in the weaker part of the "global capital structure", namely some leveraged EM countries. For some indeed, there is some risk of balance of payments crisis à la 1998 it seems as pointed out by Nomura in their Emerging Market Insights note from the 11th of May entitled "Looming balance of payment risks in EM":
"The pressure is building for several central banks to hike rates sooner than we thought
On 9 May, Argentina requested financing from the IMF to avoid a crisis. This came after the central bank hiked policy rates to 40% in response to the Peso’s sharp depreciation. From Turkey to Indonesia, the one-two punch of rising US rates and USD appreciation is leading to a rising market risk premium in EM countries whose the balance of payments (BOP) is vulnerable. EM central banks are responding by allowing some exchange rate flexibility (i.e., depreciation) and some FX intervention, but if BOP pressures intensify, policy rate hikes may be needed. Our country economists have considered the likelihood of earlier and/or larger rate hikes this year relative to their base cases if BOP pressures continue to build, and the central banks that stand out are Romania (+25bp), India (+50bp), Indonesia (+50bp), Chile (+75bp) and most notably, Turkey (+300bp).
Balance of payments vulnerability
The trio of higher US bond yields, USD appreciation and rising oil prices has led to some market repricing of balance of payment (BOP) risk – e.g., large current account deficit, high short-term external debt, limited buffer of FX reserves – resulting in capital outflow pressure. A scatter plot of current accounts against local currency moves against USD since the start of the year highlights that, with the exception of Russia, EMs with large current account deficits have generally experienced large currency depreciations (Figure 1).
The amount of local government debt owned by foreign investors and the share of corporate debt denominated in foreign currencies are also under close scrutiny (Figure 2).

Our house view is that the weak economic data outside the US represents a temporary soft patch and that market concerns over global growth desynchronising (rising in the US, but falling elsewhere) will soon fade, which should help temper USD appreciation (see Asia Economic Monthly, One step at a time, 11 May 2018).
However, even if we are right that global growth is holding up, this is likely to be only a brief respite for EM. In our mind, Q3 2018 is the high-risk quarter for a painful EM snapback, as this is the quarter in which markets will likely focus not just on the US but a global QE unwind, which could lead to a larger repricing of EM risk premia and the evaporation of market liquidity. Moreover, George Goncalves, our US rate strategist, is warning that, as US inflation rises, UST debt supply balloons and the Fed keeps hiking, there is an upside risk of a bearish overshoot relative to his base case of UST 10s hitting 3.25% in Q3 (see Global macro trade ideas in summer 2018, 2 May 2018).
The US decision to exit the Iran nuclear deal and reinstate sanctions (see US to withdraw from Iran Nuclear Agreement, 8 May 2018) has increased the risks of instability in the Middle East and further oil prices increases (Figure 3).
This could further widen the twin current account and fiscal deficits of large net energy importers – Turkey, India and the Philippines (see Higher oil prices drive EM divergence, 25 April 2018). Q3 will also be around the time that President Trump is likely to double-down on America First policies, such as trade protectionism, ahead of November mid-term elections.
Overall, while there may be a brief, near-term respite, there is a risk that BOP pressures in EM continue to build and possibly intensify in coming quarters. We updated our BOP risks scorecard of 20 EM economies that we introduced in our anchor report (see In an EM snapback, where do the risks lie?, 23 March 2018). Of the 20 EMs, the most exposed to BOP risks are Hong Kong, Romania, Hungary, Turkey and Chile, and for varying reasons (Figures 4 and 5).

For example, Hong Kong’s exposure is due to its massive cumulative capital inflows since 2010 and low interest rate compensation for BOP risk; in Romania and Turkey, it is because of their large current account deficits and low FX reserves; in Hungary it is due to high external debt and relatively low FX reserves. The least-exposed countries to BOP risk are Singapore and Taiwan, according to our scorecard.
We acknowledge that there are a host of country-specific factors (beyond variables that we use for scorecard; current account, FX reserves, external debt, cumulative portfolio flows, real interest rates and interest rate differential) that can also impact EM, most notably geopolitics and domestic politics. For example, the Russian Ruble (RUB) and Brazilian Real (BRL) depreciated against USD by 8.8% ytd and 7.9%, respectively, despite showing lower BOP risks in the scorecard.
Policy response to balance of payment pressures
Those EM central banks facing BOP pressures are mostly responding to in an eclectic manner (see First Insights - Turkey: Core problem, 3 May and Asia Insights - IDR: Challenging flow backdrop amid global risks, 9 May). They are allowing for some exchange rate flexibility (i.e., depreciation) and some FX intervention (drawing down FX reserves), but if BOP pressures intensify, these initial policy responses may become constrained. For example, the larger the currency depreciation the greater the risk of an inflation overshoot and a foreign currency debt mismatch problem or, if FX reserves are drawn down too far, the market may lose confidence in the ability of authorities to defend the exchange rate.
If BOP pressures mount, policymakers could shift to more draconian responses, such as interest rate hikes, tapping central bank FX swap lines, borrowing from the IMF (or in Asia, utilising the Chiang Mai pooled FX reserve initiative), tightening fiscal policy or, in the extreme case, imposing capital controls.
Our country economists have focused on the possible interest rate response. They have considered, on the assumption that BOP pressures continue to build (and oil prices stay at these levels or go higher), the likelihood of earlier and/or larger policy rate hikes over the rest of this year relative to their current base cases (Figure 6).

This “what if” exercise highlights that, if BOP pressures continue to build, there is a 50% or higher likelihood that we will need to build more rate hikes into our base case forecasts for  Romania (+25bp), India (+50bp), Indonesia (+50bp), Chile (+75bp) and most notably, Turkey (+300bp). The likelihood is lower, but if we added rate hikes in Brazil and Chile, it would be several, not one and done. Also, instead of our current base case forecasts of rate cuts by year-end, if BOP pressures continue to build, it could be that we have rates on hold (Colombia, Mexico and South Africa)." - source Nomura
We agree with Nomura that the trio of higher US bond yields, USD appreciation and rising oil prices has led to some market repricing of balance of payment resulting in capital outflow pressure (what we called in our last musing as a reminder "reverse osmosis"). "Reverse osmosis" as well as QT make more and more the front-end of the US risk curve appealing from a risk management perspective and ensures as well US dollar cash is back in the allocation tool box. Furthermore, as Renaissance Macro pointed out on their Twitter feed, when it comes to the 2013 Taper Tantrum comparison, this time it's different when it comes to current account deficits:

"A more hawkish Fed is a risk for emerging markets, but for most EM economies, current account positions have improved relative to the 2013 taper tantrum year, Argentina being a notable exception." - source Renaissance Macro
Argentina of course continues to be in the line of fire with FX reserves being burn rapidly to support currency woes. It is always the leverage players who blow up first when financial conditions are gradually tightening with Fed's hikes and QT. No surprise as well to see Turkey in the crosshair facing the Superposition principle. This is clearly highlighted by David Goldman again in Asia Times in his comment from the 11th of May entitled "Buy ruble, sell Turkish lira":
"After two sets of emergency conferences with economic leaders and Turkey’s ebullient president, the Turkish lira dropped from a peak of 4.38 to the dollar to 4.23 this morning, before weakening back to 4.25. Turkey’s economic problems remain insoluble: The Turkish economy is a credit-fueled bubble with a growing current account deficit and dangerous dependency on short-term capital inflows and interbank borrowings.
As Swaha Pattanik wrote this morning at Reuters, “Turkey’s president is pursuing contradictory goals. Tayyip Erdogan wants to support the sagging lira. That would require measures to curb inflation and the current account deficit. However, his efforts to pump prime growth, especially before June elections, will achieve the exact opposite.”
The ruble is a different story. The political threat of sanctions against Russia caused the currency to collapse from a low of 57 to the dollar on April 1 to a high of 64 to the dollar on May 2. Since then it has rallied a bit, trading at 61.7 at noon EST on May 10. The ruble is a pretty good proxy for the price of oil (the r-squared of regression of the ruble on the oil price since 2010 is around 93%).
As the chart above shows, regression analysis of the ruble vs oil puts the Russian currency three standard errors away from the regression line. The currency’s fair value vs oil is around 50. Sanctions against Russia are not likely to continue (Washington wants Russia’s cooperation in keeping the Iranian genie in the bottle). They will be flouted in any event by the Europeans, whose trade with Russia is a multiple of Russian-US trade. The market vastly overreacted to US sanctions, and the ruble’s cheapness continues to represent a buying opportunity." - source Asia Times - David Goldman
Not only is the Russian currency attractive, but we would contend that local currency bonds also are enticing from a yield perspective, so what's not to like about them? And if you believe in a commodity "rebound" thanks to rising inflation expectations why not buying what is cheap in terms of PE? Russian equities are relatively cheap and offer decent dividend yields as well we think.

What we think we are seeing in Emerging Markets is similar to what we are seeing in High Yield, namely a rise in "dispersion", which means in effect some investors are becoming more discerning when it comes to reassessing "credit risk" and issuer profiles on the back of a weaker "global market put" provided by central bankers. This rise in dispersion means that everything is not rising anymore in synchronized fashion thanks to massive liquidity injections given now it is being gradually withdrawn. As we pointed out recently in various musings, this could mean that some active players could potentially start outperforming again passive strategies. This also mark we think the return of the global macro game thanks to volatility being less repressed by the central bankers/planners as of late. 

From a fund outflows and risk perspective, for a continuation of pressure on the weaker links in the EM segment, the direction of yields and the US dollar matters for the pressure to continue or subside somewhat as far as the Superposition principle is concerned. On that subject we read with interest Deutsche Bank's take from their 9th of May note entitled "EM Flows and Risk Sentiment: Outflows, but size still contained":
"The EM Flow Indicator (chart below) shows that outflows are emerging – the last two weekly prints have been negative (indicating outflows from EM).

The last time there were two consecutive weekly outflow prints was in Dec 2016, thus this is a significant development. However, the size of outflows remains relatively contained, with the magnitude of the flow indicator nowhere near as stretched as in late 2016. Therefore, it is likely that the recent sharp EM FX depreciation has been driven more by FX hedging of EM assets held by foreign investors, rather than the outright selling of these assets (which would have triggered larger outflows). This remains the main risk for EM – the potential transition from FX hedging to outright outflows – but would require continued significant dollar strength and rising US yields. Over the coming weeks, the EM flow data will take on even greater importance, as it could provide a signal on whether we transition from phase 1 of the EM FX sell-off (FX hedging) to phase 2 (outright asset sales).
[Note that the indicator captures flows normalized by the standard deviation, with values greater than +0.5 indicating sizable inflows and values less than -0.5 indicating sizable outflows.]
The EM Risk Monitor – an EM-specific measure of risk sentiment – has entered risk negative territory, but is by no means stretched. This indicates that if external conditions remain unfavourable (e.g. continued broad dollar strength) there is potential for more negativity in EM sentiment.
The additional charts below show that both debt and equity flows have dipped into negative territory; but the magnitude of outflows remains relatively contained. Meanwhile, the charts displaying the raw flow data by source show outflows on IIF (local source) data, but flat flows on EPFR (ETF + mutual funds) data.
- source Deutsche Bank

Of course as the Superposition principle goes, it is contained when it comes to outflows until it isn't . Continued capital outflows pressure could lead to more pronounced "derisking". We highlighted in our last musing how hedge funds had already cut on their beta exposure in EMs. It remains to be seen with continued pressure on yields and in particular the US front-end how long this stability will last. 
This is Barclays take on the recent bout of EM volatility from their The Emerging Markets Weekly note from the 10th of May entitled "After the volatility eruption":
"Pressures on EM assets have accelerated over the past week. And although improved market sentiment fueled a relief rally on Thursday, concerns of a negative performance - outflow loop, which we discussed in the EM weekly: No spring in EM’s step last week appear to remain very much alive. While the market has focused on countries with external vulnerabilities and financing needs, especially Argentina and Turkey, market volatility has significantly broadened in scope over the past few weeks. This has evoked memories of the 2013 taper tantrum, as investor concerns have been centred on higher UST yields and tighter USD funding conditions, coupled with a painful parallel strengthening of the USD.
More granularly, we see four issues as having driven the weaker risk appetite in EM asset markets: (1) signs of softening activity relative to expectations; (2) increased risks of supply side shocks (eg. oil/Iran and trade protectionism); (3) the cascading sharp selloffs in some heavily-owned EM asset markets likely causing some investors to breach their risk limits; and (4) the correlation between EM credit spreads and US rates having turned positive (ie. higher UST yields being aligned with wider spreads) – a pattern usually only observed in periods of sharp UST adjustments. The last point, especially, illustrates the resemblances of the current sell-off with the taper tantrum.
However, we also think that there are important differences to 2013. Although it is difficult to see where the upside surprises in activity or a reduction in supply side shock risks will come from in the near term, we think EM fundamentals provide some buffers against a period of flow retrenchment. EM growth is stronger now than in 2013 and current account deficits in most market-relevant EM countries are smaller than they were in 2013 – with some notable exceptions (Figure 1).

And while EM debt levels are generally higher (Figure 2), EM countries have used the favourable issuance environment over the past few years to lengthen maturity profiles.

For example, the share of newly issued EM sovereign and corporate eurobonds with a tenor of 15 years or longer has increased significantly over the past few years (Figure 3), while near-term maturities have in many cases been addressed pro-actively via early buybacks/tenders.
We think that these buffers make it possible that, eventually, the negative cycle can be broken. In EM credit, flows should be supported by a pick-up in redemptions in June/July and the self-regulatory effect of supply, which we would have expected to slow down in any case after the record pace in Q1 18. Moreover, the recent underperformance of EM versus rating-and-maturity matched DM credit (see the Global EM Credit Monitor, 8 May 2018) has reversed the relative richening of EM in the early weeks of 2018 (Figure 5).

While EM is still not cheap relative to DM based on historical ranges, this should provide an eventual anchor for crossover sponsorship.
More generally, cheapening in the EM asset class may help normalize spread-rates correlations, when portfolios have fully adjusted to the higher levels of market volatility. This would support a technical retracement of EMs, absent additional idiosyncratic risks developing in key markets. We note that alongside the modest cheapening in EM credit, local rates have cheapened as well (Figure 6) but spreads vs. UST (on an FX hedged basis) remain shy of the midpoint of historical averages.

This is because much of the selloff in EM local rates has been driven by a weaker FX (Figure 7), which is now approaching lows after  stripping out their relation with broader asset market variables (Figure 8).

Therefore, we see greater opportunities to express near-term constructive views on EM FX than local rates if position reduction and the USD rally take a breather. We hit our stop loss in our long HGB October 2027 and long SAGB February 2048 positions but FX-hedging in the case of the former was able to more than offset for the loss on the local bond position. We do think there is scope for a near-term EM FX retracement and see value in short USDZAR through options.
However, a more lasting recovery may require increased investor confidence in a pick-up in EM fundamentals, a dovish shift by core market central banks (or a shift in investor perceptions of the likely path of core rates) and/or a reduction in global risks. The decision of the US to withdraw from the Iran nuclear deal does not suggest that a reduction in global geopolitical risks is imminent. President Trump was widely expected to withdraw from the Iranian nuclear deal but his announcement was one of the most hawkish options we previously discussed (Iran Special Report: Trump and the Art of (Breaking the Iran) Deal, 8 May 2018). Leaving the JCPOA may not only ultimately increase transatlantic tensions as many European companies have signed contracts to increase investments in Iran, but geopolitical risks in the Middle East will equally be on the rise. The recent escalation between Israel and Iran in Syria is perhaps the most concerning near-term risk which may be exacerbated by tensions with Saudi Arabia and the Yemeni conflict.
At a country-specific level, the market’s focus has been on Argentina and Turkey, as well as elections in Asia and the ongoing NAFTA negotiations involving Mexico.
The dramatic change in sentiment in Argentina has exposed its vulnerabilities given its large financing needs and twin deficits. In an effort to prevent a sharper weakening of the exchange rate, the central bank hiked the policy rate in three out-of-cycle decisions by a total of 1275bp, taking it to 40%, alongside other measures including interventions in FX markets. A stabilization of the exchange rate remains vital to the macroeconomic outlook with a high level of pass through into inflation. The government has sought to reassure markets by also announcing a more ambitious primary fiscal target for 2018 of 2.7% of GDP (down from 3.2% of GDP), which we think can be met, and which will also make the 2019 target of 2.2% of GDP attainable. Finally, as the ARS continued to selloff this week, the government announced its intention to enter into negotiations with the IMF for a high-access stand-by agreement. The program is meant to be precautionary but is planned to secure Argentina’s 2019 financing needs. It remains to be seen how stringent the conditionalities imposed by the IMF program will be but it remains crucial to assess the impact on the short-term macroeconomic outlook, as well as its longer-term political costs for the Macri government. With regards to the latter, the government has sought to allay concerns by expecting fiscal targets to be similar to the current official ones.
We think that geopolitical risks expose Turkey’s external vulnerabilities against a backdrop of rising USD funding costs and increasing concerns about EM capital inflows’ outlook (25% of Turkish banks’ liabilities are foreign and gross external financing needs are c.20% GDP). This, accompanied by the market's perception of the CBT being behind the curve amid a deteriorating inflation narrative and de-anchored medium-term inflation expectations, has amplified the pressures on Turkish assets. Nevertheless, as discussed in Turkey MPC Preview: Early elections strengthen the case for a hike, 18 April 2018, the early elections also increased the desire of politicians for a stable TRY, as indicated in Wednesday’s economic coordination council (ECC) meeting chaired by President Erdogan and the statement that followed. The CBT could come under pressure again going into the 7 June MPC meeting and any decisive action could provide a temporary backstop for Turkey assets." - source Barclays
For now the markets is playing the dispersion game even in US high yield. The CCC energy bucket in US high yield is of course benefiting from rising oil prices leading to a significant recent rally in the high beta space. But, as the Superposition principle goes no offense to the "contained crowd", problems can be additive it seems given flows follow performance usually for some "usual suspects" in the EM world...

When it comes to investor becoming more discerning risk wise hence the rise in dispersion, this is most likely due to the gradual fading of the powerful anesthetic provided by central banks and more importantly the Fed during so many years. While we keep indicating that we are moving in the final innings of this long credit cycle, though we do see cracks showing up in the goldilocks narrative which has prevailed for so long, we still haven't reached the end of the game and still remain short term "Keynesian" for various technical reasons such as prolonged buybacks activity, US tax reform and record earnings and strong M&A activity to name a few. The perma bear crowd will eventually get their day, but we still haven't gotten to that point yet we think. In our final point below we touch on the pace of the flattening of the US yield curve, being an important topic in these days and ages.

  • Final charts - Flatter for longer 
Given the gradual hiking pace followed by the Fed, on the back of still loose financial conditions has indicated by the most recent Fed quarterly Senior Loan Officer Opinion Survey, this is not playing out like the previous rapid hiking pace of the Fed of the 2004 period. Therefore, the flattening process will take a little bit longer to play out before we see the dreaded inversion so many financial pundits are talking about. Our final charts comes from Bank of America Merrill Lynch Securitized Products Strategy weekly note from the 11th of May and indicates that the inversion of the curve necessary to display a recession signal may take indeed a while to manifest itself:
"The ongoing flattening of the yield curve to post-crisis lows – the 2yr-10yr spread hit 43 bps this week – continues to elevate concerns among some that recession is on the verge of being signaled. For example, (dovish) St. Louis Fed President Bullard said “yield curve inversion is getting close to crunch time” and that “yield curve inversion would be a bearish signal for the US economy if that develops.” From our perspective, the key part of that quote is “if that develops:” 43bps may be closer to curve inversion than before, but it is still not inverted.
As Chart 1 shows, yield curve inversion has been relatively rare over the past 30 years, occurring briefly in 1989, 2000, and 2006, about 12-18 months in advance of the recessions of July 1990-March 1991, March 2001-November 2001, and December 2007-June 2009. We find the 1995-2000 timeframe in Chart 1 especially noteworthy.

The average 2yr-10yr spread over the 5-year period was 35 bps, flatter than today’s level of 43 bps, yet it was only when the curve finally inverted in early 2000 that the 2001 recession was ultimately signaled. The point here is that the curve may have flattened substantially, but, by the standards of the late 1990s, it’s nowhere near the level that it is signaling recession.
Another way of saying this is: “it may be late cycle, but it’s not end of cycle.” We think this distinction is important when it comes to recognizing that securitized products spreads may have at least a couple more years of tightening ahead of them, in a grind lower; in our view, meaningful spread widening is not expected until the cycle comes to an end. We don’t expect this to happen until at least 2020-2021. We are waiting for curve inversion as the first signal that the cycle will be ending. The lesson of the late 1990s is that inversion could take much longer to experience than some or many might expect.
Next, we consider interest rate volatility, as measured by the MOVE index in Chart 2.

Most of the spike in late January/early February has been retraced and volatility is back near the all-time lows seen in late 2017. Given the flattening move in the yield curve, we suspect that new lows in the MOVE index will be seen in the near term.
As seen in Chart 3, in the past two late cycle curve flattening environments (1990s, 2000s), interest rate volatility generally grinded lower as the yield curve flattened/inverted and only increased when the curve began to steepen. In the 2005- 2007 period, for example, as the curve flattened and then inverted, rate volatility moved steadily lower.

For example, the MOVE index went from 75 in May 2005 (about the time the 2yr-10yr spread was near today’s level of 43 bps) to a low of 59 bps in May 2007, when the yield curve had flattened to -3bps. (In the subsequent seven months, as the 2yr-10yr spread went from -3 bps to 120 bps, volatility more than doubled, with the MOVE index jumping to 145 by December 2007.)
We’re looking for similar late cycle behavior this time around. Following the yield curve flattening lead, the MOVE index appears poised to head to new post-crisis lows over the near term." - source Bank of America Merrill Lynch
One caveat is that the Superposition principle when it comes to Argentina has shown sentiment can indeed turn on a dime, or simply a rising US dollar. When it comes to credit markets and high beta, for "goldilocks" to return in the short term, lower rate volatility does indeed help out carry players and yield hogs alike. Yet, one would be wise to start using even at least partially the new tool in the tool box, namely cash in US dollar thanks to the front-end of the US yield curve. It has become more and more enticing relative to dividend yields as of late but we ramble again...

"Attachment is the great fabricator of illusions; reality can be attained only by someone who is detached." -  Simone Weil
Stay tuned!

Saturday, 5 May 2018

Macro and Credit - The Wilson cycle

"Economic progress, in capitalist society, means turmoil." -  Joseph A. Schumpeter


Looking at the growing outflows in the Emerging Markets hard dollar bond funds universe and with the Mexican Peso and Turkish currency taking a correlated pounding, when it came to selecting our title analogy we decided to go for a seismic one such as The Wilson cycle, given we are wondering if indeed following the short-vol pigs house of straw blow up, we are wondering if the house built by the "carry tourists" pigs is next on the line. The Wilson cycle is a model where a continent rifts, from an ocean basin in-between, and then begins a process of convergence that leads to the collision of the two plates and closure of the ocean. Obviously, Quantitative Tightening initiated by the Fed, one might opine, is leading to the closure of the "ocean of liquidity". The model is named after its originator John Tuzo Wilson. Emerging Markets have been impacted by the return of US rates into positive real yields territory as we argued in our conversation "Osmotic pressure" back in August 2013 during "Taper Tantrum":
"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013
The mechanical resonance of bond volatility in the bond market in 2013 started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:
"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment."

Of course, what we are seeing right now in Emerging Markets is the continuation of "reverse osmosis" but we ramble again...

In this week's conversation, we would like to look at the potential blow-up of the carry trade, and the pressure it is putting on specific Emerging Markets such as Mexico and Turkey. If indeed the short-vol pigs house of straw was the first casualty, one might wonder if after the little fishes, some larger whales might turn up "belly up" thanks to QT and reverse osmosis.

Synopsis:
  • Macro and Credit - Allocate to cash in US dollar because the tourist trap is closing 
  • Final chart -  Dude where is my raise?


  • Macro and Credit - Allocate to cash in US dollar because the tourist trap is closing 

The "Tourist Trap" (a tourist trap being an establishment, that has been created or re-purposed with the aim of "attracting tourists" and their money), is in effect closing, hence our "Wilson cycle reference given we are facing a dwindling "ocean" of liquidity. In our previous conversation we indicated that cash has made a return in the allocation tool box. We do think that while cracks have starting to show up in the credit narrative, pointing to a slow turn in the credit cycle, we are closely looking at what is happening right now in Emerging Markets. We are wondering if indeed the next shoe to drop following the short-vol explosion will not be an unwind in the "carry trade". 

On the subject of additional "canaries" showing up in the credit "coal mine" we would tend to agree with our former esteemed colleague David Goldman's recent post in Asia Times from the 2nd of May entitled "Canaries start to die in coal mine":
"Emerging market carry currencies are the financial assets most sensitive to tightening of global financial conditions — the proverbial canaries in the coal mine. The near-perfect correlation between the Mexican peso and the Turkish lira during the past two weeks strongly suggests that a global shift out of highly-levered assets has begun, starting with the most exposed assets.

There are political problems bearing on both TRY and MXN, to be sure, but they are entirely different; MXN doesn’t care about Syria (the currency is positively exposed to oil prices in a small way), while TRY doesn’t care about the NAFTA negotiations. Mexico does most of its trade in dollars with North America, while Turkey does most of its trade in euros with the EU.
The fact that they have traded in virtual lockstep suggests that the problems that afflict each country separately have little to do with the trading patterns of the past couple of weeks. A global monetary phenomenon — a general tightening of credit conditions — appears to have begun at the weakest point in the credit system." - source David Goldman - Asia Times
You probably understand more about our "tectonic" reference pointing towards the closing of an ocean of liquidity where macro tourists have been basking in recent years. We are closely watching outflows in Emerging Markets given they have been significant as indicated by Bank of America Merrill Lynch GEMs Flow Talk note from the 4th of May entitled "EXD bleeding escalates...ETFs EXD suffering the biggest outflows":
ETF flows were down hardest: EXD (-1.0%), LDM (-0.7%)

EPFR fund flows down: EXD (-0.5%), LDM (-0.1%), -0.3% total, +0.1% blended funds and +0.1% EM equity. EM debt inflows YTD at 2.8%.
Rotation out of EXD into LDM
Investors are rotating toward local markets debt (LDM) vs external debt (EXD) now at a rate of $500mn/wk, while six months ago the preference was the opposite – over $500mn/wk in favor of EXD vs LDM. These rotation flows are based on EPFR LDM flow - EXD flow weekly average over 3 mo.
By looking at the difference in EXD vs LDM flows from EPFR, we remove some of the effect of general flows of all debt or EM classes (Chart 1). These rolling 3m flows show strong EXD outflows this year, with LDM compensating. Further problematic is the high March issuance.

LDM Real Money Positioning: Our Asia strategists launched our real money positioning tracker to see the allocation of 28 EM local currency bond funds versus the JPM GBI-EM in mutual funds of 28 large managers ($58bn AUM) (GEMs Viewpoint: Tracking real money positioning 25 April 2018). This will help identify significant benchmark deviations and potentially give some indication of future movements in FX and bonds.
Total foreign holdings of LDM: Outflows in March so far
• March China inflows of +$3.2bn do not even cover other country outflows reported so far: total -$0.1bn. China inflows more than offset outflows elsewhere in last 6m.
Flows winners: China and Mexico
• March: China (+$3.2bn), Mexico (+$1.4bn). Wk ending April 20: Mexico (+$0.5bn), Turkey (+$0.5bn).
Flows losers: Brazil
• March: Brazil (-$4.3bn); Wk ending Apr 27: Indonesia (-$1.6bn) and India (-$0.3bn).
After 2013 retail investors never came back
In 2013, retail investors and small institutions were sellers and large institutional investors were buyers, adding as asset prices fell. Most of the weakest hands in 2013, who were small retail investors, never returned to EM debt markets (Charts 23 and 25):
- source Bank of America Merrill Lynch

Whereas we pointed out in previous conversations that US High Yield was still in the retail's feeble hands, it is not the case since the 2013 Taper Tantrum for Emerging Market Debt Markets. The big question of course in the coming weeks will be surrounding the pace of the "derisking" being currently seen. Is it about to get worse one might rightly ask.

On this question we read with interest JP Morgan's take from their Flows & Liquidity note from the 4th of May entitled "Is the EM selling overdone":
  • We find that the EM position reduction over the past two weeks was confined to hedge funds.
  • Real money EM equity and bond managers do not appear to have reduced their exposures materially over the past two weeks.
  • Retail investors’ selling has been modest also.
  • We thus conclude that EM selling is not overdone and that EM assets still look vulnerable if real money investors decide to join hedge funds in reducing their EM exposure.
  • US banks sold bonds YTD raising questions about bond demand for this year.
  • However, we believe that this selling was partly distorted by one-off factors and that the average bond buying by US banks since last October is a better reflection of the underlying pace.
EM assets, which up until mid April were perceived to be relative immune to the weakness in DM asset classes, slumped over the past two weeks posting the steepest underperformance since the third quarter of last year. Who has been driving this sharp reduction in EM exposures over the past two weeks and how far are we from capitulation?
EM dedicated hedge funds appear to have been mostly responsible for the recent EM correction. This is shown in Figure 1 which depicts the beta of EM dedicated hedge funds proxied by the HFRX EM Composite Index vs. the JPM EM currency index. EM currency exposure represents an important component of both EM equity and EM bond exposures and thus the single best metric to assess EM hedge fund betas.
The betas in Figure 1 are proxied by the ratio of the performance of EM hedge funds over a particular time period divided by the return of the JPM EM currency index over the same period. The time periods in the beta tables are chosen so that there is enough change in the underlying currency index. Otherwise too small changes can create spikes in the calculated betas due to very small values of the denominator.
Figure 1 shows a big and abrupt drop in EM hedge fund beta to the EM currency index for the most recent period since April 19th, pointing to currently low EM exposure and the lowest since last November. Effectively, the entire previous rise in the EM hedge fund beta seen between November last year and March this year has been unwound in recent weeks.
However, in contrast to hedge funds, real money EM managers do not appear to have lowered their beta over the past two weeks. We proxy EM real money managers by the 20 biggest EM active equity mutual funds and the 20 biggest EM active bond mutual funds, the betas of which are shown in Figure 2 and Figure 3.
Similar to hedge fund betas in Figure 1, the betas of EM real managers in Figure 2 and Figure 3 are proxied by the ratio of the performance of EM active equity or bond mutual funds over a particular time period divided by the return of the MSCI EM index or the GBI-EM unhedged local bond index respectively, over the same time period. Again the time periods in the beta tables are chosen so that there is enough change in the underlying equity or bond index to avoid spikes in the calculated betas.
Figure 2 and Figure 3 show little change in the betas of real money EM equity or bond managers, pointing to little position adjustment by them over the past two weeks.
What about retail investors? Figure 4 and Figure 5 depict the EM equity and bond ETF flows by week. The outflows over the past two weeks have been rather small in both the equity and bond ETF space suggesting that retail investors likely played a small role in the recent EM correction.

The muted selling by retail investors over the past two weeks perhaps reflects the fact that retail investors’ inflows into EM funds were rather modest in previous months before April, so there was not a big ramp up that needed to be unwound. Or it could reflect the relatively low or average shares of EM in the equity or bond ETF universe, suggesting that retail investors are not overweight EM. These EM shares in the equity and bond ETF universes are shown in Figure 6 and Figure 7, respectively, over the EM shares in global equity and bond indices.

The share of EM in the bond ETF universe has been declining this year and stands at its lowest level since the beginning of 2017, post the US election. The share of EM in the equity ETF universe has been rising this year but stands in the middle of the past few years’ range.
What about currencies? What picture do we get from the available spec positions on EM currencies? We use two proxies to gauge overall EM currency positions: 1) the aggregate spec positions on the USD (Figure 8) and 2) our spec position indicator on Risky vs. Safe currencies (Chart A17 in the Appendix).

The former suggest that a previous short base in the USD is still being covered but has yet to be covered completely. The latter suggest that while “Risky” currencies including EM currencies saw a significant reduction in their positions vs “Safe” currencies, they are still far from capitulation.
In all, we find that the EM position reduction over the past two weeks was confined to hedge funds. Real money EM equity and bond managers do not appear to have reduced their exposures materially over the past two weeks. Retail investors’ selling has been modest also. We thus conclude that EM selling is not overdone and that EM assets look still vulnerable if real money investors decide to join hedge funds in reducing their EM exposure." - source JP Morgan
We would have to agree with JP Morgan, that when it comes to the build up in the "osmotic pressure" and the slow turn in the "Wilson cycle", this doesn't mark the beginning of the end but most likely the end of the beginning to paraphrase Winston Churchill. "Smart money" aka Hedge Funds have already proceeded in reducing their beta exposure whereas "Real money" has not even started. When it comes to retail, as pointed out by Bank of America Merrill Lynch's note, they are pretty much not into the "game" so they do not represent a concern when it comes to EM outflows we think. 

What we think is happening in conjunction with the Fed's QT is that the carry trade is fading and losing its allure, this is of course putting pressure on fund flows as US dollar cash becomes more appealing from a risk reward and low beta perspective. The reduction of the "beta" factor coming from FX carry in EM has been highlighted by UBS in their Global Macro Strategy note from the 20th of April entitled "Lesson Learned: All dressed up with nowhere to go":
"Drivers of equities and currencies are diverging
Over the last two years, EM equities have been driven largely by the tech cycle. But a tech boom does precious little for EM currencies; the countries that make up pretty much the entire EM tech index—China, Korea, Taiwan—have historically been amongst the most interventionist central banks. To the extent they are driven by one variable, EM currencies price off the commodity cycle, which typically coincides with a weak USD cycle. A caveat, though: supply-driven oil price gains, which we are arguably witnessing today, have had little discernible impact on EM assets.
Growth thresholds not being met
Lastly, under the radar, EM growth has been slowing sequentially, with annualized GDP growth coming in at 3.3% (Q4 2017); still better than the sharp slowdown of 2015/2016, but only just. This occurred as DM growth has sequentially improved. And EM growth has had to rise to around 5% for EM currencies to appreciate in trade weighted terms (Figure 5). We are just about half way off that mark.

What to do? Beta is not your friend in this asset, but alpha is still interesting
A 'global' or common factor defining performance across EM currencies, as measured by the first principal component, has fallen sharply over the last two years (Figure 6).

The beta call is less than exciting for EM, but there is plenty of alpha still to be had, evidenced from the recent divergent performances of Mexico and Turkey. Screening by looking for a combination of strong real rates and attractive valuations, we would highlight the RUB and BRL as good opportunities. The good news seems to be quickly getting priced in ZAR, & there is more downside to come, we believe, in the TRY.
- source UBS


As the Fed continues its hiking path, the Wilson cycle means that "carry" is less and less a source of "beta" in the EM world, which will no doubt put additional pressure on Emerging Markets bond markets we think as the "Ocean" of liquidity is slowly but surely closing. On the fall of carry, we read with interest Bank of America Merrill Lynch Cause and Effect note from the 30th of April entitled "The stars are finally aligned":
"Central bank reserve rebalancing:Swings in the foreign reserves of emerging central banks can have a big impact on the USD against other reserve currencies. For example, USD tends to fall against the EUR when these reserves are going up while the USD tends to rise when they fall (Chart 6).

Following the violent capital flight from emerging markets in 20 15 (during which the USD appreciated 20 % against the EUR), investors began to tiptoe back to EM in 20 16. A trickle turned into a flood and we saw a record 50 weeks of inflows into EM fixed income funds in 20 17 (GEMs Flow Talk, December 22). This allowed EM central banks to rebuild their reserves which in turn would have led them to sell USD against the likes of the EUR and the JPY. There are signs that the pace of reserve accumulation may be about to slow once again. Over the past month, EM equities have been underperforming their developed market counterparts which have slowed inflows (Chart 7).

Moreover, with many EM central banks (eg, Brazil, Russia) having cut rates in the face of Fed hikes  over the past year, carry offered by EM fixed income assets has fallen to the lowest levels since 20 12 (Chart 8) when depressed EM risk premium worsened the exit from the asset class in 20 13.
 - source Bank of America Merrill Lynch


While the retail macro tourists got burn during the Taper Tantrum of 2013 in Emerging Markets playing the high beta game, many investors have extended their stay. Given the "smart money" is already leaving the "beta party", one might indeed wonder if in true "Wilson cycle" fashion we are heading towards more trouble ahead with this time around our "reverse osmosis" thesis playing in earnest. We do think there is more "macro" volatility coming, particularly in Emerging Markets hence our recent focus on US dollar cash thesis as far as allocation is concerned. If indeed Turkey and Mexico are the canaries in the "carry" coal mine then again there is potential for more trouble ahead. On this particular matter we agree with Kit Juckes take from Société Générale in his Forex Weekly note of the 12th of April entitled "Is a new age of turbulence coming":
"Is a new age of turbulence coming?
When the dollar de-couples from US rates, financial market turbulence seems to come along at the same time. So far, all we have are (geo-political) straws in the wind, but after the relative calm of 2014-2017, when everyone stuck to the task of buying yield and selling volatility, we may be in for a sustained period of FX/rate de-coupling that eventually leads to a higher volatility regime.
The collapse of the correlation between currency pairs and relative interest rates (short, or long term, real or nominal) has been one of the challenges facing the currency market in recent months, along with the divergence of G10FX volatility from anything happening elsewhere and, during the last three months, the tendency of the EUR/USD to meander around in a narrow range. The chart below plots the rolling 75-day correlation between the DXY index and 10-year Treasury yields, which has now turned negative.

What we have seen so far is by no means a confirmed change of long-term regime. As the chart shows, even if I break the last 27 years down into five periods of positive and negative correlation, there have been a number of short-lived breaks. But it’s interesting to think about the FX/rate regime in this way, all the same. This would be the third time we saw the correlation turn negative for a sustained period. The first came with the 1994 Fed rate-hiking cycle, when higher US rates triggered risk aversion, emerging market weakness and a lot of yen strength. The correlation remained negative on balance for the rest of the decade, until the end of the Fed tightening cycle, after the LTCM collapse and the Russian default. The second break came ahead of the financial crisis in 2008 and lasted until after 2013’s taper tantrum, when the market started to price in Fed rate hikes and the dollar rallied. If these two episodes share anything, it’s market turbulence.
Perhaps the clearest conclusion for me is that the periods of non or negative correlation between the dollar and rates have come at times when equity volatility and corporate or emerging market credit spreads have been wide. Of course, there’s the question of what is the chicken and what is the egg in this regard, since a spike in vol can drive yields down, and simultaneously drive the dollar up, but perhaps what is more important is that a persistent change in the relationship between the dollar and yields points to something more than a one-off risk event. By the same token, there’s no great surprise in the spike in USD/RUB vol or indeed in USD/TRY vol in recent days/weeks, but if we get a cluster of these unrelated, idiosyncratic events at the same time, maybe it reflects a market that has been sitting on the carry trade for too long, and whose appetite for yield has become unhealthy." - source Société Générale
We would have to agree, macro tourists carry players have been overextending their stay in the Ocean of liquidity provided in particular by the Fed and now that thanks to the Wilson cycle is turning, the Ocean of liquidity is closing. You have been warned and we would side with the wise words once again of our friend David Goldman from one of his note from the 3rd of May in Asia Times entitled "Time to be in cash":
"While trade tensions threaten to break up global supply chains, heavily-indebted emerging markets  are hanging in the balance – this isn’t a time to buy anything
 Asia Unhedged called the end of the tech boom on March 29 (The tech bubble gets its (w)reckoning). The Trump Administration poured gasoline onto the fire by cutting off ZTE’s access to US-made chips. That persuaded China that building up its own chip-making sector was not only an economic priority, but a national security requirement. And that means a global glut of semiconductors.
The SOX semiconductor index has fallen by 16% since its March 3 peak. The US negotiating team now in Beijing wants China to stop subsidizing its semiconductor industry, a difficult argument to make after refusing to sell American chips to Chinese companies. That sets up a tough outcome for this week’s trade talks, and the market doesn’t like it. A simple way to think about it is that the expansion of world trade has centered on the creation of a global supply chain in electronics and other products that maximizes efficiency and reduces prices. The trade issues between the US and China threaten to break up the supply chain.
Contributing to the shakiness of global equity markets is the rupture in some of the world’s most heavily-indebted emerging markets, notably Turkey, whose currency is in free fall and whose stock market has lost 31% in US dollar terms since its August 29th peak. Asia Unhedged has been a Turkey bear since early September, and we note with satisfaction that Turkey is the worst-performing major market in the world.
Although Chinese stocks offer good value, the threats to world trade and the prospective disruption of the global supply chain are a powerful headwind for the time being. The most widely-traded China ETF in US markets, FXI, today fell below its 200-day moving average. So it isn’t a time to buy anything. Stay warm and dry." - source David Goldman
Now if indeed we are in a Wilson cycle, then any increase in the trade war narrative will lead to a collision course and an acceleration in the drying up of the liquidity ocean provided in recent years. For that reason we remain bullish gold. On a side note we recently attended a roundtable in London with the CEO of Polymetal Vitaly Nesis. Polymetal happens to be the third global primary silver producer, the largest silver and the fourth gold producer in Russia. Vitaly Nesis is very bullish on silver and thinks the gold/silver ratio should go to 60.

As a reminder we also mused on Emerging Markets risks in our conversation "The Tourist trap" back in September 2013:
"Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: 
Wave number 1 - Financial crisis 
Wave number 2 - Sovereign crisis 
Wave number 3 - Currency crisis
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"
If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike. As a reminder and what is playing out again is what we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates". Our reverse osmosis process theory from a macro perspective can be ascertained by monitoring capital flows. Carry trades love low risk-free interest rates, but they love low interest rate volatility even more. This is why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving their risk premiums to abnormally low levels.

In our final point below, we would like to point out that once again wage growth is still tepid, so the Fed is probably somewhat relieved that the market doesn't think yet it is behind the curve (though the curve is clearly behind them, flatter that is...).


  • Final chart -  Dude where is my raise?
For the second month in a row, payrolls in the US were below consensus yet the still weak labor participation doesn't make the latest unemployment number any good. At least for the Fed, tepid wage acceleration is still supportive of their gradual hiking approach. Our final chart comes from Bank of America Merrill Lynch Securitization Weekly note from the 4th of May entitled "Recovery can be hard" and shows that there has not been any acceleration in wages in spite of declining unemployment (at the same time healthcare and rent have gone up big time...):
"Even though the unemployment rate dropped to an 18-year low in April, labor force participation dropped slightly to 62.8% and YOY average hourly earnings growth remained stuck at 2.6%. At least for now, the low unemployment rate is not translating into the requisite increase in labor force participation and wage growth that would force the Fed to change its stance to become less accommodative. That’s good news for our spread tightening view for securitized products in Q2 and beyond." - source Bank of America Merrill Lynch
It might be good news for some part of the credit markets, such as low beta, less so for the time being for both High Yield and Emerging Markets.  We have yet to see the return of "Mack the Knife" aka King Dollar in conjunction with positive real US interest rates. For the moment it seems the crown once again could go to "Cash" being the King, no offense intended to some hedge fund honchos.


"The best thinking has been done in solitude. The worst has been done in turmoil." - Thomas A. Edison

Stay tuned !

 
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