Sunday, 1 September 2013

Credit - Misstra Know-it-all

"The only thing we have to fear is fear itself." - Franklin D. Roosevelt 

While we ventured back last week towards biology analogies in our chosen title, we have chosen again to venture towards our beloved musical analogies in this week chosen title. This time around we decided to pick probably our favorite song from Stevie Wonder, namely 1974 hit "He is Misstra Know-it all", from his "Innervision" album masterpiece. 

Why our chosen title?

The song "He is Misstra Know-it-all" is essentially a long description of a know-it-all confidence trickster character (in our case our "omnipotent" central banker at the Fed) who is a "man with a plan", who has a slick answer to all his critics and who has "a counterfeit dollar in his hand."

Looking at the continuing "funk" in Emerging Markets, courtesy of many years of lax ZIRP monetary policies by the Fed, we were, like many pundits, taken aback by the latest comment coming from the Fed during their latest Jackson Hole meeting in particular coming from the president of Atlanta Fed Dennis Lockhart on Bloomberg TV:
“You have to remember that we are a legal creature of Congress and that we only have a mandate to concern ourselves with the interest of the United States” 
“Other countries simply have to take that as a reality and adjust to us if that’s something important for their economies.”

Although Chinese Sheng Laiyun, a spokesman for the National Bureau of Statistics, said in a press briefing in Beijing reported by Bloomberg the following:
“Given that U.S. monetary policy has a huge influence on emerging markets and the global economy, we hope that U.S. monetary policy authorities, whether exiting or scaling down stimulus, will not only consider the U.S.’s own economic needs but also think about economic circumstances in emerging markets,”

Don't bet on that, given James Bullard president of the Saint Louis Fed comments as reported by Bloomberg:
“We’re not going to make policy based on emerging-market volatility alone"

"If you tell him he's livin' fast 
He will say what do you know 
If you had my kind of cash 
You'd have more than one place to go oh
Lyrics from "He is Misstra Know-it all", Stevie Wonder, 1974.

By suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns. As displayed in the below graph from Nomura's recent paper from the 30th of August entitled "EM performance, renewed outflows, chicken & egg", inflows in Emerging Markets have been significant since 2010, as US real rates stayed in negative territory. 
"Our local bond market analysis using country-specific data from official sources shows much less outflows, suggesting to us that the first round of outflows by retail investors in July was possibly met by institutional investors buying EM. Note that some bond markets (in this most recent sell-off) with high weights in EM local bond indices have started to lose liquidity quite significantly (Indonesia and Turkey are the key examples) and asset swaps in markets with good liquidity turned negative. Bad liquidity markets saw asset swaps widen considerably (making swap paying less of a hedge) and start to trade like credit products. This phenomenon, if it continues, could result in a lot of proxy hedging through FX, FX vol, buying CDS and, at a more serious stage, selling what investors could unwind. Clearly, we are not there, but the performance deterioration is probably a good reason to pause and think about liquidity more than usual before entering fresh trades (as being too liquid now would be a concern for that market which could be subject to "proxy hedging")." - source Nomura

Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse.

The volatility in the fixed income space has remained elevated as displayed by the recent evolution of the Merrill Lynch's MOVE index rising from early May from 48 bps  towards the 100 bps level, whereas the VIX, the measure of volatility for equities is reacting as well. We have also added JP Morgan Emerging Markets Currencies Volatility Index - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.
EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

So in this week's conversation, and in continuation to our "reverse osmosis" analysis from last week, we will look at"positive correlations" and outflows courtesy of central banks meddling as we enter the "decisive" month of September as far as risky assets are concerned. 

As we argued in  our conversation "Alive and Kicking":
"For us, there is no "Great Rotation" there are only "Great Correlations""

A perfect example of the illustration of positive correlations and the meddling of our "Misstra Know-it-all" with financial prices, has been, no doubt, in the commodity space.

The Fed tried to increase jobs by lowering interest rates, weakening the dollar in the process, boosting exports but exporting inflation on a global scale, particularly in the commodities space, leading to political instability in the process with QE 2. The effect QE 2 has had on the commodity sphere has been well described in a Bank of Japan research paper entitled "What Has Caused the Surge in Global Commodity Prices and Strengthened Cross-Market Linkage?", published in 2011.

Like we said about "positive correlations", "Misstra Know-it'all" has indeed played a quick hand, lifting stock prices, playing on the wealth effect game and exporting "hot money" flows in Emerging Markets.

We have been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:
In our "Pareto Efficiency" conversation back in September 2012 we indicated:
"QE2 saw a surge of the SPX (Standard and Poor's 500) as well as a surge in oil prices as well as significant surge in US Treasuries yield, which surge by 100 bps from 2.50% to 3.50%. 2011 saw a significant correlation with SPX, Oil and US treasury yields falling significantly during the "risk-off" period triggered by liquidity. This time around, one can expect during the on-going "risk-on" period to see as well rising US Treasury yields in conjunction with surging SPX and oil prices."

This of course exactly the same movie...

When it comes to "Misstra Know-it-all" and positive correlations in the commodity space, we have read with interest Barclays note from the 30th of August 2013 entitled "Untangling commodity correlations":
"Commodity markets continue to chart a path of independence, reflecting a breakdown in recent patterns with lowered commodity/equity correlations, a downtrend in cross commodity correlations, as well as changed relationships between the US dollar and oil prices.

The reputation of commodities as a portfolio diversifier, lacking a consistent correlation with equities based on historical trends has been undermined following the 2008 recession, with commodity/equity correlations moving and staying in highly positive territory from September 2008 onwards. However, of late, commodity markets have been reflecting a breakdown in recent patterns with lowered commodity/equity correlations, a downtrend in cross commodity correlations, as well as changed relationships between the US dollar and oil prices. The recent sell-off in equity markets, particularly in emerging markets, has not been replicated in commodities. Instead, commodity prices have been rather stable in the current market environment where sentiment is being dominated by expectations regarding the start of QE tapering and negative newsflow from emerging markets. Not only have commodities been stable, they are actually among the strongest performing assets this quarter and gaining, in contrast to the losses in equity markets. The positive correlation between commodities and equities has continued to trend lower and has recently fallen into negative territory (see Figure 1). 
While it may be premature to say that the long period of positive commodity correlations with equities is now over, the latest move is part of a consistent trend of diminishing positive correlations in place since late last year, suggesting that commodities can still provide investors with diversification.

After an extended period of trading as a derivative of risk-on, risk-off sentiment through much of 2011 and all of 2012, commodity markets have also been less shackled by macro drivers this year. While the flow of economic data, liquidity and monetary policy continue to affect commodity prices, they have ceased to be the dominant driver, which is in stark contrast to the way commodities traded in line with the European debt crisis."  - source Barclays

What has changed as well is the relationship of Oil and the US dollar as indicated in the same note:
"Typically, a stronger US dollar has implied weaker dollar denominated commodity prices and vice versa but recent performances reflect a more mixed outcome. Broadly the commodities complex has followed that logic but a notable absence has been WTI crude oil where the recent rally has gone hand in hand with a stronger dollar, leading to a stark rise in the positive correlation between these two variables. At 58%, that positive correlation between WTI crude oil prices and the US$ trade weighted index has spiked sharply higher (see Figure 3). 
However, in other commodity markets like base and precious metals, the dollar has continued its negative correlation." - source Barclays

Not so fast...

We do believe that increasing tensions in the Middle-East make it very likely to see an additional rise in WTI Oil prices, which could "roil" the "nascent" US recovery and gold is likely to rebound further from a positioning point of view (we will look at positioning further on).

Dollar index versus Gold - graph source Bloomberg:
Looking at the ongoing predicament in emerging markets, in similar fashion to our May 2012 conversation "Risk-Off Correlations - When Opposites attract", the Greenback remains a powerful magnet as far as capital flows are concerned.

Last week, we indicated:
"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up." - David Goldman's article about Gold and Treasuries and bonds in general written in August 2011 (the former global head of fixed income research for Bank of America)

So far we have bought the put leg of the put-call parity strategy and we are indeed thinking of adding the call leg shortly."

As we stated above, for us, there is no "Great Rotation" but "Great Correlations".
Also as we have argued in "Pareto Efficiency":
"Given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, investors are facing indeed an increasingly strong dilemma, due to the growing number of US retirees and a falling yield environment"
"The Baby Boomers Generation is that huge post-war cohort born between 1946 and 1964. The first wave of baby boomers turned 65 in 2011. It is estimated that during the next 20 years, roughly 74 million "boomers" will retire in the United States. That is an average of more than 10,000 new retirees a day!
The rest of the world also had their own "baby booms". The United Kingdom, France, Denmark, The Netherlands, and Australia are just some of the other countries considered to have had Baby booms starting around 1946." - source Keenan Overseas Investors.

As far as consumers and The Wealth effect are concerned QE wise, as indicated by Keenan Overseas Investors:
"- Many US and European property markets have significant unsold inventories.
- New generation of young adults in the US weighed down by student debt.
- Consumer demand reduced when people consider themselves poorer.
If interest rates increase, all of these problems get worse!"

Exactly! And if you are expecting that Baby Boomers will not influence US Treasuries and we have escaped the deflationary environment, you are wrong as displayed by Bloomberg's Chart of the Day from the 25th of August:
"Baby Boomers’ influence on U.S. Treasuries will help hold yields down as people born in the initial decades after World War II shift to fixed-income assets to prepare for retirement, mirroring a pattern in Japan.
The CHART OF THE DAY shows Treasury yields have gradually declined as the proportion of U.S. citizens over 65 years climbed. The age group will swell to 20 percent of the population by 2030 from 14 percent now, according to the U.S. Census Bureau. The chart tracks a similar trend in Japan, where 24 percent are over 65 years, the world’s highest ratio of seniors, up from 19 percent a decade ago.
“As Japan’s population aged, that suppressed bond yields,” said Larry McDonald, the chief equity, credit and policy strategist at Newedge USA LLC in New York. About 4,100 Americans are turning 65 every day, quadruple the number in 2003, he told Bloomberg Radio’s “The Hays Advantage” earlier this month. “Those people are more likely to own bonds,” he said. Baby boomers are considered people born from 1946 to 1964.
Demand from retirees hasn’t been enough to offset a bond market rout this year. Treasuries have tumbled on speculation the Federal Reserve will taper an $85 billion monthly debt-buying program designed to stimulate the economy amid signs output and jobs are growing. Government securities have fallen 3.9 percent through Aug. 22, based on the Bloomberg U.S. Treasury Bond Index.
Japan’s 10-year bonds yielded 0.765 percent at the end of last week, the lowest of 27 developed markets Bloomberg tracks. The nation’s central bank has its own debt-buying program, worth about 7 trillion yen ($71 billion) of securities a month.
Investors are snapping up Japanese bonds even though the nation’s debt is equivalent to more than double its gross domestic product, McDonald said. The ratio is the highest in the world, data compiled by Bloomberg show. The U.S. debt is equivalent to 74 percent of GDP." - source Bloomberg

In continuation to Baby Boomers' impact on yields and the effect of demography, this is what we said on the subject in June this year in our conversation "Lucas critique":
"What are "inflationistas" of the world and "tapering believers" fail to take into account in their analysis is the importance of demography we think in true Lucas critique fashion. Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":
"The older a country’s population, the lower its inflation rate, posing a challenge for central banks in the world’s industrial nations, according to a UBS AG report.
Singapore-based economist Andrew Cates of the Swiss bank’s global macro team plotted average inflation levels over the last five years against changes in the dependency ratio, which compares the very old and very young to the working-age population.
The resulting chart showed nations that have aged in recent years typically faced very low inflation and, in the case of Japan, deflation. By contrast, those that have been getting younger, such as India, Turkey and Brazil, have relatively strong price pressures.
“Since ageing demographics will now start to feature more prominently in the outlook for many major developed and developing countries this is clearly of some significance for how inflation might evolve,” said Cates in a May 30 report.
The finding clashes with the view of economics textbooks, according to Cates, which tend to say a slowdown in population growth should put upward pressure on wages -- and therefore inflation -- as labor supply shrinks. Still, this ignores how demographics influence demand for durable goods and property, Cates said.
He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.
By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.
“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg

When it comes to Baby Boomers, additional lyrics from Stevie Wonder's song point towards the direction yields will take. It might be time to put on the additional leg of the put-call parity (long gold / long US Treasuries):
"Any place 
He will play 
His only concern is how much you'll pay 
He's Misstra Know-It-All"
Lyrics from "He is Misstra Know-it all", Stevie Wonder, 1974.

We have long argued that the fight over deflation is still going on as illustrated by the evolution of container prices in the shipping industry. 

We have on numerous occasions discussed shipping as being not only a leading credit indicator (with the collapse in European structured finance) but as well a leading economic growth indicator (on that subject please refer to "The link between consumer spending, housing, credit and shipping"), our "Bear Case" is still playing out (as mentioned in our conversation "The Dunning-Krueger effect"), excess capacity and a weak global economy with a China slowdown will drive rates down even with price increases, pressuring margins - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5.2% to $1,836 in the week ended Aug. 28, dropping 14.1% after carriers implemented a $400 peak season surcharge the last week in July. Rates are at the lowest levels since June. Even with five increases in 2013, rates are 17.1% lower ytd and 26.5% lower yoy, as slack capacity continues to pressure pricing." - source Bloomberg

These five increases in 2013 have followed eight rate increases in 2012, totalling $3,650. It is still a question of excess capacity in a weak global economy. Of course high unemployment (12.1% in the Eurozone) will continue to weight on the economic "recovery" in general and shipping in particular.

Moving on to outflows and positioning, particularly in relation to "reverse osmosis" for Emerging Markets, the latest report from Deutsche Bank from the 30th of August entitled "Positioning Amidst Rising Risks" indicated the following:
"As the market once again faces a number of risks going into September (Syria, EM, taper, etc), we assess how investors are positioned for those risks across asset classes. Oil positioning is already at peak levels while EM bond and equity outflows have surpassed 2008-09 levels suggesting Syria and EM risks are being priced in. Down from a peak long in May, rates positioning on the other hand has remained stubbornly near neutral despite the rise in yields. With bond outflows just 20% of the way through the 1994 scenario, bonds and EM bonds in particular are likely to remain under pressure from outflows. Finally, aggregate equity positioning is overweight. This in large part reflects sector positioning for higher rates but the cyclical tilt makes equities susceptible to disappointing growth." - source Deutsche Bank

From the same report and in relation to Emerging Markets:
"EM outflows surpass 2008 levels but positioning not yet underweight.
Outflows of over $20b from both EM bond and equity funds have already exceeded 2008-09 outflows; but not as a % of AUM. 
We note that world bond fund outflows were 20% of AUM in 1994 suggesting EM outflows could have further to run. EM equity and bond outflows of 3% and 7% of AUM, respectively, have likely drained cash balances. Accordingly, GEM equity fund beta is well above average levels, suggesting exposures could be cut further. EM equity vol skew is also well below average despite the rising risks." - source Deutsche Bank

As far as Gold is concerned, we are confident Gold, being one of the legs in our put-call parity strategy, has further to run as indicated by Deutsche Bank when it comes to positioning:
- source Deutsche Bank

But moving back to our "reverse osmosis" thesis, it has been recently validated by looking at outflows taking place in the Emerging Markets space. The rising tapering signs could no doubt spell additional trouble and outflows for the asset class as also indicated by Barclays in their Emerging Market Flows Snapshot from the 26th of August:
"• EPFR data shows that since 22 May, cumulative outflows from EM bonds topped USD23bn and almost fully reversing the USD30bn of inflows between mid-2012 and May. The scale and positive correlation between consecutive outflows suggests a self-reinforcing wave of stop-loss selling of EM bonds. 
After the initial selloff in May-June, EM FX performed well in July (with the obvious exceptions of TRY, BRL, IND, IDR) amid a slight fall of US long-term real interest rates. But even in that period, EPFR data indicated continued outflows. The acceleration of outflows in last two weeks (particularly last week) was triggered by a spike in US real interest rates, which overtook the rise in nominal yields (Figure 1B).
This time around though, rising real rates in the US have hurt flows into both EM and US equities. This might be a sign that further increases in US real rates could negatively affect developed market equities generally. Since 22 May, US real rates (10y) have jumped 150bp. Given that US debt is on the order of 267% of GDP, (sovereign debt + private debt excluding financial institution debt), the rise in yields implies a higher real cost of debt servicing equal to 4% of GDP. There is a growing risk to the cyclical recovery from an overshoot of real rates, in our view. Thus additional guidance from the Fed, about future rates, is probably needed. Such guidance would have positive implications for EM especially where real rates are high (BRL) or where positioning is light and the country has access to an FCL (eg, Mexico)." - source Barclays

And like Ian Keenan said:
"If interest rates increase, all of these problems get worse!"

When it comes to "Forward Guidance" by "Misstra Know-it-all" we keep reminding to ourselves the lyrics of Stevie Wonder's song:
"When you say that he's living wrong 
He'll tell you he knows he's livin' right 
And you'd be a stronger man 
if you took Misstra Know-It- All's advice oh oh "

Emerging-market stocks have lost more than $1 trillion since May, according to data compiled by Bloomberg. The MSCI Emerging Markets Index has fallen about 12 percent this year, compared with a 13 percent gain in the MSCI gauge of shares in advanced countries. When one looks at the relative performance of the S&P 500 versus MSCI Emerging, one can easily see EM equities have been clearly lagging. Emerging markets (MXEF) continue to underperform developed markets  - source Bloomberg:

On a final note for illustrative purposes, we have been plotting the growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:
As we argued in our "Fears for Tears" conversation, the rally has been as well sustained by multiple expansions and very significant stock buy-backs:
- source Deutsche Bank
We share our concerns with Bloomberg as indicated by Inyoung Hwang and Alexis Xydias in their article from the 26th of August entitled "Multiples Growing Fastest Since Dot-Com Bubble as Rally Ages":
"Price gains of stocks in the Standard & Poor’s 500 Index are outpacing profits by the fastest rate in 14 years as the bull market extends beyond the average length of rallies since Harry S. Truman was president.
The benchmark gauge for U.S. equities has risen 14 percent relative to income over the past 12 months to 16 times earnings, according to data compiled by Bloomberg. Valuations last climbed this fast in the final year of the 1990s technology bubble, just before the index began a 49 percent tumble. The rally that started in March 2009 has now outlasted the average gain since 1946, the data show.
Bears say the failure of earnings to keep up with prices signals the bull market is in its last stages, as companies from Caterpillar Inc. and Danaher Corp. forecast slower profit growth and the Federal Reserve prepares to reduce stimulus. Optimists point to expanding multiples as proof individual investors are growing confident enough in the economy to return to stocks.
History shows the final phases of rallies have provided some of the biggest gains. “Markets have been running away,” Robert Royle, who helps oversee $21 billion as manager of the North American Trust at Smith & Williamson Investment Management LLP in London, said by telephone on Aug. 20. “Everyone is hoping for a second-half recovery in fundamentals,” he said. “I am just not sure what will drive the recovery.” - source Bloomberg.

From the same article:
"The last time gains in stocks outpaced profit expansion by this much was in 1999, when equity valuations surged 19 percent in a year to 30 times reported profit, according to data compiled by Bloomberg. That bull market ended the following year, with the S&P 500 tumbling 49 percent from March 2000 through October 2002 as the dot-com bubble burst.
In 1987, prices rose so fast, valuations increased 43 percent through August, about twice the pace of the year before. That month marked the peak in a five-year rally, followed by a 34 percent loss through December 1987.
U.S. equities have been whipsawed since May, when Fed Chairman Ben S. Bernanke first indicated that the central bank may start to reduce its quantitative easing bond buying this year. The S&P 500 fell 5.8 percent from a high on May 21 through June 24 and rallied 8.7 percent through Aug. 2, before declining 2.7 percent.
Corporate earnings need to accelerate to justify the surge in equities as the central bank begins to scale back its unprecedented monetary stimulus, according to Joost van Leenders of BNP Paribas Investment Partners in Amsterdam." - source Bloomberg

So "Misstra Know-it-all" might indeed try to makes us fall with some "Forward Guidance", but given not many companies are giving their own "Forward Guidance" and that those who are a giving negative outlooks, and "Misstra Know-it-all" being the confidence trickster character we know, we wonder if he will stay true to his current "tapering" stance...
Oh well...

"If he shakes 
On a bet 
He's the kind of dude that won't pay his debt 
He's Misstra Know-It-All" 

"If we had less of him 
Don't you know we'd have a better land 
He's Misstra Know-It-All" 
Lyrics from "He is Misstra Know-it all", Stevie Wonder, 1974.

Stay tuned!

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