Monday, 30 September 2013

Credit - The Rambler

"Men more frequently require to be reminded than informed.", Samue Johnson, The Rambler (1750-1752).
While last week we asked ourselves if equities had not become indeed "the last refuge of the yield/returns scoundrels" given the recent inflows into the equities sphere and the "Cantillon effect" with the bubble inflated by the "wealth effect" courtesy of Ben Bernanke's, we decided this week to make another reference to English writer Samuel Johnson. 

Yes, in our numerous posts, we have indeed on many occasions been frequently "rambling". It was therefore necessary for us to pay homage to Samuel Johnson, due to the fact that some of our friends and readers have frequently told us that because of our many references to past writings we have become somewhat some kind of a "rambler". We do agree. 

But, as Samuel Johnson's quote goes, we have preferred reminding than informing as we have often based our thought process on the following premises: 
"-He who has the gold, does not always make the rules.
-The market does not learn for long.
-Human nature does not change."

When it comes to human nature and "Cantillon effect" leading to the formation of bubbles in risky assets, one might rightly ask if the last refuge of the scoundrels, being equities, are "fully valued" or not?

This week we will therefore focus our attention on "valuations".

The "Cantillon effect" at play, the rise of the Fed's Balance sheet, the rise of the S&P 500, the rise of buybacks and of course the fall in the US labor participation rate (inversely plotted) - source Bloomberg:
In red: the Fed's balance sheet
In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

On that subject, Nomura's Macro Systematic Snapshot from the 26th of September made some interesting points:
"Are equities "fully valued"?
-Some high profile US investors have recently claimed equities are "fully valued".
Figure 1 shows our global aggregate value measure which has been gradually increasing since the end of 2012. 
Globally, stocks are not as expensive as they were in 2007/8 but are approaching similar levels. One caveat: this measure is based on free cash flow yield, which excludes financials. And financials look generally cheap.
-There are large regional differences in valuation. US and Japan look expensive whereas Europe and Asia ex-Japan look more fairly priced.
-This is consistent with our corporate fundamentals class where US looks weaker while Europe looks more robust.
-However, value is not the only style in town and our momentum and carry signals are more bullish leaving us net long in many markets including S&P 500 and Eurostoxx."  - source Nomura

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). Emerging Markets have continued to underperform developed markets  - source Bloomberg:
While the absolute spread between the S&P 500 and MSCI Emerging Markets has touched a record low level in the middle of May this year, 

In our early September conversation "The Tourist Trap" we argued:
"Yes, the bounce in Emerging Markets has indeed occurred in the past after similar redemptions, but we disagree with Bank of America Merrill Lynch. We have not seen the bottom yet, and that the rebound could probably materialize at a later stage, maybe in 2014."

But, looking at the most recent inflows and the improvement we have seen towards Emerging Markets, with the lack of "tapering" leading to a compression in the 10 year US Treasury yield, had led us to reassess our current stance towards Emerging Markets. The following chart from Bank of America Merrill Lynch Flow Show from the 26th of September is indicative of the sentiment upturn:
"Weekly flows show that the Fed decision of no-taper has caused 3% to become the "ceiling" for UST10, which in turn has granted a reprieve for all the summer tapering victims. Highlights include:
-Biggest inflows to bond funds in 5 months ($4.5bn)
-First inflows to unloved EM debt funds in 18 weeks ($0.6bn)
-First inflows to Muni funds in 18 weeks (albeit small $59mn)
-Largest inflows to IG bond funds in 17 weeks ($1.0bn)
-And, for first time in 7 months EM equity inflows coincided with DM equity outflows"
- source Bank of America Merrill Lynch

And from a valuation point of view, and contrarian stance, we would have to side on Barclays take, from the 26th of September in their Equity outlook entitled "Looking beyond the US":
"• Emerging market equities in particular now appear very cheaply priced relative to their US peers, while EPS upgrades may support European stocks. In Japan, the central bank’s very determined policy easing has yet to be fully reflected in the relative performance of that market.
• So for differing reasons, we suspect that non-US equities will prove more rewarding for investors than those listed in the US.
The relative performance and valuation of emerging market stocks is especially striking. As Figure 5 demonstrates, since their relative high point in October 2010, emerging markets have underperformed the world index (ex-EM) by 31% and sit at relative levels last seen at the height of the global financial crisis.

The relative valuation attached to emerging market equities has also collapsed. As Figure 6 shows, the price/book multiple is now 40% below that of the US market. This is the cheapest they have been since 2004.
- source Barclays

MSCI EM versus Nikkei - source Bloomberg:
So we could indeed see a continuation of the bounce in Emerging Markets to the pleasure of the "yield/returns scoundrels" particularly in the fixed income space.

But as per our "rambling habits", in numerous conversations, we pointed out we had been tracking with much interest the relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - graph source Bloomberg:
Back in April 2013 we argued in our conversation "The Awful Truth" the following:
"The decline in the oil price may prove to be another sign of deflationary pressure and present itself as a big headwind. Why is so?

Whereas oil demand in the US is independent from oil prices and completely inelastic, it is nevertheless  a very important weight in GDP (imports) for many countries. Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.

Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.  As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets."

We also quoted Bank of America Merrill Lynch on the subject:
"Whether it is high energy costs, expensive labor costs, a rising cost of capital, declining profitability, or misdirected investment into unproductive assets, the dislocations created by five years of zero interest rate policy in DMs will likely have some negative consequences in EMs. With oil demand growth exclusively supported by buoyant EM growth for years, lower global GDP trend growth (say from 4% down to 3%) could push Brent firmly out of the recent $100-120/bbl band into a lower $90-100/bbl range." -source Bank of America Merrill Lynch  - 17th of April 2013.

So could it be that the recent rebound in Emerging Markets has more road to make or is it only a temporary relief?

To that effect, we think shipping is still indicative of the powerful deflationary forces at play, which so far have prevented the Fed from "tapering", giving much need relief to many risky assets classes and are sending conflicting informations. On one hand, shipping rates continue to be weak for 40-foot containers as indicated by Bloomberg:
"Shipping rates for 40-foot containers (FEU) fell 7.9% sequentially to $1,665 for the week ending Sept. 26, the third straight decline, according to World Container Index data. Weakness was driven by Asia, with rates from Shanghai to Rotterdam falling 19% to $1,703, followed by a 14% decline in Shanghai to Genoa and a 1% decrease in the Shanghai-to-Los Angeles routes. Rates were mostly unchanged for freight moving between New York and Rotterdam." - source Bloomberg

On the other hand, the Baltic Capesize Index as increased by 114% to 4,018 since the 1st of August as reported by Bloomberg:
"The Baltic Capesize Index has increased by 114% to 4,018 since Aug. 1, spurring debate about whether the worst is over for the dry bulk market. Capesize vessels have outperformed panamax (up 38%), supramax (up 5.7%) and handysize (up 5.1%), and the broader Baltic Dry Index, which has climbed 79.3% in the same period. Shipping bulls and bears are debating if the move has been spurred by seasonality or if there is some sustainable demand behind the move." - source Bloomberg

For some, like ourselves, the relief rally can only be temporary given the deflationary forces at play and the on-going deleveraging, which is also indicated by Bloomber Chart of the Day when it comes to shipping as a leading indicator and valuation indicator:
"The biggest rally in iron-ore freight costs since 2009 is temporary and traders should bet against it lasting because there’s still a ship glut, according to an analyst who predicted the industry’s worst slump.
The CHART OF THE DAY shows, in white, how spot rates for iron-ore carrying Capesize ships rose to 34-month high of $42,211 a day on Sept. 25, one month after China’s imports of the commodity from Brazil, in purple, rose to the highest since February. Freight costs will slump 55 percent in the next three months, according to Sverre Bjorn Svenning, a director at Fearnley Consultants A/S, a research company in Oslo, who says he’s been bearish since 2007, the record year for average rates.
Brazil’s iron-ore producers accelerated exports of the commodity in July and August, compensating for shipments that slumped to a two-year low in June, Svenning said by phone today. Demand for ships will be curbed because the expansion in cargoes won’t continue at the same rate, he said. Total capacity of commodity-carrying ships expanded 62 percent since 2008, during which time global trade in the steelmaking raw material grew 40 percent, data compiled by Bloomberg show. “I can’t see that underlying demand can sustain the massive fleet,” Svenning said. “There was a massive tsunami of delivery of new vessels in 2009. The market will come off again.” His estimate for the fourth quarter is for rates to average about $19,000 a day, 34 percent below freight swaps that investors use to bet on, or hedge, future shipping prices. They traded at about $29,000 a day as of 10:21 a.m. today in London, according to data from Clarkson Securities Ltd." - source Bloomberg

While no doubt the Baltic Dry Index has indeed broken ou from its downward channel at a rapid pace since August - graph source Bloomberg:
"The dry-bulk market, which accounts for about 50% of shipped freight, is driven by steel demand, as iron ore and coking coal make up about 40% of volumes. Utility coal, grain, bauxite-alumina and phosphate are also major dry-bulk commodities. The Baltic Dry Index, a major barometer for the industry, has more than doubled ytd." - source Bloomberg

Overall the shipping industry continues to be plagued by overcapacity as the overbuilt legacy from the credit bing days continues to be dealt with - graph source Bloomberg:

When it comes to shipping and the conflicting message sent across, it might be just a case of a market of a market over extending its gains based on future expectations which have been distorted by ZIRP policies, hence the over optimistic reaction since August in that space. Last time the gap between the order book for bulk vessels and the US recession was one year. Once again, we are left wandering if the very large gap between the number of bulk vessels on order and the bulk vessel orderbook as a percentage of capacity is not a reflection of yet another "Cantillon effect" transmitted by ZIRP to the shipping industry - graph source Bloomberg:

 So from a valuation point of view and looking at the recent evolution in shipping it appears to us very difficult to point to a strong rebound in the near terms for Emerging Markets equities, although valuations for some do appear clearly enticing.
"Shallow men believe in luck. Strong men believe in cause and effect." - Ralph Waldo Emerson, American poet.

Stay tuned!

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