Sunday, 27 October 2013

Credit - Bread and Circuses

"Bread and circuses" (or bread and games) (from Latin: panem et circenses) is a metaphor for a superficial means of appeasement." - source Wikipedia

Given the continuation of the "Cantillon Effects" in risky assets thanks to the generosity of our "omnipotent" central bankers and the "tapering" withdrawal syndrome which has affected many central banks, we thought using this week our chosen title would be appropriate. It is a reference to the old Roman practice of providing "free wheat" to Roman citizens (plenty of abundant liquidity for the 1%) as well as costly circus games (the US shutdown and debt ceiling stand-off) as a means this time around of maintaining power we think. Bearing in mind that in ancient Rome, Roman citizenship was a privileged political and legal status afforded to freeborn individuals with respect to laws, property, and governance. A true Roman citizen could not be tortured or whipped, nor could he receive the death penalty, unless he was found guilty of treason. Are Bankers the new Roman citizens? We wonder and ramble again.

But as we have argued in numerous previous conversations, our central theme is around the desperate struggle of central banks to bend the velocity curve in this deflationary environment. We described back in April 2013 in our conversation the "The Night of The Yield Hunter" the epic struggle between "inflation" and "deflation":
"In the 1955 movie classic "The Night of the Hunter Reverend Harry Powell, a serial killer and self-appointed preacher has tattooed across the knuckles of his right and left hands two words "LOVE" and "HATE" so that he can use them in a sermon about the eternal struggle between good and evil. As investors, we think you should have two words tattooed across your hands: "INFLATION" and "DEFLATION" so that you can use them in assessing the eternal struggle between inflation and deflation in this current environment."

Shipping for us has always been the illustration of this on-going struggle as well as an indicator of the reflationary "Cantillon Effect" played by central banks in providing cheap credit, leading to yet again mis-allocation of capital on a global scale. For instance, Bulk vessels and Container ships have seen a steady number of ships being broken up due to weak rates and  tied up to the weakness in global economic activity - source Bloomberg:

What of course if of interest is the growing divergence in the number of bulk vessels on order and where the order book stands as a percentage of capacity - graph source Bloomberg:
Either, there is indeed a true growing global growth recovery at play, or this only yet another manifestation of "Cantillon Effects" in the shipping space leading to a surge of vessels on order thanks to cheap credit and high expectations, or put it simply what Keynes called the manifestation of the "animal spirits" leading to damaging speculation.

So, in this week conversation, we will look at where we stand in terms of complacency in risky assets prices and the jump in flows, as we think we move into the last inning of the reflation game put on in 2009.

The "Cantillon Effects" 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.

Of course the recent tempering stance of many central banks relating to a potential tapering has led to renewed significant appetite for risky assets, as indicated by Bank of America Merrill Lynch recent note from the 24th of October 2013 entitled "SPX 2014 by 2014?":
"Fed goes AWOL...investors go All-In. Big, frothy inflows to stocks, European equities (record inflows -see Chart 1), 
high-yield bonds and floating-rate notes. BofAML Bull & Bear Index rises to 7.0, i.e. closing in on 8.0, the "greed" threshold and "sell" signal for risk assets (Chart 3 - note B&B index gave "buy" signal July 3rd when SPX 1615).
Since June $83bn into equity funds versus $80bn out of bond funds (Chart 2); 
investors beginning to worry about a repeat of Q4'99 when the Fed left the liquidity gates wide open because of “Y2K” fears with tech bubble outcome." - source Bank of America Merrill Lynch

And with some much "Greed" and no "Fear" which has been removed with the postponement of "tapering" in the near future, no wonder risky assets have rallied hard on the back of it, as displayed in the rally seen in High Yield and the continuous rally in the S and P 500 - graph source Bloomberg:
The correlation between the US, High Yield and equities (S&P 500) is back thanks to "no tapering". US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG.

This surge in risky assets is of course entirely linked to the fall in volatility as a whole in various asset classes as displayed in the below Bloomberg graph:
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.

Similar pattern has been observed in the European space where European equities have benefited from the outflows from Emerging Markets as investors have repositioned themselves accordingly as displayed by the rally in the Eurostoxx 50, the diminishing spread risk premium in the Itraxx Financial Senior 5 year CDS index and the relief rally in the 10 year German yield - graph source Bloomberg:

Looking at the current "complacency" one may rightly ask if  "Something is rotten in the state of markets" in true Marcellus fashion (no it is not Hamlet).

What we care about, in similar fashion to our good friends at Rcube Global Macro Asset Management, is the consequences of a US Budget Balance Improvement as recently discussed. But another point we would like to highlight as well is the consequences of an improvement of the US current account. 

When you get both a fast improving current account for the US as well as an improving budget balance in the US, this will lead to fewer dollars available to the rest of the world in the next few years. Currently the US dollar is undervalued. As of late, thanks to the "Debt ceiling" stand-off, the Dollar Index fell to around 79 with Gold rising slightly in the process as indicated in the below graph displaying the Dollar Index versus Gold since June 2011:

The two points above always lead to international liquidity crisis over a long time. Liquidity crisis always lead to financial crisis. Why? The US Current account is the primary source of liquidity for other countries given the US doesn't have a foreign trade constraint.

On that matter it is interesting to note that the Fed taper fears did induce another stall in global FX reserve accumulation as indicated by JP Morgan in their Economic Research Note from the 25th of October entitled "Another pause in global FX reserve accumulation":
"The trembles sent through global financial markets at the prospect of an earlier-than-anticipated end to the Fed’s easy money campaign put a hold on the accumulation of foreign exchange reserves over the past few months. Global FX reserves stood at an estimated US$11.3 trillion as of August, down a touch from their April high. With global activity expected to accelerate and pull trade up with it, the pace of FX reserve accumulation is likely to rise with the level possibly breaching the US$12 trillion mark by the end of next year. However, this rate of increase would be modest compared to the breakneck pace seen during the last expansion.
The seemingly endless rapid increase in central bank holdings that took place last decade through to the middle of 2008 has been interrupted three times over the past five years. The first pause came during the global financial crisis, when a sudden stop in global trade and financial market flows led to a massive US$416 billion decline in reserves as numerous EM central banks moved to protect their currencies and their economies. The second pause occurred from mid-2011 to mid-2012, when downshifting economic growth across the EM and an intensification of the Euro area crisis generated a rare non-recessionary contraction in global trade. Over this period, FX reserves slipped US$21 billion. In contrast to the global financial crisis, when EM Europe (and Russia in particular) comprised the bulk of the reserve losses, the 2011-12 decline was focused more in EM Asia, with China experiencing a very rare US$56 billion decline.
Despite the deceleration in global trade flows as a result of the Euro area recession and continued disappointing growth across much of the EM over the past year, the pace of reserve accumulation actually picked up considerably in the year through April 2013, with the level of reserves expanding by US$802 billion (8.3%). Indeed, the expansion of reserves is somewhat puzzling given the aforementioned weakness of trade flows. This puzzle has been partly rectified in recent months, however, as reserves have once again contracted outright, declining US$17 billion in the four months through August. Excluding China, which saw a US$57 billion increase over this period, reserves of EM central banks tumbled US$68 billion from April to August. 
The largest declines in reserves over the past few months have been in EM Asia excluding China, although EM Europe has also experienced a sizable drop. As a group, reserves of EM Asian central banks outside China dropped US$46 billion, or 6.3%.
The declines have been broadly based, with large drops seen in India, Indonesia, and Thailand. In percentage terms, Indonesia has experienced the largest fall, at 13% of its total holdings. India’s decline of nearly US$16 billion amounts to a 6% contraction, while Thailand’s US$9 billion decline is a 5.5% drop. Outside Asia, Hungary experienced a very large US$6 billion decline (over 13% of its total holdings), but half of this reflected an early repayment of its IMF loan. Relatively sizable declines in reserves were seen in Argentina,Turkey, South Africa, Russia, and Brazil." - source JP Morgan

The key question of course is the level of imbalances, on that point JP Morgan makes the following remarks in their recent note:
"The obverse of the surge in official exchange reserves over the past 15 years has been the rise in global imbalances as viewed through the balance of payments accounts around the world. The rise of global current account imbalances is often cited as either a contributing factor to the global financial crisis or, at minimum, a symptom of the factors underlying the crisis. The word “imbalance” is in itself a loaded concept, implying a fundamental tension that can reach a tipping point that results in a rapid unwind. Of course, this need not be the case, as the flip side to the current account is the financial/current account whereby trade imbalances are offset through a transfer of assets from borrowers (current account deficit countries) to creditors (current account surplus countries), leading to a reshuffling in the net international investment position of countries.
So long as both parties are accepting and there are sufficient assets “for sale,” current account imbalances can continue. However, the rapid acceleration in current account positions over the last decade pushed the flow of goods and capital to an unsustainable point. Between 1999 and 2007, the trade deficit of the major deficit economies more than doubled as share of global GDP from a reasonable 1% in 1999 to a more concerning 2.3% as of 2007. The 1.3%-pt rise owed only 0.3%-pt to the US, where a declining USD helped keep a check on trade even as rising oil prices fueled a sharp rise in the energy deficit. A larger 0.6%-pt rise in the global trade deficit owed to rising deficits in Europe (excluding Germany). Mirroring the rise in these deficits was an equally strong ramp up in trade surpluses from Germany, Japan, China, and large commodity exporting countries (including OPEC)." - source JP Morgan.

But as far as the markets are concerned, for the moment only "greed" prevails, "bread" abounds and political "circuses" have been kept to a minimal.

On a final note, it is going to fathom a continuation of the "Cantillon Effects" in 2014 if history is any guide as displayed by Bloomberg's recent Chart of the Day indicative of the hurdles face by the S and P 500 in 2014:
"Investors in funds that track the Standard & Poor’s 500 Index may have to reacquaint themselves with year-to-date losses in 2014, if history is any guide.
As the CHART OF THE DAY shows, the S&P 500 has been higher than last year’s close throughout 2013. The index, which showed a 23 percent gain for the year through yesterday, accomplished the same feat in 2012. This hasn’t taken place in consecutive years since 1975-1976, according to data compiled by Bloomberg.
The earlier streak effectively ended on the first trading day of 1977, as the S&P 500 dropped that day and stayed lower the rest of the year. At year-end, the index posted a loss of 11.5 percent, as the chart depicts.
More restrictive monetary policy, increased sales of new stock or falling earnings might trigger a reversal this time, according to Michael Shaoul, chairman and chief executive officer of Marketfield Asset Management LLC. “Eventually circumstances will change sufficiently to make the equity market a treacherous place to invest,” Shaoul wrote yesterday in a report. The New York-based money manager cited the S&P 500 performance comparison in his research. “We would allow for an increase in volatility and the potential for some violent bull-market corrections,” he wrote. On the other hand, he added: “It is easier to see the market move higher than lower overall in the months ahead.”" - source Bloomberg.

"Optimism is the opium of the people." - Milan Kundera 

Stay tuned!

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