Saturday, 24 August 2013

Credit - Osmotic pressure

"We want a story that starts out with an earthquake and works its way up to a climax." - Samuel Goldwyn 

Looking at the continued sell-off in Emerging Markets currencies with the Indian Rupee touching a record low level of 65.56 before bouncing back by 2.1%, on Friday the biggest move since June 2012 and the Brazilian Real which continued its slide before bouncing back as well 3.7% to 2.3488 following a 60 billion US dollar central bank pledge, made us venture towards our distant memories, in similar fashion like our previous posts made us revisit our musical souvenirs from the 80's.

Emerging Currencies "tapering" in true MMA fashion since Bernanke started mentioning "tapering" its QE programme, graph source Thomson Reuters Datastream / Fathom Consulting / Macronomics:

So why "Osmotic pressure" as our chosen title you might rightly ask?

This time around, our chosen title is directly linked to capital flows we are seeing, with the outflows from Emerging Markets towards Developed Markets. 

As the Osmosis definition goes:
"When an animal cell is placed in a hypotonic surrounding (or higher water concentration), the water molecules will move into the cell causing the cell to swell. If osmosis continues and becomes excessive the cell will eventually burst. In a plant cell, excessive osmosis is prevented due to the osmotic pressure exerted by the cell wall thereby stabilizing the cell. In fact, osmotic pressure is the main cause of support in plants. However, if a plant cell is placed in a hypertonic surrounding, the cell wall cannot prevent the cell from losing water. It results in cell shrinking (or cell becoming flaccid)." - source Biology Online.

Nota bene: Hypertonic
"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

So the reasoning behind our chosen title is linked to our past "biology" classes of course, given since 2009, 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.

We did send a warning in June in our conversation "The Daisy Cutter":
"If you think rising yields are only putting global trade at risk, think as well how it will ripple through in various sectors and countries." - source Macronomics 

This is what we envisaged in our conversation "Singin' in the Rain" as well:
"If the dollar goes even more in short supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the Rain", could it mean we will have wave number 3 namely a currency crisis on our hands? We wonder..."

The mechanical resonance of bond volatility in the bond market started the biological process of the buildup in the "Osmotic pressure" we think and bond volatility has yet to recede. 

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 again, whereas the VIX, the measure of volatility for equities is finally reacting - 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.

Of course, what we have been tracking with interest is the ratio between the ML MOVE index and the VIX which remains elevated from an historical point of view if we look back since October 2000 - graph source Bloomberg:
With VIX picking up, no wonder the ratio between the MOVE index and VIX has fallen from last week 7.06 level towards 6.10 as the contagion in the equities space is finally picking up. Hence, last week our "Fears for Tears" concerns for our equities friend as the "tapering" noise increases as we move towards September.

As a reminder, we started pondering about the potential end of the goldilocks period of "low rates volatility / stable carry trade environment in June:
"As pointed out by Bank of America Merrill Lynch's note stable carry thrives in low rates volatility environment, the recent spike in US bonds volatility has had some devastating effect in high yielding assets:
"Carry trades love low risk-free interest rates, but they love low interest rate volatility even more. This is why over the past three 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."

So what we are witnessing right now is indeed "reverse osmosis" in Emerging Markets, and the osmotic pressure which has been building up is no doubt leading to an "hypertonic solution" when it comes to capital outflows in Emerging Markets.

Let us explain:
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.

So in this week's conversation, as we moved towards the "interesting" month of September we will revisit some of our thoughts from our conversation "Singin' in the Rain" and look at the risk and opportunities lying ahead.

As a reminder from our June conversation:
"We got seriously wrong-footed by the market's reaction to the "tapering QE" scenario and we still think at some point the Fed will maybe redirect its buying towards MBS, given that rising rates could seriously dent any hope of a "housing recovery" should the move continue at a rapid pace like it has this week."

The "housing recovery is indeed at risk - graph source Thomson Reuters Datastream / Fathom Consulting:
As indicated by Prashant Gopal on the 22nd of August in Bloomberg in his article "U.S. Mortgage Rates Jump to Two-Year High With 30-Year at 4.58%": 
"The average rate for a 30-year fixed mortgage rose to 4.58 percent this week from 4.4 percent, Freddie Mac said in a statement today. The average 15-year rate climbed to 3.6 percent from 3.44 percent, the McLean, Virginia-based mortgage-finance company said. Both were the highest since July 2011.
Homebuyers are rushing to take advantage of historically low borrowing costs before they increase any more. Existing-home sales in July jumped 6.5 percent to the second-highest level in six years, the National Association of Realtors reported yesterday. Those transactions largely reflect closings of contracts signed a month or two earlier, when mortgage rates were just beginning to edge up." - source Bloomberg

From the same article:
"The Mortgage Bankers Association’s index of applications to lower monthly payments fell 7.7 percent in the week ended Aug. 16, the 10th straight decline. A measure of purchases rose 1.2 percent, the trade group said yesterday.
The 30-year fixed mortgage rate is well below its average of about 6.3 percent for the past 20 years, according to data compiled by Bloomberg. The 20-year average for a 15-year loan is about 5.83 percent." - source Bloomberg

Yes but, there is indeed a "convexity issue at play" given the US average Maturity of Fixed Rate Mortgages has been steadily increasing in the last decades - graph source Thomson Reuters Datastream / Fathom Consulting:
 And as our very wise credit friend former head of credit research said on the subject of convexity in June in our conversation "Singin' in the Rain":
"Convexity is a bigger issue in all the pensions + fixed income funds. That's one reason mortgages have been whacked. the Fed will basically have to do a ECB - stop buying USTs and start buying RMBS. But pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it with LIBOR"

At the time we argued:
"The Fed is likely to step in and actually increase QE to try and hold rates down, because mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3%, we have to agree with our friend that a "new dance" routine from the Fed might be coming." 

Central Banks Assets - graph source Thomson Reuters Datastream / Fathom Consulting:

Why the Fed might indeed increase QE? 
Point number 1:
Because the Fed is facing a raft of sellers and the economy is not as strong as it seems.
For instance, China’s holdings in May were $1.297 trillion, less than the $1.316 trillion reported by the Treasury last month. China’s stake dropped by $21.5 billion in June, or 1.7 percent according to Bloomberg as per Treasury Department data released on the 14th of August. On top of that US Commercial Banks as well have been selling as indicated by Bloomberg Chart of the Day from the 19th of August - graph source Bloomberg:
"U.S. commercial banks are dumping Treasuries at the fastest pace in a decade and boosting loans, helping make the debt securities the world’s worst performers as the economy gains momentum.
The CHART OF THE DAY shows banks’ holdings of U.S. Treasury and agency debt tumbled $34.7 billion to $1.81 trillion in July, the biggest monthly decline in 10 years, according to the Federal Reserve. The level dropped to $1.79 trillion in the first week of August, Fed data showed on Aug. 16. Also tracked are 30-year bond yields climbing to a two-year high. The lower panel records commercial and industrial loans as they surged to $1.57 trillion, the highest since 2008.
Bank sales of Treasuries accelerated after Federal Reserve Chairman Ben S. Bernanke said on June 19 policy makers may reduce the bond-buying program they use to support the economy. Concern the Fed will trim its $85 billion a month of Treasury and mortgage purchases helped send notes and bonds due in a decade or longer down 11 percent in the past 12 months. It was the biggest loss of 174 debt indexes tracked by Bloomberg and the European Federation of Financial Analysts Societies." - source Bloomberg.

Point number 2:
Our "omnipotent" magicians are desperately trying to "bend" the velocity curve and anchor higher inflation expectations. On that note we read with interest Professor Rogoff comments in Bloomberg article by Aki Ito and Michelle Jamrisko on the 12th of August - "Rogoff Saying This Time Different Calls for Reflation":
"Rogoff is espousing aggressive monetary stimulus, even at the cost of moderate price increases. At a time of weak global inflation, higher prices may even help the U.S. economy by lowering real interest rates and reducing debt burdens, he said.
“In more normal times, you’re looking for the central banker to be an anchor against high inflation expectations and to assure investors that inflation will stay low and stable to keep interest rates down,” Rogoff, co-author with Carmen Reinhart of the 2009 book “This Time Is Different: Eight Centuries of Financial Folly,” said in an interview. Now “we’re in this situation where many of the central banks of the world need to convince the public of their tolerance for inflation, not their intolerance.”

G-7 Inflation
Central banks across the developed world are struggling with inflation that’s too low. Consumer price increases in all but one of the Group of Seven economies are currently running under 2 percent, which has become the standard goal in recent years for monetary authorities. Two years ago, deflationary Japan was the only country struggling with below-target inflation."  - source Bloomberg.

The only issue is once the "Inflation Genie" is Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:
“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it”

While the recent jump in interest rates, has created an "hypertonic surrounding" in the reverse osmosis plaguing Emerging Markets, it has had some positive effect somewhat for the insurance sector as well as the Auto Industry given that it has provided some relief in terms of "reserve adequacy" for insurers and a relief on "reinvestment rates" to plug the growing gap in pensions liabilities hindering the allocation of capital for the Car industry giants.

As a reminder from our conversation "Cloud Nine": 
"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2."

But, of course, what matters is indeed the "velocity" of the movement, and the intensity. So far we have avoided a major sell-off in credit. 

As indicated by Megan Hickey and Zachary Tracer in their Bloomberg article from the 1st of August commenting on US insurer's Metlife's results entitled "Metlife Says $10.9 billion of Bond Gain Erased, More Than Crisis", what matters is the pace of the rise in interest rates:
"MetLife Inc., the largest U.S. life insurer, saw $10.9 billion in bond gains wiped out in the three months ended June 30 as interest rates rose, exceeding the decline in any quarter of the financial crisis.
Net unrealized gains narrowed to $20.9 billion on the portfolio of available-for-sale fixed-maturity securities, from $31.8 billion three months earlier. The tumble helped cut MetLife’s bond holdings about 4.8 percent to $356.5 billion." - source Bloomberg

They also added the following comments from a Fitch Ratings analyst:
"Losses tied to deterioration in the creditworthiness of issuers are more worrisome than the more recent fluctuations related to interest rate movements, said Douglas Meyer, an analyst at Fitch Ratings. He said higher rates can help increase investment income at insurers and improve profitability on some products.
“The jump in interest rates, the way we look at it, it has a positive impact on the industry,” he said. “This will provide relief in terms of reserve adequacy, it will provide relief on reinvestment rates.”
An extreme spike in rates of more than 5 percentage points could hurt insurers, he said. Clients might redeem products that offered lower yields, forcing insurers to sell securities at a loss to meet withdrawal demands, he said." - source Bloomberg.

We quoted our fellow blogger and friend Martin Sibileau back in June in "Singin' in the Rain" on the risk ahead for credit:
"If Ben triggers a sell off in credit with the insinuation of tapering, the dealers on the other side, making the bid for the investors, will be forced to do the rate hedge their investors did not do, because they must be interest rate neutral! That means selling US Tsys for an average of 85% and 50% of positions in HY and IG respectively! In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?" - Martin Sibileau

And as we discussed above, "macro" osmosis has led to "positive correlations". When it comes for risks ahead, we share CITI's Matt King views from his European Credit Weekly, namely that after a pleasant summer for credit, it might be time indeed to continue to reduce exposure to neutral:
One of my favourite games as a child was always dominoes. No, not the rather tedious business of laying tiles end to end and trying to match up their spots.
Rather, the much more thrilling challenge of creating long and winding lines before knocking them over, and being amazed at the far-reaching devastation which could be caused with a single flick of the finger.
European credit feels at present to us like the last asset in a similarly long chain – seemingly remote from the problem of higher UST yields, almost immune to date to the outflows starting to occur elsewhere, and yet nevertheless with an intricate linkage to other assets which belies its apparent distance.
Ironically, our best guess has been and remains that the domino run will not quite get started in the first place – or, at a minimum, that some benign and omnipotent central banker will reach in to remove a domino or two and stop any run before it reaches us. Our house forecasts show the UST backup abating, show credit spreads remaining tight, and the EM sell-off remaining contained to mid-2014.
Moreover, it is striking just how well spreads have generally performed in the face of the backup in UST yields to date. EM hard currency mutual funds, for example, have lost nearly one-third of the last three years’ cumulative inflows (Figure 2), against which the backup in EM spreads, while notable, is hardly cataclysmic. 
The outflows from credit funds have been tiny by comparison, and in Europe have been almost negligible. Unless outflows pick up very significantly, there is every reason to think € spreads remain resilient." 
Besides, in many respects the risks as we head into September seem rather obvious. Tapering has been extremely well flagged. The Fed minutes suggest it will happen this year, but did not seem overly attached to our view of a September start.
German elections have been talked about a great deal, but seem ever less likely to bring about a significant change in the political landscape. Conscious corporate releveraging seems largely confined to the US. Supply is likely to pick up significantly, but is likely to have been widely anticipated. Above all, we have little sense of any build-up in complacent longs during the summer in the way we earlier feared, as is vouched for by the lack of outperformance of most high-beta names.
And yet despite all this, we still recommend reducing any remaining longs in € credit to neutral." - source CITI

CITI's Matt King also added:
"When playing dominoes, it usually takes a few goes before the run really gets started (unless, of course, you didn’t mean for it to start, in which case there’s no stopping it). Our best guess is likewise that, despite the somewhat precarious lineup, not a great deal happens over the next few weeks, and that spreads trade more or less sideways.
But that’s a bit like leaving the room and hoping that when you come back later you’ll still find all the dominoes standing just as you left them. As those with younger brothers will know, you ought to be okay – but at this point we just don’t think you’re being paid for it." - source CITI

The issue for us is that from a "macro" perspective, if the reverse "osmosis" has truly started and with "positive correlations" still in place, there is indeed not only heightened risk from the continuation of the sell-off in Emerging Markets which could affect Developed Markets in the process, but, exogenous factors with political tensions and agendas could indeed roil further risky asset classes.

The $3.9 trillion of cash that flowed into emerging markets over the past four years has started to reverse, indicative of the "Osmotic Pressure" and "reverse osmosis" process taking place.

As we posited back in June for Emerging Markets:
"Why are we feeling rather nervous?

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?" - source Macronomics, June 2013"Singin' in the Rain"

Moving back to our friend Martin Sibileau's June question on "precious metals":
"In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?"
At the time we argued that precious metal had further to fall and they did.

But, as we move towards September and what has already started is a bounce back. In similar fashion to what we confided in our January conversation "If at first you don't succeed...", we have once again put in practice the effect of our magicians ("omnipotent" central bankers practicing their "secret illusions") by starting being long gold miners via ETF GDX and some selected miners as well.

The S&P 500, the US 10 year breakeven, please note we have added Gold into our previous Chart,  graph source Bloomberg:
Once again we have broken our Magician's Oath:
"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

What is the rationale behind our call? We once again come back to our June conversation "Singin' in the Rain" where we quoted David Goldman's article about Gold and Treasuries and bonds in general which he wrote in August 2011 (the former global head of fixed income research for Bank of America):
"Why should gold and Treasury bonds go up together? Gold is an inflation signal and bonds are a deflation hedge. At first glance it seems very strange for both of them to rise together. Why should this be happening?
 The answer is simple: bonds are an option on the short-term interest rate, and gold is a perpetual put option on the dollar. Both rise with volatility.
 It’s like the old joke about the thermos bottle: “How does it know if it’s hot or cold?” 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."

Our thermos bottle is lately behaving accordingly because the YTD movements in 5 year forward breakeven rates is falling again, which is indicative of the strength of the deflationary forces at play - source Bloomberg:

The 5 year forward breakeven was at 2.56% on the 21st of August but it has been breaking lower as per the most recent reading - graph source Thomson Reuters Datastream / Fathom Consulting:

QE and the US Dollar - graph source Thomson Reuters Datastream / Fathom Consulting:

Dollar index versus Gold - graph source Bloomberg:

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. That's all for magic tricks. We enjoy your company, dear readers, but we should not be breaking our Magician Oath too often as you haven't sworn to uphold the Magician's Oath in turn yet...

On a final note, in true Pareto efficient economic allocation, while some pundits wager about simultaneous developments having contributed to the weakness in Emerging Market equities, for us Emerging Markets have been simply the victims of currency wars ("Have Emerging Equities been the victims of currency wars?"), "Abenomics", and of course "reverse osmosis" courtesy of positive real interest rates in the US. It is therefore not a surprise to see that the biggest beneficiary of "reflationary"policies have indeed been the Japanese as displayed in Bloomberg's Chart of the Day from the 22nd of August displaying the Earnings Per Share for 6 regions:
"Prime Minister Shinzo Abe’s policies to lower the yen and end deflation are already paying off for corporate earnings, with Japanese companies’ profits outpacing the rest of the world.
The CHART OF THE DAY shows earnings per share in six regions tracked by Bloomberg rebased to 100 at the end of June 2011. Profits for the Topix climbed the most, rising 32 percent as companies in Japan’s equity benchmark recovered from the March 2011 earthquake that damaged large parts of the country’s north east. The lower panel of the chart shows the yen’s decline against nine other world currencies.
“Japan has been through a full earnings cycle over the past two years,” said Mert Genc, a London-based strategist at Citigroup Inc., which composed the graph. “First, largely as a result of the earthquake, earnings halved. But then they doubled again, with the latest boost coming from weakness in the yen and improving economic performance.”
Japanese exports jumped by the most since 2010 in July, showing the economy has benefited from the yen’s 22 percent slide against the dollar since the end of 2011. Earnings in the U.S. have climbed 16 percent since June 2011 as the Federal Reserve’s bond-purchasing program helped to stimulate growth. Profits in the U.K., the euro area, emerging markets and Australia have declined in the same period.
Analysts estimate earnings in the Topix will grow 11 percent in 2014, according to Bloomberg data, in line with the average for the other regions in the chart of the day." - source Bloomberg.

The MSCI Emerging Markets Index has declined 12 percent this year, compared with a 12 percent gain for the MSCI World Index of companies in advanced economies.

"Remember, the storm is a good opportunity for the pine and the cypress to show their strength and their stability." - Ho Chi Minh 

Stay tuned!

Saturday, 17 August 2013

Credit - Fears for Tears

"A person's fears are lighter when the danger is at hand." - Lucius Annaeus Seneca

In continuation to our musical title analogies and given we have been revisiting old classic "New Wave" music from the 80's while enjoying the quiet daily commute, looking at the continuation of the build in risk (US equities making new highs using margin debt, the great return of covenant-light loans, etc.), we thought this week, we would use a somewhat veiled reference to UK group Tears for Fears for our chosen title, given this year was the 30 year anniversary since the release of their first debut album "The Hurting" (released on the 7th of March 1983). Looking at the increasing risks of a Fed "Tapering" and the poor liquidity experienced in the secondary space during the previous bout of bond volatility, we thought using "Fears for Tears" as a title would conveniently illustrate our growing "fears" concerns that could no doubt led to "tears" and to large inflicted "hurting" in risky assets.

Of course, some will describe us as being outright "bearish" given everyone is vaunting the much improved economic data in the US as well as in Europe. As we pointed out last week, there are indeed a few clouds gathering on the horizon thanks to rising "forced correlations" which could lead to some  additional repricing, and not only in the equities space.

In this week's conversation, we will focus on these risks as well as what capital shortfalls entails in the credit space for subordinated bond holders, which have become again quite complacent on the matter.

We have been tracking with interest not only the rise of the S&P index (blue) versus NYSE Margin debt (red) but we also added S&P EBITDA growth (yellow) as well as the S&P buyback  index (green) since 2009 - graph source Bloomberg:

Of course this only telling half the liquidity induced rally courtesy of our "omnipotent" central bankers and their wealth effect strategy, leading to the use of leverage of any kind, which, leading to some "risk parity" strategic users to rediscover with much "hurting" the inherent risk in too much leveraged risk piled into interest rate sensitive asset which our friends at Rcube Global Macro Research have been discussing as of late. We will touch more on liquidity further in our conversation.

Some argue that concerns on the record amount of borrowing for US stocks are misplaced because, lower interest rates have made the borrowing much less expensive, as illustrated by Bloomberg in a recent Chart of the Day (15th of August):
"Concern that a record amount of borrowing to buy U.S. stocks foreshadows an end to the current bull market is misplaced, according to Michael Shaoul, chairman and chief executive officer at Marketfield Asset Management.
The CHART OF THE DAY illustrates why the issue has emerged in the top panel, which compares total margin debt at New York Stock Exchange member firms with the value of the Standard & Poor’s 500 Index. April’s debt was a record $384.4 billion, according to the exchange.
Lower interest rates have made the borrowing much less expensive -- and less significant -- than it was when the last two bull markets concluded in 2000 and 2007, Shaoul wrote in an e-mailed note yesterday.
Investors are paying about 72 percent less interest than they were at the 2007 peak, as displayed in the chart’s bottom panel. This estimate was calculated by multiplying margin debt by the broker call rate, charged by banks on similar loans to securities firms, as Shaoul did in his note.
Companies’ rising earnings also suggest borrowing is far from excessive, the e-mail said, because they have made stocks more valuable. By this yardstick, the amount of margin debt has to climb 40 percent to reach an equivalent to the two previous market peaks, even if S&P 500 company profit stays unchanged.
“Margin debt expansion will remain in place until corporate earnings falter” or the Federal Reserve raises its target interest rate significantly, the New York-based investor wrote. “We do not expect to see either of these take place for a number of quarters.”" - source Bloomberg.

But corporate earnings are, we think exposed, and the rally has been as well sustained by multiple expansions and very significant stock buy-backs.

Reading through CLSA's weekly Greed & Fear note from the 15th of August, written by Christopher Woods, we could not agree more with his comments, where he indicated that risks on the S&P 500 are rising:
"What does all this mean for the American stock market? Well in one paradoxical sense if growth in the US is not as robust as hoped for, that means quanto easing continues which should support the equity market. Still at some point common sense takes over and a lack of growth is plain bearish for equities, most particularly in the context of an American stock market which in recent months has been driven far more by multiple expansion rather than earnings growth. Thus, the S&P500 trailing PE has risen from 15.6x in late December to 18.4x" - source CLSA - Greed & Fear, 15th of August 2013.

For illustrative purposes, we have been plotting the growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

On top of that multiple expansion and the induced rally by central banks liquidity injections have been boosted as well by a reduction in denominator via stock buy-backs. The complacency in the equity space is starting to raise our "fears" for "tears" as displayed by Deutsche Bank's US equity strategist at Deutsche Bank graph indicating the price-earnings ratio for the Standard & Poor's 500 with the VIX:
"Investors are becoming overly content about the prospects for stocks after more than four years of gains, according to David Bianco, chief U.S. equity strategist at Deutsche Bank AG.
The CHART OF THE DAY shows how Bianco reached his conclusion: by comparing the price-earnings ratio for the Standard & Poor’s 500 Index with this quarter’s average close for the Chicago Board Options Exchange Volatility Index. The latter gauge, known as the VIX, is based on S&P 500 options.
Bianco’s P/E-VIX ratio closed yesterday at 1.20. At that level, a lack of concern that share prices may fall starts to supplant “realistic and disciplined” investing, he wrote in an Aug. 9 report.
“This complacency signal may pertain more to the derivatives market than the equity market,” he wrote. This quarter’s closing VIX average as of yesterday was 13.59, just above the first-quarter figure of 13.53. The latter reading was the lowest since 2007, when a five-year bull market came to an end, according to data compiled by Bloomberg.
While stocks have room to extend their advance since March 2009, increased volatility is likely to accompany any further gains, he wrote. This would allow stocks to rise relative to earnings without sending another warning sign, the New York-based strategist wrote.
Bianco expects the index to end next year at 1,850, which is 9.2 percent higher than yesterday’s close. His projection for the end of this year is 1,675, in line with the average among 17 strategists in a Bloomberg survey." - source Bloomberg.

Whereas the volatility in the fixed income space has remained elevated as displayed by the recent evolution of the Merrill Lynch's MOVE index falling from early May from 48 bps  towards the 87 bps level, the VIX, the measure of volatility for equities has remained fairly muted - 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.

Of course when ones look at European government yields and in particular peripheral yields, both Italy and Spain are trading towards the lowest level since 2011 relative to German government yields - graph source Bloomberg:
While the German 10 year government bond has moved in sympathy with the 10 year US treasuries breaking its 1.60% - 1.70% range towards 1.90%, Spanish and Italian yields have so far remained fairly muted. 
In relation to our "Fears" for "Tears", we share the same views as Morgan Stanley, from their Credit Strategy note from the 16th of August entitled "Working Through Our Worries", namely that Europe remains on our top concern list:
"Why Europe is the risk we’d stay focused on
We’re relatively relaxed about higher rates and the EM slowdown, but it’s the risk of renewed volatility in the eurozone that causes us the most discomfort. This may sound odd, given that Spanish sovereign spreads are at their year-to-date tights, but is based on a couple of factors unique to this risk.
First, it enjoys especially high uncertainty: One can look to Fed speeches and US data to inform a view of ‘tapering’. One can follow EM currencies or commodity prices to get a sense of regional stress. No similar metric exists for measuring the cohesion of the Italian government or the likelihood of a rating agency downgrade.
Second, it can strike with high intensity: The large rate move since May has so far been weathered well. No more than a handful of European corporates are experiencing serious credit trouble from a sharper China slowdown.
Sovereign weakness, in contrast, has repeatedly shown the ability to drive severe, broad-based weakness in our market.
Third, while it is not our base case, there are plausible reasons why a eurozone crisis could re-emerge: Improving economic data in Europe are encouraging. Yet the ratings of nearly all eurozone sovereigns remain on negative outlook. Debt/GDP will likely rise and unemployment should stay high well into 2014, even if growth ‘improves’ to ~1%. The eurozone’s ability to backstop a crisis remains hamstrung by the continued lack of a banking union, an OMT programme that our economists believe will be difficult to activate, and a continued reluctance by the ECB to use QE." - source Morgan Stanley

Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to be tested. But what we are concerned about is, as we indicated in our conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR 
As a reminder: AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase.
"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending.

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.
"Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments"

It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record as displayed in the below table by Bloomberg:
"Euro zone financial institutions' sovereign holdings totaled 1.78 trillion euros in June, up from 1.4 trillion euros in December 2011. In efforts to maintain asset values and lower auction costs, banks have increasingly supported their sovereigns by purchasing sovereign debt, which may stop their own associated CDSs and funding costs from rising aggressively. Over-exposure to sovereign debt (and loans) can threaten solvency should conditions deteriorate enough." - source Bloomberg.

In that sense the European Banking Union is more akin to a Government/Bank Union when it comes to sovereign bonds holdings.

As we indicated back in our conversation "Cloud Nine", indeed the government is the preferred borrower when it comes to lending as displayed in Bloomberg Chart of The Day from the 13th of August:
"Italian banks are increasingly using liquidity to buy more profitable sovereign debt, reducing loans to companies and households, as Italy’s longest recession in 20 years makes lending more risky.
The CHART OF THE DAY compares the banks’ purchase of Italian government bonds and loans made to the private sector.
Italian banks increased their holdings of the country’s debt by almost 100 billion euros ($133 billion) in the 12 months ended June 30 to a record 402 billion euros. In the same period, loans decreased by 55 billion euros, or 3.3 percent, to 1.63 trillion euros.
There’s a crowding-out effect,” said Carlo Alberto Carnevale Maffe, professor of business strategy at Milan’s Bocconi University. “The public debt is soaking up resources from the private sector, offering higher yields on capital and a lower investment risk, at a time in which companies and families are struggling to repay their debt.”
Italian banks, which have borrowed more than 255 billion euros from the European Central Bank’s longer-term refinancing program, are investing part of the liquidity obtained at lower interest rates in short-term government bonds that offer higher yields. That’s favored by Italy’s government, which is seeking domestic buyers to replace lower purchases from foreign investors so it can cover a monthly average issuance of 40 billion euros in securities to finance its $2.7 trillion debt. At the same time, banks are more reluctant to lend as a recession saddles them with mounting bad loans." - source Bloomberg

Should Mario Draghi feel the urge to trigger is "nuclear" device, it will have to be "Brighter than a Thousand Suns", to quote, J. Robert Oppenheimer...
Oh well...

So when it comes to our "Fears for Tears", liquidity has always been our top concern, credit wise.
As we posited in "The Unbearable Lightness of Credit":
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital

The recent surge in the fixed income space of May and June have indeed been very stark reminder of the importance of liquidity. On that subject we came across a article entitled "The great unwind: Buy-side fears impact of market-making constraints" which struck as a perfect illustration of Roger Lowenstein's quote:
"At the start of May, as prices for US agency bonds reached what would later prove to be a peak, one New York-based hedge fund decided to sell its portfolio of roughly $100 million in AAA-rated mortgage-backed securities. The fund’s senior trader expected to be out of the position in a day, or even less. If it had gone to plan, it would have been beautifully timed, but it didn’t go to plan.

“You’re talking about AAA agencies – OK, with some callable features – and you don’t expect there would be no liquidity for that kind of instrument. The only reason I allowed us to carry that position is that, in my mind, you should be able to blow out of it in basically a day, or even an hour for that kind of size. But the reality was it took us a month,” he says.

The fund initially turned to a single dealer, which bought less than $10 million of the bonds upfront, promising to take the rest as and when it could find bids from other clients. Over the course of the next four weeks, the position shrank slowly, and the price of the bonds steadily slipped. The trader declines to say how much value was given up, but he admits the fund’s hedges did not work perfectly, and says it lost money on the portfolio during the month. Eventually, losing patience, the fund brought in a second bank to speed up the process.

“Effectively, there was no liquidity for that stuff. The discrepancy between the expectation and the actual liquidity was one of the largest I’ve ever experienced,” he says.

This fund was one of the lucky ones, selling the bulk of its portfolio before bond market jitters turned into a full-scale rout in the last week of May. The sell-off was triggered by the fairly innocuous statement from Federal Reserve chairman, Ben Bernanke, that the central bank might rein in its programme of quantitative easing. As fixed-income investors sought to pare back the huge positions they have built up in recent years, prices moved dramatically, triggering further waves of selling – yields on 10-year US Treasury bonds leapt 80 basis points in six weeks to close at 2.73% on July 5, but everything from emerging market sovereign debt to corporate bond exchange-traded funds (ETFs) was hit.

“I’ve never seen markets move so far on so little news,” says one senior, London-based trader – a sentiment shared by many other market participants.

Some banks, plus buy-side firms including BlackRock, Deutsche Asset & Wealth Management and Fortress Investment Group, now explain this episode in the same way: the problem was illiquidity, and the cause was bank regulation.

New capital, liquidity and leverage rules are making it more expensive to carry inventory, they say, meaning banks have less capacity to take principal risk. The consequence is that market-makers were not initially willing to absorb the supply of securities: orders were broken into smaller clips, bid-offer spreads exploded, in some cases even enquiries had the power to move markets. Once prices had collapsed, demand strengthened, enabling bank trading desks to match up buyer and seller more rapidly, and stabilising the market.

Or so the argument goes, and there is a lively debate, particularly among dealers, about how important these factors were. But the bigger question is what happens next. As interest rates normalise, investors that have gorged on fixed-income securities will all be trying to cut their exposure – a prospect the chief risk officer at one US bank’s asset management arm calls “the great unwind”. With market-makers unable to provide the kind of liquidity many investors are used to, he predicts a period of sustained, savage volatility, and the head of rates distribution at one UK bank agrees: “We’ve just had a 30-second trailer for the full movie.”

For now, there is little science to back up these scary predictions, but there are anecdotes, intuition, a lot of first-hand experience – and some numbers.

“There’s never been a wider gap between the amount of overall product out in the market versus dealer balance sheets. When you start looking at the size of the institutional market and daily turnover as a function of the dealer balance sheet, you get some pretty horrific stats,” says Richard Prager, head of trading and liquidity strategies at BlackRock in New York.

Others see it the same way. “There is a pent-up mismatch that has been built as real-money asset managers have swelled in size while dealers have reduced their inventories, and there is a real risk that some investors may not understand the effect this structural imbalance has on the underlying liquidity of some of those portfolios,” says Randy Brown, co-chief investment officer at Deutsche Asset & Wealth Management in London.

According to data compiled by the Federal Reserve Bank of New York, the inventory of corporate bonds held by primary dealers plunged from a high of $235 billion on October 17, 2007 to just $55.9 billion as of March 27 this year. An even bigger drop has been seen in holdings of agency debt, which fell from a high of $69 billion in May 2008 to $6.8 billion by March 27 – a decline of 90%.

The same trend has been seen in corporate bonds, according to Peter Duenas-Brckovich, global co-head of credit flow trading at Nomura in London. “If, 10 years ago, the Street was willing to hold 4.5 to 5% of the outstanding debt, that number is now only 0.5%,” he says.

The major constraint has been the introduction of the Basel Committee on Banking Supervision’s new trading book capital rules – known as Basel 2.5 – which has forced dealers to hold more capital against trading book assets through the use of a general market risk charge measured using a 10-day value at risk at a 99% confidence interval, a stressed VAR charge and, for banks that model specific risk, an incremental risk charge (IRC) (see box, The roots of the problem). But banks also face a new leverage ratio and structural restrictions on their ability to take proprietary trading positions – however those are defined.

“Post-crisis, the proportion of inventory held by dealers has diminished dramatically; collectively, dealers’ inventory is a tenth of what it once was,” says Chris Murphy, global head of rates and credit at UBS, and a member of the bank’s investment bank executive committee. “Banks were complacent about housing inventory in the pre-crisis years, and balance sheets were out of whack with the industry’s real risk-bearing capacity. That has been corrected by the Basel capital overlay, where warehousing credit products in the lower-rated space – like high-yield or emerging markets – is extremely punitive. And banks also have to comply with leverage ratios, which act as a major constraint on balance sheet size.”

Large asset managers agree on both the cause and the effect. “Holding securities longer term has always been challenging for dealers. Today, constraints on funding cash inventory are even more pronounced because of new regulations, lower credit ratings for most dealers, and mark-to-market concerns if credit spreads widen. Dealers will assume positions temporarily while trying to place bonds elsewhere, but I would not expect them to offer significant additional longer-term capacity,” says Hilmar Schaumann, chief risk officer of Fortress Investment Group in New York.

What this means, simply put, is that markets are likely to move further and faster when clients are selling – and traders say the reaction to Bernanke’s comments is the perfect example.

“He basically said, ‘At some point in the future, there is a possibility we might think about maybe – maybe – not doing quite as much bond buying’. And we still had a complete meltdown. That’s a lot of movement for not a lot of news. Imagine if they’d actually changed rates,” says the London-based head of European fixed-income trading at one large European bank.

Another example is the reaction to the July 1 resignation of the Portuguese finance minister. By July 3, the country’s 10-year bonds had jumped from 6.38% to 7.46%. The price of the bonds fell around five points – or 5% of par.

“It’s a peripheral credit that is expected to have problems, but a five-point drop? I’ve been doing this for 20 years – the news does not justify the move. This is not a corporate where the head of accounting quit because of accounting fraud. This is highly suggestive of poor liquidity in the market,” says Nomura’s Duenas-Brckovich." - source

Moving on to the subject of complacency in the subordinated bond space, we eagerly await the results of the AQR tests which will be conducted by the ECB and we agree with CITI's take from their credit note from the 13th of August:
"European Union finance ministers recently reached an agreement on several topics which should form the backbone of the European bail-in legislation (expected to be implemented from 2015): e.g. the priority of payments in the event of a bail-in and the creation of national based resolution funds. Essentially, the agreement specifies a list of liabilities which will not be bailed-in (e.g. guaranteed deposits); this list excludes equity, sub and senior debt, i.e. they are “bail-inable”.
According to our interpretation of the draft directive, national authorities will only have the ability to inject “public” money into a bailed-in bank once losses of 8% of total assets have already been absorbed. In other words, for sub or senior debt not to be bailed-in, other (presumably more junior obligations like equity) securities would have to have already absorbed (i.e. bailed-in) 8% of the total liabilities of the bank. What does this mean (to us at least)?
-If the equity to total liabilities ratio in a bank were more than 8%, there would be a chance that sub debt may not be bailed-in. However, the average equity to total liabilities ratio in European banks is 5% and very rarely exceeds 8%, which means that sub bail-ins appear very likely.
-The ratio of equity plus subordinated debt to total liabilities for the average European bank is around 7%, which means that national authorities would pretty much be forced to “fully” bail-in equity and subordinated bondholders. Figure 4 shows the distribution of the ratio of equity plus subordinated debt to total liabilities across European banks.
In many cases, the ratio is below 8%. Even if the ratio is above 8%, sub debt would likely be bailedin if losses are above that level and/or national authorities want the post “bailined” bank to have a meaningful capital base
-What about senior debt? In the average European bank, equity plus subordinated debt will make up around 7-8% of total liabilities, which means that national authorities will likely have discretion not to bail-in senior debt.
National authorities will, in our view, make use of bail-in legislations when dealing with distressed banks going forward. We expect that bail-ins will trigger restructuring credit events in current CDS contracts, as was the case in SNS and Bankia, and “bail-in” credit events in the new CDS contract."  - source CITI

Of course we have long voice our "Fears for Tears" for the subordinated bond holders and it has been a recurring subject in our numerous credit conversations. It support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

Back in our conversation "The Week That Changed The CDS World", we indicated that the recent SNS case has derailed the auction process and the validity of the current CDS subordinated contract. In the case of SNS, because the auction used senior bonds, the recovery was around 95.5 for the bucket at 2.5 years and 85.5 for other maturities segment. Given the payout equates to par minus recovery, a CDS subordinated bondholder only received 14.5 (100-85.5) much for taking a CDS in the first place...

  1. The issue was that the auction could not operate due to lack of deliverable, it reminds us of a similar case with Delphi Automotive when a market maker had squeezed the market and cornered the bonds which had led to a higher recovery rate and smaller payout to the CDS holders. The markets then moved towards cash settlement to avoid some players to rig on purpose the auction process.

    In the case of the SNS expropriation, the CDS mechanism has derailed somewhat the auction process, hence the need to ensure with the new contracts a smoother payout mechanism. Obviously going forward Sub CDS protection should trade wider. 

    One of our prime candidate for "Fears for Tears" and for failing the upcoming AQR tests in relating to the subordinated bond holders risks, is troubled Italian bank MPS (Montei Dei Paschi). We agree with Bank of America Merrill Lynch's recent note on MPS from the 14th of August entitled "Defusing the capital problem" about the increasing probability of a debt-to-equity swap for the Italian lender:
    "A sub-debt-to-equity swap could help MPS’s capital position
    In our view, an effective solution to the capital issue could be a subordinated debt to equity swap. This is not without recent precedents (Commerzbank, Portuguese banks). Some issues may arise in connection with the Italian rules on dedicated capital increases and pre-emptive rights, but we do not think that these are insurmountable. Incidentally, Banco Popolare has a convertible outstanding which allows the bank to trigger anticipated conversion effectively at a discount to market value (bondholders will receive the face value plus 10%)". Besides, according to new EC rules “state aid must not be granted before equity, hybrid capital and subordinated debt have fully contributed to offset any losses”. If our interpretation is correct, this may imply that ahead of conversion of the state aid into equity, current shareholders and sub-bond holders might have to bear the losses. In our view, this should be a good enough reason for bondholders to accept trading out of (relatively illiquid) bonds into shares. In July 2012, MPS launched a senior-to-sub swap, which was a wasted opportunity as MPS realised just a modest capital gain. A sub-debt-to-equity swap would have the advantage of moving the full sub-debt balance exchanged for equity (rather than just the delta between market price and tender in a cash-to-debt deal).
    MPS has relatively limited options with respect to using its subordinated debt to recapitalise the bank because of the relatively high cash prices that many of the bonds trade at. In some other examples, banks have been able to take advantage of the discount at which their bonds trade to par and monetise this – this seems less clearly an option here given that many bonds trade in the 90s or even higher. We do not exclude that cash prices could fall in the coming months of course but our assessment is that MPS sub bond prices have been surprisingly resilient in the face of the bad news emanating from the bank on the one side and a clearly underperforming sub CDS which is currently indicated at well over +1,000bps on the other side. This is a level that we’d generally associate with very high default risk. There is a big disconnect between MPS cash bonds and its CDS. The latter is implying that there is a high likelihood of a Credit Event. 
    We think this is most likely to be a Restructuring Credit Event rather than a Failure to Pay. We estimate that MPS has subordinated debt with a face value of about €5.3bn, not including the FRESH, all of which essentially could be made available to recapitalise the bank if there was a debt-for-equity swap. In our view, the bank could offer to buy back its subordinated bonds for shares, albeit that this would be very dilutive given that MPS’s current market value is around €2.5bn. Even if the bank decided to focus on the more subordinated parts of its capital structure (T1 and UT2), there would still be potentially €3bn that could be raised in this way. Part of the capital raised would be the gain from taking out any liabilities below par but most of the capital would come from a straight swap of the liabilities for equity. "- source BAML

    But there is a catch for the holders of the current CDS subordinated contract as pointed out by CITI:
    "Under the current CDS contract, if sub debt is converted into equity before the auction date there will be no subordinated deliverables for the auction, as was the case in Bankia." - source CITI

"Fears for Tears"...

On a final note, German exporters should start to have as well their "Fears for Tears" given the Chinese slowdown will continue to weigh on German output as indicated by Bloomberg Chart of The Day:
"China’s credit squeeze is signaling a downturn in German manufacturing, according to ING Groep NV.
The CHART OF THE DAY shows that Germany’s factory output as gauged by a manufacturing purchasing-managers’ index has mirrored Chinese bank-lending growth since a credit boom that began in 2008. As China’s Communist Party seeks to rein in lending on concern that wasteful investment will threaten
longer-term growth, Germany’s export-oriented manufacturers are poised to suffer.
“China’s economy is shifting from domestic investment to more of a domestic consumption model,” said Martin van Vliet, senior euro-zone economist at ING in Amsterdam. “If you’re a German exporter selling machinery, that’s bad news.” China will start a nationwide audit of public-sector debt this week as the government pressures banks to better manage their balance sheets after the record surge in credit. The nation’s economic growth slowed for a second quarter to 7.5 percent in the three months ended June and the government has set a target of 7 percent a year for the five years through 2015. China hasn’t expanded at a slower than 7.6 percent pace
since 1990.
A reduction in debt-fueled Chinese investment spending may hurt German machinery orders in particular. Machinery sales to China last year were valued at 16.9 billion euros ($22.5 billion), accounting for more than a quarter of total shipments to the country, according to the Federal Statistics Office in Wiesbaden.
German exports to China have increased at an average rate of 15.8 percent a year since 1995, more than twice as fast as the total gain. That’s helped Germany weather the effects of the euro-area’s sovereign debt crisis, now in its fourth year." - source Bloomberg.

"Prosperity is not without many fears and distastes; adversity not without many comforts and hopes." -Francis Bacon 

Stay tuned!

Wednesday, 14 August 2013

Guest post - Is Risk Parity a Scam - Rcube Global Macro Research

"We have a natural right to make use of our pens as of our tongue, at our peril, risk and hazard." - Voltaire 

Courtesy of our friends at Rcube Global Macro, please find enclosed their latest publication where Paul Buigues looks at Risk Parity strategies:
(for PDF please use the following link:

Risk parity strategies experienced large drawdowns between early May and late June due to a combination of rising government yields and falling equities.
Note: The original and largest fund in the sector (Bridgewater All Weather Fund) does not publish daily NAVs.

This rather significant correction raised quite a few eyebrows, particularly because risk parity strategies are often marketed as being able to withstand a wide range of economic environments (and, unlike 2008, today’s environment is rather benign).

Although it would be preposterous to disparage a strategy based on two months of negative returns, this drawback gave us the impetus to express our thoughts on risk parity as an investment strategy, as it emerged from relative obscurity just a few years ago, only recently becoming fairly popular among investors.

Like other passive asset allocation strategies,1 the basic premise of risk parity is that asset returns are unpredictable, at least in the short] and medium]term. Consequently, investors should only attempt to capture risk premia, without wasting their time and energy trying to forecast the behavior of specific asset classes.
According to the Modern Portfolio Theory (which is, itself, based on a dozen theoretical assumptions), the only rational choice for an investor is consequently to own the gmarket portfolioh which contains every asset available in the market, weighed according to its relative size. Because this is difficult to implement in practice, investors often settle for a (generally more granular) version of the 60/40 allocation between equity and fixed income.

Risk parity is a different viewpoint on how not to exert judgment on any asset class. According to risk
parity proponents, investors should try to own all major investable asset classes on an equal risk basis.

Supposedly, this results in portfolios that have better risk/reward characteristics than traditional asset allocations. Moreover, as mentioned above, some argue that risk parity portfolios can generate quasi-absolute performances, even in the face of stormy markets.

Before going any further, it is worth stating that implementing a portfolio that contains all assets on
an equal-risk basis is even more challenging to implement than implementing the "market portfolio".
This explains the existence of many different variants of risk parity.2

Recap: Portfolios that express a neutral view on future asset class returns

After selecting a specific variant of risk parity, many implementation choices need to be made:

‐ What universe of assets should be used, and how should they be regrouped them in asset classes?

‐ Should asset class correlations be taken into account? And if so, how?

- How should we define risk? In our understanding, most risk parity implementations use volatility,
which obviously exists in many different varieties (historical, implied, predicted, GARCH, etc.) and
calculation horizons.

- What leverage should be applied to the portfolio for it to reach an acceptable rate of return? (Risk
parity generally involves leverage.)

- What frequency should be used for portfolio rebalancing and volatility calibration?

1 Although risk parity strategies have to be managed actively (if only to equalize risk levels on a regular basis), we consider them to be passive, in the sense that they are not based on trying to forecast future asset returns.
2 Here are just a few implementations of risk parity: the “All weather” portfolio, classical risk parity, cluster risk parity, risk factor parity, and equal risk contribution.
To our understanding, the “All weather” strategy is not risk parity in the strict sense. From the way it has been described in various papers, it basically consists in choosing a set of asset classes, and in leveraging each of them to obtain a common expected return (generally the expected return of equities). In that sense, this strategy should be called return parity, rather than risk parity. Unless we expect all asset classes to have the same Sharpe ratio, these two approaches are not equivalent.

Due to this large number of degrees of freedom and parameters, this paper will present risk parity from a generic viewpoint. It will contain case studies and thought experiments rather than backtests (as we will see, backtests are generally biased towards risk parity strategies).

Although the term “risk parity” was only introduced in 2005, we can trace the origins of the concept
to a strategy that Ray Dalio (3) started using in 1996 to manage his family trust. Despite Bridgewater’s success in generating sizeable alpha for their clients, Dalio wanted to create an investment process that would not depend on his own ability to manage funds or to select managers (as he wouldn’t be able to do so after his death).

The strategy (named the “All Weather portfolio”) also had to deliver returns, regardless of economic
conditions. Dalio therefore concluded that the portfolio should maintain 25% of the portfolio’s risk in
each of the four following quadrants:

This is clearly an excessively simplified portrayal of a strategy that now has $70Bn under management and that has generated an annualized performance of around 8.5% with a volatility of around 10% since 1996, inspiring many fund managers and institutional investors to run the same type of strategies in-house.

However, despite its commercial and financial success, many observers consider risk parity to be an
investment scam. Finding a strategy that might dominate the classical 60/40 portfolio is one thing. Pretending that this strategy is able to produce stable returns (without attempting to predict those returns) sounds a lot like a "get rich steadily and without effort" scheme.

Even though wefre not into passive asset allocation strategies (otherwise, we would look for another
line of work), we will try to contribute to the debate. We will organize our thoughts by looking at
three intertwined dimensions of risk parity: diversification, returns, and risk. In each section, we will
express our opinion on the conceptual merits of risk parity, as well as its prospects in the current

(3) Ray Dalio is Bridgewater’s founder and one of risk parity’s pioneers. Despite the criticism against risk parity expressed in this paper, Dalio is at the very top of our pantheon of financial thinkers.

1. Diversification

From a passive asset allocation standpoint, it is hard to argue against diversification, which
constitutes the core of risk parityfs philosophy.

The idea of spreading risk among different asset classes obviously precedes risk parity by a few millennia, as we can find references to it in the Talmud ("One's assets should be divided into thirds: 1/3rd in land, 1/3rd in business, 1/3rd in gold") or in the Ecclesiast ("Divide your investments among many places, for you do not know what risks might lie ahead").

In the early 1980s, Harry Browne introduced the gpermanent portfolioh, an investment strategy whose aim was to withstand all sorts of economic environments, and which was originally composed of an equally weighted portfolio of four asset classes: 25% US stocks, 25% long-term bonds, 25% cash, and 25% precious metals.

However, it is worth noting that these simple equal]weight approaches only aim at minimizing the risk of ruin from a personal wealth standpoint, which is not the modern view of how portfolios should be managed (i.e., maximizing investment returns for a given level of risk).

In terms of diversification, the major innovation of risk parity over these early approaches resides in
equally weighting risks, instead of allocations.

In that respect, risk parity proponents are indisputably right when they state that traditional 60/40 asset allocations are not truly diversified, as they have had a correlation of 0.90 with equities over the last 40 years.

That being said, we believe that placing diversification above everything else can lead to unpleasant consequences. The main advantage of a passive gmarket portfolioh approach is that, by definition, it does not disturb the market's equilibrium, as every asset class is weighted according to its relative importance in the market. On the opposite side, once it becomes popular, any other passive investment process that significantly deviates from market weights can wreak havoc in market valuations, precisely because passive investment processes entail not caring about valuations.

For example, letfs take a small exotic asset class (public Timber REITS, for instance), which would display nice diversification properties in the eyes of many different diversification]minded managers. Although each individual manager might decide not to own more than 1% of the total float, their combined buying power could very well provoke a bubble in the asset class.

A real-life example of the damage that can be caused by a blind quest for diversification can be found
in the way in which CDOs used to be managed before the credit crisis. In order to increase their contractual Moody's "diversity score", CDO managers were forced to diversify their exposures in terms of industries. As a consequence, some industries that had little outstanding debt became heavily sought after and, therefore, completely mispriced. In the end, a supposedly superior diversification did not help CDO managers, as correlations converged towards 1.00 during the 2008 credit crunch.

To a certain extent, the appeal of diversification might also explain investorsf willingness to buy TIPS
at negative yields (down to around -1% for the 10 years recently). While being a relatively small part of government debt (around 10%), TIPS' characteristics make them very attractive in the eyes of
investors who value diversification far above everything else, including valuation (in this particular
case, however, the jury is still out in determining whether we’re all “turning Japanese”).

One last word about diversification: as we will see in our next section, we’re not convinced that financial markets offer a sufficient number of uncorrelated risk premia in order to be able to reach a “true” diversification.

2. Returns

2.1. Risk premia

Like any other passive asset allocation strategies, risk parity relies on the assumption that some asset
classes should structurally outperform the risk‐free rate. Although there are theoretical justifications and ample empirical evidence for some of these risk premia, their number and their magnitude is ‐ and will always be ‐ subject to intense debate.

To us, the most convincing and economically meaningful risk premium resides in equities. Because of
the high covariance of corporate asset values with the state of the economy, equities have to compensate investors for the risk they take (no one wants to lose his job and experience portfolio losses at the same time). We can obviously only make rough estimates of the forward equity risk premium (letfs settle for 5% on a global basis), but we do have little doubt about its existence.

Even if they might offer some diversification benefits from a marked]to]market perspective, we believe that many asset classes (e.g., high yield bonds, REITS, or private equity) have a risk premium that originates from the same covariance with the state of the economy. Whether they should be considered as completely separate assets classes is, therefore, debatable. In fact, this question is specifically addressed by newer risk parity implementations, such as cluster risk parity and equal risk contribution.

For some asset classes, the very existence of a positive risk premium can be questioned. In the case
of commodities, for instance, the classical justification for a risk premium (i.e., Keynesf "normal backwardation") is nowadays dubious, as an increasing number of investors have been willing to take hedgersf opposite side. Roll yields, which had been the sole source of excess returns for commodities, have been centered on zero for the last 10 years.

For other asset classes, risk premium prospects currently look rather grim, the most obvious example
being Treasuries. If we look at 10]year Treasuries, their historical long-term return over short-term
rates has been around 1.6% since 1920. Since the early 1980s however, 10-year Treasuries have produced far higher excess returns (around 5%), as 10]year yields went from 15.8% to the current 2.5%.

Although there are only a few things about which we can be certain in finance, we can safely proclaim the mathematical impossibility of getting 5% excess returns by rolling 10-year treasuries over the next 10 years.

Therefore, because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a gbig rotationh that would bring 10-year yields back to a theoretical long]term equilibrium value.

There are obviously many other sources of risk premia. However, most of them (liquidity‐based ones,
for instance) are the “bread and butter” of specialized hedge funds. Therefore, they are outside of the scope of risk parity, which is not a bad thing, as many of these arcane risk premia tend to display a very negative skewness.

Our main point is that, even if we consider a large universe of asset classes, it’s not as if there were dozens of investable and economically meaningful risk premia waiting to be harvested by passive investors. In the end, when we take into account the fact that many risk premia actually originate from the same basic sources, we might end up with just a few investable risk premia. Additionally, as more people reach for diversification, those few risk premia tend to become more correlated over time.

2.2. Leverage

One important point regarding returns resides in the fact that risk parity strategies generally involve
leverage—that is, unless the investor is satisfied with long‐term returns of 2 to 2.5% over the risk-free rate.

Risk parity practitioners generally characterize leverage as a mere “implementation tool”, and they
believe that their superior diversification outweighs the disadvantages of running a levered strategy.

Although a reasonable use of leverage might not be fatal to a portfolio, it can irremediably hurt its
returns. Indeed, as we will see in our section about risk, leverage introduces a path dependency issue.
We can very well imagine a “black swan” situation, in which a supposedly safe asset class experiences a price trajectory that forces a deleveraging of the portfolio and, therefore, wipes out a large chunk of it.

3. Risk

We believe that the subject of risk is the one wherein risk parity is the most open to criticism.

Indeed, to reach the gparityh in risk parity, one has to reduce the risk of an asset to a single number
one way or another (generally a specific variant of the assetfs volatility). Although it is not a very original point of view, we believe that the risk of an asset cannot be quantified in this simplistic way.

Despite the fact that there is a certain level of stickiness in an assetfs risk (or volatility), every now
and then, assets - even supposedly gsafeh ones - have the nasty habit of breaking the parameters of
the equations that are supposed to describe their behavior (especially if these equations do not take
into account skewness).

To illustrate this point with a little story, letfs imagine a situation that could very well have happened
during the last decade:
In the aftermath of the 2000s tech crash, John becomes yet another young unemployed electrical
engineer (as Taleb, the inventor of the Black Swan theory, likes to characterize most quants). He decides to start a new career by getting a masterfs degree in finance. Armed with his solid math skills, John quickly digests modern portfolio theory, basic statistics, and all varieties of volatility calculations. He finds a job at an institutional investor and quickly moves up the corporate ladder.

In 2006, John convinces his board to apply a risk parity strategy to manage the firm's portfolio. Because he has a fresh and open mind about finance, he decides to spice up the asset mix by adding an exposure to mortgage]backed securities in the form of newly-minted ABX indices.

Who could blame him, based on the information available in 2006?
- The total size of the US mortgage debt is huge ($13 trillion in 2006), comparable to US equities, and larger than government debt.

- ABX indices are highly diversified, as each index is based on 20 distinct RMBS transactions. Each RMBS containing a minimum of $500 million worth of homes, an ABX investor is exposed to more than 50,000 homeowners throughout the US. What can possibly go wrong with such a diversified pool of debtors?
- ABX products are rated by respectable institutions, such as Standard & Poorfs (1860) and Moody's (1909), and they offer a wide variety of risk levels (from AAA to BBB).
- The volatility of the underlying financial products that compose the index is minuscule (they always trade around par).
Even if John had opted to buy the safest AAA ABX tranches (with, consequently, a high allocation due to their glowh risk), he would have experienced heavy losses during the 2007-2008 crisis. Additionally, he would have been forced to drastically reduce his allocation to the asset class as the gtrueh risk (or volatility) of ABXs revealed itself, preventing it from benefiting from any subsequent recovery.

Consequently, given that he was running a leveraged portfolio, John would have been forced to crystallize his losses.

This story might sound far]fetched, but we could have invented a similar story about Georgios implementing a risk parity strategy for a Greek institutional investor by leveraging on domestic government debt.

Some might argue that both of these examples involve blatantly asymmetric assets, which could have
easily been filtered out (especially in retrospect) by an experienced risk parity practitioner.

However, we can also imagine a forward‐looking scenario that would involve one of the most respectable assets on earth ‐ US Treasuries ‐ as the main culprit of a risk parity carnage:

Let’s imagine that, a few years down the road, Bernanke’s successor has to manage another “great
recession”. This time, the Fed decides to go beyond QE by pegging long‐term rates at a very low level (let’s say 0.5% for the 10year).4

As the Treasury remains stuck at 0.5%, there is no more volatility on Treasuries.

According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…

From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself.

 4 This solution was discussed by the Fed in late 2010, and it has already been experimented with
between 1942 and 1951.


Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance]based arguments that are often put forward by the proponents of risk parity.

From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:

1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategyfs performance under different scenarios.

2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.

3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.

4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.

5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly 
asymmetric returns, which can happen to any asset class given the right set of circumstances.
If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.

For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).

There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's
numerous flaws. However, we have little doubt that when the next gblack swanh terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage onefs life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.

That being said, the idea of a passive investment strategy that would be able to withstand any kind of financial weather is not unrealistic. However, its goal should be the long]term preservation of capital and not its theoretical maximization under a theoretical risk constraint. Additionally, the strategy should make very little use of leverage, and it should not make too many assumptions on the risk of a given asset (as risk becomes an unpredictable beast every now and then). In the end, we would probably end up with something quite similar to the Talmudic portfolio (N equally-weighted assets).

We realize that, without adhering completely to risk parityfs principles, many institutional investors
are implementing it as a part of their portfolio alongside other "absolute return" strategies. This approach is clearly less dangerous than an all]in commitment to risk parity. At a portfolio level, it simply results in overweighting low]volatility assets, which is obviously far-removed from the original purpose of risk parity.that is, true diversification at a portfolio level.

"Living at risk is jumping off the cliff and building your wings on the way down." - Ray Bradbury 

Stay tuned!

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