"I go with the flow. Whatever music you play for me, I'll dance." - Gael Garcia Bernal, Mexican actor
"Under the availability heuristic, humans are not reliable because they assess probabilities by giving more weight to current or easily recalled information instead of processing all relevant information. Since information regarding the current state of the economy is readily available, researchers attempted to expose the properties of business cycles to predict the availability bias in analysts' growth forecasts. They showed the availability heuristic to play a role in analysis of forecasts and influence investments because of this.
In effect, investors are using availability heuristic to make decisions and subsequently, may be obstructing their own investment success. An investor's lingering perceptions of a dire market environment may be causing them to view investment opportunities through an overly negative lens, making it less appealing to consider taking on investment risk, no matter how small the returns on perceived "safe" investments. To illustrate, Franklin Templeton's annual Global Investor Sentiment Survey 1 asked individuals how they believed the S&P 500 Index performed in 2009, 2010 and 2011. 66 percent of respondents stated that they believed the market was either flat or down in 2009, 48 percent said the same about 2010 and 53 percent also said the same about 2011. In reality, the S&P 500 saw 26.5 percent annual returns in 2009, 15.1 percent annual returns in 2010 and 2.1 percent annual returns in 2011, meaning lingering perceptions based on dramatic, painful events are impacting decision-making even when those events are over." - source Wikipedia
- Global growth is changing and FX is the "real issue" for financial markets
- "Availability heuristic" is driving outflows in EM funds and credit
- Global growth is changing and FX is the "real issue" for financial markets
"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." - Macronomics, August 2013.
"This piece argues that 2015 will mark the peak in global FX reserve accumulation. Following two decades of unremitting growth, we expect global central bank reserves to at best stabilize but more likely to continue to decline in coming years.
The US Dollar being the currency reserve of the world and thanks to interest rates in the US moving into positive territory, this has reversed the movement of investors from EM to DM, which was initially driven by the pressure coming from real negative interest rates hence massive inflows pouring into EM.
- Three cyclical drivers point to further reserve draw-downs in the short term: China’s economic slowdown, impending US monetary tightening, and the collapse in the oil price.
- Structural changes have permanently reduced the need for reserves as well. China’s new FX regime would lead to less intervention in the medium-term. EM external positions are stronger than two decades ago reducing the need to recover reserves beyond prior peaks. Oil prices are unlikely to return to previous highs reducing petrodollar recycling. And both the SNB and BoJ have moved away from currency intervention as their primary monetary policy tools.
- The implications of our conclusions are profound. Central banks have accumulated 10 trillion USD of assets since the start of the century, heavily concentrated in global fixed income. Less reserve accumulation should put secular upward pressure on both global fixed income yields and the USD. Many studies have found that reserve buying has reduced both bund and US treasury yields by more than 100bps. For every $100bn (exogenous) reduction in global reserves, we estimate EUR/USD will weaken by ~3 big figures.
- Against this new secular trend, there are forces that point in the opposite direction. The Euro-area with its huge current account surplus has become the world’s largest saver implying persistent capital outflows and European demand for foreign assets, a term we have previously called “Euroglut”. The BoJ and ECB quantitative easing programs remain in full swing, generating downward pressure on global yields.
- Placed against global QE, the secular shift in global reserve manager behavior represents the equivalent to Quantitative Tightening, or QT. This powerful, but countervailing force is likely to present additional headwinds towards developed market central banks’ exit from unconventional policy in coming years." - source Deutsche Bank
"Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely:
Wave number 1 - Financial crisis
Wave number 2 - Sovereign crisis
Wave number 3 - Currency crisis
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?" - source Macronomics, September 2013
"GLOBALcycle eases in August
Our GLOBALcycle coincident indicator weakened in August. Economic conditions deteriorated in EM, led by softer conditions in China and Poland. Business conditions in the developed world were largely unchanged, however. The activity pace seems to have held up in the US, euro area and the UK, but appears to have slowed notably in Japan. All in all, our indicator suggests that global growth has slipped below 3%.
The worsened EM outlook casts a shadow on the global economy. Emerging markets are facing tighter global financial conditions, lower commodity prices and wobbling business confidence. Concerns about the extent of the Chinese slowdown, in particular, are likely to linger. This poses downside risks to DM, but we still expect solid expansions in the US and the euro area. All told, we have trimmed our EM growth forecasts and now look for 4.1% (-10bp) in 2015 and 4.7% (-20bp) in 2016. In the developed world, we expect GDP growth to edged higher to 2.0% this year and 2.5% in 2016.
What is the GLOBALcycle?
The GLOBALcycle is a real-time indicator of economic activity covering 80% of the world economy. The indicator extracts a common factor from weekly, monthly and quarterly data. The GLOBALcycle is a GDP-weighted average of Economic Conditions Indices for (i) the US, euro area, Japan, the UK, Canada and Australia in the developed world, and (ii) Brazil, Russia, India, China, Indonesia, Korea, Poland, Turkey, Mexico and S. Africa in EM. The GLOBALcycle is based on the ADS index developed at the Federal Reserve Bank of Philadelphia." - source Bank of America Merrill Lynch
"Comparing the GLOBALcycle to the OECD leading indicator
The OECD leading indicator has a two-month lag, while our GLOBALcycle is calculated in real time, providing a timely assessment of current economic conditions in each country. Chart 7 emphasizes the leading aspects and forecasting ability of our indicators."
- source Bank of America Merrill Lynch
If we take a large perspective, looking at the economic growth in the World, we would conclude that the situation is unchanged, almost boring as the expected growth for 2015 and 2016 should equal that of the past three years, at around the 3% level (see the below left chart).
This benign situation on the surface could question the recent behaviour of financial markets: why anxiety would be back given the absence of any changes at the global growth level??? The answer lies therefore elsewhere and we think it lies in the content of this growth. Global growth has not changed but the contribution to this growth has well evolved, affected in our opinion, by the levelling off of the global trade (right chart below).
These two charts are a good summary of the current economic situation in the world: decent global growth but subdued growth of exports as the super cycle of the global trade is over. This super cycle started in 2001 with the entry of China in the WTO (World Trade Organisation) and seems to have ended in 2012 with the European double-dip. The collapse of commodity prices since the summer 2014 has accentuated the negative trend but it would be dishonest to limit the explanation of the decline of the global trade to the decline of commodity prices. The volume of goods traded as a share of GDP is finding a plateau at the aggregate level and there is no surprise here. The outsourcing process of the domestic industrial production is reaching its limit and automatic stabilisers (through the currency) have also played a role. It means today that countries should lean less and less on their foreign trading partners to revive their domestic economic growth. This is not a new diagnosis but it is the lesson to draw from the past years: the domestic demand becomes more than ever the main driver of the economic cycle for many countries like Europe, the US, Japan or China.
The US economy is very strong because its domestic demand is strong, supported by jobs’ creation, a buoyant housing market and a strong dynamism of the services sector. The Chinese economy is weak because its domestic demand is weak, pressurized by a declining construction sector and a weak private consumption.
The below left chart illustrates how the contributors to the global growth are changing: EM countries are in a significant deceleration mood while developed countries are in an acceleration mood.
Thus, the problem is not about a weakening world economy but about the end-cycle that is gaining momentum in the EM world.
This divergence is sustainable and we would not embrace the scenarios of a spill over of the EM meltdown to the transatlantic world. As we have just said, the strong US economy and the European recovery have nothing to do with the EM world because they are domestic driven. This is slightly different for Japan which could suffer a little more from the Chinese economy’s deceleration.
Anyway, the decoupling thesis is more than ever accurate to describe the world economy. Last time it happened was in 2007-2008 when the slowdown of the housing sector in the US was dragging down the economy whilst the commodity price boom was supporting the strong growth cycle in the EM world. At that time, the equity markets in the developed world were not too much affected. It is only when the banking system started to feel the pain with the rise of non-performing loans that equity indices entered a downward trend. The crisis was global because the roots of the crisis were the developed world whose economic weight was huge.
This time is a bit different because the problem is the EM world and its economic influence on the developed world remains weak. That’s for the economic diagnosis: if the client is healthy, the illness of the supplier will not affect him. This is therefore well different from the 2007-2008 situation when it was the client who was ill.
The market perspective is however less different because during the past years, the equity market has adapted to the new world’s order. The “domestic players” have been under pressure whilst the “global players” have grown up. The structure of the equity market today is therefore tilted towards the “global players”. This could explain why the equity market seems to have reacted earlier this time. Although the impact on the profits of listed companies cannot be felt significantly (with the exception of the commodity-related sector) the volatility of equity indices is increasing." - source Louis Capital Markets Cross Asset Research
"There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis."
"We will not repeat what we have just said for many months now but the end of the depreciation of the US dollar and of the EUR is a serious headwind for the global companies. In fact, the currency is the real issue for financial markets. On the previous right chart we show a basket of EM currencies against the US dollar and the speed of their depreciation is alarming. The intensification of the globalisation over the past two decades has increased the sensitivity of developed companies to the behaviour of currencies. The financial instability in the EM world is therefore affecting the equity markets in the developed world through the currency’s channel. To sum-up, we get the following scheme:
We do not expect the collapse of EM currencies to stabilise by themselves. We said it before in 2013 and we got wrong as they managed to stabilise by themselves in 2014. We think they benefited from the softness of the US economy that allowed 10y US bond yield to decline from 3% to 1.7% during that year. This unexpected support should not repeat in the coming months so this is why we expect the downward trend of EM currencies to continue.
No More Slack in the US Economy
An aggravating factor of the EM meltdown could be the necessary normalisation of the extremely accommodative US$ financial conditions. We have discussed it before: the last intention of the Fed is to create a global financial shock but at the same time, the Fed has to take into account the decline of the output gap of the US economy.
We belong now to the (small) group of economists who think that the Fed is not there to support the foreign economic agents who have abused of the eased US$ financial conditions during the past decade. In other words, if financial imbalances have emerged in the US$ semi-pegged world (China, Honk-Kong, Middle East) or in countries that have benefited from the low funding cost in US dollar, this is not the problem of the Fed. The potential moral hazard induced from this favourable financial context should not affect the Fed’s decisions.
The above chart is a reminder of how strong is the US economy. If the Fed misses the opportunity in the next FOMC meetings to “reload its ammunition in terms of interest rates” new questions will rise:
1) What is the needed economic context for the Fed to raise rates?? Does it exist?
2) Are short term rates still the relevant monetary policy or can we envisage that short term rates remain anchored to 0% and that long term rates become the new main monetary policy tool (through Q.E)?
The only relevant reason to justify another postponement of the first rate hike in the US is the behaviour of prices in our opinion. With the collapse of commodity prices and the tendency of economic agents to extrapolate short term trends, we can see that inflation expectations in the US are back at a level very close to their all-time lows.
- source Louis Capital Markets Cross Asset Research
- "Availability heuristic" is driving outflows in EM funds and credit
"Emerging Markets including China are in a hypertonic situation; therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates)." - source Macronomics
"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013When it comes to "availability heuristic" and "flows", investors do tend to react on recent news and particularly continuous outflows. When it comes to "outflows in both the EM related world and credit, these outflows have been nearly as significant as during the "taper tantrum" as indicated by Bank of America Merrill Lynch's High Yield Flow Report from the 3rd of September entitled "Ex-US funds post outflows":
"EM funds record another large outflow
Ex-US flows dominated the picture this week with Emerging Markets again taking center stage with their third consecutive billion+ outflow. Retail investors pulled out $3bn from EM funds this week, which has put the last four week total to -$10bn, rivaled only by the -$12bn during taper tantrum. The relatively weak economic data coming out of China is weighing on Emerging Markets because not only do EM countries export to China, but they also compete with it for US market share. Weak Chinese domestic demand along with the recent Yuan devaluation is spelling trouble for these countries on both accounts. Also registering outflows were non-US HY funds which put up a -$1.1bn outflow, a decline from last week’s -$2.5bn.
US HY funds posted a small inflow as ETF inflows balanced outflows from open-ended mutual funds. Also returning to inflows was US IG which attracted $1.2bn. Equities saw +$5bn flowing in. Commodity funds gave back some of the inflows of the month registering -$430mn in outflows. Loans, the worst performing asset class this year in terms of % of AUM added, saw another -$440mn leave the asset class. Loan funds have underperformed this year on the back of the diminishing potential of rate increases. It also doesn’t help that most of these securities won’t truly float in the near term due to their embedded LIBOR floors.
- source Bank of America Merrill LynchBut, when it comes to outflows in EM land, all regions have not fared the same when it comes to "outflows" and "availability heuristic" investors' bias.
For instance, when it comes to capital flows into EM Asia, there has been some stability as of late as reported by Bank of America Merrill Lynch in their "Asia in Focus" note from the 4th of September 2015 entitled "Portfolio flows and reversal":
"Portfolio flows and reversals
Capital flows into Emerging Asia have come to a stop and turned negative in recent weeks. The magnitude of recent EM Asia portfolio outflows is comparable to the 2013 “taper tantrum” episode. Most of the recent portfolio outflows however are equity, not bond outflows. Size of the foreign equity outflows is comparable to the 2013 “taper tantrum” episode and the sharp withdrawals seen during the early phase of the global financial crisis. Foreign bond outflows however remain muted and significantly less than the “taper tantrum” episode.
The divergent behavior of bonds versus equity suggests that recent sell-off may be due more to China fears than the impending Fed rate hikes. Bond outflows could intensify when the Fed eventually hikes sometime this year, which our US economics team thinks will likely be this month (Sep). Recent pressure on Asian currencies and central bank FX reserves are therefore coming more from the Asian equity (than bond) sell-off. Currency hedging on foreign bond holdings may have nevertheless contributed to the Asian currency weakness, even though foreign positions have not been pared so far.
We capture the recent movements of non-resident portfolio flows to Emerging Asia, by using the high-frequency Institute of International Finance (IIF) data on equity and bond flows. Data available for Asia include India, Indonesia, Korea and Thailand. We think the sum of these countries should capture the broader foreign portfolio flow behavior. The IIF data are sourced from national central banks or exchanges, and are defined as nonresident purchases of stocks and bonds. Balance of payments data on capital flows are available only on a quarterly basis and comes with a long lag.
EM Asia foreign portfolio flows – inclusive of both equity and bonds – have turned consistently negative since 10 August, a day before the People's Bank of China (PBoC) devalued its CNY daily fix by 1.9% (Chart 1).
During August (up to the 28th), total foreign portfolio outflows reached $8.7bn. In the last week of August, foreign portfolio outflows averaged a staggering $1bn daily, compared to the average of +$156mn inflows daily during the first seven months of the year. The 7-day moving average of portfolio flows is already at 1 standard deviation below the 28-day mean.
Flow reversals have been driven largely by foreign equity, not bond outflows (Chart 2).
This is quite different from the 2013 “taper tantrum” episode, when both foreign equity and bond flows saw sharp reversals. Some cumulative foreign outflows of $9.4bn in equities have occurred over the roughly one month period since the “cut off” date of 20 July when the reversals started (Chart 3).
This is comparable to the $9.8bn over the same period during the 2013 “taper tantrum” episode and $10.8bn during the global financial crisis.
Foreign bond holdings have been remarkably stable so far. The IIF data shows only some cumulative foreign outflows of $1.4bn in bonds since the “cut off” date of 20 July.
During the same period of the 2013 taper tantrums, the cumulative bond outflows had
already reached some $10.2bn over a month (Chart 4).
The dynamics so far looks not too different from the global financial crisis, when the Fed’s QE and zero interest rates pushed capital flows into Asia for yields and protection from a falling US dollar.
Foreign ownership of Indonesia government bonds remains at a high 37.8% of outstanding, slightly lower compared to the 40.3% at peak in January this year, but far higher than the 16% pre-Fed QE (Chart 5). Foreign ownership of Malaysia government bonds (MGS) has fallen only slightly from over 50% at the peak in May 2013 to 47.8% as at end-July. In Korea and Thailand, foreign ownership has also declined only marginally to 12.6% and 17.1% of the total respectively.
Divergent behavior of foreign equity versus bond flows suggests that the recent sell-off is driven more by China’s slowdown and devaluation fears than the looming Fed hike rate cycle. Foreign positioning in Asian local currency bonds remain high and the risk is that Fed rate hikes will likely tighten global monetary conditions, raise global interest rates and increase foreign selling of Asian bonds. We argued that Indonesia and Malaysia are probably the most vulnerable to large capital outflows on steeper-than expected Fed rate increases. Both countries have seen a surge in the foreign ownership of local currency bonds following the Fed’s QE programs from the lows during the global financial crisis. Indonesia is vulnerable given its current account deficit, faltering growth and the government’s slow progress in reviving investment. Malaysia is vulnerable given its high external debt, low FX reserves cover to short-term external debt, high household debt, and the ongoing political crisis. We are also worried about the return of “original sin” – the higher proportion of foreign currency debt – as funding costs in local currency rises and foreign appetite wanes.
Asian central banks and governments will try to support growth and defend their currencies, but several central banks, including Malaysia and Indonesia, are increasingly constrained in their policy options. Year-to-date, Malaysia’s foreign reserves have plunged $21.4bn to $94.5bn at mid-August, down from the peak of $141bn in May 2013 (Chart 6).
We don’t think capital controls is likely but cannot longer rule out the risk. Reserves have declined $4.3bn so far in Indonesia, falling to $107.6bn at end-July. Declining reserves and weaker currencies are limiting Bank Negara Malaysia and Bank Indonesia’s room to ease monetary policy and cut policy rates." - source Bank of America Merrill Lynch.Hence our concerns for Wave number 3, currency crisis emerging and a big US dollar "margin call "on some vulnerable EM issuers.
In our conversation "Magical thinking" we have argued:
"To repeat ourselves, leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...). Now in EM, our "reverse macro osmosis" theory is clearly playing out."
To be continued...
"Men often act knowingly against their interest." - David Hume, Scottish philosopherStay tuned!