Monday, 14 May 2018

Macro and Credit - The Superposition principle

"The highest ecstasy is the attention at its fullest." - Simone Weil, French philosopher

Watching with interest the Wilson cycle playing in earnest on some various Emerging Markets, leading to additional significant fund outflows in the process, with effectively our previously discussed reverse osmosis theory playing out on some weaker EM players, when it came to selecting our title analogy, we reminded ourselves the "Superposition principle" from physics and systems theory. It states that, for all linear systems, the net response caused by two or more stimuli is the sum of the responses that would have been caused by each stimulus individually. So that if input A produces response X and input B produces response Y then input (A + B) produces response (X + Y). The homogeneity and additivity properties together are called the "Superposition principle". Also, wave interference is based on this principle.  When two or more waves traverse the same space, the net amplitude at each point is the sum of the amplitudes of the individual waves. In some cases, such as in noise-cancelling headphones, the summed variation has a smaller amplitude than the component variations; this is called destructive interference. In other cases, such as in Line Array, the summed variation will have a bigger amplitude than any of the components individually; this is called constructive interference, which one could imply it could be the situation for some specific Emerging Markets countries currently facing tremendous pressure from rising US interest rates and in conjunction with the recent surge of the US dollar but we ramble again...

In this week's conversation, we would like to continue to look at the outflows from some Emerging Markets and the consequences of the global tightening financial conditions we are seeing thanks to the Fed's rate hikes in conjunction with its Quantitative Tightening (QT) process.

  • Macro and Credit - Balance of Payments pressures in some EMs are building up
  • Final charts - Flatter for longer 

  • Macro and Credit - Balance of Payments pressures in some EMs are building up
In our previous conversation we touched on the fact that for some macro tourists which had extended their stay in the carry trade that, the tourist trap was closing. QT to some extent is leading to the weaker leveraged hands being blown apart it seems. After the explosion of the house of straw of the short-vol pigs, it seems to us that next on the line, given the intensity in fund outflows and pressure on some EM currencies will be some of the "usual suspects" such as Turkey, Argentina to name a few. The global tightening of financial conditions has indeed been induced by the Fed with its hiking process in conjunction with QT. In similar fashion to the "Superposition principle", this process seems to be homogeneous and additive. As the noose of financial conditions is slowly tightening, the pressure is showing up in earnest in the weaker part of the "global capital structure", namely some leveraged EM countries. For some indeed, there is some risk of balance of payments crisis à la 1998 it seems as pointed out by Nomura in their Emerging Market Insights note from the 11th of May entitled "Looming balance of payment risks in EM":
"The pressure is building for several central banks to hike rates sooner than we thought
On 9 May, Argentina requested financing from the IMF to avoid a crisis. This came after the central bank hiked policy rates to 40% in response to the Peso’s sharp depreciation. From Turkey to Indonesia, the one-two punch of rising US rates and USD appreciation is leading to a rising market risk premium in EM countries whose the balance of payments (BOP) is vulnerable. EM central banks are responding by allowing some exchange rate flexibility (i.e., depreciation) and some FX intervention, but if BOP pressures intensify, policy rate hikes may be needed. Our country economists have considered the likelihood of earlier and/or larger rate hikes this year relative to their base cases if BOP pressures continue to build, and the central banks that stand out are Romania (+25bp), India (+50bp), Indonesia (+50bp), Chile (+75bp) and most notably, Turkey (+300bp).
Balance of payments vulnerability
The trio of higher US bond yields, USD appreciation and rising oil prices has led to some market repricing of balance of payment (BOP) risk – e.g., large current account deficit, high short-term external debt, limited buffer of FX reserves – resulting in capital outflow pressure. A scatter plot of current accounts against local currency moves against USD since the start of the year highlights that, with the exception of Russia, EMs with large current account deficits have generally experienced large currency depreciations (Figure 1).
The amount of local government debt owned by foreign investors and the share of corporate debt denominated in foreign currencies are also under close scrutiny (Figure 2).

Our house view is that the weak economic data outside the US represents a temporary soft patch and that market concerns over global growth desynchronising (rising in the US, but falling elsewhere) will soon fade, which should help temper USD appreciation (see Asia Economic Monthly, One step at a time, 11 May 2018).
However, even if we are right that global growth is holding up, this is likely to be only a brief respite for EM. In our mind, Q3 2018 is the high-risk quarter for a painful EM snapback, as this is the quarter in which markets will likely focus not just on the US but a global QE unwind, which could lead to a larger repricing of EM risk premia and the evaporation of market liquidity. Moreover, George Goncalves, our US rate strategist, is warning that, as US inflation rises, UST debt supply balloons and the Fed keeps hiking, there is an upside risk of a bearish overshoot relative to his base case of UST 10s hitting 3.25% in Q3 (see Global macro trade ideas in summer 2018, 2 May 2018).
The US decision to exit the Iran nuclear deal and reinstate sanctions (see US to withdraw from Iran Nuclear Agreement, 8 May 2018) has increased the risks of instability in the Middle East and further oil prices increases (Figure 3).
This could further widen the twin current account and fiscal deficits of large net energy importers – Turkey, India and the Philippines (see Higher oil prices drive EM divergence, 25 April 2018). Q3 will also be around the time that President Trump is likely to double-down on America First policies, such as trade protectionism, ahead of November mid-term elections.
Overall, while there may be a brief, near-term respite, there is a risk that BOP pressures in EM continue to build and possibly intensify in coming quarters. We updated our BOP risks scorecard of 20 EM economies that we introduced in our anchor report (see In an EM snapback, where do the risks lie?, 23 March 2018). Of the 20 EMs, the most exposed to BOP risks are Hong Kong, Romania, Hungary, Turkey and Chile, and for varying reasons (Figures 4 and 5).

For example, Hong Kong’s exposure is due to its massive cumulative capital inflows since 2010 and low interest rate compensation for BOP risk; in Romania and Turkey, it is because of their large current account deficits and low FX reserves; in Hungary it is due to high external debt and relatively low FX reserves. The least-exposed countries to BOP risk are Singapore and Taiwan, according to our scorecard.
We acknowledge that there are a host of country-specific factors (beyond variables that we use for scorecard; current account, FX reserves, external debt, cumulative portfolio flows, real interest rates and interest rate differential) that can also impact EM, most notably geopolitics and domestic politics. For example, the Russian Ruble (RUB) and Brazilian Real (BRL) depreciated against USD by 8.8% ytd and 7.9%, respectively, despite showing lower BOP risks in the scorecard.
Policy response to balance of payment pressures
Those EM central banks facing BOP pressures are mostly responding to in an eclectic manner (see First Insights - Turkey: Core problem, 3 May and Asia Insights - IDR: Challenging flow backdrop amid global risks, 9 May). They are allowing for some exchange rate flexibility (i.e., depreciation) and some FX intervention (drawing down FX reserves), but if BOP pressures intensify, these initial policy responses may become constrained. For example, the larger the currency depreciation the greater the risk of an inflation overshoot and a foreign currency debt mismatch problem or, if FX reserves are drawn down too far, the market may lose confidence in the ability of authorities to defend the exchange rate.
If BOP pressures mount, policymakers could shift to more draconian responses, such as interest rate hikes, tapping central bank FX swap lines, borrowing from the IMF (or in Asia, utilising the Chiang Mai pooled FX reserve initiative), tightening fiscal policy or, in the extreme case, imposing capital controls.
Our country economists have focused on the possible interest rate response. They have considered, on the assumption that BOP pressures continue to build (and oil prices stay at these levels or go higher), the likelihood of earlier and/or larger policy rate hikes over the rest of this year relative to their current base cases (Figure 6).

This “what if” exercise highlights that, if BOP pressures continue to build, there is a 50% or higher likelihood that we will need to build more rate hikes into our base case forecasts for  Romania (+25bp), India (+50bp), Indonesia (+50bp), Chile (+75bp) and most notably, Turkey (+300bp). The likelihood is lower, but if we added rate hikes in Brazil and Chile, it would be several, not one and done. Also, instead of our current base case forecasts of rate cuts by year-end, if BOP pressures continue to build, it could be that we have rates on hold (Colombia, Mexico and South Africa)." - source Nomura
We agree with Nomura that the trio of higher US bond yields, USD appreciation and rising oil prices has led to some market repricing of balance of payment resulting in capital outflow pressure (what we called in our last musing as a reminder "reverse osmosis"). "Reverse osmosis" as well as QT make more and more the front-end of the US risk curve appealing from a risk management perspective and ensures as well US dollar cash is back in the allocation tool box. Furthermore, as Renaissance Macro pointed out on their Twitter feed, when it comes to the 2013 Taper Tantrum comparison, this time it's different when it comes to current account deficits:

"A more hawkish Fed is a risk for emerging markets, but for most EM economies, current account positions have improved relative to the 2013 taper tantrum year, Argentina being a notable exception." - source Renaissance Macro
Argentina of course continues to be in the line of fire with FX reserves being burn rapidly to support currency woes. It is always the leverage players who blow up first when financial conditions are gradually tightening with Fed's hikes and QT. No surprise as well to see Turkey in the crosshair facing the Superposition principle. This is clearly highlighted by David Goldman again in Asia Times in his comment from the 11th of May entitled "Buy ruble, sell Turkish lira":
"After two sets of emergency conferences with economic leaders and Turkey’s ebullient president, the Turkish lira dropped from a peak of 4.38 to the dollar to 4.23 this morning, before weakening back to 4.25. Turkey’s economic problems remain insoluble: The Turkish economy is a credit-fueled bubble with a growing current account deficit and dangerous dependency on short-term capital inflows and interbank borrowings.
As Swaha Pattanik wrote this morning at Reuters, “Turkey’s president is pursuing contradictory goals. Tayyip Erdogan wants to support the sagging lira. That would require measures to curb inflation and the current account deficit. However, his efforts to pump prime growth, especially before June elections, will achieve the exact opposite.”
The ruble is a different story. The political threat of sanctions against Russia caused the currency to collapse from a low of 57 to the dollar on April 1 to a high of 64 to the dollar on May 2. Since then it has rallied a bit, trading at 61.7 at noon EST on May 10. The ruble is a pretty good proxy for the price of oil (the r-squared of regression of the ruble on the oil price since 2010 is around 93%).
As the chart above shows, regression analysis of the ruble vs oil puts the Russian currency three standard errors away from the regression line. The currency’s fair value vs oil is around 50. Sanctions against Russia are not likely to continue (Washington wants Russia’s cooperation in keeping the Iranian genie in the bottle). They will be flouted in any event by the Europeans, whose trade with Russia is a multiple of Russian-US trade. The market vastly overreacted to US sanctions, and the ruble’s cheapness continues to represent a buying opportunity." - source Asia Times - David Goldman
Not only is the Russian currency attractive, but we would contend that local currency bonds also are enticing from a yield perspective, so what's not to like about them? And if you believe in a commodity "rebound" thanks to rising inflation expectations why not buying what is cheap in terms of PE? Russian equities are relatively cheap and offer decent dividend yields as well we think.

What we think we are seeing in Emerging Markets is similar to what we are seeing in High Yield, namely a rise in "dispersion", which means in effect some investors are becoming more discerning when it comes to reassessing "credit risk" and issuer profiles on the back of a weaker "global market put" provided by central bankers. This rise in dispersion means that everything is not rising anymore in synchronized fashion thanks to massive liquidity injections given now it is being gradually withdrawn. As we pointed out recently in various musings, this could mean that some active players could potentially start outperforming again passive strategies. This also mark we think the return of the global macro game thanks to volatility being less repressed by the central bankers/planners as of late. 

From a fund outflows and risk perspective, for a continuation of pressure on the weaker links in the EM segment, the direction of yields and the US dollar matters for the pressure to continue or subside somewhat as far as the Superposition principle is concerned. On that subject we read with interest Deutsche Bank's take from their 9th of May note entitled "EM Flows and Risk Sentiment: Outflows, but size still contained":
"The EM Flow Indicator (chart below) shows that outflows are emerging – the last two weekly prints have been negative (indicating outflows from EM).

The last time there were two consecutive weekly outflow prints was in Dec 2016, thus this is a significant development. However, the size of outflows remains relatively contained, with the magnitude of the flow indicator nowhere near as stretched as in late 2016. Therefore, it is likely that the recent sharp EM FX depreciation has been driven more by FX hedging of EM assets held by foreign investors, rather than the outright selling of these assets (which would have triggered larger outflows). This remains the main risk for EM – the potential transition from FX hedging to outright outflows – but would require continued significant dollar strength and rising US yields. Over the coming weeks, the EM flow data will take on even greater importance, as it could provide a signal on whether we transition from phase 1 of the EM FX sell-off (FX hedging) to phase 2 (outright asset sales).
[Note that the indicator captures flows normalized by the standard deviation, with values greater than +0.5 indicating sizable inflows and values less than -0.5 indicating sizable outflows.]
The EM Risk Monitor – an EM-specific measure of risk sentiment – has entered risk negative territory, but is by no means stretched. This indicates that if external conditions remain unfavourable (e.g. continued broad dollar strength) there is potential for more negativity in EM sentiment.
The additional charts below show that both debt and equity flows have dipped into negative territory; but the magnitude of outflows remains relatively contained. Meanwhile, the charts displaying the raw flow data by source show outflows on IIF (local source) data, but flat flows on EPFR (ETF + mutual funds) data.
- source Deutsche Bank

Of course as the Superposition principle goes, it is contained when it comes to outflows until it isn't . Continued capital outflows pressure could lead to more pronounced "derisking". We highlighted in our last musing how hedge funds had already cut on their beta exposure in EMs. It remains to be seen with continued pressure on yields and in particular the US front-end how long this stability will last. 
This is Barclays take on the recent bout of EM volatility from their The Emerging Markets Weekly note from the 10th of May entitled "After the volatility eruption":
"Pressures on EM assets have accelerated over the past week. And although improved market sentiment fueled a relief rally on Thursday, concerns of a negative performance - outflow loop, which we discussed in the EM weekly: No spring in EM’s step last week appear to remain very much alive. While the market has focused on countries with external vulnerabilities and financing needs, especially Argentina and Turkey, market volatility has significantly broadened in scope over the past few weeks. This has evoked memories of the 2013 taper tantrum, as investor concerns have been centred on higher UST yields and tighter USD funding conditions, coupled with a painful parallel strengthening of the USD.
More granularly, we see four issues as having driven the weaker risk appetite in EM asset markets: (1) signs of softening activity relative to expectations; (2) increased risks of supply side shocks (eg. oil/Iran and trade protectionism); (3) the cascading sharp selloffs in some heavily-owned EM asset markets likely causing some investors to breach their risk limits; and (4) the correlation between EM credit spreads and US rates having turned positive (ie. higher UST yields being aligned with wider spreads) – a pattern usually only observed in periods of sharp UST adjustments. The last point, especially, illustrates the resemblances of the current sell-off with the taper tantrum.
However, we also think that there are important differences to 2013. Although it is difficult to see where the upside surprises in activity or a reduction in supply side shock risks will come from in the near term, we think EM fundamentals provide some buffers against a period of flow retrenchment. EM growth is stronger now than in 2013 and current account deficits in most market-relevant EM countries are smaller than they were in 2013 – with some notable exceptions (Figure 1).

And while EM debt levels are generally higher (Figure 2), EM countries have used the favourable issuance environment over the past few years to lengthen maturity profiles.

For example, the share of newly issued EM sovereign and corporate eurobonds with a tenor of 15 years or longer has increased significantly over the past few years (Figure 3), while near-term maturities have in many cases been addressed pro-actively via early buybacks/tenders.
We think that these buffers make it possible that, eventually, the negative cycle can be broken. In EM credit, flows should be supported by a pick-up in redemptions in June/July and the self-regulatory effect of supply, which we would have expected to slow down in any case after the record pace in Q1 18. Moreover, the recent underperformance of EM versus rating-and-maturity matched DM credit (see the Global EM Credit Monitor, 8 May 2018) has reversed the relative richening of EM in the early weeks of 2018 (Figure 5).

While EM is still not cheap relative to DM based on historical ranges, this should provide an eventual anchor for crossover sponsorship.
More generally, cheapening in the EM asset class may help normalize spread-rates correlations, when portfolios have fully adjusted to the higher levels of market volatility. This would support a technical retracement of EMs, absent additional idiosyncratic risks developing in key markets. We note that alongside the modest cheapening in EM credit, local rates have cheapened as well (Figure 6) but spreads vs. UST (on an FX hedged basis) remain shy of the midpoint of historical averages.

This is because much of the selloff in EM local rates has been driven by a weaker FX (Figure 7), which is now approaching lows after  stripping out their relation with broader asset market variables (Figure 8).

Therefore, we see greater opportunities to express near-term constructive views on EM FX than local rates if position reduction and the USD rally take a breather. We hit our stop loss in our long HGB October 2027 and long SAGB February 2048 positions but FX-hedging in the case of the former was able to more than offset for the loss on the local bond position. We do think there is scope for a near-term EM FX retracement and see value in short USDZAR through options.
However, a more lasting recovery may require increased investor confidence in a pick-up in EM fundamentals, a dovish shift by core market central banks (or a shift in investor perceptions of the likely path of core rates) and/or a reduction in global risks. The decision of the US to withdraw from the Iran nuclear deal does not suggest that a reduction in global geopolitical risks is imminent. President Trump was widely expected to withdraw from the Iranian nuclear deal but his announcement was one of the most hawkish options we previously discussed (Iran Special Report: Trump and the Art of (Breaking the Iran) Deal, 8 May 2018). Leaving the JCPOA may not only ultimately increase transatlantic tensions as many European companies have signed contracts to increase investments in Iran, but geopolitical risks in the Middle East will equally be on the rise. The recent escalation between Israel and Iran in Syria is perhaps the most concerning near-term risk which may be exacerbated by tensions with Saudi Arabia and the Yemeni conflict.
At a country-specific level, the market’s focus has been on Argentina and Turkey, as well as elections in Asia and the ongoing NAFTA negotiations involving Mexico.
The dramatic change in sentiment in Argentina has exposed its vulnerabilities given its large financing needs and twin deficits. In an effort to prevent a sharper weakening of the exchange rate, the central bank hiked the policy rate in three out-of-cycle decisions by a total of 1275bp, taking it to 40%, alongside other measures including interventions in FX markets. A stabilization of the exchange rate remains vital to the macroeconomic outlook with a high level of pass through into inflation. The government has sought to reassure markets by also announcing a more ambitious primary fiscal target for 2018 of 2.7% of GDP (down from 3.2% of GDP), which we think can be met, and which will also make the 2019 target of 2.2% of GDP attainable. Finally, as the ARS continued to selloff this week, the government announced its intention to enter into negotiations with the IMF for a high-access stand-by agreement. The program is meant to be precautionary but is planned to secure Argentina’s 2019 financing needs. It remains to be seen how stringent the conditionalities imposed by the IMF program will be but it remains crucial to assess the impact on the short-term macroeconomic outlook, as well as its longer-term political costs for the Macri government. With regards to the latter, the government has sought to allay concerns by expecting fiscal targets to be similar to the current official ones.
We think that geopolitical risks expose Turkey’s external vulnerabilities against a backdrop of rising USD funding costs and increasing concerns about EM capital inflows’ outlook (25% of Turkish banks’ liabilities are foreign and gross external financing needs are c.20% GDP). This, accompanied by the market's perception of the CBT being behind the curve amid a deteriorating inflation narrative and de-anchored medium-term inflation expectations, has amplified the pressures on Turkish assets. Nevertheless, as discussed in Turkey MPC Preview: Early elections strengthen the case for a hike, 18 April 2018, the early elections also increased the desire of politicians for a stable TRY, as indicated in Wednesday’s economic coordination council (ECC) meeting chaired by President Erdogan and the statement that followed. The CBT could come under pressure again going into the 7 June MPC meeting and any decisive action could provide a temporary backstop for Turkey assets." - source Barclays
For now the markets is playing the dispersion game even in US high yield. The CCC energy bucket in US high yield is of course benefiting from rising oil prices leading to a significant recent rally in the high beta space. But, as the Superposition principle goes no offense to the "contained crowd", problems can be additive it seems given flows follow performance usually for some "usual suspects" in the EM world...

When it comes to investor becoming more discerning risk wise hence the rise in dispersion, this is most likely due to the gradual fading of the powerful anesthetic provided by central banks and more importantly the Fed during so many years. While we keep indicating that we are moving in the final innings of this long credit cycle, though we do see cracks showing up in the goldilocks narrative which has prevailed for so long, we still haven't reached the end of the game and still remain short term "Keynesian" for various technical reasons such as prolonged buybacks activity, US tax reform and record earnings and strong M&A activity to name a few. The perma bear crowd will eventually get their day, but we still haven't gotten to that point yet we think. In our final point below we touch on the pace of the flattening of the US yield curve, being an important topic in these days and ages.

  • Final charts - Flatter for longer 
Given the gradual hiking pace followed by the Fed, on the back of still loose financial conditions has indicated by the most recent Fed quarterly Senior Loan Officer Opinion Survey, this is not playing out like the previous rapid hiking pace of the Fed of the 2004 period. Therefore, the flattening process will take a little bit longer to play out before we see the dreaded inversion so many financial pundits are talking about. Our final charts comes from Bank of America Merrill Lynch Securitized Products Strategy weekly note from the 11th of May and indicates that the inversion of the curve necessary to display a recession signal may take indeed a while to manifest itself:
"The ongoing flattening of the yield curve to post-crisis lows – the 2yr-10yr spread hit 43 bps this week – continues to elevate concerns among some that recession is on the verge of being signaled. For example, (dovish) St. Louis Fed President Bullard said “yield curve inversion is getting close to crunch time” and that “yield curve inversion would be a bearish signal for the US economy if that develops.” From our perspective, the key part of that quote is “if that develops:” 43bps may be closer to curve inversion than before, but it is still not inverted.
As Chart 1 shows, yield curve inversion has been relatively rare over the past 30 years, occurring briefly in 1989, 2000, and 2006, about 12-18 months in advance of the recessions of July 1990-March 1991, March 2001-November 2001, and December 2007-June 2009. We find the 1995-2000 timeframe in Chart 1 especially noteworthy.

The average 2yr-10yr spread over the 5-year period was 35 bps, flatter than today’s level of 43 bps, yet it was only when the curve finally inverted in early 2000 that the 2001 recession was ultimately signaled. The point here is that the curve may have flattened substantially, but, by the standards of the late 1990s, it’s nowhere near the level that it is signaling recession.
Another way of saying this is: “it may be late cycle, but it’s not end of cycle.” We think this distinction is important when it comes to recognizing that securitized products spreads may have at least a couple more years of tightening ahead of them, in a grind lower; in our view, meaningful spread widening is not expected until the cycle comes to an end. We don’t expect this to happen until at least 2020-2021. We are waiting for curve inversion as the first signal that the cycle will be ending. The lesson of the late 1990s is that inversion could take much longer to experience than some or many might expect.
Next, we consider interest rate volatility, as measured by the MOVE index in Chart 2.

Most of the spike in late January/early February has been retraced and volatility is back near the all-time lows seen in late 2017. Given the flattening move in the yield curve, we suspect that new lows in the MOVE index will be seen in the near term.
As seen in Chart 3, in the past two late cycle curve flattening environments (1990s, 2000s), interest rate volatility generally grinded lower as the yield curve flattened/inverted and only increased when the curve began to steepen. In the 2005- 2007 period, for example, as the curve flattened and then inverted, rate volatility moved steadily lower.

For example, the MOVE index went from 75 in May 2005 (about the time the 2yr-10yr spread was near today’s level of 43 bps) to a low of 59 bps in May 2007, when the yield curve had flattened to -3bps. (In the subsequent seven months, as the 2yr-10yr spread went from -3 bps to 120 bps, volatility more than doubled, with the MOVE index jumping to 145 by December 2007.)
We’re looking for similar late cycle behavior this time around. Following the yield curve flattening lead, the MOVE index appears poised to head to new post-crisis lows over the near term." - source Bank of America Merrill Lynch
One caveat is that the Superposition principle when it comes to Argentina has shown sentiment can indeed turn on a dime, or simply a rising US dollar. When it comes to credit markets and high beta, for "goldilocks" to return in the short term, lower rate volatility does indeed help out carry players and yield hogs alike. Yet, one would be wise to start using even at least partially the new tool in the tool box, namely cash in US dollar thanks to the front-end of the US yield curve. It has become more and more enticing relative to dividend yields as of late but we ramble again...

"Attachment is the great fabricator of illusions; reality can be attained only by someone who is detached." -  Simone Weil
Stay tuned!

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