Guest Post - China’s Devaluation, EM Corporates and Rising Risk Aversion.

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

Please find below a great guest post from our good friends at Rcube Global Asset Management written on the 20th of August. In this post our friends go through the numerous risks pointing towards a Chinese devaluation, EM Corporate credit risks and rising risk aversion:

Since Q4 2014, we have been explaining why China had little option but to devalue its currency (Rcube Macro Portfolio 20/11/2014). Last week’s move is just the early step of a much more meaningful devaluation. Authorities always choose to devalue as opposed to reforms when a crisis hits. China is currently dealing with deflating housing and equity bubbles, but also debt and economic restructurings all at the same time. The odds that in such difficult environment they choose reform over devaluation are extremely low in our opinion.

On a trade weighted basis,August devaluation puts the yuan only back to where it was in May. Since mid‐2011, the real effective exchange trade weighted yuan has appreciated by 43%. It is no coincidence that it is precisely since then that economic conditions have started to worsen. The Yuan needs to weaken much more.

Chinese equities will keep plunging as long as the currency is not devalued more meaningfully.

Capital outflows are intensifying.

Authorities are tapping reserves which have fallen by $350bln to prevent the yuan from falling sharply, which de facto tightens financial conditions. FX reserves as % of M2 is crashing.

Authorities had to cut reserve requirements to offset the unintended monetary tightening. As the inflation rate is falling faster than the PBOC can ease, monetary policy easing is hard to achieve.

The China Momentum Indicator (CMI) weights together information on electricity consumption, rail freight volumes and credit growth. Based on those three 'easy to measure' indicators preferred by Premier Li, the indicator tells us where growth is heading over the next year or so. Based on the indicator, Chinese GDP is estimated to be below 3% and still falling.

As a result, the Chinese government could be facing both a crashing equity market and a weaker currency in the medium term. The perception by Chinese people that the government advertised so strongly investing in equities creates a political risk if the market were to crash. This could be the catalyst for a more meaningful currency move.
The MSCI emerging market has finally broken below its key support (900). An acceleration is underway. 2008 low is our target.

EM corporate bond spreads do not reflect current risks properly, they have barely started to widen. EM financial conditions are tightening, EM corporations have borrowed almost 5trn of US dollars, and their currencies are plunging together with their cash flows (commodity crash). At the same time because the US twin deficits are shrinking, there are less dollars in circulation. This is a recipe for disaster. It is now unfolding.

EM corporate bonds have massively outperformed equities over the last 5 years, we think this is unsustainable given the EM credit channel tightening, weakening cash flows, capital outflows, and the substantial refinancing needs coming to maturity.

The current disconnect between credit risk and equities in the US (Rcube Macro Portfolio 27/07/2015) relies on the belief that there will be no contagion from the energy sector credit risk to the overall market. We believe otherwise.

Furthermore, deteriorating corporate credit health is visible across all sectors. US financing needs are going through the roof. As a result, corporate credit spreads remain extremely mispriced. The energy story only adds risk to this phenomenon by intensifying outflows. Equity volatility will spike higher and close the gap with credit risks soon.

Additionally, bullish sentiment is falling from historical highs as fast as in 2007. This is a major new development since we strongly believe that it is a prerequisite condition for risky assets to fall further. As John Hussmann regularly says, “the difference between an overvalued market that becomes more overvalued, and an overvalued market that crashes has little to do with the level of valuation and everything to do with the attitude of investors toward risk.”

Diminishing risk seeking attitude visible through sentiment measures, widening credit spreads, and negative market internals represent clear warning signs for global equities.

EM assets have entered a panic/liquidation phase that will end when EM corporate bonds will have priced in correctly the risks facing the asset class. We are still far away in terms of valuations.

Investors should watch carefully EM corporate bond spreads as well as US high yield ones for clues about potential risk aversion contagion. A break below 2040 on the SPX will confirm a medium term top is in.

"Only those who will risk going too far can possibly find out how far one can go." - T. S. Eliot

Stay tuned!

Guest Post - US Corporate Profits Under Threat

"Human behavior flows from three main sources: desire, emotion, and knowledge."- Plato

Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the numerous factors pointing towards corporate profits in the United States surprising on the downside in coming quarters:

Michal Kalecki was a Polish neo‐Marxist economist who, during the mid‐30s, undertook the difficult task of explaining why, contrary to Marx’ predictions, corporate profit rates in capitalist societies were not converging towards zero.

The starting point of his argument lies in the fact that an economy can only save (i.e. increase its aggregate wealth) by investing. Kalecki’s profit equation therefore begins with the following equation:

Saving = Investment

If we divide saving into Business Saving (= Profits after taxes and dividends) and Non‐business saving (Personal saving + Foreign saving + Government saving), the equation becomes:

Profit after taxes and dividends = Investment ‐ (Household + Foreign +

Government) savings

=> Profit after taxes = Investment + Dividends ‐ (Household + Foreign + Government) savings

The Kalecki profit equation is not a mere macroeconomic model. It is an accounting identity that remains true at all times. One can always verify its validity by checking the following items in the National Income and Product account.

Interestingly, the Kalecki equation implies the following paradox: although the business sector often advocates for balancing governments’ budgets, the Kalecki equation undeniably shows that a large part of corporate profits actually derives from budget deficits. It has certainly been true over the last 70 years.

Following Kalecki’s equation, the fiscal cycle can be used as a lead indicator for corporate profits and the business cycle.

In a recently published piece, John Hussmann explains that because in the US, investment,dividends and foreign savings usually cancel each other, the Kalecki equation can be reduced to:

Corporate profits = ‐ (government + household savings).

In recent years, this has however not been the case. Investment rose while the current account improved (imports‐ exports= foreign savings). Therefore, as the chart from Hussman’s blog shows, the relationship broke down over the last 5 years.

- source Hussman funds

This explains why, despite reduced savings from the combined government and household sectors, profits have held up quite well. Part of the answer comes from quantitative easing. Debt issuance to repurchase shares has artificially lifted profits. Additionally, the last few years also correspond to the shale oil revolution. It is therefore possible that with a lower energy bill, the US was able to “self‐finance” investments without the usual help of imported foreign savings. The question is, can that last now that QE is over and with the FED about to lift interest rates? Given the strength of the dollar and the weakness of the global economy, the most likely scenarios are that investment weakens and/or that the current account improvement goes into reverse. Already, capital goods’ spending is weakening, and the oil crash has increased the odds that it will weaken substantially more.

Furthermore, over the last 3 years, consumers have tapped into their savings. The saving rate went from a high of 8.5% in 2012 to 4.5% today. It is unlikely that the saving rate will drop further given 1/ the close memory of 2008 2/ demographics 3/ current households behavior (consumer are using their strong cash flows to pay down debt).

At more than 600% of GDP, the US government + unfunded off balance sheet debt leaves no options on the fiscal side of the Kalecki equation when the cycle turns.

As a result the boost to private consumption from consumers is unlikely to be repeated. And since government dissaving has more than offset consumer spending it is likely that profits will surprise on the downside in coming quarters. Even more so, if investment weakens on top.

We can also observe a strong link (with a lead) on both corporate credit spreads….

and thus equity volatility.

As we have shown recently, the strength of the US currency is another threat to corporate profits and forward earnings estimates. When the supply of dollars globally shrinks (budget and current account improve together) overseas earnings tend to crash, hence the relationship below.

Current consensus believes that extremely low yields and energy prices will more than offset these threats.

With US equity volatility as mispriced as it was back in 2007 according to our model, now is not the time to be overly complacent.

Finally we would like to also add an important point made by David Goldman which can be found on Reorient Group's website from his note from 31st of March entitled "US Corporate Profits Inflated by Undersestimated Depreciation":

"If the United States wants to attract Chinese investors, it had better improve accounting standards. That sounds like the beginning of a joke, but it’s not. There have been isolated cases of accounting fraud in Chinese companies listed on US exchanges, but there appears to be systematic distortion of US corporate profits across the board. The issue is depreciation of plant and equipment. This is another reason we don’t like US stocks at present valuations.

Before-tax earnings of US companies in the GDP accounts are reported two ways: with Inventory Valuation Adjustment (IVA) and Capital Consumption Allowance, and without. The two measures have diverged by about 25%, or US$500 bn, since 2012. That’s a big divergence. The stricter measure (based on the Commerce Department’s depreciation model) shows that Q4 corporate profits in 2015 were lower than in Q4 2011; the looser measure shows substantial growth. Note that the S&P 500’s earnings per share track the higher, not the lower number."

- source Reorient Group

"When growth is slower-than-expected, stocks go down. When inflation is higher-than-expected, bonds go down. When inflation is lower-than-expected, bonds go up." - Ray Dalio

Stay tuned!