Charts of the Day - Why top-down Macro remains more important than ever

"Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passions, they cannot alter the state of facts and evidence." - John Adams, American president

While we recently indicated our concerns relating to the relationship between rising positive correlations thanks to central banks' markets meddling and rising +/-4 standard deviations moves or more in asset classes in our August short conversation "Charts of the Day - Positive correlations and large Standard Deviation moves", we believe that top-down Macro remains more important than ever thanks to these rising correlations.

This can be ascertained from Bank of America Merrill Lynch's "Global Focus Point note from the 7th of September entitled "3 million data points soared":

"Correlations skyrocketed in August
In August, global stock-to-stock correlations jumped to the highest level in four years. Macro concerns ranging from fear of the Fed raising rates, China slowdown, risk of Greece contagion, and falling GDP forecasts have marred equity market returns recently. Stock-to-stock correlations are signaling that stocks are performing similarly to each other. Factoring in macro issues becomes much more important than pure fundamentals during phases of rising correlations.

3 million data points
Stock-to-stock (or pair-wise) correlation is correlation between daily price returns of each stock in the MSCI ACWI index to the daily price returns of every other stock (i.e., 3 million calculations each month). Last month correlations jumped above long-term averages in all major regions and sectors of the world. Correlations are highest in Japan, followed by Europe and the US. Previous jumps in correlations have coincided with falls in global equity markets, on average.

Signals from the Global Wave critical
Rising stock-to-stock correlation coupled with weakening Tactical Indicators suggests that macro is more important than ever. The Global Wave, our macro indicator, continues to fall after signaling a peak in the global economic cycle in January. Investors should closely monitor the signals from the Global Wave for clarity on the macro environment.

What to buy?History suggests defensive styles and sectors tend to do well when the Global Wave is falling. This suggests overweighting the Bunkers which are based on styles for a downturn including earnings stability, low beta, low estimate dispersion and high dividends.

The best performing sectors when the Global Wave is falling tend to be Health Care and Consumer Staples, and the worst include Materials and Industrials." - source Bank of America Merrill Lynch

Furthermore a low beta strategy of "overweighting sectors such as "Consumer Staples" can be seen as an embedded free "partial crash" put option.

We already approached this very subject in our 3rd of April 2013 conversation "Equities, playing defense - Consumer Staples, an embedded free "partial crash" put option":

"The value of the put option offered by the Consumer Staples sector protects investors from monthly declines of 5% or more i.e. you can generate market performance and be insulated to a degree from major market shocks." - source Société Générale

As per our previous April 2013 note:
Consumer Staples are mostly a defensive play that can outperform during phases of "Risk-Off" which we have been experiencing on numerous occasions since the financial crisis of 2008:

"The low-volatility index did best in times when stocks fell, such as 2000 to 2002, and in 2008, according to S&P data. In 2008 the low-volatility index fell 21 percent compared with 37 percent for the S&P 500." - source Bloomberg.

As a reminder, another way in protecting a portfolio is investing on ETFs such as the PowerShares S&P Low Volatility Portfolio for protection from stock-market swings because Consumer Staples account for around 22%.

Some inconvenient facts: Low volatility stocks have provided the best long-term returns, one of the greatest anomalies in finance.

 "Defense is a definite part of the game, and a great part of defense is learning to play it without fouling." - John Wooden, American coach

Stay tuned!

HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?

"Be able to defend your arguments in a rational way. Otherwise, all you have is an opinion." - Marilyn vos Savant, American writer

Even during the height of the Asian crisis in 1997, the HKD peg was never challenged, shorting the currency is similar to shorting the Japanese long bond JGB, a true "widowmaker" trade.

We have a growing interest in evaluating the potential consequences of a Chinese devaluation of the Yuan (CNY). 

Like our good friends at Rcube Global Asset Management, we remain convinced it is on the cards particularly with the growing noise coming from government officials/agencies expecting at least a devaluation of 10% in 2016/2017.

The below graph shows the pressure on Hong Kong's exchange rate system: forex reserves have been exploding since 2008:

-source Sem Huizer - Twitter

For now there is continued buying pressure on HKD. This has led on Tuesday, the Hong Kong Monetary Authority to intervene and buy $1.2 billion at HKD 7.75, the upper limit of the band of the peg to relieve some pressure on the HKD. This marked the second intervention of the HKMA since April according to Bloomberg:

"Hong Kong’s de facto central bank stepped in for the first time in more than four months to prevent the city’s currency from breaking out of the strong end of its pegged range against the U.S. dollar. The Hong Kong Monetary Authority said it bought $1.2 billion late Tuesday at HK$7.75 a dollar, the upper limit of a band that triggers intervention, taking today’s injection to $2 billion. It last intervened in April, buying $9.2 billion in total during the month. The HKMA “will monitor the market developments closely and maintain the stability of the Hong Kong dollar,” it said in a statement.
Hong Kong’s dollar is drawing funds as last month’s surprise yuan devaluation and the prospect of higher U.S. interest rates push currencies lower across Asia’s developing economies. The weakening of the yuan was followed by exchange-rate shifts in Kazakhstan and Vietnam, making investors nervous about regime changes in other currencies.
“The demand for Hong Kong dollars comes from the unwinding of yuan after the devaluation,” said Raymond Yeung, a senior economist at Australia & New Zealand Banking Group Ltd. in Hong Kong. “It also reflects demand for safe-haven assets as Hong Kong’s dollar is pegged to the U.S. dollar. We aren’t seeing a huge amount of speculation on changes in the peg.”

- source Bloomberg

The pressure to devalue the HKD is going to increase with the loss of competitivity of Hong Kong versus its Asian peers as its currency has been soaring in conjunction with the US dollar.

The more we think about it, the more it appears to us that Hong-Kong is the most exposed Asian economy to such a currency move. We also share our concerns with UBS who recently published a very interesting note entitled "What if the CNY depreciated by 10%?":

"The increasingly difficult position of Hong Kong
In our view, no equity market in APAC is more vulnerable to a potential 10% devaluation of the RMB than Hong Kong. We are currently underweight Hong Kong equities, after Japan, APAC's second best performer this year.

As it stands Hong Kong has seen a significant increase in private sector credit to GDP in the last few years. 

The real effective exchange rate has increased 10% since 2007, while the economy faces the prospect of rising US rates. 

To experience on top of this 10% devaluation from its major trading partner and the deflation this implies, is a challenging combination especially without the ability to lower nominal or real interest rates. For further details on the challenges HK faces, please see our colleague Silvia Liu's note "Hong Kong: near the tipping point?" - source UBS

A weaker CNY would trigger a fall in competitivity for the entire Asian region and would massively impact the retail sector of Hong-Kong with additional fall in the number of visitors from mainland China and even more pressure on property developpers. Hong Kong property sales plunged to 17-month low in August amid increasing economic uncertainty in China. The slowdown in the number of visitors is already visible as per the below chart from Bloomberg:

- source Bloomberg

To be short HKD looks similar today to the interesting trades of the previous months of being long CHF and/or short CNY: These "ultra-convex" positions are often very "cheap" to carry and amounts to betting against pegs being "highly disconnected" from economic "reality.

By looking at what is happening in the FX options market, we noticed that some players have started to look at setting up this "short" trade idea via options as suggested in the below graph displaying 3 months volatility on the HKD:

-graph source Bloomberg


This we think warrants, monitoring in the foreseeable future...

"When men sow the wind it is rational to expect that they will reap the whirlwind." - Frederick Douglass, American author.

Stay tuned!

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!