Sunday 23 December 2012

Merry Christmas and a happy new year to all!

This year Macronomics is celebrating its third year of existence. The blog started early December 2009.

On that special occasion, we would like to extend our thanks for the support of many and to our growing number of our readers (thanks for your praise). 

To name a few:
We would like to especially thanks Cullen Roche from Pragmatic Capitalism for putting us in the front stage of his great blog. We would also like to extend our thanks to fellow bloggers Juhani Huopainen from MoreLiver's Daily for his encouragements as well as Rom Badilla from Bondsquawk.

We would also like to thanks our good friends from Rcube Global Macro Research for the many interesting conversations we had in 2012 and for the quality of the notes they have authorised us to reproduce. 

We also would like to extend our thanks to our good cross-asset friend, for providing us with his superb insight on the volatility world and some interesting posts as well coming from the numerous interesting exchanges of market views we have had throughout the course of 2012. 

We must as well praise our good credit friend with whom we have exchanged many credit thoughts and predictions (which on many occasions have materialised: bond tenders, skip of calls, debt to equity swaps and more...).

We would also like to thanks Martin Sibileau from A View from the Trenches for his constructive critics (we know some of our posts are too long, we endeavour to behave in 2013!) and the interesting exchanges we had in 2012 as well as for allowing me to quote some of his work on numerous occasions. 

Finally, on personal note, Macronomics would have never come to life without the prior encouragements and the infinite patience from my fiancée Maï.

Wishing you all a Merry Christmas and a happy new year!

Macronomics will be back in the new year!

Stay tuned in 2013!

Friday 21 December 2012

Update - Credit / Equities & Credit / Equities Volatility in Europe

"I conceive that the great part of the miseries of mankind are brought upon them by false estimates they have made of the value of things." - Benjamin Franklin

In continuation of our July conversation relating to the relationship between  European Credit versus Equity volatility from our good cross-asset friend (who pointed at the time to the relative attractiveness of being long credit and long volatility), please find enclosed his latest remark on the relationship between Credit and Equities.

Although cross-asset correlations have been diminishing in the last couple of weeks with credit spreads moving tighter and equities markets moving higher, they nevertheless remain globally elevated and statistically significant. The strength in this cross-asset relationship requires close attention, given the on-going excessive search for yields which could have a long-term impact (relative immunisation risk of credit versus equities).

Graph: Correlation R square between Credit Index Itraxx Crossover (High Yield gauge) and Eurostoxx 50 Volatility 1 year (rolling 6 months: -  source Bloomberg:

Couple of points:
- the current levels of Investment Grade Credit / Equities / Equities Volatility are coherent, on High Yield, spreads seems to be relatively tight versus equities.
- the relationship between credit / spot equities has been through two significant diverging periods in 2012. First in early 2012 (where IG spreads and High Yield did lag the rally in equities) then in March / April (the sell-off in equities only marginally spread to credit, which offered an attractive opportunity of buying CDS / Equities).
- the relationship between credit and Equities Volatilities only went through one clear disconnect versus Investment Grade in June / July: sell CDS signal versus buying Equities volatility and two periods of clear disconnect with High Yield (end of May: selling Equities volatility / Buying Itraxx Crossover - June / July, same  opportunity for IG (see July post quoted above on that subject).

Please see below charts displaying the relationships YTD. These relationships are expressed via power regressions on the period, please note the roll impact for credit indices has been taken into account.

Investment Grade : Itraxx MAIN vs Eurostoxx 50 spot - source Bloomberg:

Investment Grade : Itraxx MAIN vs Eurostoxx 50 volatility 1 yeat ATM (At The Money) - source Bloomberg:

High Yield : Itraxx Crossover vs Eurostoxx 50 spot - source Bloomberg:

High Yield : Itraxx Crossover vs Eurostoxx 50 volatility - source Bloomberg:

Stay tuned!

Wednesday 19 December 2012

Guest post - US Equities' Long Term Real Returns

"The three great essentials to achieve anything worth while are: Hard work, Stick-to-itiveness, and Common sense." - Thomas A. Edison 

Courtesy of our good friends at Rcube Global Macro Research, please find enclosed their recent note focusing on US Equities' Long Term Real Returns. Enjoy!

Our research generally focuses on tactical investment horizons (3‐6 months). In this paper, however, we consider long‐term real returns for US equities, for which we have reliable data since 1871.

Nota bene:
By real returns, we mean total returns (i.e. dividend included) divided by the CPI. We chose to analyze the US market as it has longest and most accurate historical data. Our data originates from Shiller’s website: Earlier data exists (as early as 1802), but is plagued with survivorship bias.

When we look at price alone (as many observers do), we see no evidence of a long term trend. Rather, we have two distinct 70‐year periods: pre‐WW2: +1.0% annual  price appreciation; and post‐WW2: +7.4% annual price appreciation.
However, as we know, price appreciation is insufficient to quantify returns, especially when we consider long investment periods.
Indeed, a rational long‐term investor should look at (and hope to maximize) real total returns, which take into account dividends and inflation.

When we look at the S and P 500’s real total return, the picture looks very different:

Taking into account dividends and inflation, we can admire the remarkable stationarity of S and P 500’s real returns around a long‐term trend (6.5% per year). Even the 1929 crash and the 1970s’ stagflation represent small deviations from the overall trend. 

A long‐term trend of around 6.5% essentially means that an equity investor’s purchasing power doubles every 11 years, which is in itself the strongest argument for permabulls and buy‐and‐hold proponents. 

That being said, many believe that the 6.5% real return – which is also known as “Siegel’s Constant” – is a historical freak and is unlikely to continue further. 

In a controversial Investment Outlook published last August, Bill Gross compared this 6.5% long‐term real return to long‐term real GDP growth (around 3.5%), and concluded that the stock market was a “Ponzi scheme”, with stockholders having been "skimming 3% off the top each and every year, at the expense of lenders, laborers and the government”. In a comment that reminisced Business Week’s famous 1979 cover, the “Bond King” then proclaimed that the “cult of equity was dying”. 

It appears to us that this analysis is flawed (and indeed, it was immediately rebutted by Dr. Jeremy Siegel, as well as other academics). Although it is true that the market value of equities cannot grow above GDP forever, Bill Gross seems to have ignored the fact that around half of stock returns originate from distribution to shareholders, in the form of dividends and share buybacks

There is therefore nothing wrong in the fact that equity real returns are higher than real GDP growth. Even in a zero‐growth economy, companies would still have earnings that can be used to distribute dividends or buy back shares, which would lead to higher than zero real returns for equities.
We’ll return later to the question of the link between equity real returns and economic growth.

Regardless of the sustainability of 6.5% real returns in the future, nobody would dispute that it is hardly a“constant”, especially for short‐term horizons.

If we define 10 years as the lower range of what constitutes a long‐term investment horizon, the standard deviation of forward returns is still fairly wide (around 5.2%). This highlights the need to look for methods of predicting 10‐year forward returns.

One such method, introduced by Robert Shiller in his 2000 book Irrational Exuberance, involves using cyclically adjusted P/E ratios (CAPEs) to predict 10‐year forward returns. CAPEs are P/E ratios that use past 10‐year average earnings in order to smooth out cycles.

The S and P 500’s CAPE is currently around 21, which is substantially higher than its long‐term average (16.5). 
Although bearish observers use these figures as a sign of overvaluation, it is worth noting that 10‐year forward real returns would be around 4.4% according to the above regression equation.

In any case, the CAPE regression only explains around 25% of 10‐year forward returns. Moreover, this analysis is performed in‐sample, whereas an investor operating in real time during the sample period would not have access to the whole dataset.

If we remain in an in‐sample framework, we can obtain R2s that are much better than 25%.

First we can note that corporate profits as a proportion of GDP are one of the most mean‐reverting time series in economics. 

Nota bene:
Although total corporate profits and S and P 500 profits are not the same thing, their growth rate is rather similar over long time periods (3.23% per year for total corporate profits vs. 3.17% for S and P 500 profits between 1947 and 2008):
Low profits as a proportion of GDP lead to business failures, reduced competition, and therefore higher margins further down the road (and vice versa).

From this point of view, buying when earnings are high and selling when earnings are low (as suggested by PE‐based methods) does not seem such a great idea.
Rather than taking the 10‐year earnings average as the denominator, we could therefore use real GDP.
Incidentally, the total market cap / GDP ratio (which is a related concept) is Buffet’s favourite macro measure of value for stocks.
This time, we find a long‐term trend of around 3% for the ratio (i.e. the same 3% that stockholders
supposedly “skim off” at the expense of others, according to Bill Gross).
Although the S and P 500 real return / real GDP ratio looks rather trend‐stationary, it has had rather wild swings around the trend, which indicate potentially interesting opportunities to trade in and out of the market.

Indeed, we obtain a rather nice R2 of 57% when we regress the detrended ratio against 10‐year forward real returns.

Currently, we’re close to fair value, as the overshoot from the 90s (Greenspan’s “irrational exuberance”) finally seems to have been digested. This does not preclude another “undershoot”, such as the one we had in 2008, as investors revise their economic growth assumptions downwards, especially in deleveraging developed economies.

Nota bene:
Although there seems to be a long‐term elasticity of one between equity real returns and realized economic growth, changes in long‐term growth expectations and/or risk premia can have a huge impact on valuations. If we simply look at the Gordon‐Shapiro model and assume a denominator (expected rate of return – expected growth) of around 5%, a 1% decrease in long‐term expected growth decreases the value of equities by 20%. We believe that this explains much of equities’ “excess volatility puzzle”.

Again, this is an in‐sample analysis (just like the CAPE model). Although we still get an R2 of around 40% if we use a running regression instead of a fixed in‐sample regression (and use the first 40 years of the sample as a “learning period”), no one can assert that 3% long‐term returns above real GDP growth are an intangible law of nature.

To conclude, assuming long‐term forward equity real returns to be around 3% plus foreseeable economic growth provides us with a ballpark figure. It avoids making blatantly wrong assumptions about long‐term equity real returns (such as believing that they can be around 10%, like many investors still do).

Additionally, it is important to note that this brief study concerns only the United States, a country that won two world wars and avoided socialist experiments during the last century. It would be interesting to calculate the trend of the real equity return / real GDP ratio for other countries. Unfortunately, reliable data on long‐term real returns is hard to obtain for most countries, as they generally originate in the early 1970s (e.g. MSCI Indices).

We will however try to gather more data on this vast subject, as well as publish additional short studies about long‐term returns of other asset classes.

"Common sense is the most fairly distributed thing in the world, for each one thinks he is so well-endowed with it that even those who are hardest to satisfy in all other matters are not in the habit of desiring more of it than they already have." - Rene Descartes, French philosopher. 

Stay tuned!

Tuesday 11 December 2012

Credit - Synchronicity

"When coincidences pile up in this way, one cannot help being impressed by them—for the greater the number of terms in such a series, or the more unusual its character, the more improbable it becomes." - Carl Gustav Jung

Dear credit ramblings readers, apologies for the recent lack of posting, but, as of late we have been travelling, to attend a board meeting, windsurfing that is, hence our lack of "availability" in posting our regular  weekly credit feature. Yet, we did manage to take with us the laptop, to keep abreast of the evolution, or should we say lack of resolution of the on-going European debt crisis. We also manage to take with us some handful of books, one being "The Debt-Deflation Theory of Great Depressions" by the great Irving Fisher, which was originally published in Econometrica, Vol. 1, No. 4 in October 1933.

In this 1933 publication, Irving Fisher pointed out some very relevant points in relation to debt and deflation (which has been a regular theme on this blog). For instance, according to Irving Fisher, "the chief secret of most, if not all great depressions: The more the debtors pay, the more they owe. The more the economic boat tips, the most it tends to tip. It is not tending to right itself,  but is capsizing."

Looking at some of our 2012 conversations, we have used in numerous occasions sailing analogies for this very precise reason, and, in particular back in May 2012 in our conversation "The Raft of the European Medusa":
"Following up on the theme of navigation and sailing dear to our heart, given "The Tempest" raging and the unraveling of the "Mutiny on the Euro Bounty" courtesy of the high stakes poker game being played by Greek politicians and their European creditors (reminiscent of "Schedule Chicken" once more...), we have decided to use yet another sailing analogy but this time referring to Géricault's painting masterpiece "The Raft of the Medusa". 
Similar to the fate of the Medusa ship, the story so far has been the European Commission in an effort to make good time in reducing budget deficits, decided to impose unrealistic budget reduction objectives ("A Deficit Target Too Far") while imposing drastic reduction in bank leverage and balance sheets, courtesy of the European Banking Association (EBA) June 2012 deadline of 9% of Core Tier 1 capital. These combined actions led to credit contractions, no surprise there, leading to reduced economic growth in Europe compared to the US ("Growth divergence between US and Europe? It's the credit conditions stupid..."). While utter financial meltdown disaster was narrowly avoided thanks to the ECB's LTRO operations, the lack of experience or ability (or both...) of the captains of our "European Flutter" ship have indeed landed the European project on a sandbank, with of course, a "raft" full of "unintended consequences" such as mutiny, with Greek bond subordination during the recent PSI leading to insubordination (a buyers strike...) in parts of the European bond market."

When it comes to Europe, we have not changed "tack", as we pointed in a "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October 2011 when discussing circularity issues:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

So, why our chosen title and what is the link with Irving Fisher you might rightly ask? Well, dear readers we owe you some explainations. Synchronicity is the experience of two or more events that are apparently causally unrelated or unlikely to occur together by chance, yet are experienced as occurring together in a meaningful manner. The concept of synchronicity was first described in this terminology by Carl Gustav Jung, a Swiss psychologist, in the 1920s.

When one look at the event of the 1930s as related by Irving Fisher and the on-going discussions surrounding the "Fiscal Cliff", we could not resist but refer to Carl Jung's principle of Synchronicity:
"In fact under President Hoover, recovery was apparently well started by the Federal Reserve open-market purchases, which revived prices and business from May to September 1932. The efforts were not kept up and the recovery was stopped by various circumstances, including the political "campaign of fear". - source "The Debt-Deflation Theory of Great Depressions" by Irving Fisher, originally published in Econometrica, Vol. 1, No. 4 in October 1933.

Carl Jung believed, like we do, that many experiences that are coincidence due to chance in terms of causality could be an expression of deeper order. Concurrent event that first appear to be coincidental can later turn out to be causally related are termed incoincident. The "collective unconscious" defined by Jung is inherited, which is supportive of the idea of Synchronicity he developped:
"When coincidences pile up in this way, one cannot help being impressed by them - for the greater the number of terms in such a series, or the more the unusual its character, the more improbalbe it becomes." - Carl Jung

Admittedly, Carl Jung's theory of synchronicity is equal to intellectual intuition, but we digress as per our usual rambling habits.

Therefore in this week credit conversation, we would like to point out to the upcoming subordination of European sovereign debt courtesy of the much anticipated broad introduction of CACs (Collective Action Clauses) by January 2013 which implies at some point, debt will be much more easily repudiated. Given our title is namely Synchronicity, we will of course make further references to the great work of legendary Irving Fisher.

While musing through Irving Fisher's nine factors occuring and recurring (together with distress selling), indicative of cross-currents of a depression, we could not resist but focus on point VII from Irving Fisher's table leading us to experience Carl Jung's Synchronicity theory.
- (5) Decrease in Profits
- (5) Increase in Losses
- (7) Increase in Pessimism (fall in Consumer Confidence in Europe is indicative, we think)
- (8) Slower Velocity
-  (1) More Liquidation
- Reduction in Volume of Stock Trading
- source JP Morgan 2013 Derivatives Outlook.

In addition to factor (8) coined "Hoarding" by Irving Fisher, Europe is as well a good example of the application of "Synchronicity" given as described by Irving Fisher, "Banks have been curtailing Loans for Self-Protection" courtesy of the European Banking Association rule of reaching 9% of Core Tier 1 Capital before the end of June 2012 with the economic impact we all have witnessed by now mostly in peripheral countries (see our conversation "Money for Nothing"):
"We mean "Money for Nothing" given our friends at Rcube Global Macro, in their latest study of the ECB quarterly bank lending survey indicate a significant worsening of the credit crunch in Europe, meaning plenty of liquidity impact for banks but confirming our 2011 fears of credit contraction for corporates and households ("Money for nothing and the Casino Chips for free..." - Macronomics)- February 2012

No wonder European Banks CDS spreads receded significantly in 2012, touching an 18 months low - source Bloomberg:
"European bank CDS levels have fallen to lows not held since June 2011, before the sovereign crisis and funding concerns in Spain and Italy flared aggressively and markets fell heavily. Down more than 250 bps since November 2011 highs, the improvement in European bank perceived creditworthiness has far outpaced that of U.S. and Asian peers" - source Bloomberg

In addition to factor number 8 and as indicated in Irving Fisher's work, banks have been busy selling investments.

Looking at rising correlations, in conjunction with the fall in volatilties which we tackled courtesy of our friends at Rcube Global Macro in our conversation "Why have Global Macro Hedge Funds underperformed", the recent rise in these correlations as indicated by this graph from JP Morgan 2013 Derivatives Outlook, it is, we think a cause for concern:
- source JP Morgan 2013 Derivatives Outlook.

As our friend Martin Sibileau puts it in his latest post "The year 2012 in perspective":
"At the end of 2011, when the collapse of the banking system in the Euro zone (courtesy of M. Trichet) was dragging the rest of the world, the Swiss National Bank established a peg on the Franc to the Euro and the Federal Reserve extended and cheapened its currency swaps with the European Central Bank. These two measures –indirectly- coupled the fate of the assets in the balance sheets of the Euro zone banks to the balance sheets of the central banks of Switzerland and the US. As in any other Ponzi scheme, when the weakest link breaks, the chain breaks. The risk of such a break-up, applied to economics, is known as systemic risk or “correlation going to 1”. As the weakest link (i.e. the Euro zone) was coupled to the chain of the Fed, global systemic risk (or correlation) dropped. Apparently, those managing a correlation trade in IG9 (i.e. investment grade credit index series 9) for a well-known global bank did not understand this. But it would be misguided to conclude that the concept has now been understood, because there are too many analysts and fund managers who still interpret this coupling as a success at eliminating or decreasing tail risk. No such thing could be farther from the truth. What they call tail risk, namely the break-up of the Euro zone is not a “tail” risk. It is the logical consequence of the institutional structure of the European Monetary Union, which lacks fiscal union and a common balance sheet. I am not in favour of such, but in its absence, to think that the break-up is a tail risk is to hide one’s head in the sand. And to think that because corporations and banks in the Euro zone now have access to cheap US dollar funding, the recession will not bring defaults, will be a very costly mistake. Those potential defaults are not a tail risk either: If you tax a nation to death, destroy its capital markets, nourish its unemployment, condemn it to an expensive currency and give its corporations liquidity at stupidly low costs you can only expect one outcome: Defaults. The fact that they shall be addressed with even more US dollars coming from the Fed in no way justifies complacency."

In relation to our "Synchronicity" theory and Irving Fisher, let us quote him again:
"When the starter consists of new opportunities to make unusually profitable investments, the bubble of debts tends to be blown bigger and faster than when the starter is great misfortune causing merely non-productive debts. The only notable exception is a great war and even then chiefly because it leads after it is over to productive debts for reconstruction purposes".

Furthermore, if Irving Fisher's debt-deflation is correct and if Synchronicity is correct as well, the "infectiousness of depressions internationally is chiefly due to a common gold (or other) monetary standard and there should be found little tendency for depressions to pass from a deflating to an inflating, or stabilizing country". We can easily conclude that the infectiousness of the European depression is chiefly due to a common monetary standard, namely the Euro. Therefore a break-up of the Euro would not be a "Black-Swan" per se, but the Euro not breaking up would be one.

Moving on to the subject of CACs namely Collective Action Clauses, the European Commission has agreed with the other European countries that as of the 1st of January 2013, all new issues will include CACs. Welcome to subordination in the European government space!

What are CACs?
"CACs are contractual provisions that:
1. Facilitate an issuer approaching bondholders with a proposal to modify ey terms of the relevant bond;
2. Enable a majority of these bondholders to agree to the proposed modifications; and
3. (where the requisite majority has so agreed) provide that the modifications are binding on all bondholders." - source Linklaters

As of the 1st of January, all new debt maturing above 1 year will include these clauses. According to a recent report published by Natixis, the European model for CACs allows for a much easier mobilisation process as well as an easier way of reaching majority and impacting similar securities at the same time. The modification of single series of one bond necessitate 75% of the notional represented in the meeting and 66 2/3 % of the total notional for the written resolution, but as well as for any securities taken individually (66 2/3% and 50% respectively). The objective is to reduce the majority level for a bond taken individually to facilitate the process.

CACs will be integrated to new issues, and the European Commission has imposed a threshold of a minimum of 55% of new issues including CACs, the other 45% will enable the liquidity of non-CAC related stock of government bonds. Going forward, the European Commission ambitions to reach a level of 95% of CAC bearing government bonds by 2023, the additional 5% will remain to maintain the liquidity of the current 10-30 year range. According to the note from Natixis, European issuers will need 5 to 7 years to obtain a stock level equivalent to the existing stock of non-CAC bonds. Since the default of Mexico in 1997, and Argentina in 2001, the use of CACs has risen significantly.

But what are the "unintended consequences"?

According to the same note from Natixis, with the introduction of CACs, one of the very first unintended consequences, will be that government will be tempted by using restructuring via CACs rather than solve their budgetary issues.
This moral hazard come with a cost, namely, rather than lowering the cost of funding, it will raise it given most new issues coming with CACs will be issued under domestic law.

We see another parallel with one of our pet subject, namely "bond tenders" in the capital structure of banks which has been a regular topic. Raising subordinated debt always come at the price because of the risk taken by the investor. For instance the possibility of coupon deferrals for Tier 1 bonds as well as UT2 make these junior subordinated debt instruments ineligible as reference obligations for CDS.

With the arrival of CACs and the already dwindling liquidity in the sovereign CDS space courtesy of the naked ban effective the 1st of November, one can only wonder about the attractiveness or use of the Sovereign CDS market in Europe.

Another important point from the Natixis note from an historical point of view (or maybe from a "Synchronicity" point of view) in relation to CACs, is the ability of these instruments to avoid default. A preemptive restructuring is always preferable to a post restructuring. Caveat creditor (let the lender beware...). The difference between haircuts from a pre-restructuring (CACs) and post-restructuring is close to 55% according to Natixis, in the case of restructuring occurring in Emerging Markets. Greece with its PSI and 53.5% is in the higher range of pre-emptive restructuring.

Although the introduction of CACs reduces restructuring costs and facilitate the process, it should nevertheless increase risk premiums attached to the new issues. Welcome to subordination in the European government bond market!
But as we stated, "caveat creditor" given that even non-CACs bondholders can face the music with the introduction of retroactive CACs.

On a final note, some pundits are indicating that Americans could be soon buying again durable goods - source Bloomberg:
"Americans may soon start buying more cars, appliances and other items because the ones they own are the oldest in almost half a century, according to Neil Dutta, Renaissance Macro Research LLC’s head of U.S. economics. The CHART OF THE DAY displays the average age of so-called consumer durable goods, as compiled by the Commerce Department since 1925. Dutta referred to the annual figures in a note to clients yesterday. Last year, the average climbed to 4.6 years, the highest since 1962. The increase from 4.5 years was the fourth in a row, the longest streak since the Great Depression. “Consumers are increasingly likely to commit to big-ticket purchases” as their finances improve, wrote Dutta, who is based in New York. Household debt fell to 81.5 percent of gross domestic product as of Sept. 30 from 97.5 percent at the end of June 2009, when the most recent recession ended, according to the Federal Reserve. Disposable income rose 12 percent during the same period, based on Commerce Department data. Increased spending on durable goods is one reason why U.S. economic growth is poised to accelerate, the report said. Dutta also cited a rebound in housing and the potential for growth in business investment." - source Bloomberg.

While the above sounds reasonable looking at the historical time frame used, when one thinks about "Synchronicity" and the theories of Irving Fisher and the events from May to September 1932, one might begin to wonder because the definition of Zemblanity is "The inexorable discovery of what we don't want to know":
"MV=PT as per Irving Fisher's equation. Unfortunately, it looks like the increase in M with a falling V, is not leading to a rise in T nor in a rise in the US labor participation rate for "Doc" Bernanke. "

Until we see a significant rise in Velocity M2 (a subject we discussed in Zemblanity), we will remain cautious on the US economic outlook and we would like to conclude this conversation with one graph displaying the US Labor Participation Rate with the Unemployment rate in the US since 2007 - source Bloomberg:

"Everything has been said before, but since nobody listens we have to keep going back and beginning all over again" - André Gide, French writer.

Stay tuned!

Wednesday 5 December 2012

Chart of the Day - Convergence between VIX and V2X

"To every action there is always opposed an equal reaction." -  Isaac Newton 

The convergence between VIX and its European equivalent V2X - Source Bloomberg:

The last few days have seen a pick up in demand for downside protection on the S and P500, when it seems no one at the moment has nothing left to protect against in Europe, which explains somewhat the recent convergence move between the VIX and its European equivalent V2X - source Bloomberg:

Please note Futures have yet to realise this convergence.

As a reminder from our March conversation (The two main drivers of equity volatility), and as indicated by our Global Macro friends at Rcube at the time:
"The two main drivers of equity volatility are for us, credit availability (Merton model) and revisions of earnings forecasts estimates. Equity volatility is also logically driven by the direction and the magnitude of revisions of forward earnings estimates. In 2010 and again in 2011, equity vol spiked while earnings forecasts remained strong."

"Hesitation increases in relation to risk in equal proportion to age." - Ernest Hemingway

Stay tuned!

Tuesday 4 December 2012

Chart of the Day - Economists and Markets Optimistic ahead of US Fiscal Cliff

"Hope is definitely not the same thing as optimism. It is not the conviction that something will turn out well, but the certainty that something makes sense, regardless of how it turns out." - Vaclav Havel

"The policy uncertainty index has three underlying components: 1). newspaper coverage of policy-related economic uncertainty; 2). number of federal tax code provisions set to expire; 3). disagreement among economic forecasters as a proxy for uncertainty." - source, Bloomberg, Societe Generale Cross Asset Research - 27th of November 2012

Stay tuned!

Monday 3 December 2012

Credit - The Regret Theory

"In history as in human life, regret does not bring back a lost moment and a thousand years will not recover something lost in a single hour."  - Stefan Zweig

This year, we have on numerous occasions touched on game theory in our posts (The European iterated prisoner's dilemma, Agree to Disagree) and we also used an analogy relating to project management linked closely to the famous game of chicken, namely the Nash equilibrium concept (Schedule Chicken). We even ventured towards computational analogies in our title selection process (Bankers' algorithm). Given the latest raft of European PMIs, pointing to a continued (albeit much smaller) divergence between the United-States Growth and Europe (Growth divergence between the USA and Europe), reason being the lack of credit provided to the real economy due to:
-inappropriate European Banking Association decision of imposing banks to reach a 9% Core Tier 1 ratio by June 2012 
-unrealistic budget deficit targets (A Deficit Target Too Far), 

We came to the conclusion that we ought to use in our title a reference to the Regret decision theory.

The divergence between US and European PMI indexes - source Bloomberg:

The Regret theory (also called opportunity loss) being defined as the difference between the actual payoff and the payoff that would have been obtained if a different course of action had been chosen by our European politicians. The Regret theory is also a model of choice under uncertainty defined as the difference between the outcome yielded by a given choice (credit crunch, economic recession) and the best outcome (muddle through) that could have been achieved in that state of nature (deflationary forces at play). 

As far as Europe is concerned, one can wonder what would have been the "economic outcome" if a different course of action would have been undertaken. On that matter we wonder why our "European elites" did not use the minimax regret approach being a decision rule used in decision theory, game theory, statistics and philosophy for minimizing the possible loss for a worst case (maximum loss) scenario. One approach is to treat this as a game against nature (deflation in our case) and using a similar mindset as "Murphy's law" ("Anything that can possibly go wrong, does"), taking an approach which minimizes the maximum expected loss, but we ramble again...

And what could possibly go wrong in relation to European growth in 2013? After all, one might posit it is only a game of confidence. Well, looking at consumer confidence in Europe, "Murphy junior" would certainly comment that his father is probably too optimistic when looking at European Consumer Confidence.

European consumer confidence indicators for some European countries - source Bloomberg:

We already looked at the link between consumer confidence and consumption back in our June conversation "Yogurts, European Consumer Confidence and Consumption" where we undertook at an interesting exercise following Yogurt giant Danone profitability warning announcement (affected by Spanish woes), namely plotting Danone share price against consumer confidence - source Bloomberg:
We wrote at the time:
"Yogurts matter as an indicator? One has to wonder...
As austerity bites consumer spending and with Italy and Spain in recession, companies have been forced to lower cost to protect earnings so far. End of May the ECB also indicated that loans to households and companies in the euro zone grew at the slowest pace in two years as the on-going crisis curbed demand for credit."

In relation to European Consumption, Consumer Confidence is key. The latest data relating to car sales in Europe, confirms the deflationary forces at play in Europe with car registrations falling plunging 19.2% in November in France on a monthly basis and 13.8% in the first 11 months of the year and Italian care sales by 20.1% in November (for a lengthy analysis on the subject of the car market in Europe please check - "The European Clunker - European car sales, a clear indicator of deflation").
As far as 2013 is concerned, European car sales are at risk on weaker consumer consumption as indicated by Bloomberg:
"Bears suggest discounting by automakers may not be enough to boost unit sales in Europe. Austerity in Europe is straining disposable incomes, with consumer household expenditure falling for three consecutive quarters. Car sales in Europe fell 4.2% yoy in the first three quarters of 2012 and any sustained recovery will be challenging as economic pressures mount." - source Bloomberg

One could also look at car sales and European Consumer confidence since 2007, the relationship seems pretty clear even though the cash for clunkers program have indeed been highly supportive of car sales whenever consumer confidence needed some government "artificial boost" - source Bloomberg:

Weak economy, low consumer confidence and high unemployment are indeed the deflationary forces at play plaguing European consumption and impacting car sales in the process. 2012 will be the fifth consecutive year of declines in the European car market below 12.8 million units, 20% below pre-crisis levels.

Strong macro drivers such as consumer confidence set the trends for the demand in the auto sector but for consumption levels as well.

France Consumer Confidence and Household Consumption YoY since 2001 - source Bloomberg:

For instance, another indicator of the divergence between Europe and the United States, comes from the auto sector where demand for US light vehicle sales were up 7% year over year in October and 14% year to date, whereas Europe was the only region to decline in 2012, down 4.6% in October and down 6.9% in 10 months. Even China, passenger car sales were up 6.4% in October and nearly 7% year to date. In Europe the European Automobile Manufacturers Association, or ACEA, indicated in November car sales decreased 6.9 percent to 10.7 million cars. The ACEA indicated Europe’s car sales would reach a 17-year low in 2012. It also estimates that as much as 30 percent of production capacity is not used.

We think our European politicians would be wise to look at the minimax regret approach given Intrade is now putting a 30.6% chance of breakup of the Euro by December 31st 2013 as reported by Stephen Rose from Bloomberg on the 3rd of December: 
"Following is a table listing the odds that one country currently using the Euro will change its official currency by the expiration date, based on bets made at"

Europe is still a story of deleveraging and as pointed out by a recent note from Credit Agricole Cheuvreux from the 29th of November entitled "EU, The Road through purgatory", should our European politicians decide to tackle the minimax regret approach, there are indeed four possible recipes: "There are four basic recipes for deleveraging: austerity, inflation, growth, and default. The optimal is growth but Europe as whole cannot export its way out of its challenges and nor does it need to. Europe overall runs a current account surplus; the challenge lies in the balance within the Union. Europe needs further debt restructuring, inflation and a rebound in consumption (domestic growth). Deflation is the key risk here, but Draghi appears to understand this danger and has proved a better lateral thinker than his predecessor." - source Credit Agricole Cheuvreux.

Yes, our "Generous Gambler" aka Mario Draghi has been clearly a better lateral thinker in preventing a financial meltdown following the acute liquidity crisis of the financial sector in 2011. But as far as our Regret Theory is concerned, we previously indicated that in the case of Europe, causation implied correlation:
"Admittedly, a correlation between two variables does not necessary imply that one causes the other, but when it comes to European woes, not only did the ECB's LTROs amounted to "Money for Nothing" given the lack of transmission to the real economy as we posited in February this year, but looking back at the overzealous deficit targets set up by the European Commission which we discussed in our conversation "A Deficit Target Too Far", we are not surprised to see that the economic causation does indeed implies correlation to current European economic woes unsurprisingly due to poor loan growth."

Looking at the prospect for the younger generation of Europeans and high level of youth unemployment, maybe Murphy junior is correct in assessing his father's law after all:
-source CA-Cheuvreux / Eurostat.
"These unemployment trends are very worrisome and if they are not reversed in the short term they may lead to increased social tensions and structurally higher long-term unemployment, which has negative effects on a country's growth prospects as part of the workforce becomes impaired. Also, youth unemployment leads to emigration, which will have a negative impact on demographics, as will be seen in most European countries in the medium term." - source Credit Agricole Cheuvreux.

Deleveraging leads to lower domestic consumption while tax rates are increasing with a shift from income taxes to consumption taxes:
"As taxes increase, and penalise an already fragile economy, consumption decreases exponentially and corporate investment is postponed, which leads to lower tax intakes. This means that more taxes are levied on the economy to try to cover the shortfall and a vicious circle is perpetuated." - source Credit Agricole Cheuvreux.

Maybe the minimax regret approach is the right approach after all. Oh well...

On a final note and in relation to struggling peripheral countries, Spain has indeed very apt in avoiding "tapping out" for help in this European fight of the Century, given it has so far managed to retain market access with timely sales as indicated by Bloomberg Chart of the Day:
"The CHART OF THE DAY shows Spain, which has auctioned about 82 billion euros ($106.7 billion) of bonds this year, sold the most debt when borrowing costs were at their lowest. That’s allowed it to retain market access and so far avoid a sovereign bailout even as 10-year rates surged to a euro-era record. “Spain has been smart in timing the issuance in the market,” said Alessandro Giansanti, a senior rates strategist at ING Groep NV in Amsterdam. “A loss of market access in July this year could have easily driven Spanish yields to the 8 to 9 percent area.” The nation’s 10-year bond yielded about 5.32 percent on Nov. 30, down from 7.75 percent on July 25. The yield touched 5.20 percent last week, the lowest since March 20. Spain sold the biggest proportion of its debt in January, when the 10-year yield averaged 5.30 percent, and auctioned the lowest amount of bonds in August, when yields ranged from 6.15 percent to 7.44 percent. The Treasury completed its program of medium- and long-term debt sales earlier this month, and has used subsequent auctions to raise funds for 2013." - source Bloomberg

"Uncertainty is the worst of all evils until the moment when reality makes us regret uncertainty."
- Alphonse Karr, French critic

Stay Tuned!

Thursday 29 November 2012

Why have Global Macro Hedge Funds underperformed?

"There is no better than adversity. Every defeat, every heartbreak, every loss, contains its own seed, its own lesson on how to improve your performance the next time." - Malcolm X 

Many pundits have recently looked at the lackluster performances of Hedge Funds from the European crisis perspective. We would like to have a different approach, namely the one of volatilities.

Courtesy of our good friends at Rcube Global Macro Research, the answer appears to be more simpler. It's the volatility stupid! Or lack thereof....

"Volatility across all asset classes has crashed. As the chart below highlights, when this happens, global macro strategies tend to suffer on both an absolute and relative basis."

"While investors have poured massive amounts in long equity volatility products over the last 9 months, as a hedge against long stocks exposure, this strategy failed spectacularly. We believe more pain lies ahead for long equity volatility trades."

We would like to highlight an interesting pattern on VIX future, illustrated by the following kernel regression analysis between these variables:

X: the sum of 100 days Z-Score of the S and P500 Index and the SPVXSTR Index (a rolling long VIX strategy, tracked by the VXX ETF).

Y: Annualized expected returns of the SPVXSTR Index

We see that when we are at the lowest of the range (meaning that volatility does not react to a market dip, which is currently the case), further weakness should be expected on vol forwards. 

Regarding other measures of sentiment/positioning, investors still seem to be extremely defensive while stock markets have substantially rallied over the last few months. This remains the most hated bull market in recent history. 

Classic measures of sentiment are still deeply negative and at levels that are usually reached after medium to long term bear markets.

The CBOE put call ratio reached historical highs on both the 10 and 90 days sma last week:

Stocks have very substantially lagged credit this year. We have advertised in recent publications why
we believe corporate credit outperformance is over.

The recent sharp improvement in US consumer sentiment doesn’t seem to have been priced by the stock to bond ratio.

We are also aware that earnings revisions have been on the weak side recently.

In addition to the great points made by our good friends from Rcube, with interest rates at zero it is as well very challenging for Global Macro Hedge Funds to play an economy against another in currencies markets due to the fall in volatilities.

To bring some solace to Global Macro Hedge Funds, their biggest liquidity and volatility providers, namely   top investment banks, are suffering as well, as reported by Neal Amstrong article in Bloomberg - Biggest Traders Hurt as Fed to ECB Crush Volatility - on the 23rd of November:
"The world’s largest currency traders say foreign-exchange revenue is sliding as central-bank policies stifle price swings and cut volumes by $300 billion a day. Deutsche Bank AG, the biggest dealer based on Euromoney Institutional Investor Plc data, says narrower margins cut revenue “significantly” last quarter. Barclays Plc, the third-largest, says foreign-exchange sales are dropping and fourth-placed UBS AG says it has been hurt by lower volatility. Daily turnover as measured by CLS Bank, operator of the largest currency-transaction settlement system, slid 6 percent to $4.72 trillion in the third quarter from the year-earlier period. The combination of interest rates at, or near, record lows in the U.S., Europe and Japan is diminishing the allure of the dollar, euro and yen, the three most-traded currencies. From Switzerland to Brazil, central banks are establishing controls on exchange rates, making it less lucrative to trade the franc to the real. “With interest rates being at zero it’s very difficult now to play the cyclical differences in economies,” David Bloom, global head of currency-market strategy at HSBC Holdings Plc in London, said in a telephone interview on Nov. 20. “We’re in a structural world where if you have an economic event, you are best placed to think about it in terms of equities or bonds rather than foreign exchange.”

"Past performance speaks a tremendous amount about one's ability and likelihood for success."
Mark Spitz

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