Saturday 7 September 2013

Credit - The tourist trap

"Employ your time in improving yourself by other men's writings, so that you shall gain easily what others have labored hard for." - Socrates

Looking at the continuous outflows from Emerging Markets funds and in continuation of our recent title analogies relating to the "reverse osmosis" thesis, we thought this time around we would use a simpler analogy in our title reference namely the colloquial "tourist trap". As per the definition of a "tourist trap", a tourist trap is an establishment, or group of establishments, that has been created or re-purposed with the aim of "attracting tourists" and their money.

Our favorite "magician central banker in chief", namely Ben Bernanke, has indeed engineered the "best" of tourist trap when it comes to Emerging Markets. 

In our case, Ben's "tourist trap" involved ZIRP, low volatility and high carry trades in Emerging Markets currencies which, for many years, had the favors of Japanese retail investors in the form of the "double-deckers" (the famous Uridashi funds which particularly favored the Brazilian real). 

Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely:
 Wave number 1 - Financial crisis
 Wave number 2 - Sovereign crisis
 Wave number 3 - Currency crisis
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"

"Wave number 3", namely a Currency crisis is still in its infancy and is highly dependent on the "tapering" stance of the US Fed although, as per its members, the fate of Emerging Markets, is not really their "primary" concern...
"An appropriate next step toward normalizing monetary policy could be to reduce the pace of purchases from $85 billion to something around $70 billion per month." - Kansas City Federal Reserve Bank President Esther George - 6th of September 2013.

So in this week's conversation, and in continuation to our "reverse osmosis" analysis from previous weeks, we will look at the evolution of the "tourist trap" as well as the "Great Rotation" story as far as flows are concerned and the potential evolution in the markets (our own "Forward Guidance" so to speak), which warrants caution we think in this "statistically" bearish month of September ("Over the long haul, September has been the weakest of the 12 calendar months" - Doug Short).

A good illustration of our chosen theme of "tourist trap" can be seen in the slide of India's rupee which saw its dollar denominated external debt swell in recent years courtesy of "hot money" thanks to the "generosity" of our "magician-in-chief" aka Ben Bernanke:
- graph source Thomson Reuters Datastream / Fathom Consulting / Macronomics.

Also, when it comes to India's external debt and as illustrated recently by Bloomberg Chart of the Day, the rise of its external debt burden does complicate the situation for India in defending its currency. We could in fact call it the rupee "tourist trap" we think:
"India’s record foreign debt threatens to undermine the government’s plan to halt the rupee’s biggest slide in more than 20 years by reining in the budget and current-account deficits.
The CHART OF THE DAY shows the rupee weakened to an all-time low this year even as the combined deficits shrank. Previously the currency rose when the shortfalls narrowed and fell when they widened. The rupee dropped 8.1 percent last month to as weak as 68.845 per dollar. The lower panel tracks external debts owed by Indian governments and companies, which swelled to $390 billion as of March 31.
“Until the start of the current sell-off, the rupee had stuck pretty closely within the confines of its combined current-account and budget deficits,” said Philip Wee, a senior currency economist in Singapore at DBS Group Holdings Ltd. “By that measure, the rupee should be between 50 and 60 to the dollar, not 65 and 70.” 
India’s offshore liabilities rose to 21.2 percent of gross domestic product in the year ended March 31, according to official estimates, the highest since 2001. The rupee has plummeted 18 percent since then, the steepest drop among 24 emerging-market currencies tracked by Bloomberg. This has made refinancing the debt more expensive as global borrowing costs climb because investors expect the U.S. to pare stimulus thisyear, curtailing flows to emerging-market assets.
Finance Minister Palaniappan Chidambaram told the lower house of parliament on Aug. 27 that India’s twin deficits are responsible for the rupee’s fall, and that external debt was manageable.
He announced plans on Aug. 12 to reduce the current-account shortfall to within 3.7 percent of GDP this fiscal year from a record 4.8 percent in the prior period. The government us seeking to contain the budget shortfall to 4.8 percent of GDP from 4.9 percent." - source Bloomberg.

All the investors that piled in "high beta trade", namely our "tourist trap", in the form of Asian High Yield, Emerging Debt Bonds and Equities as well as Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play courtesy of repressed volatility thanks to central bank meddling due to negative real US interest rates.

And, when volatility is not repressed due to "tapering", this is what you get as illustrated by Merrill Lynch MOVE index rising back towards its record high of 118 bps:
We recently added JP Morgan Emerging Markets Currencies Volatility Index to our graph to display the on-going effect US Treasury volatility has on Emerging Market currencies.
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.
EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

With US real interest rates moving into positive territory, it is therefore not really a surprise to read that Asian dollar denominated bonds have dropped below par for the first time since 2011 as reported by David Yong in Bloomberg in his article from the 2nd of September 2013 entitled "Asian Bonds Tumble Below Par in Capital Flight":
"Asia dollar-denominated bonds have dropped below par for the first time since 2011 as investors pull money out of the region amid concerns that growth is slowing and as currencies from the rupee to rupiah plunge.
Average prices of company debentures in the region fell to 98.61 cents on the dollar on Aug. 22, the least since October 2011, Bank of America Merrill Lynch indexes show. Dollar bonds globally have held above 100 cents since September 2009. Both investment- and non-investment-grade debt in Asia were below par on Aug. 22. The last time that happened was in September 2008, when Lehman Brothers Holdings Inc. collapsed.
Investor sentiment toward Asia is shifting as economic growth in China slows and currencies in India and Indonesia -- the two countries with the biggest external funding needs in the region -- plunge. About $44 billion has been pulled from emerging-market stock and bond funds globally since the end of May, data provider EPFR Global said on Aug. 23." - source Bloomberg

Investors are indeed trying to escape the "tourist trap" while some others are seeing their "tourist clients" finding their debt "less appealing" as witnessed in the recent auction failures for Russia, India and Taiwan, as discussed by Alex Nicholson and Lyubov Pronina in Bloomberg on the 4th of September in their article entitled "Russia joins India to Taiwan as Emerging Debt Sales Miss Targets":
"Russia failed to raise as much money as planned at a government bond auction, joining nations from India to Taiwan in missing borrowing targets as investors keep away from emerging-market assets.
The Finance Ministry in Moscow sold 6.07 billion rubles ($182 million) of its so-called OFZ notes due May 2016 after offering 13.6 billion rubles, according to a statement on its website. Russia canceled an auction last week as only one bidder took part. The ministry issued today’s bonds at a 6.5 percent average yield, the top of its proposed range.
Developing nations are trimming auctions as the prospect of the U.S. paring financial stimulus measures and tensions over Syria curb investor appetite for riskier assets. India’s central bank said it cut the size a debt auction this week to 100 billion rupees ($1.5 billion) from 150 billion rupees. Indonesia scaled back an Islamic debt offering for the first time since July, while Taiwan’s note sale yesterday fell short of the government’s goal for the first time since 2011." - source Bloomberg.

When it comes to the famous "Great Rotation" story from bonds to equities put forward since the beginning of the year, the only "Great Rotation" story as far as equities are concerned appears to be from Emerging Markets to Developed Markets as displayed by the cumulated weekly flows into Developed Markets and Emerging Markets from Nomura's recent Global Equity Fund Flow report from the 6th of September:
- source Nomura.

Of course some would argue that this "Great Rotation" story from bonds to equities, as far as flows are concerned, has been playing out in earnest in 2013 as displayed in Nomura's recent report:
- source Nomura.

So far, so right...but, if one looks at the inflows into bonds versus equities since 2010, then the "Great Rotation" story does seem much ado about nothing as displayed once more in Nomura's recent chart:
- source Nomura.

In fact, what seems to be happening, when it comes to "Great Rotation" for equities is a rotation out of equities except for European equities according to Nomura:
"Equity and bond funds both suffered outflows last week with USD 11bn redemptions from equity funds and a small net outflow of USD 0.8bn from bond funds according to EPFR. Money market funds also saw net sales totalling USD 7.5bn last week. Both developed market and emerging market equity funds suffered net selling and European funds once again outperformed, being the only region that we track to have received net inflows last week. Our global composite flows based equity sentiment indicator has oscillated fairly tightly around 1 standard deviation over the most recent eight weeks and last week dropped marginally to 0.97 standard deviations, a reading that we would consider as bullish but just below extended levels.
-US fund investors sold USD 5bn from equity funds last week. Over the past three weeks they have withdrawn a total net USD 15bn from equity funds, reversing only a fraction of the net USD 141bn invested into equity funds in the 33 weeks of the year to 14 August, according to the Lipper weekly reported dataset. Our US flows based indicator continued to moderate last week and now reads 0.7 standard deviations, signalling moderately bullish sentiment in our view.
-European equity funds bucked the global selling trend as they attracted an additional USD 0.8bn of net inflows last week. This is the 10th consecutive week of net inflows into European equity funds, a major reversal from the persistent selling seen in recent years. However, last week's inflow showed a moderation in the magnitude of money flowing recently into European equity funds. Consequently, our European flows based equity sentiment indicator was unchanged over the week at 2.24 standard deviations but remains close to the historical bullish extremes of sentiment measured over the past nine years.
-Emerging market equity investors continued selling equity funds last week with an additional net USD 2.8bn outflow from GEM equity funds. Although last week's outflow was the most significant since the end of June, our GEM sentiment indicator rose to -1.4 standard deviation but still reflects very depressed sentiment towards EM equities. Furthermore, investors continued to exit from the dedicated regional EM equity funds with net outflows of USD 1.1bn from Asia ex Japan funds, USD 0.1bn from LatAm funds and the highest weekly outflow (USD 0.5bn) from emerging EMEA funds in almost two years." - source Nomura.

"Great Rotation" or "Great Escape" you decide, given Bank of America Merrill Lynch also indicated on a note from the 5th of September entitled "EM Pain trade is up" the following:
Big weekly equity redemptions of $11.4bn. Past 3 weeks equity outflow of $29bn largest in 2 years (Chart 1). 
Investors reduced exposure in run-up to payroll. Big $6.1bn redemptions from EM stock & bond funds. Massive $60bn outflows from EM equity & bond funds over past 3 months = capitulation. Note EM equities outperformed after similar redemptions Jul'04, Aug'06 and Sep'08 (Chart 2).
Tactical bounce in EM equities continues unless a big payroll print (>250K) causes gap higher in treasury yields (>3%).
Inflows to Treasury funds this week despite historic sell-off. Follows 8 weeks of redemptions. Suggests onset of smart short-covering in recent days. Blowout payroll required for clean immediate break of 2%, 3%, 4% levels by 5, 10, 30-year Treasury respectively. No jobs blowout...look for reversals in recent sell-offs in bonds and EM." - source Bank of America Merrill Lynch.

Yes, the bounce in Emerging Markets has indeed occurred in the past after similar redemptions, but we disagree with Bank of America Merrill Lynch. We have not seen the bottom yet, and that the rebound could probably materialize at a later stage, maybe in 2014.

Why so?

Because of tightening financial conditions, particular in China following a massive credit growth, which will impact bank lending behavior in a negative way. China is increasing the clampdown on credit and on industrial overcapacity. Given banks are always a leverage play on economic growth, despite record profits at China's largest banks, stock valuations are not benefiting from this surge given the significant rise in nonperforming loans as displayed in the below Bloomberg graph:
"The CHART OF THE DAY shows that while combined net income of Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd. and Bank of China Ltd. for the three months to June 30 was 72 percent higher than three years ago, their price-to-estimated earnings ratios have fallen since then. The lower panel shows total nonperforming loans in the nation started increasing in September 2011.
Default risk is rising in the world’s second-largest economy, which economists forecast will grow this year at the slowest pace in 23 years. The government has been clamping down on excess capacity in industries including steel and cement as it tries to transition to a more sustainable economic growth model based on consumption rather than export-driven production." - source Bloomberg.

The delicate rebalancing act for the Chinese economy is in fact being put at risk by the aggressive "tapering" stance at the Fed as indicated by Chinese Vice Finance Minister Zhu Guangyao comments at the G20 as reported by Bloomberg:
"The U.S. should be mindful of a possible “very significant spillover effect,” said Zhu, who called for greater coordination between nations and added that there’s no need for a rescue plan for developing countries."

He also added:
“Some emerging-market economies are facing difficulties,” Zhu said. “Capital is flowing out of these countries and their currencies are under pressure of depreciation, and the major direct cause of such a phenomenon is the Fed’s announcement that it may exit its unconventional monetary policy. However, on the other hand, there are some structural problems with these emerging market economies as well.” - source Bloomberg, "China Asks U.S. to Cap QE Exit Risk as Indonesia Warns of Impact"

Therefore the impact of a tightening credit channel in China means more pain for the current account of countries exporting to China (including Germany), given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off.

The tightening credit channel in China and the clampdown on overcapacity will of course hurt Germany.

These were our concluding remarks in our recent conversation "Fears for Tears":
"The CHART OF THE DAY shows that Germany’s factory output as gauged by a manufacturing purchasing-managers’ index has mirrored Chinese bank-lending growth since a credit boom that began in 2008"
No surprise therefore to see German industrial production falling more than expected in July after surging in June, adding to signs that growth in Europe’s biggest economy is moderating:
-Output, adjusted for seasonal swings, fell 1.7 percent from June, when it jumped a revised 2 percent, the Economy Ministry in Berlin said on the 6th of September when economists were only expecting a decline of 0.5%.
-German exports, adjusted for working days and seasonal changes, fell 1.1 percent in July from the prior month, the Federal Statistics Office in Wiesbaden. Economists predicted an increase of 0.7 percent in a Bloomberg News survey.

On the impact of current account for countries exporting to China, we agree with our friends at Rcube Global Macro Asset Management:
"Current account of countries exporting to China are turning negative (and will remain so as long as China tighten its flow of credit). FX reserves’ pace of accumulation reverse and with them a host of asset prices that have been tightly correlated with it over the last decade: domestic real estate and equity prices, private consumption, commodity prices etc…"
- source Rcube Global Macro Asset Management

So, due to our Pareto efficient economic allocation, the weakness in Emerging Market equities, which have been simply the victims of currency wars and "Abenomics" mostly, (see our post "Have Emerging Equities been the victims of currency wars?"), will continue further, because the "reverse osmosis" occurring in Emerging Markets as displayed by "funds allocation" is positively correlated to US real rates moving into positive territory, or put it simply, when the risk doesn't match the reward anymore. 

The velocity in the "allocation" is entirely due of course to the speed of rising yields in developed countries as displayed in the chart below from Thomson Reuters Datastream / Fathom Consulting displaying by how many basis points 10 year yields have risen since the 30th of April:
- graph source Thomson Reuters Datastream / Fathom Consulting:

On a side note, those who piled into Apple 30 years, part of their $17 billion bond auctioned on the 30th of April are probably still licking their wounds given these bonds are currently trading around 83 in cash price...But, don't despair, you might get a "second chance" with Verizon which plans a record $25 billion debt offering as it gathers financing to buy Vodafone’s stake in their Verizon Wireless joint venture...

Moving on to our own "Forward Guidance", as we enter the statistically dangerous month of September, some additional signs in the markets, apart from "tapering" noise, Syrian issues, European political jitters in Italy and Emerging Markets tantrums, can be seen in the currency market according to our Rcube friends, in particular in the AUDCHF currency pair:

"The world’s economic momentum is slowing not accelerating, as evidenced by the AUDCHF:

The AUDCHF is a much better leading indicator of global growth than PMIs:
The Australian dollar is a commodity currency, with a high sensitivity to cyclical commodities, and hence to world growth. On the contrary, the CHF is a defensive, safe haven currency; it tends to appreciate when investors become risk averse.

As a result, the AUDCHF usually weakens when global growth economic momentum slows down and/or when financial stress kicks in. When the two happen at the same time (1998, 2001, 2008, 2011) the move is all the more violent. 

Today, the AUD is weakening because of the EM slowdown, but more recently the CHF has strengthened on its own, probably on the back of rising risk aversion due to the FED tapering anxieties (EURCHF peaked on May 22nd)." source Rcube Global Macro Asset Management

And if you think that the "reverse osmosis" plaguing Emerging Markets has touched a bottom, think again because as our Rcube friends put it, regardless of the incoming chatter surrounding the "debt ceiling" debate, budget balances do matter, but the US budget balance, when it comes to Emerging Markets, it matters A LOT:
"Additionally, the US budget balance is improving faster than at any time in history. In the past this has been associated with a tighter liquidity environment (fewer dollars in circulation) which was particularly negative for emerging markets. As shown in the chart below, when the budget balance improves (deviation from 2yr trend goes up), emerging markets underperform DM equities, and inversely. Given the current expectation for the budget deficit to shrink further (‐2% of GDP in 2015 vs. ‐4.6% today), the relationship will remain negative for EM equities in the foreseeable future."
Another evidence that deflation might be a bigger threat than inflation is the fall of breakeven rates. In that sense, the negative correlation between equities and inflation expectations could be a complacency sign. Japan has won the currency war, it is now exporting deflation through lower export prices, and it is forcing others to do so as well. But because Europe is in a current account surplus and the US is moving towards the neutral zone, the currency war will be much less effective. This is also why inflation expectations are currently falling fast.
This would be worrying enough on its own. The problem is that Europe is deleveraging at the same time. Its credit channel remains weak. As a result, unemployment keeps rising." 
source Rcube Global Macro Asset Management

On a final note, we would like to provide you with another "out of the box" interesting indicator we follow namely Sotheby's stock price versus World PMIs since 2007 - graph source Bloomberg:
The performance of Sotheby’s, the world’s biggest publicly traded auction house is indeed a good leading indicator and has led many global market crises by three-to-six months.

The recent stellar performance of the art market in general and Sotheby's in particular can also be partly explained by the flood of global liquidity provided by our "omnipotent" central banker at the Fed. Art markets and economic growth tend to be positively correlated we think.

And, when it comes to providing "liquidity" and market backstop, rest assured that Sotheby's has been as involved as any central bank, given it has started again into auction guarantees totaling $166.4 million in a move aimed at winning more consignments. But, more recently the New York-based auction house said last night it’s reducing its exposure by “irrevocable bids” of $23.5 million, which are from undisclosed third-party guarantors. It may further reduce risk by additional “irrevocable bids” before auctions in the fourth quarter, it said in the filing with the U.S. Securities and Exchange Commission as reported by Bloomberg.

Looks like even auction houses are preparing for "tapering"...
Oh well...

So move along, no risk of financial crisis:
“The probability of it happening again in our lifetime is as close to zero as I could imagine"

“The way these firms are managed, the amount of capital that they have, the amount of liquidity that they have, the changes in their business mix -- it’s dramatic.”

“The largest financial institutions in the U.S. are as healthy now as they have ever been,”

“There’s a difference between incompetence or mismanagement or poor judgment or excessive risk taking from actually breaking the law,”

“There’s nothing I’ve seen that would suggest that any of the major participants in the financial crisis should be in jail for their actions.”
- Morgan Stanley Chief Executive Officer James Gorman, on the Charlie Rose show.

Stay tuned!

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