Sunday, 17 November 2013

Credit - Cold Turkey

"Every form of addiction is bad, no matter whether the narcotic be alcohol or morphine or idealism." - Carl Jung 

While listening to future Fed in Chief Janet Yellen first public appearance as nominee to succeed Fed Chairman Ben Bernanke in front of the Senate Banking committee, who:

-could "see no evil" when questioned about the housing market:

"a rational response by the market" - Janet Yellen
- source Bank of America Merrill Lynch - The Thundering Word - 13th of November 2013.
and also added:
“I don’t see evidence at this point, in major sectors of asset prices, misalignments,”- Janet Yellen

- could "hear no evil" about QE being an elitist policy, favoring those holding financial assets failing to trickle down to Main Street:
“Stock prices have risen pretty robustly but if you look at traditional measures,” such as price-earnings ratios, “you would not see stock prices in territory that suggests bubble-like conditions,” - Janet Yellen
"Global stocks are annualizing 22% gains in 2013 (versus -2% for bonds, and -6% for commodities). Wall Street's boom in recent years has been caused by Main Street's bust and a “High Liquidity-Low Growth” regime." - source Bank of America Merrill Lynch - The Thundering Word - 13th of November 2013.

- could "speak no evil":
“Although there is limited evidence of reach for yield, we don’t see a broad buildup in leverage, where the development of risks that I think at this stage poses a risk to financial stability.” 

and added:
"It could be costly to fail to provide accommodation (to the market)". - Janet Yellen
- source Bank of America Merrill Lynch - The Thundering Word - 13th of November 2013.
she also said:
"I don’t think the Fed should be a prisoner of the market," - Janet Yellen

Given we are coming closer to "Thanksgiving Day" which is a national holiday to celebrate primarily in the United States and Canada as a day of "giving thanks" for the blessing of the harvest and of the preceding year, no doubt Wall Street could indeed be giving thanks for the blessing of QE and the Fed's unaltered generosity, which will of course continue in the near future, be rest assured.

So you might already see the relationship with this week chosen title in relation to upcoming "Thanksgiving Day". 

Our title is a clear reference to the addiction to QE as it seems the current Fed leadership and the future Fed leadership has no "appetite" for "cold turkey" as posited by the astute Christopher Wood from CLSA:
"There is no benign exit from QE and that the Fed is in a trap of its own making in the sense that stronger data will lead to renewed tapering concerns, leading to a tightening in financial conditions and a resulting reluctance on the part of the central bank to taper. In this respect, the correct analogue remains that of a heroin addict. The tapering concerns are the equivalent of withdrawal symptoms. Obviously, it is possible to exit an addiction if the addict is willing to go through “cold turkey”. But GREED & fear’s base case is that the current Fed leadership has no stomach for “cold turkey”." - CLSA - Christopher Wood - Greed and Fear - 14th of November 2013

Nota bene: "Cold turkey" describes the actions of a person who abruptly gives up a habit or addiction rather than gradually easing the process through gradual reduction or by using replacement medication." 

In the case of dependence upon certain drugs, including opiates such as heroin, going cold turkey may be extremely unpleasant, but less dangerous. Life-threatening issues are unlikely without a pre-existing medical condition." - source Wikipedia.

On a side note we chuckled when the future of the Fed stated the following in relation to Gold:
“Well, I don’t think anybody has a very good model of what makes gold prices go up or down,” - Janet Yellen.

It seems to us that Janet Yellen seems oblivious to "Cantillon Effects", and the return of the Gibson paradox, and as far as "tapering" is concerned we think that "the Buying will continue until moral improves" but we ramble again:
“A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases” - Janet Yellen

While everyone has been focusing on the Fed's "tapering" stance since May 2013, for us the "real game changer" in 2013 has no doubt been the true elephant in the room, namely Japan's truly aggressive reflation policy. Therefore this week, we will focus our attention back to Japan.

Japan has already been the subject of numerous posts already on Macronomics, such as "Big in Japan", "Japan - the rise of the Kagemusha", "If at first you don't succeed..." or  "Have Emerging Equities been the victims of currency wars?".

Of course when one looks at the relative performance of the MSCI Emerging versus the S&P 500, one can easily see that EM equities have been clearly lagging. Emerging markets (MXEF) have underperformed the S&P 500 - source Bloomberg:

But as we posited in early 2013, Emerging Markets have indeed been the victim of "Abenomics" given in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off.

It has clearly been the case for Emerging Markets which have been lagging as well the surge in the Nikkei index - graph source Bloomberg:

The aggressiveness in the reflation trade has once again been further illustrated by Friday's price action, which saw the Nikkei surge by 1.95% and the Topix by 1.68% - graph source Barclays / Bloomberg:
"UNSTOPPABLE! NKY went up another 2% pushed by USDJPY going through 100. Intraday was one way: NKY opened up 75bps to close up 1.95%. With realized volatility going higher and high demands for options from clients, VNKY remained elevated at 25.6. The volatility curve went up sharply today again with high correlation to the cash spot. 1Y +1.2% 5Y +0.5%. Option market was very busy as each move up of spot was triggering volatility moves. We saw a lot of interests on calendar spreads, call ratios and skew. Long term volatility remained well bid as Structured Products desks are looking to buy back volatility in the rally. Client flows were active: lot of interests in 2014 upside calls from Jan14 to Dec14. We saw a lot of risk reversal crossed on the exchange for clients getting exposure on the upside. At this level even if Bollinger bands & RSI suggest NKY is overbought, we should expect NKY to go higher and test the 16,000 level again very soon. Interesting to notice the dynamic between rates, FX and Equities at the moment. We saw a large drop in JGB around the close, triggering some weakness in USDJPY (yield adjustment)." - Barclays 

Dynamic between FX and Equities? Of course there is! As illustrated by this Bloomberg graph displaying the not only the surge of the Nikkei and the weakness in the USD/JPY but also the reverse Itraxx Japan CDS index:

And went it comes to expect more from the Nikkei until at least the end of the year, this is as well validated by the fall in the Nikkei 3 month 100% Moneyness Implied Volatility and the fall in the Itraxx Japan, representative of the credit risk perception for corporate Japan - graph source Bloomberg:

As per our January conversation, "If at first you don't succeed...", once again we will slightly break our Magician's Oath.
As a reminder on the Magician's Oath:
"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

Back in January we argued:
"We have to confide, that since our October post, we have continued "practicing" the effect of our magicians "secret illusions" by having been short JPY against USD (via proshare ETF YCS) and we have been as well long Nikkei but in Euros via a quanto ETF (currency hedged) but until you all become magicians, we have to stop revealing tricks unless, of course, dear readers, you all swear to uphold the Magician's Oath in turn*, but we ramble again..."

When it comes to going long Nikkei but in Euros, we must confess, we have been adding again. Reason being, and on that point we agree with Exane's note from the 8th of November entitled "The end", is that Japan might be high risk but worth it for now:
"Overweight Japan- but currency hedged
If markets have at times fought the Fed this year, and driven Treasury yields up, it looks very unwise to fight the Bank of Japan – that is busy hoovering up 70% of JGB issuance. Economic momentum in Japan looks robust – with little real obvious test to that momentum prior to the sales tax increase in April. If the economy suffers as a result of April’s tax change, the BoJ has stated its intention to respond with increased monetary stimulus.
Looking into Q1, if the USD strengthens as a result of tapering, the Yen looks one of the currencies liable to weaken as a result. A fall in the real effective exchange rate should feed back into more supportive domestic liquidity conditions. For us, the Yen still looks materially overvalued.
While the Japanese equity market has re-rated significantly over the last year, it still does not look particularly expensive and remains on course to provide one of the big earnings growth stories of 2014. We like the market on a currency-hedged basis." - source Exane

While Exane like the Japanese market on a currency-hedged basis, we like it too as the Nikkei keeps going one way with higher conviction, more volumes (highest in last 3 months) and more inclusive client/investor participation. JPY cemented 100 level as a strong support and went as high as 100.4 in the evening session. We have been liking it since January this year.

Furthermore Exane added on Japan the following points:
"After 6-months consolidation, corporate earnings have grown into share prices. Valuations are reasonable, and there is still plenty of upside to the earnings base. We see the Yen headed south and equity prices north.

From setting the investment world on fire in the first 5-months of the year, Japan has morphed into something of a forgotten story over the last 5-months. USDJPY has traded sideways over this period, as has the Nikkei. And after May’s spike higher, the 10-year JGB yield is back at April’s levels too.

After such an aggressive price move earlier in the year, a period of consolidation is understandable. But this has allowed the Japanese market’s earnings base to grow into the pricing move. EPS for the MSCI Japan is on course to advance almost 60% in 2013.

The dynamics of the Japanese equity market, as they stand on consensus numbers looking into 2014 are summarised in the following table:
Of course a large component of the Japanese policy framework involves weakening the Yen. This is an obvious and clear benefit to the Japanese corporate sector with a positive direct translation impact on overseas earnings and also potentially the secondary transaction impact – whereby improved Japanese competitiveness leads to market share gains. The following chart shows that the Japanese equity market’s EPS forecast has followed the path of USDJPY over the course of the last year:
The currency support for the Japanese economy, Japanese stock prices and for the earning base of Japanese companies is unequivocal. And in our view this is likely to go materially further than we have seen to date.
As the US cycle matures the downward pressure on the Yen is likely to intensify. The BoJ is likely to hold bond yields lower via direct asset purchases at a time when the US backs out of QE. Further as the Japanese start to have some success in creating a degree of inflation, the real yield on Japanese government debt is likely to fall.

As we show in the following chart the yield premium on 2-year JGBs deflated by CPI over the 2-year Treasury deflated by US CPI has captured pretty well the big directional moves in USDJPY. With the ‘real yield’ on 2-year JGBs likely to fall and the real yield on 2Y US bonds potentially rising this clearly points to downward pressure on the Japanese currency. That should feed straight back in to supporting Japanese shares.

Put simplistically we fail to understand how a 20% fall in trade-weighted Yen fully reflects the central bank’s commitment to double the monetary base. There must be, to our minds at least, further to go in this trade.
From a valuation standpoint, the rehabilitation of the Japanese economy combined with the boost to export earnings is helping the Japanese corporate sector lift ROE. The 12- month forward ROE – using consensus forecasts – has now reached nearly 9%. The uplift in the price-to-book value has been substantive – and now stands at around 1.2x 2014F." - source Exane

While some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we think that we are in an early second stage for the Multistage Japan rocket:
"A multistage (or multi-stage) rocket is a rocket that uses two or more stages, each of which contains its own engines and propellant. A tandem or serial stage is mounted on top of another stage; a parallel stage is attached alongside another stage. The result is effectively two or more rockets stacked on top of or attached next to each other. Taken together these are sometimes called a launch vehicle. Two stage rockets are quite common, but rockets with as many as five separate stages have been successfully launched. By jettisoning stages when they run out of propellant, the mass of the remaining rocket is decreased. This staging allows the thrust of the remaining stages to more easily accelerate the rocket to its final speed and height." - source Wikipedia

On that point we agree with Exane's take for more Japanese upside:
"Potential catalysts
The underpinnings of the Japanese equity story are still there. It seems to us more likely the market has just got a little trade fatigue. In this respect, there are potential catalysts on the horizon that can re-create a degree of enthusiasm.
First, most clearly the sales tax increase of next April is seen by many economists as likely to prompt an acceleration in the pace of central bank asset purchases. That should clearly be helpful for the assets bought directly – but also in suppressing bond yields and forcing yield-seeking investors up the risk curve. Furthermore, this is likely to put more downward pressure on the Yen that should feed back into enthusiasm for the earnings prospect of Japanese companies. The stock market should respond.
Second, the missing link in the Japanese story this year has been some evidence that labour market reforms – a key component of PM Abe’s third arrow – can be pushed through the Japanese parliament. This is clearly the most controversial and politically difficult element of the policy suite. While so far Mr Abe has chosen to use his bullets on politically easier reform measures, progress on labour markets would be seen as a particularly important development by international investors." - source Exane

We don't see Japanese going "cold turkey" for the time being hence our stance.

Of course given everyone and his dog has been focused as of late on the "magician tricks" from the Fed, we would have to agree with David Bowers take in the Financial Times in his article from the 13th of November entitled - Monetary shock from Japan eclipses Fed taper concerns :
"If you cannot see the wood for the trees, then how do you expect to see the elephant in the room? One of the casualties of the market’s obsession with the Federal Reserve’s monetary easing “non-taper” has been a loss of perspective. The world has forgotten that the real monetary shock of 2013 has been the change in policy by the Bank of Japan. 

In the words of the Bank for International Settlements’ annual report, when the world’s third-largest central bank decides “to double the size of its monetary base, double its holdings of Japanese government bonds and exchange traded funds and more than double the average maturity of its government bond purchases”, investors ought to sit up and take note, especially when it comes with a 20 per cent currency depreciation. 

This is “unilateral QE” with a vengeance – of a similar magnitude to the Fed’s QE3 but applied to an economy a third the size of the US. Japanese monetary policy is never going to be the same again, with consequences that will extend beyond Japan’s borders

The main reason why Japan is still a sideshow in the minds of investors is because that is exactly where it has been for the past 20 years. Many asset managers have only known Japan as a taker, rather than a maker, of the global narrative. The sharp rise in the Nikkei in the first few months of this year may have been impressive, but it is the seventh occasion in 21 years when the market delivered six-month returns in excess of 30 per cent; the previous six were all false dawns." - source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.

"If Mr Kuroda is indeed serious about "reflating" in this on-going currency wars, the "rise of the Kagemusha", no doubt, represents a serious headwind for some Emerging Markets in general and their equities in particular."

It seems that David Bowers is indeed confirming our Pareto efficient economic allocation concept where no one can be made better off without making at least one individual worse off, in that case Emerging Markets:
"This year, many investors have chosen to focus on the strategic risks facing emerging markets instead. Over the past three years, EM equities have underperformed the global benchmark by almost 30 per cent, confounding the conventional wisdom. Fed tapering has been the catalyst for this soul-searching. But this year’s underperformance is in part due to Japan. 

One of the consequences of the BoJ’s policy shift has been to weaken the yen and boost the dollar. In recent years, dollar strength has been associated with soft commodity prices and weak pricing power in the traded goods sector. That has hurt emerging markets with their high exposure to commodities and global supply chains. 

In short, the initial impact of Abenomics has been to export deflation to the rest of the world. This can also be seen in the lower-than-expected inflation rates in the US and eurozone. These are the unintended consequences of the BoJ’s actions. You may not want to invest in Japan, but you do have to understand that it matters enormously whether Abenomics succeeds or fails

The initial shock may have been deflationary; but it could yet turn out to be reflationary if Japan succeeds in getting companies to save less and invest more. Japanese corporates have run themselves for cash rather than for growth; their saving has been the counterpart to the government’s borrowing. Were we to see double-digit capex growth next year – led by the non-manufacturing sector – the labour market would tighten to a point where real wage growth returns." source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.

We also have to agree with David Bowers from Absolute Strategy Research, Japan is the real elephant in the room:
"For the past quarter of a century monetary policy has been run for creditors, not debtors. That favoured instruments such as Japanese government bonds. But if the BoJ succeeds in generating sustained inflation then the asset allocations of the past 20 years could quickly become obsolete. The launch of the Nippon Individual Savings Accounts, and the review of public pension funds’ asset allocation, are important developments. 

Japan has been practically invisible for the past two decades, a passive bystander to China’s rise. But Japan’s moves clearly have the potential to disrupt the Asian narrative. If Japan recovers, it would provide a new source of final demand for the region; if it fails, then the risk is it exports more deflation via further yen depreciation. It would be ironic if Japan’s attempt to reform ended up destabilising China’s own reform process. The stakes could not be higher."  source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.

We would recommend you closely monitor Japan's foreign bond buying spree. Nomura in their 14th of November note indicated the following when it comes to foreign bond buying:
"Japanese investors were net buyers of foreign bonds last week for the fifth consecutive week. Net buying totalled JPY357bn (USD3.6bn), increasing slightly from JPY277bn the previous week. The strong US NFP data and following rises in US yields are likely to have increased expectations of a weaker JPY, encouraging Japanese investors to invest in foreign bonds" - source Nomura

Also, Nomura added:
"Retail investment in domestic and foreign assets via toshins remains stronger than the past five-year average, according to NRI"
- source Nomura

Furthermore, in another report Nomura also made the following points:
"Retail investors. risky asset investment activities via toshins have accelerated since the early 2000s, and they have preferred foreign assets to domestic assets owing to higher income returns. The foreign asset share of total toshin outstanding is now above 50%, but it was below 20% in 2000 (Figure 2). 
Thus, it is unsurprising that the liquidation of toshins before the capital gains tax hike is a bit concentrated in foreign assets selling. As a result, net purchases of foreign securities via toshins may continue to lag net buying of domestic assets by year-end.
At the same time, foreign investment activity via toshins has not been meaningfully weaker than the previous five-year average, even though the scheduled capital gains tax hike may be depressing momentum. Furthermore, total buying of domestic and foreign securities via toshins remains net positive, showing strong underlying momentum of toshin investment. The job market remains strong, while winter bonuses at large Japanese companies are estimated to have risen by 5.8% from a year ago, the biggest increase since 1990, according to a survey by business lobby Keidanren. Strong risk appetite supported by better income conditions, combined with the introduction of NISA next January, is likely to accelerate foreign investment activity via toshin next year." 
- source Nomura

As we posited in the "Coffin Corner" back in Europe, the aggressiveness of the Japanese reflationary stance spells indeed more deflation for Europe and we think the US will as well withhold its tapering stance, spelling more trouble ahead, unless the ECB of course decides to engage as well in a QE of its own:
"Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think." - Macronomics - 27th of April 2013.

On a final note the Euro curse is clearly illustrated by Bloomberg's recent Chart of the Day showing that the Euro remains the best performer this year:
"The European Central Bank’s surprise cut in interest rates last week failed to dislodge the euro from its position as 2013’s best-performing major currency, a potential blow to the region’s nascent recovery.
The CHART OF THE DAY shows the euro strengthened 6.2 percent this year, the biggest gain among 10 developed-nation currencies tracked by Bloomberg Correlation-Weighted Indexes.
That’s a reversal from four years of declines as the sovereign debt crisis engulfed the 17-nation currency bloc. The dollar appreciated 4.4 percent this year, while the yen slumped more than 10 percent, the indexes show.
The euro surged as the region exited its longest recession on record and central banks in the U.S. and Japan pursued bond-buying programs that tend to debase their currencies. While ECB President Mario Draghi said the exchange rate wasn’t part of the ECB’s decision to lower its main refinancing rate, French Industry Minister Arnaud Montebourg said on France Inter radio yesterday the currency is too strong. Inflation fell to the least in almost four years last month.
“Draghi knows his ability to control and steer the euro is woolly at best,” said Jane Foley, a senior currency strategist at Rabobank International in London. “Although he did say that the euro was not discussed in the policy meeting, it’s very clear that when you fight disinflation you really do want a weaker currency. The relief that the crisis is over has created another problem, which is a better euro.”
The euro traded at $1.3417 as of 4:14 p.m. London time on the 13th of November, after climbing to $1.3832 on Oct. 25, the highest since November 2011. The correlation-weighted indexes show the currency gained 1 percent since Nov. 7, the day the ECB cut its benchmark rate to a record 0.25 percent as predicted by only three of 70 economists in a Bloomberg News survey." - source Bloomberg

"A moderate addiction to money may not always be hurtful; but when taken in excess it is nearly always bad for the health." - Clarence Day, American author.

Stay tuned!

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