Saturday 22 February 2014

Credit - Crosswind

"The myth of unlimited production brings war in its train as inevitably as clouds announce a storm." - Albert Camus

Looking at the preliminary China Purchasing Managers' Index from HSBC/Markit for February falling to a seven-month low of 48.3 in conjunction with Japan's record trade deficit, France's disappointing PMI for services pointing towards lower growth ahead, and disappointing shipping data, made us think about using the analogy of the "crosswind" which is any wind that has a perpendicular component to the line or direction of travel. In aviation, as shown by the recent European storms, it does make landing and take-offs much more tricky. In similar fashion, all the recent economic developments as of late, such as China's tightening credit conditions, and continued Fed tapering, make it extremely tricky for the global economy at present times, and could have the potential effect of veering the global economy sharply towards a downturn and a deflationary environment.

Of course the Chinese crosswind is of two folds, on one hand China's deflating exercise is akin to a "controlled demolition" and will need to allow at some points some defaults to take place, on the other hand, it has to maintain sufficient credit conditions to ensure a certain level of growth for its economy.

As we wrote back in September 2011 in our conversation "Controlled demolition", as far as Europe and China are concerned, nothing has really changed in terms of the treatment of the on-going crisis:
"While Europe is busy with the demolition, we have China attempting deconstruction. In both case we have an attempt of controlled demolition, it is just a question of style." - Macronomics, 19th of September 2011.

We do hate sounding like a broken record, but the deflationary forces at play have been gathering strength we think as of late. Deflation risk is growing no doubt when one looks at the 5 year forward breakeven rate, which has been falling since the beginning of the year - graph source Bloomberg:
The Fed’s five-year, five-year forward break-even rate, fell to 2.23% last week, getting closer to the lowest since the central bank launched operation Twist back in September 2011. Back to the future? We wonder because every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully.

Because, if indeed the US economic recovery is genuine and the US has finally reached "escape velocity" as posited by Chicago Federal Reserve Bank President Charles Evans a year ago, then we wonder why (apart from the now famous "weather effect") US Family Housing Starts has been falling in conjunction with US Furniture sales, as well as the Baltic Dry Index as of late, pointing, we think to some important "crosswind" - graph source Bloomberg:
Since 2006:
- in yellow the Baltic Dry Index,
- in orange US Family Housing Starts
- in white US Furnitures Sales.

As we indicated in our January 2013 conversation "The link between consumer spending, housing, credit growth and shipping" :
"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."

Any change in consumer spending trends is depending on a more pronounced housing market revival and will directly impact container traffic. In similar fashion, container shipping rates fell 4.8% recently, the first decline in 10 weeks as shown by the latest reading from the Drewry Hong-Kong/Los Angeles container rate benchmark - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell 4.8% to $1,986 in the week ended Feb. 19, the first decline in 10 weeks and the lowest rate since early January. Slack capacity continues to pressure prices, with rates 21.7% lower yoy and 21.2% below the July 2012 peak of $2,519. Carriers are expected to implement a $300 general rate increase on containers from Asia to the U.S., effective March 15." - source Bloomberg

 The container rate increased by $400 USD on the 15th of November already on all US destinations with no impact so far for the "recovery" desired by Private Equity busy investing in the shipping space as discussed back in our December conversation. What is of course of interest is an additional rate increase to counter the deflationary forces at plague still plaguing the shipping industry as a whole. As a reminder, Containership lines have announced 12 rate increases, totaling $5,250, on Asia-U.S. routes since the beginning of 2012.

The surge in the Baltic Dry Index before the start of the financial crisis was a clear indicator of cheap credit fuelling a bubble, which, like housing, eventually burst. In the chart below, you can notice the parabolic surge of the index in 2006 leading to the index peaking in May 2008  at 11,440;  with the index touching a low point of 680 in January 2012  -  Evolution of Baltic Dry Index from 1990 until today - source Bloomberg:
One thing for sure, it doesn't seem for now that the Baltic Dry Index has indeed reached "escape velocity" although, recently, one would have thought it did...Oh well. Yet another "crosswind" in the "recovery" scenario.

On top of continued "shipping woes", an additional "crosswind" we are seeing is Citigroup Inc.’s U.S. Economic Surprise Index, which measures data against analysts’ expectations, fell to minus four on the 19th of February, from 73 on January 15, suggesting that economic reports are increasingly missing forecasts.

We have indeed been sitting in the deflationary camp for a while and when it comes to assessing the risk of deflation, we think the Fed might be again behind the curve as indicated in Simon Kennedy's Bloomberg article from the 21st of February entitled "Deflation Risk Growing in Wells Fargo Model":
"The U.S. economy may prove more prone to deflation than the Federal Reserve acknowledges and that may present a reason to keep monetary policy loose, according to a model created by Wells Fargo Securities LLC.
Deflationary pressures have been “relatively high” since January 2010 and now have a 66 percent chance of prevailing in the U.S., according to Charlotte, North Carolina-based economists John Silvia, Azhar Iqbal and Blaire Zachary. Their calculations include factors such as the personal consumption expenditures price deflator, unemployment rate and the Fed’s inflation target.
The model is “useful for policy makers, investors and consumers who can attach a probability with each more-likely scenario of future price trends: inflationary, deflationary or price stability,” the economists said in a Feb. 17 report.
They say that such a persistently higher probability can highlight a looming threat. In the 1980s, for example, the model would have pointed to the risks of higher inflation, which did mark that decade.
“The recent year’s surge in the deflationary pressure probabilities may offer a justification for the highly accommodative monetary policy,” the authors said in the report.
The Wells Fargo model is more worrying than one created by the Federal Reserve Bank of Atlanta, which is based on the market for Treasury inflation-protected securities. As of Feb. 14, that gauge said the probability of deflation was steady at zero.
Central bankers so far don’t sound worried by a deflation threat. Fed Chair Janet Yellen told lawmakers on Feb. 11 that some of the recent softness in prices “reflects factors that seem likely to prove transitory.”" - source Bloomberg.

We have long argued that what we have been fearful of when it comes to the meteoric rise of the S&P 500 in recent years was "peak earnings", of course what has been justifying more and more "lofty" valuations, has been the growing recourse to buybacks which has been very successful indeed in "boosting" US stock prices overall as displayed in the below graph from Bloomberg showing the impact of multiple expansion. 

For illustrative purposes, we have been plotting the growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

Buybacks have indeed counted more in recent years for US stocks returns than dividends as illustrated by Bloomberg's recent Chart of the Day from the 19th of February:
"Share repurchases may do more to explain gains in U.S. stocks during the past five years than dividends increases, according to Sean Darby, Jefferies Group Inc.’s chief global equity strategist.
As the CHART OF THE DAY shows, the Standard & Poor’s 500 Buyback Index has advanced further in the current bull market than either the S&P 500 Dividend Aristocrats Index or the S&P 500 itself. The comparisons are based on total returns, which account for dividend payments.
Repurchases have left stock investors with “an ever decreasing pool of opportunities,” Darby wrote yesterday in a report. They help explain why share prices have risen relative to earnings, the Hong Kong-based strategist added.
The S&P 500 was valued at 17 times profit as of yesterday, according to data compiled by Bloomberg. The ratio increased from 13.5 at the end of March 2009, the month when the bull market started.
Growth in mergers and acquisitions, inflows of funds into U.S. stocks and “limited equity issuance” also contributed to the higher price-earnings ratio, Darby wrote. He cited S&P 500 data showing more common and preferred shares were repurchased than issued last year for the ninth year in a row.
The buyback index tracks the 100 companies in the S&P 500 whose spending on repurchases in the previous 12 months was the highest percentage of their market value when the period began. The dividend index is comprised of 54 companies that increased payouts annually for at least 25 years." - source Bloomberg.

In similar fashion, low quality stocks overall have more benefited from the liquidity FED/ZIRP induced rally that quality paying dividend stocks overall since March 2009 - graph source Bloomberg:

But when it comes to our concerns with "peak earnings" and US inflation, we have indeed looked at the relationship between both the S&P 500 Ebitda since 2008 and the US CPI - graph source Bloomberg:
If indeed inflation is trending down and deflationary forces are still acting as strong "crosswinds", then again there is a rising risk for some "unforeseen" (by the Fed) adjustments we think.

On a final note, another "crosswind" for earnings in particular and stocks in general, is coming from Emerging Markets' woes, given the withdrawal of liquidity by the Fed will no doubt curb somewhat global growth as displayed in Bloomberg's Chart of the Day from the 11th of February:
"Declines in emerging-market currencies are a signal that stocks worldwide will extend this year’s drop because cuts in Federal Reserve stimulus will curb growth, said Gautam Batra of Signia Wealth Ltd.
As the CHART OF THE DAY shows, the MSCI All-Country World Index and a Bloomberg gauge of 20 emerging-market currencies moved in tandem from 1999 to 2012. The two measures then diverged and widened to a record on Jan. 22. Since then, equities have dropped 2 percent, more than the 0.3 percent decline for the currencies.
Weakness in emerging-market currencies will hurt profit at global companies, which are increasingly dependent on those nations, according to Batra, managing director and investment strategist at Signia in London. Almost 53 percent of U.S. trade came from developing countries in 2012, up from 39 percent in 2002, data compiled by Bloomberg show. For the European Union, the proportion rose to 28 percent from 18 percent.
“We will absolutely recalibrate between stocks and emerging-market currencies,” Batra said in a telephone interview. His firm manages 2.2 billion pounds ($3.6 billion).
“The potential for a negative feedback loop from the emerging markets to the developed markets is huge.”
The gauge of emerging-markets currencies fell 3 percent last month, extending last year’s 7.1 percent decline. That helped send worldwide shares down 4.1 percent in January as the Fed’s decision to press on with bond-buying reductions spurred concern the economic expansion may falter. Equities jumped 20 percent in 2013, their biggest annual gain since 2009." - source Bloomberg

So don't jump to fast on the "Great Rotation" bandwagon from bonds to stocks...

"It's a fool's paradise. We're basically printing money to keep everybody happy in the short term" - Steve Miller, Chairman of American International Group, 12th of February 2012 on Bloomberg TV.

Stay tuned!

Tuesday 11 February 2014

Credit - The Magnus Effect

"As long as the world is turning and spinning, we're gonna be dizzy and we're gonna make mistakes." - Mel Brooks

While looking at the disappointing US macro data (ISM and nonfarm payrolls), we reminded ourselves of the Magnus effect, which the commonly observed effect in which a spinning ball curves away from its principal flight path. Our analogy refers somewhat to golf given backspin generates lift by deforming the airflow around the ball, in a similar manner to an airplane wing. This is called the Magnus effect. A ball moving through air experiences two major aerodynamic forces, lift and drag. Modern golf balls called Dimpled balls fly farther than non-dimpled balls due to the combination of these two effects. In relation to our chosen title and the analogy with economy, looking at the performance of the US 10 year treasuries since the beginning of the year is directly countering the thesis that the American economy has truly achieved "escape velocity". When it comes to lift and drag, no doubt to us that the US economy recent economic data is more indicative of "stalling momentum" rather than "escape velocity momentum" when ones look at the recent ISM new orders index (-13.2 points to 51.2, the largest decline since December 1980) as well as pending home sales.

We argued in the past that the growth divergence between US and Europe were due to a difference in credit conditions. In this short post we will look at the reverse in the divergence between US growth and Europe in conjunction with the significant flows out of Emerging Markets Equities seen in recent weeks.

The divergence between US and European PMI indexes is all about credit conditions. This is why the US was ahead of the curve when it comes to economic growth compared to Europe since December 2011. We have discussed this before, the US PMI versus Europe - source Bloomberg:
The Fed’s January Senior Loan Officer Opinion Survey released this week indicated weaker demand in mortgages over the past quarter. A net 28.2% and 45.7% of banks reported weaker demand for prime and non-traditional residential mortgages, the worst data since April 2011 and January 2009 respectively.

Of course when it comes to "Magnus effect" and major aerodynamic forces, some Emerging Markets have suffered the full force of outflows as "tourist" investors have been leaving in drove. For instance EM retail outflows represented -18 billion $ year to date according to JP Morgan's recent EM Fixed Income Flows Weekly:
"EM equity retail outflows persisted with $6.5bn of outflows this week, comparable to last week's $6.4bn in redemptions as the MSCI EM extended YTD losses to -8.4%. Meanwhile, EM woes drive flight-to quality as US bond funds experienced a surge in demand as inflows reached $14.6bn, the largest single weekly inflow in EFPR's history." - source JP Morgan

What is of interest as well have been the outflows from the famous Japanese Double-Deckers which favorite "carry" currency has long been the Brazilian real as indicated as well in JP Morgan's note:
"Japanese funds experienced outflows of $254mn with dedicated local Brazil funds accounting for most of this (-$222mn)." - source JP Morgan

The reason behind the depreciation of the Brazilian Real in 2011 was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again. It looks to us that, in similar fashion to what happened in 2011, a similar exit by these Japanese retail funds is adding pressure on the Brazilian currency:
In blue the Brazilian real versus the US dollar, in red the Australian dollar versus the US dollar, as one can see the correlation between the Australian currency and the Brazilian real broke down spectacularly in 2011.

But when it comes to Brazil, not only the Japanese outflows have been putting additional pressure on the currency but the slack in industrial production is as well putting some pressure as indicated by Bloomberg's recent Chart of the Day:
"The biggest monthly plunge in Brazil’s industrial output since December 2008 shows policy makers’ confidence that a weaker real will stimulate manufacturing is proving misguided.
The CHART OF THE DAY tracks Brazil’s industrial production index, the real on a percentage-change basis and exports on a rolling six-month average. Output fell in December by the most in five years even as the exchange rate weakened 34 percent since the manufacturing index reached a record-high in May 2011.
The currency is the biggest decliner against the U.S. dollar in the last three years among 16 major currencies tracked by Bloomberg after the South African rand.
President Dilma Rousseff said on Feb. 3 that a weaker real would help drive exports this year, an affirmation of Finance Minister Guido Mantega’s comments in September that a currency drop would make Brazilian products more competitive and boost manufacturing. Goldman Sachs Group Inc.’s Alberto Ramos said the government’s optimism isn’t warranted, as companies are hampered by rising labor costs and lack of incentives to modernize.
“The bottom line is that we expect the industrial sector to underperform,” said Ramos, Goldman’s New York-based chief Latin American economist. “It is a sector that is still facing significant foreign competition and cost-competitiveness issues, which will handicap performance.”
The country’s main manufactured exports and destination by value last year included passenger cars to Argentina and Mexico and automobile parts to Argentina and the U.S., according to Trade Ministry data. Brazil, which is the world’s largest emerging market behind China, saw its economy contract in the third quarter by the most since 2009 as investments dropped.
Fiat SpA is one manufacturer that has seen financial results hindered by Brazil operations. The carmaker’s 2013 trading profit in Latin America dropped 41 percent largely from price increases in Brazil, Chief Financial Officer Richard Palmer said in a Jan. 29 earnings call." - source Bloomberg.

When it comes to outflows as well, it is worth noticing the significant outflows from equities, putting somewhat a dent to the "Great Rotation" story from bonds to equities as indicated by Bank of America Merrill Lynch's note from the 6th of February entitled "Stampeding Bears":
"The bottom-line: big capitulation out of stocks into US Treasuries…marks end of Jan/Feb correction
The big numbers: largest weekly equity fund outflow since Aug’11 ($28bn); largest equity ETF outflow since Feb’09 ($26bn); largest bond fund inflow since Apr’10 ($15bn)
The caveat: our trading rules not yet flashing “strong buy”… Bull & Bear index now down to 4.2 (hit 1.8 late-June – Chart 1); Global Breadth index now up to 44% (hit 96% late-June – Chart 3) and…
…EM Flow Trading Rule: another $7-8bn outflow next week triggers contrarian buy-signal (last buy-signal on 6/27/13 followed by 14% rally in EEM next 3 months)" 
- source Bank of America Merrill Lynch

As far as equity flows are concerned, the "reverse osmosis" namely the tapering impact on some Emerging Markets have led to the following as detailed in Bank of America Merrill Lynch's note:
"Equity Flows
$6.5bn outflows from EM equity funds (15 straight weeks of outflows = longest outflow streak on record – Table 3)
4-week outflows from EM equities = 2.1% of AUM; another $7-8bn outflows next week would trigger contrarian “buy” signal from our EM Flow Trading Rule (3.0% is threshold)
Huge $24bn outflows from US equity funds (almost all via ETF’s SPY, IVV, IJH – but see above for caveat on Good Harbor)
Business as usual for Europe (32 straight weeks of inflows) and Japan (7 straight weeks of inflows)" - source Bank of America Merrill Lynch

Whereas Fixed Income Flows,such as the ones seen in US Treasuries, shows the asset class hasn't lost its appeal:
"Monster $13.2bn inflows to Govt/Tsy funds (caveat: $10bn inflows likely due to Good Harbor rebalancing from SPY to SHY, IEI & UST)" - source Bank of America Merrill Lynch

When it comes to Emerging Markets woes, not all countries in the Emerging Markets suffer from acute imbalances and as far as the long term trend is concern in true "Angus Maddison" fashion, the future is brighter for many Emerging countries than it look in the near term. Just wait for the "tourists" to exit and value will come back, no doubt to the fore-front.

"There's no limit to how complicated things can get, on account of one thing always leading to another." - E. B. White, American writer

Stay tuned!

Sunday 2 February 2014

Credit - The Runaway Horse

"One way to stop a runaway horse is to bet on him." - Jeffrey Bernard, British journalist.

Looking at the trouble brewing in Emerging Markets, fuelled by outflows from "tourist" investors, as well by political turmoil, our chosen title is of course a reference to the Chinese New Year, placed under the sign of the "Wood Horse" which according to feng shui experts could be a "combustible" year. 

But, being movie "aficionados", our chosen title is as well a reference to 1907 early movie "The Runaway Horse". In this 7 minutes short movie a laundry man parks his horse-drawn cart to make a delivery. While he is inside, his horse sees a bag of oats and starts to eat them. By the time the man comes back outside, the horse has eaten a whole bag of oats, and has so much energy that he begins to race out of control. Of course any reference to the "unfortunate" emerging markets inflows/outflows courtesy of ZIRP/QE induced policies introduced by the FED and now leading to "reverse osmosis" in truly cinematic lingo would be truly fortuitous. 

The film "The Runaway Horse" was produced by Société Pathé Frères, a company created by four brothers in 1896 dealing with motion picture production and the distribution business. The two brothers also created Pathé records and both companies would become a dominant international force in their respective industries. Pathé became the world's largest film equipment and production company, as well as a major producer of phonograph records before the founders sold their international businesses in 1929. The company went bankrupt in 1935 under new ownership but we ramble again...

In this week's conversation we will focus on the contagion in Emerging Markets, which, in earnest has indeed increased as seen in the latest outflows coming out from the asset class in true "Runaway Horse" fashion we think. 

We did remind ourselves last week our musings from our previous conversation entitled "Misstra Know-it-all" that, when it comes to undoing the great "destabilizing" work from Ben Bernanke (aka "The Departed"), rising volatility would lead to re-calibration of risk exposure:
"Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse."

When it comes to volatility, Emerging Market VIX has indeed surged the most in two years as reported by Nikolaj Gammeltoft and Callie Bost from Bloomberg on the 27th of January 2014 in their article "Emerging-Market VIX Surges Most in Two Years on Selloff":
"Equity volatility from India to Brazil and Turkey jumped the most in two years as turmoil spread across global markets amid a selloff in developing-country currencies and growing concern over China’s economy.
The Chicago Board Options Exchange Emerging Markets ETF Volatility Index rose 40 percent to 28.26 last week, the biggest increase since September 2011, according to data compiled by
Bloomberg. Bearish bets outnumber bullish ones on the underlying exchange-traded fund by the most since July with about 60 percent more puts than calls. Developing-nation stocks extended declines from a 4 1/2-month low today, with MSCI’s Emerging-Markets Index losing 1.2 percent by 1:09 p.m. in Hong Kong.
The devaluation of Argentina’s peso, data signaling a possible contraction in China’s factory output and declines from the Turkish lira to the South African rand shook investor confidence. Emerging-market equities have tumbled since the Federal Reserve signaled in May that it could start scaling back bond purchases that boosted demand for higher-yielding assets.
“There’s concern that the downtrend may continue,” Walter “Bucky” Hellwig, who helps manage $17 billion at BB&T Wealth Management in Birmingham, Alabama, said by phone Jan. 24. “Protection is being purchased or bets are being made that it will.
The MSCI emerging-markets gauge fell 2.3 percent to 949.90 last week, extending this year’s slump to 5.3 percent. The European equity benchmark lost 3.3 percent, while the Dow Jones Industrial Average sank 3.5 percent for the biggest weekly decline since May 2012." - source Bloomberg

In last week's conversation we also underlined what Nomura indicated at the time of our September 2013 "Misstra Know-it-all" conversation, the risk of the situation turning nasty for lack of liquidity is significant:
"Bad liquidity markets saw asset swaps widen considerably (making swap paying less of a hedge) and start to trade like credit products. This phenomenon, if it continues, could result in a lot of proxy hedging through FX, FX vol, buying CDS and, at a more serious stage, selling what investors could unwind."

According to Bloomberg, investors traded almost 600,000 puts on the iShares MSCI Emerging Markets ETF on Jan. 24, three times the average from the past 20 days, data compiled by Bloomberg show. About 150,000 calls changed hands, 45 percent more than the mean.

One space though where volatility has not been contained has been of course in the bond space, as depicted by the significant evolution of the MOVE index in 2013. But what we have seen in Emerging Markets currencies in early 2014 has indeed been in the rapid surge of the EM VYX index, following the Fed's tapering stance:
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.

So what you have in Emerging Markets is the above playing out: namely proxy hedging in the first place and additional "de-risking" taking place as indicated by Bank of America Merrill Lynch's note on the 30th of January 2014 entitled "First Signs of Panic", the stampede in Emerging Markets has somewhat started in earnest, validating amply our chosen title:
"Largest EM equity fund outflows since Aug’11 ($6.4bn); $15bn outflows over next 2-3 weeks triggers contrarian “buy” signal from our EM Flow Trading Rule (Chart 1).
Largest EM debt fund outflows since Jun’13 ($2.7bn); selling concentrated in LDM (local debt markets).

EM debt & equity funds see combined outflows of $9.1bn; magnitude almost rivals outflows during Taper (May’13), Debt Ceiling (Aug’11) & Lehman (Sep’08) (Chart 2).
$6.4bn outflows from EM equity funds (largest since Aug’11) (14 straight weeks of outflows = tied for longest outflow streak on record.
4-week outflows from EM equities = 1.4% of AUM; another $15bn outflows over next 2-3 weeks would trigger contrarian “buy” signal from our EM Flow Trading Rule (3.0% is threshold)
- source Bank of America Merrill Lynch.

Of course, the use of our Jeffrey Bernard as our "commencing" quote, is by no way innocent. 

While it is too early to become "contrarian", we will be patiently monitoring the EM space waiting for the herd of "runaway horses" (namely tourists) to vacate the place as no doubt, opportunities will materialise eventually. 

On that subject we agree somewhat on the subject with Skagen AS, the Norwegian fund top Emerging Markets manager, as reported by Jonas Bergman in Bloomberg on the 29th of January in his article "Emerging Market Bull Who Beat Wall Street Sees Rout Passing":
"Skagen AS, the Norwegian fund manager who has outperformed some of Wall Street’s biggest banks over the past decade, is urging clients to sit out the turmoil gripping developing nations.
Kristoffer Stensrud, whose 50 billion-krone ($8 billion) Kon-Tiki A emerging market fund has returned an annualized 14 percent over the past 10 years, said there’s “nothing new really” in the recent turbulence, in an e-mailed reply to questions. He characterized the moves as “some contagion” in Latin America from Argentina, while reactions in the east remained “calm.”
“Emerging market economies hit by currency falls will probably be more competitive going forward,” according to 60-year-old Stensrud, who started Skagen in 1993. A lack of inflationary pressure from commodities will also be “positive,” giving a longer period with “low inflation and low interest rates in developed markets than generally perceived presently,” he said." - source Bloomberg.

Skagen AS are not the only ones taking the long term "macro" views, for instance legendary Mark Mobius chairman of Templeton Emerging Markets Group is also sitting in the "contrarian" camp as indicated by Jaco Viser in Bloomberg on the 29th of January in his article "Mobius Sees Money Flowing Back Into Emerging Markets on Growth":
"Mark Mobius, chairman of Templeton Emerging Markets Group, said inflows into developing nations will resume later this year following a selloff triggered by the Federal Reserve tapering monetary stimulus.
“People are enjoying what they see as a bull market in the U.S.,” he said in an interview in Johannesburg today. “As we go forward, we’re going to see a lot of overweight positions in the U.S. So, given the fact that emerging markets are still growing fast, given that they have low debt-to-GDP ratios, given that they have high foreign-exchange reserves, we believe that money will be flowing back in again to emerging markets.”
Investors sold $1.87 trillion in stocks worldwide in the week to Jan. 27 ahead of the Fed’s two-day meeting, which ends today, where the central bank will announce reducing bond purchases by a further $10 billion next month, according to the median estimate of 78 economists surveyed by Bloomberg. The selloff spurred a rout in emerging-market currencies with central banks in Turkey, India and South Africa unexpectedly
increasing benchmark interest rates.
The effectiveness of higher interest rates “depends on the country and it depends on the degree,” Mobius, 77, said. “In India it is working OK. The jury is still out on Turkey. The picture becomes a little complicated in certain countries because of upcoming elections. Despite the rise in interest rates, you’re not going to see a big, big flow back in, but it will eventually come.”" - source Bloomberg

We might be short-term pessimists, but, overall we remain long term optimists for Emerging Markets. 

After all, as we did indicate back in March 2012, that, when it comes to "Equities, there is life (and value) after default!". Russia, Argentina, Iceland, and as of late Greece are all living proofs that there life (and value!) after a default.  It turns out that our "early call" on Greece based on our long-term macro analysis rewarded handsomely investors in 2013 as presented by Namitha Jagadeesh in Bloomberg in October 2013 in his article "Greek Recovery Makes Stocks World’s Best as Paulson Buys":
"Since June 5, 2012, two weeks before MSCI Inc. gave notice it may reclassify Greece as an emerging market, the country’s ASE Index (ASE) has surged 146 percent, trimming the decline from its 2007 peak to 79 percent. The gains topped all 94 national benchmarks globally in the period, except Venezuela, according to data compiled by Bloomberg. Yields on Greece’s 10-year government bonds have dropped to 8.31 percent from a peak of 33.7 percent in March 2012." - source Bloomberg.

When it comes to opposing credit to equities, we have also argued in 2013 in our conversation "Credit versus Equities - a farming analogy", the following:
"-Bonds = Tenant farming
-Equities = Metayage

Therefore when ones look at credit volumes, you need to not only include the total of financial claims but as well equities.

When there is a recession or even worse a depression, equities will fall towards zero, in the case of bankruptcy. It is a very painful but it is a very fast adjustment.

The increasing recourse towards bond issuing by companies will be increasing "difficulties" at the end of the on-going credit cycle, when entering a recession or depression.

What has made the resounding success of the US economy throughout many decades was its capitalistic approach and recourse to equities issuance for financing purposes rather than bonds.

We believe the global declines in listings is indicative of growing instability in the financial system and increasing risk as a whole." - Macronomics - 15th of October 2013

So before betting on the "runaway horse", you need to see a clear "restructuring" such as what happened with Greece, or Russia, before setting up a hugely profitable "contrarian" bet but currency hedged we think.

When it comes to "true" returns, of course, one need to take into account the currency effect. 

"Big in Japan", yes we had "lift-off in risky assets" or "Risk-On" that is, in Japan in 2013, as indicated in the below graph where we have been monitoring the USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:

While we recommended last year to go long Nikkei in euro terms, a similar strategy would have been successful with countries such as Argentina as displayed in Bloomberg's recent Chart of the Day displaying 105% stock gain as long as you ignore inflation and depreciation of the currency:
"Argentine stocks posted some of the best returns in the world in President Cristina Fernandez de Kirchner’s second term, as long as you ignore inflation and depreciation. In reality, they were among the worst.
The CHART OF THE DAY shows that while the Merval index doubled in peso terms since her re-election Oct. 24, 2011, the shares lost 15 percent once returns were converted to dollars at the rate investors use to avoid currency controls. While the 105 percent local-currency return was the fifth-biggest among 94 indexes globally during the period, the drop in dollar terms made the gauge the world’s 12th-worst performer.
“Argentina is a high-risk, high return market and there has been more risk than return lately,” said Eric Conrads, a money manager who helps oversees $750 million of Latin American stocks at ING Investment Management in New York. He said he sold the last of his Argentine shares last year.
Fernandez devalued the peso last week in a bid to shore up foreign reserves that sunk to a seven-year low amid a surge in government spending, inflation estimated at about 30 percent and declining prices for the country’s soy and wheat exports.
Restrictions on dollar purchases mean investors use the so-called blue-chip swap, under which local assets are sold abroad for foreign currency at a discount to the official exchange rate of 8.0177 per dollar.
The blue-chip rate of 11.5697 pesos per dollar has depreciated 58 percent since the election, more than the 47 percent drop in the official rate and the worst among 31 major dollar counterparts. “The intelligent people in Argentina invest in property,” Conrads said." - source Bloomberg

When it comes to Argentina's woes, Bank of America and Moody's suggest that only 40% interest rate can arrest Peso's fall as reported by Katia Porzecanski and Camila Russo on the 30th of January in their article "Only 40% Interest Rate can Arrest Peso's Swoon":
"Argentina’s decision to ratchet up interest rates to 24 percent is failing to convince Bank of America Corp. and Moody’s Analytics Inc. the nation can stem demand for dollars in the wake of the peso’s devaluation.
Argentina needs to offer 37.5 percent to attract enough investors to halt peso losses, according to the average of five forecasters surveyed by Bloomberg News, even after the nation’s benchmark deposit rate surged 2 percentage points this week to a five-year high. Bank of America says a rate of 40 percent is needed to effectively compensate for consumer prices rising an estimated 28 percent annually.
 While the devaluation was intended to bolster the nation’s foreign reserves that were depleted as the central bank sold dollars to support the peso’s official rate, Argentina faces the prospect of savers dumping a currency that has lost more value than any time in a decade. Higher interest rates would mirror increases by developing nations such as Turkey, which doubled its benchmark rate to shore up the lira, as the Federal Reserve fuels a rout in emerging-market currencies by paring stimulus.
“Argentina’s got to do something similar,” Daniel Kerner, an analyst at political consultancy Eurasia Group, said in a telephone interview from Washington. “I get the feeling they don’t have a clear strategy, they don’t really understand the problem and they don’t believe in incentives.” Kerner said Argentina needs to lift its deposit rate to 40 percent to boost demand in the peso, which has lost 18.5 percent this year." - source Bloomberg.

Unfortunately, this time "it's different" we think. As it seems in Argentina, not only FX reserves have been disappearing fast, but confidence in the currency as well has completely vanished, meaning Argentina is experiencing yet again another bout of hyperinflation in the process. In that context, the "runaway horse" has further to go, given that ZIRP, and QEs have led to increased connectivity and positive correlations and therefore negative feedback loops. We agree with Nomura's recent take on Argentina from the 24th of January entitled "Argentina: Bowing to the inevitable":
"Devaluation of the Argentinean peso this week, in our view, is the inevitable result of an unsustainable mix of monetary and fiscal policies. The move is probably intended to preserve falling reserves, yet greater exchange rate volatility could open up a series of political and economic uncertainties. Developments in Argentina have generated knockon effects in Brazil, and the risk of contagion across EM has now become more real." - source Nomura

When it comes to rising risks, negative feedback loops and positive correlations, its biggest trading partner Brazil is in the front line according to Nomura's note:
"The events in Argentina have generated knock-on effects across the region, especially for Brazil, which has Argentina as its third largest trading partner after China and the United States (Figure 7). 
In terms of real exchange rates, ARS has grown steadily stronger than BRL since mid-2011 (Figure 8). 
Given the expanding current account deficits in Brazil, there is a risk of BRL suffering in sync with a weaker ARS." - source Nomura

Given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, no wonder Brazil will suffer from the "competitive" sudden devaluation from its largest trading partner.

In blue the Brazilian real versus the US dollar, in red the Australian dollar versus the US dollar, as one can see the correlation between the Australian currency and the Brazilian real broke down spectacularly in 2011- source Bloomberg:
In similar fashion to Brazilian woes stemming from Argentina's devaluation, Australia is exposed clearly to China's tightening stance and commodities slowdown.

If all is well when it comes to the world growth outlook, maybe someone can tell us why Copper futures are headed for the longest slump in 15 months? In similar fashion all is not well for Iron Ore, as displayed in the below graph from Bloomberg:

Or maybe our preferred credit and deflationary indicator, namely shipping and the Baltic Dry Index, recent weakness is only a "temporary" blip in the much vaunted "recovery"? Graph source Bloomberg:

Our biggest concerns doesn't lie much in sovereign woes but much more to surging defaults risks in the corporate space, given since May 2011, Brazilian companies have sold the most junk bonds on record and accounted for 81% of Brazil's corporate debt sales versus 34% globally, another consequences of ZIRP on "mis-allocation" of capital. The recent default of OGX in Brazil on $3.6 billion of bonds is a stark reminder of default risk in the Emerging Corporate sector.

Of course it interesting to read that the Brazilian oil company OGX has been delaying a restructuring for a second week in after BlackRock and Blackstone Group pulled out of the deal as reported by Bloomberg.

It reminds us of one of our quotes:
"He who rejects restructuring is the architect of default." - Macronomics.

What is of interest to us of course is that what credit investors forget in this deflationary environment, is that, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield, not inflation. A rise in defaults would likely be the consequences of a deterioration in credit availability. Credit ratings are in fact a lagging indicator.

When it comes to European exposure to Emerging Markets, Nomura in another note entitled "Assessing the linkages between EM and the euro area" published on the 27th of January, gives us more insight:
"After reviewing the trade and financial linkages, we conclude that a protracted slowdown in these countries would shave around 0.1 percentage point (pp) from euro area GDP growth. This compares to the 0.3pp reduction observed in the China/Asia slowdown simulation that we conducted last summer.
-Unsurprisingly, Spain and its banking sector are most exposed. However, it is important to note that these subsidiaries across LatAm operate as fully independent entities, supported by capital retained at the local level and funding that is independent from the parent company. As a result, most of the risk to BBVA and Santander stem from the potential lower earnings contribution.
-Among the Spanish banks, we believe BBVA is most at risk to FX markets given its greater exposure to Argentina, Venezuela and Turkey. While this is partly reflected in our earnings estimates, it may not be reflected in the consensus.
-In our view, risks to the euro area do not stem from a country-specific bout of volatility in select emerging markets, like the one taking place in Argentina, but rather from a broad-based EM slowdown, which would have potential to threaten the region's recovery. In this sense, we view the past week as more of a warning should contagion become more entrenched and broad-based across EM." - source Nomura

In terms of banking exposure, Spain is the most exposed according to Nomura's note:
"Financial channels: The bank exposure channel – the case of Spain
European banks are known to be significantly exposed to Latin America. Figure 7 shows that European banks had EUR564bn of claims against Latin American countries and EUR136bn of claims against Turkey.
When looking at the various European countries, Spain is clearly most exposed, with around EUR160bn of claims against stressed countries or about 5% of its total banking assets. Importantly, these subsidiaries across LatAm operate independently from the parent, with capital retained at the local level and independent funding from the parent company. As a result, most of the risk to BBVA and Santander stems from the potential for a lower earnings contribution." - source Nomura

On a final note, Oil and Mining Stocks are the most exposed to Emerging Currency risk as displayed by Bloomberg's Chart of the Day from the 30th of January:
"Energy and raw-material producers may have the most at stake among U.S. stocks as emerging-market currencies fall, according to Gina Martin Adams, a Wells Fargo & Co. strategist.
The CHART OF THE DAY shows the relationship between the MSCI Emerging Markets Currency Index and the Standard & Poor’s 500 Energy Index since March 2009, when the shares began their
current bull market.
MSCI’s index dropped this week to its lowest reading since September as the Russian ruble, South African rand, Turkish lira and other currencies tumbled against the dollar. Each currency’s weight matches the country’s proportion of the MSCI emerging-market stock index.
“High correlations between emerging-market currencies and commodity prices suggest commodity-sensitive sectors in the S&P 500 are likely to suffer most” as the decline worsens, Martin Adams wrote in a Jan. 24 report.
Oil and gas stocks were the most closely linked to the foreign-exchange index among 64 industry groups in the S&P 500, according to data that the New York-based strategist cited. The correlation was 0.94 since January 1999, when MSCI started its calculations. Comparable figures for chemicals and mining were 0.87 and 0.66, respectively. The highest potential reading was 1, showing the currency and stock indexes moved in lockstep.
China’s yuan, South Korea’s won and the Taiwan dollar account for about half of the MSCI index’s value, the report said. Argentina’s peso is excluded because MSCI classifies the country as a frontier market, not an emerging market. The peso was devalued by 15 percent last week." -source Bloomberg

In relation to gold, once forced liquidation hits EM and wipe out leveraged players and "carry" tourists, gold could go lower first for these simple 3 reasons:

"-He who has the gold, does not always make the rules.
-The market does not learn for long.
-Human nature does not change."

"When you have got an elephant by the hind legs and he is trying to run away, it's best to let him run." - Abraham Lincoln

Stay tuned!
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