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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