Friday 12 June 2015

Guest Post - US Dollar Upside & Under-priced Financial risks

"Only those who will risk going too far can possibly find out how far one can go." - T. S. Eliot, American poet
Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the numerous factors pointing towards US Dollar Upside risks and under-priced financial risks:
(Notes to Readers Source for all charts: Rcube, DataStream, Bloomberg, Fred, BIS)
Has the second upleg in the US dollar already started? Is the FED, reassured by the recent batch of positive data, about to raise interest rates into what still looks like a slowdown. If so, how will emerging market corporate borrowers and global investors react to both a rising US dollar and rising interest rates?

Because the dollar remains the undisputed global unit of account in debt contracts, a significant rise in the US currency automatically tightens financial conditions for non‐US based borrowers. This is why the supply of dollars measured by the twin deficits is such a great leading indicator for EM assets. We believe that this mechanism is probably the most misunderstood and underestimated financial risk today.

As the dollar rises, and global financial conditions consequently tighten, global growth slows down, re‐enforcing the dollar strength. This negative feedback loop is where our scenario diverges from the consensual bullish outlook currently held by investors.

As we have repeated many times, 9 trln US dollars have been borrowed by non‐US corporates over the last decade, more than half by EM‐based companies.

Bond issuance by nonfinancial corporations outside the United States have been rising at 15% per year on average for more than 7 years in a row. This is historical.

A large part of that borrowing has been contracted by commodity or commodity related sectors.

The vicious part of the current cycle is that these companies are now facing a double hit. As the Chinese investment cycle slows down…..

commodity prices weaken.

In parallel, monetary policy divergences boost the US currency, which mechanically depresses commodities.

The impact of China’s slowdown on global growth further accentuate the dollar rise. This negativefeedback loop has been in place since 2011 (mostly centered around EM currencies) and has started to accelerate in Q3 last year. Japanese and European QEs have been obviously adding fuel on the fire.

If rates start rising, on top, all non US‐based borrowers will be facing higher borrowing costs (weaker local currencies and higher US reference rates), at a time when the redemption wall will hit borrowers. The BIS estimates that about 700bln us dollars need to be refinanced every year in the next three for EM corporations. This is already massive but imagine what might happen if suddenly global investors risk appetite deteriorates.

During the commodity boom years (China’s investment bubble 2000/2011), EM corporate credit risk improved meaningfully, allowing them to borrow massively. As a result, deposits at local banks surged, creating a domestic lending boom to borrowers that could only rely on bank loans for credit. The risk now is that as the cost of the existing stock of debt rises (higher yields, weaker currencies and deteriorating credit risk), large companies draw their deposits at local banks to pay down their maturing debt (even more so if the rollover window closes down). This mechanically tightens the local credit channel because banks’ loan to deposits ratios surge, forcing them to significantly cut lending. The tightening is already observable:

Since 2000 the average duration of emerging market corporate bonds has doubled, moving from less than 6 years to more than 12 years today. This means that investors who have poured more than 2.5 trn US dollar into these bonds are now much more sensitive to US rates than in the past.

So the main question that we have to answer is where is the US dollar heading from here?

We believe that a disorderly unwind of the 9trn carry trade is not a remote possibility any longer but a real threat.

Dollar yen has once again broken out on the upside after a 5 months consolidation.

Commodity currencies are also accelerating lower.

EM currencies’ down trend is intact.

The supply of dollar is shrinking at a time when the demand for it is surging. Notice how in the past 50 years, each time the supply of dollar shrunk, the most leveraged economies peaked. Latin America in the early 80s, Japan in 1990 , Asian economies and Russia in 1997/98 and in 2007 the US housing crash. We believe EM corporates are the most likely candidate this time around.

This is bearish for EM assets

990 on the MSCI EM is a key level. We believe that if the index breaks below, 900 will be tested and broken soon after.

The risk regime we are in at the moment has been showing signs of fatigue since last summer.

Corporate credit spreads have bottomed in July last year,

so did currency and interest rates implied volatilities.

Equity market breadth is slowly deteriorating, while valuations are historically very high. As an example German mid‐caps that we consider as a global benchmark because of their exporting feat trade at 2.5 times book value. Last time they reached that level was in 2007 and 2000.

The pattern of financial intermediation has radically changed over the last 10 years. The most important protagonists for credit availability are now private investors as opposed to banks. This is why we believe that investors’ sentiment has become so important for forecasting risky assets’ expected returns.

The signs of changing risk behavior mentioned above should be taken seriously. Already, financial conditions are slowly tightening while economic momentum is decelerating.

Our VIX model has its fair value more than 100% above spot level. This is the largest mispricing in
more than 30 years.

Long Dollar remains a key investment theme, together with the conviction that risk is now severely underpriced. We are therefore buying VIX forwards (4th contract), in addition to adding a long USDJPY to our long USDNZD.

"Living at risk is jumping off the cliff and building your wings on the way down." - Ray Bradbury

Stay tuned!

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