Tuesday 22 December 2015

Macro and Credit - The Ghost of Christmas Past

"These are the shadows of things that have been. That they are what they are, do not blame me!" - The Ghost of Christmas Past, A Christmas Carol by English novelist Charles Dickens, 19th December 1843

While discovering with great pleasure that we had won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our recent "Cinderella's golden carriage", we reminded ourselves for this week's title analogy of the sayings of the Ghost of Christmas Past that came to haunt Ebenezer Scrooge in Dicken's 1843 masterpiece "A Christmas Carol". This angelic spirit showed Scrooge scenes from his past that occurred on or around Christmas, in order to demonstrate to him the necessity of "changing his ways", as well as to show the reader how Scrooge came to be a bitter, cold-hearted miser. Looking at where some High Yield Energy spreads are close to ending the year with the continuous downward pressure on oil prices and most of the commodity sector, is indeed, an illustration of the Ghost's philosophy. Credit spreads are what they are and do not blame us for having commented over the last few years over the deterioration of the credit cycle. If the Ebenezer Scrooges of the credit world have been hurt in the latest sell-off in the High Yield space, they had it coming. Low spreads of yesterday are indeed the shadows of things that have been to paraphrase Charles Dickens.

While typing this very note, we watched with great interest Central Bank of Azerbaijan (CBAz) decision to devalue the AZN by another 35% to AZN1.55/$ and deciding to shift to a fully floating exchange rate starting from December 21. We pointed out in our recent conversation "Cinderella's golden carriage" that in similar fashion to AAA ratings, currency pegs are as well a dying breed:
"In similar fashion AAA ratings are a "dying breed" and "golden carriages" often return to "pumpkin" state, currency pegs are not eternal as we reminder ourselves in our long September 2015 conversation "Availability heuristic - Part 2":
"There is indeed a clear trend in "de-pegging" currencies in the Emerging Market world, but in Developed Markets (DM) as well, the CHF event of this year has shown that pegging a currency in the current monetary system is bound to fail at some point. The sovereign crisis in Europe has also shown the inadequacy of the Euro for various European countries with different economic and fiscal policies as well as different composition (hence our negative stance on the whole European project...).
When it comes to our recent "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop" - Macronomics
 - source of the table - Société Générale 

Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. These are indeed the "shadows of things that have been", hence our recent HKD peg break case that earned us some praise from Saxo Bank.

Before we move on towards our usual ramblings, it is that time of the year where we would like to take the time to wish you dear reader and your family a wonderful Christmas and a happy and prosperous New Year. On that special occasion, we would like to extend our thanks for the support we received on our blogging journey and to our growing number of our readers (thanks for your praise in 2015). We would also like to thanks our good friends from Rcube Global Macro Asset Management for their numerous qualitative and quantitative contributions throughout 2015. We also would like to extend our thanks to our good cross-asset friend "Sormiou" for providing us with his great insights on the subject of volatility and his regular comments, and interesting exchanges we had during the course of 2015. We are looking forward to hearing more of him in 2016 given the clear potential for more volatility to come in that respect. We also hope we will hear more from you dear reader in 2016. Don't hesitate to reach out and comment!

As we move towards the last few days of yet another eventful year full of "sucker punches" such as the CHF move thanks to yet another peg blowing out courtesy of the SNB and the Yuan "surprise" of the summer thanks to the PBOC, we would like this week in our closing conversation for 2015 to continue looking forward towards 2016, as we think, the rising instability will generate interesting proposals for the "contrarian" punters. Also we do think that our "outrageous" prediction prominently featured in Saxo Bank's recent publication is by no mean "outrageous", more on this later in the conversation. Similar  "convex" trades abound, as central banks' magic spells are losing their strength, and these "macro" trades will go hand in hand with "volatility" in 2016. To reiterate ourselves, there lies the crux of central banks interventions, there is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis.

  • 2016, will be all about "risk-reversal" trades
  • The EM 2016 outlook - its weaker than you think
  • Final chart - Short Hong-Kong? Go long Japan "tourism"

  • 2016, will be all about "risk-reversal" trades
It seems to us that many investors today are "living in the shadows of things that have been", namely that they live under the "pretence" that the "central bank put" is still in play. This "pretence", we think is particularly entrenched within the "equities" crowd who suffers from "overoptimism", whereas us, in the "credit" crowd, we suffer from "overpessimism". Overall, investors, suffer from deep bipolar disorder but, that is another subject.

Furthermore, as we have shown in our last conversation "Charles' law", rising positive correlations due to the intervention of our "generous gamblers" aka "omnipotent" central bankers have led to significant rising "instability" à la Minsky, and they also have induced a reach for yield, pushing many "players" outside of their "comfort zone" leading to "yield compression" on a "grand scale" as displayed in the below chart from Bank of America Merrill Lynch's Global Equity Derivatives Outlook for 2016 published on the 9th of December:
"Reaching for yield in Europe given QEWith almost €3trn of negative yielding govt debt (~45% of the total outstanding), the hunt for yield in Europe is as strong as ever. With such low (negative) returns on safe haven assets, central banks have pushed income-seeking investors further out on the risk curve, resulting in a policy-induced contraction in yields across asset classes (Chart 26). 

With Mario Draghi unleashing QE in 2015 and leaving room to further expand it in 2016, the hunt for yield will likely gather steam, in our view. Indeed, the higher yields on offer in both EU equities and HY credit relative to safe haven assets are among the key investment reasons cited by our equity & credit strategists in their 2016 outlooks.
Yield is only half the story: need to weigh vs. asset riskYield vs risk framework: With a lack of assets offering reasonable yields, investors often focus excessively on (just) the yield on offer with less attention to the associated investment risk." - source Bank of America Merrill Lynch
Indeed, "yield hogs" are still on the "yield trail" and have been enticed by our generous gamblers to play on the "beta" game a little further up the risk scale.

What is once again "striking" to us, as me move towards 2016 is the "consensus" in many positions, which we think that from a "positioning" perspective and contrarian approach could be enticing. Could it be that when everyone is thinking the same, that no one is really thinking? We wonder.

In terms of "risk-reversal" punts, we read with interest Bank of America Merrill Lynch's Futures and HF positioning report from the 20th of December entitled "Leveraged Funds bought record S&P 500 –tugging a war with Asset Manager":
"Futures positioning across asset classes (CFTC data) 
Equities (disaggregated data)
S&P 500 (consolidated) – Leveraged Funds (LF) decrease short by $34.6bn over four week to -$16.6bn – a record buy since the consolidated TFF data started in June 2010. Asset Manager/Institutional (AI) decrease long by $6.1bn last week to $40.5bn. AI net position is near 3-year low (3.2%tile); LF near 3-year high (98%tile).
NASDAQ 100 (consolidated before June 2013) - Asset Manager/Institutional increase long by $0.2bn to $10.1bn. Leveraged Funds increase long by $1.5bn to $4.0bn.
Russell 2000 - Asset Manager/Institutional increase short by $0.7bn to -$6.4bn. Leveraged Funds decrease short by $0.6bn to -$0.9bn. One-year z-score is above two for LF (i.e. contrarian bearish). Total Open Interest is near a 3-year high (95.5%tile). 
Interest Rates (disaggregated data)
CBT US Treasury - Asset Manager/Institutional decrease long by $1.3bn to $19.3bn. Leveraged Funds decrease short by $3.0bn to -$1.4bn. Other reportables (sovereign) net
position is near a 3-year low (1.9%tile), with one year z-score below two.
10-yr T-notes - Asset Manager/Institutional decrease long by $2.6bn to $28.1bn. Leveraged Funds increase short by $0.7bn to -$28.8bn.
2-yr T-notes - Asset Manager/Institutional bought $4.1bn and flipped to a long for the first time since Nov. 3rd, with one-year z-score above two (abnormally bullish sentiments among AI). Leveraged Funds decrease long by $0.9bn to $11.2bn, with one year z-score below two (i.e. abnormally bearish sentiments among LF). 
FX (disaggregated data)
EURO - Asset Manager/Institutional increase short by -$1.4bn to -$2.2bn. Leveraged Funds decrease short by $1.7bn to -$17.3bn.
JPY - Asset Manager/Institutional (AI) decrease short by $0.9bn to -$3.7bn. Net position stays near 3-year low for AI (5.7%tile) and sentiment is on a buy signal (one-year z-score rallying from the Nov. 3rd low). Leveraged Funds decrease short by $2.7bn to -$5.7bn.
AUD – Asset Manager/Institutional decrease short by $0.2bn to -$1.9bn. Leveraged Funds bought $1.2bn and flipped to a net long for the first time since Oct. 2014; z-score is above two (contrarian bearish). Meanwhile, net positon for Other Reportables -(sovereign) remains near 3-year low (6.4%tile)." - source Bank of America Merrill Lynch
Whereas Asset Managers and Leveraged Funds agree on the Russell 2000 short position, which is of no surprise given its correlation with High Yield, what seems to us very interesting is the significant positioning of the Leverage community in being short 10 year T-Notes to the tune of -$28.8bn as per the chart below from Bank of America Merrill Lynch's report:
 - source Bank of America Merrill Lynch

Given the recent US Q3 GDP print at 2% (well below 3.9% growth in Q2) and given the current high level of inventories we highlighted recently in our conversation "Cinderella's golden carriage", it seems to us that US GDP is weaker than expected and is going to be "weaker for longer". On a side note, we have increased our US long duration exposure for this very reason. As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:
"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."
From a "risk-reversal" perspective, we think, the current sizable "short positioning" from the "Leveraged crowd", offers a good contrarian punt, given the "weaker" outlook as of late of the US economy. 
In similar fashion, the "consensus" trade of being "short" the Euro versus the USD, appears to us overly "crowded". In that sense, Steen Jakobsen's CIO of Saxo Bank's call of EURUSD flying towards 1.23 in the latest Outrageous Predictions for 2016  is not that "outrageous" we think, particularly if you factor in that for the 12 months to October, the cumulated current account surplus represented 2.9% of eurozone gross domestic product, compared with 2.4% for the 12 months to October 2014. The latest October figure for the current account surplus came at €19.8bn, which is €9bn more than at the same period in October 2014 (€10.8bn).

Here is below the significant positioning of the Leverage community in being short EUR/USD to the tune of -$17.3bn as per the chart below from Bank of America Merrill Lynch's report:
 - source Bank of America Merrill Lynch

It certainly looks crowded to us, and are the shadows of things that have been, given that as of late,  Le Chiffre aka Mario Draghi, hasn't been on his best "bluffing/betting" behavior.

When it comes to Emerging Markets woes which have been well commented by all the usual suspects, when it comes to our prognosis for 2016, we think that there is indeed more pain to come rather than to expect a "relief rally" from an "outrageous prediction" perspective. Our "reverse osmosis" macro theory we touched on again recently is still playing out. This brings us to our second point.

  • The EM 2016 outlook - its weaker than you think
While the "commodity rout" is well documented, we think that in 2016, we will the materialization of defaults and restructuring in the EM world given the exposure of the banking sector in these countries to the sector. In relation to this exposure, we would like to point out to a Bank of America Merrill Lynch report published on the 16th of October and entitled "China spillovers and the leverage channel":
"The commodity channelCommodity exporters – Malaysia, Thailand and Indonesia (see Chart 2) – have been disproportionately impacted, largely as commodity prices slump on weaker demand, as China rebalances away from investment-driven growth. 

Casualties include coal, base metals (iron and copper) and palm oil. Coal prices, for instance, have fallen some 62% since January 2011. Falling commodity exports hurt the current account balance, fiscal revenue and also the wages of lower income, rural households.
Lower export revenues and the declining terms of trade have weighed on the growth of commodity exporters. Indonesia’s GDP growth is at its weakest since the Global Financial Crisis, at +4.7%. Infrastructure spending is failing to offset slumping commodity exports so far, given the slow progress. Malaysia's GDP growth will likely slow markedly in the second half of the year, as slowing exports spill over to weaker consumer and investment spending.
The IMF highlighted in its latest October WEO report that the weaker outlook for commodity prices implies that the annual growth in output for net commodity exporters will decline further, by almost 1% point, in 2015–17 compared with 2012–14. The reduction in growth for energy exporters is projected to be larger, at about 2.25ppt over the same period.
The leverage channelConcerns over financial system vulnerabilities have risen, given the commodity downcycle and the sharp depreciation of currencies in emerging economies, particularly commodity exporters. The latter has implications for foreign-denominated debt. Economies with high foreign currency borrowings and high exposure to commodities are particularly at risk of loan defaults and banking system losses.
We identify loan exposures to the commodity sector, defined as loans extended to the agriculture, forestry & fishing, and mining & quarrying segments. Singapore (9.2% of GDP), India (7.2%), Malaysia (3.7%) and Indonesia (3.4%) have the largest share of bank loans to the commodity sector, as a proportion of nominal GDP (see Chart 3).
As a share of total corporate debt, Thailand and Indonesia rank highest, with about 31% and 30% of corporate debt borrowed by commodity producers. China (26% of total), India (26%) and Malaysia (18%) also have relatively sizeable amounts of debt borrowed by energy and metals & mining companies (see Chart 4). This is worrying and may have profound implications on financial stability, as commodity demand and prices remain under pressure. Based on IMF data, ASEAN countries Indonesia (52% of total corporate debt), the Philippines (28%), Malaysia (18%) and Thailand (16.5%) have the largest share of foreign-currency non-financial corporate debt out of total company borrowings in Emerging Asia.
Our Asia Pacific financials team recently highlighted that Hong Kong banks would be the most directly impacted by a China hard-landing. Many Chinese firms borrow funds offshore in Hong Kong and firms in Hong Kong are also reliant on cross-border businesses (tourism, trade, shipping, etc.). Among banks in the rest of Asia, Singapore banks DBS and OCBC have the largest loan book exposure to HK/China, accounting for 36% and 26% of total loans, respectively. The exposure of UOB, Taiwanese financials, Public Bank in Malaysia, and Australian banks are generally much smaller, in the 4% to13% range. Banks in other markets have insignificant exposure, but could be indirectly impacted by any slowdown in their domestic economies. 
Defaults and restructuring of commodity-related firms may be early indicators of potential financial stress for banks. High gearing and foreign currency-denominated debt appear to be a characteristic of commodity producers and trading companies. Commodities are priced in US dollars and are, therefore, hedged, goes one argument. Exploration and mining often require heavy capital investment and, hence, large-financing requirements. Commodity trading companies are also highly geared by their very nature. The China contagion may be far from being over, as the financial stress on commodity and debt-laden firms starts testing banks." - source Bank of America Merrill Lynch.
The path of normalization of the Fed has continued to exert additional pressure on already strained EMs thanks to Global Tightening Financial Conditions triggered by the US Dollar "margin call" thanks to the tapering of the Fed and now with the latest small increase in rates.

When it comes to the Fed's hiking cycle, the Fed is not only hiking in an environment of slowing earnings in the US, it is also hiking in an environment where Asian growth is slowing as displayed by Deutsche Bank in the below chart from their report from the 17th of December entitled "Asia Macro in a non-zero world":
"Business cycles in the region are in much weaker shape, with growth slowing – not accelerating – into this Fed hike (Chart above). Export growth has been printing in negative territory across Asia, a far cry from the double-digit growth seen when the Fed last raised rates (2004). Asian central banks will not be able to keep up with even a gradual Fed this time, and front-end rate differentials will narrow. The only central bank we think could hike rates is the Philippines. Elsewhere, rates in China, Taiwan, Korea, and Thailand could be very close to, or even below, US rates by end-2016. The market appears underpriced for this divergence." - source Deutsche Bank
Furthermore, when it comes to EMs' growth, this time it's different as their growth have been much tepid as of late. On the subject of the outlook for EMs, we read with interest LCM's take from their Cross Asset Weekly Report from the 15th of December entitled "Themes for 2016":
"EM: How Will It End?This is a good transition for our second point: the EM situation. We wonder how it could end because we do not see any positive outcome for them. In the developed world, the most flexible economies that have enjoyed the highest accommodative financial conditions of history have needed several years to recover after the US centric financial crisis. How long will need an EM country under
financial repression to recover from an EM centric financial and economic crisis? We do not know precisely but we suspect much longer than the US.
The chart below gives an indication of the negative pressure on the whole EM universe. If we exclude the global crisis of 2009, never before so many EM countries have failed to generate an economic growth rate above 3-4%. 
High economic growth is becoming scarce for these countries so clearly, we can talk about a new paradigm for them. On the right, the chart shows that a consequence of that lower growth is a higher accumulation of the public debt, leading to a rise of the Debt/GDP ratio towards its 90’s level. The current crisis seems deeper than the 97/98 crisis which was initiated by a financial crisis. 
This time, it is not a financial crisis that triggers the economic crisis but an endogenous economic crisis that arises following excess investment in assets that turned unproductive (real estate and manufacturing for China and commodity-related sectors for LatAm, the Middle East and Russia). This is a big difference. This economic crisis is not the result of a fundamental financial vulnerability that would have been exploited by investors. There has been no US$ interest rates shock, no speculative attacks on countries. The weakness comes from the real economy and the depreciation of the currency is the consequence of that weakness, not the cause. 
We show with the following chart the Budget balance for 2015 of selected EM countries and their short term cost of funding (5-year sovereign bond yield). There is a clear discrimination: Brazil suffers unaffordable rates whilst Chile and Peru, its neighbours that are also affected by weaker growth, maintain access to global markets. 
On the right, we see that the Government bond yields of Brazil and Russia have reached very high levels. Contrary to Turkey, these countries are already in recession making the situation desperate. The financial system is under great pressure, NPLs are on the rise, the risk for them of running out of a US$ financing is a reality. Equity valuation is therefore intriguing as Brazilian banks trade at 0.7 times their book value and Russian banks at 1.0 times their book value. In other words, this does not look to be a capitulation phase. The situation is critical but investors have not thrown in the towel and this is why in our opinion the downside for the most fragile EM equities is intact.
The underweight position on EM assets is supposedly consensual but as we discussed in our weekly note #115 “Story Positioning”, we do not believe this lie. PMs are not underweight EM assets because they cannot short an oversold asset; it is inconceivable for them.
This negative trend is therefore intact because the investor participation rate is very low. The EM currencies are depreciating because of two events: 1) the US dollar rise with the expectations of higher real rates and 2) because of financial outflows resulting from a deterioration of the EM external position and a loss of investor confidence. 
 - source LCM, Bloomberg
The new story among EM countries is the weakness of the rich Middle East countries. Their economic disarray looks like 1998 as they return to deficit in terms of budget balance and current account position. It is clear that they can afford it after having benefited for several years from the oil rent but as is often the case, the deterioration is faster and stronger than the improvement. The currency peg of these countries may be tested. We should therefore keep an eye on this region because being anchored to the winner when you are a loser is of limited interest. 
The consequences of the reduced amount of petrodollars flooding to developed and emerging markets are unknown but in the EM case it helps to further reinforce the vicious circle they suffer. The later, slower and weaker recovery scenario that we mention is obvious and this is why on financial markets investors should not expect too much from EM assets.
The accumulation of debt adds another challenge to EM countries that could act as an accelerating factor for the economic crisis. Within the EM world we continue to distinguish three groups: 1) commodity exporting countries 2) China and 3) the rest (mainly EM Asia ex-China). This EM crisis started with the first group as the decline of commodity prices quickly revealed their intrinsic weaknesses. Now it is moving to Asia and because there remain many unanswered questions, it should be a recurring topic for 2016.
For markets, this change of focus from LatAM/Russia to China does not mean that the situation is fixed but that it is extending. This is the problem and this is why 2016 could be another bad year for EM assets. The corporate bond defaults remain limited, the help of the IMF has not been required, so we have not as yet seen the classic indicators of capitulation that increases the reward/risk ratio of being contrarian." - source LCM, Cross Asset Weekly Report, 15th of December 2015.
While these are the shadows of things that have been in 2015, we have to agree, with LCM. We do not think we have yet reach the "capitulation" point that would make the asset class an "enticing" investment proposal.

In terms of "enticing" proposal, we would like to end up on a more "positive" note in our final point of our conversation, with the "attractiveness of the Japanese tourism sector.

  • Final chart - Short Hong-Kong? Go long Japan "tourism"

We think that the Hong-Kong woes which we have again highlighted in our conversation "Cinderella's golden carriage" have greatly benefited Japan and will continue to do so in 2016. This has been furthemore highlighted by the WSJ in their article from the 17th of December entitled "Hong Kong Retailers Lost in Currency Translation":
"Retail goods in Tokyo are on average 34% cheaper than in Hong-Kong. Hong Kong retailers lost in currency translation as Chinese shoppers turn to Japan amid cheaper prices and yen." - source The Wall Street Journal
Given Japan has been the big beneficiary as highlighted in our previous conversations when looking at air travel surge towards Japan from China mainland, it makes sense we think, to continue to play this theme in 2016. On that note we read with interest Société Générale's Best Trade Ideas for December and January and would like to point out to additional points made in their research note on the subject of Japanese tourism:
"Japanese tourism is a long-term theme and its development is a pillar of Abe’s growth strategy. The government objective of reaching 20m visitors by 2020 is within reach. 
Consumer demand, a tailwind for Asian equities. Tourism expansion in Japan results from a combination of factors, including a weaker yen and government policy encouraging foreign visitors flows (for instance through easing visa deliveries). Rising wages and robust Asian consumer demand is another key element. In the past three years, the bulk of Japan’s tourism growth is attributable to Asian visitors. 
Exposure to tourism through SG Japan Tourist Basket. The basket, launched in March 2015, has been constructed along liquidity and diversification constraints. Sectors represented in the basket include transportation, appliances (30%) and retail trade (25%). Given the liquidity constraints, the basket consists of a combination or “pure” and “less pure” players, with a significant overall flavour of outbound travel.
- source Société Générale
When it comes to Honk-Kong's retail woes thanks to its US dollar peg, Japan is indeed the prime beneficiary, particularly when one notices that luxury watches exports from Switzerland to Hong-Kong have fallen by 28% according to Bloomberg.

In relation to Hong-Kong's currency peg, we are left wondering if indeed the fall in "luxury watches" is not indicating that "time" is running out? Is our prediction for 2016 so "outrageous"? We will soon find out...

"Every adversity, every failure, every heartache carries with it the seed of an equal or greater benefit." - Napoleon Hill, American writer

Stay tuned!

Tuesday 15 December 2015

Macro and Credit - Charles' law

"There is no such thing as talent. There is pressure." - Alfred Adler, Austrian psychologist

Watching with interest the demise of some Distressed/High Yield funds thanks to "price action" and "low liquidity", with continuous pressure as well on some other asset classes in true "Risk-Off" fashion, we reminded ourselves for this week's title analogy of Charles' law, or the law of volumes. Charles' law simply states that a gas tends to expand when heat is applied to it. This law was published in 1802 by French chemist Joseph Louis Gay-Lussac, who credited Jacques Charles for all his work on the subject. Jacques Charles was a French scientist and inventor whose most notable work came during the late 18th century. Charles was presumably the first to discover that hydrogen could be used as a lifting agent in balloons. More recently, central bankers discovered that liquidity injections could be used as a lifting agent in "asset prices" ("Cantillon Effects"). In similar fashion, in our "macro" world, credit spreads "expand" (widen) when heat is applied to it. In physics, when the combustion starts, it is difficult to stop, same happens in credit and macro, when the credit cycle is turning, leading as well to "capital outflows" and surge in yields. When it comes to lifting agent, balloons, and combustion, we remember what happened to the LD129 Zeppelin Hindenburg on the 6th of May 1937 but, that's another story...

In this week's conversation, we would like to look at the continuous effect of positive correlations and large standard deviations move we discussed in August. Given the rise in volatility, we will also look at why we think "volatility" is the asset class to own as we move towards 2016 and the gradual erosion of central banks' credibility in 2016.

  • The opportunities in unprecedented turbulences
  • "Negative carry" - Central banks' credibility is effectively suffering from "time decay"
  • Final chart - CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies
  • The opportunities in unprecedented turbulences
As we posited back in August, rising positive correlations due to the intervention of our "generous gamblers" aka "omnipotent" central bankers have led to significant rising "instability" à la Minsky. We argued at the time:
"There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, August 2014
And we concluded:
"Expect more violent moves going forward as a consequence. For us, there is no "Great Rotation" there are only "Great Correlations"..." - source Macronomics, August 2014
The 3rd of December was a good illustration of the "instability" due to rising "positive correlations" which inflicted havoc on "balanced fund". Below are two charts illustrating the large standard deviations move in Europe following the ECB - graph source Bloomberg:

German 10 year Bund:
- Graph source Bloomberg

To illustrate further our prognosis of "rising instability" à la Charles' law, we read with interest Bank of America Merrill Lynch's take in their Global Equity Derivatives Outlook for 2016 published on the 9th of December:
"As we highlighted in our 2015 outlook, the most distinguishing feature of markets today is not the general trend in volatility, but the unprecedented turbulence.
Rising fragility; moving deeper into uncharted waters
In 2016 we expect volatility to maintain its gradual upward trend, however, to continue to be punctuated with violent but short-lived shocks owing to poor liquidity, extreme positioning and a market still heavily manipulated by (and dependent on) the central bank put. Despite below-normal levels of volatility across asset classes, we are in uncharted waters in terms of a lack of stability: 
• Markets are setting records in terms of jumping from calm to stressed & back
• Our indicator of cross-asset market fragility is near its highs (Chart 1)
• CB liquidity is tightening, making markets more accident prone (Chart 7)
Asset managers are struggling, with the poorest hedge fund performance relative to the risk they are taking since 2008, despite overall market volatility being only 1/4th of 2008 levels. Their poor performance is better explained by the extreme levels of market fragility, which by our metric is at 80% of its 2008 highs (Chart 1 above).
Unfortunately, we don’t see conditions improving and only becoming more acute as liquidity continues to deteriorate, asset valuations become increasingly stretched, and the Fed navigates the unwind of the greatest policy experiment in history. " - source Bank of America Merrill Lynch
We don't see conditions improving either in 2016 and last Monday was once again an illustration of "Blue Monday" in the works we think. With liquidity deteriorating and hydrogen having been used by our "generous gamblers" as a lifting agent in  "asset balloons", there is indeed no surprises in seeing a significant rise in idiosyncratic risk leading to significant price movements. 2015 saw an increase in the number of "sucker punches" inflicted to the "cross-asset" crowd. By no means 2016 is going to be different.

When it comes to High Yield's jitters, we have long seen it building up as we carefully studied the credit cycle, it doesn't come to us as a surprise. As a reminder, this is what we have repeated in numerous conversations:
"The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield spaceIn the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."
But, from a short term tactical "contrarian" perspective, we are seeing in US High Yield and Equity / Credit volatility some early signs of "capitulation" (volumes, implied volatilities for ETFs) which, would make for the "adventurous" punter some interesting entry point, to play a short term rally in the making.

Following Friday's move, we have noticed a multiple of "alarmist articles/headlines" from various pundits which have been late to the "party" on the matter of US credit. We believe it is a short term contrarian sign from our behavioral psychologist mantra, given we prefer to focus on the process rather than the content. For instance, we are seeing real signs of capitulation, via flows and implied volatilities on listed options on both principal liquid ETFs.

Volumes for iShare HYG:
- graph source Bloomberg

Implied Volatility 3 months HYG US:
- graph source Bloomberg

Spread volatility Russel / volatility HYG : 
It represents some good entry points for a tactical short term long/short strategy. The implied volatility on credit is trading on comparable levels with "mid-cap" equity volatility.  We believe it is an interesting "capital structure trade" that warrants attention, either from a "directional" perspective (selling straight "Put" options on HYG / buying straight "Put" options on RTY/SPX) or through a "pure" volatility strategy. 

In fact as we were typing this very post, we noticed a rebound on the aforementioned HYG. To paraphrase our November 2015 conversation "Ship of Fools", this time around on HYG we remain tactically short-term "Keynesian" bullish but, remain long term "Austrian" bearish given the lateness in the US credit cycle.

More and more in 2016, we believe there will be many opportunities in unprecedented turbulences movements we have seen so far in 2015. 2016 will be a year in which "tactical" global macro "convexity" trades such as the one highlighted above will be plentiful. Volatility will therefore be one of the core asset class to own, in various "cross-assets" (FX, rates, commodities, credit, etc.). On that point we agree with Bank of America Merrill Lynch's take from their latest Global Equity Derivatives Outlook:
"Successfully trading a less stable worldWhile many are struggling with this new market dynamic, we believe there are smart ways to combat it – and even profit – by monitoring cross-asset risk, and taking advantage of the inflection point in asset correlations. For example:• Gaps in cross-asset volatility can aid in differentiating between “local” and global risks, to determine when to fade the market or add a hedge• Shocks create entry points for cross-asset RV between leader and laggard assets which has been successful in generating alpha• Risks implied by derivatives, including correlation, often are unlikely to realize as stress unfolds, allowing for cheap directional trades• Cheaper hedges can be constructed by harvesting underpriced volatility through proxy puts overlaid on standard put spreads• Strategies that collect the volatility risk premium, for example through call overwriting, while dynamically managing these risks can add alpha" - source Bank of America Merrill Lynch
Although "volatility" is a "negative carry" proposal, the events of the 3rd of December on the German Bund following the ECB, which were close to a 7 standard deviation move, have shown how quickly your "carry" can be wiped out. But, as liquidity is being drained by the Fed and given the increasing signs of global financing conditions tightening, if the "trend" is your "friend", then we are bound to see a surge in volatility in 2016. This trend is pointed in the same report from Bank of America Merrill Lynch:
"A trend of rising vol as liquidity drains
Our Economics of Volatility1 framework has been anticipating the 2015 starting point to a turn in volatility for the last two years2. From here on we expect to see a rising trend in equity volatility levels, a trend that could last 1-2 years, transporting us from the low volatility regime of the last 3 years towards a sustained high volatility regime.
Our expectation for a turn in the volatility cycle follows from a clear turn higher in 5Yr real rates in 2013, and allows for a 2-year lag (Chart 6).  
High volatility regimes may resemble periods like 1998-2003 or 2008-2011, as two examples. Transition periods can also take various forms. Unlike the 1996-1998 transition period which was gradual and well behaved, the 2008-2009 transition was short and violent, as a suppressed and overdue re-pricing of risk finally manifested itself. It’s hard to predict the exact form the next transition will take. While our base case is for an orderly transition, we are wary of the possibility of unpleasant surprises resulting from an unwinding of the highly unusual monetary policy of the last 7 years.
Unwinding extreme easy monetary policy is a tightening
The monetary tightening cycle which started with the 2013 taper has continued its progress, reflected in rising 5yr real rates. This in turn has driven a significant tightening in global liquidity as capital flows from developed to emerging markets start to reverse, evidenced in a slowdown and reversal of FX reserve accumulation."
Tightening liquidity combined with fragility: equity markets are accident proneChart 7 (earlier in our post) shows a measure of global US$ liquidity derived from the momentum of the Fed’s balance sheet. Historically we see that tightening cycles have typically started at high liquidity levels. The current cycle in fact started in anticipation of the tapering of the open-ended QE3 program in 2013, with the impact evident in the sharp turn in the 5Yr TIPs rate (Chart 6), and the subsequent fall in US$ liquidity. Given how far liquidity has already dropped, it is going to be interesting to watch the impact of the more traditional part of the tightening cycle – actual rate hikes – which are expected to start imminently. Combined with our view of an increased likelihood of local shocks due to deteriorating trading liquidity, we may find the markets more accident prone in 2016 than they have been in some time. "- source Bank of America Merrill Lynch

This "reversal" of capital flows in Emerging Markets is exactly the manifestation of our "reverse osmosis" macro theory playing out we think. As a reminder from our August 2013 conversation "Osmotic pressure":
"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - source Macronomics
Of course as the Fed is on the "normalization" path as anticipated by market participants, stemming capital flows will continue to be increasingly difficult, particularly for the hard hit commodity players and as well China, trying to "deflate" its "hydrogen fueled "credit" balloon.

Whereas volatility is a "negative carry" proposal, so is central banks' credibility which is effectively suffering from "time decay" we think. 2015 has already shown the weak hand for some of the central banks "punters" such as the SNB and the PBOC losing its cool during the summer. "Le Chiffre", aka Mario Draghi, as well, our "poker prodigy" has shown some weakness in his "bluffing" abilities as of late. We wonder if 2016 will not see further "erosion" in their "ability" to steer markets. This brings us to our second point.

  • "Negative carry" - Central banks' credibility is effectively suffering from "time decay"
Whereas "volatility" is a "negative carry" proposal" as posited earlier one, as we move towards 2016, it remains clear to us that 2015 saw many players at the "poker" table fold earlier (such as the SNB). On the 3rd of December, our "Le Chiffre" bluffing abilities suffered as well at the "poker table." As we move towards 2016, we are wondering wether 2016 will see additional weaknesses from our powerful "omnipotent" central bankers. For sure, we think their abilities will be tested even further, given the high deflationary forces at play, particularly with the further weakening of the CNY/Yuan, which will represent yet an additional "headache" for our enduring "gamblers".

On that subject, once more, Bank of America Merrill Lynch's 2016 Global Equity Derivatives Outlook makes some very interesting remarks relating to the "weakening" of the global markets "Central banks Put":
"Power of CB put shows risk of its lossCentral banks have had a tremendous impact on financial markets in the last seven years, which is never more apparent than when looking at the world through the volatility lens. As shown in Chart 12, cross-asset volatility reached all-time lows in the summer of 2014, falling even below the 2007 pre-GFC bubble lows, crushed under the weight of unprecedented monetary policy (or in the ECB case, the promise of policy). This is remarkable considering the size of the risk “bubble” created pre-GFC.
The result is that risk is not fairly priced based on fundamentals but rather is better explained by investors not wanting to stand in front of central banks as they embark on QE. As Chart 13 shows, when decomposing the 41 factors of risk covering 5 asset classes from our GFSI index into regions, both Europe and Japan (the two regions still actively engaging in QE) are the two regions with the most depressed price of risk.
This is despite being the two developed regions with some of the greatest fundamental risk.
Unprecedented CB – market co-dependenceCentral banks have never been more sensitive to financial market conditions as they are today. This hyper-sensitive reaction function has placed huge downward pressure on volatility, and has accentuated local shock behavior as investors have become accustomed to CBs verbally supporting the market at very low levels of stress compared to the past.
In the last three instances when our GFSI critical stress signal has triggered, during the taper tantrum in June 2013, the Oct 2014 growth tantrum, and the Aug 2015 China tantrum, central banks have stepped in to verbally support the market (Chart 14). 
In each case central banks have reversed market stress, creating a string of three false signals, which is historically unusual. From 2000-2012, the GFSI’s critical stress signal triggered 15 times, 12 of which resulted in a further escalation of risk and a pull-back in global equities of at least 5%. This illustrates the extent to which central banks have essentially capped risk at levels where it historically was likely to spill over. 
This has self-reinforced a “buy-the-dip” mentality which, together with the fact that investors have generally been underweight US equities this year, has caused the S&P to record larger returns on days the market was rising than when it was falling. Combined with the fact the S&P fell more days than it rose YTD but the market overall was up makes this historically unusual, occurring only 5 other years since 1928.
Pulling the safety net away will be riskyArguably one of the reasons central banks have been so sensitive to market risk is that they are fearful of a negative wealth effect resulting from a financial market sell-off hurting the real-economy, given they have little monetary ammunition left. Keeping rates low to avoid the rising costs of record high debt burdens could also be a motive. 
The US Fed’s fear was made particularly clear by Yellen’s decision to not hike in September, citing the sell-off in equities and China weakness, at a time when the S&P
500 was only about 10% below all-time highs. 
However, the challenge will be to remove this safety net given how dependent the market has become. And once the Fed begins its hiking cycle, it may be implicitly less able to provide the support for fear of being seen as making a policy mistake. This reduced power of the CB put will only help increase market fragility.
Central bank’s risk manipulation well explains local tails
A good way to explain why we have seen local tail risks arise so frequently since central banks began to heavily manipulate asset prices is with the following analogy, illustrated in Exhibit 1.
Essentially central banks, by unfairly inflating asset prices have compressed risk like a spring to unfairly tight levels. Unfortunately, the market is aware the price of risk is not correct, but they can’t fight it, and everyone is forced to crowd into the same trade. By manipulating markets they have also reduced investors’ inherent conviction by rendering fundamentals less relevant.
This then creates a highly unstable (fragile) situation that breaks violently when a sufficient catalyst causes risk to rise – overly crowded positioning meets a market with little conviction.
Catalysts can range from a “valuation scare” similar to Oct-14 or Aug-15 to a prominent investor stating that assets (e.g. bunds) are not fairly priced and are the “short of the century”. 
The unwinds from these crowded positions are violent, but almost equally violent in some cases are the reversals, which are driven from investors crowding back in when they realize central banks are still there providing protection. 
From this vantage point, it becomes clear that the biggest visible risk to financial markets is a loss of confidence in this omnipotent CB put." - source Bank of America Merrill Lynch
Exactly, 2016, will be all about "risk-reversal" trades. Given the extreme positioning and crowded positions in some asset classes, we expect to see much more "risk-reversal" pain trades aka "sucker punches" being delivered in 2016. From a global "macro" convex positioning, there are already many cheap "convex" overcrowded consensus trades, such as "short gold", "short oil", to name a few. From an "opportunistic approach, there is potentially tremendous "upside" in taking the opposite view via the option markets on various asset classes we think. 

Indeed, the "omnipotent CB put", that's why "Theta" is always "negative". Same goes with central banks' credibility. Whereas up until now, to be fair, thanks to the "omnipotent CB put", options sellers experienced lots of small wins, while getting lulled into a false sense of success and "security", in 2016 they might eventually suddenly find their profits (and possibly worse) obliterated in one ugly move against them as we pointed out in our previous conversation when using our "Cinderella's golden carriage" analogy. 

What would most likely dent even further "central banks' credibility" in general and the Fed in particular is indeed the biggest "deflationary" threat coming from China with a continuous "stealth devaluation" of its currency. This would indeed send a very strong "deflationary" impulse to Developed Markets (DM) and represents a major headwind for our "generous gamblers" as per our final chart.

  • Final chart - CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies
We believe that a steady grind lower in Yuan/CNY will occur in 2016, this will put additional pressure on the rest of the world and won't be enough to counter "capital outflows" in China. This we think is a "big risk" for 2016 and amounts in effect to Charles' law playing out. On this subject, we would like to point out Société Générale's take from their Fixed Income Weekly note from the 10th of December entitled "EM deleveraging":
"CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies, creating a disinflationary shock in developed economies – bullish for bonds. ADXY is threatening to break YTD lows (Graph 3).  
Our Asian strategists warn that a currency war induced by CNY depreciation may take either a direct form, with policymakers trying to match CNY weakness, or an indirect one, with investors shorting Asian currencies as a proxy trade. If the depreciation in the CNY accelerates or volatility increases significantly, the risk is a destabilisation of the entire EM currency complex: an example of the butterfly effect we refer to in our 2016 FI Outlook.
When the PBoC fights excessive weakness to discourage capital outflows, it is a seller of bonds, especially Treasuries. However, the recent bout of CNY weakness has not seen any particular pressure on Treasury yields or USD swap spreads. If anything, the latter have recently recovered. That suggests lighter PBoC intervention, which might support the idea that it will be less proactive now that the IMF has given the green light on CNY inclusion to SDR." - source Société Générale
Finally, when it comes to Charles' law and our "reverse osmosis" macro theory and capital outflows from China, we would like to point out towards JP Morgan's chart below from their "China: Devaluation in 2016 - the why, the how and when it will occur" note from the 9th of December:
"Capital outflows will persist and will become an increasingly important driver of currency weakness. Capital outflows will persist for two reasons: firstly, growth headwinds are unlikely to dissipate, which, as chart 3 below highlights, should correlate well with further capital outflows.

The second factor will be continued corporate unwinding of dollar liabilities (we estimate another $400bn dollar liability needs to be deleveraged after recent rise of corporate hedging)" - source JP Morgan.
One thing for sure and as far as Charles' law is concern, in our "macro" driven world, trouble "expand" (widen) when heat is applied to it. Trouble will indeed expand to Asia, should the pressure on ADXY continues, rest assured.
"There are plenty of recommendations on how to get out of trouble cheaply and fast. Most of them come down to this: Deny your responsibility."- Lyndon B. Johnson, US President
Stay tuned!

Tuesday 8 December 2015

Macro and Credit - Cinderella's golden carriage

"The very concept of objective truth is fading out of the world. Lies will pass into history." - George Orwell
Listening with amusement to "Le Chiffre" aka Mario Draghi, losing some of his "Sprezzatura" ("studied carelessness") following the ECB meeting last week, leading to some significant "sucker punches" being delivered for the "Balanced funds crowd" (long German government bonds and European equities) and Euro short punters alike, given that all market pundits have been used to the "fairy tales" from the "Generous Gambler" and "happy endings" for risky assets, we decided this week to steer towards a European folk tale as an analogy for our chosen title. The story of Rhodopis, about a Greek slave girl who marries the king of Egypt, is considered the earliest known variant of the "Cinderella" story (published 7 BCE), and many variants are known throughout the world. One of the most popular versions of the story was written in French by Charles Perrault in 1697 under the name "Cendrillon" and in his version he introduced the "pumpkin". While the fairy godmother turned a pumpkin into a golden carriage in the story depicted by Walt Disney, she did warn Cinderella to return before midnight. Central bankers with their various iterations of QE have provided "balanced fund managers" a tremendous goldilocks period for investing. While we have warned of the rising instability risk caused by positive correlations in August this year , which is leading more and more to "large standard deviation moves" (sucker punches) in various asset classes, it seems to us that investors are not taking seriously fairy godmother Janet Yellen as we are indeed approaching midnight (watch what our US CCC credit canary is doing as of late...). One of the moral of Charles Perrault's version is as follows:
"That "without doubt it is a great advantage to have intelligence, courage, good breeding, and common sense. These, and similar talents come only from heaven, and it is good to have them. However, even these may fail to bring you success, without the blessing of a godfather or a godmother"
No doubt to us that without the blessing of the "fairy godmother from the Fed" aka Janet Yellen, we think, it is going to be incredibly difficult to achieve significant "positive returns" in 2016 for the "long only" crowd, as in similar fashion to the fairy tale, Cinderella's golden carriage spell is about to be broken and return to being a simple pumpkin (hence our call for heightened volatility in 2016 and the need to put on some still "cheap hedges").

In this week's conversation, we will continue to look at 2016 prospects. We will also touch on some "macro convex trade" of interests (by the way we submitted our HKD idea from September to Saxo's 2016 "Outrageous predictions", so let's see if we make the cut...).

  • One "macro convex trade" to think about for 2016
  • Container shipping and large surge in US inventories, a great cause for concern
  • Final chart - Global equities: more de-equitisation to come in 2016

  • One "macro convex trade" to think about for 2016
Our own "outrageous 2016" prediction - A HKD devaluation.
Back in September this year in our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen.

At the time we argued the following:
"A weaker CNY would trigger a fall in competitivity for the entire Asian region and would massively impact the retail sector of Hong-Kong with additional fall in the number of visitors from mainland China and even more pressure on property developers. Hong Kong property sales plunged to 17-month low in August amid increasing economic uncertainty in China." - source Macronomics
Given that the latest data from Hong Kong’s Land Registry shows sales of registered residential units in November slumped to their lowest in nearly two decades with Residential mortgage approvals falling 40 percent in October as reported by Reuters in their 3rd of December article entitled "We need to talk about Hong Kong’s property market. Again.":
"The second major factor, and arguably the more important one in the short term, is what is happening on the mainland. China’s marked slowdown has taken a toll on everything from property transactions to tourist arrivals and retail sales in Hong Kong.
Chinese tourists buying up everything from Louis Vuitton bags to milk powder in Hong Kong’s shops accounted for nearly half of the city’s retail sales last year. This is slowing sharply as the economy slows and as Chinese tourists prefer to take their shopping to Korea and Japan instead. The knock-on impact is putting rents in shopping malls at risk.
The backdrop appears anything but sanguine.
But Macquarie takes a calmer view. It estimates that there is a decade worth of pent up demand (roughly amounting to 262K households) in Hong Kong that has built up as buyers got increasingly priced out of the property market. Unless there are widespread job losses it is unlikely that this demand will disappear.
If they’re right, that suggests every dip is likely to find buyers come back in even if interest rate slowly nudge higher.
Dents in the armour are showing. But 2016 may still be too early for the start of the collapse." - source Reuters
And this is indeed is a big if à la Cinderella's golden carriage being able to return before midnight no offense to Macquarie. If we want to add more "ammunitions" to our "simple" macro convex trade we can simply point out to a few factors, one being the approximate direct contribution of China tourist revenues as a percentage of GDP in 2014 and 2015, as indicated by CITI in their very interesting Emerging Markets Macro and Strategy Outlook - Prospects for 2016" recent note. Spot the "outlier":
"Direct contribution to GDP on recipients of China outflows are very small for most except in “special” territories (Macau, HK), which are suffering from a Chinese tourist slump. While tourist arrivals are booming in Japan, the biggest beneficiary of strong mainland arrivals relative to the size of their economy appears to be Thailand.
A second important constraint is the overhang from the build-up of nonfinancial private sector leverage, in the backdrop of a maturing credit cycle.
While we don’t expect any disorderly deleveraging/credit crunch given stronger balance of payment/less FX mismatch risks for most (though Indonesia corporates have some issues), with room for some to pursue counter-cyclical monetary easing in contrast to the Fed rate hiking cycle, there are a few FX-managed regimes with very open capital accounts– HK and Singapore – that inevitably will see rates rise alongside the US and will need some monitoring, especially given its knock-on impact on property markets and household balance sheets. Moreover, persistent capital outflows could tighten domestic financial conditions, especially for those without offsetting current account buffers and/or had been significant recipient of those volatile types of capital flows– e.g. Indonesia and Malaysia look vulnerable here. Even if central banks keep monetary conditions accommodative through interest rate and liquidity tools, we note that many countries in Asia -- notably China, HK and ASEAN countries – have seen a notable rise in “credit intensity” of output in the post-GFC years. We think this is a sign of credit being increasingly allocated to less productive sectors that, over time, manifests itself in weakening cash flows relative to debt service payments. This dynamic will lead to two things: first, greater demand for balance sheet repair among indebted entities, which will drag aggregate demand, or second, if balance sheet is irreparable, rising default rates and loan losses in the banking system, which will then feed into tightening of credit standards and higher costs to credit. Our bank analysts see the biggest NPL risks arising in China, Indonesia, Thailand and eventually Malaysia. Thus, a more mature phase of the credit cycle will mean that even the effectiveness of monetary policy as a counter-cyclical policy easing will weaken." - source CITI
Very open capital accounts means that as CNY/Yuan downward pressure continues to intensify, the pressure upwards on HKD will intensify leading to more and more intervention from the HKMA to defend the peg. Defending a peg, as clearly shown by the Swiss National Bank (SNB) in 2015 works, until it doesn't.

If indeed Hong-Kong is highly dependent on Chinese tourism, then particularly the study of the "Luxury" sector and the CNY/Yuan impact is paramount. When it comes to the "Luxury" sector and Hong-Kong, we read with interest Bank of America Merrill Lynch's Luxury Goods note from the 7th of December entitled "2016 years ahead: Luxury sector embedded with earnings & valuation risk":
"2016 likely to be another weak year for Hong Kong, don't count on the weak base to support growth 
The weakness in Hong Kong is driven by lower traffic. Total visitation is flat in 2015 ytd, but down about 7% in the last 3 months. The quality of the tourist is also lower, which is leading to lower conversion rates & basket sizes. Most European luxury companies have reported Hong Kong revenues down 15-25% in the most recent quarter. Based on conversation with Hong Kong based luxury companies weak trends have continued into October despite an easy comparison base, which included the impact of Occupy Central last year. The outlook for 2016 remains subdued.

We track Watches & Jewellery retail sales to gauge luxury market demand in Hong Kong. In 2015 ytd HK Watches & Jewellery retail sales are down -13.1%, with September down 23% despite an easier comparison base. September volumes decreased 16.7% and average selling price was down by 6.2% in the month. This is shown in the charts below.

We believe monthly retail turnover for Harbour City & Times Square luxury malls in Hong Kong also provide a guide to market growth. Revenue is down around 9-10% in 2015 ytd, with the biggest declines since in the most recent quarters. This is shown in the charts below.
- source Bank of America Merrill Lynch
Now if tourism growth is close to zero and direct contributions from Mainland China tourists amounts to more than 12% of  Hong-Kong to GDP, we hope "Cinderella" investors have not forgotten that indeed the "golden carriage" can turn into a "pumpkin".

Indeed has shown in Bank of America Merrill Lynch's note, it seems the Hong Kong "golden carriage" is losing some of its appeal. We do like to track "traffic" as great macro "growth" indicators, such as Air Cargo, Container traffic and many more. What is indeed of great interest is that no new seats are being added to China-Hong-Kong flight routes for 2016 YTD:
"Hong Kong continues to lose its appealChinese consumers no longer see Hong Kong as an attractive luxury shopping destination. We think this stems from a lack of newness, increased social tension, occupy central and a strong HKD.
Total visitation is flat in 2015 ytd, but down 7% in the last 3 months, which reflects the decline in Chinese inbound tourism. However this still under-states the decline being felt by luxury companies in HK given the quality of the tourist is also lower, which is leading to lower conversion rates & basket sizes. Chart 76 shows no new seats are being added to China-Hong Kong flight route for 2016 YTD, suggesting the underlying weakness in traffic is expected to continue.
- source Bank of America Merrill Lynch
And of course the winner of the "currency war" when it comes to the "Shrinking pie mentality" we discussed in April 2014:
"When the economic pie is frozen or even shrinking, in this competitive devaluation world of ours, it is arguably understandable that a "Winner-take-all" mentality sets in." - source Macronomics, April 2014.
No wonder Japan is "winning it all" when it comes to tourists and "competitive devaluation" as indicated by Bank of America Merrill Lynch:
"Japan has grown 100% in 2015, strong growth likely to continue as appeal picks up
The number of China outbound tourist to Japan has increased by more than 100% in 9m 2015. This has led to 35% growth in luxury consumption in Japan. We expect Japan to continue to take share from Hong Kong, which is still 7x the size in terms of inbound tourist from China. As a result we expect ongoing solid luxury goods revenues in Japan (+25% cFX), despite a very tough comparison base. 

Chart 78 15-20% more seats are being added to China-Japan route for 2016 YTD, suggesting the increased in traffic is expected to materialise.

- source Bank of America Merrill Lynch
So, from an "allocation" perspective, if you want to play the "luxury" and "tourism" theme, then "overweight" the "golden carriage" in Japan, as Hong-Kong is more likely to turn into a "pumpkin"....but we ramble again.

Also with continuous pressure on China's FX reserves  which have fallen by $87.2 billion to $3.44 trillion at the end of November, from $3.53 trillion a month earlier, and in conjunction with China 's bad exports/imports data (-6%/-8%) this will further accentuate the pressure on the HKD in the coming year. The latest CNY/Yuan picture, graph source Bloomberg:
- source Bloomberg.

On that matter we read with interest Société Générale's take on the subject:
"China's FX reserve data, released yesterday morning European time, had an impact on Asian markets today. The USD 87.2bn fall was a good bit bigger than expected, even if about half off the fall is due to FX valuations. Throw is some more weak trade data this morning (surplus USD 54.1bn as exports fall 6.8% y/y, imports fall 8.7%) and the stage is set for more CNH weakness. As USD/CNY edges higher again, to 6.42, the currency's stealth-like depreciation since the start of November is looking less stealthy. Once USD/CNY breaks 6.45 or USD/CNH breaks 6.50, this is likely to be a major source of concern to markets globally, let alone in Asia." - source Société Générale
If Asia is one the receiving end of further "Chinese" devaluation, then, for us, Hong-Kong is indeed in a "very weak position" to maintain both its peg and its competitivity. Something is going to give we think.

Furthermore, as we mused in our November 2014 conversation "Chekhov's gun":
"Interesting thing happens during currency wars, currency pegs like cartels do not last eternally." - source Macronomics - November 2014.
 We would also like to point out that, in similar fashion AAA ratings are a "dying breed" and "golden carriages" often return to "pumpkin" state, currency pegs are not eternal as we reminder ourselves in our long September 2015 conversation "Availability heuristic - Part 2":
"There is indeed a clear trend in "de-pegging" currencies in the Emerging Market world, but in Developed Markets (DM) as well, the CHF event of this year has shown that pegging a currency in the current monetary system is bound to fail at some point. The sovereign crisis in Europe has also shown the inadequacy of the Euro for various European countries with different economic and fiscal policies as well as different composition (hence our negative stance on the whole European project...).
When it comes to our recent "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop" - Macronomics
 - source of the table - Société Générale
More closely to "home", in Europe that is, of course we continue to believe that Denmark will as well eventually be forced to "ditch" its peg to the Euro. On that take we read with interest Bloomberg's article from the 7th of  December entitled "Currency Battle-Front Reset as Danes Seek Euro Peg Normalization":
"While Denmark won its battle against currency speculators earlier this year, there’s still far to go before the central bank can consider a “normalization” of its monetary policy.
Governor Lars Rohde says Denmark’s benchmark interest rate will over time be closer to the European Central Bank’s. The Danish deposit rate is now minus 0.75 percent, and the ECB’s is minus 0.3 percent. Denmark pegs its krone to the euro in a tight band, forcing the central bank to track ECB policy closely.
“One might ask if minus 0.75 percent as a marginal rate is normal, and the answer is that it’s probably not and neither is minus 0.3 percent at the ECB,” Rohde said on Monday in an interview in Copenhagen.
How soon Denmark acts to reduce that spread “will largely depend” on the actions of the ECB. President Mario Draghi’s decision last week to deliver a smaller-than-expected stimulus package certainly provided relief to the Danish central bank. “It turned out to be very easy not to do anything,” Rohde said.
The ECB on Dec. 3 cut its deposit rate less than some traders and investors expected. It also extended, but didn’t raise, its bond-purchase program. The news sent the euro more than 3 percent higher against the dollar and took pressure off a number of central banks across Europe that had previously struggled to prevent their currencies from strengthening against the euro.
“The projected krone appreciation pressure is unlikely to intensify materially after the ECB left the big easing bazooka at home,” Danske Bank analysts said in a note on Tuesday. The Danish central bank “effectively delivered a small rate hike by not shadowing the ECB last week.”
Nykredit, Denmark’s biggest mortgage bank, says Denmark is now set to raise rates twice next year, following the “soft” package unveiled by Draghi last week."  - source Bloomberg
While indeed the Danish central bank has won a battle, it hasn't won the war and at some point we think, that in similar fashion to the SNB, it will lose the war but that's another story.

When it comes to Denmark, and in particular the "game of survival of the fittest" being played in this "shrinking pie mentality" world, we previously pointed out Danish A.P. Moller Maersk as a "survivor" in the container shipping industry in our August 2012 conversation "The link between consumer spending, housing, credit and shipping":
"If you want to pick winners in this survival of the fittest contest, you have A.P. Moeller-Maersk A/S investing in fast and fuel efficient vessels (Maersk vessels are designed to operate efficiently at both high and low speeds),  and so is Evergreen Group, owner of Asia's second biggest container line is as well adding more fuel efficient vessels to its fleet as well as Neptune Orient Lines Ltd" - source Macronomics - August 2012
What is getting us more and more worried for the  probability of the "golden carriage" to turn into a "pumpkin" is that even our identified "champion" has not been immuned to the very strong deflationary forces at play and is in fact moving towards "loss-making". This brings us to our second point of our conversation.

  • Container shipping and large surge in US inventories, a great cause for concern
Containerized traffic is dominated by the shipment of consumer products. Weaker traffic means very simply weaker demand (and no we don't care about what European PMIs are supposedly saying).

Back in March 2012 in our conversation "Shipping is leading deflationary indicator", we argued that shipping was in fact an important credit and growth indicator, but most importantly a clear deflationary indicator. We also indicated that consolidation, defaults and restructuring were going to happen, no matter what in the shipping industry, and guess what, it did! Not to mention the fact that we indicated some forced exposed players such as Commerzbank with their nonperforming shipping loans had resorted to running themselves the ships rather than recognizing the losses as pointed out in our June 2013 conversation "Lucas critique":
"In similar fashion to the extend and pretend game being played by banks relating to their real estate exposure and negative equity, some German banks, which total exposure to shipping loans amount to 125 billion USD with a nonperforming ratio of 65%, have resorted to avoid recognizing the losses by acquiring some ships in a bid to salvage their bad loans as reported by Nicholas Brautlecht in Bloomberg on June 13 in his article "Commerzbank Acquires First Ships in Bid to Salvage Bad Loans":
"Commerzbank AG, the German lender whose soured shipping loans prompted a ratings downgrade by Standard & Poor’s last month, is taking the helm as it tries to salvage some of the 4.5 billion euros ($6 billion) it holds in bad debt from the crisis-hit industry.It plans to take over two feeder ships from debtors this month, holding off on a sale until values recover, said Stefan Otto, 42, the head of the shipping unit. The vessels, which can transport as many as 3,000 standard 20-foot containers, or TEU, are the first the Frankfurt-based bank will actively manage as part of a goal to reduce shipping losses and exit ship financing." - source Bloomberg" - Macronomics - June 2013
If indeed our favorite "survivor of the fittest" Danish giant A.P. Moller Maersk is turning into "loss-making", then indeed, we would caution investors to start in earnest to think about "battening down the hatches" to use a shipping analogy.

On the subject of shipping we read with great interest Nomura's Special Report on Container Shipping entitled "Counting Containers - Unprecedented action required" published on the 26th of November:
"Container shipping lines have a choice: return chartered vessels, or face the consequences

Supply-demand balance to deteriorate significantly in 2016-17E
Supply outstripping demand is nothing new in the container shipping industry, as evidenced by nominal capacity +53% during 2008-14, vs volumes +22%. What is new, however, is that slow steaming – which absorbed 26% of capacity during this period – is now reversing, adding new capacity on top of that provided by the orderbook. With nominal capacity expected to increase by 5-6% CAGR during 2016-17E, and volumes unlikely to exceed 3%, the supply-demand balance is set to deteriorate even without increased vessel speeds. If this trend continues, the industry will face an even more severe imbalance.
Freight rates can – and most likely will – decline further
With headline freight rate indices currently at historical lows, further reductions may appear unlikely. However, on a cost-adjusted basis, freight rates remain well above the trough levels seen in 2009 and 2011, periods during which the industry suffered heavy losses. With supply-demand set to deteriorate, and contract rates to be revised downwards, we believe freight rates can – and most likely will – decline further, driving the industry back into financial losses. 
Maersk Line case study provides some grounds for hope… 
With supply-demand fundamentals overwhelmingly bearish, container shipping investors could be forgiven for giving up hope. However, our analysis shows that, if other shipping lines follow Maersk Line's successful recent strategy – of maximising utilisation rates by returning chartered capacity to owners – the supply-demand imbalance can be rectified, with persistent losses averted.
…but only if the industry can act with unprecedented discipline
Our analysis shows that competitor shipping lines should narrow Maersk Line's cost advantage during 2016-17, but only if utilisation rates can be maintained. Returning chartered capacity to owners, culminating in a significant increase in idled capacity, provides the best means to facilitate this. Yet we estimate idled capacity would need to reach 14% for this to be achieved – materially ahead of the previous peak of 11-12% seen in 2010. Whether the container shipping industry has the discipline required to achieve this, only time will tell.

- source Nomura
When it comes to "hope" being a bad "strategy" such as expecting a "golden carriage" not to return to its initial "pumpkin" state, we reminded our thoughts from January 2013 from our conversation "The Fabian Strategy":
"People are trading on hope: "Please make Mario Draghi keep his word", we could posit in similar fashion to what we commented in our September 2011 conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!""So far the devil's best trick has been to persuade us that risk-free interest rates did exist. It ain't working anymore and that is a big cause of concern." - Macronomics.
We could not resist but we chuckled when we read the following comment from a credit desk:
"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."
Looking at the growing divergence between "hope" (equities) and reality (US High Yield), we wonder when "reality" will settle in. Could it be that in 2016 we will see the return of the "pumpkin"?

When it comes to the "reality" that can be assessed from Shipping, demand outlook is not favorable as pointed out by Nomura in their special report:
"Demand outlook remains tepid, at best
The world has changed. Let’s accept it and get on with it
The days of 3-4x GDP multipliers are gone – possibly forever
The 3-4x multiplier of GDP at which global container volumes used to grow is well known – for instance, with the volume CAGR of +12.5% seen during the period between China joining the WTO in December 2001 and the start of the global financial crisis (GFC) in 2008 equating to an average GDP multiplier of 3.8x.
Since this time, the high growth rates of 14.9% seen in 2010 and 7.4% in 2011 were driven by the end of destocking, which occurred towards the end of 2009, rather than underlying strength. When global inventory levels had returned to more normalised levels, the volume CAGR of 3.5% seen during 2012-14 equated to an average GDP multiplier of 1.4x.
2015 will likely be the first ‘normal’ calendar year to see a multiplier <1 b="" x="">
We often find that investors and industry commentators alike take a global container GDP multiplier in excess of unity for granted. Yet a multiplier of 1.0x was recorded for 2013, and for 2015 we expect volume growth of c+0.8%, equal to just 0.3x of the 2.9% increase in global GDP that is forecast by the OECD.
This would be the first time, on our records, that the global container volume multiplier has fallen below unity during what we consider to be a relatively ‘normal’ calendar year of economic activity.

…but this is not unprecedented on a rolling 12-month basis
On a rolling 12-month basis, the global GDP multiplier has already fallen below unity during what we classify as a ‘normal’ period without any major macroeconomic fluctuations or inventory swings – specifically, the 12-month period to 4Q13.
Although this weakness was only temporary, we do consider it to be important, given that it demonstrates that, even during a period of steady-state economic conditions, a global container GDP multiplier of less than 1.0 x is not unprecedented.
Looking ahead, ‘GDP plus a bit’ feels about rightAlthough forecasting global container volume growth will never be a precise science, we continue to believe that a growth rate of ‘GDP plus a bit’ remains an appropriate rule of thumb. We assume a multiplier of 1.1x for 2016-17, consistent with the 1.0-1.3x range that we consider to be reasonable during steady-state economic conditions. 

In reality, fluctuations during this period are inevitable, but for reasons that are difficult or impossible to forecast (eg, inventory movements, currency swings, technological changes, among others). As such, we do not attempt to incorporate such factors into our mid-term forecasts." - source Nomura
Conclusion: secular stagnation is here to stay and one can expect "rates" to stay lower for longer and demand to be weaker as well. "Mind the gap" between effective capacity and total demand as it is widening...because "demand" is not outstripping "supply". Another illustration of the "shipping glut", is that for the first 10 months of 2015, Chinese ship builders saw orders for new vessels plunge 62% from to same period last year, for a total of 20.3 million tons, according to data from the China Association of the National Shipbuilding Industry (CANS)

Apart from "weaker demand" another concern which has been highlighted justifiably so is the current US level of inventories. This worrying trend has been as well clearly highlighted in Nomura's recent Shipping special report:
"US inventories peaked in February 2015, at a level that warrants major concern
Although our analysis suggests the destocking that has prevailed in Europe during 2015 will soon moderate, the situation in the US suggests concern for import volumes in 2016As shown in Fig. 43, the total business inventories-to-sales ratio spiked up sharply during the several months to February 2015, and showed smaller increases during the months leading into September 2015.

This upward movement bucks the downward movement in US inventories-to-sales that has prevailed over the past 20+ years, and after controlling for this trend by considering inventory-to-sales in terms of the number of standard deviations from the trend line, the recent upward spike in inventories is even more apparent. Specifically, inventories-to-sales are more than 1.5 StDev from the trend, not far off the peak of 2.0 StDev seen in January 2009, around which time US imports fell precipitously.

Irrespective of the sector, US inventories appear ominously highFigs. 45 and 46 summarise the split of US Business inventories (measured in US dollars) between the retail, manufacturing and wholesale sectors. The current share is remarkably uniform, with manufacturing the largest sector with a share of 36%, but retail and wholesale not far behind on 32%.

- source Nomura
You can expect this level of inventories to be a drag on fourth quarter GDP when the Fed is about to "hike" in a weak demand environment. It looks like the "fairy godmother from the Fed" aka Janet Yellen is about to pull the spell which has so far being "levitating" the "golden carriage".

When it comes to continuing with the "golden carriage", one thing we are certain in 2016 is that the global "de-equitisation" process will continue to run its course and generates further instability into the financial system as per our final point.

  • Final chart - Global equities: more de-equitisation to come in 2016
In June 2015 in our conversation "Eternal Return" we made the following point:

"The "de-equitisation" process is a cause for concern as it creates increasing instability in the financial system. It will as well reduce significantly the recovery value in the next credit downturn with rising defaults we think." - Macronomics, June 2015.
The above debilitating effect on corporate balance sheets was already highlighted in October 2013 in our conversation "Credit versus Equities - a farming analogy" we indicated the following:
"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, October 2013.
What is concerning is that ZIRP has accentuated the "de-equitisation process fueled by "cheap credit". This has also been again indicated by CITI in their Globaliser Chartpack from the 30th of November 2015 and is our chosen final chart:
"Global equities: more de-equitisation?De-equitisation should remain a key global investment theme for the next 12-18 months; the most represented sector in the screen is Consumer Discretionary (13 out of 50), followed by Industrials (9)‘More de-equitisation’, declares Global Strategist Robert Buckland, ‘for deequitisation should remain a key global investment theme for the next 12-18 months.The cost of equity remains high relative to the cost of debt, so it makes sense for companies to de-equitise – use cheap financing to buy back their own shares. Since 2011, global non-financial corporates have bought back over $2.2trn of their own shares (equivalent to 9% of average market cap over the period). The most represented sector in the screen is Consumer Discretionary (13 out of 50), followed by Industrials (9). Share buybacks is currently a very US-heavy theme; we also note positive momentum in Japan. Names like Ahold, Boeing, Xerox, Allstate, Adecco and Yahoo! feature’." - source CITI
In 2013 we concluded our 2013 conversation as follows:
"We can therefore make this over-simplistic yet provocative conclusion that:
Equities = Freedom
Debt = Road to serfdom"
Although the "fairy godmothers from the Fed" did put a spell on for many years, we think we are indeed coming closer to midnight and the "Cinderella" investors of the world would be well advised to "hedge accordingly" before they are left holding the "pumpkin", as it looks increasingly clear to us that 2016 will be indeed a very challenging year.

"A powerful idea communicates some of its strength to him who challenges it." - Marcel Proust, French writer

Stay tuned!

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