Saturday, 5 May 2018

Macro and Credit - The Wilson cycle

"Economic progress, in capitalist society, means turmoil." -  Joseph A. Schumpeter

Looking at the growing outflows in the Emerging Markets hard dollar bond funds universe and with the Mexican Peso and Turkish currency taking a correlated pounding, when it came to selecting our title analogy we decided to go for a seismic one such as The Wilson cycle, given we are wondering if indeed following the short-vol pigs house of straw blow up, we are wondering if the house built by the "carry tourists" pigs is next on the line. The Wilson cycle is a model where a continent rifts, from an ocean basin in-between, and then begins a process of convergence that leads to the collision of the two plates and closure of the ocean. Obviously, Quantitative Tightening initiated by the Fed, one might opine, is leading to the closure of the "ocean of liquidity". The model is named after its originator John Tuzo Wilson. Emerging Markets have been impacted by the return of US rates into positive real yields territory as we argued in our conversation "Osmotic pressure" back in August 2013 during "Taper Tantrum":
"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013
The mechanical resonance of bond volatility in the bond market in 2013 started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:
"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."

Of course, what we are seeing right now in Emerging Markets is the continuation of "reverse osmosis" but we ramble again...

In this week's conversation, we would like to look at the potential blow-up of the carry trade, and the pressure it is putting on specific Emerging Markets such as Mexico and Turkey. If indeed the short-vol pigs house of straw was the first casualty, one might wonder if after the little fishes, some larger whales might turn up "belly up" thanks to QT and reverse osmosis.

  • Macro and Credit - Allocate to cash in US dollar because the tourist trap is closing 
  • Final chart -  Dude where is my raise?

  • Macro and Credit - Allocate to cash in US dollar because the tourist trap is closing 

The "Tourist Trap" (a tourist trap being an establishment, that has been created or re-purposed with the aim of "attracting tourists" and their money), is in effect closing, hence our "Wilson cycle reference given we are facing a dwindling "ocean" of liquidity. In our previous conversation we indicated that cash has made a return in the allocation tool box. We do think that while cracks have starting to show up in the credit narrative, pointing to a slow turn in the credit cycle, we are closely looking at what is happening right now in Emerging Markets. We are wondering if indeed the next shoe to drop following the short-vol explosion will not be an unwind in the "carry trade". 

On the subject of additional "canaries" showing up in the credit "coal mine" we would tend to agree with our former esteemed colleague David Goldman's recent post in Asia Times from the 2nd of May entitled "Canaries start to die in coal mine":
"Emerging market carry currencies are the financial assets most sensitive to tightening of global financial conditions — the proverbial canaries in the coal mine. The near-perfect correlation between the Mexican peso and the Turkish lira during the past two weeks strongly suggests that a global shift out of highly-levered assets has begun, starting with the most exposed assets.

There are political problems bearing on both TRY and MXN, to be sure, but they are entirely different; MXN doesn’t care about Syria (the currency is positively exposed to oil prices in a small way), while TRY doesn’t care about the NAFTA negotiations. Mexico does most of its trade in dollars with North America, while Turkey does most of its trade in euros with the EU.
The fact that they have traded in virtual lockstep suggests that the problems that afflict each country separately have little to do with the trading patterns of the past couple of weeks. A global monetary phenomenon — a general tightening of credit conditions — appears to have begun at the weakest point in the credit system." - source David Goldman - Asia Times
You probably understand more about our "tectonic" reference pointing towards the closing of an ocean of liquidity where macro tourists have been basking in recent years. We are closely watching outflows in Emerging Markets given they have been significant as indicated by Bank of America Merrill Lynch GEMs Flow Talk note from the 4th of May entitled "EXD bleeding escalates...ETFs EXD suffering the biggest outflows":
ETF flows were down hardest: EXD (-1.0%), LDM (-0.7%)

EPFR fund flows down: EXD (-0.5%), LDM (-0.1%), -0.3% total, +0.1% blended funds and +0.1% EM equity. EM debt inflows YTD at 2.8%.
Rotation out of EXD into LDM
Investors are rotating toward local markets debt (LDM) vs external debt (EXD) now at a rate of $500mn/wk, while six months ago the preference was the opposite – over $500mn/wk in favor of EXD vs LDM. These rotation flows are based on EPFR LDM flow - EXD flow weekly average over 3 mo.
By looking at the difference in EXD vs LDM flows from EPFR, we remove some of the effect of general flows of all debt or EM classes (Chart 1). These rolling 3m flows show strong EXD outflows this year, with LDM compensating. Further problematic is the high March issuance.

LDM Real Money Positioning: Our Asia strategists launched our real money positioning tracker to see the allocation of 28 EM local currency bond funds versus the JPM GBI-EM in mutual funds of 28 large managers ($58bn AUM) (GEMs Viewpoint: Tracking real money positioning 25 April 2018). This will help identify significant benchmark deviations and potentially give some indication of future movements in FX and bonds.
Total foreign holdings of LDM: Outflows in March so far
• March China inflows of +$3.2bn do not even cover other country outflows reported so far: total -$0.1bn. China inflows more than offset outflows elsewhere in last 6m.
Flows winners: China and Mexico
• March: China (+$3.2bn), Mexico (+$1.4bn). Wk ending April 20: Mexico (+$0.5bn), Turkey (+$0.5bn).
Flows losers: Brazil
• March: Brazil (-$4.3bn); Wk ending Apr 27: Indonesia (-$1.6bn) and India (-$0.3bn).
After 2013 retail investors never came back
In 2013, retail investors and small institutions were sellers and large institutional investors were buyers, adding as asset prices fell. Most of the weakest hands in 2013, who were small retail investors, never returned to EM debt markets (Charts 23 and 25):
- source Bank of America Merrill Lynch

Whereas we pointed out in previous conversations that US High Yield was still in the retail's feeble hands, it is not the case since the 2013 Taper Tantrum for Emerging Market Debt Markets. The big question of course in the coming weeks will be surrounding the pace of the "derisking" being currently seen. Is it about to get worse one might rightly ask.

On this question we read with interest JP Morgan's take from their Flows & Liquidity note from the 4th of May entitled "Is the EM selling overdone":
  • We find that the EM position reduction over the past two weeks was confined to hedge funds.
  • Real money EM equity and bond managers do not appear to have reduced their exposures materially over the past two weeks.
  • Retail investors’ selling has been modest also.
  • We thus conclude that EM selling is not overdone and that EM assets still look vulnerable if real money investors decide to join hedge funds in reducing their EM exposure.
  • US banks sold bonds YTD raising questions about bond demand for this year.
  • However, we believe that this selling was partly distorted by one-off factors and that the average bond buying by US banks since last October is a better reflection of the underlying pace.
EM assets, which up until mid April were perceived to be relative immune to the weakness in DM asset classes, slumped over the past two weeks posting the steepest underperformance since the third quarter of last year. Who has been driving this sharp reduction in EM exposures over the past two weeks and how far are we from capitulation?
EM dedicated hedge funds appear to have been mostly responsible for the recent EM correction. This is shown in Figure 1 which depicts the beta of EM dedicated hedge funds proxied by the HFRX EM Composite Index vs. the JPM EM currency index. EM currency exposure represents an important component of both EM equity and EM bond exposures and thus the single best metric to assess EM hedge fund betas.
The betas in Figure 1 are proxied by the ratio of the performance of EM hedge funds over a particular time period divided by the return of the JPM EM currency index over the same period. The time periods in the beta tables are chosen so that there is enough change in the underlying currency index. Otherwise too small changes can create spikes in the calculated betas due to very small values of the denominator.
Figure 1 shows a big and abrupt drop in EM hedge fund beta to the EM currency index for the most recent period since April 19th, pointing to currently low EM exposure and the lowest since last November. Effectively, the entire previous rise in the EM hedge fund beta seen between November last year and March this year has been unwound in recent weeks.
However, in contrast to hedge funds, real money EM managers do not appear to have lowered their beta over the past two weeks. We proxy EM real money managers by the 20 biggest EM active equity mutual funds and the 20 biggest EM active bond mutual funds, the betas of which are shown in Figure 2 and Figure 3.
Similar to hedge fund betas in Figure 1, the betas of EM real managers in Figure 2 and Figure 3 are proxied by the ratio of the performance of EM active equity or bond mutual funds over a particular time period divided by the return of the MSCI EM index or the GBI-EM unhedged local bond index respectively, over the same time period. Again the time periods in the beta tables are chosen so that there is enough change in the underlying equity or bond index to avoid spikes in the calculated betas.
Figure 2 and Figure 3 show little change in the betas of real money EM equity or bond managers, pointing to little position adjustment by them over the past two weeks.
What about retail investors? Figure 4 and Figure 5 depict the EM equity and bond ETF flows by week. The outflows over the past two weeks have been rather small in both the equity and bond ETF space suggesting that retail investors likely played a small role in the recent EM correction.

The muted selling by retail investors over the past two weeks perhaps reflects the fact that retail investors’ inflows into EM funds were rather modest in previous months before April, so there was not a big ramp up that needed to be unwound. Or it could reflect the relatively low or average shares of EM in the equity or bond ETF universe, suggesting that retail investors are not overweight EM. These EM shares in the equity and bond ETF universes are shown in Figure 6 and Figure 7, respectively, over the EM shares in global equity and bond indices.

The share of EM in the bond ETF universe has been declining this year and stands at its lowest level since the beginning of 2017, post the US election. The share of EM in the equity ETF universe has been rising this year but stands in the middle of the past few years’ range.
What about currencies? What picture do we get from the available spec positions on EM currencies? We use two proxies to gauge overall EM currency positions: 1) the aggregate spec positions on the USD (Figure 8) and 2) our spec position indicator on Risky vs. Safe currencies (Chart A17 in the Appendix).

The former suggest that a previous short base in the USD is still being covered but has yet to be covered completely. The latter suggest that while “Risky” currencies including EM currencies saw a significant reduction in their positions vs “Safe” currencies, they are still far from capitulation.
In all, we find that the EM position reduction over the past two weeks was confined to hedge funds. Real money EM equity and bond managers do not appear to have reduced their exposures materially over the past two weeks. Retail investors’ selling has been modest also. We thus conclude that EM selling is not overdone and that EM assets look still vulnerable if real money investors decide to join hedge funds in reducing their EM exposure." - source JP Morgan
We would have to agree with JP Morgan, that when it comes to the build up in the "osmotic pressure" and the slow turn in the "Wilson cycle", this doesn't mark the beginning of the end but most likely the end of the beginning to paraphrase Winston Churchill. "Smart money" aka Hedge Funds have already proceeded in reducing their beta exposure whereas "Real money" has not even started. When it comes to retail, as pointed out by Bank of America Merrill Lynch's note, they are pretty much not into the "game" so they do not represent a concern when it comes to EM outflows we think. 

What we think is happening in conjunction with the Fed's QT is that the carry trade is fading and losing its allure, this is of course putting pressure on fund flows as US dollar cash becomes more appealing from a risk reward and low beta perspective. The reduction of the "beta" factor coming from FX carry in EM has been highlighted by UBS in their Global Macro Strategy note from the 20th of April entitled "Lesson Learned: All dressed up with nowhere to go":
"Drivers of equities and currencies are diverging
Over the last two years, EM equities have been driven largely by the tech cycle. But a tech boom does precious little for EM currencies; the countries that make up pretty much the entire EM tech index—China, Korea, Taiwan—have historically been amongst the most interventionist central banks. To the extent they are driven by one variable, EM currencies price off the commodity cycle, which typically coincides with a weak USD cycle. A caveat, though: supply-driven oil price gains, which we are arguably witnessing today, have had little discernible impact on EM assets.
Growth thresholds not being met
Lastly, under the radar, EM growth has been slowing sequentially, with annualized GDP growth coming in at 3.3% (Q4 2017); still better than the sharp slowdown of 2015/2016, but only just. This occurred as DM growth has sequentially improved. And EM growth has had to rise to around 5% for EM currencies to appreciate in trade weighted terms (Figure 5). We are just about half way off that mark.

What to do? Beta is not your friend in this asset, but alpha is still interesting
A 'global' or common factor defining performance across EM currencies, as measured by the first principal component, has fallen sharply over the last two years (Figure 6).

The beta call is less than exciting for EM, but there is plenty of alpha still to be had, evidenced from the recent divergent performances of Mexico and Turkey. Screening by looking for a combination of strong real rates and attractive valuations, we would highlight the RUB and BRL as good opportunities. The good news seems to be quickly getting priced in ZAR, & there is more downside to come, we believe, in the TRY.
- source UBS

As the Fed continues its hiking path, the Wilson cycle means that "carry" is less and less a source of "beta" in the EM world, which will no doubt put additional pressure on Emerging Markets bond markets we think as the "Ocean" of liquidity is slowly but surely closing. On the fall of carry, we read with interest Bank of America Merrill Lynch Cause and Effect note from the 30th of April entitled "The stars are finally aligned":
"Central bank reserve rebalancing:Swings in the foreign reserves of emerging central banks can have a big impact on the USD against other reserve currencies. For example, USD tends to fall against the EUR when these reserves are going up while the USD tends to rise when they fall (Chart 6).

Following the violent capital flight from emerging markets in 20 15 (during which the USD appreciated 20 % against the EUR), investors began to tiptoe back to EM in 20 16. A trickle turned into a flood and we saw a record 50 weeks of inflows into EM fixed income funds in 20 17 (GEMs Flow Talk, December 22). This allowed EM central banks to rebuild their reserves which in turn would have led them to sell USD against the likes of the EUR and the JPY. There are signs that the pace of reserve accumulation may be about to slow once again. Over the past month, EM equities have been underperforming their developed market counterparts which have slowed inflows (Chart 7).

Moreover, with many EM central banks (eg, Brazil, Russia) having cut rates in the face of Fed hikes  over the past year, carry offered by EM fixed income assets has fallen to the lowest levels since 20 12 (Chart 8) when depressed EM risk premium worsened the exit from the asset class in 20 13.
 - source Bank of America Merrill Lynch

While the retail macro tourists got burn during the Taper Tantrum of 2013 in Emerging Markets playing the high beta game, many investors have extended their stay. Given the "smart money" is already leaving the "beta party", one might indeed wonder if in true "Wilson cycle" fashion we are heading towards more trouble ahead with this time around our "reverse osmosis" thesis playing in earnest. We do think there is more "macro" volatility coming, particularly in Emerging Markets hence our recent focus on US dollar cash thesis as far as allocation is concerned. If indeed Turkey and Mexico are the canaries in the "carry" coal mine then again there is potential for more trouble ahead. On this particular matter we agree with Kit Juckes take from Société Générale in his Forex Weekly note of the 12th of April entitled "Is a new age of turbulence coming":
"Is a new age of turbulence coming?
When the dollar de-couples from US rates, financial market turbulence seems to come along at the same time. So far, all we have are (geo-political) straws in the wind, but after the relative calm of 2014-2017, when everyone stuck to the task of buying yield and selling volatility, we may be in for a sustained period of FX/rate de-coupling that eventually leads to a higher volatility regime.
The collapse of the correlation between currency pairs and relative interest rates (short, or long term, real or nominal) has been one of the challenges facing the currency market in recent months, along with the divergence of G10FX volatility from anything happening elsewhere and, during the last three months, the tendency of the EUR/USD to meander around in a narrow range. The chart below plots the rolling 75-day correlation between the DXY index and 10-year Treasury yields, which has now turned negative.

What we have seen so far is by no means a confirmed change of long-term regime. As the chart shows, even if I break the last 27 years down into five periods of positive and negative correlation, there have been a number of short-lived breaks. But it’s interesting to think about the FX/rate regime in this way, all the same. This would be the third time we saw the correlation turn negative for a sustained period. The first came with the 1994 Fed rate-hiking cycle, when higher US rates triggered risk aversion, emerging market weakness and a lot of yen strength. The correlation remained negative on balance for the rest of the decade, until the end of the Fed tightening cycle, after the LTCM collapse and the Russian default. The second break came ahead of the financial crisis in 2008 and lasted until after 2013’s taper tantrum, when the market started to price in Fed rate hikes and the dollar rallied. If these two episodes share anything, it’s market turbulence.
Perhaps the clearest conclusion for me is that the periods of non or negative correlation between the dollar and rates have come at times when equity volatility and corporate or emerging market credit spreads have been wide. Of course, there’s the question of what is the chicken and what is the egg in this regard, since a spike in vol can drive yields down, and simultaneously drive the dollar up, but perhaps what is more important is that a persistent change in the relationship between the dollar and yields points to something more than a one-off risk event. By the same token, there’s no great surprise in the spike in USD/RUB vol or indeed in USD/TRY vol in recent days/weeks, but if we get a cluster of these unrelated, idiosyncratic events at the same time, maybe it reflects a market that has been sitting on the carry trade for too long, and whose appetite for yield has become unhealthy." - source Société Générale
We would have to agree, macro tourists carry players have been overextending their stay in the Ocean of liquidity provided in particular by the Fed and now that thanks to the Wilson cycle is turning, the Ocean of liquidity is closing. You have been warned and we would side with the wise words once again of our friend David Goldman from one of his note from the 3rd of May in Asia Times entitled "Time to be in cash":
"While trade tensions threaten to break up global supply chains, heavily-indebted emerging markets  are hanging in the balance – this isn’t a time to buy anything
 Asia Unhedged called the end of the tech boom on March 29 (The tech bubble gets its (w)reckoning). The Trump Administration poured gasoline onto the fire by cutting off ZTE’s access to US-made chips. That persuaded China that building up its own chip-making sector was not only an economic priority, but a national security requirement. And that means a global glut of semiconductors.
The SOX semiconductor index has fallen by 16% since its March 3 peak. The US negotiating team now in Beijing wants China to stop subsidizing its semiconductor industry, a difficult argument to make after refusing to sell American chips to Chinese companies. That sets up a tough outcome for this week’s trade talks, and the market doesn’t like it. A simple way to think about it is that the expansion of world trade has centered on the creation of a global supply chain in electronics and other products that maximizes efficiency and reduces prices. The trade issues between the US and China threaten to break up the supply chain.
Contributing to the shakiness of global equity markets is the rupture in some of the world’s most heavily-indebted emerging markets, notably Turkey, whose currency is in free fall and whose stock market has lost 31% in US dollar terms since its August 29th peak. Asia Unhedged has been a Turkey bear since early September, and we note with satisfaction that Turkey is the worst-performing major market in the world.
Although Chinese stocks offer good value, the threats to world trade and the prospective disruption of the global supply chain are a powerful headwind for the time being. The most widely-traded China ETF in US markets, FXI, today fell below its 200-day moving average. So it isn’t a time to buy anything. Stay warm and dry." - source David Goldman
Now if indeed we are in a Wilson cycle, then any increase in the trade war narrative will lead to a collision course and an acceleration in the drying up of the liquidity ocean provided in recent years. For that reason we remain bullish gold. On a side note we recently attended a roundtable in London with the CEO of Polymetal Vitaly Nesis. Polymetal happens to be the third global primary silver producer, the largest silver and the fourth gold producer in Russia. Vitaly Nesis is very bullish on silver and thinks the gold/silver ratio should go to 60.

As a reminder we also mused on Emerging Markets risks in our conversation "The Tourist trap" back in September 2013:
"Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: 
Wave number 1 - Financial crisis 
Wave number 2 - Sovereign crisis 
Wave number 3 - Currency crisis
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"
If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike. As a reminder and what is playing out again is what we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates". Our reverse osmosis process theory from a macro perspective can be ascertained by monitoring capital flows. Carry trades love low risk-free interest rates, but they love low interest rate volatility even more. This is why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving their risk premiums to abnormally low levels.

In our final point below, we would like to point out that once again wage growth is still tepid, so the Fed is probably somewhat relieved that the market doesn't think yet it is behind the curve (though the curve is clearly behind them, flatter that is...).

  • Final chart -  Dude where is my raise?
For the second month in a row, payrolls in the US were below consensus yet the still weak labor participation doesn't make the latest unemployment number any good. At least for the Fed, tepid wage acceleration is still supportive of their gradual hiking approach. Our final chart comes from Bank of America Merrill Lynch Securitization Weekly note from the 4th of May entitled "Recovery can be hard" and shows that there has not been any acceleration in wages in spite of declining unemployment (at the same time healthcare and rent have gone up big time...):
"Even though the unemployment rate dropped to an 18-year low in April, labor force participation dropped slightly to 62.8% and YOY average hourly earnings growth remained stuck at 2.6%. At least for now, the low unemployment rate is not translating into the requisite increase in labor force participation and wage growth that would force the Fed to change its stance to become less accommodative. That’s good news for our spread tightening view for securitized products in Q2 and beyond." - source Bank of America Merrill Lynch
It might be good news for some part of the credit markets, such as low beta, less so for the time being for both High Yield and Emerging Markets.  We have yet to see the return of "Mack the Knife" aka King Dollar in conjunction with positive real US interest rates. For the moment it seems the crown once again could go to "Cash" being the King, no offense intended to some hedge fund honchos.

"The best thinking has been done in solitude. The worst has been done in turmoil." - Thomas A. Edison

Stay tuned !

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