Macro and Credit - The recurrence theorem

"Some things never change - there will be another crisis, and its impact will be felt by the financial markets." - Jamie Dimon

Looking at the elevated volatility in Emerging Markets in conjunction with continued outflows and pressure on the asset class, on the back of rising US yields and a strengthening US dollar marking the return of "Mack the Knife", with losses not limited to the currencies but with Emerging Markets Yields continuing surging throughout, when it came to selecting our title analogy we reacquainted ourselves with French mathematician Henri Poincaré's 1890 recurrence theorem building on the previous work of fellow mathematician Simeon Poisson. In mechanics, Poincaré recurrence theorem states that an initial state or configuration of a mechanical system, subjected to conserved forces, will reoccur again in the course of the time evolution of the system. The commonly used example to explain the theorem is that if one inserts a partition in a box, pumps out all the air molecules on one side, then opens the partition, the recurrence theorem states that if one waits long enough that all of the molecules will eventually recongregate in their original half of the box. The theorem is often found mixed up with the second law of thermodynamics to the effect that some will loosely argue that there exists a very small probability that an isolated system will reconfigure to a more ordered state (thus effecting an entropy decrease).The theorem is commonly discussed in the context of dynamical systems and statistical mechanics. When it comes to pressure and outflows, as we mused in our last conversation, one would argue that continued capital outflows pressure is contained until it isn't. 

In this week's conversation, we would like to look at the return of "Mack the Knife" in conjunction with rising oil prices and what it entails. 

Synopsis:

• Macro and Credit - US yields - It's getting real!
• Final chart - US core CPI tends to rise in the two years leading up to a recession

• Macro and Credit - US yields - It's getting real!

While US 10yr Real Yields are a key macro driver, the US dollar so far in 2018 has dramatically diverge from yields. "Mack the Knife" aka the King Dollar also known as the Greenback in conjunction with US real interest rates swinging in positive territory has recently put some pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation:

"When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - Macronomics

With the start of an unwind in global carry trade,  "Mack the Knife" aka King Dollar is making a murderous ballad on the EM tourists and carry players alike. Back in July 2015 in our conversation "Mack the Knife" we indicated the following as well:

"More liquidity = greater economic instability once QE ends for Emerging Markets. 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." - source Macronomics, July 2015

The question for continued pressure on Emerging Markets when it comes to "Mack the Knife" is are we beginning to see a reconnect between the US dollar and yields? The jury is still out there. Rising Breakevens tend to be negative for the US dollar. Also what matters for US equities given they have remained relatively spared so far would be a meaningful widening in credit spreads. This would be accompanied of course by higher volatility.

Right now, as we pointed out last week, dispersion is the name of the game in both credit and Emerging Markets with the usual suspects and weaker players getting the proverbial trouncing as of late such as Turkey and Argentina. We also indicated recently that the continuous rise of volatility in Emerging Markets would lead to additional outflows given the Hedge Funds were the first to reduce their beta exposure. Some investors might follow suit and follow a similar pattern of "derisking" it seems. On the subject of continuous volatility on EM assets we read with interest Barclays take from their Emerging Markets Weekly note from the 17th of May entitled "Shaken and stirred":

"Volatility in EM assets remains elevated. As 10y UST yields have moved further above 3% and the USD has resumed its strengthening trend, total returns in EM assets have taken a further hit – which in turn continues to weigh on flows: YTD returns in EM credit and EM local markets now stand at -3.7% and -2.4%, respectively (Bloomberg Barclays USD EM Agg and EM local-ccy government bond indices), while EM dedicated bond and equity funds had their worst week of outflows last week since the volatility spike in February (see EM flows: Outflows materialize, 11 May 2018). Economic data has hardly helped to improve sentiment, with weaker European and Chinese activity data feeding concerns about weakening global growth momentum.

The market’s focus remains firmly on those countries with external vulnerabilities and financing needs, especially Turkey and Argentina. Even though current account balances can only provide a partial reflection of external positions and vulnerabilities, there has been an interestingly clear correlation between current account dynamics (changes, rather than levels) and asset performance both in EM credit (Figure 1) and local markets (Figure 2).

Although we have argued in the past that aggregate vulnerabilities have improved in EMs since the 2013 ‘taper tantrum’, they have deteriorated over the past year (see the EM Quarterly Outlook: The going gets tougher, 27 March 2018). Furthermore, the confluence of Fed balance sheet reduction, increased UST issuance, effect of US tax law changes on the repatriation of offshore USDs alongside a wider US CA deficit has implied a potentially more challenging capital flow environment for EM.

As the flow environment for financing in international markets has become more difficult, countries’ plans (or necessity) to tap primary markets have also been in the spotlight. While EM sovereign Eurobond supply has run at a record pace in January to April, recent issuance volumes have fallen short of expectations (including the recent Ghana and South Africa bond issues). We would interpret the latter point as a market positive, however. Given the frontloading of issuance in Q1, there are few countries with sizeable issuance needs for the remainder of 2018. Based on our updated supply expectations for individual countries shown in Figure 4, we now expect an additional USD 41bn of supply in 2018.

Given that c.USD104bn has been issued YTD already, this would result in 2018 full-year supply of USD155bn. In this context, we think there is an interesting divergence between Turkey and Argentina: Argentinean authorities have indicated that they do not want to issue any more in international markets in 2018. Remaining financing needs for this year are c.USD5bn on our estimates, which could potentially be covered by an initial disbursement of the requested IMF programme, or by local currency issuance. In contrast, Turkey’s fiscal measures (including this week’s announcement to reduce the special consumption tax on fuel products) will likely keep incentives to raise financing in international markets in place, even in a less receptive market.

Supply-redemption dynamics in EM credit are not the only silver lining for markets. While recent China data has been weak, we see signs of a shift in priorities towards growth, with deleveraging de-emphasised (see China: Softer FAI and retail sales; signs of pro-growth priority and trade tension de-escalation, 15 May 2018). This should in turn support commodities and while well-supported oil and commodity prices have not been able to prevent the sell-off in EM assets, they should at least provide some fertile ground for differentiation.

With regard to oil prices, Venezuela’s election on Sunday 20 May may be of particular importance (see The ship is taking on water, 15 May 2018). Even if President Maduro is reelected, against a backdrop of the main opposition parties boycotting the process and the government’s control over the electoral system, the vote could still be a catalyst for fractures within the regime. Meanwhile, Venezuela oil exports have been disrupted, amid legal action against PDVSA and a broader decline of oil production – one of the likely drivers of the recent increase in oil prices, in addition to US sanctions on Iran.

EM oil exporters naturally benefit from the surge in oil prices. In Iraq, however, this is overshadowed by uncertainties following last week’s legislative elections (and we recommend switching out of Iraq and into Angola and Gabon in our top trade recommendations this week). Full results are yet to be announced but the partial count indicates a clear defeat of current PM al-Abadi favouring cleric Muqtada al-Sadr who has called for the end of corruption and opposed both the US and Iran. The emergence of the Saeroun and Fateh coalition as winners would complicate political negotiations to form a coalition government and it is still unclear whether PM Abadi will be able to secure a second mandate. Ultimately, we believe coalition talks may be protracted, adding uncertainty to the outlook, also with respect to the IMF talks to finalise the third review under the three-year Stand-By Arrangement. The 2018 budget and transfers to the semi-independent region have represented contentious issues which could be exacerbated by negotiations between Kurdish political parties and Baghdad over government formation." - source Barclays

When it comes to "dispersion" we continue to view favorably Russian local bonds in that context, thanks to the support of oil prices on the ruble and central bank easing that will continue.  On the subject of "dispersion" and weaker players in the EM space, we read with interest UBS take from their EM Equity Strategy note from the 18th of May 2018 entitled "This is not a 'Crisis': It is Rising Yields + a Strong $":

"The central story here, in our view, is that the recent 'less friendly' global market environment has allowed investors to 'pick away' at some of the weaker EM stories, especially via FX (Figure 5 below), as the dollar has continued to rebound. These are the EMs that typically do well when the dollar is weak, as the 'carry trade' holds sway. In the face of recent dollar strength, the result has been significant localized EM FX weakness (Figure 6).

Further, several of these so-called 'weaker' markets have also faced idiosyncratic domestic concerns:

• Turkey (-25% in USD, year-to-date): fears over central bank independence, concerns around monetary policy, widening current account deficit;
• Brazil (+1.7%): weaker than expected economic recovery, uncertainty ahead of the October elections;
• India (-6.8%): higher oil prices and higher inflation with residual concerns over whether Prime Minister Modi's BJP will be re-elected in 2019;
• Indonesia (-16.7%): current account worries and a slow policy response by the Bank of Indonesia;
• The Philippines (-12.6%): domestic overheating.

To this list, we could add South Africa (-6.3% year-to-date, on a minor hangover from the euphoria of Ramaphosa's elevation to the presidency as the market begins to understand the substantial policy challenges ahead) and Mexico (also - 6.3%, as the July 1st 'first-past-the-post' Presidential election approaches with a shift to the left seeming almost inevitable now).

Further, the dramatic weakness of financial markets in Argentina in recent weeks has added to the sense of 'crisis' in emerging markets, even though technically (from an equity perspective) the country is still, for now anyway, in the MSCI Frontier index. MSCI Argentina is down just over 25% so far this year, almost entirely due to the plunge in the peso (from ARS/USD18.35 to 24.40), which has forced a double-digit rise in interest rates to 40%.

However, the major theme of this report is that, in our view, this is far from being an EM 'crisis'. Several EM equity markets continue to do well such as China, by far the biggest EM with a weight of over 31% in the EM benchmark (+5.1% year-to-date, aided by a resilient CNY, even as other EM currencies have fallen sharply), Taiwan (+2.2%), Russia (+4.1%, which has become a relative 'safe haven' again recently as Brent oil prices hover close to $80/bbl) and parts of the ASEAN and Andean regions, notably Colombia (+10.8%) and Peru (+7.7%).

As with the equity markets, the dramatic differences in currency performance across EM so far this year are very clear from Figure 6.

By de-composing the drivers of 2018 total returns in individual markets in Figure 7 below, we partly combine the results from the two previous charts. The blue bars below show the contributions of currency movements to total returns; these are significantly negative for many markets, especially Turkey, Brazil, Russia, India, Poland and the Philippines.

It is also notable how, for most markets, there has been a negative contribution to returns from the P/E ratio, showing the breadth of the de-rating of EM equities so far this year; Peru (given very strong earnings expansion) is a small but truly remarkable example. In the other direction, sharply lower earnings in Greece and Egypt have translated into a significant re-rating in both this year. For EM as a whole, decent earnings growth (+6%) has been fully offset by currency weakness and a lower P/E ratio to leave the 2018 total return close to zero.

'Correction Counter' Update: The Dollar Rears its Head

With the recent minor break of the early-February post-correction low for MSCI GEMs, we update our 'correction counter' from earlier in the year (Figure 8).

The interpretation of this data is more important than the actual figures themselves. In our February report, we noted that the fall in the EM Currency Proxy accounted for a smaller share (14%) of the early 2018 correction in EM equities than its average share (22%) in previous bull market corrections back to 2003. Therefore, one reason, in our view, why the early 2018 correction (-10.2%) was less severe than the average of previous 'bull market corrections' (-17.2%) was the lack of a major USD rally or, alternatively, the resilient behaviour of EM currencies.

This is no longer true, given that the recent action involves more FX weakness in EM, compared to the initial correction. The updated table shows that this FX factor now accounts for much more (28%) of the newly-defined correction (-10.8% to May 5th). Even more tellingly, after EM rallied to an interim peak in mid-March, MSCI GEMs is down 5.6% since then and, with the EM Currency Proxy down by 2.8% over this period, FX weakness has accounted for exactly half of the EM pullback over the past two months. The US dollar has 'reared its ugly head' for EM equities in recent weeks." - source UBS

There goes the murderous propensity of "Mack the Knife" on EM equities. In similar fashion to the recurrence theorem, the US dollar has indeed "reared its ugly" head and reoccurred again in the course of the time evolution of the "financial system" or, to some effect our macro reverse osmosis theory once again playing out as discussed in our recent ramblings. Add to the mix rising oil prices, and if oil stays above $80/bbl (Brent) this will clearly hurt growth in all major net oil importing countries. That's a given.

Moving back to the subject of US yields and real rates, we think they matter a lot for the direction of the US dollar. On this subject Nomura published a very interesting Rates Weekly note on the 18th of May entitled "Did UST sell-off awaken bond vigilantes?":

"10yr Treasuries break 3% with conviction

The 3% level on 10s has been frustrating to break through of late, having failed once in late April and again last week. However, as with all things related to three, the third time is usually a charm as 10yr USTs are now clearly on the other side of 3%.

All along through this process to higher rates we have sensed a great level of investor skepticism about how high rates could go and how long they would stay at higher levels. This is one reason why we are not overly concerned that spec accounts have a historical short in place. For once, as far as we can recall, specs are being proven right; so why cover now unless the economy and/or financial conditions unravel? The bigger risk we think is that those under-hedged and exposed to convexity start paying rates now.

Overall the market seems too dismissive of how high rates could go in this cycle. We think the Fed has conviction and may continue with its quarterly hikes until “something breaks.” Even then, the Fed might have a hard time throttling back if the real economy is doing well but the financial economy suffers a blow that results in lower valuations. Meanwhile, the perfect storm of more UST debt and less foreign buyers may lie ahead.

We explore some drivers that may impact our overall US rates views. Overall we expect duration dynamics to matter more now than the curve; meanwhile spreads and vols will likely have stronger correlations to higher rates and real rates could hold the key ahead.

Even if this sell-off takes a pause, we continue to see 10s moving towards our 3.25% target and are positioned paid on 5y5y US-IRS and in similar conditional expressions.

US rates views update: Still bearish but now real rates hold the directional key

Duration: 3%, besides being a nice round number, has been a hard nut to crack as the last time we crossed this level was during 2013, a year made famous by taper tantrum. For us, a move beyond 3% was always the next logical step as the Fed is hiking rates and shrinking the B/S during a period of decent growth and more UST supply.

The 3% nominal level seems to be all the focus, but in actuality the next big step for US rates is what happens with real rates. Fig. 1 highlights a few regimes for the 10yr real rate vs the real Fed Funds rate (see note for calculation).

Real rates were in a tight range during the last cycle as well, it was only once the Fed was mid-way through its hiking campaign that market real rates began to rise. The past ten years of financial repression (driven by the Fed’s QE and then Global QE) has kept 10yr real rates in a tight range. Just like the 10yr UST was held captive by the taper-tantrum high of 3%, 10yr TIPS have been unable to break and stay above 0.90-1.00% levels. We believe the Fed is on track to deliver many multiple hikes (which could drive real rates higher in the process too).

3%, well specifically the 3.05%, has been a technical level on which markets seem to have been obsessed with. The market cleared that level for the first time on Tuesday this past week and intra-week the 10yr hit an intra-day high of 3.12% before settling into the end of the week around 3.07%. We usually refrain from being super technical, with both what these levels mean and we do not like to be handicapped by chart formations; however markets often pay attention to these wrinkles. Fig. 2 shows that 10s once again broke out of the range and this time term premia is also rising with the move too.

Net net, we believe it will take a serious breakdown in all the trade talks, geopolitical tensions and/or economic data to weaken (where instead our economists are projecting stronger growth and higher inflation ahead) for 10s to start a massive rally now. It is also interesting to see that stocks, although down on the day 10s broke 3%, took it in stride. In Fig. 3 we list the top 3 two-day yield changes in 2018 vs the S&P500 reaction. If stocks do not correct meaningfully, the full UST yield curve should rise as Fed hikes.

Curve: Earlier in the year we opportunistically traded the curve before going neutral on curve spreads in late Q1 (after the last micro-steepening). Recently the sell-off has also coincided with some bear-steepening. We think this is a healthy development that serves as a reminder that the curve is not pre-destined to fully flatten in this cycle, at least not at these yield levels. The Fed is raising rates but also shrinking its bond holdings, at a time when US fiscal stimulus is resulting in a spike in govie issuance. The curve never fully flattened in Japan during its low rate experience (Fig 4).

We argue that we need a higher overall level of rates (and many more Fed hikes) before we go fully flat too.

Spreads: 10yr swap spreads have begun to see a stronger correlation with the level of 10yr USTs in the current cycle, especially since last September (Fig. 5).

In past hiking cycles, 10yr spreads tended to have a positive slope relative to 10yr UST yields. We expect this correlation to be maintained, similar to the dynamics at the end of the ’04-06 cycle. Also with higher yields, 10yr spreads are more likely to widen due to convexity hedging activities from mortgages portfolios. Less need for corporate issuance due to overseas dollar repatriation would also reduce the tightening pressure on belly spreads." - source Nomura

The continued pressure on EMs can only abate if the US dollar finally mark a pause in its recent surge. A toned down trade war rhetoric would obviously continue to be supportive of a rising dollar and support stronger US growth in the process. The trajectory of the US dollar when it comes to the recurrence theorem for EM is essential. Morgan Stanley in their EM Mid-Year Outlook published on the 18th of May reminded us in the below four graphs what to look for when assessing the US dollar in terms of being bearish (their take) or bullish:

"Why USD Is in a Long-Term Bear Market

 - source Haver Analytics, Bloomberg, Macrobond, Morgan Stanley Research

With mid-term elections coming soon in the US, it is clear to US that the administration would not like to rock the boat and therefore would favor "boosting" the US growth narrative. This would entail further gain on both US yields and the US dollar in the near term we think. 

Also of interest when it comes to growth outlook, UBS made an important point in their EM Economic Perspectives note of the 17th of May entitled "EM by the Numbers: Where is EM's growth premium over DM?":

"EM growth spread over DM has fallen close to its lowest decile since 2001

Strong Chinese growth and low US inflation strongly supported EM asset markets over the last two years. But the growth levers have slowly been shifting in the background. Having registered a cycle high in early 2017, EM growth has moderated sequentially since, while DM growth has picked up. The levels were strong enough in both to keep the market uninterested as to how far EM growth was above DM growth. Now, however, sequential EM growth has slowed to 20th percentile of its distribution since 2001, and, more importantly, the premium of EM growth over DM has shrunk to the bottom decile of its historical distribution.

The spread between EM and DM is an important input in the call of relative stock market returns in the two regions. In y/y terms, this spread is now at 15th percentile of its distribution since 2001. In q/q terms this spread has shrunk to the sixth percentile of its historical distribution." - source UBS

Whereas EM equities clearly outperformed DM in 2017, it might be that 2018 could make the reverse with DM outperforming. Reduced carry has obviously been a headwind for EM equities as discussed above. If the US dollar strength can persist then indeed, US equities will continue to outperform EM equities on a relative basis we think.

For our final chart, as we posited in numerous conversation, we have often repeated that for a bear market to materialize, you would need an "inflation" spike as a trigger. 

• Final chart - US core CPI tends to rise in the two years leading up to a recession

Positive shock to inflation would coincide with a negative shock to growth, leading to higher bond yields and lower equities. Moreover, higher inflation will coincide with lower growth, therefore bonds will not be a good hedge for an equity portfolio. As we pointed out in our conversation "Bracket creep" that bear markets for US equities generally coincide with a significant tick up in core inflation, this the biggest near term concern of markets right now we think. Our final chart comes from CITI Emerging Markets Strategy Weekly note from the 17th of May entitled "Fragile 5 now down to Fragile 2" and shows that US core CPI tends to rise in the two years leading up to a recession:

"US rates with more upside. 

After US CPI release last week we had wondered whether or not the EUR was in a bottoming process. While it had been trading better for a few days, the move higher in US rates has led to renewed USD strength. To be clear, we have been expecting higher US rates based on our belief in late-cycle behavior. Figure 4 shows that core inflation typically rises by 50bp in the last two years of an expansion.

Over the same two-year period, 10-year US Treasury yields tend to go up in the first year before retreating as rate cuts get priced by the market. Higher yields are therefore not surprising to us." - source CITI

If indeed a rising US Core CPI is a leading US recession indicator then again, we would have another demonstration of the recurrence theorem one could argue...

"Any idiot can face a crisis - it's day to day living that wears you out." -  Anton Chekhov

Stay tuned!

Credit - The Magnus Effect

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

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

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

The divergence between US and European PMI indexes is all about credit conditions. This is why the US was ahead of the curve when it comes to economic growth compared to Europe since December 2011. We have discussed this before, the US PMI versus Europe - source Bloomberg:

The Fed’s January Senior Loan Officer Opinion Survey released this week indicated weaker demand in mortgages over the past quarter. A net 28.2% and 45.7% of banks reported weaker demand for prime and non-traditional residential mortgages, the worst data since April 2011 and January 2009 respectively.

Of course when it comes to "Magnus effect" and major aerodynamic forces, some Emerging Markets have suffered the full force of outflows as "tourist" investors have been leaving in drove. For instance EM retail outflows represented -18 billion $ year to date according to JP Morgan's recent EM Fixed Income Flows Weekly:

"EM equity retail outflows persisted with $6.5bn of outflows this week, comparable to last week's $6.4bn in redemptions as the MSCI EM extended YTD losses to -8.4%. Meanwhile, EM woes drive flight-to quality as US bond funds experienced a surge in demand as inflows reached $14.6bn, the largest single weekly inflow in EFPR's history." - source JP Morgan

What is of interest as well have been the outflows from the famous Japanese Double-Deckers which favorite "carry" currency has long been the Brazilian real as indicated as well in JP Morgan's note:

"Japanese funds experienced outflows of $254mn with dedicated local Brazil funds accounting for most of this (-$222mn)." - source JP Morgan

The reason behind the depreciation of the Brazilian Real in 2011 was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again. It looks to us that, in similar fashion to what happened in 2011, a similar exit by these Japanese retail funds is adding pressure on the Brazilian currency:

In blue the Brazilian real versus the US dollar, in red the Australian dollar versus the US dollar, as one can see the correlation between the Australian currency and the Brazilian real broke down spectacularly in 2011.

But when it comes to Brazil, not only the Japanese outflows have been putting additional pressure on the currency but the slack in industrial production is as well putting some pressure as indicated by Bloomberg's recent Chart of the Day:

"The biggest monthly plunge in Brazil’s industrial output since December 2008 shows policy makers’ confidence that a weaker real will stimulate manufacturing is proving misguided.

The CHART OF THE DAY tracks Brazil’s industrial production index, the real on a percentage-change basis and exports on a rolling six-month average. Output fell in December by the most in five years even as the exchange rate weakened 34 percent since the manufacturing index reached a record-high in May 2011.

The currency is the biggest decliner against the U.S. dollar in the last three years among 16 major currencies tracked by Bloomberg after the South African rand.

President Dilma Rousseff said on Feb. 3 that a weaker real would help drive exports this year, an affirmation of Finance Minister Guido Mantega’s comments in September that a currency drop would make Brazilian products more competitive and boost manufacturing. Goldman Sachs Group Inc.’s Alberto Ramos said the government’s optimism isn’t warranted, as companies are hampered by rising labor costs and lack of incentives to modernize.

“The bottom line is that we expect the industrial sector to underperform,” said Ramos, Goldman’s New York-based chief Latin American economist. “It is a sector that is still facing significant foreign competition and cost-competitiveness issues, which will handicap performance.”

The country’s main manufactured exports and destination by value last year included passenger cars to Argentina and Mexico and automobile parts to Argentina and the U.S., according to Trade Ministry data. Brazil, which is the world’s largest emerging market behind China, saw its economy contract in the third quarter by the most since 2009 as investments dropped.

Fiat SpA is one manufacturer that has seen financial results hindered by Brazil operations. The carmaker’s 2013 trading profit in Latin America dropped 41 percent largely from price increases in Brazil, Chief Financial Officer Richard Palmer said in a Jan. 29 earnings call." - source Bloomberg.

When it comes to outflows as well, it is worth noticing the significant outflows from equities, putting somewhat a dent to the "Great Rotation" story from bonds to equities as indicated by Bank of America Merrill Lynch's note from the 6th of February entitled "Stampeding Bears":

"The bottom-line: big capitulation out of stocks into US Treasuries…marks end of Jan/Feb correction

The big numbers: largest weekly equity fund outflow since Aug’11 ($28bn); largest equity ETF outflow since Feb’09 ($26bn); largest bond fund inflow since Apr’10 ($15bn)

The caveat: our trading rules not yet flashing “strong buy”… Bull & Bear index now down to 4.2 (hit 1.8 late-June – Chart 1); Global Breadth index now up to 44% (hit 96% late-June – Chart 3) and…

…EM Flow Trading Rule: another $7-8bn outflow next week triggers contrarian buy-signal (last buy-signal on 6/27/13 followed by 14% rally in EEM next 3 months)" 

- source Bank of America Merrill Lynch

As far as equity flows are concerned, the "reverse osmosis" namely the tapering impact on some Emerging Markets have led to the following as detailed in Bank of America Merrill Lynch's note:

"Equity Flows

$6.5bn outflows from EM equity funds (15 straight weeks of outflows = longest outflow streak on record – Table 3)

4-week outflows from EM equities = 2.1% of AUM; another $7-8bn outflows next week would trigger contrarian “buy” signal from our EM Flow Trading Rule (3.0% is threshold)

Huge $24bn outflows from US equity funds (almost all via ETF’s SPY, IVV, IJH – but see above for caveat on Good Harbor)

Business as usual for Europe (32 straight weeks of inflows) and Japan (7 straight weeks of inflows)" - source Bank of America Merrill Lynch

Whereas Fixed Income Flows,such as the ones seen in US Treasuries, shows the asset class hasn't lost its appeal:

"Monster $13.2bn inflows to Govt/Tsy funds (caveat: $10bn inflows likely due to Good Harbor rebalancing from SPY to SHY, IEI & UST)" - source Bank of America Merrill Lynch

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

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

Stay tuned!

Credit - The Runaway Horse

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

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

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

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

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

We did remind ourselves last week our musings from our previous conversation entitled "Misstra Know-it-all" that, when it comes to undoing the great "destabilizing" work from Ben Bernanke (aka "The Departed"), rising volatility would lead to re-calibration of risk exposure:

"Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse."

When it comes to volatility, Emerging Market VIX has indeed surged the most in two years as reported by Nikolaj Gammeltoft and Callie Bost from Bloomberg on the 27th of January 2014 in their article "Emerging-Market VIX Surges Most in Two Years on Selloff":

"Equity volatility from India to Brazil and Turkey jumped the most in two years as turmoil spread across global markets amid a selloff in developing-country currencies and growing concern over China’s economy.

The Chicago Board Options Exchange Emerging Markets ETF Volatility Index rose 40 percent to 28.26 last week, the biggest increase since September 2011, according to data compiled by

Bloomberg. Bearish bets outnumber bullish ones on the underlying exchange-traded fund by the most since July with about 60 percent more puts than calls. Developing-nation stocks extended declines from a 4 1/2-month low today, with MSCI’s Emerging-Markets Index losing 1.2 percent by 1:09 p.m. in Hong Kong.

The devaluation of Argentina’s peso, data signaling a possible contraction in China’s factory output and declines from the Turkish lira to the South African rand shook investor confidence. Emerging-market equities have tumbled since the Federal Reserve signaled in May that it could start scaling back bond purchases that boosted demand for higher-yielding assets.

“There’s concern that the downtrend may continue,” Walter “Bucky” Hellwig, who helps manage $17 billion at BB&T Wealth Management in Birmingham, Alabama, said by phone Jan. 24. “Protection is being purchased or bets are being made that it will.”

The MSCI emerging-markets gauge fell 2.3 percent to 949.90 last week, extending this year’s slump to 5.3 percent. The European equity benchmark lost 3.3 percent, while the Dow Jones Industrial Average sank 3.5 percent for the biggest weekly decline since May 2012." - source Bloomberg

In last week's conversation we also underlined what Nomura indicated at the time of our September 2013 "Misstra Know-it-all" conversation, the risk of the situation turning nasty for lack of liquidity is significant:

"Bad liquidity markets saw asset swaps widen considerably (making swap paying less of a hedge) and start to trade like credit products. This phenomenon, if it continues, could result in a lot of proxy hedging through FX, FX vol, buying CDS and, at a more serious stage, selling what investors could unwind."

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

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

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

So what you have in Emerging Markets is the above playing out: namely proxy hedging in the first place and additional "de-risking" taking place as indicated by Bank of America Merrill Lynch's note on the 30th of January 2014 entitled "First Signs of Panic", the stampede in Emerging Markets has somewhat started in earnest, validating amply our chosen title:

"Largest EM equity fund outflows since Aug’11 ($6.4bn); $15bn outflows over next 2-3 weeks triggers contrarian “buy” signal from our EM Flow Trading Rule (Chart 1).

Largest EM debt fund outflows since Jun’13 ($2.7bn); selling concentrated in LDM (local debt markets).

EM debt & equity funds see combined outflows of $9.1bn; magnitude almost rivals outflows during Taper (May’13), Debt Ceiling (Aug’11) & Lehman (Sep’08) (Chart 2).

$6.4bn outflows from EM equity funds (largest since Aug’11) (14 straight weeks of outflows = tied for longest outflow streak on record.

4-week outflows from EM equities = 1.4% of AUM; another $15bn outflows over next 2-3 weeks would trigger contrarian “buy” signal from our EM Flow Trading Rule (3.0% is threshold)

- source Bank of America Merrill Lynch.

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

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

On that subject we agree somewhat on the subject with Skagen AS, the Norwegian fund top Emerging Markets manager, as reported by Jonas Bergman in Bloomberg on the 29th of January in his article "Emerging Market Bull Who Beat Wall Street Sees Rout Passing":

"Skagen AS, the Norwegian fund manager who has outperformed some of Wall Street’s biggest banks over the past decade, is urging clients to sit out the turmoil gripping developing nations.

Kristoffer Stensrud, whose 50 billion-krone ($8 billion) Kon-Tiki A emerging market fund has returned an annualized 14 percent over the past 10 years, said there’s “nothing new really” in the recent turbulence, in an e-mailed reply to questions. He characterized the moves as “some contagion” in Latin America from Argentina, while reactions in the east remained “calm.”

“Emerging market economies hit by currency falls will probably be more competitive going forward,” according to 60-year-old Stensrud, who started Skagen in 1993. A lack of inflationary pressure from commodities will also be “positive,” giving a longer period with “low inflation and low interest rates in developed markets than generally perceived presently,” he said." - source Bloomberg.

Skagen AS are not the only ones taking the long term "macro" views, for instance legendary Mark Mobius chairman of Templeton Emerging Markets Group is also sitting in the "contrarian" camp as indicated by Jaco Viser in Bloomberg on the 29th of January in his article "Mobius Sees Money Flowing Back Into Emerging Markets on Growth":

"Mark Mobius, chairman of Templeton Emerging Markets Group, said inflows into developing nations will resume later this year following a selloff triggered by the Federal Reserve tapering monetary stimulus.

“People are enjoying what they see as a bull market in the U.S.,” he said in an interview in Johannesburg today. “As we go forward, we’re going to see a lot of overweight positions in the U.S. So, given the fact that emerging markets are still growing fast, given that they have low debt-to-GDP ratios, given that they have high foreign-exchange reserves, we believe that money will be flowing back in again to emerging markets.”

Investors sold $1.87 trillion in stocks worldwide in the week to Jan. 27 ahead of the Fed’s two-day meeting, which ends today, where the central bank will announce reducing bond purchases by a further $10 billion next month, according to the median estimate of 78 economists surveyed by Bloomberg. The selloff spurred a rout in emerging-market currencies with central banks in Turkey, India and South Africa unexpectedly

increasing benchmark interest rates.

The effectiveness of higher interest rates “depends on the country and it depends on the degree,” Mobius, 77, said. “In India it is working OK. The jury is still out on Turkey. The picture becomes a little complicated in certain countries because of upcoming elections. Despite the rise in interest rates, you’re not going to see a big, big flow back in, but it will eventually come.”" - source Bloomberg

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

After all, as we did indicate back in March 2012, that, when it comes to "Equities, there is life (and value) after default!". Russia, Argentina, Iceland, and as of late Greece are all living proofs that there life (and value!) after a default.  It turns out that our "early call" on Greece based on our long-term macro analysis rewarded handsomely investors in 2013 as presented by Namitha Jagadeesh in Bloomberg in October 2013 in his article "Greek Recovery Makes Stocks World’s Best as Paulson Buys":

"Since June 5, 2012, two weeks before MSCI Inc. gave notice it may reclassify Greece as an emerging market, the country’s ASE Index (ASE) has surged 146 percent, trimming the decline from its 2007 peak to 79 percent. The gains topped all 94 national benchmarks globally in the period, except Venezuela, according to data compiled by Bloomberg. Yields on Greece’s 10-year government bonds have dropped to 8.31 percent from a peak of 33.7 percent in March 2012." - source Bloomberg.

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

"-Bonds = Tenant farming

-Equities = Metayage

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

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

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

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

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

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

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

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

While we recommended last year to go long Nikkei in euro terms, a similar strategy would have been successful with countries such as Argentina as displayed in Bloomberg's recent Chart of the Day displaying 105% stock gain as long as you ignore inflation and depreciation of the currency:

"Argentine stocks posted some of the best returns in the world in President Cristina Fernandez de Kirchner’s second term, as long as you ignore inflation and depreciation. In reality, they were among the worst.

The CHART OF THE DAY shows that while the Merval index doubled in peso terms since her re-election Oct. 24, 2011, the shares lost 15 percent once returns were converted to dollars at the rate investors use to avoid currency controls. While the 105 percent local-currency return was the fifth-biggest among 94 indexes globally during the period, the drop in dollar terms made the gauge the world’s 12th-worst performer.

“Argentina is a high-risk, high return market and there has been more risk than return lately,” said Eric Conrads, a money manager who helps oversees $750 million of Latin American stocks at ING Investment Management in New York. He said he sold the last of his Argentine shares last year.

Fernandez devalued the peso last week in a bid to shore up foreign reserves that sunk to a seven-year low amid a surge in government spending, inflation estimated at about 30 percent and declining prices for the country’s soy and wheat exports.

Restrictions on dollar purchases mean investors use the so-called blue-chip swap, under which local assets are sold abroad for foreign currency at a discount to the official exchange rate of 8.0177 per dollar.

The blue-chip rate of 11.5697 pesos per dollar has depreciated 58 percent since the election, more than the 47 percent drop in the official rate and the worst among 31 major dollar counterparts. “The intelligent people in Argentina invest in property,” Conrads said." - source Bloomberg

When it comes to Argentina's woes, Bank of America and Moody's suggest that only 40% interest rate can arrest Peso's fall as reported by Katia Porzecanski and Camila Russo on the 30th of January in their article "Only 40% Interest Rate can Arrest Peso's Swoon":

"Argentina’s decision to ratchet up interest rates to 24 percent is failing to convince Bank of America Corp. and Moody’s Analytics Inc. the nation can stem demand for dollars in the wake of the peso’s devaluation.

Argentina needs to offer 37.5 percent to attract enough investors to halt peso losses, according to the average of five forecasters surveyed by Bloomberg News, even after the nation’s benchmark deposit rate surged 2 percentage points this week to a five-year high. Bank of America says a rate of 40 percent is needed to effectively compensate for consumer prices rising an estimated 28 percent annually.

 While the devaluation was intended to bolster the nation’s foreign reserves that were depleted as the central bank sold dollars to support the peso’s official rate, Argentina faces the prospect of savers dumping a currency that has lost more value than any time in a decade. Higher interest rates would mirror increases by developing nations such as Turkey, which doubled its benchmark rate to shore up the lira, as the Federal Reserve fuels a rout in emerging-market currencies by paring stimulus.

“Argentina’s got to do something similar,” Daniel Kerner, an analyst at political consultancy Eurasia Group, said in a telephone interview from Washington. “I get the feeling they don’t have a clear strategy, they don’t really understand the problem and they don’t believe in incentives.” Kerner said Argentina needs to lift its deposit rate to 40 percent to boost demand in the peso, which has lost 18.5 percent this year." - source Bloomberg.

Unfortunately, this time "it's different" we think. As it seems in Argentina, not only FX reserves have been disappearing fast, but confidence in the currency as well has completely vanished, meaning Argentina is experiencing yet again another bout of hyperinflation in the process. In that context, the "runaway horse" has further to go, given that ZIRP, and QEs have led to increased connectivity and positive correlations and therefore negative feedback loops. We agree with Nomura's recent take on Argentina from the 24th of January entitled "Argentina: Bowing to the inevitable":

"Devaluation of the Argentinean peso this week, in our view, is the inevitable result of an unsustainable mix of monetary and fiscal policies. The move is probably intended to preserve falling reserves, yet greater exchange rate volatility could open up a series of political and economic uncertainties. Developments in Argentina have generated knockon effects in Brazil, and the risk of contagion across EM has now become more real." - source Nomura

When it comes to rising risks, negative feedback loops and positive correlations, its biggest trading partner Brazil is in the front line according to Nomura's note:

"The events in Argentina have generated knock-on effects across the region, especially for Brazil, which has Argentina as its third largest trading partner after China and the United States (Figure 7). 

In terms of real exchange rates, ARS has grown steadily stronger than BRL since mid-2011 (Figure 8). 

Given the expanding current account deficits in Brazil, there is a risk of BRL suffering in sync with a weaker ARS." - source Nomura

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

In blue the Brazilian real versus the US dollar, in red the Australian dollar versus the US dollar, as one can see the correlation between the Australian currency and the Brazilian real broke down spectacularly in 2011- source Bloomberg:

In similar fashion to Brazilian woes stemming from Argentina's devaluation, Australia is exposed clearly to China's tightening stance and commodities slowdown.

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

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

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

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

It reminds us of one of our quotes:

"He who rejects restructuring is the architect of default." - Macronomics.

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

When it comes to European exposure to Emerging Markets, Nomura in another note entitled "Assessing the linkages between EM and the euro area" published on the 27th of January, gives us more insight:

"After reviewing the trade and financial linkages, we conclude that a protracted slowdown in these countries would shave around 0.1 percentage point (pp) from euro area GDP growth. This compares to the 0.3pp reduction observed in the China/Asia slowdown simulation that we conducted last summer.

-Unsurprisingly, Spain and its banking sector are most exposed. However, it is important to note that these subsidiaries across LatAm operate as fully independent entities, supported by capital retained at the local level and funding that is independent from the parent company. As a result, most of the risk to BBVA and Santander stem from the potential lower earnings contribution.

-Among the Spanish banks, we believe BBVA is most at risk to FX markets given its greater exposure to Argentina, Venezuela and Turkey. While this is partly reflected in our earnings estimates, it may not be reflected in the consensus.

-In our view, risks to the euro area do not stem from a country-specific bout of volatility in select emerging markets, like the one taking place in Argentina, but rather from a broad-based EM slowdown, which would have potential to threaten the region's recovery. In this sense, we view the past week as more of a warning should contagion become more entrenched and broad-based across EM." - source Nomura

In terms of banking exposure, Spain is the most exposed according to Nomura's note:

"Financial channels: The bank exposure channel – the case of Spain

European banks are known to be significantly exposed to Latin America. Figure 7 shows that European banks had EUR564bn of claims against Latin American countries and EUR136bn of claims against Turkey.

When looking at the various European countries, Spain is clearly most exposed, with around EUR160bn of claims against stressed countries or about 5% of its total banking assets. Importantly, these subsidiaries across LatAm operate independently from the parent, with capital retained at the local level and independent funding from the parent company. As a result, most of the risk to BBVA and Santander stems from the potential for a lower earnings contribution." - source Nomura

On a final note, Oil and Mining Stocks are the most exposed to Emerging Currency risk as displayed by Bloomberg's Chart of the Day from the 30th of January:

"Energy and raw-material producers may have the most at stake among U.S. stocks as emerging-market currencies fall, according to Gina Martin Adams, a Wells Fargo & Co. strategist.

The CHART OF THE DAY shows the relationship between the MSCI Emerging Markets Currency Index and the Standard & Poor’s 500 Energy Index since March 2009, when the shares began their

current bull market.

MSCI’s index dropped this week to its lowest reading since September as the Russian ruble, South African rand, Turkish lira and other currencies tumbled against the dollar. Each currency’s weight matches the country’s proportion of the MSCI emerging-market stock index.

“High correlations between emerging-market currencies and commodity prices suggest commodity-sensitive sectors in the S&P 500 are likely to suffer most” as the decline worsens, Martin Adams wrote in a Jan. 24 report.

Oil and gas stocks were the most closely linked to the foreign-exchange index among 64 industry groups in the S&P 500, according to data that the New York-based strategist cited. The correlation was 0.94 since January 1999, when MSCI started its calculations. Comparable figures for chemicals and mining were 0.87 and 0.66, respectively. The highest potential reading was 1, showing the currency and stock indexes moved in lockstep.

China’s yuan, South Korea’s won and the Taiwan dollar account for about half of the MSCI index’s value, the report said. Argentina’s peso is excluded because MSCI classifies the country as a frontier market, not an emerging market. The peso was devalued by 15 percent last week." -source Bloomberg

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

"-He who has the gold, does not always make the rules.

-The market does not learn for long.

-Human nature does not change."

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

Stay tuned!