Macro and Credit - A Pyrrhic victory

“You were given the choice between war and dishonour. You chose dishonour, and you will have war.' - To Neville Chamberlain” - Winston S. Churchill

Looking at the results of the French presidential elections with keen interest given our involvement in the process, us being French, we reminded ourselves, for the title analogy of the definition of Pyrrhic victory, where the heavy toll negates any sense of achievement or profit. King Pyrrhus of Epirus suffered irreplaceable casualties in defeating the Romans at the Battle of Heraclea in 280 BC and the Battle of Asculum in 279 BC during the Pyrrhic War. In both victories, while the Romans suffered greater casualties but they had a much larger pool of replacements, so the casualties had less impact on the Roman war effort than the losses of King Pyrrhus. While financial markets are going through yet another relief rally thanks to the victory of the Media darling Macron, we would point out that, no matter what some pundits think, Marine Le Pen and her party are, to use a financial term and analogy "positive carry" (inequality and unemployment, immigration, terrorism, etc.). Let us explain ourselves. Most of the beneficiaries of what "populists" would label "crony capitalism" and the "elites" have been behind Macron's candidacy, so all in all they are today sighing with relief. Yet, we believe his upcoming victory would amount to a Pyrrhic victory, in the sense that, unless there are very important structural reforms implemented which have been postponed in France for the last 20 years (under Chirac, Sarkozy and Hollande), there is a high probability of another 5 years wasted under Macron. While the quotation we have used above from Winston S. Churchill sounds a little bit off the mark from a historical perspective, we do feel, to paraphrase Mark Twain, that history for France is not repeating itself, yet it rhymes with the troubled 30s. We could even rephrase Winston S. Churchill quote as follows when it comes to France: "You were given the choice between status quo to avoid bankruptcy and dishonour.  You chose status quo and you will have bankruptcy and dishonour. Unless we see some very bold structural changes in France, not only in order to reform inefficient and inept systems in place but with significant tax reforms and supply side policies as well, we do believe there is a very high probability that Macron's victory will be a Pyrrhic one down the line but we ramble again.

In this week's conversation we would like to look at what to expect in terms of the continuation and sustainability of the rally which climbed the most recent "wall of worry" of the French elections. 

Synopsis:

• Macro and Credit - Paris in Spring?
• Final chart - Bank of Japan, the ETFs whale

• Macro and Credit - Paris in Spring?

While this bullet point could as well be a title analogy on its own and a reference to 1935 black and white musical comedy film directed by Lewis Milestone for Paramount Pictures, the relief rally seen so far, from our perspective has been mostly a beta play, particular in the light of the performances on the Monday following the elections on French bank stocks. As we have pointed out in numerous recent conversations, we continue to remain short term "Keynesian" when it comes to us being "risk-on", yet we remain medium term "Austrian" when it comes to tracking the weakness in credit growth, surging delinquencies and the credit cycle being long in the tooth. From an equities allocation perspective, we do think that Europe and other markets offer better prospects than US markets given the most recent macro data. Yet, with the slowdown in US hard data, we think at current levels US credit offers still better prospects than European credit both for Investment Grade and High Yield for which oil prices matter a lot.

For now the market wants to rally and will rally, as we often see significant rally in late stages in the credit cycle. For the time being the allocation tool DecisionScreen for High Yield is still in the buying zone for the aggregate signal which comprises the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score), US GOV 10 Year Yield (1Y Z-Score).

- source DecisionScreen

It remains to be seen how long US High Yield will continue its upward trajectory. This of course to a large part as we discussed recently on the trajectory that will be taken by oil prices in the second quarter. 

As far as US High Yield and the S&P 500 are concerned, correlation between both asset classes remains very strong as per the below chart from MacroCharts.pro we also used in several conversations:

Correlation 0.938, R2 0.881 - source MacroCharts.pro

Same goes for the correlation between the S&P500 and the synthetic CDS High Yield US index CDX:

Correlation 0.987, R2 0.973 - source MacroCharts.pro

Of course when it comes to Bayesian learning history shows the final phases of rallies have provided some of the biggest gains. But we are driveling again given in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":

"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent), then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

So all in all, you can probably see we are not part of the "permabear" camp, though we are acutely aware of the lateness stage we are in the credit cycle. It might be "Paris in the Spring" and "risk-on" for the time being, but, we do feel more cautious as we stated about the second part of 2017.

Given we have climbed the "French wall" of worry for the time being, while European investors had already been front running their Japanese peers, we do expect higher overseas demand for US Investment Grade credit thanks to improved cross-currency basis. On this subject we read with interest JP Morgan's Credit Outlook and Strategy note from the 20th of April 2017: 

"The US election results were followed by strong market optimism that US growth and corporate results would benefit. UST yields went from 1.83% on November 7 (the day before the election) to a peak of 2.61% on March 13th. The S&P rallied 12% from pre-election to its recent peak, and JULI spreads tightened by 24bp as well, to their recent low. Currently the UST 10yr yield is at 2.23%, unwinding 37bp or 50% of its post-election move. In contrast, the JULI is just 7bp wider so has unwound 30% from the post election tightest level, and the S&P is just 2% off of its recent peak, still up 11% post election, so it has given up 15% of its post election rally.

These developments suggest that markets have become less optimistic on growth and inflation picking up, while maintaining most of the optimism that drove equities up and credit spreads down on the election results. The move lower in UST yields reflects, in part, a flight to quality with the French election and increased geopolitical tension, but this "flight" didn't meaningfully hurt risk markets. There are several factors that can explain at least part of the strength of credit and equity markets even with rates markets suggesting rising risks to growth. These include:

1) Solid earnings expectations:

Consensus equity analysts estimates are for 7.4% revenue growth and 8.9% EPS growth in 1Q17 vs 1Q16, for the S&P500. Excluding Energy revenue and earnings growth forecasts are 5.3% and 5.1%. The weaker USD so far in 2017, down 4% in trade weighted terms, is a contributing factor to better earnings, as is the recovery in Energy prices and higher interest rates helping bank earnings. These earnings forecasts are much stronger than nominal GDP growth in 1Q17, which is likely to come in at just 4.1% higher than 1Q16. This is the most straightforward driver of the outperformance of credit and equities vs. US rates. That said, if low US rates are correctly predicting a slowdown in US growth, then earnings optimism will fade as well.

2) The regulatory reforms and pro-business agenda of the new administration as a driver of better corporate earnings, separate from the macroeconomic drivers of growth. It will be difficult to quantify the earnings impact of actual and potential regulatory relief, but it is hard to argue that it is not positive for corporate earnings over time. Related to this, potential changes to Dodd-Frank and new appointments at the Fed are fueling optimism in the Financial sector for some types of regulatory relief. As the legislative path of reform continues to be challenging for the new administration it is logical to assume there will be increasing focus on reforms and appointments that the executive branch can institute without congressional approval. M&A has been quiet recently but there is a lot of M&A discussion, particularly in the TMT sector. The assumption is that the new administration will be more likely to approve transactions that might have been blocked by the prior administration. This may or not be positive for credit markets, but it is usually positive for stocks.

3) The Fed rate hiking cycle is directly supportive of US bank earnings.Net interest margin rose for most banks in 1Q17. The most recent Fed hike was on March 15 so only a small portion of its impact was reflected in higher earnings in 1Q, while 2Q will reflect the full impact of this hike, and perhaps the beginning of the next Fed hike, which we continue to expect on June 14.

4) Lower sovereign yields in Europe have increased the need to diversify and are contributing for overseas demand for US HG credit. The 10yr bund is now at 33bp, down from a 2017 peak of 48bp on January 26th. The percent of JPM’s global sovereign bond index offering a negative yield was at a recent low of 17.6% on March 13, and has since ticked up to 21%. In the first part of 2016 low global bond yields contributed to overseas demand for US credit. This impact faded in the 2nd part of 2016 and in early 2017, but has increased once again. Some of the recent move lower in European sovereign yields is tied to the risks seen around the French election so may dissipate (or get worse) after Sunday’s vote.

The FX-hedged pickup of USD credit vs European and Yen credit has narrowed recently.

For Euro based investors USD credit, hedged with a 3m FX swap, now offers a pickup of 31bp. This is on the low end of the 31-68bp three month range.

For Yen based investors this pickup is now 63bp, also near the bottom of the 58- 93bp range. Still, with sovereign bond yields so low the need for diversification remains. The decreases in spread pickup for European and Japanese investors buying USD HG corporates is primarily due to a decrease in US HG corporate yields. The annualized cost of the USD/EUR and USD/JPY 3m FX hedges has remained relatively stable recently while the absolute unhedged yield differences have decreased.

Even taking account of these factors, the extent of the difference between UST and equity/credit spread movements over the past few weeks seems extreme.

The drivers of the equity rally and credit spread rally post the election were then described as tax reform (including overseas cash tax repatriation relief), infrastructure spending and fiscal stimulus. All of these are, at a minimum, delayed, and there is growing skepticism that the magnitude of corporate tax relief and infrastructure spending will match the Administration’s goals.

Some of the macro data would support higher UST yields as well, with consumer and business confidence near multi-year peaks and PMIs also very strong. 

Global Economic Activity Surprise indices reached multi year peaks in March but have receded since then. The Fed has raised rates in 2016 and a couple of weeks ago signaled that it would change its balance sheet reinvestment policy later in 2017. These factors might have been expected to keep UST yields high, but instead they have declined.

There are countervailing factors in the macro data, which are getting the focus of the Treasury market, however. Bank lending slowed in the later part of 2016 and this trend has continued, despite the strong consumer and business confidence figures, which might have been expected to lead to more loan demand.

Auto sales have also slowed, and retail sales growth overall has been modest.

GDP growth in 1Q is coming in weak, though there has been an historical pattern of weak 1Q initial prints, which are then revised higher. CPI last month came in very weak, though again the magnitude of the drop seems overdone and may be revised in subsequent updates. This more cautious data, if truly predicting weaker growth, would be expected to impact stocks and corporate spreads, as well as Treasury yields, but this has not been the case so far." - source JP Morgan

As John Maynard Keynes aptly said:

 “The market can stay irrational longer than you can stay solvent.”

While it is indeed "Spring in Paris" with new records being broken in the equities space as we type, and pundits including us are watching with interest the divergence between hard data and soft data including retail woes, rising delinquencies and weaker credit growth in the US that portend most likely towards a weak US Q1 GDP print on Friday, you might rightly ask yourselves if indeed, when it comes to chasing this really fundamentals matter anymore. Earnings wise, no doubt the picture seems to be better, when it comes to US equities and the continuing surge. Yet, as we pointed out on numerous occasions and particularly for Fixed Income allocations, flows matter and they matter more and more particularly when you think that "Bondzilla" the NIRP monster is "made in Japan". We keep hammering this, but the Japanese investment crowd and their allocations should never be underestimated. These guys mean business when it comes to flows as we pointed out in our conversation "Drums Along the Mohawk" in early April:

"The February sell-off in French government bonds was significantly large and amounted to all Japanese purchases for Q3 2016 as per the table below. 

 - source Bank of America Merrill Lynch

 - source Bank of America Merrill Lynch

Indeed, if the French elections delivers yet another sucker punch à la BREXIT, this "exogenous" factor could precipitate additional pressure on French government yields given Japanese investors have been the largest purchasers of French debt since 2012 and hold 13% of it. When it comes to flows for foreign bonds, "Bondzilla" the NIRP monster is indeed Japanese and you would be wise to track is appetite when it comes to country allocation." - source Macronomics, April 2017

So yes, Macron's Pyrrhic victory in the first round of the French elections in conjunction with the recent start of Japan's new fiscal year might explain the recent rally in French debt but it is could be coming from a renewed appetite from foreign investors in particular "Bondzilla". He had offloaded a sizable chunk of French bonds in February as indicated in the table above we used in our previous post.

When it comes to Japan and their appetite for risky assets, if indeed Japan is Bondzilla when it comes to foreign bonds, for domestic ETFs it is indeed a whale.

• Final chart - Bank of Japan, the ETFs whale

Whereas it is very important to track Japan flows, regardless of the fundamentals narrative when it comes to valuation when it comes to Fixed Income, it is interesting to focus as well to Bank of Japan who has indeed become a "Tokyo Whale" in the domestic ETFs market. On that subject, our final chart comes from Société Générale Cross Asset note from the 21st of April entitled "Where is the Tokyo Whale - Analysing the impact of equity ETF purchases by the Bank of Japan":

"The “Tokyo Whale” in the ETF market...

The term “whale” is frequently used to qualify big money participants in the market. The Bank of Japan has often been qualified as the “Tokyo Whale” since it became a major participant and holder in the Japanese government bond (JGB) market. Recently, this situation was replicated in the ETF market. At end-March 2017, BoJ’s cumulative ETF purchases were ¥13.1tn, with Japanese equity ETFs subject to BoJ purchases totalling ¥21.3tn assets. Based on the price performance of the Nikkei 225 and Topix indices and as dividends are not reinvested in Japanese equity ETFs but distributed, we can estimate the mark-to-market value of historical purchases. We assume the BoJ’s current ETF holdings stand around ¥15.7tn ($144bn), i.e. approximately 75% of the total assets in Japanese equity ETFs (orange line on below chart).

Eligible ETFs are physically replicated, which implies the ETF providers hold the underlying index constituents. From the estimated BoJ ETF holdings and index constituents list, we can deduce how much of the Japanese equity market is indirectly held by the BoJ through these ETFs.

... but also, indirectly, in the Japanese stock market
BoJ implicit holdings are quite small at the index level but significant on some specific
stocks

Comparing the BoJ’s ETF holding amounts per benchmark to each index’s market capitalisation is not relevant as many companies are common to the three (or two) indices. We have totalled the estimated amounts held for each stock through the three benchmark exposures and concluded that the BoJ may indirectly hold around 3.2% of the Nikkei 225 market capitalisation, 2.0% of the TOPIX and 3.1% of the Nikkei 400. These figures may seem quite low compared to the respective 75% and 40% estimated BoJ ownership of the Japanese ETF and government bonds markets. The impact at the stock level, however, can vary greatly from one stock to another." - source Société Générale

So you might ask yourselves, how long can this rally in equities continue? Well if indeed Central Banks such as the Bank of Japan, the SNB and others are now in the "investment business", the sky's the limit but we ramble again...

On a final note we think Macron's potential victory will be a Pyrrhic one given the growing divisions in France à la 30s and he would be wise to remember the latin words "Arx tarpeia Capitoli proxima", (“the Tarpeian Rock is close to the Capitol”) which some have interpreted to mean that "one's fall from grace can come swiftly". As a reminder to be hurled off the Tarpeian Rock was, from a certain perspective, a fate worse than mere death, because it carried with it the stigma of shame. The standard method of execution in ancient Rome was by strangulation in the Tullianum. The rock was reserved for the most notorious traitors, and as a place of unofficial, extra-legal executions such as the near-execution of then-Senator Gaius Marcius Coriolanus by a mob whipped into frenzy by a tribune of the plebs.

"History repeats itself, first as tragedy, second as farce." -  Karl Marx

Stay tuned!

Credit - The European Catharsis

"We can easily forgive a child who is afraid of the dark; the real tragedy of life is when men are afraid of the light." - Plato

Looking at the continuation in yield compression in the European government bond space, in conjunction with the deliquescence of French political parties with the Socialist party risking outright implosion with François Hollande shifting towards "Macron-nomics" (Emmanuel Macron being a young  former investment banker and new French minister for the economy), we reminded ourselves for our chosen title of the definition of the Aristotelian "Catharsis", the dramatic art that describes the effect of tragedy. The German philosopher, dramatist, publicist and art critic Gotthold Ephraim Lessing translated "Catharsis as a purification, an experience that brings pity and fear into their proper balance: "In real life," he explained, "men are sometimes too much addicted to pity or fear, sometimes too little; tragedy brings them back to a virtuous and happy mean." Tragedy is then a corrective; through watching tragedy, the audience learns how to feel these emotions at proper levels.

In similar fashion we would argue that in real life, European politicians have been sometimes too much addicted to debt and popularity, indeed, one would hope that the European tragedy unfolding would bring them to more virtuous and happy mean, but, hearing the departing French minister of the economy Montebourg blaming entirely French woes on the implementation of "austerity", we thought this week's chosen title was appropriate given "Catharsis" can apply to both tragedy as well as comedy. Given, purgation and purification, used in previous centuries are still the common interpretations of catharsis and still in wide use today, we wonder when the purgation and purification of the European debt market will happen via "restructuring"? We reminded ourselves as well our January 2012 conversation "The European Overdiagnosis" where our friends from Rcube Global Asset Management pointed out the inherent flaws of the European currency construct when discussing "The likelihood of a Euro Breakup": "By eliminating currency crises, which were common until the mid-1990s (and at the same time preventing evil “speculators” from making billions on them), the Euro built an economic crisis of far larger proportions. Once again, economics provides a good illustration of the old proverb “the road to hell is paved with good intentions”.

In this week's conversation we will look at the prospect for the continuation of the performance of credit and the continuation in the contrarian tactical trade, namely being long European equities (playing the rebound or when "bad economic" news is "good market" news...) and short the Euro.

While Europe continues to go through "Catharsis" as indicated by the latest raft of economic data pointing to weaker growth, European credit continued to post strong performances so far in 2014 with Total Return for Investment Grade Credit at 6.5% and High Yield slightly behind at 5.5%. Talking about "Credit Bubble", Investment Grade did reach last week it's lowest historical yield at 1.55% validating our 2012 conversation "Deleveraging - Bad for equities but good for credit assets"but we ramble again...

The latest flows of funds indicate as reported by Deutsche Bank on the 1st of September in their report entitled "Investors return back to European equities on hopes of (private) QE":
"European funds attract solid inflows on hopes of (private) QE: A week after the Jackson Hole symposium, Total equity funds recorded the 3rd consecutive week of inflows (+0.1% as % of NAV), led by solid flows into Western European and Emerging Asia equity funds.
Following a stack of disappointing economic data releases in Europe over the last few weeks and subsequent outflows thereafter, Western Europe equity funds rebounded strongly with solid inflows (+0.2%, highest inflows in 11 weeks) in anticipation of a possible (private) QE announcement during this week’s ECB meeting. DB’s economists are bringing forward the timing of the announcement of private QE (ABS purchasing) to 4th Sep’14, though admitting it’s a very close call. They expect it not to be a generic QE with government bond purchases and expect ABS purchasing would act as a complement to the already announced TLTRO. What to make out of this?
Observing flows returning back to Europe, we think investors would play this trade mostly via ETFs (Europe ETFs had +0.4% of inflows last week). A basket of common names constituent to the ES50 and the DAX30 could benefit overproportionally as 1) these indices are by far the two largest targets to invest the region via ETFs and 2) where the share of equity held by ETFs is particularly pronounced for these names. This basket’s outperformance in Europe correlates well with flows (top below chart)."

- source Deutsche Bank

Another important point from Deutsche Bank's note relates to ETF flows becoming an increasingly important indicator:
"ETF flow has become an increasingly important driver of stock returns over the past years as the share of equity held by ETFs has gone up significantly. In case of the DAX, this share has increased to 6.2% from 0% 10-years ago (Figure 1)."

The two largest ETFs to invest Europe based on AuMs are those on the ES50 + DAX30.

Hence, it doesn’t seem too far-fetched assuming that stocks constituent to both benchmarks could benefit/suffer over-proportionally depending on flow in and out of these vehicles. Figure 2 highlights the blend of stocks constituent to both indices.

We can show that ever since the Great Financial Crisis (GFC) hit markets and ETFs became common tools to implement (rather short-term oriented) market views, flows into Western European ETF funds correlate well with this basket’s outperformance in Europe, based on market cap weights (Figure 3).

The basket P/E ratio trades at a 20% premium to Europe (Stoxx600) and at a 10% discount using P/B (Figure 4). 

Since the basket comprises Financials as well as Industrials, we consider the P/B ratio as more meaningful in this context since Financials are generally valued over their book value of equity rather than earnings.
Should the money flow return to Europe (predominantly via ETFs) once positive economic surprises come through as implied by our credit impulse framework, we think the recent pull-back (and subsequent underperformance of the basket) should be seen as an attractive entry point." - source Deutsche Bank

In similar fashion to Deutsche Bank our good friends at Rcube Global Asset Management in their latest note entitled "Is Europe's situation so bad that it is good?", posit the following:
"Global equities have reached a strong resistance level, sentiment is frothy (EM and US), breadth is poor, bearish technical divergence abound; all this makes a larger correction likely. This would create a great buying opportunity for European equities for a year end and H2 2015 rally. The periphery and banks should be the clear winners".

During this summer, European equities have indeed been punished due to the significant fall in European inflation expectations as shown as well by our friends in their note:

"European Inflation expectations have crashed this summer. French 3 year breakevens have lost 100 bps since April. This has worried equity investors who punished European equities both on absolute and relative basis

If left unanswered for too long by the ECB, the deflation scare could clearly trigger more selling pressure, this would be we think a major opportunity to play both a rebound on absolute terms and a catch up with US stocks from a relative perspective. When met with action by the European central bank, the European and US liquidity environment will look very different (QE ending in the US, starting in Europe; Monetary tightening in the US, Negative interest rates in Europe, EURUSD weakness).

In the very short term, the gap that has opened up between inflation expectations and equity prices is such that if deflation fear persist, the selloff could be more severe, or it is also possible that financial markets stress will be the trigger for the ECB to act, in which case lower equity prices are likely before the rebound set up gets clearer. In the past this is exactly what happened. Inflation expectations following a market shock would melt, prompting a response from the central bank. Hence this is why inflation expectations are such a good contrarian explanatory factor equities forward returns.

As the back test below shows, the lower the forward inflation rate, the higher the Stoxx 600 forward returns. This clearly makes the decision process harder this time around since there has not been any correction in equities following the crash in breakevens. This is explained by the high hopes over Quantitative easing by the ECB, the lower inflation expectations are falling the higher are the hopes for QE, and its positive impact on equities.

As explained below, in the medium term we strongly believe that European equities are going higher. So this is only a question of timing.

Our Equity model for European equities is sending its stronger buy signal since just after the 1987 crash

Valuations according to our methodology are the cheapest since March 2009 thanks to the yield meltdown

- source Rcube Global Asset Management

Where we slightly disagree with our friends is that should QE materialise banks should be the clear winners. We'd rather hold bank debt than bank equities given the upcoming AQR which should highlight the capital needs of some European banks. Given banks' stocks are a leverage play on the economy and looking at the weakening economic growth outlook, we would rather hold bank senior debt than their stocks from an investor point of view. We will in another post touch again on the European banking situation rest assured.

In similar fashion to Deutsche Bank and our friends at Rcube, Barclays as well on the 2nd of September also added to the contrarian views of a possible tactical rebound in European equities in their note entitled "Don't exit Europe":

"Recent trends suggest we are near a turning point for continental European equities.

While the poor performance of Continental European equities since May owes something to the ongoing conflict in Eastern Ukraine, the main cause is more fundamental.

Negative data surprises have now reached an extreme relative to those in the US with underperformance to match. History suggests such episodes have been turning points.

The weakening in the Euro should help revenue and earnings growth, while there is evidence that bottom-up earnings estimates are responding to a solid Q2 reporting season and no doubt the weaker Euro.

While we have cut our forecast for earnings growth in Continental Europe to 10% in 2014, this should accelerate to 17% in 2015. Both forecasts are slightly above the bottom-up consensus.

There is an increasing chance the ECB will ease monetary policy further with full blown QE becoming more likely. Such a move would represent a major regime change and echoes some past experiences such as the major ERM realignments of the early 1990s.

Finally, Europe’s underperformance has not been confined to domestically focused stocks. Several globally focused sectors such as Energy, Industrials and Healthcare are trading at multi-year lows compared with their US peers."

- source Barclays

This adds more ammunition to our views expressed in our 19th of August conversation "Thermocline - What lies beneath":

"The lag in European stocks given the very recent negative tone in Europe due to the Russian sanctions have made them much more volatile. Should the "Risk-On" scenario persist in the coming weeks it should lead once again to an outperformance of European stocks versus US stocks."

Of course all eyes are on the ECB and expectations are high the ECB will sooner rather than later unleash a QE of its own. On that matter we agree with Bank of America Merrill Lynch's take from their Liquid Insight note of the 1st of September entitled "Muddle-nomics", that, QE won't happen just yet:

"No QE, yet

Draghi’s speech at Jackson Hole was dovish enough to confirm our view that small scale ABS purchases will take place, very likely before year-end, but not to change our view that QE is unlikely to happen within 12 months (a close call and in contrast to our view that more aggressive action by the ECB is warranted).

For this week’s meeting, we do not rule out smaller measures, such as fine-tuning the upcoming TLTROs or a detailed timeline of how and when ABS purchases could take place, given the need to deliver after the market’s reaction to Draghi’s speech. However, in our view, none of these would change the outlook substantially. The key issue will be to understand how many members of the governing council share Draghi’s latest concerns, particularly since his comments on inflation expectations were not included in the original text posted on the ECB website. We believe Draghi will not be able to convince the governing council to adopt broad-based QE just yet. But we think further disappointments in inflation data could do the trick." - source Bank of America Merrill Lynch

We also agree with Bank of America Merrill Lynch when it comes to further yield compression in our "Japanification process":

"Rates: Trade the journey not the destination

The reaction in the rates market will not just be a function of what specific measures the ECB announces, but also the extent to which the ECB lays out the conditions for future action. Even if the market would arguably be disappointed by our central scenario, a dovish press conference would still be possible. We have argued here that rates are not pricing in a significant QE probability. Following the Jackson hole repricing, we would argue this statement generally still holds. We remain constructive European rates and express that by being long duration in the periphery." - source Bank of America Merrill Lynch

Moving on to the subject of the Euro, with the on-going "Japanification" process, what appears clear to us is that you can expect significant rise in volatility in the FX space particularly with EUR/USD, in similar fashion you had significant volatility throughout the years in USD/JPY. On that note Mohamed El-Erian's recent comments in the Financial Times in his article "Foreign exchange volatility is the risk to watch" are worth mentioning:

"The biggest threat to investors may come from the foreign exchange market rather than directly from the stretched prices of equity and bond markets. Judging by recent policy and technical signals, the forex market may be about to exit an unusual phase of low volatility." - Mohamed El-Erian - FT.

We expect a "regime change" in FX volatility as well. In fact we voiced our concern with the impact the end of tapering would have in terms of dollar liquidity in June 2013 in our conversation "Singin' in the Rain":

"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?

It is a possibility we fathom." - Macronomics, June 2013 

We also reminded ourselves in this particular conversation the following: 

"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 dollar goes even more in short supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the Rain", could it mean we will have wave number 3 namely a currency crisis on our hands? We wonder..."

Rest assured that higher real yield on US debt will continue to attract foreign investors towards US Treasuries hence our continued expectations for lower US long term yields. We have made no secret that we have been riding the long duration trade since early January 2014 via ETF ZROZ has a good proxy exposure to long US duration with some success...

When it comes to net USD buying the trend has continued as displayed by Bank of America Merrill Lynch in their CFTC FX Futures Watch from the 29th of August entitled "Largest USD longs in a year":

"EUR selling continues; short positioning stretched

Speculators this week sold $1.7bn of EUR contracts, increasing net short positioning to $24.8bn. Speculators have sold $30.5bn of EUR contracts since the dovish ECB meeting in May. Net short EUR positioning is beginning to look stretched (Chart 2). 

Technicals suggest the near term trend is pointing to a maturing decline and a range trade, while our positioning models suggest a medium risk of reversal in the EUR/USD downtrend. - source Bank of America Merrill Lynch

On a final note and from a contrarian point of view, should the ECB disappoint there is potential for some heightened volatility and reversal given the short consensus trade on the Euro we think. What has been driving the move have been flows and QE expectations rather than "fundamentals" which can be seen when one looks at the forward curve at the 5 year point (we look at the 5 year point because for the ECB the five-year forward break-even in five years is certainly one of the important indicator) - table source Bloomberg - EURO/USD Forward Curve:

Flow matters...but the stock of European debt too.

When it comes to our European Catharsis, being the prelude to the European tragedy and the current high expectations of QE we think our final quotes resonate well with our sentiment on European woes and QE:

"There are only two tragedies in life: one is not getting what one wants, and the other is getting it." - Oscar Wilde

Stay tuned!

Guest post - Is Risk Parity a Scam - Rcube Global Macro Research

"We have a natural right to make use of our pens as of our tongue, at our peril, risk and hazard." - Voltaire 

Courtesy of our friends at Rcube Global Macro, please find enclosed their latest publication where Paul Buigues looks at Risk Parity strategies:

(for PDF please use the following link: http://www.rcube.com/docs/Rcube_Is_Risk_Parity_a_Scam.pdf)

Risk parity strategies experienced large drawdowns between early May and late June due to a combination of rising government yields and falling equities.

Note: The original and largest fund in the sector (Bridgewater All Weather Fund) does not publish daily NAVs.

This rather significant correction raised quite a few eyebrows, particularly because risk parity strategies are often marketed as being able to withstand a wide range of economic environments (and, unlike 2008, today’s environment is rather benign).

Although it would be preposterous to disparage a strategy based on two months of negative returns, this drawback gave us the impetus to express our thoughts on risk parity as an investment strategy, as it emerged from relative obscurity just a few years ago, only recently becoming fairly popular among investors.

Like other passive asset allocation strategies,1 the basic premise of risk parity is that asset returns are unpredictable, at least in the short] and medium]term. Consequently, investors should only attempt to capture risk premia, without wasting their time and energy trying to forecast the behavior of specific asset classes.

According to the Modern Portfolio Theory (which is, itself, based on a dozen theoretical assumptions), the only rational choice for an investor is consequently to own the gmarket portfolioh which contains every asset available in the market, weighed according to its relative size. Because this is difficult to implement in practice, investors often settle for a (generally more granular) version of the 60/40 allocation between equity and fixed income.

Risk parity is a different viewpoint on how not to exert judgment on any asset class. According to risk

parity proponents, investors should try to own all major investable asset classes on an equal risk basis.

Supposedly, this results in portfolios that have better risk/reward characteristics than traditional asset allocations. Moreover, as mentioned above, some argue that risk parity portfolios can generate quasi-absolute performances, even in the face of stormy markets.

Before going any further, it is worth stating that implementing a portfolio that contains all assets on

an equal-risk basis is even more challenging to implement than implementing the "market portfolio".

This explains the existence of many different variants of risk parity.2

Recap: Portfolios that express a neutral view on future asset class returns

After selecting a specific variant of risk parity, many implementation choices need to be made:

‐ What universe of assets should be used, and how should they be regrouped them in asset classes?

‐ Should asset class correlations be taken into account? And if so, how?

- How should we define risk? In our understanding, most risk parity implementations use volatility,

which obviously exists in many different varieties (historical, implied, predicted, GARCH, etc.) and

calculation horizons.

- What leverage should be applied to the portfolio for it to reach an acceptable rate of return? (Risk

parity generally involves leverage.)

- What frequency should be used for portfolio rebalancing and volatility calibration?

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1 Although risk parity strategies have to be managed actively (if only to equalize risk levels on a regular basis), we consider them to be passive, in the sense that they are not based on trying to forecast future asset returns.

2 Here are just a few implementations of risk parity: the “All weather” portfolio, classical risk parity, cluster risk parity, risk factor parity, and equal risk contribution.

To our understanding, the “All weather” strategy is not risk parity in the strict sense. From the way it has been described in various papers, it basically consists in choosing a set of asset classes, and in leveraging each of them to obtain a common expected return (generally the expected return of equities). In that sense, this strategy should be called return parity, rather than risk parity. Unless we expect all asset classes to have the same Sharpe ratio, these two approaches are not equivalent.

Due to this large number of degrees of freedom and parameters, this paper will present risk parity from a generic viewpoint. It will contain case studies and thought experiments rather than backtests (as we will see, backtests are generally biased towards risk parity strategies).

Although the term “risk parity” was only introduced in 2005, we can trace the origins of the concept

to a strategy that Ray Dalio (3) started using in 1996 to manage his family trust. Despite Bridgewater’s success in generating sizeable alpha for their clients, Dalio wanted to create an investment process that would not depend on his own ability to manage funds or to select managers (as he wouldn’t be able to do so after his death).

The strategy (named the “All Weather portfolio”) also had to deliver returns, regardless of economic

conditions. Dalio therefore concluded that the portfolio should maintain 25% of the portfolio’s risk in

each of the four following quadrants:

This is clearly an excessively simplified portrayal of a strategy that now has $70Bn under management and that has generated an annualized performance of around 8.5% with a volatility of around 10% since 1996, inspiring many fund managers and institutional investors to run the same type of strategies in-house.

However, despite its commercial and financial success, many observers consider risk parity to be an

investment scam. Finding a strategy that might dominate the classical 60/40 portfolio is one thing. Pretending that this strategy is able to produce stable returns (without attempting to predict those returns) sounds a lot like a "get rich steadily and without effort" scheme.

Even though wefre not into passive asset allocation strategies (otherwise, we would look for another

line of work), we will try to contribute to the debate. We will organize our thoughts by looking at

three intertwined dimensions of risk parity: diversification, returns, and risk. In each section, we will

express our opinion on the conceptual merits of risk parity, as well as its prospects in the current

environment.

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(3) Ray Dalio is Bridgewater’s founder and one of risk parity’s pioneers. Despite the criticism against risk parity expressed in this paper, Dalio is at the very top of our pantheon of financial thinkers.

1. Diversification

From a passive asset allocation standpoint, it is hard to argue against diversification, which

constitutes the core of risk parityfs philosophy.

The idea of spreading risk among different asset classes obviously precedes risk parity by a few millennia, as we can find references to it in the Talmud ("One's assets should be divided into thirds: 1/3rd in land, 1/3rd in business, 1/3rd in gold") or in the Ecclesiast ("Divide your investments among many places, for you do not know what risks might lie ahead").

In the early 1980s, Harry Browne introduced the gpermanent portfolioh, an investment strategy whose aim was to withstand all sorts of economic environments, and which was originally composed of an equally weighted portfolio of four asset classes: 25% US stocks, 25% long-term bonds, 25% cash, and 25% precious metals.

However, it is worth noting that these simple equal]weight approaches only aim at minimizing the risk of ruin from a personal wealth standpoint, which is not the modern view of how portfolios should be managed (i.e., maximizing investment returns for a given level of risk).

In terms of diversification, the major innovation of risk parity over these early approaches resides in

equally weighting risks, instead of allocations.

In that respect, risk parity proponents are indisputably right when they state that traditional 60/40 asset allocations are not truly diversified, as they have had a correlation of 0.90 with equities over the last 40 years.

That being said, we believe that placing diversification above everything else can lead to unpleasant consequences. The main advantage of a passive gmarket portfolioh approach is that, by definition, it does not disturb the market's equilibrium, as every asset class is weighted according to its relative importance in the market. On the opposite side, once it becomes popular, any other passive investment process that significantly deviates from market weights can wreak havoc in market valuations, precisely because passive investment processes entail not caring about valuations.

For example, letfs take a small exotic asset class (public Timber REITS, for instance), which would display nice diversification properties in the eyes of many different diversification]minded managers. Although each individual manager might decide not to own more than 1% of the total float, their combined buying power could very well provoke a bubble in the asset class.

A real-life example of the damage that can be caused by a blind quest for diversification can be found

in the way in which CDOs used to be managed before the credit crisis. In order to increase their contractual Moody's "diversity score", CDO managers were forced to diversify their exposures in terms of industries. As a consequence, some industries that had little outstanding debt became heavily sought after and, therefore, completely mispriced. In the end, a supposedly superior diversification did not help CDO managers, as correlations converged towards 1.00 during the 2008 credit crunch.

To a certain extent, the appeal of diversification might also explain investorsf willingness to buy TIPS

at negative yields (down to around -1% for the 10 years recently). While being a relatively small part of government debt (around 10%), TIPS' characteristics make them very attractive in the eyes of

investors who value diversification far above everything else, including valuation (in this particular

case, however, the jury is still out in determining whether we’re all “turning Japanese”).

One last word about diversification: as we will see in our next section, we’re not convinced that financial markets offer a sufficient number of uncorrelated risk premia in order to be able to reach a “true” diversification.

2. Returns

2.1. Risk premia

Like any other passive asset allocation strategies, risk parity relies on the assumption that some asset

classes should structurally outperform the risk‐free rate. Although there are theoretical justifications and ample empirical evidence for some of these risk premia, their number and their magnitude is ‐ and will always be ‐ subject to intense debate.

To us, the most convincing and economically meaningful risk premium resides in equities. Because of

the high covariance of corporate asset values with the state of the economy, equities have to compensate investors for the risk they take (no one wants to lose his job and experience portfolio losses at the same time). We can obviously only make rough estimates of the forward equity risk premium (letfs settle for 5% on a global basis), but we do have little doubt about its existence.

Even if they might offer some diversification benefits from a marked]to]market perspective, we believe that many asset classes (e.g., high yield bonds, REITS, or private equity) have a risk premium that originates from the same covariance with the state of the economy. Whether they should be considered as completely separate assets classes is, therefore, debatable. In fact, this question is specifically addressed by newer risk parity implementations, such as cluster risk parity and equal risk contribution.

For some asset classes, the very existence of a positive risk premium can be questioned. In the case

of commodities, for instance, the classical justification for a risk premium (i.e., Keynesf "normal backwardation") is nowadays dubious, as an increasing number of investors have been willing to take hedgersf opposite side. Roll yields, which had been the sole source of excess returns for commodities, have been centered on zero for the last 10 years.

For other asset classes, risk premium prospects currently look rather grim, the most obvious example

being Treasuries. If we look at 10]year Treasuries, their historical long-term return over short-term

rates has been around 1.6% since 1920. Since the early 1980s however, 10-year Treasuries have produced far higher excess returns (around 5%), as 10]year yields went from 15.8% to the current 2.5%.

Although there are only a few things about which we can be certain in finance, we can safely proclaim the mathematical impossibility of getting 5% excess returns by rolling 10-year treasuries over the next 10 years.

Therefore, because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a gbig rotationh that would bring 10-year yields back to a theoretical long]term equilibrium value.

There are obviously many other sources of risk premia. However, most of them (liquidity‐based ones,

for instance) are the “bread and butter” of specialized hedge funds. Therefore, they are outside of the scope of risk parity, which is not a bad thing, as many of these arcane risk premia tend to display a very negative skewness.

Our main point is that, even if we consider a large universe of asset classes, it’s not as if there were dozens of investable and economically meaningful risk premia waiting to be harvested by passive investors. In the end, when we take into account the fact that many risk premia actually originate from the same basic sources, we might end up with just a few investable risk premia. Additionally, as more people reach for diversification, those few risk premia tend to become more correlated over time.

2.2. Leverage

One important point regarding returns resides in the fact that risk parity strategies generally involve

leverage—that is, unless the investor is satisfied with long‐term returns of 2 to 2.5% over the risk-free rate.

Risk parity practitioners generally characterize leverage as a mere “implementation tool”, and they

believe that their superior diversification outweighs the disadvantages of running a levered strategy.

Although a reasonable use of leverage might not be fatal to a portfolio, it can irremediably hurt its

returns. Indeed, as we will see in our section about risk, leverage introduces a path dependency issue.

We can very well imagine a “black swan” situation, in which a supposedly safe asset class experiences a price trajectory that forces a deleveraging of the portfolio and, therefore, wipes out a large chunk of it.

3. Risk

We believe that the subject of risk is the one wherein risk parity is the most open to criticism.

Indeed, to reach the gparityh in risk parity, one has to reduce the risk of an asset to a single number

one way or another (generally a specific variant of the assetfs volatility). Although it is not a very original point of view, we believe that the risk of an asset cannot be quantified in this simplistic way.

Despite the fact that there is a certain level of stickiness in an assetfs risk (or volatility), every now

and then, assets - even supposedly gsafeh ones - have the nasty habit of breaking the parameters of

the equations that are supposed to describe their behavior (especially if these equations do not take

into account skewness).

To illustrate this point with a little story, letfs imagine a situation that could very well have happened

during the last decade:

In the aftermath of the 2000s tech crash, John becomes yet another young unemployed electrical

engineer (as Taleb, the inventor of the Black Swan theory, likes to characterize most quants). He decides to start a new career by getting a masterfs degree in finance. Armed with his solid math skills, John quickly digests modern portfolio theory, basic statistics, and all varieties of volatility calculations. He finds a job at an institutional investor and quickly moves up the corporate ladder.

In 2006, John convinces his board to apply a risk parity strategy to manage the firm's portfolio. Because he has a fresh and open mind about finance, he decides to spice up the asset mix by adding an exposure to mortgage]backed securities in the form of newly-minted ABX indices.

Who could blame him, based on the information available in 2006?

- The total size of the US mortgage debt is huge ($13 trillion in 2006), comparable to US equities, and larger than government debt.

- ABX indices are highly diversified, as each index is based on 20 distinct RMBS transactions. Each RMBS containing a minimum of $500 million worth of homes, an ABX investor is exposed to more than 50,000 homeowners throughout the US. What can possibly go wrong with such a diversified pool of debtors?

- ABX products are rated by respectable institutions, such as Standard & Poorfs (1860) and Moody's (1909), and they offer a wide variety of risk levels (from AAA to BBB).

- The volatility of the underlying financial products that compose the index is minuscule (they always trade around par).

Even if John had opted to buy the safest AAA ABX tranches (with, consequently, a high allocation due to their glowh risk), he would have experienced heavy losses during the 2007-2008 crisis. Additionally, he would have been forced to drastically reduce his allocation to the asset class as the gtrueh risk (or volatility) of ABXs revealed itself, preventing it from benefiting from any subsequent recovery.

Consequently, given that he was running a leveraged portfolio, John would have been forced to crystallize his losses.

This story might sound far]fetched, but we could have invented a similar story about Georgios implementing a risk parity strategy for a Greek institutional investor by leveraging on domestic government debt.

Some might argue that both of these examples involve blatantly asymmetric assets, which could have

easily been filtered out (especially in retrospect) by an experienced risk parity practitioner.

However, we can also imagine a forward‐looking scenario that would involve one of the most respectable assets on earth ‐ US Treasuries ‐ as the main culprit of a risk parity carnage:

Let’s imagine that, a few years down the road, Bernanke’s successor has to manage another “great

recession”. This time, the Fed decides to go beyond QE by pegging long‐term rates at a very low level (let’s say 0.5% for the 10year).4

As the Treasury remains stuck at 0.5%, there is no more volatility on Treasuries.

According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…

From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself.

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 4 This solution was discussed by the Fed in late 2010, and it has already been experimented with
between 1942 and 1951.

 Conclusion

Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance]based arguments that are often put forward by the proponents of risk parity.

From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:

1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategyfs performance under different scenarios.

2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.

3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.

4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.

5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly 

asymmetric returns, which can happen to any asset class given the right set of circumstances.

If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.

For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).

There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's

numerous flaws. However, we have little doubt that when the next gblack swanh terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage onefs life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.

That being said, the idea of a passive investment strategy that would be able to withstand any kind of financial weather is not unrealistic. However, its goal should be the long]term preservation of capital and not its theoretical maximization under a theoretical risk constraint. Additionally, the strategy should make very little use of leverage, and it should not make too many assumptions on the risk of a given asset (as risk becomes an unpredictable beast every now and then). In the end, we would probably end up with something quite similar to the Talmudic portfolio (N equally-weighted assets).

We realize that, without adhering completely to risk parityfs principles, many institutional investors

are implementing it as a part of their portfolio alongside other "absolute return" strategies. This approach is clearly less dangerous than an all]in commitment to risk parity. At a portfolio level, it simply results in overweighting low]volatility assets, which is obviously far-removed from the original purpose of risk parity.that is, true diversification at a portfolio level.

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

Stay tuned!