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

"Only those who will risk going too far can possibly find out how far one can go." - T. S. Eliot, American poet

Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the numerous factors pointing towards US Dollar Upside risks and under-priced financial risks:

(Notes to Readers Source for all charts: Rcube, DataStream, Bloomberg, Fred, BIS)

Has the second upleg in the US dollar already started? Is the FED, reassured by the recent batch of positive data, about to raise interest rates into what still looks like a slowdown. If so, how will emerging market corporate borrowers and global investors react to both a rising US dollar and rising interest rates?

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

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

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

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

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

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

commodity prices weaken.

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

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

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

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

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

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

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

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

Commodity currencies are also accelerating lower.

EM currencies’ down trend is intact.

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

This is bearish for EM assets

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

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

Corporate credit spreads have bottomed in July last year,

so did currency and interest rates implied volatilities.

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

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

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

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

more than 30 years.

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

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

Stay tuned!

Guest post - Consequences of a US Budget Balance Improvement

"Logical consequences are the scarecrows of fools and the beacons of wise men." - Thomas Huxley 

Please find below a great guest post from our good friends at Rcube Global Macro Asset Management. In this post our friends go through the consequences of a US Budget Balance Improvement.

The US budget deficit which has already shrunk at a pace never seen over the last 50 years is likely to shrink even more going forward given the ongoing republican fight for more spending cuts. This trend is likely to have some consequences on financial markets. We have selected 4 investment themes that we think, should materialize as a consequence.

• Rising volatility
• Consumer discretionary stocks underperformance
• EM assets underperformance
• Widening US long end swap spreads

The dollar is the reserve currency of the world, hence when the US runs a budget deficit it increases the amount of dollars in circulation, and provides the world with liquidity. When its financing needs shrink like it has been the case since 2010, global liquidity is reduced. This has ALWAYS created or exacerbated some kind of crisis around the world when it happened (Lat Am in the mid 80s, Asia in the late 90s followed by the tech bubble in 2000, the great recession in 2007).

Will it be different this time? QE has provided a necessary buffer to the liquidity shock that the sharp budget balance improvement has created. When QE ends, and if in the meantime spending cuts have intensified (budget ceiling debate) the pain will start being felt.

• Equity volatility has probably bottomed.

The pace of the deficit reduction is historical. it has shrunk by more than 6% of GDP over the last 3 years. In the past, this has pushed equity volatility upward systematically. Less liquidity means higher volatility, it is as simple as that as the chart below shows.

In previous cycles the trigger for the volatility to spike was bank lending behavior. So far no signs of the cycle being less supportive but there are hints that banks could become less accommodative going forward. Nevertheless this time, the trigger should be around the time investors will price the end of QE.

Another way to look at it is through the strong historical link between the fiscal cycle and corporate profit margins. As the chart below shows, corporate profits have followed the budget deficit momentum closely (with a lag) over the last 40 years. Fiscal gifts have in a way subsidized non]financial corporate profits. It is thus illusory and naive to believe that the ongoing war in Washington over spending cuts wonft have any impact on profits over time.

Earnings growth has also logically been correlated to the budget balance cycle.

The IMF just released global financial stability report highlights the recent rise in corporate leverage which on many counts now exceeds 2007 extremes.

As a result, the IMF baseline scenario for US HY default is to rise to about 10% by 2015. Clearly not priced in by investors at the moment...

Thus it will be particularly interesting to watch the Senior Loan Officer Survey Q3 results early November for clues about bank lending behavior. Both the rise in the financing gap and corporate leverage hint that banks could become slightly less accommodative going forward.

Our US Lending Standard model based on both the financing gap and non-financial corporate leverage suggests so.

• Consumer discretionary stocks should underperform.

The sector has been the main beneficiary of the fiscal cycle. Now that it has clearly turn, and that republicans will fight for more fiscal austerity, headwinds for the sector are clearly rising. Fiscal largeness or austerity impacts logically ones propensity to spend on discretionary items. As a consequence the relative performance of the sector can be explained by the fiscal cycle.

The urgency of its implementation came from another explanatory driver: interest rates. The spike in

mortgages and short term forward rates, creates further headwinds to an over loved, over owned, and overpriced sector.

Interestingly the same story holds in Europe. The luxury sector has underperformed its benchmark recently by more than 12%. LVMH earnings miss is we think another clear signal that developed markets consumer discretionary equities are set to underperform going forward. Fiscal tightening in developed countries combined with lower growth in Emerging markets are strong headwinds.

• Emerging market assets will underperform.

Emerging market assets have shown a remarkable negative correlation with the US financing needs. Since proper data began for EM equities, their relative performance versus developed markets has been strongly explained by the US budget balance.

The US budget went from 0 in early 1980 down to a deficit of 5% of GDP in the early 1990s, EM equities enjoyed simultaneously a powerful relative bull market. During the Clinton years, and the US boom, the deficit turned into a surplus of 2.6% in 2000, EM stocks crashed on a relative basis. From 2000 until early 2010 the budget balance nose-dived, and turned into a deficit of 10% of GDP. EM equities which were in the early 2000s extremely cheap on top, outperformed DM equities by close to 300%. Since then, the 6% shrinkage of the deficit has left EM equities underperforming by 35%. During that phase the underperformance was realized with a flat equity market. The MSCI EM is at the same level it was trading at in late 2009. We fear the next phase will see EM equities underperforming in a bear market.

Additionally, as we have mentioned more recently, we believe that China’s massive investment and property bubble is also at risk of rolling over. Private sector credit can’t rise at 40% of GDP every year for ever.

So, emerging markets could be hit from both sides. First by the liquidity withdrawal that the budget deficit reduction and the end of QE imply, second by the coming weakening investment cycle in China. Countries running a budget and current account deficit, together with a large export (to China) GDP ratio are at a particular risk here.

IBM results were we think very interesting; their sales in China were down 20% yoy. 20% is a big number. LVMH painted a similar message the day before. Caterpillar earnings next week will be another interesting read.

• US Long end swap spreads will widen

Long end swap spreads are a function of relative financing needs between the private and the public 

sector. At this time, the private sector is re-leveraging through increased shares buybacks, dividend 

payments and Capex spendings, while the public sector deleverages. This classic inverse relationship 

implies just like it did in the late 1990s that long end US swap spreads will widen from current levels.

"The consequences of an act affect the probability of its occurring again." -

B. F. Skinner 

Stay tuned!

Credit - The Rambler

"Men more frequently require to be reminded than informed.", Samue Johnson, The Rambler (1750-1752).

While last week we asked ourselves if equities had not become indeed "the last refuge of the yield/returns scoundrels" given the recent inflows into the equities sphere and the "Cantillon effect" with the bubble inflated by the "wealth effect" courtesy of Ben Bernanke's, we decided this week to make another reference to English writer Samuel Johnson. 

Yes, in our numerous posts, we have indeed on many occasions been frequently "rambling". It was therefore necessary for us to pay homage to Samuel Johnson, due to the fact that some of our friends and readers have frequently told us that because of our many references to past writings we have become somewhat some kind of a "rambler". We do agree. 

But, as Samuel Johnson's quote goes, we have preferred reminding than informing as we have often based our thought process on the following premises: 

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

-The market does not learn for long.
-Human nature does not change."

When it comes to human nature and "Cantillon effect" leading to the formation of bubbles in risky assets, one might rightly ask if the last refuge of the scoundrels, being equities, are "fully valued" or not?

This week we will therefore focus our attention on "valuations".

The "Cantillon effect" at play, the rise of the Fed's Balance sheet, the rise of the S&P 500, the rise of buybacks and of course the fall in the US labor participation rate (inversely plotted) - source Bloomberg:

In red: the Fed's balance sheet

In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

On that subject, Nomura's Macro Systematic Snapshot from the 26th of September made some interesting points:

"Are equities "fully valued"?

-Some high profile US investors have recently claimed equities are "fully valued".

Figure 1 shows our global aggregate value measure which has been gradually increasing since the end of 2012. 

Globally, stocks are not as expensive as they were in 2007/8 but are approaching similar levels. One caveat: this measure is based on free cash flow yield, which excludes financials. And financials look generally cheap.

-There are large regional differences in valuation. US and Japan look expensive whereas Europe and Asia ex-Japan look more fairly priced.

-This is consistent with our corporate fundamentals class where US looks weaker while Europe looks more robust.

-However, value is not the only style in town and our momentum and carry signals are more bullish leaving us net long in many markets including S&P 500 and Eurostoxx."  - source Nomura

When one looks at the relative performance of the S&P 500 versus MSCI Emerging, one can easily see EM equities have been clearly lagging. Emerging markets (MXEF). Emerging Markets have continued to underperform developed markets  - source Bloomberg:

While the absolute spread between the S&P 500 and MSCI Emerging Markets has touched a record low level in the middle of May this year, 

In our early September conversation "The Tourist Trap" we argued:

"Yes, the bounce in Emerging Markets has indeed occurred in the past after similar redemptions, but we disagree with Bank of America Merrill Lynch. We have not seen the bottom yet, and that the rebound could probably materialize at a later stage, maybe in 2014."

But, looking at the most recent inflows and the improvement we have seen towards Emerging Markets, with the lack of "tapering" leading to a compression in the 10 year US Treasury yield, had led us to reassess our current stance towards Emerging Markets. The following chart from Bank of America Merrill Lynch Flow Show from the 26th of September is indicative of the sentiment upturn:

"Weekly flows show that the Fed decision of no-taper has caused 3% to become the "ceiling" for UST10, which in turn has granted a reprieve for all the summer tapering victims. Highlights include:

-Biggest inflows to bond funds in 5 months ($4.5bn)

-First inflows to unloved EM debt funds in 18 weeks ($0.6bn)

-First inflows to Muni funds in 18 weeks (albeit small $59mn)

-Largest inflows to IG bond funds in 17 weeks ($1.0bn)

-And, for first time in 7 months EM equity inflows coincided with DM equity outflows"

- source Bank of America Merrill Lynch

And from a valuation point of view, and contrarian stance, we would have to side on Barclays take, from the 26th of September in their Equity outlook entitled "Looking beyond the US":

"• Emerging market equities in particular now appear very cheaply priced relative to their US peers, while EPS upgrades may support European stocks. In Japan, the central bank’s very determined policy easing has yet to be fully reflected in the relative performance of that market.

• So for differing reasons, we suspect that non-US equities will prove more rewarding for investors than those listed in the US.

The relative performance and valuation of emerging market stocks is especially striking. As Figure 5 demonstrates, since their relative high point in October 2010, emerging markets have underperformed the world index (ex-EM) by 31% and sit at relative levels last seen at the height of the global financial crisis.

The relative valuation attached to emerging market equities has also collapsed. As Figure 6 shows, the price/book multiple is now 40% below that of the US market. This is the cheapest they have been since 2004.

- source Barclays

MSCI EM versus Nikkei - source Bloomberg:

So we could indeed see a continuation of the bounce in Emerging Markets to the pleasure of the "yield/returns scoundrels" particularly in the fixed income space.

But as per our "rambling habits", in numerous conversations, we pointed out we had been tracking with much interest the relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - graph source Bloomberg:

Back in April 2013 we argued in our conversation "The Awful Truth" the following:

"The decline in the oil price may prove to be another sign of deflationary pressure and present itself as a big headwind. Why is so?

Whereas oil demand in the US is independent from oil prices and completely inelastic, it is nevertheless  a very important weight in GDP (imports) for many countries. Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.

Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.  As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets."

We also quoted Bank of America Merrill Lynch on the subject:

"Whether it is high energy costs, expensive labor costs, a rising cost of capital, declining profitability, or misdirected investment into unproductive assets, the dislocations created by five years of zero interest rate policy in DMs will likely have some negative consequences in EMs. With oil demand growth exclusively supported by buoyant EM growth for years, lower global GDP trend growth (say from 4% down to 3%) could push Brent firmly out of the recent $100-120/bbl band into a lower $90-100/bbl range." -source Bank of America Merrill Lynch  - 17th of April 2013.

So could it be that the recent rebound in Emerging Markets has more road to make or is it only a temporary relief?

To that effect, we think shipping is still indicative of the powerful deflationary forces at play, which so far have prevented the Fed from "tapering", giving much need relief to many risky assets classes and are sending conflicting informations. On one hand, shipping rates continue to be weak for 40-foot containers as indicated by Bloomberg:

"Shipping rates for 40-foot containers (FEU) fell 7.9% sequentially to $1,665 for the week ending Sept. 26, the third straight decline, according to World Container Index data. Weakness was driven by Asia, with rates from Shanghai to Rotterdam falling 19% to $1,703, followed by a 14% decline in Shanghai to Genoa and a 1% decrease in the Shanghai-to-Los Angeles routes. Rates were mostly unchanged for freight moving between New York and Rotterdam." - source Bloomberg

On the other hand, the Baltic Capesize Index as increased by 114% to 4,018 since the 1st of August as reported by Bloomberg:

"The Baltic Capesize Index has increased by 114% to 4,018 since Aug. 1, spurring debate about whether the worst is over for the dry bulk market. Capesize vessels have outperformed panamax (up 38%), supramax (up 5.7%) and handysize (up 5.1%), and the broader Baltic Dry Index, which has climbed 79.3% in the same period. Shipping bulls and bears are debating if the move has been spurred by seasonality or if there is some sustainable demand behind the move." - source Bloomberg

For some, like ourselves, the relief rally can only be temporary given the deflationary forces at play and the on-going deleveraging, which is also indicated by Bloomber Chart of the Day when it comes to shipping as a leading indicator and valuation indicator:

"The biggest rally in iron-ore freight costs since 2009 is temporary and traders should bet against it lasting because there’s still a ship glut, according to an analyst who predicted the industry’s worst slump.

The CHART OF THE DAY shows, in white, how spot rates for iron-ore carrying Capesize ships rose to 34-month high of $42,211 a day on Sept. 25, one month after China’s imports of the commodity from Brazil, in purple, rose to the highest since February. Freight costs will slump 55 percent in the next three months, according to Sverre Bjorn Svenning, a director at Fearnley Consultants A/S, a research company in Oslo, who says he’s been bearish since 2007, the record year for average rates.

Brazil’s iron-ore producers accelerated exports of the commodity in July and August, compensating for shipments that slumped to a two-year low in June, Svenning said by phone today. Demand for ships will be curbed because the expansion in cargoes won’t continue at the same rate, he said. Total capacity of commodity-carrying ships expanded 62 percent since 2008, during which time global trade in the steelmaking raw material grew 40 percent, data compiled by Bloomberg show. “I can’t see that underlying demand can sustain the massive fleet,” Svenning said. “There was a massive tsunami of delivery of new vessels in 2009. The market will come off again.” His estimate for the fourth quarter is for rates to average about $19,000 a day, 34 percent below freight swaps that investors use to bet on, or hedge, future shipping prices. They traded at about $29,000 a day as of 10:21 a.m. today in London, according to data from Clarkson Securities Ltd." - source Bloomberg

While no doubt the Baltic Dry Index has indeed broken ou from its downward channel at a rapid pace since August - graph source Bloomberg:

"The dry-bulk market, which accounts for about 50% of shipped freight, is driven by steel demand, as iron ore and coking coal make up about 40% of volumes. Utility coal, grain, bauxite-alumina and phosphate are also major dry-bulk commodities. The Baltic Dry Index, a major barometer for the industry, has more than doubled ytd." - source Bloomberg

Overall the shipping industry continues to be plagued by overcapacity as the overbuilt legacy from the credit bing days continues to be dealt with - graph source Bloomberg:

When it comes to shipping and the conflicting message sent across, it might be just a case of a market of a market over extending its gains based on future expectations which have been distorted by ZIRP policies, hence the over optimistic reaction since August in that space. Last time the gap between the order book for bulk vessels and the US recession was one year. Once again, we are left wandering if the very large gap between the number of bulk vessels on order and the bulk vessel orderbook as a percentage of capacity is not a reflection of yet another "Cantillon effect" transmitted by ZIRP to the shipping industry - graph source Bloomberg:

 So from a valuation point of view and looking at the recent evolution in shipping it appears to us very difficult to point to a strong rebound in the near terms for Emerging Markets equities, although valuations for some do appear clearly enticing.
 
"Shallow men believe in luck. Strong men believe in cause and effect." - Ralph Waldo Emerson, American poet.

Stay tuned!