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!

Credit - The Cantillon Effects

"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased."- Adam Smith 

Last week, we concluded our post by indicating of one of our "outside the box indicator" namely Sotheby's stock price versus world PMIs since 2007 - graph source Bloomberg:

We argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months.

Of course, our reference to this "outside the box" relationship was by no mean "innocent". In fact it was the perfect way for us to justify this week's chosen title given that "Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with an increasing "exogenous" (central bank) money supply.

So why choosing art as a reference market in describing Cantillon effects and asset bubbles you might rightly ask? 

Well, as posited by a very interesting study by Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":

"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.

Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

Nota bene: Classical equation of exchange, MV = PQ, also known as the quantity theory of money. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.

-Endogenous money, PQ => MV (Hume, Wicksell, Marx)

-Exogenous money, MV => PQ (Keynes, Monetarist)

In our Cantillon Effects, we get:

Δ M  => Δ Asset Prices

Our friend Cullen Roche recently argued that the "Austrian Business Cycle Theory is inherently flawed and built on misunderstandings about the way the modern monetary system actually works.":

"Austrian Business Cycle Theory Misunderstands Endogenous Money.  Like many other economic schools of thought, Austrian economics is predicated on a loanable funds model with a world view designed to demonize just about everything the central bank does.  As I’ve explained before, the primary purpose of the central bank is not a conspiratorial attempt to enrich bankers, but to help oversee and regulate the smooth functioning of the payments system." - Cullen Roche

As far as we are concerned, if economy is a "religion" then we are agnostic, but, we do believe that, there are some points which are valid in some theories, Austrians included.

By no mean, we would like to enter into endless economic arguments. We have no point to prove, just common sense to display. 

Our objective in this week's conversation, is rather to expand our vision (and maybe yours) to our understanding of "Cantillon effects", asset prices bubbles and "mis-behaviors" of markets (in true Mandelbrot fashion that is...).

"Cantillon effects" in the market for art:

"Money supply is “M1” based on methodology used by Bessler 1984 and Devadoss  & Meyers 1987, in order to compare results of Cantillon Effects versus money supply effects on output prices.

Art data based on 1,336 repeated sales from 1830 – 2007 on the London market. 

Data provided by Goetzmann et al 2010, data commonly used by cultural economists to measure returns to art versus other assets, updated by Goetzmann et al for error correction, contemporary art (1960s onward) and a more recent method for inflation indexing.

We find two distinct periods of monetary history, leading to the need for data bifurcation between the pre-war Classical Gold Standard (1830 – 1913) and the post-war central-banking era (1946 - 2007)."

 - source Cameron Weber, PhD Student in Economics and Historical Studies.

From the same study from Cameron Weber we learn the following interesting point:

"Bessler 1984 and Devadoss & Meyers 1987 use a VAR log likelihood model to estimate the most likely lagtimes between a monetary change and effects on output prices.  They find (using monthly data) that the most likely lagtime is 13 and 14 months with a rapidly dissipation of the price increase immediately following the most likely effect.

Using the same methodology we find that the most likely effect of a money supply change on art prices is also between the 13th and 23rd month (e.g., during the 2nd year using yearly data).

However, unlike the earlier work on output prices, we find that the effect on art prices does not decay rapidly after the monetary increase, showing perhaps that money changes are cumulative (and/or have momentum) and could lead to an ‘asset bubble’."  - source Cameron Weber, PhD Student in Economics and Historical Studies.

The most interesting part of using the art market as a "proxy" for asset bubbles is indeed that money changes (namely the monetary base) leads to the creation of "asset bubbles".

Back in December 2010, in relation to the launch of QE2, in our conversation "Inception - Bernanke's QE2 Experiment" we argued:
"Like in the movie Inception, the Fed is trying to plant an idea into people's mind. Bernanke idea's with QE2 is to create a wealth impression which would increase consumption and economic growth, with the help of rising assets prices. We had the Greenspan put and the Bernanke put, we also now have to contend with the same bubble creation plan which was initially followed by Alan Greenspan.
We all know now the results of creating asset bubbles and the consequences.

It is a very dangerous game." - source Macronomics.

And as we posited in our January conversation "If at first you don't succeed...": 

"Arguably the strategy of our "Sorcerer's apprentice" has been to try to induce a rise in velocity, but, we have shown in our post "Zemblanity" that the "relationship" between US Velocity M2 index and US labor participation rate over the years is clearly indicative of the failure of the theories of Friedman and Keynes because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of "stocks" versus "flows." - source Macronomics

Another illustration of the cumulative effect in the change of money leading to asset bubble has been clearly illustrated by the housing bubble leading to the financial crisis given we are now at the 5 year anniversary mark. 

Once again "Cantillon effects" were at play as clearly demonstrated by Cameron M Weber, Cameron Weber, a PhD Student in Economics and Historical Studies, in the following abstract - "The Economic History of the Recent Financial Crisis Using Cantillon and Intervention Effects as a Basis for Explanation":

"This research uses Cantillon effects and institutional, policy, incentives created in the market for home purchases in the US to show correlation and causation between an increase in the quantity of money and an increase in home prices during the housing “boom” and the subsequent financial collapse based on the “bust” of the housing boom. Initial results show that the FHA policy initiated in 1998 to encourage 0% down-payment mortgages for housing triggered a relationship between an exponential growth in housing prices with that of an exponential increase in the money supply. Initial results also show that this structural relationship ended in May 2006 when the SEC declared “accounting irregularities” at Fannie Mae, which also coincides with the downturn in housing prices." - source Cameron Weber.

When it comes to the current market conditions and "Cantillon Effects", and asset bubbles, as well as other valid economic theories, Keynes coined the term "Animal spirits" in his 1936 book "The General Theory of Employment, Interest and Money" to describe the instincts, proclivities and emotions that influence human behavior, consumer confidence, as well as speculation:

"Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." - John Maynard Keynes, The General Theory of Employment, Interest and Money, 1936.

In similar fashion to the Cantillon Effects, which led to the Austrian Business Cycle Theory and the role of "exogenous" money, Keynes held the view that "animal spirits" lead to damaging speculation and he was a proponent for government restrictions on investment to avoid the formation of "asset bubbles".

But, the "behavioral psychologist" in us would argue that large speculative episodes throughout histories are not engendered solely by human nature. Multiple examples of boom, and bust cycles have shown that the "Cantillon Effects" leading to the formation of asset bubbles shared common trait of "stimulation". For instance the housing bubble in the US was clearly the result of government policy in conjunction with increases in the money of supply with incorrect interest rate levels leading to speculation and "mis-allocation" of capital.

In similar fashion, as we argued recently, the effect of the last few years of ZIRP has led to speculative inflows in Emerging Markets. Current outflows are due to "flows" issues rather than "stocks" issues (debt levels in many Emerging Markets remain well below Developed Markets), confirming therefore our "reverse osmosis" theory.

We did give an early warning on the risk for Emerging Markets on the 14th of April in our conversation "The Night of the Yield Hunter" though:

"The risk of a deflationary bust validates our negative stance towards commodities and emerging markets as indicated last week for the second quarter.

In similar fashion UBS in their March 2012 note entitled "The Ides of March" made an interesting point which could validate the on-going weakness in both commodities and Emerging Markets:

"The end of Federal Reserve and European Central Bank (ECB) stimuli will cause an acceleration of capital flows out of emerging markets, hitting commodity demand."  - source UBS

The work done by Didier Sornette's team relating to the prediction of the formation of asset bubbles as indicated on the "Financial Crisis Observatory" site clearly illustrates the "Cantillon Effects" at play.

For instance their recent study of the "behavior" and bubble formation for Tesla's share price is also illustrative of "bubble formation" and "animal spirits" or when "our positive activities depend on spontaneous optimism rather than mathematical expectations", to quote Keynes:

"Inflated high-tech stocks like Tesla (or LinkedIn) are particularly vulnerable during a global correction in stock markets.

Without judging the value of Tesla’s technology, innovation and management, it is a textbook example of a bubble.

See this paragraph from our recent article D. Sornette and P. Cauwels The Illusion of the Perpetual Money Machine, Notenstein Academy White Paper Series (Dec. 2012)

(http://arxiv.org/abs/1212.2833 and http://ssrn.com/abstract=2191509)

(https://www.notenstein.ch/sites/default/files/publications/notenstein_white_paper_series_041212.pdf)

“First, a novel opportunity arises. This can be a ground-breaking technology or the access to a new market. An initial strong demand from first-mover smart money leads to a first price appreciation. This often goes together with an expansion of credit, which further pushes prices up. Attracted by the prospect of higher returns, less sophisticated investors then enter the market. At that point, the demand goes up as the price increases, and the price goes up as the demand increases. This is the hallmark of a positive feedback mechanism. The behavior of the market no longer reflects any real underlying value and a bubble is born. The price increases faster and faster in a vicious circle with spells of short-lived panics until, at some point, investors start realizing that the process is not sustainable and the market collapses in a synchronization of sale orders. The crash occurs because the market has entered an unstable phase. Like a ruler held up vertically on your finger, any small disturbance could have triggered the fall.” 

It is also important to stress that in the same manner Tesla is the textbook example of the importance of bubbles in innovation and technological revolutions, as explained within our "social bubble'" hypothesis [1-4].

If you look at the income statement of Tesla you see that the company has been losing money consequently. This is no surprise for such a high-tech startup.

If investors would only focus on fundamental value, Tesla would not be able to raise money through the stock-market. However, because of the anticipations, hence, the bubble effect on the price, investors are nevertheless attracted by expected profits. This would not be possible if the price would be fully fundamentally driven." - source ETH, Financial Crisis Observatory.

Tesla Market value exceeded $20 billion on the 26th of August - graph source Bloomberg:

There you go, "spontaneous optimism rather than mathematical expectations" to paraphrase Keynes.

The Log-Periodic Power Law Oscillations (LPPL), is part of the methodology used by Professor Sornette  to ascertain the "bubble" level (here comes the notion of fractals and our prior reference to Mandelbrot and his book The (Mis)Behaviors of Markets).

Of course, another illustration of "Cantillon Effects", credit creation and "bubbles", as we have long ascertained, has been in the shipping industry as illustrated by the "boom" and "bust" of the Baltic Dry Index.

The Baltic Dry Index aggregates the costs of moving freight via 23 seaborne shipping routes. It covers the movement of dry-bulk commodities, such as iron ore, coal, grain, bauxite and alumina.

In similar fashion the burst of the credit bubble had a dramatic impact on housing, shipping was as well not spared as cheap credit did indeed fuel a bubble of epic proportion - 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.

The deflationary environment, and "Schumpeter" like creative destruction has enabled innovation, in the container shipping space benefiting, the fittest to survive such as Danish Maersk currently busy upgrading massively its container fleet. Maersk remains our favorite, when it comes to identifying the survivors in this game of "survival of the fittest" but we digress.

As we indicated in our January conversation entitled "The link between consumer spending, housing, credit growth and shipping - A follow up":

"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."

We have indeed seen such a rebound in the Baltic Dry Index - graph source Bloomberg:

"Containerized traffic is dominated by the shipment of consumer products, and a resurgence in international volumes is dependent on the housing market. Furniture and appliances are some of the top freight categories imported into the U.S. and euro zone from Asia. Furniture demand has been picking up, after bottoming in 2009 following the collapse of the housing market." - source Bloomberg.

As far as the Baltic Dry Index is concerned, while US Family Housing Starts looks fairly flat, US Furniture sales have indeed been very strong explaining therefore the pick-up in the aformentioned Baltic Dry Index:

Since 2006:

- in yellow the Baltic Dry Index, 

- in orange US Family Housing Starts 

- in white US Furnitures Sales.

The "Cantillon Effects" of cheap credit led to an inflation of both the housing bubble and the baltic dry bubble. The increase of US demand led to an increase in Chinese production, and a rise in commodities prices. 

In similar fashion, we indicated the "Cantillon Effects" of QE2 has been exporting inflation in our conversation "Misstra Know-it-all":

"The Fed tried to increase jobs by lowering interest rates, weakening the dollar in the process, boosting exports but exporting inflation on a global scale, particularly in the commodities space, leading to political instability in the process with QE 2. The effect QE 2 has had on the commodity sphere has been well described in a Bank of Japan research paper entitled "What Has Caused the Surge in Global Commodity Prices and Strengthened Cross-Market Linkage?", published in 2011.

Like we said about "positive correlations", "Misstra Know-it'all" has indeed played a quick hand, lifting stock prices, playing on the wealth effect game and exporting "hot money" flows in Emerging Markets."

When it comes to inflation, the "Cantillon Effects" are another way of looking at inflationary pressures, but of different nature. Inflationary pressures are not always strictly tied up to consumer prices, but, can be transmitted first in asset prices. While inflation in the US peaked at 5.6% in August 2008 prior to the stock market crash of October, the "Cantillon Effects" witnessed in the surge of assets prices were largely ignored by the US central bank - graph source Trading Economics:

As far as markets are concerned and in respect to the current level of prices, whereas market's performance in the 5 years that followed the demise of Lehman Brothers has been stellar, we agree with Bank of America Merrill Lynch's recent note entitled "Tinker, Taper, Told Ya, Buy" from the 12th of September, the next 5 years will probably be more "problematic"

"Asset markets will not do as well in the next 5 years, no matter what “nouveau bulls” say. Central banks will be less generous, corporations less selfish. And should excess liquidity be quickly removed markets will get “CRASHy”." - source Bank of America Merrill Lynch

Truth is the big beneficiary of the "Cantillon Effects" in the reflation game played out by the Fed has indeed been Wall Street versus Main street as indicated by Bank of America Merrill Lynch in the same note:

"After Lehman…

An unprecedented financial and economic crisis, crystallized by the September 15th 2008 bankruptcy of Lehman Brothers, was followed by an unprecedented monetary policy response, which in turn has been followed by unprecedented bull markets in bonds, stocks and now real estate. Wall Street has soared, but Main Street has soured (Chart 2). The exceptional “sweet spot” engendered by generous central banks and selfish corporations has been great for owners of capital, but bad for labor.

The "race to reflate" in the developed world and faltering Chinese macro leadership dictated the winners & losers of the past 5 years: Gold, High Yield, EM debt & Asian equities have been big winners; Commodities, Government Bonds & Japanese equities have been the big losers (see Table 1 on front page).

QE was the prime driver of the ‘09 trough in stocks & the ‘11 trough in real estate, and liquidity withdrawal has driven the jump in global interest rates in 2013. A further rapid, jump in rates would destabilize asset markets, but this threat remains low in coming quarters. The 100 basis point summer surge in the 30-year Treasury yield has tethered the S&P500 index to a tight 1600-1700 range and traumatized many fixed income & emerging markets." - source Bank of America Merrill Lynch

So if markets, does indeed become crashy in the next five years, we suggest you check, once in a while the   bubble index blog:

LPPL Market Watch

On a final note, if indeed rates are for "normalization", in similar effect, the world is "normalizing" as well given the Syrian crisis has seen the return of the Russia to world center stage, making us believe into a new era of "bipolarization". Market wise, we believe as well the Russian ruble is poised for a rebound as indicated by Bloomberg Chart of the Day:

"The ruble is poised to rebound from a four-year low as oil’s climb to the highest since February lures investors who fled during an emerging-market selloff after the Federal Reserve said it would taper economic stimulus.

The CHART OF THE DAY shows the currency of Russia, the world’s biggest oil producer, tumbling to its weakest since August 2009 against the central bank’s dollar-euro basket, even as Brent crude futures rallied to $117.34 a barrel last month. Previously the ruble had largely kept pace with changes in the price of crude, the country’s main export earner.

About $24 billion has been taken from emerging-market bond funds since the end of May, OAO Gazprombank and Morgan Stanley said, citing EPFR Global data. That’s the same month Fed Chairman Ben S. Bernanke first said U.S. policy makers were contemplating reducing quantitative easing.

“For the past few months, the market has been fixated on the Fed,” said Dmitry Dorofeev, a trader and strategist at BCS Financial Group in Moscow. “The ruble’s relationship with oil should re-establish itself once the initial taper is out of the way, and we should get a nice bounce.”

The ruble also may recover as energy exports climb from seasonal lows and local demand for foreign currency declines after annual dividend payments by large Russian companies and the peak of the tourist season, Dorofeev said. Russia is the world’s biggest supplier of natural gas and the No. 2 oil exporter, according to the International Energy Agency. The ruble has dropped 7 percent against the dollar and 7.8 percent against the euro this year, on track for its worst annual performance since the 2008 financial crisis." - source Bloomberg

"If liberty means anything at all, it means the right to tell people what they do not want to hear." - George Orwell 

Stay tuned!

Credit - The tourist trap

"Employ your time in improving yourself by other men's writings, so that you shall gain easily what others have labored hard for." - Socrates

Looking at the continuous outflows from Emerging Markets funds and in continuation of our recent title analogies relating to the "reverse osmosis" thesis, we thought this time around we would use a simpler analogy in our title reference namely the colloquial "tourist trap". As per the definition of a "tourist trap", a tourist trap is an establishment, or group of establishments, that has been created or re-purposed with the aim of "attracting tourists" and their money.

Our favorite "magician central banker in chief", namely Ben Bernanke, has indeed engineered the "best" of tourist trap when it comes to Emerging Markets. 

In our case, Ben's "tourist trap" involved ZIRP, low volatility and high carry trades in Emerging Markets currencies which, for many years, had the favors of Japanese retail investors in the form of the "double-deckers" (the famous Uridashi funds which particularly favored the Brazilian real). 

Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:

"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely:

 Wave number 1 - Financial crisis

 Wave number 2 - Sovereign crisis

 Wave number 3 - Currency crisis

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"

"Wave number 3", namely a Currency crisis is still in its infancy and is highly dependent on the "tapering" stance of the US Fed although, as per its members, the fate of Emerging Markets, is not really their "primary" concern...
"An appropriate next step toward normalizing monetary policy could be to reduce the pace of purchases from $85 billion to something around $70 billion per month." - Kansas City Federal Reserve Bank President Esther George - 6th of September 2013.

So in this week's conversation, and in continuation to our "reverse osmosis" analysis from previous weeks, we will look at the evolution of the "tourist trap" as well as the "Great Rotation" story as far as flows are concerned and the potential evolution in the markets (our own "Forward Guidance" so to speak), which warrants caution we think in this "statistically" bearish month of September ("Over the long haul, September has been the weakest of the 12 calendar months" - Doug Short).

A good illustration of our chosen theme of "tourist trap" can be seen in the slide of India's rupee which saw its dollar denominated external debt swell in recent years courtesy of "hot money" thanks to the "generosity" of our "magician-in-chief" aka Ben Bernanke:

- graph source Thomson Reuters Datastream / Fathom Consulting / Macronomics.

Also, when it comes to India's external debt and as illustrated recently by Bloomberg Chart of the Day, the rise of its external debt burden does complicate the situation for India in defending its currency. We could in fact call it the rupee "tourist trap" we think:

"India’s record foreign debt threatens to undermine the government’s plan to halt the rupee’s biggest slide in more than 20 years by reining in the budget and current-account deficits.
The CHART OF THE DAY shows the rupee weakened to an all-time low this year even as the combined deficits shrank. Previously the currency rose when the shortfalls narrowed and fell when they widened. The rupee dropped 8.1 percent last month to as weak as 68.845 per dollar. The lower panel tracks external debts owed by Indian governments and companies, which swelled to $390 billion as of March 31.
“Until the start of the current sell-off, the rupee had stuck pretty closely within the confines of its combined current-account and budget deficits,” said Philip Wee, a senior currency economist in Singapore at DBS Group Holdings Ltd. “By that measure, the rupee should be between 50 and 60 to the dollar, not 65 and 70.” 
India’s offshore liabilities rose to 21.2 percent of gross domestic product in the year ended March 31, according to official estimates, the highest since 2001. The rupee has plummeted 18 percent since then, the steepest drop among 24 emerging-market currencies tracked by Bloomberg. This has made refinancing the debt more expensive as global borrowing costs climb because investors expect the U.S. to pare stimulus thisyear, curtailing flows to emerging-market assets.
Finance Minister Palaniappan Chidambaram told the lower house of parliament on Aug. 27 that India’s twin deficits are responsible for the rupee’s fall, and that external debt was manageable.
He announced plans on Aug. 12 to reduce the current-account shortfall to within 3.7 percent of GDP this fiscal year from a record 4.8 percent in the prior period. The government us seeking to contain the budget shortfall to 4.8 percent of GDP from 4.9 percent." - source Bloomberg.

All the investors that piled in "high beta trade", namely our "tourist trap", in the form of Asian High Yield, Emerging Debt Bonds and Equities as well as Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play courtesy of repressed volatility thanks to central bank meddling due to negative real US interest rates.

And, when volatility is not repressed due to "tapering", this is what you get as illustrated by Merrill Lynch MOVE index rising back towards its record high of 118 bps:

We recently added JP Morgan Emerging Markets Currencies Volatility Index to our graph to display the on-going effect US Treasury volatility has on Emerging Market currencies.

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.

With US real interest rates moving into positive territory, it is therefore not really a surprise to read that Asian dollar denominated bonds have dropped below par for the first time since 2011 as reported by David Yong in Bloomberg in his article from the 2nd of September 2013 entitled "Asian Bonds Tumble Below Par in Capital Flight":
"Asia dollar-denominated bonds have dropped below par for the first time since 2011 as investors pull money out of the region amid concerns that growth is slowing and as currencies from the rupee to rupiah plunge.
Average prices of company debentures in the region fell to 98.61 cents on the dollar on Aug. 22, the least since October 2011, Bank of America Merrill Lynch indexes show. Dollar bonds globally have held above 100 cents since September 2009. Both investment- and non-investment-grade debt in Asia were below par on Aug. 22. The last time that happened was in September 2008, when Lehman Brothers Holdings Inc. collapsed.
Investor sentiment toward Asia is shifting as economic growth in China slows and currencies in India and Indonesia -- the two countries with the biggest external funding needs in the region -- plunge. About $44 billion has been pulled from emerging-market stock and bond funds globally since the end of May, data provider EPFR Global said on Aug. 23." - source Bloomberg

Investors are indeed trying to escape the "tourist trap" while some others are seeing their "tourist clients" finding their debt "less appealing" as witnessed in the recent auction failures for Russia, India and Taiwan, as discussed by Alex Nicholson and Lyubov Pronina in Bloomberg on the 4th of September in their article entitled "Russia joins India to Taiwan as Emerging Debt Sales Miss Targets":
"Russia failed to raise as much money as planned at a government bond auction, joining nations from India to Taiwan in missing borrowing targets as investors keep away from emerging-market assets.
The Finance Ministry in Moscow sold 6.07 billion rubles ($182 million) of its so-called OFZ notes due May 2016 after offering 13.6 billion rubles, according to a statement on its website. Russia canceled an auction last week as only one bidder took part. The ministry issued today’s bonds at a 6.5 percent average yield, the top of its proposed range.
Developing nations are trimming auctions as the prospect of the U.S. paring financial stimulus measures and tensions over Syria curb investor appetite for riskier assets. India’s central bank said it cut the size a debt auction this week to 100 billion rupees ($1.5 billion) from 150 billion rupees. Indonesia scaled back an Islamic debt offering for the first time since July, while Taiwan’s note sale yesterday fell short of the government’s goal for the first time since 2011." - source Bloomberg.

When it comes to the famous "Great Rotation" story from bonds to equities put forward since the beginning of the year, the only "Great Rotation" story as far as equities are concerned appears to be from Emerging Markets to Developed Markets as displayed by the cumulated weekly flows into Developed Markets and Emerging Markets from Nomura's recent Global Equity Fund Flow report from the 6th of September:

- source Nomura.

Of course some would argue that this "Great Rotation" story from bonds to equities, as far as flows are concerned, has been playing out in earnest in 2013 as displayed in Nomura's recent report:

- source Nomura.

So far, so right...but, if one looks at the inflows into bonds versus equities since 2010, then the "Great Rotation" story does seem much ado about nothing as displayed once more in Nomura's recent chart:

- source Nomura.

In fact, what seems to be happening, when it comes to "Great Rotation" for equities is a rotation out of equities except for European equities according to Nomura:
"Equity and bond funds both suffered outflows last week with USD 11bn redemptions from equity funds and a small net outflow of USD 0.8bn from bond funds according to EPFR. Money market funds also saw net sales totalling USD 7.5bn last week. Both developed market and emerging market equity funds suffered net selling and European funds once again outperformed, being the only region that we track to have received net inflows last week. Our global composite flows based equity sentiment indicator has oscillated fairly tightly around 1 standard deviation over the most recent eight weeks and last week dropped marginally to 0.97 standard deviations, a reading that we would consider as bullish but just below extended levels.
-US fund investors sold USD 5bn from equity funds last week. Over the past three weeks they have withdrawn a total net USD 15bn from equity funds, reversing only a fraction of the net USD 141bn invested into equity funds in the 33 weeks of the year to 14 August, according to the Lipper weekly reported dataset. Our US flows based indicator continued to moderate last week and now reads 0.7 standard deviations, signalling moderately bullish sentiment in our view.
-European equity funds bucked the global selling trend as they attracted an additional USD 0.8bn of net inflows last week. This is the 10th consecutive week of net inflows into European equity funds, a major reversal from the persistent selling seen in recent years. However, last week's inflow showed a moderation in the magnitude of money flowing recently into European equity funds. Consequently, our European flows based equity sentiment indicator was unchanged over the week at 2.24 standard deviations but remains close to the historical bullish extremes of sentiment measured over the past nine years.
-Emerging market equity investors continued selling equity funds last week with an additional net USD 2.8bn outflow from GEM equity funds. Although last week's outflow was the most significant since the end of June, our GEM sentiment indicator rose to -1.4 standard deviation but still reflects very depressed sentiment towards EM equities. Furthermore, investors continued to exit from the dedicated regional EM equity funds with net outflows of USD 1.1bn from Asia ex Japan funds, USD 0.1bn from LatAm funds and the highest weekly outflow (USD 0.5bn) from emerging EMEA funds in almost two years." - source Nomura.

"Great Rotation" or "Great Escape" you decide, given Bank of America Merrill Lynch also indicated on a note from the 5th of September entitled "EM Pain trade is up" the following:
Big weekly equity redemptions of $11.4bn. Past 3 weeks equity outflow of $29bn largest in 2 years (Chart 1). 

Investors reduced exposure in run-up to payroll. Big $6.1bn redemptions from EM stock & bond funds. Massive $60bn outflows from EM equity & bond funds over past 3 months = capitulation. Note EM equities outperformed after similar redemptions Jul'04, Aug'06 and Sep'08 (Chart 2).

Tactical bounce in EM equities continues unless a big payroll print (>250K) causes gap higher in treasury yields (>3%).
Inflows to Treasury funds this week despite historic sell-off. Follows 8 weeks of redemptions. Suggests onset of smart short-covering in recent days. Blowout payroll required for clean immediate break of 2%, 3%, 4% levels by 5, 10, 30-year Treasury respectively. No jobs blowout...look for reversals in recent sell-offs in bonds and EM." - source Bank of America Merrill Lynch.

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.

Why so?

Because of tightening financial conditions, particular in China following a massive credit growth, which will impact bank lending behavior in a negative way. China is increasing the clampdown on credit and on industrial overcapacity. Given banks are always a leverage play on economic growth, despite record profits at China's largest banks, stock valuations are not benefiting from this surge given the significant rise in nonperforming loans as displayed in the below Bloomberg graph:

"The CHART OF THE DAY shows that while combined net income of Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd. and Bank of China Ltd. for the three months to June 30 was 72 percent higher than three years ago, their price-to-estimated earnings ratios have fallen since then. The lower panel shows total nonperforming loans in the nation started increasing in September 2011.
Default risk is rising in the world’s second-largest economy, which economists forecast will grow this year at the slowest pace in 23 years. The government has been clamping down on excess capacity in industries including steel and cement as it tries to transition to a more sustainable economic growth model based on consumption rather than export-driven production." - source Bloomberg.

The delicate rebalancing act for the Chinese economy is in fact being put at risk by the aggressive "tapering" stance at the Fed as indicated by Chinese Vice Finance Minister Zhu Guangyao comments at the G20 as reported by Bloomberg:
"The U.S. should be mindful of a possible “very significant spillover effect,” said Zhu, who called for greater coordination between nations and added that there’s no need for a rescue plan for developing countries."

He also added:
“Some emerging-market economies are facing difficulties,” Zhu said. “Capital is flowing out of these countries and their currencies are under pressure of depreciation, and the major direct cause of such a phenomenon is the Fed’s announcement that it may exit its unconventional monetary policy. However, on the other hand, there are some structural problems with these emerging market economies as well.” - source Bloomberg, "China Asks U.S. to Cap QE Exit Risk as Indonesia Warns of Impact"

Therefore the impact of a tightening credit channel in China means more pain for the current account of countries exporting to China (including Germany), given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off.

The tightening credit channel in China and the clampdown on overcapacity will of course hurt Germany.

These were our concluding remarks in our recent conversation "Fears for Tears":
"The CHART OF THE DAY shows that Germany’s factory output as gauged by a manufacturing purchasing-managers’ index has mirrored Chinese bank-lending growth since a credit boom that began in 2008"

No surprise therefore to see German industrial production falling more than expected in July after surging in June, adding to signs that growth in Europe’s biggest economy is moderating:
-Output, adjusted for seasonal swings, fell 1.7 percent from June, when it jumped a revised 2 percent, the Economy Ministry in Berlin said on the 6th of September when economists were only expecting a decline of 0.5%.
-German exports, adjusted for working days and seasonal changes, fell 1.1 percent in July from the prior month, the Federal Statistics Office in Wiesbaden. Economists predicted an increase of 0.7 percent in a Bloomberg News survey.

On the impact of current account for countries exporting to China, we agree with our friends at Rcube Global Macro Asset Management:
"Current account of countries exporting to China are turning negative (and will remain so as long as China tighten its flow of credit). FX reserves’ pace of accumulation reverse and with them a host of asset prices that have been tightly correlated with it over the last decade: domestic real estate and equity prices, private consumption, commodity prices etc…"

- source Rcube Global Macro Asset Management

So, due to our Pareto efficient economic allocation, the weakness in Emerging Market equities, which have been simply the victims of currency wars and "Abenomics" mostly, (see our post "Have Emerging Equities been the victims of currency wars?"), will continue further, because the "reverse osmosis" occurring in Emerging Markets as displayed by "funds allocation" is positively correlated to US real rates moving into positive territory, or put it simply, when the risk doesn't match the reward anymore. 

The velocity in the "allocation" is entirely due of course to the speed of rising yields in developed countries as displayed in the chart below from Thomson Reuters Datastream / Fathom Consulting displaying by how many basis points 10 year yields have risen since the 30th of April:

- graph source Thomson Reuters Datastream / Fathom Consulting:

On a side note, those who piled into Apple 30 years, part of their $17 billion bond auctioned on the 30th of April are probably still licking their wounds given these bonds are currently trading around 83 in cash price...But, don't despair, you might get a "second chance" with Verizon which plans a record $25 billion debt offering as it gathers financing to buy Vodafone’s stake in their Verizon Wireless joint venture...

Moving on to our own "Forward Guidance", as we enter the statistically dangerous month of September, some additional signs in the markets, apart from "tapering" noise, Syrian issues, European political jitters in Italy and Emerging Markets tantrums, can be seen in the currency market according to our Rcube friends, in particular in the AUDCHF currency pair:

"The world’s economic momentum is slowing not accelerating, as evidenced by the AUDCHF:

The AUDCHF is a much better leading indicator of global growth than PMIs:

The Australian dollar is a commodity currency, with a high sensitivity to cyclical commodities, and hence to world growth. On the contrary, the CHF is a defensive, safe haven currency; it tends to appreciate when investors become risk averse.

As a result, the AUDCHF usually weakens when global growth economic momentum slows down and/or when financial stress kicks in. When the two happen at the same time (1998, 2001, 2008, 2011) the move is all the more violent. 

Today, the AUD is weakening because of the EM slowdown, but more recently the CHF has strengthened on its own, probably on the back of rising risk aversion due to the FED tapering anxieties (EURCHF peaked on May 22nd)." - source Rcube Global Macro Asset Management

And if you think that the "reverse osmosis" plaguing Emerging Markets has touched a bottom, think again because as our Rcube friends put it, regardless of the incoming chatter surrounding the "debt ceiling" debate, budget balances do matter, but the US budget balance, when it comes to Emerging Markets, it matters A LOT:
"Additionally, the US budget balance is improving faster than at any time in history. In the past this has been associated with a tighter liquidity environment (fewer dollars in circulation) which was particularly negative for emerging markets. As shown in the chart below, when the budget balance improves (deviation from 2yr trend goes up), emerging markets underperform DM equities, and inversely. Given the current expectation for the budget deficit to shrink further (‐2% of GDP in 2015 vs. ‐4.6% today), the relationship will remain negative for EM equities in the foreseeable future."

Another evidence that deflation might be a bigger threat than inflation is the fall of breakeven rates. In that sense, the negative correlation between equities and inflation expectations could be a complacency sign. Japan has won the currency war, it is now exporting deflation through lower export prices, and it is forcing others to do so as well. But because Europe is in a current account surplus and the US is moving towards the neutral zone, the currency war will be much less effective. This is also why inflation expectations are currently falling fast.

This would be worrying enough on its own. The problem is that Europe is deleveraging at the same time. Its credit channel remains weak. As a result, unemployment keeps rising." 
- source Rcube Global Macro Asset Management

On a final note, we would like to provide you with another "out of the box" interesting indicator we follow namely Sotheby's stock price versus World PMIs since 2007 - graph source Bloomberg:

The performance of Sotheby’s, the world’s biggest publicly traded auction house is indeed a good leading indicator and has led many global market crises by three-to-six months.

The recent stellar performance of the art market in general and Sotheby's in particular can also be partly explained by the flood of global liquidity provided by our "omnipotent" central banker at the Fed. Art markets and economic growth tend to be positively correlated we think.

And, when it comes to providing "liquidity" and market backstop, rest assured that Sotheby's has been as involved as any central bank, given it has started again into auction guarantees totaling $166.4 million in a move aimed at winning more consignments. But, more recently the New York-based auction house said last night it’s reducing its exposure by “irrevocable bids” of $23.5 million, which are from undisclosed third-party guarantors. It may further reduce risk by additional “irrevocable bids” before auctions in the fourth quarter, it said in the filing with the U.S. Securities and Exchange Commission as reported by Bloomberg.

Looks like even auction houses are preparing for "tapering"...
Oh well...

So move along, no risk of financial crisis:
“The probability of it happening again in our lifetime is as close to zero as I could imagine"

“The way these firms are managed, the amount of capital that they have, the amount of liquidity that they have, the changes in their business mix -- it’s dramatic.”

“The largest financial institutions in the U.S. are as healthy now as they have ever been,”

“There’s a difference between incompetence or mismanagement or poor judgment or excessive risk taking from actually breaking the law,”

“There’s nothing I’ve seen that would suggest that any of the major participants in the financial crisis should be in jail for their actions.”
- Morgan Stanley Chief Executive Officer James Gorman, on the Charlie Rose show.

Stay tuned!