Macro and Credit - Road to Nowhere

"The person attempting to travel two roads at once will get nowhere." -  Xun Zi, Chinese Philosopher

Looking at the Japanese PMI coming at 47.7, and Japan recording its seventh straight month of falling exports in April down 10.1% on-year with Haruhiko Kuroda, Bank of Japan's governor declaring at a two-day Group of Seven (G-7) meeting in Sendai:

"I think, yes, we have enough ammunition," Kuroda said, when asked whether the BOJ had sufficient monetary policy options, or "ammunition," left to achieve the target. "If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates." - Haruhiko Kuroda, Bank of Japan's governor

We had Japan in mind when we selected our title analogy for this week's musing "Road to Nowhere", the 1985 rock song written by David Byrne from the Talking Heads album "Little Creatures". What is of "humoristic" interest is that David Byrne indicated the following about his song:

"I wanted to write a song that presented a resigned, even joyful look at doom," - David Byrne

Clearly when one looks at the recent raft of dismal data from the Japanese behemoth, one can relates to our chosen title and analogy we think. Haruhiko Kuroda, also added when asked about what remained in Bank of Japan's "tool box" the following:

"I think, yes, we have enough ammunition," (when asked whether the BOJ had sufficient monetary policy options, or "ammunition," left to achieve the 2% inflation target). "If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates." Haruhiko Kuroda, Bank of Japan's governor

As far as we are concerned, we think Japan is indeed on a "Road to Nowhere". In this week's conversation we will look at Japan's "achievements" after 3 years of "Quantitative and Qualitative Easing (QQE), and what the lackluster Nonfarm payroll number means to us as well as the growing complacency in the on-going risk-on rally which we thinks warrants not only caution, but probably "hedging" as well.

Synopsis:

• Macro and Credit - Looking back a the "Three arrows"
• Macro and Credit  - Is the Fed on a "Road to Nowhere"?
• Final chart: Now is the right time to "hedge"

• Macro and Credit - Looking back at "The Three arrows"

As a reminder, the massive experience that started on the 4th of April 2013 by the Bank of Japan ambitioned to achieve a 2% inflation rate within 2 years by expanding drastically the monetary base.
In our April conversation "Shrugging Atlas" we already touched on the impact of three years of QQE and the impact of the deflationary mindset that has taken hold in Japan. We argued at the time:

"It seems more and more evident that, the experiment overtaken by the BOJ in the last three years has failed to move upwards inflation thanks to any significant wage increases. The Japanese government cannot afford to allow rates to rise, and yet by keeping rates so low it increases distortions in the economy through the "mispricing" of risk. This is clearly evident by the inversion in correlation between bond prices and the Nikkei index!
Furthermore, the size of the BOJ's buying spree in the Japanese market has led to the market becoming not only unstable but as well as totally broken and volatile. Basically what was supposed to be riskless in the Japanese Government Bond (JGB) has become the most risky and volatile investment of all thanks to the BOJ" - source Macronomics, April 2016

We also argued that the headwinds facing Japan and as well Europe in our April conversation stem from "demography", rendering the problems more "structurally" acute. When it comes to Japan and its central bank and credit transmission we have a case of "broken arrow". Europe seems to be as well facing very similar difficulties we think.

When it comes to assessing the effectiveness of the "Three arrows", we read with interest Nomura's take on the subject in their Japan Economic Weekly note from the 20th of May entitled "Taking a fresh look at the three arrows":

"Summary: 1) Reconstructing the "three arrows"

When the second Abe administration was formed in December 2012, it announced what it called "the three arrows." Since last year, the government has been talking about "three new arrows," policies aimed at achieving its goal of the "dynamic engagement of all citizens." While the label may have changed, the government is presumably still committed to what it has called "growth strategies," structural reforms aimed at supporting economic growth.

Summary: 2) Shortcomings of existing economic policies

While the government has in the past claimed that deflation would soon be overcome, it cannot be said to have achieved this or to have boosted economic growth. We see two shortcomings in its policies. First, it has failed to sufficiently counter dwindling expectations of economic growth, with the result that the first and second arrows of traditional monetary and fiscal policy have not had the expected impact. Such policies seek to bring forward demand at the expense of the future. With demographics depressing growth expectations, policies that seek to bring forward future demand can make households and companies even more reluctant to spend. Second, in terms of the third arrow of growth strategies, the government may not have properly considered whether to bias its policies in favor of either labor or capital or, how in what order to do so.

Summary: 3) Some distinctive features of the Japanese economy now

The government's focus, which during the early stages of its strategies for growth was on capital (specifically on increasing corporate earnings power by means of structural reforms such as corporate governance), has since gradually shifted to trying to boost the labor participation rate (eg, by means of the government's Plan to Realize the Dynamic Engagement of All Citizens) and improving the share of labor. As a result of implementing policies biased towards capital and, especially, improving shareholders' rights, Japanese companies have probably become more focused on efficiency, productivity, and profitability than ever. The result is a state of affairs where wage growth and the labor share have failed to increase and a virtuous cycle of rising employment, incomes, and consumption has failed to develop.

Summary: 4) Challenges

It would seem fairly clear what kinds of policies are needed in order to increase Japan's economic growth. What the government needs to do next is to increase the number of companies that succeed in improving their earnings power, thereby increasing both employment and the labor share, rather than encourage such companies to use those earnings to increase the labor share." - source Nomura

When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited. This is clearly explained in Nomura's interesting note:

"To put it rather bluntly, traditional fiscal and monetary policies seek to boost the real economy and stir inflation by bringing forward demand at the expense of the future. Monetary policy basically works by artificially reducing the future value of a currency, whether by means of positive or negative policy interest rates or by means of interest rates or the quantity of money, in order to encourage companies and households to spend more. Fiscal policy, on the other hand, does not exactly bring forward future demand but achieves a similar effect by using (increased) future government revenue as collateral to fund current spending.
The Nikkei and other news media reported on 14 May that Mr Abe is probably going to announce that the planned increase in the consumption tax is going to be postponed for a second time. Bolstering current demand by postponing a tax increase is also a kind of fiscal policy as it tries to encourage current spending by using future government revenue as collateral.
However, policies that try by one means or another to bring forward future spending in order to boost current economic growth assume that people will expect the economy to grow. However, if people are convinced that the economy is going to shrink, traditional economic policies may have the unintended consequence of making people even more reluctant to spend. We cannot rule out the possibility that the demographic headwinds facing the Japanese economy in the form of a declining and aging population may have led many Japanese households and companies to assume that the Japanese economy will inevitably shrink. This may explain why traditional fiscal and monetary policies have not had the expected impact." - source Nomura

While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) as displayed in Nomura's note:

"ROIC, far from declining, has been rising despite a substantial decline in interest rates in general suggests to us that companies have increasingly been focusing their capex on projects with better returns than in the past. In other words, that companies have been increasing their capex and stepping up depreciation of their existing plant and equipment without raising more capital suggests to us that they have managed to both increase their capex and improve their margins without expanding their balance sheets.
At the same time, we note a marked tendency for the profits generated by this efficient capex to accumulate as retained earnings and to be paid out as shareholder returns in the form of dividends, etc without impairing ROE." - source Nomura

If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere". The challenges facing Japan in revisiting its "three arrows" are clearly underlined in Nomura's note:

"Challenges

Assuming the above analysis is correct, it would seem fairly clear what kinds of policies are needed in order to increase Japan's economic growth. The main challenge is how to raise growth expectations, and the solution probably lies in the existing policy mix.
Two of the existing growth strategies that have proved relatively successful are probably (1) the corporate governance reforms aimed at increasing corporate earnings power and (2) the resulting increase in capex. If that is indeed the case, the next step that needs to be taken is presumably to implement a strategy for increasing the number of companies that succeed in increasing their earnings power.
The labor and employment policies the government has begun to push strongly should focus on those aimed at further improving corporate earnings power as well as on increasing employment and the labor share by increasing the number of Japanese and foreign companies that develop their earnings power, rather than focus on policies aimed at increasing labor participation or the labor share that target existing Japanese companies.
With a widening income gap becoming a social problem on a global scale and politics heading in a direction that reflects that trend, coming up with such policies will be no easy matter. However, in view of Japan's position as the most disadvantaged country in terms of the impact of its demographics on growth expectations, the need for such policies is all the greater." - source Nomura

We could not agree more, unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable".

Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street".

When it comes to the effect NIRP has had on Japanese Life insurers, we have discussed on numerous conversations the impact it has had on their foreign allocations and in particular bonds. This was as well clearly displayed in Nomura FX Insights note from the 26th of May entitled "JPY: Lifers' hedge ratio inched up":

"As monthly flow data have been showing, the nine major lifers accumulated foreign exposures aggressively during H2 FY2015 (Figure 2). 

Total foreign exposures held by the nine lifers increased to JPY42.9trn ($391bn) from JPY40.2trn six months ago. After considering the FX valuation impact, we estimate they have increased foreign exposures by JPY4.9trn ($44bn) during H2 FY2015, the highest pace at least since FY2002, which is consistent with the historically biggest foreign bond investment by lifers in February and March, after the introduction of negative rates by the BOJ (see “Temporary pause in portfolio outflows”, 12 May 2016).

Unhedged foreign exposures stood at JPY18.8trn ($171bn), largely unchanged from JPY18.7trn in September 2015. As we expected, most of the recent foreign bond investment by lifers has been on an FX-hedged basis. At the same time, they kept unhedged exposures almost constant despite JPY appreciation in Q1, which suggests lifers were likely small dip buyers of USD/JPY, to keep FX exposures.

US assets remained preferred

A large part of the foreign investment during H2 FY2015 was in USD-denominated assets as expected. The nine major lifers’ exposures in USD assets increased to JPY26.9trn ($245bn) from JPY24.6trn. The USD share in total foreign assets increased to 62.7% in March from 61.3% in September 2015, recording the highest share since September 2002. The FX hedge ratio for USD assets increased to 55.7% from 51.6% during the same period (Figure 3).

As a result, unhedged exposures in USD assets stayed at JPY11.9trn ($108bn), largely unchanged from September last year (Figure 4).

Lifers’ preference for US assets remained strong, but they still prefer FX hedged investment for now.

Fed policy and political risk to be important for lifers’ hedging stance

Major lifers’ FY2015 financial results confirmed their strong appetite for foreign bond investment, without increasing FX risks for now. The results also showed stronger preference for US assets over other foreign assets. As JGB yields remain low, UST investment could give lifers slightly higher yields than JGB investment even after FX hedging (see “Lifers’ shift into foreign bonds continues”, 20 May 2016). The major lifers’ investment plans for FY2016 showed a strong appetite for foreign bond investment this fiscal year, but their investment should be largely FX hedged for the time being (see “JPY: The shift into foreign assets by lifers should continue”, 27 April 2016).
At the same time, the likelihood of a Fed rate hike by July is clearly rising now, which will increase hedging costs further. Lifers’ risk appetite could also improve after the UK referendum on Brexit. Thus, lifers may consider taking more FX risks in H2 this year." - source Nomura

Of course the latest "sucker punch" delivered to the US dollar versus the Japanese yen thanks to the clearly weak Nonfarm payroll data could somewhat tamper the hedging appetite of the Lifers and trigger some additional volatility on the currency pair.

Whereas Japan has stronger demographic headwinds, the latest miss in the United States coming from the labor market pushes us to ask ourselves on our second point if indeed the Fed is not as well on a "Road to Nowhere" when it comes to its willingness in hiking further during this summer.

• Macro and Credit  - Is the Fed on a "Road to Nowhere"?

Looking at the miserable May employment report published on Friday, one might rightly ask itself if indeed the Fed is not on the "Road to Nowhere". With only 38,000 jobs created in nonfarm payroll growth and a -59,000 of net revisions, given employment is a lagging indicator on the state of the economy and that we have long argued that the US economy was weaker than expected, it seems to us particularly clear that our long US duration stance will continue to be rewarding. 

While our stance relating gold miners had been vindicated in recent weeks, another surge in gold was clearly expected with this type of miserable NFP. We agreed with Martin Sibileau's view when he posted in his blog A View from the Trenches, on April 4th, 2011 "Gold, the Fed, Ron Paul and Napoléon Bonaparte" at the time he made the following comment:

"The Fed is not stimulating anything. The Fed is only massively monetizing the US fiscal deficit. Therefore, a lower unemployment rate is actually worse, because a lower unemployment rate implies higher wages, sooner rather than later. And if wages rise, people will have more purchasing power to afford the increasingly higher commodity prices. The higher wages will validate the higher prices of food and oil. In the process, the supply of money, ceteris paribus, will decrease. If the US fiscal deficit continues unabated (our key assumption here), the Fed will be forced to engage again in quantitative easing. For this reason, we think that the unemployment rate announced on Friday was actually bullish of gold."

In our previous conversation "Through the Looking-Glass", we argued that the Fed was in a bind given the late state of the credit cycle and tightening lending standards. What is of course of interest as well from the previous comments of our friend Martin Sibileau quoted above is that contrary to the key assumption, because the US fiscal deficit has fallen, the Fed had to start "tapering as displayed in the below chart from TradingEconomics:

- source TradingEconomics.com

What is of interest today is that with this kind of employment report, the job of Janet Yellen at the Fed has become even more complicated. On that note we read with interest Bank of America Merrill Lynch's take from their US Economic Watch note from the 3rd of June entitled "Payroll pain for the Fed":

"As expected, average hourly earnings grew 0.2% mom and 2.5% yoy, the latter pace holding steady from April. The modest acceleration in wage growth from last year reflects the tightening in the labor market, although there is still a debate as to whether we have reached full employment. Indeed, the broader measure of the unemployment rate, the U6 figure, held at 9.7%.

What does this mean for the Fed?

There was no saving grace in this disappointing report, and the recent sluggishness in the labor market warrants increased Fed cautiousness. We think a June hike is off the table (and the markets agree, pricing in less than a 5% chance of hike after the number this morning). While a hike in July is still a possibility, we are increasingly comfortable with our September call. There is simply not enough time leading up to those summer FOMC meetings to see the growth and labor data rebound convincingly, and inflation continue to accelerate—all necessary conditions for another increase in rates. After today’s report, Fed Chair Yellen’s speech on Monday will be even more important." - source Bank of America Merrill Lynch

As a reminder if a lower unemployment rate implies higher wages, sooner rather than later, then indeed Janet Yellen's hiking job is difficult. So far wage acceleration doesn't seem to be that material from the latest readings. A real tightening scare from the Fed would only happen if there is concrete evidence of an acceleration in wage pressure. On the other hand, deteriorating market conditions, meaning falling share prices and rising credit spreads à la Q1, would most likely lead the Fed to some renewed easing we think.

What is more and more apparently clear is that too much conflicting communication snippets from Fed members are leaving market pundits puzzled and are indeed eroding more and more the Fed's credibility. This was bound to happen and was clearly illustrated by Nomura's economist Richard Koo, quoted in our November 2014 conversation "Chekhov's gun":

"Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members."- source Richard Koo, Nomura Research Institute

This outcome of "eroding credibility" has been highlighted in our musings and has also been put forward by Bank of America Merrill Lynch in their Ethanomics note from the 3rd of June 2016 entitled  "The Fed's risk management":

"Dazed and confused

It is fair to say that many clients are a bit confused and frustrated with Fed communication. The Fed seems to be constantly changing its focus from one meeting to the next. They seem to regularly promise hikes, only to back off at the last second. Fed statements often seem stale, reflecting where the economy and markets were a couple months ago, rather than current conditions. They say their 2% inflation target is not a ceiling, and yet they only plan to bring inflation back to 2%. They argue that the risks to the outlook are very asymmetric—with rates near zero they have limited anti-recession ammunition—and yet their inflation target is symmetric. This is policy transparency?

Here we pierce the cacophony and offer a simple guidebook to understanding the Fed. The core lesson here is simple: until the Fed is able to achieve significant separation from the zero lower bound for interest rates they will remain highly risk averse. This means they will:
• focus on the latest risk factor rather than their baseline,
• pause at relatively small signs of trouble,
• be very slow to “turn off” risk warnings,
• take a very high risk of overshooting their inflation target,
• and take very little risk of an economically meaningful hawkish “policy mistake.” 

Attention deficit disorder

A common complaint from clients is that the Fed seems to be constantly shifting its focus. One day it is the labor market, and then it is GDP, then inflation, then global developments and then financial conditions. No wonder markets are confused about just what “data” the Fed are “dependent” on.
Contrary to popular belief, the Fed is not constantly changing its mind. Instead, their shifting focus is a sign of very high risk aversion. With the Fed and many other central banks facing chronically low inflation, a weak recovery and near-zero rates they are much more sensitive to downside risks to growth than to upside risks to inflation. As a result, their focus tends to shift to whatever is causing downside risks at the moment.
The labor market has been out of the Fed spotlight for a long time because it is the healthiest part of the economy. By contrast, there have been a number of troubling dead spots for GDP growth and there have been repeated periods of elevated global economic and financial risks.
We expect the Fed to remain highly risk aversion until they have created significant separation from the zero lower bound. Get used to it: as risks rotate, so will the Fed’s focus.

Markets are fast, the Fed is slow

Despite a rebound in the markets in late February and March, Fed officials remained super dovish until after the April 26-27 FOMC meeting. Some investors wondered “what more are they looking for to become more optimistic” and “if this improvement is not enough, will they ever hike?” Recall that even in normal times, there is a good deal of inertia in Fed decision making as they have a very strong aversion to flip flopping. This is one reason why the lagged funds rate is often included in econometric models of the Fed reaction function. Moreover, in our view, each shock is making the Fed a bit more risk averse, making them a bit slower to give the “all clear sign.”. Yellen’s next major speech is on June 6th and we expect her to offer a much less stale view, given months of better markets and no sign that the risk-off trade damaged the economy. There are two lessons here: (1) what the Fed is looking for is more time to decide, and (2) their caution means slow hikes, not no hikes.

The inflation target: do the right thing

Another confusing part of the Fed’s message is the way they describe their inflation target. On the one hand, they swear 2% is “not a ceiling” and they want to average 2% over time. On the other hand, they only want to raise inflation to 2% in the next few nyears, taking an equal risk of overshooting and undershooting. As we noted here, inflation tends to be low early in business cycles and then rise late in the cycle. Hence achieving average inflation of 2% requires overshooting in the second half of economic recoveries. As we also note, this has nothing to do with making up for past low inflation, but is a requirement if the Fed is going to avoid repeatedly undershooting its target in the future.

They also have an inconsistent message on the risks around policy. On the one hand, they underscore that their targets are “symmetric”; on the other hand, they argue that with interest rates near zero the risks to the economy are asymmetric to the downside.
If the risks are asymmetric, why would they have a symmetric target? Moreover, the zero lower bound constraint is one of many things arguing for asymmetry:
• Inflation expectations have clearly slipped below their 2% target, restoring
expectations requires proving that they can achieve average inflation of 2%.
• The increased volatility of the business cycle means the Fed needs to have a higher
nominal funds rate at the end of an expansion to have sufficient ammunition to
fight the next recession.
• The drop in the equilibrium real funds rate lowers the equilibrium nominal funds
rate, giving the Fed less anti-recession ammunition, not more.
• The risks of deflation have risen relative to when the Fed first set its target.
• With other central banks stuck at zero, the Fed may be alone to fight the next
recession.

We see only two offsetting arguments. First, overshooting could trigger political backlash. The Fed can deal with this by quietly overshooting and assuring that the overshoot will be limited. Second, a slow exit adds to bubble risks. However, even with its slow exit the Fed has already taken some of the froth out of high yield bonds and commercial real estate lending.1 Ultimately, we expect the Fed to do the right thing and acquiesce to a moderate overshooting of their inflation target. Hence we expect them to act like they have a de facto target of 2.5% over the next several years.

It is hard to fall down when you are crawling

For much of the economic recovery, the bond market consistently priced in rate hikes that never materialized, but the last two years the roles have reversed with the market pricing in less hikes than the Fed is forecasting. Thus a common refrain is that the Fed is “making a policy mistake.” They are going to hike too quickly, damaging the recovery and may be forced to reverse course.
We are skeptical. A corollary of this high risk aversion is that the Fed is unlikely to make a “hawkish” policy mistake. The Fed is moving at a snail’s pace and pauses at every sign of downside risks. Indeed, they have delayed every planned tightening. Moreover, the economy has done fine despite the “taper tantrum,” the “surging dollar” and repeated stock market corrections. The Fed may be making small tactical mistakes, but their goslow-and-hesitate strategy makes an economically meaningful tightening error very unlikely.

Damned if you do; damned if you don’t

The bond market sees a relatively low probability of a rate hike in the second half of the year (Chart 2).

Presumably this is partly because of the looming Presidential election. Clearly the Fed is under political pressure: some candidates have been quite critical of the Fed, there are several bills in Congress designed to reduce Fed independence and a move near the election is likely to attract a good deal of criticism. In our view, political pressure on the Fed is the highest since Paul Volcker broke the back of inflation in the early 1980s. A risk-averse central bank may decide to go into hibernation around the election." - source Bank of America Merrill Lynch

In relation to Bank of America Merrill Lynch's point about inflation tending to be low early in business cycles and then rising late in the cycle, we reminded ourselves that equity bear market tend to coincide with high global core inflation as we wrote about in June 2014:

"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008:

 - source TradingEconomics.com

When it comes to "inflation" being the "Unobtainium" element we wrote about in March this year, we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "most important" piece of the puzzle the Fed has so far been struggling to "generate":

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014

And if historically, a true peak in the equity market always happens between 2 and 14 months before recessions, a sudden burst of inflation on conjunction with heightened velocity in the rise in oil prices could indeed have severe consequences on equities we think. Given the on-going complacency and significant rally seen since the bottom of the first quarter, and the low level attained by the Vix, it seems to us that the time is right to start thinking about "hedging" your US equity risk as per our final chart.

• Final chart: Now is the right time to "hedge"

As clearly we are moving towards the final inning of this credit cycle and given the signs we pointed out recently coming from the Commercial Real Estate market (CRE) indicative of tightening financial conditions, we have to agree with Société Générale's Cross asset Quant Research note from the 26th of May entitled "The Right Hedge for You", now is the right time to hedge as per their table below:

"We’ve been here before

We also looked at buying options opportunistically, using various tactical indicators. We find that it is relatively easy to identify economic crises of a more cyclical nature by monitoring such indicators as the valuation of the stock market, high-yield spreads and the cost of hedging. Forecasting financial and geopolitical crises is a much more daunting task.
Using risk indicators can help reduce the cost of hedging in good times, and possibly buy more options in times of stress. But in the long run, such tactical choices matter less than such seemingly mundane issues as selecting the right expiry, leverage, and strike.
It is interesting to note that most of the indicators we have selected show that now is the right time to hedge equity risk. Volatility is cheap, especially for the S&P and Eurostoxx. As Andrew Lapthorne argues in ‘High aggregate PE valuations and weak profits and not wholly down to Energy’ [GS5], price/earnings valuations are high and profits weak. US high-yield spreads are wide, as they were in the late 1990’s and before the subprime crisis.

Nobody can predict exactly what will happen next, but we think it is a good time to take a serious look at hedging strategies." - source Société Générale

While nobody can predict exactly what will happen next, from our point of view, we know from the early signs of the growing stress in some segments of the credit markets, that it will happen, how it will happen, namely what will be the trigger remains a big unknown. Revisiting hedging strategies, we agree with Société Générale is essential particularly if one believes the US economy is indeed, like Japan on  a "Road to Nowhere".

"Fun without sell gets nowhere but sell without fun tends to become obnoxious." -  Leo Burnett, American businessman

Stay tuned!

Credit - The Golden Mean

"Extreme positions are not succeeded by moderate ones, but by contrary extreme positions." - Friedrich Nietzsche

Looking at the much vaunted 288 K NFP print in conjunction with the 6.1% and the continuation of the rally in risky asset prices, it means of course that the "hunt for yield" will intensify in true "Cantillon Effects" fashion. We were expecting the 5 year European CDS index for Investment Grade, the Itraxx Main to close around 50 bps at the end of June, with the index at 57 bps today, we were not that far off, rest assured the "japonification" process in the credit space will continue further.  For us"Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with "exogenous" liquidity induced central bank money supply. 

When it comes to choosing this week's title, we were inspired by Gavyn Davies' take on the diverging views between Janet Yellen at the Fed and the BIS take in his post "Keynesian Yellen versus Wicksellian BIS" which we read with great interest:

"Let us start with a few similarities between them. There is agreement that financial crashes that trigger “balance sheet recessions” lead to deeper and longer recessions than occur in a normal business cycle. There is also agreement that inflation is not likely to re-appear any time soon, and that the current recovery should be used to strengthen the balance sheets of the financial sector through regulatory and macro-prudential policy. That, however, is where the agreement ends.

The roots of disagreement can be traced back to the causes of the GFC. The BIS views the crash as the culmination of successive economic cycles during which the central banks adopted an asymmetric policy stance, easing monetary policy substantially during downturns, while tightening only modestly during recoveries (ie the Greenspan and Bernanke “puts”).

On this view, monetary policy has been too easy on average, leading to a long term upward trend in debt and risky financial investments. The financial cycle, which extends over much longer periods than the usual business cycle in output and inflation, eventually peaked in 2008. But, even now, the BIS says that the central banks are attempting to validate the long term rise in debt and leverage, instead of allowing it to correct itself. Excessive debt, it contends, is preventing the rise in capital investment needed for a healthy recovery. Financial and household balance sheets need to be repaired (ie debt needs to be reduced) before this can take place.

In contrast, the mainstream central bank view denies that monetary policy has been biased towards accommodation over the long term. Ms Yellen’s speech claims that higher interest rates in the mid 2000s would have done little to prevent the housing and financial bubble from developing. She certainly admits that mistakes were made, but they were in the regulatory sphere, where there was insufficient understanding of the new financial instruments that would eventually exacerbate the effects of the housing crash. Higher interest rates, she says, would have led to much worse unemployment, without doing much to reduce leverage and dangerous financial innovation." - source FT - Gavyn Davies

Our chosen title the Golden Mean reflects the great Aristotelian philosophical difference between both the Fed and the BIS given that, in philosophy, the 'golden mean' is the desirable middle between two extremes, one of excess and the other of deficiency. Whereas the Keynesian Fed is arguably one of excess (liquidity and ZIRP triggering "Cantillon Effects" aka bubbles), the other, the BIS, could be argued as one of deficiency (lack of sound financial regulation in the first place) but we ramble again.

A good illustration of this philosophical argument and Janet Yellen's perspective comes from Bank of America Merrill Lynch's Thundering Word note from the 2nd of July entitled "I'm so bullish, I'm bearish":

"Is the Fed Losing the Dot?

The Fed’s “print & regulate” mantra has boosted Wall St not Main St (Chart 1); the longer it takes for growth and rates to normalize, the greater the risk of speculative credit excesses (and a policy response to curb speculation). Our base case remains higher growth/yields/$. Bank lending; small business confidence hint at H2 macro; rate normalization. If so, expect an autumn correction in risk assets (hence “I’m so bullish, I’m bearish”). Either way, volatility will rise." - source Bank of America Merrill Lynch

What is truly interesting, we think, is the analogy that can be made from a financial markets perspective with the Eastern philosophy's take on the "Golden Mean". Thiruvalluvar, the celebrated Tamil poet and philosopher wrote in his Tirukkural of the Sangnam period of Tamizhagam about the "middle state" (the Golden Mean) which is to preserve equity. He emphasises this principle and suggests that the two ways of preserving equity is to be impartial and avoid excess.

Credit bubbles generated by ZIRP will not preserve equity, rest assured.

From our Wicksellian penchant, we would therefore argue that when it comes to the Fed's record, the Fed has repeatedly failed in being "impartial" and in "avoiding excesses" which led to one the biggest equity wipe-out in 2008 the world has ever known. We will therefore discuss in this conversation the slack in the unemployment since the great "reflation" trade and the materialisation of our past concerns justifying the tapering stance of the Fed.

Like the preeminent medieval Spanish, Sephardic Jewish philosopher Maimonides said:

"If a man finds that his nature tends or is disposed to one of these extremes..., he should turn back and improve, so as to walk in the way of good people, which is the right way. The right way is the mean in each group of dispositions common to humanity; namely, that disposition which is equally distant from the two extremes in its class, not being nearer to the one than to the other."

Of course given the rising "inequalities" given the "extreme" reflating policies followed by the Fed, no wonder that the "Golden Mean" has been broken favoring Wall-Street in the Process versus Main Street. Using Maimonides "philosophical take, the Fed has indeed been nearer a "class" rather than equally distant we think, with Wall Street and the owners of capital booming while Main Street and the workers struggling:

- source Bank of America Merrill Lynch, June 2014 - The Thundering Word.

Another illustration of the divergence between Wall Street and Main Street and how broken the "Golden Mean" is can be seen in the significant fall in the US Labor Participation rate compared to previous "recoveries" following US recessions as per the below Bloomberg graph:

We have long argued that the Fed is continuing on a "wrong" path and ignoring basic relationship such as Okun's law and the prolonged negative effects of ZIRP on the labor force (capital being mis-priced, it is mis-allocated to speculative purposes rather than productive purposes):

"In economics, Okun's law (named after Arthur Melvin Okun, who proposed the relationship in 1962.is an empirically observed relationship relating unemployment to losses in a country's production. The "gap version" states that for every 1% increase in the unemployment rate, a country's GDP will be roughly an additional 2% lower than its potential GDP." - source Wikipedia

In our conversation "The Last refuge of a scoundrel" back in September 2013 we argued the following:

"To that effect we wanted to illustrate more clearly this week the "Cantillon effect" of Bullard's effective way to conduct monetary "stabilization" policy, so, we plotted on Bloomberg not only the rise of the Fed's Balance sheet, but also the rise of the S&P 500, buybacks and of course the fall in the US labor participation rate (inversely plotted) - source Bloomberg (chart updated as of 7th of July 2014):

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.

We think this graph clearly illustrates the Fed's conundrum in the sense that with the Fed's dual mandate of promoting "maximum employment" since 1978, it cannot promote both employment and sustain the "wealth effect" through capital growth with ZIRP. 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, as well as lifting stock prices, playing on the wealth effect game.

Something will have to give.

ZIRP, we think is the main culprit."

We also added at the time:

"If capital cannot be re-allocated to "productive" endeavors, enabling companies to focus their resources on their core business, how can labor thrive in such a ZIRP environment? Please feel free to explain us how."

Of course companies have been focusing more on the wealth effect game leading to record stock prices and record buybacks as one can see from the performance of stock prices from companies which have boosted their stock prices through buybacks - graph source Bloomberg:

The performance of the US stock market has been artificially "boosted" by "de-equitization", namely the reduction of the number of shares courtesy of buybacks thanks to increase leverage, leading the "Golden Mean" to be even further damaged by the Fed's extreme reflating policy. 

When it comes to US unemployment figure at 6.1% and the latest NFP of 288 K we would like to re-iterate what we said in our conversation "Goodhart's law" in June 2013:

"When a measure becomes a target, it ceases to be a good measure." - Charles Goodhart

Conducing monetary policy based on an unemployment target is, no doubt, an application of the aforementioned Goodhart law. Therefore, when unemployment becomes a target for the Fed, we could argue that it ceases to be a good measure. - Macronomics

In the same conversation, we argued:

"We think that QE is not the core issue but ZIRP, which is in effect preventing creative destruction in a Schumpeter fashion and delaying much needed adjustments such as the ones needed from the European banking sector."

No wonder investing in European banks shares have been less profitable than investing in financial bonds from the European sector. In the deleveraging and credit "japonification", we expected financial credit to outperform. While the ECB has so far delayed deploying a QE buying spree in true Japanese fashion, no wonder investors have been more skeptical about the industry and its share prices as described by Bloomberg:

"European bank valuations show investors’ are skeptical about the industry.

Lenders in the Stoxx Europe 600 Index are trading near their lowest valuation in a year versus banks in developed economies worldwide, as the CHART OF THE DAY highlights. After reaching a seven-month high in January, the European group’s price-to-earnings ratio lost 5 percent to 47.55, compared with a 2 percent increase for lenders in the MSCI World Index.

While the European Central Bank introduced a negative deposit rate and announced targeted loans to stimulate lending last month, it held off on a securities-purchasing program. For European banks to rally, investors need to see the ECB buying assets, which it probably won’t do until after giving current policies more time, said Ian Richards of Exane BNP Paribas.

“It’s too early to be buying aggressively on the prospect of a euro-zone recovery,” Richards, the head of equity strategy in London, said by phone. “The prospect of supporting material credit growth and better earnings revisions in the banking sector is further down the line than the market had hoped.” U.S. regulatory probes and penalties that have slammed some European lenders are adding to concerns. Barclays Plc tumbled 14 percent in June, the most since May 2012, as New York’s attorney general said the bank lied to customers and masked how much high-frequency traders were buying and selling in its LX dark pool. BNP Paribas SA and Credit Suisse Group AG posted their worst quarterly performances in two years after being fined for U.S. sanctions violations and to help Americans evade taxes, respectively. “These one-offs in conduct issues keep on coming back and haunting the sector,” Richards said." - source Bloomberg

For us a bank is a second derivative of an economy. No growth, no stock performance.

When it comes to our contrarian take on US yields since early January 2014 we argued the following in our conversation "Supervaluationism" back in May this year:

"We recently pointed out the strength of the performance of US long bonds as well as the "Great Rotation" from Institutional Investors to Private Clients". As posited by Cam Hui on his blog "Humble Student of the Markets", the "great rotation" has indeed been triggered somewhat by defined benefit pension funds locking in their profits. One of the chief reason therefore behind this rotation has been coming from US Corporate pensions, as indicated by Gertrude Chavez-Dreyfuss and Richard Leong in Reuters in their article from the 24th of April entitled "US Corporate pensions bet on bonds even as prices seen falling":

"Major U.S. companies including Clorox and Kraft are favoring more bonds in the mix for their employees' defined benefit pension plans, even amid signs the three-decade bull run in bonds is on its last legs.

The $2.5 trillion U.S. corporate pension market enjoyed a robust recovery in 2013, paced by stocks, as the Standard & Poor's 500 Index rose the most since 1997. That helped pension funds close a funding hole that opened after the global credit crisis of 2008, so that the average corporate pension was funded at about 95 percent at the end of 2013, compared with 75 percent at the end of 2012, Mercer Investments data show.

Now that they're more confident that they have the money to meet their pension obligations, corporate pension managers are pulling back from the perceived risk of the stock market and buying U.S. government and corporate bonds, even though many expect bond prices to fall in coming years.

"Even if interest rates rise more than the market predicts, you do get the income component that offsets the price loss of those bonds," said Gary Veerman, managing director of U.S. Client Solutions Group at BlackRock in New York, which has $4.4 trillion under management, of which two-thirds are retirement-related assets. Veerman's group advises corporate treasurers how to manage their pensions.

The allocation to bonds by the top 100 publicly-listed U.S. companies in their defined benefit pension plans increased to a median of 39.6 percent in 2013 from 35.9 percent in 2010. Stock allocation in the plans fell to 40.9 percent in 2013 from 44.6 percent in 2010, according to global consulting firm Milliman." 

"Now they're in a position to say: 'I don't need all those equities because my funding status is in the mid- to low-90s,'" said Dan Tremblay, director of institutional fixed-income solutions at Fidelity unit Pyramis in Merrimack, New Hampshire, which manages more than $200 billion.

To further illustrate the "pension fund" effect and the increase in duration risk with the "great rotation" in 2014 from equities to bonds please find below the iBoxx U.S. Pension Index up 11% YTD which "validates" our previous take on the subject - graph source Bloomberg:

The chart tracks the iBoxx U.S. Pension Index, designed to mirror the performance of a typical plan with defined benefits.

What our "wealth effect" planners at the Fed should take into account is that rising stock prices may do relatively little to bolster the finances of corporate pension funds. Bonds matter because increases in projected distributions put even more pressure on yield hunting leading to an increase in duration risk exposure and high yield exposure. Volatility in funds’ asset value and relatively low interest rates have made managing pensions increasingly difficult for corporate managers, one of the solution they have found is shifting into bonds and away from stocks. Of course if the "magicians" at the Fed had respected the "Golden Mean" and prevented past and present excesses, funding gaps and overall pension pressures would have been avoided in the first place, but we are ranting again...

As a reminder from our conversation "Goodhart's law" in June 2013:

As indicated by CreditSights in their 29th of May 2013 Asset Allocation Trends - 2012 Pension Review:

"Key among the prevailing market realities in the post-financial crisis environment has been the extended period Quantitative Easing and the continuation of the Fed's prevailing zero interest rate policy and in the latest year's plan asset allocation data there was evidence of the effect this was having. As noted above, historically low interest rates have not only inflated the calculated liabilities of pension plans via the downward pressure on interest rates, they have also deflated assumed plan asset return rates as fixed income has increased as a percentage of plan assets." - source CreditSights.

So much for the great rotation, given, as indicated in the same report from CreditSights:

"One of the notable observations from our data analysis was that there was very little change in the allocation across the plans vs. the prior year. The median allocation to equity fell only marginally (from 50.8% to 50.0%) and the allocation to fixed income, rather than increasing, fell from 37.0% to 36.4%. This suggests that the trend towards Liability Driven Investment has slowed. While this, at least in part, likely reflects that the shifts made over the last seven years have better aligned many plans with their desired allocations, it also is undoubtedly influenced by the interest rate environment. Historically low interest rates across the full maturity spectrum make it an inopportune time to be increasing the allocation to fixed income assets (or to be increasing the duration of those assets in the portfolio!) " - source CreditSights.

Hence the reason of our Wicksellian stance relating to the distortion created by ZIRP, because of the increasing duration risk which has to be taken by players such as pension funds!

Moving on to the justification of the tapering of the Fed, we reminder ourselves of some of our previous observations:

First observation from our good credit friend in 2013 from our conversation "Simpson's paradox" as the Fed tries to re-establish somewhat the "Golden Mean":

"There have been a lot of talks recently about the FED decision to possibly reduce its liquidity injection at the end of the summer. Some market participants still think the FED will not taper as the economy is not yet on a very strong footing, and because the various thresholds announced by B. Bernanke (unemployment level, inflation,…) are still far from being reached. These arguments are undeniably right and strong, but one must consider other information prior to declare the “tapper” off.

First of all, B. Bernanke has explicitly announced that the FED will not look at economic data over the next few months, but rather at the trend which has developed.

Second, and more importantly, the FED currently owns about 33% of the outstanding US Federal debt. As funding needs of the US Treasury are diminishing following the sequester, there is less issuance and the FED ownership of bonds in percentage is rising quicker. Should the Central Bank continue buying the same amounts of bonds, it will own 40% of the outstanding in 2014, then north of 50% in 2015. The subsequent volatility on the interest rate market will increase drastically as the liquidity of the bond market disappears, and the currency could debase very quickly, creating a new crisis.

Third, and also a cause of concern, the bond market repo activity is facing an increasing number of failures (fails to deliver are on the rise exponentially) due to the large FED holding, which has ripple effect on the overall bond market activity. 

Fourth, and finally, economic growth in a society based on consumption requires credit. In order for credit to grow, or in other words banks to lend, collateral must be available. Since the 2007-2008 financial crisis, high quality collateral has slowly but surely become less available. If Central Banks continue to buy various government bonds (and US Treasuries are among those bonds), the available collateral will trend lower and the economy will stall, or worst spiral down as a credit crunch will occur at some point. So the FED has no other choice than to slow and even stop its QE if it wants the game to go on.

To resume, the FED may have more incentive to tapper and even stop its QE over time than to continue it, even if the economy slows down and some asset prices move lower. Apparently, it is the price to pay if one wants to avoid bigger problems in the future. The only remaining question is the following : “Is it the right time to do the tapper, or did the CB already crossed an invisible dangerous line?”  The way asset prices will behave and re-price in the coming weeks/months will give us the answer (nice retreat or collapse)."

One of the most important point validating our good credit friend's take on the tapering necessity and repo can be ascertained from Liza Capo McCormick article in Bloomberg on the 7th of July entitled "Bond Anxiety in $1.6 Trillion Repo Market as Failures Soar":

"In the relative calm that is the market for U.S. Treasuries, a sense of unease over a vital cog in the financial system’s plumbing is beginning to rise.

The Federal Reserve’s bond purchases combined with demand from banks to meet tightened regulatory requirements is making it harder for traders to easily borrow and lend certain desired securities in the $1.6 trillion-a-day market for repurchase agreements. That’s causing such trades to go uncompleted at some of the highest rates since the financial crisis.

Disruptions in so-called repos, which Wall Street’s biggest banks rely on for their day-to-day financing needs, are another unintended consequence of extraordinary central-bank policies that pulled the economy out of the worst financial crisis since the Great Depression. They also belie the stability projected by bond yields at about record lows.

“You have a little bit of a perfect storm here,” said Stanley Sun, a New York-based interest-rate strategist at Nomura Holdings Inc., one of the 22 primary dealers that bid at Treasury auctions, in a telephone interview June 30.

A smoothly functioning repo market is vital to the health of markets. The fall of Bear Stearns Cos., which was taken over by JPMorgan Chase & Co. in 2008 after an emergency bailout orchestrated by the Fed, and collapse of Lehman Brothers Holdings Inc., whose bankruptcy in September of that year plunged markets into a crisis, was hastened after they lost access to such financing." - source Bloomberg

Remember financial crisis are always triggered by liquidity crisis. From the same article:

"Liquidity Issues

“The effect of all the collateral issues we see now is an indication of not so much how things are, but how bad things will be when you really need liquidity,” said Jeffrey Snider, chief investment strategist at West Palm Beach, Florida-based Alhambra Investment Partners LLC, in a telephone interview June 30. “That’s when you get into potentially dire situations.”

The conditions for repo stress were on display last month. The 2.5 percent note due in May 2024 reached negative 3 percentage points in repo in the days preceding a June 11 Treasury auction of $21 billion in notes to finance government operations.

Dealer Constraints

Repo rates have been most prone to go negative, a situation known as specials in the market, in the days preceding an auction as traders who previously sold the debt seek to buy the securities to cover those positions.

In this week’s note and bond sales, the U.S. plans to auction $27 billion of three-year Treasuries tomorrow, $21 billion of 10-year debt on July 9 and $13 billion of 30-year securities July 10.

Signs of dysfunction are coming at a sensitive time for markets. The Fed is paring its stimulus and futures show traders expect the central bank may start raising interest rates in the middle of next year.

The concern is that dealers, which have pared inventories to meet more-stringent capital requirements required by the 2010 Dodd-Frank Act mandated by the Volcker Rule and Basel III, won’t have as much capacity to handle any surge in volumes or volatility.

Securities Industry and Financial Markets Association data show the average daily trading volume in Treasuries has fallen to $504 billion this year from $570 billion in 2007, even though the amount outstanding has risen to more than $12 trillion from $4.34 trillion.

Available Securities

Bank of America Merrill Lynch’s MOVE Index, a measure of expectations for swings in bond yields based on volatility in over-the-counter options on Treasuries maturing in two to 30 years, reached 52.7 percent on June 30, almost a record low.

The Fed is partly to blame. Through its policy of quantitative easing, it now owns about 20 percent of all Treasuries, or $2.39 trillion. Banks hold $547 billion of Treasury and agency-related debt.

In addition, the Fed’s holdings have shifted in ways that leave fewer central-bank-owned Treasuries available to be borrowed. The shifts were caused by Operation Twist during the November 2011 to December 2012 period when the Fed sold shorter-dated Treasuries and bought more bonds, plus self-imposed central-bank restrictions on holdings of specific maturities.

Stimulus Withdrawal

The Fed’s lack of certain holdings “appears to be driving the surge in fails, which has been concentrated in the on-the-run five- and 10-year notes,” Joe Abate, a money-market strategist in New York at primary dealer Barclays Plc, wrote in a note to clients on June 27. On-the-run refers to the most recently issued Treasuries of a specific maturity.

While the Fed has sought to cut risk in the repo market since the crisis, it still sees the chance that rapid sales of securities, known as fire sales, could disrupt the financial system. Fails reached a record $2.7 trillion in October 2008.

Repos are also important to the Fed because it has been testing a program in the market that is seen as a potential tool to withdraw some of its unprecedented monetary stimulus.

Eric Pajonk, a spokesman at the New York Fed, decline to comment on the Fed’s reaction to the movements in recent weeks in the repo market.

The amount of securities financed daily in the tri-party repo market has declined 18 percent an average $1.60 trillion May, from $1.96 trillion in December 2012, data compiled by the Fed show. In a tri-party agreement, one of two clearing banks functions as the agent for the transaction and holds the security as collateral. JPMorgan Chase & Co. and Bank of New York Mellon Corp. serve as the industry’s clearing banks.

 Supply Falls

Another difficulty in the repo market has been the decline in Treasury bill supply, with the U.S. having sold $264 billion fewer short-term bills in the April-through-June period than those that matured, according to John Canavan, a fixed-income strategist at Stone & McCarthy Research Associates in Princeton, New Jersey.

“The repo market itself provides lubricant to the entire Treasury market,” Canavan said in a July 3 telephone interview. “Bills are a key lubricant to the repo market, and the supply of bills has fallen sharply. If this situation were to continue longer-term, it would be a more substantial problem.”"  - source Bloomberg.

Second observation from our 2012 conversation "Zemblanity" (The inexorable discovery of what we don't want to know"): 

"In similar fashion to the current Japanese plight, the Fed will eventually discover soon that company debt sales will counter its bond buying plan"

As a reminder, back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":

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

So enjoy the final melt-up because if the Fed had indeed respected the "Golden Mean" there would not be greater risk of overshooting mean reversion on the way down. Of course timing is everything, but it looks to us we are indeed in the final innings of the great reflation trade.

On a final note in our previous conversation we voiced our concerns on the impact of the velocity of rising oil prices and their ability in triggering recessions, seeing US gasoline in at a 6 year high on Iraq, is,  requires close monitoring we think as it is a cause for concern - graph source Bloomberg:

"U.S. drivers will pay the most for gasoline over the July 4 holiday weekend in six years after the conflict in Iraq boosted crude oil last month, preventing the typical June decline in pump prices.

The CHART OF THE DAY shows how gasoline at $3.67 a gallon is the highest for this time of year since 2008. Retail prices rose 0.3 cent in June, compared with an average drop of 20.8 cents during the month in the past three years. While prices have slipped in the past five days, they probably won’t fall much more before the weekend as almost 35 million people hit the road, according to AAA.

“I’m not expecting any big changes,” Michael Green, a spokesman for Heathrow, Florida-based AAA, the biggest U.S. motoring organization, said by telephone from Washington. “We might see a drop of a few tenths of a cent.”

Regular gasoline in the U.S. costs 19.2 cents a gallon more than a year ago, dragged up by oil prices that jumped last month as fighting in Iraq threatened to cut off supplies from OPEC’s second-largest producer. International benchmark Brent crude rose $2.95 a barrel in June, and settled at $111.24 a barrel

on the 3rd of July.

The increase came just as the most people since 2007 made plans to travel over the July 4 holiday. About 34.8 million people will drive 50 miles or more from home during the five days ending July 6, up from 34.1 million last year, AAA estimates.

“Last year, prices peaked around March, and now they’ve peaked basically in June,” Sean Hill, petroleum economist for the Energy Information Administration, the Energy Department’s statistical arm, said by telephone from Washington. “This is all a function of what crude oil has done because of the Middle

East.”" - source Bloomberg

"The extreme limit of wisdom, that's what the public calls madness." - Jean Cocteau

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!