Macro and Credit - The Great Wall of China hoax

"The secret of life is honesty and fair dealing. If you can fake that, you've got it made." -  Groucho Marx

Looking at the Chinese currency falling against "Mack the Knife" aka King Dollar + positive real US interest rates, moving in sympathy with Bitcoin sailing through the 1000 threshold, with 2016 closing on arguably the epic failure of Mainstream Media (MSM) being the most prominent feature as pointed recently by Ray Dalio from Bridgewater Associates, we reminded ourselves for our title analogy of the Great Wall of China hoax faked newspaper story concocted on June 25, 1899 by four reporters in Denver, Colorado about bids by American businesses on a contract to demolish the Great Wall of China and construct a road in its place. The story was reprinted by a number of newspapers. We found it interesting that this hoax was created at the height of imperialism during late 19th Century when Great Britain obtained its 99 year lease for the New Territories, extending the Hong-Kong colony that had been ceded in 1841 while Germany seized the Chinese port of Kiaochow and used it as a military base, and French leased Kouang-Tchéou-Wan from China. Of course, this hoax coming at the very height of imperialism is reminiscent of our October 2016 musing "Empire Days" in which we pointed out that the "status quo" was failing:

"It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "status quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us." - source Macronomics, October 2016

The hoax began with four Denver newspaper reporters, Al Stevens, Jack Tournay, John Lewis and Hal Wilshire, who represented the four Denver newspapers - the Post, the Republican, the Times and the Rocky Mountain News. met by chance at Denver Union Station where each were waiting in hopes of spotting someone of prominence who could become a subject for a news story. Seeing no celebrities and frustrated with no story in sight and deadlines due, Stevens remarked: 

"I don't know what you guys are going to do, but I'm going to fake it. It won't hurt anybody, so what the Devil." 

The other three men agreed to concoct a story and walked on 17th Street toward the Oxford Hotel to discuss possible ideas and came up with a story in which the Chinese planned to demolish the Great Wall, constructing a road in its place, and were taking bids from American companies for the project. Chicago engineer Frank C. Lewis was bidding for the job. The story described a group of engineers in a Denver stopover on their way to China. That's how the hoax began and spread like wildfire, even making a comeback in 1939 as an urban legend due to Denver songwriter Harry Lee Wilber claiming in a magazine article that the 1899 hoax had ignited the Boxer rebellion of 1900. The cultural historian Carlos Rojas comments that the original hoax being perpetuated by a second hoax, a "metahoax," illustrates the ability of the Great Wall to "mean radically different things in different contexts."

By now, you are probably asking yourselves where are we going with our analogy? Have we already lost the plot early on in 2017? Recent geopolitical events have clearly shown that in some instances MSM like to fake it. This of course can have some unintended consequences leading to a hoax becoming a metahoax as pointed out by Ray Dalio from Bridgewater Associates in his latest missive:

"If you have a society where people can't agree on the basic facts, how do you have a functioning democracy?" Distorted pictures lead us to make bad decisions. In my opinion, if people don't correct such inaccuracies and don't fight against this problem, continued distortions in the media will prevent the public's accurate understanding of what is happening, which will threaten our society's well-being. We in the financial community now openly talk about fake or distorted media being used to manipulate market prices to the harm of many, and similar conversations are taking place in most areas.
This is not just a fringe media problem; it is a mainstream media problem. And while it is widely recognized, there is no discussion underway about how to rectify it." - source Linkedin Pulse, Ray Dalio, Bridgewater Associates

Fake news and fake prices thanks to central banks meddling with interest rates for too long can obviously lead to "unintended political" consequences as we have seen last year. Given 2017, is the 100th anniversary of the Russian revolution, we will not be surprised to see some more "sucker punches" being delivered in various asset classes and issuers (such as what we have seen with French issuer Vinci in 2016, Japanese Toshiba, UK retailer Next as of late). Both the MSM and central bankers are losing their aura, this will have some "unintended consequences" on asset prices rest assured.

Before we go into the nitty gritty of this year's musing, we would like to extend dear readers our best wishes for 2017 and we are looking forward to more discussions and comments. Moving to what we will cover in this conversation, we would like to turn our attention to the impact "Mack the Knife" is going to have on housing demand, and therefore gradually and most probably putting a dent into the much vaunted "Trumpflation" story. While the feel good effect on the year might be lasting some more thanks to better macro data from PMIs overall, it remains to be seen how long hope and complacency will trump reality...

Synopsis:

• Macro and Credit -  Japan as a base case - when low yield assets become nonperforming assets
• Final chart - Chinese credit is currently under-pricing rising risks in CNH

• Macro and Credit -  Japan as a base case - when low yield assets become nonperforming assets

In numerous conversations we have pointed out about our difficulty in embracing the recovery mantra story playing out in the United States thanks to lack of solid evidence in wage growth which would as well confirm the reflation story playing out, in a world awash in debt which, is no doubt weighting on growth prospect. As an illustration of political hope versus economic reality, no offense to ex French Prime Minister Manuel Valls but, his 1.9% GDP growth hypothesis in his just published political program for the presidential run of 2017, where he indicates that he will reduce the budget deficit while increasing public spending by 2.5% is hogwash. It just doesn't add up when public spending is already close to 58% of GDP (we are still laughing about this). No matter how ambitious a political program is, even with the benefit of the doubt, that market pundits seems willing to give, it seems to us that expectations are going to get at some point a reality check in 2017. 

When it comes to fake prices and fake inflationary expectations, Japan comes to our mind given its prolonged monetary easing stance and its consequences, leading to a vicious cycle of low growth where Europe seems to be heading thanks to a similar "japanification" process, and unresolved nonperforming loan issues in large swath of the European banking system. Japan is as well of interest, not only due to poor demographics (as in Italy these days) but also from the perspective of low-yield assets becoming nonperforming. To that instance Japanese real estate is a good illustration of the process as highlighted by Deutsche Bank in their Real estate sector note from the 4th of January entitled "Investment strategy for 2017: time to heed warnings of intellectuals":

"Heading for a world predicted 150 years ago

We believe the election of Donald Trump as US president and the UK's Brexit decision are outcomes of overly successful capitalism instead of heightened populism. These events expose the risks of capitalism that were predicted by Karl Marx, Adam Smith, and other intellectuals in the past. Japan has not recognized the trend changes, and we expect Japan’s real estate market to worsen in 2017.

Karl Marx, Adam Smith, and other intellectuals from the past predicted these risks 150 years ago. Continuing deregulation leading to a world dominated by "survival of the fittest" naturally breeds success for those with capital and intelligence. It fosters dominance by the elite. Capitalism is fundamentally aggressive. Various regulations have been enacted for dampening this aspect of it. However, continuous deregulation has created a "winner takes all" world and expanded disparities between rich and poor.
Several intellectuals understood the risks of capitalism. For example, Karl Marx warned that "successful capitalism means victory for those with capital and knowledge, and when left unaddressed, creates a society with large disparities and monopolies and leads to higher prices." Adam Smith, known for the "invisible hand," wrote "The Theory of Moral Sentiments" in 1759 prior to the "Wealth of Nations" (1776). In this book, he acknowledged that competition is important, but explained that the spirit of fair play and consideration for others is an essential premise. Even Max Weber, who argued that making money is good, noted that capitalism requires high moral sensitivity in order to succeed.
In Japan, Sontoku (Takanori) Ninomiya famously stated that "economic activity that ignores morality is a crime, and morality that forgets economic activity is nonsense." Japan also had the “Sanpo Yoshi” spirit exemplified by Omi merchants that calls for benefits to the buyer, seller, and local communities together. In other words, risks of capitalism were predicted in both the east and the west.
However, it is getting difficult to find a new frontier beyond extension of the frontier to the middle class through deregulation. Capitalism appears to be reaching its limits in its current form. Natural redistribution (trickle-down theory) has failed, and calls for redistribution are making headway among the middle class. We believe this sentiment is behind the results seen in the election of Trump as US president and the UK's Brexit decision. The world may be entering a chaotic age as it seeks new types of capitalism.
Important elections will take place in Europe in 2017, including legislative elections in the Netherlands in March, presidential votes in France in April and May, legislative elections in France in June, and a general election in Germany in September. Results in Italy's national referendum in December 2016 forced the resignation of Prime Minister Matteo Renzi. We believe people may follow the Italian case in quite a few countries and expect disruptions and crises to pick up momentum worldwide in 2017. 

NIRP transforms low-yielding properties into non-performing assets

We believe that lowering nominal interest rates via the NIRP (negative interest rate policy) weakens the financial intermediary function and leads the Japanese economy to deflation. As a result of the prolonged monetary easing in Japan, companies have accumulated low-yielding investments, leading the country into a vicious cycle of low growth. We see the risk of low-yielding assets becoming non-performing and triggering a significant setback to the NAV in Japan during 2017 in light of the approaching limits to monetary easing amid increased uncertainty in global political and economic conditions.

String of failures

Measures such as monetary easing that exceeded market expectations, a consumption tax hike amid a recovering economy to spur fiscal structural reform, and a strong ROE emphasis on shareholders have been adopted by the BoJ, the government, and the private industry, with each of them considered optimal. However, all have contributed to deterioration in Japan's economy and its real estate market. This is a classic example of the proverb, ‘the road to hell is paved with good intentions’. Excessive monetary easing has increased the risk of a surge in real interest rates and deleveraging, an excessive bias towards ROE has led to lower wage growth for general employees and reduced capex, and the consumption tax hike has caused consumer spending to stagnate.

To avoid the extreme ultimate decision

As countries worldwide reconsider their positions due to widened disparities driven by overly successful capitalism, Japan has yet to reflect on this. It remains one step behind, as it moves forward with minor government and deregulatory policies. Japan should realize that it needs to foster stronger ethics and morals and pursue policies that break away from excessive focus on ROE and encourage long-term investment and higher wages for employees. Unless these changes are adopted, we see increasing likelihood that Japan will be faced with the ultimate decision.

Bursting of "quiet bubble" to accelerate in 2017

In 2016, the real estate market started heading towards the end of the “quiet bubble”. We see this move picking up pace in 2017. We see hardly any factors supporting optimism. We determine our target prices for the real estate sector by using a residual income model. We also take NAV into account. Downside risks include: 1) a rise in risk premiums due to a decline in bank lending to the real estate sector; 2) the hasty implementation of a hike in consumption tax and/or income tax, or a decline in government spending due to a rush toward fiscal restructuring; and 3) deepening NIRP amid another monetary easing. Upside risks include: 1) significant salary increases in private sector companies, and 2) consumption tax and income tax cuts as well as large-scale fiscal spending." - source Deutsche Bank

As clearly highlighted by Ray Dalio in his latest missive, playing a hoax for too long, ultimately has unintended consequences and bring about political instability. The impact of globalization have been clearly leading to some political discontent given it has fostered dominance from the elites as highlighted by Deutsche Bank in their note. We touched on the impact of globalization back in February 2015 in our conversation "The Pigou effect" and we indicated Populism was bound to happen as predicted by the maverick Sir James Goldsmith and his 1993 insightful book The Trap which was followed by The Response:

"We also took into interest in the wise but gloomy comments from Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February 2015: 

“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey. “And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian 

This struck a chord with us as it indeed reminded us of Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. 

He violently criticized the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais. 
In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided above): 

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith 

While MSM is still wondering why there is a global rise in populism and why Trump got elected, for us it  fairly is very simple, the social contract between society and the economy has been truly broken. 

So the poor "schmucks" or "deplorables" as some politicians were calling them that were initially sold the "greatness" of "globalization" are now realizing they have been fleeced and obviously they are not happy about it:

U.S. Wage Growth Since 1973* Upper / High Income: +52% Everyone Else: -4.6% 

Distribution of U.S. Household Wealth to the Bottom 90% 

2016: 22% 2005: 30% 2000: 31% 1995: 32% 1985: 37%

Young Americans living w Parents*

2016: 40%2000: 31%1990: 30%1980: 30%1970: 23%1960: 23%1950: 22%

*18-34 yr olds - H/T Lawrence McDonald

This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, 22nd of July 2014

Clearly the latest spat between president elect Donald Trump and Ford might be an illustration of the US administration's trying to counter the fundamental aggressiveness of US capitalism that strongly benefited from the Fed's generosity. Put it simply, it might look as an attempt (or a hoax) to favor Main Street against Wall Street. It remains to be seen what the new US administration will set in motion and to paraphrase Groucho Marx, maybe faking is making it after all and the deplorables might have once again been conned, we shall see.

But, moving back to low yields becoming nonperforming, we remain very wary of the destructive trail of "Mack the Knife". 

While we continue to see pressure building up on China and capital outflows, we are eagerly waiting for the 7th of January where we sill the publication of the latest state of Chinese FX reserves. On that subject Bank of America Merrill Lynch in their Asia FX Strategy Watch note from the 4th of January anticipates that China FX reserves have fallen by $25 billion in December:

"We forecast China’s FX reserves to fall by USD 25bn in December to USD 3,027bn. Our forecast is less than the Bloomberg consensus forecast for a fall of USD 42bn to USD 3,010bn in FX reserves.

We estimate an intervention effect of USD -15bn in December, which is less than the USD -40bn reading for November (Chart 1). Onshore FX volume rose from USD 670bn to USD 740bn in December; an increase in onshore FX volumes are associated with a larger estimated intervention effect. Some of that impact on the estimated intervention effect may have been offset by the narrower average CNH-CNY basis of -55bps in December, from -167bps in November, leading to our smaller than consensus forecast decline in China’s FX reserves.

Our estimate of the valuation effect in December is USD -10bn. While the USD continued to strengthen against the EUR, GBP and JPY, the rate of USD appreciation
was less than the previous month.
As China’s FX reserves falls towards the USD 3trn level, we believe officials may act to contain RMB depreciation expectations because:

1. The USD 3trn could be of psychological importance to investors and officials. We show in our year-ahead report that this will ultimately be crossed in 2017, though capital controls are being engaged to sure-up credibility.
2. Capital outflows from China picked up to USD 205bn 3Q 2016, especially through trade credits and the use of CNH.
3. Inflation has maintained its upward trend in 2016, especially according to the PPI measure, raising concerns over FX inflation pass-through.

Indeed, the USD/CNY fixing rate has been notably lower than that implied by the 16:30 closing rate and the basket implied change throughout December 2016. Furthermore, FX purchases by individuals are now under greater scrutiny than before as the annual USD 50,000 limit was reset on 1 January 2017." - source Bank of America Merrill Lynch

On top of the unabated outflows from China thanks to "Mack the Knife", US rate hikes envisaged by the Fed will no doubt have an impact not only on US housing but, on the US economy as a whole as pointed out in Deutsche Bank aforementioned note:

"Are there any adverse impacts from the US rate hike?

We view 2017 as the start of major changes in trends as we mentioned above. The FRB increased the interest rate in December 2016 despite the increased possibility of major changes in global tides. We agree that conditions are healthier in the US than in Japan and Europe, which have adopted negative interest rates. However, the US rate hike may weaken its economy.

We are particularly concerned about auto loans and student loans in the US, which are now at all-time highs, having increased to $1.1tr and $1.3tr, respectively. Home mortgage loans have not recovered to the level before the Lehman collapse but are substantial. We believe that the US rate hike holds the risk of causing a downturn in housing demand.

 (click to enlarge)

We expect the rate hikes to gradually have a negative impact on the US economy and thus force a rate reduction in 2017 rather than further increases in rates. Hence, we believe investors should consider the potential for a shift back to yen appreciation. The risk of the economies in the emerging countries needs to be closely monitored as well. Even if faced with such conditions, the BoJ lacks additional options as it is already approaching limits of monetary easing.

The only possible action by the BoJ is widening negative interests. However, this may further undermine financial intermediation in the economy and accelerate a deflationary trend. We believe widening the negative interest rate would be a critical failure that adversely affects not only the real estate and stock markets but also the entire economy.

We expect a new era of global disruption over the long-term horizon, while we believe it will become apparent in 2017 that the US rate hike will have an adverse effect on the global economy and that Japan will not be able to cope with the impact. The environment for the Japanese real estate market is likely to present even stronger headwinds, in our view." - source Deutsche Bank

Of course, if the reflationary story turns out to be a hoax in a world where growth is stifled by high levels of debt, it will materialize itself at some point in 2017 and one would expect, the bond bears to retrench and yields to resume their downward trajectory during the course of the year. While hope is the ongoing "winning" strategy", at some point reality could reassess itself. On a side note, we have turned slightly positive on gold and gold miners over the course of December.

But moving back to Japan being a case study for monetary experiments, the impact of monetary policies have clearly shown their effect on real estate as pointed out by Deutsche Bank in their long interesting note:

"When expanded low-yield properties become nonperforming assets

As a result of the prolonged monetary easing in Japan, companies have accumulated low-yielding investments, leading the country into a vicious cycle of low growth.

In fact, Mitsubishi Estate's yield on leased properties has slumped from over 9% (FY3/00) to the 5% range, and Sumitomo R&D’s yield has fallen below 5%. A flurry of designation of special economic zones led by deregulation has created incentives for investment in low-yield assets. Low-cost finance also enables it.

Cumulative free cash-flow deficits at Mitsui Fudosan, Mitsubishi Estate, and Sumitomo R&D totaled ¥1.9tr from FY3/00 to FY3/16, due to continuous excessive investments over a long period (free cash flow: operating cash flow -
capex).

As long as the current level of large investments continues, these companies cannot buy back shares or raise dividends significantly because they simply do not have the necessary funds.

Locations that previously did not have offices have suddenly transformed into cutting-edge office districts, further heightening supply. The office stock in Tokyo's 23 wards has increased 1.7x since 1991. Rents, meanwhile, are at all-time lows following repeated ups and downs over economic cycles because of flat demand.

Alongside excessive investment in rental assets, inventory assets have risen sharply and the turnover ratio has dropped to an all-time low. For example, Sumitomo R&D's inventory assets have increased by ¥720bn, from ¥128.3bn in FY3/00 to ¥846.7bn as of end-FY3/16.

Meanwhile, Sumitomo R&D's real estate sales rose modestly from ¥150.5bn in FY3/00 to ¥274.8bn in FY3/16, reducing the turnover rate from 1.17 to 0.32, an all-time low. Similarly, Mitsui Fudosan's turnover ratio dropped to an all-time low of 0.4.

Low-yielding assets have been accumulating in Japan due to the prolonged monetary easing climate. We believe the BoJ's negative interest rate policy, which lowers nominal rates, is worsening the situation, since the policy further undermines the function of financial intermediation and thereby encourages deflation.

Japan, which is approaching the limits of monetary easing, has limited response options and faces significant risk of low-yield assets becoming nonperforming assets if the yield upswing, yen strength, or other factors create headwinds for the economy amid heightened uncertainty in global political and economic conditions in 2017. We believe this implies the possibility of significant erosion in the NAV." - source Deutsche Bank

Clearly the prolonged downturn of the Japanese economy in conjunction with the implementation of Negative Interest Rate Policies (NIRP) have led to excessive investment in rental assets and inventory assets have risen accordingly.

But, for us, the greater distortion coming out from NIRP is the distortion it is creating in terms of "credit allocation". As we pointed out in our conversation "Goodhart's law", back in June 2013, there is "good credit" (infrastructure and productive investments) and "bad credit" (real estate):

"Credit is like cholesterol, there is bad cholesterol that can’t dissolve in the blood (Low-density lipoprotein) and good cholesterol (High-density lipoprotein).

When too much LDL (bad cholesterol) circulates in the blood, it can slowly build up in the inner walls of the arteries that feed the heart and brain. This condition is known as atherosclerosis, and heart attack or stroke can result.

In 2008, we came very close to a global heart failure. The world had a stroke.

But, what led to the bad cholesterol in the first place? Bad credit. So betting on a government making the right choice of allocation with "fiscal stimulus" is wishful thinking, we think.

Government policies favoring housing bubbles have led to mis-allocation of credit (bad cholesterol), like in the US, the UK, Hungary, Ireland and Spain. Bad cholesterol (the "credit stroke) has led to "Balance Sheet Recession" (Japan).
Government policies favoring infrastructure investment is good cholesterol:
One can posit that President Eisenhower when he signed the 1956 bill that authorized the Interstate Highway System in 1956 was of great benefit to the US. In his parting speech of the White House on the 17th of January 1961, he warned about the risk of bad cholesterol (military complex) but that's another story..." - source Macronomics, June 2013

In terms of Japan, there is clearly indication that NIRP is already leading to "bad credit" as per Deutsche Bank's report:

"Excessive monetary easing has increased the risk of a surge in real interest rates and deleveraging, an excessive bias towards ROE has led to lower wage growth for general employees and reduced capex, and the consumption tax hike has caused consumer spending to stagnate.

The first problem is BoJ’s policy. We believe its monetary easing policy has been excessive. We are not negative about monetary easing, but we believe this has started doing more harm than good.

The worst setback has been the decline in demand for non-real estate loans since the adoption of the NIRP, creating tightening rather than easing effects. Recent data actually show a 7.2% increase in loans to the real estate industry versus a slowdown to 1.4% in other areas (Figure 11).

The NIRP has proved dysfunctional in Japan due to record-low loan-deposit ratios (demand for bank loans is low and has moved little in response to lower interest rates). In addition, the NIRP, which lowers nominal interest rates, promotes deflation by weakening financial intermediation. Slowing loan growth to industries other than real estate is evidence of this.

Furthermore, the BoJ has adopted yield-curve controls because the volume of JGB holdings at banks that can be sold to the BoJ has already reached a limit. This has raised the risk of investors pricing in the limitations of monetary easing. We believe this is a problem too.

The BoJ's introduction of measures to control the yield curve amid NIRP promotion of deflation negates any benefits from lower interest rates. Yield-curve controls that prevent yields from declining are contradictory to the NIRP's reduction of the nominal interest rate. We believe this presents a nightmare scenario for the real estate sector.

Put differently, we see expected revenues declining, risk premiums rising, and risk-free rates trending upward. This means the three key determinants for stock prices in the real estate sector should move into a direction that is detrimental for the sector.

Our worst-case risk scenario would be widening of the negative interest rate by the BoJ that prompts banks to impose account management charges on large deposits. We believe this would start triggering further deleveraging.

Many Japanese companies are effectively debt-free and take bank loans mainly to maintain friendly relations with banks. If they are charged management fees for those accounts, we suspect many of them would reduce their deposits as much as possible and work to repay their loans.

Banks would then suffer not only a narrowing lending spread but also a drop in the lending balance. Japan would experience credit contraction (deleveraging), and as a result, slip into deflation again, in our view.

It is also important to consider market risk. The BoJ's massive JGB purchases have lowered JGB liquidity. Therefore, we see the risk of a sudden steep rise in interest rates if some type of shock occurs.

Furthermore, dark clouds are gathering over upbeat lending in the real estate industry because restrictions may be imposed on loans to the industry (as reported by some media sources). In fact, banks’ outstanding loans to the real estate industry have climbed to a record high of 14.8% of total loan value. We believe this already exceeds the acceptable level.

Second culprit is excessive focus on ROE

We believe the second culprit is an excessive focus on ROE. The behavior of Japanese corporations changed considerably after the 1997 financial crisis, and companies have stopped increasing employee compensation even with profit growth.
Since then, their more shareholder-centric stance has resulted in a greater tendency to distribute profits to shareholders rather than use them to boost employee compensation. If we assign 1997 a base value of 100, dividends would now be 500 while employee compensation is still 100.

We believe the domestic demand economy cannot grow without corresponding growth in employee compensation. On the other hand, executive compensation has been increasing. This would be understandable if management generated strong results, but in one case, executive compensation increased by more than ¥200m YoY even when the firm made a loss due to failed M&A and other initiatives. This is the tragedy of Japan copying the negative aspects of a shareholder-centric stance.

Shareholders are not a company's only stakeholders. Other stakeholders include clients, employees, and the society to which the company belongs. Although shareholders can easily cut off their ties by selling their shares, clients and employees are unable to end their relationship so easily. From this point of view, shareholders are not even the most important stakeholders.

We are not suggesting that companies ignore shareholders. Rather, we believe that insufficient attention given to employees and other stakeholders could destabilize a society. This is already happening in other advanced nations. In our opinion, it is a big problem for Japanese companies when managements fail to consider the experiences of other nations as related to its own issues." - source Deutsche Bank

The Japanese story, to some extent is clearly indicative of the challenges faced by the new US administration. This is for us the biggest headwind for the Fed, given it has accentuated through its loose policies the rift between the have and the have not. We have reached the limit of what monetary policies can do and the toxicity it has brought in terms of mis-allocation. It remains to be seen how the new US administration can encourage real wage growth and the latest Ford episode, lack for us an essential part to ensure a real recovery taking place and not a hoax, namely that the new Donald Trump administration needs more than having companies investing "in America", because if the new elected president wants to "make America great again", it certainly needs to learn from the Japanese experience and ensure US companies invest "on Americans" we think.

Deutsche Bank's note also clearly makes some solid points relating to the Japanese tragedy:

"Need to avoid ultimate decision

We see voters worldwide are calling into question the widening disparities caused by capitalism's overwhelming success, as evidenced by Trump's victory in the US presidential election, the UK's decision to exit the EU, and the resignation of Italian Prime Minister Renzi as a result of a national referendum in December.

However, the changing trend poses risks that were predicted long ago by intellectuals like Karl Marx and Adam Smith. Continuing deregulation funnels control to the elites, expanding disparities between rich and poor in a "winner takes all" scenario. Furthermore, it is difficult to find new frontiers because they have already been expanded to the middle class, raising the specter that capitalism in its current form will disappear. Natural redistribution (trickledown theory) has failed, and calls for redistribution are making headway among the middle class.

Even as the “quiet bubbles” approached their demise in 2016 and will likely accelerate in 2017, Japan remains mired in a dilemma. Instead, it seems to be standing still as a laggard, unaware of the growing chaos and crisis and the major changes taking place worldwide.

At this juncture, we believe Japan needs to foster a spirit of fair play that takes into account the interests of all parties and cultivates strong ethics and moral values, stop focusing too much on ROE, and enact policies that encourage long-term investment and higher wages for employees, as were outlined in the writings of Adam Smith, Karl Marx, and other intellectuals in the past. Without these changes, Japan may not be able to avoid the ultimate decision.

Specifically, companies are expanding shareholder returns to boost their share prices and increasing M&A because their own R&D reduces ROE. Innovation cannot be achieved this way. Companies should not refrain from long-term investments. Honda's ASIMO, linear-motor bullet trains, hydrogen engines, carbon fiber, and Japan's other impressive technologies obtained through long-term investment would not have been realized in a world focused on ROE.

We also believe that profits should be fairly allocated to employees, not just to shareholders and executives. Unless this happens, the cycle of "widening disparity → excess savings → low rates and low growth → asset price gains → bubble collapse → monetary easing" will continue unabated. Nevertheless, it seems that this cycle is at its limits.

We see need for tighter regulations, not just deregulation. This is particularly important in the real estate industry. Locations that did not have offices are suddenly being transformed into cutting-edge office districts, further heightening supply as a result of continuous deregulation. Therefore, rents are at all-time lows after repeated ups and downs during economic cycles.

We believe it is possible to achieve strong economic growth by ending sluggish consumption and increasing new products through innovation if Japan stops focusing excessively on ROE, and ends wage-curtailment for ordinary employment and restraints on capital investment. It is also time to halt deregulation and restore strong ethics and morality, along with more measured competition.

We believe the "quiet bubbles" started to collapse in 2016, and expect the downturn to accelerate in 2017. The economy and the real estate market will likely remain sluggish because of inadequate policies being pursued in the public and private sectors. We find almost no factors that support optimism. We believe Japan will likely face an ultimate decision unless the reforms we discussed above are enacted." - source Deutsche Bank

The wise words of Sir James Goldsmith from 1993 we mentioned back in June 2013 in our conversation  "The Pigou effect"  still resonate with the above and the risk for capitalism's demise:

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith

The ongoing rise in populism thanks to globalization and aggressive capitalism, in search of maximizing ROE and shareholders return have had the desired effects in leading towards a surge in populism, it remains to be seen how the new US administration will ensure that the economy serves the US society, or put it simply, make sure Main Street gets its fair share of the pie which has been lacking in recent years thanks to the Fed's bold monetary policies which were a boon to Wall Street.

In similar fashion, China is playing a difficult balancing act in trying to deflate its induced credit bubble while ensuring social stability which is illustrated in our final chart.

• Final chart - Chinese credit is currently under-pricing rising risks in CNH

Our final chart illustrates the complacency between upwards pressure on the Chinese currency thanks to "Mack the Knife" and China credit risk and comes from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 4th of January entitled "Let's get technical". It displays the rise of USD/CNH 3 months ATM (At the Money) volatility versus China exposed names 5 year CDS index:

- source Bank of America Merrill Lynch

If "Mack the Knife" continues its unabated run, it remains to be seen how long China related credit is going to be able to hold the line. When it comes to Great Wall and hoaxes, it remains to be seen if indeed The Great Wall of Mexico will be one after all, but we ramble again...

"This nation is notorious for its ability to make or fake anything cheaply. 'Made-in-China' goods now fill homes around the world. But our giant country has a small problem. We can't manufacture the happiness of our people." - Ai Weiwei, Chinese artist

Stay tuned!

Macro and Credit - When Prophecy Fails

"Experience is the only prophecy of wise men. Alphonse de Lamartine," - French poet

Looking at the dislocation and violent bond market gyrations that followed our second "prescient" call (following our correct Brexit call) on Trump being elected in the US as indicated in our conversation "Empire Days" which by the way earned us two nice bottle of wines thanks to our friends being plagued by "Optimism bias", we decided to steer towards "behavioral psychology" for our chosen title analogy this time around by referencing the classic 1964 book of social psychologists Leon Festinger, Henry Riecken and Stanley Schachter where they deal with the psychological consequences of disconfirmed expectations. While we have already used "Cognitive dissonance" as a previous title, this book was very importance in the sense that it published the first cases of dissonance. The chief reason for us selecting the above title reside in the fact that not only did the US election was a case of disconfirmed expectations and of course "Optimism bias" but, the resulting wakening of "Bondzilla" the NIRP monster led to the reversing of Gibson paradox given the sudden rise in real yields that lead to not only a bloodbath in the bond space but also a vicious sell-off in both gold and gold miners, with silver not spared either. As a reminder about Gibson paradox from previous conversations: When real interest rates are below 2%, then you get bull market in gold, the reverse also works. There has never been an episode in history when Gibson's paradox failed to operate. Real interest rate is the most important macro factor for gold prices. Also the relationship between the gold price and TIPS (or “real”) yields is strong and consistent. Gold and TIPS both offer insurance against “unexpected” (big and discontinuous) jumps in inflation. The price of gold normally falls along with the price of TIPS (which means that TIPS yields rise). So to conclude, gold and gold miners are not the best hedge at the moment given the negative correlation with real rates and the aforementioned "sucker punch" delivered in a very short order. So while many noses have been bloodied in recent days following Trump's victory, our contrarian and behavioral posture tells us we think the market might be trading way ahead of itself given the uncertainties relating to what the policies which will be implemented by the new US administration. When it comes to disconfirmed expectations and its inflationary bias as of late, we are still awaiting to see additional pressures coming from wages before we embrace the recovery mantra. Nonetheless we have been gradually de-risking our early 2016 barbell position significantly (long US long bonds / long gold miners) in favor of cash in US dollar terms waiting for the time being for the dust to settle and the fury to abate before dipping back our toes.

In this week's conversation we would like to revisit our July 2015 theme of "Mack the Knife", also known as the Greenback in conjunction with US real interest rates swinging in positive territory hence the pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation. Of course what is happening in the Emerging Markets space is of no surprise to us given we mused on Emerging Markets risks in our conversation "The Tourist trap" back in September 2013:

"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?"

Real interest rate and US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple.

Synopsis:

• Macro and Credit - Gold and Emerging Markets : The return of Mack the Knife
• Final chart - People are trading on hope: Higher growth or higher inflation?

• Macro and Credit - Gold and Emerging Markets : The return of Mack the Knife

For us, Mack the Knife = King Dollar + positive real US interest rates. 

When it comes to the acceleration of flows out of Emerging Markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2016 after the US elections in very short order) started once again the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.

More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike.

A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been China with the acceleration in capital outflows put forward by many pundits and displayed in the below chart from Bank of America Merrill Lynch from their Global Emerging Markets Weekly note from the 10th of November entitled "Should I stay or should I go":

"Asia: It’s complicated

We expect weaker Asian currencies vs USD. In addition to the higher US rates channel, Asia is very exposed to US trade protectionism and will rely on rate cuts, weaker currencies and domestic fiscal policies to offset those risks. We like short KRW and SGD vs USD, and we remain short CNH against a narrow CFET basket as outflows are expected to continue (Chart 2). A complicating feature will be the greater scrutiny on USDCNH and whether President elect Trump will come true on his election threat to charge 45% punitive tariffs on Chinese exports to the US." -source Bank of America Merrill Lynch

Nota bene: Hypertonic

"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

As a reminder and what is playing out again is what we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs China). So, all in all, the likely Fed hike in December in conjunction with USD strength will once again result in additional capital outflows which are leading not surprisingly to textbook bigger CNY depreciation from China.

When CNY / USD depreciation expectations continue to rise or USD strengthens, you can expect once again more pressure on capital outflows if other macro factors remain relatively stable. Emerging Markets including China are in a hypertonic situation; therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield (ETF JNK and outflows) and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates) hence our propensity in this kind of situation to raise significantly cash levels in US dollar terms.

Our reverse osmosis process theory from a macro perspective can be ascertained by monitoring capital flows. On the subject of monitoring for the purpose of the exercise, we read with interest Nomura's latest Capital Flow Monitor from the 14th of November entitled "EM Pressure Index Update":

• EM central banks (excluding China and the OPEC countries) continued to buy reserves in foreign currencies to the tune of $37.7bn in October vs. $12.0bn the prior month, led primarily by strong purchases from Hong Kong (around $25.3bn). This is the eighth consecutive month of net buying by these EM central banks. Of these 20 EM central banks, two sold reserves, nine bought, and nine did not intervene.

• After adjusting for FX valuation and coupon payment effects, we estimate that China sold FX to the tune of $11.2bn in October, after having sold around $29.8bn in September.

• EMFX pressure rose moderately: Our Global EM FX Pressure Index (excluding China and the OPEC countries) continues to deteriorate. The main contributors to the pick-up in pressure are the South Korea, Indonesia, Israel and Russia, in that order of significance. This was partly offset by lower FX pressure in the Philippines, Mexico (MXN appreciated significantly in October), and Brazil.

Global EM FX Pressure Index

The Global EM FX Pressure Index combines information on EM central bank reserve dynamics and EM FX price action.
EM FX price action is measured by the monthly percentage change in EM currencies against the USD. Reserve dynamics are measured by EM central bank intervention (in USDbn) scaled by the money base. EM central bank intervention is estimated to be based on changes in the level of FX reserves, adjusted for valuation effects. The two indicators are then summed up on a vol-adjusted basis to arrive at the final index value.
The methodology above is developed by the IMF

• EMFI pressure rose in October: Our Global EM Fixed Income Pressure Index, which combines information on cross-border flows into EM local bonds and price action, indicates a significant increase in pressure. The absolute pressure level was high in October relative to history.

Global EM Fixed Income Pressure Index

The Global EM Fixed Income Pressure Index follows a similar methodology and combines information on cross-border flows into EM local currency bonds and EM local currency bond price action.
EM local currency bond price action is measured by the change in bond prices, computed based on the monthly change in 10yr sovereign yields and a 7yr duration assumption. Cross-border flows are acquired from various local sources; most of them are estimated based on changes in foreign holdings of local currency bonds. The two indicators are then summed up on a vol-adjusted basis to arrive at the final index value.
Estimates for the current month are made based on flow data from Mexico, India, Indonesia, Hungary, South Africa, and Turkey. A revision will be made (in the following month) once data from Colombia, Brazil, Malaysia, Korea, Russia, Poland, Israel, Thailand, and the Czech Republic are released.

Pressure on EM bonds rose in October

• EMFI pressure rose: The index fell to -1.2% (a significant rise in pressure). As indicated in Figure 2, this level of pressure is low compared to historically.
• Bond flow: EM local bond markets saw an estimated outflow of $4.3bn, compared with an inflow of $9.1bn of inflows in September and $2.0bn of inflows in August (based on a consistent sample of six countries that have reported for May: Mexico, India, Indonesia, Hungary, South Africa, and Turkey).
• Price action: Of the 19 EM countries we track, two countries saw their sovereign yields fall, while 17 rose (Figure 9). Russia (+54bp) and Turkey (+33bp) saw their sovereign yields rise the most, while Brazil (-19bp) and India (-2bp) saw their yields fall the most. Yields in the advanced economies rose, with US 10yr yields up around 23bp, Japanese only up 4bp, and eurozone up an average of 35bp, led by Italian bonds.

- source Nomura

From our monitoring perspective and our interest in dwindling currency pegs with Egypt being the latest one to throw in the towel, given that we won the "best prediction" from Saxo Bank community in their Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September 2015 conversation and with the additional points made in our conversation "Cinderella's golden carriage", we might have had once again our timing wrong in 2016 as far as the HKD is concerned. But, when it comes to dwindling currency pegs and with our own prophecy failing so far to materialize in 2016 we would like to remind you the trend for currency pegs so far. When it comes to our 2016 "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop if Mack the Knife continues his run unabated:

-source Société Générale

Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. These are indeed the "shadows of things that have been". We also note from Nomura's research piece that when it comes to intervention by country and capital flows, once again Hong Kong Monetary Authority (HKMA) had to step in significantly in October:

- source Nomura

What has been happening of course for Emerging Markets and yield hunters alike is that central bank's meddling with interest rates (ZIRP, QE, NIRP) drove traditional investors seeking mid-to-high single digit yields out of investment grade/ crossover credit into high yield, leveraged loans and emerging market debt to satisfy their yield appetite. The problem, however, is some of these "macro tourists" underappreciating exponential loss and mark-to-market functions for low quality high yield assets. As we have noted previously when the credit cycle will eventually turn in earnest (not yet the case according to the latest US Senior Loan Officer Survey showing some easing as of late) annual triple C default rates can surge from 5% to 30% while average triple C prices can fall into the $40 - $50 range as we have seen earlier on in 2016 for the energy sector. Yet, it seems given the significant returns delivered in the second part of the year to the High Yield sector, that some of these "macro dimwits" have not learned their lesson, given that not only they have increased their credit exposure, but, they have also extended their duration exposure at the same time! Hence the on-going bloodbath. As a reminder, in the current low yield environment, both duration and convexity are higher; therefore price movements lower for bonds are larger.

In August 2013 in our conversation "Alive and Kicking" we argued the following:

For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":

"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 

However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 

Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

It seems to us the central bank "deities" are in fact realizing the dangers of using too much "overmedication" in the sense that the Fed paved the way for "mis-allocation" and the rise in inflows into the credit space and Emerging Markets bond funds alike. Even the Fed's generosity cannot offset the rising risks of a broad exit in a disorderly fashion in bond funds given that the Fed's role is supposedly one of "financial stability". We will not delve again into our views relating to positive correlations and large standard deviation moves as we have already tackled the subject in February in our conversation "The disappearance of MS München" conversation. We commented at the time that the fate of the attack of the Yuan and in effect the attack of the HKD peg could be analyzed through the lens of the Nash Equilibrium Concept:

"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

It seems to us that speculators, so far has not been able to "hunt" together or at least one of them, did not believe enough in the success of the attack to break the HKD peg. It all depends on the willingness of the speculators rather than the fundamentals for a currency attack to succeed we think.

When it comes to the much feared Mack the Knife and Asia, Bank of America Merrill Lynch in their Global Emerging Markets Weekly note from the 10th of November entitled "Should I stay or should I go" looks further into the dominating risk from a rising US dollar:

"Does dollar strength dominate everything?

The sharp reversal higher in risk assets following the Republican clean sweep has raised the question of whether reflation optimism (driven by the end of gridlock and expectations of US fiscal stimulus) could support Asia FX over the coming months. We are skeptical, at least vs the USD. As we have argued, the biggest implication of a Republican clean sweep is a stronger USD and higher US rates– this should lead to higher USD/Asia, even if trade-weighted FX performance remains more sensitive to risk.

US tax cuts – this time is different for Asia

Historically, large US tax cuts have been followed by a widening of the US current account deficit driven by higher imports (Chart 9).

This supported Asia export growth and exchange rates, especially during the Bush tax cuts of 2004 (Chart 10).

However, this time could be different, partly because the US household spending has been shifting towards non-tradable services. More importantly though, Trump’s policy platform itself is geared towards reducing dependence upon foreign goods and services.

Trade policy risks

While the prospect of draconian trade restrictions is still uncertain under a Trump Presidency, some risk premium is likely to be factored into Asia FX. There will be particular focus on the trade policy stance towards China. China is currently far from meeting the existing US Treasury criteria for currency manipulation, primarily because it has not engaged in RMB weakening intervention. It will be important to watch if the US Treasury amends these criteria under the new Administration. Another issue would be China’s expectations to be granted market economy status on 11 December 2016, fifteen years after its WTO accession, and the negotiations around this. A key risk is if China chooses to weaken its currency more quickly ahead of these events and the new Administration taking office." - source Bank of America Merrill Lynch

In the current context, from an allocation perspective, we are neutral on gold and silver until we see more stabilization in the move in real rates. While many have been jumping on the "equity" bandwagon, if indeed there is further weakening of the yen relative to the USD then again, the Japanese Nikkei should benefit so what is not to like in going long Nikkei hedged in either USD or Euro? Also, the strengthening of the HKD, should benefit Chinese shoppers and Japan from a "retail" perspective. This is already a subject we discussed in our conversation"Cinderella's golden carriage" in December 2015 as  tourists amounts to more than 12% of  Hong-Kong to GDP:

"So, from an "allocation" perspective, if you want to play the "luxury" and "tourism" theme, then "overweight" the "golden carriage" in Japan, as Hong-Kong is more likely to turn into a "pumpkin"....but we ramble again." -source Macronomics, December 2015

As we stated before, if Asia is one the receiving end of further "Chinese" devaluation, then, for us, Hong-Kong is indeed in a "very weak position" to maintain both its peg and its competitivity. Something is going to give we think. While our "prophecy" failed in 2016, if the trend continues, who knows how long Hong Kong can hold the line.

When it comes to failing prophecies and high expectations, particularly of the inflationary type and the market trading ahead of itself our final chart below is highlighting once again the gap between equity investors (the eternal optimists) and fixed income investors (the eternal pessimists). 

• Final chart - People are trading on hope: Higher growth or higher inflation?

While the Fixed Income crowd continues to be trounced by rising real rates and surging inflation expectations we do believe that the market is trading way ahead of itself and speculating already on what the new Trump administration will be able to deliver. The significant rise in interest rate volatility in conjunction with real rates means that not only fixed income in general and emerging markets in particular are getting slammed, but, it means once more that Gibson's paradox is at play at the moment hence our neutral stance for the time being and cautiousness. Our final chart from Deutsche Bank's Torsten Slok Chief International Economist and illustrates the different trajectories of volatility between rates markets and equities:

"Fixed income markets and equity markets are following completely different narratives after the election. Rates markets are focusing on higher inflation and what it means for rates across the curve, including the risk of the Fed falling behind the curve. Equity markets, on the other hand, are focusing on higher GDP growth, and equity markets don’t seem to worry about the risks of an overshoot of inflation and the Fed falling behind the curve. These different ways of looking at the election outcome have opened up a huge gap between rates volatility and equity volatility." - source Deutsche Bank

Indeed, mind the gap, because if volatility continues to surge in rates markets, we have a hard time believing it will not eventually spill-over to equities. We shall see if the inflationary prophecy materializes itself in the coming months. For the time being, like any good behavioral therapist, we'd rather focus on the process of a rising US dollar rather than on the prophetic content of the policies which will be followed by the new US administration.

"In the computer field, the moment of truth is a running program; all else is prophecy." -  Herbert Simon, American scientist

Stay tuned!

Macro and Credit - Cinderella's golden carriage

"The very concept of objective truth is fading out of the world. Lies will pass into history." - George Orwell

Listening with amusement to "Le Chiffre" aka Mario Draghi, losing some of his "Sprezzatura" ("studied carelessness") following the ECB meeting last week, leading to some significant "sucker punches" being delivered for the "Balanced funds crowd" (long German government bonds and European equities) and Euro short punters alike, given that all market pundits have been used to the "fairy tales" from the "Generous Gambler" and "happy endings" for risky assets, we decided this week to steer towards a European folk tale as an analogy for our chosen title. The story of Rhodopis, about a Greek slave girl who marries the king of Egypt, is considered the earliest known variant of the "Cinderella" story (published 7 BCE), and many variants are known throughout the world. One of the most popular versions of the story was written in French by Charles Perrault in 1697 under the name "Cendrillon" and in his version he introduced the "pumpkin". While the fairy godmother turned a pumpkin into a golden carriage in the story depicted by Walt Disney, she did warn Cinderella to return before midnight. Central bankers with their various iterations of QE have provided "balanced fund managers" a tremendous goldilocks period for investing. While we have warned of the rising instability risk caused by positive correlations in August this year , which is leading more and more to "large standard deviation moves" (sucker punches) in various asset classes, it seems to us that investors are not taking seriously fairy godmother Janet Yellen as we are indeed approaching midnight (watch what our US CCC credit canary is doing as of late...). One of the moral of Charles Perrault's version is as follows:

"That "without doubt it is a great advantage to have intelligence, courage, good breeding, and common sense. These, and similar talents come only from heaven, and it is good to have them. However, even these may fail to bring you success, without the blessing of a godfather or a godmother"

No doubt to us that without the blessing of the "fairy godmother from the Fed" aka Janet Yellen, we think, it is going to be incredibly difficult to achieve significant "positive returns" in 2016 for the "long only" crowd, as in similar fashion to the fairy tale, Cinderella's golden carriage spell is about to be broken and return to being a simple pumpkin (hence our call for heightened volatility in 2016 and the need to put on some still "cheap hedges").

In this week's conversation, we will continue to look at 2016 prospects. We will also touch on some "macro convex trade" of interests (by the way we submitted our HKD idea from September to Saxo's 2016 "Outrageous predictions", so let's see if we make the cut...).

Synopsis:

• One "macro convex trade" to think about for 2016
• Container shipping and large surge in US inventories, a great cause for concern
• Final chart - Global equities: more de-equitisation to come in 2016

• One "macro convex trade" to think about for 2016

Our own "outrageous 2016" prediction - A HKD devaluation.

Back in September this year in our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen.

At the time we argued the following:

"A weaker CNY would trigger a fall in competitivity for the entire Asian region and would massively impact the retail sector of Hong-Kong with additional fall in the number of visitors from mainland China and even more pressure on property developers. Hong Kong property sales plunged to 17-month low in August amid increasing economic uncertainty in China." - source Macronomics

Given that the latest data from Hong Kong’s Land Registry shows sales of registered residential units in November slumped to their lowest in nearly two decades with Residential mortgage approvals falling 40 percent in October as reported by Reuters in their 3rd of December article entitled "We need to talk about Hong Kong’s property market. Again.":

"The second major factor, and arguably the more important one in the short term, is what is happening on the mainland. China’s marked slowdown has taken a toll on everything from property transactions to tourist arrivals and retail sales in Hong Kong.

Chinese tourists buying up everything from Louis Vuitton bags to milk powder in Hong Kong’s shops accounted for nearly half of the city’s retail sales last year. This is slowing sharply as the economy slows and as Chinese tourists prefer to take their shopping to Korea and Japan instead. The knock-on impact is putting rents in shopping malls at risk.

The backdrop appears anything but sanguine.

But Macquarie takes a calmer view. It estimates that there is a decade worth of pent up demand (roughly amounting to 262K households) in Hong Kong that has built up as buyers got increasingly priced out of the property market. Unless there are widespread job losses it is unlikely that this demand will disappear.

If they’re right, that suggests every dip is likely to find buyers come back in even if interest rate slowly nudge higher.

Dents in the armour are showing. But 2016 may still be too early for the start of the collapse." - source Reuters

And this is indeed is a big if à la Cinderella's golden carriage being able to return before midnight no offense to Macquarie. If we want to add more "ammunitions" to our "simple" macro convex trade we can simply point out to a few factors, one being the approximate direct contribution of China tourist revenues as a percentage of GDP in 2014 and 2015, as indicated by CITI in their very interesting Emerging Markets Macro and Strategy Outlook - Prospects for 2016" recent note. Spot the "outlier":

"Direct contribution to GDP on recipients of China outflows are very small for most except in “special” territories (Macau, HK), which are suffering from a Chinese tourist slump. While tourist arrivals are booming in Japan, the biggest beneficiary of strong mainland arrivals relative to the size of their economy appears to be Thailand.

A second important constraint is the overhang from the build-up of nonfinancial private sector leverage, in the backdrop of a maturing credit cycle.

While we don’t expect any disorderly deleveraging/credit crunch given stronger balance of payment/less FX mismatch risks for most (though Indonesia corporates have some issues), with room for some to pursue counter-cyclical monetary easing in contrast to the Fed rate hiking cycle, there are a few FX-managed regimes with very open capital accounts– HK and Singapore – that inevitably will see rates rise alongside the US and will need some monitoring, especially given its knock-on impact on property markets and household balance sheets. Moreover, persistent capital outflows could tighten domestic financial conditions, especially for those without offsetting current account buffers and/or had been significant recipient of those volatile types of capital flows– e.g. Indonesia and Malaysia look vulnerable here. Even if central banks keep monetary conditions accommodative through interest rate and liquidity tools, we note that many countries in Asia -- notably China, HK and ASEAN countries – have seen a notable rise in “credit intensity” of output in the post-GFC years. We think this is a sign of credit being increasingly allocated to less productive sectors that, over time, manifests itself in weakening cash flows relative to debt service payments. This dynamic will lead to two things: first, greater demand for balance sheet repair among indebted entities, which will drag aggregate demand, or second, if balance sheet is irreparable, rising default rates and loan losses in the banking system, which will then feed into tightening of credit standards and higher costs to credit. Our bank analysts see the biggest NPL risks arising in China, Indonesia, Thailand and eventually Malaysia. Thus, a more mature phase of the credit cycle will mean that even the effectiveness of monetary policy as a counter-cyclical policy easing will weaken." - source CITI

Very open capital accounts means that as CNY/Yuan downward pressure continues to intensify, the pressure upwards on HKD will intensify leading to more and more intervention from the HKMA to defend the peg. Defending a peg, as clearly shown by the Swiss National Bank (SNB) in 2015 works, until it doesn't.

If indeed Hong-Kong is highly dependent on Chinese tourism, then particularly the study of the "Luxury" sector and the CNY/Yuan impact is paramount. When it comes to the "Luxury" sector and Hong-Kong, we read with interest Bank of America Merrill Lynch's Luxury Goods note from the 7th of December entitled "2016 years ahead: Luxury sector embedded with earnings & valuation risk":

"2016 likely to be another weak year for Hong Kong, don't count on the weak base to support growth 

The weakness in Hong Kong is driven by lower traffic. Total visitation is flat in 2015 ytd, but down about 7% in the last 3 months. The quality of the tourist is also lower, which is leading to lower conversion rates & basket sizes. Most European luxury companies have reported Hong Kong revenues down 15-25% in the most recent quarter. Based on conversation with Hong Kong based luxury companies weak trends have continued into October despite an easy comparison base, which included the impact of Occupy Central last year. The outlook for 2016 remains subdued.

We track Watches & Jewellery retail sales to gauge luxury market demand in Hong Kong. In 2015 ytd HK Watches & Jewellery retail sales are down -13.1%, with September down 23% despite an easier comparison base. September volumes decreased 16.7% and average selling price was down by 6.2% in the month. This is shown in the charts below.

We believe monthly retail turnover for Harbour City & Times Square luxury malls in Hong Kong also provide a guide to market growth. Revenue is down around 9-10% in 2015 ytd, with the biggest declines since in the most recent quarters. This is shown in the charts below.

- source Bank of America Merrill Lynch

Now if tourism growth is close to zero and direct contributions from Mainland China tourists amounts to more than 12% of  Hong-Kong to GDP, we hope "Cinderella" investors have not forgotten that indeed the "golden carriage" can turn into a "pumpkin".

Indeed has shown in Bank of America Merrill Lynch's note, it seems the Hong Kong "golden carriage" is losing some of its appeal. We do like to track "traffic" as great macro "growth" indicators, such as Air Cargo, Container traffic and many more. What is indeed of great interest is that no new seats are being added to China-Hong-Kong flight routes for 2016 YTD:

"Hong Kong continues to lose its appealChinese consumers no longer see Hong Kong as an attractive luxury shopping destination. We think this stems from a lack of newness, increased social tension, occupy central and a strong HKD.

Total visitation is flat in 2015 ytd, but down 7% in the last 3 months, which reflects the decline in Chinese inbound tourism. However this still under-states the decline being felt by luxury companies in HK given the quality of the tourist is also lower, which is leading to lower conversion rates & basket sizes. Chart 76 shows no new seats are being added to China-Hong Kong flight route for 2016 YTD, suggesting the underlying weakness in traffic is expected to continue.

- source Bank of America Merrill Lynch

And of course the winner of the "currency war" when it comes to the "Shrinking pie mentality" we discussed in April 2014:

"When the economic pie is frozen or even shrinking, in this competitive devaluation world of ours, it is arguably understandable that a "Winner-take-all" mentality sets in." - source Macronomics, April 2014.

No wonder Japan is "winning it all" when it comes to tourists and "competitive devaluation" as indicated by Bank of America Merrill Lynch:

"Japan has grown 100% in 2015, strong growth likely to continue as appeal picks up
The number of China outbound tourist to Japan has increased by more than 100% in 9m 2015. This has led to 35% growth in luxury consumption in Japan. We expect Japan to continue to take share from Hong Kong, which is still 7x the size in terms of inbound tourist from China. As a result we expect ongoing solid luxury goods revenues in Japan (+25% cFX), despite a very tough comparison base. 

Chart 78 15-20% more seats are being added to China-Japan route for 2016 YTD, suggesting the increased in traffic is expected to materialise.

- source Bank of America Merrill Lynch

So, from an "allocation" perspective, if you want to play the "luxury" and "tourism" theme, then "overweight" the "golden carriage" in Japan, as Hong-Kong is more likely to turn into a "pumpkin"....but we ramble again.

Also with continuous pressure on China's FX reserves  which have fallen by $87.2 billion to $3.44 trillion at the end of November, from $3.53 trillion a month earlier, and in conjunction with China 's bad exports/imports data (-6%/-8%) this will further accentuate the pressure on the HKD in the coming year. The latest CNY/Yuan picture, graph source Bloomberg:

- source Bloomberg.

On that matter we read with interest Société Générale's take on the subject:

"China's FX reserve data, released yesterday morning European time, had an impact on Asian markets today. The USD 87.2bn fall was a good bit bigger than expected, even if about half off the fall is due to FX valuations. Throw is some more weak trade data this morning (surplus USD 54.1bn as exports fall 6.8% y/y, imports fall 8.7%) and the stage is set for more CNH weakness. As USD/CNY edges higher again, to 6.42, the currency's stealth-like depreciation since the start of November is looking less stealthy. Once USD/CNY breaks 6.45 or USD/CNH breaks 6.50, this is likely to be a major source of concern to markets globally, let alone in Asia." - source Société Générale

If Asia is one the receiving end of further "Chinese" devaluation, then, for us, Hong-Kong is indeed in a "very weak position" to maintain both its peg and its competitivity. Something is going to give we think.

Furthermore, as we mused in our November 2014 conversation "Chekhov's gun":

"Interesting thing happens during currency wars, currency pegs like cartels do not last eternally." - source Macronomics - November 2014.

 We would also like to point out that, in similar fashion AAA ratings are a "dying breed" and "golden carriages" often return to "pumpkin" state, currency pegs are not eternal as we reminder ourselves in our long September 2015 conversation "Availability heuristic - Part 2":

"There is indeed a clear trend in "de-pegging" currencies in the Emerging Market world, but in Developed Markets (DM) as well, the CHF event of this year has shown that pegging a currency in the current monetary system is bound to fail at some point. The sovereign crisis in Europe has also shown the inadequacy of the Euro for various European countries with different economic and fiscal policies as well as different composition (hence our negative stance on the whole European project...).

When it comes to our recent "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop" - Macronomics

 - source of the table - Société Générale

More closely to "home", in Europe that is, of course we continue to believe that Denmark will as well eventually be forced to "ditch" its peg to the Euro. On that take we read with interest Bloomberg's article from the 7th of  December entitled "Currency Battle-Front Reset as Danes Seek Euro Peg Normalization":

"While Denmark won its battle against currency speculators earlier this year, there’s still far to go before the central bank can consider a “normalization” of its monetary policy.
Governor Lars Rohde says Denmark’s benchmark interest rate will over time be closer to the European Central Bank’s. The Danish deposit rate is now minus 0.75 percent, and the ECB’s is minus 0.3 percent. Denmark pegs its krone to the euro in a tight band, forcing the central bank to track ECB policy closely.
“One might ask if minus 0.75 percent as a marginal rate is normal, and the answer is that it’s probably not and neither is minus 0.3 percent at the ECB,” Rohde said on Monday in an interview in Copenhagen.
How soon Denmark acts to reduce that spread “will largely depend” on the actions of the ECB. President Mario Draghi’s decision last week to deliver a smaller-than-expected stimulus package certainly provided relief to the Danish central bank. “It turned out to be very easy not to do anything,” Rohde said.
The ECB on Dec. 3 cut its deposit rate less than some traders and investors expected. It also extended, but didn’t raise, its bond-purchase program. The news sent the euro more than 3 percent higher against the dollar and took pressure off a number of central banks across Europe that had previously struggled to prevent their currencies from strengthening against the euro.
“The projected krone appreciation pressure is unlikely to intensify materially after the ECB left the big easing bazooka at home,” Danske Bank analysts said in a note on Tuesday. The Danish central bank “effectively delivered a small rate hike by not shadowing the ECB last week.”
Nykredit, Denmark’s biggest mortgage bank, says Denmark is now set to raise rates twice next year, following the “soft” package unveiled by Draghi last week."  - source Bloomberg

While indeed the Danish central bank has won a battle, it hasn't won the war and at some point we think, that in similar fashion to the SNB, it will lose the war but that's another story.

When it comes to Denmark, and in particular the "game of survival of the fittest" being played in this "shrinking pie mentality" world, we previously pointed out Danish A.P. Moller Maersk as a "survivor" in the container shipping industry in our August 2012 conversation "The link between consumer spending, housing, credit and shipping":

"If you want to pick winners in this survival of the fittest contest, you have A.P. Moeller-Maersk A/S investing in fast and fuel efficient vessels (Maersk vessels are designed to operate efficiently at both high and low speeds),  and so is Evergreen Group, owner of Asia's second biggest container line is as well adding more fuel efficient vessels to its fleet as well as Neptune Orient Lines Ltd" - source Macronomics - August 2012

What is getting us more and more worried for the  probability of the "golden carriage" to turn into a "pumpkin" is that even our identified "champion" has not been immuned to the very strong deflationary forces at play and is in fact moving towards "loss-making". This brings us to our second point of our conversation.

• Container shipping and large surge in US inventories, a great cause for concern

Containerized traffic is dominated by the shipment of consumer products. Weaker traffic means very simply weaker demand (and no we don't care about what European PMIs are supposedly saying).

Back in March 2012 in our conversation "Shipping is leading deflationary indicator", we argued that shipping was in fact an important credit and growth indicator, but most importantly a clear deflationary indicator. We also indicated that consolidation, defaults and restructuring were going to happen, no matter what in the shipping industry, and guess what, it did! Not to mention the fact that we indicated some forced exposed players such as Commerzbank with their nonperforming shipping loans had resorted to running themselves the ships rather than recognizing the losses as pointed out in our June 2013 conversation "Lucas critique":

"In similar fashion to the extend and pretend game being played by banks relating to their real estate exposure and negative equity, some German banks, which total exposure to shipping loans amount to 125 billion USD with a nonperforming ratio of 65%, have resorted to avoid recognizing the losses by acquiring some ships in a bid to salvage their bad loans as reported by Nicholas Brautlecht in Bloomberg on June 13 in his article "Commerzbank Acquires First Ships in Bid to Salvage Bad Loans":

"Commerzbank AG, the German lender whose soured shipping loans prompted a ratings downgrade by Standard & Poor’s last month, is taking the helm as it tries to salvage some of the 4.5 billion euros ($6 billion) it holds in bad debt from the crisis-hit industry.It plans to take over two feeder ships from debtors this month, holding off on a sale until values recover, said Stefan Otto, 42, the head of the shipping unit. The vessels, which can transport as many as 3,000 standard 20-foot containers, or TEU, are the first the Frankfurt-based bank will actively manage as part of a goal to reduce shipping losses and exit ship financing." - source Bloomberg" - Macronomics - June 2013

If indeed our favorite "survivor of the fittest" Danish giant A.P. Moller Maersk is turning into "loss-making", then indeed, we would caution investors to start in earnest to think about "battening down the hatches" to use a shipping analogy.

On the subject of shipping we read with great interest Nomura's Special Report on Container Shipping entitled "Counting Containers - Unprecedented action required" published on the 26th of November:

"Container shipping lines have a choice: return chartered vessels, or face the consequences

Supply-demand balance to deteriorate significantly in 2016-17E
Supply outstripping demand is nothing new in the container shipping industry, as evidenced by nominal capacity +53% during 2008-14, vs volumes +22%. What is new, however, is that slow steaming – which absorbed 26% of capacity during this period – is now reversing, adding new capacity on top of that provided by the orderbook. With nominal capacity expected to increase by 5-6% CAGR during 2016-17E, and volumes unlikely to exceed 3%, the supply-demand balance is set to deteriorate even without increased vessel speeds. If this trend continues, the industry will face an even more severe imbalance.

Freight rates can – and most likely will – decline further
With headline freight rate indices currently at historical lows, further reductions may appear unlikely. However, on a cost-adjusted basis, freight rates remain well above the trough levels seen in 2009 and 2011, periods during which the industry suffered heavy losses. With supply-demand set to deteriorate, and contract rates to be revised downwards, we believe freight rates can – and most likely will – decline further, driving the industry back into financial losses. 

Maersk Line case study provides some grounds for hope… 
With supply-demand fundamentals overwhelmingly bearish, container shipping investors could be forgiven for giving up hope. However, our analysis shows that, if other shipping lines follow Maersk Line's successful recent strategy – of maximising utilisation rates by returning chartered capacity to owners – the supply-demand imbalance can be rectified, with persistent losses averted.

…but only if the industry can act with unprecedented discipline
Our analysis shows that competitor shipping lines should narrow Maersk Line's cost advantage during 2016-17, but only if utilisation rates can be maintained. Returning chartered capacity to owners, culminating in a significant increase in idled capacity, provides the best means to facilitate this. Yet we estimate idled capacity would need to reach 14% for this to be achieved – materially ahead of the previous peak of 11-12% seen in 2010. Whether the container shipping industry has the discipline required to achieve this, only time will tell.

- source Nomura

When it comes to "hope" being a bad "strategy" such as expecting a "golden carriage" not to return to its initial "pumpkin" state, we reminded our thoughts from January 2013 from our conversation "The Fabian Strategy":

"People are trading on hope: "Please make Mario Draghi keep his word", we could posit in similar fashion to what we commented in our September 2011 conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!""So far the devil's best trick has been to persuade us that risk-free interest rates did exist. It ain't working anymore and that is a big cause of concern." - Macronomics.

We could not resist but we chuckled when we read the following comment from a credit desk:
"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."

Looking at the growing divergence between "hope" (equities) and reality (US High Yield), we wonder when "reality" will settle in. Could it be that in 2016 we will see the return of the "pumpkin"?

When it comes to the "reality" that can be assessed from Shipping, demand outlook is not favorable as pointed out by Nomura in their special report:

"Demand outlook remains tepid, at best

The world has changed. Let’s accept it and get on with it

The days of 3-4x GDP multipliers are gone – possibly forever
The 3-4x multiplier of GDP at which global container volumes used to grow is well known – for instance, with the volume CAGR of +12.5% seen during the period between China joining the WTO in December 2001 and the start of the global financial crisis (GFC) in 2008 equating to an average GDP multiplier of 3.8x.

Since this time, the high growth rates of 14.9% seen in 2010 and 7.4% in 2011 were driven by the end of destocking, which occurred towards the end of 2009, rather than underlying strength. When global inventory levels had returned to more normalised levels, the volume CAGR of 3.5% seen during 2012-14 equated to an average GDP multiplier of 1.4x.

2015 will likely be the first ‘normal’ calendar year to see a multiplier <1 b="" x="">
We often find that investors and industry commentators alike take a global container GDP multiplier in excess of unity for granted. Yet a multiplier of 1.0x was recorded for 2013, and for 2015 we expect volume growth of c+0.8%, equal to just 0.3x of the 2.9% increase in global GDP that is forecast by the OECD.

This would be the first time, on our records, that the global container volume multiplier has fallen below unity during what we consider to be a relatively ‘normal’ calendar year of economic activity.

…but this is not unprecedented on a rolling 12-month basis
On a rolling 12-month basis, the global GDP multiplier has already fallen below unity during what we classify as a ‘normal’ period without any major macroeconomic fluctuations or inventory swings – specifically, the 12-month period to 4Q13.

Although this weakness was only temporary, we do consider it to be important, given that it demonstrates that, even during a period of steady-state economic conditions, a global container GDP multiplier of less than 1.0 x is not unprecedented.

Looking ahead, ‘GDP plus a bit’ feels about rightAlthough forecasting global container volume growth will never be a precise science, we continue to believe that a growth rate of ‘GDP plus a bit’ remains an appropriate rule of thumb. We assume a multiplier of 1.1x for 2016-17, consistent with the 1.0-1.3x range that we consider to be reasonable during steady-state economic conditions. 

In reality, fluctuations during this period are inevitable, but for reasons that are difficult or impossible to forecast (eg, inventory movements, currency swings, technological changes, among others). As such, we do not attempt to incorporate such factors into our mid-term forecasts." - source Nomura

Conclusion: secular stagnation is here to stay and one can expect "rates" to stay lower for longer and demand to be weaker as well. "Mind the gap" between effective capacity and total demand as it is widening...because "demand" is not outstripping "supply". Another illustration of the "shipping glut", is that for the first 10 months of 2015, Chinese ship builders saw orders for new vessels plunge 62% from to same period last year, for a total of 20.3 million tons, according to data from the China Association of the National Shipbuilding Industry (CANS)

Apart from "weaker demand" another concern which has been highlighted justifiably so is the current US level of inventories. This worrying trend has been as well clearly highlighted in Nomura's recent Shipping special report:

"US inventories peaked in February 2015, at a level that warrants major concern

Although our analysis suggests the destocking that has prevailed in Europe during 2015 will soon moderate, the situation in the US suggests concern for import volumes in 2016. As shown in Fig. 43, the total business inventories-to-sales ratio spiked up sharply during the several months to February 2015, and showed smaller increases during the months leading into September 2015.

This upward movement bucks the downward movement in US inventories-to-sales that has prevailed over the past 20+ years, and after controlling for this trend by considering inventory-to-sales in terms of the number of standard deviations from the trend line, the recent upward spike in inventories is even more apparent. Specifically, inventories-to-sales are more than 1.5 StDev from the trend, not far off the peak of 2.0 StDev seen in January 2009, around which time US imports fell precipitously.

Irrespective of the sector, US inventories appear ominously highFigs. 45 and 46 summarise the split of US Business inventories (measured in US dollars) between the retail, manufacturing and wholesale sectors. The current share is remarkably uniform, with manufacturing the largest sector with a share of 36%, but retail and wholesale not far behind on 32%.

- source Nomura

You can expect this level of inventories to be a drag on fourth quarter GDP when the Fed is about to "hike" in a weak demand environment. It looks like the "fairy godmother from the Fed" aka Janet Yellen is about to pull the spell which has so far being "levitating" the "golden carriage".

When it comes to continuing with the "golden carriage", one thing we are certain in 2016 is that the global "de-equitisation" process will continue to run its course and generates further instability into the financial system as per our final point.

• Final chart - Global equities: more de-equitisation to come in 2016

In June 2015 in our conversation "Eternal Return" we made the following point:

"The "de-equitisation" process is a cause for concern as it creates increasing instability in the financial system. It will as well reduce significantly the recovery value in the next credit downturn with rising defaults we think." - Macronomics, June 2015.

The above debilitating effect on corporate balance sheets was already highlighted in October 2013 in our conversation "Credit versus Equities - a farming analogy" we indicated the following:

"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, October 2013.

What is concerning is that ZIRP has accentuated the "de-equitisation process fueled by "cheap credit". This has also been again indicated by CITI in their Globaliser Chartpack from the 30th of November 2015 and is our chosen final chart:

"Global equities: more de-equitisation?De-equitisation should remain a key global investment theme for the next 12-18 months; the most represented sector in the screen is Consumer Discretionary (13 out of 50), followed by Industrials (9)‘More de-equitisation’, declares Global Strategist Robert Buckland, ‘for deequitisation should remain a key global investment theme for the next 12-18 months.The cost of equity remains high relative to the cost of debt, so it makes sense for companies to de-equitise – use cheap financing to buy back their own shares. Since 2011, global non-financial corporates have bought back over $2.2trn of their own shares (equivalent to 9% of average market cap over the period). The most represented sector in the screen is Consumer Discretionary (13 out of 50), followed by Industrials (9). Share buybacks is currently a very US-heavy theme; we also note positive momentum in Japan. Names like Ahold, Boeing, Xerox, Allstate, Adecco and Yahoo! feature’." - source CITI

In 2013 we concluded our 2013 conversation as follows:

"We can therefore make this over-simplistic yet provocative conclusion that:
Equities = Freedom
Debt = Road to serfdom"

Although the "fairy godmothers from the Fed" did put a spell on for many years, we think we are indeed coming closer to midnight and the "Cinderella" investors of the world would be well advised to "hedge accordingly" before they are left holding the "pumpkin", as it looks increasingly clear to us that 2016 will be indeed a very challenging year.

"A powerful idea communicates some of its strength to him who challenges it." - Marcel Proust, French writer

Stay tuned!