Macro and Credit - Another Brick in the Wall

"Success is having to worry about every damn thing in the world, except money." -  Johnny Cash

Looking with interest at the elections of new French president maverick Macron, in effect putting another brick in the wall of worry, hence our title analogy, we reminded ourselves of Pink Floyd's 1979 rock opera with "Another Brick in the Wall being the title of three songs set to the variations of the same basic theme:  subtitled Part 1 (working title "Reminiscing"), Part 2 (working title "Education"), and Part 3 (working title "Drugs"). Part 2 was in fact a protest song which somewhat resonates clearly with the rise of populism in general leading to Brexit and Trump's election, whereas the results so far in 2017, seems to be the reverse of what has been playing out in Financial markets in 2016 where we had a dismal first part of the year and political surprises in the second part of 2016 in conjunction with a very significant rally in all things beta in the second part of 2016. 2017 so far has seen significant records being broken for equities indices, tighter credit spreads, and record low vix, which many pundits punting towards "complacency". In our previous conversations, we have indicated that while we did remain short-term "Keynesian" when it comes to our "risk-on" feeling, hence our reduction in both our gold miners exposure and duration exposure, we believe that the second part of 2017 could play as a reverse of the second part of 2016.

In this week's conversation we would like to look at a trade which has been put forward by many pundits including Jeffrey Gundlach of DoubleLine Capital, which is the case for EM equities versus the S&P 500 from an allocation and macro point of view.

Synopsis:

• Macro and Credit - Emerging Markets vs S&P 500, the old versus the new or the new versus the old?
• Final chart - Weak loan demand tends to be associated with high volatility

• Macro and Credit - Emerging Markets vs S&P 500, the old versus the new or the new versus the old?

While many pundits have been mesmerizing at the record low level touched recently by the "fear index" VIX, we reminded ourselves a previous conversation from 2013 entitled "Long dated volatilities: a regime change". As we posited back in 2013, it seems we are clearly back in the low regime of 2004-2007, and credit spreads as of late are also a reminder of the tightness in credit we experienced firsthand in our banking days at the time. Back in our old conversation we made some interesting comments relating to Emerging Markets and volatility which, we think, from a macro perspective are still extremely valid:

"Financial liberalization, for instance in Emerging Markets, has been a good way to attract foreign investments. It has often led to a rise in volatility given investors had been reaping in the process higher daily return rates. When equity market becomes more open, there are increases in stock return volatility (on the subject see the study realised by Vuong Thanh Long, Department of Economic Development and Policies at the Vietnam Development Forum - Tokyo Presentation - August 2007).

Regime switches also lead to potentially large consequences for investors' optimal portfolio choice hence the importance of the subject." - source Macronomics, January 2013.

We also mentioned at the time that different regimes corresponds to period of high and low volatility, and long and bull market periods in conjunction with the credit cycle. At the time of our previous post we also indicated that the importance of regime change was paramount to asset allocation given:

"The relation between the investor horizon of a buy-and-hold strategy and the optimal portfolio varies considerably from one regime to the other.

• For example, in a bear regime, stocks are less favored and short-term investors allocate a smaller part of their portfolio to stocks. 
• On the contrary, in the longer run, there is a high probability to switch to a better regime and long-term investors dedicate a larger part of their portfolio to stocks. 
• In a bear regime the share allocated to stocks increases with the investor’s horizon." 

- source The Princeton Club of New-York, 27th of April 2012, EDHEC-PRINCETON Institutional Money Management Conference.

Also we mentioned at the time that retail investors had been net sellers of stocks since 2007. Yet, in recent years, it seems many have returned using ETFs as an investment vehicle of choice, shunning active management to passive management in the process.

Returning to the very subject of our conversation, there is indeed a case being made which so far year-to-date has been validated performance wise to go long EM equities versus the S&P 500. As a reminder, since the inception of the MSCI EM index back in 1988, the MSCI EM / S&P 500 ratio has experienced two significant boom/bust cycles:

Arguably there has been a significant growing gap between both indices since 2014, while the S&P 500 has been no doubt racing ahead:

- source MacroCharts.pro

With the benefit of hindsight, we can summarize those two cycles in the following way:

Cycle 1 (1988-1999)

• Boom phase (EM outperforming between 1988 and 1996): With the disappearance of the Eastern Bloc, Second and Third World countries were bound to join the First World, and mankind would reach Fukuyama’s “End of history” (1992). Trade barriers fell, stable governments became the norm, and EMs became an investible asset class. The first EM boom culminated with the 1997 Asian crisis.
• Bust phase (S&P outperforming between 1996 and 1999): As EMs were still suffering from the aftermath of the crisis, US equities were led by the first tech bubble.

Cycle 2 (1999-Now)

• Boom phase (EM outperforming between 1999 and 2011): Following the tech crash 2000, investors turned away from the new economy. The term itself became used derisively, as the tangible economy came back with a vengeance, introducing new investment themes: the commodities super cycle, stagflation, the Hubbert peak, etc.
• Bust phase (S&P outperforming since 2011): In the early 2010s, the new economy finally started to become a reality, capitalizing on the huge infrastructure investments that were made during the first tech bubble. At the same time, new technologies (fracking, clean tech, electric cars…) made the developed world less dependent on energy and raw materials.

To sum up, EMs vs. S&P is not a merely a bet on global growth but put it simply a sectorial bet:

• MSCI EMs returns are dominated by old economy industries, commodity- and more generally stuff-producing companies. EM equities are a bet on scarcity and inflation.
• S&P 500 returns are dominated by the new economy: tech, platform companies, business services etc. The S&P is a bet on innovation, deflation and creative destruction.

One might argue that EMs are not pure old economy with the significant weight of Samsung and Tencent for example. But, one might also opine that Korea and Taiwan are not really truly Emerging Markets anymore. Though our simplified interpretation doesn't match the truly "old economy", you get our point when it comes to the sectorial bias.

After its nearly 60% correction since its 2011 heights, there are currently several factors at play indicating that we could be at the beginning of a third cycle in the MSCI EM / S&P ratio.

The CRB Industrial Metals Equity Index (CRBIX Index) has had a significant rally since January 2016:

Following the same trend until recently, there were some indications that there was somewhat a revival in the Chinese materials sector:

- source MacroCharts.pro

(Correlation 0.909, R2 = 0.826, 228 months in sample).

But given our premises that EM being a sectorial bet, still dominated by old economy industries, commodity and more generally stuff-producing companies, EM does indeed appear to be a bet on scarcity and inflation. With Chinese PPI slowing down, one might rightly ask, what's the overall picture if we take into account Chinese Iron Ore spot prices?

- source MacroCharts.pro

(Correlation 0.907, R2 = 0.823, 72 months in sample).

Clearly Iron Ore spot prices are very volatile particularly given the recent clamp down on the famous Wealth Management Products (WMP) by the Chinese government but also reflects a tightening in Chinese financial conditions as well.

After all, weaker commodity prices was reflected in the latest data out of China given the  producer price index (PPI) slowed more than expected in April, falling to a year-on-year pace of 6.4% from 7.6% in March.

Regarding commodities themselves, Dr. Copper, (the PhD in economics) is something we would like to look at to get some cues on this sectorial premise of ours:

- source MacroCharts.pro

(Correlation 0.896, R2 = 0.802, 228 months in sample).

Australia’s terms of trade is also an interesting indicator of MSCI EM/ S&P ratio, due to Australia’s heavy reliance on commodities:

- source MacroCharts.pro

(Correlation 0.932, R2 = 0.869, 228 months in sample).

After all, we are seeing tighter liquidity from China in its moves to rein in leverage which could potentially weigh on economic growth as it is attempting a "controlled demolition" of the shadow banking bubble which was let loose.

Regarding inflation, the recent increase in inflation expectations hasn’t yet been factored in by the MSCI EM vs. S&P ratio:

- source MacroCharts.pro

(Correlation 0.859, R2 = 0.737, 132 months in sample).

Additionally, Chinese devaluation fears, which roiled world markets during the summer of 2015, have substantially receded since the beginning of the year:

- source MacroCharts.pro

(Correlation -0.869, R2 = 0.741, 36 months in sample).

Yet the pullback in TIPS inflation "breakeven" rates with US 5 year breakeven rates trending lower have shown that the "Trumpflation" trade has been cooling as of late. Though the recent weakness in precious metals with silver getting spanked daily can be attributed to a gradual rise in real rates we think, another manifestation of Gibson's paradox as a reminder:

"Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get a bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - source Macronomics

On a side note, there has never been an episode in history when Gibson's paradox failed to operate. The 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 our side note, gold and gold miners are not the best hedge at the moment given the negative correlation with real rates. This is clearly illustrated in the below chart from Deutsche Bank European Equity Outlook note from the 11th of May:

- source Deutsche Bank

So far in 2017, the outperformance continues to play out in favor of EM as per the chart below displaying the S&P 500 performance relative to iShares MSCI EM:

- source Bloomberg

Flow wise commodities funds according to the latest Follow the Flow note from Bank of America Merrill Lynch have seen their eighth week of inflows, however showing signs of slowing down with gold and oil prices moving lower recently. We think most of the ongoing correction in the commodity complex is tied up to the "controlled demolition" of WMP led by China. Emerging market equities have historical strong correlation to commodities, yet, investors have continued pushing emerging market equites higher.

Given the pressure on Chinese A shares, should you want to play this trade via ETFs we would agree with Bloomberg's take from the video embedded in their article  "Gundlach Says Short the S&P 500 and Buy Emerging Market ETF" from the 9th of May, that you would be better off using IEMG ETF (South Korea and no China A shares) rather than EEM ETF given the ongoing tightening pressure in China. Yet, with KOSPI rallying as well 13.6% and breaking through the 2300 at an all-time high, the rally has been significant but mostly led by Samsung. We continue to believe that overall markets are trading on expectations of structural reforms in many instances (US, France, South Korea, etc.).

In relation to Emerging Markets, if in Macro, demography is destiny, we continue to like the asset class given as shown in the recent Bloomberg graph workforces are still expanding in India, Southeast Asia, Vietnam as well has a very young population and Southeast Asia overall is offering very compelling growth prospects:

- source Bloomberg (H/T Tiho Brkan

On top of that, China's Silk Road initiative with their willingness in expanding towards the West is clearly going to spur in its surroundings economic growth and renewed demand for commodities while China is transitioning its internal imbalances towards consumption rather than domestic fixed asset investments. The long term macroeconomic impact of such endeavor should not be underestimated.

While we still believe in some continuation of "risk-on", yet we could potentially get a pullback, we are closely watching oil, being at the moment the major brick within our wall of worry when it comes to potential credit spreads widening and spillover. We continue to follow closely the credit cycle and the global credit impulse which has shown recently by China and as well from the latest US Fed Senior Loan Officer survey, continues to point towards a slowdown thanks to weaker demand as per our final chart below.

• Final chart - Weak loan demand tends to be associated with high volatility

While markets have successfully climbed the wall of worry with the French elections angst, we continue to track the slowly but surely eroding credit cycle and credit impulse. The significant performance of risky asset classes and beta in particular since the second part of 2016 in the on-going low volatility regime thanks to central banks meddling, makes us feel a tad more nervous about the continuation of the rally in the second part of the year while we are acutely aware as we wrote recently that the final inning in a credit cycle always is often associated with a final large melt-up.

When it comes to the volatility quandary, we read with interest DataGrapple's take on the subject from their blog post from the 9th of May entitled "Is volatility a thing of the past?":

"Most of the political risk is behind us in Europe. Unless his party shows very poorly during the general election next month, Mr Macron should be in a position to at least form a coalition with the center right. In the UK, there seems to be little doubt that the Conservative will secure a strong majority in Parliament in a few weeks. In Germany, whoever comes on top in the September ballot will be a member of the current ruling coalition. So the main source of uncertainty is Italy where the 5-star movement and its anti-euro stance is leading the poll, but elections should not be held this year. We know that they will take place before May 2018, but their exact date has not been set. With talks around the restructuring of the Greek debt apparently making progress, the euro area should enjoy a period respite. That is the message sent to the market by investors who are selling options, betting on a very low realized volatility up to the September expiry. The implied volatility of options with a strike 10% out of the money are trading sub 40% on all indices for the next 5 expiries." - source DataGrapple.

Have reached peaked complacency? One might wonder. Our final chart comes from Bank of America Merrill Lynch Situation Room note from the 8th of May and displays C&I Loan demand versus the VIX index which clearly shows that often weak credit demand tends to be associated with high volatility which shouldn't be that surprising given we live in a credit based world:

"Senior loan officers vs. VIX

One of the key stories we have been tracking for most of the year is the lack of loan demand in the US across the board. That was apparent in the February Senior Loan Officer Survey as well as subsequently weekly bank asset data from the Fed. Hence not surprisingly today's fresh Sr. Loan Officer Survey showed continued very negative
growth in consumer loan demand as well as deterioration into negative territory for C&I lending. It thus appears that the key post-election story continues - i.e. while optimism is high everybody is in wait-and-see mode pending details on tax reform from the new administration. The longer this lasts the greater the risk of more weakness in hard data. It appears a great contradiction to these circumstances that the VIX closed today at 9.77 - the lowest since December 1993. Weak loan demand tends to be associated with high volatility, not low (Figure 1)."

- source Bank of America Merrill Lynch

If credit conditions are tightening in both China and the US, and we continue to see a weaker tone in the commodities space, it is hard not to start worrying about weaker aggregate demand overall and not only in oil prices. Yet another brick to keep an eye on in your personal wall of worry we think but we ramble again...

"Worry is interest paid on trouble before it comes due." - William Ralph Inge, English clergyman.

Stay tuned!

Time for a pullback? Get some greenbacks!

"If a window of opportunity appears, don't pull down the shade." - Tom Peters

As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets.

In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:

Looking at the recent weaknesses in commodities such as oil and copper, one could decently argue that the time might have come to take a few chips off the gambling table.

This feeling of "uneasiness" seems to be shared by Bank of America Merrill Lynch which indicated on the 21st of February the following important points:

"This week’s Thundering Word from our investment strategists reiterates their view that a pullback is likely across risk assets but that this would be very healthy for the longer-term reflation story. 

On this basis they advocate buying volatility near term. We highlight 3 key reasons for a near term pullback in risk assets: 

-Market complacency: our Global Financial Stress Index (GFSI) is at a multi-year low, while the new BofAML Bull &Bear index which measures market sentiment is at a multi-year high (chart 1).

 -Easing has eased: Monetary policy minutes of both the Fed and the Bank of England indicated this week that the era of QE is slowly coming to an end. 

-Defensive price action: The two best performing US equity sectors year-to-date are Staples and Health Care. Credit markets have stalled. We remain bullish on the reflation story in Japan but note that domestic small caps, a key barometer of local belief in domestic demand, just dropped 20%. 

A longer term trade is to buy the USD which is no longer correlated with volatility and has benefitted from the recent increase in risk appetite. Our house view is that the USD may be embarking on a strong secular uptrend; the only risk being any unexpected derailment of the US house price recovery.

A key element of the USD strengthening story is global rebalancing with Asia no longer deemed the world’s producer and the US the world’s consumer. As a result assets tied to the China production story are slowly derating - note the underperformance of materials stocks versus the global equity market in the past 12 months. However, some currencies also tied to the story such as the Australian dollar and the Canadian dollar are taking longer to derate and hence constitute good shorts against our long USD stance."

As per our previous May 2012 conclusion, whereas opposite attracts during "Risk-Off" periods, the greenback could still prove to be a powerful magnet should we experience a bout of pullback in risky assets.

"If you are not willing to risk the unusual, you will have to settle for the ordinary." - Jim Rohn, American businessman

Stay tuned!

Risk-Off Correlations - When Opposites attract

"Commodities tend to zig when the equity markets zag."
Jim Rogers

Looking at the recent sell-off in broad asset classes with the spill-off from the ongoing European crisis, we thought it would be interesting to look into asset correlation movements during "Risk-Off" periods such as today. We already touched in 2011 on asset correlation during the sell-off experienced in our conversation "Misery loves company".

More recently in our conversation "St Elmo's fire", we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:

We argued at the time:
"We do expect the SPX index to fall further in conjunction with Oil prices. We saw that "Misery loves company" back in 2011. In similar fashion, many various asset classes are experiencing significant correlation on the downside, following a similar pattern."
Indeed, both SPX and Oil prices are lower, with Oil dropping another 1.67% toady to 86.35 dollars.

We also indicated that Oil prices were poised to fall further because drilling-rig use and stockpiles are at their highest levels in decades, according to Michael Shaoul, Oscar Gruss and Son Inc.’s chief executive officer as reported by Bloomberg:

"The CHART OF THE DAY compares weekly data on the number of oil rigs, as compiled by Baker Hughes Inc., with the Department of Energy’s weekly figures on crude inventories. Last week’s rig count of 1,382 was the highest in 30 years, Shaoul wrote yesterday in an e-mailed note. The number increased 45 percent from a year ago. Oil stockpiles totaled 382.5 million barrels, the most since mid-1990.
“Even though demand has remained steady, it has been overwhelmed by supply,” the New York-based analyst wrote. “The clear risk is that this will be resolved by sharply lower prices in the coming months.” Oil has tumbled 14 percent on the New York Mercantile Exchange this month. The loss exceeds an 11 percent decline in Brent crude, another benchmark, and would amount to the biggest monthly loss in two years." - source Bloomberg.

Commodities, like in 2011, have experienced some significant retracement in conjunction with equities with Cash silver losing as much as 1.3 percent to $27.9275 an ounce and to around $28.30 last week. The metal was 1.5 percent lower last week for a fifth weekly drop, the longest losing streak since July 2011. Raw materials slid to a five-month low as well and more than $4.3 trillion was erased from the value of global equities this month on concern that Greece will exit the euro as the region’s debt crisis deepens according to Bloomberg. Even Gold Bullion wasn't spared and declined 1.9 percent last week as the dollar advanced 1.1 percent against a six-currency basket including the euro, which is poised for its biggest weekly drop in five months versus the U.S. currency according to Bloomberg.

Moving back to Oil and SPX, it seems other pundits as well are following the same disconnect between Oil and SPX as indicated by the below graph from Daiwa produced on Bloomberg, wondering:

** 3yr OIL V SPX: SPX to reset? ** Or Oil to bounce?

Truth is, in similar fashion to 2011, positive correlation between growth assets is most notable when investors are most concerned about risk according to AMP Capital's Oliver - source Bloomberg:

By Sungwoo Park and Saeromi Shin -May 31 (Bloomberg):
"The relationship between commodities and equities is the strongest in more than a year and near a 16-year record, as risks posed by Europe’s debt crisis and a global slowdown make the asset categories “more closely intertwined.”
The CHART OF THE DAY shows the 200-day correlation coefficient between the Standard and Poor’s GSCI Spot Index of 24 raw materials and the MSCI All-Country World Index of shares rose to 0.73 on May 25, the highest since January 2011 and near the strongest since at least 1994, data compiled by Bloomberg show. A correlation of 1 indicates the gauges move in lockstep, a value of zero shows there is no relationship.
When investors are most concerned about risk, “positive correlation between growth assets is most notable,” said Shane Oliver, head of investment strategy at AMP Capital Investors Ltd., which has almost $124 billion under management. “Everyone is looking at the same threats to growth, and so they are all selling together.”
The S and P GSCI index declined 4.2 percent this year through May 29 while the MSCI equities gauge gained 1.5 percent in the period. By contrast, the Dollar Index, a measure of the greenback against six currencies, touched a 20-month high on May 25. Investors are seeking safer assets, such as the dollar, as Europe wrestles with Greece’s debt and the possibility of that nation exiting the euro. Also of concern is the slowest economic expansion in about three years in China, the world’s biggest consumer of metals and cotton. Copper slipped to a four-month low last week, while cotton tumbled to a two-year low. Commodities and stocks have become “far more closely intertwined” as resources have taken on a greater role amid China’s economic expansion and increasing consumption in emerging-market nations, Oliver said. In 2000, after a 25-year commodity bear market, resource companies had low weightings in share gauges. “This has now reversed,” he said. When global risks are perceived as limited, “individual assets are largely driven by their own fundamentals and so the correlation between growth assets such as equities and commodities was low,” Oliver said. “In the current environment of heightened macro instability due to debt problems in Europe and the U.S., this is no longer the case. It’s either ‘risk on’ or ‘risk off’ with growth assets moving together.”

In fact, the only commodity that appears to be running scarce in "Risk-Off" periods appears to be the dollar - source Bloomberg:

According to John Detrixhe from Bloomberg on the 29th of May:

"The dollar is proving scarce, even after the Federal Reserve flooded the financial system with an extra $2.3 trillion, as the amount of the highest-quality assets available worldwide shrinks.

From last year’s low on July 27, the greenback has risen against all 16 of its major peers. Intercontinental Exchange Inc.’s Dollar Index surged 12 percent, higher now than when the Fed began creating dollars to buy bonds under its extraordinary stimulus measures at the end of 2008.

International investors and financial institutions that are required to own only the highest quality assets to meet investment guidelines or new regulations are finding fewer options beyond dollar-denominated assets. The U.S. is one of only five major economies with credit-default swaps on their debt trading at less than 100 basis points, meaning they are viewed as almost risk free. A year ago, eight Group-of-10 nations fit that category, data compiled by Bloomberg show."

From the same article:
"The greenback’s share of global foreign-exchange reserves climbed in the last three-months of 2011 to 62.1 percent, the highest since June 2010, while holdings of euros fell to the lowest since September 2006 at 25 percent, according to the latest quarterly data from the International Monetary Fund.
Foreign official holdings of U.S. government debt increased in each of the first three months of 2012, climbing by 3.24 percent to $3.73 trillion in the best start to a year since2009, according to data from the Treasury Department." - source Bloomberg.

Whereas opposite attracts during "Risk-Off" periods, it looks like the greenback is still working so far as a powerful magnet.

"Which would you rather have, capital lined up on your borders, trying to get into your country or trying to get out of your country? We are the capital magnet of this planet and we are the savior for not only people, for not only freedom, but also for capital."
Arthur Laffer

Stay tuned!

Markets update - Credit - Anterograde and Retrograde amnesia.

"Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past is unaltered.
Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible."

Another day in the trenches in the credit space, and given the acceleration in the deterioration of the market context, yet another long post starting with a quick review of the price action.
The Itraxx credit indices overview:

The Itraxx SOVx 5 year CDS Western Europe index (15 countries) broke a new record to around 362 bps.
The Itraxx Crossover 5 year CDS index (High Yield) soared to 846.5 bps, highest level since April 2009, a 59 bps increase on the day. Intraday it was almost up by 70 bps.
The Itraxx Main Europe 5 year index (Investment Grade) passed the 200 bps level.
And Itraxx Financial Senior 5 year CDS index as well as Itraxx Financial Subordinate 5 year index widened significantly as well. 318 bps at some point before receding a bit to 302 for the Senior index and 555 bps for the subordinate index, receding in the end to around 540 bps level. Truly nasty price action.

The significant moves today were on the Sovereign CDS space with Germany breaking through 100 bps to 109 bps (39 bps in July) and France breaking the 200 bps level to 205 bps.

Spain 5 year Sovereign CDS versus Italy 5 year Sovereign CDS - we know the story by now. Spain is decoupling:

Another session marked by flight to quality with the 10 German Government bond reaching a new low in terms of yield::

Source Bloomberg - morning snap.
The Bund reached a record low yield of 1.67% and even 30 years reached a record low to 2.47%.

10 year Sweden government bonds versus 10 year German bund, still a correlation of 1:

The liquidity picture, still on the weak side:

But the interesting development we have seen today has been coming from the accelerated deterioration of emerging markets, which so far up had been spared to a certain point.
The SOVX western europe 5 year CDS index versus the SOVx CEEMA (Central Europe and Middle-East and Africa) tells the story:

From divergence back to convergence for both credit indices.

The trigger has been the clear slowdown in Chinese manufacturing, meaning China will not be strong enough to counterweight the US and European slowdown we are seeing.
So, we get a sell-off in emerging equities (down by 4%, a 15 months low), a sell-off in credit, a sell-off in currencies (currencies backed by commodities taking a serious beating in the process), and a sell-off in commodities.

A sell-off in Emerging debt - JP Morgan EMBI Global Diversified:
The J.P.Morgan Emerging Markets Bond Index Global ("EMBI Global") tracks total returns for traded external debt instruments in the emerging markets:

A sell-off in equities - HAIER Electronics Group Co, one of the world's leading white goods home appliance manufacturers. We know it is relevant from the previous post - "Markets - Credit - Controlled demolition" and it follows the decision from the Chinese government to pul its subsidy program it had in place in four Chinese regions:

A sell-off in commodities - pop goes the bubble in copper artificially inflated prices, with China having pulled on the 31st of August another artificial stimulus, namely letters of credit which funded the cash-for-copper collateral game (used as financing instrument...). And copper is closely linked to economic activity as well as fluctuations in Chinese demand, so with a PMI at 49.4 that is what you get:

A sell-off in currencies:
Russian Ruble in trouble:

Indian rupee:

As a reminder from previous post:
"But it isn't only Russia trying to sustain its local currency by buying rubles, it is also happening in India with the regulators also starting to buy local currency and selling dollars and Argentina as well."

Brazilian real - BRL:

Here is the reason:
From Bloomberg - Ye Xie and Josue Leonel.
"The real’s biggest five-day plunge since 2008 is fueling speculation Brazil will sell dollars to shore up the currency, reversing a 28-month-old strategy aimed at stemming gains.
Brazil’s currency has lost 8.6 percent against the dollar since Sept. 14, the most since the global financial crisis drove it down 10.9 percent in the five days through Dec. 3, 2008, according to data compiled by Bloomberg. The slump handed investors in real-denominated bonds a loss of 13.5 percent in dollar terms this month, the worst performance in emerging markets, according to data compiled by JPMorgan Chase & Co.
Speculation is mounting that the real’s slide may deepen, pushing up import prices and adding to the highest inflation rate in six years, if the central bank fails to deploy some of its $352 billion in reserves to defend the currency. Concern policy makers’ surprise rate cut last month signals they are giving up on their goal of slowing inflation is compounding the real’s decline as Europe’s debt crisis erodes demand for emerging-market assets."

From the same Bloomberg article we learn the following:
"The central bank hasn’t bought dollars in the spot market since Sept. 13, breaking a practice it adopted since May 2009. It bought $47.6 billion in the first eight months of this year, surpassing the $41.4 billion it purchased in 2010. It last sold dollars on Feb. 3, 2009, when the real closed at 2.3052 per dollar. It closed yesterday at 1.8756."

Also from Bloomberg:
"Brazil’s central bank yesterday decided not to roll over reverse-currency swap contracts expiring in October, which will lead to the unwinding of $2 billion worth of bets against the dollar. It’s the first time policy makers refrained fromrenewing the contracts since January."

Which led to a surge in Brasil Sovereign CDS of 23 bps to 196 bps on the 5 year. At the same time, Argentina's reserves, following the same path, is seeing its dollar reserves depleted:
"Policy makers on Sept. 20 sold around $700 million in futures contracts due through October to show investors they are maintaining a policy of sustaining the peso and to discourage speculation in the currency, said a central bank official who asked not to be named because of the institution’s policy. The bank buys and sells dollars in futures markets on a regular basis, he said." - source Bloomberg - Camila Russo and Katia Porzecanski - 22nd of September.
Argentina's bonds are now yielding 972 bps more than US treasuries with the 5 year CDS trading at 983 bps according to CMA.

And contagion we have now in emerging markets.


Sovereign CDS 5 year wideners on the 22nd of September - source CMA:

In relation to the credit funding issues story in the European space with have been discussing in various credit related posts, the consequences of the deterioration in liquidity are reaching alarming levels. While we know from the post "Macro and Markets update - It's the liquidity stupid...and why it matters again...", that European banks are on average issued 90% of their term funding needs for 2011, with significant liquidity pools and ECB support, the impossibility for banks to issue term funding and in particularly issue unsecured funding is a big concern given funding needs for 2012.
As Bloomberg points out in an article published by John Glover and Ben Martin:
"It’s been 2 1/2 months since a bank managed to sell a conventional bond in Europe’s public markets, the longest period without a deal ever and another example of the sovereign crisis choking off funding.
UniCredit SpA was the last non state-owned bank to issue senior, unsecured benchmark notes in Europe with a 1 billion-euro ($1.4 billion) sale on July 13, according to data compiled by Bloomberg. That compares with deals worth 41.9 billion euros in the third quarter of last year."

And Bloomberg to add:
"The extra yield investors demand to hold banks’ senior bonds instead of benchmark government debt has soared to 320 basis points, from 202 at the end of July, according to Barclays Capital’s Euro Aggregate Banking Senior Index. The gauge reached an all-time high 325 basis points on Dec. 30, 2008."

From "Markets update - Credit - Crossing An Event Horizon", we know that banks have only managed to issue recently covered bonds, backed by pools of prime loans:
"Lenders, by using prime assets are willing to do whatever is necessary to get funding, as other sources, such as unsecured issuance have dried up, clearly reflected by the very high level reached by the Itraxx Financial Subordinate 5 year index."

Covered bonds - Bloomberg:
"Pioneered in 18th century Prussia, covered bonds give holders first call on a pool of assets that’s managed by the borrower, with the debt given preferential treatment in a default to senior, unsecured notes.
Covered bond issuance rose to 287 billion euros this year, up from 268 billion euros in the same period of 2010, Bloomberg data show."

And we know:
"The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates."

Given ongoing market concerns on potential losses on sovereign bonds, banks prefer to deposit their cash at the ECB (135 billion euros in the last 10 days). So access to term funding for banks in Europe being very weak is a clear and present danger.

And on a final note, last chart of the day, following the downgrade of US banks by Moody's, this is the picture between Bank of America 5 year CDS and Citi 5 year CDS:

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867

Stay tuned!