Guest Post - Equity volatility - Going Higher

"When dealing with people, remember you are not dealing with creatures of logic, but creatures of emotion." - Dale Carnegie, American writer

Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the numerous factors pointing towards a volatility regime shift.

Equity investors are about to face a volatility regime shift. The low volatility regime US equities have enjoyed since 2010 is over. This document will try to demonstrate why.

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

Equity volatility can be explained (with a lead) using 3 different sets of inputs:

Corporate balance sheet leverage, credit availability, and earnings revisions.

Our VIX model’s fair value has recently spiked to above 26, more than 10 points above spot, and 7 points above forwards. This is meaningful. As we will explain below, we strongly believe that equity volatility, which we view as an asset class, is a now a buy.

Corporate balance sheet leverage

When corporate balance sheet leverage rises, default probability increases down the line. We use two sets of indicators to track it.

The first one is our own definition of the financing gap. The FED only looks at the difference between internal funds and capital spending. We prefer adding to that equation the net amount of equity issuance (positive when issuance > shares buyback and negative when it is the opposite). The logic is straightforward. Shares buybacks drain liquidity away from balance sheets while share issuance replenishes coffers. When, like in 2007 or today, debt issuance is used to buy back shares, the impact on leverage is very substantial. In our model, it is captured by our second input tracking balance sheet strain: private sector credit growth. In the financial account of the United States, we look at non‐financial corporate business total credit instrument liability year on year growth rate.

The two mentioned indicators give us information on the financing needs of the private sector (rising leverage = rising financing needs) and debt accumulation. 

Today, shares buybacks equal 25% of cash flows.

The financing gap as we measure it has risen back to around 4% of GDP.

Private sector credit growth is rising fast, bank loan growth is running at almost 15% yoy, while total credit market instrument is rising at close to 10% above the last 3 years’ trend. In 2000 and 2007, it had reached 14% and 13% respectively. Since it works with a lag, the rapid debt accumulation over the last 6 years should only now start to impact balance sheet health.

Credit availability

Credit availability is another important input since, as long as credit is cheap and available, companies can roll over debt, minimizing default risk in the short term.

Bank lending behavior used to be the main indicator that we used, simply because banks were until recently the main suppliers of liquidity to the private sector through loans (this is still the case in Europe but not anywhere else). To track this supply side of the credit channel, we use the senior loan officer survey.

Bank lending behavior remains ample. The % of banks tightening lending standards is negative (banks on average are still easing terms). Nevertheless, there is no better indicator than the financing gap to anticipate bank lending attitude. The recent sharp releveraging implies that loan officers will soon react to this balance sheet health deterioration.

As they should, since rising financing needs cripple corporate profits down the line….

Our bank lending behavior model sees lending standards in the US being tightened this year:

However, as the BIS recently highlighted, the ratio of loans to corporate bonds has collapsed over the last 20 years in the US. This is why, now that investors have become the main providers of capital to the private sector, it is essential to look at risk appetite/sentiment set of indicators to evaluate that part of the supply dynamic.

On the investors’ sentiment front, the picture is we think quite worrying. The best measure of investors’ risk appetite is high yield corporate credit spreads. They have been widening since last summer in part due to the oil crash, but not only.

If we look at FX volatility, which is another good proxy for risk appetite, it is the same story. FX volatility is, in our opinion, a major input. When it rises, hedging overseas profits becomes more expensive, and overall visibility for global CEOs gets much more blurred.

We have used EURCHF as a risk appetite proxy for a very long time. Back in Q3 2010, we warned that Europe was in a meltdown as evidenced by the massive capital inflows into Switzerland. The EURCHF was crashing and its implied volatility soaring. Six months later, equities were plummeting and risk appetite completely gone.

This is exactly what is happening today. Just like back then, most investors we speak to tell us that European QE, which is responsible for the EURCHF turmoil, is a good thing for risk appetite. We agree, but we would add that the CHF strength, just like a host of historical indicators of risk aversion, tell us that at the global level, there has been no appetite for risk since last summer.

The MSCI World is flat since July, corporate credit spreads are widening everywhere, commodities and FX volatility have soared since then, and financial conditions have tightened globally as a result.

Retail investors’ sentiment is also important since they hold a lot of corporate debt through mutual funds or ETFs. Their sentiment remains bullish but it is probably the most volatile of all, and one that should be looked at more from a contrarian point of view, especially at extremes like is the case today.

Earnings revisions

Cash flows are the last variable bloc of our model. To repay debt, a company needs stable to rising cash flows. Earnings thus need to be watched closely. We look at earnings revisions (the one month change on 12mth forecasts) as the best leading indicator for expected cash flow momentum. Negative earnings revisions imply weakening cash flows and inversely.

It is astonishing to realize that today, earnings revisions are the most negative since 2008, and almost equal to the peak level of the 2002 bear market, while US equities have just printed a new historical high. Earnings forecasts are being revised lower at an alarming pace, mostly because of the dollar’s strength but also because capital goods spending are being cut aggressively. In the meantime US equities are being lifted on the back of European and Japanese QE. This tells us that we could be in the very final stages of the equity bull market that started 6 years ago. Complete disconnect between fundamentals (earnings) and prices are a classic signs of a top formation.

The current environment reminds us of 2011 but totally reversed. Back then, US earnings revision were strong, balance sheet were still healthy, and credit availability was large. As a consequence, the VIX fair value was substantially lower than spot level. Fears about the Eurozone sovereign crisis pushed US equity volatility to levels completely unjustified by US fundamentals. In time, the VIX converged towards its fair value. Today, US fundamentals have deteriorated but equities are at historical highs and volatility in the mid 10s. We think that unless earnings estimates are not revised upwards very quickly, a burst of downside volatility will materialize. Between 2009 and 2012, selling equity implied volatility was part of our investment strategy. For the first time in more than 6 years we are now looking to buy it.

While timing a market top can be costly and energy consuming, we are convinced that equity volatility will soon rise very sharply. Equity prices could rotate in a range for a while longer before moving down, but volatility will rise in the process.

Furthermore, the US dollar strength is tightening financial conditions globally. Because cheap dollar funding has infiltrated the corporate world from Moscow to Beijing and Sao Paolo, defaults will inevitably rise together with equity volatility. Implied volatility bottomed exactly when the US dollar started rallying in July 2014. This is because in a world where the stock of dollar credit to non‐banks outside the United States has reached $9.2Trn, to which we should also add sovereign debt in USD, a sharp appreciation of the US currency equals a sharp tightening of financial conditions for non US borrowers. And we know that tighter financial conditions imply increased risks of defaults and hence higher volatility.

All the factors mentioned above (balance sheet leverage, private sector credit growth, credit availability) are even more stretched for Emerging Market equities.

The EM Earnings Revision Ratio is weak.

Private sector credit growth has been buoyant since 2009, dollar denominated debt has spiked, rising at close to 15% every year since 2009. EM corporates balance sheet leverage has significantly risen as a consequence.

The credit channel, as evidenced by the IIF EM lending survey, is tightening domestically. The EM currencies crash vs. the dollar are tightening financial conditions even more. NPLs are on the rise. Rating downgrades are accelerating sharply. In Q4 2014 there were 111 more downgrades than upgrades, up from 26 in Q3. In 2015, there has already been 56 net downgrades.

As downgrades outnumber upgrades, the weakest borrowers are shut from capital access, which exacerbates further the default cycle, which leads to more net downgrades and so on: a classic negative feedback loop.

The situation in China is probably worse than anywhere else. If we had proper data on corporate financing needs, balance sheet leverage and credit availability, the fair value on HSCEI implied vol would be we believe quite elevated. It is also interesting to highlight that all previous housing  downturns triggered a spike on volatility. Housing prices are now down 5.5% yoy, and with 69 out of 70 cities registering negative yoy prices, the momentum on the downside is alive.

Emerging market implied volatilities are interestingly cheap today.

If we look at EEM, the 12mth implied volatility it is at the 8 percentile so is the 12mth implied ratio with SPX (7 percentile)


EEM, KOSPI and HSCEI implied volatilities are cheap on both an absolute and relative basis.

"Logic is the technique by which we add conviction to truth.' - Jean de la Bruyere

 Stay tuned!

Guest Post - US Equity / Credit Divergence: A Warning

"One thorn of experience is worth a whole wilderness of warning." - James Russell Lowell, American poet.

Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the growing divergence in the US between credit and equities:

Major equity / Credit divergences should always be taken very seriously.

They were among the best forward looking indicators at almost every major turning point for equities over the last 20 years.

To recap:

In 1998, equities were rallying hard, but US HY spreads failed to print new lows. Instead, they started widening in late 1997. Credit was telling us back then that Asia and Russia were severely slowing down while corporate balance sheet health was deteriorating. It preceded the 1998 crash.

In 1999/2000, the divergence was even more pronounced. The S&P500 not only recovered from the Asian crisis but rallied strongly during the Tech bubble. US HY spreads had bottomed 3 years earlier! Corporate balance sheet were at the time very stretched. As a result, banks were tightening lending standards. The equity market eventually crashed, tracking the signal sent by widening credit spreads.

During 2007/2008, credit spreads bottomed in May 2007 and started widening immediately after, while equities kept moving higher for another 5 months (October 2007). Spreads were telling us just like in 2000 that private sector leverage had reach such an elevated level that banks were starting to close the credit flows. Again, the divergence timed the bear market that followed.

In 2008/2009, spreads topped out in December while equities made new lows that were not confirmed by a new high on HY spreads. At that time, corporate balance sheet had started to adjust violently to the crisis. Capex had been cut to zero, the corporate sector was issuing equity (net positive liquidity impact) and cash flows had already bottomed and were starting to rise. Balance sheet health was improving, as evidenced by tightening credit spreads. The bullish divergence timed the end of the bear market.

In 2011, spreads bottomed in February while equities made a new high in April, as spreads widened further due to the European sovereign crisis. Equities reversed shortly after.

Today, the divergence is visible again. US High Yield spreads bottomed in June and have widened substantially since then. Equities are still printing new highs. Are US HY spreads telling us that global growth is weaker than expected, a message also sent by flattening yield curves, depressed bond yields, defensive massive outperformance relative to cyclicals. Is it Europe? Russia? Emerging Markets?

The fact that all this is happening while bullish sentiment in the US is at record highs is of particular worry. Everyone is expecting higher equities due to lower yields and depressed food and energy prices. But when everyone is thinking alike, no one is really thinking….

The expanding wedge pattern, has a target for US equities below the October low.

Investors should at least start hedging risk. The most aggressive can simply trade the downside. Volatility has crashed, especially on the very short expiries, as no one is expecting any hiccups before early 2015. This makes short dated puts quite attractive.

"History is a vast early warning system." - Norman Cousins, American author

Stay tuned!

Japan and Nikkei volatility - Time for some Abe fireworks?

"I guess we all like to be recognized not for one piece of fireworks, but for the ledger of our daily work." - Neil Armstrong

Interesting comments today from a trading desk relating to the technical situation for Nikkei volatility:

"Long-dated Nikkei volatilities getting destroyed – time to BUY? Not a consensus trade yet but worth a look

Hearing from the street main exotic houses down $US250mm in 5mth…a blood bath.

Volatilities look cheap and you keep accumulating at a cheaper level…averaging down. Until when do you have to add? Main issue on the Buy-side is you can’t wait and need to show a steady growing P&L.

Issuance from the Uridashi is 2-3 times less than 2012, vega outstanding is only at $US20mm and we are already at the same volatility levels than in 2012 with a market at 14000…What's going to happen if we correct even more and test the 13000 level? It will be a disaster! Very tough time for pure volatility accounts

Until 6 months ago, the street was thinking that tapering would create some volatility. Now nobody believes in it. When the market goes down, FED prints a lot. When the market goes up, FED still print… but less. In fine, FED maintains the equity market high and rates low. Their politics have zero impact on the real economy but brings the market’s volatility at zero…Believe the current trend in volatilities will continue…more downside.

If there is a risk of a massive unwind of the “Japan trade” in the next 3 to 6 months, why looking at 2 year maturity options? Better to focus on September/December maturities. More gamma / more liquid. If you anticipate high realized volatility before the year-end, why trading long-dated volatilities with the risk of seeing them dropping an additional 2 vol points? Exotic desks are bleeding and if spot keeps dropping, their long vega exposure will keep growing…

Nikkei 2 year ATM (at the money) IV is now at 18.90% so down 2.5 points in one month. 4 year percentile at 4.9% so we're extremely closed to the historical lows. That trend is not only specific to equity. Vols across all the asset class are at their lows. FX (USDJPY) 1 month vol is at absolute historic lows. The market seems to be too complacent, something is "mispriced" and we think it’s the right time to accumulate volatility.

Why Nikkei and not another index or asset? Because that's the only one with catalyst... a ticking bomb or a fireworks box depending on the efficiency of Abe's government and the BOJ/GPIF action over the next few months."

Nikkei 2 year ATM IV since 2008:

-market source

The market has been driven mostly by structured products with dealers getting more and more long 2 year vega short the spot. It has been a regular trend for quite a few years, but in recent weeks, there has been some capitulation with the Nikkei falling from 15000 to 14000 in addition to the index trading in a tight range. If one thinks the Nikkei index could move either way strongly during the second part of the year, then going long volatility on December 2014 could make sense for exemple. In similar fashion volatility on the Japanese Yen has followed the same path.

Dynamic between FX and Equities as illustrated by this Bloomberg graph displaying not only the surge of the Nikkei and the USD/JPY but also the reverse Itraxx Japan CDS index:

If the economy suffers as a result of April’s tax change, the BoJ has stated its intention to respond with increased monetary stimulus.

As we have argued in our November 2012 conversation "Cold Turkey", while some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we still think that we are in an early second stage for the Multistage Japan rocket:

"A multistage (or multi-stage) rocket is a rocket that uses two or more stages, each of which contains its own engines and propellant. A tandem or serial stage is mounted on top of another stage; a parallel stage is attached alongside another stage. The result is effectively two or more rockets stacked on top of or attached next to each other. Taken together these are sometimes called a launch vehicle. Two stage rockets are quite common, but rockets with as many as five separate stages have been successfully launched. By jettisoning stages when they run out of propellant, the mass of the remaining rocket is decreased. This staging allows the thrust of the remaining stages to more easily accelerate the rocket to its final speed and height." - source Wikipedia

We still don't see Japanese going "cold turkey" on liquidity "injections" for the time being hence our "contrarian" volatility take and we still recommend you closely monitor Japan's foreign bond buying spree. 

On the Abenomics "second stage rocket" subject here is what Barclays had to say in their latest Japan update from the 14th of May entitled "Abenomics trades - Standing at a crossroads":

"Financial markets I (Abenomics trades; long Nikkei/short JPY) – One more leg towards summer? As mentioned above, market positioning in Abenomics trades appears to have become much cleaner in both Japanese equities and forex. Given the significant drawdown of positions since the beginning of the year, it is most likely that equity prices and USDJPY will respond to developments in a fairly straightforward manner in near term. In other words, we expect one more leg of Abenomics trades to be initiated on the back of series of events expected in next couple of months, including additional QQE by the BoJ (expected in July, but might be frontloaded depending on financial conditions), announcements on asset reallocation by GPIF and other public pension funds (likely in June), and another for growth initiative proposal (also likely in June) along with additional fiscal stimulus measures (in July-September). That being said, whether overseas investors are likely to take the lead in these trades and hold the positions beyond the summer remains uncertain. With less risk-taking capability and less enthusiasm (or sense of urgency) in being re-involved in Abenomics trades, their investments may remain within the range of opportunistic trades, rather than those with long-term commitments. For overseas investors to share a firmer and longer-term commitment to Japanese markets, the government and corporates will likely have to deliver something new, rather than continue to depend on QQE by the BoJ. Some measures to encourage corporate management to promote shareholders value through share buybacks and/or higher dividends, given ample cash on hand, would be one example, along

Financial markets II (JGBs) – A “widow maker” for overseas investors? Last, but not least, we have not observed any significant positioning in JGBs. Most overseas investors are still tempted to trade JGBs on the back of a “terminal” view of Abenomics (regardless of whether it is succeeding or not): rising long-term rates with steepening bias to the curve. If Abenomics is successful, higher and more sustainable inflation expectation should lead to higher yields, with the BoJ most likely to stay behind the curve by remaining patient on the timing of alternating the direction of policy. If Abenomics fails, there will be resurgence of deflation fears, at least at the initial stage, so that yields could be lower. However, this will eventually lead to less sustainability of government debt with a structural bias towards an external deficit so that long-term rates should imply higher fiscal premium. That being said, there is a limited amount of conviction in terms of whether or not to trade JGBs now based on these terminal views of Abenomics, given the dominance of the BoJ in the market as the sole provider of liquidity. At least in the near term, if there is a temporary selloff in the JGB market, it will be either liquidity-driven, as was observed in 2003 and after the introduction of QQE in 2013; policy-driven, as JGB purchasing operations by the BoJ may fail at a certain point; or flow-driven on the back of rapid portfolio rebalancing by GPIF and other public entities. With the terminal views on Abenomics mentioned above in mind, however, whether JGBs remain the widow maker they have been in the past is essential for understanding the future prospects of Abenomics." - source Barclays

Finally here what is we had to say on Japan's reflationary play in April 2013 and the impact on Europe:

"Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think." - Macronomics - 27th of April 2013 - "The Coffin Corner"

"A kamikaze is a surprise attack, according to our ancient war tactics. Surprise attacks will be successful the first time, maybe two or three times. But what fool would continue the same attacks for ten months? Emperor Hirohito must have realized it. He should have said 'Stop.'" 

- Saburo Sakai, IJN flying ace (quote used in our conversation "The Coffin Corner" 27th of April 2013).

Stay tuned!

Credit - The Runaway Horse

"One way to stop a runaway horse is to bet on him." - Jeffrey Bernard, British journalist.

Looking at the trouble brewing in Emerging Markets, fuelled by outflows from "tourist" investors, as well by political turmoil, our chosen title is of course a reference to the Chinese New Year, placed under the sign of the "Wood Horse" which according to feng shui experts could be a "combustible" year. 

But, being movie "aficionados", our chosen title is as well a reference to 1907 early movie "The Runaway Horse". In this 7 minutes short movie a laundry man parks his horse-drawn cart to make a delivery. While he is inside, his horse sees a bag of oats and starts to eat them. By the time the man comes back outside, the horse has eaten a whole bag of oats, and has so much energy that he begins to race out of control. Of course any reference to the "unfortunate" emerging markets inflows/outflows courtesy of ZIRP/QE induced policies introduced by the FED and now leading to "reverse osmosis" in truly cinematic lingo would be truly fortuitous. 

The film "The Runaway Horse" was produced by Société Pathé Frères, a company created by four brothers in 1896 dealing with motion picture production and the distribution business. The two brothers also created Pathé records and both companies would become a dominant international force in their respective industries. Pathé became the world's largest film equipment and production company, as well as a major producer of phonograph records before the founders sold their international businesses in 1929. The company went bankrupt in 1935 under new ownership but we ramble again...

In this week's conversation we will focus on the contagion in Emerging Markets, which, in earnest has indeed increased as seen in the latest outflows coming out from the asset class in true "Runaway Horse" fashion we think. 

We did remind ourselves last week our musings from our previous conversation entitled "Misstra Know-it-all" that, when it comes to undoing the great "destabilizing" work from Ben Bernanke (aka "The Departed"), rising volatility would lead to re-calibration of risk exposure:

"Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse."

When it comes to volatility, Emerging Market VIX has indeed surged the most in two years as reported by Nikolaj Gammeltoft and Callie Bost from Bloomberg on the 27th of January 2014 in their article "Emerging-Market VIX Surges Most in Two Years on Selloff":

"Equity volatility from India to Brazil and Turkey jumped the most in two years as turmoil spread across global markets amid a selloff in developing-country currencies and growing concern over China’s economy.

The Chicago Board Options Exchange Emerging Markets ETF Volatility Index rose 40 percent to 28.26 last week, the biggest increase since September 2011, according to data compiled by

Bloomberg. Bearish bets outnumber bullish ones on the underlying exchange-traded fund by the most since July with about 60 percent more puts than calls. Developing-nation stocks extended declines from a 4 1/2-month low today, with MSCI’s Emerging-Markets Index losing 1.2 percent by 1:09 p.m. in Hong Kong.

The devaluation of Argentina’s peso, data signaling a possible contraction in China’s factory output and declines from the Turkish lira to the South African rand shook investor confidence. Emerging-market equities have tumbled since the Federal Reserve signaled in May that it could start scaling back bond purchases that boosted demand for higher-yielding assets.

“There’s concern that the downtrend may continue,” Walter “Bucky” Hellwig, who helps manage $17 billion at BB&T Wealth Management in Birmingham, Alabama, said by phone Jan. 24. “Protection is being purchased or bets are being made that it will.”

The MSCI emerging-markets gauge fell 2.3 percent to 949.90 last week, extending this year’s slump to 5.3 percent. The European equity benchmark lost 3.3 percent, while the Dow Jones Industrial Average sank 3.5 percent for the biggest weekly decline since May 2012." - source Bloomberg

In last week's conversation we also underlined what Nomura indicated at the time of our September 2013 "Misstra Know-it-all" conversation, the risk of the situation turning nasty for lack of liquidity is significant:

"Bad liquidity markets saw asset swaps widen considerably (making swap paying less of a hedge) and start to trade like credit products. This phenomenon, if it continues, could result in a lot of proxy hedging through FX, FX vol, buying CDS and, at a more serious stage, selling what investors could unwind."

According to Bloomberg, investors traded almost 600,000 puts on the iShares MSCI Emerging Markets ETF on Jan. 24, three times the average from the past 20 days, data compiled by Bloomberg show. About 150,000 calls changed hands, 45 percent more than the mean.

One space though where volatility has not been contained has been of course in the bond space, as depicted by the significant evolution of the MOVE index in 2013. But what we have seen in Emerging Markets currencies in early 2014 has indeed been in the rapid surge of the EM VYX index, following the Fed's tapering stance:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

So what you have in Emerging Markets is the above playing out: namely proxy hedging in the first place and additional "de-risking" taking place as indicated by Bank of America Merrill Lynch's note on the 30th of January 2014 entitled "First Signs of Panic", the stampede in Emerging Markets has somewhat started in earnest, validating amply our chosen title:

"Largest EM equity fund outflows since Aug’11 ($6.4bn); $15bn outflows over next 2-3 weeks triggers contrarian “buy” signal from our EM Flow Trading Rule (Chart 1).

Largest EM debt fund outflows since Jun’13 ($2.7bn); selling concentrated in LDM (local debt markets).

EM debt & equity funds see combined outflows of $9.1bn; magnitude almost rivals outflows during Taper (May’13), Debt Ceiling (Aug’11) & Lehman (Sep’08) (Chart 2).

$6.4bn outflows from EM equity funds (largest since Aug’11) (14 straight weeks of outflows = tied for longest outflow streak on record.

4-week outflows from EM equities = 1.4% of AUM; another $15bn outflows over next 2-3 weeks would trigger contrarian “buy” signal from our EM Flow Trading Rule (3.0% is threshold)

- source Bank of America Merrill Lynch.

Of course, the use of our Jeffrey Bernard as our "commencing" quote, is by no way innocent. 

While it is too early to become "contrarian", we will be patiently monitoring the EM space waiting for the herd of "runaway horses" (namely tourists) to vacate the place as no doubt, opportunities will materialise eventually. 

On that subject we agree somewhat on the subject with Skagen AS, the Norwegian fund top Emerging Markets manager, as reported by Jonas Bergman in Bloomberg on the 29th of January in his article "Emerging Market Bull Who Beat Wall Street Sees Rout Passing":

"Skagen AS, the Norwegian fund manager who has outperformed some of Wall Street’s biggest banks over the past decade, is urging clients to sit out the turmoil gripping developing nations.

Kristoffer Stensrud, whose 50 billion-krone ($8 billion) Kon-Tiki A emerging market fund has returned an annualized 14 percent over the past 10 years, said there’s “nothing new really” in the recent turbulence, in an e-mailed reply to questions. He characterized the moves as “some contagion” in Latin America from Argentina, while reactions in the east remained “calm.”

“Emerging market economies hit by currency falls will probably be more competitive going forward,” according to 60-year-old Stensrud, who started Skagen in 1993. A lack of inflationary pressure from commodities will also be “positive,” giving a longer period with “low inflation and low interest rates in developed markets than generally perceived presently,” he said." - source Bloomberg.

Skagen AS are not the only ones taking the long term "macro" views, for instance legendary Mark Mobius chairman of Templeton Emerging Markets Group is also sitting in the "contrarian" camp as indicated by Jaco Viser in Bloomberg on the 29th of January in his article "Mobius Sees Money Flowing Back Into Emerging Markets on Growth":

"Mark Mobius, chairman of Templeton Emerging Markets Group, said inflows into developing nations will resume later this year following a selloff triggered by the Federal Reserve tapering monetary stimulus.

“People are enjoying what they see as a bull market in the U.S.,” he said in an interview in Johannesburg today. “As we go forward, we’re going to see a lot of overweight positions in the U.S. So, given the fact that emerging markets are still growing fast, given that they have low debt-to-GDP ratios, given that they have high foreign-exchange reserves, we believe that money will be flowing back in again to emerging markets.”

Investors sold $1.87 trillion in stocks worldwide in the week to Jan. 27 ahead of the Fed’s two-day meeting, which ends today, where the central bank will announce reducing bond purchases by a further $10 billion next month, according to the median estimate of 78 economists surveyed by Bloomberg. The selloff spurred a rout in emerging-market currencies with central banks in Turkey, India and South Africa unexpectedly

increasing benchmark interest rates.

The effectiveness of higher interest rates “depends on the country and it depends on the degree,” Mobius, 77, said. “In India it is working OK. The jury is still out on Turkey. The picture becomes a little complicated in certain countries because of upcoming elections. Despite the rise in interest rates, you’re not going to see a big, big flow back in, but it will eventually come.”" - source Bloomberg

We might be short-term pessimists, but, overall we remain long term optimists for Emerging Markets. 

After all, as we did indicate back in March 2012, that, when it comes to "Equities, there is life (and value) after default!". Russia, Argentina, Iceland, and as of late Greece are all living proofs that there life (and value!) after a default.  It turns out that our "early call" on Greece based on our long-term macro analysis rewarded handsomely investors in 2013 as presented by Namitha Jagadeesh in Bloomberg in October 2013 in his article "Greek Recovery Makes Stocks World’s Best as Paulson Buys":

"Since June 5, 2012, two weeks before MSCI Inc. gave notice it may reclassify Greece as an emerging market, the country’s ASE Index (ASE) has surged 146 percent, trimming the decline from its 2007 peak to 79 percent. The gains topped all 94 national benchmarks globally in the period, except Venezuela, according to data compiled by Bloomberg. Yields on Greece’s 10-year government bonds have dropped to 8.31 percent from a peak of 33.7 percent in March 2012." - source Bloomberg.

When it comes to opposing credit to equities, we have also argued in 2013 in our conversation "Credit versus Equities - a farming analogy", the following:

"-Bonds = Tenant farming

-Equities = Metayage

Therefore when ones look at credit volumes, you need to not only include the total of financial claims but as well equities.

When there is a recession or even worse a depression, equities will fall towards zero, in the case of bankruptcy. It is a very painful but it is a very fast adjustment.

The increasing recourse towards bond issuing by companies will be increasing "difficulties" at the end of the on-going credit cycle, when entering a recession or depression.

What has made the resounding success of the US economy throughout many decades was its capitalistic approach and recourse to equities issuance for financing purposes rather than bonds.

We believe the global declines in listings is indicative of growing instability in the financial system and increasing risk as a whole." - Macronomics - 15th of October 2013

So before betting on the "runaway horse", you need to see a clear "restructuring" such as what happened with Greece, or Russia, before setting up a hugely profitable "contrarian" bet but currency hedged we think.

When it comes to "true" returns, of course, one need to take into account the currency effect. 

"Big in Japan", yes we had "lift-off in risky assets" or "Risk-On" that is, in Japan in 2013, as indicated in the below graph where we have been monitoring the USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:

While we recommended last year to go long Nikkei in euro terms, a similar strategy would have been successful with countries such as Argentina as displayed in Bloomberg's recent Chart of the Day displaying 105% stock gain as long as you ignore inflation and depreciation of the currency:

"Argentine stocks posted some of the best returns in the world in President Cristina Fernandez de Kirchner’s second term, as long as you ignore inflation and depreciation. In reality, they were among the worst.

The CHART OF THE DAY shows that while the Merval index doubled in peso terms since her re-election Oct. 24, 2011, the shares lost 15 percent once returns were converted to dollars at the rate investors use to avoid currency controls. While the 105 percent local-currency return was the fifth-biggest among 94 indexes globally during the period, the drop in dollar terms made the gauge the world’s 12th-worst performer.

“Argentina is a high-risk, high return market and there has been more risk than return lately,” said Eric Conrads, a money manager who helps oversees $750 million of Latin American stocks at ING Investment Management in New York. He said he sold the last of his Argentine shares last year.

Fernandez devalued the peso last week in a bid to shore up foreign reserves that sunk to a seven-year low amid a surge in government spending, inflation estimated at about 30 percent and declining prices for the country’s soy and wheat exports.

Restrictions on dollar purchases mean investors use the so-called blue-chip swap, under which local assets are sold abroad for foreign currency at a discount to the official exchange rate of 8.0177 per dollar.

The blue-chip rate of 11.5697 pesos per dollar has depreciated 58 percent since the election, more than the 47 percent drop in the official rate and the worst among 31 major dollar counterparts. “The intelligent people in Argentina invest in property,” Conrads said." - source Bloomberg

When it comes to Argentina's woes, Bank of America and Moody's suggest that only 40% interest rate can arrest Peso's fall as reported by Katia Porzecanski and Camila Russo on the 30th of January in their article "Only 40% Interest Rate can Arrest Peso's Swoon":

"Argentina’s decision to ratchet up interest rates to 24 percent is failing to convince Bank of America Corp. and Moody’s Analytics Inc. the nation can stem demand for dollars in the wake of the peso’s devaluation.

Argentina needs to offer 37.5 percent to attract enough investors to halt peso losses, according to the average of five forecasters surveyed by Bloomberg News, even after the nation’s benchmark deposit rate surged 2 percentage points this week to a five-year high. Bank of America says a rate of 40 percent is needed to effectively compensate for consumer prices rising an estimated 28 percent annually.

 While the devaluation was intended to bolster the nation’s foreign reserves that were depleted as the central bank sold dollars to support the peso’s official rate, Argentina faces the prospect of savers dumping a currency that has lost more value than any time in a decade. Higher interest rates would mirror increases by developing nations such as Turkey, which doubled its benchmark rate to shore up the lira, as the Federal Reserve fuels a rout in emerging-market currencies by paring stimulus.

“Argentina’s got to do something similar,” Daniel Kerner, an analyst at political consultancy Eurasia Group, said in a telephone interview from Washington. “I get the feeling they don’t have a clear strategy, they don’t really understand the problem and they don’t believe in incentives.” Kerner said Argentina needs to lift its deposit rate to 40 percent to boost demand in the peso, which has lost 18.5 percent this year." - source Bloomberg.

Unfortunately, this time "it's different" we think. As it seems in Argentina, not only FX reserves have been disappearing fast, but confidence in the currency as well has completely vanished, meaning Argentina is experiencing yet again another bout of hyperinflation in the process. In that context, the "runaway horse" has further to go, given that ZIRP, and QEs have led to increased connectivity and positive correlations and therefore negative feedback loops. We agree with Nomura's recent take on Argentina from the 24th of January entitled "Argentina: Bowing to the inevitable":

"Devaluation of the Argentinean peso this week, in our view, is the inevitable result of an unsustainable mix of monetary and fiscal policies. The move is probably intended to preserve falling reserves, yet greater exchange rate volatility could open up a series of political and economic uncertainties. Developments in Argentina have generated knockon effects in Brazil, and the risk of contagion across EM has now become more real." - source Nomura

When it comes to rising risks, negative feedback loops and positive correlations, its biggest trading partner Brazil is in the front line according to Nomura's note:

"The events in Argentina have generated knock-on effects across the region, especially for Brazil, which has Argentina as its third largest trading partner after China and the United States (Figure 7). 

In terms of real exchange rates, ARS has grown steadily stronger than BRL since mid-2011 (Figure 8). 

Given the expanding current account deficits in Brazil, there is a risk of BRL suffering in sync with a weaker ARS." - source Nomura

Given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, no wonder Brazil will suffer from the "competitive" sudden devaluation from its largest trading partner.

In blue the Brazilian real versus the US dollar, in red the Australian dollar versus the US dollar, as one can see the correlation between the Australian currency and the Brazilian real broke down spectacularly in 2011- source Bloomberg:

In similar fashion to Brazilian woes stemming from Argentina's devaluation, Australia is exposed clearly to China's tightening stance and commodities slowdown.

If all is well when it comes to the world growth outlook, maybe someone can tell us why Copper futures are headed for the longest slump in 15 months? In similar fashion all is not well for Iron Ore, as displayed in the below graph from Bloomberg:

Or maybe our preferred credit and deflationary indicator, namely shipping and the Baltic Dry Index, recent weakness is only a "temporary" blip in the much vaunted "recovery"? Graph source Bloomberg:

Our biggest concerns doesn't lie much in sovereign woes but much more to surging defaults risks in the corporate space, given since May 2011, Brazilian companies have sold the most junk bonds on record and accounted for 81% of Brazil's corporate debt sales versus 34% globally, another consequences of ZIRP on "mis-allocation" of capital. The recent default of OGX in Brazil on $3.6 billion of bonds is a stark reminder of default risk in the Emerging Corporate sector.

Of course it interesting to read that the Brazilian oil company OGX has been delaying a restructuring for a second week in after BlackRock and Blackstone Group pulled out of the deal as reported by Bloomberg.

It reminds us of one of our quotes:

"He who rejects restructuring is the architect of default." - Macronomics.

What is of interest to us of course is that what credit investors forget in this deflationary environment, is that, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield, not inflation. A rise in defaults would likely be the consequences of a deterioration in credit availability. Credit ratings are in fact a lagging indicator.

When it comes to European exposure to Emerging Markets, Nomura in another note entitled "Assessing the linkages between EM and the euro area" published on the 27th of January, gives us more insight:

"After reviewing the trade and financial linkages, we conclude that a protracted slowdown in these countries would shave around 0.1 percentage point (pp) from euro area GDP growth. This compares to the 0.3pp reduction observed in the China/Asia slowdown simulation that we conducted last summer.

-Unsurprisingly, Spain and its banking sector are most exposed. However, it is important to note that these subsidiaries across LatAm operate as fully independent entities, supported by capital retained at the local level and funding that is independent from the parent company. As a result, most of the risk to BBVA and Santander stem from the potential lower earnings contribution.

-Among the Spanish banks, we believe BBVA is most at risk to FX markets given its greater exposure to Argentina, Venezuela and Turkey. While this is partly reflected in our earnings estimates, it may not be reflected in the consensus.

-In our view, risks to the euro area do not stem from a country-specific bout of volatility in select emerging markets, like the one taking place in Argentina, but rather from a broad-based EM slowdown, which would have potential to threaten the region's recovery. In this sense, we view the past week as more of a warning should contagion become more entrenched and broad-based across EM." - source Nomura

In terms of banking exposure, Spain is the most exposed according to Nomura's note:

"Financial channels: The bank exposure channel – the case of Spain

European banks are known to be significantly exposed to Latin America. Figure 7 shows that European banks had EUR564bn of claims against Latin American countries and EUR136bn of claims against Turkey.

When looking at the various European countries, Spain is clearly most exposed, with around EUR160bn of claims against stressed countries or about 5% of its total banking assets. Importantly, these subsidiaries across LatAm operate independently from the parent, with capital retained at the local level and independent funding from the parent company. As a result, most of the risk to BBVA and Santander stems from the potential for a lower earnings contribution." - source Nomura

On a final note, Oil and Mining Stocks are the most exposed to Emerging Currency risk as displayed by Bloomberg's Chart of the Day from the 30th of January:

"Energy and raw-material producers may have the most at stake among U.S. stocks as emerging-market currencies fall, according to Gina Martin Adams, a Wells Fargo & Co. strategist.

The CHART OF THE DAY shows the relationship between the MSCI Emerging Markets Currency Index and the Standard & Poor’s 500 Energy Index since March 2009, when the shares began their

current bull market.

MSCI’s index dropped this week to its lowest reading since September as the Russian ruble, South African rand, Turkish lira and other currencies tumbled against the dollar. Each currency’s weight matches the country’s proportion of the MSCI emerging-market stock index.

“High correlations between emerging-market currencies and commodity prices suggest commodity-sensitive sectors in the S&P 500 are likely to suffer most” as the decline worsens, Martin Adams wrote in a Jan. 24 report.

Oil and gas stocks were the most closely linked to the foreign-exchange index among 64 industry groups in the S&P 500, according to data that the New York-based strategist cited. The correlation was 0.94 since January 1999, when MSCI started its calculations. Comparable figures for chemicals and mining were 0.87 and 0.66, respectively. The highest potential reading was 1, showing the currency and stock indexes moved in lockstep.

China’s yuan, South Korea’s won and the Taiwan dollar account for about half of the MSCI index’s value, the report said. Argentina’s peso is excluded because MSCI classifies the country as a frontier market, not an emerging market. The peso was devalued by 15 percent last week." -source Bloomberg

In relation to gold, once forced liquidation hits EM and wipe out leveraged players and "carry" tourists, gold could go lower first for these simple 3 reasons:

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

-The market does not learn for long.

-Human nature does not change."

"When you have got an elephant by the hind legs and he is trying to run away, it's best to let him run." - Abraham Lincoln

Stay tuned!

Credit - The Anna Karenina principle

“In the chaos of maladaptation, there is an order. It seems, paradoxically, that as systems become more different they actually become more correlated within limits.” -  Professor Alexander Gorban

While looking at Europe's inflation level coming at 0.7%, indicative of the seriousness of the deflationary threat in conjunction with the rise of unemployment to 12.2%, we thought we would use this week in our title, a reference to the Anna Karenina principle:

"The Anna Karenina principle describes an endeavor in which a deficiency in any one of a number of factors dooms it to failure. Consequently, a successful endeavor (subject to this principle) is one where every possible deficiency has been avoided.

The name of the principle derives from Leo Tolstoy's book Anna Karenina, which begins:

Happy families are all alike; every unhappy family is unhappy in its own way." - source Wikipedia

Indeed when one looks at the European family and the diverging data, it seems that every member of the family has been unhappy somewhat in its own way. For instance Cyprus  has seen its unemployment in one year jump from 12.7% to 17.1% while Ireland following years of misery due to the excruciating price for bailing out its financial system has been on the slow mend train and having its unemployment falling from 14.7% a year ago to 13.6% today. At the same time Italy is sinking in the deflationary trap set up by the euro with unemployment rising to 12.5%, the highest since 1977, while Germany enjoys an unemployment rate of 5.2%. Compared with a year ago, the unemployment rate increased in sixteen Member States, a clear unhappy family in its own way, but we ramble again...

While we mused at length on the "Cantillon Effects" generated by the abundant liquidity provided by our "generous gamblers" aka central bankers around the world, as far as the Anna Karenina principle goes, in this chaos of "mal-investment", there is indeed an order and of course rising "forced positive correlations" which we mused on in our previous conversation "Alive and Kicking".  We agreed at the time with Martin Hutchinson's take on the subject of positive correlations in his article "Forced Correlations" published in Asia Times:

"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play."

The rise of the S&P 500 and the rise of the Balance Sheet of the Fed in conjunction with the fall in the US Labor Force Participation Rate - graph source Bloomberg:

The rise of the S&P 500 a story of growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

So you might be already asking yourselves where we going with this Anna Karenina principle and all our gibberish surrounding correlations and forced correlations and growing disconnects.

It is very simple:

"By studying the dynamics of correlation and variance in many systems facing external, or environmental, factors, we can typically, even before obvious symptoms of crisis appear, predict when one might occur, as correlation between individuals increases, and, at the same time, variance (and volatility) goes up. ... All well-adapted systems are alike, all non-adapted systems experience maladaptation in their own way,... But in the chaos of maladaptation, there is an order. It seems, paradoxically, that as systems become more different they actually become more correlated within limits." - University of Leicester - Anna Karenina principle explains bodily stress and stock market crashes.

In the "chaos" of mal-investment there is indeed an order we think. So, in this week conversation, we will look into correlations, volatility (which has become the wrong signal thanks to central banks meddling), correlation breakdowns and rising correlations, and the risk for "disorder" with increasing disconnections.

As reported in Bloomberg by Nikolaj Gammeltoft, Nick Taborek and Audrey Pringle on October 28th in their article "Correlations Bets at Six-Year Low as Debt Turmoil Fades" complacency is clear and present:

"U.S. options traders are convinced that profits, buybacks and takeovers will exert a greater influence on stock prices in coming months, sending an index tracking expectations for lockstep moves to a six-year low.

The Chicago Board Options Exchange S&P 500 Implied Correlation Index tumbled 37 percent to 37.21 since Oct. 8, according to data compiled by Bloomberg. The gauge, which uses options to indicate how closely stocks in the Standard & Poor’s 500 Index will move together, reached 36.07 on Oct. 18, the lowest level since February 2007." - source Bloomberg.

From the same Bloomberg article:

"The CBOE Volatility Index, the gauge of S&P 500 options prices known as the VIX, has fallen 36 percent to 13.09 since Oct. 8, according to data compiled by Bloomberg. The measure soared 23 percent from the beginning of the government shutdown on Oct. 1 to Oct. 8 as politicians struggled to reach an agreement to avoid a default."

‘Big Deal’

“It’s a big deal because when correlation gets this low in conjunction with low levels of volatility,” Peter Cecchini,global head of institutional equity derivatives and macro strategy at New York-based Cantor Fitzgerald LP, said in an interview, “it may mean that market participants are complacent and markets are vulnerable to a correction.” 

This month’s drop in the CBOE’s correlation index has been greater than the retreat at the beginning of 2013 after U.S. lawmakers agreed to pass a bill averting spending cuts and tax increases known as the fiscal cliff. The measure dropped as much as 20 percent in the two months after Dec. 28, 2012." - source Bloomberg

The evolution of VIX versus its European counterpart V2X since April 2011 - source Bloomberg:

The highest point reached by VIX in 2011 was 48 whereas V2X was 51. VIX is around 14, at 13.65 and V2X at 15.54, highlighting as well the significant drop between US and Europe in relation to risk perception.

As CITI indicated back in August from our previous conversation "Alive and Kicking":

"It's not hard to figure out why the 'Great Rotation' has been such a hot topic this year. It seems so intuitive: as yields rise over the next few years in response to a gradual economic recovery, total returns in fixed income will be weighed down, if not outright negative. The asset class that has the most to benefit from growth is equities.
For example, for the past year we have continuously highlighted the asymmetry in risk/reward between equities and credit. As illustrated in Figures 2 and 3, credit and equities have correlated closely over the last few years and almost in a constant ratio. We don't see why that wouldn't work in reverse also.

However, as credit spreads get closer and closer to the lower bound it becomes increasingly difficult for them to continue performing in the historical relationship with equities. The slight gap that appears to be opening up in both charts recently seems to bear that out.
In other words, to our minds there is an obvious long-equities-short-credit relative value trade insofar as credit has all the downside potential of equities, and much less of the upside." - source CITI

We also argued at the time:

"For us, there is no "Great Rotation" there are only "Great Correlations""

An evidence from our statement can be seen in the rising positive correlation between Asian currencies and the S&P 500 which have been moving in lockstep for the first time in a year as per Bloomberg's Chart of the Day from the 30th of October:

"Asian currencies are moving in lockstep with the Standard & Poor’s 500 Index for the first time

in a year, suggesting investors are returning to riskier assets on bets the world’s biggest economies will strengthen.

The CHART OF THE DAY shows the Bloomberg-JPMorgan Asia Dollar Index rebounded to 116.84 after falling to a three-year low of 113.58 on Aug. 28, while the S&P 500 surged to a record yesterday. The lower panel shows the 60-day correlation coefficient between the two gauges rose 50 percent in the past two months to 0.56 out of a maximum of 1, approaching the highest in a year and the 0.64 average from 2009 to 2012, when markets worldwide were roiled by Europe’s debt crisis.

Investors are seeking higher-yielding assets as concern over a breakup of the euro bloc evaporates, optimism the U.S. and China are rebounding from slowing growth increases, and speculation rises the Federal Reserve won’t slow quantitative easing until the first quarter. In the past four years, Asian currencies gained 5.1 percent on average when the correlations strengthened and peaked over the 0.7 zone, according to data compiled by Bloomberg.

“The market is looking for a sweet spot -- an improving global growth and a dovish Fed pushing QE tapering further out,” Marcelo Assalin, who oversees $3 billion of local-currency emerging-market debt in Atlanta for ING Groep NV, said in a phone interview on Oct. 28. “I honestly don’t see catalysts for a breakdown in correlation in the near term.” China’s economy, the world’s second-biggest after the U.S., expanded at a faster pace for the first time in three quarters, quickening 7.8 percent in the three months through September from a year earlier. The Fed decided to press on with $85 billion in monthly bond purchases yesterday, saying it needs to see more evidence that the economy will continue to improve.

Investors should buy India’s rupee and Indonesia’s rupiah as a delayed tapering bolsters carry trades, where investors borrow in low-interest-rate currencies to buy higher-yielding assets, Assalin said. The Fed has maintained its target rate for overnight loans between banks in record-low range of zero to 0.25 percent since December 2008." - source Bloomberg

Another impact of the "tampering in the tapering stance" by the Fed has as well led to the breakdown in the correlation between bond yields and equity prices as investors keep on hoping the punchbowl will not be pull back too soon by the everlasting accommodative Fed as displayed in another Chart of the Day from Bloomberg from the 24th of October:

"Emerging-market currencies are benefiting from the breakdown in the correlation between bond yields and equity prices as investor expectations for monetary stimulus by the Federal Reserve lengthen.

The CHART OF THE DAY shows that a Bloomberg index of the 20 most-traded emerging-market currencies and the Standard & Poor’s 500 Index have, since the beginning of July, appreciated when 10-year U.S. Treasury note yields declined on an average of 14 out of the previous 50 days on a rolling basis. The figure compares to an average of five days out of a similar period from the start of 2012 through June 2013.

“What the Fed really wanted was to get interest rates low and get real activity going,” Steven Englander, the global head of Group of 10 currency strategy at Citigroup Inc. in New York, said in a phone interview. “As a side effect, what happened was this was a spur to asset markets. This is spilling over into EM currencies.”

Bloomberg’s emerging-market currency index has increased 3.7 percent since the start of September after declining 7.9 percent in 2013 through August. Meanwhile, the S&P 500 has climbed 7.2 percent since the beginning of September after increasing 2 percent over the previous two months.

Fed policy makers last month cited the need for more evidence that economic growth will be sustained for continuing to pump $85 billion a month into the economy by purchasing bonds. BlackRock Inc. and Pacific Investment Management Co. have said the central bank will postpone tapering stimulus.

A rebound in the carry trade, which lost money for four straight months through August in the longest slump since 2011, bodes well for high-yielding emerging-market currencies such as Brazil’s real and South Africa’s rand." - source Bloomberg

So while investors continue to get "carried away" in "beta" terms in this sea of liquidity plentiness, what has caught our attention is another breakdown in correlation in the credit space, namely the one between credit volatility and spreads that is. This specific matter has been highlighted by CITI on the 29th of October in their note entitled "Has Credit Vol Decoupled from Spreads?":

• "Relationship between credit volatility and spreads has broken down - Using CDX IG as an example, we find that after September 2012, the traditionally high volatility/spread correlation drops from 85% to 10%. In contrast, the correlation between CDX IG spreads and equity volatility has remained meaningful.
• Price volatility is a better risk indicator - In contrast to the spread volatility quoted in volatility markets, the equivalent price volatility exhibits better sensitivity and much stronger correlation to credit spread moves. We find that this relationship persists for recent (post September 2012) data.
• Credit spreads are currently tight relative to price volatility - A simple regression model using the past 1 year of spread/price volatility data indicates that index spreads are too low compared to both 1M and 3M price volatility levels." - source CITI

In their note CITI highlights this correlation disconnect, which is of great interest bearing in mind the Anna Karenina principle mentioned above:

"The Great Disconnect

Traditionally, investors have used volatility in risk asset classes as a measure of systemic risk. This is because, while (in theory) volatility can spike when markets make large moves, the reality is different. Given human psychology, risky asset volatility has always tended to spike during periods of market downturns because of the gappy nature of selloffs, while market rallies have tended to be relatively smooth. Therefore, volatility has always been regarded as a good hedge against sharp market down turns, and both options and volatility indices (e.g. VIX) have found a good market in hedge buyers.

What if that situation were to change? If we take a look at what is going on in the US credit volatility markets, it would certainly appear that there has been a regime change, and one that does not bode well for those that hedge with credit volatility products.

To illustrate this issue, we use the CDX IG index as an example. Using data dating back to 2011, we find that the traditionally strong positive correlation (volatility rises as spreads widen during a market selloff) between CDX IG index spreads and ATM implied volatility has taken a nosedive recently (see Figure 1).

Figure 1. Strong correlation between 1M or 3M ATM volatility and CDX IG spreads breaks down post Sep 2012 (left). Simple linear regressions between 3M ATM volatility (X-axis) and the underlying index spread (Y-axis) confirm the strong relationship pre-Sep 2012 (top right) and almost no relationship post-Sep 2012 (bottom right).

Specifically, it would appear that the market has undergone a regime change after Sep 2012, and for the past year, the correlation between index spreads and implied volatility has been extremely weak – for example, the correlation between 3M ATM volatility and IG spreads has gone from a respectable 85% pre Sep 2012 to a paltry 10% post Sep 2012, and the weak correlation persists to this day." - source CITI

CITI's conclusion that this disconnect does not bode well for those that hedge with credit volatility products is not surprising to us. It validates our January 2013 take on the subject of the impact central banks play on volatility which we wrote about in our post "Volatility Regime Change and Central Banks - a key driver":

"One thing for sure, the on-going excessive search for yields could have a long-term impact (relative immunisation risk of credit versus equities)."

CITI also makes the following interesting point in their note on the correlation breakdown between index spreads and implied volatility being extremely weak:

"Furthermore, this is true across credit indices and option maturities – both 1M and 3M ATM implied volatility for CDX IG and HY indices exhibit the same behavior recently. At the same time, we find that the correlation between equity volatility (e.g. 3M ATM SPX volatility) and credit spreads does not suffer to this extent (see Figure2). 

Figure 2. In contrast to credit volatility, equity volatility shows stronger correlation to CDX IG index spreads in the post-Sep 2012 period (left). This is confirmed by regressions between 3M ATM SPX vol (X-axis) and CDX IG spreads (Y-axis) in the pre-Sep 2012 (top right) and post-Sep 2012

(bottom right) periods.

Does this mean that the credit volatility market has lost its signaling power as a

barometer of systemic risk? Further, are equity volatility markets a better barometer for credit risk itself?" - source CITI

Why  such a decoupling? It's the Low Spread Regime stupid! According to CITI:

Why are we seeing this apparent decoupling? After all, the only significant thing that happened in Sep 2012 was the OMT announcement from ECB president Draghi which did send spreads tighter, and volatility lower, across the board. However, while this announcement served to take tail risk off the table for most investors, it is unlikely that it would cause the correlation between spreads and volatility to break down in this spectacular fashion.

We believe that the reason is different, but related. Once systemic risk was off the table after the OMT announcement, there was a sustained rally in spreads that has more or less continued unabated to the present. For most of this period, CDX IG spreads have remained at relatively low levels (see Figure 1). As spreads have gone tighter, implied (spread) volatility levels have approached a floor.

Why did this happen? Remember that implied volatility for credit spreads is represented as a percentage of the underlying spot (spread) level. For example, when the CDX IG index is trading at 120bp, an implied spread volatility of 40% means that the index is expected to move around 3bp/day1. However, if the index spread falls to 60bp, the expected move falls to 1.5bp/day.

As spreads go tighter, the expected implied move in bp/day approaches a floor which is determined by the bid/ask spread for the index. In other words, in a tight spread regime, the implied volatility for the index cannot go below a floor that puts the corresponding expected index move in bp/day below the index bid/ask spread.

As we approach this implied (spread) volatility floor, the behavior of implied volatility begins to exhibit less sensitivity to spread moves, thus giving rise to convexity. This kind of behavior is a well-known phenomenon and can readily be seen in the relationships between other asset pairs, such as credit spreads and equity prices (e.g., CDX IG versus S&P 500), where credit spreads at very tight levels become de-sensitized to equity index moves." - source CITI

With so much "Greed" and no "Fear" thanks to the postponement of "tapering" in the near future, risky assets have rallied hard, as displayed in the rally seen in High Yield and the continuous rally in the S&P 500, but increasingly the performances for credit  investment grade is being "capped" due to the growing disconnect and correlation breakdown mentioned by CITI - graph source Bloomberg:

The correlation between the US, High Yield and equities (S&P 500) is back thanks to "no tapering". US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG.

The surge in risky assets is of course entirely driven by the fall in volatility as a whole in various asset classes as displayed in the below Bloomberg graph:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

In true Anna Karenina principle, we think the rising disconnect and positive correlations are tantamount to rising instability in the system as a whole as posited by Gorban's work quoted by  the University of Leicester - Anna Karenina principle explains bodily stress and stock market crashes:

"Adaptation energy as described by Selye, represents physiological resources that can be drawn on when an organism is under biological stress. Gorban and colleagues have demonstrated that the same notion can be applied to financial systems.

This is not the end of the story. If the load increases further then the "order of maldaptation disorder" is destroyed and the systems progress to a fatal outcome in a fully disordered state. This conclusion is the complete realisation of the Anna Karenina Principle, Gorban says.

The research was published in the August 15 issue of the journal Physica A, (Vol. 389, Issue 16, 2010, pp 3193-3217). A preprint is also available online: http://arxiv.org/abs/0905.0129"

The regime change in both lower volatility and lower yields is indicative of the adaptation of the financial system not under biological stress but under central banks "financial repression" that is:

"Many examples from human physiology support this observation: from the adaptation of healthy people to a change in climate conditions to the analysis of fatal outcomes in oncological and cardiological clinics.

The same effect is found in the stock market. For example, in the dynamics of the 30 largest companies traded on the London Stock Exchanges, from 14/08/2008 to 14/10/2008 the correlations increased five times and the variance increased seven times." - source University of Leicester - Anna Karenina principle explains bodily stress and stock market crashes

In addition to the adaptation of the financial system under this time around "regulatory repression", the growing instability can be ascertained we think in "dwindling liquidity" as indicated in Bloomberg by Lisa Abramowicz on October 18th in her article entitled "Wall Street Dodging Bonds Lifts Risk in Tapering: Credit Markets":

"Wall Street’s biggest banks are demonstrating an unwillingness to wager on corporate debt in times of stress, raising concern that any losses will be magnified when the Federal Reserve tapers its record stimulus.

As speculation mounted in the two weeks ended Oct. 9 that the U.S. could default on its debt, the 21 primary dealers that trade directly with the central bank sold a net $180 million of investment-grade notes, Fed data show. The flight was bigger four months ago as the market spiraled into its worst performance since the financial crisis, with dealers slicing inventories by a net $4.77 billion.

Banks that traditionally sought to profit from debt-market dislocations now are shunning risk during periods of deteriorating sentiment as they eliminate proprietary trading groups and reduce leverage. Dealer reluctance to use balance sheets to absorb investment-grade credit amplified the 4.98 percent loss in May and June on the Bank of America Merrill Lynch U.S. Corporate Index as central bankers considered reducing the monthly bond purchases and Treasury yields soared toward a two-year high, New York Fed researchers wrote in an Oct. 16 report." - source Bloomberg.

The article also fuels our "liquidity" concerns which have been a regular feature in our numerous "credit" conversations. The increased volatility and sensitivity in bond prices are clearly for us an indication of the system adapting in true "Anna Kareninia principle" fashion leading to an overall significant build-up in "instability":

"Corporate-bond prices are experiencing bigger swings as policy makers debate slowing the economic stimulus that’s boosted the Fed’s balance sheet to $3.8 trillion. The central bank may start reducing bond purchases as soon as December, according to 59 percent of 41 economists in a Sept. 18-19 Bloomberg survey.

After cutting a broad measure of corporate and some asset-backed debt from a peak of $235 billion in October 2007, dealers pared investment-grade holdings to a net $11.5 billion as of Oct. 9, Fed data show. That’s down from $13.5 billion at the end of May, when Fed Chairman Ben S. Bernanke said sustainable labor-market progress could prompt a reduction in the $85 billion of monthly bond purchases through the quantitative easing program." - source Bloomberg

We used a reference to Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit": "That Which is Seen, and That Which is Not Seen". 

As we have argued in so many conversations, the credit space is still enjoying a "sugar rush" courtesy of our Central Bankers", and to quote again our friend Anthony Peters in one of his column:

"Somewhere out there, the next big bubble is forming and it will catch the unwary cold. Banks no longer have the risk capital to make big markets in all issues, least of all unconventional ones, and investors would be well served to ask themselves now where the pockets of liquidity will be when they are most needed. Don't disregard the old definition of liquidity as being something which, when needed, isn't there. I can't say where that there will be but I can be pretty certain that it won't be in corporate perp land. I rest my case." - Anthony Peters - IFR - Investors queue up for perp walk. 

"If you think liquidity is coming back in the credit space, then you are indeed suffering from Anterograde amnesia" - Macronomics - May 2013 - "What - We Worry?"

Of course when it comes to the "Anna Karenina principle" as well as Bayesian learning history shows the final phases of rallies have provided some of the biggest gains.

But we are drivelling again given in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":

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

On a final note, given shipping has been our favorite deflationary indicator we give you the latest reading of the Drewry-Hong-Los Angeles container rate benchmark given it will be raised again by $400 USD on the 15th of November on all US destinations - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles container rate benchmark was unchanged at $1,736 in the week ended Oct. 30, holding at the lowest level since December 2011 ($1,436) for a third week. Even with six increases in 2013, rates are 27.7% lower yoy and down 21.6% ytd, as slack capacity continues to pressure pricing. Carriers are expected to implement a $400 general rate increase on containers from Asia to all U.S. destinations, effective Nov. 15. Containership lines have announced 11 rate increases, totaling $4,850, on Asia-U.S. routes since the beginning of 2012. The increases have largely failed to hold because of excess capacity and a sluggish global economy. As such, benchmark Hong Kong-Los Angeles rates have only risen 21% since the end of 2011 and are down 33% yoy. In a Bear Case scenario, operators will continue to struggle to sustain rate increases." - source Bloomberg

"Even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative." - Martin Hutchinson - "Forced Correlations" published in Asia Times

Stay tuned!