Credit - Information cascade

"Every market is in transition." - Kenneth Lay, former CEO of Enron

Watching with interest the impressive melt up in European equities during the month of February (with French index CAC40 up close 14% since the beginning of the year), in conjunction with continuous credit and rates compression, marking the return of leverage structured credit as the hunt of yield runs unabated, we reminded ourselves of the "information cascade" model when choosing our title analogy:

"An information (or informational) cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts. A cascade develops, then, when people “abandon their own information in favor of inferences based on earlier people’s actions”." - source Wikipedia

In the specific case of the current equity melt-up helped recently in Europe supported as well by "better" economic data, no doubt that some investors have abandoned their own information in favor of inferences based on earlier central bankers actions when it comes to implementing QE, with Europe on the verge of launching a program of its own.

When it comes to assessing the on-going lift-off in European equities, it follows the lift-off we have seen in the US as well as in Japan, following the various rounds of QEs. 

In the "Information cascade model", there are four key conditions:

"1. Agents make decisions sequentially
2. Agents make decisions rationally based on the information they have
3. Agents do not have access to the private information of others
4. A limited action space exists (e.g. an adopt/reject decision).
One assumption of Information Cascades which has been challenged is the concept that agents always make rational decisions. More social perspectives of cascades, which suggest that agents may act irrationally (e.g., against what they think is optimal) when social pressures are great, exist as complements to the concept of Information Cascades." - source Wikipedia

Of course we agree with point number 2. When it comes to financial markets, agents often seems to act "irrationally", and display what former Fed Chairman Alan Greenspan called "Irrational exuberance" but then again, as we posited in our conversation "Pascal's Wager" investors are indeed making a "rational" decision based on the premises that central bankers are "deities":

"In the investment world, we think investors are betting with their "life savings" that central bankers are either gods or not."

Obviously investors that believed that the SNB's had a "godly' status met their makers when the SNB finally pulled the plug on the Euro peg but we ramble again...

When it comes to markets and the choice of our specific title, no doubt that the current "euphoric" environment is a clear display of "Information cascades being at work:

"Information cascades have become one of the topics of behavioral economics, as they are often seen in financial markets where they can feed speculation and create cumulative and excessive price moves, either for the whole market (market bubble...) or a specific asset, like a stock that becomes overly popular among investors." - source Wikipedia

What we also find of interest is that marketers also use the idea of cascades to attempt to get a buying cascade started for a new product:

"If they can induce an initial set of people to adopt the new product, then those who make purchasing decisions later on may also adopt the product even if it is no better than, or perhaps even worse than, competing products. This is most effective if these later consumers are able to observe the adoption decisions, but not how satisfied the early customers actually were with the choice. This is consistent with the idea that cascades arise naturally when people can see what others do but not what they know." - source Wikipedia

In similar fashion, central bankers around the world have done the same "marketing" exercise. They have induced other central bankers to adopt QE, although it is fairly clear that the real economic benefits of QE are dubious at best.

Therefore this week will review the current "risk-on" information cascade environment given, we think it is entirely flow driven with one of the main culprit being Japan's GPIF and we will also muse around the utility of a European QE in the current context.

Synopsis

• Under a dovish monetary global policy, both stock and bond markets will strengthen concurrently
• In the equity space, it's "party on" with a caveat
• We have moved from a low volatility regime to a higher volatility regime
• QE + Austerity = road to growth disillusion/social tensions but road for heaven for financial assets
• QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term
• Final note: Why European banks deleveraging has much further to go and why it means more pain for shareholders and bondholders

• Under a dovish monetary global policy, both stock and bond markets will strengthen concurrently. 

The current European "melt-up" in European equities is driven by investors' flows and in particular by Japan's GPIF allocations. As reported by Nomura in their 2nd of March note entitled "GPIF Q3 FY14 investment results", there has been significant progress in portfolio rebalancing from the GPIF:

"The Government Pension Investment Fund (GPIF) released its investment results for Q3FY14 and reported that investment income totalled JPY6,623.3bn for a total return of
5.16%.
Beginning this quarter, the GPIF adopted a new method for announcing the amount of its investment assets – it no longer discloses investment assets by asset.
By making certain assumptions, we estimate the GPIF reduced its domestic bond holdings by JPY6.4trn, added JPY1.9trn in domestic stocks and shed JPY0.8trn short term investment. It increased its investments in international bonds and international stocks by JPY0.7trn and JPY1.9trn, respectively.
Compared with the JPY3.3trn reduction in Q2, the GPIF accelerated its domestic bond selling significantly in Q3 (JPY6.4trn reduction including matured investments). This is consistent with October-December JSDA data showing that trust banks were net sellers of yen bonds by a total of JPY3.1trn (vs. JPY0.5trn net buying in July-September).
By comparing the asset mix at end-December and the new Basic Portfolio, we have estimated how much GPIF assets need to increase or decrease to achieve the target median weightings. According to our calculations, GPIF should shed JPY13.3trn in domestic bonds, and increase domestic stocks by JPY5.7trn, international bonds by JPY1.7trn and international stocks by JPY5.9trn.
Assuming the GPIF reduces domestic bonds at a similar pace to Q3, it could achieve the target weighting in six months. Similarly, it would achieve the target weighting in 12 months if the reduction continues at a pace on par with Q2, and eight months if it proceeds at the Q2-Q3 average pace (Case [1] in Figure 2). The amount of portfolio shift necessary would be smaller if we reflect mark-to-market changes since end-December (i.e., higher stock prices, etc.; Case [2] in Figure 2). We will monitor how market movements affect the GPIF’s portfolio shift.
Looking at supply and demand factors alone, the GPIF’s portfolio shift should cause stock prices and yen bond rates to rise and JPY to weaken further. In our view, however, JGB investors may highlight the fact that the GPIF has made significant progress in its yen bond selling, and gradually shift their focus to when it is completed, as well as subsequent supply and demand dynamics.
We also note that public pensions other than the GPIF appear to have lagged in their portfolio shifts, and may begin to accelerate yen bond selling. In this case, the portfolio shift by public pension funds as a whole would be a longer process. However, we believe the market will begin to wonder if the BOJ can continue QQE2 purchases as it heads toward end-FY15, when the GPIF is likely to complete its rebalancing." - source Nomura

And as we posited in our post "The Vortex Ring", the re-allocation process from Japanese behemoth GPIF, has continued to put additional downward pressure on core government bonds:

"It is important to note as well that for the Japanese investors, adjusted for living expenses, US treasuries still yield more this year than Japanese government debt than at any time since 1998". - source Macronomics, 26th of May 2014

Go with the flow:
One should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower. Key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets.

When it comes to Toshin funds, as reported as well by Nomura in their 4th of March note entitled "Toshin momentum remains strong", retail investors are also piling in international markets:

"Retail investors accelerated their investment in foreign assets via toshins last week, according to NRI (Figure 1). They bought JPY136bn ($1.1bn) of foreign securities, the highest pace in three weeks. This was the 14th week in a row of net purchases, and retail investors' cumulative foreign security buying via toshins this year has reached JPY1.2trn ($10bn), about JPY856bn ($7.2bn) bigger than for the same period in 2014
(Figure 2). 

Toshin momentum remains relatively strong, as risk sentiment among retail investors has improved gradually.
Retail investors continue to prefer foreign equities to other asset classes. They are estimated to have purchased JPY56bn ($0.5bn) of foreign equities via toshins, while purchasing JPY27bn ($0.2bn) of foreign bonds and JPY52bn ($0.4bn) of foreign hybrid securities. They continued to sell domestic assets via toshins for the third week in a row, while the pace of selling slowed to JPY60bn ($0.5bn) from JPY98bn the previous week. Japanese equity prices have been performing well since mid-January, and this likely encourages retail investors to book profits. Retail investors’ expectations for USDJPY appreciation have also led to stronger investment in foreign equities than in domestic assets via toshins (see "Retail investors still see USD/JPY upside", 12 February 2015). Lower yields globally may reduce the appeal of foreign bonds to retail investors. We expect toshin momentum to remain strong, because of better risk sentiment and expectations for JPY weakness, while their preference for foreign equities relative to bonds will remain strong for the time being." - source Nomura

Arguably, the GPIF has not been the only game in town with the pending European QE which, in terms of flows has driven them into overdrive when it comes to European markets as indicated by Bank of America Merrill Lynch Flow Show note from the 5th of March entitled "Carry On Risk":

"Risk-On: cash down for 3rd straight week to fund $7bn into equity funds and $6bn into bond funds Europe the Consensus Darling: euphoric 99th percentile inflows over past 8 weeks ($31bn)…heaviest since Dec'08 (Chart 1)

Retail loves Income: chunky $2.8bn inflows to equity income funds this week; note BofAML private clients have significantly raised allocation to equity income ETF’s past 24 months (Chart 2)

Carry On Risk: incessant central bank rate cuts + rising macro optimism = risk taking on the rise...our Bull and Bear Index (flashed contrarian “buy” in Jan) up to 4.3 (Chart 3); 

big payroll/strong avg hourly earnings would cause risk to pause but Feb small biz hiring intentions today was not strong." - source Bank of America Merrill Lynch

The sentiment of bullishness in February has run unabated but, once again the "strong" NFP data in the US came back to spoil somewhat the party in the US equity space has "good" news once again meant "bad" news and increasing the possibility of a rate hike by the Fed in the near future (we still very much doubt about this).

• In the equity space, it's "party on" with a caveat, 

Not only have foreign flows and the ECB QE path pushed equities into overdrive, but the renewed appetite for buybacks in conjunction with a rise in M&aA operations have also been supportive of the aforementioned rally. But there is indeed a caveat, because while the party is going strong, earnings have reverted in the US and remain flat in Europe. On that note we agree with Louis Capital Markets Cross Asset Strategy note from the 2nd of March, that fundamentals do not seem to matter in this market cycle when it comes to equities behavior to say the least:

"The reading of financial markets has been an understandable process when regarding the bond, the currency and the commodity markets. The equity market however has been a real enigma and its recent behaviour has not helped to better our comprehension of it. What is the driver of equity indices??? We thought that the expected stream of companies’ earnings was the main driver however this market cycle has demonstrated that this assumption is a false one. Subsequently, we are having significant difficulty in identifying the main drivers of the market.

Equity indices are reaching new highs in this cycle contrary to earnings that have reverted in the US and that remain flat in Europe. The P/E expansion has been very strong as a consequence and its limit is unknown. The current level of investor confidence is amazingly high and it contrasts strongly with the business climate in the real sphere that has not shown similar signs of overheating.
This kind of context is obviously very positive for equity investors. Some will say “it’s crazy, it’s going to crash”. However, history has repeatedly proven that high-levels of hubris often take a while before inevitably ending in tears. We did not expect to live through another mania in our life after the one experienced at the end of the 90’s, but we were wrong. This cycle is even more impressive that the one at the end of the 90’s, because it has come from nowhere and has so far lasted longer.

These days many commentators are explaining that, contrary to the TMT bubble, as profits are rising on this occasion current circumstances cannot be diagnosed as a “bubble”. We do not believe the current context constitutes a bubble. However, we were more comfortable in paying Cisco 100x expected earnings in 2000 than paying today 18x the earnings for Endesa or 20x for Belgacom. In the 2000’s the story was a strong one. A sort of revolution was taking place and it was consistent from a market perspective to dream of a new world emerging. Today, we are failing to find a similar story for Endesa and Belgacom, and our dreams are not stimulated when listening to the IR’s presentation of Belgacom.
The “low interest rates environment” are the words that can be found in every mouth during this cycle. The argument appears so obvious that everybody embraces the idea that the influence of central banks on the bond market also impacts the equity market through the discount factor mechanism. If profits of Belgacom remain flat for the next 20 years, paying the stock 20x current earnings roughly implies the recovery of its investment in 20 years. This is a long period of time, but the 20-year government bond yield of Belgium is close to 1%, thus implying a 100 year time horizon needed to recover its investment. 20 years vs. 100 years would represent the “equity risk premium”.
We fully disagree with this rationale, because it implies a “by default” investment. The pricing of equities is not driven by the pricing of bonds. Their underlying drivers are too different to think there are spill-over effects that inflate “naturally” equities. The Japanese experience has been crystal clear on this subject: long term bond yields have oscillated between 1% and 2% between 1998 and 2008, and despite this low remuneration of the bond asset class, the performance of the Nikkei was null during this period of time.We do not want harp-on regarding this subject as it one of weak importance for many PMs. The long only PMs are fighting against a benchmark regardless of the global mood of the equity market, whilst macro traders focus on relative value trades. The main beneficiaries of this equity mania are diversified PMs, because they have the choice between two asset classes that have been in a bullish mood for 6 years now. So even if they are wrong in their assets’ selection, they have not lost money in absolute terms." - source Louis Capital Markets

For us, and as per our title, the "Information cascade is at play and feeding speculation and create cumulative and excessive price moves on a grand scale for the whole market (market bubble...).

• We have moved from a low volatility regime to a higher volatility regime

As per our title analogy, the more central banks meddle with asset prices, the more disconnected and unstable markets are becoming.

On the subject of a higher volatility regime which was discussed in our previous conversation by our friends at Rcube Global Asset Management , European equities have started 2015 on very strong note as highlighted above by the amount of flows in the asset class, but implied volatility have risen across financial markets as depicted by Louis Capital Markets in their monthly report entitled "Europe In Sight":

"The European equity market has been very strong since the beginning of the year, outpacing most equity indices. It is difficult to find a tangible and credible reason behind this move because nothing has really changed in the real economy. It seems it is first of all “sentiment driven” and that the perspective of an aggressive central bank has helped to lift this sentiment.We are surprised by this reaction because the “central bank” argument remains by nature fragile and because we had previously signs of cautiousness with the rising implied volatility across financial markets (see chart below).

In the previous cycle, the 2002-2007 cycle, the rising volatility coincided with the end of the bull market. Although we do not call for the end of this bull market, we thought that the rising volatility since last summer would have prevented an “upward crash” like we got in January/February (15%+ for the Eurostoxx50 in less than 2 months). The chart below shows to what extent this move is unusual.

The sector hierarchy shows that this move corresponds to a pure re-rating as all sectors, with a small dispersion, benefited from this euphoria. The consumer segment has led a little thanks to the decline of oil prices but this is not the whole story. The median 12m Fwd PER of the Stoxx Europe 600 universe stands now at 16.8 and it is well above the top of 2007. That’s the most important story because it questions the valuation regime of European equities. Is this level exaggerated or will we see a median PER at 20 before the end of the year (implying an additional upside potential of 20%+)??? This context is perturbing for investors because it blurs the notion of “cheap” and “expensive” stocks, and lowers in the end, the relevance of the valuation factor." - source Louis Capital Markets

As far as the Information cascade is concerned and the on-going "melt-up" we would repeat what we indicated back in January 2012 in our conversation "Bayesian thoughts" when 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."

Bayesian learning today is indeed leading towards an acceleration in the rise in asset prices, while the end of the low volatility regime in conjunction with the rise in the US dollar (meaning a global tightening from a pure "macro" perspective) indicate we are indeed in the final innings of the game we think.

• QE + Austerity = road to growth disillusion/social tensions but road for heaven for financial assets

In our November 12 2014 conversation "Chekhov's gun" we put forward our take on QE in Europe:

"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).
“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?"  - source Macronomics 12th of November 2014

We also indicated at the time:

"Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)"

Given France has now postponed any chance of meaningful structural reforms until 2017 with the complicity of the Europe Commission, (again a complete sign of lack of credibility while imposing harsh austerity measures on others), and that the government will face an electoral onslaught in the upcoming local elections which will see yet another significant progress of the French National Front, we are convinced the"Current European equation" will breed more instability and not the safer road longer term.

This brings us to a subject we have already tackled when it comes to differentiating QE in Europe versus QE in the US. It is all about Stocks versus Flows:

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

"Credit growth is a stock variable and domestic demand is a flow variable" as indicated by Michael Biggs and Thomas Mayer in voxeu.org entitled - How central banks contributed to the financial crisis.

On that essential difference we came across a very interesting note from BNP Paribas from the 6th of March entitled "The ECB wants to buy but who wants to sell?"where they highlight 3 main differences between QE in Europe versus QE in the US which we summarized below:

1. Size matters: the corporate credit market/ABS market in Europe is not as deep as in the US. It is very difficult for institutional investors in Europe to switch from holding government bonds to corporate credit/ABS.
2. Timing: QE 1,2,3 in the US were done when the amount of US Treasuries issued was rising due to the US budget deficit! In Europe, QE is being launched when there is a very weak net issuance level due to austerity measures being implemented.
3. Liquidity constraints for Banks and Insurers are much more harsher than in 2010/20111, meaning that these institutions will hang onto their holdings, negative yields or not.

Stocks versus Flows, is for us a key element in terms of the macro understanding of the ECB's position versus the Fed as highlighted in BNP Paribas's note:

"The stock of bonds versus the flow
Over the past few weeks, much has been written about the risk that the ECB may not be able to find all the bonds it is intending to buy. This seems a strange predicament, since not so long ago many people were worried about the eurozone having too much debt. Before we go into more detail, it is worth remembering that someone’s debt is somebody else’s asset, so saying that there is too much debt would be equivalent to saying that there are too many assets, which we never hear (and for good reason). The main focus should rather be more on the quality of the debt (and how it would be repaid) instead of the size.
Why is there such a worry about the execution of QE? As we have pointed out several times, the size of the buying is relative to the size of bonds for sale. We show in Table 1, that the net issuance for 2015 is negative by EUR 200bn after taking into account the bonds bought under QE. This is the major difference with the US and the UK, as QE in those countries were done at a time of greater budget deficit, therefore limiting the concern about supply.

Other differences and specific points about European QE
When the FED was buying T-Notes, sellers had the opportunity to re-invest in the US fixed
income markets. They could also re-invest the proceeds into corporate bonds or in the mortgage markets, where the liquidity was enough to absorb part of the money that used to be in US government bonds. Investors could also choose lower quality bonds, investing some proceeds into municipal bonds for example. Obviously, it is unlikely that holders of AAA-rated US government bonds bought a lot of lower quality US paper (but some spillover must have taken place as we can see in Chart 1 and chart 2), and at the very least they were not penalised by negative deposit rates if the cash was not re-deployed immediately. So if they were not able to extend the duration or go lower into credit quality, they always had the choice to park (at least momentarily) some of the cash into very short-dated bonds at zero.

This is not the case in Europe today. When holders of a government bond from a eurozone country sell a bond, they do not have much of an alternative in the fixed income markets for reinvestment. The European corporate bond market is not liquid enough, the ABS market is too small and the ECB also has a programme to buy covered bonds. So unlike in the US, once a bond is sold to the ECB, the buyer is likely to look for another … government bond. So in the context where the offer of bonds is less (because deficits are lower) and there is a large marginal buyer, there is upward pressure on prices.
There are other differences. QE in the US and UK was done when the rules for liquidity constraints were easier. As regulation pushes banks to hold large amounts of collateral in order to comply with stricter liquidity rules, there is a natural extra bid for short-dated bonds. These bonds are also supported by the fact that the overnight rate is negative (unlike in the US) and as large investment funds do not have access to the deposit facility of the ECB, they have no choice but to buy short-dated bonds. This is why there are so many bonds with negative yields (up to 25% of the outstanding bond market size) – another significant difference with the US.

A word of caution
We should keep in mind that the ECB is officially trying hard to create inflation in line with its mandate. In that context the very long-dated bonds remain particularly vulnerable if CPI inflation numbers start to pick up. Nobody is expecting a bounce anytime soon, but when the base effect of oil fades (towards the end of 2015) and the weaker euro eventually lets some imported inflation in the eurozone, the picture could be very different. Also when QE started in the US, the economic situation was deteriorating following the 2008 crisis, which is not the case in Europe, where some early signs are that the situation is at the very least stabilising or getting slightly better. Forward inflation expectations in the eurozone have already corrected higher at 1.77% (5-year, 5 years forward implied inflation expectations) and are not far off from the ECB’s target, hinting that QE will be successful over the medium term, (Chart 6). 

Such high inflation anticipations combined with the suppression of nominal yields means that investors going into the long end are forced to accept very negative real returns (Chart 7). 

This is a highly unusual situation, which cannot be sustained over the medium term, hinting that at some stage the long end of bond prices will drop." - source BNP Paribas

Caveat creditor...as we posited in our September 2014 conversation "Sympathy for the Devil":

"The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.

"Investors have indeed Sympathy for the Devil we think, as they continue to pile up with much abandon and more and more getting "carried away" in their insatiable hunt for yield. In that sense Baudelaire's 1869 poem rings eerily familiar with the current investment situation in the sense that investors have been giving our "Generous Gambler" the benefit of the doubt (OMT - and now full blown QE) and shown their sympathy and their blind beliefs in "implicit" guarantees, rather than "explicit" (such as the German Constitution as we argued in various conversations)" - source Macronomics, September 2014

As we indicated in our conversation "Eastern promises" on the 9th of June 2012 we continue to think Germany could be the prime suspect in triggering a breakup (Greece being the perfect scapegoat):
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

Keep in mind that Angela Merkel while only appearing to be making material sacrifices has managed to keep Germany's liabilities unchanged so far.

• QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term"

We will never understand why the European QE is not made alongside some form of New Deal with massive infrastructures in Europe, which would put people back to work and improve the odds of a self-sustaining economic model with better preservation of social cohesion.

On a side note, if you are fans of the US TV series "House of Cards", you will have noted that in season 3, Frank Underwood (Kevin Spacey) now president of the United States is fighting against an hostile US Congress. In terms of his proposed economic policies, President Underwood wants a hostile Congress to cut Social Security and appropriate $500 billion on public spending to boost jobs in infrastructure, government and the private sector.

In the "real world", as reported by Bloomberg  on the 4th of March, "U.S. Companies Are Stashing $2.1 Trillion Overseas to Avoid Taxes":

"Obama earlier this year proposed applying a 14 percent mandatory tax on the stockpiled profits and a 19 percent minimum tax on foreign earnings going forward.
The one-time tax would generate $268 billion over six years, which Obama wants to use for infrastructure." - source Bloomberg

We find this interesting particularly around the discussions about "Biotechs" current valuations, which for us are clearly representative of their "tax advantage" compared to the "Utilities" sector for example. We touched on this subject in our October conversation "A Descent into the Maelström":

"We think that the "too much liquidity" popular trades of biotech, internet, gaming and small cap are up for more pain in the future. Technology and Health Care Companies in the S&P 500 index are both heavy users of adjusted earnings measures in their financial statements: Of 69 technology companies in the index, 56 use non-GAAP earnings, of 56 Health Care companies, 45 use them. (source "Earnings, but Without the Bad Stuff", Gretchen Morgenson, November 9 2013 - New-York Times). The vast majority of public biotech companies in the U.S. (87%) do not pay taxes because they lose money as they pursue breakthrough therapies and cures as well as using non-GAAP metrics to boast are more "positive" accounting picture. Young high tech companies often end up paying less than 10% of income in taxes whereas old railroads and utilities often pay more than 25% and cannot easily "jump" countries using M&A for tax inversion purposes"

Should the US administration decide to "close the tax gap", rest assured that your "Biotech Bubble" would burst in an instant, but, that's another subject...

• Final note: Why European banks deleveraging has much further to go and why it means more pain for shareholders and bondholders

While the Hypo Alpe Aldria drama is unfolding in Austria with additional losses of €5.1bn to €8.7bn meaning more pain to come for bondholders  (€9.8bn senior and sub, €1.2bn Pfandbriefe), we leave you with Louis Capital Market chart displaying the relative performance of the the STOXX Banks sector (SX7P) versus SXXP:

- source Louis Capital Market

As a reminder, US banks have increased their capital basis by 57% since 2007 until 2012 while Western European banks by only 37% on the same period as per our conversation "Sympathy for the Devil". So keep on playing the "Dead Cat Bounce" game in European banks stocks the on-going "Information Cascade", rest assured that when it comes to European banks, the trend is indeed your friend...

Sic transit gloria mundi -  "Thus passes the glory of the world." 

Stay tuned!

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!

Credit - The Pigou effect

"Nothing is perfect. Life is messy. Relationships are complex. Outcomes are uncertain. People are irrational." - Hugh Mackay, Australian scientist

While continuously following the evolution of the Euro convolution, with the temporary relief of the outcome for a Greece and the high probability of a Grexit in the end, as well as looking at the continuous fall in one of our favorite global demand indicator namely the Baltic Dry Index falling below its 1986 level towards 513 on the 22nd of February, we reminded ourselves for our title analogy of the Pigou effect, which is the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation. For Arthur Cecil Pigou, real wealth was simply defined as the sum of the money supply and government bonds divided by the price levels. He argued that when an economy was in a liquidity trap, monetary stimulus to increase output could not be used given there is little connection between personal income and money demand. Of course what we find of interest is that if the Pigou effect had been effective, then Japan should have exited deflation much sooner. Pigou, (just like our central bankers of the world today) hypothesized that falling prices would make consumers feel richer (and increase spending, that famous "wealth" effect) but Japanese consumers tended to report that they preferred to delay purchases, expecting that prices would fall further, which of course is exactly what has been happening.
It appears that "The Pigou effect" has been highly criticized as well by Michał Kalecki because: "The adjustment required would increase catastrophically the real value of debts, and would consequently lead to wholesale bankruptcy and a confidence crisis."

But, when it comes to our title analogy and the "Pigou effect", we find it quite amusing that Pigou had been John Maynard Keynes' professor. Pigou's theory is completely flawed as it is based on the hypothesis that there cannot be a prolonged period of overproduction (China) and the artificial life support of "zombie" companies (European banks, Chinese shipping companies, etc). Arguably, the trajectory of the Baltic Dry Index is indeed putting to the test that very assumption from the University of Cambridge professor. It is interesting to note that his student, John Maynard Keynes argued that a drop in aggregate demand could lower both employment and the price level in unison, an occurrence observed in the deflationary depression, which is what we are currently seeing in Europe and what is also coined by some economists the "Keynes effect":

"The effect that changes in the price level have upon goods market spending via changes in interest rates. As prices fall, a given nominal money supply will be associated with a larger real money supply, causing interest rates to fall and in turn causing investment spending on physical capital to increase." - source Wikipedia

Of course both the teacher and the student were wrong, as the former ignored the probability of extended oversupply and the latter implied that insufficient demand in the product market cannot exist forever. The Keynes effect does not occur in a "liquidity trap" according to "Keynesians", which is the result we are seeing in Europe with lack of aggregate demand due to lack of private credit as most European banks as they are constrained by their inherent "lack of capital". It is also particularly due to ZIRP and the Zero Lower Bound Problem. The result of this "liquidity trap" is, for us, self-inflicted. We discussed the issue of "crowding out" of the private sector in our conversation "Fears for Tears":

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector."Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments. It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

In this week's conversation we will take another look at the long term prospect for the European banking sector, as we strongly sit in the deflationary camp. We believe that rates will stay low for longer, particularly in Europe, which is caught in a vicious "japanification" process. We will also reassess some of our earlier views (long US treasuries, long Gold, short JPY), particularly in the light of the increased volatility and the impressive rise in US yields during the month of February which we highlighted in our most conversation.

Synopsis:

• The "crowding out" effect
• Banks stocks or credit?
• Banking crisis? Sweden lead the way
• Why Pigou failed in Japan and why QE is like aspirin? It's the demography stupid!
• Reassessing some of our earlier views
• The battle against the deflationary bust looming will not be won by ZIRP and QEs
• Real wage growth is the Fed's greatest headache
• Volatility is a buy and will greatly impact negative convexity assets
• On the fallacy of "Balance accounting" as per Sir James Goldsmith

• The "crowding out" effect:

The "crowding out" effect we mentioned on numerous conversations pushes yields down further meaning bonds investors are having a field day. Weak demand and ZIRP entices speculations and buy-backs rather than investments and employment. Banks play heavily the carry trade and therefore increase their link to their respective sovereigns while the private sector (SMEs) hasn't been able to easily access credit, leading to a credit crunch in Europe in the last couple of years triggering weaker aggregate demand, surging unemployment, etc.

In similar fashion to Japan, government bonds have replaced private sector lending on European banks' balance sheet. The comparison between Japan and Europe in terms of "evergreening" bad loans (extend and pretend that is, such as "shipping loans" for instance) and impaired financial sector can be ascertained from German bank Berenberg's note entitled "Turning Japanese...we really think so" published on the 10th of February.

"Policy responses – lessons not learned: In terms of fixing the banking system (the need to recapitalise banks rapidly and early on) and monetary policy (the need for shock and awe), European policy makers appear to be aware of, but have not taken on board, the lessons from Japan or the US in the 1930s. Perhaps, like their Japanese peers before them, they believe the economy is facing cyclical not structural challenges, or maybe they are concerned about their reputations or wish to prevent panic. But to be clear: fixing the European banking system remains unresolved and will remain so until hidden loan losses are dealt with.
● Interest rates will be lower for longer than anyone is prepared for: Deflationary forces arising from the balance sheet recession will see loose monetary policy
persist for another 10-15 years. For European banks, the implications are clear.

o Balance sheet structures to transform: Private sector deleveraging, continuing fiscal deficits and tightening regulation will make balance sheets smaller, drive the loan-deposit ratio below 100%, see (sovereign) fixed income assets double their share of bank assets, and lead to ever increasing equity-to-assets ratios.
Non-performing loan (NPL) ratios may yet double as they did in Japan following the onset of deflation.
o Balance sheet profitability to decline: Flat yield curves close to the zero bound and a substitution of private sector loans with sovereign bonds will push the net interest margin lower for many years to come. Combined with elevated loan losses, returns on assets (RoAs) will remain at half the levels of the precrisis, golden age.

● Share price and valuation parallels offer no support: The parallels with Japan have also held at a share price and valuation level, and suggest that there remains considerable relative downside to come (30-40%?) for European banks." - source Berenberg

Japan and the "crowding out" effect as illustrated by Berenberg in their lengthy note:

- source Berenberg

• Banks stocks or credit?

As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe. This can also be ascertained by the comparison in terms of returns for banks between Japan and Europe as highlighted by Berenberg in their great note:

"Given the continuing poor disclosure of loan quality by the European banks, we cannot say for certain what the capital deficit really is. However, history consistently shows that at the end of a 60-70 year debt cycle when an extended balance sheet recession takes hold, there are substantial hidden loan losses. But at some point, in the face of continuing weak nominal economic growth, banks must move from forbearance to foreclosure within their loan books and thus crystallise the loan losses." - source Berenberg

This support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

The extend and pretend game of hidden losses has been of course been supported by both LTROs and by now the much anticipated ECB QE.  So, forget about "dead cat bounces" in European banks share prices, as Japanese history has shown, pain is here to stay for shareholders as illustrated as well clearly by Berenberg:

"In Figure 29 we compare the relative performance of banks against the market in Europe and the US with that of Japan (with the Europe/US data rebased by 11 years to map the timescale of Japan). The good news is that the material relative underperformance of Eurozone, UK and US banks matches that of Japan both in terms of scale and duration. The bad news, however, is that the worst is not over. Japanese banks staged a three-year rally on the back of the restructuring of the banking system driven by the 2002 Takenaka plan (which forced the recognition of NPLs and the recapitalisation of banks). However, the underperformance resumed over the last eight years and Japanese banks are now at close to their 40-year+ relative lows. With Europe yet to achieve closure on balance sheet uncertainty (ie achieve a successful restructuring of the banking system) and with flat yield curves at the zero bound squeezing net interest margins, European banks are likely to continue to grind lower relative to the market. Further, as we show in Figure 30, banks do not like QE. In Japan and the US, banks underperformed during episodes of QE (QE flattens yield curves thus squeezing net interest margins and also signals an environment of low nominal growth which is negative for asset quality)."

- source Berenberg

• Banking crisis? Sweden lead the way

When it comes to the outperformance of "Nordics" share prices versus Japanese banks as displayed above it can be very simply explained. Sweden decided to tackle head on the issues of its ailing banking sector on numerous occasions. Sweden has a good firsthand experience of financial crisis unlike Europeans. 

Sweden suffered through a banking crisis in the early 1990s and then again in 2008 and 2009. It chose to inject capital into struggling banks only in return for equity to avoid raising deficits and burdening taxpayers. The government in 2008 set up a financial stability fund by charging banks an annual fee and enacted various crisis-management measures including a bank guarantee program to help support lending.

The fund will grow to 2.5 percent of gross domestic product by 2023 and stood at 35 billion kronor ($5.2 billion) at the end of 2010, including shares in Nordea Bank AB, according to the Swedish National Debt Office. 

As far as European banks are concerned, regardless of the European Banking Union, AQR and other shenanigans, we agree with Berenberg's take on the triviality of the AQR adjustments:

"The triviality of the AQR adjustments was the most damning in our view. It is simply not credible that at the end of a 60-70 year debt cycle and after seven years of near nonexistent economic growth that the adjustment to Non-Performing Exposures equalled just 62bp of total assets. Charitably, this could be blamed on IFRS and its requirement to only identify losses on an “incurred” basis rather than expected one (indeed, rephrasing the critique given IFRS only allows provisioning on an incurred basis and given the adjustments were so trivial, it must imply that the ECB acquiesced in covering up the scale of hidden losses in banks’ balance sheets). Indeed, as Hoshi and Kashyap wrote presciently in October 2013, the European authorities “appear to be hesitant to admit to the size of the problems facing the banks” perhaps out of fear of triggering a panic.

In short, until there is true clarity in the value of European banks’ assets, then the value of the equity is highly uncertain, making European banks uninvestable. In our view, what Europe needs to do, and what happened in Japan, is to force banks to dispose of a material proportion of their non-performing loans. As shown in Figure 36, NPLs were over-valued for in excess of a decade.

Such forced disposals should help achieve price discovery around the true value of bank assets. And in turn, this should pave the way to achieving confidence around the capital bases of the European banks." - source Berenberg

• Why Pigou failed in Japan and why QE is like aspirin? It's the demography stupid!

In relation to our title the "Pigou effect" and central banks' intervention leading to a "liquidity trap therefore neutralizing the "Keynes effect" , Japan is clear illustration of the failure of the "wealth effect" of Pigou's proposal as pointed out by Berenberg:

"In Japan, where the burden was shifted early on from monetary to fiscal policy, a Catch-22 is emerging. The Japanese government cannot afford to allow rates to rise, yet keeping rates low risks increasing distortions in the economy through the mispricing of risk. It has been estimated that a 2ppt increase in average bond yields would require almost all tax revenues to be used to service the government’s debt. Thus QE and the monetisation of the national debt must continue in size (apparently the Bank of Japan purchases the majority of all new debt traded) until the Bank of Japan owns most of the government’s debt. But if the quantity of something is increased and demand is constant then the price must fall, ie the yen must weaken further (and Japan exports deflation).

As noted in the previous section, abundant liquidity and low interest rates squeezed net interest income for Japanese banks (two-thirds of the revenues for a typical bank). This arose through two effects. Ample liquidity and a lack of private sector demand for credit meant that the Japanese banks materially increased their holdings of government bonds (with typically lower yields than private sector loans). Secondly, low interest rates and QE flattened the yield curve, reducing the benefit of the maturity transformation.

Markets are rejoicing that the ECB is finally following the Bank of Japan and other central banks in embracing QE. But what if, as Kiyohiko Nishimura observed (the former deputy governor of the Bank of Japan), the problems facing Europe and Japan are driven by a demographic not financial cycle. He has noted that in Europe and Japan, as well as the UK and US, crises have almost always coincided with a decrease in the ratio of the working-age population to the non-working age population":

- source Berenberg

 You probably better understand now much better our long standing deflationary stance and lack of "appetite" for European banks stocks (we are more credit guys anyway...). It's the demography stupid! Beside's that we have pointed out in our conversation "Stimulant psychosis:

"Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment."

Both the master Pigou and the student Keynes have inadvertently grant unprecedented capital gains to rentiers in the form of exorbitant bond price! Exorbitant bond prices? How about Portuguese 10 year bonds at 2.13% trading briefly below US 10 year bonds?

• Reassessing some of our earlier views

Duration - party on Wayne! party on Garth!

While we endured the proverbial battering on our long duration exposure during February (offset somewhat by our short JPY stance), as discussed in our last conversation, the latest raft of weaker than expected US data such as US home resales falling to their lowest level in nine months last month at an annualized rate of 4.82-million units, as well as Industrial companies indicating they would only raise capacity by 1.8 percent in 2015, which is  the smallest increase since 2011, after boosting it 3.1 percent in 2014 according to  the Fed said in its Feb. 18 release on production, reinforce our view that we have probably seen the top of widening move in US yields for the time being. The current levels make it interesting to think about increasing slightly more our own long duration exposure.

Gold - everything that glitters...

In terms of flows, it seems precious metals saw their first outflows of $0.3bn in 5 weeks according to Bank of America Merrill Lynch "The Flow Show" from the 19th of February entitled "Out with the Safe, In with the Risk":

"YTD asset returns: stocks +3.1%, bonds -1.0%, commodities +1.4%, US dollar +4.4%; vol, gold & long duration bonds were the clear Jan “winners”; but risk assets have rallied big in Feb and quietly Treasury yields have jumped sharply (30-year up 50bps in Feb)" - source Bank of America Merrill Lynch

Our gold and duration calls from our conversation of the 6th of January entitled the "Fright of the Bumblebee" performed well in January and got punished in February:

"In terms of "allocation", we think we are looking more towards the upper left part of the Credit Channel Clock which means:
-a continuation of flattening yield curves,
-being long volatility as we enter a higher volatility regime
-a continued exposure to US long government bonds. Long dated US government bonds from a carry and roll-down perspective continue to be enticing at current levels compared to the "unattractiveness" of the mighty German 10 year bund indicating a clear "japanification" process in Europe.
-adding again some gold exposure in early 2015. We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it is going to be working again nicely in the first part of 2015"

The latest US raft of economic data has given some support of the $1200 level. We still remain positive for gold prices, given the lack of clear resolution of the Greek situation in conjunction with geostrategic tensions flaring with interventions looming in the Middle-East and with Ukraine 's economy in complete meltdown.

• The battle against the deflationary bust looming will not be won by ZIRP and QEs:

Looking at the global economy as a whole, we think the globalization of ZIRP is not reducing the deflationary forces at play but in fact reinforcing them, pushing us towards additional currency war which is reminiscent of the build up towards the crash of 1929 and the Great Depression that ensued. On that specific matter we share Dr Lacy Hunt's views and concerns. He is the Executive Vice President of Hoisington Investment Management and gave a month ago a long interview with Gordon T Long on the current economic situation. While gathering our thoughts since our previous conversation, we also took into interest in the wise but gloomy comments from Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February:

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

This struck a chord with us as it indeed reminded us of Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. He violently criticizes the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.

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

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

• Real wage growth is the Fed's greatest headache

In similar fashion the slack in US real wage growth is the real problem to clearly validate the much vaunted US recovery  according to a University of Wharton article entitled "The Economy Is Coming Back — Why Wages Are Stuck in a Rut" and published on the 23rd of February:

"Despite that one bright moment in the late 1990s, U.S. real average hourly wages haven’t budged much for decades. The U.S. average hourly wage of $20.80 in January 2015 is about the same as that in January 1973, adjusted for inflation, according to the Bureau of Labor Statistics." - source Wharton University

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

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, 22nd of July 2014

Real wage growth, we think is the most important indicator to follow we think from a Fed tightening perspective.

We also indicated at the time:

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

• Volatility is a buy and will greatly impact negative convexity assets

From a market perspective, we recommended in our first conversation of 2015 that investors needed being long volatility as we enter a higher volatility regime, this is confirmed by the rise in the CVIX index (CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs) as displayed by Bank of America Merrill Lynch in their Liquid Insight note from the 23rd of February entitled "Letting the data speak again on G10 FX":

"This is just the beginning
We expect that the year so far is a preview of what will follow. Our year-ahead had argued FX volatility would increase as data dependence replaces forward guidance in monetary policy, ECB and BoJ QE would not be enough to replace Fed QE as boosters of global risk appetite, and oil prices would be lower and more volatile. In the global monetary union with the US we pointed out that loose Fed policy and forward guidance in G10 central banks had killed market volatility and FX correlations with data and fundamentals, and argued volatility and such correlations would come back as Fed QE ends, G10 monetary policies diverge and USD strengthens.
We believe these forces remain valid. We recently argued FX volatility has become the prime driver of global volatility, as central banks react differently to the common oil price shock and some are behaving as if they are in a currency war. The latest FOMC minutes also suggest the Fed is unlikely to continue ignoring the drop in inflation expectations, suggesting the upward USD." - source Bank of America Merrill Lynch

As a reminder and going forward, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger!

•  On the fallacy of Balance accounting as per Sir James Goldsmith

"The idea that accounts must balance, and that inflows must ultimately match outflows, is an accountant's idea.
But there is a fundamental misunderstanding here. If you make a loss, perhaps because you own a business that is trading unprofitably or because you have made a bad investment, you will not get rid of the loss by borrowing the amount needed to pay for it. You will have avoided or postponed a personal liquidity crisis, but you will still be poorer by the amount of the loss. You will also have to pay interest on the loan.
Alternatively, you might sell your house and rent somewhere else to live. You will have used the proceeds of the sale to pay your debts, but you will remain poorer by the value of the house. And in future, you will have to pay rent.
When the Asian countries, as mentioned by the European Commission, invest their 'excess cash' abroad, normally they do so by buying into businesses or by lending money. The latter normally takes the form either of buying government debt or of deposits, say in sterling or dollars, in the banking system. Now consider the position of the nations which, unlike the Asian countries, import more than they export and which, as a result, have a deficit as opposed to an excess of cash.
To finance their deficit, businesses or other assets are sold and debt is issued. This puts them in exactly the same position as an individual who sells his house or borrows money to cover his debts. Such a haemorrhage can last only a limited time before ending in bankruptcy." - Sir Jimmy Goldsmith

Hence the need for central banks to issue more debt to sustain the global financial system...until it doesn't work but that's another story...

Thanks to Global ZIRP and our central bankers we are indeed living on the Planet of the Apes...oh well.

"If you pay peanuts, you get monkeys."- Sir James Goldsmith

Stay tuned!