Credit - Ephedrine

"Between stimulus and response there is a space. In that space is our power to choose our response. In our response lies our growth and our freedom." - Viktor E. Frankl, Austrian psychologist

Watching with curiosity our "secondguessing" playing out on our Chinese exposure supported by PBOC intervention in the process, it reminded us of course of our October 2014 note "Pascal's Wager" as the only "rational" explanation coming from the impressive surge in stock prices courtesy of QEs and monetary base expansion has been to choose the belief that our central bankers are indeed "Gods". 

When it comes to choosing this week's title analogy, we remembered the herb Ephedra sinica used in traditional Chinese medicine which contains ephedrine and pseudoephedrine as its principal active constituents. Ephedrine in its natural form was known as má huáng (麻黄) in traditional Chinese medicine and has been documented in China since the Han dynasty (206 BC – 220 AD) as an antiasthmatic and stimulant. In traditional Chinese medicine, má huáng has been used as an attempted treatment for asthma and bronchitis for centuries so no wonder when economies catch the proverbial cold, it can also be used as a powerful "stimulant". What we find of historical interest is that in 1885, the chemical synthesis of ephedrine was first accomplished by Japanese organic chemist Nagai Nagayoshi based on his research on traditional Japanese and Chinese herbal medicines. In similar fashion the Japanese chemist/central bankers at the Bank of Japan were the first to realise the chemical synthesis of ephedrine and its "stimulant" effect on "asset prices". Though Ephedrine is a potentially dangerous natural compound as it can sometimes lead to mania/hallucinations as well as delusions but we ramble again...

What we find of interest with this week's analogy is many pundits musing around the probability of China launching a QE of its own to offset the debilitating effects of its past credit binge. Therefore in this week's musing we would like to focus our attention on China's potential approach in offsetting the effects of past excesses given that as we pointed out previously, while Europe is attempting to avoid demolition, China as we pointed out in our February 2014 "Crosswind" conversation is attempting to deflate these past excesses:

"Chinese crosswind is of two folds, on one hand China's deflating exercise is akin to a "controlled demolition" and will need to allow at some points some defaults to take place, on the other hand, it has to maintain sufficient credit conditions to ensure a certain level of growth for its economy.
As we wrote back in September 2011 in our conversation "Controlled demolition", as far as Europe and China are concerned, nothing has really changed in terms of the treatment of the on-going crisis:
"While Europe is busy with the demolition, we have China attempting deconstruction. In both case we have an attempt of controlled demolition, it is just a question of style." - Macronomics, 19th of September 2011." - source Macronomics

Synopsis:

• China's debt pile and household debt
• Private debt matters but so does private consumption
• US and Europe = reducing "equity" versus China increasing "equity"
• China and QE and the myth of the Opium plague
• Final note: Dr Copper, the metal with the economics Ph.D is still in a bear market

• China's debt pile and household debt

China's Purchasing Managers' Index from HSBC/Markit slowed to 48.9 in April vs 49.6 last month, We saw a similar pattern in 2014. But, when it comes to assessing the meteoric rise in China's debt, one need to take into account household debt relative to GDP as indicated in Bank of America Merrill Lynch's Cause and Effect note from the 27th of April entitled "The great US-China convergence trade":

"Between 2011 and 2014, loans from financial institutions to Chinese households more than doubled; during the same period, the debt of US households was unchanged. As a result, Chinese household debt as a share of GDP has climbed to 36% while US household debt as a share of GDP has fallen to 77% (Chart 14). 

By the way, the McKinsey Global Institute recently estimates that total debt to GDP ratio for China has reached 282%, versus 269% for the US." - source Bank of America Merrill Lynch

To quote Bastiat, when it comes to debt levels:

"That Which is Seen, and That Which is Not Seen" - Frédéric Bastiat

From our macro perspective, low household debt levels versus GDP is an essential positive factor when it comes to the "deleveraging" exercise undertaken by China. Therefore, given the lower leverage of Chinese households we think the bubble watchers will watch with interest the Chinese market continue to surge in the near future. In fact as indicated by Asia Times, and relating to our HSI exposure, April saw significant inflows into the Chinese stock market:

"April saw HK$20.5 billion ($2.6 billion) flow into the Hang Seng H-Share Index Fund (SEHK STOCK CODE 2828). It was the largest monthly inflow since 2010 and the third-most among equity ETFs globally, according to data compiled by Bloomberg.
The Hang Seng H-share ETF holds the stocks of 40 of China’s biggest state-owned companies. Financials make up 67% of the portfolio. The fund is valued at about 10 times forward earnings, compared with the 17 multiple on the Shanghai Composite Index, according to Bloomberg.
The ETF’s shares rose 17% last month to HK$145.20, its third consecutive month of gains. Over the past four months, the ETF has received a total of HK$29 billion, its longest stretch since 2013. Total assets grew to HK$57.1 billion.
The U.S.-listed iShares China Large-Cap ETF (FXI) received $385 million last month, the biggest inflow in eight months. It jumped 16% in April, for a 51% return over the past 12-months.
One big reason for the rally is that Chinese companies trading in Hong Kong are priced at a significant discount to their dual-listed counterparts on the mainland. UBS said even though the Hang Seng China Enterprises Index leapt 17% in April, its largest jump since October 2011, Chinese A shares still trade at a 31% premium to Hong Kong stocks." - source Asia Times

Given the discount and the lag in term of performance of the Hang Seng China Entreprises benchmark versus the Shanghai Composite Index's A shares (up 48% vs 119%), there is still some upside move to close the gap.

• Private debt matters but so does private consumption

While arguably China has experienced a slowdown and is playing a complicated "rebalancing" act from investment towards domestic consumption, we agree with Jeffrey Towson and Jonathan Woetzel from the adapted book excerpt from their follow-up to their "The One Hour China Book" as displayed by McKinsey in their article "Why China's consumers will continue to surprise the world":

"China has an awesome consumer story. Yet lately you can’t pick up a newspaper, go online, or watch television without hearing continual moaning about the country’s slowing economic growth and the need for “rebalancing.” The reality is that Chinese consumers are going to continue to increase in wealth and complexity. And if you’re worried the country’s economic importance is declining, you’re probably looking at its performance the wrong way.
Don’t worry about consumer spending as a percentage of GDP
As in most developing Asian economies, China’s early growth was based on savings, investment, and exports. You get your population to save, move to the cities, work in factories, and make stuff. This is sold, and cash is brought back home for investment. Plus, you get some foreign investment as well. This process enabled China to develop its infrastructure largely with its own cash. That, by the way, is not the norm. Developing economies typically borrow from foreigners and then default—for example, American states such as Mississippi and Florida were chronic defaulters on foreign debt as they initially developed.
One of the downsides of this investment-first approach is that it makes consumption look small and often like it’s shrinking. Chinese consumption decreased from approximately 51 percent of gross domestic product in 1985 to 43 percent in 1995, 38 percent in 2005, and 34 percent in 2013. By comparison, consumption is around 61 percent in Japan and about 68 percent in the United States. In fact, China’s small and decreasing consumption percentage is one reason why people keep talking about “rebalancing”—the need for the economy to become driven more by consumer spending than investment and exports.

Our position? Don’t worry about this stuff.

First, from 2000 to 2010, the size of the Chinese economy more than doubled
So consumption grew from around $650 billion to almost $1.4 trillion. Regardless of its relative percentage of GDP, China’s consumption has been growing faster than just about any other country’s in absolute terms. Second, just getting consumer spending back to 43 percent of GDP, the level in 1995, would have a huge impact on “rebalancing.” It would also create the largest consumer market in the world. Third, most of these numbers are wildly inaccurate. Consumer spending is nearly impossible to measure in such a big, complicated economy. Combining a vague number with two other big vague numbers (investment and net exports) is very fuzzy math. Until economists start putting uncertainty estimates on their China calculations, relative percentages aren’t worth paying much attention to.

Household income is what matters, and it’s great
The number you really want to keep in mind is household income. You can’t have consumption without income. And here’s where it gets really awesome. China’s household income is huge. It is now likely above $5 trillion a year. Plus, lots of income is unreported, so this is really the lower boundary for true household income. Developing economies—especially the BRIC nations of Brazil, Russia, India, and China—are frequently grouped together, but Chinese consumers dwarf all the others in terms of household income.

Rising discretionary spending is the exciting part
Discretionary spending is buying the stuff you like but don’t need. Or you only sort of need. And, fortunately, people seem to have an endless appetite for everything from entertainment to skiing to caffe lattes. Chinese citizens are now moving beyond being able to only afford the basics of life, and their discretionary spending is taking off. Growth in spending on annual discretionary categories in China is forecast to exceed 7 percent between 2010 and 2020, and growth of 6 to 7 percent annually is expected in a second category of “seminecessities.” Both of these categories are growing faster than spending on actual necessities, which are expected to grow around 5 percent a year, about the same as expected GDP growth
Finally, an important related issue is the Chinese tradition of saving. If we compare spending and saving rates across the emerging markets, we see a spike in savings in China. That spike is fairly understandable. First, it’s cultural. Second, they are precautionary savings—no social safety net means if you get sick, it’s all on you. Third, Chinese savings are not unique. Japan, Korea, and Taiwan all hit 30-percent-plus savings rates in their early development. And fourth, without much of a consumer-finance system, it’s tough to use debt to hit truly spectacular consumption levels. After all, a vacation home or car may cost the equivalent of a year’s income.

That’s our rant on China’s macro consumer situation. Basically, we believe it remains a great story. It may be volatile. It’s also somewhat unpredictable. But you just don’t get a consumer growth story this good anywhere else." - edited excerpt from The One Hour China Consumer Book: Five Short Stories That Explain the Brutal Fight for One Billion Chinese Consumers (Towson Group, 2015). 

Compared with other latecomer countries, China has its own advantages. 

First, with a total population of 1.3 billion people, China contends with a huge domestic market that is rapidly growing. 

Second, although China has faced shortage of rural labor force, the influx of 6 to 7 million college graduates into the job market every year will satisfy an increasing demand for high skilled workers to fuel further growth.

China's manufacturing advantages are conducive to the industrialization of scientific and technological achievements. Over the past three decades, China has achieved enormous economic growth, but its market economy system still has substantial room for improvement.

Manufacturing is going up the « added value » chain: high-speed rail, nuclear power, construction, biotechnology to name a few.

Asia for us continues to be a good value play given they are much more positively impacted by the fall in oil prices but more importantly by the fall in food prices as displayed by Société Générale in a recent cross-asset note:

"Asia is the EM region where the share of food in the consumer price index is the highest on average." - Source Société Générale

With food prices falling for Chinese households, this is indeed an additional boost for discretionary spending as displayed in McKinsey's projection of per-household annual consumption in China by category in percentage terms:

- source McKinsey

China’s consumption strength is real and the economic rebalancing is happening with a growing role of the Services sector as indicated in CITI Asia Macro and Strategy Outlook 30th of March 2015:

“Services sector account for an average of 58% share of EM Asia’s GDP (vs. 22% share in manufacturing), accounted for 43% of real GDP growth in EM Asia over the last decade (vs. 32% contribution from manufacturing sector), and employed 2.3x more people than manufacturing sector to account for the jobs of 35% of EM Asia’s working population (manufacturing accounts for 16% of jobs).”- source CITI Asia Macro and Strategy Outlook 30th of March 201

Strong services demand is linked to rising per capita income leading to stronger consumption. This has generated real sales growth which have been trending up since July 2014

• US and Europe = reducing "equity" versus China increasing "equity"

The "controlled demolition" of their credit bubble has been sustained by the two recent interest rates cuts and the banks' reserve requirement ratios by the PBOC in conjunction with the high level of savings of the Chinese household than can be "redirected" from housing towards an additional "equitization" of the Chinese market as put it by Asia Times in their April 22nd article entitled "China's stealth deleveraging":

" Western analysts remain obsessed with the size of China’s debt problem.
China is gradually deleveraging, though, through the following mechanisms:
1) Equity is slowly replacing debt as the soaring stock market cheapens the cost of equity capital, including at the small-and-medium enterprise level through the Shenzhen and Qianhai stock exchange;
2) Debt is shifting out of the usurious shadow banking market (where loan rates for small businesses can reach 20%) to banks, and to securitized debt markets (Alibaba, China’s e-commerce giant, has listed an asset-backed security based on small business loans on the Shenzhen stock change;
3) The commercial banks are recapitalizing (including $110 billion of preferred debt issuance in 2014);
4) The government is starting to swap high-yield and sometimes dodgy Local Government Financing Vehicles (LGTV’s), the equivalent of US municipalities’ economic development bonds, for provincial bonds backed by tax revenues–at much lower interest rates;
5) The overall level of interest rates is coming down from the highest in world (4% real short-term yields vs. negative yields in most of the industrial world." - source Asia Times

We would also like to make the following point, on the contrary, in the US and now Europe, debt has indeed been replacing equity thanks to debt issuance to fuel a buy-back binge as of late, meaning that leverage once more is trending up, which can be viewed as "credit negative" from a "ratings" perspective. For illustrative purposes, this trend of "releveraging" in Europe can be ascertained in Bank of America Merrill Lynch's graph below from their European Credit Strategy note from the 1st of May entitled "Who has done the deleveraging or not?":

- source Bank of America Merrill Lynch

On a side note, given the particular weaker tone for France's PMI and rising unemployment, as per our conversation "A Deficit Target Too Far" from the 18th of April 2012, we continue to think the following: "We also believe France should be seen as the new barometer of Euro Risk

From a credit perspective not only French "corporates" have been releveraging but in terms of EBITDA, Germany's growth, once again, is making outsized gains thanks to its "mercantilism" approach with its low wages/strong export model helped even more by a weaker Euro as displayed as well in Bank of America Merrill Lynch's European Credit Strategist note:

- source Bank of America Merrill Lynch

And, when it comes to France's unemployment woes, we have yet to see a rise in CAPEX in France clearly showing that French president Hollande's economic's policy is based more on hope than reality as again indicated in the below Bank of America Merrill Lynch graph below from the same report:

- source Bank of America Merrill Lynch

But being French ourselves, we ramble again and get sidetracked in the process. Let's move back to our traditional Chinese medecine má huáng (麻黄).

• China and QE and the myth of the Opium plague

While musing around QE and it similarities with narcotics given our choosing title, we reflected on the history of drugs in China and the myth of the "Opium Plague" as there is indeed a case for the myth of the "QE" plague when it comes to perceiving China's PBOC actions.

Many pundits believe that, China will eventually resort to QE and face a similar demise due to imperialist Britain's most desirable trade commodity namely opium.

From a historical perspective we would like to point towards Frank Dikotter, Lars Lamann and Zhou Xun 2004 book entitled "A history of drugs in China" published by the University of Chicago:

"To this day, the perception persists that China was a civilization defeated by imperialist Britain's most desirable trade commodity, opium—a drug that turned the Chinese into cadaverous addicts in the iron grip of dependence. Britain, in an effort to reverse the damage caused by opium addiction, launched its own version of the "war on drugs," which lasted roughly sixty years, from 1880 to World War II and the beginning of Chinese communism. But, as Narcotic Culture brilliantly shows, the real scandal in Chinese history was not the expansion of the drug trade by Britain in the early nineteenth century, but rather the failure of the British to grasp the consequences of prohibition.
In a stunning historical reversal, Frank Dikötter, Lars Laamann, and Zhou Xun tell this different story of the relationship between opium and the Chinese. They reveal that opium actually had few harmful effects on either health or longevity; in fact, it was prepared and appreciated in highly complex rituals with inbuilt constraints preventing excessive use. Opium was even used as a medicinal panacea in China before the availability of aspirin and penicillin. But as a result of the British effort to eradicate opium, the Chinese turned from the relatively benign use of that drug to heroin, morphine, cocaine, and countless other psychoactive substances. Narcotic Culture provides abundant evidence that the transition from a tolerated opium culture to a system of prohibition produced a "cure" that was far worse than the disease.
Delving into a history of drugs and their abuses, Narcotic Culture is part revisionist history of imperial and twentieth-century Britain and part sobering portrait of the dangers of prohibition." - source The University of Chicago Press Books

In similar fashion we think that the "war on the savers" thanks to ZIRP and QE, that, in the future historians will paint a sobering portrait of the dangers of meddling with markets and interest rates, but we are ranting again.

When it comes to "easing" the POBC will be launching soon its own credit-easing but in no way a QE sort of program as interestingly described in Asia Times on the 28th of April in their article "PBOC goes back to drawing board on bond/loan swaps":

"After going back to the drawing board, the People’s Bank of China now plans to launch its own version of the credit-easing programs seen in the U.S. and Europe, reported the Wall Street Journal on Tuesday.
The central bank will allow Chinese banks to swap local-government bailout bonds for loans as a way to bolster liquidity and boost lending, said the Journal.
The big problem is that in an effort to stimulate the economy regional governments have borrowed huge amounts of cash to fund infrastructure projects, said the Financial Times. Now the Chinese economy is slowing down and many citizens are pulling huge amounts of capital out of the country and investing it overseas. But as the property and manufacturing industry suffer, policy makers want to cushion the economic slowdown into a soft landing with more infrastructure spending.
Amid all this many of these loans are coming due. So the central bank wants to help the local governments by converting short-term high interest loans into low-interest long-term bonds.
Strictly speaking it’s not quantitative easing. The central bank just wants more people to buy the debt of the cash-strapped local governments. And one way it hopes to accomplish this is by letting institutions use the debt as collateral for loans to commercial lenders. China’s Finance Ministry said it would do this by allowing heavily indebted local governments to sell new bonds with explicit government guarantees to replace their existing debt — mostly bank loans,” said the Journal" - source Asia Times

Hence our title, this PBOC monetary policy amounts to "Ephedrine" or "Opium", not the highly addictive "heroin" QE like embraced by central bankers of the BOE, FED, BOJ and ECB.

We agree with Asia Times. This does not amount to QE.

Nomura also shared the same views on the 28th of April in their Asia Insights note entitled "China QE on the way? No!":

"Is the PBoC’s liquidity injection equivalent to a Chinese version of QE? No. QE, in essence, is a monetary policy regime change with an accelerated expansion of a central bank’s balance sheet while policy rates are close to zero. Given China’s monetary background, QE would mean a more aggressive expansion of the PBoC’s balance sheet, but this is not what is happening. As explained above, the recent liquidity injections have mainly been to offset shrinking FX purchases in the maintenance of the normal expansion of the central bank’s balance sheet. The bottom line is that there is no extra liquidity growth in terms of the monetary base or broad money (M2) from the PBoC’s liquidity injections.

Will the PBoC inject liquidity by buying local government bonds? Unlikely, and not in any QE way. First, the PBoC is forbidden by law to buy government bonds directly; second, the primary aim of injected liquidity is to provide the monetary base rather than bailing out local governments. The PBoC already has enough tools to create the monetary base, so has no need to buy government bonds in the secondary market. That said, we suspect that the PBoC may participate in local government bonds in some way in future. According to a recent Xinhua article, local governments have had difficulty in issuing bonds as banks are reluctant to buy them at such low yields.1 To encourage the banks to replace current high yield local government debt – mainly in form of loans and LGFV bonds – with low yield local government bonds, the PBoC may need to provide banks with some compensation via RRR cuts or low interest rate re-loans, or some other creative arrangement. In particular, as the policy banks – such as the China Development Bank (CDB) – hold lots of local government debt, there could be some special arrangement between the PBoC and CDB in future to deal with a debt swap.

To sum up, we believe the PBoC will continue to ease monetary policy through RRR cuts, rate cuts and liquidity injections. But QE is not the correct term to describe the PBoC’s framework of monetary easing – because its balance sheet has never stopped expanding and will not suddenly jump due to asset buying like that of the Fed, ECB and the BOJ." 

- source Nomura

Indeed, as depicted by Professor Frank Dikotter  in an inaugural lecture given in 2003 and entitled "Patient Zero": China and the Myth of the "Opium Plague", is the growing "demonisation" of central banks intervention when it comes to assessing the "QE" factor such as the PBOC:

"Another problem which needs to be addressed is the demonisation of 'opium' into a single and uniform substance. The paste varied immensely in strength and quality, while many consumers were connoisseurs who could distinguish between a large variety of products, ranging from expensive red Persian opium to qualitatively poor local produce. Opium is an extremely complex compound containing sugars, gums, acids and proteins as well as dozens of alkaloids which varied in proportion and content. General statements about the purported effects of 'opium' are thus as vague as blanket condemnations of 'alcohol': a world of difference existed between weak homebrewed beers in medieval Europe and strong spirits in Victorian England, and both were used in radically different social contexts. Most of the imported paste from India and the locally cultivated opium in China had a very low morphine content, on average 3 or 4 per cent. On the other hand, the opium imported every year into England from Turkey in tens of thousands of tonnes was very rich in morphine, ranging from 10 to 15 per cent. Moreover, smoking was generally acknowledged to be more wasteful than ingestion, although the morphine content reached the bloodstream more quickly and caused a rush: 80-90 per cent of the active compound was lost from fumes which either escaped from the pipe or were exhaled unabsorbed by the smoker." - source Professor Frank Dikotter.

In similar fashion, China's current's monetary easing stance has a very low morphine content whereas the BOE, the FED, the BOJ and the ECB's QE have become highly addictive and are more akin to heroin than opium we think. As pointed out by Professor Frank Dikotter's lecture, opium was a medical panacea for many working people before modern synthetic medications became available in similar fashion "Ephedrine" is used a stimulant for the "ailing" Chinese economy by the PBOC.

• Final note: Dr Copper,  the metal with the economics Ph.D is still in a bear market

While Dr Copper, the metal with the economics Ph.D has seen a recent rally, as a final note this was merely driven by short covering as indicated by Bank of America Merrill Lynch's Global Metals Weekly note from the 1st of May entitled "Do you believe in the copper rally":

"Near-term strength, followed by weakness
We believe the immense weakness of copper prices in the first quarter was driven partially by flows, so was not entirely justified. As such, we kept an average 2Q15 forecast of $6,150/t ($2.79/lb). Considering more policy support by Chinese authorities and keeping in mind that demand usually strengthens seasonally after winter, prices may rally further through 2Q, a point we made in various notes. Yet, that rebound does not change our view that copper fundamentals are structurally challenged, with prices likely coming under renewed pressure in 2H15 and 2016 at the latest" - source Bank of America Merrill Lynch

Of course we agree as we are not "believers" in the copper rally.

"Religion is the opium of the masses."- Karl Marx

Stay tuned! 

Credit - The Secondguesser

"Do not try to second-guess or master-mind our military officials. Leave this for established military analysts and experts, who are experienced enough to await the facts before drawing conclusions." - Broadcasting magazine, December 1941

While playing with interest the Hang Seng Index rally game given we have taken some exposure since the 30th of March and enjoying the ride so far, we reminded ourselves the definition of "second-guess" for our title analogy, as it can be of two folds:

1. To criticize and offer advice, with the benefit of hindsight.
2. To foresee the actions of others, before they have come to a decision themselves.

Of course when it comes to our "Asian allocation", we have indeed played number two and decided to "front-run" somewhat the appetite for Chinese investors moving from Shanghai towards Hong-Kong when it comes to their regional "appetite". As far as our title is concern and the choice of allocation, it stems from learning from the wise Charles Gave of Gavekal research for whom we have great respect: 

"if there is more money than fools then market rise, and if there are more fools than money markets fall"

In the case of the HSI, there is indeed more money than fools, whereas when one look at the European government bond markets and in particular the state of the corporate Hybrid debt market we touched on last week, there are indeed more fools than money in Europe. This ties up nicely to definition number 1 for "second-guess" and the benefit of hindsight, given that the "bond" risk in Europe doesn't justify anymore the reward we think.

A commonly used meaning of "to second-guess" is to criticize the actions of others, after the event. On this blog, we try to criticize the actions before the events. When it comes to choosing our title we also reflexionated around the meaning and the origin of the expression as defined by Gary Martin:

The umpire in a baseball game used to be called, rather unkindly, 'the guesser'. People who were continually telling the guesser, the manager or the players what they were doing wrong were known as 'secondguessers' and were so defined in the Sporting News Record Book, 1937:
"Secondguesser, one who is continually criticizing moves of players and manager."

Therefore one could unkindly define us as being "Seconguesser" when it comes to assessing the macro and credit environment and the decisions taken by our brazen central bankers, but we ramble again. Although one could indeed unkindly defined as "Secondguessers" with these few examples:

• we have been short yen since November 2012 when the Japanese yen was trading around 80 as described in our conversation "Cold Turkey" (partly via ETF YCS) guessing that the Bank of Japan had a lot of catch-up to do when it came to QEs and expanding its balance sheet .
• Following the BOJ move, in early 2013 we went long Nikkei but in "Euros" via a quanto ETF (currency hedged).
• Of course our biggest 2014 call has been to go long US duration in January (partially via ETF ZROZ).

As per our January 2013 conversation, "If at first you don't succeed...", we have repeatedly broken our Magician's Oath:
"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

We have to confide, that we have continued to become clear "Seconguessers" as per definition number 2 above when it comes to "second-guessing" the "Black Magic" practices of our magicians of central bankers and their "secret illusions".

So never mind the practices of our "dark sorcerers apprentice", as in this week conversation, while we will briefly touch on the attractiveness of Asia versus Europe, we will look at the supposed end of the European banks/sovereign nexus particularly in the light of the latest Icelandic proposal, namely the Sovereign money proposal which we think is a must read.

Synopsis:

• Yes, for now Asia is a buy and it will continue to be so
• A large number of European banks still destroy value
• Many Southern European banks are still capital impaired
• Don't count on the end of the banks/sovereign nexus in Europe
• Final note: Flows have lagged performance in EM

• Yes, for now Asia is a buy and it will continue to be so

As me mentioned, playing our "Secondguesser" role has meant we have gotten on the HSI exposure since the 30th of March and we do believe in the compelling valuation story in Asia, regardless of the recent parabolic rise in the equity space.

So one might wonder why there has been such a rally in the equity space. It all has to do with the collapse in China money market rates as displayed by Bank of America Merrill Lynch in their recent Liquid Insight note from the 15th of April 2015 entitled "What's driving China rates":

"More to lower rates than just policy easing
The rally in the China stock market since March has been significant and in our view at least partly related to expectations of policy stimulus, as reflected in lower rates (Chart of the Day). In particular, there has been a lot of focus on China’s money market rate – the 7-day repo – which has dropped about 200bp to 3.0%. The decline should come as no surprise as market rates were high relative to inflation, and high real rates were probably the last thing the government wanted to see given the slowdown in investment and economic growth. The market move has been consistent with our view that 7d repo should come off to 3.0-3.5% in the short term.

But a closer analysis suggests banks’ liquidity management also played an important role in the decline of repo rates, over and above the PBoC’s policy guidance. The question is how fast and to what extent can money market rates fall from the current low level, in particular after the latest weaker-than-expected financing and economic data. We argue that the 7d repo rate could fall moderately further to an average of 2.5-3.0% in the coming months, but that the sharp decline of recent months seems unlikely to repeat itself." - Bank of America Merrill Lynch.

We are not the only one thinking about the China "reflation" trade as we see maverick money manager Stanley Druckenmiller recently commenting on this very subject on April 15th in Bloomberg article from Katherine Burton and Stephanie Ruhle entitled "Druckenmiller Bets on Market Surprise With China Boom, Oil Rise":

"Chinese stocks have soared with the Shanghai Composite Index doubling in the last 12 months.
“Whenever I see a stock market explode, six to 12 months later you are in a full blown recovery,” he said.
A recovery in China, the world’s second-biggest economy, would influence securities and commodities prices around the globe, said Druckenmiller. For instance, it would send German government bond prices lower, boost European exporters and lift the price of oil, he said in a separate interview." - source Bloomberg

When it comes to valuation, while the rally in Asia has been epic, when it comes to Europe, we would rather "cash in" given current valuation levels as displayed in the latest note by Louis Capital Markets from the 13th of April entitled "Three For The Price Of One" where one can see in their bonus chart the percentage of Stoxx Europe 600 members trading above their 200-day Moving Average:

 - source Louis Capital Markets

With the liberalization of personal account rules in China and a forward PE around half of the S&P500 and a free cash flow yield or around 20% according to Asia Times, Hong-Kong appears to us a better "value proposition" in these global inflated markets if we would need to second-guess investors' appetite.

• A large number of European banks still destroy value

When it comes to Europe and in particular many points to cheap valuation in the European banking space. As we have argued in our conversation "The Pigou effect" in February this year, we have argued around the "japanification" process of Europe:

"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 "japanification process can be seen with the rapid disappearance of "positive" yields in the European Government space with German Bunds closing on the zero bound.

We have also long argued that regardless of QE, ZIRP and AQR, European banks would be facing continued deleveraging and that both bondholders and shareholders alike would in many instances get punished for their holdings. The reason is that European banks, in many cases still destroy value. On this subject, we read with interest Nomura's EU banks strategy note from the 10th of April entitled "Why European banks still destroy value":

"Why do half Europe's banks not make a 10% cost of equity?
Even by 2016, Bloomberg consensus implies that half of Europe’s larger banks will not make a return on tangible equity above their historical 10% cost of equity. This contrasts with US banks where almost all exceed the hurdle.
In this report, we decompose profitability to identify the main drivers. Low ROE banks are mainly a result of higher costs, and to a lesser extent higher provisions and higher taxes. Margins (mix) and leverage together account for less variation between high and low ROE banks. Nordic and Benelux banks show the highest ROEs, while German and Italian banks are lowest, with UK, France and Spain around the 10% hurdle.
How and where can banks improve their profitability?
We show that cutting costs would deliver the biggest improvements in ROE, but given the consistency of national cost/income ratios, much of the differences in costs appear to be structural. Although most banks have some form of cost reduction plan in place, few target an absolute reduction in the cost base, suggesting it will take some time for banks in the least profitable countries to converge their ROEs (hence valuations) with the best in class." - source Nomura

Truth is most European banks offer poor value in terms of returns as shown in Nomura's report:

"Even by 2016, Bloomberg consensus implies that half of Europe’s larger banks will not make a return on tangible equity above their historical 10% cost of equity. This contrasts with US banks where the average ROTE of banks in the BKX index is just over 13% and where almost all exceed the10% hurdle."

- source Nomura

As pointed out by Nomura's note we were note surprise to read that US banks higher ROE was driven by fewer lower risk mortgages on balance sheets:

"The higher ROE of US banks is driven by higher revenue margins given fewer low risk mortgages on balance sheet. This (and to a lesser extent a lower cost of risk) helps compensate for a considerably better leverage (equity/assets), as well as a slightly higher cost/income ratio and tax rate."

This is not a surprise for a "secondguesser" as we have highlighted on numerous occasions the very important concept namely the accounting principles of "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."

After all, credit growth is a stock variable and domestic demand is a flow variable. We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe:

"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012.

Of course, the availability of credit is only beginning to be restored in Peripheral Europe and has been encouraged by the ECB's recent QE.

The core of our macro thought process is based upon the difference between "stocks" and "flows", which we highlighted when discussing the growing difference between Europe and US growth (see our post "Shipping is a leading deflationary indicator"). The same approach can be applied in relation to the growing divergence between US banks versus European banks we think. 

This difference can be ascertained from the difference in return on assets for EU banks versus US banks as displayed in Nomura's recent report:

- source Nomura

Given the amount of deleveraging that still needs to occur in the European banking space, this divergence will continue to grow.

Although European banks have risen 16% YTD, they are still underperforming the market and when it comes to their peers in the global space they do stand out less cheap as indicated by Nomura in their report:

"EU banks stand out less as cheap vs global peers …
With the 16% rise in European banks YTD, the market capitalization weighted SX7P banks index trades at 1.2x 2015E TBV for a consensus 2016E ROTE of 11.7%, which limits aggregate re-rating opportunities (absent a sustained fall in the cost of equity).
At a global level within the banking sector, European valuations generally appear proportionate to forward ROE expectations, with some countries already implying further profitability improvements." 

- source Nomura

When it comes to a better "value" proposal, China stands out as having much better 12m forward ROE. It is also not a surprise for a "Secondguesser" to see Chinese banks listed on the Hang Seng China entreprises index rallying hard as well as indicated by Asia Times in their article from the 15th of April entitled "Chinese bank soar on valuations":

"Industrial and Commercial Bank of China led gains on the Hang Sang China Enterprises Index overnight, up 4.86%, followed by China Construction Bank (+4.39%), Bank of Communications (+4.31%), China Minsheng Bank (+3.93%), Bank of China (+3.56%) and Agricultural Bank of China (+3.50%). Banks rallied after ICBC reported mediocre 4th quarter earnings, with a big pop in loan loss provisions and a modest decline in YOY net revenue.
Mediocre is beautiful when stocks are cheap. Chinese banks non-performing loans were a mystery wrapped in an enigma wrapped in plastic explosive, and the market bid down bank stocks because of uncertainty about future write-offs. A year ago, ICBC traded at a multiple of just 4 to earnings. Now investors are convinced that banks can earn their way out their bad loss positions over time, and bank multiples have recovered–to just one-third their pre-2008 levels.
At the peak of the 2007 China equity boom ICBC traded at 21 times earnings, or three times its present valuation. The bank stock recovery reflects greater confidence in regulatory transparency under the ongoing financial reform regime. The banks have gone from distressed valuations to merely low valuations.
As global managers pile into the China trade, moreover, bank stocks are among the few vehicles with enough market capitalization and liquidity to meet the requirements of large portfolio managers." - source Asia Times

From a "second-guesser" perspective, there is indeed better value in Asia at the moment and particularly in the banking space we think whereas European banks doesn't offer that much value particularly when one takes into account the quality of capital in Southern European banks. This brings us to our next item

• Many Southern European banks are still capital impaired

Many Southern European banks' capital basis are made up for a large part of Deferred Tax Assets (DTAs) as reported by Nomura in their Southern European Banks report of the 7th of April entitled "Quality of Capital":

"Deferred tax assets (DTAs) under the microscope
European authorities are reported to be considering whether or not the legislation and guarantees on DTAs in southern Europe can be considered state aid (FT, 7 April 2015). This is in addition to the ECB looking for greater harmonisation of European capital ratios by attempting to correct for some of the different national definitions.

How big an issue are DTAs for southern Europe?
DTAs have increased significantly in southern Europe over the past few years (generated by the significant losses incurred by many of the banks). However, under Basel III’s definition, the bulk of the DTAs will be deducted from capital ratios (a change vs the previous regulatory environment). To minimise the impact of this regulatory treatment, many countries in southern Europe enacted legislation to limit the impact of this deduction. DTAs currently represent c42% of tangible equity in southern Europe and contribute a median of c300bp to core capital ratios.

Raise capital or improve quality over time? 

Given the extent and the size of the DTAs in southern Europe, and taking into account political considerations, we think it unlikely that the banks will be forced to raise capital specifically to address this issue. However, with the ECB increasingly looking to harmonise capital ratios, the banks could be required to continue to build and strengthen capital ratios over time. This issue could also be a hurdle to those banks looking to significantly increase dividends or payout ratios. For the moment though, the majority of dividend policies for southern European banks target moderate payout ratios of c40%- 50% (with Intesa the one major exception – targeting a payout ratio of c70% in 2015 and c82% in 2016)." - source Nomura

Hence our negative stance on European Banks and Southern European Banks in particular given the additional "real capital" that is needed to compensate for the "favorable" DTA treatment offered by the local regulators.

The exposure to DTAs while often overlooked when it comes to the quality of capital is not trivial as per the same report and is very significant in the Spanish banking system as indicated by Nomura in their report:

"Exposure to DTAs
As we can see from Fig. 1 banks in southern Europe have built up significant amounts of DTAs. In Spain alone total DTAs reached cEUR 77bn in 2013, although net DTAs (ie, net of tax liabilities) were cEUR 68bn. Low levels of profitability have meant that for the moment the amount of DTAs continues to increase.
Under Basel III, the treatment of DTAs is harsher vs the previous regulatory regime. However, in an effort to minimise the negative impact on capital from holding large levels of DTAs, governments in southern Europe have enacted legislation to reduce some, if not most, of this impact. In Spain, for example, the value of the DTAs is underwritten by the Spanish government. The DTAs that are not used up within 18 years are considered a credit against the Spanish government and exchangeable for Spanish public debt. Of the total amount of net DTAs in Spain, the government has guaranteed c 60% or cEUR 40bn. As we can see in Fig. 2, DTAs account for a significant part of the current capital ratios for the banks.

Our base-case scenario is that the banks do not have to raise capital to specifically address this issue. However, we do believe capital ratios could be raised to higher levels. The level of DTAs could also affect banks looking to raise payout ratios to high levels or significantly increase dividends, although most dividend policies are targeting a moderate payout ratio of c40%-50% (which we believe is achievable)." - source Nomura

When it comes to "capital", what matters therefore is the "quality" of the capital. In the case of some Spanish banks, the capital levels made up mostly by DTAs are not sufficient regardless of the AQR. Given in the case of Spain, these DTAs constitute a "credit" against the Spanish government and are exchangeable for Spanish public debt we doubt this marks the end of the banks/sovereign nexus discussed in our next bullet point.

• Don't count on the end of the banks/sovereign nexus in Europe

As highlighted by the DTAs issue in our last bullet point, the last couple of years have seen the banks/sovereign nexus increasing thanks to the "carry trade" financed by cheap LTROs allowing Peripheral banks to gorge on the domestic debt of their country (Italy and Spain). On the subject of the banks/sovereign loop in Europe we read with interest Bank of America's take on the subject in their Euro Area Economic Viewpoint from the 13th of April entitled "Towards the end of the banks/sovereign nexus":

"Banks/sovereign loop in the EA was worse, absent QEIn the Euro area, the impact of the banks/sovereign negative feedback loop was even more acute than in the rest of the developed world, given the tardiness in addressing the structural issues of the banking sector and more fundamentally because, in the absence of QE, banks played the role of marginal lender to the government - thanks to the ECB's generous liquidity policy - at the expense of funding the private sector.

But things are improvingHowever, thanks to progress in the capital position of banks and the new "presumption of bail-in" - which in our view could only come after the most acute systemic banking risks were actually alleviated thanks to government support (e.g. in Spain) - member states' exposure to the financial sector has now fallen. This liberates more room for manoeuvre for counter-cyclical fiscal policy. The recent shift, in the Euro area, from all-out austerity to a neutral, or even slightly stimulative, fiscal stance would not be sustainable, in our view, if government faced massive contingent liabilities.

And QE will help reduce the loop even further
At the same time, to wean banks off lending to the governments at the expense of the private sector without jeopardizing the governments' funding capacity - which would be equally detrimental to economic growth - the Euro area needed to find an alternative marginal lender. This is achieved by QE. In a nutshell, QE is the necessary complement to banking union and the Single Resolution Mechanism to break the banks/sovereign nexus. This is another, indirect, transmission mechanism of QE to the real economy. Under cover of QE, we think that the regulatory authorities will try to incentivize banks to reduce their exposure to sovereigns. This is the message that Daniele Nouy, head of SSM, sent in a recent interview in the Handelsblatt, in which she opined that holdings of government bonds should be limited to a quarter of banks' equity." - source Bank of America Merrill Lynch

We disagree with the aforementioned progress made in the capital position of banks, particularly in the light of the DTAs for Southern European banks. While QE will certainly try to incentivize banks to reduce somewhat their exposure to sovereigns, we have a hard time seeing most of these banks part with some of their highly collateral such as German government bonds due to bond scarcity with the German budget being balanced and the reduction in their debt to GDP level.

In the US the problem were dealt swiftly and differently as highlighted by Bank of America Merrill Lynch's note:

"In the US, vigorous monetary policy action - in the form of early QE - managed to offset much of the fiscal drag. To put things simply, if fiscal support is unavailable and sensitivity to interest rates is lower, then monetary policy needs to "go an extra-mile'. In our view, QE in the US has been instrumental in making sure the economy remained on the recovery track in spite of a i) effective fiscal drag and ii) unprecedented threats of "catastrophic withdrawals" in public spending, with the various "debt ceiling" and sequester episodes. The UK is another example of a country which managed to control the impact of a major fiscal drag - after a just as major public bailout of the financial system - thanks to extraordinary monetary support.

In the Euro area, in our view, the "banks/sovereign" nexus played a more acute role than in the US and the UK, not simply because monetary policy did not offer as much support, at least until very recently, but more fundamentally because the "banking issue" had a more durable, complex and pervasive effect on the economy and policy-making.

The banks/sovereign nexus is bad everywhere, but it's even worse in Europe
The reaction of the US authorities - after the initial "bail in" temptation on Lehman Brothers - was remarkably swift. Forcing a recapitalisation and imposing management decisions on banks complemented state support on liquidity. In Europe, while support came very quickly, there was comparatively little attempt at dealing with the structural issues surrounding the national banking systems. Probably to some extent because European policy-makers considered that this was primarily an "Anglo-Saxon crisis", the onus was on dampening the contagion effects of a New York born financial meltdown, without necessarily a clear awareness of the depth of the local difficulties.

This timing difference is plain to see in banks’ capital to asset ratio across the regions (see Table 3).

For simplicity of analysis, we look here at total assets, not risk weighted assets. This measure, which we take from the IMF’s financial stability report, is therefore close to a leverage ratio. Before the Great Recession, the ratio was already much higher in the US than in Europe (roughly twice as large), but what is striking is that within only three years, it had already improved by more than 2 percentage points. The best European performer during this period (France) managed an increase of only 1.2 pp, from a very low starting point.
The irony, then, is that the Europeans ended up spending slightly more government money on their banks than the Americans (4.9% of GDP instead of 4.5% of GDP for on-balance sheet expenditure alone) while triggering a much smaller improvement in their banks' capital position. To some extent, this mechanically reflects the difference in size between the two banking systems - the same public spending in % of GDP has a much lower impact on the financial position of the much larger European banking sector - but we also consider that, at least at the onset of the crisis, European governments failed to emulate their US counterpart in making public support conditional on significant and rapid efforts from banks under their jurisdiction to deal with their underlying problems.
Europe’s tardiness in dealing with the structural issues of the banking sector proved particularly toxic given the much more central role it plays in funding the economy, relative to the US. Indeed, in the US bank loans accounted for only 20% of the total liabilities of the corporate sector before the Great Recession, roughly half the proportion found in the Euro area (see Chart 2). 

It was not only a matter of quantities but also, as suggested above, of price. As we have argued before (see EEW), the health of the demand and particularly the supply of credit are key to understand the broken transmission of monetary policy, the very limited sensitivity of lending rates to policy rates in most of the periphery for most of the post-crisis period and the increased sensitivity of lending rates to sovereign yields.

Another consequence of the belated reaction of the European public sector was, that by the time the banking sector was blatantly on the brink of collapse in number of countries, the governments there had already lost market access – or at the very least was already paying crippling interest rates – precisely on account of the market’s anticipation of the bailout costs. Spain probably is the best example of this type of behaviour. Exactly at the time public sector support became crucial, its cost was impossible to shoulder.
This gets us to the second significant difference between the US and the Euro area as far as the "banks/sovereign nexus" is concerned: the "imperfect mutualization issue". In the US, even if various bodies compete in the regulation of the banking industry, two centers of decision matter: the White House and Congress, as it is ultimately a federal issue. In the Euro area, a major difficulty arose from a discrepancy, across member states, between banks' need for funds and fiscal capabilities. Ireland is the best example of this. As it can be seen in Table 2, the total of approved support to the financial sector there - on and offbalance sheet potential liabilities - amounted to 500% of GDP, while the effective cost of support exceeded twice local GDP."

   - source Bank of America Merrill Lynch

In the US QE was more effective for a simple reason: stocks vs flows as highlighted earlier. The problems facing Europe and Japan are driven by a demographic not financial cycle. 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. As shown above in our post in Nomura's chart,  the difference in return on assets for EU banks versus US banks improved much faster in the US thanks to the swift approach by the US in dealing with the crisis as well as their existing resolution framework absent in Europe at the time.

The main reason we had recession and credit crunch in Europe was the ill-fated decision of the EBA to impose banks to reach a core tier one level of 9% by June 2012.

Of course the 2011 debacle was avoided by LTRO 1 and 2 but what the "geniuses" at the EBA did not understand was that European banks were "capital" constrained hence the speed of the deleveraging and the epic credit crunch (Italy/Spain) that followed which led to a fall in "Aggregate Demand" a point which we agree with Bank of America Merrill Lynch:

"The political balance within the central bank - compounded by, until recently, the absence of clear deflationary pressure at the aggregate regional level - made it impossible to break this negative feedback loop via direct purchases of government bonds, which at the very least would have isolated sovereign funding costs from the consequences of the banking crisis.
Instead, the ECB approach - understandable from an emergency management point of view - added another layer to the banks/sovereign nexus by turning the banks into the lender of last resort of their local sovereign. Indeed, the ECB, by allowing access to long term cheap liquidity, through the LTROs, allowed banks to engage in safe carry-trade, parking liquidity into government bonds at a time when non-residents were leaving the periphery in droves.

Banks always tend to skew their asset allocation towards government bonds in bad cyclical times, as the demand for credit from the private sector diminishes while the quality of the banks' loan books deteriorates. Still, the ECB's generous approach to liquidity clearly was a facilitator. Italy in our view managed to avoid a recourse to the EFSF/ESM only because banks, which in 2009 held only 14% of the stock of public debt, ended up absorbing 75% of the increase in public debt between 2009 and 2014.

This was probably an acceptable "second best" to QE in terms of maintaining some funding capacity for embattled governments, as well as keeping the banking sector alive in the absence of clear progress on recapitalisation and balance sheet clean-up, but such approach presented the major risk of keeping the real economy into a recessive regime. Indeed, in this configuration, peripheral banks could make a more than decent living purely on the carry-trade, with little incentives for them to try to re-start lending to the private sector." - Bank of America Merrill Lynch

And of course the above approach, for any reasonable "Secondguesser" led the real economy into recessive regime thanks to the "crowding-out" effect mentioned in numerous conversations.

Where we slightly disagree with Bank of America Merrill Lynch is that while QE seems to be a necessary condition to alleviate the distortion created on Peripheral banks' balance sheet when it comes to their overall exposure to their sovereign, it is creating yet another distortion in "valuations" triggering in effect financial instability on a grand scale:

"Beyond institutional progress on banking union, QE is the necessary condition for breaking the banks/sovereign nexus
The two key institutional elements allowing the Euro area to deal with the banks/sovereign nexus are i) the Single Resolution Fund, funded by the banks and ii) the possibility, finally adopted on 8 December 2014, for the ESM to recapitalize banks directly, i.e. without leaving the financial cost, ultimately, on the balance sheet of the sovereign in the concerned banks' jurisdiction. These two instruments' capability is limited (1% of insured deposits for the first one and EUR 60bn for the second) but this is a first, important step towards a mutualization of the banking risk across the Euro area, which is in our view made possible by the federalization of banking supervision under the SSM framework.
In both cases, however, in principle mutualized support can be triggered only after a bail-in of the private creditors. This leaves the "financial stability" issue unanswered. Indeed, if the Euro area was faced with a major banking incident in which "burning" private shareholders and bondholders would trigger an unstoppable, generalized crisis, it remains unclear how a collective response would be organized." - source Bank of America Merrill Lynch

QE on its owned as we have argued recently is not enough to put Europe on the right track as we pointed out in our conversation "Chekhov's gun":

"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, November 2014 

QE without private demand for funds only generates bubbles. The liquidity it supplies will not enter the real economy as long as there are no private sector borrowers. From our take, as "secondguessers" the Icelandic proposal of Sovereign money would break this toxic nexus between banks and sovereigns. To explain further why the Icelandic proposal is very appealing we would like to re-quote Dr Jochen Felsenheimer from asset management XIAI we used in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!" in September 2011:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy." - Dr Jochen Felsenheimer

Looking at the current stalemate surrounding Greece in particular and Europe in general nothing has really changed from our "secondguesser" perspective.

• Final note: Flows have lagged performance in EM

While some EM markets have continued to post on stellar performances, there is indeed a disconnect between EM equity flows and EM equity performance as displayed in Bank of America Merrill Lynch's recent Flow Show note from the 9th of April entitled "EM Disconnect":

"Europe hogs the spotlight: $3.9bn inflows this week, extending inflow streak to 13…
…meanwhile EM can’t catch a bid: flows have lagged performance (Chart 3); 8 straight weeks of outflows from China equity funds (despite her being the best performing global market past 12 months) and LatAm equity funds only see a tiny $37mn after 9 straight weeks of outflows" - source Bank of America Merrill Lynch

As "secondguessers", we would expect flows to resume in the coming weeks/months.

"Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcome after-effects. Their precise nature is anyone's guess, though one likely consequence is an onslaught of inflation." - Warren Buffett

Stay tuned!

Guest Post - US Corporate Profits Under Threat

"Human behavior flows from three main sources: desire, emotion, and knowledge."- Plato

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 corporate profits in the United States surprising on the downside in coming quarters:

Michal Kalecki was a Polish neo‐Marxist economist who, during the mid‐30s, undertook the difficult task of explaining why, contrary to Marx’ predictions, corporate profit rates in capitalist societies were not converging towards zero.

The starting point of his argument lies in the fact that an economy can only save (i.e. increase its aggregate wealth) by investing. Kalecki’s profit equation therefore begins with the following equation:

Saving = Investment

If we divide saving into Business Saving (= Profits after taxes and dividends) and Non‐business saving (Personal saving + Foreign saving + Government saving), the equation becomes:

Profit after taxes and dividends = Investment ‐ (Household + Foreign +

Government) savings

=> Profit after taxes = Investment + Dividends ‐ (Household + Foreign + Government) savings

The Kalecki profit equation is not a mere macroeconomic model. It is an accounting identity that remains true at all times. One can always verify its validity by checking the following items in the National Income and Product account.

Interestingly, the Kalecki equation implies the following paradox: although the business sector often advocates for balancing governments’ budgets, the Kalecki equation undeniably shows that a large part of corporate profits actually derives from budget deficits. It has certainly been true over the last 70 years.

Following Kalecki’s equation, the fiscal cycle can be used as a lead indicator for corporate profits and the business cycle.

In a recently published piece, John Hussmann explains that because in the US, investment,dividends and foreign savings usually cancel each other, the Kalecki equation can be reduced to:

Corporate profits = ‐ (government + household savings).

In recent years, this has however not been the case. Investment rose while the current account improved (imports‐ exports= foreign savings). Therefore, as the chart from Hussman’s blog shows, the relationship broke down over the last 5 years.

- source Hussman funds

This explains why, despite reduced savings from the combined government and household sectors, profits have held up quite well. Part of the answer comes from quantitative easing. Debt issuance to repurchase shares has artificially lifted profits. Additionally, the last few years also correspond to the shale oil revolution. It is therefore possible that with a lower energy bill, the US was able to “self‐finance” investments without the usual help of imported foreign savings. The question is, can that last now that QE is over and with the FED about to lift interest rates? Given the strength of the dollar and the weakness of the global economy, the most likely scenarios are that investment weakens and/or that the current account improvement goes into reverse. Already, capital goods’ spending is weakening, and the oil crash has increased the odds that it will weaken substantially more.

Furthermore, over the last 3 years, consumers have tapped into their savings. The saving rate went from a high of 8.5% in 2012 to 4.5% today. It is unlikely that the saving rate will drop further given 1/ the close memory of 2008 2/ demographics 3/ current households behavior (consumer are using their strong cash flows to pay down debt).

At more than 600% of GDP, the US government + unfunded off balance sheet debt leaves no options on the fiscal side of the Kalecki equation when the cycle turns.

As a result the boost to private consumption from consumers is unlikely to be repeated. And since government dissaving has more than offset consumer spending it is likely that profits will surprise on the downside in coming quarters. Even more so, if investment weakens on top.

We can also observe a strong link (with a lead) on both corporate credit spreads….

and thus equity volatility.

As we have shown recently, the strength of the US currency is another threat to corporate profits and forward earnings estimates. When the supply of dollars globally shrinks (budget and current account improve together) overseas earnings tend to crash, hence the relationship below.

Current consensus believes that extremely low yields and energy prices will more than offset these threats.

With US equity volatility as mispriced as it was back in 2007 according to our model, now is not the time to be overly complacent.

Finally we would like to also add an important point made by David Goldman which can be found on Reorient Group's website from his note from 31st of March entitled "US Corporate Profits Inflated by Undersestimated Depreciation":

"If the United States wants to attract Chinese investors, it had better improve accounting standards. That sounds like the beginning of a joke, but it’s not. There have been isolated cases of accounting fraud in Chinese companies listed on US exchanges, but there appears to be systematic distortion of US corporate profits across the board. The issue is depreciation of plant and equipment. This is another reason we don’t like US stocks at present valuations.

Before-tax earnings of US companies in the GDP accounts are reported two ways: with Inventory Valuation Adjustment (IVA) and Capital Consumption Allowance, and without. The two measures have diverged by about 25%, or US$500 bn, since 2012. That’s a big divergence. The stricter measure (based on the Commerce Department’s depreciation model) shows that Q4 corporate profits in 2015 were lower than in Q4 2011; the looser measure shows substantial growth. Note that the S&P 500’s earnings per share track the higher, not the lower number."

- source Reorient Group

"When growth is slower-than-expected, stocks go down. When inflation is higher-than-expected, bonds go down. When inflation is lower-than-expected, bonds go up." - Ray Dalio

Stay tuned!