Macro and Credit - The Great Wall of China hoax

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

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

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

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

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

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

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

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

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

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

Synopsis:

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

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

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

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

"Heading for a world predicted 150 years ago

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

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

NIRP transforms low-yielding properties into non-performing assets

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

String of failures

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

To avoid the extreme ultimate decision

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

Bursting of "quiet bubble" to accelerate in 2017

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

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

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

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

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

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

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

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

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

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

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

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

Young Americans living w Parents*

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 (click to enlarge)

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

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

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

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

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

"When expanded low-yield properties become nonperforming assets

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Second culprit is excessive focus on ROE

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

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

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

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

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

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

"Need to avoid ultimate decision

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

- source Bank of America Merrill Lynch

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

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

Stay tuned!

Macro and Credit - Tantalizing takeoffs

"When everything seems to be going against you, remember that the airplane takes off against the wind, not with it." -  Henry Ford

Watching at the dizzying summits reached by US stock market indices with the Dow flirting with 20,000 on the back of the Trump rally, as we move towards the final days of 2016, with a continuation of US Treasuries getting pummeled, when it comes to selecting our title analogy, we decided to go for a vintage flying analogy this time around, "Tantalizing takeoffs" being the nickname for the 50th Beechcraft AT-11 Kansan AT-11 built in 1941 and being currently the oldest flying. The AT-11 was setup as a smaller version of the B-17 Flying Fortress or B-24 Liberator. This provided a simulated training environment similar to the full sized bombers. While in the past we have used as well a reference to aircrafts, particularly in our long 2013 post "The Coffin Corner", which is the altitude at or near which a fast fixed-wing aircraft's stall speed is equal to the critical Mach number, at a given gross weight and G-force loading. At this altitude the airplane becomes nearly impossible to keep in stable flight:

"We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy.
In similar fashion to Chuck Yeager, Alan Greenspan made mistakes after mistakes, and central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate! Maybe our central bankers like Chuck Yeager, just ‘sense’ how economies act or work.
We believe our Central Bankers are over-confident like Chuck Yeager was, leading to his December 1963 crash. Central Bankers do not understand stability and aerodynamics..." - source Macronomics, April 2013.

On a side note the latest decisions from the ECB amounts to us as clear confirmation of that indeed Mario Draghi is clearly affected by "the spun-glass theory of the mind" given that he stated that “uncertainty prevails everywhere,”

The current melt-up dynamics reminds us 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." 

Are we entering the final melt-up for asset prices, or is really the much vaunted "reflationary story" playing out in earnest? Or is it simply a case of "Information cascades playing out again 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...)? We wonder.

In this week's conversation we would like to look again at some Emerging Markets vulnerabilities given the recent hike by the FED and the continued pressure stemming from "Mack the Knife" aka King Dollar + positive real US interest rates. 

Synopsis:

• Macro and Credit -  Emerging Markets, from convexity to concavity?
• Final chart - In recent years rising yields have been followed by declining breakevens and real rates.

• Macro and Credit -  Emerging Markets, from convexity to concavity?

Back in 2013 we expressed our concern regarding the impact a dollar squeeze of epic proportion would have on Emerging Markets in our conversation "Singin' in the Rain":

"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013

Also back in December last year we indicated a macro convex trade to think about for 2016 relating to a potential devaluation of the HKD which won the "best prediction" from Saxo Bank community in their Outrageous Predictions for 2016. We made our call for a break in the HKD currency peg as per our September conversation and made additional points made last year in our conversation "Cinderella's golden carriage". In February in our conversation "The disappearance of MS München", we also looked out the Yuan hedge fund attack through the lenses of the Nash Equilibrium Concept :

"When it comes to the risk of a currency crisis breaking and the Yuan devaluation happening, as posited by the Nash Equilibrium Concept, it all depends on the willingness of the speculators rather than the fundamentals as the Yuan attacks could indeed become a self-fulfilling prophecy in the making." - source Macronomics, February 2016

While obviously our prediction was too outrageous for 2016, we do think that the HKD peg will once again come under pressure in 2017. On that very subject we read with interest Bank of America Merrill Lynch Asia FI and FX Strategy Viewpoint note from the 15th of December entitled "HKD to be challenged in 2017":

"HKD under pressure again

The HKD is under depreciation pressure again. We believe investors’ recent positions were based more on speculative than on fundamental reasons. These positions may be supported by the increase in the US Federal Reserve’s rate hike expectations for 2017. There is a risk of a pullback in USD/HKD forward points and HKD rates if RMB depreciation expectations stabilise over the coming weeks and investors take profit.

Brace the outflows

We believe 2017 will be a year of outflows from Hong Kong. The current account surplus is expected to decrease while capital outflows accelerate. That would cause Hong Kong to draw down its foreign exchange reserves.

Weaker FX, higher rates

Outflows, a slowdown of CNH-HKD conversion, and a declining aggregate balance will shape the HKD market next year. We forecast USD/HKD to rise to 7.80 and 3M HIBOR to rise to 1.50% by end-2017. We are biased to pay USD/HKD forward points and biased to pay front-end HKD rates." - source Bank of America Merrill Lynch

As we pointed out back in November in our conversation "When Prophecy Fails", when it comes to currency attacks it is more about the resolve of the speculators than the fundamentals:

"It seems to us that speculators, so far has not been able to "hunt" together or at least one of them, did not believe enough in the success of the attack to break the HKD peg. It all depends on the willingness of the speculators rather than the fundamentals for a currency attack to succeed we think." - source Macronomics, November 2016

As pointed out by Bank of America Merrill Lynch in their note, we are seeing a repeat of last year brief attack on the HKD:

"The HKD is under depreciation pressure again. Investors have recently long USD, short HKD forward outright, which has pushed up USD/HKD forward points to its highest level since early 2016. HKD rates have consequently increased and the 3M Hong Kong Interbank Offered Rate (HIBOR) fixing jumped over 10bps (Chart 1).

Both speculative and fundamental reasons related to Mainland China supported the recent market movement (Exhibit 1):

Speculative

The correlation between the HKD and CNH broke down in 3Q: while the RMB continued to depreciate, the HKD was stable (Chart 2). 

But the strong economic links and the growing impact of China on Hong Kong’s interest rates suggest insufficient risk premium was priced into the HKD. So even if Hong Kong’s currency board is credible, which is our base case not least because it has withstood multiple tests in the past, interest in the market to hedge against tail risks persists.

The HKD is also sometimes used as a proxy for the CNH. Proxies for the CNH are attractive when the associated carry costs on shorting the CNH are high (Chart 3).

But provided Hong Kong’s currency board does not change, we believe the potential gains from shorting the HKD as a proxy for the CNH are ultimately limited. In our view, trades based on this rationale are vulnerable to being unwound in the short term.

Fundamental

Hong Kong has started to experience outflows so far this year: in 1H 2016, Hong Kong recorded outflows equivalent to -0.9% of GDP. As such, there are already signs that the HKD will be under fundamental depreciation pressure. We believe the outflow theme in Hong Kong will be much more pronounced in 2017 than in 2016, especially since the US Federal Reserve raised its policy rate for the second time after the global financial crisis in December.

We believe recent positions were based more on speculative than on fundamental reasons, based on the timing of the move.

Speculative depreciation pressure on the HKD picked up after concerns over the RMB increased due to:

• China’s low FX reserve numbers in November
• Reports of curbs on capital outflows from China
• Growing uncertainty over the US-China trade relationship

These speculative pressures may persist in the near-term after the US Federal Reserve raised its Federal Funds rate projections from two hikes to three hikes in 2017. A broad USD rally could raise concerns over capital outflows from China and, ultimately, raise RMB depreciation expectations: we showed that broad USD strength and an increase in policy uncertainty raise capital outflows from China by Chinese investors.

But we also point out that Hong Kong’s 2Q balance of payments (BoP) data have been available since September 2016 and so we think the outflow theme was not the main driver behind the recent move.

As such, there is a risk of long USD, short HKD forward outright positions based on speculative reasons being unwound if the RMB depreciation expectations stabilise over the coming weeks and investors take profit." - source Bank of America Merrill Lynch

While clearly the current pressure on the HKD is based on rising speculations, obviously, the amount of currency reserves is a crucial parameter. The accumulation of reserves by the Hong Kong Monetary Authority (HKMA), make the current speculative move difficult to sustain.

One thing for certain, when it comes to Hong Kong and its vulnerability with their currency board matching the path of the Fed with rate hikes is clearly its real estate market. On that matter we read with interest Deutsche Bank's Hong Kong Property note from the 16th of December entitled "Risk of falling off the edge":

"Every 25bps rate hike would push up mortgage payments by about 2.4%

By looking at the sensitivity of residential affordability in Hong Kong to mortgage rate hikes, every 25bps increase in mortgage rates would translate into an approximate 2.4% increase in monthly mortgage payments or to push down residential affordability (i.e. increasing the debt-servicing ratio) by about two percentage points. Conversely, residential property prices would need to fall by about 2.4% in order to maintain the debt-servicing ratio at the current 68%. By assuming Hong Kong will follow the 75bps rate hike expectation in the US in 2017, residential prices would need to fall by 7.2%. Alongside our expectation of a 3% decline in median household income, we anticipate an 11% decline in Hong Kong residential prices in 2017. If mortgage rates are to normalize to the level of 2005/06 at about 5.75%, residential prices would need to fall by 28% from current levels.

Liquidity conditions look ample for now, although downside risks are rising

Liquidity conditions remain ample in Hong Kong so far, with a stable monetary base, currency lying in strong side convertibility and composite interest rates remaining low. However, the recent surge in interbank rates in HK has led to some concerns about the need to lift the Prime rate in HK. We believe that the near-term spike in interbank rates could be a reflection of expectations of higher rates, potential liquidity outflow and HIBOR finally catching up with USD LIBOR.

Although the large banks have signaled that the Prime rate will remain unchanged, we believe there is a risk that HK banks may need to move the Prime lending rate upward if: 1) HIBOR continues the upward shift that led to increasing the proportion of mortgage loans moving to capped rate Prime loans, 2) a strong liquidity outflow leads to higher deposit funding costs for large banks, and 3) there is much weaker/reversal of system deposit growth, with more signs of a tightening of loan-to-deposit ratios.

- source Deutsche Bank

So overall while our outrageous predictions seems difficult to materialize, the pressure on HKMA to intervene again in 2017 will rise again and if indeed there is vulnerability somewhere, then it might be smarter to "short" some Hong Kong real estate players rather than betting for now the demise of the currency peg.

When it comes to Asia and vulnerabilities, clearly China comes to mind particularly given its rapid credit expansion and the potential for a trade war to flare up with the new US administration. In relation to China being concerning, we read with interest Deutsche Bank take in their Asia Local Markets Weekly note from the 16th of December entitled "Jamais vu":

"Fed & AsiaFor all of the Draghi like nuances, Yellen (& the Fed) sounded and acted hawkish this week. And for once, it looks like the market has no choice but to chase the dots, which are moving away (and up).

For Asia, that should mean,

• Policy divergence will get more acutely in focus in 2017. The market is pricing in slightly over 60bp of tightening by the Fed next year - and still below the dots - but at best one rate hike anywhere in Asia. Indeed, DB Economics, and most of consensus forecasts, do not think even this modest amount of tightening will be realized. FX is then the natural outlet for this divergence in policy outlooks. And like we have been arguing, not just in the high yielders which run the risk of capital reversal - or more likely, no fresh inflows - but also in the low yielders, and ones which also map to the trade/geopolitical policy narrative of the incoming US administration (think Korea, think Taiwan)
• China in particular has some tough policy choices to make here. The Fed tailwind to the dollar will only make these choices harder for the Chinese. Either allow a significant re-pricing of the RMB complex (and take the risk of an unstable cobweb pattern), or burn down reserves (and take the 'credit' hit on the sovereign), or shut the capital gates down even tighter. Likely that they will opt for a mix of the lot. Importantly, though, none of these options look supportive of the liquidity or rates complex - offshore and (increasingly) onshore. Overnight CNH rates are trading at 12%; trading in key bond futures has been halted for the first time; and local press (Caixin) is reporting of big banks suspending lending to non-financial institutions. The move up in inflation only makes the rates re-set story in China that much more compelling to own.
• The local stories will likely define the axis of differentiation in 2017. The dollar move will probably take most of the Asia currency and rates complex with it, to begin with. But the local stories will likely define where on the dollar smile each market ends up next year - be it the policy choices the central banks make (rates, FX, regulatory), or the headwind from political noise (Korea, Malaysia, India)." - source Deutsche Bank

Obviously until "Mack the Knife" aka King Dollar + positive real US interest rates ongoing rampage stops, there is more pain to come for some Emerging Markets players in 2017. Yet, we think that the movement has been too rapid on both the US dollar and interest rates and have yet to be meaningfully confirmed by US fundamentals. While the EM fund flows hemorrhage has stabilized, at least for equities, it remains to be seen how long the resiliency will remain with a continuation of rising yields and we agree with Deutsche Bank's comments from their note:

"US equity bullishness has likely helped arrest outflows from Asia

The buoyancy in US equities – despite the large repricing in US yields – and the softness in vol indicators like VIX has helped contribute to a general resilience in risk. After close to $10bn of outflows from Asian equities in November, the outflows have stopped, although money has not really returned. Again we remain skeptical on the durability of this calm. The correlation of Asian equities to US stocks has been falling since the election and indeed with the US less likely to share the spoils of growth with the world, a decorrelation in returns should widen. Moreover, January has been seasonally weak for US equities for the last three years, which suggests a correction could lie ahead. Chinese equities have also been under strain given the rates market developments, with Asia straddling the divergence.

The market has not been as focused on the potential negative Trump dynamics for Asia from trade, geopolitics, and widening policy divergence 

The market has primarily focused in this first-round on the fiscal implications of a Trump administration, and the re-pricing of growth and inflation expectations. The other side of the coin – of potential protectionist and geopolitical disruption – has been harder to price given large outstanding uncertainties about Trump’s approach off the campaign trail. Once Trump actually assumes office in January, this uncertainty should fade, with a need to take a formal stance on issues like labeling China a currency manipulator, imposition of tariffs and the bargaining chips in play from the One China Policy to North Korea. There has also been outsized focus on the divergence theme between US versus Europe and Japan, but this is equally pertinent for Asia where markets have been in a multi-year easing mindset driven by disinflation, poorer demographics, sensitive credit cycles, and little external lift. If, as DB Economics believes, there is little appetite and ability in Asia to follow the Fed, rate differentials are going to impose pressure on Asian FX. On the other hand, if markets begin to price rate hikes, then unwind of duration stories and debt outflows from the region could be equally painful.

The market has been fighting the “major” battles

With dramatic moves in major G10 currency pairs like USD/JPY, EUR/USD, and in US rates, it is quite likely that macro positioning has been concentrated on trading these bigger themes and breaks. Indeed, even as JPY shorts were being added last week (on the IMM), investors were believed to be squaring back on KRW shorts. However as price action in the majors gets more stretched, the market should begin to look for catch-up trades and mis-pricings elsewhere.

End of year and idiosyncratic effects may have helped slowed moves

While market illiquidity into year-end could have exaggerated negative price action, there are other yearend forces which could have helped. There has been little fresh supply of debt in local markets which should have helped with bond technicals. Similarly, on the debt side, major asset allocation decisions are likely to be taken only in the New Year. Issuance calendars will start up afresh in January, when demand-supply mismatches would be more acutely felt. Central banks  may have also been more active in supplying dollars to manage FX weakness, given greater sensitivity to year-end closing levels. In individual markets like  Indonesia, inflows related to tax amnesty repatriation are likely helping contain the moves. In Malaysia, the wind down of the NDF market, and the immediate provision of greater exporter supply may have helped, but we estimate that significant hedges from real money, equity, and banks could be transitioning onshore in the coming months as offshore hedges roll off. Current account surpluses in much of North Asia are seasonally stronger around year-end, but dip significantly in Q1, with Chinese New Year inactivity, and with holiday export orders behind them

In sum, we are unconvinced that regional FX resilience can last, and would be positioning for a catch-up move higher in USD/Asia into the New Year. We continue to concentrate our USD longs against North Asian pairs that would be most exposed to any worsening in Chinese stress, fallout from a US equity market correction, a negative shift in the regional trade/geopolitical order, and where currencies have relatively poorer seasonality at the start of the year." - source Deutsche Bank

As we posited in our recent musing, the biggest "known unknown" remains the political stance of the US administration relating to trade with China. From our perspective, 2017, will continue, as per 2016 to offer renewed volatility on the back of political uncertainties given the new year will have plenty of political events, ensuring therefore an increase in volatility and large standard deviation moves like we have been used so far this year. Overall "Mack the Knife" will continue to weight on global financial conditions, particularly in EM where there has been a significant amount of US dollar denominated debt issued in recent years. As pointed out as well by Deutsche Bank, the pressure of the US dollar and rising rates will put further pressure on Chinese financial conditions:

"Risk of further capital measures remains high.

In response to the ongoing RMB weakness, driven in part by the divergence in US-China monetary policy, China has again introduced a series of capital measures particularly on RMB cross-border flows (see Trying Times for RMB, 7 December 2016). However, with outflows not abating and as RMB depreciation pressure continues to build, the risk of more such controls remains high, which are likely to drive further tightening in offshore RMB liquidity.

Reversal of RMB internationalisation should tighten

RMB liquidity further. The latest regulations introduced are likely to have accelerated the decline in RMB deposits in the offshore market again, shrinking the overall RMB liquidity pool in the offshore market.

Possible maturing of USD/CNH forwards. 

China earlier this year accumulated a large chuck of short USD forward positions, which are likely to mature in the coming months. If a part of these are allowed to mature, like in August/September, it could well be sufficient to create CNH tightness." - source Deutsche Bank

Whereas for now, convexity rules, be aware that concavity could once again come back to the forefront in early 2017 with markets at the moment continuing the probe again the willingness of the HKMA to defend the peg with additional weakness coming from the RMB and a potential slowing growth outlook for China.

If indeed there is a potential in 2017 for an early "risk-reversal" à la 2016, then again, it looks to us that, from a contrarian perspective the level reach by long US treasuries is starting to become enticing.

• Final chart - In recent years rising yields have been followed by declining breakevens and real rates.

Whereas gold and gold miners in conjunction with bonds have been on the receiving end of "tantalizing takeoffs" for equities on the back of the US election, our final chart comes from Bank of America Merrill Lynch Securitized Products Strategy Weekly report from the 16th of December shows that in recent years, rising yields have been followed by declining breakevens, which have been therefore followed by declining real rates:

• The 60 basis point rise in the breakeven rate since late June 2016 is the largest rise of the past 4 years. The unusually large move would seem to have some room to give back some of the recent gains.
• The past month’s rise in the real rate is the second largest of the past 4 years. Over the 4-year period, sharply rising real rates have been followed by declines in the breakeven rate, which in turn have been followed by declines in the real rate.

"Given the persistence of the patterns in recent years, we think that over the next 4-8 weeks, the odds favor a decline first in the breakeven rate and then in the real rate. Overall, nominal yields are therefore likely to move lower. Given that the nominal rate has risen by 80 basis points over the past month, we would not be surprised to see a 50% retracement over the next 4-8 weeks, which would bring the 10yr yield back to the 2.20% area. Time will tell." - source Bank of America Merrill Lynch

If indeed, this scenario plays out, then we could see some reversal of Gibson's paradox given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond rising fast since the US elections, gold prices went down rapidly as a consequence of the interest rate impact. End of the day the most important factor for gold prices is real interest rates. One thing for sure 2017 will have sufficient political events to offer yet again plenty of risk-reversal opportunities rest assured.

"The political graveyards are full of people who don't respond."- John Glenn, Astronaut

Stay tuned!

Macro and Credit - The spun-glass theory of the mind

"Success consists of going from failure to failure without loss of enthusiasm." - Winston Churchill

Looking at the results stemming from the Italian referendum in conjunction with the continued gyrations in financial markets on the back of rising FX volatility thanks to "Mack the Knife" aka King Dollar + positive real US interest rates, when it came to selecting our title analogy for this week's musing, we reminded ourselves of "The spun-glass theory of the mind" which is the belief that the human organism is so fragile that minor negative events, such as criticism, rejection, or failure, are bound to cause major trauma to the system (think Brexit, Trump's election). "The spun-glass theory of the mind" is essentially not giving humans, and sometimes patients, enough credit for their resilience and ability to recover, like central banks have been doing, dealing with economic woes with their "overmedication" programs (ZIRP, QE, NIRP, etc). In 1973, the brilliant University of Minnesota clinical psychologist Paul Meehl poked fun at what he called the “spun glass theory” of the mind which is the false notion that most of us are delicate, fragile, and easily damaged creatures that need to be handled with kid gloves. Since then, many researchers have shown that most people are surprisingly resilient even in the face of extreme trauma. Economies are similar, such as the United Kingdom which showed it was more than tremendously resilient while many pundits were predicting "trauma" and disaster should Brexit happens. In similar fashion, Nassim Nicholas Taleb in his book "Antifragile" showed that there's an entire class of other things that do not simply resist stress but actually grow, strengthen, or otherwise gain from unforeseen and otherwise unwelcome stimuli (Iceland). The main underlying concepts of both "The spun-glass theory of the mind" and "Antifragile" is that the majority of causal relationships are nonlinear and so are market movements (hence the relative ineffectiveness of VaR models - Value At Risk we discussed in February in our conversation "The disappearance of MS München"). Typically both have a convex section where the curve rises exponentially upward and is associated with a positive effect (antifragile) and a concave section that declines exponentially downward and has a negative effect (fragile). Think of the dose of a prescription drug. At first, as central banks increase the dose, the health benefits improve (convexity) for financial assets. But, beyond a certain dose side effects and toxicity cause harm (concavity), such as Debt-fueled economies given debt has no flexibility. Therefore highly leveraged economies cannot stand even a slowdown without risking implosion like our current situation, but we ramble again. 

How do you "hedge" in such a nonlinear world? The way to do it, we think, is to use a barbell strategy that positively captures the optionality of the variable (being long in the convex area and short in the concave area).  If indeed, we live in a nonlinear world and given correlations are less and less static and change more and more frequently, leading to larger and larger standard deviation moves such as typically going way up during downturns, it therefore eliminates Markowitz portfolio theory of diversification benefit. Just when you think your diversification will render your portfolio "antifragile" it brings instability and "fragility" to it. A barbell strategy should render your portfolio more "antifragile". Why is so? Markowitz portfolio theory causes investors to "over allocate" to risky asset classes such as "High Yield" and/or Emerging Markets and play the same crowded "beta" game. In similar fashion, "The spun-glass theory of the mind" cause central bankers to "overmedicate". One could conclude that "Overmedication" leads to "Over allocation". 

In this week's conversation we would like to look again at the importance of flows versus stocks from a macro and credit perspective, taking into account "overmedication" and "over allocation".

Synopsis:

• Macro and Credit -  It's a question of flows versus stocks
• Final chart - Could Japanese equities be antifragile in 2017?

• Macro and Credit -  It's a question of flows versus stocks

Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity":

"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."

Before we delve more into the nitty-gritty, it is important, we think to remind our readers of what is behind our thought process of the "stocks" versus "flows" macro approach.

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: 

"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 

We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on voxeu.org

We have always wondered in relation to the global rounds of quantitative easings the following:

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy at least in Europe has been in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.

As we have argued before QE in Europe is not sufficient enough on its own to offset the lack of Aggregate Demand (AD) we think.

As a reminder, in our part 2 conversation "Availability heuristic" from September 2015, the liabilities structure of industrial countries is mainly made up of debt (they are “short debt”), in particular in Japan, the US and the UK. In contrast, the international balance sheet structure of emerging markets is typically composed of equity liabilities (“short equity”), which is the counterpart of strong FDI inflows that contributed to improve emerging markets’ external profile in the last decade. With a rising US dollar, what has been playing out is a reverse of these imbalances hence our "macro reverse osmosis" discussed again recently relating to violent rotations in flows. 

From that perspective, we read with interest Citi Research note from November entitled "How does active fund management survive in 2017?" where as well they tackle the very important point of stock versus flows:

"Is it the stock or the flow of QE that matters?

Essentially, central banks tend to think in "stock" terms

 “Reduce the quantity available to investors & prices will lift permanently”

 To us, QE flows seem very important empirically

Reduce the QE flow by just ~1/3 & markets are quite likely to fall

That makes an asset not priced to fundamentals but to policy …

… prone to non-linear reactions when perceptions of policy change" - source CITI

As we have seen in recent weeks, and as we have remarked in our conversation  "Critical threshold", higher yields leads to material fund outflows in the short-term as indicated by Bank of America Merrill Lynch Follow the Flow note from the 2nd of December entitled "Where's the money going?":

"High grade funds had their fourth week of outflows, and the third that exceeds the $1bn mark. High yield funds recorded their fifth week of outflows in a row; so far this year they have lost more than $10bn. As chart 13 below shows, the outflows this time came mainly from European and global funds, where on the other hand US high yield funds recorded an inflow.

Government bond funds had yet another outflow, the eighth in a row, reflecting rising QE-tapering risks. Money market weekly fund flows were relatively subdued recording a negative flow. Overall, fixed income funds flows remain largely negative, and over the past four weeks almost $20bn has flown out of European domiciled funds.

European equity funds flows switched aggressively to the negative side again, post a short stint of inflows. Last week the asset class had its biggest outflow in eleven weeks. Outflows so far this year are just shy of $100bn.

Global EM debt fund flows remained negative for the fourth week in a row; nonetheless we note a significant improvement in the trend, with the latest outflow being significantly smaller than that of the previous two weeks. Commodities funds also were in negative territory for a third week, as higher inflation expectations support reflation trades.
On the duration front, short-term IG funds flows remained negative for a second week. Mid-term funds had their fourth outflow in a row but riding an improving trend; while long-term funds recorded a marginal inflow." source Bank of America Merrill Lynch

Whereas central banks tend to focus their attention on "stocks", we'd rather focus ours on "flows", from a macro perspective as well as from a fund perspective. Evidently the consequences of "Mack the Knife" aka King Dollar + positive real US interest rates can also be seen in the "Great Rotation" from Europe and Emerging Markets towards the US hence validating our "macro osmosis process":

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

As a reminder, more liquidity = greater economic instability once QE ends for Emerging Markets. Now if indeed "flows" matter, we took a keen interest in reading the impact  "Mack the Knife" has had on Emerging Markets as indicated by Bank of America Merrill Lynch in their GEMs Flow Talk note from the 1st of December 2016 entitled "Reported foreign holdings of local debt dropped 6% in November so far":

"EPFR weekly fund flows
• EPFR measures mutual funds and ETFs (AUM about $225bn)
• This week’s outflows were less than last week which was less than the prior week.
• EPFR outflows in the 3 weeks since the election were:
-4.0% for EXD
-3.7% for LDM
• Part of that is ETFs, whose outflows since the election as a % of ETF AUM were:
-8.1% for EXD
-7.3% for LDM

2013 lessons were learned well, take fast action
• Outflows have been faster than in 2013 (Chart 1)

• Largest 3 week outflow in 2013 was only -4.2% for all currency funds.

Foreign holdings of local debt sharp drop – $40bn implied
• We track $640bn of foreign holdings of local debt
• We observed 6.2% outflows for the month of November in 4 countries (India,
Indonesia, Hungary and Turkey) with foreign holdings of $107bn.
• If all countries had the same average outflow of 6.2%, then applied to the $640bn
of foreign holdings, this implies we could have had a $40bn total outflow in Nov.
Since the election – $35bn potential outflow
• We observed 5.5% outflow since the election.
• If we apply this rate to the $640bn foreign holdings, it implies a $35bn total
outflow in the few weeks since the election." - source Bank of America Merrill Lynch

We recently pointed out that "macro tourists" and levered carry players alike did play the second half of 2016 more aggressively hence the extension of their credit risk and duration risk leading to faster deleveraging and consequently outflows and pain inflicted. Obviously we guess that your next question is going to be how much more additional outflows could be expected particularly from the impact of a rising US dollar is having on Asia for example given capital outflows matter and matter a lot, so does a US dollar shortage as well although Stanley Fischer from the Fed thinks as of late there is no liquidity issue. Regarding this matter we read yet another Bank of America Merrill Lynch note from their Connecting Asia series entitled "Flow and flight":

"We examine two of the most pressing issues facing Asia investors in the Post-Trump election victory world.
The first, is how much capital reversal and outflow in Asia is yet to run amid USD strength, rising yield differential with the US and CNY depreciation. Thus far, some USD24bn in foreign bond and equity portfolio flows are being unwound and compares with the maximum drawdown of USD55bn during the GFC – see front page chart.

The countries that we find are at the sharp end of this outflow are Korea, India, Indonesia and Malaysia.
The second is how investors should evaluate Asia FX and rates vulnerability to the tail risk of rising trade protectionism and confrontation. The brief answer to this is that China, Korea, Taiwan and Thailand appear most vulnerable, while Indonesia and India may be the least.
Ultimately, the combination of capital outflows and rising trade protectionism discussed in this report, suggests that FX risk premiums and volatility for CNY and KRW will rise. From an FX hedging strategy perspective, we continue to recommend low delta 6M USD call, CNH puts such as our year-ahead top trade recommendation for USD/CNH 7.60 strikes.

Portfolio drawdowns – how much more to go?We highlight the maximum drawdown Asian markets have previously seen in terms of outflows. This gives us a sense of the worst case scenario as far as outflows are concerned relative to FX reserves. The bottom line is:
• The largest outflow Asia saw on a cumulative basis was ~USD 55bn during 2008. In comparison to this, Asia has seen about USD 24bn of outflows since October 2016 (see Chart 1 for cumulative outflows during other risk off periods).
• Equity outflows so far have been around 9.9bn USD since October 2016, led by. India, Taiwan and Thailand. When compared to historical drawdowns, the larger equity markets of Korea, Taiwan and India stand to lose the most, although only in Korea’s case does the worst case scenario account for a substantial portion of FX reserves (19%, see Table 1).

• Bond outflows, so far have been about 14bn USD since October 2016, with most seeing outflows of at least 2bn USD. When compared to historical drawdowns, Malaysia stands to lose the most, with the worst case scenario representing about 6.3% of current FX reserves (see Table 2).

- source Bank of America Merrill Lynch

While obviously the biggest "known unknown" lies in the foreign trade policies which will be adopted by the new US administration. As we pointed out in our last musing, measures that would restrict global trade would no doubt be bullish for gold in that particular case. For now, in relation to gold we still remain neutral.

But moving back to credit and nonlinearity, one way of "mitigating" dwindling policy support given recent talks from the ECB in tapering its stance would be to "embrace" a barbell strategy as pointed out by Citi Research note from November entitled "How does active fund management survive in 2017?":

"Barbell when repression is at risk of being wound down

Belly of the credit curve holds disproportionate amount of unpaid β" - source CITI

What would be an interesting barbell credit wise in our opinion? We would favor US credit markets obviously from a flow and currency perspective. We would go long US investment grade credit than European investment grade and even selectively long European non-financial High Yield issuers due to lower leverage than their US peers. But should you want to play the beta game from a "barbell" perspective, then again US High Yield via its derivatives US CDX High Yield, given that it is less sensitive to convexity and interest rate risks and less exposed to CCCs (10% versus 16% weight in cash index), should the risk-on environment persist on the back of favorable macro data. 

From an allocation perspective, we are already seeing once again decoupling between US credit and Europe, because, as we stated on many occasions, the Fed tackled earlier one "stocks" issues on banks balance sheet, which in effect, enabled a stronger credit income and better economic growth relative to Europe, whereas the ECB has in no way alleviated the burden of "stocks" plaguing peripheral banks in the form of nonperforming loans, therefore in no way repairing the broken credit mechanism that stills explain the on-going "japanification" process and much weaker growth prospects. To that effect, if indeed the US reflation story is playing out, then again it makes sense to "over allocate" to US credit as once again decoupling could be on the menu between both regions. This is clearly illustrated by Bank of America Merrill Lynch in their European Credit Strategist note from the 2nd of December entitled "The Italian job":

"The last month has presented something rather rare: a truly decoupled global credit market. For instance, US high-grade spreads went 2bp tighter in November, while Euro high-grade spreads went 16bp wider. And the phenomenon seeped into high-yield credit too: US spreads tightened by 24bp in November, while European spreads widened by 47bp. After the moves of the last month, headline IG spreads in Europe are now wider than US high-grade spreads out to almost 10yrs in maturity.

“Politics” has been the undoing of European credit lately. Italy heads to the polls on Sunday amid a climate of rising global populism. And ECB tapering noises have driven a pattern of rising rates and wider spreads in Europe over the last month (note, though, BofAML base case is for an €80bn QE extension until Sep-17).
Yet, even with all the political hiccups that Europe has encountered over the last 5yrs, genuine decoupling of credit markets has not been common. Chart 2 shows that there have only been 3 periods over the last 10yrs when European and US credit spreads went in different directions.

Decoupling – the new norm for ‘17

We think decoupling between US and European credit will be a lot more common in 2017 though. In fact, our US credit strategy colleagues forecast US high-grade spreads to tighten by 20bp next year. In Europe, we expect high-grade spreads to widen by 20bp.

Much of the divergence in views is simply down to technicals – which shouldn’t come as a surprise given how technicals have been the be-all and end-all of credit markets for the last few years. In the US, we expect Republican tax proposals to lead to a big drop in US high-grade net supply next year. But in Europe, we expect shareholder-friendly activity (M&A, in particular) to broaden out in 2017, and contribute to a further jump in supply. This should leave the Euro market with too many bonds and not enough buyers.

Get in quick…

In fact, lingering QE tapering noises may just coax European companies to speed up their spending and issuance plans, for fear of missing the (low-yield) boat. This means the risk of supply being front-loaded in the first half of next year, leading to some heavy indigestion for the Euro credit market.
Recall that this is not too dissimilar to what US companies did in 2014 as the Fed drew closer to their first interest rate hike. As chart 3 shows, US M&A volumes were brisk in the middle of 2014. Then, as better US data pushed yields higher, issuers moved quickly to fund the M&A backlog, leading to some big months of US high-grade supply in September and November 2014.
This also caused a big decoupling in credit markets: US high-grade spreads widened by almost 40bp in the second half of 2014, while European high-grade spreads went slightly tighter. We fear the same bad technicals could be at work in Europe next year if companies rush to issue ahead of any potential QE tapering." - Bank of America Merrill Lynch

If indeed we get this "reflationary" case playing out, then again we might have a situation where US credit continues to outperform European credit in 2017.

Going forward, when it comes to following a potential deterioration in US High Yield we encourage you to keep an eye on a possible flattening of the CDX HY curve, being the derivatives proxy for the US High Yield market. As per Credit Market Analysis (CMA) latest chart, it is worth following the trend to see if indeed the CDX HY series 27 will be getting flatter as we move towards 2017. We noticed that one year protection has started to move upwards albeit very slowly, while it is yet a meaningful move for the moment contrary to what we had back in November last year where 1 year was only 50 bps apart from 3 year, you should keep an eye on the shape of the curve:

- source Credit Market Analysis

Right now, it is hard to be as sanguine as we were in November regarding US High Yield given at the time of the fast flattening movement we were seeing at the end of 2015. We continue to see a risk-on environment for the time being, although as we pointed out last week when discussing credit conditions in the US for Commercial Real Estate, it does appears to us that some segments including our CCC credit canary are already experiencing tightening financial conditions. The most important indicator to track, risk wise is "Mack the Knife" aka King Dollar + positive real US interest rates. 

Finally for our final chart and if the "spun-glass theory of the mind" is correct, then indeed we think if the US dollar continues to shine, then it makes sense to "over allocate" to Japan given earnings are higher there.

• Final chart - Could Japanese equities be antifragile in 2017?

While the risk-on mode is still prevailing thanks to the strong beliefs in the reflation story playing out, from an equity perspective, corporate earnings and payouts remain the principal drivers of equity returns. To that extent, our final chart comes from Barclays Global equity and cross-asset strategy note from the 28th of November entitled "Reassessing the rotations" and displays earnings in Japan relative to the US and Europe:

- source Barclays

While it remains to be seen how long the "reflationary story" continues to play out, for now it is indeed "risk-on", but no doubt there are many political events lining up in 2017 that could put a spanner in the works. One thing is clear to us though, is that when it comes to markets commentators and some members of the sell-side, 2016 has proven with both Brexit and the US election that the spun-glass theory of the mind is alive and well...

"Success breeds complacency. Complacency breeds failure. Only the paranoid survive." -  Andy Grove, former CEO of Intel.

Stay tuned!