Recap 08-27-15: Looking Good

IMO, the most important thing that happened today was the move in oil prices. Oil prices lead the way lower starting in June (see my update on 7/27) which then impacted credit spreads and then equities. (see my update on 8/21) Thus, a stabilization at these levels should allow other asset classes to re-price toward fundamentals. The price action across the oil strip today was impressive, with the ~$4 rally off of a higher low similar the bounce at the end January. Remember, we don’t need to see oil to rally, just for it to stabilize.

The Mexican Peso looks very cheap here. I think it’s pretty reasonable to expect a 15% strengthening over the next year or two.

Oh, and by the way, the S&P is now up on the week. IMO, a lot of the extraordinarily fast move lower was driven by algo driven selling that reduces exposure to higher volatility. As both implied and realized volatility falls, these programs will increase exposure again. Remember the breath taking drop and rally last October? Well, I have a hunch those are going to get more common…

Recap 08-21-15: What’s Happening and What’s Likely to Happen

There has sure been a lot of noise in the financial media the last couple days. From fears of China, to fears of a HY default spiral, to fears of a Fed hike, to fears of the Fed not hiking, people seem to be manufacturing reasons across the board.

The real reason is much simpler and none of the above.

The reason behind much of the price action year to date is the widening in credit spreads. The chart below illustrates the relationship between credit spreads and equity returns throughout the cycle. And it makes sense – more expensive credit is a tightening of financial conditions, which slows expenditures. As the chart shows, spread widening has been a drag on equity returns for more than 12 months now:

Now, the knee jerk reaction here may be: crap! Spreads are now at the 2011/2012 wides! Risk off!! Sellllll!!!!

Well, maybe that’s not everyone’s reaction but it seemed like it yesterday. But let’s dig a little deeper.

Credit spreads are obviously composed of two legs, corporate bond yields – treasury bond yields.

Treasury yields have been falling – with most of the move in the inflation expectations component due to oil. Quite arguably, in some parts of the curve it’s getting a bit overdone. The chart below from Barclays illustrates that even in the 5y5y inflation forwards, we are back down to 1Q levels:

At the same time, corporate bond yields not falling. Why? Well, issuance is probably a pretty strong reason. After all, pretty much the entire world is expecting the first Fed hike this year, with consensus expectations most of the year set for September. As a result, corporations have scrambled to front load their issuance. Goldman had a couple good charts on that. Not only has total issuance hit new highs:

But the duration of issuance has as well, as corporations have extended the duration of their borrowing:

By default, with corporate bond yields stable and treasury yields lower, that means the spread is widening. And with the issuance pattern and the front end of the US curve pinned, that means the widening pressure is strongest at the long end.

So does that mean it’s time to liquidate? Well, that depends on how spreads move from here.

Let’s take a look at spreads historically. In prior recessions, wider spreads unsurprisingly got wider, as bond buyers became increasingly concerned that economic weakness would translate to higher default rates. Is that the case this time?

Here’s a chart of spreads (red, RHS) vs a proxy for growth, the ISM composite survey. (blue, LHS, inverted) See anything that stands out?

A model that regresses macro data vs spreads suggests that spreads have overshot by the largest extent since 2012 and potentially 2009:

In addition, if you think that corporations have been front loading their issuance ahead of the Sept FOMC, that suggests the possibility that issuance is likely to slow regardless of whether the Fed hikes in Sept or not. In addition, oil will bottom (at some point, right?) which should support inflation breakevens and help treasury yields to rise. This all points to the likelihood of spread tightening in 4Q. And not just in 4Q… given how wide spreads are given the economic backdrop, we are likely to see sequential quarters of it.

Furthermore, many positioning indicators suggest that we are at or near capitulation levels. Here are two.

First, a Barclay’s chart of money market fund flows:

And the BAML survey cash indicator:

In addition, note that European equities are now cheap vs UK, US, Japan. Furthermore, relative prices vs the US is at most attractive level since January. (The chart below is the ratio of the S&P vs the Eurostoxx 50)

It’s hard to get the timing exactly right, obviously, but I do think that we are getting set up for a strong risk-on move into 4Q and 2016 here, likely lead by Europe.

Recap 08-12-15: Yuan Conjecture

Well… what a time to be getting back! I was hoping for a quiet period to catch up on things, but instead we get the first major CNY shift in a decade. There are already so many words published on it, but much of it seems not dissimilar to rambling. Amidst all the noise, I wanted to share a few thoughts.

The fact of the matter is, no one knows exactly how this CNY move will affect things. To begin with, much will depend on how fast, how far, and how long the depreciation goes. How the Chinese policy makers and Chinese banks manage the move is also a major factor. Then there are the multiple indirect effects from things like the impact on other EM currencies, commodity prices, etc.

Having said that, here are a few things that I think we can say with a reasonable amount of confidence:

The PBoC communications department is very inexperienced. Go ahead and read the series of press releases from 8/11:

  1. The PBC Announcement on Improving Quotation of the Central Parity of RMB against US Dollar
  2. The PBC Spokesman Answered Press Questions on Improving Quotation of the RMB Central Parity
  3. The PBC Spokesman Answered More Press Questions on the RMB Exchange Rate

Now, maybe the Chinese press releases are much better (I highly doubt it) but without a doubt the English press releases were confusing at best and misleading at worst. What does ‘significant fluctuation’ mean? How about ‘basically stable at an adaptive and equilibrium level?’ It remains unclear, still, what the primary objectives of the recent moves are. In conjunction with the policy flailing following the stock market collapse, I think it’s reasonable to say that Chinese policy makers have much to learn about managing markets. This implies that the volatilities of currencies linked to China are likely to be higher.

The direct economic impacts from the currency move so far on DM economies are limited. China remains a fairly closed economy, with high barriers to entry for foreign corporations. The estimates of the impact on US inflation that I’ve seen is in the area of 10bps or so. Pass through is also mitigated by the fact that many foreign corporations have moved their production to cheaper locals like Vietnam in recent years.

The indirect effects are likely to be much more numerous, and likely stronger. How will the other EM currencies and economies adjust? How will Chinese commodity demand adjust?

China will need to continue to rebalance its economy – away from investment, and toward consumption. Michael Pettis has written reams of posts on this, so I won’t repeat them here.

The policy moves thus far are far from sufficient from addressing the major drivers of capital outflows. Ultimately, expected real investment returns in CNY assets are too low relative to opportunities abroad. This includes returns from export businesses – otherwise companies more exporting companies would be set up. There are a couple ways to rectify this – either real interest rates can move somewhat higher, or the currency can move quite a bit weaker. The former option runs the risk of cascading defaults, so it seems like the Chinese authorities are trying the second option.

In addition, there is one thing I would venture to conjecture:

I think there is a good chance the RMB ultimately depreciates 20% or more in real terms. Now, it’s hard to put a tight confidence band around how far a currency ‘needs’ to move in the best conditions, but it is particularly hard for China because of the lack of reliable economic statistics. This itself suggests a higher probability of an overshoot. But we do have a bit of precedence to guide us. The last time the RMB REER has depreciated significantly was from 2002-2005, with the BIS measure of CNY REER going depreciating almost exactly 20%. The appreciation move leading up to that was ~55% from 1994 (when the data started) to the highs in Jan 1998. By comparison, the move from the 2005 lows to March 2015 highs was 60%. In addition, China has often been compared to Japan in the 70’s. This chart from the San Fran Fed highlights:

This is relevant because we can use the 1970’s Japanese experience to draw some parallels. Interestingly, the Yen appreciated a similar 50% from Jan 1976 to Oct 1978, (admittedly a much faster pace) but then ultimately depreciated 27%, hitting a low in Oct 1981. The slower pace of the RMB appreciation suggests a more moderate correction.

With respect to other assets:

In the absence of strong fundamental trends, the majority of S&P price action this year seems to be driven by changes in the ‘uncertainty risk premium.’ IMO, the uncertainty around what the PBoC is trying to accomplish and/or do was a major driver of recent gyrations, even as most agree that the direct economic effects are not large. The PBoC seems to be learning as it goes though (there is a pre-announced press conference late tonight US time) so hopefully we get some stability.

Global yields are starting to look too low again. My 3% fair value estimate for the US long end remains, so current levels look decent enough to start establishing opportunistic shorts.

The 1y1y forward oil strip is showing tentative signs of stabilization. Levels are now basically unchanged since 8/3, the longest stretch since late June.

Recap 07-27-15: It’s Nominal

I’ll be away for a couple weeks, so I wanted to share a few thoughts before I head out.

First, I think the importance of oil as a driver of all major nominal asset prices this year remains under appreciated. Here are a few charts comparing major asset prices vs the 1y1y forward WTI oil strip:

Oil vs S&P

10y vs Oil

HY Spreads (Barclay’s HY OAS, inverted) vs Oil:

EUR vs Oil (since Jan here, post ECB QE meeting)

This makes sense of course. Financial assets are priced in nominal terms, so to the extent that inflation expectations fall sharply, it shouldn’t be a surprise that nominal return expectations also fall. 1y fwd inflation swaps have declined from a high of 1.76% to just ~90bps. That is still a far cry from the -32bps from this January, but the magnitude of the drop remains very fast by historical standards.

In addition to the impact on yields, the drop in inflation expectations have also resulted in a fall in expected SPX earnings. The deflationary impact from commodities prices is quite significant. My estimate of consensus earnings expectations now shows a negative YoY print. This is probably the biggest surprise to my expectations from Dec. In addition to this, the rise in credit spreads is pressuring risk premiums wider across the capital structure. The chart below highlights this, show how the Barclay’s US Credit Avg OAS is now just below ~150bp level that has historically coincided with recessions and periods involving systemic shock.

How much more downside for oil is thus a key question for near term nominal financial asset prices. Forward markets suggest that the Iranian deal has had a substantive impact on the marginal cost of production. 1y1y fwd strip in WTI has broken below January lows, and continues to fall. How far it can go is anyone’s guess at this point, but it should not be a surprise if we do wind up seeing new YTD lows for spot crude prices. Having said that, my naïve read of positioning data suggests that there is some chance of a bottom in the near term.

BUT let’s take all of that into context. While oil prices are certainly affecting near term nominal expectations, ultimately the effects will be contained, if for no other reason that that there is a limit to how low oil prices can go. By January next year, the vast majority of the base effects will have filtered out from market calculations, even if spot oil prices do fall sharply from here.

With respect to longer term factors, here are a few things I see:

The effect of base effects on inflation means that the Fed may delay its first hike, then hike more aggressively, inline with the eventual jump in inflation to more normal levels.

EMU leading indicators are getting stronger and stronger, recent PMI prints notwithstanding. This is likely to provide further support for the EUR vs the dollar, ceterus paribus. But it will also provide solid support for EU equities, the currency effects notwithstanding. My model projections for consensus estimated earnings growth for the Eurostoxx 50 index has ticked up to +12% through year end, non-annualized. Note that the MSCI EU ex-UK index is at the cusp of breaking 15 year highs: (Recall that the SPX broke through in March 2013)

In an even longer context, current EMU travails are very comparable the post revolutionary US period. The Alexander Hamilton biography by Chernow (which I am reading based on a suggestion in a Michael Pettis post) is excellent, and provides many parallels.

I’ve expected Gold to fall for a long time now – see post on 1/14/15. I expect another 10% downside over the next couple years at a minimum, though spec positioning suggests a potential near term bounce.

Interesting food for thought:

Recap: 2H Outlook

I haven’t written much about the whole Greek saga because I didn’t think I had anything new to add to what I had said before and what was being reported elsewhere. But now it appears that the general perception of the process is vindictiveness by Germany. Now, perhaps this is right, but that is also short sighted. The fact is that with the expiry of the previous deal, the parliaments of the other EU countries would have to approve new packages. The representatives of many EU countries will have a hard time selling anything except a more draconian package to their constituents, especially given all the good will that the Tsiparis government has burned up over the past few months. This is not a major mistake by Merkel. This is the reality of the politics and laws of the EU, driven by all the foibles of democratic constructs. The fact that the fiscal transfers require the buy in of all EU countries is equivalent to requiring that the US pass all budget bills with a majority in every state house.

Moving on, from a high level macroeconomic perspective, the broad themes continue to drive longer term trends.

  • US Growth remains decent. But the recent drop in oil prices may give the Fed a bit more room to hold off.
  • EU Growth likely to continue picking up. The recent Greek saga has been too short to have had a major effect on the data released so far
  • Chinese Growth looks likely to continue to slow for at least another 6 months. The stock market there remains overvalued, IMHO, but the economic ramifications seem limited. In the short run, all the trading is really just a shuffling around of paper wealth from one group of constituents to another. There does not appear to be any large scale bankruptcies or credit defaults directly related to the bubble, at least not yet.

With respect to asset prices:

  • US yields look near a top. Same for EUR yields. I noted a while ago that valuation wise they look pretty fair, but now price action supports that view. In both areas, yields were not able to sustain new highs despite the equity market rallies.
  • Credit spreads are quite wide relative to where we are in the economic cycle. By some measures, they are implying nearly recessionary level default risks. Perhaps it is related to the fixed income market liquidity fears that may be more acute now that we are nearing the first hike, but it is affecting risk premiums across the capital stack. The widening has driven financial condition readings (as published by several sources) to unusually tight levels. I am willing to bet that this is something the Fed is monitoring reasonably closely.
    Barclay’s had a couple interesting charts on this, noting that investment grade issuance is up 15% vs where we were last year:

  • I have been sanguine on EU equities in the 1H of this year, as they were plagued by duration exposure since the ECB’s QE announcement. But the improvement in the data and in earnings since then, along with the stabilization of yields and the recent position washout means that all the pieces are now in place for a decent rally. My models suggest 1y fwd EPS estimates are likely to pickup up ~10% by year end (non annualized) from here.
  • Equities in aggregate look set for a strong 2H given investor positioning. The BAML Fund Manager Survey shows the highest cash balance since Lehman, and before that Nov 2001:

  • EURUSD downside is probably limited. At this point, I think relative policy rate differentials are broadly priced in here.
  • AUDUSD is very overvalued, and the impetus for further downside look very attractive. Despite the employment data recently, the broader economic backdrop both there as well as in China will require a further adjustment in the currency. I expect a depreciation in excess of 20% over the next couple years.

Recap 2015-06-18: Some Thoughts


The FOMC was dovish as expected, but the effects have mostly impacted the belly of the curve. Long dated yields remain higher.

I’ve previously noted that sentiment was unusually pessimistic, and so the removal of near term FOMC uncertainty seems to have allowed the S&P to begin rallying. I think the rally has a good chance of extending for a few weeks. In addition to the sentiment backdrop, earnings estimates may start picking up soon as well.

As most readers know, the weakness in earnings has mostly been due to the Energy sector. Below is a chart of the average 12m change in 1y ahead EPS estimates by various groups. As the chart shows, the non-commodities sectors have been fairly resilient.

Unsurprisingly, the Energy sector EPS is fairly highly correlated to trailing measures of oil prices. Below is the rolling 2qtr median (with extrapolations out a few weeks) vs EPS estimates:

The point is that given the likely small uptick in expected Energy sector earnings, along with dropping out of base effects, the YoY change in Energy earnings estimates are likely to pick up over the next couple months.

This suggests that rising earnings is likely to once again start helping SPX performance over that time frame. The effects, however, are likely to be fairly mild until late in the year.

In addition, with the backup in yields, the supply dynamics for US credit may be changing soon. Blackrock noted that the US IG issuance since March has been double the average rate of the prior 4 years.

The majority of this seems to be related to M&A.

With the backup in global yields since March, there should be a slowdown in those activities, and hence issuance. That may allow long dated spreads to stabilize and eventually compress. The compression of credit risk premia is likely to also support equity prices.

Separately, the moves in EUR yields continue to be a key driver of EUR asset prices. 30y EUR swap yields are now 30bps higher than where they closed on the day QE was announced. The 2003 BoJ analog suggests that the broader sell off may be over for a bit, volatility not withstanding. Nevertheless, the effects on EUR assets has been powerful. That is likely to continue until it becomes more clear that we’ve past a local high for yields.

The EUR charts are looking… bullish. Momentum had turned by April, but the rising wedge suggests a potential break through 1.15 resistance. Through there, the next level of serious resistance doesn’t come into play until ~1.20.

Like the EUR, almost all of the Eurostoxx outperformance vs the SPX following the ECB meeting announcing QE has been unwound. The burden for outperformance remains on rising earnings. IMO, at current levels it’s not obvious that EU equities are cheap vs SPX even after adjusting for the better EPS growth over the next couple quarters. One possibility is that the (eventual) outperformance may not come until late this year.

Finally, I though this article from the WSJ was VERY interesting:

Prime Minister Shinzo Abe is expected to unveil a plan to balance Japan’s budget in five years, a move that underscores Tokyo’s resolve to improve its deficit-ridden finances even as it continues to pursue costly economic-stimulus programs. In a draft plan to be released early next week, Mr. Abe is expected to reiterate his long-held goal of eliminating a deficit in the government’s primary balance—the difference between tax revenues and government spending minus debt-servicing costs—as a step toward reducing the country’s debt burden, according to government officials.

This is a big deal because now it appears that Japanese fiscal policy makers is backing away from easing. In conjunction with Kuroda’s statements on the Yen, it appears that both fiscal and monetary policy makers in Japan expects to gradually wind down stimulus going forward.

Recap 2015-06-12: Europe now vs Japan a decade ago, SPX upside next few weeks


I’ve written in the past that the current EU bond market price action has many similarities to that of the Japanese bond market in the early 2000’s. The chart below shows the German 2s30s curve (blue) vs the Japanese 2s30s curve starting in 2002. (red) I used the 2s30s curve instead of outright yields because we need to adjust for the fact that the ECB has cut rates into negative territory:

I’ve noted in the past that perhaps the comparisons are of limited value because of the differences in the economic back drop. The more I’ve thought about it, however, the more I think that the similarities are bigger than I originally realized. For example, the EU unemployment rate (white) topped out at 12.1%, whereas the Japanese UER (orange) topped out at 5.5%. While the difference looks massive at first glance, I didn’t take into account the difference in the measurement of the data, i.e. who qualifies as unemployed. If we look at the change in the UER instead, the picture looks much more alike. By 2002, Japanese UER rose had risen by 3.5 percentage points from the 1992 lows, where as the EU UER, currently at 11.2%, is up 3.9 percentage points from the 2008 lows:

Of course, no historical analog is exactly alike. In 2002, the global economy was coming out of a recession. But it’s interesting to note that even US interest rates now seem to compare well with then. Here is a chart of the Fed Funds rate now (blue) vs then, (red) with futures-implied levels included:

And here is the overlay of the US 10y yields:

Of course, the axes are different between now and then, reflecting the different levels of growth and inflation, but the resemblances are quite remarkable, at least to me. These resemblances made me dig a bit further.

A simple comparison of the Real Trade Weighted currency levels between Europe now and Japan then initially shows low correlation until recently:

But a look at the longer term picture shows more similarities. The trade weighted EUR peaked in 2008, fell for 4 years, bounced, then resumed falling. The trade weighted Yen peaked in 1995, fell for 3 years, bounced, then resumed falling.

The point is that in the case of the Yen, further depreciation on a trade weighted basis did not occur until 2005, about two years after the BoJ initiated QE and well after the Fed started hiking. Note that this occurred even as the Fed’s hiking path is projected to be roughly comparable to the path then. The take away for the EUR, in other words, is that the further depreciation that is very widely expected may not be coming for several quarters. Specifically, the start of Fed hikes may not cause the EUR to immediately depreciate as is widely assumed.

It’s a bit harder to get a read on how the Eurostoxx will perform using this analog. One reason is that the global economy was in a recession in 2002, which obviously had a large effect on how Japanese equities performed. Japanese equities also started with zero or negative earnings. Differences in the moves in the currency between now and then obviously also has an effect on earnings. There really isn’t a good way to reconcile all these differences, so what I did was rebase the indicies to 12/31/14 and 3/3/03, respectively.

Now, because Japanese equities benefited from a global recovery, one could argue that Japanese corporate earnings benefited more than what could be expected for EU equities this time. EU equities, after all, are already up 65% from the May 2012 closing low. So perhaps the Equities analog is not particularly informative in this case. Readers are welcome to judge for themselves.

Separately, based on sentiment measures, the S&P looks ready to rally. The AAII survey reported that just 20% of respondents were bullish this week, which is very pessimistic reading indeed. In fact, in the past 10 years, the reading has only been lower 4 times. Unsurprisingly, this level of pessimism has historically preceded decent rallies over the subsequent weeks:

This dovetails with my comments earlier this week. Equity market pessimism, a potentially dovish Fed, and economic data that is starting to improve vs expectations. They are all fuel for a risk rally.

Anecdotally, GS notes that calls are quite attractively priced here as well: