Monday, 21 May 2018

Macro and Credit - The recurrence theorem

"Some things never change - there will be another crisis, and its impact will be felt by the financial markets." - Jamie Dimon


Looking at the elevated volatility in Emerging Markets in conjunction with continued outflows and pressure on the asset class, on the back of rising US yields and a strengthening US dollar marking the return of "Mack the Knife", with losses not limited to the currencies but with Emerging Markets Yields continuing surging throughout, when it came to selecting our title analogy we reacquainted ourselves with French mathematician Henri PoincarĂ©'s 1890 recurrence theorem building on the previous work of fellow mathematician Simeon Poisson. In mechanics, PoincarĂ© recurrence theorem states that an initial state or configuration of a mechanical system, subjected to conserved forces, will reoccur again in the course of the time evolution of the system. The commonly used example to explain the theorem is that if one inserts a partition in a box, pumps out all the air molecules on one side, then opens the partition, the recurrence theorem states that if one waits long enough that all of the molecules will eventually recongregate in their original half of the box. The theorem is often found mixed up with the second law of thermodynamics to the effect that some will loosely argue that there exists a very small probability that an isolated system will reconfigure to a more ordered state (thus effecting an entropy decrease).The theorem is commonly discussed in the context of dynamical systems and statistical mechanics. When it comes to pressure and outflows, as we mused in our last conversation, one would argue that continued capital outflows pressure is contained until it isn't. 

In this week's conversation, we would like to at the return of "Mack the Knife" in conjunction with rising oil prices and what it entails. 

Synopsis:
  • Macro and Credit - US yields - It's getting real!
  • Final chart - US core CPI tends to rise in the two years leading up to a recession

  • Macro and Credit - US yields - It's getting real!
While US 10yr Real Yields are a key macro driver, the US dollar so far in 2018 has dramatically diverge from yields. "Mack the Knife" aka the King Dollar also known as the Greenback in conjunction with US real interest rates swinging in positive territory has recently put some pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation:
"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 getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - Macronomics
With the start of an unwind in global carry trade,  "Mack the Knife" aka King Dollar is making a murderous ballad on the EM tourists and carry players alike. Back in July 2015 in our conversation "Mack the Knife" we indicated the following as well:
"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike." - source Macronomics, July 2015
The question for continued pressure on Emerging Markets when it comes to "Mack the Knife" is are we beginning to see a reconnect between the US dollar and yields? The jury is still out there. Rising Breakevens tend to be negative for the US dollar. Also what matters for US equities given they have remained relatively spared so far would be a meaningful widening in credit spreads. This would be accompanied of course by higher volatility.

Right now, as we pointed out last week, dispersion is the name of the game in both credit and Emerging Markets with the usual suspects and weaker players getting the proverbial trouncing as of late such as Turkey and Argentina. We also indicated recently that the continuous rise of volatility in Emerging Markets would lead to additional outflows given the Hedge Funds were the first to reduce their beta exposure. Some investors might follow suit and follow a similar pattern of "derisking" it seems. On the subject of continuous volatility on EM assets we read with interest Barclays take from their Emerging Markets Weekly note from the 17th of May entitled "Shaken and stirred":
"Volatility in EM assets remains elevated. As 10y UST yields have moved further above 3% and the USD has resumed its strengthening trend, total returns in EM assets have taken a further hit – which in turn continues to weigh on flows: YTD returns in EM credit and EM local markets now stand at -3.7% and -2.4%, respectively (Bloomberg Barclays USD EM Agg and EM local-ccy government bond indices), while EM dedicated bond and equity funds had their worst week of outflows last week since the volatility spike in February (see EM flows: Outflows materialize, 11 May 2018). Economic data has hardly helped to improve sentiment, with weaker European and Chinese activity data feeding concerns about weakening global growth momentum.
The market’s focus remains firmly on those countries with external vulnerabilities and financing needs, especially Turkey and Argentina. Even though current account balances can only provide a partial reflection of external positions and vulnerabilities, there has been an interestingly clear correlation between current account dynamics (changes, rather than levels) and asset performance both in EM credit (Figure 1) and local markets (Figure 2).


Although we have argued in the past that aggregate vulnerabilities have improved in EMs since the 2013 ‘taper tantrum’, they have deteriorated over the past year (see the EM Quarterly Outlook: The going gets tougher, 27 March 2018). Furthermore, the confluence of Fed balance sheet reduction, increased UST issuance, effect of US tax law changes on the repatriation of offshore USDs alongside a wider US CA deficit has implied a potentially more challenging capital flow environment for EM.
As the flow environment for financing in international markets has become more difficult, countries’ plans (or necessity) to tap primary markets have also been in the spotlight. While EM sovereign Eurobond supply has run at a record pace in January to April, recent issuance volumes have fallen short of expectations (including the recent Ghana and South Africa bond issues). We would interpret the latter point as a market positive, however. Given the frontloading of issuance in Q1, there are few countries with sizeable issuance needs for the remainder of 2018. Based on our updated supply expectations for individual countries shown in Figure 4, we now expect an additional USD 41bn of supply in 2018.

Given that c.USD104bn has been issued YTD already, this would result in 2018 full-year supply of USD155bn. In this context, we think there is an interesting divergence between Turkey and Argentina: Argentinean authorities have indicated that they do not want to issue any more in international markets in 2018. Remaining financing needs for this year are c.USD5bn on our estimates, which could potentially be covered by an initial disbursement of the requested IMF programme, or by local currency issuance. In contrast, Turkey’s fiscal measures (including this week’s announcement to reduce the special consumption tax on fuel products) will likely keep incentives to raise financing in international markets in place, even in a less receptive market.
Supply-redemption dynamics in EM credit are not the only silver lining for markets. While recent China data has been weak, we see signs of a shift in priorities towards growth, with deleveraging de-emphasised (see China: Softer FAI and retail sales; signs of pro-growth priority and trade tension de-escalation, 15 May 2018). This should in turn support commodities and while well-supported oil and commodity prices have not been able to prevent the sell-off in EM assets, they should at least provide some fertile ground for differentiation.
With regard to oil prices, Venezuela’s election on Sunday 20 May may be of particular importance (see The ship is taking on water, 15 May 2018). Even if President Maduro is reelected, against a backdrop of the main opposition parties boycotting the process and the government’s control over the electoral system, the vote could still be a catalyst for fractures within the regime. Meanwhile, Venezuela oil exports have been disrupted, amid legal action against PDVSA and a broader decline of oil production – one of the likely drivers of the recent increase in oil prices, in addition to US sanctions on Iran.
EM oil exporters naturally benefit from the surge in oil prices. In Iraq, however, this is overshadowed by uncertainties following last week’s legislative elections (and we recommend switching out of Iraq and into Angola and Gabon in our top trade recommendations this week). Full results are yet to be announced but the partial count indicates a clear defeat of current PM al-Abadi favouring cleric Muqtada al-Sadr who has called for the end of corruption and opposed both the US and Iran. The emergence of the Saeroun and Fateh coalition as winners would complicate political negotiations to form a coalition government and it is still unclear whether PM Abadi will be able to secure a second mandate. Ultimately, we believe coalition talks may be protracted, adding uncertainty to the outlook, also with respect to the IMF talks to finalise the third review under the three-year Stand-By Arrangement. The 2018 budget and transfers to the semi-independent region have represented contentious issues which could be exacerbated by negotiations between Kurdish political parties and Baghdad over government formation." - source Barclays
When it comes to "dispersion" we continue to view favorably Russian local bonds in that context, thanks to the support of oil prices on the ruble and central bank easing that will continue.  On the subject of "dispersion" and weaker players in the EM space, we read with interest UBS take from their EM Equity Strategy note from the 18th of May 2018 entitled "This is not a 'Crisis': It is Rising Yields + a Strong $":
"The central story here, in our view, is that the recent 'less friendly' global market environment has allowed investors to 'pick away' at some of the weaker EM stories, especially via FX (Figure 5 below), as the dollar has continued to rebound. These are the EMs that typically do well when the dollar is weak, as the 'carry trade' holds sway. In the face of recent dollar strength, the result has been significant localized EM FX weakness (Figure 6).
Further, several of these so-called 'weaker' markets have also faced idiosyncratic domestic concerns:
  • Turkey (-25% in USD, year-to-date): fears over central bank independence, concerns around monetary policy, widening current account deficit;
  • Brazil (+1.7%): weaker than expected economic recovery, uncertainty ahead of the October elections;
  • India (-6.8%): higher oil prices and higher inflation with residual concerns over whether Prime Minister Modi's BJP will be re-elected in 2019;
  • Indonesia (-16.7%): current account worries and a slow policy response by the Bank of Indonesia;
  • The Philippines (-12.6%): domestic overheating.
To this list, we could add South Africa (-6.3% year-to-date, on a minor hangover from the euphoria of Ramaphosa's elevation to the presidency as the market begins to understand the substantial policy challenges ahead) and Mexico (also - 6.3%, as the July 1st 'first-past-the-post' Presidential election approaches with a shift to the left seeming almost inevitable now).
Further, the dramatic weakness of financial markets in Argentina in recent weeks has added to the sense of 'crisis' in emerging markets, even though technically (from an equity perspective) the country is still, for now anyway, in the MSCI Frontier index. MSCI Argentina is down just over 25% so far this year, almost entirely due to the plunge in the peso (from ARS/USD18.35 to 24.40), which has forced a double-digit rise in interest rates to 40%.
However, the major theme of this report is that, in our view, this is far from being an EM 'crisis'. Several EM equity markets continue to do well such as China, by far the biggest EM with a weight of over 31% in the EM benchmark (+5.1% year-to-date, aided by a resilient CNY, even as other EM currencies have fallen sharply), Taiwan (+2.2%), Russia (+4.1%, which has become a relative 'safe haven' again recently as Brent oil prices hover close to $80/bbl) and parts of the ASEAN and Andean regions, notably Colombia (+10.8%) and Peru (+7.7%).
As with the equity markets, the dramatic differences in currency performance across EM so far this year are very clear from Figure 6.
By de-composing the drivers of 2018 total returns in individual markets in Figure 7 below, we partly combine the results from the two previous charts. The blue bars below show the contributions of currency movements to total returns; these are significantly negative for many markets, especially Turkey, Brazil, Russia, India, Poland and the Philippines.

It is also notable how, for most markets, there has been a negative contribution to returns from the P/E ratio, showing the breadth of the de-rating of EM equities so far this year; Peru (given very strong earnings expansion) is a small but truly remarkable example. In the other direction, sharply lower earnings in Greece and Egypt have translated into a significant re-rating in both this year. For EM as a whole, decent earnings growth (+6%) has been fully offset by currency weakness and a lower P/E ratio to leave the 2018 total return close to zero.
'Correction Counter' Update: The Dollar Rears its Head
With the recent minor break of the early-February post-correction low for MSCI GEMs, we update our 'correction counter' from earlier in the year (Figure 8).

The interpretation of this data is more important than the actual figures themselves. In our February report, we noted that the fall in the EM Currency Proxy accounted for a smaller share (14%) of the early 2018 correction in EM equities than its average share (22%) in previous bull market corrections back to 2003. Therefore, one reason, in our view, why the early 2018 correction (-10.2%) was less severe than the average of previous 'bull market corrections' (-17.2%) was the lack of a major USD rally or, alternatively, the resilient behaviour of EM currencies.
This is no longer true, given that the recent action involves more FX weakness in EM, compared to the initial correction. The updated table shows that this FX factor now accounts for much more (28%) of the newly-defined correction (-10.8% to May 5th). Even more tellingly, after EM rallied to an interim peak in mid-March, MSCI GEMs is down 5.6% since then and, with the EM Currency Proxy down by 2.8% over this period, FX weakness has accounted for exactly half of the EM pullback over the past two months. The US dollar has 'reared its ugly head' for EM equities in recent weeks." - source UBS
There goes the murderous propensity of "Mack the Knife" on EM equities. In similar fashion to the recurrence theorem, the US dollar has indeed "reared its ugly" head and reoccurred again in the course of the time evolution of the "financial system" or, to some effect our macro reverse osmosis theory once again playing out as discussed in our recent ramblings. Add to the mix rising oil prices, and if oil stays above $80/bbl (Brent) this will clearly hurt growth in all major net oil importing countries. That's a given.

Moving back to the subject of US yields and real rates, we think they matter a lot for the direction of the US dollar. On this subject Nomura published a very interesting Rates Weekly note on the 18th of May entitled "Did UST sell-off awaken bond vigilantes?":
"10yr Treasuries break 3% with conviction
The 3% level on 10s has been frustrating to break through of late, having failed once in late April and again last week. However, as with all things related to three, the third time is usually a charm as 10yr USTs are now clearly on the other side of 3%.
All along through this process to higher rates we have sensed a great level of investor skepticism about how high rates could go and how long they would stay at higher levels. This is one reason why we are not overly concerned that spec accounts have a historical short in place. For once, as far as we can recall, specs are being proven right; so why cover now unless the economy and/or financial conditions unravel? The bigger risk we think is that those under-hedged and exposed to convexity start paying rates now.
Overall the market seems too dismissive of how high rates could go in this cycle. We think the Fed has conviction and may continue with its quarterly hikes until “something breaks.” Even then, the Fed might have a hard time throttling back if the real economy is doing well but the financial economy suffers a blow that results in lower valuations. Meanwhile, the perfect storm of more UST debt and less foreign buyers may lie ahead.
We explore some drivers that may impact our overall US rates views. Overall we expect duration dynamics to matter more now than the curve; meanwhile spreads and vols will likely have stronger correlations to higher rates and real rates could hold the key ahead.
Even if this sell-off takes a pause, we continue to see 10s moving towards our 3.25% target and are positioned paid on 5y5y US-IRS and in similar conditional expressions.
US rates views update: Still bearish but now real rates hold the directional key
Duration: 3%, besides being a nice round number, has been a hard nut to crack as the last time we crossed this level was during 2013, a year made famous by taper tantrum. For us, a move beyond 3% was always the next logical step as the Fed is hiking rates and shrinking the B/S during a period of decent growth and more UST supply.
The 3% nominal level seems to be all the focus, but in actuality the next big step for US rates is what happens with real rates. Fig. 1 highlights a few regimes for the 10yr real rate vs the real Fed Funds rate (see note for calculation).

Real rates were in a tight range during the last cycle as well, it was only once the Fed was mid-way through its hiking campaign that market real rates began to rise. The past ten years of financial repression (driven by the Fed’s QE and then Global QE) has kept 10yr real rates in a tight range. Just like the 10yr UST was held captive by the taper-tantrum high of 3%, 10yr TIPS have been unable to break and stay above 0.90-1.00% levels. We believe the Fed is on track to deliver many multiple hikes (which could drive real rates higher in the process too).
3%, well specifically the 3.05%, has been a technical level on which markets seem to have been obsessed with. The market cleared that level for the first time on Tuesday this past week and intra-week the 10yr hit an intra-day high of 3.12% before settling into the end of the week around 3.07%. We usually refrain from being super technical, with both what these levels mean and we do not like to be handicapped by chart formations; however markets often pay attention to these wrinkles. Fig. 2 shows that 10s once again broke out of the range and this time term premia is also rising with the move too.

Net net, we believe it will take a serious breakdown in all the trade talks, geopolitical tensions and/or economic data to weaken (where instead our economists are projecting stronger growth and higher inflation ahead) for 10s to start a massive rally now. It is also interesting to see that stocks, although down on the day 10s broke 3%, took it in stride. In Fig. 3 we list the top 3 two-day yield changes in 2018 vs the S&P500 reaction. If stocks do not correct meaningfully, the full UST yield curve should rise as Fed hikes.
Curve: Earlier in the year we opportunistically traded the curve before going neutral on curve spreads in late Q1 (after the last micro-steepening). Recently the sell-off has also coincided with some bear-steepening. We think this is a healthy development that serves as a reminder that the curve is not pre-destined to fully flatten in this cycle, at least not at these yield levels. The Fed is raising rates but also shrinking its bond holdings, at a time when US fiscal stimulus is resulting in a spike in govie issuance. The curve never fully flattened in Japan during its low rate experience (Fig 4).

We argue that we need a higher overall level of rates (and many more Fed hikes) before we go fully flat too.
Spreads: 10yr swap spreads have begun to see a stronger correlation with the level of 10yr USTs in the current cycle, especially since last September (Fig. 5).

In past hiking cycles, 10yr spreads tended to have a positive slope relative to 10yr UST yields. We expect this correlation to be maintained, similar to the dynamics at the end of the ’04-06 cycle. Also with higher yields, 10yr spreads are more likely to widen due to convexity hedging activities from mortgages portfolios. Less need for corporate issuance due to overseas dollar repatriation would also reduce the tightening pressure on belly spreads." - source Nomura
The continued pressure on EMs can only abate if the US dollar finally mark a pause in its recent surge. A toned down trade war rhetoric would obviously continue to be supportive of a rising dollar and support stronger US growth in the process. The trajectory of the US dollar when it comes to the recurrence theorem for EM is essential. Morgan Stanley in their EM Mid-Year Outlook published on the 18th of May reminded us in the below four graphs what to look for when assessing the US dollar in terms of being bearish (their take) or bullish:
"Why USD Is in a Long-Term Bear Market

 - source Haver Analytics, Bloomberg, Macrobond, Morgan Stanley Research

With mid-term elections coming soon in the US, it is clear to US that the administration would not like to rock the boat and therefore would favor "boosting" the US growth narrative. This would entail further gain on both US yields and the US dollar in the near term we think. 

Also of interest when it comes to growth outlook, UBS made an important point in their EM Economic Perspectives note of the 17th of May entitled "EM by the Numbers: Where is EM's growth premium over DM?":
"EM growth spread over DM has fallen close to its lowest decile since 2001
Strong Chinese growth and low US inflation strongly supported EM asset markets over the last two years. But the growth levers have slowly been shifting in the background. Having registered a cycle high in early 2017, EM growth has moderated sequentially since, while DM growth has picked up. The levels were strong enough in both to keep the market uninterested as to how far EM growth was above DM growth. Now, however, sequential EM growth has slowed to 20th percentile of its distribution since 2001, and, more importantly, the premium of EM growth over DM has shrunk to the bottom decile of its historical distribution.
The spread between EM and DM is an important input in the call of relative stock market returns in the two regions. In y/y terms, this spread is now at 15th percentile of its distribution since 2001. In q/q terms this spread has shrunk to the sixth percentile of its historical distribution." - source UBS
Whereas EM equities clearly outperformed DM in 2017, it might be that 2018 could make the reverse with DM outperforming. Reduced carry has obviously been a headwind for EM equities as discussed above. If the US dollar strength can persist then indeed, US equities will continue to outperform EM equities on a relative basis we think.

For our final chart, as we posited in numerous conversation, we have often repeated that for a bear market to materialize, you would need an "inflation" spike as a trigger. 


  • Final chart - US core CPI tends to rise in the two years leading up to a recession
Positive shock to inflation would coincide with a negative shock to growth, leading to higher bond yields and lower equities. Moreover, higher inflation will coincide with lower growth, therefore bonds will not be a good hedge for an equity portfolio. As we pointed out in our conversation "Bracket creep" that bear markets for US equities generally coincide with a significant tick up in core inflation, this the biggest near term concern of markets right now we think. Our final chart comes from CITI Emerging Markets Strategy Weekly note from the 17th of May entitled "Fragile 5 now down to Fragile 2" and shows that US core CPI tends to rise in the two years leading up to a recession:
"US rates with more upside. 
After US CPI release last week we had wondered whether or not the EUR was in a bottoming process. While it had been trading better for a few days, the move higher in US rates has led to renewed USD strength. To be clear, we have been expecting higher US rates based on our belief in late-cycle behavior. Figure 4 shows that core inflation typically rises by 50bp in the last two years of an expansion.

Over the same two-year period, 10-year US Treasury yields tend to go up in the first year before retreating as rate cuts get priced by the market. Higher yields are therefore not surprising to us." - source CITI
If indeed a rising US Core CPI is a leading US recession indicator then again, we would have another demonstration of the recurrence theorem one could argue...

"Any idiot can face a crisis - it's day to day living that wears you out." -  Anton Chekhov
Stay tuned!

Monday, 14 May 2018

Macro and Credit - The Superposition principle

"The highest ecstasy is the attention at its fullest." - Simone Weil, French philosopher

Watching with interest the Wilson cycle playing in earnest on some various Emerging Markets, leading to additional significant fund outflows in the process, with effectively our previously discussed reverse osmosis theory playing out on some weaker EM players, when it came to selecting our title analogy, we reminded ourselves the "Superposition principle" from physics and systems theory. It states that, for all linear systems, the net response caused by two or more stimuli is the sum of the responses that would have been caused by each stimulus individually. So that if input A produces response X and input B produces response Y then input (A + B) produces response (X + Y). The homogeneity and additivity properties together are called the "Superposition principle". Also, wave interference is based on this principle.  When two or more waves traverse the same space, the net amplitude at each point is the sum of the amplitudes of the individual waves. In some cases, such as in noise-cancelling headphones, the summed variation has a smaller amplitude than the component variations; this is called destructive interference. In other cases, such as in Line Array, the summed variation will have a bigger amplitude than any of the components individually; this is called constructive interference, which one could imply it could be the situation for some specific Emerging Markets countries currently facing tremendous pressure from rising US interest rates and in conjunction with the recent surge of the US dollar but we ramble again...

In this week's conversation, we would like to continue to look at the outflows from some Emerging Markets and the consequences of the global tightening financial conditions we are seeing thanks to the Fed's rate hikes in conjunction with its Quantitative Tightening (QT) process.

Synopsis:
  • Macro and Credit - Balance of Payments pressures in some EMs are building up
  • Final charts - Flatter for longer 


  • Macro and Credit - Balance of Payments pressures in some EMs are building up
In our previous conversation we touched on the fact that for some macro tourists which had extended their stay in the carry trade that, the tourist trap was closing. QT to some extent is leading to the weaker leveraged hands being blown apart it seems. After the explosion of the house of straw of the short-vol pigs, it seems to us that next on the line, given the intensity in fund outflows and pressure on some EM currencies will be some of the "usual suspects" such as Turkey, Argentina to name a few. The global tightening of financial conditions has indeed been induced by the Fed with its hiking process in conjunction with QT. In similar fashion to the "Superposition principle", this process seems to be homogeneous and additive. As the noose of financial conditions is slowly tightening, the pressure is showing up in earnest in the weaker part of the "global capital structure", namely some leveraged EM countries. For some indeed, there is some risk of balance of payments crisis Ă  la 1998 it seems as pointed out by Nomura in their Emerging Market Insights note from the 11th of May entitled "Looming balance of payment risks in EM":
"The pressure is building for several central banks to hike rates sooner than we thought
On 9 May, Argentina requested financing from the IMF to avoid a crisis. This came after the central bank hiked policy rates to 40% in response to the Peso’s sharp depreciation. From Turkey to Indonesia, the one-two punch of rising US rates and USD appreciation is leading to a rising market risk premium in EM countries whose the balance of payments (BOP) is vulnerable. EM central banks are responding by allowing some exchange rate flexibility (i.e., depreciation) and some FX intervention, but if BOP pressures intensify, policy rate hikes may be needed. Our country economists have considered the likelihood of earlier and/or larger rate hikes this year relative to their base cases if BOP pressures continue to build, and the central banks that stand out are Romania (+25bp), India (+50bp), Indonesia (+50bp), Chile (+75bp) and most notably, Turkey (+300bp).
Balance of payments vulnerability
The trio of higher US bond yields, USD appreciation and rising oil prices has led to some market repricing of balance of payment (BOP) risk – e.g., large current account deficit, high short-term external debt, limited buffer of FX reserves – resulting in capital outflow pressure. A scatter plot of current accounts against local currency moves against USD since the start of the year highlights that, with the exception of Russia, EMs with large current account deficits have generally experienced large currency depreciations (Figure 1).
The amount of local government debt owned by foreign investors and the share of corporate debt denominated in foreign currencies are also under close scrutiny (Figure 2).

Our house view is that the weak economic data outside the US represents a temporary soft patch and that market concerns over global growth desynchronising (rising in the US, but falling elsewhere) will soon fade, which should help temper USD appreciation (see Asia Economic Monthly, One step at a time, 11 May 2018).
However, even if we are right that global growth is holding up, this is likely to be only a brief respite for EM. In our mind, Q3 2018 is the high-risk quarter for a painful EM snapback, as this is the quarter in which markets will likely focus not just on the US but a global QE unwind, which could lead to a larger repricing of EM risk premia and the evaporation of market liquidity. Moreover, George Goncalves, our US rate strategist, is warning that, as US inflation rises, UST debt supply balloons and the Fed keeps hiking, there is an upside risk of a bearish overshoot relative to his base case of UST 10s hitting 3.25% in Q3 (see Global macro trade ideas in summer 2018, 2 May 2018).
The US decision to exit the Iran nuclear deal and reinstate sanctions (see US to withdraw from Iran Nuclear Agreement, 8 May 2018) has increased the risks of instability in the Middle East and further oil prices increases (Figure 3).
This could further widen the twin current account and fiscal deficits of large net energy importers – Turkey, India and the Philippines (see Higher oil prices drive EM divergence, 25 April 2018). Q3 will also be around the time that President Trump is likely to double-down on America First policies, such as trade protectionism, ahead of November mid-term elections.
Overall, while there may be a brief, near-term respite, there is a risk that BOP pressures in EM continue to build and possibly intensify in coming quarters. We updated our BOP risks scorecard of 20 EM economies that we introduced in our anchor report (see In an EM snapback, where do the risks lie?, 23 March 2018). Of the 20 EMs, the most exposed to BOP risks are Hong Kong, Romania, Hungary, Turkey and Chile, and for varying reasons (Figures 4 and 5).

For example, Hong Kong’s exposure is due to its massive cumulative capital inflows since 2010 and low interest rate compensation for BOP risk; in Romania and Turkey, it is because of their large current account deficits and low FX reserves; in Hungary it is due to high external debt and relatively low FX reserves. The least-exposed countries to BOP risk are Singapore and Taiwan, according to our scorecard.
We acknowledge that there are a host of country-specific factors (beyond variables that we use for scorecard; current account, FX reserves, external debt, cumulative portfolio flows, real interest rates and interest rate differential) that can also impact EM, most notably geopolitics and domestic politics. For example, the Russian Ruble (RUB) and Brazilian Real (BRL) depreciated against USD by 8.8% ytd and 7.9%, respectively, despite showing lower BOP risks in the scorecard.
Policy response to balance of payment pressures
Those EM central banks facing BOP pressures are mostly responding to in an eclectic manner (see First Insights - Turkey: Core problem, 3 May and Asia Insights - IDR: Challenging flow backdrop amid global risks, 9 May). They are allowing for some exchange rate flexibility (i.e., depreciation) and some FX intervention (drawing down FX reserves), but if BOP pressures intensify, these initial policy responses may become constrained. For example, the larger the currency depreciation the greater the risk of an inflation overshoot and a foreign currency debt mismatch problem or, if FX reserves are drawn down too far, the market may lose confidence in the ability of authorities to defend the exchange rate.
If BOP pressures mount, policymakers could shift to more draconian responses, such as interest rate hikes, tapping central bank FX swap lines, borrowing from the IMF (or in Asia, utilising the Chiang Mai pooled FX reserve initiative), tightening fiscal policy or, in the extreme case, imposing capital controls.
Our country economists have focused on the possible interest rate response. They have considered, on the assumption that BOP pressures continue to build (and oil prices stay at these levels or go higher), the likelihood of earlier and/or larger policy rate hikes over the rest of this year relative to their current base cases (Figure 6).

This “what if” exercise highlights that, if BOP pressures continue to build, there is a 50% or higher likelihood that we will need to build more rate hikes into our base case forecasts for  Romania (+25bp), India (+50bp), Indonesia (+50bp), Chile (+75bp) and most notably, Turkey (+300bp). The likelihood is lower, but if we added rate hikes in Brazil and Chile, it would be several, not one and done. Also, instead of our current base case forecasts of rate cuts by year-end, if BOP pressures continue to build, it could be that we have rates on hold (Colombia, Mexico and South Africa)." - source Nomura
We agree with Nomura that the trio of higher US bond yields, USD appreciation and rising oil prices has led to some market repricing of balance of payment resulting in capital outflow pressure (what we called in our last musing as a reminder "reverse osmosis"). "Reverse osmosis" as well as QT make more and more the front-end of the US risk curve appealing from a risk management perspective and ensures as well US dollar cash is back in the allocation tool box. Furthermore, as Renaissance Macro pointed out on their Twitter feed, when it comes to the 2013 Taper Tantrum comparison, this time it's different when it comes to current account deficits:

"A more hawkish Fed is a risk for emerging markets, but for most EM economies, current account positions have improved relative to the 2013 taper tantrum year, Argentina being a notable exception." - source Renaissance Macro
Argentina of course continues to be in the line of fire with FX reserves being burn rapidly to support currency woes. It is always the leverage players who blow up first when financial conditions are gradually tightening with Fed's hikes and QT. No surprise as well to see Turkey in the crosshair facing the Superposition principle. This is clearly highlighted by David Goldman again in Asia Times in his comment from the 11th of May entitled "Buy ruble, sell Turkish lira":
"After two sets of emergency conferences with economic leaders and Turkey’s ebullient president, the Turkish lira dropped from a peak of 4.38 to the dollar to 4.23 this morning, before weakening back to 4.25. Turkey’s economic problems remain insoluble: The Turkish economy is a credit-fueled bubble with a growing current account deficit and dangerous dependency on short-term capital inflows and interbank borrowings.
As Swaha Pattanik wrote this morning at Reuters, “Turkey’s president is pursuing contradictory goals. Tayyip Erdogan wants to support the sagging lira. That would require measures to curb inflation and the current account deficit. However, his efforts to pump prime growth, especially before June elections, will achieve the exact opposite.”
The ruble is a different story. The political threat of sanctions against Russia caused the currency to collapse from a low of 57 to the dollar on April 1 to a high of 64 to the dollar on May 2. Since then it has rallied a bit, trading at 61.7 at noon EST on May 10. The ruble is a pretty good proxy for the price of oil (the r-squared of regression of the ruble on the oil price since 2010 is around 93%).
As the chart above shows, regression analysis of the ruble vs oil puts the Russian currency three standard errors away from the regression line. The currency’s fair value vs oil is around 50. Sanctions against Russia are not likely to continue (Washington wants Russia’s cooperation in keeping the Iranian genie in the bottle). They will be flouted in any event by the Europeans, whose trade with Russia is a multiple of Russian-US trade. The market vastly overreacted to US sanctions, and the ruble’s cheapness continues to represent a buying opportunity." - source Asia Times - David Goldman
Not only is the Russian currency attractive, but we would contend that local currency bonds also are enticing from a yield perspective, so what's not to like about them? And if you believe in a commodity "rebound" thanks to rising inflation expectations why not buying what is cheap in terms of PE? Russian equities are relatively cheap and offer decent dividend yields as well we think.

What we think we are seeing in Emerging Markets is similar to what we are seeing in High Yield, namely a rise in "dispersion", which means in effect some investors are becoming more discerning when it comes to reassessing "credit risk" and issuer profiles on the back of a weaker "global market put" provided by central bankers. This rise in dispersion means that everything is not rising anymore in synchronized fashion thanks to massive liquidity injections given now it is being gradually withdrawn. As we pointed out recently in various musings, this could mean that some active players could potentially start outperforming again passive strategies. This also mark we think the return of the global macro game thanks to volatility being less repressed by the central bankers/planners as of late. 

From a fund outflows and risk perspective, for a continuation of pressure on the weaker links in the EM segment, the direction of yields and the US dollar matters for the pressure to continue or subside somewhat as far as the Superposition principle is concerned. On that subject we read with interest Deutsche Bank's take from their 9th of May note entitled "EM Flows and Risk Sentiment: Outflows, but size still contained":
"The EM Flow Indicator (chart below) shows that outflows are emerging – the last two weekly prints have been negative (indicating outflows from EM).

The last time there were two consecutive weekly outflow prints was in Dec 2016, thus this is a significant development. However, the size of outflows remains relatively contained, with the magnitude of the flow indicator nowhere near as stretched as in late 2016. Therefore, it is likely that the recent sharp EM FX depreciation has been driven more by FX hedging of EM assets held by foreign investors, rather than the outright selling of these assets (which would have triggered larger outflows). This remains the main risk for EM – the potential transition from FX hedging to outright outflows – but would require continued significant dollar strength and rising US yields. Over the coming weeks, the EM flow data will take on even greater importance, as it could provide a signal on whether we transition from phase 1 of the EM FX sell-off (FX hedging) to phase 2 (outright asset sales).
[Note that the indicator captures flows normalized by the standard deviation, with values greater than +0.5 indicating sizable inflows and values less than -0.5 indicating sizable outflows.]
The EM Risk Monitor – an EM-specific measure of risk sentiment – has entered risk negative territory, but is by no means stretched. This indicates that if external conditions remain unfavourable (e.g. continued broad dollar strength) there is potential for more negativity in EM sentiment.
The additional charts below show that both debt and equity flows have dipped into negative territory; but the magnitude of outflows remains relatively contained. Meanwhile, the charts displaying the raw flow data by source show outflows on IIF (local source) data, but flat flows on EPFR (ETF + mutual funds) data.
- source Deutsche Bank

Of course as the Superposition principle goes, it is contained when it comes to outflows until it isn't . Continued capital outflows pressure could lead to more pronounced "derisking". We highlighted in our last musing how hedge funds had already cut on their beta exposure in EMs. It remains to be seen with continued pressure on yields and in particular the US front-end how long this stability will last. 
This is Barclays take on the recent bout of EM volatility from their The Emerging Markets Weekly note from the 10th of May entitled "After the volatility eruption":
"Pressures on EM assets have accelerated over the past week. And although improved market sentiment fueled a relief rally on Thursday, concerns of a negative performance - outflow loop, which we discussed in the EM weekly: No spring in EM’s step last week appear to remain very much alive. While the market has focused on countries with external vulnerabilities and financing needs, especially Argentina and Turkey, market volatility has significantly broadened in scope over the past few weeks. This has evoked memories of the 2013 taper tantrum, as investor concerns have been centred on higher UST yields and tighter USD funding conditions, coupled with a painful parallel strengthening of the USD.
More granularly, we see four issues as having driven the weaker risk appetite in EM asset markets: (1) signs of softening activity relative to expectations; (2) increased risks of supply side shocks (eg. oil/Iran and trade protectionism); (3) the cascading sharp selloffs in some heavily-owned EM asset markets likely causing some investors to breach their risk limits; and (4) the correlation between EM credit spreads and US rates having turned positive (ie. higher UST yields being aligned with wider spreads) – a pattern usually only observed in periods of sharp UST adjustments. The last point, especially, illustrates the resemblances of the current sell-off with the taper tantrum.
However, we also think that there are important differences to 2013. Although it is difficult to see where the upside surprises in activity or a reduction in supply side shock risks will come from in the near term, we think EM fundamentals provide some buffers against a period of flow retrenchment. EM growth is stronger now than in 2013 and current account deficits in most market-relevant EM countries are smaller than they were in 2013 – with some notable exceptions (Figure 1).

And while EM debt levels are generally higher (Figure 2), EM countries have used the favourable issuance environment over the past few years to lengthen maturity profiles.

For example, the share of newly issued EM sovereign and corporate eurobonds with a tenor of 15 years or longer has increased significantly over the past few years (Figure 3), while near-term maturities have in many cases been addressed pro-actively via early buybacks/tenders.
We think that these buffers make it possible that, eventually, the negative cycle can be broken. In EM credit, flows should be supported by a pick-up in redemptions in June/July and the self-regulatory effect of supply, which we would have expected to slow down in any case after the record pace in Q1 18. Moreover, the recent underperformance of EM versus rating-and-maturity matched DM credit (see the Global EM Credit Monitor, 8 May 2018) has reversed the relative richening of EM in the early weeks of 2018 (Figure 5).

While EM is still not cheap relative to DM based on historical ranges, this should provide an eventual anchor for crossover sponsorship.
More generally, cheapening in the EM asset class may help normalize spread-rates correlations, when portfolios have fully adjusted to the higher levels of market volatility. This would support a technical retracement of EMs, absent additional idiosyncratic risks developing in key markets. We note that alongside the modest cheapening in EM credit, local rates have cheapened as well (Figure 6) but spreads vs. UST (on an FX hedged basis) remain shy of the midpoint of historical averages.

This is because much of the selloff in EM local rates has been driven by a weaker FX (Figure 7), which is now approaching lows after  stripping out their relation with broader asset market variables (Figure 8).

Therefore, we see greater opportunities to express near-term constructive views on EM FX than local rates if position reduction and the USD rally take a breather. We hit our stop loss in our long HGB October 2027 and long SAGB February 2048 positions but FX-hedging in the case of the former was able to more than offset for the loss on the local bond position. We do think there is scope for a near-term EM FX retracement and see value in short USDZAR through options.
However, a more lasting recovery may require increased investor confidence in a pick-up in EM fundamentals, a dovish shift by core market central banks (or a shift in investor perceptions of the likely path of core rates) and/or a reduction in global risks. The decision of the US to withdraw from the Iran nuclear deal does not suggest that a reduction in global geopolitical risks is imminent. President Trump was widely expected to withdraw from the Iranian nuclear deal but his announcement was one of the most hawkish options we previously discussed (Iran Special Report: Trump and the Art of (Breaking the Iran) Deal, 8 May 2018). Leaving the JCPOA may not only ultimately increase transatlantic tensions as many European companies have signed contracts to increase investments in Iran, but geopolitical risks in the Middle East will equally be on the rise. The recent escalation between Israel and Iran in Syria is perhaps the most concerning near-term risk which may be exacerbated by tensions with Saudi Arabia and the Yemeni conflict.
At a country-specific level, the market’s focus has been on Argentina and Turkey, as well as elections in Asia and the ongoing NAFTA negotiations involving Mexico.
The dramatic change in sentiment in Argentina has exposed its vulnerabilities given its large financing needs and twin deficits. In an effort to prevent a sharper weakening of the exchange rate, the central bank hiked the policy rate in three out-of-cycle decisions by a total of 1275bp, taking it to 40%, alongside other measures including interventions in FX markets. A stabilization of the exchange rate remains vital to the macroeconomic outlook with a high level of pass through into inflation. The government has sought to reassure markets by also announcing a more ambitious primary fiscal target for 2018 of 2.7% of GDP (down from 3.2% of GDP), which we think can be met, and which will also make the 2019 target of 2.2% of GDP attainable. Finally, as the ARS continued to selloff this week, the government announced its intention to enter into negotiations with the IMF for a high-access stand-by agreement. The program is meant to be precautionary but is planned to secure Argentina’s 2019 financing needs. It remains to be seen how stringent the conditionalities imposed by the IMF program will be but it remains crucial to assess the impact on the short-term macroeconomic outlook, as well as its longer-term political costs for the Macri government. With regards to the latter, the government has sought to allay concerns by expecting fiscal targets to be similar to the current official ones.
We think that geopolitical risks expose Turkey’s external vulnerabilities against a backdrop of rising USD funding costs and increasing concerns about EM capital inflows’ outlook (25% of Turkish banks’ liabilities are foreign and gross external financing needs are c.20% GDP). This, accompanied by the market's perception of the CBT being behind the curve amid a deteriorating inflation narrative and de-anchored medium-term inflation expectations, has amplified the pressures on Turkish assets. Nevertheless, as discussed in Turkey MPC Preview: Early elections strengthen the case for a hike, 18 April 2018, the early elections also increased the desire of politicians for a stable TRY, as indicated in Wednesday’s economic coordination council (ECC) meeting chaired by President Erdogan and the statement that followed. The CBT could come under pressure again going into the 7 June MPC meeting and any decisive action could provide a temporary backstop for Turkey assets." - source Barclays
For now the markets is playing the dispersion game even in US high yield. The CCC energy bucket in US high yield is of course benefiting from rising oil prices leading to a significant recent rally in the high beta space. But, as the Superposition principle goes no offense to the "contained crowd", problems can be additive it seems given flows follow performance usually for some "usual suspects" in the EM world...

When it comes to investor becoming more discerning risk wise hence the rise in dispersion, this is most likely due to the gradual fading of the powerful anesthetic provided by central banks and more importantly the Fed during so many years. While we keep indicating that we are moving in the final innings of this long credit cycle, though we do see cracks showing up in the goldilocks narrative which has prevailed for so long, we still haven't reached the end of the game and still remain short term "Keynesian" for various technical reasons such as prolonged buybacks activity, US tax reform and record earnings and strong M&A activity to name a few. The perma bear crowd will eventually get their day, but we still haven't gotten to that point yet we think. In our final point below we touch on the pace of the flattening of the US yield curve, being an important topic in these days and ages.

  • Final charts - Flatter for longer 
Given the gradual hiking pace followed by the Fed, on the back of still loose financial conditions has indicated by the most recent Fed quarterly Senior Loan Officer Opinion Survey, this is not playing out like the previous rapid hiking pace of the Fed of the 2004 period. Therefore, the flattening process will take a little bit longer to play out before we see the dreaded inversion so many financial pundits are talking about. Our final charts comes from Bank of America Merrill Lynch Securitized Products Strategy weekly note from the 11th of May and indicates that the inversion of the curve necessary to display a recession signal may take indeed a while to manifest itself:
"The ongoing flattening of the yield curve to post-crisis lows – the 2yr-10yr spread hit 43 bps this week – continues to elevate concerns among some that recession is on the verge of being signaled. For example, (dovish) St. Louis Fed President Bullard said “yield curve inversion is getting close to crunch time” and that “yield curve inversion would be a bearish signal for the US economy if that develops.” From our perspective, the key part of that quote is “if that develops:” 43bps may be closer to curve inversion than before, but it is still not inverted.
As Chart 1 shows, yield curve inversion has been relatively rare over the past 30 years, occurring briefly in 1989, 2000, and 2006, about 12-18 months in advance of the recessions of July 1990-March 1991, March 2001-November 2001, and December 2007-June 2009. We find the 1995-2000 timeframe in Chart 1 especially noteworthy.

The average 2yr-10yr spread over the 5-year period was 35 bps, flatter than today’s level of 43 bps, yet it was only when the curve finally inverted in early 2000 that the 2001 recession was ultimately signaled. The point here is that the curve may have flattened substantially, but, by the standards of the late 1990s, it’s nowhere near the level that it is signaling recession.
Another way of saying this is: “it may be late cycle, but it’s not end of cycle.” We think this distinction is important when it comes to recognizing that securitized products spreads may have at least a couple more years of tightening ahead of them, in a grind lower; in our view, meaningful spread widening is not expected until the cycle comes to an end. We don’t expect this to happen until at least 2020-2021. We are waiting for curve inversion as the first signal that the cycle will be ending. The lesson of the late 1990s is that inversion could take much longer to experience than some or many might expect.
Next, we consider interest rate volatility, as measured by the MOVE index in Chart 2.

Most of the spike in late January/early February has been retraced and volatility is back near the all-time lows seen in late 2017. Given the flattening move in the yield curve, we suspect that new lows in the MOVE index will be seen in the near term.
As seen in Chart 3, in the past two late cycle curve flattening environments (1990s, 2000s), interest rate volatility generally grinded lower as the yield curve flattened/inverted and only increased when the curve began to steepen. In the 2005- 2007 period, for example, as the curve flattened and then inverted, rate volatility moved steadily lower.

For example, the MOVE index went from 75 in May 2005 (about the time the 2yr-10yr spread was near today’s level of 43 bps) to a low of 59 bps in May 2007, when the yield curve had flattened to -3bps. (In the subsequent seven months, as the 2yr-10yr spread went from -3 bps to 120 bps, volatility more than doubled, with the MOVE index jumping to 145 by December 2007.)
We’re looking for similar late cycle behavior this time around. Following the yield curve flattening lead, the MOVE index appears poised to head to new post-crisis lows over the near term." - source Bank of America Merrill Lynch
One caveat is that the Superposition principle when it comes to Argentina has shown sentiment can indeed turn on a dime, or simply a rising US dollar. When it comes to credit markets and high beta, for "goldilocks" to return in the short term, lower rate volatility does indeed help out carry players and yield hogs alike. Yet, one would be wise to start using even at least partially the new tool in the tool box, namely cash in US dollar thanks to the front-end of the US yield curve. It has become more and more enticing relative to dividend yields as of late but we ramble again...

"Attachment is the great fabricator of illusions; reality can be attained only by someone who is detached." -  Simone Weil
Stay tuned!
 
View My Stats