Tuesday, 11 February 2014

Credit - The Magnus Effect

"As long as the world is turning and spinning, we're gonna be dizzy and we're gonna make mistakes." - Mel Brooks

While looking at the disappointing US macro data (ISM and nonfarm payrolls), we reminded ourselves of the Magnus effect, which the commonly observed effect in which a spinning ball curves away from its principal flight path. Our analogy refers somewhat to golf given backspin generates lift by deforming the airflow around the ball, in a similar manner to an airplane wing. This is called the Magnus effect. A ball moving through air experiences two major aerodynamic forces, lift and drag. Modern golf balls called Dimpled balls fly farther than non-dimpled balls due to the combination of these two effects. In relation to our chosen title and the analogy with economy, looking at the performance of the US 10 year treasuries since the beginning of the year is directly countering the thesis that the American economy has truly achieved "escape velocity". When it comes to lift and drag, no doubt to us that the US economy recent economic data is more indicative of "stalling momentum" rather than "escape velocity momentum" when ones look at the recent ISM new orders index (-13.2 points to 51.2, the largest decline since December 1980) as well as pending home sales.

We argued in the past that the growth divergence between US and Europe were due to a difference in credit conditions. In this short post we will look at the reverse in the divergence between US growth and Europe in conjunction with the significant flows out of Emerging Markets Equities seen in recent weeks.

The divergence between US and European PMI indexes is all about credit conditions. This is why the US was ahead of the curve when it comes to economic growth compared to Europe since December 2011. We have discussed this before, the US PMI versus Europe - source Bloomberg:
The Fed’s January Senior Loan Officer Opinion Survey released this week indicated weaker demand in mortgages over the past quarter. A net 28.2% and 45.7% of banks reported weaker demand for prime and non-traditional residential mortgages, the worst data since April 2011 and January 2009 respectively.

Of course when it comes to "Magnus effect" and major aerodynamic forces, some Emerging Markets have suffered the full force of outflows as "tourist" investors have been leaving in drove. For instance EM retail outflows represented -18 billion $ year to date according to JP Morgan's recent EM Fixed Income Flows Weekly:
"EM equity retail outflows persisted with $6.5bn of outflows this week, comparable to last week's $6.4bn in redemptions as the MSCI EM extended YTD losses to -8.4%. Meanwhile, EM woes drive flight-to quality as US bond funds experienced a surge in demand as inflows reached $14.6bn, the largest single weekly inflow in EFPR's history." - source JP Morgan

What is of interest as well have been the outflows from the famous Japanese Double-Deckers which favorite "carry" currency has long been the Brazilian real as indicated as well in JP Morgan's note:
"Japanese funds experienced outflows of $254mn with dedicated local Brazil funds accounting for most of this (-$222mn)." - source JP Morgan

The reason behind the depreciation of the Brazilian Real in 2011 was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again. It looks to us that, in similar fashion to what happened in 2011, a similar exit by these Japanese retail funds is adding pressure on the Brazilian currency:
In blue the Brazilian real versus the US dollar, in red the Australian dollar versus the US dollar, as one can see the correlation between the Australian currency and the Brazilian real broke down spectacularly in 2011.

But when it comes to Brazil, not only the Japanese outflows have been putting additional pressure on the currency but the slack in industrial production is as well putting some pressure as indicated by Bloomberg's recent Chart of the Day:
"The biggest monthly plunge in Brazil’s industrial output since December 2008 shows policy makers’ confidence that a weaker real will stimulate manufacturing is proving misguided.
The CHART OF THE DAY tracks Brazil’s industrial production index, the real on a percentage-change basis and exports on a rolling six-month average. Output fell in December by the most in five years even as the exchange rate weakened 34 percent since the manufacturing index reached a record-high in May 2011.
The currency is the biggest decliner against the U.S. dollar in the last three years among 16 major currencies tracked by Bloomberg after the South African rand.
President Dilma Rousseff said on Feb. 3 that a weaker real would help drive exports this year, an affirmation of Finance Minister Guido Mantega’s comments in September that a currency drop would make Brazilian products more competitive and boost manufacturing. Goldman Sachs Group Inc.’s Alberto Ramos said the government’s optimism isn’t warranted, as companies are hampered by rising labor costs and lack of incentives to modernize.
“The bottom line is that we expect the industrial sector to underperform,” said Ramos, Goldman’s New York-based chief Latin American economist. “It is a sector that is still facing significant foreign competition and cost-competitiveness issues, which will handicap performance.”
The country’s main manufactured exports and destination by value last year included passenger cars to Argentina and Mexico and automobile parts to Argentina and the U.S., according to Trade Ministry data. Brazil, which is the world’s largest emerging market behind China, saw its economy contract in the third quarter by the most since 2009 as investments dropped.
Fiat SpA is one manufacturer that has seen financial results hindered by Brazil operations. The carmaker’s 2013 trading profit in Latin America dropped 41 percent largely from price increases in Brazil, Chief Financial Officer Richard Palmer said in a Jan. 29 earnings call." - source Bloomberg.

When it comes to outflows as well, it is worth noticing the significant outflows from equities, putting somewhat a dent to the "Great Rotation" story from bonds to equities as indicated by Bank of America Merrill Lynch's note from the 6th of February entitled "Stampeding Bears":
"The bottom-line: big capitulation out of stocks into US Treasuries…marks end of Jan/Feb correction
The big numbers: largest weekly equity fund outflow since Aug’11 ($28bn); largest equity ETF outflow since Feb’09 ($26bn); largest bond fund inflow since Apr’10 ($15bn)
The caveat: our trading rules not yet flashing “strong buy”… Bull & Bear index now down to 4.2 (hit 1.8 late-June – Chart 1); Global Breadth index now up to 44% (hit 96% late-June – Chart 3) and…
…EM Flow Trading Rule: another $7-8bn outflow next week triggers contrarian buy-signal (last buy-signal on 6/27/13 followed by 14% rally in EEM next 3 months)" 
- source Bank of America Merrill Lynch

As far as equity flows are concerned, the "reverse osmosis" namely the tapering impact on some Emerging Markets have led to the following as detailed in Bank of America Merrill Lynch's note:
"Equity Flows
$6.5bn outflows from EM equity funds (15 straight weeks of outflows = longest outflow streak on record – Table 3)
4-week outflows from EM equities = 2.1% of AUM; another $7-8bn outflows next week would trigger contrarian “buy” signal from our EM Flow Trading Rule (3.0% is threshold)
Huge $24bn outflows from US equity funds (almost all via ETF’s SPY, IVV, IJH – but see above for caveat on Good Harbor)
Business as usual for Europe (32 straight weeks of inflows) and Japan (7 straight weeks of inflows)" - source Bank of America Merrill Lynch

Whereas Fixed Income Flows,such as the ones seen in US Treasuries, shows the asset class hasn't lost its appeal:
"Monster $13.2bn inflows to Govt/Tsy funds (caveat: $10bn inflows likely due to Good Harbor rebalancing from SPY to SHY, IEI & UST)" - source Bank of America Merrill Lynch

When it comes to Emerging Markets woes, not all countries in the Emerging Markets suffer from acute imbalances and as far as the long term trend is concern in true "Angus Maddison" fashion, the future is brighter for many Emerging countries than it look in the near term. Just wait for the "tourists" to exit and value will come back, no doubt to the fore-front.

"There's no limit to how complicated things can get, on account of one thing always leading to another." - E. B. White, American writer

Stay tuned!

No comments:

Post a Comment

View My Stats