Thursday, 29 May 2014

Chart of the day, or "dislocation of the year"? S&P 500 vs US 10 year

"I believe in social dislocation and creative trouble." - Bayard Rustin

The S&P 500 vs US 10 year bonds - Graph source Bloomberg:
We discussed this topic with our good cross-asset friend and fellow "Macronomics" blogger "Sormiou". We thought this time around we would entertain you with some interesting points he made and add our comments as well:
"The dislocation that started mid-April is becoming more and more "puzzling":

Noise 1: on-going Chinese Treasuries buying, through Belgium, cf the on-going CNY slide and Belgium Treasuries holdings stats strangely exploding

Noise 2: simply short covering on T-Note

Or bond markets sending alarming growth/inflation message, that equity markets do not want to hear?"

As we posited in our last post "The Vortex Ring", the upcoming re-allocation process from Japanese behemoth GPIF, will continue to put additional downward pressure on core government bonds. For instance the pressure can already been seen coming from Japanese investors as indicated by Nomura in their latest "Summary of Japanese investment in April". While banks have been shedding foreign assets, key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets:
"Insurance companies: Insurance companies accelerated their investment in foreign bonds, while slowing their investment in JGBs (Figure 1). 
They purchased JPY633bn ($6.2bn) in foreign bonds, and there has been net buying of foreign bonds by insurance companies for three months in a row. Major lifers. financial results show they increased their exposures in EUR-denominated assets aggressively in FY2013, and they are likely
to keep adding exposures in EUR-denominated assets in April, as the share of EUR in total foreign assets remains lower than before the Euro crisis. While the strong investment in foreign bonds was partly owing to the beginning of the new fiscal year, we expect lifers to be more positive on foreign bond investment as Japanese yields are still low. In fact, insurance companies. superlong JGB investment slowed to JPY226bn ($2.2bn), the smallest amount since April 2013. Their investment in JGBs also slowed to its smallest amount since May 2012 (JPY567bn or $5.5bn). The liquidation of domestic equity exposures continued at a moderate pace (-JPY35bn or $0.3bn).
Banks: Banks sold JGBs at the highest pace since April 2012 (-JPY2632bn or $25.7bn), while also selling foreign bonds at a high pace (-JPY2021bn or $19.7bn. This was the fifth month in a row of banks. foreign bond selling, while recent MOF weekly datasuggest their selling of foreign bonds has been slowing lately.
Pension funds: Pension funds accelerated their investment in foreign assets in April. They purchased JPY510bn ($5.0bn) of foreign bonds, the biggest amount since 2005 when data begun (Figure 3).
The biggest pension fund, GPIF, is expected to change its target portfolio to add more foreign assets, and smaller pension funds may have already started increasing foreign asset exposures ahead of the expected GPIF announcement. Pension funds continued selling domestic equities, albeit by a small amount (-JPY94bn or $0.9bn)." - source Nomura

Another illustration from the bond buying spree from Japanese investors can be seen below coming from the same Nomura report:
As per our last post "The Vortex Ring":
"It is worth noting Japanese have bought a record $86 billion of US treasuries in the last 12 months according to Bloomberg data. It is important to note as well that for the Japanese investors, adjusted for living expenses, US treasuries still yield more this year than Japanese government debt than at any time since 1998,  as per monthly data compiled by Bloomberg showed recently. So if the GPIF starts deploying its "allocation firepower" in June, maybe you ought to cling to your US treasuries a little bit longer, and maybe after all the Belgian central bank is just a very "astute" investor after all..."

We still sit tight in the deflationary camp, meaning you should go with the "flow" and expect further compression in core government yields and spread in this "japonification" process. 

Key take aways from our last post "The Vortex Ring"  are as follows:
-Don't sell your US Treasuries yet (you might want to "front run Godzilla", namely Japan's GPIF),

-Play the rebound of the Nikkei with weakening yen again in June (but first short term pain has been and is on the cards)

-Don't expect QE yet in Europe.

"We spend more time developing means of escaping our troubles than we do solving the troubles we're trying to escape from." - David Lloyd, British artist.

Stay tuned!

Monday, 26 May 2014

Credit - The Vortex Ring

"When a system is in turbulence, the turbulence is not just out there in the environment, but is a part of the organization or organism that you are looking at." - Kevin Kelly

While looking at the burst of turbulences last week in the credit and government bond high beta space, in conjunction with the expected results coming out of the European elections and given our fondness for "flying" analogies which we abundantly used in our conversation "The Coffin Corner", in this "Tapering" environment we reminded ourselves of the Vortex Ring when it came to choosing our post title. The famous Vortex Ring also known as the "Helicopter Stall" can happen easily under certain specific conditions particularly when approaching landing, as illustrated more recently in the movie Bravo Two Zero when the Special Operations 160th SOAR helicopter came crashing down in Abbottabad during Operation Neptune Spear after experiencing the infamous vortex ring state.

You are probably already asking yourselves where we are going with this analogy already but, given Ben Bernanke's various QE programs have been compared to "helicopter money", we thought a reference to a "helicopter stall" given the Fed's tapering stance would be more than appropriate for this week's chosen title. 

Therefore in this week's conversation we will review various states of central banks at play, between the Fed, Japan and the much expected ECB move in June.

In a "helicopter stall" or vortex ring state, the helicopter descends into its own downwash. Under such conditions, the helicopter can fall at an extremely high rate (deflationary bust). 

For such structural failure or crash to occur you need the following three factors to be present as indicated by Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'":
"To get into vortex ring, three factors must all be present:
  • There must be little or no airspeed.
  • There must be a rate of descent.
  • There must be power applied.
Note that all three of these must be going on at the same time."

  • There must be little or no airspeed.
In our conversation"The Coffin Corner" we indicated the following:
"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."
With the latest reading from the US GDP coming at 0.1% for the 1st quarter indicates for us little or no "airspeed" for the US economy and the aforementioned "economic" stability we mused on last year.

For Europe the latest inflation readings indicates little or no "airspeed" on top of the very weak economic growth reading making it paramount for the ECB to act sooner rather than later in order to avoid the Vortex Ring state.
  • There must be a rate of descent.
Tightening policies to preserve price stability and unwind some of the trillions of dollars pumped into global economies since 2007 via "helicopter"easing will require interest rate hikes, and will also necessitate asset sales by central banks, according to April's IMF Stability Report. The tapering stance of the Fed does include indeed a rate of descent of $10 billion a month.

Of course another rate of descent which we have been following has indeed been US Velocity. What we have found most interesting is the "relationship" between US Velocity M2 index and US labor participation rate over the years. Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3% - Graph source Bloomberg:
It has been downhill from 1997 with velocity falling linked to factor number three of the "vortex ring" namely "There must be power applied" (ZIRP in conjunction with the various iterations of QE).

Yet, the recent fall in unemployment has been masking the Fed's progress in avoiding the dreaded Vortex Ring as seen in the lack of breakout in the employment population ratio. The Fed has not been able yet to reach "escape velocity" from this vortex ring as displayed in the Bloomberg graph below indicative of the conundrum:

The lack of "recovery" of the US economy has indeed been reflected in bond prices, which have had so far in 2014 in conjunction with gold posted the biggest returns and upset therefore most strategists' views of rising rates for 2014 (excluding us given we have been contrarian). Those who read between our lines have done well so far in 2014 given we hinted  a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":
"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

  • There must be power applied.
When it comes to applying power, like many pundits, we have been baffled by the action in US Treasury bond buying from Belgium which increased its holdings in US debt by $201 billion in five months to $381 billion at the end of March this year, making it the third largest holder after China and Japan - graph source Bloomberg:
Helicopter pilot students, have a tendency to slow down, if they are afraid of overshooting their landing point, which can put the helicopter they are flying in a vortex ring state. In similar fashion, central bankers have a tendency to slow down if they are afraid of overshooting. 

It is not only the Fed and its central bankers which have a tendency to overshoot, likewise, Governor Haruhiko Kuroda in Japan has failed to convince he had done enough to spur 2% inflation and that his policies will be enough to pull Japan out of 15 years of deflation, risking in effect another Vortex Ring state for the Japanese markets as displayed by the below graph plotting the performance of the Nikkei index, the USD/JPY currency pair and the inverse Itraxx Japan indicative of credit risk for corporate Japan:

If one looks at unemployment levels and inflation levels for a gauge of the respective situation of various central banks it seems that, while Japan has achieved full employment, it has failed for many years to spur inflation, while the US as well as the United Kingdom, have achieved to reduce their unemployment levels, Europe is still closer to the Vortex Ring State (deflationary bust) given it boasts very low inflation levels compared to the other G4 and record unemployment level, as displayed in this Barclays graph from their recent Market Strategy note entitled "Japan at the end of the post VAT hike tunnel" from the 26th of May:
"Monetary policy: Potential growth & expected inflation, quantity & quality
Opinion regarding deflation in Japan has long been divided between those who believe the problem cannot be solved by monetary policy alone, ie, potential growth is tied with inflation expectations, and those arguing conversely that inflation is a pure monetary phenomenon that can be controlled by monetary policy independently of potential growth. For some reason, the latter group appears to overlap almost completely with those claiming that the degree of monetary easing can be measured unambiguously via the monetary base (monetarists). We agree with the second group that deflation can be overcome by monetary policy without a change in potential growth, and believe that this is in fact occurring at present. However, we think that the driving force behind the BoJ’s present Quantitative and Qualitative Easing (QQE) is not the quantitative but the qualitative side.
Japanese market participants tend to subscribe to the former view. This may reflect a general feeling based on experience rather than the result of academic study. The nation has failed to quash deflation despite 15 years of sundry monetary easing measures, which may have convinced many that inflation expectations are being affected by factors that cannot be controlled by monetary policy, such as a decline in potential growth (including demographic trends). For those holding to this argument, the opposing view sounds like a vacuous theory ignoring a decade and a half of actual events. In particular, since the majority of those supporting the second view are “reflationists”, who believe monetary policy should give greatest weight to quantity, the two sides basically find themselves talking at cross purposes.

Those taking the former view, which is the market consensus, feel that events in 2001-06 proved that the size itself of the BoJ’s balance sheet has no impact. They claim therefore that if the QQE focuses solely on increasing this volume, it cannot achieve a change in inflation expectations. However, we think instead that the important point is the quality of the bank’s balance sheet; ie, the volume of risk in the bank’s acquired assets. We believe the effectiveness of the monetary easing by the Fed and BOE after the Lehman shock and the rapid turnaround in the Japanese economy after the launch of the BoJ’s QQE stemmed from their purchases of long government bonds and risk assets, pushing supply/demand above levels (in other words, pushing yields below levels) that the economic fundamentals would indicate as fair. The general social principle that economic policy should not intervene in the free market, which prior to the Lehman shock also applied tacitly to monetary policy and financial markets, prevented the BoJ from turning to asset purchases in JGB markets even in deflation-racked Japan. The serious crisis brought about by the Lehman collapse led to market intervention by countries worldwide and a shared belief that the ideology itself needed to change. With the success of this monetary policy approach in the US and UK, the BoJ also shifted its focus from quantity to quality, carrying out a market intervention of unprecedented scale with the QQE.
That is, QQE is a new monetary easing stance that had not been tried in over 15 years of deflation. Still, the markets perceived this to be little more than an extension of previous policy and assumed from past experience that it would have no effect on inflation expectations. A good number of market participants still dismiss the claim by BoJ Governor Haruhiko Kuroda and other BoJ executives that the bank’s 2% price stability target is achievable. Some likely hold the view that the BoJ itself is simply maintaining the 2% target in the hope of raising inflation expectations in the market.
In contrast, we think the bank is conducting an easing policy with entirely different effects than its earlier efforts, and we do not believe its past inability to beat deflation means that it will be unsuccessful this time as well. Furthermore, we suspect that the BoJ itself likely shares this view. Its confidence in the price stability target may well have deepened in light of ongoing developments in the Japanese economy. The statement from last week’s Monetary Policy Meeting noted anew that “QQE has been exerting its intended effects”. As we have explained, we see this not as calculated optimism designed to perk up the Japanese public but as a straightforward reflection of the bank’s actual belief at this time. As long as the bank maintains this stance, we think it is unlikely to alter its monetary policy. At the same time, we believe it will be relatively flexible in adjusting its current policy in the event of any upward or downward risk to the economy." - source Barclays.

When it comes to the US and the United Kingdom, it is interesting to note the very strong correlation between 10 year bond yields throughout the years as displayed in the below graph from Bloomberg comparing yields for UK gilts and US treasuries since March 1994:

And on a shorter time frame since 2011, UK 10 year yields versus US 10 year yields - graph source Bloomberg:
The question on everyone lips is of course who will blink first (raise rates that is), the Bank of England or the US Fed? One thing we are certain of, not anytime soon.

So in relation to the veiled question from our title and from Barclays take, the big question is of course can the "Vortex Ring" (aka deflationary bust) can be avoided by monetary policy alone?

We are still sitting tightly in the deflationary camp and expect further yield compression on US Treasuries. As such, we agree with the Wall Street Rant Blog on that subject:
"Many Government Bonds Yielding Less Than United States
I can't listen to a talking head, bond manager, strategist or seemingly anyone without hearing about how "Rates can only go higher from here". When in reality THEY CAN go lower! In fact, when you look around the world, on a relative basis, THEY SHOULD!" - source Wall Street Rant Blog

Indeed they should. To add ammunition to this, one should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower, in particular its upcoming reforms and asset shift scenarios as reported by Nomura in their recent report from the 23rd of May:
"The yen bond market remains range-bound as market participants’ interest in Abenomics and expectations of additional BOJ action fall. The consensus view is that the USD/JPY outlook is dependent on the US economy and yields. However, it is increasingly likely that the government’s June growth strategy will exceed market expectations, which have dropped markedly. We are focused on the likely scenario that the GPIF and other public pensions will start shifting from a yen bond bias in the near future. In our upside scenario, these reforms would lead to approximately JPY20trn in foreign securities investment in the next 12-18 months, potentially weakening JPY by about 10%." - source Nomura

Here are the two potential "re-allocation" scenarios according to Nomura's paper:
"As of end-
December 2013, the GPIF had JPY128.6trn ($1.3trn) in managed assets. Of 
the three associations, KKR had JPY7.8trn ($78bn), Chikyoren had JPY17.5trn ($175bn) 
and Shigaku Kyosai had JPY3.6trn ($36bn, all as of end-March 2013). Total managed 
assets for the four pension funds amount to almost JPY160trn ($1.6trn). The GPIF has 
attracted the most attention because of the sheer scale of its assets, but the three 
associations manage about JPY30trn or $300bn in assets.

The GPIF‟s weighting of Japanese bonds had fallen to 55% as of end-December 2013. It was reported that after the Industrial Competitiveness Council‟s follow-up section meeting on 8 April, the GPIF‟s head office explained that this weighting had dropped to 53.4% on the withdrawal of pension benefits. Thus the weighting of Japanese bonds is already below 55% and could be nearing the 52% floor of the allowable deviation. At the same time, the weighting of Japanese equities stood at 17.2% at end-December 2013, close to the maximum allowable deviation of 18%. Foreign bonds. weighting was 10.6%, close to the standard median value of 11.0%. At 15.2%, foreign equity's weighting is still some way from the maximum deviation (17.0%). Trends in the weightings of Japanese bonds and Japanese equities suggest that, as described in the FY14 investment plan, the GPIF has already been investing flexibly within the permissible range of deviation, and it may be investing such that the respective weightings do not approach the median value. As the strong equities/weak JPY trend has continued since end-2012 and the fund has changed its basic portfolio in June 2013, the GPIF.s portfolio is already shifting gradually from domestic bonds to risk assets.

Asset shift scenarios based on the new basic portfolio
We look at simulations for fund shifts following changes in the basic portfolios of the GPIF and the three public pension funds, in line with two scenarios, based on their current portfolios as described above. In Scenario (1), the four funds lower the weighting of Japanese bonds to 40% and allocate 8% of the money thus freed up to Japanese equity (from 12% to 20%) and 6% each to foreign bonds (11% to 17%) and foreign equity (12% to 18%), as Panel Chairman Takatoshi Ito recommended. Scenario (2) assumes more moderate changes, with the Japanese bond weighting lowered 10% to 50%, the Japanese equity weighting raised 4% (12% to 16%) and the foreign bond and foreign equity weightings raised 3% each (from 11% to 14% and from 12% to 15%). As we expect a compromise between the stance of President Mitani, who is cautious about portfolio changes, and Mr. Ito, who is more aggressive, a reduction in the Japanese bond weighting to about 50% is close to our main scenario for now. If the aggressive scenario (1) advocated by Mr Ito is realized, the GPIF.s balance of Japanese bond holdings would drop by about JPY19.6trn ($196bn), from JPY71.0trn ($710bn) at end-2013 to JPY51.4trn ($514bn). This JPY19.6trn decrease would translate into a JPY3.6trn ($36bn) increase in Japanese equity, a JPY8.3trn ($83bn) rise in foreign bonds and a JPY3.6trn ($36bn) increase in foreign equity. This scenario assumes that the weighting of short-term assets would recover to 5% of the basic portfolio, with short-term assets rising by JPY4.1trn ($41bn). Assuming that the ratio of short-term assets is fixed at the 1.8% level of end-2013 and that money is allocated to risk assets, the increase in respective assets would expand accordingly. When including the three public pension funds, the decrease in the Japanese bond balance would balloon to JPY26.8trn ($268bn), and the funds could allocate JPY5.8trn ($58bn) to Japanese equity, JPY10.8trn ($108bn) to foreign bonds and JPY6.0trn ($60bn) to foreign equity.

In Scenario (2), the GPIF.s and three public pension funds. balance of Japanese bond holdings would decrease about JPY11.1trn ($111bn). The GPIF.s Japanese equity weighting has already increased to 17.2%, so if we assume that it returns to the median after the basic portfolio change (16%), the balance of Japanese equity would fall about JPY0.5trn ($5bn). At the same time, the balance of foreign bonds would rise by JPY6.1trn ($61bn) and the balance of foreign equity would increase about JPY1.2trn ($12bn).

The above figures are rough estimates that do not take valuation gains or losses into account. Amounts may also differ considerably depending on fluctuations in short-term assets and investments within the permissible range of deviation. As noted above, our main scenario at this point expects changes in the basic portfolio to be around the scale of Scenario (2) in the near term. However, in what we can Scenario (2)-2, we assume that Japanese bonds account for 50% of the basic portfolio, the permissible range of deviation expands to }10“, the ratio of risk assets is kept higher than the median value to avoid a sharp drop in Japanese bonds as a result of a sharp acceleration in the inflation rate, and the weighting of short-term assets is kept at about 2% (permissible range of deviation from median value set at -10% for Japanese bonds, +5% for Japanese equity, +4% for foreign bonds, 4% for foreign equity and -3% for short-term assets). In this case, similar to Scenario (1) the balance of Japanese bonds held by the GPIF and the three public pension funds would decrease by JPY26.8trn ($268bn), the balance of Japanese equity would increase JPY7.4trn ($74bn), the balance of foreign bonds would rise JPY12.4trn ($124bn) and the balance of foreign equity would increase JPY7.5trn ($75bn). At first glance, Scenario (2) looks like a conservative change, but depending on the actual stance on investments after the basic portfolio is changed, the asset mix could be significantly changed as envisioned by Mr. Ito." - source Nomura

No wonder peripheral bonds in Europe have been benefiting from Japan's appetite as displayed by Bloomberg's recent Chart of the Day entitled "Euro-Area Periphery Hooked on BOJ stimulus":
"The CHART OF THE DAY shows Europe’s peripheral bond rally stalled this month as the yen strengthened versus the euro. Last week the Bank of Japan refrained from adding to the 60 trillion yen ($589 billion) to 70 trillion yen poured into the monetary base each year that has encouraged Japanese investors to put money into higher-yielding European assets.
“Peripheral yield spreads appear vulnerable to a correction following the strong rally and the yen tends to often strengthen on credit risk,” said Anezka Christovova, a foreign- exchange strategist at Credit Suisse Group AG in London.
“Japanese portfolio flows usually have an impact. Those flows could now divert elsewhere. We don’t expect any substantial action from the Bank of Japan in coming months and that could also lead the yen to strengthen.”
Japanese investors bought a net 1.41 trillion yen of long-term foreign debt in the week ended May 16, the most since Aug. 9, data from the finance ministry in Tokyo showed on May 22.
Flows into Europe may be tempered as yields in Europe’s periphery climb. The average yield spread of 10-year Portuguese, Greek, Spanish and Italian bonds over German bunds has risen 20 basis points this month to 270 basis points, after touching 239 basis points on May 8, the lowest since May 2010, based on closing prices.
New York-based BlackRock Inc., the world’s biggest money manager, said on May 8 it had cut its holdings of Portuguese debt, while Bluebay Asset Management said on May 9 it had seen the majority of spread tightening it was looking for.
Trading euro-yen based on movements in the bond-yield spreads of the euro area’s peripheral nations would have been a successful strategy, Credit Suisse strategists, including Christovova, wrote in a May 21 note." - source Bloomberg.

It is worth noting Japanese have bought a record $86 billion of US treasuries in the last 12 months according to Bloomberg data. It is important to note as well that for the Japanese investors, adjusted for living expenses, US treasuries still yield more this year than Japanese government debt than at any time since 1998,  as per monthly data compiled by Bloomberg showed recently. So if the GPIF starts deploying its "allocation firepower" in June, maybe you ought to cling to your US treasuries a little bit longer, and maybe after all the Belgian central bank is just a very "astute" investor after all...

One thing for sure our "Generous Gambler" aka Mario Draghi has shown he is truly a magician when it comes to driving market expectations and given all of the above, maybe just a few tricks such as a rate cut and negative deposit rates will do the trick nicely to provide continued support for European government bond markets. Eurozone-residents' demand for foreign assets could be further extended and exacerbated if the ECB were to try introducing negative rates on deposits rather than the proverbial QE bazooka unless of course he goes for the €1 trillion option. The current account excesses which so far have been supportive of a strong euro versus the dollar have been the result of Eurozone residents wish of increasing savings as security against an uncertain future. The willingness of Eurozone residents to accept net receipts of foreign-currency assets  has weighted on the value of the euro in recent years and has forced the current account into surplus. Given that surplus it seemed unlikely for us until recently that the euro would fall much against other currencies unless credible fears of currency break-up re-emerge. Of course the latest European elections results could has well re-ignite fears in the coming months and allow for Mario Draghi to enjoy a depreciation of the euro without having to resort to the proverbial QE bazooka in conjunction with the help from the Japanese pension funds allocation.

In recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have significantly diverged as displayed in the below Bloomberg chart:
Mario Draghi is definitely the greatest central bank magician and probably an astute student of Sun Tzu and the Art of War we think:
"The best victory is when the opponent surrenders of its own accord before there are any actual hostilities... It is best to win without fighting." - Sun Tzu

It is as well probably worth taking Sun Tzu's wise quote in anticipation of the next ECB meeting:
"All warfare is based on deception. Hence, when we are able to attack, we must seem unable; when using our forces, we must appear inactive; when we are near, we must make the enemy believe we are far away; when far away, we must make him believe we are near."

On a final note, when it comes to avoiding the dreaded helicopter stall aka the Vortex Ring,  as per Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'" it is supposed very easy. It wasn't for the ace helicopter pilots of the 160th SOAR during Operation Neptune Spear, There is "no easy day", same goes with QEs:
"It is actually very easy to get out of vortex ring… at least in the incipient stage when the juddering and yawing starts. Some say it is impossible to get out of the fully developed state, but when you start to perceive signs of vortex ring, all you need to do is remove one of the three factors noted above. So, you push the cyclic forward to increase airspeed, or lower the collective to reduce power.  It is not possible to reduce the rate of descent to stop vortex ring, as that would involve increasing power.  In practice, pilots usually increase the airspeed, as unless the helicopter is very high, you don’t want to lower the collective and risk hitting the ground!" - source Helen Krasner - Decoded Science - January 8, 2013.

Unfortunately, getting out of vortex QE ring won't be that easy rest assured, particularly given we have not been in the incipient stage given Japan, the Fed and the Bank of England have all been repeated "QE offenders", but we ramble again...

"Well, I think we tried very hard not to be overconfident, because when you get overconfident, that's when something snaps up and bites you." - Neil Armstrong

Stay tuned!

Wednesday, 14 May 2014

Japan and Nikkei volatility - Time for some Abe fireworks?

"I guess we all like to be recognized not for one piece of fireworks, but for the ledger of our daily work." - Neil Armstrong

Interesting comments today from a trading desk relating to the technical situation for Nikkei volatility:
"Long-dated Nikkei volatilities getting destroyed – time to BUY? Not a consensus trade yet but worth a look

Hearing from the street main exotic houses down $US250mm in 5mth…a blood bath.
Volatilities look cheap and you keep accumulating at a cheaper level…averaging down. Until when do you have to add? Main issue on the Buy-side is you can’t wait and need to show a steady growing P&L.

Issuance from the Uridashi is 2-3 times less than 2012, vega outstanding is only at $US20mm and we are already at the same volatility levels than in 2012 with a market at 14000…What's going to happen if we correct even more and test the 13000 level? It will be a disaster! Very tough time for pure volatility accounts

Until 6 months ago, the street was thinking that tapering would create some volatility. Now nobody believes in it. When the market goes down, FED prints a lot. When the market goes up, FED still print… but less. In fine, FED maintains the equity market high and rates low. Their politics have zero impact on the real economy but brings the market’s volatility at zero…Believe the current trend in volatilities will continue…more downside.

If there is a risk of a massive unwind of the “Japan trade” in the next 3 to 6 months, why looking at 2 year maturity options? Better to focus on September/December maturities. More gamma / more liquid. If you anticipate high realized volatility before the year-end, why trading long-dated volatilities with the risk of seeing them dropping an additional 2 vol points? Exotic desks are bleeding and if spot keeps dropping, their long vega exposure will keep growing…

Nikkei 2 year ATM (at the money) IV is now at 18.90% so down 2.5 points in one month. 4 year percentile at 4.9% so we're extremely closed to the historical lows. That trend is not only specific to equity. Vols across all the asset class are at their lows. FX (USDJPY) 1 month vol is at absolute historic lows. The market seems to be too complacent, something is "mispriced" and we think it’s the right time to accumulate volatility.

Why Nikkei and not another index or asset? Because that's the only one with catalyst... a ticking bomb or a fireworks box depending on the efficiency of Abe's government and the BOJ/GPIF action over the next few months."
Nikkei 2 year ATM IV since 2008:
-market source

The market has been driven mostly by structured products with dealers getting more and more long 2 year vega short the spot. It has been a regular trend for quite a few years, but in recent weeks, there has been some capitulation with the Nikkei falling from 15000 to 14000 in addition to the index trading in a tight range. If one thinks the Nikkei index could move either way strongly during the second part of the year, then going long volatility on December 2014 could make sense for exemple. In similar fashion volatility on the Japanese Yen has followed the same path.

Dynamic between FX and Equities as illustrated by this Bloomberg graph displaying not only the surge of the Nikkei and the USD/JPY but also the reverse Itraxx Japan CDS index:

If the economy suffers as a result of April’s tax change, the BoJ has stated its intention to respond with increased monetary stimulus.

As we have argued in our November 2012 conversation "Cold Turkey", while some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we still think that we are in an early second stage for the Multistage Japan rocket:
"A multistage (or multi-stage) rocket is a rocket that uses two or more stages, each of which contains its own engines and propellant. A tandem or serial stage is mounted on top of another stage; a parallel stage is attached alongside another stage. The result is effectively two or more rockets stacked on top of or attached next to each other. Taken together these are sometimes called a launch vehicle. Two stage rockets are quite common, but rockets with as many as five separate stages have been successfully launched. By jettisoning stages when they run out of propellant, the mass of the remaining rocket is decreased. This staging allows the thrust of the remaining stages to more easily accelerate the rocket to its final speed and height." - source Wikipedia

We still don't see Japanese going "cold turkey" on liquidity "injections" for the time being hence our "contrarian" volatility take and we still recommend you closely monitor Japan's foreign bond buying spree. 

On the Abenomics "second stage rocket" subject here is what Barclays had to say in their latest Japan update from the 14th of May entitled "Abenomics trades - Standing at a crossroads":
"Financial markets I (Abenomics trades; long Nikkei/short JPY) – One more leg towards summer? As mentioned above, market positioning in Abenomics trades appears to have become much cleaner in both Japanese equities and forex. Given the significant drawdown of positions since the beginning of the year, it is most likely that equity prices and USDJPY will respond to developments in a fairly straightforward manner in near term. In other words, we expect one more leg of Abenomics trades to be initiated on the back of series of events expected in next couple of months, including additional QQE by the BoJ (expected in July, but might be frontloaded depending on financial conditions), announcements on asset reallocation by GPIF and other public pension funds (likely in June), and another for growth initiative proposal (also likely in June) along with additional fiscal stimulus measures (in July-September). That being said, whether overseas investors are likely to take the lead in these trades and hold the positions beyond the summer remains uncertain. With less risk-taking capability and less enthusiasm (or sense of urgency) in being re-involved in Abenomics trades, their investments may remain within the range of opportunistic trades, rather than those with long-term commitments. For overseas investors to share a firmer and longer-term commitment to Japanese markets, the government and corporates will likely have to deliver something new, rather than continue to depend on QQE by the BoJ. Some measures to encourage corporate management to promote shareholders value through share buybacks and/or higher dividends, given ample cash on hand, would be one example, along

Financial markets II (JGBs) – A “widow maker” for overseas investors? Last, but not least, we have not observed any significant positioning in JGBs. Most overseas investors are still tempted to trade JGBs on the back of a “terminal” view of Abenomics (regardless of whether it is succeeding or not): rising long-term rates with steepening bias to the curve. If Abenomics is successful, higher and more sustainable inflation expectation should lead to higher yields, with the BoJ most likely to stay behind the curve by remaining patient on the timing of alternating the direction of policy. If Abenomics fails, there will be resurgence of deflation fears, at least at the initial stage, so that yields could be lower. However, this will eventually lead to less sustainability of government debt with a structural bias towards an external deficit so that long-term rates should imply higher fiscal premium. That being said, there is a limited amount of conviction in terms of whether or not to trade JGBs now based on these terminal views of Abenomics, given the dominance of the BoJ in the market as the sole provider of liquidity. At least in the near term, if there is a temporary selloff in the JGB market, it will be either liquidity-driven, as was observed in 2003 and after the introduction of QQE in 2013; policy-driven, as JGB purchasing operations by the BoJ may fail at a certain point; or flow-driven on the back of rapid portfolio rebalancing by GPIF and other public entities. With the terminal views on Abenomics mentioned above in mind, however, whether JGBs remain the widow maker they have been in the past is essential for understanding the future prospects of Abenomics." - source Barclays

Finally here what is we had to say on Japan's reflationary play in April 2013 and the impact on Europe:
"Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think." - Macronomics - 27th of April 2013 - "The Coffin Corner"

"A kamikaze is a surprise attack, according to our ancient war tactics. Surprise attacks will be successful the first time, maybe two or three times. But what fool would continue the same attacks for ten months? Emperor Hirohito must have realized it. He should have said 'Stop.'" 
- Saburo Sakai, IJN flying ace (quote used in our conversation "The Coffin Corner" 27th of April 2013).

Stay tuned!

Sunday, 11 May 2014

Credit - Supervaluationism

"Vagueness is at times an indication of nearness to a perfect truth." - Charles Ives

While looking with interest the continuation of the "japonification" of the credit markets with continued spread compression, with the Dow setting up a new record at the close on Friday, and given the numerous discussions surrounding the valuation level reached, we reminded ourselves this week of the supervalutionist theory of vagueness for this week chosen title. Supervaluationism, also called the logic of vagueness, involves the idea that truth and reference need not be logically connected in the normally expected ways. It holds that the future is undetermined (The quality or state of being settled; confirmed state), making borderline statements such as "the market is in a bubble" to retain all the theorems of standard logic while admitting "truth-value gaps". For instance, in the supervaluationist theory of vagueness means that ambiguous statements are true when they come out true under all disambiguations whereas normally, logicians require that a statement be disambiguated before logic is applied. For the supervaluationist, a demonstration that a statement is not true does not guarantee that the statement is false. Meaning for us that, some pundits would argue that the statement "the market is in a bubble" to be a false statement, but not guaranteeing it to be false either.

 You are probably already asking yourself where we are going with the above, for us the lack of volatility and the distortion created by Central Banks meddling with interest rates through ZIRP are inherently destabilizing. The continuation of spread compression in credit and the obvious reduction of dealers' balance sheet and lack of secondary liquidity are evidence of our "supervaluationist" statement we think. Therefore in this week's conversation we will delve further into the meaning of the lack of volatility, which is somewhat a continuation of what we approached in terms of understanding "bubbles" and market dynamics we previously discussed in our conversation "The Cantillon Effects".

The lack of volatility and spread compression is illustrated in the below graph displaying the Itraxx Crossover 5 year generic CDS index (50 European High Yield entities) versus the Eurostoxx 50 Implied volatility since 2008 - graph source Bloomberg:
We are now below 2008 levels for both the Itraxx Crossover index and Eurostoxx volatility.

The small divergence between VIX and its European equivalent V2X - Source Bloomberg:
The highest point reached by VIX in 2011 was 48 whereas V2X was 51. VIX is around 13.81,  and V2X at 16.94. Overall volatility remains muted. 

While European government bonds continue to fall, indicative of the flows rather than a reduction of the stock of debt, which in Europe continues to grow, not helped much by the latest benign inflation figures - graph source Bloomberg:
Yields on Italian and Spanish 10-year bonds hit record lows of 2.90 percent and 2.87 percent respectively on Friday with Irish 10-year bonds falling to 2.65 percent, below the equivalent borrowing costs of the UK.

On another note, equities in Europe have continued to rally and credit spreads have continued to tighten while the 10 year German yield has continued to fall, while volatility (bottom graph) has remained muted
 - graph source Bloomberg:

When it comes to volatilities, they have been repressed, no doubt by central banks intervention as illustrated in the below graph displaying the VIX, the MOVE index, the CVIX index and EM FX volatility index, the JP Morgan EM-VXY - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.
EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

As we posited in our conversation "The Anna Karenina Principle" in November 2013:
"The regime change in both lower volatility and lower yields is indicative of the adaptation of the financial system not under biological stress but under central banks "financial repression" ".

We also commented at the time:
"Of course when it comes to the "Anna Karenina principle" as well as Bayesian learning history shows the final phases of rallies have provided some of the biggest gains.
But we are driveling again given in January 2012 in our conversation "Bayesian thoughts" 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."

When it comes to volatility, we agree with BNP Paribas's recent note from the 7th of May entitled "Volatility is An Iceberg". After all we used a similar analogy quoting Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit": "That Which is Seen, and That Which is Not Seen". In similar fashion, in volatility there is indeed the visible part and the invisible part:
"-Think of Volatility as an Iceberg: There is the Visible part reflected in daily returns of asset prices and there is the Invisible part that is submerged under water. Water is to an iceberg what Liquidity by central banks, excess cash on balance sheet, government current account surplus or excess reserves, lows geopolitical tensions are to asset prices. Low volatility does not mean no volatility, it simply means less Visible vol.
-"Stability is inherently destabilizing“: The key message in this chart can be summarized with the quote of Hyman Minsky "Stability is inherently destabilizing" where one can replace 'stability' with 'low volatility'. 3mth implied volatility continue to be supressed across asset classes as the per the clustering effect at the bottom of the chart. This is most significant in EURUSD volatility as the gravitational put of deleveraging forces and dovish ECB rhetoric are offset by current account surplus and strong trade flows couple with large inflows into European fixed incomes and equities. In addition, EM equities, commodities and rates implied volatility are recoupling downward to already subdued DM equity vols.
-The fundamental drivers of low volatility aside from the distortive effects of QE are important to consider. After a debt/credit crisis, there is always a process of 'balance sheet repair', deleveraging and natural selection of more risk averse and conservative investors, businesses, management and governments that usually drive earnings and economic volatility down. You see this with the
Credit Cycle clock where credit outperforms equity at 12 o'clock, then a co-recovery phase at 3 o'clock that eventually leads to releveraging phase at 6 o'clock when debt funded buyback and LBOs booms outpace cash flow growth where investors gravitate from 'hunt for yield' to 'hunt for return/capex. This, inexorably, leads to the next crisis at 9 o'clock aka "Mynski Moment"... We think Europe is at 2.30pm and US is at 5pm and EM at 9pm and this is corroborated by the current state of cross asset volatility. Take the SPX for example, with $1.7 trill of cash on balance sheet out of $18trill of market cap, 'equity easing/share buyback' of $40bn a month and record FCF/dividends generation and accumulation, it is tough to see volatility explode endogenously especially when you consider that cash has a volatility of ZERO. One can even run a Sum of the Volatility Parts at a macro level to make this casemore explicit.
Companies evolve and adapt in the same way single cell organisms become more complex and resilient multi-cells biological entities. You see this with the structural decline in asset intensity via DM to EM outsourcing of capex in US and German companies, globalization of supply chain and human resource management, Ricardo's labour theory of value, technology processing intensity and output etc...As such, their valuation multiples and intrinsic volatility ought to change structurally. Low volatility is a distortion by central banks but it is also and more importantly a symptom of deleveraging and balance sheet repair of both private and public balance sheet." - source BNP Paribas

But low volatility, thanks to central banks distortion doesn't equate to low risk. On the contrary, as explained recently by JP Morgan on the 2nd of May in their note "Low volatility is not low risk":
"-Most perplexing and challenging for market participants this year has been the tight trading ranges and dramatic falls in volatility in bond, equity, and commodity markets. Low volatility is in principle good for markets and the economy as it boosts confidence and investment. All policy makers have as an objective to reduce uncertainty and to maximize transparency and predictability. But low volatility is no panacea and has a number of downsides. Most importantly, it creates moral hazard as it eliminates caution and thus creates excess risk taking and leverage. This in turn lays the basis for a market reversal, as market participants become too levered and have no defenses anymore against adverse events. In addition, low volatility amid directionless markets destroys trading and liquidity.
-Most dangerous to markets is that low volatility is not the same as low risk. It can be, as fewer shocks depress volatility. But markets can also move in tight trading ranges if the shocks hitting them neatly offset each other. And that is probably what has happened this year. The continued lack of a yield on cash remains a powerful stimulant for financial assets. But economic activity data have seriously disappointed so far this year. By our estimates, Q1 global growth is only coming in near 2%, well down from the 3% we expected at the start of the year. We have kept our growth projections for the rest of the year largely unchanged, balancing off the possibility that Q1 weakness was just due to temporary factors -- suggesting upside from Q2 on -- and the possibility that something more fundamental is going wrong in the world economy.
-Similarly on the monetary policy side, the lack of any change in the zero-interest rate policy in major DMs has depressed volatility in global bond market and currencies. But this low policy volatility is also not the same as low policy risk. Policy makers themselves are facing serious conflicting incentives and signals. At the global level, low growth and inflation suggest the need for continued easy money. But the massive rise in asset prices over the past few years is raising the risk of asset booms and busts that have produced huge economic instability over the past two decades. The US housing market, where activity is weak but prices are up 13% oya, is a microcosm of this conundrum facing the Fed. Our economists this week in GDW comment on other conflicts facing central banks, such as the one between weak growth and falling unemployment in the US, and improving growth but falling inflation in the Euro area. The message is that policy is on hold, but risk is two-sided.
-A return of volatility, resulting from a change in the current balance between bearish and bullish forces, is not automatically a negative for risk markets. Our preferred scenario remains an end to economic growth downgrades and reduced geopolitical risk, which would boost equity prices and push up bond yields. But clearly, bearish forces might come to dominate also. Our main point is that volatility rarely stays this low for long.
-What can we do about this? Low market volatility has boosted the search for yield in fixed income, as discussed last week. A return of vol would threaten this, making up prefer liquid equities over less liquid credit as the main risk asset to own. Elsewhere, given how low implied volatility is in equities, it would make sense to be long here." - source JP Morgan

Indeed, end of the low volatility regime period generally leads to a strong and sudden crash in prices, bringing us to our "supervaluationist" statement of the market being in a bubble, which has been the question asked recently by Deutsche Bank in their recent Quant View report from the 3rd of April entitled "Are we in a tech bubble yet again?":
"Recently there has been a wave of buyouts, acquisitions and initial public offerings of technology and social media companies. With tech startups at multi-billion dollar valuations and with a growing number of technology billionaires in their twenties and thirties, it’s not surprising that many investment managers are asking if we are in the midst of yet another technology bubble. One of the most cited charts that support this argument is Figure 1 below. It shows the outperformance of the NASDAQ index (compared to other US indices) during the Dot-Com bubble of the late nineties. Interestingly, the outperformance in the NASDAQ during the Dot-Com Bubble appears eerily similar to the outperformance in the NASDAQ in more recent periods. Could this suggest the onset of yet another technology bubble?
This is not an easy question to answer especially since there is no formal “definition” of 
a bubble. However, merely comparing the performance of the wealth curves in isolation 
lacks the empirical and analytical rigor to determine the presence of a technology 
bubble. As such, in the month’s novel edition of the quantview, we analyze various 
quantitative, fundamental, market, and sector indicators to help answer this question. 
Additionally, we teamed up with our fundamental technology analysts to incorporate 
their valuations and analysis on answering this question. In short, our findings suggest that we are NOT in the midst of a technology bubble and here’s why:
1. Compared to the Dot-Com Bubble, tech stocks are 
currently cheaper
We start by simply analyzing whether technology stocks are currently trading at similar 
multiples compared to the Dot-Com bubble. To do this, we simply calculate the 
aggregate earnings yield for the entire technology sector over time. We define our 
technology sector as the stocks in the Russell 3000 with a MSCI GICS code of 45 (i.e. 
Information Technology Sector) Recall that earnings yield is simply the inverse of 
trailing 12 month price-to-earnings. A relatively lower earnings yield (i.e. higher PE) 
signals that a stock or sector is relatively expensive. We compute the aggregate 
earnings yield overtime for the entire information technology GICS sector (Figure 2). 
Interestingly, our findings show that the technology sector was significantly more 
expensive during the Dot-Com Bubble than in recent periods.
Additionally, we computed the aggregate time-series earnings yield for each industry 
group within the technology sector to determine if a certain industry group within 
technology was expensive . Note that the technology 
sector has three industry groups: Software & Services, Technology Hardware & 
Equipment, and Semiconductors & Semiconductor Equipment. The results show that 
even at the industry group level, technology stocks were significantly more expensive 
during the Dot-Com Bubble. In conclusion, our findings indicate that in aggregate, 
technology stocks were significantly more expensive during the Dot-Com bubble.

In their report Deutsche Bank goes into more details about the many reasons why they think we are not in a midst of a technology bubble, which for us is indeed illustrative of "supervaluationism we think given that for the supervaluationist, a demonstration that a statement is not true does not guarantee that the statement is false, meaning for us that their demonstration might be valid, it does not guarantee we are not in a bubble, created once more by "easy money".

On a side note, we recently pointed out the strength of the performance of US long bonds as well as the "Great Rotation" from Institutional Investors to Private Clients". As posited by Cam Hui on his blog "Humble Student of the Markets", the "great rotation" has indeed been triggered somewhat by defined benefit pension funds locking in their profits. One of the chief reason therefore behind this rotation has been coming from US Corporate pensions, as indicated by Gertrude Chavez-Dreyfuss and Richard Leong in Reuters in their article from the 24th of April entitled "US Corporate pensions bet on bonds even as prices seen falling":
"Major U.S. companies including Clorox and Kraft are favoring more bonds in the mix for their employees' defined benefit pension plans, even amid signs the three-decade bull run in bonds is on its last legs.
The $2.5 trillion U.S. corporate pension market enjoyed a robust recovery in 2013, paced by stocks, as the Standard & Poor's 500 Index rose the most since 1997. That helped pension funds close a funding hole that opened after the global credit crisis of 2008, so that the average corporate pension was funded at about 95 percent at the end of 2013, compared with 75 percent at the end of 2012, Mercer Investments data show.
Now that they're more confident that they have the money to meet their pension obligations, corporate pension managers are pulling back from the perceived risk of the stock market and buying U.S. government and corporate bonds, even though many expect bond prices to fall in coming years.
"Even if interest rates rise more than the market predicts, you do get the income component that offsets the price loss of those bonds," said Gary Veerman, managing director of U.S. Client Solutions Group at BlackRock in New York, which has $4.4 trillion under management, of which two-thirds are retirement-related assets. Veerman's group advises corporate treasurers how to manage their pensions.
The allocation to bonds by the top 100 publicly-listed U.S. companies in their defined benefit pension plans increased to a median of 39.6 percent in 2013 from 35.9 percent in 2010. Stock allocation in the plans fell to 40.9 percent in 2013 from 44.6 percent in 2010, according to global consulting firm Milliman." 
"Now they're in a position to say: 'I don't need all those equities because my funding status is in the mid- to low-90s,'" said Dan Tremblay, director of institutional fixed-income solutions at Fidelity unit Pyramis in Merrimack, New Hampshire, which manages more than $200 billion.
Because many defined benefit plans are closed to new workers, managers are more concerned with having a steady stream of income every year to meet their annual payout than generating an above average market return or even meet the historical 6% - 8% returns on equities. Retirement plans offered to new workers are mainly 401(k) plans in which the worker is responsible for making investment allocation decisions.
Federal Reserve data show private pensions began reducing risk in the second half of 2013, shedding $11.3 billion in stocks and loading up on more than $100 billion in Treasuries, agency debt and corporate bonds. Tremblay believes this trend could last for a decade." - source Reuters.

On the 24th of March, CITI estimated in their Quantitative Pension Strategy report the following:
"De-risking Flow Scenarios
Based on the model we introduced in the outlook, we also update the simulation results for pension de-risking flows.
-In our faster with limits de-risking scenario, we could see $213 billion in equity assets being sold and replaced with fixed income assets based on our 2014 baseline projections, representing 7% of total pension assets.
-The updated transition amounts under different models are $40 to $80 billion lower than our initial projections, presumably caused by reduced funded-status estimates and a lower initial equity/debt ratio as of the end of 2013.
-Rebalancing needs could still increase by approximately 50% to 60% over the year based on our updated estimates.
Note that the timing of any potential de-risking or rebalancing flows is likely to be drawn out. Realistically, we would expect such flows to occur over the course of perhaps two to six quarters." - source CITI

What could curtail outflows from pension funds from Equities to Fixed Income could come from Updated Mortality Tables according to another CITI report from the 10th of April:
"The Society of Actuaries released drafts of proposed new mortality tables (RP- 2014) and mortality improvement scales (MP-2014) that provide the basis for determining pension liabilities. These are significant updates.
-The new tables and schedules increase life expectancy at age 65 by 2.0 years for males (from 84.6 years to 86.6 years) and by 2.4 years for females (from 86.4 years to 88.8 years).
-The previous set of mortality tables was published in 2000 (RP-2000), and the most widely used mortality improvement scale (Scale AA) dates back to 1995.
We have estimates that longer life expectancies resulting from the updated mortality tables will increase the value of pension liabilities by 3% to 10% depending on the nature of the plan and prior assumptions.
-If we take Aon Hewitt's estimate of a 7% increase in plan liabilities, that would reduce funded status by approximately 6%, or about half of the improvement experienced in 2013.
-Plan durations should extend, but we do not have good estimates of how much.
With lower funded statuses using the updated tables, it is likely that de-risking flows from equities to fixed income will be lower than they otherwise would have been under the previous mortality regime." - source CITI

On a final note, and in "true" supervaluationism fashion, it seems individuals are backing away from US stock optimism as per Bloomberg's recent Chart of the Day:
"Smaller investors are demonstrating a renewed reluctance to view U.S. stocks favorably as the current bull market extends to a sixth year.
Bulls trailed bears by 0.3 percentage point in the most recent weekly survey by the American Association of Individual Investors after leading by the same margin a week earlier. The figures contrast with this year’s widest gap in favor of the optimists: 19.4 points, set in the week ended Feb. 20.
As the CHART OF THE DAY shows, the latest results are also at odds with a more gradual shift in investors’ attitude toward stocks. The chart displays the 52-week average of the bull-bear gap, which climbed to the highest level since June 2006 before falling this week, along with the Standard & Poor’s 500 Index.
“You see scared individual investors right now,” Justin Walters, co-founder of Bespoke Investment Group LLC, said in an interview yesterday. “Just as they were coming back into the market, they started getting burned” as many of last year’s best-performing stocks tumbled, he said.
Institutions have a more positive outlook, based on the results of weekly surveys of investment advisers by Investors Intelligence. The latest results showed bulls at 55.8 percent, the highest reading since January and almost twice the number in the AAII survey.
Bespoke wrote about the divergence between the bullish readings yesterday. “The emotional individual investor usually ends up being wrong” when the gap is as wide as it is now, the Harrison, New York-based research and money-management firm wrote in a report." - source Bloomberg

"It is a thousand times better to have common sense without education than to have education without common sense." - Robert Green Ingersoll

Stay tuned!

Thursday, 8 May 2014

Chart of the Day - European Car Sales and Consumer Confidence

"Confidence is contagious. So is lack of confidence." - Vince Lombardi

As we posited in our conversation "The Regret Theory" back in December 2012, in relation to European Consumption, Consumer Confidence is key (in continuation to our extensive look at car sales in Europe from our conversation of April 2012 - "The European Clunker - European car sales, a clear indicator of deflation"):
"One could also look at car sales and European Consumer confidence since 2007, the relationship seems pretty clear even though the cash for clunkers program have indeed been highly supportive of car sales whenever consumer confidence needed some government "artificial boost"

Strong macro drivers such as consumer confidence set the trends for the demand in the auto sector but for consumption levels as well as per the below Chart of the Day - graph source Bloomberg:
New car registrations in Western Europe have continued their positive trend in conjunction with European Consumer Confidence:
-UK +8.2%
-France +5.8%
-Spain +28.7%
-Italy +1.9%
-Germany -3.4% (slightly off this month)

European's five largest markets for passenger car sales have generated 817,158 units sale, up 4.1% from a year ago. The big winner has been Renault group reporting double-digit growth in sale in Spain (+43.3%) driven by the domestic market France with 18.4% growth according to CreditSights from their European Morning comment of the 8th of May.

"If you have no confidence in self, you are twice defeated in the race of life. With confidence, you have won even before you have started." - Marcus Tullius Cicero

Stay tuned!

Thursday, 1 May 2014

Chart of the Day - "Great Rotation" from Institutional Investors to Private Clients

"For a traveler going from any place toward the north, that pole of the daily rotation gradually climbs higher, while the opposite pole drops down an equal amount." - Nicolaus Copernicus

As we enter the "Sell in May" period, it looks like Insitutional investors have continued to be net sellers for the last five consecutive weeks and are, according to Bank of America Merrill Lynch from their recent Equity Client Flow Trends report of the 29th of April. Institutional investors have been the biggest net sellers year-to-date:
"Net sales by this group last week were their largest since January and the fourth-largest in our data history (since 2008). Hedge funds were net buyers for the fourth consecutive week, and private clients also continued their net buying streak. Clients sold both large and small caps but bought mid caps last week; year-to-date only small caps have seen outflows." - source Bank of America Merrill Lynch

Arguably the Chart of the Day is indeed the "Great Rotation" from Institutional Investors to Private Clients from 2008 to present:
- source Bank of America Merrill Lynch

From a shorter term perspective the "Great Rotation" by client type is as follows as per Bank of America Merrill Lynch's recent report:
"Weekly flows by sector, client & size (4/21-4/25)
Net sales last week were driven by outflows from Energy, Health Care and Financials. Tech saw the largest net buying amid better-than-expected earnings results from most companies in the sector. Discretionary and Telecom were the other two sectors that saw inflows. Tech is the only sector which has seen two consecutive weeks of net buying; Utilities has the longest net selling trend at five consecutive weeks.
Institutional clients led net sales last week, while both hedge funds and private clients were net buyers. By size segment, outflows were chiefly from large caps but also small caps, as only mid caps saw inflows." - source Bank of America Merrill Lynch

What is for us of interest is that we have been tracking for some months the convergence between Small caps and Utilities as displayed in the below Bloomberg graph showing the Russell 2000 index ratio to S&P 500 against the S&P500 Utilities Index ratio to S&P 500:
Although Utilities are seeing net selling trends, they are no doubt outperforming Small Caps' relative performance against the broader S&P 500. 

We have been tracking with interest this convergence since beginning of 2014. This convergence should accelerate in the coming weeks as shares of smaller companies may be especially vulnerable to declines with market volatility rising, particularly valuation wise given that according to Bloomberg, the Russell index's price-earnings ratio increased to 49 in 2013 from 30 at the end of 2012. Russell 2000 companies have a median market capitalization of around $692 million versus the median value of $15 billion of the S&P 500 according to Bloomberg data.

On another note, shares of these smaller companies are destined for further declines in conjunction with the Fed's tapering which first impacted large capitalization companies, which have been more sensitive to interest  rates such as Utilities. This is reflected as well in the above graph.

"The glory that goes with wealth is fleeting and fragile; virtue is a possession glorious and eternal." - Sallust

Stay tuned!

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