Ten Seconds Into The Future

Equity Markets. Wait. Worry.

Bryan Goh — Thu, 08 Jul 2010 13:15:00 +0000

Most hedge fund managers waited too long when the markets corrected sharply in May, preferring to stay long of the market. As European sovereign default risk rose in the eyes of the media and investors, investors began to revise their views. The popular press and newspapers like the Economist began to write about the tight spot that governments are in, caught between fiscal stimulus and having to pay for it. Many hedge fund managers turned bearish and reduced their long bets.

Markets are in their third day of positive territory. This is likely a technical rebound from a heavily oversold position at the end of June. However, there is another risk. Its all too easy to be a bear when markets are falling but the weaker the economic data, the more governments will have to abandon fiscal austerity and return to priming the pump. It may be a disastrous policy in the longer run but human beings are very short term in their outlook.

I would expect markets to carry the rebound through for at least another 2 weeks purely based on the technicals. If the economic data is sufficiently poor, I would expect policy noises to lean towards stimulus again. I would expect investors who previously penalized governments for profligacy to change their tune and look to them for fiscal support. This is likely to sustain the market rally into a multi month rally.

The risks are: economic data comes out more positive and therefore policy becomes increasingly hawkish, individual earnings miss estimates.

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Stress Testing the European Banks

Bryan Goh — Thu, 08 Jul 2010 12:11:14 +0000

As Europe’s banks undergo so-called stress tests, an old adage comes to mind. Every failed trade becomes an investment. Every failed investment becomes a strategic holding.

Apart from specifying the nature of the stress, what is being assumed in each stress scenario, what probabilities have been assigned to sovereign default, etc etc, the valuation of assets and the assessment of the variability of the valuation of those assets is key in a stress test. Who is providing that valuation? Who is providing the assessment of variability and reliability?

Or is this a take home test?

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Addressing weak output growth

Bryan Goh — Tue, 06 Jul 2010 15:52:53 +0000

Governments are torn between fiscal austerity and stimulating economic growth. Since credit driven growth ceased in 2008 private sector economic growth has been muted. Consumption has been hampered by the need to restore household balance sheets. Such restoration is likely to overshoot as the lessons of 2008 linger, so savings rates are likely to be higher than expected. Corporate investment is likely to be less robust as well as managers risk management is highly autocorrelated and corporates are likely to retain a high buffer of cash on their balance sheets. This leaves exports as the driver of growth. Not every country can be a net exporter.

Governments had been quick to pick up the slack left by private consumption and investment. This fiscal stimulus has left sovereign balance sheets stressed. A balanced budget approach to stimulus is not effective since it is only a reallocation of resources which may or may not be better than the status quo. Also, in the US, it is important to measure the net stimulus taking into account Federal and State policies.

The efficacy of fiscal stimulus is in the details. Should government cut taxes effectively outsourcing its fiscal stimulus to the private sector or should it directly engage in productive activities? The psychology of the consumer will likely drive them to save any additional disposable income they receive. Policy may be better served by government directly engaging in economic activity. It should do this in the form of building infrastructure and capacity for the future productivity of the country. There is the risk that government is a poor allocator of resources and that resource allocation is suboptimal. However, in the face of a private sector that is unwilling to deploy new resources, government is the best available solution.

The problem faced by most governments is paying for the fiscal stimulus. Governments with weak balance sheets may not be able to fund their fiscal plans. Their ability to fund their ongoing liabilities and operations may require them to operate a policy of fiscal restraint or austerity.

Economic policy is not one dimensional. While a government operates fiscal policy, its monetary authorities or central banks operate monetary policy, in the form of market intervention or determination of interest rates. In the acute liquidity crisis of 2008, central banks the world over increased the leverage on their balance sheets in an effort to prevent the failure of the financial system. They continued to print money in 2009 in an effort to compensate for the sharp decline in the velocity of money in circulation. This strategy works by inflating the nominal output of the economy but is unable to ensure that the nominal output increase is evenly distributed across all segments of the economy, and can thus be highly inflationary in certain sectors or industries, and is also unable to ensure that real output will increase, i.e. can lead directly to inflation. This strategy has worked to a certain extent and failed in others. In capacity constrained markets it has created inflation while in non capacity constrained markets it has increased real output. In particular it has caused asset price inflation in financial assets, which have now become acutely sensitive to monetary policy.

Monetary policy has its limitations. In developed markets, interest rates are already close to zero. In the absence of inflation, it is not possible to induce negative real interest rates. Fiscal stimulus needs to be brought to bear. The current issue is how to fund that stimulus. Since the beginning of May, Europe has focused on the ability of Greece to repay its debts. Similar concerns arose about Portugal and Spain. The likely outcome will be that developed market central banks will have to purchase sovereign debt thus inflating money supply substantially and accelerating the debasement of fiat currency. This is highly inflationary. High debt to GDP countries will likely favour this type of inflationary policy since they have few options and this option is least worst.

Inflation, however, is measured with a CPI or RPI. The mechanical and defined specification of a price index can hide or degrade information. Owner’s imputed rent features significantly in most inflation measures, yet is never paid, and thus has little income effect. It is likely that inflation may be underestimated for some time while eroding real incomes and purchasing power. Inflation can occur not only in goods markets, service markets, but in the market for future claims on goods and services, in other words, the asset markets.

The future direction of asset markets whether equities, credit, commodities or real estate is likely to be highly sensitive to economic policy. While global growth remains fragile and uncertainty is high, economic policy will have a high impact on prices. Only when certainty returns to the global economy will idiosyncratic risk return to markets.

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Macro: Equity Markets and Policy

Bryan Goh — Wed, 30 Jun 2010 13:51:27 +0000

In economic policy there is a difference of view between the US and the rest of the world. As Japan’s largest trading partner the US is especially empathic to the deflation scenario that has plagued Japan since 1990. Therefore, US monetary policy is likely to err on the side of being too loose rather than vigilant on inflation.

Europe has a history of hyperinflation and is therefore likely to tighten sooner than might the US. The current focus on the health of sovereign balance sheets strengthens the case for a retraction of quantitative easing and expansionary fiscal policy.

The flexibility of the CNY is likely to reduce the demand for US treasuries and lead to a de linking between US and China monetary policy. China economic policy will be more hawkish on inflation than before.

All these point to the resumption of de risking that began in May that has led to falling markets and a rise in correlations.

This is all backward looking.

The economy and markets have reacted to the financial crisis of 2008 and the subsequent stimulus policies quite predictably. It rebounded and rallied hard as governments printed money thus debasing their currencies and inflating the value of real assets and future claims on the cash flows expected to be generated by real assets, and quite a little relief and hope.

We have seen in past crises like the one in Asia that post the initial decline, 100% rallies are possible and post those, 50% retracements are also possible. Equity markets are technically weak. They may strengthen over the next few weeks as corporate earnings come in reflecting 2Q financial results, but the trend is down. Earnings, however, are not the driver of markets. Liquidity and policy are.

There are many factors that can drive equity markets over time, but there is usually only one or maybe two factors that drive them at any moment in time. Equity markets are likely to continue to fall until weaker economic numbers prompt policy makers to revise their stance on fiscal rectitude and start printing money again. Who will go first? The US has not tightened policy. Australia, Canada and Norway, for example, have already been running tight monetary policy for some time, since 2009. China has been selectively reigning in leverage in particular sectors of the economy to prevent overheating. The commodity countries and Asia are unlikely to loosen policy again soon. The more likely candidates for reverting to expansionary economic policy are the Europeans on the basis that European economies are likely to be weakest.

Germany is exposed to exports to Asia; a more domestic centric China will impact European exporters. Domestic Europe remains weak and disconsolate. Unemployment remains high, balance sheet repair is slow. Spain is in a depression. Greece is insolvent. The PIIGs face a liquidity crisis. The outlook for Europe is poor. Able or unable, Europe will print money. Interest rates will remain low and if anything head to zero. Fiscal policy is constrained which will put even more pressure on monetary policy.

Europe is likely to be the first to resume printing. And the debasement of currency has as its dual, the inflation of goods and services, and assets.

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China Signals Flexibility in the CNY exchange rate

Bryan Goh — Mon, 21 Jun 2010 16:57:42 +0000

On Saturday, 19 June, China signalled the end of its currency peg which fixed the CNY at 6.83 to the USD and said it would gradually make the its currency more flexible. The CNY appreciated to 6.80 on Monday.

A stronger CNY it was hoped would:

Address the trade imbalances between the US and China.
Address inflationary pressures in China.
Provide impetus to developing a more balanced Chinese economy away from exports towards domestic consumption.
Increase outward overseas investment due to increased purchasing power.
Reduces foreign debt obligations and debt service, China had in 2005 about 180 billion USD of external debt.
Ease the risk of asset bubbles by delinking Chinese monetary policy from US policy.
Keep the Washington trade hawks at bay and reduce the risk of a trade war.
Be a vote of confidence for the global economy in general and the Asian and Chinese economies in particular.

However:

One wonders how prepared China’s companies are for FX volatility, especially smaller and less sophisticated exporters.
A stronger CNY can become a much stronger CNY as capital inflows increase in anticipation of further CNY appreciation. Such capital inflows can exacerbate existing asset bubbles such as real estate.
A stronger CNY will put pressure on the agricultural sector as imports become cheaper. There are some 500 million farmers in China.
What is the PBOC’s objective, is it a stronger CNY or a freely floating one? There are pros and cons of each route. A freely floating CNY would imply independent monetary policy. On the other hand the PBOC might not want to live with the volatility of a market determined exchange rate.
A lot depends on the magnitude of the CNY appreciation. Elasticity of exports and imports takes a long time to adjust and usually adjusts to secular trends, of which it is a circular driver, which by implies that the trade balance will adjust more to larger and more established moves in the exchange rate.
Given the behaviour of CNY when it was allowed to appreciate from 2005 to 2008, it is likely that the PBOC does not intend a floating exchange rate but rather will manage the exchange rate in very tight fashion to achieve a steady and controlled appreciation. This addresses many of the risks of a floating exchange rate that the Chinese economy might otherwise struggle to manage.
Absent a managed float, market forces are likely to encourage a weaker CNY not a stronger one, as the balance of trade swings towards balance with the US.
Allowing more flexibility in the CNY exchange rate is likely to translate into a reduction of demand by the PBOC for US treasuries which is a de facto withdrawal of vendor financing for Chinese exports. Demand for trade settlement is likely to strengthen the USD. The natural pressure on CNY is not clear.

Murphy’s Law:

Forecasts and expectations are often confounded as reality has an uncanny tendency to defy all logic and reason.

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Hedged.biz Downgrades Credit Ratings Agencies

Bryan Goh — Tue, 15 Jun 2010 13:33:41 +0000

Hedged.biz has downgraded Fitch, Moody’s and Standard and Poors from AAA directly to junk.

For downgrading (upgrading) issuers only after price discovery has occurred and being reactive rather than proactive. For downgrading (upgrading) issuers only after bad (good) stuff has happened and been priced in. Downgrading BP over a month after their rig in the Gulf blew up is not very useful.

For operating a conflicted model whereby the issuer pays the credit ratings agency to provide a rating.

For the audacity to rate instruments which they did not fully understand.

For being part of a feedback mechanism of automatic leverage and deleverage.

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The State of The Craft

Bryan Goh — Tue, 01 Jun 2010 12:04:52 +0000

We are not rewarded to bolster the base of the pyramid but to reach for the stars. Too often intermediate levels are built upon a deck of cards. Where the potential to build highest lies, most effort is directed there, often in disregard of the frailty of the supporting levels below.

The engineer knows that they cannot build to the edge of tolerance, there must be some cushion, for often lives are at stake. What better risk management than that lives are at stake, to shake the engineer’s faith in himself and his tools, in the work of his brethren before him.

Danger lies in faith, in comfort in a higher power, in complacency that error will not be catastrophic, that loss is not loss of life for then the engineer builds to the edge of knowledge.

But how many look at the foundations before they build a tower? The Craft has grown in convolution so much that to do so is an uneconomic endeavour. How many understand the Grand Structure we have built? It has grown without design, evolved beyond our comprehension, that now to break the ramparts, one has but to shake the tower.

The Craft now seeks to mend the Structure, but it will take time, generations perhaps. First is to understand and to understand is to deconstruct. This will not be linear. Charlatan will vie with Sage and Jujuman.

In the meantime, what can the body of the Craft do? Reinvent the wheel. Some of us have done this everyday of our lives. The populist Heretics rail against the reinvention of the wheel, but it is in First Principles that we truly understand, and in Knowledge that we have power, if over no one else then over ourselves in the avoidance of an unceremonious and unnecessary suicide.

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Country versus Sector Effects: A Trading Strategy

Bryan Goh — Tue, 01 Jun 2010 11:20:41 +0000

With the acceleration of globalization in the last 20 years up until 2008 sector risk has risen relative to country risk. The classic example is in Europe where a stock like RWE starts trading less like a German stock and more like a European utility stock. With the credit crisis of 2008 came a number of factors that reversed this phenomenon. World trade was severely affected by both a fall off in demand as well as a sudden withdrawal of trade finance and other related credit. Also, as countries were forced to bailout their financial systems and their economies, country risk had risen as a proportion of total risk.

Globalization has certainly taken a hit and reversed somewhat, but the underlying current remains intact. Economies continue to become more interconnected and interdependent. With time we are likely to see a resumption of the correlation effects seen in the last 10 years pre 2008.

Based on this premise, I expect correlations between stocks to decline within country indices. The way to capture this is to be short country index volatility and long component stock volatility. This leaves the trade net short covariance. This trade makes money as stocks become less correlated at the country index level.

Also based on this premise, I expect correlations between stocks to increase within sector indices. The way to capture this is to be long sector index volatility and short component volatility. This leaves the trade net long covariance. This trade makes money as stocks become more correlated at the country index level.

One can use strangles and straddles to obtain exposure to volatility in both the index or the components.

Residual delta is hedged with the index futures or component stocks themselves.

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European Equity Markets – Country Risk Back Again

Bryan Goh — Thu, 27 May 2010 16:27:43 +0000

Prior to the adoption of the EUR, European equity markets were segmented by country. Since the adoption of the EUR, however, European equity markets became segmented by sector, as the funding costs between countries converged. With the recent rise of country risk and the divergence of funding costs, Europe is trading by country segmentation again. Its a subtle difference but an important one to the stock picker who must now place a higher priority on country risk in his trading, whether such risk is material or not. If enough people give it credence, it becomes a reality.

Thus Telefonica trades more like a Spanish stock then a telco, BP more like a UK stock than an oilco, RWE more like a German stock than a utility. You get the idea.

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Ten Seconds Into The Future 2010

Bryan Goh — Thu, 27 May 2010 13:51:25 +0000

In a simple world, we eat what we kill today, we consumer what we produce today. With trade in its simplest form, barter, we are able to specialize and be more efficient, focusing our talents and gifts on what we have an advantage in. The invention of money, whether gold or fiat currency, allowed us to grease the wheels of trade. The invention of credit allowed us to trade with the each other and the future, allowing us to consume what others have produced today and pay for it with what we produce tomorrow, accounted for in some convenient measure of currency.

Note that the uncertainty over one’s ability to produce tomorrow translates into one’s inability to repay and hence impairs one’s ability to borrow to consume today. Imprudent financial management will also impair the ability to repay and hence the abiltiy to borrow.

For the last decade, the West has clearly over consumed and over borrowed. This has been financed by savings in the developing world. From a flow and stock perspective, this is unsustainable, as has been demonstrated. While the credit crisis of 2008 has exposed imbalances and corrected a few, the more fundamental issue of savings and consumption is still being resolved and could take several years to unfold.

The chronic indebtedness of individuals was always unsustainable. At some stage, like now, the government would have to step in to bail out the consumer. As consumers or Main Street rails at Wall Street, thought should be given for the role the consumer played in the origination of credit in the form of mortgages, credit card loans, auto loans, which were securitized and structured for trading. The only politically viable short term or even medium term solution was to transfer most of the private debt onto the public balance sheet.

A combination of financial system rescues, emergency fiscal spending, falling tax revenues has resulted in serious degradation of public balance sheets, in some cases threatening liquidity and in others solvency of sovereign issuers.

Developed countries will spend the next 5 to 7 years reducing their indebtedness across public and private balance sheets. Developing countries will be doing the reverse. The relative value lies therefore in developed countries’ sovereign debt relative to emerging market debt. This is of course dependent on current pricing as it can be an expensive trade to carry.

Inflation is likely to impact the emerging markets disproportionately given the composition of consumption baskets in developed markets versus emegring markets.

Developed markets are likely to continue operating relative loose monetary policy. Inflation is less of a problem for them. Inflation comes from two sources, internal and external prices. The recent weakness in GBP and EUR will introduce inflation purely mechanically from an accounting perspective. The other source is from internal inflation from capacity constraints. The latter does not appear to be a source of concern. Rich world capacity utilization has only barely approached 2001 recession levels and this after a year long recovery.

Inflation will likely be very product market specific. Inflation is indiscriminate only in cases of hyperinflation where the trigger is a loss of confidence in a currency rather than a continuous erosion in purchasing power. Absent a loss of confidence, inflation will likely only affect capacity constrained product markets, and may just as easily also manifest in asset markets. This is stating the obvious but directs the search for inflationary areas to capacity constrained areas. Commodities like gold are obvious markets which are likely to see inflation, although in the particular case of gold, its increasing use as an inflation or risk asset hedge is likely to introduce linkages to the risk assets it is intended to hedge, degrading its utility as a hedge. Land and real estate are other areas where particular capacity constrained locations and asset types are likely to see inflation. Ags and softs are complicated by the noise introduced by technology, weather, access to water, regulation and policy.

In indebted countries, policy will lean towards creating inflation. In less indebted countries, policy will lean towards price stability. Aims and results are different things. Short rates are likely to remain low in developed markets as their economies remain weak and policy will lean towards growth rather than inflation. The reverse is likely to be true in emerging markets where the same inflationary pressures will have more severe wealth effects and policy has to be more hawkish. At the long end, rates are expected to remain high for both emerging and developed countries reflecting both inflation expectations and balance sheet strength.

As the balance of savings mean reverts between East and West, trade imbalances will also mean revert towards balance. The impact on FX is likely to bring strength to EUR and USD and weakness to JPY (and CNY, BRL, AUD). This is quite a long term theme likely to be subject to signficant volatility.

Globally, as represented by the MSCI World Index, stocks are cheap to credit and fairly priced to Treasuries. Given the inflation outlook and the outlook for credit quality of sovereigns going forward, stocks are preferable. Geographically, stocks are fairly priced on a relative basis. The Dow trades at a 4% yield gap to treasuries while Shanghai and Bombay trade at 2% yield gaps over US treasuries and at 2% and -2% gaps to local respectively. The Hang Seng interestingly is at a 4% gap to US treasuries and to local HKD. Australia trades at 2.7% over UST and flat over local, Canada trades at 3.3% over UST and 3.5% over local, just as a rough guide.

Simply buying and holding equities is insufficient. Indices hide a multitude of data issues such as survivorship bias. In the last 100 years, only 1 stock has remained in the Dow Jones Industrial Average, General Electric. All the other components have changed, merged, fallen away. Stock selection is important. Stock selection per se is an established and valuable way of generating returns. Stock selection is also important as a means of more intelligently representing broad macro views.

The theme of growing domestic consumption in emerging markets such as China, India, Brazil and Indonesia is a long term theme that had been brewing since before 2008 and continues to hold. The developed world will increase its savings rates simply and mathematically based on the dearth of de facto vendor financing – the over saving of emerging market consumers and their central bank purchases of US treasuries.

The developed world is steadily becoming a net exporter. The emerging markets will steadily become a net importer. This hides a multitude of detail and colour, however, the basic message is to buy developed world exporters and short emerging market exporters, to buy emerging market domestic plays and short developed market domestic plays. World trade will rebound, only the net direction will change. Container ships which were empty to Asia and full to the US and Europe are likely to reverse that phenomenon. The developed world has much to offer: high tech, intellectual property heavy products and services, and brands and franchises such as luxuries. Emerging markets will with time develop their own intellectual property to the level of the developed world but this will take time. They may be better at commercialization of developed world technologies for distribution to a domestic client base.

Emerging markets have been chronically starved of credit relative to developed markets. Barriers to entry to international banks are unlikely to fall quickly. They will more likely erode with time and consolidation. In the meantime, the acceleration of emerging market growth on the back of a globally coordinated quantitative easing, transmitted through sclerotic developing world capital markets and de facto currency pegs and managed floats, is unlikely to find credit capacity from the domestic banking systems, and the peripheral access afforded international banks. There will be an undersupply of capital leading to an undersupply of credit. Emerging markets need and will develop, a shadow banking system. The sophistication of Western central banks and financial market regulators was insufficient to control the growth of the shadow banking system, allowing it to grow out of hand in size, complexity, and audacity, to the extent that it became an integral part of the credit crisis of 2008. What is the probability that less experienced, granted, no less shrewd regulators in emerging markets will be able to guide and regulate the new shadow banking industry as it evolves on their patch?

The obvious opportunities are to replicate the bubble inflating strategies in the US pre credit crisis adjusted for local particularities. Spread compression, cheap and excessive leverage, real estate, LBOs, M&A, levered loans, securitization, structured credit. History will not repeat itself precisely, but the plot devices are likely to be the same.

The implications of emerging market populations not only converging to developed world per capita ouput, but also in their levels of indebtedness and the concomitant credit creation are profound. Inflationary pressures will be significant both in the real economy and in asset markets. The prognosis for emerging markets in the long run is positive. The risks, however, lie in the way the 2008 credit crisis has been addressed by Western governments and regulators. Many inefficiencies and imbalances remain unaddressed, moral hazard being foremost among them. But that will be somebody else’s’ crisis.

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