Déjà vu

Last August, and again earlier this year, Chinese devaluation and the threat of a more serious decline in the Yuan (combined with USD strength) sowed the seeds of brief periods of significant drawdown in Global equity markets: the Global Index fell 12% in the month after last August’s trivial devaluation, and almost 14% in the weeks leading up to mid-February, when Yuan devaluation fears again re-surfaced.

Despite net outflows continuing apace through the first quarter – almost matching the entire outflow in the first 11 months of last year – and heavy Central Bank intervention, together with some tightening of controls at the margin, the Yuan actually strengthened in a move (vindictive, some speculators might say!) designed to head off speculative pressures and provide reassurance that all is well in the East. Another $1trillion in loans helped, but that’s neither here nor there in China these days. Move along, nothing to see here…

But we know differently. We know that you simply cannot grow credit $2.5 trillion annually with no corresponding nominal income growth; we know you cannot add capacity where there is already too much capacity; and that you cannot grow bank balance sheets at a rate annually equivalent to 40% of nominal GDP. Not if you want to keep your exchange rate fixed, you can’t.

And that’s where recent developments are interesting, the Chinese officially target the Yuan against the CFETs index – against a basket of 13 currencies (about one quarter USD weighted) and the Yuan has depreciated 1.3% since the end of March (5.9% year to date). From the mid-January low, the Yuan appreciated 2.1% against the USD through the end of March but has depreciated 1.2% versus the USD subsequently. They’ve unwound half the appreciation of the prior weeks.

Quietly, and under the radar, the Chinese have been letting the Yuan slide against the CFETs basket and, probably more importantly for the market, against USD.

Graph 1

This USD strength is seen in the broad USD appreciation in recent weeks: the next chart shows the percentage of currencies in the US effective exchange rate basket that the US has appreciated against in the last 20 days: the USD has appreciated against 80% of the currencies in its own basket.

Graph 2

We are seeing broad USD strength, broad Yuan weakness and, significantly, the Chinese quietly letting the Yuan slide against the USD.

This feels like déjà vu from our standpoint.

The global economy is already at low altitude, the median annual growth rate in our broad national sample is just 1.9% with over half growing less than 2% annually, and appears to be losing speed, again over half have growth slowing. Another round of Yuan/USD weakness into that mix is likely to precipitate just the same reaction as we saw last summer and earlier this year. Perhaps it’s time to seek out that tin hat again…

It is the US… again!

May 8, 2015

The last two weeks in financial markets have been somewhat of a rollercoaster, with bonds, stocks and the US Dollar selling off in unison, wiping out several hundred billion dollars off global wealth in a matter of days. European bonds took a severe beating, which, as explained in one of our previous blogs, was inevitable considering that a large proportion of them were trading at prices that guaranteed a loss at maturity.

Panics in financial markets always show up unannounced, which makes it all the more interesting to understand ex-post what triggered these brutal moves. Friends of MONOGRAM have heard us mention many times that in essence, this is all about the US. The US drives capital and sentiment, and are therefore more often than not the culprit behind volatility bouts. All major crises in the last 30 years have started in the United States: the 2008 Lehman debacle, the 2000 Tech bubble, the 1998 LTCM bailout, and the 1987 market crash.

This time around, two factors seem to have been the catalyst behind the coordinated retreat in assets markets. First, a couple of fixed-income investment luminaries, Bill Gross of Janus Capital and Jeffrey Gundlach of DoubleLine Capital (who incidentally are both American), have been vocal about the inflated valuation of European sovereign bonds. Gross going on to call long-dated German bonds “the short of a lifetime”. This means that betting on these bonds going down is effectively almost a sure bet, the closest thing to free money.

Secondly, the US economy is going through a bit of a soft patch. This should in theory be favourable to bonds, and perhaps not so good for equities, but both asset classes have gone down. Why? Mostly because the US Federal Reserve said that this would not change its perception of the overall upwards trajectory of the US economy, and therefore it would not change its plan to tighten monetary conditions by the end of the year.

But perhaps the Federal Reserve is wrong. Perhaps the US, which has been expanding modestly over the last 6 years, is starting to turn the corner for the worst. This of course, would be supportive to bonds, although interest rates are so low that upside here is limited. This would also be a headwind to stock market performance, not only in the US, but also in Europe; and this is even if European economies finally break out of the stagnation world it has been living in for years.

Why is that? Because the US economy actually has a much larger influence on the fate of developed markets than the local economies themselves.  This means that what matters most to the performance of say, UK stocks, is not so much whether the UK is in recession or not, but whether the US is in recession or not.

To show this, we look at the performance of 5 local markets on a quarterly basis, selecting only the quarters when (i) the US was in recession, but not the local markets, and (ii) local economies were in recession, but not the US. Our sample includes France, Germany, Italy, Spain and the UK. Going back to 1992, our findings are crystal clear. The simple average annualised performance of local markets when we observe:

  • Local expansion and US recession is -22.0%
  • Local recession and US expansion is 13.1%.
1992 – 2015 Annualised Local Markets Performance
US recession France expansion -25%
US recession Spain expansion -13%
US recession UK expansion -21%
US recession Germany expansion -30%
US recession Italy expansion -20%
US expansion France recession 21%
US expansion Spain recession -1%
US expansion UK recession 21%
US expansion Germany recession 20%
US expansion Italy recession 5%

In light of these results, it is certainly worth keeping a very close eye on the fundamental US dynamic- and hope that the Federal Reserve is right. As former US President Bill Clinton once famously said- “It is (about) the economy, stupid”. That is right, it is about the economy … of the US.


Should we fear a strong US Dollar?

March 18, 2015

Towards the summer of 2014, the US Dollar, measured against a trade-weighted basket of currencies, started to rally. Fast-forward 9 months and this move has become parabolic, with US currency trades at a 12-year high and on course to record its best quarterly return since 1992. Part of this strength is attributable to the weakness of two of the US’s main trading partners – Japan and Europe. Both the Bank of Japan and the European Central Bank are in the midst of a massive-scale money printing program, a combined $120bn-a-month exercise, whose goal is to stimulate growth and boost exports through the depreciation of their own currency. In contrast, the US Federal Reserve has indicated that it might be considering an increase in interest rates, thus making dollar-denominated assets relatively and increasingly attractive.

Yet at 0.24% for one year, the yield on US government bonds is hardly mouth-watering. But in a world flirting with deflation this is almost as good as it gets for a safe asset since, according to JPMorgan, approximately 16% of global government bonds with maturity higher than 1 year trade at a negative yield. Buy a Danish or a Swiss bond and you are sure to get less than what you paid for when they mature. From a currency standpoint, American assets are therefore attractive. However, since a strong Dollar is an impediment to the competitiveness of US businesses, investors have reduced their US holdings mostly in favour of European assets. According to Merrill Lynch, the cumulative flow out of US equities has amounted to $50bn so far this year. Unsurprisingly, European equities have outperformed US equities by no less than 16 percentage points in 2015.

This rationale makes sense on paper, but as Thomas Huxley, a British biologist contemporary of Darwin once said – “the great tragedy of Science is the slaying of a beautiful hypothesis by an ugly fact”. This holds true for the hypothesis where a strong US Dollar is bad for US equities since a simple regression of monthly US stock returns against the performance of the US Dollar since 1980 shows that American equities trade completely independent to the performance of the Dollar. While it is true that the recent past (the last 3 to 5 years) shows a degree of negative correlation, two time series can be strongly negatively correlated while evolving in the same direction. This is what has happened to the USD and US equities – they have both gone up. In another exercise, we observed the average annual performance of US equities against that of the US Dollar by quintile and see results that are completely consistent with previous findings.


Asian borrowers in trouble

March 13, 2015

With the US dollar trading close to a 12-year high, over-leveraged Emerging Market currencies look very vulnerable. This is because Emerging Market financial assets (read debt levels) have approximately doubled since 2008. Asian countries in particular have pilled foreign debt at an accelerating pace with the year-on-year debt growth for the Asian block now reaching 35%.

From the perspective of an Asian investor, leverage makes sense. Borrowing large amounts of money in a depreciating currency means less capital to pay back at maturity. And low interest rates (US rates have been close to zero for 6 years) make for negligible interest payments. Asian countries have gorged on this bonanza and the jury is out as to whether this is going to result in a painful indigestion.

The moment of truth might be near. The US dollar is powering ahead as the US Federal Reserve (the “Fed”) has indicated that its next monetary policy move will be restrictive, not accommodative. The Fed is remarkably lonely here as 9 countries have lowered their main interest rate since the beginning of the year already.  Yesterday again, the Korean Central Bank reduced its key rate to a historical low of 1.75% and the Chinese are considering a similar move. With comparatively fewer dollars and more of other currencies in the system, the value of the greenback has to go up.  This is exactly what is happening, and this is happening quick- the USD trades 10% higher than at the end of 2014.

At MONOGRAM we are staying away from Emerging Market stocks, since a forced de-leveraging caused by a strong dollar will certainly translate into substantial downside in domestic equities. But should the going get tough, these assets will probably trade low enough to present a bargain. Until then, we prefer the safety of the US market.