Rising systemic risk in China?

I got quite a few responses to my post when I speculated about the possible outcome of a Chinese hard landing (see What a Chinese hard-landing might look like). Many readers took offense at what I wrote and characterized it as fear-mongering.

They got me wrong. No one knows whether China will experience a hard landing, but I sketched out several scenarios IF China should hard land.

I did, however, offer the opinion that the risks of a hard landing was rising. Last week, we saw further signs indicating that systemic risk is rising in China.


When does the credit bubble pop?
To set the stage, FT Alphaville highlighted research from Nomura indicating that the entire region is vulnerable as a major credit bubble seems to be forming:

Past financial crises in major economies are often preceded by the private credit-to-GDP ratio rising sharply by 30 percentage points (pp) in the five years before the crisis. We call this the “5-30” rule, and many Asian countries have either breached, or are close to, the 30pp since 2008 (Figure 24). Asia is also experiencing house price booms. If we overlay residential property prices in the US (indexed to 100 in January 2000) on residential property prices in several Asian countries, it is striking how many Asian property markets are tracking above the US price bubble.

The x-axis of the chart on the left shows how the private credit-to-GDP ratio has risen for the Asia Ex-Japan region. Note how China and Hong Kong are the outliers and literally off the chart compared to the other countries. In the right chart, Nomura overlaid the path of the property prices in the pre-Lehman US to other countries in the region to highlight the rising level of systemic risk.

Riding around without a helmet
Just because a system is increasingly risky doesn't mean that a crash will happen. It just means that you have a risky system.

The best analogy is a motorcyclist riding around at 100 mph without a helmet. It doesn't mean that he is going to get hurt, it just means that the results will be very ugly if he does get into an accident.

You need a catalyst for the accident to happen, or, to use the motorcyclist analogy, a pothole in the road.

We may be seeing that pothole in the road ahead and the credit markets are starting to price in the risk of a meltdown, according to Bloomberg [emphasis added]:

Chinese companies’ borrowing costs are climbing at a record pace relative to the government’s, increasing the risk of defaults and prompting state newspapers to warn of a limited debt crisis.

The extra yield investors demand to hold three-year AAA corporate bonds instead of government notes surged 35 basis points last week to 182 basis points, the biggest increase since data became available in September 2007, Chinabond indexes show. That exceeds the similar spread in India of 120 basis points. The benchmark seven-day repurchase rate has averaged 4.47 percent in November, the highest since a record cash crunch in June and up from 3.21 percent a year earlier.

“Existing interest-rate levels and tighter credit conditions will pose downward pressure on growth,” said Kewei Yang, head of Asia-Pacific interest-rate strategy at Morgan Stanley in Hong Kong. “Any potential defaults or bankruptcies in 2014 will trigger the market to reprice credit risk.”

Markets are getting worried by the excessive leverage:

The nation’s total debt, led by state-owned enterprises and local governments, may exceed 200 percent of gross domestic product, according to a Barclays Plc report yesterday. Implicit government guarantees and soft budget constraints have encouraged excessive borrowing and increased the potential for defaults, the analysts wrote.

These guarantees are now looking increasingly uncertain with China’s Communist Party saying at the Nov. 9-12 plenum that it would encourage private investment in state-owned enterprises, which have enjoyed sheltered monopolies for years, and allow competition. The leadership pledged also to give markets a “decisive” role in the allocation of resources.

Could this be a tipping point?

I wouldn't panic. My Chinese canaries, which measures the price performance of Mainland banks listed in Hong Kong, are still quite healthy and behaving well - for now.

Nevertheless, these signs of increasing anxiety in the credit markets need to be monitored - just in case these jitters turn out to be something more serious.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Humble Student turns six

Six years ago today, I started this blog with a single post about hedge fund returns and that analysis remains true even today. My purpose in writing is to put my thoughts down on paper (or actually, on the screen) to foster a discussion with like-minded individuals on the markets.

I have not asked for financial support before, but if you value my writing, please consider supporting the Vancouver Youth Symphony Orchestra Society, to which I am on the board of directors. Canadian donors can receive a tax receipt for their donations.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Is Black Friday the time to sell the Retailers?

Barry Ritholz recently wrote to ignore the Black Friday hype, especially NRF survey results:

The track records of these surveys are awful. In 2005, the NRF forecast a 22 percent increase in holiday shopping gains for the Thanksgiving weekend. Full holiday retail sales were up just 1 percent. In 2006, it was 18.9 percent sales increase, versus less than 5 percent actual gains. In 2007, a 4 percent gain was actually a 0.4 percent drop. NRF forecasts for 2008 were even worse, 2.2 percent sales gain versus a drop of 6 percent.

But nothing compares to the NRF’s 2009 Holiday Consumer Intentions and Actions Survey for holiday shopping -- it forecast a stunning 43 percent fall versus actual sales, which were up about 3 percent.

He concluded:

Investors who don’t enjoy losing money should ignore the media coverage of these misleading, inaccurate surveys with extreme prejudice.

I would tend to agree. I played around with the seasonality chart function at stockcharts.com and came up with the following for the Retailing ETF (XRT).

Retailing stocks tend to underperform the market in December. An analysis of the less liquid RTH, which had a 13 year history compared to XRT's 8 year history, showed that retailing stocks only outperformed SPY 25% of the time in December (though it outperformed 54% of the time in November). I have also seen other studies that indicate that this stock group tends to peak out about US Thanksgiving.

Bottom line: Beware of the Black Friday and Cyber Monday hype. This may a case of where you should buy the rumor and sell the news.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

What a Chinese hard-landing might look like

Further to my last post on China (see Where's the short-term pain in China?), I am turning to the view that a hard landing is a rising possibility for a number of reasons.

First of all, the reforms announced in the wake of the Third Plenum are all right steps in the right direction. Open up the economy to more market forces as a way of reducing the domination of the SOEs on the economy and to end the financial repression of the household sector; rural land reform and the ending of the one-child policy as a way to squeeze more out of the labor force; and political and administrative reform to reduce the effects of corruption and crony capitalism. These steps are all to be lauded, but in the context of a growing investment and credit bubble, they may be too little too late.

In effect, the government is trying to sail between Scylla and Charybdis. Its stated goal is to re-focus economic growth from a quantity strategy to a quality strategy, from infrastructure-led growth to consumer-led growth. To re-balance and re-focus its growth, Chinese growth would have to slow. But a policy induced slowdown has its constraints. The constraints on government policy is seen in the twin infrastructure and credit bubbles created by years of financial repression, which was described in my previous post (Where's the short-term pain in China?) that I won't repeat.

One example of the constraints that the authorities operate under is shown by Premier Li Keqiang's recent statement that 7.2% GDP growth rate represented the "stall speed" for the economy:

In one of the few occasions when a top official has specified the minimum level of growth needed for employment, Li said calculations show China's economy must grow 7.2 percent annually to create 10 million jobs a year.

That would cap the urban unemployment rate at around 4 percent, he said.

"We want to stabilize economic growth because we need to guarantee employment essentially," Li was quoted by the Workers' Daily as saying on Monday. His remarks were made at a union meeting two weeks ago but were only published in full this week, just days before a pivotal Communist Party plenum to set policy opens.

7.2%? That doesn't give much room for growth to slow. In the past, whenever growth has slowed to levels the authorities deemed to unacceptable, the policy has been to stimulate using the same-old-same-old tactic of infrastructure growth, fueled by credit extension.

Indeed, Benn Steil and Dinah Walker asked Is a “Decisive Role” for Market Forces in China Compatible with a 7 Percent Growth Target?

The communique released following the recent Third Plenum of the Chinese Communist Party included the much-heralded statement that market forces should play a “decisive role” in allocating resources going forward, but this is likely to be difficult to reconcile with a 7% growth floor. Many, ourselves included, have argued that China’s recent growth has been driven by unsustainable overinvestment. Since growth in recent years has slowed virtually to match the 7.5% target that had been set for 2012 and 2013, we doubt that a 7% target can be met over the coming several years without the government steering lending and investment even more aggressively towards manufacturing and construction, where the bubble-evidence is most compelling.

These circumstances are highly suggestive that the risks of a Minsky Moment style hard landing are growing.


Mapping out hard landing scenarios
In that case, what might a hard landing in China look like? In addition, I have been asked what the effects of a hard landing might have on the United States.

Here's where it gets tricky. I can outline a bull case and a bear case for America.

If a hard landing were to occur, the first-order effect would be a collapse in infrastructure spending which would lead to falling would commodity demand. Global commodity prices would crater under such a scenario.

Here's the super-bull case: If the government stays the course and continue to re-focus growth to the Chinese consumer, relative wages would remain sticky upwards and Chinese labor would become less competitive compared to its global counterparts. Such a scenario would be incredibly bullish for the American economy. With commodity prices falling, which imply lower input prices and higher profit margins, and more competitive labor rates, which imply more onshoring of production and a boost for the US consumer, a Chinese hard landing could conceivably spark an American Renaissance.

A more moderately bullish scenario for America would occur if Chinese labor rates fall because of mass unemployment and falling consumer inflation rates and make Chinese production more competitive. In that case, American corporate bottom lines would be boosted by lower input costs from commodity prices, but the tailwind from onshoring, though Chinese goods at the likes of WalMart, etc. would be cheaper for the US consumer.


Financial contagion effects
What about the financial contagion effects? That's the wildcard that can't be forecast.

A collapse in infrastructure spending and property prices would mean a banking crisis in China as bad loans to property developers and local authorities become an enormous black hole in the balance sheets of Chinese banks. Arguably, the global financial contagion effect could be limited because the Chinese owe money to themselves. As long as the losses are socialized, foreign banks would have limited exposure and the integrity of the global financial system would remain intact.

While that school of thought has its merits, there are a number of problems with that analysis. The Telegraph reported that the BIS is increasingly concerned about foreign currency loans, which are typically denominated in USD, to China, which has skyrocketed since the Lehman Crisis:

Foreign loans to companies and banks in China have tripled over the last five years to almost $900bn and may now be large enough to set off financial tremors in the West, and above all Britain, the world’s banking watchdog has warned.

“Dollar and foreign currency loans have been growing very rapidly,” said the Bank for International Settlements in a new report.

“They have more than tripled in four years, rising from $270 billion to a conservatively estimated $880 billion in March 2013. Foreign currency credit may give rise to substantial financial stability risks associated with dollar funding,” it said. China’s reserve body SAFE said 81pc of foreign debt under its supervision is in dollars, 6pc in euros, and 6pc in yen.

Notwithstanding the foreign currency loans, I am concerned about the opaqueness of large Too-Big-To-Fail financial institutions. We will never know, until it becomes a problem, whether some TBTF bank has some oversized exposure to Chinese paper. Recall that the public had no inkling about problems at Barings until we woke up one morning and the venerable British bank's balance sheet had evaporated.

Even if western TBTF financial institutions were to be relatively insulated from a collapse in the Chinese economy and financial system, another impossible to forecast effect is how risk premiums would be affected in the wake of such a crisis. We saw in the May-September period when the emerging market economies caught a case of "Taperitis", risk premiums on EM bonds surged and several EM countries were on the verge of a currency crisis. Should China experience a hard landing, what would happen to EM risk premiums? If they were to skyrocket, can we be assured that no TBTF bank isn't exposed to EM bond markets and currencies in a way that would cause a Lehman-like panic?

The chart below of the EM bond ETF (EMB) relative to US junk bond ETF (HYG), which is a measure of low-quality paper against low-quality paper, shows that EM bond market anxieties haven't really recovered from the Fed tapering scare. What happens if China experiences a hard landing?

To summarize, I want to make it clear that I am not forecasting a Chinese hard landing, only that the hard landing scenario is more likely. Even if such a scenario were to come to pass, I have no idea of what the timing is.

The global effects of a hard landing in China is highly depending on how well contained the financial contagion effects are. I can sketch out scenarios where it could be incredibly bullish for America, or scenarios where we could see another Lehman or Credit Anstalt style banking crisis whose effects reverberate around the world.

If a Chinese hard landing were to occur, keep these scenarios in mind in order to be prepared for the eventualities.






Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

He who solves this puzzle shall be King

OK, the title was a bit of hyperbole reminiscent of the story of the sword in the stone, but I have encountered an important investment puzzle which, when solved, would address the issue of whether stocks are cheap or expensive.


Why are margins so high?
At the heart of the question is this chart from BoAML (via FT Alphaville) showing that US market cap to GDP to be highly elevated relative to its own history. Market cap to GDP can be thought of as a proxy for Price to Sales.

By extension, the P/E ratio is Price to Sales divided by net profit margins. So the question then becomes, why are profit margins so high?

On one hand, you have the likes of John Hussman who believes that profit margins are likely to mean revert. His analysis of non-financial market cap to GDP and subsequent 10-year returns indicates that the potential for equity capital appreciation is limited.

Non-financial market cap to GDP and subsequent 10-year returns

On the other hand, analysts like Dan Suzuki of BoAML (via Business Insider) wrote that the improvements in margins are the result of lower interest rates, lower tax rates, technology and energy costs. He believes that roughly two-thirds of the improvements in net margins, namely lower rates and taxes, are sustainable.

I have also seen Street analysis (that I can't find) which indicates that US multi-national margins are much higher than companies focused on the domestic economy. This effect is likely due to the tax avoidance schemes of multi-nationals whereby they shelter much of their income in offshore subsidiaries.


The investment puzzle
These arguments about whether net margins are elevated amount to a top-down macro analysis (they are elevated and therefore should mean revert) vs. a bottom-up micro analysis (it`s a regime change because interest rates are low and companies have learned to lower their effective tax rates). A better way of phrasing the real top-down economic puzzle was raised by Ben Inker of GMO, namely that if margins are so high and returns so attractive, then why has corporate investment been so low?

Here is an excerpt of a Morningstar interview with Inker [emphasis added]:

Kinnel: In April, you wrote about how corporate profits have been very high for a long time, leading you to wonder why reversion to the mean hasn't hit yet. What's your current thinking on this?

Inker: The behavior of corporate profits in the U.S. for the last 10 or 15 years is weird. It doesn't follow a standard capitalist script. If you've got a situation where there is a very high return on capital, which there has been on average for the last 10 or 15 years, you would expect to get a lot of investments. If the return on investment is high, capitalists go out there and invest. [If] the return on investment is low, they don't.

Well, the return on investment has been high, and yet we have been investing really quite little. There was a burst associated with the Internet bubble, but since then investment has been somewhere between a little bit anemic and, today, downright depressing. That doesn't do anything for expectations of future growth, because productivity growth really does require investment and we're not getting much investment. So, it's hard to see how we're going to get productivity growth, but profits for companies are really less about productivity growth and more about the return on capital. And if you are not getting a lot of investment, then you don't get one of the avenues towards pushing profit margins back down. Normally, higher investment would happen and that would lead to higher competition and the erosion of profit margins. So, if we're looking for reversion in profit margins, which we are, it's sort of the longer-term more subtle issues about what does it mean to have high profits in the corporate sector that is not accompanied by high investment.

Antonio Fatas, Professor of European Studies and Professor of Economics at INSEAD, asked a similar question on his blog, why did investment decline?

When we compare the last four expansions in the US economy we can see that while the real interest rate kept going down (especially in the 2001-2007 expansion), investment rates remained flat or even declined. I have included the current expansion in the chart although is not comparable to the others as it has not finished yet.

What happened to investment? Why didn't it go up as real interest rates fell and the pool of saving was increasing? I am not sure we have an answer to these questions but what the data suggests is that we are not just facing the negative consequences of a deep recession, we should also have some concerns about the strength of the recovery based on the weakness of investment in the previous expansion (once we take into account the low level of interest rates).

In a separate post, Fatas pointed to a similar pattern of falling investments worldwide:

Below is a chart that I have constructed using data from the IMF (World Economic Outlook database). I have calculated the aggregate investment rate (as % of GDP) for all advanced economies using the GDP share of each of these countries as weights [using PPP adjusted weights makes no difference for these countries].

The Big Question
So here is the Big Question. If net margins are so high, what happened to the missing investment?

The analysis from Dan Suzuki of BoAML indicating that net margins are elevated screams "low cost of capital" to me. In past instances where we have see low costs of capital (Japan in the 1980's and China today), we have seen an investment bubble form. When companies enjoy low cost of capital, the proper response is to raise as much money as you can and buy something, anything, to raise your returns. So if the cost of capital is so low, why haven't we seen a surge in corporate investments in the developed markets?

Something is not adding up here. The analyst who solves this puzzle will resolve the margin puzzle and therefore the question of whether stock prices are cheap or expensive.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Where's the short-term pain in China?

China's Third Plenum has come and gone and the market reaction has been cautiously positive, as shown by the chart of the Shanghai Composite and the Hang Seng Index, with the grey area shown as the post-Plenum period.

Unraveling the financial repression bubble
I had expected the reforms unveiled at the Plenum was supposed to be a story of short-term pain for long-term gain.

The State's control of the banking system had led to artificially low interest rates for the household sector and resulted in financial repression in the following form. The ordinary Zhangs in China's household had few avenues for excess savings. If he put it into the banking system, he got negative real interest rates (financial repression). The stock market is tiny and amounts to little more than a casino; there was no bond market to speak of; and there were limited ways of taking money out of the country. Meanwhile, the state owned banks lent to the SOEs at below market rates, because of the banks' cheap funding, and the SOEs, having also benefited from fixed prices and little or no competition, made out like bandits - as did the Party insiders running these enterprises. The household sector channeled its savings to the only place it could - property. In effect, financial repression led to an enormous property and credit bubble in China.

The bubble was exacerbated by the USD peg. Consider the following news from the FT. State controlled China Development Bank recently issued a bond with a yield of 5.5%:

CDB, the policy bank whose credit profile is as good as the government of China itself, was forced last week to cut a proposed Rmb24bn ($3.9bn) deal by 60 per cent to Rmb10bn and pay a yield of more than 5.5 per cent.

“Chinese 10-year Treasury bond yields are at a six-year high and are up about 100 basis points versus a year ago,” said one senior bond banker in Beijing. “CDB’s yields have widened by a bit more than 100 basis points and other corporate bonds are seeing yields rise by 150-200 basis points.”

The article went on to state that these yields were  not competitive with wealth management products with 8-9% yields:

[A] big problem for Chinese issuers right now is the tougher competition from alternative fixed income investments, such as wealth management and trust products, which offer yields of 8 or 9 per cent and are guaranteed by the issuing banks.

5.5% yields in a sovereign guaranteed instrument and 8-9% yield for "junk" paper in a currency pegged to the USD ? What would you do?

This yield differential was an open invitation for a carry trade. While outsiders in the West have limited means to execute that trade, Chinese companies with offshore subsidiaries can use transfer pricing to shift funds either onshore (to Mainland China in RMB) or offshore (in USD and other currencies), depending on return differentials. In addition to the excesses that I mentioned before spawned by the practice of financial repression, the USD peg no doubt created a carry trade - borrow in USD and invest it in RMB denominated assets.

The authorities understand these problems. They also understand that the country's growth path had become overly reliant on export-led and infrastructure-led growth. The reforms announced by the Third Plenum are intended to re-focus growth and unwind some of these excesses.


Who are the losers?
There are no free lunches and there is a cost to this policy. Growth has to slow and there will be losers and winners under the new policy. The way I see it, there are two distinct sets of losers under the latest round of reforms:

• Local governments: Local governments had been highly dependent on the sale of land to developers for funding. The latest reforms shifted the power over land use from local authorities to residents (as per Nomura via FT Alpahville):

We expect this reform to have small to moderate positive impact on the economy, depending on the implementation. Many of reform measures in this area actually had been proposed in the third plenary session of the 17th CCP Congress in 2008, but there has been no meaningful progress thus far. Local governments are not keen to implement these measures as they heavily rely on land sales for financing local projects and daily operations.

• Farmland. Reiterates the confirmation of rural land rights and developing modern agriculture with larger-scale farms, while strictly maintaining farmland purpose. We believe this, if implemented successfully, will improve productivity in agriculture and rural areasw, but the implementation is likely to be very slow.

• Rural residential land. Carefully and properly promotes collateralisation, guarantee, and transfer of rural properties to increase farmers’ asset revenue through a few pilot regions, as well, as it establishes the rural property market. The tone here is very cautious. Also, there is, expectedly, no mention of transactions between rural and urban citizens/property developers on rural residential land. This requires revising “Land Management Law” and resolving the problem of many rural properties with limited property rights – i.e., where properties were built on rural residential land but purchased by non-local residents.

• Rural construction land for commercial use. Allows rural construction land for commercial use to be transferrable and rentable and establishes an integrated market for construction land for commercial use. This part of land – mainly occupied by township and village enterprises (TVEs) – consists of a very small portion of rural land, and has been in land market for trading with certain restrictions for some time already. As such, this is not a significant measure.

• Rural land expropriation system. Reduces the scope of taking over land from farmers by local governments and standardises the land expropriation procedure. Usually, farmers are under-compensated for their expropriated land, while local governments can benefit significantly from land sales. If this measure can be implemented, it will reduce local government land sales revenue significantly, so we expect local governments will resist such reform as usual. 

• State owned enterprises: The latest reforms reduces their monopolistic power, deprives them of their cheap funding through financial reform and deprives them of retained earnings by forcing them to remit more dividends to the State by 2020.

All of these steps are positive steps to re-balancing China growth path. If the plan is executed properly, then there should be some short-term pain as existing structures get torn down and better market and political structures get created.

Pick your poison

Given the recent market reaction, where's the pain? 

If the market is rallying, then what it's telling me is that there is no short-term pain. In that case, the imbalances build and the whole thing comes down in a Crash some time in the future. In fact, that's what Andy Xie recently wrote in an article called No sugarcoating it: A hard landing is likely. He had believed that a soft landing was possible, but he changed his mind:

I believed for a long time that China would have a soft landing. When its economy began to descend in 2012, fear of a hard landing permeated financial markets for several months. My view on a soft landing was based on the dominance of bank loans in credit creation. The country's banks are government-owned. When property developers face a liquidity crunch, the banks are likely to reschedule their loans. A hard landing is a consequence of the snowball effect from creditors liquidating delinquent borrowers. When there is a big bubble funded by debt, as is usually the case, its bursting would lead to a hard landing if the credit agreements are stuck to. Hence, a soft landing is usually due to either an inability or unwillingness of creditors to enforce debt contracts. Japan, for example, was in such a situation in the 1990s.

That's because the carry trade has spawned an enormous bubble, which I described above:

The carry trade is the most important and speculative force in international capital flows. Interest rates are different in different currencies and the across spectrum of credit quality. When the interest rate is higher in one currency than in another, it usually reflects a higher inflation rate in the former, which would lead to its depreciation against the latter. The interest rate difference reflects the inflation difference and the former's depreciation. Similarly, when two bonds have different interest rates, the difference reflects their different bankruptcy probability. Because currency depreciation and corporate bankruptcy happen infrequently, many investors or speculators cannot resist the temptation of arbitraging interest rate differences.

This force has come to China lately and in force, especially after the Fed defied market expectations and declined to taper its US$ 85 billion monthly QE in September. The money has shown up as foreign exchange reserves, prompting the rise of shadow bank financing and land kings lately in big cities.

When the Fed starts to unwind its QE program, that's when Xie thinks that it all comes crashing down on us:

China's shadow banking system has become the main source of financing for the ongoing speculation. Nearly half of the credit growth this year can be classified as that. As such financing is usually short term, the speculative game depends on rollover confidence, as the underlying assets need years to become liquid. The confidence depends on faith in land prices surging for years to come. Such confidence is on thin ice to begin with because it is only working in big cities currently, and small and medium-sized cities are all facing difficulties. Any psychological shock could trigger rollover failures.

When the Fed does unwind its QE, China's shadow banking system will likely face a severe liquidity squeeze. Janet Yellen, the new Fed chairwoman, has expressed her disregard for asset bubbles and determination to push on until either the unemployment rate falls below the Fed's target or inflation breaches the Fed's limit. It is likely that either or both could be breached in 2014. It may mean the end of China's decade-long property bubble.

Andy Xie's China hard landing scenario depends on how the Fed navigates its QE exit (see Zen and the Art of the Fed Taper). Can the Fed manage to taper and maintain a narrow risk premium through its communication policy?

Regardless, I am puzzled by the market's reaction to the details of the reforms from the Third Plenum. If Chinese sensitive markets fall, then that's good long-term news as pain is being felt by existing players as the economy restructures. If it doesn't fall, then the market doesn't believe that listed companies are likely to feel much pain. In that case, we could be setting ourselves up for a crash down the road, possibly triggered by a Fed taper as postulated by Andy Xie.

Pick your poison.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Is this end of the line for energy bulls?

Ah, those unfortunate energy bulls. Their returns over the last few years have been nothing to write home about.

As shown by the chart below, the relative performance of the energy sector against the market has been topping out for the last few years (blue line), though bulls can be console by the fact that the long-term relative uptrend that began in 1999 remains intact. From a technical perspective, there is a decent chance that the relative decline could be halted at the 50% Fibonacci retracement level, which roughly coincides with the long relative uptrend that began in 1999.

What's more depressing for energy bulls, the press and blogosphere has been full of bearish stories about oil prices, largely because of the shale boom seen in the US:

• Recalling the false messiah of peak oil (FT Alphaville)
• For Oil, Conventional Wisdom No Longer Applies (WSJ)

Is this the end of the line for secular bulls on energy?


Watch the smart money
Before getting overly bearish on the long-term outlook for the energy sector, consider this. Warren Buffett was interviewed recently and said that he thought stock prices were fairly valued and he couldn't find much to buy (via Business Insider, emphasis added):

[Buffett] noted that the equity market was fairly valued and stocks were not overvalued. Specifically, Buffett said “They were very cheap five years ago, ridiculously cheap,” and “That’s been corrected.” He also noted, “We’re having a hard time finding things to buy.” One has to take note when the world’s most high profile investor (a long investor), cannot find stocks to buy although he reports his business is improving.

If Warren Buffett is having such a difficult time finding values in the market, then why did he put $3.5 billion into Exxon Mobil and $500 million into Suncor Energy?

Just asking...

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Zen and the Art of the Fed taper

Tim Duy had an interesting comment about the bind that the Fed finds itself in today:

Confusion arises when one realizes the Fed does not intent to use all of its available tools to meet its goals. In particular, there is no inclination to expand the pace of asset purchases, and is instead every inclination to end the program. They are looking forward to normalizing policy by shifting the focus to forward guidance on interest rates.

In other words, they would like to taper and stop expanding the Fed's balance sheet. They believe that forward guidance is another tool that they can use instead of QE:

Bottom Line: Policymakers would like to normalize policy by moving away from asset purchases to interest rates. Emphasizing forward guidance is part of that process. Incoming research suggests not only that threshold based forward guidance is effective, but has room to be even more effective. That should be a comfort to policymakers who worry that ending asset purchases will excessively tighten financial conditions; they have a tool to change the mix of policy while leaving the level of accommodation unchanged. Whether they use it or not is another question. There has clearly been some discomfort among policymakers regarding changing the unemployment threshold. This suggests it would not necessarily be an immediate replacement for ending asset purchases. That said, it is difficult to see how the current threshold is meaningful at all if the Fed is still purchasing assets when the threshold is breached. Indeed, the current low level of unemployment relative to the threshold, combined with clear indications that the Fed has no intention of raising rates anytime soon, argues by itself that a change in the thresholds is a likely scenario in the months ahead.

How to taper without tapering?
There has been a lot written about quantitative easing. Does it work? Is is as effective as it could be?

Recent analysis by prominent policy makers and analysts suggest otherwise. Larry Summers' IMF speech indicated that the world is stuck in an era of stagnation and serial central bank bubble and Ray Dalio of Bridgewater believed that QE is running of gas. The episode in the May-September period demonstrated how the market perceived QE, which seemed to have caught policy makers by surprise.

I argued before that the main effect of QE is risk premium compression, which produces a wealth effect (see It's the risk premium, stupid!)..By pushing down Treasury yields and mortgage rates with asset purchases, the Fed forced investors to take more risk, which, by definition, QE forces down the risk premium. When the Fed signals that it is about to taper, risk premiums rose. Why is that market response such a surprise to the Fed?

The greatest risk from the recent rise in risk premiums came from emerging markets. Cullen Roche at Pragmatic Capitalism highlighted a SocGen report of the effects of tapering on EM sovereign funding costs:

Fed policy, a sword of Damocles for emerging markets

Following the Fed’s decision in September to postpone tapering, emerging markets (EM) rebounded strongly. But this relief rally has now stalled, as investors are cautious about the central bank’s next move (see chart). Indeed the latest FOMC meeting confirmed the Fed’s bias for tapering and the very good employment report released last Friday reinforces our economists’ expectation of a March 2014 taper. The threat of rising global yields is a key downside risk for EM assets near term. Higher bond yields should trigger portfolio rebalancing and the “repricing of risk could spark a run by investors holding speculative positions”, says the IMF. The shock will be further amplified in countries with external imbalances and vulnerable financial systems.

Indeed, the relative performance of emerging market bonds (EMB) against US junk bonds (HYG), as a measure of "junk" against "junk", that the relative performance of EM bonds have stabilized against US high yield, but there has been no relative recover yet. Technicians will note that this pair violated a multi-year relative support level but rally attempts have failed at a key support-turned-resistance.

In effect, any rise in risk premiums from Fed tapering has the potential to cause an emerging market crisis, whose contagion effects could spill over and threaten the stability the global financial system. Even though Fed officials stated at Jackson Hole that they are not responsible for EM economies (see this Bloomberg report), the market selloff in the wake of the May 22 hints of tapering might have been a concern to a Federal Reserve concerned with financial stability and systemic risks.

For central banker policy makers, the May-September episode presents a Zen-like problem, especially for FOMC members who are concerned about the expansion of the Fed's balance sheet: "How do you taper, but avoid the market effects of tapering?"


The Fed giveth and the Fed taketh away
John Hilsenrath penned an article last week that explained the likely way forward for the Fed. It could begin to taper, but present forward guidance that signals greater accommodation than what the market expects:

One idea under discussion is to lower that unemployment threshold from 6.5%, which could mean keeping rates down longer. Fed staff research suggests the economy and job market might grow faster, without much additional risk of inflation, if the Fed promised to keep rates near zero until the unemployment rate gets as low as 5.5%. Goldman Sachs economists predict the Fed will lower the threshold to 6% as early as December and reduce the bond-buying program at the same time.

Could that form of forward guidance serve to hold down the risk premium while the Fed reduces the rate of growth of its balance sheet? My gut reaction is no - that risk premiums would rise, largely because that form of guidance only serves to hold down interest rates and does little to direct affect the risk premium between mortgage rates and Treasury yields. But then, I have been wrong before.

Central bankers are truly sailing in uncharted waters. The Fed has discovered the non-linear effects of adaptive expectations. I am closely watching emerging market currencies and bonds for the real market reaction should the Fed adopt such a course of action.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

A consolidation instead of a correction

About three weeks ago, I wrote that stock prices appeared to be extended and due for a pause (see Time for a market pause? and A time for caution). I had expected a brief and shallow correction, but equity prices remain in an uptrend and to expect a Santa Claus rally late in the year.

I was wrong on the correction. The overbought condition in the stock market resolved itself in a sideways consolidation. Moreover, the consolidation period seems to be over as several major US equity rallied to all-time highs last week.


Reasons to be bullish
There are multiple reasons for my inner trader to get more bullish on stocks. First of all, the excessive bullishness seems to have retreated, which is supportive of further new highs. The AAII sentiment readings, which can be volatile, show that bullishness has fallen while bearishness has risen (via Bespoke):

As well, Arthur Hill at ChartWatchers pointed out that market breadth is improving and confirming the current advance in stock prices.

What's more, George Soros has significantly reduced his SPX put position which suggests that the position was a hedge and not a directional bet on the market.


Cyclical strength continues
I am also seeing signs of continued cyclical strength. Earnings Season has come and gone and the result can be best described as "Meh!" In the meantime, the American economy continues to muddle through. What is particularly constructive for the intermediate term economic outlook is the positive relative performance exhibited by cyclical stocks:

In particular, we can see that kind of relative performance behavior in the Consumer Discretionary sector:

...and the capital goods sensitive Industrial sector:

Broker-Dealers strengthening
One important "tell" of market direction has been the relative performance of the Broker-Dealers, which has rallied through relative resistance and remains in a shallow relative uptrend against the market:

The relative performance of the Broker-Dealers is important because of their *ahem* ability to extract extraordinary profits from the market. The #AskJPM event was a poster child of the manifestation of this "ability". Here are a few of my favorite questions from that event:

Junk bonds as a measure of risk appetite
J.C. Parets wrote last week that we should watch the junk bond market, citing a post from stockcharts.com, largely because junk bond prices have been highly correlated with stock prices.

I would add that the performance junk bond are a reflection of risk appetite. This chart of the relative performance of junk bonds (HYG) relative to 7-10 Treasuries (IEF) indicate a relative uptrend and therefore rising risk appetite:

What to watch for
To be sure, the bulls don't necessarily have clear sailing ahead. I am watching a trio of Risk-On/Risk-Off indicators for signs that stock prices are ready to roar ahead into a Santa Claus rally. These indicators consist of:

1. Consumer Discretionary/Consumer Staples pair, measured by XLY/XLP as an indicator of the cyclical strength of the American consumer (shown in black in the chart below);
2. Sotheby's/Walmart pair, as a measure of the champagne/beer trade (in orange); and
3. Small cap/large cap pair, as a measure of risk appetite (in green).

All three pairs rolled over in early October, but the XLY/XLP has ticked up in the last week indicating a return of cyclical strength.

As the US calendar heads into Thanksgiving and the Black Friday kick-off of the year-end shopping season, I am also watching carefully the behavior of retailing stocks for an indication of consumer strength. Retailing stocks remain range-bound relative to the stock market and it will be interesting to see which way it breaks out:

Bottom line: My inner trader is cautiously bullish on market direction, but risks remain. If you get long, it's important to define your risk parameters and maintain a stop-loss discipline.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Does China need a "Night of the Long Knives"?

The Chinese Communist Party's Third Plenum has come and gone. The communiqué was, as expected, vague on details, but the market reaction in Asia was less than impressed as stock prices tanked. Here were my key takeaways:


What role for the markets?
While the Party was said to have pledged a "decisive" role for the market, Ting Lu of BofAML was underwhelmed and confused (via FT Alphaville):

The communique changes the role of “Market Economy” from “基础性 (Jichuxing)” (used in the past 20 years) to “决定性 (juedingxing)”. For native Chinese speakers like us with years of intensive training in Chinese (and we did well on the grueling GRE too), we found it very difficult to tell the real difference. Bloomberg translated “ 基础性 (Jichuxing)” to “basic”, but we think it could be translated to “fundamental (foundational)” or “essential” as well. Regarding “决定性 (juedingxing)”, it could be translated to “deciding”, “determining” or “decisive”. We suspect the Chinese people won’t interpret too much from this change.

No SOE reform
What I found more interesting was that the Party's affirmation of the dominant role of public ownership, which was a signal that any reform of state owned enterprises  (SOE) was unlikely. The reason why that is significant is that since the time of the Deng Xiaopeng reforms, China has grown in leaps and bounds, but most of the wealth have accrued to the Party cadres and insiders. The combination of regulated prices and a crony capitalist culture has made many Party officials obscenely wealthy, with most of the fund stashed offshore. It has only been recently that the term "naked official" has crept into common usage.

In order to achieve its stated goal of re-focusing growth from export and infrastructure to the consumer, the authorities would have to stop, or at least lessen, the financial repression of the household sector with higher wages and interest rates for household savings. All those steps would hurt the interest of the Party insiders who got filthy rich.

Andrew Sheng and Xiao Geng put it this way in a Project Syndicate article:

A successful transition to the next phase of wealth creation – driven by the services sector and knowledge-based industries – will require a more market-oriented approach, in which the state cedes some control over the economy and focuses instead on protecting property rights, administering welfare services, reducing pollution, and eliminating corruption. Improved governance, together with greater support for market-based innovation, is needed to sustain a thriving economy.

Instead, what did we get? No SOE reform. Instead of ceding some control over the economy, we got the affirmation that dominance of public ownership. Moreover, the Party tightened control, instead of ceding control, over the economy via the establishment of a state security committee and a leading group on deepening reform. Depending on how the "leading group" is composed, it could be a mechanism for which market liberalization efforts are obstructed and buried by the bureaucracy.

If China's top leadership really wanted to signal the seriousness of its intention of re-balancing growth and market based reforms, maybe what it needs is a Night of the Long Knives, which refers to an event in 1934 when Adolf Hitler instituted a purge of his enemies. One of the victims of the purge was the SA, otherwise known as the brown-shirts, because they had outlived their usefulness.

Maybe what China needs is its own purge of Party cadres, because they have outlived their usefulness and become an impediment to stable long-term growth.







Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Any Ph.D. can model, but judgement is priceless...

I have long been a proponent of the intelligent use of quantitative models on this blog. To illustrate my point, I compare and contrast the work of two prominent economists, Ed Yardeni and Janet Yellen. Both are at the top of their respective professions. Yardeni has been a Wall Street forecaster for as long as I can remember. He is the epitome of the practical market savvy modeler. Yellen has a sharp mind and she is about to become the Fed Chair, though her thinking appears to be more academic in orientation.


China bottoming?
Now consider how these two economists analyzed issues that arose in each of their own realms. Recently, Yardeni pointed out a possible positive divergence in China. The forward earnings of emerging market equities are correlated to commodity prices, he wrote:

Emerging markets, which account for 20% of the World ex US MSCI, have lost their earnings groove. The forward earnings for the EM MSCI rose to a new record high during 2009 through mid-2011. However, it stalled since then and continues to flat-line. As I’ve noted before, the forward earnings of EM MSCI has been highly correlated with the CRB raw industrials spot price index since the mid-1990s. The commodity index has been slowly losing altitude since the start of the year.

He went on to point out that the forward estimated margins of the components of MSCI China is rising. Since China is has a large weight within MSCI EM, then, by implication, this development should provide some positive fundamental backdrop for EM stocks.

I have the greatest of respect for Ed Yardeni as he has been an insightful Wall Street economist since the time I started to discover girls. In this case, I would add the following caveats to his analysis of Chinese stocks:

• How much noise is in the Street's earnings estimates? Here are a couple of sources of "noise" in Chinese companies earnings:to think about:

1. Chinese stocks have been the source of well-known accounting frauds and outfits like Muddy Waters has made a good living exploiting this anomaly.
2. The effects of crony capitalism, opaque accounting and corporate structures may make profits elusive. Consider the case of disgraced party official Bo Xilai, who was reputed an avowed Maoist. How did the family of an "avowed Maoist" amass a fortune of at least USD 136 million, according to this Bloomberg report? 

• Don't forget the effects of government policy. China is still a "communist" country based on a command economy. In the wake of the Lehman Crisis of 2008, the government decreed that SOEs, some of which are listed on stock exchanges, go on a spending spree and state-owned banks were told to lend in order to finance this recovery effort. All duly followed orders without regard to the profit motive. As we await the policy announcements from the Party's Third Plenum (see my previous comments What Li Keqiang's 7.2% growth stall speed means and The stakes are rising for China's Third Plenary), one wildcard is the effect of direction of government policy on profit margins. The key takeaway here is revenue growth does not equal profit growth! So be careful about the assertions about profit margins.

Sometimes it is easy to forget that when analyzing foreign stocks, the companies do not live in America.


Yellen and optimal control theory
By contrast, consider the buzz in the last week that arose in some circles about the prospects for a Yellen Fed's implementation of "optimal control theory". The idea behind this approach was described in a Yellen speech on November 13, 2012 where the Fed tests out the effects of different policies and a quadratic penalty, e.g. the square of the distance, is imposed from the dual objectives of inflation and unemployment:

To derive a path for the federal funds rate consistent with the Committee's enunciated longer-run goals and balanced approach, I assume that monetary policy aims to minimize the deviations of inflation from 2 percent and the deviations of the unemployment rate from 6 percent, with equal weight on both objectives. In computing the best, or "optimal policy," path for the federal funds rate to achieve these objectives, I will assume that the public fully anticipates that the FOMC will follow this optimal plan and is able to assess its effect on the economy.

The blue lines with triangles labeled "Optimal policy" show the resulting paths. The optimal policy to implement this "balanced approach" to minimizing deviations from the inflation and unemployment goals involves keeping the federal funds rate close to zero until early 2016, about two quarters longer than in the illustrative baseline, and keeping the federal funds rate below the baseline path through 2018. This highly accommodative policy path generates a faster reduction in unemployment than in the baseline, while inflation slightly overshoots the Committee's 2 percent objective for several years.

The Street got excited because, under such a regime, the Fed would be more accommodative than previously thought. The Street got doubly excited when the William English, who is the head of the Fed's director of monetary affairs wrote a paper discussing different approaches to Fed policy, including optimal control theory. The combination of these events prompted Jan Hatzius of Goldman Sachs to forecast that the Fed would lower the unemployment threshold range from 6.5% to 6.0% before tapering its QE program (via Business Insider).

Whoa! Don't get so excited yet. In a separate speech on April 12, 2012, Janet Yellen cautioned against the blind use of models like optimal control theory:

While optimal control exercises can be informative, such analyses hinge on the selection of a specific macroeconomic model as well as a set of simplifying assumptions that may be quite unrealistic. I therefore consider it imprudent to place too much weight on the policy prescriptions obtained from these methods, so I simultaneously consider other approaches for gauging the appropriate stance of monetary policy.

Having worked with models that use quadratic penalties before, I know that these models can be highly sensitive to the economic forecasts and the controls can be touchy. A small change in the dial can result in huge changes in market expectations. In quant-speak, it means that outputs can be non-linear to changes in inputs. I believe that Yellen understands that and therefore cautioned against the blind adherence to this model.

This does not mean that a Yellen Fed will follow the precepts of optimal control, just that if it chose to go down that path, it would be well aware of the limitations of such an approach. Tim Duy had a more sober take on the application of optimal control theory [emphasis added]:

[I]f you focus on the possibility of lowering the unemployment thresholds to 5.5%, you should expect only a minor shift in the timing of the first rate hike. The reason for this is obvious - everyone already believes that, under the current circumstances, the 6.5% threshold is no longer meaningful. No one expects a rate hike when the 6.5% mark is crossed. A threshold of 5.5% is largely just a recognition of the reality of the likely policy path.

In contrast, the 2017 number falls out of the optimal control problem in which the Fed credibily commits to holding rates near zero through that date. That is a different policy than the threshold based guidance currently in play. And I would say that persistent concerns about financial stability make it difficult for the Fed to credibly commit to such a period of low rates, even if policymakers wanted to make such a commitment. Hence the exercise with threshold-based guidance to begin with - it is intended to capture as many of the gains of the optimal control approach as possible assuming the optimal control approach is not a realistic policy option.

Who is the more intelligent modeler?
So having read these accounts, who do you think is the more intelligent modeler? Yardeni or Yellen?

There are lots and lots of models out there. Any Ph.D. can build a model, but judgement is priceless and how you earn your keep.






Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

The bulls' European refuge

My inner trader has been relatively cautious in the past few weeks on US equities (see A soft November, but wait for the Santa rally), as the technical picture continues to deteriorate. Consider this chart of the relative performance of the Russell 2000 small cap stocks against the large cap SPX. Small caps violated a relative uptrend line and started to roll over, indicating that the bears are gaining the upper hand.

As well, defensive sectors like Consumer Staple stocks are starting to outperform, which is another telltale sign that the risk-off trade is becoming dominant.

The other signs that the risk-on trade is rolling over is everywhere. The chart below shows two measures of the risk-on/risk-off trade. The first is the Tiffany/WalMart pair (in black) and the second is the Consumer Discretionary/Consumer Staple pair (in purple). Both are turning down, indicating that bullish enthusiasm is softening.

Uncertainty over China
Globally, I have also been cautious about China because of the political uncertainties surrounding the Third Plenary this weekend (see What Li Keqiang's 7.2% growth stall speed means and The stakes are rising for China's Third Plenary). There will no doubt be some volatility as we hear the policy announcements as the plenary wraps up early next week.

Given the uncertainties involved, both in the nature and scope of the announcements as well as the likely market reaction, my inclination is to stand aside for now.


Still risk-on in Europe
On the other hand, European equities continue to show signs that the bulls remain in control. Compare and contrast, for example, this chart of the relative performance of European small caps to European large caps to the US chart above. This spells "risk-on" to me!

Also consider other key risk-on/risk-off indicators in Europe. Here is the 10-year chart of the relative performance of Greek stocks (yes, that Greece) to eurozone equities, as measured by the Euro STOXX 50. The long term pattern shows that Greek stocks rallied through a relative downtrend line and they appear to be staging a relative bottom against eurozone stocks. The short term picture, shown by the red arrow, is equally encouraging as Greek stocks continue to outperform in the last few months.

Here is the same 10-year relative performance chart of Spanish stocks against the Euro STOXX 50, which shows a similar relative bottoming pattern.

Here is Italy. While the Italian MIB Index remains in a relative downtrend against the Euro STOXX 50, it is also displaying a similar relative bottoming pattern as Greece and Spain.

Draghi: Whatever it takes...
Despite the equity market's sell-the-news reaction to the ECB rate cut decision, Mario Draghi seemed to be sticking by his "whatever it takes" pledge to rescue the euro and eurozone in his statements (see FT Alphaville's coverage The ECB rate cut: the analyst reaction). The ECB appeared to be relative relaxed over inflationary expectations and open to the prospect of further LTRO programs. You can't get too much more dovish than that.

Financial tail-risk is fast disappearing because of the ECB. Here is the 10-year chart of the relative performance of European financials relative to the market. The technical pattern is similar to the ones seen for the relative performance of other eurozone peripheral markets. Financials have rallied out of a relative downtrend and their performance is starting to turn up.

By contrast, consider this chart of the relative performance of US financials against the SPX. Sure, they bottomed and rallied out of a relative downtrend line and started to outperform. But why is their relative performance starting to roll over again?

Rally not yet overdone
My preliminary conclusion is therefore investors should look towards Europe for their equity commitments as both the short and longer term picture are supportive of further gains. There is the caveat, however, that European equities have rallied a lot and they may be no longer be cheap.

Ed Yardeni addressed this issue with his chart of European forward P/E ratios, which have now recovered to their pre-Lehman Crash levels.

He concluded that there may be further upside because European growth is likely to push earnings upward:

The question is whether there is more upside for the region’s valuation multiples.

I think there might be, but forward earnings, which has been flat-lining since 2011, as I noted yesterday, needs to show some signs of life. That, in turn, requires that European economic indicators show that the region’s economy hasn’t just bottomed, but is actually recovering. The latest batch of these indicators does show a recovery, but a slow-paced one that may already have been discounted by the rebound in valuation multiples.

So there you are. Even for the cautious about stocks, Europe might be a place to hide.






Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.