Sunday, July 14, 2013

Regime shifts = Volatility

Having reflecting on the global situation, it seems to me that there are two or perhaps three regime shifts occurring. Markets don't handle single regimes shifts well and there will be volatility, but multiple regime shifts is going to mean uber-volatility.

My inner trader wants to dial down the risk in his portfolio as the moves could be treacherous. We will see rip-your-face-off rallies (for anyone caught short) and bayonet-the-wounded downdrafts (for anyone with long positions).

US: Tapering = Rising risk premiums
Let me explain by going through the Big Three global regions one at a time: the US, Europe and China. In the US, the Fed indicated on May 22 that it is considering a plan to taper off its QE purchases. In other words, it may be taking its foot off the accelerator but it is not about to stomp on the brakes (raise rates).

The more subtle message that the market still hasn't gotten is that the various QE programs succeeded in lowering risk premiums by pushing market participants to take on more risk (reaching for yield, carry trades, etc.) Undoing the effects of QE, even though slowly, represents a regime change as risk premiums will start to rise. This will represent a headwind for equity valuations longer term, though the markets will be choppy as it adjusts by focusing on the headline of the day (see my previous blog post It's the risk premium, stupid!)

Some market participants such as banks and hedge funds appear to have gotten the risk premium message. In the wake of the May 22 tapering comments, we have seen the start of a positional risk-off trade, which is less bearish globally than the macro risk-off trade. Positional risk-off means that traders are unwinding the hedged carry trades of borrowing short and lending low, or borrowing cheaply and lending to lower credits. Longer term, it will affect risk premiums worldwide, but remember that this is a regime shift and not all market participants in a regime shift move at the same time because not everyone gets the message at the same time. Moreover, even though the Fed's tapering process is slow and linear, the market reaction may not be - and that's a characteristic of regime shifts.

Despite last week's rally, I have been watching a couple of key indicators of the positional risk-off trade and it seems that many carry trades are getting unwound into market strength. Here is the chart of EMB (emerging market bond ETF) against HYG (junk bond ETF). Note how money continues to flee the low-credit emerging markets:

Similarly, I monitor DBV as a proxy for the currency carry trade and came to the same conclusion:

In the short-run, equities may have risen too far too fast. Consider this CNBC video of an interview with Jon "Fedwire" Hilsenrath last week. Note how bullish the panelists have become in the wake of the Bernanke comment that the Fed isn't going to raise rates anytime soon. Now consider what Hilsenrath said:
Now see how skeptical the panel became with this bearish message from a well-sourced Fed

I recognize that US equities have become the global leadership, but for any investor with a time horizon more than a few weeks, consider US valuations. Simply up, US CAPE does not stack up well against the rest of the world.

Europe: The party continues
Moving across the Atlantic, the ECB and BoE have taken steps to blunt the Fed's rising risk premium message. On July 4, both Mario Draghi and the newly installed Mark Carney embraced the idea of forward guidance in official statements. In its statement, the ECB said:
The Governing Council sharpened its communication by announcing that it expects the key ECB interest rates to remain at present or lower levels for an extended period of time. This expectation was based on the overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the real economy and subdued monetary dynamics.
Wow! What happened to the previous policy that the ECB never "pre-commits" to any course of action?

Carney's statement was somewhat milder, as the BoE stated that it would move toward forward guidance at its August meeting.

In effect, the ECB and BoE effectively told the market: "The Fed has been throwing a giant party and they told you that "last call" would be some time late this year. If you are worried, come over here. The party is going to continue over at our place!"

These statements represent another form of regime shift. Europe is trying to de-couple from US monetary policy and these kinds of policy divergences will mean important shifts in capital flows that will affect the currency markets and the cost of capital for companies operating in the US and Europe. Watch for that adjustment process to play out over the next few months.

China: Re-balancing over growth
Meanwhile, China's new leadership seems intent on cooling down an overheated economy and  re-balancing the source of economic growth from an infrastructure and export oriented source to consumer led source. It has signaled that it is not afraid of slower short-term growth in order to achieve its objectives.

An additional objective is to rein in the shadow banking system in order to achieve greater financial stability. Here is an FT article describing how the shadow banking system based on the proliferation of "wealth management products" works:
It quickly became apparent that these products were very popular with the banks’ clients and it was easy to see why. They paid yields above 7 per cent, far more than the meagre amount offered on deposits. Less apparent was what these clients were actually investing in, or under what terms.

Some involved loaning money to buy land for property developments, despite banks not being allowed to lend money for land acquisition. Others involved investing in the pet projects of local governments, such as building roads in remote border areas or the debt of water pipelines. In many cases, the loans being offered to potential investors had virtually no conditions to protect the lenders, while the collateral – if there was any – often consisted of unnamed items or personal guarantees.
“Hordes of retail investors are attracted by the 7 per cent yield,” one analyst reported to his boss after a visit to local bank branches in Shenzhen last month. “Many WMPs were fully subscribed within hours.”

A week before, the same analyst came across another wealth management product promising a 12 per cent yield without a word on the actual underlying investment project. “Investors don’t care about the underlying project,” he noted. “They think everything is backed by the government. One salesman told me that as long as the Communist party remains in power, these products are safe.”
These wealth management products have become China's subprime market. FT Alphaville pointed to analysis from Credit Insights as to how the money gets invested, which is mostly in real estate projects and local government paper:

The risk of a policy accident is high:
As Michael Pettis said near the end of June, “the PBoC has almost no experience of any kind of financial market condition except that of soaring money creation and credit expansion. Until last year they have never had to deal with a stable or even contracting money supply, and consequently they have had little experience in dealing with these kinds of conditions.” Simply the fact that the PBOC is looking at this market is enough to warrant caution.
Despite these risks, the authorities are determined to move forward with their program of re-balancing and defusing their runaway credit time bomb.  Bloomberg reported that Lou Jiwei, China's finance minister, indicated that China is not afraid of lower growth:
Chinese Finance Minister Lou Jiwei signaled the world’s second-biggest economy may expand less than the government’s target this year and that growth as low as 6.5 percent may be tolerable in the future.

While the government in March set a 2013 growth goal of 7.5 percent, Lou said he’s confident 7 percent can be achieved this year. He spoke yesterday at the U.S.-China Strategic and Economic Dialogue in Washington. The nation’s broadest measure of credit fell to a 14-month low in June during an interbank cash squeeze, central bank data showed today.
In addition, Lou Jiwei revealed the government's short-term pain for long-term gain philosophy in its re-structuring process [emphasis added]:
Lou ruled out the possibility of widening the budget deficit to stimulate the economy. Instead, policy makers have decided to cut the spending of central government agencies by 5 percent, and may use the savings to reduce taxes or increase spending on measures to support jobs and growth, he said.

“I want to emphasize that the structural economic adjustment is a painful process,” Lou said. “It won’t be possible to enjoy a comfortable life and a rapid growth rate with the structural adjustment.”
The new leadership's focus on these structural adjustments  represent a major regime shift from the previous leadership's policy of stimulating with more credit driven growth whenever the economy slowed and damned the consequences. Given the PBoC's lack of experience with slower growth, the risk of a policy accident is high.

How do you write volatility in Chinese?

Fade the rallies, accumulate the sell-offs
In conclusion, we are in the vortex of several storms and volatility will be high. Expect that the markets will oscillate between euphoria and despair in the space of a few days.

My inner investor, who has a long-term plan, is going to relax, go on holiday and ignore the volatility. My inner trader is lightening up positions and keeping his powder dry. He is hoping to fade the rallies and accumulate the sell-offs in order to clip a few pennies here and there.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned


Bill Luby said...

Excellent geographical summary of some of the key issues, Cam.

I always enjoy your analysis.



Anonymous said...

Good summary thanks. My take is that they say something but quickly panic when it happens. Even my inner trader is positive for the moment. I think Europe will panic soon with Portugal.

Anonymous said...

> How do you write volatility in Chinese?

May you live in interesting times? :P