"Ending in tears" doesn't mean the market goes down right away

This is the second part of a two-part post. In part 1, I outlined the risks to the equity market (see This will end in tears, but when?). The markets are getting frothy. The combination of too much complacency, which leads to excessive risk appetite, and diminishing margins of safety will magnify the downside effect of any negative catalysts. However, the existence of such a high risk environment doesn't mean that stock prices go down right away.

In part two, I examine the likely bearish triggers for risky assets such as stocks. In summary, there are four broad categories of risks to the US equity market:

• Geopolitics
• US politics
• Inflation scare
• Earnings growth scare

Stripped to the basics, stock prices respond to either changes in earnings multiples (P/E ratio) or changes in earnings growth expectations (the E in the P/E ratio). The metric for each of these risks is whether there are any possible developments that could be equity unfriendly, i.e. will the development either affect P/E or E?

Geopolitical risks: Well contained

There are three main sources of geopolitical risks that the market is focused on right now:

• Middle East
• Russia/Ukraine
• South China Sea

I have written about the market risks from the Middle East and Ukraine before (see Apocalypse Later and Are you a good capitalist?). As for the developments in Iraq, it is highly unfortunate that ISIS has become so prominent in the region. The news that ISIS has declared a caliphate and called itself Islamic State is highly contrary to western interests. The "bleedout" risk of foreign fighters who have flocked to the ISIS banner returning to their homeland to engage in terrorism is acute and growing.

Despite this geopolitical risk, investors have to ask themselves, what does any of this have to do with the market? Will it affect oil production in the region? No - ISIS has shown itself to be disciplined and interested in cash flow to fund itself so investors can count on little or no interruption in oil production. While the market may engage in minor sell-offs from developments in the Middle East, I can`t envision much that would have a substantial effect on either the P/E ratio or E of the stock market.

As for Russia/Ukraine situation, the news of the EU association agreements with Ukraine, Georgia and Moldova was probably an unfortunate geopolitical miscalculation on the part of the European Union. While thumbing your nose at the Russians is not a good idea, we have seen lots of behind the scenes lobbying from western companies to blunt the effects of American sanctions on Russia. My best guess is that the worst of the crisis is over and the geopolitical risks to the markets from this region is minimal.

The last major source of geopolitical risk comes from a possible outbreak of hostilities in the South China Sea. China has been engaged in simmering conflicts with many of its neighbors, Japan, the Philippines and Vietnam, just to name a few. Notable exceptions have been the Koreas and Taiwan, which has enjoyed warmer relations with the Mainland in the last few years.

In order to soothe any potential panic over possible Chinese military flare-ups with her neighbors, Bloomberg reported that President Obama recent stated that he would prefer to see the peaceful rise of Chinese influence in the region (emphasis added):

“We welcome China’s peaceful rise,” Obama said in a recent NPR interview. “In many ways, it would be a bigger national security problem for us if China started falling apart at the seams.”

There are worse alternatives, much worse:

The U.S. has a great deal riding on the outcome. China is the single largest holder of U.S. debt with $1.3 trillion in Treasury securities, and Sino-U.S. trade last year topped $562 billion, up 38 percent from five years earlier. In an extreme scenario, major turmoil could spark massive refugee flows or even endanger control of China’s estimated 250 nuclear warheads, said Lieberthal, a senior fellow at the Brookings Institution.

“That’s not a future you want to contemplate,” he said.

Here is my take on the geopolitical risk in the region. The Chinese are playing the long game and they recognize that they are not in a position to actively push back against an American ally (Japan, Philippines) just yet. Vietnam, on the other hand, is a different story as it has no strong allies. Watch for more developments in the simmering China-Vietnam dispute in the near future.

In terms of market impact, what would be global growth implications of rising tensions between China and Vietnam? Would the P/E or E effect on US or global equities be any different than if Botswana and Zimbabwe went to war?


US political risk rising

The US midterm elections are coming up and we have seen little political impact from the pre-election rhetoric. The only discernible effect so far has been the surprising loss by Republican Eric Cantor to his Tea Party backed opponent Dave Brat. There are two likely fallouts from this development:

1. The risks to the renewal of the Export-Import Bank charter, which the new Republican House Majority Leader Kevin McCarthy has stated he will not support.
2. Further risks of a government shutdown should Tea Party activists gain the upper hand.

The demise of the Export-Import Bank would be negative for capital goods companies such as GE, Caterpillar and Boeing, but the downside from such a development would be limited to companies in the sector. It would be difficult to see more than a 3-5% hiccup in the major market averages to the elimination of the Ex-Im Bank.

Market bulls should be consoled by the fact that gains by Tea Party activists were halted in Mississippi as the Establishment GOP candidate Thad Cochrane defeated Tea Party challenger Chris McDaniel. Nevertheless, political analyst Greg Valliere believes that the Cantor defeat spells the death of immigration reform and a tough fight on the debt ceiling next spring.

Next spring? That's a problem for after the election and next year! The immediate market impact is likely to minimal.

Unless we see more unexpected US political developments, I see no signs of a major bearish trigger from this quarter.

Rising inflation = Rising interest rates

The third market risk comes from upward pressure on interest rates from rising inflation. If interest rates were to rise, P/E multiples are likely to contract and, everything else being equal, therefore put downward pressure on stock prices.

In short, rising inflation and inflationary expectations are a definite threat to stock prices. There is no doubt that measures of inflation are starting to rise. The question is, "How long before the Fed starts to react to rising inflationary pressures?"

Cardiff Garcia of FT Alphaville put the issue into perspective: With the Fed`s target of a 2% core PCE inflation rate, Garcia highlighted the following comment from the Dallas Fed:

The Dallas Fed writes that its “rule-of-thumb forecast for headline PCE inflation over the coming 12 months is just the current 12-month trimmed mean rate. We thus expect headline PCE inflation to average 1.7 percent over the next 12 months, little different from its current 12-month rate”.

In other words, don`t expect policy makers to get overly excited about getting near the 2% target. What about the dangers of overshooting the inflation target? More here from Garcia:

Greenspan averaged 2.5 per cent PCE inflation and 3.1 per cent CPI inflation throughout his entire tenure. And that’s on the low side of post-war Fed chairs. Volcker allowed it to fluctuate between 2 and 4 per cent even after he had famously pounded it into submission from the terrifying levels of the 1970s and early 1980s.

More recently, both core and headline PCE have been below 2 per cent since the middle of 2012.

In other words, don`t worry so much about rising interest rates.

Jeff Miller of A Dash of Insight recently had some very sensible words about the Fed and inflation (emphasis added):

I have been extremely accurate in my Fed forecasts, but I am not claiming any prizes. It has not been difficult. I simply read information carefully and understand that it is a committee at work. Here are the key takeaways. You will disagree. You will hate them all. Keep reminding yourself that even if you are right and Yellen is wrong, you will lose on your investments. The Fed has the power. Figure out how to use the knowledge to your advantage.

1. The Fed is attempting to increase inflation. They seek 2% on the PCE index. This runs about 0.5% cooler than the CPI.
2. The Fed does not measure inflation through commodity prices.
3. The Fed believes that 2% is price stability. They think that traditional measures overstate inflation. They do not subscribe to ShadowStats (and neither do any of the people they respect). They also see a touch of inflation as easier to fix than deflation. They bias is toward stimulus.
4. The Fed will tolerate as much as 2.5% inflation (on the PCE index) for a time.
5. The Fed has a dual mandate – inflation and employment. It does not protect savers or emerging markets. Learn to live with it and ignore pundits who think this is important.
6. The Fed sees food and energy as noisy components of inflation – wild movements that do not relate to the dual mandate. If food prices are up because of a drought or disease in hog herds, how could this be controlled by raising interest rates? Middle East geopolitics and oil? Same question. These price changes are certainly real, but they are volatile and not relevant for policy. 
7. The Fed does not shift policy based upon small monthly changes in data. Longer trends are demanded.

The conclusion is that Fed policy is on a relatively stable course, but data dependent. The market does not like this, since the preference is for certainty.

Some time in the future, inflationary pressures will rise to a level where the Fed will feel compelled to act. That day is not likely to be in the near future. The immediate risks of P/E ratio contraction are low.


Earnings growth scare
I believe that the most serious risk to the bullish scenario comes from a possible growth scare. Mark Hulbert recently highlighted a decline in corporate profitability that could foreshadow slowing EPS growth, which would be highly negative to US stock prices:

Here’s the sobering data: According to the latest calculations of the U.S. Department of Commerce, corporate profits in the first quarter of this year represented 8.8% of gross domestic product. That’s the lowest level in nearly four years, and represents a big drop from the 10%-plus profitability that prevailed in the last quarter of 2013.

Those who focus on corporate profitability have worried for some time that such a decline was imminent. That’s because, in the past, profit margins have exhibited a strong tendency to “revert to the mean,” according to James Montier, a member of the asset allocation team at Boston-based GMO. In other words, margins in the past have eventually declined whenever they rose significantly above their long-term average, and vice versa.

There has been much debated over the issue of sky high net margins. I have highlighted analysis from BoAML (via Business Insider) that high net margins are mainly the result of low tax rates and low interest costs.

There has also been insightful analysis from Philosophical Economics that the profitability measure used by Hulbert, corporate after-tax profits to GDP, doesn't matter. What investors should focus on is ROE, or at least ROCE.

As you can see, the two terms have risen to record highs together. Relative to the historical average, the Profit/GNP term is elevated by around 383 bps. But of that amount, 252 bps is already accounted for in a higher Dividend/GNP term. To achieve an equilibrium at current Profit/GNP levels, then, all that is needed is an additional net 131 bps of reduced Saving/GNP from the other sectors of the economy. That’s a relatively modest amount–a small increase in the government deficit relative to the average could easily provide for it, and almost certainly will provide for it as baby boomers age over the next few decades.

So there really isn’t any problem here. Corporations will earn whatever amount of profit they earn. If they can’t find useful targets for reinvestment, they will distribute the profit as dividends (or buybacks–which get ignored here because of the way NIPA calculates “saving”), in which case the balance of payments condition set forth in the Kalecki-Levy equation will be satisfied.

In other words, corporate profitability shouldn't matter. If they can't find useful investments, they just re-distribute the profits either as dividends or buybacks.

Here's what should worry the bulls. Both profitability (red line) and distributions (blue line) have ticked down. For the time being, Street consensus EPS growth continues to march upwards. Brian Gilmartin's latest weekly forward EPS analysis shows "year-over-year growth rate of the forward estimate rose to 8.69% this past week, versus 8.60% last week". Consensus YoY EPS growth rate is continuing to rise, which is bullish.

EPS can continue to grow even if corporate profitability falls as long as the number of shares outstanding declines from share repurchases. Indeed, share buybacks have been growing steadily from 2009 and has reached new highs. Nevertheless, this may not be a problem as Ed Yardeni observed that there are definite incentives for companies to buy back their own shares in the current environment (emphasis added):

As I have often observed in the past, corporations have an incentive to borrow in the bond market and use the proceeds to buy back shares when their earnings yield exceeds the corporate bond yield. That’s been the case since 2004 thanks to the Fed’s easy monetary policies under both Alan Greenspan and Ben Bernanke, and now Janet Yellen.

Buybacks are a form of financial engineering since they boost earnings per share whether a company’s fundamentals are improving or not. They’ve certainly contributed to the bull market’s great run in an economic environment that has been widely described as “subpar.”

When the next recession hits, corporate cash flow will decline and investors are likely to be less willing to buy corporate bonds. As a result, buybacks will dry up as they did during 2008, exacerbating the eventual bear market in stocks.

Here is the problem. Bloomberg reports that buyback announcements have start to decline. If profitability is falling and so are buybacks, what will drive EPS growth?

Bullish or bearish? It depends on your time horizon
So where does that leave me? My inner long-term investor, whose time horizon is 5-10 years and a single tick is one quarter, is very cognizant of the high risk environment for stock prices. He is more concerned today about the return of capital than return on capital.

By contrast, my inner investor (6-24 month time horizon) and inner trader (1 week-1 month time horizon) are a nervous bulls. They recognize that investors are taking on excessive risk and it will not end well one day (see This will end in tears, but when?). In addition, Macro Man highlighted the degree of frothiness in the high yield bond market with the following factoid:

Did you know that the one year Sharpe ratio of the Iboxx US$ high yield index is roughly 8? As the chart below illustrates, the rolling 1 year Sharpe of the HY index has approached that level 3 previous times since the crisis (never having been anywhere close to it before the crisis, mind you.) On each occasion, the risk adjusted return moved swiftly lower.

On the other hand, most of the immediate risks are well contained for the time being. The greatest latent risk comes from a growth scare from the combination of declining profitability and falling share buybacks - a double whammy that could serve to blindside US equity investors. While we may be seeing early top-down sides of an EPS growth slowdown, we need to see some bottom-up evidence before taking action. I am therefore carefully watching the corporate guidance coming out of Earnings Season.

For now, the Fed and the ECB are throwing parties and there is no reason to enjoy them. Risk appetite continues to trend upwards. This chart of the high yield bond ETF compared to 3-7 year Treasuries (which I believe is a much better comparison because of the similarities in duration) shows that the relative uptrend, or risk appetite, to be intact:

My vote in the TickerSense Blogger Sentiment Poll is bullish, but I am a nervous bull. I am maintaining my bullish view but be watching carefully for signs of EPS growth hiccup and diminishing global risk appetite.






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.

This will end in tears, but when?

I have outlined in the past my long-term concerns over expected equity returns. Valuations are stretched (see More evidence of a low-return equity environment), but there is no immediate signs of a bearish trigger.

This would have been a very long post so I decided to split it into two parts. The first part outlines the risks to the stock market. The second is an analysis of possible bearish triggers and discusses the likely intermediate path for stock prices.


This will end in tears
In addition to my valuation concerns, Tom Bradley, who is a well-respected local money manager, recently penned an essay outlining what he saw as the risks to the stock market. While the concerns that Bradley expresses are very real, timing is uncertain and the theme of the essay is ”this will end in tears”.

The first concern Bradley outlined is excessive complacency:

It feels like investors have become complacent about – well – everything.

The strongest consensus I’ve seen in recent years relates to low interest rates. The rationale is, rates won’t go up because we can’t afford it. A question from a client last week embodies this view. He asked, “Can interest rates actually increase?”

Related to rates is an increasing comfort with debt. Carrying costs are low and families are okay with heavily leveraged balance sheets. Instead of, “How fast can I get my house paid off?,” the question is, “Should I get an investment loan to go with my mortgage, home equity loan, credit line, car lease and credit cards?”

Too much complacency has shown up in low volatility in all asset classes. Such an environment encourages investors to take on too much risk. Indeed, the Bank for International Settlements has warned of euphoric markets being detached from reality:

The Bank for International Settlements has warned that “euphoric” financial markets have become detached from the reality of a lingering post-crisis malaise, as it called for governments to ditch policies that risk stoking unsustainable asset booms.

While the global economy is struggling to escape the shadow of the crisis of 2007-09, capital markets are “extraordinarily buoyant”, the Basel-based bank said, in part because of the ultra-low monetary policy being pursued around the world.

Leading central banks should not fall into the trap of raising rates “too slowly and too late”, the BIS said, calling for policy makers to halt the steady rise in debt burdens around the world and embark on reforms to boost productivity.

It also prompted Zero Hedge to post articles like "My Credit Score Is Terrible...I'm Surprised They'd Give Me So Much [Credit]".

On the other hand, it could be argued that rising risk appetite is precisely what the economy needs to grow. If people refrain from taking risks, then they will not invest and there will be no growth and employment will stagnate. New Deal Democrat argued that the US economy is showing the typical signs of being in the mid-cycle phase of an expansion, where retail sales growth start to fall below PCE growth (emphasis added):

Early in economic expansions, YoY real retail sales growth far outstrips YoY PCE growth. As the economy wanes into contraction, YoY real retail sales grow less and ultimately contract more than YoY. Retail sales minus PCE's are always negative BEFORE the economy ever tips into recession. That's 11 of 11 times. Further, in 10 of those 11 times (1957 being the noteworthy exception), the number was not just negative, but was continuing to decline for a significant period before we tipped into recession. This makes perfect sense, as retail sales generally include many far more discretionary purchases. As the economy accelerates, consumers make more discretionary purchases. As it slows, the more discretionary retail purchases are the first things cut.

The bill for excessive risk-taking only comes due when the economy starts to turn south. Even if the rate of retail sales growth were to slow below PCE growth, it is a very early warning sign of a slowdown. As the above chart indicates, the lead time from the time this signal was triggered to the start of the recession was over a year. So should investors be overly worried at this point?


Falling margin of safety
Tom Bradley expressed a second concern - that the market has little room for error:

There’s also little margin of safety built into valuations. With bond yields edging down this year and inflation gaining momentum, real interest rates (adjusted for inflation) are again approaching zero. The 2.3 per cent yield on a 10-year Government of Canada bond is right in line with the latest inflation numbers.

The extra yield from owning riskier income vehicles is also on the skinny side. The spread on corporate and high yield bonds is modest and capitalization rates on income properties are extremely low.

Over the past two years, the move in the stock market has largely been driven by rising valuations. Price-to-earnings multiples have gone from below historical averages (low teens) to above (mid to high teens). P/Es are not extreme, but in my view, they have more room to go down than up.

I agree 100%. I have already expressed my concerns over valuation. In addition, I was shocked to see the price of investors have paid to reach for yield. Sober Look (via Pragmatic Capitalism) observed that investors have significantly extended duration (or maturity) risk in striving for higher yield:

A glance at the WSJ's table of market P/E ratios show that the DJ Utilities is trading at a higher trailing P/E ratio than the SPX. Are Utilities the new growth stocks?

As an alternative measure and to confirm the somewhat shocking valuation of Utilities, the P/E of XLU is at 20x earnings, with a dividend yield of 3.6%:

Aren't Utilities supposed to be defensive? While I understand that the 3.6% yield may appear attractive, but 20x earnings for a low-growth sector appears expensive. The P/E valuation of XLP, the Consumer Staples ETF, also showed little margin for error should the stock market decline. If so-called defensive sectors like Consumer Staples are trading at premium valuations to the underlying index, how much downside protection can investors expect in a bearish environment?

A cracked tree in the backyard
Tom Bradley concluded his essay by quoting Bank of Canada governor Poloz about the stock market:

Bank of Canada Governor Stephen Poloz captured the safety net issue well. He was talking last week about the Canadian housing market, but his comments apply to the capital markets in general. He said, “It’s like if the tree in the backyard has a crack in it, you worry it’s vulnerable to a storm.”

The metaphor about the cracked tree in the backyard perfectly captures the current environment. Indeed, the markets have begun to react to the latent risks in the current environment by bidding up the price of tail-risk. The CBOE SKEW Index, which is a measure of tail-risk, is nearing all-time highs:

Moreover, J. Lyons Fund Management pointed out that the SKEW to VIX ratio, a volatility-adjusted measure of tail-risk, is at all-time highs:

Beware the widowmaker
What I have painted so far is a ”this will end in tears” environment, but it is unclear what the bearish trigger might be. I tell two cautionary tales about getting bearish too early.

The first came from my own experience. I can recall analyzing the Netscape IPO (yes, remember them?) and deciding that the valuations were sky-high and I was going to avoid internet stocks. While my judgement ultimately proved to be correct, it took several years for the Tech Bubble to pop and the intervening period was highly painful.

The second is a reminder of how many have been devastated Japanese widowmaker trade (from FT Alphaville):

Japan is the home of the “widowmaker” trade: the obviously mispriced Japanese government bonds (JGBs) which keep getting more and more mispriced until all the short-sellers have gone out of business.

JGBs claimed victims in 1993, 2003 and 2013, when yields plunged in the face of all the arguments presented by the bond vigilantes worried about the slow economy and government debt at levels unheard of elsewhere in the world.

This year was meant to be different. Frantic money-printing by the Bank of Japan last year weakened the yen and so pushed up the price of imported goods, particularly energy, while signs of consumer spending allowed shops to push through price increases.

Sure enough, inflation hit 3.7 per cent in May, helped on by the rise in the consumption tax. With deflation in the past, bonds must now sell off and offer fat profits to the ragged survivors of the anti-JGB trade.

Not so much. Japanese bond bears are having an awful time, with the yield on the 7-year JGB, closely watched by traders, dropping to just 0.28 per cent so far this year, only 6bp above its all-time low. Rising inflation has been met by falling yields, in a reversal of all bond logic, as this chart shows:

No analysis can just end with ”this will end in tears” because it is doomsterism. Doomesterism is an ideology and not an investment approach and I try to be apolitical in my investment analysis (see Are you a good capitalist?).

Unless you have a very long time horizon, investing based on ”this will end in tears” exposes you to the widowmaker trade.

In my next post, I examine the likely bearish triggers and their chances of triggering a bear phase in stock prices.






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.

How to be bullish and bearish, part 2

In a past post, I had outlined my long-term concerns for US equities, though I remain relatively constructive on the intermediate term outlook for stock prices (see How stocks are both cheap AND expensive).


Belski long-term bullish
Now BMO strategist Brian Belski has taken a mirror image of my views, which is long-term cautious but short-term bullish, with a long-term bullish but short-term cautious stance. First, Belski explained his bullishness based on the thesis that we are seeing a secular bull market after a Lost Decade and therefore long-term equity return expectations of 10% are plausible (via FT Alphaville):

Secular Bull Markets Are Born Out of Lost Decades: Based on historical evidence, stocks typically enter a very long period of expansion after emerging from a period of negative 10-year holding period returns. We found that, on average, these periods last for roughly 15 years and deliver average annual returns of about 16%. Given that 10-year holding period returns emerged from negative territory a little over five years ago and currently stand at 5.5%, it is not unreasonable to assume that there is about 10 years and 10% of average annual returns left to the current bull market should performance follow historical patterns.

Short-term cautious
On the other hand, Belski was featured in a recent Financial Post story with the title "5 signs Canadian stocks are frothy", namely:

1. Forward P/E ratios are near the highest level since 2000
2. More than 35% of TSX companies are hitting 52-week highs
3. Volatility is at a record low
4. Stock performance is significantly outpacing underlying commodities
5. Recent TSX outperformance has been highly concentrated in energy stocks

Now I recognize that the Canadian stock market is not the same as the US market, but the two economies are tightly bound to each other and the returns of the two markets have shown a high degree of correlation.

While I disagree with Mr. Belski's conclusions (see my previous post How stocks are both cheap AND expensive for the reasoning), but this is another example of how someone can be both bullish and bearish at the same time. It just depends on your time horizon.

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.

China's new paper tiger?

In 1956, Mao Zedong described the United States as a paper tiger:

In appearance it is very powerful but in reality it is nothing to be afraid of; it is a paper tiger. Outwardly a tiger, it is made of paper, unable to withstand the wind and the rain. I believe that it is nothing but a paper tiger.

Today, as Chinese foreign exchange reserves top $4 trillion, it too may be a paper tiger. The level of FX reserves are impressive to behold, but it may be unable to "withstand the wind and the rain". That's because the $4 trillion in reserves doesn't just sit there burning a hole in China's pocket.


Large FX reserves have costs
Consider this account from the San Francisco Fed of what happens when the PBoC gets USD in reserves:

Consider the example of a Chinese exporter earning $100 in U.S. currency from sales of goods to foreign buyers. Under China’s closed capital account, the exporter is required to sell the $100 to the central bank at prevailing exchange rates, which currently equals approximately 600 renminbi in domestic currency. The central bank then invests its $100 in foreign assets, say U.S. Treasury bonds. If the central bank did nothing further, then China’s money supply would go up by 600 renminbi. To avoid inflation, the central bank sterilizes the transaction, that is, it withdraws 600 renminbi from circulation by selling domestic assets worth that amount and retiring the proceeds.

That process of selling the RMB 600 in domestic bonds is called "sterilization". Of course, the process isn't perfect and there is a negative carry to the process under a closed capital account and fixed exchange rate regime. When Chinese domestic interest rates are higher than US rates, it encourages a long RMB-short USD carry trade and, under a floating exchange rate system, the RMB should depreciate, not appreciate as many in the United States would like to see:

But what if the renminbi-denominated assets pay a higher interest rate than the U.S. Treasury bond? In that case, the central bank exchanges a higher-yielding asset for a lower-yielding asset, posting a loss. Thus, the PBOC faces a tradeoff. It either takes a loss from sterilization or it risks increasing inflation by expanding the money supply. Importantly, this tradeoff only happens under a closed capital account regime in which exporters can’t hold foreign assets.

Ballooning debt
It seems that some of the leakages from unsterilized currency imports and the inflation rate differential have combined to balloon Chinese domestic debt. Indeed, Bloomberg reported that Chinese total corporate debt now exceeds total US corporate debt:

China now has more outstanding corporate debt than any other country, having surpassed the U.S. last year, 12 months sooner than expected, S+P said.

Cash flow and leverage at China’s companies, while better than global peers in 2009, have worsened in subsequent years, according to S+P, which compared corporates in Asia’s biggest economy with more than 8,500 listed companies globally.

This development has increased  the level of risk for the global financial system (emphasis added):

China’s corporate issuers account for about 30 percent of global corporate debt, with one-quarter to one-third of it sourced from China’s shadow banking sector, S+P said. That means as much as 10 percent of global corporate debt, about $4 trillion to $5 trillion, is exposed to the risk of a contraction in China’s informal banking sector.

Michael Pettis (via FT Alphaville) became concerned when Chinese debt began going external. In effect, Chinese SOEs were borrowing on the back of the excellent credit rating of Beijing, while the financials of the SOEs tend to be poor on a standalone basis:

My concern was that as China began to face borrowing constraints from within its banking system, Chinese borrowers would be able to exploit China’s excellent external credit ratings, its huge foreign exchange reserves, and the residual global excitement over China’s unlimited economic potential, to turn to foreign creditors to raise money. It would be easy for Chinese borrowers to fund domestic projects with foreign money.

This, I suggested, was potentially very dangerous. If domestic debt capacity constraints were a consequence of poor investment decisions, the “correct” resolution of the problem was to constrain investment and redirect it into more productive, if less politically popular, projects, not to open new avenues of credit creation for the same old borrowers. The latter would only lead to even greater hidden losses and what is more would increase China’s vulnerability to foreign capital markets, perhaps even subjecting China to the risk of a “sudden stop” in foreign lending.

For now, SOE credit quality does not seem to be an immediate problem:

This isn’t happening yet. We are nowhere near the danger point for foreign borrowing in China. My sense is that foreign debt has risen quickly in the last year, but is probably only equal to roughly one-quarter of reserves, which is a fairly “safe” level. In fact I have no doubt that China specialists on the sell side will assure investors that it is silly to worry about foreign debt at all – just as they assured investors four and five years ago that it was silly to worry about domestic debt.

But they will be wrong again, and for the same reasons. Their data-drenched but theory-poor analyses failed to understand the dynamics of the Chinese growth model during President Hu’s administration (2003-13) and there is little evidence even today that they fully understand the causes of the debt problem which, at least, they now readily recognize. Even a decade ago it should have been obvious that growth in China required mechanisms that severely unbalanced the economy and forced debt up faster than debt servicing capacity.

Unexpected conseuqences
I detailed how Chinese non-RMB denominated external debt had reached $1 trillion (EM tail risks are rising).

Today, many foreigners appear awed by the mountain of Chinese FX reserves. But it seems that holding such enormous foreign exchange reserves comes with unexpected consequences in the form of imbalances, such as inflation, bubbles and a risky buildup of debt that could eventually blow-back into the global financial system.

A paper tiger indeed!





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 financial tour around the world

I haven`t done this in a while, but it would be a good idea to take a financial tour around the equity world to see what Mr. Market is telling us about the current environment. From that, I can explain the market outlook and the risks to the forecast.

For this tour, I thought that I would use point and figure charts instead of the more common open-high-low-close or candlestick charts as point and figure charts take out a lot of the price noise and reveal the underlying trend a lot better.


Upside breakouts everywhere
In general, there seems to be upside breakouts everywhere around the world. Let`s start with the United States. As the chart below shows, the SPX has staged an upside break and moved to all-time highs. While other indices, such as the NASDAQ and small cap Russell 2000 have not broken out to new highs, the upside breakout by the SPX remains impressive, though a little extended and may need some consolidation.

Across the Atlantic, the STOXX 600 displayed a similar pattern of an upside breakout indicating continued strength.

The STOXX 600 represents European equities, but that market is not necessarily monolithic. In particular, these markets are split into eurozone and non-eurozone economies. The latter group consists of countries that can chart a somewhat independent monetary policy, such as Switzerland and the UK, and others that have not adopted the euro but remain under the sway of the ECB, such as Denmark and many of the eastern European countries. Switzerland, the first independent (recall how fiercely the SNB defended the 1.20 exchange rate level), has shown a breakout-pullback pattern, with the Swiss index staging an upside breakout and pulling back to test support near the former breakout level:

The UK market, as represented by the FTSE 100, is the weakest of the major European markets as it has not staged an upside breakout as it is just testing a long-term resistance level. Despite these minor blemishes, I would score European stocks as being in an uptrend.

Moving to Asia, the Japanese market has also staged an upside breakout:

By contrast, the technical pattern of many Chinese related markets are mixed. The Shanghai Composite is one of the weakest bourses globally:

The South Korean KOSPI is showing a similar pattern:

The Hong Kong Hang Seng Index has been the strongest of the Chinese related markets as it seems to be in a high level consolidation. I would note that while these markets are showing more weakness on a relative basis, none of them are showing bearish signs of technical breakdowns.

Indeed, the MSCI Emerging Market Index is showing a pattern of range-bound sideways consolidation. From a trend-following point of view, the jury is still out on these stocks.

I am somewhat constructive on commodity prices. The CCI Index, which is the equal-weighted CRB Index that I find useful in the current environment to mitigate the geopolitical effects of Iraqi on energy prices, has rallied out of a downtrend and is now consolidating sideways. This is a good-news-bad-news story:

Interestingly enough, the stock markets of commodity-sensitive economies are seeing upside breakouts. Here is Australia:

Canada has clearly staged an upside breakout, though the TSX appears a bit extended in the short-term:

Rising earnings = Bullish
When I put it all together, I see a global economy that is firing on most of its cylinders. This is the picture of a mid-cycle expansion. The US is leading the recovery, followed by Europe and with China bringing up the rear. There appears to be little sign of any developed market recession around the corner, so that kind of macro risk is well contained for the next 12 months.

The main risk to US equity prices appears to be valuation. Michael Cembalest of JP Morgan Asset Management showed this chart of the median PE of the US market indicating that valuations are elevated.

Cembalest went on to liken the current rally from the 2009 bottom to the 1982-1987 rally:

If I had to choose, this cycle is more reminiscent of the pattern in the mid-1980’s than the tech boom, particularly given how low interest rates fuel demand for stocks.

Indeed, the level of PE expansions are very similar:

Let me make this very clear: I am not implying that the stock market is likely to crash as it did in 1987. There seems to be no likely trigger in sight.

Little immediate risk of a crash
Given the stretched valuations, the main fundamental reason holding up this current bull are earnings - and we are seeing positive momentum there. As Ed Yardeni showed, Street consensus forward EPS estimates continue to rise, so downside risks are well-contained.

Brian Gilmartin confirmed this assessment when his analysis showed that forward EPS growth is rising. That should be supportive of further equity price gains and further PE expansion:

The year-over-year growth rate of the forward estimate is now 8.60%, once again at a new multi-year high, after dipping slightly last week. The forward growth rate hasn’t been this high since January 13, 2012 when it was 9.4%.

Analysis / commentary: If you’ve scrutinized SP 500 earnings as long as we have, the action in the SP 500 understandable this year, just looking at the revisions and forward estimates around SP 500 earnings. The fact is, despite the negativity, SP 500 earnings are growing at mid to high single digits, and starting to improve.

For all practical purposes, with the SP 500 at 16(x) forward earnings, and with it becoming increasingly likely that SP 500 earnings growth could hit 10% (easily) this year, p.e expansion to 20(x) that forward estimate wouldn’t be a stretch.

Watch the growth outlook!
What if the growth outlook were to falter? That's what I am watching carefully. I have written about the lack of CapEx among companies (see What equity bulls need for the next phase and CapEx: Still waiting for Godot). While improving corporate cash flows and balance sheet strength should foreshadow more capital expenditures and investments from the corporate sector, they have not been forthcoming. What's more, analysis of research and development expenditures, which could be a substitute for CapEx, have not increased very much either globally (via Business Insider):

In the meantime, the relative performance of the Morgan Stanley Cyclical Index (CYC) has broken down through a relative uptrend and CYC is undergoing a relative sideways consolidation. While that may appear to be bad news for the bull camp, bears are frustrated because there is no sign of a relative breakdown indicating a downturn in the cyclical outlook.

The trend is your friend
In summary, my tour around the world is giving me a picture of global equity markets in an intermediate uptrend. As they say, the trend is your friend (until it`s not).

While some equity markets, such as US stocks, appear to be a little extended in the short-term, pullbacks are likely to be relatively minor. Until more definitive signs of global weakness occurs, the intermediate term uptrend needs to be respected.




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.

Have we seen this golden movie before?

In recent days, the blogosphere has gotten excited about a potential turnaround in gold and gold stocks. Specifically, technicians have pointed to the rally in gold (top panel of chart), the gold stock to gold ratio (GDX/GLD, middle panel) and the better performance of high-beta silver to gold ratio. All of these point to better times for the bullion price.

The jury is still out
I wrote in a recent post that it is important to remain apolitical in investing (see Are you a good capitalist) and Barry Ritholz has also reiterated this theme in recent days as well. In that spirit, I want to analyze the excitement about the possible technical breakout in gold and gold stocks.

First of all, consider the chart above, but with a five-year time horizon. An examination of the longer term pattern shows that only the GDX/GLD ratio (middle panel) has staged a rally out of a relative downtrend and now displaying a sideways basing pattern.

The other two, namely gold and silver/gold ratio, are rallying up to test their long-term downtrends. A more bullish interpretation could be that these two ratios have rallied out of relative downtrend (dotted lines) and they are now consolidating sideways (shown in grey).

What about the dovish message from Janet Yellen? Could that not spark better performance for inflation hedges like gold?

Yes, but other charts of inflationary hedges have not confirmed the upside breakouts in gold and gold stocks. The relative performance of TIP to AGG (Barclays Aggregate Bond Index) shows that TIPS have started to turn around in relative performance against the bond market. However, we have not seen any signs of a breakout.

Similarly, the relative performance of metal and mining stocks (XME) against the SPX shows a similar pattern of a rally out of a relative downtrend, but XME remains in a sideways relative consolidation pattern.

In conclusion, the short-term outlook for gold is promising. However, with the golds having moved so far so fast, they are a little extended here. I would like to wait for more conclusive evidence of upside breakouts before jumping on the gold bull story.

So rant about the Janet-the-dove-Yellen and the Fed all you want. Wear the tinfoil hat if you want, but I would remind readers who are overly dogmatic about gold that the ultimate truth about being a gold bug can be found here.

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.

Are you a good capitalist?

Are you a good investor? Do you believe in the supremacy of free markets? Let's test your convictions.

I have always believed that investors should be politically agnostic about their market views. While I have my own political beliefs, I try to keep them away from the way I invest, because allowing political views to influence how funds are deployed can be detrimental to a portfolio. The better question should be how a specific approach or event is likely to affect the risk and return characteristics of a portfolio.


How socially responsible?
I offer two examples, one as a criticism of the Left and the other of the Right. The first is a board or the staff of a fund, whether pension, endowment or other, to consider socially responsible investing for political reasons. Unless the owners of the fund have explicitly specified a social theme to the investing process as part of the investment mandate, the board could be in breach of their fiduciary responsibility for venturing into socially responsible investing, as such an approach is likely to deliver inferior risk-adjusted expected returns compared to a similar unconstrained portfolio.


Knee-jerk reaction to Iraqi developments
The second example is the reaction by the talking heads to the military gains by ISIS in Iraq. The reaction falls into two categories, both wrong. The first is a knee-jerk fear of a cutoff in oil supply:

As I showed in a previous post, most of current Iraqi oil production goes through the south and there is little chance that southern production will be endangered (see Apocalypse Later). As this oil map from Morgan Stanley shows, Iraqi oil production is well insulated from the rebels (via Business Insider):

Madmen or pragmatists?
Let's consider the worst case analysis. What if the Baghdad government were to crumble and ISIS were to take over? What are the market implications?

Even though ISIS has been labeled as an al-Qaeda affiliate (AQIQ) in the press, an article in the Guardian indicates that the leadership is skilled and highly pragmatic. Here is what western intelligence found in a raid. In particular, pay attention to their finances (emphasis added):

The group's leaders had been meticulously chosen. Many of those who reported to the top tier – all battle-hardened veterans of the insurgency against US forces nearly a decade ago – did not know the names of their colleagues. The strategic acumen of Isis was impressive – so too its attention to detail. "They had itemised everything," the source said. "Down to the smallest detail."

Over the past year, foreign intelligence officials had learned that Isis secured massive cashflows from the oilfields of eastern Syria, which it had commandeered in late 2012, and some of which it had sold back to the Syrian regime. It was also known to have reaped windfalls from smuggling all manner of raw materials pillaged from the crumbling state, as well as priceless antiquities from archaeological digs.

But here before them in extraordinary detail were accounts that would have breezed past forensic accountants, giving a full reckoning of a war effort. It soon became clear that in less than three years, Isis had grown from a ragtag band of extremists to perhaps the most cash-rich and capable terror group in the world.

"They had taken $36m from al-Nabuk alone [an area in the Qalamoun mountains west of Damascus]. The antiquities there are up to 8,000 years old," the intelligence official said. "Before this, the western officials had been asking us where they had gotten some of their money from, $50,000 here, or $20,000 there. It was peanuts. Now they know and we know. They had done this all themselves. There was no state actor at all behind them, which we had long known. They don't need one."

The scale of Isis's resources seems to have prepared it for the improbable. But even by its ruthless standards, occupying two major cities in Iraq in three days, holding on to parts of Falluja and Ramadi, and menacing Kirkuk and Samara, was quite an accomplishment.

Therein lies the Achilles Heel of ISIS. They are prepared for power. They want to govern. An article in The Atlantic indicated that they even built a bureaucracy to fix potholes, create health and welfare programs and and even built a consumer protection agency! Most of all, they are interested in money to fund their operations.

Now consider the dire scenario where ISIS overran all of Iraq and the market implications of such a development. Would oil production stop? Maybe briefly, then it would resume.

So what is the market so worried about? They people may seem like madmen intent on destroying western influence and culture, but their actions have shown themselves to be rational actors. This means that they not madmen at all, but relatively predicable and could be bargained with.


Political implications are dire
To be sure, these people are bad news for western interests. Even if a stalemate were to set in today, ISIS has sufficient territory that it can create another safe haven for terrorists to raid western interests. The Guardian article mentioned "foreign jihadists", many of whom presumably have western passports and have the potential to eventually infiltrate back into western countries to cause havoc:

Foreign jihadists, many from Europe, were among those who stormed into Mosul and have spread through central Iraq ever since. Most of their names were already known to the intelligence agencies which had tried to track their movements after they arrived in Turkey, then disappeared, initially across the Syrian border. But noms de guerre given to the new arrivals had left their trails cold. Now officials had details of next of kin, and often phone numbers and emails.

(As an antidote to MSM reporting, consider this analysis of ISIS from Juan Cole as to why the group is not as big a threat as many think.)

As a market participant, I view any market weakness caused by fears of ISIS gains to be a buying opportunity. As someone whose futures are tied to western interests (as are virtually all of my readers), I view the emergence of ISIS as bad news.

However, I am able to divorce my political views from my investment views, just as board members eschew socially responsible investing without an explicit mandate, regardless of their own personal views.

In that sense, Karl Marx was right when he said, "The last capitalists we hang will be the one who sold us the rope."







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.

Watching the Fed's body language on growth and inflation

As the markets await the FOMC statement on Wednesday, I want to highlight one risk that I outlined before about rising inflationary pressures. As I highlighted in my post (see Correction, interrupted) and Joe Wiesenthal correctly pointed out, PCE inflation rates are fast closing in on the Fed's 2% target.

I also said that shorter annualized rates of core PCE inflation and trimmed mean PCE were already above the 2% target:

Wiesenthal also added that the unemployment rate is dropping relatively quickly and approach NAIRU, the natural rate of unemployment, which would be a signal for the Fed to start tightening.

Blinder: Greater volatility ahead?
I am therefore carefully watching the FOMC statement about the inflation and employment outlook for hints that that day of tightening is getting closer. Former Fed vice-chair Alan Blinder stated that the current environment may create greater uncertainty about Fed actions going forward as an active debate about the sequencing process of QE withdrawal starts to heat up. Blinder explained it this way in a Marketwatch interview (emphasis added):

There has been very little division on the Fed, because everybody has signed on to gradual tapering of the quantitative easing. That has left undebated, I mean it’s been debated but it has not been debated intensely and not very much publicly, about what happens when this [QE] is over...

The Fed has previously announced, it is on record, but the record goes back a few years, that there would be some draw down of the size of the portfolio before any interest rate increases. A number of Fed spokesman have started, either tacitly or very explicitly, backing away from that and saying that is now under reconsideration and so on. It is clear that that is up to debate inside the Federal Reserve, whether interest rates will start going up first or the balance sheet will start shrinking first, but that is a subtle issue of timing. And as we think of the exit proceeding over months and years, it is clear that both have to happen. The Fed is not going to stay at near-zero interest rates as the economy strengthens and the Fed is not going to stay with a $4.5 trillion balance sheet as the economy strengthens.

How the process works could be a source of uncertainty:

I think the sequencing — what comes first and what comes second — matters a little bit but the speed matters a lot – really, a lot.

Let’s do a thought experiment. If everybody — hawk and dove and everybody, agreed on the endpoint, say, the federal funds rate will be 3.75% and the balance sheet will be $1.5 trillion — the speed with which we get there is hugely consequential for the economy. That’s what the hawks and doves will be arguing about.

Macro Man had an amusing and more dramatic example of why this all matters:

Is there anyone out there who still doesn't understand what artificially depressing volatility does? OK. Last time.

This is your market volumes when you promise low rates forever:

This is your market volumes on talk of a possible rate hike.

Much ado about nothing?
Even though my inner trader is cautiously bullish on stocks, he is holding back from taking too big a directional bet on the markets until after the FOMC announcement. Of course, it could all turn out to be nothing and the market reaction to the Fed statement could be relatively benign, as per Tim Duy`s forecast:

All that said, if such a (hawkish) change were to occur, it will not be in this week's statement. My expectation is that Yellen sticks to the fairly dovish tune she has been singing. If there are clues that the tenor of the tune is changing I think they would be subtle. Watch for any language from Yellen regarding proximity to goals, optimism on the JOLTS numbers, or references to inflation bottoming out and turning higher. These would be hints that the Fed is increasingly concerned of the possibility of falling behind the curve. Such talk would also hint at the possibility that the new Board members seek to edge policy in a different direction.

I would also point out that the IMF is lowering its US growth forecast and believes that rates will stay low for longer than the market expects (emphasis added):

The International Monetary Fund cut its growth forecast for the U.S. economy this year and said the Federal Reserve may have scope to keep interest rates at zero for longer than investors expect.

The Washington-based IMF now sees the world’s largest economy growing 2 percent this year, down from an April estimate of 2.8 percent. The IMF left a 2015 prediction unchanged at 3 percent, and said it doesn’t expect the U.S. to see full employment until the end of 2017, amid low inflation...

For the Fed, the IMF’s employment and inflation forecasts mean “policy rates could afford to stay at zero for longer than the mid-2015 date currently foreseen by markets,” the fund said in its annual assessment of the U.S. economy.

In other words, the FOMC statement on Wednesday could be pivotal to market psychology. That's it might not pay to try to be a hero going into the FOMC meeting.





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.

Apocalypse Later

I have been thinking about the kind of tail-risk posed by sudden events that could tank global risk appetite and therefore the financial markets. My conclusion is that the so-called tail-risk are wrong and the immediate threat posed by tail-risk is lower than the market thinks.

Let me explain. There are three sources of event risk that could cause the markets to swoon:

• Iraq
• Russia-Ukraine
• Chinese financial crisis

As I go through this analysis, bear the following in mind. Don't consider the event through a geopolitical lens, which could be potentially serious, but through a market lens. For the purpose of this analysis, it's important to be politically agnostic and think about the potential market impact of the event.


The threat from Iraq
Let's start with the freak-out du jour, Iraq. Andrew Critchlow of The Telegraph sums up the economic risks posed by higher crude prices because of a curtailment of Iraqi oil production (emphasis added):

Open warfare between the government and rebels in Iraq would pose a threat to the global economic recovery should oil production from the war-torn Middle East state suffer a serious disruption, analysts have warned.

Brent oil prices climbed as high as $110.25 (£65.59) on Wednesday amid concerns that 3.5m barrels per day of Iraqi exports could be knocked out of the market by the violence that has seen al-Qaeda forces seize control of Mosul, Tikrit and Samarra.

"The worst case scenario is that we see production from Iraq slip down to levels in the last Gulf war, then oil could spike $20 a barrel very quickly," Ole Hansen, vice-president and head of commodity strategy at Saxo Bank told The Telegraph.

"In that scenario, the entire economic recovery, which is still fragile, could stall and we could even slip back into recession in some regions."

It didn't help matters when elements of the Iraqi Army engaged in mass desertions in the face of the assault, and leaving weapons, vehicles and depots intact for the rebels to seize (via DEBKA):

The Islamists also took over the main crossing from Iraq to Syria at Yaaroubiyeh.

They rode out of the Mosul battle Tuesday with 260 new armored vehicles of various types – enough to equip a full division - taken booty from the Iraqi army. The roads out of the city are clogged with an estimated half a million refugees in flight from the bloodshed and chaos with no means of support.

Although he declared a national state of emergency, Prime Minister Nuri al-Maliki has no illusions about his army standing up to the ferocious al Qaeda fighters. And indeed the tens of thousands of troops stationed in Mosul turned tail Tuesday and fled under the onslaught.

Further analysis reveals that the majority of current Iraqi oil production comes from the south as these graphics from Marketwatch show:

The Marketwatch article went on to detail the current threat to Iraqi oil production, which is not very much at the moment.

An underlying fear in the oil market is that the fighting will spread to Iraq’s main oil-producing areas in the south. Meanwhile, Iraq’s biggest refinery at Baijii in the north remains under government control , Iraqi oil minister Abdul Kareem Luaibi said Thursday, according to Reuters. Luaibi said Iraqi crude exports from its southern terminal at Basra were running at an average of 2.6 million to 2.7 million barrels a day on Wednesday.

(Other reports filed on Friday and over the weekend indicate that ISIS is in control of the Baijii oil refinery.) The threat to oil production is not serious, so far:

“The northern oil fields have been taken yet that area of the country was not really active. There had been damaged pipelines due to sabotage,” said Phil Flynn, senior market analyst at Price Futures Group. “Basra in the south of Iraq seems to be operating normally and any attack on Baghdad may be met with much tougher resistance.”

Most of current Iraqi production leaves through the Persian Gulf. This map of rebel gains (shown in red) and battles (yellow) from The Long War Journal shows the current battle map of Iraq (h/t Across the Curve) :

The rebels appear to be trying to encircle Baghdad, as they are not strong enough to take it by direct assault:

The lightning advance of the Islamic State of Iraq and the Sham and its allies from Mosul to the outskirts of Samarra, as well as its capture of several towns in eastern Diyala, all over the course of several days, appears to be part of a greater strategy to surround the capital of Baghdad before laying siege to it. This plan, to take over the "belt" region outside of Baghdad and cut off the capital, appears to be the same strategy used by the ISIS' predecessor back in 2006.

The 2006 plan, which was drawn up by the Islamic State of Iraq (ISI), the forerunner of the Islamic State of Iraq and the Sham (ISIS), was discovered after the US found a crude map on the body of Abu Musab al Zarqawi, al Qaeda in Iraq's leader who was killed by US forces in Baqubah in June 2006. The "Baghdad belts" map was released by Multinational Forces-Iraq during its offensive to liberate vast areas under al Qaeda/ISI control in 2007 and 2008.

Zarqawi's plan was to seize control of the outer provinces and Baghdad's belts, or key areas surrounding the capital. The ISI would then use its bases in the belts to control access to Baghdad and funnel money, weapons, car bombs, and fighters into the city. The ISI also planned to strangle the US helicopter air lanes by emplacing anti-aircraft cells along known routes in the belts areas around Baghdad.

In the ISI's 2006 plan, the Baghdad belts were divided into five regions: the "Southern Belt," which included northern Babil and southern Diyala provinces; the "Western belt," which included eastern Anbar province and the Thar Thar area; the "Northern belt," which included southern Salahaddin province and cities such as Taji; the "Diyala belt," which included Baqubah and Khalis; and the "Eastern belt," which included the rural areas east of Baghdad.

Watching the ISIS' operations today, it appears the group is attempting to implement a strategy which is very similar, if not identical, to the previous one. This should come as no surprise; Nasser al Din Allah Abu Suleiman, ISIS' current war minister, was a leader in al Qaeda in Iraq/ISI when the Baghdad belt strategy was implemented. Suleiman was appointed by al Qaeda in May 2010 to serve as the terror group's top military commander after his predecessor, Abu Ayyub al Masri, was killed in a raid by Iraqi and US forces in April 2010.

Stratfor's analysis came to a similar conclusion - that these military gains pose no immediate threat to the regime in Baghdad (via Across the Curve, emphasis added):

The Islamic State in Iraq and the Levant knows that its opportunity in Iraq will not stay open for long given that demographic trends in Iraq favor the Shia. It also recognizes its limits among Iraq’s Sunnis. Most important, it understands the convergence of U.S., Iranian and Turkish interests that is underway; for different reasons, none of these three countries can tolerate its expansion in Iraq.

This means the group knows it is not in a position to seize Baghdad just yet. For now, it must try quickly to consolidate itself in the Sunni-dominated provinces of Anbar, Ninawa and Salah ad Din, as well as the mixed provinces of Kirkuk and Diyala. It knows that the outside countries will not send ground forces into Iraq’s Sunni areas and instead will rely on air power and special operations forces against its fighters.

Therefore, the Islamic State in Iraq and the Levant will limit itself to establishing a presence in western Iraq similar to what it has in eastern Syria, where outsiders will fear to tread and where neither the Shiite-dominated central government nor the Kurdistan Regional Government can impose its writ. If the jihadist group can survive, any amount of space where it can enjoy freedom of activity will suffice for its purposes of establishing an emirate in the roughly contiguous cross-border area, affording it strategic depth and a launchpad for later offensives against Baghdad and Damascus.

If there is no immediate military threat to Baghdad regime and the status quo, then there is no no immediate threat to southern oil production. Even if the rebels were to be successful, they have shown themselves to be highly calculating in their management of captured oil production facilities. The Telegraph reported in January that ISIS was selling Syrian oil through the Syrian regime. As well, the New York Times recently reported that ISIS was selling Syrian oil and electricity to finance their military campaign.

While the emergence of this group in Middle East is a geopolitical threat to the status quo, there does not seem to be any threat to global oil production, even if they are successful. (Remember my earlier warning to be politically agnostic when investing.) We are likely seeing the start of a protracted military campaign by ISIS. The current minor market freak-out should fade, just as the last freak-out over the Russia-Ukraine crisis faded from the headlines.


The dire warnings about Russian sanctions
Speaking of Russia-Ukraine,  it seems that news of fighting doesn't matter to the markets anymore. That's why it pays to take a deep breath and be cautious about the market's initial reaction to geopolitical events. If most Americans have trouble placing Ukraine on a world map, as per this Washington Post article, how can you trust the initial knee-jerk market reaction?

Where’s Ukraine? Each dot depicts the location where a U.S. survey respondent situated Ukraine; the dots are colored based on how far removed they are from the actual country, with the most accurate responses in red and the least accurate ones in blue. (Data: Survey Sampling International; Figure: Thomas Zeitzoff/The Monkey Cage)

Recall the headlines then and what has happened since. Ambrose Evans-Pritchard of The Telegraph warned us how American sanctions could bring Russia to its knees:

The United States has constructed a financial neutron bomb. For the past 12 years an elite cell at the US Treasury has been sharpening the tools of economic warfare, designing ways to bring almost any country to its knees without firing a shot.

The strategy relies on hegemonic control over the global banking system, buttressed by a network of allies and the reluctant acquiescence of neutral states. Let us call this the Manhattan Project of the early 21st century...

The stealth weapon is a "scarlet letter", devised under Section 311 of the US Patriot Act. Once a bank is tainted in this way - accused of money-laundering or underwriting terrorist activities, a suitably loose offence - it becomes radioactive, caught in the "boa constrictor's lethal embrace", as Mr Zarate puts it.

This can be a death sentence even if the lender has no operations in the US. European banks do not dare to defy US regulators. They sever all dealings with the victim.

Notwithstanding the fact that an economic war sparked by sanctions could slow eurozone growth and a Russian collapse could threaten the West as the effects of financial contagion ripples through the global financial system, the repercussions could have even been greater. Evans-Pritchard painted an Apocalyptic scenario of what might happen if Putin decided to retaliate:

The greatest risk is surely an "asymmetric" riposte by the Kremlin. Russia's cyber-warfare experts are among the best, and they had their own trial run on Estonia in 2007. A cyber shutdown of an Illinois water system was tracked to Russian sources in 2011. We don't know whether US Homeland Security can counter a full-blown "denial-of-service" attack on electricity grids, water systems, air traffic control, or indeed the New York Stock Exchange, and nor does Washington.

"If we were in a cyberwar today, the US would lose. We're simply the most dependent and most vulnerable," said US spy chief Mike McConnell in 2010.

The US defence secretary Leon Panetta warned of a cyber-Pearl Harbour in 2012. "They could shut down the power grid across large parts of the country. They could derail passenger trains or, even more dangerous, derail passenger trains loaded with lethal chemicals. They could contaminate the water supply in major cities, or shut down the power grid across large parts of the country,” he said. Slapstick exaggeration to extract more funds from Congress? We may find out.

The British, with their classical education, can be always counted on to give us lessons from ancient history:

Sanctions are as old as time. So are the salutary lessons. Pericles tried to cow the city state of Megara in 432 BC by cutting off trade access to markets of the Athenian Empire. He set off the Pelopennesian Wars, bringing Sparta's hoplite infantry crashing down on Athens. Greece's economic system was left in ruins, at the mercy of Persia. That was a taste of asymmetry.

In light of these dire warnings, consider what has happened since. This Bloomberg report informs us that corporate America has been quietly lobbying behind the scenes to blunt the effects of sanctions:

The U.S. is holding off on sanctions against some Russian companies because it doesn’t want to hurt American holders of their debt, according to Fitch Ratings.

“We’ve heard quite a lot of anecdotal evidence that there’s actually a lot of consultation with big investors and bondholders in terms of what sanctions might be imposed by the U.S.,” James Watson, a managing director at Fitch, told reporters today in London. “It seems there has been a significant push back on potentially sanctioning companies that have significant foreign debt.”

So even as Gazprom threatens to cut off gas to Ukraine if the outstanding bills aren't paid, the WSJ reports that the CEO of Exxon Mobil is scheduled to speak at an energy summit in Moscow with Rosneft CEO Sechin. Ho hum  - Apocalypse Later, or maybe Apocalypse Never.


China is (not) collapsing
I have written much about China (see my last two posts Measuring market expectations on China and China turning Japanese). The main catastrophic risk posed to the global markets is a banking crisis in China which unleashes a wave of defaults that spill over to the global financial system. Indeed, the Chinese financial system is looking more wobbly these days as almost every day we are seeing stories of falling property prices and languishing real estate inventory in over-supplied markets. This is particularly important as loans anchored by collateral, namely real estate, rather than cash flow, because financial statements about cash flow are *ahem* unreliable, while real estate is *cough*cough* solid. Falling property prices could therefore set off a wave of defaults as collateral values collapse.

While this dire scenario could still very much in the cards, the near-term outlook seems to be improving. This Bloomberg report indicates that the authorities have resorted to the same-old-same-old policy instrument of credit growth to boost the economy (emphasis added):

China’s new yuan loans and money supply topped estimates in May as the government supports economic growth while reining in shadow banking. 

Local-currency loans were 870.8 billion yuan ($140 billion), the People’s Bank of China said on its website yesterday, higher than 42 out of 43 analyst estimates in a Bloomberg News survey. M2, the broadest measure of money supply, rose 13.4 percent, compared with a median projection for 13.1 percent.

China is in danger of missing a 2014 target for economic growth of about 7.5 percent, prompting Premier Li Keqiang to speed up government spending and make limited cuts to lenders’ reserve requirements. The World Bank warned last week that rapid credit growth and debt accumulation by local governments are risks to financial stability.

“May is the first month this year we’ve seen a sizable easing of liquidity as evidenced by the strong new bank loans,” said Larry Hu, head of China economics at Macquarie Securities Ltd. in Hong Kong. “It suggests that policy makers are turning more serious about the downside risks to the economy and began ramping up pro-growth measures.”

Indeed, the markets seem to have discounted the risk of an immediate collapse in the Chinese financial system. One measure is the Old China-New China pair trade (see An New China-Old China pair trade). The New China basket (PBJ) consists mainly of shares of companies exposed to the Chinese consumer, while the Old China basket (FXI) is tilted towards the financial sector, which has been the instrument of past government policy to stimulate the economy via credit-driven infrastructure growth. Note how the Old China basket has been rallying against the New China basket since the pair bottomed out in March.

As well, despite the Australia-bearish news about falling iron ore and other base metal prices and the scandal over metal rehypothecation, the AUDCAD cross-rate remains in an uptrend. This cross-rate is an important barometer of market sentiment of infrastructure spending in China because both the Australian and Canadian economies are resource-based, with the Canadian economy more exposed to US growth while the Aussie economy is more sensitive to Chinese growth:

In effect, Mr. Market is telling us that the near-term outlook for China is improving.

Oh well, Apocalypse Later for China, Russia-Ukraine and Iraq. This does not mean that these risks have totally gone away, just that there is little imminent threat of a collapse. This also doesn't mean that I am not concerned about the markets (see How stocks are both cheap AND expensive).

In the meantime, bring on the low VIX and low volatility for financial assets! The current readings of the VIX term structure suggests that complacency levels are not all that elevated (see Worried about a low VIX?). The ECB has decided to throw a party and the party in America is still continuing, so don't be such a worry-wart.




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.