Tuesday, March 31, 2015

The Great Titration Continues

Over the past two weeks, China's Shanghai Composite index shattered overhead resistance (see Here) - tacking on another ~10% to its already prodigious returns for 2015. To date, the SSEC is up roughly 85% over the past year, with the vast majority of gains realized since last July. To put it mildly, China's equity markets have been set on fire, trouncing world indexes that has seen the S&P 500 tread water over the past four months. 

Consequently, the SSEC's steep trajectory has resulted in growing skepticism by those who have either a) looked for a crash in China to no avail over the past several years or b) simply expect that what goes up must come down. Our general perspective, however, remains that the breakout in China is real - and there's more than just ephemeral speculative spirits behind the move. 

The fine folks at BCA Research had a nice piece up on China yesterday (see Here), which hit on a number of the key factors greatly impacted by the significant move in their equity markets over the past year. We highlighted the main points below with emphasis on their parting statement.

  • Rising stock prices increase household wealth and boost confidence, which in turn supports consumer demand. 
  • The numbers of investor accounts in the Shanghai Stock Exchange recently hit 125 million, almost triple the level in 2007 during the previous equity mania. 
  • This amounts to over 16% of the urban population, compared with a mere 6% eight years ago.
  • Consumer confidence has surged to its highest level in recent years, a highly unusual development considering the weak growth environment. 
  • Rising consumer confidence will eventually benefit retail sales.
From policymakers’ perspective, however, a much more important consideration is the funding mechanism of the stock market. - The Feedback Loop of a Bull Market - BCA Research Blog


From our perspective, the recent surge in investor participation in China should be received with less speculative skepticism and more as a positive quantifier that the potential for the economy can transition from being driven solely by exports and infrastructure construction - to a greater capacity for domestic growth and consumption. 

With their equity markets acting as a wealth transmission mechanism to a growing percentage of the population, the great titration from communism to capitalism continues. While we wouldn't be surprised to see a modest short-term retracement decline, considering the outcome and proportions of the historic breakout pattern - as well as the discrete traction and growing confidence from President Xi Jinping's major reform initiatives, we believe the potential in Chinese equities remains substantial.

For further reading on this idea and concept, see:

Tuesday, March 24, 2015

Old School Currency Parables

And the LORD commanded the fish, and it vomited Jonah onto dry land. - Jonah 2:10

Delivered from the swirling seas of U.S. dollar strength, the euro rose sharply over the past six sessions - roughly up 4.25% through Monday's close. And although it's just a blip on the 11 month downtrend that saw the euro lose nearly one quarter of its value, the winds have shifted for the moment in the currency markets with all the wrath and fury of Old Testament scripture. 

A few weeks back, we carried a nautical theme through the story of Jonah (see Here), speculating that the currency markets were poised for significant trend reversals - with a technical set-up in the yen similar to the upside reversal in the summer of 1998. Two weeks ago, the yen was flirting below long-term support as the currency tested the lows from early December. While the subsequent upside move in the yen (~1.25%) has been weaker than its European counterpart, it currently resides above long-term support and is positioned going into the end of the month with similar positive strength and momentum divergences - with the lows from last December. 
Considering our long-term read of the dollar (see Here), the structural and pattern similarities with the yen - circa August 1998, dovetails into a general reflationary thesis that would be driven on the back of broad dollar weakness. As mentioned in the past, the yen has exhibited strong positive correlation with the trends in precious metals over the past four years. At this point, we suspect this relationship would maintain correlation and continue to look for gold and silver to lead the respective reflationary pivot in assets most closely tied to rising inflation expectations. 
Over the past few months - where we have expected to see a correlation shift, is between the extreme negative correlation between the yen and the Nikkei. Overall, this longer-term reversal has started to materialize, with the yen treading water over its December low - while the Nikkei has rallied another 10%. Although we suspect it will be sawtoothed moving away from the correlation extreme, we still believe both assets will trend together over time for a spell. Our 1987 Nikkei comparative continues to be an excellent guide towards future expectations in the Nikkei - as it has been over the past year. 

Sunday, March 22, 2015

Size Matters & Their Estimates are Still Too Damn High

With the U.S. equity markets continuing to make and trade near their all-time highs, and as the U.S economy further distinguishes itself as the best street in an otherwise downtrodden neighborhood, it's easy to get lost in the minutia of yet another Fed meeting deliberating a strong dollar and future rate hikes - and forget where we currently reside in the trough of the long-term yield cycle and the considerable history that brought us to this point. Looking back at the span of the broader cycle, you'll find it was a period in history that encompasses 70+ years of remarkable growth - the last 30+ of which were traveled with increasingly benevolent credit conditions, in which the U.S. has enjoyed elevated equity market valuations on the back of a proportionately massive secular downdraft in yields. 

Click to enlarge Figures
Figure 1
Historically speaking, the significant investments and advancements in the world economy that took place directly after World War II, helped drive growth - inflation and eventually yields to such icarus heights, that countries, corporations and individuals have enjoyed the voluminous book-end benefits of a declining rate environment for well over 30 years. Comparatively, the secular peak in yields in 1981 was over three times as high as the previous secular peak in 1921 - and the broader span from trough to trough of the current move (1941-2021' ~80 years) will likely be over twice the previous cycles length (1901-1941'). Simply put, there's a lot of debt out there in the world. Raising rates here at home in the U.S. will have significant knock on effects throughout the financial markets - especially if the balance of the world is aggressively easing monetary policy. Believing that the broader system can normalize and reboot to the next long-term cycle without a prolonged period of transition (i.e. some call it secular stagnation - we like transitional divide) - even proportional and commensurate with the previous trough, is illogical even along the irrational continuum we often find ourselves walking out on. 

The underlying takeaway for us, is that participant expectations - as well as most members of the FOMC, have found themselves significantly ahead of reality when it comes to the prospect of rate hikes. This has been one of the main drivers of the dollar's moonshot over the past eight months, which has been motivated by persistent expectations of a more traditional tightening regime normalizing policy (as it has in recent past), while the rest of the world opens their monetary spigots. Over the past two years, by the FOMC's own telegraphed forecasts to the market, they have speculated that short-term rates would rise above ZIRP to around three percent by 2017. In our opinion, this outcome remains exceedingly optimistic when you consider the long-term yield cycle and what we can glean about the trough from the previous cycle.

Figure 2
Over the past four years since we first started sharing our thoughts on the market, we've commented on the relative symmetrical retracement in yields from their secular peak in 1981, extrapolating a mirrored projection that has rightfully guided our future expectations of lower for longerMany times, complexity can be distilled with a simple solution or explanation. Einstein's genius frequently displayed this kind of elegance. "It is the theory that describes what we observe", he said - and his theories were as elegant as his understanding brilliant. Along those lines, although admittedly less brilliant (but certainly simple), we've observed great symmetry in the rise and return of the long-term yield cycle, with the basic theory that the return would be commensurate with the rise - as markets and economies wrangled with the complex and interconnected webs of their respective credit and growth cycles. 
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Interestingly, the relative symmetry represented in the current yield cycle is not unusual and quite characteristic when you look back at history. The previous cycle (from trough to trough) spanned 40 years to the month; a period in which yields rose for 20 years - followed by a 20 year decline. Unlike the current downtrend in yields that has trended to the trough with increasingly more symmetry with the mirrored rise in yields from 1941 to 1981, the previous cycle exhibited an asymmetric return below the 1901 lows, as economies pushed up against the limits and unbalances exposed and magnified during the great depression - and markets stumbled their way across the transitional divide to the next growth cycle. 
Figure 5
When we approach future market expectations from a comparative perspective of low yields facilitated by extraordinary monetary policies following a financial/debt crisis, you arrive at a similar appraisal with the mirrored return profile - in that yields will be low for the foreseeable future. Even for long-term investors, patient may well prove to be an understatement when it comes to the length of the broader cycle's trough. As shown above in Figures 3 and 4 - and especially evident below in Figure 6, the historic profile of the previous trough throws cold water on expectations that the Fed will be capable of raising the fed funds rate to ~ 3 percent by 2017 - or even 2027. Moreover, if our theory that the broader cycles "size matters" and influences the proportions of the return, it should be noted that the previous trough in yields followed a significantly smaller secular peak and cycle. All things considered, while they may look to raise rates marginally off ZIRP over the next year, expectations are still too damn high with respect to the magnitude of the potential move. Nevertheless, as mentioned in previous notes and implied by the mirrored return and historic analogs, we would still estimate that risk over the intermediate-term is for higher yields. The difference, however, is that we do not expect a sustained move higher - and would look for a trough range to continue to develop, with a mid-point ~ 2.25% for the 10-year. 
Figure 6
In many ways - although the Fed likely had good intentions at the time and was dealt a very difficult hand to play, their increasingly transparent policy approach with the market appears to have severely limited their capacity to act - as misplaced as it may be these days. With the majority of the worlds largest central banks continuing to ease aggressively, while rate hike expectations in the U.S. remain steadfast, the dollar has reached a level in such a short period of time that it now limits the Fed's ability to tighten without causing serious dislocations and distortions around the world - that would inevitably reach back with known and unknown consequence in the U.S. Although the consensus opinion in the market is that the dollar is on a secular updraft that could continue for years, considering the strong ties of globalization that bond us with the world and proportions and profile of the long-term yield/growth/debt cycles - in our opinion, those expectations are as misplaced as looking for a secular rise in yields today.  

As mentioned in previous notes, we expect the dollar to once again modulate and follow last years move in yields back down into the trough of its long-term range, as expectations come in with regards to the magnitude and timing of potential rate hikes and as markets slowly transition and stumble their way across the transitional divide to the next growth cycle. Despite it's current disposition - and contrary to popular opinion in the market these days, we expect lower for longer will eventually apply to the world's primary reserve currency as well. If not, the Fed's haunting specter over the past two decades - that of deflation, will eventually drift over onto our shores. That said, we suspect it will be more of a push and pull with cyclical inflationary and disinflationary moves across the transitional divide, with the markets currently situated for another reflationary upturn. 

To a large degree this relies on the trend of the two largest reserve currencies in the world (dollar/euro), which from a long-term performance perspective of its proxy (U.S. dollar index) - is almost as stretched as it was at its secular peak in February 1985. 
Figure 7
Similar to the relative performance extreme registered in 10-year yields at the end of 2013 (which was also the closest move from a relative performance perspective with its secular peak in 1981), the USDX may be poised to complete a more symmetrical retracement of the potential blowoff move in the dollar that began last spring. If so, Treasury Secretary Lew's  "strong dollar/strong U.S" will be just a faded memory come Christmas and a potential foreboding premonition for what has been leading strength in U.S. markets over the past several years. 
Figure 8
Figure 9

Monday, March 16, 2015

China Flirts with a Major Breakout

Headed into the end of last year, China's Shanghai Composite Index had become significantly extended, registering an unsustainable weekly RSI above 90. At the time (see Here), we expected the index to work off its overbought condition by churning with greater volatility as the market consolidated the massive move that began that summer.     

Over the past three months, the SSEC has traded in a wide ~10 percent range, working off the overbought condition as it prepared to challenge the previous highs from 2009. While the week is still young, last night the SSEC broke above its weekly benchmark high set in the summer of 2009.
Taking its cue from the Shanghai, our equity ETF proxy - ASHR, made a 52 week closing high today, loosely following the consolidation range of our historic breakout pattern.
While the previous closing weekly high for the SSEC is ~3412, the daily close from August 4th, 2009 measures above to ~3471. Assuming the index continues the move higher over the short-term, similar to the breakout leg for the SPX in January 1983, it wouldn't surprise us to see the market retrace back later in the month and test the level one last time before continuing higher. 
As a reference guide, we shifted the index marginally to match up with the breakout leg in the historic SPX comparative.

For further reading on this idea and concept, see:

Tuesday, March 10, 2015

The Dollar's Perfect Storm

"Meteorologist see perfect in strange things, and the meshing of three completely independent weather systems to form a hundred-year event is one of them. My God, thought Case, this is the perfect storm." - Sebastian Junger, The Perfect Storm
Far and away the biggest thorn in a reflatationist outlook has been the stalwart strength of the U.S. dollar since last July. Nautically speaking, it's been an everlasting red sunrise on the decks of those participants looking to navigate the narrows of the lost reflationary straits. Swiftly dumping the wind out of the sails of commodities and inflation expectations as they tacked higher in the first half of 2014, the thesis trade once again rolled over in heavy waters as rogue waves from the dollar surprised out of the southwest and made a strong move towards shore.

While the dollar found its sea legs at the top of the previous reflation cycle in the spring of 2011, it treaded water in a narrowing range for the better part of two years, alternating listless runs with the euro as both currencies floated towards a denouement in the third quarter of last year. Waking from its range with a thunder clap as the euro sank like Jonah - cast overboard and into troubled waters; resistance has been futile as the dollar has drawn broad support from the differentials in monetary policy, economic data and future policy expectations in the U.S. 

Over the past few months we've contrasted comparative studies of previous deflationary (08/09') and disinflationary (85/86') markets, as the current trend attempts to exhaust. With the major central banks in the world making their respective policy pivots in the face of varying economic growth and with underlying disinflationary conditions broadly prevalent, conditions for the perfect storm in the dollar came together as rate hike expectations have continued to rise at home,  Japan pauses and reflects on previous accommodations - and as Europe and China ease monetary policy once again. The net effects in the currency markets have provided a gale force wind behind the dollar, a listless drift in the yen and a swooning euro that has yet to find much traction, as it has in the past with major ECB initiatives intended to restore confidences in the eurozone. 

With an echoed refrain of conditions witnessed in the summer of 2008, the moves in the dollar and euro since last summer had similar seasonal instigations with disinflationary cascades lower in commodities, yields and inflation expectations. However, it should be noted that during the financial crisis, conditions were broadly flamed in a risk-off environment - with the yen taking the safe have pole position and sharply bid higher. As mentioned in previous notes (see Here), this dynamic is diametrically opposite of the kinetic drive of the current market, which has generally been nurtured in a risk-on environment, with the dollar acting as its primary soldier of fortune and the yen playing possum in another round of carry the leader. In this regard, there are similarities in the currency markets with the buoyant conditions of the mid to late 1990's, where the dollar led the U.S. equity markets higher as traders piled into short positions in the yen, further dampening inflation expectations downstream.

While it's certainly an understatement that the dollar continues to exceed most upside expectations, similar to the summer of 1998, conditions are ripe in the currency markets for a significant reversal of trends.  From our perspective, we are still of the opinion that Old Testament lessons will be taught, as we expect Jonah (the euro and yen) to re-emerge - shaken, but reborn from the sea. 
  • For a chart series of referenced work, as well as other comparative studies, see (Here)

Connecting the Dots - 3/10/15

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