Tuesday, July 28, 2015

Traders - Take your Marks

A potential equity market set-up from our often cited 1946 cyclical top, may be finally getting ready to "set the hook", as participants brace for a future rate hike from the Fed this fall. Should the historical guideposts prove prescient, downside support in the equity markets will fail over the coming weeks, opening the door to the first material correction in US equities since the summer of 2011. 

Assuming the correction materializes, whether the Fed choses to act in September - subsequent to a market development such as this, predominantly remains contingent on the magnitude of a potential dislocation and its broader kinetic impact in the markets. That said, based on our research of the long-term yield cycle (see Here & Figures 4-6), we have always believed that the Fed's latitude to tighten would ultimately be limited by developments in the market and the economy's capacity to carry the burden of higher rates (see Here).

Cyclically speaking, from a top down view of the long-term yield cycle (Figure 1) - as well as the reach of equity market valuations (which we've argued are greatly driven by rates disposition within the cycle), we have approached the 1946 cyclical peak in equities as the closest market and policy environment with today. From a historical perspective, the trough of the long-term yield cycle in the mid to late 1940's, where the Fed began to normalize policy after extraordinary support was extended in the market with significant Treasury purchases by the Fed between 1942 and 1946 - remains this cycle's mirror equivalent. 

As such, since the Fed began to normalize policy through the taper last year, we have panned the longer-term prospects of the US equity markets and largely viewed them pushing up against another valuation ceiling, similar to what transpired in 1946 (Figure 2) as accommodative policy support was removed. 

While a potential downside pivot will invariably make its own distinct path (Figure 3), from our perspective, the risks of such a decline have not diminished and now appear to be preemptively butting up against a starters gun - that may or may not go off. 
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Thursday, July 23, 2015

Gold is Dead, Long Live Gold

- Heavy is the head that wears the crown.

Among our less prescient perspectives has been the expectation that the precious metals sector would rekindle the flame it fervently held over the previous decade. Despite successfully exploiting the explosive downside pivots in silver and gold from May and August 2011 through the second quarter of 2013, the sector has continued to disappoint our more bullish leanings, while slowly circling the drain in a disinflationary counterclockwise rotation.

Over the past few months, we have taken a more agnostic approach to precious metals across the intermediate-term; primarily, due to 1) the further breakdown in the yen this May (see Here) and 2) the growing likelihood of a rate hike by the Fed - and greater similarities that gold was expressing with its secular low made along the Fed's march to rate hikes in the summer of 1999 (see Here). With gold achieving fresh five year lows this week, we thought we would revisit the sector and offer up some thoughts on these two points. 

Gold and the Japanese yen have trended closely together since the equity markets peaked in October 2007 and the financial crisis unfolded over the next two years. While Gold set its closing high eight weeks before the yen in 2011, it has since followed the downside breaks in the yen with varying lags of several weeks - the most recent breakdown in the yen occurring 8 weeks ago.

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Although there are a number of motivating factors inherent to each asset, the correlation relationship was principally driven by their respective values relative to the US dollar. While we're less inclined today to comment on the efficacies or conspiratorial connotations that some will wrap a currency narrative such as this in - i.e. a currency war or "exporting deflation", there is a zero sum market reality to what transpired in Japan and how it broadly affected other currencies and assets. 

Simply put, a consequence of Japan's aggressive monetary policy initiatives taking traction over the past three years, has resulted in a much weaker yen, a stronger dollar and a contributing headwind to the prolonged bear market in gold. One way of framing the relationship is that as Shinzo Abe - then the leading frontrunner for the Prime Ministership in Japan, laid out his plan to aggressively attack deflation in November of 2012, the yen began its steep depreciation - buttressing the dollar and world equity markets and weakening gold and the commodity markets, as a virtuous cycle blew across on gusts of disinflation now blowing strongly out of the east. 

Fast forward to today, both the yen and gold are down over 40% since making their respective highs in 2011 and the bold policies presented - then enacted, by Abe in early 2013, has helped lift the Nikkei over 130 percent and confidence in Japan's economy; who experienced an annualized growth rate of 3.9 percent in Q1, on the back of unexpected increases in private business spending, which was up 2.7 percent quarter to quarter, compared with previous estimates of just 0.4 percent.

Thankfully, despite our outlook on precious metals, we correctly read the tea leaves in the Nikkei, which notably from a leading perspective of Japan's 25 year asset decline, appears to have broken free of deflation's grip - well before Japan's economic data is expected to confirm later this year. Moreover, the significant decline in the yen has now brought the yen's real trade-weighted exchange rate back to its lowest level since the 1970's, with a legitimate concern that any further weakness would materially hurt Japan's domestic economy. Over the past month, comments from Haruhiko Kuroda - Governor of the Bank of Japan, has echoed these sentiments - stressing that further actions to expand QE was unnecessary, as the currency was already "very weak" and inflation was expected to rise in the coming months.

The question remains: does Japan now have the escape velocity to sustain its economy and equity markets without a weaker yen - and will gold benefit as the collateral currency effects subside from Japan's aggressive round with deflation?

In our estimation: yes and yes. 

As mentioned in previous notes, we still expect the inverse correlation extreme that has been in place over the past three years between the Nikkei and yen to reverse course (Figure 7) - and continue to like the Nikkei's long-term prospects (Figures 4-6), as recently described in Japan's "Lucky Few". As such, we view a position in the yen as a hedge to any equity market exposure in Japan and approach its more bullish future outlook relative to a broadly weaker US dollar. All things considered - a stabilizing and strengthening yen will be a step in the right direction for gold. 

Figure 2
When it comes to the 1999 market parallels, gold appears to be offering up the same fire-sale opportunity provided going into the first rate hike in June 1999, which ultimately became gold's bear market secular low one month later. Per the 1999 10-year yield model (Figure 8), the September meeting appears as its comparative equivalent - and although a rate hike in September may further roil gold over the short-term, similar to 1999, it delineates that the economy has arrived in the late expansion phase of the cycle, where commodities typically outperform equities as inflation finds a foothold and the virtuous disinflationary cycle exhausts. 
Figure 3
Despite conventional wisdom, this is why the US dollar has generally appreciated during the expectation phase and declined subsequent to rate hikes. Considering the performance extreme reached by the US dollar during the drawn out build-up to the policy shift at the Fed (Figure 9 & 10), the downside symmetry could extend below where most participants and analysts foresee.

Similar to the market environment in 1999, the "virtuous" disinflationary cycle was sustained well beyond where more prudent policy handlers would likely condone. And while we tend to have greater support of the Fed in the wake of the financial crisis, we do expect pent-up inflation - which was largely held at bay through various monetary policy initiatives at home and abroad, to have much greater capacity than current expectations - or the reach of nominal yields. From our perspective, this strongly suggests building positions in hard commodities - such as gold and oil, as the broader market takes its cue from the next policy pivot at the Fed, which appears right around the corner in September.  
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Wednesday, July 15, 2015

China's Hungry Hungry Pandas

Regardless of your investment horizons in China, there's no avoiding the fact that its equity markets suffered a major setback over the past month. Declining more than 30 percent in just 17 sessions, the move was even more extreme than we had previously suspected in our most recent note on China in June (see Here). Is it a pulled hamstring from the quick sprint - or a heart attack - remains the overarching question for investors and traders alike. 

Granted, "setback" is a matter of perspective, considering the magnitude of the move over the past year which saw the Shanghai Composite reach a high on June 12 of 5166 - more than 150 percent above it's close from a year earlier. Taking into account that many of the most vocal bears on China were calling for a crash when the index was flirting ~ 2000 last year, their triumphant refrains over the past few weeks ring as hollow as their would-be returns - should they have followed their own advice. 

In classic proof by assertion delivery, these very same pandas have now moved their goalposts and downside targets on the Shanghai up to a hopeful return to ~2000 - the same level previously believed would be the start of the downside denouement for the index as well as the beginning of the end of the great reckoning and rebalancing for China's economy. 

Nevertheless, misery loves company - and the breakdown in China's equity markets has captivated the comparative imaginations in the financial media, which was largely already primed for disaster as the Shanghai Composite defied downside expectations over the past year - much to the dismay of the hungry pandas. 

Greasing the wheels of the story has been the heavy handed actions on the part of Chinese authorities, who just last week suspended the sale of nearly half of the A share listings after the index lost traction and more than a quarter of its value since setting a high on June 12.

So - was it a pulled hamstring, a minor flesh wound or something much more serious?

Although some pundits and analysts find parallels with the severe US equity market declines in 1929 or 2008, we believe it's a more benign consequence of China's extreme outperformance, per se - closer to the likes of the severe retracement decline in the Nikkei in May 2013, rather than an early indication suggestive of much greater hardships ahead for China's equity markets and economy. 

While there's certainly enough causal concern for the perennial pandas to hang their bearish outlooks from, we maintain our long-standing belief that the market - as removed as it became from China's underlying economy, had traveled more than enough road over the past decade to largely discount these conditions and whittle down the actual bubble valuations reached at its peak in 2007. 

Per Meb Faber - the ever erudite global market surveyor, China's CAPE ratio has returned to ~ 15, significantly below its peak of 62 in October 2007 - and modestly above the level (12) reached at its trough in December 2013. Despite the greater cynicisms held towards China's equity markets and its regulating authorities today, we view them - just as the Party clearly does - as a prospective wealth transmission mechanism, as its economy matures and transitions from being driven primarily by construction and production enterprise - to greater domestic consumption.  

Prospective, because although the media has remained fixated on how many retail accounts were opened in China over the past year, retail traders represent just 4 percent of the total population and stocks currently account for less than 15 percent of all household assets. While in the short-term a continued market decline may lead to painful losses for the retail-come-lately crowd, total margin positions are equal to only 3 percent of total household bank deposits. Seemingly lost in translation is the paradoxical fact that although the Chinese are widely viewed as avid speculators - they are among the worlds greatest savers with a stash of cash worth nearly 50 percent of China's GDP. Comparatively speaking, the US holds less than half - coming in last year ~ 17 percent of its GDP.

Although certainly more nuanced when you consider the significant income disparity that exists throughout China, the greater takeaway - with respect to the current correction and future prospects for their markets - is that a majority of the population has yet to materially invest or feel the broader wealth effect from either side of the tape. The reality is that China's equity markets are quite young by global standards, resuming trading only 25 years ago after being closed for decades by the Communist revolution. Often viewed as the speculative wild west of emerging markets, they will increasingly exert a broader reach if the government succeeds at transitioning the economy to a more mature footing - without a prolonged economic contraction and market meltdown. 

Here lies the crux of China's variant perspectives today.
What the pandas are largely betting against - again, is that the new reforms brought forth by President Xi Jinping in 2013 is broadly failing - and that real structural economic improvements will only take place after a painful cyclical slowdown is digested. From their perspective, what the equity market crash exposes is the dangerous topical and speculative nature now prevalent in China, which had largely diverged from its dour economic underpinnings. Moreover, any attempts to conspicuously support or stabilize their equity markets is an act of futility, as market forces will inevitably exert a much greater influence in the face of economic weakness.

From our perspective, what these pandas fail to concede is that 1) China isn't a western economy - it is still very much a hybrid system where the state holds disproportionate influence over the private sector, and 2) they have the resources and deep pockets to instigate support where they see fit.

Although western ideals of free-market capitalism will invariably denounce China's heavy-handed efforts of late; the validity of their economic data or the efficacies of Xi Jinping's new governance platform - the same criticisms in varying circumstances have been made since they initially embarked on their historic reforms nearly four decades ago. 

Admittedly, it's still too early to determine whether China can successfully titrate the next steps and maintain its relatively high level of economic growth, while reforming its economy; we do, however, defer to their long track record of exceeding catastrophic expectations - which to a large degree has been sustained by China's uniquely powerful monetary and fiscal policy flexibility.

Over the past few years we've followed a comparative blueprint for the Shanghai Composite: the S&P 500's consolidation breakout from the secular low in 1982. And although the index got ahead of itself and filled out the proportions of the pattern quicker than expected, the retracement from the performance extreme has now tested and bounced hard from the breakout level this past March. All things considered, we maintain our expectations that a secular move higher for the index is still underway, from the consolidation breakout last year. 
In hindsight, the breakdown in the Shanghai now resembles the initial break in the Nikkei in May 2013 - subsequent to the rollout of Abenomics in Japan in the fall of 2012. During that period, the Nikkei rallied nearly 90 percent in less than 7 months, on the back of broad stimulus initiatives - before eventually retracing 20 percent over just 16 sessions.
While the short-term plight of China's equity markets is just an ancillary concern to their broader reforms platform, by the Party's own public endorsement over the past year, their stability is critical to wider participation and support. Considering that similar skepticism was levied against the Fed's extensive intervention in the markets during and subsequent to the financial crisis or the Bank of Japan's enormous efforts over the past three years to break its own deflationary quagmire - In an era where central banks have increasingly played an overtly visible role in jockeying participants to the field, we certainly don't underestimate the even greater capacity in China to step in and shore up their own markets from what we perceive is a more short-term consequence of extreme outperformance. In our opinion, betting against that here is more of a fools wager - by hanging on to a preconceived notion that China will eventually have its hard landing or 1929 market decline.

For further reading on our thoughts on China this year, see:

Thursday, July 9, 2015

A Tragedy that Need Not Happen

Either of the literary variety - or literally speaking, tragedies arrive in different ways and forms. They can hit, seemingly out of no where - or from an expected and familiar place. It is the later, that can bring with it the disquieting voyeurism of watching the drama slowly unfold - then culminate with anticipated and tragic consequence. I.e. - "It was a tragedy waiting to happen."

When it comes to the fledgling European Union today, we have all watched the current events take shape, with the protracted inevitabilities of a summer stock theatre, that shows a Greek tragedy on Friday nights and Shakespeare's take of the form on Saturday. In classical Greek structure, the protagonist's fate is sealed by the larger more divine forces at play - that controls, leads and ultimately destroys the will and life of such a character in the face of immeasurable power. Nothing sells quite like helpless destiny at the hands of the gods. In contrast, Shakespeare's emphasis was laid at the feet of the individual, who's own actions and flaws eventually brings about his untimely ruin. Never discriminating a taste for ones suffering - self inflicted misery has also done quite well at the box office over the past four hundred or so years.  

In the EU's current schadenfreudian tale, they're collectively maligned by not only an inherently flawed political structure that has seen Germany act as a less than benevolent god, but also with a large supporting cast of individuals on all sides of the aisles with questionable ambitions and intentions. Nevertheless, a tragic denouement would be inflicted broadly and harshly, with the helpless victims - or heroes, invariably those who have already suffered the most - the people.   

So is Europe's fate already sealed and are we just watching its fifth act destiny unfold?

Although it's quite cozy to don your bear attire today and declare, "All is lost!", we maintain pragmatic expectations that a Greek deal will ultimately be reached with its creditors that keeps Greece within the monetary union and avoids a broader tragedy with certain humanitarian consequences to the Greek people and largely uncertain capital consequences to the EU and abroad. Ironically, the EU's flawed structures might end up saving it this time around from cutting off its nose to spite its face. Unfortunately, we're not so sure which would end up being the larger motivation - the people or the profits. Cynically, it's easy to believe the later - realistically, we suspect it's more than a bit of both. 

From an outlook perspective, the recent developments out of Europe as well as in China, has had a less than reflationary effect across markets, notably in hard commodities such as oil, copper and silver. While we had anticipated that the 10-year yield would retrace and consolidate before resuming its test of long-term resistance later this year ~ 2.65 percent, layers of uncertainty from both Europe and China have pushed back rate hike and inflation expectations in the US as further instabilities abroad would be broadly disinflationary. That said, we perceive both threats to be overblown with the later more panic driven and continue to view another important low for the euro in the markets rearview window as the current existential threat is overcome. 

In our last note on oil (see Here), the market was situated close to overhead resistance ~ $61/barrel, with the expectations that if the market broke out above would roll momentum in the SPX:Oil reflationary ratio lower, similar to what had occurred in 1999. What actually happened was oil was rejected at resistance and subsequently broke back below support ~ $58/barrel, as the deflationary/disinflationary threats out of Europe and China roiled world markets and pushed out rate hike expectations by the Fed.

Although we still believe that the magnitude of future policy tightening by the Fed will be exceedingly modest, we do maintain expectations that the Fed will move later this year and continue to view the prospects for oil as much brighter than the US equity markets. If the threats out of Europe and China abate over the next few weeks - which we believe they will, the SPX:Oil ratio should take another leg lower, as it did in both previous major exhaustion pivots in 1986 and 1999.
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Comparative Figures 2-7 were oriented based on the respective exhaustion pivots of the SPX:Oil ratio.
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Thursday, July 2, 2015

Japan's "Lucky Few"

In what gradually became practically an anything but US equities market approach for us,  Japan's Nikkei succeeded in strongly outperforming the S&P 500 in the first half of the year; rising just under 16 percent - while the SPX barely remained in positive territory (0.20%) for 2015. 

Along with China's Shanghai Composite Index, the Nikkei remained one of our preferred equity markets going into the year, with expectations that Japan was breaking free of the long tentacles of deflation that had constricted their economy and constrained its equity markets over the past twenty-five years. 

On average, a quarter century is the generally accepted length by historians between generations. From the birth of a parent to the birth of a child, the timespan can encompass profound behavioral changes within society, many times greatly affected by shifts in economic prosperity or hardship. And while Japan's experience with perennial deflation and economic contraction was in fact much less austere than what the US experienced in the 1930's and early 1940's, similar to the US generation born during the Great Depression and World War II, historians might ironically refer to those brought up in Japan over the previous two decades as the "Lucky Few" as well.  

Over the past two years we've followed the Nikkei in relation to the US equity markets across the 1930's to 1950's (see Here), with expectations that despite a more protracted regression decline in the Nikkei - would result with a similar equity market rebound (see Here & Hereas deflationary conditions subsided in its third decade since its secular peak in December 1989.

Click to enlarge images
Both the SPX and the Nikkei contracted ~80 percent below their secular peaks. However, in the US, the equity market collapse was acute and reached a cycle low less than three years from the 1929 high. For Japan, the contraction was more gradual - reaching a secular low ~20 years from its 1989 high. One could argue that this difference reflected the broader influence the asset declines had on each society, with the more severe decline profoundly impacting the US through the Great Depression. 

That said, it's interesting to note that from a patterned perspective, by pivoting the performance regression trend of the Nikkei (~14 degrees) to the SPX, the respective cycles within the span correspond. 

Another pattern we've followed in the Nikkei over the past two years - and one that guided our expectations from the relative performance extreme reached at the end of 2013; extends from the long-term trend line resistance that begins as well at a relative performance extreme in 1987.

Overall, the Nikkei continues to follow the performance trace from the 1987 retracement decline - a pattern trajectory we expect it will continue to loosely hold this year.   

In what has increasingly become en vogue for investors today, participants have flocked to novel currency hedged ETFs - such as Wisdom Tree's DXJ, that offers equity exposure to Japan, while at the same time hedging fluctuations between the value of the US dollar and yen.

While these funds strongly outperformed non-hedged ETFs in 2014, their outperformance has been attenuating in the first half of this year. We maintain the expectation that a trend change is afoot in the yen/Nikkei relationship, which would reverse the prolonged inverse correlation extreme that's been in place since Abenomics was introduced at the end of 2012 - and shifts the equity hedge, in our opinion, in favor of a stronger yen. 

The BOJ's Kuroda would appear to agree
With another bitter milestone approaching for Greece and Europe this weekend, we'd feel remiss in not mentioning once again the fragility of where some of the key peripheral markets such as Spain's IBEX are trading across this year - in relation to our Long Tails of Deflation performance series. 

As mentioned in previous notes, from a comparative perspective - you could argue that what the ECB is attempting to avoid with its more aggressive policy pivot this year, is the missteps that were compounded by each central bank in their respective cycles; both by the Fed in late 1936 into early 1937 and the BOJ in 1997. In both occurrences, the powers that be worsened economic conditions by tightening monetary and fiscal policy, where they very likely should have eased.

With the referendum vote on deck this Sunday in Greece, it's no coincidence that the ECB just today (see Here) added corporate debt to the list of assets eligible for purchase under its new QE program. And while the ECB's bazooka would help mitigate the fallout in the debt markets should conditions in Greece remain or worsen, we would still approach the lack of compromise and resolution that currently exists between Greece and the EU a broader failure and policy misstep - with unknown negative consequences to Europe's periphery.

As outlined in Game of Loans, we'd consider that more than just a Greek tragedy.