Summary
The global macro backdrop is a mess, and it’s deteriorating quickly. Unprecedented debt levels driven by hyper-accommodative central banks have led to highly underestimated global risk exposures.
Emerging markets borrowed heavily in cheap dollars as they rolled off the Greenspan/Bernanke printing press, but now forces are moving against them and major defaults on dollar-denominated debt is imminent.
Synthetically low interest rates for extraordinary long time periods has driven unprecedented market liquidity, resulting in artificial asset inflation, capex atrophy, and an institutionalized misallocation of capital.
Equity investors can protect core, long-term holdings by offsetting the risk of a market collapse by buying volatility, using one of several strategies to do so (discussed below).
Investors can access key insights into coming volatility using a variety of leading indicators, including the VVIX, offered by the CBOE.
Today’s markets have become increasingly divorced from economic reality, thanks largely to central bankers too weak to address debt-driven growth challenges. Instead, they’ve implemented policies under which synthetically low interest rates and an endless credit convalescence is the new norm. This only leads to artificially inflated credit and equity markets, capex atrophy and an institutionalized misallocation of capital. Investors, retail and institutional, as well as the general public, are becoming increasingly cognizant of the risks pervasive throughout the global financial system.
A prudent investor would be wise to structure his portfolio to protect against any major drawdowns resulting from a collapse in the equity and credit markets. It isn’t a matter of whether markets will correct, it’s simply a question of when. And as we have learned, it’s nearly impossible to predict the actions of central banks…I know, Yellen has begun to sound like a broken record at this point, but this could shift at any time, and forecasting precisely when this might happen is a difficult endeavor. This article addresses ways in which investors can prepare for the coming correction, despite a lack of knowledge as to its timing, while also enabling continued participation in pre-correction upside. This article is intended to lay out the massive risk overhang across the global investment marketplace, to get people thinking beyond the standard bullish view you’ll hear from the investment bankers or sell-side analysts, and dig a bit deeper on their own. In doing so, I also offer below a means to protect oneself from the coming correction, but far more important is the discussion that follows regarding the mess that is today’s global macroeconomic backdrop.
Global uncertainty in both the credit and equity markets is rising, and deservedly so. So how do we, as investors or investment managers, avoid following the herd by making investments that have no real fundamental basis, without losing out on potential upside as the market’s coalescence of views continues to persist? Sad differently, how do we capitalize on investor irrationality while protecting our portfolio from massive drawdowns when the chickens come to roost? One approach is to implement a multi-asset strategy designed to hold core equities positions but also protect the overall portfolio from downside by buying market volatility.
When I refer to “buying volatility,” I’m referring to betting on a continued increase in global skepticism and market uncertainty. This can be executed in several ways, but I will begin with the more simple approach. While keeping core, long-term equity holdings for which you have strong long-term conviction, you can also purchase call options on the volatility index (VIX). As long as volatility continues to rise, these calls should increase in value and can offset losses on equity holdings when a correction eventually materializes. Given the lack of predictability as to timing, which comes with markets driven by central banks, I would recommend owning longer-term calls. Several indices exist to track volatility, including:
CBOE Volatility Index (VIX): The VIX is a leading measure of market expectations for near-term volatility conveyed by S&P 500 Index options prices. The Index is considered by many to be the world’s best barometer of equity market volatility. It is based on real-time prices for options on the S&P 500 Index and is designed to reflect investors’ consensus view of future (30-day) expected stock market volatility. The VIX is often referred to as the market’s “Fear Gauge.” The VIX Index was introduced in 1993, followed by the launch of VIX futures in 2004 and VIX options at the CBOE in 2006.
There has been growing acceptance of trading VIX and VIX-linked products as risk management tools, enabling investors to trade volatility independent of the direction or the level of stock prices. Whether your outlook is bullish, bearish, or somewhere in between – VIX options give the ability to diversify a portfolio or act as a hedge against potential volatility in existing holdings, and are also used to mitigate or to capitalize on broad market volatility.
The CBOE calculates VIX levels based on two measures that track the level of implied volatility from single SPX option maturities:
VIN (or VINX on Bloomberg): Nearer-term SPX expiration applied to VIX calculation
VIF: Farther term SPX expiration used in VIX calculation.
VIX Options have several characteristics that distinguish them from most equity and index options, including:
Prices based on forward VIX values
Pricing can vary for a number of different reasons
Wednesday settlement
Special Opening Quotation Price
Negative Correlation to Stock Indices (it’s moved opposite the S&P500 88% of the time since it began trading in 1990, with a negative daily return correlation of -0.67)
High Volatility of Volatility
On average, the VIX has risen ~17% on days where the S&P fell 3% or more. Therefore, simply buying call options ON THIS HIGHLY VOLATILE INDEX could be considered a hedge to protect against sharply falling stock prices
Similar to the VIX, the CBOE offers options on the volatility of various other market indices, including:
CBOE NASDAQ Volatility Index (VXN)
CBOE S&P 100 Volatility Index (VXO)
CBOE DJIA Volatility Index (VXD)
CBOE Russel 2000 Volatility Index (RVX)
As noted above, the CBOE offers options on the various other indices so these options may be used as better hedging instruments for portfolios with different holdings and risk exposures than the S&P 500. For instance, if your equities portfolio is comprised primarily of micro- and small-cap names you might want to hedge the risk of volatility in this market with options on VXD, though this is not necessary to execute a successful long volatility strategy. Instead of attempting to match the options perfectly to the underlying equity holdings, I would recommend evaluating the various index constituents and buying options on the index I expect will exhibit the greatest volatility over the coming 6 months relative to the volatility implied by the options’ prices.
The first and most simple strategy to capitalize on rising global uncertainty in the equity markets (which is inevitable as the risks set forth later in this article become more widely recognized) would be to simply buy call options on the VIX. I would recommend medium-term options (those that expire 6 months from now), but option prices should be taken into consideration relative to the expiration date selected (pricing can be inefficient due to illiquidity in options markets, so in certain cases it may be more sensible to buy a shorter-term call if the premium is sufficiently lower).
Volatility is rising relative to the S&P 500 as of late, as depicted in the chart below:
YTD Performance – VIX versus the S&P 500
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CBOE:VIX on the Uptick
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(Source: Bloomberg, as of late August)
While I will admit, that spike in the VIX you see in the image above occurred in late August was a bit of an anomaly. It could have been driven by the CBOE’s recalculation of index figures ahead of its release of Volatility “Weekly’s” or Weekly futures on the various volatility index. Either way, the VVIX also points to rising volatility.
CBOE:VIX – Chart with Technicals (Updated to Present)
First it’s important to note: the VIX does NOT trade on technicals, so technical analysis is not all that relevant, but I thought to include it so you can see that, while the VIX has been elevated on a longer-run, YTD basis, it’s been ticking up in the last couple of days despite approaching “oversold” status based on RSI figures (5 and 14 period), which are approaching 30. Refer to the chart below:
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(Source: FactSet, Up-to-Date)
More Advanced Strategies
The Reverse Collar
Because the VIX tracks daily volatility or fluctuations in stock prices within the S&P500, it is virtually impossible for it to go to zero, as this would mean market participants expected that all stocks would halt trading in 30 days’ time. It is also highly unlikely that the VIX will ever experience a prolonged period of very low values; in order for this to occur, there would need to be a market expectation of virtually no change in the level of the S&P 500 Index! In fact, the lowest closing level in the history of the VIX was at $9.31 on December 22, 1993, and there has only been 5 days since 1990 (when the VIX began trading) when the index closed below $10.00.
Below are call and put prices for VIX options expiring March 16, 2016. The current price of the VIX is $17.42 (as of today’s close, 10/8/2015). As you can see below (circled in red), we will buy 100 March 2016 $18 calls with a $3.85 limit (considering the last trade was at $3.73, this should be achievable) for a total cost of $38,500 and we’ll sell 100 March 2016 $15 puts at $0.60 for a total premium inflow of $6,000. Thus, are total cost for the strategy results in a net outflow of $32,500.
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Source: www.cboe.com/micro/vix-options-and-futures.aspx
Now, if we instead executed this reverse collar strategy with shorter-term options, the cost of coverage may appear to be less expensive (though is often misleading). Below you will find the option prices for calls and puts expiring December 16, 2015:
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Source: www.cboe.com/micro/vix-options-and-futures.aspx
In this case, using the shorter-term options expiring in December, we would buy 100 December 16 $18 calls (remember, the current VIX is at $17.42, as shown above as of the close on 10/8) at $2.65, for a total cost of $26,500 and sell 100 December 16 $15 puts at $0.40, for a total premium receipt of $4,000 and a net cost basis of $22,500.
Now, if we take a step back and think about this, to execute the strategy with the closer-to-expiry options we receive the option to purchase the VIX at $18 for just over 2 months’ time. This 2.25 months will cost us, on a net basis, $22,500, suggesting a monthly cost of this optionality at roughly $10k/month. With the longer-expiry options, which don’t expire until mid-March 2016 (thus giving us 5.25 months’ time to execute on this optionality), we only pay an incremental $10k in exchange for 3 more months of ownership prior to the option’s expiration. This makes the monthly cost over those three months only $3,333.33/month, or a 66.67% discount to the short-term strategy’s cost of roughly $10k per month. In this case, it becomes clear the best alternative is to go with the farther-dated options, considering their extra time value at a discounted monthly rate of $3.3k, versus paying up for a short-term contract at $10k/month. It’s important to perform this sort of analysis when considering options strategies and which options to buy/sell.
The Vertical Call Spread
Assuming we’re bullish on volatility over the coming three months, we will use the January expiration prices shown below, noting the current VIX is at $17.42 and 3 month VIX futures are trading at ~$23.60. We buy January $25 calls at $1.70 and sell January $30 calls at $1.10, for a net cost of $0.60, or $60/spread. For the sake of comparison, let’s assume we’re buying and selling 100 of each, as we did in the previous examples. This strategy would then have a net cost basis of $6k for the long option exposure over 3.5 months (roughly), giving us a net monthly cost of $1,714. As you can see, this appears to be the best strategy given current price dynamics, BUT ONE MUST CONSIDER its higher risk relative to the reverse collar, as we’re purchasing out-of-the-money calls and selling even more out-of-the-money calls, with a spread between the two of only $5 in strike price (which represents our maximum profit spread). So, if volatility surged even more than we anticipated, we would still only earn the $5 spread as the counterparty to our short calls would exercise at $30. On another token, if volatility doesn’t pan out quite as expected, the strategy may never make it into the money, in which case we lose the net premium paid.
If we wanted an even cheaper net premium, we could be more risky and purchase the January $26 calls for $1.55, thus generating a net cost per spread of $1.55 less the $1.10 earned on the January $30 premiums, or $0.45/spread (which translates to $45/spread in actuality as each contract covers 100 units of the underlying). If we execute 100 of these spreads, the net cost goes down an incremental $1500, to $4500 versus $6000 when buying the January $25 calls. On a monthly basis, that equates to a net cost per month of roughly $1,286/month, with monthly savings over the 3.5 month period at $428/mo. In my view, the $428/mo in savings is not worth the incremental risk, as we ultimately want to make sure our strategy doesn’t expire worthless.
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Source: www.cboe.com/micro/vix-options-and-futures.aspx
One key indicator worthy of monitoring which helps to measure market participants expectations for volatility is the volatility of the volatility index, or the VIX of the VIX (CBOE:VVIX):
The CBOE VIX of VIX Index (CBOE:VVIX): Every asset deserves its own volatility index, including volatility itself. The CBOE’s VVIX is an indicator of the expected volatility of the 30-day forward price of the CBOE:VIX. This underlying volatility drives nearby options prices.
Why should we prepare ourselves for a major Equity/Credit Market Drawdown?
As mentioned previously, today’s global markets have become increasingly divorced from reality. In the U.S., Washington is unable to make critical structural changes, as it stands gridlocked while our nation’s biggest economic competitors – China, Russia, and the oil-producing nations of the Middle East – are doing everything possible to end U.S. monetary hegemony. Risk has surpassed levels seen in the history of trading as we know it, yet markets have hardly made any real adjustment.
Overarching Macro-Level Indicators Point to a Deep Recession and Lengthy Recovery
While the global market confronts a minefield of risks, one of the most threatening is that of over-leverage.
Domestic debt burdens arose as a result of the extended monetary expansion the Fed’s pursued over the last 7 years or so.
Leverage levels and derivative exposures outstanding today are, by order of magnitude, larger in scale relative to any in history. Today, gross derivative exposures globally exceeds 9x global GDP. Does this make any sense in a fundamentally-driven market? No, clearly not. If all investors were keen to today’s true risk overhang, both equity and credit instruments would be valued at levels far below current prices (which have been propped by what seems to be a never-ending period of ultra-accommodative monetary policy).
Over-leverage and insolvency issues do not create themselves. Over the last decade and more so in the recent 6-7 years, the free money era has prevailed among global central banks. It first began with the Fed’s implementation of massive quantitative easing, allowing newly created dollars to roll off the Greenspan/Bernanke printing press for years on end. As the dollar became increasingly cheap, emerging market governments (and companies) took advantage of the opportunity to borrow cheap USD, but forces are now moving in the opposite direction. As the Fed looks to reverse its hyper-accommodative monetary policy, the dollar is strengthening while many emerging market currencies are being devalued. To make matters worse, these countries often produce largely commoditized products heavily reliant on demand from China, which is growing much slower than anticipated. As the impacts of both weak currency values (and thus weak operating profits relative to the value of dollar-denominated debt service requirements) and declining demand pressure these emerging markets from all angles, they’re approaching default at a rapid clip. Further strengthening in the dollar could be the straw that breaks the camel’s back. It could drive an unraveling in the domestic and international credit markets, which would leave in its wake great wreckage in global equities markets.
Fraction of Emerging Market Companies with Net Positive FX Exposure
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As depicted above, outside of Asia and particularly in the emerging countries of LatAm, FX exposures are the highest and have risen substantially since 2007, from ~45% to ~60% at YE 2014. Depicted below is a chart demonstrating ex Asia net positive FX emerging market exposures by industry segment:
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As you can see, net positive FX exposures have risen across all industry segments in non-Asia emerging markets, with a notable increase in the mining sector.
Domestic Monetary Policy, Debt Markets, and National Debt Exposure
A similar dynamic, that of overleverage, has taken place in the domestic consumer and small-to-medium-sized business (SMB) lending markets, as institutional investors with masses of cash fight for qualified borrowers after the Fed flooded the market with liquidity. This simply represents a shift in the risk factors leading to the financial crisis of 2008, away from major bank balance sheets and into the “shadow banking” system (discussed further below). As one of many examples, the market for student debt obligations has imploded, with defaults far higher than anticipated, after total outstanding loans expanded beyond the $1 trillion mark. Many graduates simply cannot afford to repay their debts, understandably so given sluggish wage growth in the domestic economy.
Hedge funds and other institutional investors that previously occupied the publicly traded credit arena have moved down the lending spectrum, looking to SMBs and consumer lending as an outlet to generate returns as the domestic Corporate and High-Yield (HY) debt markets became highly frothy, with HY debt trading far above historic norms relative to its inherent risk. Note that while this dislocation has recently begun to normalize, as high-yield spreads have tightened and interest rates risen, investment-grade corporate debt markets remain relatively frothy (with earnings yields generally much higher than corporate borrowing costs). As a result, many players are still attempting to compete in the crowded, private lending markets. Competition for qualified borrowers in the private lending arena has skyrocketed. With greater competition comes lenders willing to accept lower interest rates and implement lax underwriting standards (covenant-free, or with covenants that aren’t checked without trigger-event such as default). Private institutional lenders are battling for unqualified borrowers who would, under normal circumstances, be denied credit (due to an unhealthy balance sheet, poor credit history, or some combination thereof). We’re now seeing a similar occurrence in the auto-lending market, which just surpassed $1 trillion in outstanding loans (akin to the student-debt dilemma) issued to a basket of borrowers whose credit ratings are far from stellar.
When referring to the credit markets, Bloomberg recently indicated:
“Defaults will breach the historic high next year and the Fed is the ‘wild card’ that has the power to determine how quickly the current credit cycle ends.”
To summarize, massive debt levels have thrown us into a vicious cycle characterized by fundamentally imbalanced markets. The next great crisis will be of unprecedented magnitude, given an unprecedented debt burden (we can thank Bernanke, Greenspan and their fellow colleagues at the FOMC for this) and excessive derivative exposures (equivalent to 9x global GDP). After witnessing the global meltdown of 2008, one would have hoped the Fed and other regulators (as well as market participants) would’ve learned a critical lesson: debt can present an enormous drag on economic growth and has the potential to take down the entire system. Instead of addressing growth challenges head on, like a heroin addict the illustrious members of the Federal Reserve (in addition to several other central banks) pulled out the syringe and said “hey, let’s work our way out of this mess the way we started it.” Today there is a new conventional wisdom: “we can always print our way out of the debt-trap, by simply creating new money and issuing ever more debt”… pure genius. The optimists never falter and will argue that faith in the US dollar and fiat currency as a whole can never be broken, no matter how high our national debt or how dysfunctional our government. This argument demonstrates a lack of basic thought and logical reasoning, or simply ignorance as to our nation’s past, particularly in the financial realm.
With rates pegged at 0-.25%, they may never return to “normalized levels,” which would be roughly 4% or so. Raising rates is a daunting task for the Fed, not only due to fears about the market reaction but also because we’ve accumulated such a massive national debt problem. For every 1% the Fed raises overnight rates, the cost for the U.S. government to service its debt rises ~$150 million.
After the implementation of Dodd Frank following the 2008/09 financial crisis, regulations limiting commercial bank exposures to “assets” that are essentially bad debts helped remove some of the problems with major bank balance sheets, though derivatives exposures and counterparty risk is still pervasive and poses a serious threat to the system. As an example, global derivatives exposure on a gross basis (not to be confused with net exposure, a metric often misused to measure risk) is greater than 9x global GDP. This reflects major distortion in the global financial system, and risks far higher than are generally perceived by the investing marketplace.
The Shadow Banking System and its Role
While Dodd Frank helped resolve some problems with major banks’ balance sheets, the risk exposures have simply shifted away from the large banks and into the “shadow banking system.” Shadow banking refers to the activities of financial intermediaries who partake in credit intermediation outside the regular banking system, thus lacking a policy-driven safety net. The largest shadow banking systems are found in the developed markets or “advanced economies,” but these institutions are growing more rapidly in the emerging markets. While “shadow banking” takes vastly different forms across and within countries, some key drivers behind its growth are common to all: tightening banking regulations accompanied by ample liquidity conditions, as well as demand from institutional investors loaded with cash and a mandate to put it to work in the credit markets. As I mentioned previously, in the U.S. this is represented by hedge funds and private debt investors vying for stakes in debt syndication deals with private, small- and medium-sized businesses in exchange for yields that are mediocre at best. According to a publication by the International Monetary Fund (IMF) this month, “the current financial environment in advanced economies remains conducive to further growth in shadow banking.” In the report, the IMF notes shadow banking constitutes roughly one fourth of total financial intermediation worldwide, and has the largest presence in the United States, the Eurozone and the UK. We are particularly exposed in the U.S., as the only region with shadow banking assets that exceed those of the conventional banking system.
Broad Shadow Banking Measures by Region
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Overleverage and insolvency issues are also a problem throughout Europe and Japan, and this isn’t the first time either country has seen problems of this nature. Europe and Japan are each uniquely distorted markets, and together reflect the magnitude of the markets’ failure to properly allocate capital.
Eurozone QE, Structural and Systemic Problems:
Let’s start with Europe. The ECB, prior to announcing a QE program to buy up ~EUR1.2 trillion+ of government and private debts, chose to experiment with negative rates. It was the first central bank to venture into this uncharted territory, bringing its deposit rate to negative 0.2% in September 2014. This effectively punished the conservative banks for holding decent levels of cash with the central bank instead of extending loans to businesses or weaker borrowers. Sweden implemented a similar combination of negative rates and bond buying. Denmark pushed rates deeper into negative territory to protect its currency peg to the Euro, and Switzerland moved its deposit rate below zero for the first time since the 1970s. As central banks provide a benchmark for all borrowing costs, negative rates spill-over to a range of fixed income issues. By the end of March of this year, more than a quarter of debt issued by Eurozone governments carried negative yields, meaning investors who hold these positions to maturity will not get all their money back. With the actions of the ECB, many Eurozone banks elected to pass negative rates onto their customers.
Imagine a bank that pays negative interest. In other words, it gets paid to borrow money, and depositors are actually charged to keep their money in an account. Crazy as it sounds, several of Europe’s central banks have cut key interest rates below zero in a bid to reinvigorate an economy with all other options exhausted. No matter how you swing it, this is an unorthodox approach that has created distortions in the financial marketplace.
Negative interest rates are a sign of desperation, the most obvious signal that traditional policy options have proven ineffective, thus new limits must be explored. Despite the obvious artificial inflation that results from such policies, European markets continue to respond positively to these accommodative monetary developments – as noted previously, it is the new conventional wisdom: When all else fails to spur growth, create new money and buy bonds.
Europe: Did we forget about Basel I-III?
What was the point of the Basel regulations? They were intended to force banks across the Eurozone, primarily those in Spain, Portugal, Italy, and France, to clean up their balance sheets and avoid “toxic” corporate risks. As such, the laws limited the amounts of corporate debt these banks could hold on their balance sheets, resulting in an offloading these “high-risk” assets, often at fire sale prices (scooped up by private equity/debt players out of the U.S., the U.K., and Europe). Now, all of the sudden it’s a positive indicator that European banks are forced to retreat when it comes to underwriting standards? This is a plan certain to backfire.
Tumbling rates in Europe have put some banks in an inconceivable position: owing money on loans to borrowers. At least, one Spanish bank, Bankinter SA (OTCPK:BKNIY), has been paying some of its customers interest on mortgages by deducting the negative interest from the principal balances owed by its borrowers (WSJ). This is just one of many challenges caused by interest rates falling below zero (which makes no sense, to start). Throughout Europe, banks are now being compelled to rebuild computer programs, update legal documents and rebuild spreadsheets to account for negative rates. Interest rate have fallen sharply since the ECB introduced measures last year to reduce its deposit rate, and in March launched a new massive QE program targeted at buying public and private bonds (to the tune of EUR 1.2 trillion in EUR 60 billion monthly installments), driving down yields on Eurozone debt with the intent to foster heightened lending. The image below depicts how this situation may occur (and is occurring) as Euribor has fallen into negative territory.
In countries such as Spain, Portugal, and Italy (key countries with undercapitalized bank balance sheets leading up to the Basel regulations), the base interest rate used for many loans, especially mortgages, is based on a spread over Euribor. As rates have fallen, sometimes below zero, banks face the paradox of paying interest to their borrowers. Even still, the market and the great members of the ECB view loosening credit standards as a positive? Remind us of the driving force behind the Basel regulations…
Banks are turning to the central banks for guidance, but what they’re receiving is less than comforting.
Portugal’s central bank ruled its banks would be required to pay interest to borrowers if Euribor plus their stated spread on existing loans falls below zero. Over 90% of the 2.3 million mortgages outstanding in Portugal have variable rates linked to Euribor (WSJ). Most mortgages in the country are linked to a monthly average of three- and six-month Euribor, both of which have been steadily declining and currently hover just above zero.
Additionally, in Spain (another problem area in the Eurozone), the vast majority of Spanish home mortgages have rates that rise and fall tied to 12-month Euribor (according to statements issued by Spain’s mortgage association). That rate stands at 0.139%, down 126% over the last half-year, from 0.187% in mid-April.
Finally, another country that only recently began to pull itself out of a banking debacle ((Italy)) carries about half of its mortgages on variable rates linked to Euribor. Existing loan contracts do not stipulate how to proceed in the event Euribor falls into negative territory.
Two-month Euribor is at negative .072% (dropping 1600% since its mid-April rate of negative .004%). Hundreds of thousands of additional loans would be affected if medium-term Euribor rates enter negative territory; the six-month rate currently stands at 0.027%, significantly lower (down 165%) than its prior level of .078% in April (2015).
Recently in September, the ECB begrudgingly admitted its own asset-purchase program “hasn’t been as successful as we’d hoped…” Why? “It’s simply because they are running out. There are simply too few of these structured products out there.” Put simply, the sheer lunacy of a bond buying program that’s only constrained by the fact that there simply isn’t enough bonds to buy cannot possibly be overstated.
Today, the ECB is monetizing over half of gross issuance (and more than twice net issuance) and 12% of Eurozone GDP. The latter figure there could easily rise if GDP contracts and QE is expanded, a scenario which certainly shouldn’t be ruled out given Europe’s fragile economics and expectations for the ECB to remain accommodative for the foreseeable future. In fact, the market is already talking about the likelihood that the program will be expanded/extended. Among the program’s numerous absurdities, the glaring disparity between the size of the program and the amount of net Euro fixed income issuance it is striking how incompetent regulators can actually be. On top of this, there is the nuance that the previous ECB easing efforts virtually ensure that QE cannot succeed.
And on to Japan:
It appears the BoJ had already doubled-down on Abenomics before the Prime Minister Shinzo Abe announced a new round of Abenomics, with a goal of raising NGDP levels from JPY499 trillion to JPY600 trillion, requiring a +20% expansion in the monetary base. The difference between Abenomics and QE as we know it is that Abenomics seeks to permanently expand the monetary base, whereas QE is designed to temporarily inject liquidity into the markets but to ultimately return to a more healthy balance sheet, without any major, permanent expansion of the monetary base. With sluggish growth out of Japan in recent periods, the ability to use Abenomics to permanently expand the monetary base and its ability drive a 20% increase in nominal GDP over the next five years seems to be a bit of a stretch. While it appears, from looking at the chart below, Abenomics was successful in its permanent expansion in the monetary base driving heightened NGDP growth during the latest round of Abenomics (relative to the BoJ’s temporary, QE measures implemented in 2001-2006 which, as you can see below, did not trigger any real growth), we must consider whether the expansion in the monetary base below was accompanied by characteristics of permanent expansion of the monetary base and real NGDP growth or simply rising inflation with perhaps minor growth in real NGDP.
Some observers worry Abe’s monetary expansion is not credible and therefore will not be permanent. If so, then Abe’s latest goal of raising NGDP by 20% isn’t credible either.
Recently the Bank of Japan (BoJ) recognized it had a problem on its hands. There simply isn’t anyone out there willing to sell more JGBs. According to a BoFA strategist, “now that GPIF’s selling has finished, the focus will now be on who else is going to sell. Unless Japan Post Bank sells JGBs, the BoJ won’t be able to continue its monetary stimulus operations.“ Now that we’re in the depth of the market swoon when everyone is demanding more action from the BoJ, suddenly pundits have discovered the biggest glitch in the ongoing QE monetization regime, namely that the BoJ simply cannot continue its current QE proram, let alone boost QE as many are increasingly demanding, unless it can find willing sellers, and having already bought everything the single biggest holder of JGBs, the GPIF, had to sell, the BOJ will next shakedown the Post Bank – its sales of 45 trillion JGBs is critical to keep Japan’s QE ongoing. The sale of 45 trillion from the Post Bank, however, will only keep the BoJ going for three months. Then what? Which other pension funds holding massive JGBs will enable the BoJ to keep Japan’s stimulus going not only in 2016 but also 2017 and beyond. The answer is, there will be fewer and fewer.
Back in 2014, Takuji Okubo, chief economist at Japan Macro Advisors in Tokyo, noted that with the scale of the country’s debt monetization, the BoJ could end up owning half of the JGB market by as early as 2018. He added that “The BOJ is basically declaring that Japan will need to fix its long-term problems by 2018, or risk becoming a failed nation.”
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In short, the BOJ will not boost QE – it won’t be able to. If anything it will have no choice but to start tapering down, like the Fed did when its interventions created the current illiquidity in the US government market – especially considering liquidity in the Japanese government now is non-existent and continues to worsen by the day. All that would be needed for a massive VaR shock to play out in the region is a single exogenous JGB event for the market to realize just how little actual natural buyers and sellers exist.
The IMF recently issued a working paper on Japan and the state of its economy. Here are some key points:
The BoJ may need to reduce the pace of its bond purchases in a few years due to a shortage of sellers.
There is likely to be a “minimum” level of demand for Japanese government bonds from banks, pension funds, and insurance companies due to collateral needs, asset allocation targets, and asset-liability management requirements.
Some excerpts from the IMF’s findings:
“We construct a realistic rebalancing scenario, which suggests the BoJ may need to taper its JGB purchases in 2017 or 2018, given the collateral needs of banks, asset-liability constraints of insurers, and announced asset allocation targets of major pension funds.”
“There is likely to be a ‘minimum’ level of demand for JGBs…As such, the sustainability of the BoJ’s current pace of JGB purchases may become an issue.”
The IMF paper notes that in Japan, where there is a limited securitization market, the only “high quality collateral” are JGBs. As a result of the large scale JGB purchases by the BoJ, “a supply-demand imbalance can emerge, which could limit the central bank’s ability to achieve its monetary base targets. Such limits may already be reflected in exponentially low (and sometimes negative) yields on JGBs, amid a large negative term premium, and signs of reduced JGB market liquidity.”
The chart below illustrates the problems Japan is running up against with its excessive bond buying and the eventual lack of supply of JGBs, such that it will soon be forced to taper its QQE programs before meeting its monetary base targets.
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Central Bankers & Economists: Losing the Forest from the Trees
A one-month positive data point out of the Eurozone, be it rising industrial production in a given nation, stronger employment, higher GDP or the like do not mean the economy is on a rapid upswing to move out of its troubled position, nor can we say with certainty the ECB’s QE buying has anything to do with it. There are several complex interrelationships at play, and monthly output data can be volatile. Interpolating what the ECB might do with its EUR 1.2 trillion QE program due to a single monthly data point is a flawed approach. Europe still has more than its share of structural issues to address before it can truly be confident about long-run growth prospects.
After any (often minor and meaningless) positive data releases, economists begin to speculate whether the ECB will begin to signal its satisfaction with a supposed pickup, and how this might affect the longevity of its EUR 60 billion (per month) bond buying program. In turn, this impacts how other central banks respond.
Where Central Banks Should Direct their Focus
Central banks such as the ECB, Japan’s BoJ, the UK’s BOE and the U.S. Fed should redirect their attention from short-term, often volatile monthly data figures and open their eyes to the obvious, long-term market distortion their actions have created. With repeated communications and actions suggesting markets can simply be manipulated to spur growth through printed money in numerous countries and various global currencies, how long can we rely on the true value of fiat currency? The system has driven itself into believing in its own stability, which in actuality is non-existent.
Groupthink has muddled our views as to how financial markets should behave. A lack of fundamental economic growth, masked by debt-driven financial growth, does not resolve any underlying issues. Instead, unsustainable QE and Zero Interest Rate Policy (ZIRP) and the subsequent high (and growing) nominal levels of stock and bond markets have led investors on the hunt for yields, buying assets of increasing risk without consideration of balance sheet health and/or weakening fundamentals.
We need to criticize those who act as Fed proponents, with the only consistent argument being “well, what would you suggest the central banks do?” How about not allowing money to become so cheap that countries and, in some cases, corporations and individuals (as described above in the Eurozone) get paid to borrow. This is simply beyond the realm of sanity, and it puzzles me how many fail to understand this. How about central banks stop reminding the world that they can never run out of money, thus providing an infinite number of excuses to do nothing on the fiscal or structural side.
“One should not mistake the wanton creation of money [for] omnipotence” (Anne Stevenson-Yang re the PBOC).
The same logic could be applied to the BoJ, the Fed, the ECB, et al. It’s time to return to credible monetary policies that are sustainable over the long-run and pass the ball into the fiscal court. If that means the economy must suffer some dire misfortunes, then so be it. We have created the means of our own demise. From a fellow Seeking Alpha reader’s comment (thanks Chrislund), “Treating the financial system as an endless credit convalescence only leads to capex atrophy. Synthetically low interest rates designed to surrealistically suppress the cost of capital for this many years is a surefire way to institutionalize the misallocation of capital.“
Recent Data Suggests Recession may be Imminent
Global GDP is clearly slowing, and data we’re getting from the U.S. suggests we’re likely to see a major fall-off in GDP in the coming few quarters (following the worst quarter in years for equity markets, 3Q 2015, as shown in the chart below).
The YTD chart of the S&P 500 illustrates the high level of volatility present in today’s domestic market, and demonstrates from a technical perspective it is overbought, with a 5 period RSI (last technical chart depicted below, the green line to be precise) at 77.7. Anything above 70 is considered to be overbought, and stocks will often will turn when reaching RSIs above 70 as technical traders step-in and ultimately normalize trading levels by issuing sell orders.
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(Source: FactSet)
One should evaluate the recent employment data (which was quite disappointing, to say the least); earnings forecasts (and some shifty accounting); credit spreads; total leverage in the system; and the overall credit environment. Ephemeral, debt-driven or financial growth has supported economic growth measures for some time now, masking a deterioration in actual, fundamental growth. This data, in the aggregate, suggests we should be on “recession alert” (John Mauldin, October 4, 2015), “because a recession will mean a full-blown bear market (down at least 40%), rising unemployment, and (sadly) QE4.”
Some information provided by Reuters regarding current valuations and growth expectations, etc:
“Even with the recent selloff, stocks are still expensive by some gauges. The S&P 500 Index is selling at roughly 16 times its expected earnings for the next 12 months, lower than this year’s peak of 17.8 but higher than the historic norm of about 15.”
“Moreover, forward and trailing price-to-earnings ratios for the S&P 500 are converging, another sign of collapsing growth expectations…The last period of convergence was in 2009 when earnings were declining following the financial crisis.”
Analysts are now calculating earnings estimates “ex energy,” typical as energy has been the biggest drag on earnings. If we’re removing the bottom outlier, Mauldin points out, shouldn’t we too remove the top outlier? Healthcare has carried much of the earnings burden for the S&P, so wouldn’t it be prudent to calculate and evaluate earnings projections on an “ex energy,” “ex healthcare” basis? Mauldin also cited an unusual trend as of late:
“A funny thing about earnings: they’ve been going up for the past year, even as top-line revenue has not. Generally, those go hand-in-hand. What’s happening?”
This is likely due to simple earnings manipulation by corporate accountants. It’s easy to move expenses from one period to the next (extend salvage values and useful lives of depreciable assets; re-characterize costs that are naturally recurring as “one-time, non-recurring charges;” estimate bad debt expense relative to receivables at a lower percentage than history has shown; push forward revenues by extending greater credit to less creditworthy borrowers (the auto sector is a perfect illustration); many accounting mechanisms are available to manipulate earnings in the short-term, but this in essence equates to “stealing” from future earnings when these loose accounting measures must be reversed as actual cash transactions play out. Some recent earnings appear to be those of the “smoke and mirrors type,” as Mauldin suspects.
Tesla Motors ($TSLA) is a perfect example. They’re a role model for earnings manipulation, with capex rising at an enormous rate, while depreciation expense relative to fixed assets and capex continues to decline (exponentially). Similar phenomena can be found throughout $TSLA’s financials, though I won’t get into the weeds here.
Finally, earnings forecasts are notorious for lagging the trend. If earnings are beginning to fall – as it appears they are – it’s highly likely earnings estimates will miss to the downside. If this occurs simultaneously with the economy dipping into recession, estimates could miss to the downside quite dramatically.
Earnings estimates for Q4 2015 have been consistently revised downward since their June levels as analysts get more and more bullish on the environment and companies offer them incremental insights into a weaker expected close to the year:
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Key Metrics: S&P 500:
Earnings Growth: For Q3 2015 the blended earnings decline (based on some reported and largely expected/consensus figures) should be -5.5% (FactSet). If the index reports a decline in earnings for Q3, as is anticipated, this will mark the first back-to-back quarterly earnings decline since 2009.
Earnings Revisions: On June 30, the estimated (consensus) earnings decline for Q3 2015 was -1.0%. Nine sectors have lower growth rates today (compared to June 30) due to downward revisions across the board, led by the Materials sector.
Earnings Guidance: For Q3 2015, 76 companies have issued negative EPS guidance and 32 positive (likely due to guidance being on an “adjusted” basis, removing the effects of non-transitory FX exposures and other “one-time” or “non-recurring” add-backs to net income that in actuality are recurring, in addition to the standard GAAP manipulation tactics described abvoe.
Valuation: The 12 month forward P/E currently stands at 15.9, above its 5Y average (14.0) and 10Y average (14.1).
Earnings Scorecard: Of the 24 companies that have reported earnings to date for Q3 2015, 19 have reported earnings above the mean estimate and 14 have reported sales above the mean (reflecting that good old earnings manipulation). It is very difficult to manipulate sales figures, with the exception of channel stuffing or lending to less creditworthy borrowers and thus growing your A/R balance and days turnover, but all the items between sales and earnings have much leeway for manipulation and adjustment under GAAP, not to mention companies can make even more shifty adjustments in their reconciliation to “adjusted, non-GAAP earnings.”
Given the vast concerns in the global investment market, Factset went through earnings calls of the 23 companies that had reported by October 7 to identify management’s discussion regarding cause for concern, or key headwinds in the quarter, specifically looking for key phrases or words such as “volatility,” “uncertainty,” “headwind,” and “currency” or “China” (and “FX” or “stengthening of the dollar,” etc.). The # of companies who cited these negative global headwinds as impacting their performance, out of the total 23 companies who’ve reported, is shown in the bar chart below and broken out according to which specific factors were mentioned:
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One of the more interesting comments was from Carnival Corp (NYSE:CCL), as they were the single company to mention the ongoing refugee crisis in Germany:
“By the time we get to December, maybe those things won’t be the same, but today, with some of the headwinds in Europe, geopolitical, macroeconomic malaise, the intense tension over there around the refugee situation, that has affected all travel, not just cruise, but all travel.” – Carnival Corp. (Sep. 22)
Recent Global Developments and Data Points
Inflation expectations are coming back down again in Europe, and is expected to support incremental QE from the ECB, bringing down the Euro a bit. As I write to you, the Chinese markets are trading up 3.3% on speculation the central bank will implement additional stimulus after a long holiday, and a decline in China’s money rate (the most in a month) as the PBOC injects money into the system.
In Germany, net exports for the month of August (2015) were just released. Results were quite ominous, particularly considering the other German data points received over the past few days, with total exports down 5.9% versus consensus estimates for exports up 0.9%. Moreover, Germany’s largest investment bank, Deutsche Bank (NYSE:DB), braces for a 3Q print with a loss of ~EUR 7B, the largest loss in at least a decade. Analysts and investors are concerned the company may cut its dividend, which has never been cut since Germany’s post WWII reconstruction. Despite the negative print, the stock is trading down by a meager 1%.
Implications from German export data are interpolated into Chinese demand trends, and given the huge miss in Q3 the release is spooking emerging market investors. Emerging market trading is following the downtrend, as Germany’s weak export data solidifies the growth woes discussed previously by the IMF in addition to its statements regarding fragility in the global recovery.
In the Eurozone overall, investment levels are running well-below replacement levels, despite historically low interest rates. This suggests problems in the region are more structural and systemic in nature, and could persist longer than the markets anticipate.
In the U.S., particularly troubling developments relate to continued ultra-high monetary accommodation coupled with stagnant wage growth and employment participation levels well-below historic norms. If, for example, you looked at the U.S. economy and employment situation 25 years prior to the 2008 crisis and extrapolated current employment levels, one would anticipate employment around 63-65% (versus 59% actuals). Additionally, in the latest two reports year-on-year wage growth came in with the lowest figures in the last 25 years.
How Can Investors Address these Risks in Portfolio Management?
Global uncertainty in both the credit and equity markets is rising, and deservedly so. So how do we, as investors or investment managers, avoid following the herd by making investments that clearly have no fundamental basis, without losing out on potential upside as the market’s coalescence of views as to the new norm continues to persist? Said differently, how do we participate in the upside (as market participants continue to behave irrationally) while protecting our portfolios from massive drawdowns when the chickens come to roost?
One approach is to utilize a multi-asset strategy designed to hold equities but also protect the overall portfolio from downside by buying market volatility. This can be executed in several different ways, and one must be careful in doing so to ensure allocation is aligned with risk tolerance. When I refer to “buying market volatility,” I refer to purchasing call options on the volatility index, or the VIX, such that as global uncertainty continues to rise pending a market implosion, these options climb exponentially in value and thus offset to some extent any losses on long-term equity positions. If one was a complete risk taker with high conviction the prevailing levels of market dislocation will soon reverse, I might remove all exposure to equities and simply buy calls on the VIX, betting that uncertainty will only get worse and thus volatility will continue to rise. As market behavior and asset values become increasingly divorced from economic realities, the case for such a strategy is incrementally solid. Please note, however, that solely purchasing calls on the VIX is a risky strategy with the potential to lose your entire investment, so it is recommended that you consider your strategy to execute on buying volatility to ensure it is properly aligned with risk tolerance in your portfolio(s).
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