Brandywine’s Stephen Smith: Taking a Different Path in Global Bond Investing

Wednesday, June 19th, 2013

This week’s Great Investor guest is a maverick bond investor and a WEALTHTRACK exclusive. He is Stephen Smith, long time co-portfolio manager of the five-star rated, Brandywine Global Opportunities Bond Fund which has delivered exceptional returns over the years.

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Goldman Slams Abenomics: “Positive Impact Is Gone, Only High Yields And Volatility Remain”

Wednesday, June 19th, 2013

While many impartial observers have been lamenting the death of Abenomics now that the Nikkei – essentially the only favorable indicator resulting from the coordinated and unprecedented action by the Japanese government and its less than independent central bank – has peaked and dropped 20% from the highs, Wall Street was largely mum on its Abenomics scorecard. This changed overnight following a scathing report by Goldman which slams Abenomics, it sorry current condition, and where it is headed, warning that unless the BOJ promptly implements a set of changes to how it manipulates markets as per Goldman’s recommendations, the situation will get out of control fast. To wit: “Our conclusion is that the positive market reaction initially created by the policy has been almost completely undone. At the same time, a lack of credible forward guidance for policy duration means that five-year JGB yields have risen in comparison with before the easing started, and volatility has also increased. It will not be an easy task to completely rebuild confidence in the BOJ among overseas investors after it has been undermined, and the BOJ will not be able to easily pull out of its 2% price target after committing to it.”

Bad, bad Kuroda.

Not surprisingly, the primary driver of skepticism – both Goldman’s, and that of its clients who recently got crushed based on Goldman’s long Nikkei trade recommendations – is the epic surge in JGB vol, which Zero Hedge first cautioned about when the BOJ unleashed its monetary bazooka and since then with periodic updates. And sure enough, Goldman which disappointed with its expectation that the BOJ would unveil a 2 year LTRO equivalent operation, is once again back to tutoring its failing student, Kuroda, about what he should do in order to put Abenomics back on the tracks, or else risk the complete loss of confidence in this latest (and possibly last reflationary chance) program from both the most important bank, as well as those whose money is critical in preserving the smooth glidepath of Abenomics – overseas investors (i.e., Goldman’s clients).

Will the BOJ implement Goldman’s ultimatum, and if not, will the great Japanese reflationary experiment crash and burn? Find out soon enough.

From Goldman’s Naohiko Baba

Impact from new BOJ easing disappears, eroded confidence is one significant factor

One of the main focuses for overseas equity investors since late May has been the JGB market. They have invested in Japanese equities with one eye on the tail risk from Japan’s fiscal problems, which could explode at any time. They are therefore more nervous than most Japanese about the rise and instability in long-term JGB yields since unprecedented easing was introduced in April. We believe there is a particularly large gap in recognition between overseas investors and the BOJ on this issue.

BOJ Governor Kuroda’s comments at a press conference on May 22 after the monetary policy meeting were taken by the market as an acceptance of rising JGB yields. Overseas investor confidence in the BOJ was further undermined after the June 11 policy meeting when the committee decided not to extend the duration of fixed interest rate operations, an action that was already reported in the press and priced in by the markets.

As a result, instability in long-term JGB yields has been having a significant knock-on impact on the equity and forex markets since late May. A look at forex, equities, and the JGBi expected inflation rate shows that most of the initial positive impact from unprecedented easing was reversed in mid-June, with only high yields and volatility remaining. The BOJ urgently needs to reestablish forward guidance for its policy duration and a communication strategy that does not involve contradictory messages.

Or else… Goldman continues:

Overseas investors focused on JGB market instability

The author has recently returned from meetings with more than 100 overseas investors in Europe and Asia in early-June and have also talked to investors who visited Tokyo from around the world. Discussions with them focused on Abenomics, and we were surprised that the JGB market was not only the main focus of investors who concentrate on rates and forex, but also for equity investors.

The specific themes that came up in our meetings with these investors included: (1) reasons why long-term JGB yields rose and have become unstable after the introduction of unprecedented easing aimed at doubling the monetary base over two years through large-volume JGB purchases (announced by the BOJ on April 4); (2) how to interpret BOJ’s stance toward the JGB yields and their stability based on conflicting statements made by Governor Haruhiko Kuroda on long-term yields; (3) whether or not the government, and the Finance Ministry in particular, plans to allow the JGB market to remain unstable; and (4) the possibility that huge JGB purchases by the BOJ may cause the government to lose incentives for fiscal restructuring, given calls to postpone consumption tax hikes among some officials close to Prime Minister Shinzo Abe.

Of course, this strong interest in the JGB market among overseas investors is due to concerns over Japan’s fiscal conditions. Given government debt is currently at 240% GDP and still rising, they probably see Japan’s fiscal state as fragile, which could potentially give way under further pressure (see Exhibit 1). These overseas investors are very conscious of this huge tail risk when they invest in Japanese equities, and compared to the Japanese, they have been much more uncomfortable with the increased yield volatility under the current unprecedented easing (see Exhibit 2). In the beginning, the easing helped the yen to depreciate and pushed up the Japanese equity market, and the BOJ may be thinking that volatility on the JGB market is a small price to pay for these positive market reactions.

Up to now, the driver of Abenomics has been overseas investors, but we see a significant gap between these investors and the BOJ in terms of the degree of concern over the instability of the JGB market. As a result, Kuroda’s remarks at a press conference post the May 22 monetary policy meeting were interpreted as an acceptance of further rises in long-term rates. Overseas investor confidence in the BOJ was further undermined at the June 11 monetary policy meeting when the BOJ decided to forego an extension to fixed rate operations after it was widely reported in the media and already factored into the market.

Of course, other negative factors were present, including disappointing market reaction to the “third arrow” growth strategy in Abenomics and an increase in global volatility on expectations that the Fed could wind back its quantitative easing measures soon. However, any positive market reaction to unprecedented easing has largely been undone, leaving only high JGB yields and high volatility, and we are not in any doubt that overseas investors have started to lose their confidence in the BOJ (see Exhibit 3).

Instability exacerbated by a lack of credible forward guidance for policy duration and conflicting statements from Kuroda

The 2-year commitment for the 2% price target is the backbone of Kuroda’s unprecedented monetary easing. Under the previous BOJ governor, Masaaki Shirakawa, the duration of JGBs bought under the Asset Purchase Program was limited to three years, which acted as a sort of forward guidance for policy duration and kept short-/medium-term rates low and stable. Kuroda’s designation of a two-year time frame for the 2% price target was meant to be another such forward guidance, by which the BOJ intends to lower the short- and medium-term zones in a stable manner. Meanwhile, massive JGB purchases are meant to suppress yields for longer-term zones.

The economic outlook report issued by the BOJ on April 26 stated that it saw a high probability of achieving 2% consumer price inflation in the next two years or so. We have already pointed out that we were not convinced by the BOJ’s argument for the economic impact of monetary easing, and we do not think the BOJ is able to earn market confidence about such a commitment. Under these conditions, the two-year time frame was unlikely to take root as credible forward guidance.

We are currently hearing two main prospective scenarios from market participants. In one, the BOJ undertakes massive JGB purchases, but inflation does not go up significantly, and the BOJ is obliged to unwind its current easing policy within two years due to concerns over the possible side effects. The second scenario involves the BOJ maintaining the easing on a semi-permanent basis until it achieves its 2% price target. Either case appears to suggest rising JGB yields in the future – due to supply-demand deterioration in the first scenario and concerns about debt monetization in the second. Furthermore, JGB market volatility tends to increase when visibility of the market outlook is quite low, as suggested by the current situation. We believe this has led to the comparatively large rise in 5-year JGB yields.

At the same time, inconsistencies in statements from Kuroda have caused confusion not only on the JGB market but also in the equity and forex markets. One specific example of this relates to his claim that the BOJ would aim to bring down the yield curve as a whole through large-volume JGB purchases. Kuroda made this claim when he introduced the unprecedented easing measures on April 4, and it was intended to be an important policy transmission channel. When long-term JGB yields started rising against his intentions, Kuroda said it wasn’t a problem as it was a result of inflation/growth expectations. Somewhat sardonically, the expected inflation rate (an indicator frequently referred to by both Kuroda and Deputy Governor Iwata; represented by CPI index-linked JGB movements) began to decline sharply after May 22, when Kuroda made the statement about rising bond yields (see Exhibit 3).

The BOJ also used the buzz word “portfolio rebalancing” to describe the effects its increased presence on the JGB market would have in encouraging institutional investors (banks, life insurance companies, etc.) to move away from the JGB market and into other markets, such as lending and foreign assets. Some institutional investors actually sold off JGBs as the BOJ expected, but market liquidity dried up with the resulting exit of these liquidity providers. This in turn increased market volatility, and some other market participants came under pressure to sell their JGB holdings in order to manage their risk, which fuelled a malignant cycle of further instability. The BOJ was left as one of the few buyers on the JGB market, and it is also being criticized for reducing market liquidity because of the lack of clarity around its large-lot JGB buying operations. Also, equity prices of some regional banks declined as a result of their substantial JGB yield risk exposure and the current instability of yields as well of concerns about future yield rises. We also need to be aware of the risk that they might attempt to sell even more JGBs than they need to if the JGB market continues to be volatile in the future.

JGB market instability spilled over to the equity and forex market, further exacerbating volatility

The rumblings in the JGB market have transferred to the equity and forex markets as well. We believe this reflects concerns among overseas investors about a lack of BOJ determination to stabilize the JGB market, as mentioned at the beginning of this report. The remarks made by BOJ Governor Kuroda at the press conference after the May 22 policy meeting were particularly interpreted as an acceptance of rises in JGB yields, and this has strengthened the link between volatility in long-term yields, equities, and the forex
market (see Exhibit 5).

In order to investigate this phenomenon more rigorously, we analyzed the reaction in volatility of equity prices and forex rates when long-term JGB yield volatility changes by 1% (see Exhibit 6). We can see a big change in trend from May 22, when Kuroda held his post policy meeting press conference. Equity and forex volatility began reacting strongly to changes in JGB yield volatility with a particularly noticeable reaction in equity volatility. Of course, we do not attribute all of the market volatility to the BOJ. Other factors have impacted the markets, including disappointing market reaction to the “third arrow” growth strategy of Abenomics and an increase in global volatility on expectations that the Fed could unwind its quantitative easing measures soon. Still, our conversations with overseas investors suggest to us that instability in the JGB market is a significant factor behind the diffusion of that instability to the equity and forex markets as the BOJ gave the impression that it sees JGB market volatility as acceptable or lacks measures to stabilize it.

* * *

In conclusion, here is Goldman’s ultimatum to Japan on what it should do now – and yes, life would be so much easier if Goldman had one of its alumni running the central bank in Japan, as it does in the US, Europe and now, England.

Urgent need to rebuild the forward guidance and communication strategy

Exhibit 7 summarizes the market reaction from the start of the unprecedented easing on April 4 all the way to the present. We extracted a common factor from three variables in the BOJ’s focus for policy transmission (equity prices, forex rates, and the JGB expected inflation rate) using principal component analysis. Our conclusion is that the positive market reaction initially created by the policy has been almost completely undone. At the same time, a lack of credible forward guidance for policy duration means that five-year JGB yields have risen in comparison with before the easing started, and volatility has also increased.

It will not be an easy task to completely rebuild confidence in the BOJ among overseas investors after it has been undermined, and the BOJ will not be able to easily pull out of its 2% price target after committing to it. We therefore see a need for the BOJ to offset this with an improvement in its communication strategy. We especially see a need for the BOJ to clearly outline its basic intentions and provide, in a consistent manner, a time frame for how long-term yields will be formed under the unprecedented easing. It also needs to establish specific measures to stabilize the JGB market in case of an emergency. Unprecedented easing relies overwhelmingly on financial market transmission channels, and it is important for the central bank to urgently rebuild stability thereby enhancing thevisibility for the main players on these markets – overseas investors.

* * *

To summarize: Goldman is angry (that year end bonuses may not be at new all time highs, which after all was the whole point behind Abenomics). And you don’t want to see Goldman angry.

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Why We Shouldn’t Trust The Fed’s Inflation Target

Wednesday, June 19th, 2013

Submitted by F.F. Wiley via Cyniconomics blog,

Awhile back, I thought it might be interesting to create one of those island economy stories to demonstrate a problem with the Fed’s policy framework. I finally got around to it over the past week, after reading an article on the same policy flaw.

My island story’s relevance won’t be clear right away, but stick with it if you’re wondering what could go wrong with monetary policy (or if you like islands). I’ll show how the Fed’s inflation target can cause policymakers to do the exact opposite of what they should be doing. And then I’ll come back to the excellent article I read last week.

Introducing Debtor and Creditor Isles

Imagine an island where basic necessities are free, thanks to an abundance of miracle plants that drop a never-ending supply of shoes, clothes, fruit, vegetables, Big Macs and more. The island has mostly two types of inhabitants – those who make Gadgets and those who build houses. Each Gadget maker produces a different type of Gadget and sells one unit per year for $100. Except for the housing sector, the economy is essentially a giant Gadget exchange.

Now imagine a second island whose inhabitants expend virtually all their efforts just to produce basic necessities. But they still save a substantial portion of their incomes. Their savings are used by the government to build a brand new city – Export City – with a factory that’s equipped to produce Gadgets.

I’ll call the first island Debtor Isle and the second Creditor Isle. Let’s see what happens once Export City’s factory is complete…

Tracking the island economies

Each year, one Creditor Isle inhabitant takes a new job at the factory and produces a perfect replica of a Gadget used on Debtor Isle. She exports the Gadget to Debtor Isle for $50 and then visits the People’s Bank of Competitive Currency Controls (PBOC³) to exchange her dollars for local currency. The PBOC³ then loans the dollars back to the inhabitants of Debtor Isle.

Back on Debtor Isle, one domestic Gadget maker is priced out of the market each year by the new Creditor Isle producer. She’s only unemployed for a short moment, though, because she designs a new Gadget. Her new Gadget is priced at $100 with an annual production run of one unit (just like the other Gadgets produced on Debtor Isle). In other words, Debtor Isle produces an unchanging number of Gadgets, but it imports and consumes one additional Gadget each year. As above, the imported Gadgets are priced at $50 apiece and buyers pay for them with loans from the PBOC³.

Debtor Isle inhabitants see three key trends in their economic indicators:

• The trade deficit grows by $50 per year.
• Household and external debt grow by increasing amounts – $50 of additional debt in year one, $100 in year two and so on.
• The consumer price index falls (Gadgets priced at $50 gradually replace those priced at $100).

Enter the planners

Now let’s add the Far Reaching Bankers (FRB) of Debtor Isle to the story. The FRB are responsible for monetary policy and closely monitor the indicators above. In this instance, they ignore foreign trade and debt and adjust policy in response to inflation. They have an inflation target of sorts – a range of inflation rates that’s deemed acceptable – and the Gadget deflation sets alarms ringing. They reduce interest rates to virtually nothing (say, 1%) to stimulate the economy and encourage inflation.

Debtor Isle inhabitants take advantage of this cheap money and double their annual increase in borrowing, using the additional funds to buy newer and bigger houses. The money pouring into the housing sector enriches homebuilders, who then loan funds back to Gadget makers to keep the boom alive. Here are the effects on economic indicators:

• The trade deficit and external debt continue to climb at the same rate, while household debt rises even faster than before.
• Home prices soar.
• Increasing home building costs push inflation above the FRB’s target, while Gadget prices rise slowly because producers are wary of competition from Export City.

The Far Reaching Bankers see off the deflation “scare” and declare great success. They begin to raise interest rates toward levels more typical of a buoyant economy with inflation now above target. But they show little urgency and make only tiny, gradual changes. They aren’t especially concerned about trade deficits or external and household debt. Nor are they concerned about house prices reversing their rapid climb. That could never happen according to a review of data extending back to, well, the time period immediately after the last instance of falling house prices.

The Far Reaching Bankers’ backstory

More fundamentally (digression warning!), Far Reaching Bankers are drawn from a religious sect with core beliefs such as rational agents and a general equilibrium. In a nutshell, their religion holds that rational people always force the economy toward an ideal state of equilibrium, where it then remains. Like any other religion, their faith is guided by sacred objects. The FRB’s sacred objects are abstract mathematical models, from which they take great comfort that their beliefs are valid.

Far Reaching Bankers also believe in stabilization policies, which suggest they can guide the economy even faster to its presumed equilibrium than natural forces allow. That’s where the inflation targeting comes in. They declare that if they take care of the inflation targets, while rational agents take care of the rest, Debtor Isle inhabitants can enjoy a utopian world called a Great Moderation.

A few rogue inhabitants suggest this story is all wrong. They warn of fallacies in the FRB’s religion and dangerous imbalances in the economy. But they’re branded as heretics and relegated to often derided professions such as “hedge fund manager” and “tin foil hat wearing blogger.”

Story ending and thesis

The story ends with a mountain of bad debt leading to an implosion of the imbalances in Debtor Isle’s housing and external sectors. (I’m sure the suspense was killing you.) And here’s my thesis:

1. The story is a rough but reasonable approximation to certain developments during the housing boom – from the Fed’s concerns about falling core inflation in 2003 to its response of slashing the Fed Funds rate to 1% to its decision to normalize policy only gradually and well after the deflation “threat” receded.
2. Inflation objectives were a big part of the problem, for both the Far Reaching Bankers of Debtor Isle and the Federal Reserve Board of real life. In either case, deflation that was imported from abroad in certain sectors was merely another window on imbalances (overconsumption funded by foreign creditors, for example) that should have led to monetary restraint, not stimulus. For the Fed, the doctrine that core inflation should be kept above 1% at the lowest (later increased to 1.5%) overrode concerns about these imbalances, which received lip service at best and outright dismissals in policymakers’ worst moments.

In other words, I’m arguing that inflation targets are too narrow to play such a large policy role. What’s more, they sometimes tell you to do the exact opposite of what you should actually be doing. Disinflation in the housing boom’s early stages was closely connected to the growing external debt that helped trigger the crisis; it was like the calm that tells you to expect a storm. But thanks to their discomfort with low inflation, policymakers felt threatened by the calm and tried to stir up a breeze just as the storm was approaching.

If you agree with this thesis, then you might have been surprised when the Fed formalized an inflation target in 2012. I certainly was. But then I thought about the heuristics and biases that cloud our ability for rational decision-making. The best explanation for the Fed’s decision to formalize inflation targeting, in my opinion, gets back to the religion analogy. Real events are no match for religious fervor. As we’ve learned from studies demonstrating confirmation bias, deeply held beliefs resist contradictory evidence. History can be written in an infinite number of ways, and people generally craft it around their pre-existing positions.

The Fed’s direction since the financial crisis seems a prime example of confirmation bias. Fed researchers produced work that absolved its interest rate policies (and inflation targets) of any responsibility for the crisis. And so it is.

How else might the Debtor Isle and U.S. FRBs have viewed their housing booms?

In David Stockman’s bestseller, The Great Deformation, he describes Fed Chairman William McChesney Martin’s decision to reign in speculative excess only four months into the recovery from the 1957-58 recession. Martin increased both interest rates and stock market margin requirements. Here’s an excerpt from Stockman:

Unlike the ineffectual baby-step hikes of 25 basis points that Alan Greenspan later favored, Martin raised the discount rate by a full percentage point on each of several occasions, and also further tightened stock market margin lending.

Moreover, these moves were decisive. In one of its post-meeting statements the Fed zeroed in directly on excessive bank lending. Unlike today’s debt-besotted central bankers, the Martin-era Fed worried about too much credit growth, not too little, saying that it was “restraining inflationary credit growth in order to foster sustainable economic growth.”

Martin’s signature definition of a central banker’s job – adjusting policy when “the party gets going” by “taking the punch bowl away”– belies the Fed’s technocratic inflation targeting of today. There’s little room anymore for a broad and old fashioned assessment of speculative excess, taking account of both credit and asset markets in addition to inflation.

And it can’t be emphasized enough (I’ve emphasized it here, here and here) that there’s a close link between the Fed’s narrowing focus and the core, theoretical models that economists developed in the decades after World War II. These model builders naïvely ignored boom-bust cycles in credit and asset markets, just as the Fed disastrously eliminated the relevance of these cycles from its policy framework. Or, more precisely, policymakers reversed Martin’s maxim, spiking the punch bowl when credit and asset markets weaken but dismissing the case for action when the “party gets going”.

Recommended links

Short of conjuring up the old school policy approaches of the past, there are indicators that we can use to understand how the Fed’s inflation target might trip us up next. And this brings me to the article I mentioned at the outset. Asset manager Jake Honeycutt recently suggested one such indicator – an alternative inflation measure. He replaces the artificial “owner-occupied rent” component of the consumer price index with direct estimates of house prices (the S&P Case/Shiller Home Price Index). He concludes that the Fed should begin tightening almost immediately, although not aggressively. Here’s his article.

Also, I don’t remember when I first thought that an island economy might be an interesting way to look at inflation targeting, but it may have been when I read this post on ZeroHedge. I saved it at the time and liked it just as much on the second read as on the first over a year ago.

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Kyle Bass: “The Next 18 Months Will Redefine Economic Orthodoxy For The West”

Tuesday, June 18th, 2013

Kyle Bass covers three critical topics in this excellent in-depth interview before turning to a very wide-ranging and interesting Q&A session. The topics he focuses on are Central bank expansion (with a mind-numbing array of awe-full numbers to explain just where the $10 trillion of freshly created money has gone), Japan’s near-term outlook (“the next 18 months in Japan will redefine the economic orthodoxy of the West”), and most importantly since, as he notes, “we are investing in things that are propped up and somewhat made up,” the psychology of negative outcomes. The latter, Bass explains, is one of the most frequently discussed topics at his firm, as he points out that “denial” is extremely popular in the financial markets.

Simply put, Bass explains, we do not want to admit that there is this serious (potentially perilous) outcome that disallows the world to continue on the way it has, and that is why so many people, whether self-preserving or self-dealing, miss all the warning signs and get this wrong – “it’s really important to understand that people do not want to come to the [quantitatively correct but potentially catastrophic] conclusion; and that’s why things are priced the way they are in the marketplace.”

2:40 Bass begins

3:15 Central Bank Expansion

“We’ve essentially printed $10 trillion in the last few years”
“The first $5 trillion replaced the lost equity in the leveraged financial system and the second $5 trillion is making its way into deposits and expanding the monetary base”
“This is unprecedented… and it’s not going to change.”

The numbers that Bass reels off are incredible…

“What we’ve seen is a massive credit-led boom (+11% CAGR) and that can’t last forever”

11:00 “The next 18 months in Japan will redefine the economic orthodoxy of the West”

“Japan is so far off the bell-curve that no one wants to talk about it”

“if you repeat things enough, everyone will believe them.”

There are three key myths about Japan that Bass shows are simply false but remain repeated for the comfort of the cognitively biased investment community:

1. The current account allows the country to self-finance its deficit
2. The Bank of Japan is not monetizing debt
3. Retail investors will always support the JGB marketplace

From the nation’s own largest institutions forced to sell assets to the crushing demographics, Bass explains – in greater clarity than the soundbite-idiocy we get each night from Abe/Kuroda/Aso etc…

The smartest money is leaving Japan in a hurry already – Q4 2012 was the largest M&A quarter ever for Japanese firms buying foreign entities – Western productive assets – (just as was seen in Mexico before their crisis) as they try to get out of JPY

25:00 The Psychology of negative outcomes

“as an investor and a fiduciary, I get paid not to be an optimist or a pessimist; I get paid to be a realist”

“Denial” is extremely popular in the financial markets.

Simply put, Bass explains, we do not want to admit that there is this serious (potentially perilous) outcome that disallows the world to continue on the way it has. and that is whay so many people, whether self-preserving or self-dealing, miss all the warning signs and get this wrong.

“no one is ever going to tell you something is wrong”

“we have blind faith in the people running our institutions…that they can figure things out. They are a mental crutch to insure and placate depositors and investors that everything is going to be ok”

“we are running a huge economic experiment,” and you can’t control it all since there are too many variables

Once you understand the psychology of the participants, the key is to understand their actions based on that.

“It is the qualitative shift in the market participants’ belief systems that literally flips a switch overnight”

Bass reminds us of Taleb’s work on central planning: “if you suppress volatility long enough, then when the ‘event’ happens it is greater than the sum total of all the suppressed vol over time.”

He warns – these shifts happen so fast that you will never get hedged or out of the way in time…

32:00 Q & A begins

First he discusses the naysayers on a Japanese bear thesis

“I would like to live in a world where it’s all rainbows and unicorns and we can make Krugman the President – but intellectually it’s simply dishonest”

“If you were advising Abe, what would you say?” – “Quit!”

41:00 General China discussion (in the context of the Japanese-China rhetoric)

43:30 Iceland – not as great as some would suggest

“China is building an embassy in Iceland that can fit 500 people in it. Iceland only has a population of 300,000!”

“You have a roach motel of a country; the New York Times and Krugman saying it’s “The Model”; but they still haven’t addressed the problem of their debt.”

46:35 Do you worry about the US?

“I quit worrying about them because it’s just a waste of time – I always leave DC demoralized”

“The central bank is the great enabler of congressional profligacy”

48:00 How does the small investor play the Japanese market – Bass responds that they can’t and shouldn’t. Shorting JGB futures means high carry costs and negative convexity

And our favorites question!!

49:00 Why can’t the Central Bank just buy all the JGBs and then forgive them?

A speechless Bass responds…

52:00 Bank VaR and under-capitalization

Well worth an hour of your time before the FOMC tomorrow…

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PENN WEST PETROLEUM (PWT.TO) TSX – Jun 18, 2013 – Newly Favoured

Tuesday, June 18th, 2013

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PENN WEST PETROLEUM (PWT.TO) TSX – Jun 18, 2013 – Newly Favoured

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When The “Worked So Far” Meme No Longer Works

Monday, June 17th, 2013

There is a potentially new macro paradigm evolving which Saxo’s Steen Jakobsen calls: Reality Hits as the Marginal Cost of Capital Normalizes. The Bermuda Triangle of Economics is that the world, so far, has been kept in artificial equilibrium by the way quantitative easing (QE) and fiscal policies bring support and endless liquidity to the 20 percent of the economy that mostly comprises large and already profitable companies and banks with good credit and good political access.

The premise for supporting these companies is based on the non-existent wealth effect which unfairly culminates in supporting the haves to the detriment of the have-nots. However, as Jakobsen notes below, things are rapidly changing.

The recent increase in yields has happened despite no real improvement in the underlying data and he sees the the next few days as potential major game changers – the bloated VaRs will make people hedge and over hedge, and the normalization process of rising risk premiums due and higher real rates (higher yield plus lower inflation) will lead to more selling off of those trades that have “worked so far”… and increase volatility in their own right.

Via Saxo’s Steen Jakobsen,

Just as I felt confident in my new macro model: The Bermuda Triangle of Economics, or BTE, the market cycles are changing again. But this recent potential macro paradigm shift is interesting and can also be explained by the BTE model. I call this new phase in the market: Reality Hits as the Marginal Cost of Capital Normalises.

…

The world, so far, has been kept in artificial equilibrium by the way quantitative easing (QE) and fiscal policies bring support and endless liquidity to the 20 percent of the economy that mostly comprises large and already profitable companies and banks with good credit and good political access. The premise for supporting these companies is based on the non-existent wealth effect which unfairly culminates in supporting the haves to the detriment of the have-nots.

Meanwhile, the 80 percent of the economy that is composed of productive, innovative, job-creating and less capital intensive small and medium-sized enterprises has been left to fend for itself. This segment is starved of credit and the upshot is the current malaise of low innovation and high unemployment.

Meanwhile, despite the economic distress, we have nothing but silence on the social discontent front, which can only be explained by the “success” of generous entitlements in the developed economies. Indeed, we are the Entitlement Generation. We are not compelled to challenge the government and central bank policies when more than fifty percent of the population benefits from income transfers directly from the state. This is a proof of the old game theory idea that the individual can be rational while the sum of individuals’ behaviour is irrational.

What would upset this equilibrium?

…

the real tipping point for the old paradigm is only reached via an increase in market volatility – something that appears to be unfolding at the moment.

This is the point at which the market feeds back into the fundamentals by disturbing the false calm of equilibrium through a bloating of Value-at-risk (VaR) models.

When the market gets more nervous, volatility rises and the market jumps back and forth in a discontinuous fashion, moving away from the previous, very long one-way street lower driven by the compression of the risk premium from policy intervention and the resultant yield chasing (combined with benign inflation from the output gap). The culprit for this bout of volatility? Abenomics!

JGB contract historic volatility 50 and 100 days….(Source: Bloomberg LLP)

For all its success in getting the Nikkei higher – and until recently, USDJPY as well, Abenomics also dramatically increased volatility in Japanese government bonds (JGBs), which was certainly not the intention. This increase in JGB volatility had people like me going short USDJPY as this acts as a brake on the simple idea that the USDJPY is a straightforward carry trade driven by the anticipation that Abenomics will have Japan having its cake and eating it too. When bond market volatility jumps, carry trades head south fast. And note how the JGB volatility saw contagion in the US bond market, with the US 30-year mortgage bond yield spiking 76 basis points recently.

The benchmark US 10-year US T-note has moved so much that the world’s most famous bond investor, Bill Gross, has lost 335 bps in his PIMCO Total Return Fund from this year’s high in April. And he is down 169 basis points for the year-to-date in a fund that is known for its stability

…

30-year US Mortgage rate (Source: Bankrate)

…

So in short, the dramatic changes to fixed income and overall market volatility probably had 70 percent to do with the failure thus far of Abenomics to perpetuate the themes of QE and easy money. The reason for this (as I have stated several times) is that Japan has come far too late to the party.

…

What makes Japan’s timing even worse is the fact that risk premiums were already extremely compressed – meaning that they were pushing on a string from the very start as macro players were already gunning for yield and leveraged to the hilt.

Look at corporate and investment yield tickers like HYG and LQD, both of which are down in excess of five percent from the top. So what we are seeing now is also a “normalisation of risk premiums” – which is long-term very healthy and could at best mean that we are moving towards real “price discovery” again in the fixed income market. This will mean that we may begin to know the real price of money both in time and yield – at least in those sectors outside the control of the silly central bankers.

The other major area I want to touch on which makes this move in yield truly alarming is the trend in global current accounts. I have said a few times that the lack of recycling going forward is a major issue not only for the US, but certainly for all current account-deficit countries. (This has been a major drive for the sell-off in emerging market assets and currencies.)

The trend is clear: From surpluses of five to seven percent of GDP – ergo, savings excess that needed to be recycled into US government bonds to avoid currency appreciation, Asia is barely showing a surplus and Brazil, Russia, India and China (the BRICs) will in my estimation move to a collective deficit inside the next 12 months, with Japan joining them on the current account deficit side. This means the biggest traditional institutional buyers of government debt have effectively disappeared, and may begin to even sell their holdings.

Are you worried yet? You should be.

The final straw
Looking at the US economy, the recent increase in yield has happened despite no real improvement in the underlying data. Imagine if the US economy started to slowly pick up from these low levels of activity over the summer due to lower energy prices, a “feel-good factor” in confidence, and a slightly better housing market.

Are you ready for a three percent 10-year yield and a five percent 30-year mortgage rate in an economy with less than two percent real growth?

Probably not, because no one else is either.

Conclusion
I see the next few days as potential major game changers – the bloated VaRs will make people hedge and over hedge, and the normalisation process of rising risk premiums due and higher real rates (higher yield plus lower inflation) will lead to more selling off of those trades that have “worked so far”… and increase volatility in their own right.

I have not even mentioned the constitutional court ruling in Karlsruhe which the Anglo-Saxon press and banks with their usual naïveté of everything German have written off as a non-event. Reading Der Spiegel last night I got concerned about the consensus but judge for yourself. These are very much Decisive days for Euro: High Court considers ECB Bond buys.

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JPMorgan: “Fed Stimulus Inflated Prices Of Financial Assets…. Removal Could Create Tail Event”

Monday, June 17th, 2013

Then: Risk-On/Risk-Off. JPMorgan’s Marko Kolanovic head of Equity Derivatives Strategy explains:

Over the last 5 years, Treasuries and Equities had strong negative correlation. This was the risk-on / risk-off (RORO regime) in which Treasuries were the most broadly used ‘safe haven’ asset. In the RORO regime, investors would hold treasuries and sell them to buy risky assets (and vice versa) while being reassured that Fed will keep the price of Treasuries supported. While we are still on average in a RORO regime, the bond-equity correlation started significantly weakening due to increased risk of Fed tapering and a bond selloff. The effect of the Fed reducing the stimulus could result in lower bond prices as well as lower prices of stocks, commodities and other risky assets whose prices were inflated by the Fed’s stimulus.

Over the past month, in several instances bonds and stocks moved together as investors re-assessed the probability of early tapering. Figure 1 below shows equity-bond correlation (calculated from high frequency intraday data). Correlation turned positive on May 9, 22, and 31 and most recently over the past few days. May 9th and 31st brought better than expected macro data (jobless claims, consumer confidence and Chicago PMI). Ironically, positive data caused equities and bonds to trade lower on increased probability of tapering (good data were bad for stocks). Similarly, on May 22nd, bonds and stocks sold off as Bernanke indicated the possibility of tapering over the next few meetings.

And Now: the “Fed Regime“

A byproduct of these new bond-equity dynamics is that USD is losing its status as a ‘risk off’ currency. As expectations of more (less) stimulus pushes up (down) treasuries and US stocks (both USD denominated), resulting currency flows are weakening the historical negative USD-Equity correlation. Historically, USD had strong negative correlation to equities (i.e. EUR and EM currencies had a positive correlation to equities). This recent relationship is now undermined as treasuries are losing their appeal as a safety asset. This weakening of EM FX and EUR correlation to the S&P 500 (Figure 2) was also helped by investors putting money in US stocks, while avoiding European and Emerging markets in the last leg of market rally.

Fears of Fed tapering the massive QE program is now changing bond-equity correlation from a RORO regime towards a ‘Fed Model’ regime (coincidentally, the name ‘Fed Model’ was crafted in 90s long before invention of quantitative easing). We do not think equity-rate correlation will fully revert back to the ‘Fed Model’ regime, but the recent spikes in rate-equity correlation are worrying signs. Recent bouts of positive correlation of equities, bonds and commodities, suggest that the Fed’s stimulus inflated prices of a broad range of financial assets, and removal of the stimulus could create a tail event in which prices of all assets could go down. While it is expected that the Fed will try to avoid such a scenario by maintaining an appropriate level of stimulus, in the absence of more robust growth, this may turn out to be a difficult task (akin to driving a car without brakes). On this account, we expect more volatility in H2 as compared to the first part of the year. To reduce risk of a bond and equity tail event, investors could diversify ‘safe haven’ assets away from treasuries and into other assets that are at lower risk in case of tapering. For instance investors could increase allocations to cash or Equity Put options.

Helpful. It also appears that Marko and Tom Lee, who sees nothing but smooth sailing from here until S&P 2,000, don’t talk much.

And just so the message of JPM’s derivatives group is clear, they look at the unprecedented (and previously documented) surge in NYSE margin debt, which has risen at the fastest pace ever so far in 2013, and analyze the empirical evidence of what happens after such a radid move. The result is below:

Last month, NYSE published April data on aggregate debt balances in stock margin accounts. This measure shows how much funds were borrowed to purchase securities, and it reached all time high of $384bn. Net margin debt (calculated as a difference of debt in margin accounts and all credit balances) also reached a high level of $106bn, and the pace of net margin debt increase YTD ($87bn) was the highest on record. We have been asked whether this increase in leverage is a sign of an impending market selloff. To analyze the relationship between S&P 500 prices and margin debt we look at their historical levels over the last 15 years. Figure 7 shows a strong correlation between S&P 500 and NYSE net margin debit. Positive correlation between the S&P 500 and net margin debt indicates that clients tend to finance a fraction of their equity exposure with margin debt. We also note that peaks in margin debt are usually followed with a sharp market correction. However, this on its own does not imply that high margin debt leads to market correction (given the positive correlation of net margin debt and S&P 500, highs in margin debt coincide with highs in S&P 500).

To test for a causal relationship we looked at the changes in net margin debt against S&P 500 performance 3, 6 and 9 months afterwards. Figure 8 shows that large increases of net margin debt are indeed on average followed by weak equity returns. Note that the YTD increase of margin debt is the highest on record, as indicated by the arrow.

Another test we performed is to look at levels of margin debt normalized by the level of the S&P 500. Dividing margin debt by the level of the S&P 500 may give a more accurate measure of leverage (by remove the bias coming from correlation of S&P 500 and margin debt levels).

Figure 9 shows the ratio of margin debt to S&P 500 (red) as well as ratio of net margin debt to S&P 500 (blue). One can see that these normalized measures of leverage peaked prior to the tech bubble burst, in H2 2007 and H1 2008, and in H1 of 2011 – in all cases ahead of significant market corrections. While these are effectively only three data points and hence do not amount to a reliable statistical sample, we think that the quick increase of net margin debt, and high ratio of margin debt to S&P 500 do point to an increased probability of a market correction and volatility increase in the second half of the year.

But don’t worry. The Fed is on top of it. All of it.

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Jeffrey Saut: “The Game of Risk”

Monday, June 17th, 2013

The Game of Risk

by Jeffrey Saut, Chief Investment Strategist, Raymond James

June 17, 2013

“To be sure, there is no exact definition of what ‘calling’ a market top or bottom involves. In the case of the March 2009 bear market bottom, for example, does ‘calling’ it mean the adviser’s portfolio needs to have moved from being all cash to 100% invested in stocks on the exact day of the bottom? If my analysis had relied on a definition as demanding as this, then it wouldn’t be surprising that no timers called recent market turning points. But my analysis actually relied on a far more relaxed definition: Instead of moving 100% from cash to stocks in the case of a bottom, or 100% the other way in the case of a top, I allowed exposure changes of just ten percentage points to qualify. Furthermore, rather than requiring the change in exposure to occur on the exact day of the market’s top or bottom, I looked at a month-long trading window that began before the market’s juncture and extending a couple of weeks thereafter. Even with these relaxed criteria, however, none of the market timers that the Hulbert Financial Digest has tracked over the last decade were able to call the market tops and bottoms since March 2000. These results add up to perhaps the most important investment lesson of all that: predicting turns in the market is incredibly difficult to do consistently well.”

… Mark Hulbert, MarketWatch (3/10/10)

The above excerpt was penned by Mark Hulbert in an article titled “Fools R Us.” Appropriately, that article ran in a MarketWatch column on the 10-year anniversary of the NASDAQ Composite’s peak of March 10, 2000. Ten years ago the COMP was changing hands around 5132. It is now trading at 3423 for a 13-year loss of some 33.3%. Meanwhile, over that same timeframe, the earnings of the S&P 500 are up 83%, nominal GDP is better by some 57.6%, and interest rates are substantially below where they were back then. If you are a college professor such statistics do not “foot” with your teachings because professors tend to believe stock returns are all about earnings and interest rates. I concur, but would add the caveat, “That is if you live long enough.” As money manager Greg Evans, eponymous captain of Millstone Evans in Boulder Colorado, writes:

“Hey Jeff, I enjoyed your missive on Mr. Market. I use that Warren Buffet allegory quite a bit with clients. One interesting statistic on Berkshire is that its stock price was $38 in 1968 and 8 years later, after trading higher and lower, ended up (again) at $38. Most clients would look at that (performance) and say – it hasn’t done anything for 8 years so I am going to sell. But an astute investor, looking at the underlying growth in book value, would see an average annual growth rate of 14.6% over those 8 years and conclude they should buy more. As to your point that over the long-term stock prices are ultimately determined by their book value, earnings and cash flows, I have often run numbers on stocks over a 25-year time frame to show to clients. For example, Coca-Cola’s stock price in 1983 was $5.10 (midpoint); and, Coke earned $0.30 per share that year. The stock price today is ~$40, and they earned $1.97 last year. That’s about a 15% annualized growth rate on the stock price; and, a ~15% growth rate on earnings – QED.”

Surprisingly, however, if an investor bought Coke shares at their peak price in 1972, over the next 12 years the company compounded earnings at nearly double-digit rates (with only four down quarters), yet said shareholders actually lost money. The reason was “Mr. Market” was unwilling to capitalize that improvement in earnings anywhere near the P/E multiple of 1972. Regrettably, “Mr. Market” is indeed manic depressive, which is why the stock market is truly fear, hope and greed only loosely connected to the business cycle. And that, ladies and gentlemen, is why the successful investor needs to learn how to manage risk. As Benjamin Graham wrote, “The essence of investment management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.”

Clearly, Warren Buffet understands this “management of risk” concept for he too has learned when to “play hard” and when not to “play.” Decidedly, his insight to hoard cash, and shun internet stocks, in the late 1990s was brilliant, yet it was greeted with catcalls that “the old man has lost his touch and just doesn’t understand the Internet age.” However, investors benefitted handsomely if they heeded his advice. Enter the aforementioned quote from Mark Hulbert espousing the old market axiom, “It’s TIME in the market, not TIMING the market.” Typically such comments are accompanied with the verbiage, “If you missed the 10 best stock market sessions of the year it kills your returns.” To be sure, over the 25-year period ending on 12/31/2011 the buy and hold investor saw returns of 6.81% per year. But, if you missed the 10 best sessions your annualized return falls to 3.67%. Miss the 20 best and you experienced only a 1.65% yearly gain, and missing the 40 best yields a negative 1.62% return. However, miss the 10 worst days and a prescient investor realized a 10.89% per annum gain, while missing the 40 worst shows annualized returns leaping to a 17.74% – according to a study from Hepburn Capital Management – thus proving the management of “risks” is more important than the management of “returns” (see chart on page 3).

That said, while I too don’t believe anyone can consistently “time” the stock market, I do believe in Dow Theory. Dow Theory is like a roadmap for the “primary trend” of the stock market. Recall, Dow Theory gave you a “sell signal” in September 1999 (albeit three quarters too soon), a “buy signal” in June 2003 (a few months too late), and again a “sell signal” in November 2007 (note, it is not Jeff Saut “calling” the stock market, but Dow Theory). More importantly, the Dow Theory “buy signal” of earlier this year remains in force. Nevertheless, I continue to think we are in a short/intermediate “topping” process. The timing models that have worked so well year to date targeted June 11/12th as the days that a feint to the downside would start. While I had thought the convening of the German Constitutional Court would be the causa proxima, it turned out to be Japan and its statement that it would not increase the monetary stimulus operations. Subsequently, in Friday morning’s verbal strategy comments, I said:

“I think we are going to limp around and then try for the reaction high of 1687. If we don’t make a higher high on that attempt, and turn down from there, then the mid-July swoon I have been targeting will arrive prematurely. However, if we do make a higher high it probably means we are still going up to make a new high into the first or second week of July and then start the swoon. Indeed, I have mixed signals into the end of this week (meaning last week), as well as mixed signals into the beginning of next week (meaning this week). So, it would not surprise me to see the upside action fizzle today (last Friday) and have the market limp around with attempts to sell off into early next week. However, there are much more positive timing point signals coming next week (aka, this week), so my hunch is that the SPX limps for a few sessions and then starts to push higher.”

And while Friday’s Fade (-106 points) wasn’t much of a “limp,” Thursday’s upside action surely fizzled.

The call for this week: Nassim Taleb (trader extraordinaire) has 10 rules. Rule number 8 reads: “Always protect the downside. As pointed out ad nauseum, Black Swans do occur. No matter how much you test, there will be a ‘this time is different’ moment forcing your bank account into oblivion. No matter how confident, always protect the downside.” I agree with Taleb’s comments and therefore always try to “look” down before looking up in an attempt to manage the risk. As for the here and now, as I said on Friday, “It would not surprise me to see the upside action fizzle today (last Friday) and have the market limp around with attempts to sell off into early next week. However, there are much more positive timing point signals coming next week (aka, this week), so my hunch is that the SPX limps for a few sessions and then starts to push higher.” And this morning “higher” is the watchword as last week’s “taper tantrum” is fading on rumors of a softer Fed at this week’s meeting, leaving the preopening S&P 500 futures up about 12 points.

Click here to enlarge

Click here to enlarge

Copyright © Raymond James

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MAGNA INTL INC. (MG.TO) TSX – Jun 17, 2013

Monday, June 17th, 2013

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MAGNA INTL INC. (MG.TO) TSX – Jun 17, 2013 – Favoured

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MAGNA INTL INC. (MG.TO) TSX – Jun 17, 2013

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A Sweet Find on an African Adventure

Monday, June 17th, 2013

A Sweet Find on an African Adventure

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

After traveling nearly 6,000 miles by plane, helicopter and jeep, Evan Smith, portfolio manager at U.S. Global, is walking along a dirt path in Kenema past dilapidated shops covered with rusted, corrugated metal. He can hardly believe he has arrived at his destination. Surrounded by hundreds of miles of forest and savannah, it’s tough to imagine an agricultural diamond-in-the-rough nearby.

Kenema is in Sierra Leone, a country in the Western part of sub-Saharan Africa with 5.6 million people recovering from a decade-long civil war that ended 11 years ago. Today, the rural people, mostly farmers and fishermen, are peaceful and friendly, says Evan, who explored the opportunity for the Global Resources Fund (PSPFX).

To get here, Evan flew from San Antonio, Texas to the largest city in Sierra Leone, Freetown, making stops in New York City, Ghana and Liberia. Then he boarded a four-person helicopter to fly east 150 miles, enduring heart-pounding drops and lifts between clouds and mountains before safely arriving at a cocoa plantation development.

The heart of Africa has been beating strong in recent years due to elevated commodity prices and resilient domestic demand, despite the global economic slowdown. Among the sub-Saharan African countries, Sierra Leone was the fastest growing country last year, according to the World Bank. Its economy experienced growth that is as rare today as Fancy Red diamonds. GDP increased a whopping 18 percent.

Non-profit organizations are taking note of the country’s progress. The Freedom House recently categorized Sierra Leone as a free country, which is unusual in sub-Saharan Africa. Among 50 countries and 900 million people, only 13 percent of people are considered free under the organization’s definition.

Sierra Leone is also becoming more attractive for business. In the World Bank’s Doing Business 2013 report, the country ranked 140, up from 148. One of its main findings this year is that “among the 50 economies with the biggest improvements since 2005, the largest share—a third—are in sub-Saharan Africa.”

Looking ahead, these countries are expected to be among the fastest growing economies in the world. The International Monetary Fund estimates that out of the top 20 countries with the highest projected compound annual growth rate from 2013 through 2017, 10 are in this area of the world.

This is the growth Agriterra is looking to capture in its development of a cocoa plantation that Evan traveled across the Atlantic Ocean to check out. Agriterra is a London-based company that invests in African agricultural businesses to serve the fast-growing economies of frontier markets, such as Mozambique and Sierra Leone.

When Evan toured the grounds, he snapped pictures of the initial stages of development, as the company nurtures 250,000 seedlings in a technically advanced and irrigated nursery. Each cocoa sprout is planted in its own bag, under a canopy of screens which provides just the right amount of light. An irrigation system nourishes the plants, delivering the perfect amount of water and fertilizer.

After a few months, the seedlings will be mature enough to be transplanted to an area that provides the right amount of shade. You can see a three-meter grid of stakes designating where each plant will go in this photo below.

You may not think about where your Godiva chocolate originates, but the areas are limited. Cocoa grows best along the equator belt between the Tropic of Cancer and Tropic of Capricorn. Tropical conditions of plentiful rain and high humidity are ideal and “shading is indispensable in a cocoa tree’s early years,” says the International Cocoa Organization (ICC).

While Sierra Leone is geographically situated along this band, it isn’t among the largest cocoa-producing countries. Most of the world’s chocolate originates from beans grown in Côte d’Ivoire, Ghana and Indonesia. Cocoa has traditionally been raised on small, individually owned farms, many of which have aging plants and therefore, lower yields. But with Agriterra’s advanced applications and solid operations, the development seems to be off to a sweet start.

So why is an oil and materials manager getting his boots dirty in Sierra Leone? The cocoa plantation is only one example of a company producing a commodity that we believe will be sought by the world’s growing middle class population. As more and more people reach this status, consumption of discretionary items, including chocolate, should increase.

Rather than limit the fund to energy and materials stocks, the portfolio managers take a multi-faceted approach, looking at 10 industries. By including companies such as grain processors, plantations and ranch lands, and agriculture companies, such as chemical and fertilizer stocks, we believe the fund can enhance returns with less volatility.

That’s why we keep our eyes open and boots on the ground because you never know where in the world you’ll find a sweet or savory opportunity.

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