Behavioral Macro

Around the same time every winter I have the great fortune of getting together with a small group of ex-colleagues/friends from Hedgistan in an undisclosed mountain location for skiing and the best hot chocolate on the planet. And market talk. Lots of market talk.

It always ends up bearish. I don’t know if it’s the calendar or some kind of perverse self-selection process, but by the time we’re ready to head home it seems that the end of the world is always nigh. And, just as regularly, the trip is usually followed by a short-term market bottom. Let’s hope that happens again this year–or I’m going to have get a bigger bunker.

Market topics this year ranged through the ones you’d expect: Chinese capital flight, profit margin reversion, US recession/no recession, income/wealth inequality, technology and globalization. Honestly, fun and stimulating though it was, we came away with no iron clad answers. Except one.

As you’d also expect, we talked a bit about oil as well. What would end the bear market? Would Saudi and Russia combine forces and reduce supply? How quickly can shale producers turn production on and off? But on this subject we came away with an answer, something wiser (not smarter, wiser) market types have been susurrating for several months: the supply pressures won’t stop until debt-financed production becomes equity-financed production. It really is that simple.

The reasoning is clear: We know you can’t hold back production to get higher prices later if you have debt to service. Only equity financed production has that luxury.

The process is also clear: The highly leveraged producers drown each other with supply in an attempt to be the last man floating, but ultimately all sink. The equity holders get wiped out and the bond holders become the new equity holders in exchange for writing off their debt claims.
Sometimes the new equity holders sell their claims to others in the process. Sometimes they hold on. But either way the new owners have made time their friend instead of their enemy.

This debt for equity swap is the sine qua non for swing production to begin the long awaited, over forecast pull back in supply.

Did you see what just happened to the stock prices of Chesapeake Energy and others producers of its ilk?

The process started today.

NB: I am not saying buy oil today, that oil will be a moon shot, or that the process will be rapid or clean. In fact, the ability of shale producers with today’s technology to ‘turn the spigots back on’ very quickly should dampen any large upward thrust in the price of crude. ‘L’ is still more
likely than ‘V’. But at least it begins the process. And maybe with it we can hope against hope that the correlation between crude oil and other risk assets can begin their process of reverting to their means.

Bring on the bankruptcies.

Apologies to those who have heard me make this argument and to those who have figured this out already. You all can stop here. Others may want to read on.

The Brazilian economy boomed in the decade that started in 2003. The story was they were selling iron ore and soy beans to China and this drove growth. Simple, intuitive, compelling–and demonstrably wrong.

Brazil’s a closed economy in terms of exports as a share of GDP, but, tellingly, it became even more closed over the course of the boom. In 2003, Brazilian exports amounted to 15% of GDP. And while this is fairly closed as economies go, the part that many will find counter-intuitive is that this ratio fell to 11% by the end of the boom. Even if you adjust for exchange rate/terms of trade moves, it strains credulity to ascribe the Brazilian boom to its exports.

What did drive growth, then? Simple: domestic credit. As part of the massive global financialization that led to the Global Financial Crisis in developed economies, emerging markets, importing many of the very same ‘financial innovations’, saw cohorts that had never previously had access to credit buy on installment. Successful macro stabilization polices across EM in the early 2000s added a Minsky element to the borrowing spree.

And boy did they go on a spree. Brazil, Turkey, South Africa, Korea, etc. ‘enjoyed’ unprecedented consumer credit booms. (China had a credit boom as well, but of a slightly different nature.)

In the case of Brazil, domestic credit to the private sector grew from 28% of GDP at the beginning of the boom to 70% by 2014. This series makes it pretty hard to argue Brazil’s boom was export led. (In the case of Turkey, this ratio went from 14% to 74% over the same period.)

This is not about making the bull case for Brazil. In fact, that it is about working out from under a rapid rise in domestic credit arguably makes it a tougher slog and more prone to policy errors. But if you understand that domestic credit to the private sector, not exports to China, drove the boom, you’ll have a better idea of what to look for when the next turn comes.

We just had our avalanche–albeit stronger and faster than desirable. Now we brace for the feedback effects, against backdrop of an anemic ROW and structurally low domestic growth. And we hope it doesn’t push us into recession.

Feedback loops matter. Media, social media, technology and globalization have amplified the echo chamber, making these loops much more emotional and powerful than they used to be. They are highly path dependent and behavioral in nature, further complicating analysis. International linkages–both real and financial—play a larger role in today’s world too.

Yet, these dynamics notwithstanding, the absence of the real-economy optimism on which economic cycles die suggests to me that the US will avoid recession. But reducing financial stability risk increases financial volatility and the risks to my view are to the downside.

One final consideration is the counterfactual: had the FOMC waited until later to shake the tree with the first rate hike, odds are the avalanche would have been yet larger. And larger avalanches mean larger feedback loops.

Keeping financial stability risks from rising without damaging the long, sub-par domestic economic cycle is a challenging balancing act, but this is what Yellen’s FOMC wants.

The Fed decided to keep rates on hold today. More
surprising, they didn’t start laying the groundwork for October. This increases
the odds of a December hike.

The key elements holding the Fed back are international
weakness and stubbornly low inflation.

In the presser, Chair Yellen made it clear that the FOMC
would still like to see further strengthening of the labor market. She
indicated that they had already seen enough labor improvement to meet the
standard that had been looking for until recently, but, in light of increased
global growth concerns, they now feel they need more labor market strength to bolster
our ‘insulation’ from global vagaries.

On inflation, Chair Yellen addressed the
uncertainties regarding the weak link between monetary policy and inflation.
She reiterated the FOMC’s expectation that continued improvement in the labor
market and the fading of transitory commodity price effects would still, ultimately,
allow inflation to get back on a path up toward 2%. 

But, reading between the
lines, she sounded less confident on this point than ever.  And it is not clear if their Plan B is ‘zero
for longer’, or ‘leap of faith’. Watch this space. If inflation doesn’t respond
as the FOMC expects, the bar for labor market strength and calmer international
waters will likely be raised yet further.

Labor Day is behind us. It’s time to put down the grilling tongs and put your game face back on. Here an interview that covers the three factors that the big institutional gorillas are likely to look for before structurally allocating to emerging markets again, hosted by Drew Voros and ETF.com. The recommendation in the last para is, of course, theirs.

http://www.etf.com/publications/alpha-think-tank/alpha-articles/mark-dow-3-things-emerging-markets-need-rebound?nopaging=1

Smart guys are the most dangerous. They are the most prone to overconfidence and the most susceptible to overthinking–both deadly sins in money management.

Nowhere does overthinking seem more prevalent than in global macro. The less one knows about a topic, the easier it is to elaborate a story that fits one’s biases and ideology. And there is no shortage of people who are trying to make a living pitching to our knowledge gaps and darker instincts. These days, terrifying macro stories rush to fill our information void with disturbing speed and regularity.

My response: fight to keep it simple. And I say fight because I have the same basic impulses as everyone else. It is extremely hard to not overthink—all the more so if one has a deeply ingrained fundamental background.

‘Keeping it simple’ for me means latching onto a couple of overarching themes in which I believe strongly and using them to tune out as best I can the macro noise du jour.

In today’s environment, the anchor themes are two.

1. Disaster Myopia. We are still living in the long shadow of the global financial crisis. Six years have passed, but we still return to ‘that place’ far too quickly. Worst case scenario, daily. This ease of recall induces us to over forecast tail events—even if Macroggeddon is 0 for 500 by now. Erring on the side of optimism is still the money trade.
2. Longest, shallowest cycle ever. The world continues its deleveraging. The US appears to be leading the rest of the world in the process.  But the extrapolation of growth optimism on which all cycles end is just not there in the US—or anywhere else for that matter. And it doesn’t seem imminent, either. This implies two things: (1) the odds of a new recession in the US are low (you can’t commit suicide jumping out of the basement window), and (2) since bear markets typically come when economic cycles turn, a bear market in US equities is unlikely until the economy gets jacked up on excessive investment and hiring.

Yes, a lot of nuance is lost in these two points. But a lot of noise is left out too. Remember, it is easy to find reasons to sell; what’s hard is finding reasons not to every single day. Experienced investors know that riding winners is far harder than cutting losses. So, when your core theses prove broadly right, they are worth clinging to. It’s your best defense against getting chopped up and lost in the weeds.

No note on currencies can be taken seriously these days without at the outset swearing fealty to the mighty greenback. In short, it seems the state of the currency is sound.

And I don’t disagree. The medium term fundamentals, in terms of interest rates and growth, do still favor the USD. But does this mean it will continue to rise? Currencies are fickle things. Expectations play an outsized role in an asset class where there is no tangible value or hard measurement. And everyone has baked a stronger USD into their base case for whatever they’re doing. Everyone. Current expectations have set a high bar for dollar appreciation.

This is the story I could easily see playing out in currencies in the coming weeks/months, given current expectations and positioning. And it is not bullish the USD.

1. US rate hike. The most dollar bullish scenario is the one where the FOMC hikes in September. No one anywhere would be truly surprised if the Fed hikes rates next month. It may only be about a 60/40 proposition, but no one would be left slack-jawed. Okay, maybe there are a handful of QE4EVA crazies somewhere huddled in a bunker with Obama birthers insisting they will still be vindicated. But if the FOMC raises rates in September—or the market starts to price a much higher September probability—and it fails to boost the dollar further, there will be a lot of investors bailing out of their entrenched long USD positions, most of which are predicated on higher rates.
2. Pace of hikes. It seems unlikely that the FOMC will indicate a pace of hikes aggressive enough to sustain the degree of positioning and sentiment that is currently behind the long USD trade, especially, if, as I suspect, the Fed is hiking more as avalanche protection and not because they fear economic overheating.
3. European growth. Much of the dollar’s rise has been Europe’s fall. And expectations in Europe are now very low. Less recession would constitute a win there. Moreover, Greece has been taken off the table as a systemic risk and the ECB have made it clear that they will protect sovereign spreads if pressured. This means EZ breakup can only come from within, in response to protracted worse-than-expected growth. This risk is real, but it is likely much, much further down the road now.  Lots of room for surprise to the upside.

It’s always a dicey call to fade the fundamentals—even after a big run. But when sentiment, positioning, and expectations rise to certain levels they require ever more powerful news to be maintained.

It wouldn’t take much here to send to USD longs/EUR shorts into a scramble. And it would take even less to make a compelling narrative out of it.

The modern Chinese economic era really kicked off when it joined the WTO in 2001. This launched China’s integration into the global goods market.

It soon became a force. And the supporting exchange rate policy was simple: keep the currency weak—especially with respect to the dollar–in order to extend and protect China’s competitiveness advantage. Buy as many dollars as needed to make it happen. Invest the dollars into Treasuries.

By 2005-06 China seemed the dominant force in global trade and its exchange rate regime was receiving a lot of unwelcome political attention, most notably from Washington. Economists and politicians across the globe started to argue that China’s FX regime was fostering significant global imbalances, was not sustainable, and was not in China’s long-term interests.

Even though these pleas did not change China’s mercantilist mindset—after all, why change when times are good—China did cede to the political pressure and allowed CNY to begin to appreciate against the dollar.

But the change of heart didn’t come until later. In the global financial crisis of 2008-09, China saw the US wobble, Europe stumble, and Japan lie there without a pulse. Suddenly, for the first time in a long while, China felt vulnerable. With its major export destinations under enormous demand pressure, China was forced to face up to rebalancing.

In that connection, China did two things: launch massive credit stimulus and, starting around 2010, alter its exchange rate regime.

Instead of trying to keep the currency artificially deprecated, the new policy was to allow FX appreciation in order to support consumption, the new growth engine. This policy would also facilitate rebalancing and to put reform pressure on the Export Machine, in the hopes of catalyzing faster productivity gains for the overall economy.

And what an appreciation it was. From 2010 until last week, CNY appreciated some 13% against the USD, while, in turn, the USD appreciated 20% against the euro and over 30% against the yen. The real broad effective exchange rate for China appreciated more than 30% over this period.

But that’s not the whole story. The total effective loss of competitiveness was considerably more. Wage gains in China in this same period were outstripping inflation by 8-10% a year. Even if you generously adjust for productivity gains and modest foreign wage rises, you end up with an annual ‘loss of competitiveness’ of at least 8-10%. Compound that.

All in, this was a meaningful strengthening—even when taking into account China’s depreciated starting point. And it’s a move China would have never allowed if they were still perusing the mercantilist exchange rate policy of the earlier years.

So, is China’s currency now overvalued? Probably, but hard to say how much. China’s current account is still in surplus (see below)—and this in the face of weak partner country demand.  (Then again, it is tough to know how much moderate over/undervaluation matters in a country where the import content in exports might still be as high as 50%.)

On the other hand, the capital account has had outflows, as many Chinese have been buying assets abroad. It is hard to say how much of this is a desire to protect wealth and how much is FX-induced attractive pricing. Nonetheless, these capital account outflows have been behind the BOP pressures that led to the reserve requirement rate (RRR) cuts, and, to some degree, last week’s decision to end the policy of selling dollars to keep CNY strategically stronger than it otherwise would be.

China seems to have decided that running your exchange rate too hot or too cold can have undesirable consequences. It’s no longer about poaching exports or stimulating consumption; it’s more about letting the exchange rate help the economy find balance in a complicated world. Moreover, if in adopting a more balanced and market-based FX regime China can gain economic stature and enhance prospects for becoming a reserve currency, in China’s eyes, all the better.

This doesn’t mean that the PBOC is done intervening. They most certainly will want to ensure an orderly FX market without excessive volatility. But it does suggest they have made a quantum leap away from using the FX regime heavy-handedly to engineer outcomes. This, to me, seems like a positive development for China—despite its secular growth problem—as well as a positive one for the world. Something free marketers should welcome. This is an emerging market devaluation that has reduced global risks, not increased them. Nor has it presaged, IMO, a return of the contagion-driven emerging market crises of yesteryear.

Twice I remember reports of silver coin shortages. I vaguely remember a third, but was unable to verify. The first was in January 2013. I remember it well because of the size of the short positions in precious metals I was carrying at the time. The 2013 shortage was touted as a sign of sharply increased demand, foreshadowing a sharp price appreciation ahead.  In the event, precious metals had their worst few months ever, culminating in the waterfall decline of mid-April.

The most recent case was in early July, on the 7th. The US Mint again announced they had sold out of silver coins. It was met with a similar response from the usual commentators: harbinger of sharp price rises.

Precious metals then went on to have the roughest month since 2013, losing some 7 percent. For reference, the euro declined by about 1 percent over the same period and the yen, less than 1 percent.

To be honest, I can’t for the life of me come up with a compelling story as to why retail demand for silver coins might presage a price decline—other than mumbling something weak about dumb money.

Fear not, though, I’m sure there will be no shortage of conspiracy types who will step in and fill the void with different stories having the same conclusion, so stay tuned. As for me, for now, I’m going to lock up a physical copy of the relevant material in my secret locker in Area 51, pending further investigation.

Markets are about discounting the future. Analysis, however, starts by looking backward. When forming views for the first time we tend to get out the rear view mirror, focus on the parallel that pops most readily to mind, and then—at least initially—overstate the linkage. Most by now will recognize this as the availabity heuristic; it’s also why there is always a 1929 market somewhere.

Emerging markets are in a serious bear market, and have been for a few years (2011 for equities, since the 2013 Taper Tantrum for local currency fixed income). And old hands in emerging markets are seeing an embarrassment of riches in the rear view mirror. Some are even drooling for the kind of blood-on-the-street opportunities on which so many EM types have made their (our) bones.

But there are good reasons to believe emerging markets this time around are not going to experience the kind of crashes, deep recessions, and defaults that they are famous for. Yes, I am saying it’s different this time.

First, the negative. We had a bull market and massive inflows for some 12 years, in which higher prices flattered our perception of the fundamentals. Now we’re clearly on the downside, when investors turn more bearish as outflows intensify and price action worsens. Self-reinforcing markets are not pretty, but it’s how they work.

I don’t mean to suggest the fundamentals are good. They are not. The basic case that obtained in 2012 is still in place. It is spelled out here, here and, in the important case of China, here.

Moreover, the conditions necessary to begin to attract flows back to the asset class just aren’t there. Yes, some were tempted at the beginning of the year to make the contrarian call in the beat up asset class, but those inflows are already part of today’s outflows. For inflows to be
sustained, some combination of three things needs to work in your favor:

1. An end to US interest rate hikes. We don’t actually have to see the end of the hiking cycle, but we have to at least be able to form a confident guess about it, in terms of both time and terminal rate.  We need to have a view on what the end looks like. For now, we are still trying to figure out what the beginning looks like.
2. A weakening US dollar. Returns in EM equities and local fixed income are overwhelmingly driven by currencies. The dollar is in a bull market. Even if it weren’t to go too much further or faster, big money allocators will be loath to step in front of it until they are beat over the head with signs that it has reversed.
3. A big positive growth differential. Investors take on extra risk when they get their passports stamped. Property rights, rule of law, and corporate transparency are sketchier propositions in EM. The prospect of a significant growth differential relative to the home basket needs to be there to compensate for these risks. As far as I can see, it’s not even on the horizon. EM countries, inter alia, still have a lot of private sector credit overhang to chew through.

That’s a pretty bearish backdrop. But there are five important reasons why it is not likely to translate into an EM crash, replete with old-fashioned contagion, defaults, and recessions.

1. Most emerging markets now have flexible exchange rates and much higher levels of reserves relative to historical norms. The most spectacular EM crises took place inside the pressure cooker of fixed exchange rate regimes. The imbalances built and built and built until they gave way in spectacular fashion, shocking investors and forcing liquidations. Today, FX moves are continuous, and the ample reserves can be used to circuit break and ensure continuous pricing, since they are no longer needed to defend a peg.
2. No more Original Sin. EM sovereigns used to borrow in dollars, but collect revenue mostly in local currency. This mismatch was labeled (I think by @ricardo_hausman) as the Original Sin. The rapid development of local markets (see below) has allowed sovereigns to shift the overwhelming majority of their funding to local currency instruments, making debt service easier and creditworthiness scares less likely under a wider range of potential FX and growth outcomes.
3. Deeper local markets. A positive aspect of the global financialization over the past 10 years is the development of pension systems, asset managers and insurers domiciled and/or denominated in EM. Buyers of the first resort with steady inflows create a shock absorber when tourists rush for the exits. These entities either didn’t exist or weren’t major players in EM episodes past.
4. Short dollars, not short dollar gamma. EM corporates have issued a large amount of dollar denominated debt over the past 7 years. This makes them basically short dollars. Some of them will not have the dollar revenue to cover, and using local currency revenues at depreciated exchange rates is very expensive. This will be a problem for EM. However, in the run up to the Financial Crisis, EM corporates were heavily speculating on continued USD depreciation by selling dollar calls to finance dollar puts.  When these positions started to unwind, the negative gamma led to explosive price action, as the corporate positions grew in size as they moved against them. Given the absence of these kinds of positions today, currency moves are likely to be more continuous and manageable.
5. We have already seen a lot of outflows. We are a number of years into the bear market, and while my bias is still bearish, one has to recognize that the bear call becomes riskier the further it runs. The odds of the necessary conditions falling into place become more likely, not less likely, with each passing day.

In sum, the bad news is that the fundamentals and positioning in emerging markets are still not favorable enough to support strategic allocations to the asset class—even though sentiment is already quite negative (Just look at the discount to NAV on ticker EDD) . The good news, however, is that even though we have a tendency to overstate parallels to the past, over time we progressively refine our analysis, see the differences, and come to more nuanced views.  Bad does not equal crash.