Mere days after I wrote about how most people were deluded that prices were always rising at an increasing rate, US inflation expectations slipped to new lows. If you haven't already, read my previous article on my views regarding the complex topic of inflation, and why I think we are in for a protracted period of price deceleration, which is bad news for all of us.
Not a canary in a coal mine
I'm not mincing my syllables on this one. Disinflation is widespread. It isn't isolated to the developed economies the likes of whom are still experiencing financial repression. America will start to face declining prices after the holiday season ends and the snow thaws; Europe is on the precipice of outright deflation; Japan continues to muddle through its cyclical wax and wane cycles within its liquidity trap. As economies experiencing deceleration in inflation exports cheaper constituents to their trade partners, I can reasonably foresee this chill to spread beyond the West to the East.
The market has been dead right for years
My measure of forward inflation expectations is by way of subtracting the real yield of TIPS (treasury inflation-protected securities) that trade on the secondary bond market, from the nominal yield of similar maturity/duration treasury notes to derive the breakeven rate.
As I've elaborated in my previous article, the market's forward view on inflation is more crucial and insightful than any other measure because markets are forward looking by nature. If you subscribed to the EMH (efficient market hypothesis) train of thought it is yet another reason to embrace the breakevens.
The following charts show the breakeven rates on the USD on a 5 year and 2 year forward basis. The 5 year window remains the uglier of the two; expectations have surpassed the lows of 2008 when the oil, subprime credit and derivatives bubbles popped, sending oil from $147/bbl to $38/bbl. Texas oil currently trades at $57/bbl; even with a $20/bbl margin, the breakevens are at their lowest ever in the past decade.
So let's get this very straight: the markets are pricing in inflation expectations at levels below those seen during the deepest abyss of the Great Recession of 2008. If this doesn't set your alarm bells ringing
Black swan or new paradigm?
Although I wish to save this altercation for another day, I will let off some steam here because it has been bothering me too much lately. Are low oil prices good or bad for the global economy? Such a question remains a tough circle to square. If we broke down the major constituents of the global economy, we might be able to deduce a little more color from the otherwise severely desaturated canvas.
While under restraint from opening what is probably the most contentious Pandora Box of 2014, financial contagion is just one factor from the bevy of convoluting dynamics stemming from heightened volatility in the energy sphere. I've spoken about financial contagion in my one of my earlier articles, and it has proven to yield destructive results if its risks are not appropriately hedged against.
The period of early 2007 leading up to the first major cracks on the sheet of ice globally-interconnected financial institutions were standing on was hallmarked by calm in equities, all while its credit counterpart was trading lower. A divergence, some would say.
Over the last half a decade I've learned that there is a crucial but subtle difference between decoupling of correlations and a lead-lag cycle. 2007 is a case study of the latter; credit led equities starting late 2006 through early 2007 before equities snapped lower. Both components then rebounded (but credit failed to form a higher high), before crashing. In late 2007, equities consolidated why credit continued sharply downward; this would prove to be another example of a lead-lag cycle as equities eventually broke out lower and caught up to credit a weakness (not seen in chart).
The difference between a decoupling event and lead-lag cycle is the former involves a third vector (oil in this case) as the primary reason for the divergence, while the lead-lag eventually sees follow through from either component without the involvement of a third vector. Complicated but essential in out understanding of financial contagion.
Much more on such topics later on...
Bottom line: deflation is going to reign supreme for now
All of my arrows are pointing to a deflationary risk. There will be those that choose to play devil's advocate on every of such occasions, but let's not bother about these shenanigans because they have been plain wrong in their ludicrous calls for high inflation or even hyperinflation for the past 5 years.
So unless one wishes to be on the wrong side of the trade (yet again), take heed and weigh the odds. Depending on your investment objectives, make appropriate changes to your portfolio before the markets incapacitate you.
This coming Thursday, 23 June 2016, the United Kingdom will vote on a historical referendum deciding on the status of its European Union (EU) membership. For the last 2 years since 2014, the UK parliament, led by acting Prime Minister David Cameron have promised a public referendum on Britian's EU membership. Britain's relationship with Europe has always been one of contention, and many have long been awaiting this once in a generational lifetime opportunity to voice their opinions through the democracy of a vote.
The global financial markets have also been eying this key event risk for some time, and since events have heated up recently as we enter the final week before the ballots are cast, there has never been a more important 4 days for English markets (that's including the pound sterling, GBP) since the "Black Wednesday" of 1992 , the day the Bank of England was broken by the markets.
We are not usually pessimists but when we see the writing on the wall getting bold redder each week that passes, we can't help but to take serious note. Just last week, we warned readers that markets might be about to get nastily volatile during the summer. So far so bad. May hasn't started well at all. The S&P 500, as of the week ending this past Friday, posted its first 3-week losing streak since January.
Recent macro developments both in the U.S. and elsewhere have however strengthened the bearish case for risk, in our opinion. It might have reached a point where downside skews in risks make a derisking maneuver potentially more rewarding than chasing beta.
As such, we have shifted our bias to the short side of risk. The positions in our portfolio (which we keep private) have partially reflected this change in view and will continue to do so as the situation evolves.
It is a known fact that credit cycles often lead business and economic cycles. It makes sense on paper and even more sense in practice. This is a subject that we havehardly yet touched on, but will be doing so in this piece. For a majority of the investing community, the topic on credit cycles remain much of a novelty.
As of March 2016, total default volumes on HY bonds (high yield) and institutional loans in the U.S. hit a 6-year peak of approximately $16.2bn, almost half that seen in the entire of 2015. Just this past week alone, we saw at least 4 corporate defaults with 3 in the energy sector.
So far in 2016 (Jan-Mar) default volumes have reached a jaw dropping $32.4bn. To put this in context, 2015's default volume (which was already abnormally high) stood at $37.7bn. If this trend were to continue through 2Q and beyond, we are talking about a full-fledged wave of defaults.
For the first 3 and a half months that have already elapsed in 2016, no asset class has seen the consistent volatility that currencies have. Central banking has been busy, almost too busy, all while the macro fundamental landscape has hardly moved an inch. With all that drama, noise, and play in monetary policies throughout the global economy, one would expect sizable trends in FX. But that hasn't been the case.
For instance, when the ECB first lowered its deposit rate to zero back in the first half of 2015, that sparked a major bear market in the euro, and a bull market in risk assets including euro bonds. When the Fed announced it planned to gradually taper QE3 and eventually end it late in 2014, the U.S. dollar began building up into what we now recognize as one of the most fervent dollar bull markets ever.
Monetary policy divergences used to herald the alpha and omega of huge trends. But not today.
Now, thanks to a comprehensive piece by Bank of America Merrill Lynch, we can provide readers with a glimps of what might be the next big trend in FX.
Last week, Bloomberg broke a story which greatly fascinated us. It involves a mysterious "specter", one which we have no clue about, flooding the Turkish stock exchanges with massive buy orders, massive to the tune of some $450mn in a single day.
Turkish locals refer to this entity (whoever or whatever it is) as "the dude", crowning the figure with an amphibious demeanor worth of a chapter in Slenderman. We have no idea, absolutely no idea who or what "the dude" is, how it specifically operates, and what its motives are for slamming a relatively illiquid market with order sizes so large, they scare the living daylights out of even the staunchest of permabears.
All we know is that local authorities have been rattled, investors shaken off to the sidelines, and a stock market that is now a stellar outperformer in the emerging market (EM) space. Even with the gruesome terror attacks in Istanbul over the weekends, an attack which has killed at least 37 people the last we checked, the Borsa Istanbul Index has now rallied for the 9th straight day.
That's right, we need the U.S. dollar to be BOTH strong AND weak at the same time for continued upside in equities. Much has been said about the greenback ever since the end of the Fed's QE3 program in late 2014. It was then all about king dollar leading up to the Fed's first (in a decade) rate hike in December 2015. Speculators kept piling in on the the freight express train that was the long dollar trade du jour, creating what has become one of the most crowded trades in modern history.
It's likely going to be a tug of war between these forces we've highlighted in this piece. Again, we make no predictions as to direction. We do however expect this conundrum to continue until a novel catalyst emerges that alters the way market participants trade and position. What this novel catalyst is, we don't know.
This conundrum is big, as we shall explain below.
The top 0.01% of the erudite elites control more than 60% of the world's wealth, while the 80% of us have a collective net worth less than the top 1% of society. In a world decorated with such gaping inequalities, risk and opportunities present themselves. While problems may be plentiful, there are also long term opportunities to capitalize on the mother of all trends: A globally aging demographic.
Which is what Janus Capital's Bill Gross, well revered as being called the "Bond King", is driving at in his latest investment outlook. In the race between the tortoise and the hare, the former analogous to a gradually aging population, the latter to technological advancements, the tortoise eventually catches up. Time isn't on our side, and we're sitting in a ticking time bomb.
It's a known fact that a large majority of the world's baby boomers are not adequately primed for retirement, lack the financial resources to meet mounting healthcare and insurance obligations as they further age, and are more dependent on the state's hospitality than ever before. But who pays the ultimate price?
The prospect of $20 oil prices has been raised thanks to this one Black Swan. A Black Swan is also known to statisticians as tail risk, or events that are highly improbable but are of great significance. One can liken such an even to a large meteoroid making its way through the Earth's protective atmosphere and impacting land or sea; an extremely unlikely event but if actually true, mankind's existence would be threatened.
Low oil prices have been the bane of many oil producing and export nations, whose currencies and economies have taken incessant hits every cent crude continues to plunge. The ruthless combination of a huge supply overhang and waning global demand has led to a deadly concoction oil producers and exporters have no choice but to drink. What other choices would they have anyways?
Whatever we said on 5 November came true. For the first time in 9 years, the Fed hiked the Fed Funds target interest rate by 25bp to 0.25-0.5%, ending an eon of zero lower ground rates and marking the start of a new paradigm. A paradigm that is, much as most would hate to admit, unprecedented in terms of scale and bredth.
As we approached 16 December, markets had increasingly discounted a Fed liftoff, but there was still some element of uncertainty. That uncertainty now shifts to what the Fed will do in 2016. Will it continue to gradually hike rates? Will it reverse on its path of monetary tightening and start to ease? These are but a multitude of questions that everyone is asking, but no one can really answer.
Does dovish rhetoric from Europe's ECB, continued stimulus from China's PBoC, the reluctance of Japan's BoJ to step up QQE despite headwinds, New Zealand's RBNZ policy being put on hold signal a soon imminent Fed rate hike?
While correlation might not necessarily be causation, especially in the ubiquitously tangled web of central banking, we believe this development is too significant to turn a blind eye on. Ironically, market-based odds for a December Fed rate hike have never been higher.
Do central bankers know something about the Fed's near term actions which the general market doesn't? If anyone knows what the other will do, it's probably them.
We'll leave this up to you to decide. The proof is in the pudding, and this one's pretty dense. So take it for what it is, we're playing it cautious but not holding our breaths.