Extraordinary Popular Delusions and the Madness of Crowds
It was the Scottish journalist Charles Mackay who coined this phrase as the title of his book first published in 1841. Amongst the various matters he wrote about aside from alchemy and witch hunts were financial bubbles. Many regard it as a seminal work but it was certainly one of the first that tackled behavioural economics.
I have to confess that the title seems very apt for what is going on in many risk markets at the moment. But to me the warning lights are flashing amber, at the very least.
So what are they?
US high yield now sub 5%.
A record $57.1bn of European junk bond issuance so far this year is just one aspect of this. Admittedly issuance has hit record levels everywhere but it seems that the hunt for yield is blinding people to properly assessing credit risk.
In Asia Bloomberg reports that amongst 102 non-financial companies in the MSCI China Index total debt relative to that that repugnant measure called EBITDA (who cares about things like cashflow?) rose to 5.3 times last year from 2.5 times in 2007.
European senior debt is not reflecting bail-in risk adequately.
I’ll just deal with the big three – China , the US and Europe. I regret to say that I simply do not believe that Japan will make any significant progress.
China growing much more slowly than expected. Inward investment growth up only 0.4% YoY. Exports, after stripping out the highly spurious Hong Kong data are only growing at 6%. See chart on page 2.
The other main driver of growth , fixed asset investment is up 20.6%, but as you can see this too is pretty much at an historical low. Furthermore its effectiveness, its multiplier is much weaker than before and while the economics community talks up the beneficial effects of it increasingly being diverted to the underdeveloped inland regions there is a recent IMF working paper by Lee, Syed and Xueyan that pretty effectively demolishes that argument.
“it finds evidence that some types of investment are becoming excessive in China, particularly in inland provinces. In these regions, private consumption has on average become more dependent on investment (rather than vice versa) and the impact is relatively short-lived, necessitating ever higher levels of investment to maintain economic activity. “
China Fixed Assets Investment YoY
Other data from PMIs, to industrial production and electricity consumption have also disappointed.
What can one say? Six successive quarters of negative growth, and probably a seventh. Devastating unemployment. Bank loans still not marked properly – see today’s FT “Spanish banks face fresh hit from bad loans” http://www.ft.com/cms/s/0/b30de38a-bd52-11e2-890a-00144feab7de.html#axzz2T9k12iJI. M3 decelerating. The EUR Economic surprise index has seen its most dramatic collapse since 2008.
CITI euro Economic Surprise Index
Data continues to soften. Payrolls were the main exception but employment is a lagging indicator. Yesterday’s industrial production data saw the sharpest month on month fall since October and the year on year rate fell to 1.95%, a stark contrast to the 4.6% seen in April 2012. Similarly retail sales are growing at their weakest rate since late 2009. Worse still this anaemic rate has only been supported by a fall in the personal savings ratio to a clearly inadequate pre-crisis level of 2.6% in the first quarter of the year. This leaves the retail sector doubly exposed to any negative shocks.
Elsewhere the growth in commercial bank loans and leases has slowed markedly. This is one of my favorite indicators. I flagged it from early 2011 when it started to pick up and by the middle of 2012 it was growing at roughly 14% YoY. It represents lending to SMEs and has powerful multiplier effects. However since the end of last year it has slowed rapidly to an annualized rate of 5%. This raises questions about future investment and growth in general. In 2012 it grew by $173.5bn, 1.1% of GDP.
COMMODITIES & MINERS
This is where the title really kicks in.
The commodity sector is a major source of concern to me. The divergence between copper and equities has been noted by many. Copper is a key element of economic activity and usually its price action mimics that of US equities. However since early February there has been a marked divergence in direction.
Copper (red) S&P (white)
However, there is a much better fit with Chinese equities.
Copper (red) SHCOMP (white)
Overall that is not such a big surprise. China is the world’s largest consumer of copper. However, China has also been the big contributor to global GDP growth. In 2012 nominal GDP grew by $750bn, in 2011 by an astounding $1.2 trillion, and in 2010 by a hefty $900 bn. In contrast The US grew by $540bn, $580bn and $600 billion respectively.
This year the US and China will probably be similar at close to $600 billion each. However the risks are growing that the numbers will be lower than that as disinflation kicks in, capping nominal GDP growth.
This growing disinflation momentum can be seen in the chart below which is a GDP-weighted amalgam of CPI for the US, China, the Eurozone, Japan and the UK. The recent sharp lurch lower is concerning and to my mind reflects the growing weakness in domestic demand.
Global CPI – now at 1.2%
But I am diverging slightly my real concern lies with commodities. The great surge in commodity prices started in 2005 as the Chinese economy began to hit the tipping point of scale as growth extrapolated to something significant on a global scale. Until 2005 $3,000 a ton had always seemed the high limit on copper, much as $30 a barrel seemed on oil, and then things changed.
However, since then capital investment in the whole commodity sector has exploded and in the coming years more and more supply of copper, iron ore, gas, oil etc is set to come on line. My concern is whether the demand will be there to meet it.
In areas such as steel it already seems not. China is the world’s largest producer and consumer of steel and yet look at the chart below. Steel prices have largely remained marooned where they were at the depths of the global crisis in 2008/09. But iron ore prices are still double where they were and as a percentage of finished product costs are unsustainable. They have to fall.
China Rebar (white), Iron Ore (red) & FTSE 350 Mining Index (green)
This has very negative implications for many of the world’s mining companies who are also considerably more indebted because of their massive capex which was going to pay for itself in the future. Furthermore, it’s not just the iron ore sector, it’s the coal miners as well. Gas is killing coal but in China so too will social pressure. Air pollution is now a major issue on the national agenda and a source of growing social unrest.
From a market perspective a return to 10,000 on the FTSE 350 mining index would not be a surprise, no matter that it has already shed 12,000 points from its late 2010 high. Indeed, from a trading perspective its poor price action suggests that there are many investors who are praying it will go back up. It won’t. As my old boss many years ago said to me “sell what looks cheap rather than what looks expensive. It’s the course of maximum pain”.
But if mining equities are vulnerable then credit on miners looks even more exposed. Just look at the chart on the next page.
Spot the odd man out – China Rebar (white), Iron Ore (red) , FTSE 350 Mining Index (green) & RIO CDS (inverted & purple)
So from a market perspective what should one do?
In equity space, apart from just getting out of miners and associated industries, look to do long-shorts between the high and low quality names. Long BHP, short Fortescue is one that springs to mind.
In credit, aside from clearing one’s portfolio of anything mining related look to buy protection outright or on a similar basis to the equity long short e.g. Sell BHP CDS, Buy Rio CDS, and reinvest in high quality bonds. I’m at the extreme end so I would go with Treasurys.
Furthermore, be wary of financial institutions with heavy exposure to the mining sector. Again go underweight against those who have minimal exposure.
In FX don’t be fooled into thinking that the Aussie below parity is cheap. It’s not. It should start with an 8 handle.
Finally with specific regards to copper don’t believe that the $7,000 level is any great floor. It’s not. I see 5 handles…
Good Luck, PPG
JGBs fell again today with the 10 year yield rising to 0.63%, its highest since March 15.
So far other bond markets are ignoring the price action, preferring to think of the potential buying by Japanese investors of their higher yielding bonds – witness the ludicrous rallies in Spanish and Italian bonds and some of the stuff now being written about US Treasuries.
But with the US now voicing concerns about further yen weakness and USDJPY looking very toppy on a technical basis will Japanese investors really come charging in?
Moreover while JGB yields are at 1 month highs 10 year yields in the US and Germany are 30 and 20 basis points lower than they were. So the yield spread is that much less attractive.
I am also suffering a little bout of deja vu. Back in 2003 it was JGBs that lead the big bond sell-off. Yields doubled in a week, as they did in the immediate aftermath of the BoJ announcement.
However, perhaps the greatest risk is not so much for bonds, which are priced for low growth but equities.
Both the China and Hong Kong have entered bear territory, falling over 10% from their highs of the year.
Europe also remains a mess with PMI continuing to fall and making EU growth/deficit projections look even more fanciful – there’s more than a touch of Pravda is coming out of Brussels. And then there are the poor Cypriots, let alone Slovenians, Spaniards, Greeks etc..
So what chance bonds slipping and taking equities with them?
For info I have closed out my US and bund bond longs but like being short the S&P and Dow.
In my last post I talked about ‘risk hackles ring’ and recent events seem to give further justification.
The Italian election is a mess, plain and simple with the non-political Grillo camp taking roughly a quarter of the vote. How on earth is reform and fiscal discipline going to be forced through.
Meanwhile in France the speed of contraction seems to be worsening. last week’s PMI data corresponds with -1% GDP q-o-q, or 4% annualised. In short budget deficit hopes and by that I mean the 3.8% number not the original 3% target look like pie in the sky.
Admittedly in Germany the data remains strong, though the IFO expectations is so high that it looks as if the survey members have been overdoing the prozac. Moreover with what’s going on in the rest of Europe, China and the US disappointment seems inevitable.
Staying with Europe we now have the 2nd, 3rd and 4th largest economies all in the mire. One cannot help asking the question “Who will guarantee the guarantors?”
The ECB? How?
They already own over EUR 100bn of BTPs but how can they buy any more when there is no government and a huge anti-austerity vote by the electorate? Hmmm
As for the UK I have to admit a sneaking sympathy for George Osborne. No sooner does Moodys downgrade than the Daily Telegraph reports the surge in oil and gas investment and the likely not insignificant rise in oil tax revenues. Ultimately I’d still rather own the pound than the euro.
Turning to China there has already been much debate as to what GDP growth really is. The likes of Standard Chartered reckon that it was a lot closer to 5.5% in 2012 than the 7.6% reported. Furthermore when one considers that GDP growth in Korea, Hong Kong and Singapore in 2012 was roughly 1.5% that number rings true.
As I have said the before “there are lies, damn lies, statistics and then there are Chinese economic statistics”.
Staying with China yesterday’s HSBC/Markit manufacturing PMI was also a shocker. At 50.4 it massively missed the econobabble community’s consensus forecast of 52.0. But again rings true. There was not a component that was good and of particular concern was the weakness of new orders.
As for the bastion of hope, the US, optimism also looks to be overdone there. Looking back at the Walmart emails they make perfect sense. A dire first part of February. Why? Because most people only got their first tax-increased payslip at the end of January and most people don’t plan. they live paycheck to paycheck, as witnessed by the record numbers on food stamps.
Ultimately I believe that we could be set for a re-run of 2012. Last year we had a very bullish Jan and Feb helped by LTRO-love. This time it has again been Euroland inspired when the underlining fundamentals are dire.
As for me, I lobbed out my bund and bond longs first thing this morning. But may well look to re-enter on a retracement. Meanwhile I am staying short stocks in the US, Europe and the UK and have a cheeky bit of EURGBP for good measure.
I have never had a lot of time for Mervyn King, back in 2008 I said he should resign, but I will give him credit for highlighting the disparity between risk assets and economic reality during yesterday’s Inflation Report press conference.
Regular readers will know that I have been highlighting the growing cracks in the risk-on scenario despite the S&P hitting fresh highs. EM FX and equities (China excepted) have not been doing well and credit has started to slip.
The surge of junk issuance this year with spreads back at their lows gives investors little to no protection. Spreads should not be looked at on their own but in the context of absolute yield. 400 over in 2006 when economies were grwoing but 5y treasuries were over 5% gave one a reasonable return. Spreads at 400 with 5s at 0.87% clearly do not.
Meanwhile the data is poor. Just look at Eurozone GDP today. An annualized rate of contraction of 2.4%. And yet the media go with a story that the negligible 0.1% contraction in Q4 Japanese GDP gives Japan more ammunition in its case to ease. Doh!
Europe is not going to bounce back while the swing in sentiment over China is overdone. If everything was so fab then wouldn’t the rest of Asia and Australia be seeing the benefits? Something’s out of kilter.
In the US the tax hikes have yet to properly kick-in and consumption is being supported by a fall in the still way too low savings rate. And sequestration may stgart on March 1.
Other indicators such as magin debt and AAII surveys are also flashing. And for those still bullish equities just look back to 2007. Those of us in rates, credit and FX knew things had gone wrong by the middle of the year but the S&P only peaked in October.
I prefer to stay risk off and for now will be putting money to work in bonds.
The Italian stock market has fallen almost 900 points in a week while the IBEX in Spain has fallen over 7% from its highs. It is now lower than where it closed the year.
Spanish bond yields are (after today’s move) 13bp higher than where they finished 2012 (5.40% vs 5.27%) and more than 50bp off their best low close of 2013.
Data may be better from the US – though how much of the GDP data was flattered by all those tax avoiding dividends etc in Q4? -but the reality is that Europe continues to contract.
In that vein the collapse in France’s manufacturing PMI to 42.9 that was released and largely ignored on Friday was of particular concern.
France is far more significant than Spain or Italy and continued questions on the outlook for the French economy need to be asked.
And yet the Euro hit fresh highs on Friday. But when the IBEX was last here it was at 1.3190.
Elsewhere credit looks overextended and EM equities and FX are not doing well.
One may not like bonds much but I believe that it is time to go the other way in the ‘great rotation’. US bond yields at 10 month highs are worth a nibble and for now there is a greater chance of capital gain there than in equities over the next few week. Aussie 10s at 3.59% also look good.
Finally it looks to me as if sterling has had too much of a bad press. Things are not half as bad as the media says. EURGBP was at 0.8180 on Dec 31st. There is considerable room for catch up.