Monday, February 29, 2016

Lucky by Randomness: The Sage of Omaha

So Warrent Buffet says "Lucky to be American" in the latest Berkshire annual meet.

Indeed. Wonder what would value investing mean if he was born across the other pond, in Japan around the same time.

Friday, February 26, 2016

ECB March Meeting: Front Running

The expectations are high for March 10 ECB (Fed and BoJ will come in quick succession in the following week as well). ECB President promised action (or consideration to be precise) in the last meeting. And ever since inflation breakevens have nose-dived. This week's inflation data almost takes away the last bit of uncertainties around some action at least.
However, the major question this time is not if, but what. In the face of an unrelenting fiscal pressure, the ability of central banks to surprise and exceed expectations are increasingly under pressure. The limits of negative rates are already in mainstream discussion. Policy rate cuts are easy, but they are already on the brink. A tiered negative depo rate can be viewed positively (even for bank stocks), but that avenue is not really a surprise. Market was half expecting it back in December anyways. Any other combination of policy rates adjustment will hardly be exceeding expectation.
On the other hand, QE has more potential in this regard. For one, extending asset based (say equities) will be a really large surprise. But it is highly likely that such bazooka will be reserved for a real crisis. Not now. Other options include increasing the QE timeline (already done once), and increasing the monthly purchase amount.
We have discussed before what left in the central bankers' toolkit. For March, the most potent and practical option is the second one in the above paragraph - upsizing monthly purchase. Here it has to be both credible and effective. Given the outstanding amount of sovereign issues (I think Germany will be the limiting criterion), hitting the balance is tight. A sizable increase puts in to questions the achievability of the plan, given the current capital key ratio rule of purchase. On the other hand, a token increase will most likely be a dud. The most effective thing for now will be to hint a possible reevaluation of the capital key constraint. That will give way to a very credible QE in future from Europe perspective. This is especially true as we have seen a recent increase in peripheral spreads. The crisis has moved a little closer home already.
Here is a quick recap of last few ECB actions.

25bps cut in key rates
1. Main refi from 75bps to 50 bps
2. MLF from 150bps to 100bps
1. Main refi from 50bps to 25bps
2. MLF from 100bps to 75bps
1. Main refi from 25bps to 15bps
2. MLF from 75bps to 40bps
3. depo from 0 to -10bps
4. TLTRO announcement
1. Main refi from 15bps to 5bps
2. ABS/ covered bonds purchase program
3. depo from -10 to -20bps
4. MLF from 40bps to 30bps
Details of ABS purchase program
1. QE 60b till Sep 16
2. TLTRO pricing change (flat from 10bps over MRO)
Announcement of QE details
Increase in QE issue share limit (33% from 25%)
1. Depo from -20bps to -30bps,
2. QE from Sep 16 to Mar 17
3. reinvestment principal payments

And here is how the markets reacted historically to ECB meetings. The charts show the movements in corresponding markets over a period of 5 days before and 2 days after the ECB meeting, measuring the move in terms of number of standard deviation (then prevailing).
Observing from the graph, we see a strong positive bias for euro to respond to ECB (positive bias used to mean a rally during 2012 euro crisis and a sell off in more recent time!). At the same time  risk assets like Euro Stoxx also shows a positive skew. On the other hand, the response from rates world is much more nuanced, and has been mostly disappointing for rates levels (failure to sustain rally), and less so for less slope (sustained steepening on the back of policy easing).
This pattern is validated when we look at the relative rates spreads. These charts below shows the USD to EUR 10y swap rate spread and 5s30s steepener spread (USD less EUR). In relative terms, the slopes performed even more consistently.
Given this back ground the asymmetric tactical trades are:
1) shorting euro and long equities
2) positioning for a steepening in 5s30s.
3) And hedge the position with a short rates on the long end.
This is especially attractive given the recent risk rally in euro and flattening of the euro curve. Fine tune this based on the degree of surprise you expect. This is a tactical positioning. With little fiscal support, a monetary response will probably be still wanting in the face of deeper issues that remains. And following week can unwind the whole thing, especially after BoJ.

Wednesday, February 17, 2016

Macro: Quantitative Tightening - Revisited

Here is a fresh look on the topic from the excellent sober look blog. It also refers to a post on this blog back from September last year.

The sober look piece presents some insightful charts and raises questions that needs further re-look. One thing to add here on the top of my head - it has been alleged that petro-dollar sovereign wealth funds have been selling more of equities, sparking a flight to safety move towards the US Treasuries.

Quite the opposite what many market analysts expected.

Monday, February 15, 2016

ECB Action: The Jedi Tricks Still in Store

So ECB is almost "pre-committed" on some action in the March meeting with all the talks going on. If you are not convinced, remember how Mr. Draghi went out of turn in the last press meeting in January, to remind everyone that the decision to "consider" action in March was an "unanimous".
Since then the stock markets sold off a lot, break-even inflation went downhill (although Euro are inflation was not that much disappointing) and BoJ announced negative interest rate policy, first time in its (rather long) history of monetary stimulus.
But in spite of all these actions and promises from central banks, the response to monetary stimulus is already waning. The equity markets unwound the second round of monetary stimulus from BoJ in months, and the latest round in days in fact. And even with such a strong promise for action from ECB and relatively dovish Fed, you would have made money if you shorted euro rates vs. USD.
The question is what else the central banks are left with. Well, I think it is too early to say they are out of options.
Firstly we still have quantitative easing. It may have some limited effect on markets already under pressure from such measures, like Japan or Euro area, but in places like the US or the UK it is still very much potent. [EDIT] Even in case of the others, QE can still be very impactful, at least on the markets, in case the underlying assets are extended to other asset classes - like bank stocks!
Then the negative interest rates. This is the one I like the least. Firstly it is NOT very clear what it exactly does for the "general level of rates" in the economy. If everyone is super-rational and able to free his or her mind from this weird concept of having to pay to park cash, life can goes on as usual. But that is a lot to ask. Firstly the banks cannot pass on negative interest rates to customers effectively. This harm the banking sector profit in a big way, as we have seen in the large re-rating of banks across markets recently. Plus if your economy is dependent on banking sector lending (as opposed to direct capital market access) this can be a dangerous move. Facing negative interest rates, banks have incentives to either improve bottom line by cutting costs, or reduce lending business altogether - focusing on either best of their clients and/ or riskiest names. This is not bad for big corporates. This is not bad either for riskiest customers. But this is bad for the ones sitting in the middle, which is the vast majority of the small and medium sized business. Besides, negative interest rates are politically unpalatable, especially in election years.
Then we have the yet un-tested weapon: the ultimate Jedi mind-trick - enhancing the inflation target. The trouble is there is no fast mover yet. And it is hard to be experimental with this unless one is forced to. A bad move can displace the inflation credibility that most central banks fought hard to achieve.
I think how the central bankers will react will depend on the nature of problem they are reacting to. A minor risk-off or continued commodities sell-offs will most probably elicit a (now) conventional reaction of QE or increasing NIM. But a only a real full blown crisis will bring in the inflation retargeting (along with host of other measures presumably).
And given the specifics of the various institutions and home politics, I would bet in such a full blown crisis - the governor of the Bank of England is the most likely candidate to take the first step. And ECB will likely be the last.
Wave the hand and say inflation should be 4%, and leave the rest to the Midi-chlorians.
So if you are an investors from EU area looking for a tail risk protection, a relatively cheap hedge is paying 5s30s in GBP vs. the Euro are. And most likely this will be Brexit proof. If indeed we have such an outcome, probably a selling of the long end of curve by non-UK investors will lead to a steepening of the GBP curve.
The spread has tightened recently but still near recent lows.

Thursday, February 11, 2016

Note To Self: Bear of The Dark

“Going negative is daring but appropriate monetary policy. But it is a sign of a terrible policy failure by fiscal policymakers.” - this succinct quote from former Fed official Narayana Kocherlakota captures the very essence of the limitation of the central banks today.

I started turning bearish - like most market participants - in early January. I turned neutral here, and bearishness followed. See here and here and here. That was mostly based on reading the market information and assessing them, subjectively. Which is NOT particularly a great way to develop an outlook. Here we attempt a more formal process.

A bad time to assess if the markets are turning a bearish corner is on days like today: the markets sell off a quite a bit. First thing one has to fight even before starting to reason are a whole bunch of cognitive biases!

Let's assume we have already done that. The next thing is to take an objective view, and establish based on the current information what are the chances of a bearish market setting its foot hold firmly.

First, the base rates: to start with, only the price information and no context whatsoever. First we notice we are in some kind of cusp. The 3 month, 6 month and 12 month performance of, say, S&P 500 are more or less similar within some tolerance. That means, we are not in a steady trend, yet, in either direction - bullish or bearish. In a steady trend, it is much easier (and almost useless) to establish if we are in a bullish or bearish phase. It is very difficult to predict a trend at the onset of it. Many investors spend considerably amount of time and effort trying to achieve this, and more often than not, they fail.

But looking at data, we can make some probabilistic observation. Here we look at the historical probability distribution of S&P 500 returns - over next 3 months and 6 months - when it behaved similar to today. That is: it sold of significantly (we look at 5%, 7.5%, 10%, 12.5% and 15% prior sell-off) and that happens in a turning phase (i.e. 3, 6 and 12 months performance are equivalent within some tolerance). Here is how it looks, since the post-world ear.

For next 3 months return distribution - on the milder sell-off side, the distribution tends to the usual - hardly useful to prognosticate. However, as the sell-off amount increases it tends to widen in a bi-modal distribution - tending to either settle down in to a bearish phase or come-back sharply. And only beyond 15% the upside skew tends to dominate. We are at around 12%. Looking at the next 6 months returns - the historical distributions are more extreme, and chance of an onset of bearish trends increases with increasing sell-off, till the upside skew tilts it in bull's favor beyond 15%.

The obvious conclusion here is we are not going to settle at this stage, and likely to move to one of the peaks. And we can also say, although with less conviction, the sell-off is perhaps not large enough to be perceived over-sold and is slightly tilted in favor of the bears.

Continuing with base rate case: Equity market is related but distinct from the underlying economy. One way to approach is to ask what are the chances of a sell-off given a recession, and also what are the chances the markets sell off anyways even without any recession in the economy.

Here is a list of historical recessions in the US since the great depression, and the corresponding market sell-off

So excluding minor recession introduced by sudden fiscal tightening or monetary tightening or the very distinctive dot com crash - the average sell-off has been around 12 percentage point per percent point of GDP lost. And roughly 30% on an average.

It can be noted that we had two occasions of a market sell-off (greater than 10% peak-to-trough) without any recessions - one during 1965-66, presumably under a credit crunch and followed by a recession. The other time was 1976-78, which was actually straddled by the 1973-75 recession and early 1980s recession. So the probabilities of a sustained bear markets without a recession is much less. But of course we are looking at a more globalized world now. Hence we can expect equity underperformance in the US even without a technical recession, if there is a large scale disruption else where in the world.

Overall conclusion - we have a considerable chance of a bear market setting in. Note, a 50-50 chance of a bear market is actually a much stronger conviction than it sounds. On a rough measures, since post war era till before the current phase, we have spend roughly a 30% of months in a bearish market. So unconditional probability of a bear market will be around 30%. And given the above observations, it should be higher than 30%. May be closer to, but quite less than 50%. A good number to anchor is mid-way at 40%. And this is a conditional estimate, without considering the context or forward outlook. It depends on the probability of a economic recessions, global or in a major economy. Which comes up in the next post.

As a tail-piece, here is how the classic equity risk factors are performing lately. This is in the US, but should be similar across the board.

The value is beaten down, and it is the momentum that is the last man standing.

Monday, February 1, 2016

Ubernomics: NYC Edition

I have no idea how good or bad economic forecasts based on general chit chat with taxi-drivers are.

But according to my sizable (and arguably non-random) sample of Uber drivers in NYC over last week, the economy this January is definitely doing worse than January 2015. One of them however, helpfully pointed out that the looming election is to be blamed!

Somehow that coincided with today's data releases - both the personal spending and PMIs. Food for thought.