2015: Points to Ponder

As you gear up for the year end, here a list of things and points for the next year. To mull over, without any iota of attempts to forecast!

1. Oil: from peak-oil to freak oil. And how the story unfold will be driving a lot in 2015. IMF Direct (the blog from IMF) had a very interesting piece on this recently. They estimate unexpected lower demand can account for only 20% to 35% of the price drop. And they find little evidence of financialization. In this context what is surprising is the speed of adjustment. For 2015 most analysts maintain gloomy forecasts for oil. Perhaps rightly so. But a lot of that comes from forecast of continued lower demand from China and Europe. Given the lower contribution of demand in the price change (as above), and the still volatile geopolitics of a large part on the supply side, the question remains what if there is a strong come back of oil price in 2015? It will mostly reverse what we have seen in 2014. The hysteresis loss will be for new investments in oil sector with renewed long term risk assessment; and in Europe, especially if the ECB had not gone through with the QE by then.

2. Russia: very much related to above. Will they get out of it? yes if the oil price bounces back. What if it does not. That is the hard part to speculate. On the face of it Russia does not look particularly bad on economic parameters. Yes, the inflation is running a bit high, and the GDP has slowed down. But they have been there before. The missing links are current account weakness, ruble appreciation reversal, and the possibility of capital flight. Krugman explains the first two of them here. The last part is the hardest to explain and quantify. See here, for example. And in my opinion this is the most crucial make-or-break factor. Russia will survive in the short run if the oligarchs have a lot to lose otherwise, and if Putin survives.

3. Wage growth: That will shape the Fed policy to a large extent. We have already seen some encouraging trends. 2014 has been a great year for job growth in the US. 2015 might as well be a good (perhaps not great) year for wage growth. If that is supported by lower oil price, it is good. If that coincides with a sudden rise in oil price, that can spook the market and push up break-evens and rates.

4. Housing: One of the weakest part of the so far good enough recovery of the US, is the contribution of housing to the investment component and hence the economy. The flow of funds from the Fed has consistently shown continued deleveraging in mortgages while consumer credit picked up. The higher mortgage rates and increasing prices did not help it either. Historically the contribution of housing to GDP is near record low. And that to me seems like a lot of upside in 2015.

5. Europe: If we have a Grexit start of the year (or even a panic towards that), that will greatly ease Draghi's case for an all-out QE. European equities missed out a lot compared to elsewhere, and can benefit from both improved earnings and re-rating. As I mentioned before, I think people are unusually bearish on Europe now (just like they were unusually bullish a while back). If you think the US equities are done with most of the run, and Abenomics not really working for Japan, and missed out the Chinese rally and now scared of the EM, you do not have much choice. On the rates side, a lot of the curve flattening has been driven by global influence and a re-pricing of the long end. I do not think the rates market is nowhere near as confident of a QE as most analysts are. The European swap markets now looks hardly any different from Japan. And with much much better upside.

6. Abenomics: And speaking of Japan, which I frankly do not understand much, all I say I do not see Abenomics working. The problem with that is if Abenomics does not work, the challenge for the subsequent governments will be progressively humongous. What are the odds that we will stop to see the yen rallying in a global panic? And what are the odds we will actually see yen selling off in a panic? I will keep rolling my yen shorts. In good times or bad.

7. China: Perhaps most discussed. One good thing about China for traders and investors is that China, with its mighty central bank and strong command control hardly produces any large surprise for the markets. (Of course the antithesis is that when the surprise does come it will be huge and bad, but somehow I do not buy in to that yet). With the rally belying the economy, the central bank and policies will be in the driving seat.

8. The bull run in India: I am a believer. Well for one, the benefits of the large oil re-pricing on India is still totally lost in the panic about EM. In fact India has been a net importer of non-agri commodities. So recent secular weakness is a huge bonanza if they sustain. In terms of valuation it may not be cheap, but much scope remains for earning improvements. 

9. Return of volatility: A sustained period of low vol can be policy driven (when the central bankers become sellers of vols), or it can be just a phase of a complex system. Because low vols just happen some times. FX has already seen some uptick in vols. And yes, commodities of course. May be time for the rest.

10. What else: move away from rotation to diversification? a policy-driven liquidity crisis? year of the frontier markets? crisis in Europe? middle-east mayhem? HY melt-down? comeback from the UK? Wide open. As always.

Best wishes and a happy new year

NIFTY: Day traders Vs. Investors (+ A Christmas Present !!)

Here are some interesting charts comparing how S&P CNX Nifty has performed over last many years - split between day-session performance vs. overnight. The pattern is very interesting. In 2007-2008, the day traders dominated, both in profits and in losses. Be it the run up to the pre-crisis top in early 2008, or the crash. It was again the day traders who profited most in the comeback in 2009. This continued till the peak in 2010. 

However, after that, something changed. 2010 was the last great year for the day traders. Since 2011, the overnight returns dominated returns during the day session, far and steady. That was the case during the mild bearish runs in 2011, the sideways market in 2012. And the trend continues strongly in to the current bull period. 

The overnight returns now dominates day session so much that if this continues, going long overnight and shorting the markets during the day is now a super profitable strategy !!

What is driving this? Well to start with: the vols are down, and NIFTY (like most emerging markets) is perhaps influenced by the Feds and the BoJ much more than it used to be back in 2007. I would suspect most emerging markets will show very similar patterns. And this is VERY different than, say , S&P 500, where overnight and day-session has their fare share of misery and joy.

Will this continue? Well, the flow of funds that world-wide QEs initiated is still churning around, and will perhaps take a long time before the dust settles down. But it is an altogether different scenario if we enter a high vol regime in 2015, irrespective of market direction.

The tail piece: for folks looking for public source of intraday data on stocks - here is a quick and dirty R scripts. Feel free to use and modify as you please. Quantmod of course does a wonderful job for daily data. This routines are similar and extend to intraday.

Downloading intraday data from Yahoo or Google

. Merry Christmas and happy holidays everyone!

Freak Oil - Long Term Perspective

A long term look at crude oil price. And some fresh perspective.

Note the high correlation between bonds and oil price (correlation approx 90% on monthly differences)

And in spite the recent crash, oil still trades near all time high in terms of beer!!

Inflation - Oil and Bad Press?

"Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man" - Ronald Reagan

We had the last ECB before the holidays and before the market doubles down on its expectation of QE in January again. This is how Euro traded yesterday during the press conference

More dovish, and no actions. But action was hardly expected. We still have an TLTRO to go, and it is already almost Christmas. The positioning build up, both in Euro and in short end rates, before the meetings indicated there is a good chance of a disappointment move. And it played out more or less like that. But that should not budge the long term Euro shorts.

One important point was what Mr Draghi made clear about crude prices. For last one year, ECB has always downplayed the reduction in inflation due to energy prices, citing it as a transient and volatile component. This, for me at least, is the first time ECB showed a genuine concern that this transient impact may pass through to inflation expectation and become more permanent. ECB does not sound comfortable at all in the recent decline in crude, and in no mood to brush it aside citing energy as a volatile component any more.

This is exactly the counterpart of what happened in April 2011, when ECB unexpectedly hiked rates. ECB models are sensitive to pass through second order effect of energy inflation. This time it is acting in the favour of the doves. Keep your Euro shorts rolling.

Stepping back from ECB, and looking in to the inflation picture globally, it seems things are not as bad as made out to be. In spite of the oil crash. See these charts below

We had too much of press about deflation and disinflation this year. But globally, core inflation in fact picked up over last year (see Trend I), apart from Euro-zone. Of course the absolute level still remains uncomfortably low for many countries. And if you take a closer look you will see the chart in Trend III is remarkably similar to the first chart. Global core inflation picked up mostly driven by wage growth, in a classical manner. Change in exchange rate has lower significance on its impact on the inflation and same goes for classical money supply (note these excludes any QE or QQE).  And this also suggest the mere disparities between Euro area countries will require more innovative solutions than plain vanilla QE

ECB Today: Is Draghi Begging You To Short The Euro

I would say yes!

Especially since he labored so much on hammering home the point that "the most important message" is ECB, apart from having a balance sheet target, is committed to expand its balance sheet while other central banks are contracting. He opened with the phrase "diverging policy". It is difficult to imagine how he could ask to short the euro in a more direct manner

And I would also say listening to this man is wise. Always!

The Most Important Thing Now

Today's BoJ move sets up the tone for the rest of the year (discounting ECB, at max we can get a hint at balance sheet target). Overall, starts a new leg in carry trade and long end out-performance and general out-performance of risky assets. I would say, including European peripheries. Even if you point out risky assets are already very risky, there is not much trigger left for the rest of the year.

Now, the most important question remains. That is the price of crude.

This is not only about headline inflation, it plays an important role by pass-through effect on the core as well, plus help shape the future expectation. 

Till at least the first quarter of 2015, the best rates traders will be the best oil traders!

But there are many unanswered questions - why WTI is in backwardation, while Brent strongly contago. And how much of this represents supply and demand, and how much is carry trade. How the currently cartel will react. And what really is the break-even for US shale. Oversupply, or lack of demand, or just god damn positioning.

Points to ponder!

[EDIT 05-Nov-2014]: Ok, WTI slipped back to contago now. So one less puzzle that is.

Euro Glut: A Global Look

If you have not already read the latest note from Michael Pettis, then please do.

And also do read the note from George Saravelos on what he terms as "Euro Glut".

These are not particularly fresh new ideas, but definitely worth mulling over and have got much less attention in the media, as well as in the blogospehere, than the "new normal" and "secular stagnation" theories. In fact the original piece from George Saravelos also has a scary graph of the current account of Euro area, China and the US.

However, this graph becomes less scary in a slightly expanded perspective. Below is what I gleaned from IMF database (via Bloomberg) on excess domestic savings vs investment (equivalent to the graph mentioned above).

When you take a closer look, the "Euro glut" post 2010 is worryingly out of line. But if your focus is global, then perhaps you should also not miss the sharp drop for China post 2008 and Japan two years later. The gap between required investment and savings for emerging markets have grown stronger and the rest of the Anglo-Saxon world (the UK and the dollar-bloc) still provides a good demand for exported savings. Although it is not clear how much of it is sustainable in a world where Europe continues to build up and export excess savings. And China heads for a soft landing.

What is truly remarkable is the correction in the US, which is equivalent in magnitude in Europe. Nobody seems much concerned about it as correcting a negative current account balance is supposedly good for the economy. The question is if the US stops buying, then who else?

As pointed out in Mr. Pettis' note, there should be plenty of opportunities to invest surplus savings. The trouble will be if the excess savings export remains focused on the return of capital, than return on capital. And of course positive return investment globally can perhaps more than match exported savings from Europe in magnitude, but not necessarily in speed.

In the short run, it is speculative to worry about this. For one, apart from Europe, the world as a whole is already moving towards balance. And European imbalance is a recent phenomenon. It is not clear how long it will continue to build up. Even including Europe we are much closer to a balance than we have been in a long time among the developed economies. Which is good, as balance is good. Cheap capital for proper investment is good. But this is also a bad news, as the US apparently now have a lower capacity to absorb investments. The CAPEX figures from the Fed Flow of Fund data have been less than encouraging for years now. Excess savings in an environment of less investment opportunities mean basically a globalized version of Japan. So it all depends on if this will continue, and if yes, how much it will build up and where the savings will head to.

Of course, this assumes only the flow matters, but stock is important too. We do not know how much Chinese or European investment stock is on the sideline and waiting to be exported. (or conversely, how much unmet demand in peripheral Europe is being neglected by banks unwilling to lend, and how fast this "Euro glut" can reverse on active policy and optimism.) If they do flow out, it is positive for foreign assets in the short run. And if they do find a home in real positive return investments it is great in the long run too. If they overcrowd economies with little investment opportunities, it will push the real rate down and impact investment. So on the optimistic side, this is positive for emerging market economies (including India) in the long run. And as long as we can keep the global demand up, it is positive for pretty much everyone.

And finally, yes the absolute numbers are large. But when you compare them to world GDP, this total imbalance appears much less benign (less than 1% of world GDP for Euro area, China and Japan combined). In a world with perfect trade and capital flow, this should take care of itself. In real world, this is large, but not earth shattering!

So short the euro by all means, but not solely because of "Euro Glut". It is perhaps way too complicated than that. At least more than what Mr. Pettis seems to suggest how important the trade balance is. And more than just exports of savings. In fact in early 90s, the yen and the Japanese current account balance (as a percentage of GDP) moved in pretty much lock-step. In the way a simple trade model would suggest, currency strengthening in auto-correction when current account surplus builds up. Exactly opposite of what Mr Saravelos suggests.

People were way too complacent about Europe a decade back. And now way too pessimistic!