Month: August 2016

Earlier today, in its latest update looking at March home prices, Case Shiller pointed out that “home prices continue to appreciate across the country”, at just over 5%, a pace that has held since early 2015.

Once again that was an understatement: in 15 of 20 of the tracked metro areas, the pace of home appreciation over the past year was 5% or higher, or more than twice the pace of core inflation. And with rents continuing to soar across the country, in many cases at a double digit clip, not to mention exploding healthcare costs, one wonders just what the BLS “measures” with its monthly CPI update.

In any case, for those lucky Americans who can afford to own a house instead of being stuck renting the New Normal American dream (where they are prohibited from peddling fiction as their annual rent increases by 10% or more each year), here is the breakdown of the best and worst cities, if only from the perspective of price appreciation in the U.S.

To be sure, one can argue that the best places to buy a house is inverted from where the current appreciation is highest, since this is where housing is relatively undervalued.

At the top, with annual price increases of 10% (rounded up) to over 12%, we find the usual west coast (and thus closest to China) suspects for the second month: Portland, Seattle and Denver, with the cities closest to Vancouver not surprising continue to see Y/Y growth. What is surprising is that what until recently was a superstar in this category, San Francisco, has seen its annual price increase drop to just 6.5% from 9.3% in February.

On the other end once again are Cleveland, Washington and, the worst performer of all, New York.

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Yesterday, as the fallout from the latest Turkish incursion into Northern Syria was being digested and the US realized that far from an expansion in Ankara’s campaign on ISIS, Erdogan was merely using the Islamic State as a pretext to expand his war against the Kurdish militia, known as YPG – which also happens to be a part of the broader US-backed Syrian Democratic Forces (SDF) coalition – the DoD  said that “we want to make clear that we find these clashes — in areas where [ISIS] is not located — unacceptable and a source of deep concern.”

 

 

24 hours later Turkey responded, saying that the US comments that Turkey’s clashes in areas where ISIS is not located “are unaccpetable”, are themselves unaccpetble, and that the US should just ahead and mind its own business.

BREAKING Turkish MFA: US comments on scope and targets of #EuphratesShield op in Syria are unacceptable. http://pic.twitter.com/z9EUXkuXGv

— CNN Türk ENG (@CNNTURK_ENG) August 30, 2016

Specifically, Turkey’s Foreign Ministry Spokesman Tanju Bilgic said in a written statement on Tuesday that comments on Turkey’s operation in Syria by U.S. officials including the secretary of defense, White House spokesman, and special envoy for the fight against Islamic State are “unacceptable” adding that the goal of Turkey’s “Euphrates Shield” operation in Syria is clear: to bring the scourge of terrorism to a level that it no longer disturbs Turkish citizens.

The problem for the US is that among the terrorist Turkey also now officially counts America’s “allies” the YPG.

And so, Joe Biden’s appeasament attempt last Wednesday when he arrived in Turkey to show support for Erodgan, and which as we dubbed would be quickly seen as a humiliation, is now an even greater humiliation for US foreign policy.

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UBS' Paul Winter believes we are witnessing the end of the credit cycle – earnings growth rates are flat, and the stock market impact has been increasing. Importantly, from a risk perspective, Winter warns that Systemic Risk is rising, and Economic Policy Uncertainty has hit all-time highs, warning that the key risk today lies in low-volatility stocks and the broad market's equity risk premia – "either earnings need to pick up dramatically, or alternately, equities would need to correct by around 20% to bring the equation back into equilibrium."

The age of excess liquidity and inexpensive debt is over, according to Winter, and that makes it harder for management to use credit to satiate investors' demands for corporate profits

UBS notes that "77% of stock crashes are driven by earnings announcements," and more companies are likely to disappoint the market in the future.

We are currently witnessing the end of the credit cycle. Credit spreads have been increasing, global earnings growth rates are in aggregate flat and market impact has been increasing.

Market impact is currently running at 80bps across developed markets, a level that tends to be commensurate with negative returns and an elevated risk of correction. The risk today, oddly is in so-called ‘low risk’ assets. We show that low volatility assets are generally more highly geared than higher volatility stocks. As a consequence, they tend to have a high residual beta to credit. As lending standards tighten and credit spreads increase, it is likely that highly geared stocks underperform regardless of their volatility.

Conventional wisdom defines a bubble as any asset driven by ‘irrational exuberance’ that exhibits valuations that have drifted significantly from their long term valuations. This opens the door for bonds, property and equities to all be defined as bubbles right now, and perhaps they are. So how should we frame our thinking in terms of ‘What’s priced in?” and ‘Where’s the mispricing?”.

In theory, bubbles perpetuate themselves due to the business risk of asset managers. This motivates institutional herding and ‘rational bubble-riding’. As a consequence, bubbles, once formed, can last a long time.

What’s priced in?

If we think of asset bubbles in terms of expected growth, valuations and risk premia, then given a world of structurally low growth and low inflation, we expect structurally low bond yields, and hence earnings yields on the market to trade at lower levels. (Please see our paper on Demographics). However, we identify two key areas that may be overvalued.

Where’s the mispricing?

Equity risk premia

Firstly, equities in general are trading at very high multiples given the level of growth that the world is experiencing, which makes sense given the level of bond yields, however, this doesn’t appear to be pricing the level of macro risk that we’re witnessing in the market. Developed world earnings yields are at 4.8% and bond yields at 0.5%, as a consequence, the simple equity risk premium is trading at 4.3% (Earnings Yield – Bond Yield).

However, following Cliff Asness’s (2000) paper ‘Explaining the Equity Risk Premium’ we show the relationship between ten year earnings growth rates and the ten year volatility differential between equities and bonds (Figure 3), and subsequently the ten year volatility differential and the ten year average equity risk premium (Figure 4).

The thesis simply put is that earnings growth risk drives the volatility differential between equities and bonds, and it is this volatility differential that explains the equity risk premium. Why use ten year averages? Quite simply the short term relationships between these variables are not stable. However, Asness theorises that there is a long term generational phenomenon whereby investors frame their risk preferences and return expectations in terms of their prior experiences, as a consequence, using ten year averages (Asness uses 20 year averages) captures this effect.

Given that earnings growth rates are currently running at -1.5% per annum, we should expect a volatility differential of 11% and an equity risk premium of around 6% (assuming historical preferences hold true).

So whilst the simple equity risk premium is currently at 4.3%, the historical relationship between earnings growth, volatility differentials and risk premia, would suggest a more appropriate risk premium of around 6%.

How does this correct itself?

Either earnings need to pick up to around 4%, which would suggest a decline in equity market volatility and justify a 4% risk premium.

 

Or alternately, equities would need to correct by around 20% to bring the equation back into equilibrium.

Low volatility risk

Secondly, low volatility equities are trading at significantly higher multiples relative to the market. Importantly, whilst low volatility stocks appear to be trading on a premium to their own history, it should also be noted that these stocks make up a significant proportion of the market by weight.

Low volatility deciles 1, 2 and 3 make up approximately 45% of the market by market capitalisation. As a result, the overvaluation of low volatility stocks is significantly contributing to the valuation of the market as a whole.

These stocks tend to have higher levels of gearing and whilst they have a low beta to equity markets (Figure 7), they carry a higher residual beta to credit markets (Figure 8).

If this is indeed the end of the credit cycle, we believe these stocks are likely to underperform.

*  *  *
While the earnings and credit cycle is rolling over, it is exogenous shocks that are more likely to increase market crash risk…

Exogenous shocks: are by definition difficult (if not impossible) to predict, an example being the 1973 Oil price shock. Importantly, as we have traversed from a world of high growth into a post financial crisis world of lower growth, macro-economic risk has picked up significantly.

We measure these risks using three different approaches:

(a) Macro factor model: the level of market risk explained by macro factors,

 

(b) Policy uncertainty: the level of policy uncertainty measured using a keyword search in major news publications,

 

(c) Systemic risk: an estimate of the capital that financial institutions would need to raise in the event of another financial crisis.

Macro shocks

Macro risk has been dormant for many years, however, post the Global Financial Crisis, we have traversed into a world of structurally lower growth, and macro risk is dominating as a driver of returns. Below we show the percentage of returns driven by macro factors over time. The key point here is that pre-2007 the twoyear bond yield was a key driver of returns. However, post-2007, the market has been driven by a broader variety of macro risk factors, a key driver of which is the Corporate Credit Spread (shown below in red).

In this environment, understanding the key risk factors (drivers of volatility) is critical. From our perspective, the principal risks that we would like to understand are systemic risk and economic policy risk.

Systemic risk

This is measured as the capital shortfall within the financial system in the event of a significant market correction. We use the Robert Engle S-Risk methodology (Brownlees and Engle, 2007). It is a function of market capitalisation, leverage and volatility.

As part of their study Brownlees and Engle found that the SRISK model delivered useful rankings of financial institutions at various stages of the Global Financial Crisis and correctly identified the key contributors as early as 2005. Interestingly, they also found that aggregate SRISK provided early warning signals of weakness in indicators of real activity.

Policy uncertainty

The second principal risk that we seek to understand is economic policy risk. Here, we use data from Economic Policy Uncertainty (http://ift.tt/UIGg2l), a model that has been put together by Scott Baker (Northwestern Universtiy), Nick Bloom (Stanford University), and Steven Davis (University of Chicago).

The indices that they have developed are based on the frequency of economic policy uncertainty coverage.

The methodology is quite intuitive and searches for the trifecta of words pertaining to the economy, uncertainty and policy. They then scale this by the total number of articles in the newspaper and standardise across the newspapers covered and take the monthly average.

Using firm-level data, they find that policy uncertainty increases stock price volatility and reduces employment and investment in policy-sensitive sectors such as healthcare, infrastructure construction and defence. At a macro level, they find that increases in economic policy uncertainty foreshadow declines in economic growth and employment in subsequent months.

Conclusion

In a world of heightened macro factor, systemic and economic policy risk, we should expect higher levels of equity market volatility.

Source: UBS

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While Black Lives Matter continues to be the topic of national progressive and race debate, with its participants appearing in numerous media outlets while collecting generous donations from the likes of George Soros, its diametrical opposite, White Lives Matter – a group which calls itself an opponent of the Black Lives Matter movement – has just been declared a hate group by the Southern Poverty Law Center, an organization that tracks extremist groups in the United States.

“I can’t speak to how many chapters will be listed, but it’s clear that the leadership of the group, the ends of the group — it’s just a flat-out white supremacist group,” said Heidi Beirich, director of the center’s Intelligence Report, in an interview with Chron.com.  “The White Lives Matter website says their movement is dedicated to the preservation of the white race. That tells you all you need to know,” Beirich added cited by the NYT. “They’re against integration, immigration. This is standard white supremacist stuff.”

“The ideology behind it, the racist leaders, everything about it is racist,” Beirich has concluded.

According to the NYT, the group, which grew out of a social media meme, argues that white Americans are victims of a genocide caused by factors like the immigration of nonwhite people and marriage between white Christians and nonwhites or Jews, Ms. Beirich said. The law center’s designation is meant to draw attention to and increase scrutiny of the group’s activities. Last week, its members held a protest outside the Houston office of the National Association for the Advancement of Colored People to demand that it denounce Black Lives Matter, according to video posted online by the group. The Houston Chronicle reported that some of the protesters carried assault rifles and Confederate flags.

Researchers with the law center said White Lives Matter had been promoted by the Aryan Renaissance Society, a group in Texas that is a member of the United Aryan Front, a white nationalist coalition.

Beirich said the center’s designation focused on one chapter of the group based in Nashville that is led by Rebecca Barnette, a leader of the Aryan Strikeforce, a skinhead group, and the National Socialist Movement, America’s largest neo-Nazi group.  Barnette did not respond to a NYT email seeking comment on Monday, but White Lives Matter posted several videos criticizing the Southern Poverty Law Center to its YouTube channel in the past two days. One video described White Lives Matter’s members as “just the guy next door.”

Ms. Barnette described herself as White Lives Matter’s co-founder in her profile on Vk.com, a Russian social networking site preferred by white nationalists for its lenient approach to posts that contain racist content. She said the group’s name had “been picked up by several other groups who are doing their own things with it.” Mark Pitcavage, a researcher at the Anti-Defamation League, agreed that the phrase had spread beyond the group.

“White Lives Matter is a concept around which you can organize an event without necessarily being a formal organization,” he said. “It is essentially the sum of the number of people who have done actions in the name of White Lives Matter.” “For white supremacists, ‘White Lives Matter’ is an obvious meme, so they will use it,” he said.

Hate groups have been steadily on the rise since 1999, starting with 457 groups identified by the SPLC. The center says the number exploded around the turn of the century “driven in part by anger over Latino immigration and demographic projections showing that whites will no longer hold majority status in the country by around 2040.” The number of hate groups peaked in 2011 with 1,018 identified groups, before decreasing and reaching its lowest point of 784 groups in 2014. However, that number is back on the rise, with 892 groups identified in 2015.

So why is the SPLC branding White Lives Matter a hate group and ignoring Black Lives Matter?

Short answer: the center says the Black Lives Matter movement is not a hate group because it seeks to promote a race that has been marginalized throughout history (in other words, black lives also matter.) Plus, the center points out the movement’s leaders have condemned violence.

The center also absolved itself by saying that “thousands of white people across America – indeed, people of all races – have marched in solidarity with African Americans during BLM (Black Lives Matter) marches, as is clear from the group’s website.” 

The irony, of course, as many have pointed out is that if indeed the Black Lives Matter movement is so intent in its mission, namely explaining to the world that black lives matter, why did Chicago just record its most violent month in 20 years, as a result of hundreds of mostly black people shot, killed or wounded? Or is the group’s mission merely to explain to whites how black lives matter, even as thousands of inner-city mostly black males die every year, without anyone as much as batting an eyelid.

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