Month: July 2014

The last six months have not run according to anyone’s plan.  Who would have thought that equity market structure would yield a best-selling book, after all?  As ConvergEx’s Nick Colas notes, on the fundamental side of things, interest rates across the developed world are lower, not higher – counter to the consensus view just 180 days ago. Mutual fund investors first bought U.S. equities earlier in the year, then in the last 6 weeks have begun to liquidate in earnest. Exchange Traded Fund investors are buying more fixed income products than those dedicated to U.S. stocks. Large cap stocks are trouncing small caps in terms of performance. And as for volatility – well, Elvis has clearly left the building on that one. So which of these surprises has staying power into the back half of 2014?

Expect the market structure debate to continue, and look for higher interest rates and more of the same slow churn higher for stocks.  And that long awaited 10% correction?  Probably not until 2015 – which is only 189 days away…

Via ConvergEx’s Nick Colas,

What a year the first half of 2014 has been – one to humble the savviest prognosticator, really.  As the ball dropped in Times Square 176 days ago, the narrative for capital markets was blissfully simple:

Economic growth would accelerate in the US, stocks would do well, bonds would retreat, and investors would grow bolder in their equity allocations.

 

Small cap stocks would outperform large caps, if only because they had the wind at their sails as we exited 2013.

 

Equity markets had a good chance to see a 10% correction, probably early in the year.

We got exactly none of those outcomes, proving the old adage that “If you are going to predict the future, do it often.”  With that in mind, today we offer up a list of ‘Top Five Surprises of 2014’ and some comments about which of them has the staying power to make it to 2015.

Surprise #1: Market Structure Can Be Interesting.  The biggest surprise of the year is actually not from the world of economics or asset prices.  It is that, with a clever enough narrative, people outside the financial profession will care about the world of maker-taker pricing, high frequency trading, and how the plumbing of the U.S. equity markets actually works.  Michael Lewis’ “Flash Boys: A Wall Street Revolt” may no longer be on the Amazon best sellers list, but it’s still inside the top 150 and has over 1,500 customer reviews and a 4.5 star rating. Predictably, you can buy it as a bundle with Thomas Piketty’s “Capital in the Twenty-First Century” if you click the “We’re All Doomed” package offer.

 

Easy prediction here: this issue isn’t going away.  SEC Chairwoman Mary Jo White’s recent speech on market structure points to a lasting interest in the topic on the part of the Commission. No doubt the eventual alterations won’t be enough for some market watchers, but the Street is abuzz with chatter of the changes many traders expect to come in the next 6 months.

 

Surprise #2: Interest Rates Are Never, Ever Going Up Again – Or So It Feels, Anyway.  This was supposed to be the year where the U.S. Treasury curve steepened to reflect accelerating economic growth and the chance for greater inflation.  It was the “No Brainer” trade of the first half.  Turns out that the zombie-like move lower for rates explains the lack of brains.  Momentum, disappointing economic growth during a tough winter, a still sluggish labor market with few signs of wage inflation, a Europe on the brink of deflation – the list of reasons for a bond market rally this year are long and distinguished.

 

So where do we go from here?  It is hard to imagine a world where both 10-Year Treasury yields at 2.56% and the S&P 500 at 1960 are sustainable levels.  Either bonds are right and U.S. economic growth will remain moribund, or equity prices correctly reflect a better second half.  Yes, bond investors tend to get these calls right more often than their equity brothers and sisters, but we are going to side with stocks here.  Bond yields should back up in the second half, to the 3% on 10-year levels we had at the beginning of 2013.  The reasons – slightly better economic growth (2.0-2.5% GDP for 2H 2014) and the end of the Federal Reserve’s bond buying program.  A little more inflation – visible, CPI headline and core inflation – would be helpful too.

 

Surprise #3 – Retail Investors Are Back!  Well, they were for a while.  According to the Investment Company Institute, mutual fund investors in the U.S. finally started to buy domestic equity funds from January to April 2014, to the tune of $18 billion. The bad news?  Since the first week of May, they have redeemed $15 billion. The trend is not U.S. stock’s friend here.  Looking at Exchange Traded Fund money flows, courtesy of our friends at www.xtf.com, and the data is modestly more positive. Total ETF money flows into U.S. listed products totals $69 billion year to date. Of that, $19 billion went to U.S. equity products. Not bad, until you consider that ETF investors added $22 billion to fixed income funds over the same period.

 

Calling money flows over the back half of 2014 into ETF products is pretty simple – it will likely run about $150 billion, or just over double the first half run rate.  December is usually a big month for ETFs with tax loss selling, so that’s the reason for the slightly better whole-year numbers.

 

As for retail investors into mutual funds, that’s a tougher call.  Keep in mind that from the March 2009 lows, mutual fund investors have redeemed just over $350 billion of assets from U.S. stocks funds.  Yes, into the teeth of a massive bull market, mutual fund holders have sold their positions all the way up.  Seasonally, the balance of the year is not generally good for mutual fund money flows, as higher income earners usually hit their contribution limits with the Q1 bonus payments.

 

So who is left to buy?  We can think of three constituents.  First are public companies themselves through their buyback programs.  Second are hedge funds chasing performance.  Lastly are individual investors buying single names.  We tend to believe that ETFs have replaced a lot of single-stock asset allocation decisions for this group, even if active traders still focus on individual names.

 

Surprise #4 – Small Caps RULE!…  Until they don’t. The Russell 2000, one of the most widely followed small cap indices out there, has been a major disappointment this year to date – up only 2.0%.   By contrast, the S&P 500 is up 6.0% and the CRSP Total Market Index (a market cap weighted index of the 1475 largest names by that measure) is up 5.8%. Now, taken over the last year, the performance numbers are very close – Russell up 23.1%, S&P 500 up 23.4%, and Total Market up 24.2%.

 

So will small caps start to outperform large caps now that their performance has reset to the market averages?  I tend to doubt it, for two reasons.  First, with the European Central Bank’s aggressive monetary policies – current and future – will create hope for a better 2015 on the continent.  Larger companies tend to have more overseas operations than smaller ones, so they stand to benefit from those moves. Second, the economic picture in the U.S. is likely going to remain tenuous for much of the third quarter and perhaps into the fourth. That pesky 2.56% yield on the 10-Year Treasury tells you all you need to know there.  Larger companies tend to be more defensive than higher-beta small caps, and investors looking for equity exposure will likely dust off the late-cycle playbook and move upstream just in case the hoped-for acceleration does not come to fruition.

 

Surprise #5: Elvis – and Volatility – Has Left the Building.   Aside from the surprising fact that Michael Lewis could get people interested in how stocks trade, the biggest surprise in 2014 thus far is that no one seems to care how stocks trade.  If they did, there would be more investors expressing divergent viewpoints and pushing volatility higher.  Instead, actual volatility remains low and options prices indicate that few people think that will change materially any time soon. The long run average of the CBOE VIX Index is 20; it currently sits at 11.6, or more than one standard deviation from the mean.

 

What will drive volatility back into the markets?  Yes, a large geopolitical shock is always good for jolting investors back to reality. So that could happen. But aside from that, it seems we are in for a long slow summer and early fall for 2014.  I was writing about the VIX back in 2007, the last time it got here.  And if you want to say “Aha! – that reversion in volatility averages will happen again!”, let me remind you that the VIX was also here in 2005.  And 2006.  Volatility, or the lack of, can linger far longer than you think possible. And one last word on the topic – the VIX tends to bottom for the year in December.  Not the summer.

In the end, it seems that the first half of 2014 is largely a prologue for the second half. Would it be nice to get more volatility (better opportunities to find mispriced securities) and see rates back up (pushing money into stocks)?  Yes on both counts. And we should get some movement on rates. But as for stocks, volatility seems to be more of a 2015 game.  But don’t feel bad – that is only 189 days away.

via Zero Hedge http://ift.tt/1lCS0w4 Tyler Durden

We have written extensively about the problem surrounding the rehypothecation of “non-existent” Chinese commodities, the bulk of which have been used in some form of Commodity Funding Deal over the last few years: something which various banks have said would be the tipping point that finally launches China’s long delayed Minsky Moment. After all, if there is one thing China has taught the west, it is how to kick everything that is broken about one’s financial system as far as the eye can see, and then also eliminating any living witnesses just in case. And further, since virtually the entire Chinese financial sector is partially state-owned, it is rather easy for the politburo to reallocate funds from Point A to Point B in order to preserve that all important commodity – confidence.

But for all the theoretical explanations about China’s profound commodity rehypothecation problems, the one thing that was missing was an empirical case study framing just how substantial the problem is. After all, it is one thing to say banks expect “X millions in losses”, but totally different to see the rehypothecation dominoes falling in practice.

Today, courtesy of Bloomberg we got just such an example.

Meet Decheng Mining.

Decheng is a well-known name to those who follow developments in China’s murky shadow banking system. It is the company which was sued by China’s Shanxi Coal International Energy Group a week ago over missed payments. As Reuters reported at the time, “Shanxi Coal said in a statement to the Shanghai Stock Exchange it was suing six clients over a total of more than $177 million in missed payments. Of that total, $120.4 million of overdue payments were in dollars, plus a further 352.5 million yuan ($56.77 million).”

Sadly, that was as far as Shanxi Coal went – it did not specify how much it was owed by Decheng Mining and its parent company, Dezheng Resources. Arguably because the last thing Shanxi wanted was to spook some of its own vendors and creditors, especially as Chinese coal prices fell to record lows over the past week exacerbating the plight of the local coal industry.

Yet one reason why Decheng’s sudden insolvency did not come as a surprise is that it was one of the main companies investigated by Chinese authorities over precisely the rehypothecation scandal that was engulfed China’s third largest port, Qingdao, having been accused of obtaining multiple loans secured against a single cargo of metal.

As of today we know exactly why Decheng was unable to pay its bills.

As Bloomberg reports, Decheng Mining pledged the same metals stockpile three times over to obtain more than 2.7 billion yuan ($435 million) of loans in China’s Qingdao port, a person briefed on the matter said, citing preliminary findings of an official investigation.

From Bloomberg:

Local authorities are checking metal inventories worth about 1.54 billion yuan including 194,000 tons of alumina, 62,000 tons of aluminum and some copper, the person said, asking not to be identified as he isn’t authorized to speak publicly. Two calls to Decheng Mining, a metals trading house based in Qingdao, went unanswered.

 

Foreign and local banks are examining lending linked to metals at Qingdao amid concern that risks are more widespread in China, where traders use commodities from iron ore to rubber to get funding. Steps by the Chinese government to rein in credit raised companies’ borrowing costs in recent years and triggered a surge in commodities financing deals that Goldman Sachs Group Inc. estimates to be worth as much as $160 billion.

 

“The whole Qingdao probe will just keep fermenting, inevitably leading to banks increasing their scrutiny of commodities-backed financing activities,” Fu Peng, chief strategist at Galaxy Futures Co., said by phone from Beijing.

 

Bank of China Ltd., Export-Import Bank of China, China Minsheng Banking Corp. and 15 other Chinese banks have lent a total of about 14.8 billion yuan to Chen Jihong, Decheng Mining’s owner, and his companies, the person said.

Well that is a little over $2 billion that the lenders will never recover as the money has almost certainly been (re-re-) used to purchase commodities which were then repledged countless times in order to generate the arb we first described in May of 2013.

Chen, a Singaporean national, has been detained and the city-state’s foreign ministry is providing consular assistance to him and his family, the ministry said June 11. He is also involved in a separate inquiry in northwestern Gansu province, two bankers assisting with the probe told Bloomberg last month.

 

The collateral ratio for loans to Dezheng Group, Decheng Mining’s parent, was 55 percent as of June 13, Minsheng Bank said in a text message in response to questions last month. That means for every 100 yuan of collateral offered by the borrowers, 55 yuan was given in loans.

Unfortunately for Minsheng, that number is a clear fabrication considering the real collateral to loan ratio is more like 300%.

Press officers at Bank of China and Minsheng Bank based in Beijing declined to comment, while spokesmen for Export-Import Bank weren’t immediately available.

 

Local government officials are updating creditors about the probe on a weekly basis, with the latest meeting held on July 1, the person said.

 

Lenders are tightening their commodity financing criteria in the wake of the probe. Some Chinese banks have raised margins for letters of credit for iron-ore financing to 30-to-50 percent from 15-to-30 percent previously, people familiar with the matter said June 10. Others reduced overall credit available for iron-ore financing and have set up a cap on credit used in some locations, the people said.

As for the punchline, we hardly doubt we need to note it: if one trader effectively managed to “evaporate” half a billion in collateral and three times as many derivative loans, what does that mean for the entire Chinese rehypothecation industry? And keep in mind this is China – what is presented for public consumption is without doubt far better than what has really happened.

Recall from our CFD flowchart explanation a year ago, that the practical rehypothecation limit is, well, non-existent.

Step 1) offshore trader A sells warrant of bonded copper (copper in China’s bonded warehouse that is exempted from VAT payment before customs declaration) or inbound copper (i.e. copper on ship in transit to bonded) to onshore party B at price X (i.e. B imports copper from A), and A is paid USD LC, issued by onshore bank D. The LC issuance is a key step that SAFE’s new policies target.

Step 2) onshore entity B sells and re-exports the copper by sending the warrant documentation (not the physical copper which stays in bonded warehouse ‘offshore’) to the offshore subsidiary C (N.B. B owns C), and C pays B USD or CNH cash (CNH = offshore CNY). Using the cash from C, B gets bank D to convert the USD or CNH into onshore CNY, and trader B can then use CNY as it sees fit.

 

The conversion of the USD or CNH into onshore CNY is another key step that SAFE’s new policies target. This conversion was previously allowed by SAFE because it was expected that the re-export process was a trade-related activity through China’s current account. Now that it has become apparent that CCFDs and other similar deals do not involve actual shipments of physical material, SAFE appears to be moving to halt them.

 

Step 3) Offshore subsidiary C sells the warrant back to A (again, no move in physical copper which stays in bonded warehouse ‘offshore’), and A pays C USD or CNH cash with a price of X minus $10-20/t, i.e. a discount to the price sold by A to B in Step 1.

 

Step 4) Repeat Step 1-Step 3 as many times as possible, during the period of LC (usually 6 months, with range of 3-12 months). This could be 10-30 times over the course of the 6 month LC, with the limitation being the amount of time it takes to clear the paperwork. In this way, the total notional LCs issued over a particular tonne of bonded or inbound copper over the course of a year would be 10-30 times the value of the physical copper involved, depending on the LC duration.

Get that? A rehypothecation limit upward of 15x and as much as 30x. Now imaging the millions of tons of copper, aluminum and various other funding metals just sitting there, and collateralizing some 30 times their notional value in loans.

Surely this explains why foreign banks operating in China are starting to sweat profusely, especially since not only Qingdao, but a second port, Penglai, has now been implicated. From the WSJ:

Local authorities in Qingdao, and Penglai, another port city also in Shandong province, have been investigating whether the metals have been reused several times as collateral by traders and companies seeking funding. Already, a major state-owned enterprise, Citic Resources Holdings Ltd. , said some metals that it has stored at the Qingdao port can’t be located.

 

But because banks can’t get access to the storage facilities at Dagang in Qingdao and Penglai port where the probes are under way, the scale of any possible losses can’t be tallied up.  “I have the impression that a lot of people do not know where it stands, which makes me nervous,” said one executive at a Western bank.

Bingo. Actually, it can, and one word can be used to explain the losses: “lots.” Or “lots, lots” if the problem is not just contained to ports but, as we also warned over a year ago, is spread across the fabric of China’s entire financial system.

There is some indication that the probes may no longer be local. In recent days, one of the banks that has been seeking to access the storage facility at Penglai has been informed that the probe now include authorities from Beijing, according to a person familiar with the matter.

 

The Hong Kong Monetary Authority, or HKMA, said it is keeping a close eye on developments amid concerns that banks in the city have become dangerously exposed to China’s economy through excessive lending.

 

“The HKMA has been closely monitoring the credit exposure, including those incurred from the business of commodity finance, of the banking sector,” a spokeswoman said in an emailed response to queries Friday. “Authorized institutions are expected to maintain sufficiently robust system of controls to manage the specific risks that they are facing,” an HKMA spokeswoman said.

But why would the Hong Kong central bank be concerned? Doesn’t it know that the addition of 800,000 part-time jobs coupled with the collapse of over half a million full time jobs was just spun as the most positive jobs report in the US since 1999 and led to the first Dow Jones close over 17,000 ever? After all, can’t the HKMA just BTFATH and watch its problems disappear? After all that is precisely what the US administration beckons the local middle class to do. Because who needs a job, be it full or part time, when one has an E*trade terminal.

via Zero Hedge http://ift.tt/1lCN0aR Tyler Durden

Submitted by Michael Krieger of Liberty Bliutzkrieg blog,

On Monday, Quartz published an article by Devin Cohen titled, There is a Secret Ingredient in Your Burgers: Wood Pulp. Given the headline and people’s already present suspicion regarding all of the shady and potentially dangerous ingredients hidden in food items, the article gained a lot of traction. In subsequent days, most journalists and bloggers have focused on the dangers of this additive (unclear) and whether or not it is pervasive throughout the food chain as opposed to just fast food (it appears to be).

The one angle that has not been explored as much is the overall trend. Let’s go ahead and assume that wood pulp is a safe thing to consume, it certainly seems to have no nutritional value whatsoever. So why are companies inserting it into food items? To mask inflation and earn more profits most likely. This was a major theme I focused on last year in a series of pieces on stealth inflation and food fraud, a couple of which can be read below:

New Study Shows 59% of “Tuna” Sold in the U.S. Isn’t Tuna

New Study Shows: Food Fraud Soared 60% Last Year

The Quartz article notes that:

There may be more fiber in your food than you realized. Burger King, McDonald’s and other fast food companies list in the ingredients of several of their foods, microcrystalline cellulose (MCC) or “powdered cellulose” as components of their menu items. Or, in plain English, wood pulp.

 

The emulsion-stabilizing, cling-improving, anti-caking substance operates under multiple aliases, ranging from powdered cellulose to cellulose powder to methylcellulose to cellulose gum. The entrance of this non-absorbable fiber into fast food ingredients has been stealthy, yet widespread: The compound can now be found in buns, cheeses, sauces, cakes, shakes, rolls, fries, onion rings, smoothies, meats—basically everything.

 

The cost effectiveness of this filler has pushed many chains to use progressively less chicken in their “chicken” and cream in their “ice cream.”

This is the part that really interests me. When did these companies first introduce this substance into their products and what is the growth trend? My guess is that as food costs have risen, the proportion of non-nutritonal fillers has increased substantially. That said, I’d like to see some data and I haven’t yet.

My big takeaway here is the same as last year’s when I first started writing about the trend. As the cost of food continues to rise, the cost of not paying attention to what you are eating rises exponentially. Companies will continue to try to mask inflation by shrinking package sizes, and when that is no longer possible, increasingly inserting empty fillers (or worse) into their products.

Meanwhile, the following video is a telling spoof on the ingredients in McDonald’s Chicken McNuggets.

On a related note, if you haven’t read my recent post on BPA, definitely take the time: National Geographic Reports – Chemicals Causing Infertility in Pigs are Present Throughout Human Consumer Goods.

Bon Appétit.

via Zero Hedge http://ift.tt/1j0GCjh Tyler Durden