Japan Plans To "Nationalize" 280 More "Ownership-Unknown" Islands

15 months after acquiring three disputed islands in the Senkakus, and amid growing tensions with the Chinese following tit-for-tat air-defense zones, Abe’s visit to the war-shrine, and public-opinion battles; Japan may have just cranked the rhetoric dial to 11. As Japan Times reports, the Japanese government will nationalize about 280 islands whose ownership is unknown out of the about 400 remote islands that serve as markers for determining Japan’s territorial waters.

Under the plan, announced Tuesday, the government will complete its search for the islands’ owners (which began in August) by June. This follows already tense warnings this evening from China that “Japan’s moving in a dangerous direction.”

It seems the Abe nationalism fears were not exaggerated.

 

Via Japan Times,

The government will nationalize about 280 islands whose ownership is unknown out of the about 400 remote islands that serve as markers for determining Japan’s territorial waters, the state minister for oceanic policy and territorial issues has announced.

 

Under the plan, announced Tuesday, the government will complete its search for the islands’ owners by June. Islands whose owners have not been tracked down by then will be registered on the national asset ledger.

 

The move aims to clarify the government’s intention to protect territories and territorial waters by designating remote islands as “important national territories,” and to reinforce the management of marine resources and national security.

 

The search for owners was started in August last year by the Headquarters for Ocean Policy, led by Prime Minister Shinzo Abe.

 

 

Registering [remote islands] as Japan’s national assets would send a message that we intend to strengthen management of them,” Ichita Yamamoto, the state minister for oceanic policy and territorial issues, said at a press conference. “The government must accurately grasp the state of these remote islands.”

 

 

About 500 islands serve as the base points for establishing Japan’s territorial waters and exclusive economic zone. However, information about some of the islands, including their owners, has yet to be confirmed.

This won’t end well… especially with the Koreans now openly decrying the monetary policies of the Japanese also…


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/p8xCCuz65QY/story01.htm Tyler Durden

Libya Warns: Oil Tankers At Closed Ports “Will Be Destroyed”

Armed groups, demanding autonomy for eastern Libya, have invited foreign companies to buy oil from ports they have seized in defiance of the central government in Tripoli. As Reuters reports, “If a ship docks in one of the closed ports,” warned Libya’s defense ministry, “then we will destroy it,” but the group, led by tribal leader and 2011 civil war hero Ibrahim Jathran, shrugged off Tripoli’s warning, stating “we welcome global oil companies … The oil security guards will guarantee the safety of tankers.” The development adds to an air of chaos as the weak Tripoli government struggles to rein in the armed groups that helped oust Muammar Gaddafi in 2011 but which kept their guns and are now demanding political power and a bigger share of the country’s oil wealth.

 

Via gCaptain (Reuters),

Armed groups demanding autonomy for eastern Libya have invited foreign companies to buy oil from ports they have seized in defiance of the central government in Tripoli.

 

In an announcement on Tuesday, they also pledged to protect tankers loading crude, after the Libyan defence ministry said it would destroy vessels using ports in the east, which are under control of the protesters linked to a self-proclaimed regional government.

 

 

On Monday, the Libyan navy said it fired warning shots at a tanker trying to load oil at the eastern port of Es-Sider, which was seized with two other terminals by the autonomy group in August. The three harbours accounted previously for 600,000 barrels a day.

 

But the group, led by tribal leader and 2011 civil war hero Ibrahim Jathran, shrugged off Tripoli’s warning by inviting foreign companies to buy eastern oil.

 

 

“We welcome global oil companies … The oil security guards will guarantee the safety of tankers,” said Abd-Rabbo al-Barassi, prime minister of Jathran’s self-declared government in the eastern Cyrenaica region.

 

Workers at the seized ports had returned to work, he said. A newly founded oil company called Libya Oil and Gas Corp would be dealing with potential buyers. A new army and coast guard, made up of Jathran’s battle-hardened fighters, would secure the ports.

 

 

Libya’s defence ministry had earlier warned potential buyers against any docking at the seized ports. “If a ship docks in one of the closed ports, and it does not leave the port again, then we will destroy it,” said Defence Ministry spokesman Said Abdul Razig al-Shbahi.

 

The risks of an escalation were clear over the weekend when the Libyan navy said it opened fire on a vessel trying to reach Es-Sider before the tanker, Baku, turned back to Malta.

 

 

The confrontation has raised worries that Libya, also struggling with Islamist militias and armed tribesmen, might break apart as Cyrenaica and the southern Fezzan region demand political autonomy.



    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/bbCaQcz67xg/story01.htm Tyler Durden

Libya Warns: Oil Tankers At Closed Ports "Will Be Destroyed"

Armed groups, demanding autonomy for eastern Libya, have invited foreign companies to buy oil from ports they have seized in defiance of the central government in Tripoli. As Reuters reports, “If a ship docks in one of the closed ports,” warned Libya’s defense ministry, “then we will destroy it,” but the group, led by tribal leader and 2011 civil war hero Ibrahim Jathran, shrugged off Tripoli’s warning, stating “we welcome global oil companies … The oil security guards will guarantee the safety of tankers.” The development adds to an air of chaos as the weak Tripoli government struggles to rein in the armed groups that helped oust Muammar Gaddafi in 2011 but which kept their guns and are now demanding political power and a bigger share of the country’s oil wealth.

 

Via gCaptain (Reuters),

Armed groups demanding autonomy for eastern Libya have invited foreign companies to buy oil from ports they have seized in defiance of the central government in Tripoli.

 

In an announcement on Tuesday, they also pledged to protect tankers loading crude, after the Libyan defence ministry said it would destroy vessels using ports in the east, which are under control of the protesters linked to a self-proclaimed regional government.

 

 

On Monday, the Libyan navy said it fired warning shots at a tanker trying to load oil at the eastern port of Es-Sider, which was seized with two other terminals by the autonomy group in August. The three harbours accounted previously for 600,000 barrels a day.

 

But the group, led by tribal leader and 2011 civil war hero Ibrahim Jathran, shrugged off Tripoli’s warning by inviting foreign companies to buy eastern oil.

 

 

“We welcome global oil companies … The oil security guards will guarantee the safety of tankers,” said Abd-Rabbo al-Barassi, prime minister of Jathran’s self-declared government in the eastern Cyrenaica region.

 

Workers at the seized ports had returned to work, he said. A newly founded oil company called Libya Oil and Gas Corp would be dealing with potential buyers. A new army and coast guard, made up of Jathran’s battle-hardened fighters, would secure the ports.

 

 

Libya’s defence ministry had earlier warned potential buyers against any docking at the seized ports. “If a ship docks in one of the closed ports, and it does not leave the port again, then we will destroy it,” said Defence Ministry spokesman Said Abdul Razig al-Shbahi.

 

The risks of an escalation were clear over the weekend when the Libyan navy said it opened fire on a vessel trying to reach Es-Sider before the tanker, Baku, turned back to Malta.

 

 

The confrontation has raised worries that Libya, also struggling with Islamist militias and armed tribesmen, might break apart as Cyrenaica and the southern Fezzan region demand political autonomy.



    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/bbCaQcz67xg/story01.htm Tyler Durden

23 Reasons To Be Bullish On Gold

Submitted by Laurynas Vegys via Casey Research,

It's been one of the worst years for gold in a generation. A flood of outflows from gold ETFs, endless tax increases on gold imports in India, and the mirage (albeit a convincing one in the eyes of many) of a supposedly improving economy in the US have all contributed to the constant hammering gold took in 2013.

Perhaps worse has been the onslaught of negative press our favorite metal has suffered. It's felt overwhelming at times and has pushed even some die-hard goldbugs to question their beliefs… not a bad thing, by the way.

To me, a lot of it felt like piling on, especially as the negative rhetoric ratcheted up. Last year's winner was probably Goldman Sachs, calling gold a "slam-dunk sale" for 2014 (this, of course, after it's already fallen by nearly a third over a period of more than two and a half years—how daring they are).

This is why it's important to balance the one-sided message typically heard in the mainstream media with other views. Here are some of those contrarian voices, all of which have put their money where their mouth is…

  • Marc Faber is quick to stand up to the gold bears. "We have a lot of bearish sentiment, [and] a lot of bearish commentaries about gold, but the fact is that some countries are actually accumulating gold, notably China. They will buy this year at a rate of something like 2,600 tons, which is more than the annual production of gold. So I think that prices are probably in the process of bottoming out here, and that we will see again higher prices in the future."
  • Brent Johnson, CEO of Santiago Capital, told CNBC viewers to "buy gold if they believe in math… Longer term, I think gold goes to $5,000 over a number of years. If they continue to print money at the current rate, I think it could be multiples of that. I see a slow steady rise punctuated with some sharp upward moves."
  • Jim Rogers, billionaire and cofounder of the Soros Quantum Fund, publicly stated in November that he has never sold any gold and can't imagine ever selling gold in his life because he sees it as an insurance policy. "With all this staggering amount of currency debasement, gold has got to be a good place to be down the road once we get through this correction."
  • George Soros seems to be getting back into the gold miners: he recently acquired a substantial stake in the large-cap Market Vectors Gold Miners ETF (GDX) and kept his calls on Barrick Gold (ABX).
  • Don Coxe, a highly respected global commodities strategist, says we can expect gold to rise with an improving economy, the opposite of what many in the mainstream expect. "You need gold for insurance, but this time the payoff will come when the economy improves. In the past when everything was falling all around you, commodity prices were soaring out of sight. We had three recessions in the 1970s and gold went from $35 an ounce to $850. But this time, gold is going to appreciate when we start getting 3% GDP growth."
  • Jeffrey Gundlach, bond guru and not historically known for being a big fan of gold, came out with a candid endorsement of the yellow metal: "Now, I kind of like gold. It's definitely very non-correlated to other assets you may have in your portfolio, and it does seem sort of cheap. I also like the GDX."
  • Steve Forbes, publishing magnate and chief executive officer of Forbes magazine, publicly predicted an impending return to the gold standard in a speech in Las Vegas. "A new gold standard is crucial. The disasters that the Federal Reserve and other central banks are inflicting on us with their funny-money policies are enormous and underappreciated."
  • Rob McEwen, CEO of McEwen Mining and founder of Goldcorp, reiterated his bullish call for gold to someday top $5,000. "We now have governments willing to seize their citizens' assets. We now have currency controls on the table, which we haven't seen since the late 1960s/early '70s. We have continued debasement of currencies. And the economies of the Western world remain stagnant despite enormous monetary stimulation. All these facts to me are bullish for gold and make me believe the price will bounce back relatively soon."
  • Doug Casey says that while gold is not the giveaway it was at $250 back in 2001, it is nonetheless a bargain at current prices. "I've been buying gold for years and I continue to buy it because it is the way you save. I'm very happy to be able to buy gold at this price. All the so-called quantitative easing—money printing—by governments around the world has created a glut of freshly printed money. This glut has yet to work its way through the global economic system. As it does, it will create a bubble in gold and a super-bubble in gold stocks."

And then there's the people who should know most about how sound the world's various types of paper money are: central banks. As a group, they have added tonnes of bullion to their reserves last year…

  • Turkey added 13 tonnes (417,959 troy ounces) of gold in November 2013. Overall, it has added 143.6 tonnes (4,616,847 troy ounces) so far this year, up 22.5% from a year ago, in part thanks to the adoption of a new policy to accept gold in its reserve requirements from commercial banks.
  • Russia bought 19.1 tonnes (614,079 troy ounces) in July and August alone. With the year-to-date addition of 57.37 tonnes—second only to Turkey—Russia's gold reserves now total 1,015 tonnes. It now holds the eighth-largest national stash in the world.
  • South Korea added a whopping 20 tonnes (643,014 troy ounces) of gold in February, and now carries 23.7% more gold on its balance sheet than at the end of 2012."Gold is a real safe asset that can help (us) respond to tail risks from global financial situations effectively and boosts the reliability of our foreign reserves holdings," said central bank officials.
  • Kazakhstan has been buying gold every month, at an average of 2.4 tonnes (77,161 troy ounces) through October. As a result, the country's reserves have seen a 21% increase to 139.5 tonnes from a year ago.
  • Azerbaijan has taken advantage of a slump in gold prices and has gone from having virtually no gold to 16 tonnes (514,411 ounces).
  • Sri Lanka and Ukraine added 5.5 (176,829 troy ounces) and 6.22 tonnes (199,977 troy ounces) respectively over the past year.
  • China, of course, is the 800-pound gorilla that mainstream analysts seem determined to ignore. Though nothing official has been announced by China's central bank, the chart below provides some perspective into the country's consumer buying habits.

China ended 2013 officially as the largest gold consumer in the world. Chinese sentiment towards gold is well echoed in a statement made by Liu Zhongbo of the Agricultural Bank of China: "Because gold has capabilities to absorb external economic shocks, growth of its use in the international monetary system will be imminent."

And those commercial banks that have been verbally slamming gold—it turns out many are not as negative as it might seem…

  • Goldman Sachs proved itself to be one of the biggest hypocrites: while advising clients to sell gold and buy Treasuries in Q2 2013, it bought a stunning (and record) 3.7 million shares of GLD. And when Venezuela decided to raise cash by pawning its gold, guess who jumped in to handle the transaction? Yes, they claim the price will fall this year, but with such a slippery track record, it's important to watch what they do and not what they say.
  • Société Générale Strategist Albert Edwards says gold will top $10,000 per ounce (with the S&P 500 Index tumbling to 450 and Treasuries yielding less than 1%).
  • JPMorgan Chase went on record in August recommending clients "position for a short-term bounce in gold." Gold's price resistance to Paulson & Co. cutting its gold exposure, along with growing physical gold demand in Asia, were cited among the main reasons.
  • ScotiaMocatta's Sunil Kashyap said that despite the selloff, there's still significant physical demand for gold, especially from India and China, which "supports prices."
  • Commerzbank calls for the gold price to enter a boom period this year. Based on investment demand from Asian countries—China and India in particular—the bank predicted the yellow metal will rise to $1,400 by the end of 2014.
  • Bank of America Merrill Lynch, in spite of lower price forecasts for gold this year, reiterated they remain "longer-term bulls."
  • Citibank's top technical analyst Tom Fitzpatrick stated gold could head to $3,500. "We believe we are back into that track where gold is the hard currency of choice, and we expect for this trend to accelerate going forward."

None of these parties thinks the gold bull market is over. What they care about is safety in this uncertain environment, as well as what they see as enormous potential upside.

In the end, the much ridiculed goldbugs will have had the last laugh.

We can speculate about when the next uptrend in gold will set in, but the action for today is to take advantage of price weakness. Learn about the best gold producers to invest in—now at bargain-basement prices. Try BIG GOLD for 3 months, risk-free, with 100% money-back guarantee. Click here to get started.


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/H9SpARJA1yw/story01.htm Tyler Durden

When Risk Is Not In Parity: Bridgewater’s Massive “All Weather” Fund Ends 2013 Down 3.9%

Just over a year ago, in one simple graphic, we showed why Bridgewater, which currently manages around $150 billion, is the world’s biggest hedge fund. Quite simply, its flagship $80 billion Pure Alpha strategy had generated a 16% annualized return since inception in 1991, with a modest 11% standard deviation – returns that even Bernie Madoff would be proud of.

And, true to form, according to various media reports, Pure Alpha’s winning ways continued in 2013, when it generated a 5.25% return: certainly underperfoming the market but a respectable return nonetheless.

However, Pure Alpha’s smaller cousin, the $70 billion All Weather “beta” fund was a different matter in the past year. The fund, which touts itself as “the foundation of the “Risk Parity” movement“, showed that in a centrally-planned market, even the best asset managers are hardly equipped to deal with what has largely become an irrational market, and ended the year down -3.9%.

Ironically, we voiced our skepticism about All Weather last January long before the market’s Taper Tantrum and subsequent actual Taper, when we provided our opinion on (what was then and probably still is) the “world’s biggest and most successful “beta” hedge fund.” We said:

[W]hile we absolutely agree with Dalio that “there is a way of looking at things that overly complicates things in a desire to be overly precise and easily lose sight of the important basic ingredients that are making those things up” (they need those Econ PhDs for something), we certainly don’t agree with Bob Prince’s assessment that the entire world is merely a “machine” which can be understood, in terms of its cause-effect linkages.

 

While this may be true in simple two actor environments, and in theoretical, textbook markets, it is certainly not the case in a enviornment filled with irrational actors, who respond in times of crises – so vritually all market inflection points – with their feelings, instincts, phobias and gut reactions, than with anything resembling logic and reason. And especially not in times of “New Normal” central planning.

What happened next is well-known to most.

The NYT describes it succinctly: “A number of risk-parity funds like All Weather were caught off guard by a sudden rise in Treasury yields last summer. Treasury yields began to rise last May after speculation began that the Federal Reserve would soon scale back its monthly purchases of United States Treasury’s and mortgage-backed securities. The Fed began slowly scaling back its purchases, which are intended to stoke economic growth, last month. Last year also was a particularly rough one for TIPS and other inflation-protected securities. TIPS tend to perform poorly when Treasury yields rise and inflation is low. Last year, iShares TIPS, an exchange traded fund that tracks the inflation-protected securities market, fell about 9 percent.”

Long story short, the internal assumptions behind Risk Parity blew up spectacularly in a year in which yield soared, while equity markets dipped initially only to rebound furiously, without a concurrent spife in inflation expectations. Welcome to the New Normal.

To be sure, we narrated the implosion in Risk Parity in almost real time. Recall from When Will “Risk Parity” Blow Up Again:

In March we suggested that in a rising rate environment risk parity was susceptible to draw-down as yields gap higher. As it turned out this happened even sooner than we expected after the Federal Reserve’s June 19th FOMC statement. Despite the fact that the statement said nothing new, markets interpreted it as hawkish and Treasuries took a pounding. In the next two weeks ten year Treasuries lost over 4% in total return, creating an overall loss of 7.5% since the beginning of May. The situation was worsened by the fact that equities also fell briefly, but unlike Treasuries also rebounded quickly.

 

 

The consequence for some risk parity funds was a significant loss. For example the AQR Risk Parity Fund lost 13% from May 9th to June 24th and fared worse than shares, credit or Treasuries in response to the FOMC sell-off. The question is whether this will happen again, or was this event a one-off? We believe that this is a relatively mild foretaste of what is to come. Consider that this was a response to a hint that the Fed could start to taper its asset purchases which occurred while the Fed was moving its balance sheet far beyond historical limits at a rate of over $1 trillion per year. The responses to the actual onset of tapering and rate hikes are likely to be more severe. Our US economists believe tapering will begin in Q4 this year and end in Q2 next year but that rate hikes will be delayed.

But nobody was more critical of Risk Parity than GMO’s James Montier who in a December note equated the Risk Parity concept with “Snake oil in new bottles.”

Below are the salient points from Montier:

As I have written many times before, leverage is far from costless from an investor’s point of view. Leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one by transforming the temporary impairment of capital (price volatility) into the permanent impairment of capital by forcing you to sell at just the wrong time. Effectively, the most dangerous feature of leverage is that it introduces path dependency into your portfolio.

Ben Graham used to talk about two different approaches to investing: the way of pricing and the way of timing. “By pricing we mean the endeavour to buy stocks when they are quoted below their fair value and to sell them when they rise above such value… By timing we mean the endeavour to anticipate the action of the stock market…to sell…when the course is downward.”

 

Of course, when following a long-only approach with a long time horizon you have to worry only about the way of pricing. That is to say, if you buy a cheap asset and it gets cheaper, assuming you have spare capital you can always buy more, and if you don’t have more capital you can simply hold the asset. However, when you start using leverage you have to worry about the way of pricing and the way of timing. You are forced to say something about the path returns will take over time, i.e., can you survive a long/short portfolio that goes against you?

 

Exhibits 10 and 11 highlight this problem. Exhibit 10 shows the value/growth expected return spread over time. I’ve marked three points with red stars. Let’s imagine you had all of this time series history in the run-up to the late 1990’s tech bubble. Given history and assuming you were patient enough to wait for value to get one standard deviation cheap relative to growth, you would have put this position on in September 1998. If you had been even more patient and waited for a 2 standard deviation event, you would have started the position in January 1999. If you had displayed the patience of Job, and waited for the never before seen 3 standard deviation event, you would have entered the position in November 1999.

 

 

Exhibit 11 reveals the drawdowns you would have experienced from each of those points in time. Pretty much any one of these would likely have been career ending. They nicely highlight the need to say something about the “way of timing” when engaged in long/short space.

 

As usual, Keynes was right when he noted “An investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money.”

 

Risk Parity = Wrong Measure of Risk + Leverage + Price Indifference = Bad Idea 

 

At a fundamental level, risk parity is the antithesis of everything that we at GMO hold dear. We have written about the inherent risks of risk parity before, however I think they can be stated simply as the following:

 

I. Wrong measure of risk

 

Many proponents of risk parity use volatility as their measure of risk. As I have argued what seems like countless times over the years, risk is not a number. Putting volatility at the heart of your investment approach seems very odd to me as, for example, it would have had you increasing exposure in 2007 as volatility was low, and decreasing exposure in 2009 as volatility was high – the exact opposite of the valuation-driven approach. As Keynes stated, “It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”

 

II. Leverage

 

I’ve already discussed leverage in the previous section, enough said I think.

 

III. Lack of robustness

 

There are no general results for risk parity. That is to say that adding breadth doesn’t necessarily improve returns. The returns achieved in risk parity backtests are very sensitive to the exact specification of the assets used (i.e., J.P. Morgan Bond Indices vs. Barclays Aggregates). Furthermore, decisions on which assets to include often appear fairly arbitrary (i.e., why include commodities, which, as Ben Inker has argued, may well not have a risk premia associated with them). All in all, the general lack of robustness raises the distinct spectre of data mining, and hence fragility.

 

IV. Valuation indifference

 

Proponents of risk parity often say one of the benefits of their approach is to be indifferent to expected returns, as if this was something to be proud of. I’ve heard them argue that “risk parity is what you should do if you know nothing about expected returns.” From our perspective, nothing could be more irresponsible for an investor to say he knows nothing about expected returns. This is akin to meeting a neurosurgeon who confesses he knows nothing about the way the brain works. Actually, I’m wrong. There is something more irresponsible than not paying attention to expected returns, and that is not paying attention to expected returns and using leverage!

As it turns out, Montier was right, and all it took was for one word out of Bernanke mouth to launch an market avalance which showed just how fallible the supposedly infailable can also be when trading a “market” that now is anything but.


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/rPbiaE8gzwA/story01.htm Tyler Durden

When Risk Is Not In Parity: Bridgewater's Massive "All Weather" Fund Ends 2013 Down 3.9%

Just over a year ago, in one simple graphic, we showed why Bridgewater, which currently manages around $150 billion, is the world’s biggest hedge fund. Quite simply, its flagship $80 billion Pure Alpha strategy had generated a 16% annualized return since inception in 1991, with a modest 11% standard deviation – returns that even Bernie Madoff would be proud of.

And, true to form, according to various media reports, Pure Alpha’s winning ways continued in 2013, when it generated a 5.25% return: certainly underperfoming the market but a respectable return nonetheless.

However, Pure Alpha’s smaller cousin, the $70 billion All Weather “beta” fund was a different matter in the past year. The fund, which touts itself as “the foundation of the “Risk Parity” movement“, showed that in a centrally-planned market, even the best asset managers are hardly equipped to deal with what has largely become an irrational market, and ended the year down -3.9%.

Ironically, we voiced our skepticism about All Weather last January long before the market’s Taper Tantrum and subsequent actual Taper, when we provided our opinion on (what was then and probably still is) the “world’s biggest and most successful “beta” hedge fund.” We said:

[W]hile we absolutely agree with Dalio that “there is a way of looking at things that overly complicates things in a desire to be overly precise and easily lose sight of the important basic ingredients that are making those things up” (they need those Econ PhDs for something), we certainly don’t agree with Bob Prince’s assessment that the entire world is merely a “machine” which can be understood, in terms of its cause-effect linkages.

 

While this may be true in simple two actor environments, and in theoretical, textbook markets, it is certainly not the case in a enviornment filled with irrational actors, who respond in times of crises – so vritually all market inflection points – with their feelings, instincts, phobias and gut reactions, than with anything resembling logic and reason. And especially not in times of “New Normal” central planning.

What happened next is well-known to most.

The NYT describes it succinctly: “A number of risk-parity funds like All Weather were caught off guard by a sudden rise in Treasury yields last summer. Treasury yields began to rise last May after speculation began that the Federal Reserve would soon scale back its monthly purchases of United States Treasury’s and mortgage-backed securities. The Fed began slowly scaling back its purchases, which are intended to stoke economic growth, last month. Last year also was a particularly rough one for TIPS and other inflation-protected securities. TIPS tend to perform poorly when Treasury yields rise and inflation is low. Last year, iShares TIPS, an exchange traded fund that tracks the inflation-protected securities market, fell about 9 percent.”

Long story short, the internal assumptions behind Risk Parity blew up spectacularly in a year in which yield soared, while equity markets dipped initially only to rebound furiously, without a concurrent spife in inflation expectations. Welcome to the New Normal.

To be sure, we narrated the implosion in Risk Parity in almost real time. Recall from When Will “Risk Parity” Blow Up Again:

In March we suggested that in a rising rate environment risk parity was susceptible to draw-down as yields gap higher. As it turned out this happened even sooner than we expected after the Federal Reserve’s June 19th FOMC statement. Despite the fact that the statement said nothing new, markets interpreted it as hawkish and Treasuries took a pounding. In the next two weeks ten year Treasuries lost over 4% in total return, creating an overall loss of 7.5% since the beginning of May. The situation was worsened by the fact that equities also fell briefly, but unlike Treasuries also rebounded quickly.

 

 

The consequence for some risk parity funds was a significant loss. For example the AQR Risk Parity Fund lost 13% from May 9th to June 24th and fared worse than shares, credit or Treasuries in response to the FOMC sell-off. The question is whether this will happen again, or was this event a one-off? We believe that this is a relatively mild foretaste of what is to come. Consider that this was a response to a hint that the Fed could start to taper its asset purchases which occurred while the Fed was moving its balance sheet far beyond historical limits at a rate of over $1 trillion per year. The responses to the actual onset of tapering and rate hikes are likely to be more severe. Our US economists believe tapering will begin in Q4 this year and end in Q2 next year but that rate hikes will be delayed.

But nobody was more critical of Risk Parity than GMO’s James Montier who in a December note equated the Risk Parity concept with “Snake oil in new bottles.”

Below are the salient points from Montier:

As I have written many times before, leverage is far from costless from an investor’s point of view. Leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one by transforming the temporary impairment of capital (price volatility) into the permanent impairment of capital by forcing you to sell at just the wrong time. Effectively, the most dangerous feature of leverage is that it introduces path dependency into your portfolio.

Ben Graham used to talk about two different approaches to investing: the way of pricing and the way of timing. “By pricing we mean the endeavour to buy stocks when they are quoted below their fair value and to sell them when they rise above such value… By timing we mean the endeavour to anticipate the action of the stock market…to sell…when the course is downward.”

 

Of course, when following a long-only approach with a long time horizon you have to worry only about the way of pricing. That is to say, if you buy a cheap asset and it gets cheaper, assuming you have spare capital you can always buy more, and if you don’t have more capital you can simply hold the asset. However, when you start using leverage you have to worry about the way of pricing and the way of timing. You are forced to say something about the path returns will take over time, i.e., can you survive a long/short portfolio that goes against you?

 

Exhibits 10 and 11 highlight this problem. Exhibit 10 shows the value/growth expected return spread over time. I’ve marked three points with red stars. Let’s imagine you had all of this time series history in the run-u
p to the late 1990’s tech bubble. Given history and assuming you were patient enough to wait for value to get one standard deviation cheap relative to growth, you would have put this position on in September 1998. If you had been even more patient and waited for a 2 standard deviation event, you would have started the position in January 1999. If you had displayed the patience of Job, and waited for the never before seen 3 standard deviation event, you would have entered the position in November 1999.

 

 

Exhibit 11 reveals the drawdowns you would have experienced from each of those points in time. Pretty much any one of these would likely have been career ending. They nicely highlight the need to say something about the “way of timing” when engaged in long/short space.

 

As usual, Keynes was right when he noted “An investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money.”

 

Risk Parity = Wrong Measure of Risk + Leverage + Price Indifference = Bad Idea 

 

At a fundamental level, risk parity is the antithesis of everything that we at GMO hold dear. We have written about the inherent risks of risk parity before, however I think they can be stated simply as the following:

 

I. Wrong measure of risk

 

Many proponents of risk parity use volatility as their measure of risk. As I have argued what seems like countless times over the years, risk is not a number. Putting volatility at the heart of your investment approach seems very odd to me as, for example, it would have had you increasing exposure in 2007 as volatility was low, and decreasing exposure in 2009 as volatility was high – the exact opposite of the valuation-driven approach. As Keynes stated, “It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”

 

II. Leverage

 

I’ve already discussed leverage in the previous section, enough said I think.

 

III. Lack of robustness

 

There are no general results for risk parity. That is to say that adding breadth doesn’t necessarily improve returns. The returns achieved in risk parity backtests are very sensitive to the exact specification of the assets used (i.e., J.P. Morgan Bond Indices vs. Barclays Aggregates). Furthermore, decisions on which assets to include often appear fairly arbitrary (i.e., why include commodities, which, as Ben Inker has argued, may well not have a risk premia associated with them). All in all, the general lack of robustness raises the distinct spectre of data mining, and hence fragility.

 

IV. Valuation indifference

 

Proponents of risk parity often say one of the benefits of their approach is to be indifferent to expected returns, as if this was something to be proud of. I’ve heard them argue that “risk parity is what you should do if you know nothing about expected returns.” From our perspective, nothing could be more irresponsible for an investor to say he knows nothing about expected returns. This is akin to meeting a neurosurgeon who confesses he knows nothing about the way the brain works. Actually, I’m wrong. There is something more irresponsible than not paying attention to expected returns, and that is not paying attention to expected returns and using leverage!

As it turns out, Montier was right, and all it took was for one word out of Bernanke mouth to launch an market avalance which showed just how fallible the supposedly infailable can also be when trading a “market” that now is anything but.


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/rPbiaE8gzwA/story01.htm Tyler Durden

The Real China Threat: Credit Chaos

As Michael Pettis, Jim Chanos, Zero Hedge (numerous times), and now George Soros have explained. Simply put –

“There is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years.”

The “eerie resemblances” – as Soros previously noted – to the US in 2008 have profound consequences for China and the world – nowhere is that more dangerously exposed (just as in the US) than in the Chinese shadow banking sector as explained below…

Submitted by Minxin Pei via The National Interest,

The spectacle of a game of financial chicken in the world’s second-largest economy is both entertaining and terrifying. Twice in 2013, the People’s Bank of China (PBOC), the country’s central bank, tried to demonstrate its resolve to rein in runaway credit growth. In June, it engineered a sudden credit squeeze that sent the interbank lending rates to more than 20 percent and caused a short-lived panic in the Chinese financial markets. Apparently, the financial turmoil was too much for the Chinese government, which quickly ordered the Chinese central bank to reverse course. As a result, the PBOC lost both face and credibility.

However, as credit growth continued unabated and activities in the most risky segment of China’s financial sector – the so-called shadow banking system – displayed alarming recklessness, the PBOC was left with no choice but try one more time to send a strong message that it could not be counted on to provide unlimited liquidity to the banking system.

It did so in December 2013 with a modified approach that provided liquidity only to the selected large banks but pressured smaller banks (which are the most active participants in the shadow banking system). Although interbank lending rates did not spike to nose-bleeding levels, as they did in June, they doubled quickly. Most Chinese banks held on to their cash and refused to lend to each other. Chinese equity markets fell nearly 10 percent, giving back nearly all the gains since mid-November, when the Chinese Communist Party’s (CCP) reform plan bolstered market sentiments.

Unfortunately for the PBOC, the renewed turbulences in the Chinese banking sector were again viewed as too dangerous by the top leadership of the CCP even though it seemed that the PBOC initially received its support. Consequently, the PBOC had to beat another hasty retreat and inject enough liquidity to force down interbank lending rates. Thus, in the first two rounds of a stand-off between the PBOC and China’s shadow banking system, the latter is widely seen as the winner. The PBOC blinked first each time.

For the moment, the conventional wisdom is that, as long as the PBOC maintains sufficient liquidity (translation: permitting credit growth at roughly the same pace as in previous years), China’s financial sector will remain more or less stable. This observation may be reassuring for the short-term, but overlooks the dangerous underlying dynamics in China’s banking system that prompted the PBOC to act in first place.

Of these dynamics, two deserve special attention.

The first one is the rapid rise in indebtedness (or financial leverage) in the Chinese economy since 2008. In five years, the country’s total debt-to-GDP ratio (including both public and private debt) rose from 130 percent to 210 percent, an unprecedented increase for a major economy. Historically, such expansion of credit hasrarely failed to inflate a credit bubble and cause a financial crisis. In the Chinese case, what makes the credit explosion even more risky is the low creditworthiness of the major borrowers. Only a quarter of the debt is owed by those with relatively high creditworthiness (consumers and the central government). The remaining 75 percent has gone to state-owned enterprises, private real-estate developers, and local governments, all of which are known to have weak loan repayment capacity (most state-owned enterprises generate low cash profits, private real-estate developers are overleveraged, and local governments have a narrow tax base). Staggering under an unsustainable debt burden of roughly 160 percent of GDP (equivalent to $14 trillion), these borrowers are expected to default on a significant portion of their bank debt in the coming years.

The second dynamic, closely related to the first one, is the growth of the shadow-banking sector. Two drivers shape activities in this sector, which operates outside the banking system. To minimize their exposure to risky borrowers, Chinese banks have curtailed their lending. But at the same time, these banks have embraced the shadow banking activities to increase their revenue. Specifically, Chinese banks peddle new “wealth management products” – short-term securities promising high interest rates – to their depositors. The issuers of such securities, which are not protected or insured by the government – are typically high-risk borrowers, such as local governments (and their financing vehicles) and real estate developers.

In the meantime, these borrowers are facing rising pressures for loan repayments in an environment of overcapacity and unprofitable investments. Unable to generate cash to service their loans, they have to turn to the shadow-banking sector for credit and avoid default. The result is an explosive growth of the size of the shadow-banking sector (now conservatively estimated to account for 20-30 percent of GDP).

Understandably, the PBOC does not look upon the shadow banking sector favorably. Since shadow-banking sector gets its short-term liquidity mainly through interbanking loans, the PBOC thought that it could put a painful squeeze on this sector through reducing liquidity. Apparently, the PBOC underestimated the effects of its measure. Largely because Chinese borrowers tend to cross-guarantee each other’s debt, squeezing even a relatively small number of borrowers could produce a cascade of default. The reaction in the credit market was thus almost instant and frightening. Borrowers facing imminent default are willing to borrow at any rate while banks with money are unwilling to loan it out no matter how attractive the terms are.

Should this situation continue, China’s real economy would suffer a nasty shock. Chain default would produce a paralyzing effect on economic activities even though there is no run on the banks. Clearly, this is not a prospect the CCP’s top leadership relishes.

So the task for the PBOC in the coming year will remain as difficult as ever. It will have to navigate between gently disciplining the banks and avoiding a financial panic. Its ability to do so is anything but assured. It has already lost the first two rounds of this game of financial chicken. We can only hope that it can do better in the next round.


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/62RB6qSi-t4/story01.htm Tyler Durden

What Keeps Goldman Up At Night

If one listens to Goldman’s chief economist Jan Hatzius these days, it is all roses for the global economy in 2014… much like it was for Goldman at the end of 2010, a case of optimism which went stupendously wrong. Goldman’s Dominic Wilson admits as much in a brand new note in which he says, “Our economic and market views for 2014 are quite upbeat.” However, unlike the blind faith Goldman had in a recovery that was promptly dashed, this time it is hedging, and as a result has just released the following not titled “Where we worry: Risks to our outlook”, where Wilson notes: “After significant equity gains in 2013 and with more of a consensus that US growth will improve, it is important to think about the risks to that view. There are two main ways in which our market outlook could be wrong. The first is that our economic forecasts could be wrong. The second is that our economic forecasts could be right but our view of the market implications of those forecasts could be wrong. We highlight five key risks on each front here.”

In short: these are the ten things that keep Goldman up at night: five economic risks, and five market view risks. To summarize:

Five risks to our economic forecast

 

Our central forecasts look for accelerating growth in the DM economies, against the backdrop of continued low inflation and low policy rates. The main risks to this view are: a reduction in fiscal drag is less of a plus than we expect; deleveraging obstacles continue to weigh on private demand; less effective spare capacity leads to earlier  wage/inflation pressure; Euro area risks resurface; and China financial/credit concerns becomes critical.

 

Five risks to our market view

 

Five key risks may affect the mapping of our macro views into the market forecast: long-dated real yields rise more sharply; markets doubt G4 commitment to easy policy in the face of better growth; low risk premia create valuation challenges; margins compress more rapidly as wage share recovers; and EM assets benefit more from the DM recovery or suffer more from local imbalances.

And some more in depth:

Our forecast for 2014 is a relatively upbeat one. At the core of the outlook is a shift in US GDP growth to a sustained period of above-trend growth, alongside improved growth prospects in the developed economies in general. At the same time, owing to substantial slack in the major developed economies, we expect inflation to remain benign and G4 monetary policy to remain relatively easy. Although improving growth is likely to put upward pressure on bond yields, we think the combination of better growth and still-low yield levels remains supportive for risky assets in the developed markets. By contrast, we still see the emerging world as more constrained by tighter capacity and domestic imbalances and more vulnerable to higher global yields.

Although the mood in markets has turned more optimistic, we still encounter nervousness about the capacity for the outlook to remain positive. Much of that anxiety appears to reflect scepticism that after a strong year for stocks in 2013 – and a prolonged recovery period that has lasted nearly five years now – further gains are possible. We think this view underestimates the depth of the hole out of which the major economies and markets are climbing. But there are more concrete challenges to our forecast that go beyond the longevity of the recent rally, and that we worry about and debate ourselves. We look at some of the main issues here.

There are two main ways in which our market outlook could be wrong. The first is that our economic forecasts could be wrong. The second is that our economic forecasts could be right but our view of the market implications of those forecasts could be wrong. We highlight five key risks on each front, although in practice it is hard to separate the two categories so neatly and, if we are wrong in one area, it may increase the chance of being wrong in others.

The biggest issues revolve around two main areas. The first area is the supply side of the global economy and whether better demand growth will increase focus on capacity constraints and put upward pressure on bond yields. Arguably, the single greatest challenge to our market views would come from an environment in which wage and inflation pressure in the US and other developed markets came earlier than we expected, prompting a combination of higher inflation, greater margin erosion, earlier tightening and higher volatility than in our central case. The second area is policy risk, where the key challenge is the exit from extraordinary monetary stimulus, but where fiscal risks and the constraints on EM policymakers are also still critical. Those challenges are heightened by the difficulties of communicating with the market in the unfamiliar terrain of forward guidance and asset purchases. In laying out our Top Market Themes, we have focused on the prospects for hedging against the risk of a sharper rise in bond yields and concerns about premature monetary tightening. The risks below set out a broader range of areas where hedges could be worth exploring.

Five risks to our economic forecast

Our central forecasts look for accelerating growth in the DM economies, against the backdrop of continued low inflation and low policy rates. The shift in the US to sustained above-trend growth, in particular, has been the backbone of our economic and market views for some time. Any forecaster knows that there are many ways to be wrong, so we are not attempting to be comprehensive. But the five risks below would have a material impact on the way we see the economic backdrop. It is hard to balance how likely each risk is with how problematic they would be for our views, so the order should not be interpreted as a ranking:

1. Reduction in fiscal drag is less of a plus than we expect

The core of the story on why we expect US (and DM) growth to accelerate in 2014 is set out in Exhibit 1. The chart shows our estimates of the private- and public-sector impulses for growth in the US. On that basis, we see private-sector healing having already led to an improving impulse but this was masked by significant drag from the public sector in 2013. As that fiscal drag alleviates in 2014, alongside a still-positive private-sector story, we should see overall GDP growth pick up. A key risk is that the alleviation of fiscal drag adds less to growth than we expect. That could happen for one of two reasons. First, underlying fiscal drag in 2013 may turn out to have been smaller than we estimated. If so, this would mean that the private sector has added less to growth and, as the fiscal drag alleviated, any acceleration would be more modest. Second, our assumptions about current fiscal plans may turn out to be too optimistic. We have already highlighted the prospective drag in Japan, where the consumption tax on current plans is set to deliver a sizeable negative fiscal impulse. There is also still some risk that fiscal negotiations in the US break down again in the spring, delivering a fresh fiscal shock, although we think those risks are fairly low.

The first of these may pose the more important risk. There is room for uncertainty here, because fiscal drag is not directly observed. We do observe the shift in government tax and spending plans (and even here true ‘shifts’ are complicated to tease out of the data, in part because they also depend on estimates of spare capacity). To convert those into estimates of drag, we need to assume multipliers into broader activity. The work we (and others, such as the IMF) have done suggests that those multipliers have been quite large given the constraints on monetary policy and credit creation. But it is still possible that we have overestimated the drag from the public sector. The fact that US GDP growth accelerated from 2013H1 to 2013H2, as have measures like our Current Activity Indicator, is comforting for the story that fiscal pressures early in 2013 were a large drag. But it is not yet definitive evidence.

2. Deleveraging obstacles continue to weigh on private demand

The other half of the story of improving growth is that the US private-sector impulse remains robust. As discussed above, the flipside of a smaller estimate of fiscal drag would be that the private sector has not been adding as much as we think. The simplest version of that risk may be that the post-bust headwinds and the pattern of slow recoveries that follow financial crises continue to prevent a self-sustaining pick-up in private demand. US capital spending in particular has been lower than our forecasts. While we expect it to pick up as consumer demand growth improves, there is some risk that excess capacity and uncertainty about demand continue to weigh. In the Euro area, similar risks exist but pressures from ongoing bank deleveraging (lending to the private sector is still contracting) constitute an important additional headwind. The impact of new financial regulations and, in some places, fresh macro-prudential measures could also have a larger growth impact than we anticipate.

In assessing the broad risks to US private-sector demand, the housing market still plays a key role. Directly or indirectly, the housing recovery has been responsible for about a third of US growth over the last year (Exhibit 2). Following the rise in mortgage yields in the summer, we saw a patch of weakness in housing data that has now begun to reverse. Our assumption is that the secondary housing market will continue to improve, although at a more modest rate than last year, and that the scope for new building remains high. But the biggest risk to that view is probably a fresh tightening in financial conditions, which have reversed all of the tapering shock and are back at very easy levels, and mortgage rates in particular. Away from the US, a number of housing markets (Canada, Sweden, Switzerland and even the UK) have also shown significant gains on the back of low interest rates and could prove vulnerable to sharper reversals, rising rates or macro-prudential measures.

3. Less effective spare capacity leads to earlier wage/inflation pressure

As growth accelerates above trend for the first time in the recovery, the supply side of the US and other DM economies is likely to become a more important issue. In particular, our forecasts assume that there is plenty of effective spare capacity in the G4 economies, and that this will keep wage and price inflation well-anchored despite better growth. Underlying this view is that the financial crisis has not led to large permanent losses in potential output and that, while the NAIRU (the lowest unemployment rate consistent with stable inflation) has probably increased, it is still well below current levels. The lack of significant wage inflation suggests that those who argued in recent years that the US NAIRU may now be as high as 7%-7.5% have been wrong. But the question of where capacity pressures begin to bite is always highly uncertain and is likely to be put to a tougher test as growth picks up. The US unemployment rate has also consistently fallen faster than our forecasts anticipated, including over the last 12 months, as the participation rate continues to fall (Exhibit 3).

Surprises have not yet made a difference to the inflation picture and we still think there is plenty of slack. But systematic forecast errors naturally make us less confident. As the unemployment rate itself drops (on our forecast, it ends 2014 at 6.3%) the debate over the drivers of the US participation rate will sharpen. Outside the US, the UK is likely to see similarly intense focus on the issue of slack and labour market tightening. The unemployment rate has fallen more rapidly there too, on the back of the recent acceleration in growth, and we expect it to decline further. In the Euro area as a whole, with slower growth and higher unemployment, we see much smaller risks that capacity tightness will become an issue this year, although we do forecast a significant increase in those pressures in Germany in 2014. Even if we are right that there is plenty of slack in the developed world, the market may worry about these risks before it is convinced. And if growth is more rapid than we forecast – a possibility in the US and UK, at least – spare capacity would be eroded faster, even if our view of the starting point is correct. Our benign view of supply constraints also extends to commodity markets, where we envisage steady oil prices and falls in many other commodity prices. If that view is wrong – or if geopolitical issues disrupt supplies – that would also worsen the broader risk picture.

4. Euro area risks resurface

Although we expect the strongest impulse in 2014 to come from the US, we forecast improving Euro area growth. That improvement – and an expectation that Euro area system-wide risk will remain well-contained again in 2014 – is an important support for our benign view of the outlook. The Euro area starts 2014 on a more stable footing than it has been on for some time. Financial conditions in the periphery have continued to ease, growth has picked up somewhat since the recession in early 2013 and the Euro area should see some of the fiscal relief that is helping the US outlook. Much of the improvement can be traced back to the ECB’s commitment to “do whatever it takes” and the consequent mitigation of the risk of self-fulfilling liquidity crises. But the other economic risks considered above may apply in the Euro area in particular. And, as Huw Pill described late last year (see European Economics Analyst: 13/45 – ‘Euro area adjustment: Past, present and future’, December 19, 3013), there has been patchy progress on the larger adjustments the Euro area has needed to make.

That process, however, is incomplete (Exhibit 4). Even with the improvement in GDP growth that we forecast and the compression in sovereign spreads that we have seen, low nominal GDP (and domestic demand) growth still makes the task of restoring fiscal sustainability an uphill battle. And it serves as a reminder that neither the fiscal nor the real exchange rate adjustments that are necessary to make us confident about a stable longer-term outlook for the Euro area are yet assured. Our view is that with growth improving, concern over these issues is more likely to fall than rise. But a sharper slowing in global growth or disappointments in the local recovery, particularly in Italy, could put these issues more quickly on the agenda. Further falls in Euro area inflation may also reinforce concerns about both the fiscal and real exchange rate adjustments, particularly given worries that the ECB lacks the capacity or will to respond aggressively to that threat.

5. China financial/credit concerns become critical

Our forecast for China is for stable growth in 2014 as the global recovery helps exports, offset by a modest ongoing tightening on the domestic side. Given low expectations, we think that profile, while unimpressive, could still be modestly reassuring. But despite that relatively benign central view, we still see significant risks from the credit imbalances that have built up, an issue that we focused on in detail last year (see our Portfolio Strategists’ report entitled ‘The China credit conundrum: Risks, paths and implications’, July 31, 2013). Nominal credit growth (measured by total social financing) is still running well above nominal GDP growth (Exhibit 5). Moreover, while our forecasts implicitly envisage a narrowing of that gap this year, we do not expect it to reverse, which is what is ultimately needed to prevent debt-to-GDP ratios from rising.

The process of leaning against financial imbalances through ongoing tightening in financial conditions and increased reliance on market interest rates, while important for restoring sustainable growth, is also inherently risky. Over the last few weeks, we have seen renewed spikes in Chinese interbank rates, which have weighed on financial markets. The risk is that tightening proceeds too rapidly sparks an unexpected deterioration in credit conditions. But this is a symptom of the broader challenges of deflating the credit bubble slowly while maintaining steady rates of growth.

Five risks to our market view

The basic market outlook that we forecast is one in which equities and bond yields can continue to rise together and in which DM assets continue to offer better risk-reward than their EM counterparts. Clearly, if our economic views are wrong, that entails risk to our market views. But even if the economic landscape is broadly as we expect, the market implications of that outlook may be different to those we forecast. We see five big risks that may affect the mapping of our macro views into the market forecast:

1. Long-dated real yields rise more sharply

We forecast that real bond yields in the US (and G4) will rise modestly in 2014, at a pace close to the forwards. Given the importance of the valuation gap between bonds and equities for our story, we have highlighted the risk that this gap closes more through higher real yields than through higher equity markets. We have argued that this is probably the most likely (although not necessarily the most damaging) risk to our broad market views and, as a result, our Top Trade recommendations have been designed in part to protect against it (through short rate and long USD positions). There are good reasons to expect the rise in yields to be relatively moderate. Back-dated yields have moved much closer to normal levels than they were a year ago and our measures of G3 bond valuations are no longer ‘rich’. Inflation remains benign and major central banks still look committed to a long period of unusually low policy rates. And with Fed tapering already begun, the market has incorporated the expectation that asset purchases will end this year. But the term premium in bonds is still lower than during much of the pre-2007 period. And models of the term premium and fund rate paths that we used last March to argue that there was upside risk to yields suggest that some upside risk remains (Exhibit 6).

Exhibit 6 shows a range of yield estimates generated from simple term premium models. While these do not point to large upside risks in 2014, they do imply increased risk beyond that point. These models are based on our own benign view of the Fed funds path and inflation, so if those assumptions come under challenge, so could our yield view. We have argued that rising yields are consistent with positive equity returns as long as improving growth is driving both higher, so the driver of higher yields matters. That is a key reason why we have been mostly relaxed about the impact of higher bond yields so far. But there are two key caveats. The first is that periods where yields rise rapidly – even with strong growth – tend to hurt equities, as during the taper tantrum. Temporary periods of that kind are likely even in our central forecast. The second is that if yields rise because of expectations of tighter monetary policy, this is more unambiguously negative for equity markets. On the rates strategy front, it is the pricing of rates over the next 3-5 years where we think the risk premium looks unusually low. That takes us to our next risk.

2. Markets doubt G4 commitment to easy policy in the face of better growth

Our forecast is that although tapering will likely be completed this year, the Fed will not raise the Funds rate until early 2016. The Fed itself has worked relatively hard to try to decouple the decision to taper from the decision to hike. And while the market gave little credit to that view during the ‘taper tantrum’ last summer, expectations of the path for US policy rates fell back significantly after the non-taper in September and the nomination of incoming Fed Chair Yellen, despite rising bond yields. Despite our expectations of a friendly Fed policy stance, stronger growth is likely to make it harder to stop markets worrying about an earlier rate hike. Exhibit 7 shows that the volatility in forward views of the US policy rate has tended to be higher during periods of positive data surprises. The same dynamic is true in the UK. Over the last few weeks, as the data have improved we have already seen a fresh rise in shorter-dated yields, so anxieties here have not been calmed completely.

If growth moves decisively above 3% and the unemployment rate continues to fall steadily, the market is likely to worry more about the Fed’s resolve unless guidance is very clear. The decision not to lower the unemployment rate threshold in December, but to rely instead on a less precise description of when rates are likely to rise (“well past the time that the unemployment rate declines below 6-1/2 percent”), may have increased that risk. We expect both the UK and US to breach the formal unemployment thresholds this year. While these kinds of communication challenges will be an issue even if central banks remain committed to their current strategy, policymakers themselves may begin to sound less committed to prolonged easy policy as the recovery becomes more visible. That is clearly possible in the UK and US. But there is also a risk that the Bank of Japan may sound less committed to sustained asset purchases as inflation picks up. A premature focus on their exit strategy would pose a risk to bullish Japanese equity and bearish JPY views.

3. Low risk premia create valuation challenges

Beyond the challenges from rates markets, concerns about valuations – not just in bonds and credit but in equities too – have clearly intensified. Some of those concerns we think are really worries about the longevity of the rally rather than the levels of markets. But as the expansion and market rally have progressed, risk premia have clearly fallen and equity valuations in particular are cited more often as a constraint. On most absolute measures of valuation (P/E multiples, price-to-book, cyclically-adjusted P/E ratios), equities look modestly expensive relative to history, although they are well below the levels that have signalled significant obstacles to gains in the past. On relative measures of valuation compared with bonds or credit – the equity risk premium or equity credit premium – equities still look cheap relative to history, although less cheap than last year. So a key question (see the next risk) is whether real yields remain lower than normal and whether relative or absolute valuations are in the driver’s seat. Measures of the equity risk premium are derived rather than observed and we are conscious that more direct measures of risk premium – the VIX and credit spreads – are starting 2014 at their lowest levels since 2005-07 (Exhibit 8). So the tailwind from risk compression is less powerful than it has been.

Our view is that that relative story will remain supportive for equities, although we agree that return prospects are lower than they were coming into 2013. We think the macro environment remains one that supports low volatility and tight credit spreads. We have shown in the past that the level of the VIX is broadly related to the change in the US unemployment rate, and is also generally lower when growth is higher. As a result, volatility tends to decline during recovery periods and pick up only as the expansion matures. With another year of steady declines in the unemployment rate likely in 2014, this argues for another year of lower US volatility. But this relationship also highlights that the risk of an earlier US labour market tightening than we expect could bring forward the point at which equity volatility begins to rise. A rising volatility environment need not be inconsistent with rising equity markets, as the late 1990s powerfully demonstrated. But it would increase the risks.

4. Margins compress more rapidly as wage share recovers

One of the key supports for US equities over the last few years has been the high level of corporate margins. The US profit share has remained at historically high levels. Our expectation is that it will remain there in 2014. As described in the final US Economics Analyst of 2013, we expect price inflation to be a touch higher than unit labour cost inflation, which has historically allowed firms to maintain or improve margins.

Once again, this depends on the assumption that wage growth will remain benign and implicitly that the labour market has plenty of slack. Exhibit 9 shows that, in general, there is a strong tendency for the profit share to decline when the unemployment rate falls below the NAIRU. Given our view that we are still well above that rate and likely to remain there through 2014, it is logical to expect little margin pressure in this environment. But this means that the issue of labour market slack is relevant not just to the inflation and policy outlook, but also to the margin story. A more rapid tightening in the US labour market represents the most significant risk to record-high margins.

5. EM assets benefit more from DM recovery or suffer more from local imbalances

We have had a structurally cautious view of the EM outlook over the last year or two. As US growth and yields have begun to pick up, we have argued that this puts some of the imbalances that have built up in EM more squarely into focus. And although we expect growth to pick up slightly in EM and modest positive returns from equities in 2014, our outlook – both for EM economies and markets – is still more cautious than for the DM economies. There are risks on both sides of the EM outlook. On the downside, we could easily see greater pressure than we forecast on a range of EM economies and markets from the ongoing rise in US yields and the rebalancing of their own economies. And EM equities and currencies have generally struggled again on the back of these dynamics as 2013 has drawn to a close. A weaker growth outlook in China would be an additional negative force for many EM assets. And elections in a number of countries (Turkey, Brazil, India) may also increase political risk. Given our relative caution, this would to some extent be a reinforcement of the basic picture we expect. As a result, the main risk to our own forecasts – and perhaps the markets too – would be that EM assets do better than their DM counterparts, reversing some of the recent underperformance.

On that front, we see two main risks. The first is that we may be underestimating the impact of an improving DM demand picture on EM economic and market outcomes.
Weakness in the major advanced economies has damaged EM export growth and increased reliance on domestic demand, deteriorating current account positions in the process (Exhibit 10). An improving external environment could help to alleviate both pressures. Our forecasts capture some of that. And we agree that countries, sectors and assets that are most exposed to the DM demand cycle are likely to outperform within EM. But implicitly we are assuming that this will be insufficient for EM assets to benefit from a DM cyclical pick-up in the way that they did through much of the last expansion. We think that assumption is sensible, but it has not been tested and could prove too negative. The second risk is that many of the relationships that have held between DM and EM assets in recent years, particularly in rates and credit, show that EM assets are now trading at a notable discount. Our views imply that some of the breakdown in these relationships is likely to be persistent. We think the regime of the last 5-10 years is likely to continue to prove a poor guide to the next year or two in EM. But, once again, the risk is that the world has changed less than we think and that, with investors now less exposed to EM, the increased risk premium is sufficient to draw money back in.

The key risks: Lack of slack, policy missteps, no trend for a friend

Pulling the various pieces together, it becomes clear that the question of how much ‘effective slack’ there is in the global economy – and the US labour market in particular – is likely to become a much more critical part of the outlook as growth moves above trend and runs through several of the ten risks we have considered. Above-trend growth may also provide a tougher test of our view that there is still significant room for the expansion to continue before it hits supply constraints. If we are wrong on that assumption, not only will this shift the market’s view on how long policy rates will stay near zero in the major markets and tilt the risks towards a faster rise in long-term bond yields. It may also lead to more rapid margin compression and an earlier rise in equity volatility than we currently expect. Our confidence in our view here is relatively high. But our analysis of the risks highlights the importance of that assumption and the benefits of protecting against it. We have argued for hedging against some of these risks in our Top Themes and Trades, emphasising opportunities to be short the US 5-year segment and long the USD against some commodity and EM currencies and the JPY.

The chance of policy missteps also runs through many of the risks we worry about. A better growth picture will heighten focus even further on monetary policy exit. Even if policymakers stay the course with respect to their commitment to easy policy, they may struggle to convince markets. And structural risks in China, the broader EM and the Euro area present additional problems that have not yet been convincingly resolved.

Most of the risks above focus on circumstances in which the market environment turns much less benign. Understandably, these risks are our biggest source of concern. But a more likely source of challenges that we also worry about for 2014 may not be that markets are bad, but that they are boring. With the market broadly in agreement that the growth picture is improving, and with risk premia lower than before, there is a clear risk that we simply enter a period of low expected returns, tracking along forward paths in the major assets. That would not be a disastrous outcome for investors. But it would make the Sharpe ratio on many assets low, both for long and short positions. And navigating the inevitable fluctuations around a subdued trend could make it easy to make tactical missteps that eat into already low returns. We think the picture is likely to be brighter than that. But this – as much as a major disruption – is one of our biggest worries.


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/8km5pRafa2o/story01.htm Tyler Durden

Obamacare Is Coming… To Russia

With “keg-standing bros” and “easy women” having been tempted already (unsuccessfully from what we know) to participate in the government’s ‘affordable’ care act, Politico reports the Obama administration today unveiled its plans for an Olympic-size ad blitz during the winter games next month. No comments yet on which images will be used (it’s too soon for any Schumacher references) but we suggest ‘skeleton’ will provide the right ‘stimulation’ to get insured.

 

 

Via Politico,

HHS confirmed Tuesday that it has bought advertising time in markets with high rates of uninsured people to air during the Winter Olympics, which run Feb. 7-23.

 

To date, the administration has focused its outreach efforts in areas around Houston, Dallas, Tampa and Miami, dispatching senior officials like HHS Secretary Kathleen Sebelius to spread the word about new benefits under Obamacare.

 

The ads, which will run in markets like these across the country, will be aimed at young uninsured people and their families, an HHS official confirmed. POLITICO also confirmed that ads will run in North Carolina. According to HHS, ratings for typical primetime and sports programming dip during the Olympics, so the administration moved some of its paid media budget to the NBC Olympic inventory to maximize viewership.

 

No word on the images that might be used along with the usual messaging, although high-injury events such as the giant slalom or snowboarding offer immediate visuals to underscore the risk of going without health insurance.


    



via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/hyaNwybv_LQ/story01.htm Tyler Durden