4th October 2015 by Mark Tinker
With a new quarter starting it will be interesting to see how much of the sell-off in recent weeks has been window dressing and delta hedging from the derivative markets and whether there are genuine long term value investors prepared to confront the momentum and algorithmic traders. Meanwhile those looking for GDP growth to deliver earnings need to recognise that QE has failed to stimulate economic growth since it provides liquidity, not credit. The only area where that liquidity has turned into credit has been within financial markets themselves. Now those assets are looking vulnerable, as are the agents that benefited from them. My concern therefore remains less with the macro fundamentals and more with internal health of markets.
The failure to raise rates in September produced a response more consistent with an increase, probably because the Fed had led people to believe it really was happening this time and traders were caught out. The dollar fell, which meant a rally in Euro and Yen which in turn produced an offsetting fall in their equity markets. This then triggered some stops and technical selling, further compounded by the need for liquidity by those trying to get out of EM before end quarter. This flow of funds out of EM has produced the largest source of contagion, as exchange traded funds (ETFs) and long term investors alike capitulate on their exposure to BRICS, distressed sellers are everywhere, in equities, bonds and in particular currencies.
In the old days, distressed selling was often met by stabilising ‘value buying’ by investment bank market makers and prop books, but thanks to the so called macro prudential measures such as the Volker Rule, Dodd Frank and the new targets on capital, there is now no automatic stabiliser in the system. Indeed, by allowing the pernicious rise of High Frequency Trading (HFT) the authorities have allowed even more momentum into markets instead, as these systems will chase a trend rather than counteract it.The real risk now is liquidity and forced deleveraging. This was the problem in 2008 and nothing has really been done to address it. Last week I discussed the problems facing Glencore, something noted more widely come Monday when the share price collapsed a further 30% before a short covering rally. The problem remains one of liquidity rather than solvency and it is the worrying echoes of Lehman that are causing lost sleep at the moment. Remember, Lehman was solvent when it went bust, it just had no liquidity to fund its business model, and very few businesses can survive without working capital. This looks a little bit like long-term capital management (LTCM) with various BRICS playing the role of Russia and Glencore in the role of the overleveraged trader that ran out of money. Back then we had a similar macro consensus that it was all about GDP and a need to sell cyclicals, but Q4 1998 saw US equities rally 20%. Incidentally back then the US Purchasing Managers’ Index (PMI) was below 50 and everyone then was saying that meant a recession when actually it meant that Industrial Production growth was slowing from 4.7% to 3.7%. Plus ça change.
In many ways the rise and fall of Glencore has been a feature of the unintended consequences of QE. We know that QE drove down the price of money in bond markets and we also know that a lot of that cheap debt ended up in the commodity space, particularly in the energy complex. But also we see that financial businesses like Glencore were basically able to fund at less than 2%, encouraging the accumulation of large inventories and big balance sheets. The real concern on Glencore is, like Lehman, its credit rating and thus its ability to raise the necessary working capital.
The chart above shows the performance of Glencore alongside the High Yield Bond ETF, and the Emerging Market Debt ETF showing the rapid deterioration in all three over the last year. In fact we could add EEM, the emerging market equity index and get pretty much the same picture. Indeed I could have added the debt line for Trafigura, the third largest commodity trader which, while privately held, does have publically quoted debt. Or Noble, the biggest trader in Asia.
The other problem for commodities, EM and the rest is that the latter stage of their performance was also about leverage as supply ramped up and there was a lot of merger and acquisition activity (M&A) fuelled by QE. While Chinese demand may stabilise there is now a) too much supply and b) a need to de-leverage that whole area. Some think this is because of imminent higher Fed funds, but the truth is that the process is already happening. For Glencore and all other ‘beneficiaries’ of cheap money one major source of leverage has been the high yield debt market and cheap funding from here has basically disappeared, or at any rate is pricing things more realistically. Bank exposure to commodities and commodity producers is, in my view a much bigger issue than exposure to, say property.
Extending the analysis to the broader market and we see that the average yield on the Moody’s BAA corporate debt index is currently around 5.3% (something we mentioned a few months back), having fallen from 6.25% in 2011 to 4.3% in February this year. This is much more important than the Fed funds rate and presents a real headwind for economies as well as limiting prospects for multiple expansions in equities. However, the more immediate problem is that the two standard measures of risk – correlation and volatility – are now telling investors to sell in the same way they told them to buy. Market mechanics are dominating fundamentals once again.
The history of markets (and much else) is littered with bad ideas that seemed like good ideas at the time. I would put the notion of BRICS in that category as well as the ideas that currencies and commodities can be considered as a separate asset class.The latter notions reappeared post the global financial crisis as they always do after a period of poor returns from traditional asset classes and were warmly embraced in some circles on account of their low volatility and their lack of correlation with other assets. Naturally the financial markets were only too keen to bring some new products to meet this demand and rather like BRICS, these became product driven by marketing rather than investment characteristics.
The fundamental problem with currencies and commodities is that they are not assets, they have no cash flows or projected returns, in fact they are simply traded prices. As such they are what I refer to as ‘noise markets’, driven by momentum traders and hooked on news. Fortunately for the promoters, if not the underlying investors, the desire to measure and quantify everything has created a world in which common sense is suspended in favour of measurement. Thus the simple fact that we can measure correlation and volatility means that they have become our preferred measure of risk and anything that has low volatility and a lack of historic correlation is immediately deemed attractive. This is what led us to the follies of CDS (low volatility), commodities (low correlation) and BRICS (ditto). As cash poured in to the new ideas, correlation rose, but was overlooked because of the returns. More dangerous, leverage increased, but since the standard measures of risk tend to ignore leverage, this too was ignored. The next leg is then always the index tracking story; people will need to buy more of this because it is in the index, so Japan in 1989, tech stocks in 1999 and China this year. When there is a lot of money trading in one direction the noise gets louder in order to attract more money in to allow the original noise maker to get out and as I have noted in recent weeks and months the problem for real investors is that they tend to change their fundamental views based on this noise and are thus left stranded when the noise changes. In Q2 the noise peaked around the middle of June when the last man into the Chinese market (on the basis of China joining the MSCI and thus forcing all the index tracker money to buy at any price) suddenly realised that he was the bigger fool and tried to get out. Leverage, especially in China, then worked in reverse as did the lack of liquidity, leading to correlation with other markets such as Hong Kong and Japan that were sold down in order to meet margin calls and other liquidity drains. The noise then flipped in reverse as the traders went short everything that they had previously been long of. The so called China trade of commodities, currencies and EM flipped in Q3 and even though these assets had been poor performers, it looks very clear to me that this triggered a widespread capitulation. The flip in the noise from positive China to negative China has hammered the whole region in terms of equity indices and after a near 20% fall, Asia Ex Japan is trading on close to 70% of book value.
This is back to 2008 levels, but value investors are likely to wait for the dust to settle a little. Most important is not to lose sight of the fact that China Growth 1.0 has transformed to China Growth 2.0 and there will be different winners and losers. Some stocks really should write down their net asset value (NAV), but many should not. Here the role of government is key – not because they will introduce a broad monetary or fiscal stimulus as the macro pundits dictate, but through more targeted policies. Thus the Chinese recently announced initiatives on autos, property and Macau as well as more Keynesian type stimulus in terms of solar and ‘One–Belt-One-Road’. This type of policy support is starting to make short sellers rather nervous and one wonders how quickly the noise traders will swing around again?
As discussed in some depth last week, Chinese manufacturing is still growing at an annual rate of around 6% which is in complete contrast to the (ongoing) misleading headlines about falling production based on the PMI surveys. Interesting to note that the PMI data backs up the narrative of a shift to non-manufacturing as the survey here points to continued growth. Currently however, neither data point fits the dominant narrative of being relentlessly bearish on China, but as they say, you can ignore economics, but it won’t ignore you. Not for long anyway.
One particular headline that caught my eye was the claim that the PMI data would mean that China will depreciate the RMB further. This is classic noise trading, coming as it does from the noisiest of markets, the FX traders and following on from the ‘shock depreciation’ in August they have been very keen to play up this angle, but it was interesting to see, as Chart 2 highlights, that far from going to 7 or 8 as some were predicting, the RMB has actually been a little stronger lately and more important, the spread between onshore and offshore RMB (yellow line) has come right back in as the market sets the price as intended.
The noise from FX is being reflected in the noisy end of the equity markets with a lot of activity from hedge funds, many of whom take top down macro and implement it via funds, ETFs and other thematic trades. Flow data shows hedge funds very active in selling cyclicals and buying defensives for example as well as buying reverse ETFs and other products such as puts and CDS in order to benefit from the ‘run away from China’ trade. As far as I can tell they have not yet persuaded the majority of long-only investors to join in, except those in the BRICS area, where genuine capitulation looks to have been underway throughout Q3. Indeed many of the stocks getting hit in the commodity space remind me of the way the markets turned on their former tech and telecom darlings in the early 2000s. Back then, cheap capital, both debt and equity had led to not only a bubble but also some huge capital destruction.France Telecom for example had over-expanded, taken on far too much debt and seen its share price fall from a dot-com peak of EUR 187 down to a low at the end of Q3 2002 of below EUR6. Much of the rhetoric was the same as is currently hitting Glencore; too much debt, the need for rescue rights issues and so on. I remember commenting at the time that the hedge funds appeared to be playing both sides of the trade, long the debt, short the stock then demanding that the companies have a deeply discounted rights issue which would likely have to be taken up by the underwriters, but which naturally they would be prepared to help out and in doing so close their shorts. Meanwhile, they get made whole on the bonds. Nice work if you can get it. Despite the pessimism, the stock rallied hard in Q4 2002, almost tripling to EUR18 as the noise traders flipped.
Can we expect the same from cyclicals and mining stocks in Q4 2015? Possibly, but as investors we need to think less about the ‘triple bagger’ and more about the balance of risk and return that would enable us to pick up a much ‘safer’ 25-30%. In Q1 2003, that is exactly what we got from France Telecom, even if we missed the rally to EUR18, we still had an opportunity from EUR15 to EUR25. If we look around now at a stock like RIO for example, which I believe is a long term winner in the industry we see that it is currently on a forward price-to-earnings ratio (P/E) of 12.8 and a yield of 7.4%, having fallen 25% this year. If, as we did in 2003 and again in 2009 we view these cyclical equities like bonds trading at a large discount to par and are happy to collect the yield while not having to mark to market the equity price, then we are getting paid handsomely to wait. The fact that share prices are where they are suggests that not too many people have that option, but we need to do our homework.
The news on copper is bad of course, but is hardly new. When the stock stops reacting to the noise traders is when the value investors start looking (or should do). Another example of a high yielding China play are the Macau stocks, particularly ones like Sands China that now yields almost 8%. This week’s announcements on union pay have been used as a stick to further beat the stocks with, but the noise is now as relentlessly downbeat as it was upbeat back in early 2014 and it was interesting to see evidence of some value buying and short covering. China is shut this week, but announcements of measures that could be seen as support continue. We should also remember that the Chinese government still have plenty of levers to pull on the economy should they choose, including a stimulus to buy cars which saw Great Wall Motor rally 50% in a matter of days last week!
Finally it was interesting to note that not only are copper producing countries like Chile now running down their reserves, but a number of sovereign wealth funds are also divesting assets, seemingly in order to meet budgetary constraints, particularly in the case of Saudi where they are currently waging an expensive war in the Yemen. This obviously has implications for the assets they hold, including we suspect quite a lot of EM assets, but also for the oil price. As we noted a few months back, Saudi has clearly decided to remain the key producer and has driven prices down as a result, seemingly intending to see off the US shale producers and make life as difficult as possible for Iran before the sanctions are lifted. The recent arrival of the Russians in Syria thus adds a new twist to the saga as Russia, and for that matter Iran, clearly want oil prices higher rather than lower. A year after oil prices shocked on the downside, we shall watch closely to see if they get their wish.