Author Archive for Martin T., Macronomics

European Banks and Why the Deleveraging Has Only Just Begun

By Martin T., Macronomics

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” – Winston Churchill

Figure 1 was extracted from Bank of America’s note “Banking on the Banks” from the 16th of May, clearly illustrates why the deleveraging has only just started in Europe.

“Meanwhile, Europe continues to lag the improvements seen in the US economy and markets. Quite simply, Europe’s economy struggles with too many banks, too much debt and too little growth. A long history of empire, trade, war and commerce means a long history of banking. The world’s first state-guaranteed bank was the Bank of Venice, founded in 1157, and the world’s oldest bank today is also Italian, Monte Paschi di Siena (founded 1472). In many European countries, bank assets dwarf the size of the local economy and are far in excess of other regions in the world.” – source Bank of America Merrill Lynch.

Why the credit crunch in European countries?  Because this deleveraging was accelerated by the fateful decision taken by the European Banking Association of imposing European banks to reach a Core Tier 1 capital ratio of 9% by June 2012. It has not only broken the credit transmission mechanism to the real economy in Europe but caused a credit crunch as well (see figure 2).

mt1(Figure 1 – bank assets as % of GDP)


(Figure 2 – EU private sector credit growth)

Time for a Pullback? Get Some Greenbacks!

By Martin T., Macronomics

“If a window of opportunity appears, don’t pull down the shade.” – Tom Peters

As we highlighted in our conversation in May 2012 – “Risk-Off Correlations – When Opposites attract”: Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China’s economic expansion and increasing consumption in Emerging Markets.

In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor’s index and the US 10 year Treasury yield since QE2 has been announced.

Looking at the recent weaknesses in commodities such as oil and copper, one could decently argue that the time might have come to take a few chips off the gambling table.

This feeling of “uneasiness” seems to be shared by Bank of America Merrill Lynch which indicated on the 21st of February the following important points:

“This week’s Thundering Word from our investment strategists reiterates their view that a pullback is likely across risk assets but that this would be very healthy for the longer-term reflation story.

On this basis they advocate buying volatility near term. We highlight 3 key reasons for a near term pullback in risk assets:

-Market complacency: our Global Financial Stress Index (GFSI) is at a multi-year low, while the new BofAML Bull &Bear index which measures market sentiment is at a multi-year high (chart 1).

-Easing has eased: Monetary policy minutes of both the Fed and the Bank of England indicated this week that the era of QE is slowly coming to an end.

-Defensive price action: The two best performing US equity sectors year-to-date are Staples and Health Care. Credit markets have stalled. We remain bullish on the reflation story in Japan but note that domestic small caps, a key barometer of local belief in domestic demand, just dropped 20%.

A longer term trade is to buy the USD which is no longer correlated with volatility and has benefitted from the recent increase in risk appetite. Our house view is that the USD may be embarking on a strong secular uptrend; the only risk being any unexpected derailment of the US house price recovery.

A key element of the USD strengthening story is global rebalancing with Asia no longer deemed the world’s producer and the US the world’s consumer. As a result assets tied to the China production story are slowly derating – note the underperformance of materials stocks versus the global equity market in the past 12 months. However, some currencies also tied to the story such as the Australian dollar and the Canadian dollar are taking longer to derate and hence constitute good shorts against our long USD stance.”

As per our previous May 2012 conclusion, whereas opposite attracts during “Risk-Off” periods, the greenback could still prove to be a powerful magnet should we experience a bout of pullback in risky assets.

“If you are not willing to risk the unusual, you will have to settle for the ordinary.” – Jim Rohn, American businessman

The Change in the Volatility Regime – Part 2

By Martin T., Macronomics

“If you change the way you look at things, the things you look at change.” – Wayne Dyer, American psychologist

Yesterday we touched on the implications relating to regime changes in the volatility space.  The phenomenon currently in the US is similar in Europe where European equity volatility trading has been trading marginally below the VIX.  This is displayed in the chart below from Cheuvreux’s recent Cross Asset Research paper from the 7th of January – The Tactical Message:

“The VStoxx index of implied volatility has followed the American example by falling to a cycle-low. The increase in America’s political-fiscal risk premium since September has allowed indices of European equity volatility to trade marginally below the VIX.” – source Cheuvreux Cross Asset Research, 7th of January 2013.

Cheuvreux makes the argument that the decline in financial volatility is a general phenomenon, with the lead coming from debt markets. Further, they argue that there is more to it than financial repression:

(Source Cheuvreux/Bloomberg
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.)

Back in March 2012 our cross-asset friend noted the relationship between Treasuries vs Equities and Forex volatility:

“If the bond market’s move truly is the start of a long rates repricing for “good” reasons (namely finally validating the huge risky assets run-up of these last 4 months on better macro data) then it makes sense to see a risk transfer from the equities/forex sphere to the bond market’s sphere. As a matter of fact, we noticed this kind of discrepancy during a rather similar period : in Q4 of 2010, following the QE2 announcement, where we saw 10 year yield move up 100 bps, SPX and most risky assets rallyed hard with the same type of cross-asset vols opposite moves.

However these kind of disconnections in cross-asset vol markets generally do not last long. A correction in risky assets or a larger bond market rout would effectively probably see SPX and forex short volatilities move up rather quickly. We’re talking short-term volatility here so obviously timing is key to put on recorrelation trades as you need to be right pretty fast…”

At the time of the bond market correction of March 2012, there was a similar disconnect, as indicated by Cheuvreux’s graph between the CVIX and MOVE index, where Treasury volatilities were up substantially and risky asset volatilities (equities and Forex volatilities) remained at the low end of their recent range.

We see a similar pattern in early 2013.

“Always remember that the future comes one day at a time.” – Dean Acheson, American statesman

Stay tuned!

Long Dated Volatilities – A Regime Change?

By Matin T., Macronomics (This part 1 of a two part post)

“The cost of liberty is less than the price of repression.” – W. E. B. Du Bois, American writer

The recent significant fall in implicit volatilities  means that long dated volatilities (1 year) of most significant equity indices are now testing the frontier level between the post-crisis lows and the ultra low regime of 2004-2007.

Implicit 1 year volatility for the S and P500 (SPX) – source Bloomberg:

Could it be an attractive entry point or more simply a clear indication of regime change? We have to agree with our-good cross-asset friend that we have a hard time believing in the regime change when taking into account the fundamental macro picture. Could it simply be the broader impact of financial repression? One has to wonder.

Financial liberalization, for instance in Emerging Markets, has been a good way to attract foreign investments. It has often led to a rise in volatility given investors had been reaping in the process higher daily return rates. When equity market becomes more open, there are increases in stock return volatility (on the subject see the study realised by Vuong Thanh Long, Department of Economic Development and Policies at the Vietnam Development Forum – Tokyo Presentation – August 2007).

Regime switches also lead to potentially large consequences for investors’ optimal portfolio choice, hence the importance of the subject.

In relation to Regime Changes and Financial Markets, Andrew Ang, from Columbia University and NBER, and Allan Timmermann from the University of California, San Diego, made an interesting study in June 2011-

Regime Changes and Financial Markets:

“When applied to financial series, regimes identified by econometric methods often correspond to different periods in regulation, policy, and other secular changes. For example, interest rate behavior markedly changed from 1979 through 1982, during which the Federal Reserve changed its operating procedure to targeting monetary aggregates. Other regimes identified in interest rates correspond to the tenure of different Federal Reserve Chairs (see, for example, Sims and Zha, 2006). In equities, different regimes correspond to periods of high and low volatility, and long bull and bear market periods. Thus, regime switching models can match narrative stories of changing fundamentals that sometimes can only be interpreted ex post, but in a way that can be used for ex-ante real-time forecasting, optimal portfolio choice, and other economic applications.

Second, regime switching models parsimouniously capture stylized behavior of many financial series including fat tails, persistently occurring periods of turbulence followed by periods of low volatility (ARCH effects), skewness, and time-varying correlations. By appropriately mixing conditional normal (or other types of) distributions, large amounts of non-linear effects can be generated. Even when the true model is unknown, regime switching models can provide a good approximation for more complicated processes driving security returns. Regime switching models also nest as a special case jump models, since a jump is a regime which is immediately exited next period and, when the number of regime is large, the dynamics of a regime switching model approximates the behavior of time-varying parameter models where the continuous state space of the parameter is appropriately discretized.

Finally, another attractive feature of regime switching models is that they are able to capture nonlinear stylized dynamics of asset returns in a framework based on linear specifications, or conditionally normal or log-normal distributions, within a regime. This makes asset pricing under regime switching analytically tractable. In particular, regimes introduced into linear asset pricing models can often be solved in closed form because conditional on the underlying regime, normality (or log-normality) is recovered. This makes incorporating regime dynamics in affine models straight forward.

The notion of regimes is closely linked to the familiar concept of good and bad states or states with low versus high risk, but surprising and somewhat counterintuitive results can be obtained from equilibrium asset pricing models with regime changes. Conventional linear asset pricing models imply a positive and monotonic risk-return relation (e.g., Merton, 1973). In contrast, changes between discrete regimes with different consumption growth rates can lead to increasing, decreasing, flat or non-monotonic risk/return relations as shown by, e.g., Backus and Gregory (1993), Whitelaw (2000), and Ang and Liu (2007). Intuitively, non-monotonic patterns arise because “good” and “bad” regimes, characterized by high and low growth in fundamentals and asset price levels, respectively, may also be associated with higher uncertainty about future prospects than more stable, “normal” regimes which are likely to last longer. The possibility of switching across regimes, even if it occurs relatively rarely, induces an important additional source of uncertainty that investors want to hedge against. Inverse risk-return trade-offs can result in some regimes because the market portfolio hedges against adverse future consumption shocks even though the level of uncertainty (return volatility) is high in these regimes. Further non-linearities can be generated as a result of investors’ learning about unobserved regimes.”

As highlighted above, the importance of regime change is paramount to asset allocation given:

“-The relation between the investor horizon of a buy-and-hold strategy and the optimal portfolio varies considerably from one regime to the other. 
-For example, in a bear regime, stocks are less favored and short-term investors allocate a smaller part of their portfolio to stocks.* 
-On the contrary, in the longer run, there is a high probability to switch to a better regime and long-term investors dedicate a larger part of their portfolio to stocks. 
-In a bear regime the share allocated to stocks increases with the investor’s horizon.”
– source The Princeton Club of New-York, 27th of April 2012, EDHEC-PRINCETON Institutional Money Management Conference.

*Hence the reason why retail investors have been net sellers of stocks since 2007.
“Since they started selling in April 2007, eight months before the start of the Great Recession, individual investors have pulled at least $380 billion from U.S. stock funds, a category that includes both mutual funds and exchange-traded funds, according to estimates by the AP. That is the equivalent of all the money they put into the market in the previous five years.” (“AP IMPACT: Ordinary folks losing faith in stocks”, AP News)

U.S. Equities’ Long-Term Real Returns

By Martin T., Macronomics

Courtesy of our good friends at Rcube Global Macro Research, please find enclosed their recent note focusing on US Equities’ Long Term Real Returns. Enjoy!

Our research generally focuses on tactical investment horizons (3‐6 months). In this paper, however, we consider long‐term real returns for US equities, for which we have reliable data since 1871.

Nota bene:

By real returns, we mean total returns (i.e. dividend included) divided by the CPI. We chose to analyze the US market as it has longest and most accurate historical data. Our data originates from Shiller’s website: Earlier data exists (as early as 1802), but is plagued with survivorship bias.

When we look at price alone (as many observers do), we see no evidence of a long term trend. Rather, we have two distinct 70‐year periods: pre‐WW2: +1.0% annual price appreciation; and post‐WW2: +7.4% annual price appreciation. However, as we know, price appreciation is insufficient to quantify returns, especially when we consider long investment periods. Indeed, a rational long‐term investor should look at (and hope to maximize) real total returns, which take into account dividends and inflation.

When we look at the S and P 500’s real total return, the picture looks very different:

Taking into account dividends and inflation, we can admire the remarkable stationarity of S and P 500’s real returns around a long‐term trend (6.5% per year). Even the 1929 crash and the 1970s’ stagflation represent small deviations from the overall trend.

A long‐term trend of around 6.5% essentially means that an equity investor’s purchasing power doubles every 11 years, which is in itself the strongest argument for permabulls and buy‐and‐hold proponents.

That being said, many believe that the 6.5% real return – which is also known as “Siegel’s Constant” – is a historical freak and is unlikely to continue further.

In a controversial Investment Outlook published last August, Bill Gross compared this 6.5% long‐term real return to long‐term real GDP growth (around 3.5%), and concluded that the stock market was a “Ponzi scheme”, with stockholders having been “skimming 3% off the top each and every year, at the expense of lenders, laborers and the government”. In a comment that reminisced Business Week’s famous 1979 cover, the “Bond King” then proclaimed that the “cult of equity was dying”.

It appears to us that this analysis is flawed (and indeed, it was immediately rebutted by Dr. Jeremy Siegel, as well as other academics). Although it is true that the market value of equities cannot grow above GDP forever, Bill Gross seems to have ignored the fact that around half of stock returns originate from distribution to shareholders, in the form of dividends and share buybacks.

There is therefore nothing wrong in the fact that equity real returns are higher than real GDP growth. Even in a zero‐growth economy, companies would still have earnings that can be used to distribute dividends or buy back shares, which would lead to higher than zero real returns for equities.  We’ll return later to the question of the link between equity real returns and economic growth.

Regardless of the sustainability of 6.5% real returns in the future, nobody would dispute that it is hardly a“constant”, especially for short‐term horizons.

If we define 10 years as the lower range of what constitutes a long‐term investment horizon, the standard deviation of forward returns is still fairly wide (around 5.2%). This highlights the need to look for methods of predicting 10‐year forward returns.

One such method, introduced by Robert Shiller in his 2000 book Irrational Exuberance, involves using cyclically adjusted P/E ratios (CAPEs) to predict 10‐year forward returns. CAPEs are P/E ratios that use past 10‐year average earnings in order to smooth out cycles.

The S and P 500’s CAPE is currently around 21, which is substantially higher than its long‐term average (16.5). Although bearish observers use these figures as a sign of overvaluation, it is worth noting that 10‐year forward real returns would be around 4.4% according to the above regression equation.

In any case, the CAPE regression only explains around 25% of 10‐year forward returns. Moreover, this analysis is performed in‐sample, whereas an investor operating in real time during the sample period would not have access to the whole dataset.

If we remain in an in‐sample framework, we can obtain R2s that are much better than 25%.

First we can note that corporate profits as a proportion of GDP are one of the most mean‐reverting time series in economics.

Nota bene:
Although total corporate profits and S and P 500 profits are not the same thing, their growth rate is rather similar over long time periods (3.23% per year for total corporate profits vs. 3.17% for S and P 500 profits between 1947 and 2008):

Low profits as a proportion of GDP lead to business failures, reduced competition, and therefore higher margins further down the road (and vice versa).

From this point of view, buying when earnings are high and selling when earnings are low (as suggested by PE‐based methods) does not seem such a great idea.

Rather than taking the 10‐year earnings average as the denominator, we could therefore use real GDP.
Incidentally, the total market cap / GDP ratio (which is a related concept) is Buffet’s favourite macro measure of value for stocks.

This time, we find a long‐term trend of around 3% for the ratio (i.e. the same 3% that stockholders
supposedly “skim off” at the expense of others, according to Bill Gross).

Although the S and P 500 real return / real GDP ratio looks rather trend‐stationary, it has had rather wild swings around the trend, which indicate potentially interesting opportunities to trade in and out of the market.

Indeed, we obtain a rather nice R2 of 57% when we regress the detrended ratio against 10‐year forward real returns.

Currently, we’re close to fair value, as the overshoot from the 90s (Greenspan’s “irrational exuberance”) finally seems to have been digested. This does not preclude another “undershoot”, such as the one we had in 2008, as investors revise their economic growth assumptions downwards, especially in deleveraging developed economies.

Nota bene:
Although there seems to be a long‐term elasticity of one between equity real returns and realized economic growth, changes in long‐term growth expectations and/or risk premia can have a huge impact on valuations. If we simply look at the Gordon‐Shapiro model and assume a denominator (expected rate of return – expected growth) of around 5%, a 1% decrease in long‐term expected growth decreases the value of equities by 20%. We believe that this explains much of equities’ “excess volatility puzzle”.

Again, this is an in‐sample analysis (just like the CAPE model). Although we still get an R2 of around 40% if we use a running regression instead of a fixed in‐sample regression (and use the first 40 years of the sample as a “learning period”), no one can assert that 3% long‐term returns above real GDP growth are an intangible law of nature.

To conclude, assuming long‐term forward equity real returns to be around 3% plus foreseeable economic growth provides us with a ballpark figure. It avoids making blatantly wrong assumptions about long‐term equity real returns (such as believing that they can be around 10%, like many investors still do).

Additionally, it is important to note that this brief study concerns only the United States, a country that won two world wars and avoided socialist experiments during the last century. It would be interesting to calculate the trend of the real equity return / real GDP ratio for other countries. Unfortunately, reliable data on long‐term real returns is hard to obtain for most countries, as they generally originate in the early 1970s (e.g. MSCI Indices).

We will however try to gather more data on this vast subject, as well as publish additional short studies about long‐term returns of other asset classes.

“Common sense is the most fairly distributed thing in the world, for each one thinks he is so well-endowed with it that even those who are hardest to satisfy in all other matters are not in the habit of desiring more of it than they already have.” – Rene Descartes, French philosopher.

Stay tuned!


Chart of the Day: Convergence Between VIX and V2X

By Martin T., Macronomics

“To every action there is always opposed an equal reaction.” – Isaac Newton

The last few days have seen a pick up in demand for downside protection on the S and P500, when it seems no one at the moment has nothing left to protect against in Europe, which explains somewhat the recent convergence move between the VIX and its European equivalent V2X – source Bloomberg:

Please note Futures have yet to realise this convergence.  As a reminder from our March conversation (The two main drivers of equity volatility), and as indicated by our Global Macro friends at Rcube at the time:

“The two main drivers of equity volatility are for us, credit availability (Merton model) and revisions of earnings forecasts estimates. Equity volatility is also logically driven by the direction and the magnitude of revisions of forward earnings estimates. In 2010 and again in 2011, equity vol spiked while earnings forecasts remained strong.”

The convergence between VIX and its European equivalent V2X – Source Bloomberg

“Hesitation increases in relation to risk in equal proportion to age.” – Ernest Hemingway


Chart of the Day: Markets and Economists Optimistic Ahead of Fiscal Cliff

By Martin T., Macronomics

“Hope is definitely not the same thing as optimism. It is not the conviction that something will turn out well, but the certainty that something makes sense, regardless of how it turns out.” – Vaclav Havel

“The policy uncertainty index has three underlying components: 1). newspaper coverage of policy-related economic uncertainty; 2). number of federal tax code provisions set to expire; 3). disagreement among economic forecasters as a proxy for uncertainty.” – source, Bloomberg, Societe Generale Cross Asset Research – 27th of November 2012

Why Have Global Macro Hedge Funds Underperformed?

By Martin T., Macronomics

“There is no better than adversity. Every defeat, every heartbreak, every loss, contains its own seed, its own lesson on how to improve your performance the next time.” – Malcolm X

Many pundits have recently looked at the lackluster performances of Hedge Funds from the European crisis perspective. We would like to have a different approach, namely the one of volatilities.

Courtesy of our good friends at Rcube Global Macro Research, the answer appears to be simpler. It’s the volatility stupid! Or lack thereof….

“Volatility across all asset classes has crashed. As the chart below highlights, when this happens, global macro strategies tend to suffer on both an absolute and relative basis.”

“While investors have poured massive amounts in long equity volatility products over the last 9 months, as a hedge against long stocks exposure, this strategy failed spectacularly. We believe more pain lies ahead for long equity volatility trades.”

We would like to highlight an interesting pattern in VIX futures, illustrated by the following kernel regression analysis between these variables:

X: the sum of 100 days Z-Score of the S and P500 Index and the SPVXSTR Index (a rolling long VIX strategy, tracked by the VXX ETF).

Y: Annualized expected returns of the SPVXSTR Index.

We see that when we are at the low end of the range (meaning that volatility does not react to a market dip, which is currently the case), further weakness should be expected on vol forwards.

Regarding other measures of sentiment/positioning, investors still seem to be extremely defensive while stock markets have rallied substantially over the last few months. This remains the most hated bull market in recent history.

Classic measures of sentiment are still deeply negative and at levels that are usually reached after medium to long term bear markets.

The CBOE put/call ratio reached historical highs on both the 10 and 90 days sma last week:

Stocks have very substantially lagged credit this year. We have advertised in recent publications why we believe corporate credit outperformance is over.

The recent sharp improvement in US consumer sentiment doesn’t seem to have been priced by the stock to bond ratio.

We are also aware that earnings revisions have been on the weak side recently.

In addition to the great points made by our good friends from Rcube, with interest rates at zero it is as well very challenging for Global Macro Hedge Funds to play an economy against another in currencies markets due to the fall in volatilities.

To bring some solace to Global Macro Hedge Funds, their biggest liquidity and volatility providers, namely top investment banks, are suffering as well, as reported by Neal Amstrong article in Bloomberg – Biggest Traders Hurt as Fed to ECB Crush Volatility – on the 23rd of November:

“The world’s largest currency traders say foreign-exchange revenue is sliding as central-bank policies stifle price swings and cut volumes by $300 billion a day. Deutsche Bank AG, the biggest dealer based on Euromoney Institutional Investor Plc data, says narrower margins cut revenue “significantly” last quarter. Barclays Plc, the third-largest, says foreign-exchange sales are dropping and fourth-placed UBS AG says it has been hurt by lower volatility. Daily turnover as measured by CLS Bank, operator of the largest currency-transaction settlement system, slid 6 percent to $4.72 trillion in the third quarter from the year-earlier period. The combination of interest rates at, or near, record lows in the U.S., Europe and Japan is diminishing the allure of the dollar, euro and yen, the three most-traded currencies. From Switzerland to Brazil, central banks are establishing controls on exchange rates, making it less lucrative to trade the franc to the real. “With interest rates being at zero it’s very difficult now to play the cyclical differences in economies,” David Bloom, global head of currency-market strategy at HSBC Holdings Plc in London, said in a telephone interview on Nov. 20. “We’re in a structural world where if you have an economic event, you are best placed to think about it in terms of equities or bonds rather than foreign exchange.”

“Past performance speaks a tremendous amount about one’s ability and likelihood for success.” – Mark Spitz