Dollar shortage vs. dollar funding stress

I think we should distinguish between dollar shortage and dollar funding stress. We have a lot of the latter and much less of the former compared to any previous crisis.

‘Dollar shortage’ is your classical EM currency crisis stemming from a balance sheet currency mismatch: borrow in dollars to fund a non-dollar asset. Cue Mexico’94, Asia’97, Russia’98, Brazil’99, Turkey’01, Argentina’01. There are fewer of them nowadays.

A ‘dollar funding stress’ stems from borrowing in dollars to fund a dollar asset – that’s the problem today (see for ex. Z. Pozsar’s latest). It feels like the old EM currency crises because a lot of dollar assets are owned by foreigners but it is very different at the same time as there are no balance sheet currency mismatches.

That distinction is important because the market is treating it as if it is a dollar shortage crisis while it is a classic ‘Mark-to-market (MTM)’ crisis. If the dollars were borrowed through the swap market, refinancing would widen the basis and move the currency. If the borrowing was in the loan/bond market, it would be a credit story, not a currency story.

There is also a break even price for dollar funding above which foreigners would choose to sell the dollar asset and repay the loan, rather than continue to finance it (probably they will have to top up if the MTM has moved too much from where they bought it). All this is a very different situation from a dollar shortage crisis whereby they would need to sell a local currency asset and actually convert proceeds into dollars.

The Fed is well aware of all this and has acted very swiftly to respond to the recent strengthening of the dollar by improving massively the terms of the five existing central bank swap lines and by adding today nine more to the frame. The extraordinary moves in some DM currencies, notably NOK and AUD, has also prompted the respective central banks to verbally intervene (Norges) or ‘not to rule out’ intervention (RBA).

Some people have mentioned to me that a new Plaza Accord is needed. I am not so sure. In my opinion, it would be counterproductive. From a behavioral point of view, a weak dollar is not necessarily beneficial for US assets given that a big chunk of them is owned by foreigners. Just like a worsening of the dollar funding terms may push these people to sell, so could an attempt to substantially weaken the dollar. We shouldn’t forget a small but very much overlooked fact of the 1987 stock market crash: on the weekend before Black Monday, the US Treasury Secretary threatened to devalue the dollar.

Bottom line is that a dollar funding crisis should have a much smaller effect on weakening the local currency than a dollar shortage crisis. The market does not need a dollar devaluation, rather a stable dollar. Policy makers should make sure foreign dollar funding does not blow up. And finally, market pundits should be careful exaggerating the dollar shortage issue.

Fed’s crisis response may endanger the dollar

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The response from the two most powerful central banks could not have been more different. ECB is innovative, using fine tuning and precision in tiered rates and targeted lending; Fed is still throwing the kitchen sink at the market by flooding the banking system with liquidity.

ECB is also going more direct partially because the banking system there is in shatters, but also because it makes sense regardless. Plus, the ECB is already taking credit risk by buying corporate bonds. Surely, the next step is literally direct credit lending and massively expanding the ECB counterparty list.

Fed is still stuck in the old model of credit transmission, entirely relying on the banking system. That model died in 2008, in fact, even before that, in the early 2000s, as the first Basel rules came into effect and the shadow banking system flourished.

Post 2008 it became much more common for financial institutions, like PE etc. to get in the credit loan business. Needless to say, this carries a big risk given that they don’t have access to Fed’s balance sheet like the banks.

The US banking system is now flooded with liquidity. If the new repo auctions are fully subscribed, this will double banks’ reserve balances and will bring them to the peak post the 2008 crisis. But do banks need that liquidity?  It does not seem so: the first $500Bn repo auction yesterday had just $78Bn of demand. But that liquidity from the Fed is there on demand, plus the central banks swaps lines are open, and as of March 12, none has been drawn. And finally, the foreign reverse repos pool balance at the Fed has not shown any unusual activity (no drawdowns). All this is indicating that USD liquidity is at the moment sufficient, if not superfluous, so, it should have a negative effect on USD, given long USD has been a popular position post 2008.

All this liquidity, however, may still do nothing to stocks, as seen by their performance into the close yesterday, because balance sheet constraints prevent banks from channelling that liquidity further into the US economy where it is surely needed. From one hand, the Fed is really pushing on a string when it comes to domestic dollar liquidity, but, on the other, it is providing more than plenty abroad. 

Risky assets are still a sell on any bounce, and the USD is probably a sell as well, as the Fed will be forced to keep cutting but it is now running a risk of foreign money exiting long established overweight positions in US assets. 

Keep Calm and Stay at Home

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China went through three main changes to stem the spread of the Coronavirus:

  • Quarantine
  • Lockdown
  • Rationing

In the ‘West’, we’ve added ‘Self-quarantine’ first, in some countries. Others are in the delusional phase of ‘Delay’, because, apparently, they are worried that ‘people will get bored and break out of self-isolation if it last too long’. In fairness, there is a logical reason to delay because as China and Italy will find out, the economic costs of going through those stages above are enormous. That reason is that scientists could be able to find vaccine in time. That is a very dangerous bet for the infections grow exponentially, and if a vaccine does not come soon enough, the health care system of the country will be overwhelmed (and no, the coming warm weather in the Northern Hemisphere is unlikely to slow down the infections, like in the normal flu, because this is not the normal flu, and infections have shown to grow also in hot weather like Singapore or Iran). Then, not only the economic costs but also the societal costs will be unspeakable.

Finally, one other country’s leader still thinks this virus could be ‘fake’…

WHO went on a fact-finding mission to China and released a report on February 28. The report is unequivocal:

“China’s bold approach to contain the rapid spread of this new respiratory pathogen has changed the course of a rapidly escalating and deadly epidemic.”

There are also stories about two different strains of the virus, apparently stemming from the desire to explain higher number of infections/deaths in some countries and lower in others. I don’t know. To me this is simply a function of testing more people and proper reporting. It also makes sense to run with that story in countries which have chosen to be in the ‘Delay’ stage. Occam’s razor: even if there were two strains, I don’t see how they can be country-specific.

“Everywhere you went, anyone you spoke to, there was a sense of responsibility and collective action, and there’s war footing to get things done”

~Bruce Aylward, the epidemiologist who led the WHO mission to China 

There is no doubt that even in the best cases in the ‘West’, the ones which added ‘Self-quarantine’, it will take longer to get through this also because of culture, different societal structure and more liberal thinking. For example, the talk in Italy is that if things don’t start improving in a couple of weeks the country might have to go to the next stage, ‘Rationing’ (only one person per household can leave the house to replenish supplies).

After decades of general peace, no major natural disasters in the ‘West’, and used to thinking only in financial terms, we cannot comprehend what is happening to us and are unable to quickly make the right decision how to proceed forward. For almost everybody, understandably, limiting our movement is at minimum uncomfortable and for a lot of people, unacceptable. To go through rationing is unimaginable (even though for some of us, who grew up behind the Iron Curtain, this was a feature of daily life). But seriously, it’s not like we have been asked to go to war, like our grandparents; we are just told to sit on the couch at home and play video games!

It can’t be that bad, can it?

Oil: OPEC’s Russian Roulette

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I did not expect the ‘no deal’ from OPEC+ largely because of the urgency of the immediate demand destruction from the Coronavirus.

In hindsight, Russia’s reaction was quite rational. What about the Saudis?While they are still the lowest cost producer, the precariousness of the political situation there (see developments this weekend) makes me believe that they have a lot more to lose from the current status quo. Russia may be at a disadvantage when it comes to cost, but after years of sanctions, it is more prepared to withstand lower prices for longer.

As a result, I see Saudis’ attempt to lower prices on their products as a ‘bluff’, which, if called, they will have to fold. On the long run, lowering prices can only be counterproductive for them. First of all, it will affect their fiscal balance. Second, it will reinforce Russia’s (supposed) game plan (to push US shale out of the game) and hurt US, a Saudi ally. Therefore, this is at best an attempt to gain marginal market share; it would be extremely imprudent to begin a price war.

While indeed Trump has been very vocal on the benefit of low oil prices to US consumers, the sands started shifting in 2019 as the US became a net exporter of petroleum towards the end of the year: all of a sudden, Trump started extolling US energy independence. Would the US president be eager to keep a campaign promise to end US reliance on foreign energy? If so, he would now need to balance low oil prices with the risk of the US shale oil industry going bust. Therefore, I would not be surprised if the Saudis get a call from the White House should oil prices continue to plunge and that threatens the viability of US energy production.

I think the short-term market reaction this week will be brutal, but this is very different from 2014-2016 when we had similar producers’ dynamics and oil hit $30. First, inventory build-up back then was +230mbd, today it is -1.5mbd. Second, shale was in the upswing then, while now it is on the backfoot: oil-well declines are much bigger, costs are higher, and capital is scarcer. 

I was bullish WTI at $45 last weekend partially because I expected the markets to bounce on sentiment, which they did, but more importantly, because the price reflected a demand-supply imbalance discounting a sharp drop in demand from the Coronavirus effect – there was, I thought, a decent cushion. Moreover, it is my view that either China will use the oil price drop to simply buy more oil, or that economic activity in China, being the marginal swing buyer of oil, will slowly come back – or rather much faster than in the West thanks to the actions the authorities there took to contain the outbreak.

Oil eventually hit $30 in 2016 but did not stay there long. It is much more difficult to model today the demand destruction from the Coronavirus but also there should be some marginal energy demand coming from the digital medium as all these people staying/working from home get online (ICT energy use is now more than half travel energy use, and it is growing very fast). Supply side is always easier to model, and it shows that compared to 2014, inventories are much lower, shale is largely out, and specs are short.

We should not underestimate that lack of liquidity/margin calls work both ways depending on positioning (as per gold sell-off a week ago) That means one needs to watch the newswires and trade rather than invest. That’s what I am doing.

Toto, I’ve a feeling we’re not in Kansas anymore

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This worked out quite well. Too well given the G7 “strong and coordinated response”. Let’s not kid ourselves, unless they can build a hospital in six days, this is going to be highly inadequate.

As if rates going negative was not enough of a wake-up call that what we are dealing with is something else, something which no one alive has experienced: a build-up of private debt and inequality of extraordinary proportions which completely clogs the monetary transmission as well as the income generation mechanism. And no, classical fiscal policy is not going to be a solution either – as if years of Japan trying and failing was not obvious enough either.

But the most pathetic thing is that we are now going to fight a pandemic virus with the same tools which have so far totally failed to revive our economies. If the latter was indeed a failure, this virus episode is going to be a fiasco. If no growth could be ‘forgiven’, ‘dead bodies’ borders on criminal.

Here is why. The narrative that we are soon going to reach a peak in infections in the West following a similar pattern in China is based on the wrong interpretation of the data, and if we do not change our attitude, the virus will overwhelm us. China managed to contain the infectious spread precisely and exclusively because of the hyper-restrictive measures that were applied there. Not because of the (warm) weather, and not because of any intrinsic features of the virus itself, and not because it provided any extraordinary liquidity (it did not), and not because it cut rates (it actually did, but only by 10bps). In short, the R0 in China was dragged down by force. Only Italy in the West is actually taking such draconian measures to fight the virus.

Any comparisons to any other known viruses, present or past, is futile. We simply don’t know. What if we loosen the measures (watch out China here) and the R0 jumps back up? Until we have a vaccine or at least we get the number of infected people below some kind of threshold, anything is possible. So, don’t be fooled by the complacency of the 0.00whatever number of ‘deaths to infected’. It does not matter because the number you need to be worried about is the hospital beds per population: look at those numbers in US/UK (around 3 per 1,000 people), and compare to Japan/Korea (around 12 per 1,000 people). What happens if the infection rate speeds up and the hospitalization rate jumps up? Our health system will collapse.

UK released its Coronavirus action plan today. It’s a grim reading. Widespread transmission, which is highly likely, could take two or three months to peak. Up to one fifth of the workforce could be off work at the same time. These are not just numbers pulled out of a hat but based on actual math because scientist can monitor these things just as they can monitor the weather (and they have become quite good at the latter). And here, again, China is ahead of us because it already has at its disposal a vast reservoir of all kinds of public data, available for immediate analysis and to people in power who can make decisions and act fast, vert fast. Compare to the situation in the West where data is mostly scattered and in private companies’ hands. US seems to be the most vulnerable country in the West, not just because of its questionable leadership in general and Trump’s chaotic response to the virus so far, but also because of its public health system set-up, limiting testing and treating of patients.

Which really brings me to the issue at hand when it comes to the reaction in the markets.

The Coronavirus only reinforces what is primarily shaping to be a US equity crisis, at its worst, because of the forces (high valuation, passive, ETF, short vol., etc.) which were in place even before. This is unlikely to morph into a credit crisis because of policy support. 

Therefore, if you have to place your bet on a short, it would be equities over credit. My point is not that credit will be immune but that if the crisis evolves further, it will be more like dotcom than GFC. Credit and equity crises follow each other: dotcom was preceded by S&L and followed by GFC.

And from an economics standpoint, the corona virus is, equally, only reinforcing the de-globalization trend which, one could say, started with the decision to brexit in 2016. The two decades of globalization, beginning with China’s WTO acceptance in 2001, were beneficial to the USD especially against EM, and US equities overall. Ironically, globalization has not been that kind to commodity prices partially because of the strong dollar post 2008, but also because of the strong disinflationary trend which has persisted throughout.

So, if all this is about to reverse and the Coronavirus was just the feather that finally broke globalization’s back, then it stands to reason to bet on the next cycle being the opposite of what we had so far: weaker USD, higher inflation, higher commodities, US equities underperformance.

That’s my playbook.

To QE or not to QE? Not enough liquidity but too much risk.

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This note was first published on https://www.eri-c.com/ on 27 January, 2020

“I am here for one reason and one reason alone. I’m here to guess what the music might do a week, a month, a year from now. That’s it. Nothing more. And standing here tonight, I’m afraid that I don’t hear a thing. Just…silence”

~Margin Call

At the moment, the popular narrative in the market is that the Fed has created the greatest liquidity boost ever. On the back of it, US stock prices, in particular, have risen in an almost vertical fashion since September 2019. The irony is that this boost of liquidity was not big enough to justify such a reaction. In fact, if we compare Fed’s recent balance sheet increase to QE 1,2,3, it becomes obvious that they have little in common, which is why central bank officials have continuously stated that this is not QE. Whether that is the case or not is not a question of trivial semantics. It actually carries important market implications: once this overestimation of Fed liquidity becomes common knowledge, the stock market would have to correct accordingly.

The large increase of autonomous factors on the liability side of the Fed’s balance sheet is at the core of this misunderstanding.

Although the Fed has indeed been doing around $100Bn worth of repo operations on a daily basis since September 2019 (less so recently), these operations are only temporary (overnight and 14-days), i.e. they cannot be taken cumulatively in ascertaining the effect on liquidity. In fact, during that period, the Fed’s balance sheet increased by only about $400bn, of which about half came from repos, the other from securities purchases, mostly T-Bills, with the increase in UST (coupons) more than offset by the decline in MBS.

Source: FRB H.4.1, BeyondOverton

However, not all of the increase in Fed’s balance sheet went towards interbank liquidity: bank reserves rose by only about $150Bn (as of 22/01/2020), less than half of the total! Almost two-thirds went towards an increase in the Treasury General Account (TGA), which takes liquidity out. The growth of currency in circulation (which also decreases liquidity) was exactly offset by a net decline in reverse repos: a drop in the Foreign Reverse Repos (FRP), but a rise in domestic reverse repo.

Source: FRB H.4.1, BeyondOverton

Fed actually started increasing its T-Bills and coupons portfolio already in mid-August, three weeks before the repo spike. Part of that increase went towards MBS maturities. But by the end of August, Fed’s balance sheet had already started growing. By the third week of September, also the combined assets portfolio (T-Bills, coupons, MBS) bottomed out, even though MBS continued to decrease on a net basis.

Source: FRB H.4.1, BeyondOverton

Fed’s repo operations began the second week of September. They reached a high of $256Bn during the last week of December. At $186Bn, down $70Bn from the highs, they are at the same level where they were in mid-October.

 Source: FRB H.4.1, BeyondOverton

On the liability side, TGA actually bottomed out two weeks before the Fed started buying coupons and T-Bills, while the FRP topped the week the Fed started the repo operations. Could it be a coincidence? I don’t think so. My guess is that the Fed knew exactly what was going on and took precautions on time. Just as we found out that the Fed had lowered the rate paid on FRP to that of the domestic repo rate, we might also one day find out if it did indeed nudge foreigners to start moving funds away.

 Source: FRB H.4.1, BeyondOverton

So, while the Fed’s liquidity injection since last September was substantial relative to the period when the Fed was tapering (2018) or when the balance sheet was not growing (2015-17), it is a stretch to make a claim that this is the greatest liquidity boost ever. The charts below show the 4-week and 3-month moving average percentage change in the Fed’s balance sheet. The 4-week change in September was indeed the largest boost in liquidity since the immediate aftermath of the 2008 financial crisis. The 3-month change, though, isn’t.

Source: FRB H.4.1, BeyondOverton

The Fed pumped more liquidity in the system during the European debt crisis. In the first four months of 2013, both the growth rate of the Fed’s balance sheet and the absolute increase of assets and bank reserves were higher than in the last four months of 2019. Moreover, there were no equivalent increases in either the TGA or the FRP.

Source FRB H.4.1, BeyondOverton

In fact, the reason Fed’s balance sheet changes this time around did not provide any substantial boost to liquidity, is precisely because they are very different from the three QE episodes immediately after the 2008 financial crisis.

For example, during QE1, the increase in securities held was more than three times the increase in Fed’s total assets. That was mostly because loans and central banks (CBs) swaps declined, to make up the difference. The Fed bought both coupons and MBS. However, 75% of the increase in assets came from a rise in MBS (from $0 to almost $1.2Tn), while T-Bills remained unchanged and agencies declined.

The Fed had begun to extend loans to primary dealers (PDs) even before September 2008, but immediately after Lehman Brothers failed, it included asset-backed/commercial paper/money market/mutual fund entities to this list of loan recipients as well. At around $400Bn, these were short-term loans, designed to pretty much make sure that no other PD or any significantly important player failed.

By the time QE1 finished most of these loans were repaid. In a similar fashion, the Fed had already put in place CBs swap lines even before September 2008, but they got really filled up, to the tune of more than $500Bn, after the Lehman Brothers event. Finally, repos actually decreased during QE1. Bottom line is, as far as Fed’s assets are concerned, September 2019 had no resemblances at all to September 2008.

On the liability side, the differences were also stark. Unlike 2019, during QE1 bank reserves contributed to 95% of the overall increase of balance sheet. The FRP remained pretty much flat for the full duration of QE1, while the TGA was unchanged but it did exhibit the usual volatility during seasonal funding periods.

Source: FRB H.4.1, BeyondOverton

QE2 was much more straightforward than QE1. Fed’s assets increased only on the back of coupon purchases (around $600Bn), while the Fed continued to decrease its MBS and loans portfolio. On the liability side, bank reserves continued to contribute about 95% of the increase. The rest was currency in circulation. Bottom line here again is that there is really no resemblance to 2019.

QE3 was similar to QE2 in the sense that Fed’s reserves increased 100% on the back of securities purchases (around $1.6Tn), but this time split equally between coupons and MBS. On the liability side, however, at 80% of total, bank reserves contributed slightly less towards the overall increase than during QE1 or QE2. The rest was split between currency in circulation and reverse repos. So, during QE3 less of the Fed’s balance sheet increase, than during the previous QEs, contributed to liquidity overall, but still much more than in 2019.

Reverse repos were especially prominent after QE3, when the Fed stopped growing its balance sheet but before it actually started tapering it. Probably, that was the sign that the banking system was actually running enough surplus reserves that it was willing to give some of the liquidity back to the Fed.

To recap, whatever the Fed has been doing so far, starting in September 2019, has simply no comparisons with any of the previous QEs. The largest increases on the Fed’s balance sheet in 2019 were T-Bills and repos; the Fed never bought T-Bills or engaged in repos in any of the previous QEs – the asset mix was totally different. On the liability side, while in the QEs almost all of the increase went directly into bank liquidity, in 2019 less than 50% did. FRP was more or less unchanged, at around $100Bn, between the beginning of QE1 and the end of QE3, but by September 2019 it had tripled. TGA averaged around $60Bn before the end of QE3; thereafter the average increased four times!

As a matter of fact, when we put the whole picture together, the case could be made that the Fed did not really create any additional liquidity at all since equities bottomed in March 2009.

Fed’s assets have increased by about $2Tn since then. But only 37% of that increase went to bank reserves. 40% went towards the natural increase of currency in circulation, 14% went to the TGA and 9% went to the FRP (last three drawing liquidity out). 

Source: FRB H.4.1, BeyondOverton

Yes, bank reserves have increased by about $800Bn since then but also have bank reserves needs on the back of Basel III liquidity requirements. According to the Fed itself, the aggregate lowest comfortable level of reserve balances in the banking system ranges from $600Bn to just under $900Bn. Thus, at $1.6Tn currently, there is not much excess liquidity left in the system: on a net basis, whatever extra liquidity was created, it happened between September 2008 and March 2009.

More precisely, actually, the Fed did create surplus liquidity up to about the end of 2014. Between 2015 and the end of 2017, the liquidity in the system stayed flat. After that, the Fed started taking liquidity out, and by the middle of 2019 it left just about enough surplus liquidity (over and above the March 2009 level) to satisfy Basel III liquidity requirements.

Going forward, it is very likely that the bulk of the increase of the central bank’s balance sheet is behind us for the moment, ceteris paribus. The Fed will continue shifting from repos to T-Bills and probably coupons (especially if it hikes the IOER/repo rate, as expected). The effect on liquidity will depend on the mixture of liabilities, though. I expect the TGA to start drifting lower with seasonality as well as because it is at level associated with reversals in the past.

Source: FRB H.4.1, BeyondOverton

FRP has a bit more to go on the downside but I think it will struggle to break $200Bn, and it might settle around $215Bn. TGA and FRP declining should help liquidity even if Fed’s balance sheet does not increase. If the decline in the demand for repos is less than Fed’s securities purchases, bank reserves are likely to go up: this should help liquidity overall. Otherwise, it depends on the net effect of the change in all autonomous factors.

Source: FRB H.4.1, BeyondOverton

So, while the Fed has just about created enough liquidity to take bank reserves to the level of March 2009 (plus the reserves required to meet Basel III liquidity requirements), S&P 500 is up 10% since the Fed started this latest liquidity injections, and almost 400% since the bottom in 2009: an outstanding performance given all of the above. While the rise in the market pre 2019 can be fully attributed to massive corporate share buybacks, with active managers and real money (households, pension funds, mutual funds and insurance companies) net sellers of equities, thereafter, it is more of a mixed bag.

In 2019 retail money picked up the baton from corporates and bought the most equities since the 2008 financial crisis[1]. In addition, there has been relentless selling of volatility in the form of exotic structured retail products (mostly out of Asia[2]), betting on a continued stability and a rising trend on the back of the ongoing US corporate share buyback program, combined with the Fed’s about face on rates last year. Together with an all-time record speculative selling of VIX futures, this has left the street, generally speaking, quite long gamma, thus further helping the market’s bullish stance (to monetize their gamma exposure, dealers sell on rallies and buy on dips, thus cushioning the market on the way down, while the buying from other sources ensures the market keeps grinding higher). 

Having mostly missed the extraordinary rally in US stocks during 2009-2018 (i.e. during the Fed’s previous balance sheet expansions and before the tapering), real money did not want to be left out on this one as well. However, not only the premises for this bullishness are unfounded, as discussed above, but also the internals of the previous stock market rally might be changing.

Corporate share buybacks, while still strong, are fading. This is happening for two main reasons. First, the Boeing scandal (prior to last year, Boeing was one of the largest share buyback companies in the US), I believe, is really accelerating bipartisan support to allow regulators more leeway into scrutinizing how companies choose to spend their cash. Second, with corporate earnings growth slowing down, US companies have been substantially scaling down their plans for share buybacks in 2020, anyway.

Neither the fact that the central bank liquidity is much smaller than envisioned, nor that the breadth of the rally is narrowing, seems to be on people’s radar at the moment. On the contrary, investors might be even embracing a completely new paradigm, this-time-is-different attitude, which sometimes comes at moments preceding a market correction. For example, at Davos 2020, Bob Prince, the Co-CIO of the largest hedge fund in the world, Bridgewater, said in an interview with Bloomberg TV, that he believed the boom-bust cycle was over. In fact, he went further in elaborating on this view:

“Stability could be an opportunity…You’ll hear the tremors before the earthquake. It won’t just come upon you all of a sudden. Volatility is out there, but it is not imminent.” This reminded me of the build-up to the 2008 financial crisis[3]. It’s not that people did not see the risks in subprime mortgage CDOs back then. They did, and that was why it took them some time to get in on the


[1] See Brace Your Horses, This Carriage is Broken”, BeyondOverton, January 14, 2020

[2] “How an exotic investment product sold in Korea could create havoc in the US options market”, Bloomberg, January 20, 2020

[3] “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.”, Chuck Prince, CEO of Citibank, the largest US bank in 2007.

Corona Virus market implications

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Following up on the ‘easy’ question of what to expect the effect of the Corona Virus will be in the long term, here is trying to answer the more difficult question what will happen to the markets in the short-to-medium term.

Coming up from the fact that this was the steepest 6-day stock market decline of this magnitude ever (and notwithstanding that this was preceded by a quite unprecedented market rise), there are two options for what is likely to happen next week:

  1. During the weekend, the number of Corona Virus (CV) cases in the West shoots up (situation starts to deteriorate rapidly) which causes central banks (CB) to react (as per ECB, Fed comments on Friday) -> markets bounce.
  2. CV news over the weekend is calm, which further reinforces the narrative of ‘this too shall pass’: It took China a month or so, but now it is recovering -> markets rally. 

While it is probably obvious that one should sell into the bounce under Option 1, I would argue that one should sell also under Option 2 because the policy response, we have seen so far from authorities in the West, and especially in the US, is largely inferior to that in China in terms of testing, quarantining and treating CV patients. So, either the situation in the US will take much longer than China to improve with obviously bigger economic and, probably more importantly, political consequences, or to get out of hand with devastating consequences. 

It will take longer for investors to see how hollow the narrative under Option 2 is than how desperately inadequate the CB action under Option 1 is. Therefore, markets will stay bid for longer under Option 2.

The first caveat is that if under Option 1 CBs do nothing, markets may continue to sell off next week but I don’t think the price action will be anything that bad as this week as the narrative under Option 2 is developing independently. 

The second caveat is that I will start to believe the Option 2 narrative as well but only if the US starts testing, quarantining, treating people in earnest. However, the window of opportunity for that is narrowing rapidly.

What’s the medium-term game plan?

I am coming from the point of view that economically we are about to experience primarily a ‘permanent-ish’ supply shock, and, only secondary, a temporary demand shock. From a market point of view, I believe this is largely an equity worry first, and, perhaps, a credit worry second.

Even if we Option 2 above plays out and the whole world recovers from CV within the next month, this virus scare would only reinforce the ongoing trend of deglobalization which started probably with Brexit and then Trump. The US-China trade war already got the ball rolling on companies starting to rethink their China operations. The shifting of global supply chains now will accelerate. But that takes time, there isn’t simply an ON/OFF switch which can be simply flicked. What this means is that global supply chains will stay clogged for a lot longer while that shift is being executed. 

It’s been quite some since the global economy experienced a supply shock of such magnitude. Perhaps the 1970s oil crises, but they were temporary: the 1973 oil embargo also lasted about 6 months but the world was much less global back then. If it wasn’t for the reckless Fed response to the second oil crisis in 1979 on the back of the Iranian revolution (Volcker’s disastrous monetary experiment), there would have been perhaps less damage to economic growth.  Indeed, while CBs can claim to know how to unclog monetary transmission lines, they do not have the tools to deal with supply shocks: all the Fed did in the early 1980s, when it allowed rates to rise to almost 20%, was kill demand.

CBs have learnt those lessons and are unlikely to repeat them. In fact, as discussed above, their reaction function is now the polar opposite. This is good news as it assures that demand does not crater, however, it sadly does not mean that it allows it to grow. That is why I think we could get the temporary demand pullback. But that holds mostly for the US, and perhaps UK, where more orthodox economic thinking and rigid political structures still prevail. 

In Asia, and to a certain extent in Europe, I suspect the CV crisis to finally usher in some unorthodox fiscal policy in supporting directly households’ purchasing power in the form of government monetary handouts. We have already seen that in Hong Kong and Singapore. Though temporary at the moment, not really qualifying as helicopter money, I would not be surprised if they become more permanent if the situation requires (and to eventually morph into UBI). I fully expect China to follow that same path.

In Europe, such direct fiscal policy action is less likely but I would not be surprised if the ECB comes up with an equivalent plan under its own monetary policy rules using tiered negative rates and the banking system as the transmission mechanism – a kind of stealth fiscal transfer to EU households similar in spirit to Target2 which is the equivalent for EU governments (Eric Lonergan has done some excellent work on this idea).

That is where my belief that, at worst, we experience only a temporary demand drop globally, comes from, although a much more ‘permanent’ in US than anywhere else. If that indeed plays out like that, one is supposed to stay underweight US equities against RoW equities – but especially against China – basically a reversal of the decades long trend we have had until now.  Also, a general equity underweight vs commodities. Within the commodities sector, I would focus on longs in WTI (shale and Middle East disruptions) and softs (food essentials, looming crop failures across Central Asia, Middle East and Africa on the back of the looming locust invasion). 

Finally, on the FX side, stay underweight the USD against the EUR on narrowing rate differentials and against commodity currencies as per above.

The more medium outlook really has to do with whether the specialness of US equities will persist and whether the passive investing trend will continue. Despite, in fact, perhaps because of the selloff last week, market commentators have continued to reinforce the idea of the futility of trying to time market gyrations and the superiority of staying always invested (there are too many examples, but see here, here, and here). This all makes sense and we have the data historically, on a long enough time frame, to prove it. However, this holds mostly for US stocks which have outperformed all other major stocks markets around the world. And that is despite lower (and negative) rates in Europe and Japan where, in addition, CBs have also been buying corporate assets direct (bonds by ECB, bonds and equities by BOJ).

Which begs the question what makes US stocks so special? Is it the preeminent position the US holds in the world as a whole? The largest economy in the world? The most innovative companies? The shareholders’ primacy doctrine and the share buybacks which it enshrines? One of the lowest corporate tax rates for the largest market cap companies, net of tax havens?… 

I don’t know what is the exact reason for this occurrence but in the spirit of ‘past performance is not guarantee for future success’s it is prudent when we invest to keep in mind that there are a lot of shifting sands at the moment which may invalidate any of the reasons cited above: from China’s advance in both economic size, geopolitical (and military) importance, and technological prowess (5G, digitalization) to potential regulatory changes (started with banking – Basel, possibly moving to technology – monopoly, data ownership, privacy, market access – share buybacks, and taxation – larger US government budgets bring corporate tax havens into the focus).

The same holds true for the passive investing trend. History (again, in the US mostly) is on its side in terms of superiority of returns. Low volatility and low rates, have been an essential part of reinforcing this trend. Will the CV and US probably inadequate response to it change that? For the moment, the market still believes in V-shaped recoveries because even the dotcom bust and the 2008 financial crisis, to a certain extent, have been such. But markets don’t always go up. In the past it had taken decades for even the US stock market to better its previous peaks. In other countries, like Japan, for example, the stock market is still below its previous set in 1990.

While the Fed has indeed said it stands ready to lower rates if the situation with the CV deteriorates, it is not certain how central bankers will respond if an unexpected burst of inflation comes about on the back of the supply shock (and if the 1980s is any sign, not too well indeed). Even without a spike in US interest rates, a 20-30 VIX investing environment, instead of the prevailing 10-20 for most of the post 2009 period, brought about by pulling some of the foundational reasons for the specialness of US equities out, may cause a rethink of the passive trend.  

The Corona virus will push us further into the digital medium

The facemask will become a feature of our daily life: it was already turning into a fashion symbol before the virus hit. In the near future, the face mask will be incorporated into the VR ‘goggles’, 

The Corona virus will only accelerate the shift towards the digital medium at the expense of the physical medium of human existence. Millennials have more or less embraced this change: apart from having to go to school they do not leave their bedrooms anymore (and I suspect, if the quarantine stays on longer, governments will start to consider settling up virtual classrooms). If you don’t have a teenager just have a cursory check on some of the comments on Tiktok to get an idea that the young generation does not consider the virus a big issue at all – it affects mostly the older generation, plus a quarantine allows the young to spend more time in the digital world of their bedrooms.

But, if the quarantines remain a feature in the developed world, the virus could also have a profound effect on the older generation in terms of travel and work preferences. For example, the trend decline in car sales globally will accelerate. Long distance vacation travel is also likely to slow down; physical social interaction, already massively in decline, as well. The older generations may be ‘forced’ into the digital medium for health and safety concerns, as well as to avoid increasing living costs.

Does that mean any physical infrastructure not directly linked to the new medium becomes obsolete? This is an important question for policy makers to consider especially now as the calls for fiscal action become louder and louder. In that sense, the thinking in the higher echelons of power in the West are either at level zero (a border wall), or level one (a bridge in the Irish sea, high speed rail). Instead, we need at least second level thinking here, for example, what is the new mobility landscape?

If Chevron’s London office staff working from home proves to be either non-disruptive or even possibly increase productivity, would that become the new normal? Outsourcing office space for free from your own employees, and saving massively on real estate costs, which company wouldn’t jump at the opportunity (note this is no different to getting consumer data for free in exchange for social media access, or booking your own travels in exchange for lower prices – it’s all part of the same trend)?

This means more de-urbanization. The concept of the city as a melting pot of ideas and people is also becoming obsolete. Moreover, this is again an existing trend: urbanization rates have been decreasing in the developed world independently as a feature of decentralization.

Will the supply chains shift as a result of all this? Yes. Again, a well-established trend already which started in earnest with the decision to Brexit in 2016, Trump’s de-globalization campaign and the ensuing US-China trade war. While China is the more obvious ‘loser’ here (though, not necessarily clear, as China was already moving up the value chain and this process may have only accelerated this, as well as its push to ‘own; the digital medium through the development of 5G), the beneficiaries are not clear. It is unlikely, though, to be any other emerging market countries, as that does not take care of the issue at hand (the start of this trend in 2016).

Though actual production is likely to come back to the developed world, this does not necessarily mean higher employment long term. There is yet another trend, which has already been in place for a few years, which will get a strong push here, that of automation of production. We haven’t seen the benefits of automation yet largely because it has either not been profitable enough, or because of politics (keep employment higher until we figure out what to do with people, and in return, we ‘let’ you book revenues in tax havens so you save on corporate taxes and have more cash for share buybacks!). But automation costs have been coming down as technology advances, while human costs have been perking up. Political developments, plus massively increasing federal budget deficits, have also put pressure on clamping down on tax havens. We can finally see the seeds of 3D printing and precision manufacturing bear fruit. This is very bullish companies in these two sectors.

With manufacturing supply chains practically disintegrated, the only ones that will matter in the digital medium are commodities supplies – this is very bullish commodity exporting countries.

Is that the new normal?

My flight from London to Rome on March 26 was practically empty

We are entering a ‘Ready Player One’ world. The trend-decline in physical infrastructure, in the developed world – decades long, will probably accelerate. It is too late to build the HS2. The trend-increase in alternative ‘realities’, on the other hand, whether we call them fake news, social bubbles, or whatever, will only accelerate. So, focus is shifting to building the foundation of the equivalent of the digital ‘Interstate Highway System’: 5G is the most important development in that regard at the moment, and the main reason the US-China trade war started in the first place. 

Tesla: No Paradigm Shifts, Yet

Initially published on MacroHive on February 6, 2020

In light of the vertical rise in Tesla’s share price in the last few months, I thought it worthwhile to revisit an old narrative comparing the Apple’s iPhone moment with Tesla now. My verdict: I wouldn’t get sucked in by any ‘paradigm shift’ just yet. Though there are plenty of possible reasons and even more conspiracy theories, this share price spike is likely nothing other than mad short covering.

Having said that, Tesla might be worth this much – indeed maybe even more. But the story has to change: Tesla is not a car company, and it is not in the mobility business; instead, it is an energy storage company, and it is in the renewable energy business.

The iPhone shifted the paradigm because it distinguished itself as a mobile device, not a mobile phone. Moreover, the iPhone arrived at the very beginning of the internet/social media/digital cycle. Tesla is still a car (you need to drive it!), albeit without an internal combustion engine, and it comes at the end of the mobility cycle. After all, cars have been around in roughly the same form for at least 100 years. Air travel was a much bigger disruptor. If you want an iPhone analogy in the mobility cycle, it’s that, not Tesla. The fact that air travel is a money loser now also supports the idea that we are at the end of the traditional mobility cycle.

The Autonomous Vehicle (AV) could be the next big disruptor in the mobility sector, not the Electric Vehicle (EV) – which is what Tesla currently is. People are much more likely to use an AV than an EV because in an AV they are free to do whatever they want while it transports them. It also has the potential to be cheaper and more comfortable than a driver-operated EV taxi.

The problem with AV, still, is that it is a long way off. Elon Musk had initially set a deadline of fully autonomous driving by the end of 2019. That obviously did not happen. During the company’s Q4’2019 earnings call, Musk said that it might happen in a few months. But he downplayed how well the system would work, clarifying, “That doesn’t mean the features are working well”. This is not just a question of technology (for example, given the complexity of the urban landscape, city driving requires fully Level 5 automation), but it is also a question of regulations and costs. By the time the fully AV is available, probably not before the 2030s, especially in urban settings, the demand for it, will likely be lower simply because the digital medium would have evolved much more, surpassing the physical medium in terms of popularity.

So, if Tesla is not at its ‘iPhone’ moment, what could justify such a high share price?

Source: Nasdaq

As a car company, the $150bn market capitalisation makes little sense given comps in the industry. Though the last three quarters have finally been cash-flow positive, if the latest number of $976mm is properly discounted by the stock-based compensation of $898mm (accounted as a non-cash cost), the free cash flow (FCF) is not that big. And bear in mind that to get to it, Tesla had to halve its initial 2019 CAPEX from $2.5Bn, projected in Q1’2019, to what came to be the real 2019 number of $1.3bn. With one of the lowest CAPEX as a percentage of revenues in the business, it is difficult to imagine how Tesla will compete with the other car producers.


Tesla as a software company (similar to Uber and Lyft, i.e. turning into a utility as a platform) could possibly push the valuation up a bit, but hardly to where we are now given that Uber’s market cap is less than half of Tesla’s. The only way to get to the escape velocity we have been experiencing in the share price now is to completely exit the mobility sector and to focus on energy storage as the missing link in our society’s transition to a renewable energy future.


There is an argument to be made that this could have been Elon Musk’s initial idea. In 2004, less than a year after founding Tesla, Musk and his cousin thought of starting SolarCity during a trip to Burning Man, realising solar power’s potential in countering climate change. Tesla acquired SolarCity in 2016 and, in that same year, the company’s mission statement changed from ‘transitioning the world to sustainable transport’ to ‘accelerate the world’s transition to sustainable energy’.


But still, to get to today’s valuation, Tesla would have to put on a smart PR exercise talking about this mission statement shift in detail. To go higher from here, Tesla would need to align its vision statement, ‘to create the most compelling car company of the 21st century by driving the world’s transition to electric vehicles’ to its mission statement above. i.e.Tesla
needs to completely drop the transportation angle (where margins are only going lower) and invest a lot more in CAPEX and R&D with a focus on developing the best renewable storage options.

If then the market understands where Tesla is committed to going and believes in its technological abilities, it will drop all its requirements for near-term profitability and start pricing the stock with a much higher multiple – one more in line with other near-monopoly companies with a first-mover advantage. Barring any such efforts, Tesla’s stock is probably heading down as soon as the short covering is finished. At the end of the day, valuations are a matter of perceptions and assumptions first, and only then a question of whether the numbers fit. Wednesday [February 4] saw the start of this correction with a 17% drop. The only question now is whether the selloff will be as fast as on the way up.


Fed’s weekly balance sheet update

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Total assets down $30Bn: the biggest weekly decline since May 1, 2019, and down $27Bn from peak on Jan. 1, 2020. All of the decline is on the back of repos, down $43Bn on the week, and 70Bn from peak. At $186Bn, repos were last time here in mid October 2019.

On the liability side, bank reserves declined by $64Bn. But the liquidity dropped more because both the TGA and domestic reverse repos rose by $31Bn and $15Bn respectively. At $412, TGA is at its highest level over the last 12 months. On the other hand, and as expected, FRP continues to decline and at $250Bn is close to the low end of the 12m period. Currency in circulation also dropped for third week in a row, posting the biggest cumulative decline from its peak over the last 12m. The decline in FRP and currency in circulation cushioned the otherwise drop in overall liquidity.

Going forward, there is no doubt that the bulk of the central bank’s increase in balance sheet is behind us for the moment, ceteris paribus. The Fed will continue shifting from repos to T-Bills and probably coupons (especially if it hikes the IOER/repo rate next week). The effect on liquidity will depend on the liabilities mixture, though. Expect TGA to slowly start decreasing ($400Bn has kind of been its upper limit, rarely going above it by much).

FRP has a bit more to go on the downside but I think it will struggle to break $200Bn, probably settle around $215Bn.

That should help liquidity. If the Fed buys more securities than the decline in repos, under that scenario, bank reserves/liquidity go up. If not, it really depends on the net effect of the change in autonomous factors. 

If you are trading Fixed Income, expect a bit more pressure on the curve to continue flattening. If you are trading equities, none of this matters to you. At the moment, the only thing the equity market cares about is the size of the gamma cushion.