Category Archives: Asset Allocation

This is not a 2023 investment outlook

10 Saturday Dec 2022

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“It says in the brochure,” said Arthur, pulling it out of his pocket and looking at it again, “that I can have a special prayer, individually tailored to me and my special needs.”
– “Oh, all right,” said the old man. “Here’s a prayer for you. Got a pencil?”
– “Yes,” said Arthur.
– “It goes like this. Let’s see now: “Protect me from knowing what I don’t need to know. Protect me from even knowing that there are things to know that I don’t know. Protect me from knowing that I decided not to know about the things that I decided not to know about. Amen.” That’s it. It’s what you pray silently inside yourself anyway, so you may as well have it out in the open.”
– “Hmmm,” said Arthur. “Well, thank you”
– “There’s another prayer that goes with it that’s very Important,” continued the old man, “so you’d better jot this down, too, just in case. You can never be too sure. “Lord, lord, lord. Protect me from the consequences of the above prayer. Amen.” And that’s it. Most of the trouble people get into in life comes from missing out that last part.”

~ Douglas Adams, The Hitchhikers Guide to the Galaxy

It’s the time of the year when next year investment outlooks are released. If you are a newbie in this business, it is very important to devour as many as possible of those so that you can make as many as possible mistakes early on in your career when it is not only less painful to do so, but also when your ego is more flexible, hopefully, to allow you to learn from those mistakes.

If you are more experienced, you may be able to sift through the myriad of new investment outlooks and find that rare and original gem which may help you make money in the future. Either way, at best reading new year investment outlooks will make you look smart in the short-run when you attend those non-finance-related-but-people-want-to-know-about-investment Xmas drinks. At worst though, they will cloud your judgement as a professional investor and make you lose money in the long run.

This year has been brutal for investors, and it is very tempting to conclude that next year will be much better, which is essentially what most investment outlooks are saying. Note, 2023 is not necessarily projected to be a stellar year but still a year of small double digits returns (so slightly above the average).  It would be interesting to read therefore those people who forecast returns in the two tail distributions, especially the one on the left (another brutal year). I would say there would a be a lot of informational value if an experienced name has such a view for next year.

Looking at some of the major trends this year though, all of them have recently been at least partially unwound. Going from less to more: higher US yields have unwound about 1/4 of their move, weak US equities about 1/3, strong USD about half, strong commodities about 2/3, and last but not least, strong crude has unwound all of its move this year! We have another two weeks of trading until year end and those unwinds may be reversed (i.e., confirming the trends of the year), but that already tells us something about what to expect going forward.

These major trends will not explain everything but a good chunk of everything that is happening in the investment world. Many other trades are just a derivative of those major trends. For example, receiving Emerging Markets (EM) rates is almost a consensus trade for next year but it is heavily dependent on what happens to US rates. Long EM and European stocks are favourites for next year, but these cannot be considered in isolation to what happens in US equities. And people who trade FX for a living do not need a reminder that there are always two sides to the ‘coin’ (and one side is almost always the USD).

Commodities are slightly trickier, though. This year the correlation between individual commodities was higher than normal, but that is not always the case. Basically, the role of the USD in FX, USD rates in Fixed Income and US equities in Equities, is played by the price of oil in Commodities as energy takes such an outsized role in the cost structure of any commodity. But sanctions, tariffs, the weather etc., can also affect the way some commodities trade in markets.

This year commodities were the only asset class as a whole (looking at the five major ones, Rates, Credit, FX, Equities and Commodities) which posted positive returns. And this comes after a decade of pretty poor returns otherwise. Does it mean that is it for commodities?

There are also the odd idiosyncratic trades which offer enormous value to those who can discover them. This year some of those idiosyncratic trades were Brazil (rates, equities, FX), Turkey (both rates and equities), FTSE, India (equities), almost all Latam FX, etc. (obviously there were a lot of idiosyncratic trades in individual equities and credit). Can China provide double digit idiosyncratic equity returns next year, after two absolutely horrible years and almost a decade of flat returns? Can Japanese rates experience the opposite?

Then there are the relative value trades and those ‘technical’ trades (mostly in Fixed Income) which could provide an extra source of gains almost regardless of the direction of the major trends in the market. For example, after more than a decade of rates stuck at zero, a sufficient number of interest rates have gone up to provide now a decent cushion even if rates continue to trend upwards next year.

The table below provides the total return for each of the selected asset classes during the last major interest rate hiking cycle in the late 1970-early 1980s. Rates peaked in this cycle in 1981. It is interesting to note that 1) neither of these asset classes did that bad; 2) interest rates (especially T-Bills) did pretty good considering.

It is even more interesting to observe that USTs did not have that many more negative annual total returns when the yield on the 10yr moved from about 2.5% in 1951 after the Treasury – Federal Reserve Accord to more than 15% in 1981 than in the ensuing bull market thereafter. Moreover, during the bull market there were also significantly more years when the negative total annual return was higher than the worst negative return in the three decades after 1951. The point is that it is quite reasonable and, in fact, mathematically logical, to expect a positive return in 2023 for many fixed income markets.

The positive spin on China

30 Wednesday Nov 2022

Posted by in Asset Allocation, China

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It is not surprising that the comments and analysis on the recent protests in China have been overwhelmingly negative. Even Goldman Sachs which said China may end zero-Covid earlier than expected in Q1’23 put a negative spin (“disorderly exit”) and projected a lower-than-expected GDP in Q4’22.

There is no question that Chinese authorities are almost literally pressed to the wall with no easy options here. But what if there is a positive way out? It is no secret to anyone, including Chinese leaders, that there is a need to re-balance the economy towards domestic consumption and the best way to do that is to shift sectoral incomes towards Chinese households. For whatever reasons though Chinese authorities have not done that over the years, with the bulk of any extra income still going to the corporate (both private but mostly state) sector and local governments.

  • The Covid pandemic has however accelerated their work on DCEP, their version of CBDC, which allows for targeted transfers directly into people’s accounts. I believe, this is an avenue which will be much more explored as China gradually eases off from its zero-Covid policy.
  • Over the years Chinese authorities have been particularly slow in building the institutional infrastructure of pension and insurance vehicles and social security as a whole. But there has been substantial progress on that front this year.
  • Chinese assets, and in particular equities, have had two consecutive years of underperformance and under an extreme case scenario a third one is a distant possibility. However, the current set-up favours the establishment of a small exposure.

The Chinese household balance sheet

Chinese households’ balance sheet looks very different to US households’ balance sheet. In the US more than 2/3 of household assets are in the financial sector, the rest is in real estate (this is on average; it varies a lot depending on the income percentile though). In China, the split is more 50/50.

Within financial assets, Chinese households hold almost twice more Cash and its equivalents than US households (in % terms of the total household assets). But, on the other hand, they hold six times less Bonds and other Fixed Income equivalents and ten times less pension and insurance assets (all vehicles which come under social security). Equity allocations are very similar for both Chinese and US households, at around 1/3 of all household assets (this is direct ownership of equities; US households’ overall equity exposure is much larger as they own financial assets through their pension schemes, for example). A snapshot of Chinese household balance sheet can be seen here and of US household balance sheet here.

Basically, Chinese households have too much real estate and cash, too little exposure to bonds, and pretty much zero ‘social security’ cover. The protest against zero-Covid come at an opportune moment when the authorities have also been trying to contain the implosion in the real estate market. With Chinese households using real estate as the main source for pension coverage, creating a genuine viable alternative has become the top priority for Chinese leadership (the topic got extended coverage in China’s 14th Five-Year Plan).

The Chinese social security system

China’s pension industry framework consists of tree pillars. The first one is the basic state pension comprising of the Public Pension Fund and the National Social Security Fund. The second one is the voluntary employee pension plan in which the employer and employee make monthly contributions. And the third one is the private pension.

In April this year, China’ State Council released a document which stated that building the private pension system infrastructure is where their priorities now stand. This was followed by an announcement at a State Council meeting in September of new tax incentives to spur the development of private pensions.

The point is that a combination of an aging population, inadequate tax base and very early retirement age (60 for men and 55 for women) would eventually put the state pension system into deficit. At the same time, the employee-sponsored pension scheme is extremely inadequate covering only a tiny proportion of the population. So, the development of the private pension system has indeed taken centre stage.

DCEP can be used to top up household income

Part and parcel of that is ensuring the growth in household incomes. The authorities have been extremely slow in shifting national income more towards the private household sector. It is not clear to me why, especially given their goal of inclusive growth and the recent heavy regulations on the corporate sector in that direction. But these protests could speed up that process. For example, PBOC has been at the forefront globally in developing their CBDC (the Chinese equivalent is called DCEP – Digital Currency Electronic Payment). They have already successfully employed that in several cities on experimental basis.

In the present environment the authorities can use DCEP to help them ease out of their zero-Covid policy by directing payments to households in specific cities, neighbourhoods, even apartment buildings, which are affected by lockdowns. This kind of real-time, targeted fiscal policy can be extremely beneficial – much more so than the blanket free-for-all fiscal policy the US did during the Covid pandemic.   

Chinese assets offer an opportunity

Where does this leave your exposure to Chinese assets? If you are an institutional Fixed Income investor, you should consider the possibility of large flows into Chinese government bonds by both domestic retail as well as private pension providers, based on the analysis above (to a smaller extent, the same holds true for Chinese equities). Otherwise, it is easy to find reasons (see below) to not have any exposure to Chinese equities, but selling now here on the back of (zero) Covid does not make sense to me. In fact, the opposite is a better option.

Case in point, there was a lot of positive signalling at the latest weekly Covid briefing yesterday. For example, the authorities plan to increase vaccinations among the elderly, a move which could mean intentions to start reopening earlier. Some local governments were criticised for implementing severe lockdowns and were urged to adhere to ‘reasonable’ requests from residents. It is even possible, though I doubt it, that Beijing even decides to fully open up.

But there are two main risks to Chinese equities. The first one is regulatory and it is well known. The developments there are still in progress but if you are long CQQQ or KWEB (these are/were the popular China ETFs among foreign retail investors) and still worried US ADR delisting risk, you should know that only a small percentage of these ETFs holdings is still in ADRs. For example, CQQQ has 131 holdings worth about $767m. Of those only 8% (of the holdings and 15% of the market value) are still US ADRs.

Basically, the ETF providers have converted most of their US ADRs to equivalent HK/China listings, so the risk of substantial loss from US delisting for the whole portfolio has substantially diminished. There are though still regulatory risks. For example, the Chinese authorities can ban foreign entities from owning any China/HK listed stocks. I think the probability of this is small.

It could be also the case that US regulators ban US entities from investing in China/HK listed companies. I think the probability of that is also small but bigger than the former above. But, anyway, both of these are possible in a full-on US-China confrontation ala US-Russia now, which is the second risk to Chinese investments, and which is of truly existential nature. If this is your view, either you should not be touching any China-related investments, or, if you are a probability investor, you should appropriately scale your China exposure.

Mistakes were made

26 Saturday Nov 2022

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Mistakes become mistakes only in hindsight. The mistake I made, for example, in believing in the transitory aspect of inflation stems largely from not anticipating the extended nature of the global supply issue, sure, not helped by the war in Ukraine. I also made a mistake not investing in crypto.

Did Fed forecasters really make the same mistake on inflation? I am not sure. Regardless of what they said in public, a big driver in their decision-making process must have been the recency bias: after more than a decade of unsuccessfully grappling with disinflation, the right risk-return strategy was ‘to give inflation a chance’. And now the Fed is onto a different ‘recency bias’: having gone through the painful experience of the 1970s, the right strategy for them is to kill inflation at all costs.

That’s how decisions are made in the policy world: not based on actual forecasting outcomes but on protecting awful tail events from ever happening again. To a certain extent that’s how we also make decisions about things which concern us personally, even though we employ more of a barbel strategy: long both tails of the distribution tree.

Take crypto and the recent developments as an example. See this story. I would say, no, the majority of the people who invested in crypto were not stupid. Most were actually quite rational but lazy. Others, though, were irresponsible.

Private investors who invested a small single digit % of their wealth in crypto were logically simply playing the lottery ticket odds. VCs, which also invested a small % of their assets in crypto entities, were also, but they were lazy to do the proper due diligence.

In both cases, the decision-making process was mostly driven by aiming to hit the right-hand side (positive) tail-risk outcome. The risk-return was skewed to do that. Strictly speaking for the former that was the right decision; the latter should have done the work though. Either way, there was no risk in this case of ever landing on the left side of the distribution tree.

And then there is the third group, the pension funds, and the likes, who were simply irresponsible – they had no business investing in crypto. I think that is where one should search for accountability.

But, sure, there were perhaps some people and entities who invested the majority of their net wealth/assets in crypto. I may be wrong, but I think that is a small % of the overall money pool in crypto. And yes, they were perhaps stupid because the left side of the distribution tree was wide exposed.

I never invested in crypto. For that matter I do not remember ever buying lottery tickets in real life (though I have been the proud owner of many deep out-of-the money options which expired worthless…and a few which hit the jackpot). But to go back to inflation, I did manage to lose money being long bonds in this late cycle. I was too ‘lazy’ to do the proper ‘due diligence’ on the fundamental drivers of inflation. But once the war hit in late February, and sanctions followed soon thereafter, it all became clearer.

It was largely because I had done extensive work on the nature of low rates that I knew their gig was over. To quote from the link above: “[We] must be cognizant that a switch to higher rates will most likely only happen after the economy has first gone through one or a combination of: social unrest, debt jubilee, large increase in the money supply or natural disaster.” It turns out that we kind of almost went through all of them: war in Ukraine, student debt forgiveness initiative, yes, massive increase of the money supply, and climate change worries.

What is the right decision to make when it comes to investing now? Well, if the above framework is right, one has to acknowledge the effect of a higher rate environment not just on asset valuations but also on the incentive structure which retail and professional investors are facing in this environment. At this point, it is the second and third order effect of higher interest rates which matter, i.e., staying short bonds is now a decently negative carry trade with low risk-return profile.

Oh, yes, also, always keep small change to buy lottery tickets: in Bulgaria, where I originally come from, the slogan of the National Lottery under communism was “evert week, with a small amount”.

What explains the spectacular bounce in risk?

16 Wednesday Nov 2022

Posted by in Asset Allocation, China, Debt, Equity, Monetary Policy

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The prevailing sentiment among the people I speak to (predominantly hedge fund managers) is to sell this rally. The reasons given are (also see below for a complete list): 1) One CPI is unlikely to change the Fed’s interest rate trajectory (basically we are data dependent), 2) China has not changed its zero-Covid strategy in earnest, 3) There is still a risk of a winter energy crisis in Europe, 4) JPY weakness will not reverse before YCC is over.

All these are valid, but I will stick with a risk-on attitude a bit longer. In any case, what caused this drastic change in sentiment?

Positioning was really lopsided. See this article citing research from GS which believes CTAs were forced to buy $150Bn in equities and $75Bn in bonds. Real money is also very light risk after being forced to reduce exposures throughout the year. But what were the main drivers which changed sentiment to begin with?


It was weird to see markets actually not really selling off after Powell’s hawkish FOMC press conference. Perhaps the fact that we had a bunch of FOMC members (see here and here, for example), calling for a slowing down of the pace of Fed Fund Rate (FFR) increases, may explain to some extent the positive reaction at the time. And of course, the catalyst came when the US CPI was released lower than expected.


FFR actually does not give anymore a precise indication of the stance of US monetary policy – this is the conclusion of a new paper by FRBSF. If all data such as forward guidance and central bank balances sheet effect are taken into account, the FFR is more likely already above 6% vs the current target of 3.75-4% (the paper puts the FFR at 5.25% for September and I add the 75 bps of hikes since then).

This means monetary policy today is even more restrictive than at the peak before the 2008 financial crisis and approaching levels last seen during the tech bust in 2000. The findings in the paper make intuitive sense. Quoting from the paper:

“[W]hen only one tool was being used before the 200s, the stance of monetary policy was directly related to the federal funds rate. However, the use of additional tools and increased policy transparency by FOMC participants has made it more complicated to measure the stance of policy.”

The new tools the authors refer to are mainly forward guidance, which started to be actively used after 2003, and central bank balance sheet management, which started after 2008. The proxy FFR (see chart above) actually includes a lot more, a total of 12 market variables, including UST yields, mortgage rates, borrowing spreads, etc. It is perhaps intuitively easier to see that monetary policy was much looser at times when the FFR was at the zero-low bound and QE was in full use than it is a lot tighter today when FFR is firmly in positive territory and QT is in order, but the logic is the same.


So, I think somehow or other, the market now believes that we have seen the peak in FFR (forward) – that provided the foundation of the risk bounce.

China provided the other pillar of support for risk. Ironically, in a similar fashion to how it played out after FOMC, i.e., the consensus was that the 20th CCP Politburo meeting was an overwhelming negative for Chinses assets. And even though they sold off, there was no immediate follow through. In fact, we started hearing that Chinese authorities are looking into taking the first steps to pivot from the Zero-Covid policy, and are very serious about providing a floor for property prices. Finally, there was a genuine improvement on the US-China relations side as US regulators finished their inspection of Chinese companies in HK ahead of schedule and US President Biden and Chinese leader Xi Jinping met at the Group of 20 summit in Bali.

The third pillar of support came from Europe. First, European energy prices (see a chart of TTF) have come a long way down from their peak in the summer (almost full inventories and mild weather helped). Second, the UK pension crisis was short-lived after the change in government and did not have any spill-over effects on other markets. And third, there is genuine hope of a negotiated solution of the war in Ukraine after the Ukrainian army made some sizable advances in reclaiming back lost territory, with both the US and Russia urging now for possible talks. My personal view is that the quick withdrawal of Russia from these territories is a deliberate act to incentivize Ukraine to come to the negotiating table – even though the latter does not seem eager too . Yesterday’s missile incident, and Ukraine’s quick claim that it is Russia’s fault, which is contrary to what preliminary investigation has led to so far, might be a testament to that.

Finally, and that falls under positioning, there is the unwind of USDJPY longs spurred by heavy intervention by Japanese authorities. If there is any proof that policy makers are taking the plunge in the Yen seriously it is in the details of Japan’s Q3 GDP which shrunk unexpectedly by 1.2% (consensus was for a 1.2% increase). The bad news came almost entirely from the negative contribution of net trade. Net trade has been a drag on GDP for the last four quarters primarily from the rise in imports, i.e., the weakness in the Yen. The good news is that the economy otherwise is doing fine: private demand had a big bounce from the previous quarter and has been a net positive overall (all data can be found here): in other words, the problem is the Yen, and YCC makes that worse.

Another piece of data, released last week, which caught our attention, is Japan FX Reserves. The decline from the high in July 2020 is $241Bn, about 18% – that is a substantial amount. The interesting thing, and we kind of know this from the TIC data is that the decline is coming entirely from the sale of foreign securities; deposits actually went up marginally (some of the decline is also valuation). But we know now that when Japan was intervening in USDJPY in September/October, it was selling securities, not depos – most analysts thought Japan would first reduce depos, while intervening, before selling their security portfolio. All data is here.

In summary, CTAs’ sizable wrong way bets long USD and short equities and bonds and real money light risk exposure overall coincided with dovish economic data, reopening China and improving geopolitics (all of these happening on the margin).

Record liquidity leads to record net issuance of financial assets

06 Monday Jul 2020

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At $3.2Tn, US Treasury (UST) net issuance YTD (end of June) is running at more than 3x the whole of 2019 and is more than 2x the largest annual UST issuance ever (2010). At $1.4Tn, US corporate bond issuance YTD is double the equivalent last year, and at this pace would easily surpass the largest annual issuance in 2017. According to Renaissance Capital, US IPO proceeds YTD are running at about 25% below last year’s equivalent. But taking into consideration share buybacks, which despite a decent Q1, are expected to fall by 90% going forward, according to Bank of America, net IPOs are still going to be negative this year but much less than in previous years.

Net issuance of financial assets this year is thus likely to reach record levels but so is net liquidity creation by the Fed. The two go together, hand by hand, it is almost as if, one is not possible without the other. In addition, the above trend of positive Fixed Income (FI) issuance (both rates and credit) and negative equity issuance has been a feature since the early 1980s.

For example, cumulative US equity issuance since 1946 is a ($0.5)Tn. Compare this to total liquidity added as well as issuance in USTs and corporate bonds.*

The equity issuance above includes also financial and foreign ADRs. If you strip these two out, the cumulative non-financial US equity issuance is a staggering ($7.4)Tn!

And all of this happened after 1982. Can you guess why? SEC Rule 10b-18 providing ‘safe harbor’ for share buybacks. No net buybacks before that rule, lots of buybacks after-> share count massively down. Cumulative non-financial US equity issuance peaked in 1983 and collapsed after. Here is chart for 1946-1983.

Equity issuance still lower than debt issuance but nothing like what happened after SEC Rule10B-18, 1984-2019.

Buybacks have had an enormous effect on US equity prices on an index basis. It’s not as if all other factors (fundamentals et all) don’t matter, but when the supply of a financial asset massively decreases while the demand (overall liquidity – first chart) massively increases, the price of an asset will go up regardless of what anyone thinks ‘fundamentals’ might be. People will create a narrative to justify that price increase ex post. The only objective data is demand/supply balance.

*Liquidity is measured as Shadow Banking + Traditional Banking Deposits. Issuance does not include other debt instruments (loans, mortgages) + miscellaneous financial assets. Source: Z1 Flow of Funds

April TIC data: Continuous foreign selling of US assets

16 Tuesday Jun 2020

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April TIC data released.

  • Heavy foreign UST selling continues.
  • Foreign selling starts to pick up also in US equities and agencies.

March broke the record for Total foreign monthly outflow.

This happened largely on the back of a record Private foreign sector outflow.

April still saw a large net foreign outflow, though not as big as March. Nevertheless, this time, the Official foreign flow reached an all-time low.

This is significant because the 12-month rolling cumulative total foreign flow in US turned negative by a large amount. This is very, very unusual.

Foreigners are still focused at the moment on selling primarily USTs.

While in the past, private foreign accounts may have bought USTs even when official foreign accounts were selling, in the last two months (April-March), private foreign money turned sellers in size. In fact, their outflows have been several times bigger than the official foreign account outflows. This most recent selling put the 12-month rolling UST private foreign flow in negative territory in March. It reached an all-time low in April. The 12-month rolling UST official foreign money flow is also close to its all-time record low, reached in November 2016.

On the US equities side, unlike in March, though, this time foreigners were net sellers. The total outflow was not that large by historical standards, but the official foreign outflow was.

Foreigners continued to buy US corporate bonds, especially official foreign money. Nothing new there.

Finally, on the agencies side, official foreign accounts were a rather unusual and large seller.

Conclusion: The continuous high level of total foreign US assets outflows in April is interesting and could herald a change in trend of previous USD inflows. We can see that by looking at the rolling 12-month data which turned negative in March and is accelerating lower. In theory, there shouldn’t have been any forced pressure on foreign accounts to exit US assets in April, as Fed/Other Central Banks swap and repo lines were already in place. If this continues, the USD may be in bigger trouble than initially thought. See here, here and here.

Fed is facing a dilemma…actually a trilemma

05 Friday Jun 2020

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Fed is now probably considering which is worse: a UST flash crash or a risky asset flash crash. Or both if they play their hand wrong.

Looking at the dynamics of the changes in the weekly Fed balance sheet, latest one released last night, a few things spring up which are concerning.

1.The rise in repos for a second week in a row – a very similar development to the March rise in repos (when UST10yr flashed crashed). The Fed’s buying of Treasuries is not enough to cope with the supply hitting the market, which means the private sector needs to pitch in more and more in the buying of USTs (which leads to repos up).

This also ties up with the extraordinarily rise in TGA (US Treasury stock-piling cash). But the build-up there to $1.4Tn is massive: US Treasury has almost double the cash it had planned to have as end of June! Bottom line is that the Fed/UST are ‘worried’ about the proper functioning of the UST market. Next week’s FOMC meeting is super important to gauge Fed’s sensitivity to this development

2.Net-net liquidity has been drained out of the system in the last two weeks despite the massive rise in the Fed balance sheet (because of the bigger rise in TGA). It is strange the Fed did not add to the CP facility this week and bought only $1Bn of corporate bonds ($33Bn the week before, the bulk of the purchases) – why?

Fed’s balance sheet has gone up by $3tn since the beginning of the Covid crisis, but only about half of that has gone in the banking system to improve liquidity. The other half has gone straight to the US Treasury, in its TGA account. That 50% liquidity drain was very similar throughout the Fed’s liquidity injection between Sept’19-Dec’19. And it was very much unlike QE 1,2,3, in which almost 90% of Fed liquidity went into the banking system. See here.  Very different dynamics.

Bottom line is that the market is ‘mis-pricing’ equity risk, just like it did at the end of 2019, because it assumes the Fed is creating more liquidity than in practice, and in fact, financial conditions may already be tightening.  This is independent of developments affecting equities on the back of the Covid crisis. But on top of that, the market is also mis-pricing UST risk because the internals of the UST market are deteriorating. This is on the back of all the supply hitting the market as a result of the Treasury programs for Covid assistance.

The US private sector is too busy buying risky assets at the expense of UST. Fed might think about addressing that ‘imbalance’ unless it wants to see another flash crash in UST. So, are we facing a flash crash in either risky assets or UST?

Ironically, but logically, the precariousness of the UST market should have a higher weight in the decision-making progress of the Fed/US Treasury than risky markets, especially as the latter are trading at ATH. The Fed can ‘afford’ a stumble/tumble in risky assets just to get through the supply in UST that is about to hit the market and before the US elections to please the Treasury. Simple game theory suggest they should actually ‘encourage’ an equity market correction, here and now. Perhaps that is why they did not buy any CP/credit this week?

The Fed is on a treadmill and the speed button has been ratcheted higher and higher, so the Fed cannot keep up. It’s a dilemma (UST supply vs risky assets) which they cannot easily resolve because now they are buying both. They could YCC but then they are risking the USD if foreigners decide to bail out of US assets. So, it becomes a trilemma. But that is another story.

The Fed needs to make a decision soon.

Will the US pull the plug on investing in China?

14 Thursday May 2020

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It has been going on now for a year, at least: after stopping Chinese companies on several occasions from buying specific US assets, the US administration has been also looking into banning outward US investments in Chinese assets.

The fund in the spotlight is the Federal Government Thrift Savings Plan Fund (TSPF) – the largest defined contribution plan in the world with assets of about $558Bn. The assets are split in five core funds and one additional overlapping fund as following:

Of those above, it is the I Fund that is now in the spotlight. For the moment, it has no exposure to China as it is invested in MSCI ex US EAFE.

TSPF is an outlier amongst most large retirement plans that it still has no EM exposure. In June 2017, external consultants, Aon Hewitt, made a recommendation to the board to switch to MSCI ex US All Country which is a much broader index followed by all large retirement plans. One characteristic of this index is that it includes many EMs (and yes China). The board studied the proposal and made the decision to switch in November 2017 with a target for that sometime in 2019*.

As the US-China trade war was going in full swing, the threats of possible ramifications on US investments in China started coming in, and the I Fund never made that switch.

How big is this potential US investment?

The MSCI ex US All Country is still about 75% developed markets (DM). But China is about 11% weight (second largest now), which is rather big given the recent index inclusion (the weightings have increased progressively in the last two years). That means the I Fund would have between $6Bn exposure to Chinese equities.

Adding the L Fund exposure. The L Fund will have 9% in the I Fund (from 8% currently). Therefore, given the AUMs in each above, it will have between $1-2Bn Chinese equities exposure. So, total TSPF exposure will be max $8Bn. Note, however, the L Fund’s expected exposure going forward: projections are for a substantial reduction in the G Fund weights at the expense of all others. So, potentially the future Chinese exposure can grow substantially as also China’s weight in the MSCI ex US All Country index also grows.

What is that in the context of the big flow picture?

China is in the cross hairs of deglobalization which started before the Covid crisis, but now, that process is accelerating in direct proportion to the anger towards China amongst some of the major global players, especially the USA. In the USA, globalization coincided with financialization which promoted major capital inflows to offset the trade account outflows. Financialization is now on the wane in the USA (as per the regulations post 2008, and accelerated further post the Covid crisis), while on the rise in China (see flows below).

As the Chinese economy has been catching up to the US (and possibly the Covid crisis also accelerated this process as well), it is likely that we may see a reversal of some of these past flows, namely, a reduction in China’s current account surplus at the expense of net foreign inflows.

Equities

  • Last year passive index inflows in China A shares were $14Bn; total inflows were about $34Bn
  • Total foreign investment in Chinese A shares is about $284bn
  • Foreign equity inflows this year are still a positive $5Bn despite the Covid crisis: according to HSBC data, March recorded an outflow (largest ever) but all other months were inflows, with April inflow more or less cancelling the March outflow.

Fixed Income

  • Total foreign holdings are also around $283Bn, 70% of which are in GGBs.
  • Inflows into GGBs have been consistently positive since the index inclusion announcements last year and the year before.
  • According to Barclays, YTD net Inflows are at $17Bn (5x more than at same time last year) despite a net outflow in March (but that was only because of selling in NCDs).
  • Average monthly inflows in Chinese FI is about twice that in equities.

Domestic Flows

  • March registered the largest domestic outflow ($35Bn) of any month since the 2016 CNY crisis (largely due to southbound stock connect flow (mainland residents bought the largest amount of HK stocks on record).
  • According to HSBC, FX settlement data shows that, most likely, domestic corporates have actually been net sellers of foreign currency in Q1 this year. 

Economics

While Chinese exports are expected to decline going forward, in the short term, so are imports, especially after the collapse in oil prices. However, it is inevitable that if globalization does indeed start reversing, China’s current account will shrink and possibly go into a deficit. 

Conclusion

What happens to the overall flow dynamics then, really depends on whether foreigners continue to invest in Chinese assets (and expecting that domestic residents might look to diversify their portfolios abroad once the capital account is fully liberalized, if ever). A potential ban on US Federal Government investments in China might indeed be driven by short-term considerations and emotions following the Covid-19 pandemic developments, however, unless it is followed by also a ban encompassing all US private investment, it is unlikely to amount to anything positive for the US. Moreover, it could actually give the wrong signal to foreign investments in the US, that the administration is becoming not so ‘friendly’. That could spur an outflow of foreign money from US assets, something that I discussed at length here.

*See the memo from that meeting here: https://www.frtib.gov/MeetingMinutes/2017/2017Nov.pdf

Beware of foreigners bearing gifts

07 Thursday May 2020

Posted by in Asset Allocation, Equity

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There have been two dominant trends in the last four decades. The breakdown of the Bretton Woods Agreement in the early 1970s, the teachings of Milton Friedman, and the policies of Ronald Reagan, eventually ushered in the process of US financialization in the early 1980s. The burst of the Japan bubble in 1990, the Asian and EM financial crises of the mid-1990s, the dotcom bubble, and, finally, China’s entry into WTO in the early 2000s, brought in the era of globalization. This whole period has greatly benefited US, US financial assets and the US Dollar.

An unwind of these two trends of financialization and globalization is likely to have the opposite effect: causing US assets and the US dollar to underperform. From a pure flow perspective, going forward, foreigners are likely to invest less in the US, or may even start selling US assets outright. They are such a large player that their actions are bound to have a big effect on prices.  

Foreigners have played an increasingly bigger role in US financial markets. In terms of ownership of US financial assets, if they were an ‘entity’ on its own, they would be the second largest holder of US financial assets in the US, after US households.

Foreigners owned about 2% of all US financial assets between 1945 and the 1980s. That number doubled between 1980 and 1990 and then tripled between 1990 and 2019!

As of the end of 2019, there were a total of $271Tn US financial assets by market value. Non-financial entities owned the majority, $129Tn, followed by the financial sector, $108Tn, and foreigners $34Tn.

The financial crisis of 2008 ushered in a period of financial banking regulation (on the back of the US authorities’ bail-out), which has slowly started to dismantle some of the structures built in the previous period starting in the 1980s. The Covid-19 pandemic and the resulting government bailout of the whole US financial industry, this time, are likely to intensify this regulation and spread it more broadly across all financial entities. As a result of that, there have been already calls to rethink the concept of shareholders primacy which had been a bedrock of US capitalism since the 1980s.

In addition, the withdrawal of the UK from the EU in 2016, followed shortly by the start of a withdrawal of the US from global affairs with the election of Donald Trump, ushered in the beginning of the process of de-globalization. The US-China trade war gave a green light for many companies to start shifting global supply chains away from China. The Covid-19 pandemic intensified this process, but instead of seeking a new and more appropriate location, companies are now reconsidering whether it might make sense to onshore everything.

What we are seeing is the winding down of these two dominant trends of the last 40 years: financialization and globalization. The effects globally will be profound, but I believe US financial assets are the most at risk given that they benefited the most in the previous status quo.

De-financialization is likely to reduce shareholder pay-outs (both buybacks and dividends) which have been at the core of US equities returns over the years. The authorities are also likely to start looking into corporate tax havens as a source of government cash drain in light of ever-increasing deficits. As a result, and as I have written before, I expect US equities to have negative returns (as of end of 2019*) for the next 5 years at least.

De-globalization is likely to reduce the flow of US dollars globally. Foreigners will have fewer USD outright to invest in US assets. Those, which are in need to repay USD debt, may have to sell US assets to generate the USDs. Indeed, the USD may strengthen at first but as US assets start to under-perform, the selling by foreigners will gather speed causing both asset prices as well as the USD to weaken further.

For example, foreigners are the third largest player in US equities, owning more than $8Tn as of the end of 2019. See below table for some of the largest holders.

As a percentage of market value, foreigners’ holdings peaked in 2014, but they are still almost double the level of the early 1990s and more than triple the level of the early 1980s. Last year, foreigners sold the most equities ever. Incidentally, HHs which have been a consistent seller of equities in the past, but especially since 2008, bought the most ever. Pension Funds and Mutual Funds, though, continued selling.

Foreigners are the largest holder of US corporate bonds, owning almost $4Tn as of end of 2019, more than ¼ of the market.

As a percentage of market value, foreigners’ holdings peaked in 2017, but they are still more than double the level of the early 1990s and 8x the level of the early 1980s.

Foreigners are also the largest holders of USTs, owning almost $6.7Tn as of end of 2019, more than 40% of the overall market.

As a percentage of market value, foreigners’ holdings peaked in 2008, at 57%! At today’s level, they are still about double the levels of the early 1990s and early 1980s.

There is a big risk in all these markets if the trends of the last four decades start reversing. US authorities are very much aware of the large influence foreigners have in US markets. The Fed’s swap and repo lines are not extended abroad just for ‘charity’, but primarily to ‘protect’ US markets from forced foreign selling in case they cannot roll their USD funding.

The UST Treasury market seems to be the most at risk here given the mountain of supply coming this and next year (multiple times larger than the previous record supply in 2008 – but foreigners back then were on a buying spree). The risk is not that there won’t be buyers, eventually, of USTs as US private sector is running a surplus plus the Fed is buying by the boatload, but that the primary auctions may not run as smoothly.

It was for this reason, I believe, that the authorities exempted USTs from the SLR for large US banks at the beginning of April. If that were not done, PDs might have been totally overwhelmed at primary auctions given the increased supply size, the fact that the Fed can’t bid and if foreigners start take up less. It is not clear, still, even with the relaxed regulation, how the primary auctions will go this year. We have to wait and see.

*See ‘Stocks for the long-run: be prepared to wait’, at https://www.eri-c.com/news/380

**All data is from the Fed Flow of Funds data at https://www.federalreserve.gov/datadownload/Choose.aspx?rel=Z.1

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

03 Tuesday Mar 2020

Posted by in Asset Allocation, China, EM, Equity, Monetary Policy, Politics

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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.