Monday, September 9, 2013

Nasty Surprises Lurk Ahead?

Katya Wachtel and Jennifer Ablan of Reuters report, Hedge fund chief says Japan needs another "big round" of stimulus:
Hedge fund titan Ray Dalio said on Friday the Japanese economy will need another big round of stimulus to boost sluggish growth, and some emerging markets are on the path to crisis.

Dalio, chairman and chief investment officer of $150 billion firm Bridgewater Associates, one of the world's largest hedge funds, was speaking at the Japan Society in midtown Manhattan.

In April the Bank of Japan pledged to inject about $1.4 trillion into its flagging economy in an effort to end two decades of stagnation. The monetary easing, coupled with reflationary, pro-growth policies championed by Japan's Prime Minister Shinzo Abe, sent stocks rallying and the yen tumbling. Japan emerged from recession in 2012.

"The effects are going to wear off," Dalio said, referring to prior stimulus measures. Japan's central bank is "going to have to do another big round of purchases," he said.

In a thirty-minute talk, Dalio addressed trouble in economies from China to France. He sounded a cautious note about investing in emerging markets, especially in equities, which have plunged in value this year. Emerging markets will not be an "an attractive place" to invest in the near future "given flows and pricing."

He said emerging markets face "a major balance of payments problem" that will eventually lead to significant problems.

We are "going to have the emerging market crisis," Dalio said during a question and answer period.

India should "prepare for the worst" since it has been one of the biggest beneficiaries of foreign capital flows that are already bypassing emerging market equities, he added.

As for Europe, Dalio said that France is of particular concern to him since "it has not dealt properly with debt to income ratios rising."

Dalio is one of the $2.25 trillion hedge fund industry's best known managers, known not only for his solid long-term returns but also for a unique culture at his Westport, Connecticut-based firm, where employees are encouraged to challenge each others' and their bosses' ideas publicly.

"I want no one in the audience to be polite with me," Dalio said during the question and answer segment. "Let's have a thoughtful disagreement."
My question to Ray Dalio is if he really believes an emerging market crisis is imminent, why did Bridgewater increase its holdings of emerging market ETFs in Q3? Also, how does he foresee an emerging market crisis if he thinks China' economy has bottomed?:
"I think short term it has already bottomed in terms of data," said Dalio, the founder of the world' s largest hedge fund who oversees approximately $150 billion of assets, based in Westport, Connecticut, responding to a question from Xinhua about whether China' s economy is bottoming.

The latest manufacturing activity data from China showed that the world' s second largest economy is regaining momentum somewhat.

Dalio said the most important thing for China' s economy is to go through an adjustment and restructure different parts of the economy.

He praised Chinese leadership' s capabilities in recognizing problems and dealing with them in a balanced way, noting these problems "entirely manageable."

Dalio made the remarks shortly after delivering a speech to Japan Society based in New York.

He said in the speech that China has become an important force of the world and its debt level is lower than most other countries in the world.

But at the same time, he warned that there is also a debt bubble emerging in China. "A lot of that debt is financing investments that really do not produce the cash to service that debt. So we have an issue in terms of that weighing."

He said that China' s debts can be very well managed, taking into the account its resources and debt that' s nominated in local currency.

There still should be an adjustment to tackle the debt issue, he suggested.
The latest news suggests China's economy is recovering nicely. Bloomberg reports that China’s exports increased more than estimated in August, adding to evidence the world’s second-largest economy is rebounding after a two-quarter slowdown:
Overseas shipments rose 7.2 percent from a year earlier, the General Administration of Customs said in Beijing yesterday. That compares with the 5.5 percent median estimate of 46 economists surveyed by Bloomberg News and July’s 5.1 percent gain. Imports rose a less-than-estimated 7 percent from a year earlier, leaving a trade surplus of more than $28 billion.

China’s economy is picking up after Premier Li Keqiang announced support measures such as tax cuts for small businesses and extra spending on railways, and as confidence returns after the interbank cash squeeze in June. Exports to the U.S. and European Union grew for a second month in August, underscoring an improvement in overseas demand.
Meanwhile, Reuters reports that Australian shipments of iron ore to China stayed strong in August, a month after Australia boasted its second-highest exports ever to the Asian giant and a sign of healthy demand for resources:
Iron ore exports to China from Port Hedland, which handles about a fifth of the global seaborne market for the steel-making raw material, rose 9 percent in August from July.

Ore shipments of 22.3 million tonnes were up a hefty 33 percent on August last year and not far from all-time highs hit in May. Since the figures are released just a few days after the end of the month, they offer a timely leading indicator of demand in China.

Australia is the single largest supplier of the ore to China, ahead of Brazil.
The growth in Chinese exports and boost in its imports of iron ore suggest the global recovery is picking up steam and investors are taking notice. For example, shipping stocks which have been in the doldrums for years, have taken off recently. Beaten down coal, steel, and copper shares seem to have bottomed and are finally turning up, lending support to the global recovery theme.

And while the overall stock market is languishing from its recent highs, there are plenty of "Risk On" trades that continue to defy gravity. Just have a look at Chinese solar and biotech stocks over the past year. They are booming and some hedge funds are making a killing trading these sectors.

The focus right now is on Fed tapering. Reuters reports one of the Federal Reserve's most hawkish officials urged the central bank on Friday to curb bond buying to $70 billion a month when it meets later this month, while a noted policy dove agreed that the Fed could start to taper later this year.

Many market analysts believe Fed tapering is already priced in the market and doubt we'll see more of the bond panic that has gripped investors since mid-May. If this is the case, you shouldn't be surprised to see bonds and dividend stocks rally going into the Fed meeting and even after they announce their tapering measures. And some think the biggest bargains right now are in emerging market bonds.

But not everyone is convinced that bad news is priced in. In his latest comment, Michael Gayed, chief investment strategist at Pension Partners, writes on how nasty surprises happen:
The S&P 500 (SPY) rose last week following a very weak August as traders returned from the long weekend and re-adjusted probabilities of a Syria strike as President Obama decided to seek Congressional approval. The Fed's Beige Book emphasized moderate growth, auto sales came in better than expected, and ISM manufacturing was strong. None of this, however, translated into the Friday jobs report, which was highly disappointing. Not only did the August data miss expectations with whisper numbers considerably higher, but prior month revisions were lower. Some economists have argued the data was "just good enough" to keep the Fed on course for tapering, while others think tapering will be pushed out. Either way, the data seems to have complicated the Fed's expected timeline for pulling back on QE fully.

Emerging market stocks (EEM) staged a very powerful rally, strongly outperforming the US, but without their own credit spreads narrowing in a commensurate way. This makes the move last week a bit suspect, with persistent leadership important to keep an eye on. US bond yields rose aggressively Tuesday through Thursday as the 10 year (TENZ) yield briefly touched 3%, and then Friday resulted in a drop as jobs data was weak. US averages did well, but the move may have been more noise than signal given lower volume and historical higher volatility in September.

August was a solid month for us as our strategies outperformed both bonds and stocks as both fell through our rotation algorithms. Recently, our ATAC models used for managing our mutual fund and separate accounts rotated out of short duration bonds the week prior to longer duration exposure given confirmation in our signals. While the trade did not work last week, it is important to consider historical behavior.
First, as I have been stressing in my writings, what is happening in the bond market is factually abnormal given the speed of the yield spike to begin with, and inflation expectations which are NOT trending in the right direction. The yield curve is abnormally steep in light of this and relative to its own history. This suggests a massive overreaction has taken place in bonds. Second, when long duration bonds outperform, they tend to do so in a major way. Since 2009, during periods where the S&P 500 corrects more than 5%, 20+ duration Treasuries outperform by an average of 16.7% (hat tip to Charlie Biello for this). With weakness in September historically coming AFTER the first week, such leadership in bonds can easily happen.

Make no mistake about it - 2013 has been an outlier year and one that investors should be careful of using as a way to judge a macro buy and rotate strategy. The iShares Moderate Allocation ETF (AOM) is up a mere 3.9% for the year. This has NOT been a raging bull market for anyone adhering to time tested and proven strategies of asset class diversification. 
I will end this writing by recommending everyone click this link which shows a chart that I have used in prior articles and media appearances (click on image at top of this post). Be careful in thinking the bond market does not matter. This has never been about level of rates, but speed. What is happening now is reminiscent of historical crisis periods. For those unfamiliar with market history, I caution on looking at stock market gains month after month and assuming the past is representative of the future. Those who ignore context are likely to be as surprised about what markets do next as those investing in 1987 were in the moments leading up to the Crash.

Things will resync at some point, and we will simply keep rolling with the punches until they do. Be careful with small sample bias - its how nasty surprises happen.
I asked Michael to clarify his bullish stance on emerging markets (see below) and the possibility of a crash. He responded:
"Both on CNBC and Bloomberg, as well as in my writings on Marketwatch in addition to the piece Marc Faber of the Gloom, Boom, and Doom Report, I have addressed how emerging markets might behave. To be very clear, a 1987 style Crash is NOT my base case scenario, but I do believe the yield spike is highly underappreciated. Emerging markets are entirely about alpha potential, and can rally in the face of a correcting US stock market IF any kind of a correction is NOT a crash. Hope that helps."
I agree, a crash is unlikely but if it happens, all risk assets will get slammed and bond yields will plunge as global investors seek refuge in good old U.S. Treasuries. I'm not sure what nasty surprises lurk ahead but Syria, German elections, and the Fed meeting should make for an interesting September.

Below, Michael Gayed, chief investment strategist at Pension Partners, discusses why he is bullish on emerging markets and bearish on U.S. stocks. "China is the mother of all of the BRICs, so if China is doing well, then all of the exporting countries, including Brazil, will benefit, because everyone's selling commodities to China."