Thursday, January 20, 2011
Is it just us or does it feel to you that there is a hell of a lot of tension in the wires at the moment as the tug of war between good and evil sees every force available thrown into either argument? The interpretation of Good and Evil of course depends on whether you are a bull or bear in your chosen market, but it looks as though our two favourite concerns of the Euro and equities are the main battlegrounds of such conflicts.
First lets look at EURUSD. For the bears we have had the influences of the US equity market followed by a heavy fall in Asia. The normal response is to see the Euro get hit along with all the normal FX candidates (looking at you AUD) and so it was when we came in to London time. But since then it has been the bulls gaining ground as it has reground its way back towards yesterdays highs. The Tug continues.
And as for those equity moves? Well it seems to us that yesterday was more about trying to find an excuse to sell a new highs or lighten positions rather than occurring on any really concrete catalyst. It was most interesting to see the great Soothsayer himself breaking cover onto the mainstream news-wires to put in a "Big Call" to then be held aloft by bears, many of whom who have never heard of him, as their new totem. Even Bloomberg TV is running pieces on his "Big Call". Is the Soothsayer selling out or just trying to step up his PR in Taleb style? Anyway, from speaking to quite a few people, it seems a lot of equity longs were lifted last week. But meanwhile, Credit is still performing well due to dealers being short and the SPX VWAP since 3rd Jan is 1278 (i.e. - there isn't any pain) while yesterday's futures volumes running at ~50% above 15day average seems like a lot of risk was either taken off yesterday or shorts were added at (so far) poor levels.
Today just looks as though its going to be like playing the decider.
As the tussle in equity markets appears to be ground zero we thought today would be a good day to elaborate upon the TMM call for Emerging Markets to under-perform Developed Markets in 2011. Whilst the DM over EM argument is becoming almost mainstream in western markets we feel that it is certainly NOT considered the trade in the East, so there can still be a world of pain to come.
As the “Asian inflation” story goes tabloid its worth delving into just where we can expect this trade to go. EM inflation tends to be driven more by food which is a volatile component of CPI to say the least, see China’s food CPI vs non-food CPI below. As a result of the fact that food price shocks tend to be exogenous (bad weather, pests, etc) CBs quite reasonably tend to ignore it and focus on “core” CPI – CPI ex-food (and energy, depending on where you are) to avoid chasing their tails. The result is that food prices have to bleed into general price levels before you get much of a response. And that bleed is well and truly underway judging by China’s core CPI print which is up to the heady days of 2008 again.
The problem with this kind of inflation scare type of trade is that unless you are a commodity and particularly a softs specialist it can go away as quickly as it came, just like in 2008 when broader deflationary forces and more planting quickly overwhelmed a short term squeeze in agriculture.So naturally the question is how does one tell the difference between the real thing and the phantom food inflation that comes as quickly as it goes? TMM’s worry right now is that much of what goes into food inflation and non-core CPI is going to be far from a passing problem like in 2007-2008. The reason is below: normally when agricultural products get “squeezed” they spike up, people plant a lot more and that is reflected in futures contracts a year out. As such, when the spike is temporary and not structural the orange line (spot rough rice) is high and the white line (the fair value spread between the front and 5th rice contract) is also high. That isn’t happening now, indicating that higher prices we are seeing are likely to stick around. Rough Rice is below and doesn’t look like its coming back anytime soon...
Nor does wheat...
Soy doesn’t look like its over…
Which to TMM looks like it has pretty dire implications for CPIs in a lot of EM markets. China’s core (non-food) CPI is already at 08 highs (green below) and policy is finally catching up in 2 yr SHIBOR swaps (orange). The problem is that excluding the price controls on vegetables put in place last month food is still moving a lot faster and housing costs just printed 6% YoY. As a result, PEs of the market are coming off and coming off hard (Shanghai A Shares forward PE in white). Buying low PE stuff only works if you think the cycle is going to turn – if you want to know how low valuations can go in a strongly inflationary environment ask your parents or someone who remembers the 1970s. It was an unalloyed bad time for equity investors. TMM’s concern is that if we are early into a rate hike cycle this is going to get much, much worse before it gets better.
And for those of you who want to know what India looks like it is way worse. TMM’s India “Fed model” chart is below (inverse PE of Sensex – 1 year swap rates). If rates surprise on the upside it hard to see this market being more expensive at any time in the last few years to onshore rates.
But we hope to have a update on India for you soon after a recent visit.
In the meantime ladies and gentlemen, lets take ouur seats for todays Bull vs Bear cage fight.
One last thing, after yesterday's foray into the Menagerie, we will soon be addressing the balance and visiting the "Sell Side House".