Which of these things is not like the others?

Which of these things is not like the others:

a) Uber-bid oil and gasoline prices at record highs
b) Rising global interest rates
c) A VIX that won’t go down
d) Equities across the globe at or near their highs

OK, now let’s play again. Which of the following just doesn’t belong:

a) Double-digit broad money growth in many economies
b) Defensive positioning
c) Central banks just now starting to buy stocks
d) Near-record global growth
e) An historically favourable environment for corporate profits
f) Upside profit surprises
g) Macro Man’s bearish equity tilt in his alpha portfolio

This is the conundrum that Macro Man, and he suspects more than a few others, currently faces. He feels that equities are currently overdone and due for a correction, particularly when faced with the triple whammy of rising energy prices, rising interest rates, and unfavourable seasonality.

By the same token, he currently feels woefully underinvested, courtesy of the short SPM7 call position in the alpha portfolio. IMM specs are leaning the same way; a diffusion index of all non-commercial positions in the big and e-mini S&P futures reveals a net short position.
Moreover, we are currently living in a tremendous environment for stocks. Globalization has meant that multinational companies are able to reduce (labour) costs like never before, albeit with a concomitant rise in commodity prices. Tax regimes in both West and East are generally favourable, at least for the time being. Global growth is not only extraordinarily strong, it’s also extraordinarily broad-based.

And perhaps most importantly, the hegemonic actors in financial markets these days, FX reserve managers, are only now starting to have a bite at the stock market cherry. As Bretton Woods II starts fraying at the edges, it’s becoming clear that the returns on low-duration fixed income reserve portfolios ain’t gonna cut it.

China’s decision to create a separate investment vehicle and take a stake in Blackstone is by now well-known. But consider also that Taiwan, with a not-insubstantial $266 billion in reserves, is also setting up a sovereign wealth fund. Eventually, even Japan may follow suit. And look out for Russia as well. Vlad Putin said yesterday that oil revenues should go into the domestic equity market (presumably at the expense of FX reserves or the Stabilization Fund, which is tantamount to the same thing.) Even Norway, which has been doing the sovereign wealth thing longer than most, is feeling pressure to perform. Q1 returns for the oil fund were 1.5%- not exactly eye-popping. It surely isn’t a coincidence that the decision to raise the equity allocation of the fund was taken at the same time that returns from more traditional ‘reserve assets’ has been flagging.

Add it all up, and Macro Man is left between a rock and a hard place. He expects a correction to ensue (another Chinese export, perhaps?), but wants to use it to take off his alpha shorts and increase equity length. Positioning indicators suggest he is not alone. Could it be that the real ‘pain trade’ in equities is a continued grind higher? It may well be.

At the same time, he remains of the belief that the tactical headwinds for equity performance have strengthened considerably in recent weeks. He’s though long and hard about this, and arrived at the decision that buying volatility is the way to go. Again, the divergence of the VIX from the SPX suggests that he isn’t alone here. Macro Man needs upside deltas in the event of a continued grind higher, but wants to make hay if the much anticipated correction does finally ensue.

He will therefore buy 100 SPM7 1495 puts at the opening, and buys 500 July DAX 8000 calls at 55. Today’s ZEW confirms the German economy remains resilient against the VAT effect, higher rates, higher energy prices, and a strong euro.

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May 22, 2007 at 12:22 PM ×

I am often accused of being "slow" but can you help me with this...

You are saying there is a flight to equities (PBoC, RUS, NOR etc) then why would you expect a correction...isn't the equity markets expected to go up ?

Also, what would this mean for the greenback ?

Macro Man
May 22, 2007 at 2:05 PM ×

Well, I have thought for some time that the conditions were falling into place for a tactical correction- oil, rates, negative price divergence, etc.

I am beginning to wonder though if the longer term liquidity and supply/dynamic isn't just going to swamp everything- hence the DAX call purchase today.

The impact on the dollar will depend on the currency mix of reserves as allocated to equities versus the currency mix of reserves now. Asian EM is one obvious region where a decent equity exposure can be justified, for example, that isn't represented in reserves.

May 22, 2007 at 8:20 PM ×

With volatility subdued, interest rates still relatively low, and a implied "smile" in most equity options, it makes good sense to hedge being short of beta risk by buying calls instead of the underlying. And I think in all three respects one has a n asymmetrical potential for an increase in option value, even before any move in the underlying.

That said, I believe inflation measures are understated and this liquidity and chinese overheating, or perhaps cuts in various emerging market i-rates to stem speculative flows, is likely at some point to cause a more serious inflation scare.

And despite the initial outperformance of equities in emerging inflationary environments (historically speaking), inflation has never been good news for equity values in the intermediate term - at least in a world in which bond markets were "free" to discount money illusion.

May 22, 2007 at 8:35 PM ×


What do you think of this in the WSJ today?



Yuan Worries
May 22, 2007; Page A15

Fact 1: China runs a large and growing trade surplus with the United States. In 2006, the goods-trade surplus exceeded $232 billion. This was an increase from 2005 of $31 billion, an amount larger than the entire deficit just 12 years ago.

Fact 2: China focuses its monetary policy on fixing the exchange value of its currency, the yuan, relative to the U.S. dollar.

Many policymakers and pundits connect these two facts by asserting that an unfairly low value of the dollar-yuan peg is causing the massive bilateral trade imbalance. The 109th Congress introduced 27 pieces of anti-China trade legislation. The current Congress already has over a dozen such bills, many aiming to force an overhaul of China's exchange-rate regime. And late last week dozens of House members were poised to file a Section 301 petition, asking the U.S. Trade Representative to investigate undervaluation of the Chinese yuan.

These misgivings about the dollar-yuan peg are misplaced. Economic theory and data are very clear here on two critical points. Controlling a nominal exchange rate is a form of sovereign monetary policy. And monetary policy, in turn, has no long-run effect on real economic outcomes such as output and trade flows.

Like all other central banks, the People's Bank of China uses its monopoly power over minting its money to control one nominal price. Since 1994 the PBOC has chosen to closely target the dollar-yuan price. In recent times, maintaining this target has required the PBOC to print yuan to buy dollars and thereby accumulate dollar-denominated assets on its balance sheet.

Many central banks today use their sovereign power to fix a nominal short-term interest rate rather than a nominal exchange rate. The U.S. Federal Reserve targets the federal-funds rate; the European Central Bank targets the main refinancing operations rate; and the Bank of Japan targets the overnight call rate. But exchange-rate targets are by no means uncommon. Indeed, in 2005, 55.6% of the world's countries fixed their exchange rates. And many countries have switched their targets over time. From 1945 to 1971, for example, the Federal Reserve targeted the value of the dollar at $35 per ounce of gold.

To select a policy target, each central bank must evaluate how alternatives might (or might not) influence its monetary-policy goals. Chinese capital markets today lack many of the microeconomic institutions that transmit changes in short-term interest rates into the broader economy: e.g., a primary-dealer market in government debt securities and, more generally, a deep network of investment and commercial banks allocating credit guided by risk-adjusted returns. This may well be one reason the PBOC maintains its exchange-rate target: An interest-rate target might weaken its linkages to the real economy. And just like other central banks, the PBOC has been adjusting its target nominal price gradually, without dramatic changes that can have adverse short-run impacts.

But hasn't the nominal dollar-yuan peg unfairly driven the long-run rise in trade imbalances? No. The exchange rate that matters for trade flows is the real exchange rate -- the nominal exchange rate adjusted for local-currency output prices in both countries. Supply-and-demand pressures in international markets can, and do, alter not just nominal exchange rates, but also nominal prices for goods and services. And these pressures driving the real exchange rate, in turn, reflect the deep forces of comparative advantage such as cross-country differences in technology, tastes and endowments of labor and capital.

To demonstrate this critical point, look to Europe. The yuan floats against European currencies such as the euro and the pound. If nominal exchange rates were driving trade flows as commonly alleged, then Chinese exports to the U.S. should have been growing faster than to Europe. The data show something completely different, however. In 1995, monthly Chinese exports to both destinations averaged about $2 billion. By 2006, monthly Chinese exports to both destinations were still the same, at about $17 billion. Plotted together over that entire decade, these two series look nearly identical. This is because the same real economic forces -- e.g., China's relative abundance of less-skilled labor -- have been driving both sets of trade flows.

Put it this way: In a counter-factual world where over the past decade China allowed the yuan to float against the dollar, the U.S. would still have run a large and growing trade deficit with China. The real economic forces of comparative advantage that drive trade flows operate regardless of which nominal prices central banks choose to fix.

This week the U.S. government hosts Chinese officials for the second round of the Strategic Economic Dialogue. Treasury Secretary Henry Paulson and Chinese Vice Premier Wu Yi have framed the SED as a forum to address complex policy issues associated with the links between our two countries. In China, further capital-market reform is needed to support economic growth via better risk management and capital allocation throughout all sectors of the economy. Here at home, the large aggregate gains the U.S. has realized from freer trade and investment with China have also generated hardship, too. Many American workers, firms and communities have been hurt, not helped, by Chinese competition.

Issues like these are legitimate and real. But focusing on the dollar-yuan peg is a misplaced and counterproductive way to address them. Instead, let China continue to conduct its sovereign monetary policy and let the SED continue to engage the real challenges. Stop fixating on the fix.

Mr. Slaughter, a professor at the Tuck School of Business at Dartmouth and research associate at the National Bureau of Economic Research, was a member of the Council of Economic Advisers from 2005 to 2007.

Macro Man
May 22, 2007 at 9:11 PM ×

A couple of thoughts. Mr. Slaughter is correct that the exchange rate level of the yuan is not the primary driver of US imbalances with China. However, the example he gives is remarkably "well chosen." So Chinese export growth to the US and Europe has been about the same since 1995. Well, guess what? EUR/USD was about the same level (in DEM terms) in 1995 as it is now, so that really doesn't prove anything. I wonder why he didn't compare export growth to the US with export growth to Japan, which has a much weaker exchange rate than it did in 1995.

Moreover, he completely misses the major problem with China's exchange rate regime. It is not the level of the currency that is the big problem; it's the actions that China must take to maintain the regime, to wit pumping hundreds of billions of price-insensitive dollars into US bond market, thereby reducing US borrowing rates. This in turn has prompted a misallocation of resources away from savings and into borrowing and consumption. While the US would indubitably have a large deficit with China had US interest rates been set by the private sector, I very strongly believe that the deficit would be smaller than it is now, because consumption would be smaller.

Moreover, I am coming around to the view that China is defining the limits of neoclassical economics. Just as classical Newtonian/Einstenian physics fails to explain the world properly when you drill to a sufficiently small (particle) size, I wonder if China is too big and too populous to be explained by neoclassical economics. Are things like "comparative advantage" really relevant for a country with an 11% growth rate and 1/5 of the world's population? Regardless, China is now harvesting the fruit of its overly easy exchange rate driven monetary policy: a rather tasty stock market bubble.

Like most bubbles, it will probably last longer than anyone deems possible. In the case of China, they have every incentive not to ripple the waters until after this October's party Congress and next year's Olympics.

Of course, the longer the bubble propagates, the uglier and more serious the repercussion when it finally bursts. Perhaps the closing ceremony of the Beijing Olympics will be the long-awaited signal that volatility will make a structural comeback.

May 23, 2007 at 5:11 AM ×

Putin and his crowd are all long Gazprom.

And talks about 1 trillion mcap don't help much, share price is stagnating, btw it fell after this announcement.

The idea is disaterous ofcourse, most of the Russian stocks are fairly valued, real cheap things are illiquid and smal cap.
And most of the big caps are already state controlled.

Finance minister already opposed it, which means he is very serious about it - it's hard to argue with Putin in Russia now.

Mean while i think that we should be bullish on commodity and agricultute stocks. That else will China buy in the first place? I think they would love to take some high tech private, but US won't allow them to do so.

About misallocations - US debt and CA deficit began growing long before China was even on the radar. It has been growing ever since in absolute and relative terms. In 1987 people were worried about the same thing - double defecits. And US was trying to impose tarrifs on Germany, which caused black monday.

May 23, 2007 at 10:14 AM ×

A 20% correction in REIT's/CRE would have to be more interesting for PE, sovereign wealth and the like than a slowly crawling upward, fear infused stock market.

May 23, 2007 at 11:45 AM ×

"I am beginning to wonder though if the longer term liquidity and supply/dynamic isn't just going to swamp everything- hence the DAX call purchase today." -mm

- are you arguing for a structural 'great inflation'?


Macro Man
May 23, 2007 at 1:08 PM ×

Call it a structural risky asset great inflation: a sort of one-off shift wherein the accumulated global imbalances of the last few years are coverted from fixed income securities to equities. The hallmark of the FX reserve managers is that whatever they buy and kep buying eventually becomes very, very expensive.