Partiers and party poopers

Another day, another equity party.  While any one week rally of this magnitude inevitably brings out the equity cheer-leading squad, more macro driven investors are facing a crossroads.   Specifically, anyone who tried risky asset shorts has been forced to cover; the question now facing them is whether to stand pat and await another level to sell, or to rent some long beta and see what happens.

USD/MYR is a perfect example (though this chart will be dated by the time you read this.)  Having gone up in more or less a straight line between May and August, the price action has become increasingly erratic and overlapping, and punctuated yesterday with a sharp downmove.   True, if you were long the whole way up you still have the psychological cushion of being onside; however, as anyone who's ever taken risk will tell you, once you've banked some P/L in a prior month's return, you are loathe to give it back in a new month.  Even within the boundaries of a normal correction, USD/MYR can drop another 5% and still remain well within its secular uptrend.  That's a tradeable move...so do you stop and reverse, or merely stop?   To a large degree, it's a function of trading style and time horizon.

How markets choose to navigate the current crossroads will likely dictate the next few days' or weeks' price action.  Macro Man isn't really a short-term punter, but to him it looks like there's more to go, particularly if China re-opens today and joins the party rather than raining on the parade.  Of course, the longer the party rages, the more likely it is that the cops get called in the person of the Federales...the prospect of which could easily tip the whole thing over again and send us back to square one.

However, even yesterday there were a few turds in the punchbowl, to extend the analogy.  Oil looked set to build on breaking out of the market's pincers but was undone by a much larger than expected inventory build; while the correction was swift, crude remains comfortably above yesterday's breakout point so technically there was little damage done.

Rather more damage was announced by Deutsche Bank after the close, which disclosed an expected 6.2 billion euro loss for Q3 thanks to what owners of the stock hope is a kitchen sink goodwill impairment.  (Remember the kitchen sink write-downs of 2007-08?  You could have fed millions with the contents of those sinks.)  Significantly, the bank also suggested that it dividend would be slashed or even eliminated altogether.

Cynics can and have pointed to DB as a repository for much of the murky detritus that flows through the global and European financial systems, and its hard to argue with that assessment.   For several years after the crisis DB's balance sheet remained as bloated as it was before 2008, though over the past couple of years they've managed to shrink it a bit.  Nevertheless, slashing the dividend is not exactly what equity holders were hoping for, and served as a timely reminder that Eurostoxx dividends and banks trade cheap for a reason.   Remember, kids, you can't spell "SX7E sucks" without "SX7E"!

Finally, Brazil.   The BRL was off to the races on Wednesday, trading 1% stronger against the dollar even when Spooz briefly dipped into negative territory.   And then....bad news from Congress, which couldn't muster a quorum to vote on giving Dilma some budgetary veto powers.  When your friends not only don't support you, but can't be bothered to show up, it's not a good sign.  In any event, USD/BRL performed a volte-face, rallying even as equities came roaring back.

In the grand scheme, of course, the magnitude of the move was nothing special- certainly not in comparison with what we've observed over the past few months.  Then again, the abrupt reversal was a timely reminder that idiosyncratic factors can play a large role in EM valuation, and that Brazil has very few that aren't a headwind at the moment.

For fun, Macro Man dug up an old Brazil PPP spreadsheet that he first wrote in 2005.  The base period was 1994, the date of Brazil's last mega-devaluation (as opposed to the much more garden variety "large scale" devaluations!)

In any event, imagine his surprise when he found that the spreadsheet, this iteration of which actually hadn't been updated since 2007, spat out a PPP for USD/BRL of 3.91.   Way hey!  Of course, looking at it historically, it's kind of hard to suggest that the modeled PPP bears much resemblance to where the BRL has traded in the past.

The original piece of work actually made an adjustment to the PPP to account for shifts in the terms of trade.   As you can see, it worked very well indeed up until the currency wars/Fed forward guidance period from 2011 onwards.  It has identified that the BRL's equilibrium level has gotten weaker, but not to the magnitude of that observed in the marketplace.  That Brazil continues to run trade surpluses would appear to underline that fact.

Of course, the overall current account is well into deficit, thanks to the large and growing income deficit that Brazil runs.  Moreover, the capital account balance doesn't look particularly rosy with corporate indebtedness and foreigners fleeing Brazilian assets.   The PPP tells a story, but not the whole story, and when you add the other factors in (including Bacen perhaps playing along with the government's program) Macro Man continues to see a good old fashioned EM crisis bubbling away.  As such, this remains one market that he expects to remain a party pooper.