Snikt

As longtime Epsilon Theory readers know, I’m a big comic book fan. One of the joys of a comic done well is the effective representation of a dynamic multi-dimensional narrative within a static two-dimensional art form. As the saying goes, a picture is worth a thousand words, but occasionally so is a sound. Or rather, a picture of a sound. Whether it’s the “Thwip” of Spiderman shooting his web or the “Snikt” of Wolverine popping his claws, certain classic onomatopoeias (to use the $10 word) communicate immediately everything you need to know about what’s going on and what’s about to happen.

epsilon-theory-snikt-february-9-2016-wolverine

© Marvel Characters, Inc.

So here’s another picture of a sound, another effective representation of a dynamic multi-dimensional narrative within a static two-dimensional form.

epsilon-theory-snikt-february-9-2016-bloomberg

This is the market price of credit default swap (CDS) protection on the senior debt of the largest European banks and insurers over the past 6 months, and the sound you are hearing is the “Snikt” of systemic risk popping out its claws once again.

A month ago I wrote the following:

There were trades available [in 2008] that, in slightly different form, are just as available today. For example, it may surprise anyone who’s read or seen (or lived) “The Big Short” that the credit default swap (CDS) market is even larger today than it was in 2008. I’d welcome a conversation with anyone who’d like to discuss these systemic risk trades.

The susceptibility of credit spreads to systemic risk(s) that I was describing last month was borne out last week. Protection on the ITRAXX senior European financial debt index widened by over 45 bps from 92 bps at the close of January to 137 bps at the close on February 8, as systemic risks emanating from the deflationary hurricane coming out of Asia wreaked havoc on a financial system already reeling from the collapse of the global commodity and industrial complex. I think there’s another 50+ bps of further spread widening to go, but it’s a tougher slog from here. The money in any major market shift is generally made during the discovery phase, and once you get the third WSJ article talking about the issue (much less the thirtieth), many market participants will start trading around the position.

Now the truth is that this outcome worked faster than I thought it would, and I attribute that to two factors. First, everyone and his brother is looking for a massive correlation like this, and once George Soros and Kyle Bass and the rest of the short-the-yuan crew started talking their book on CNBC, it doesn’t take a genius to figure out what the knock-on effects of their premise might be for global recession risks and investment grade (IG) credit. But second … the speed of this outcome means that things are even worse than I thought. We don’t need a yuan float or announced devaluation to start a 1930s-esque deflationary spiral and the insanely aggressive political response to come. It’s already here.

So Epsilon Theory is ringing the bell, with three big notes over the next month or so.

First, I’ll write about the 1930s-esque deflationary spiral and why I think it’s all happening again. This is “The Thesis”, and here’s the skinny: In 1930, the United States passed the Smoot-Hawley Tariff Act, establishing a massive system of protectionist tariffs and quotas that sparked competitive protectionist measures around the world. Within a year, the largest bank in Austria, Credit Anstalt, failed, and the Great Depression was unleashed as global trade finance collapsed. Today I believe that competitive currency devaluations will lead to the failure of another massive bank, perhaps one whose native language is also German and is in fact a direct descendant of Credit Anstalt, as global trade finance collapses once again.

Second, I’ll write about what’s next. This is “Five Easy Pieces (to Wreck the World)”, and here’s the skinny in a visual format that should be familiar to anyone who’s ever taken the SAT:

Gaussian Copula : 2008     ::     Negative Rates : 2016

If you don’t know what a Gaussian copula is, do yourself a favor and read Felix Salmon’s magisterial Wired article from 2009. The Gaussian copula was the financial innovation that broke the world in 2008, and negative rates will be the financial innovation to break the world today.

Third, I’ll write about what you can do about all this. You already know part of what I’m going to say, because I’ve said it before. Now more than ever you need convexity in your portfolio. Now more than ever you need to focus on the strategies and the assets that will do well in a deflationary hurricane AND the political response to that hurricane. Once the claws of systemic risk pop out with a Snikt, you’re in for a long and bloody fight. It’s time to prepare ourselves for that fight if we’re going to be investment survivors here in the Golden Age of the Central Banker.

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You Can Either Surf, or You Can Fight

Kilgore: Smell that? You smell that?
Lance: What?
Kilgore: Napalm, son.  Nothing else in the world smells like that.

– Apocalypse Now (1979)

Hello, hello, hello, how low? [x3]
– Nirvana, Smells Like Teen Spirit (1991)

Outside the bus the smell of sulfur hit Bond with sickening force.  It was a horrible smell, from somewhere down in the stomach of the world.
– Ian Fleming, Diamonds Are Forever (1956)

There’s more than a whiff of 2008 in the air. The sources of systemic financial sector risk are different this time (they always are), but China and the global industrial/commodity complex are even larger tectonic plates than the US housing market, and their shifts are no less destructive. There’s also more than a whiff of 1938 in the air (hat tip to Ray Dalio), as we have a Fed that is apparently hell-bent on raising rates even as a Category 5 deflationary hurricane heads our way, even as the yield curve continues to flatten.

What really stinks of 2008 to me is the dismissive, condescending manner of our market Missionaries (to use the game theory lingo), who insist that the US energy and manufacturing sectors are somehow a separate animal from the US economy, who proclaim that China and its monetary policy are “well contained” and pose little risk to US markets. Unfortunately, the role and influence of Missionaries is even greater today in this policy-driven market, and profoundly misleading media Narratives reverberate everywhere.

For example, we all know that it’s the overwhelming oil “glut” that’s driving oil prices down and wreaking havoc in capital markets, right? It’s all about OPEC versus US frackers, right?

Here’s a 5-year chart of the broad-weighted US dollar index (this is the index the Fed publishes, which – unlike the DXY index and its >50% Euro weighting – weights all US trading partners on a pro rata basis) versus the price of WTI crude oil. The red line marks Yellen’s announcement of the Fed’s current tightening bias in the summer of 2014.

/wp-content/uploads/epsilon-theory-you-can-either-surf-or-you-can-fight-january-14-2016-bloomberg.jpg

Source: Bloomberg, January 2016.

Ummm … this nearly perfect inverse relationship is not an accident. I’m not saying that supply and demand don’t matter. Of course they do. What I’m saying is that divergent monetary policy and its reflection in currency exchange rates matter even more. Where is the greatest monetary policy divergence in the world today? Between the US and China. What currency is the largest contributor to the Fed’s broad-weighted dollar index? The yuan (21.5%). THIS is what you need to pay attention to in order to understand what’s going on with oil. THIS is why the game of Chicken between the Fed and the PBOC is so much more relevant to markets than the game of Chicken between Saudi Arabia and Texas.

But wait, there’s more.

>My belief is that a garden variety, inventory-led recession emanating from the energy and manufacturing sectors is already here. Maybe I’m wrong about that. Maybe I spend too much time in Houston. Maybe low wage, easily fired service sector jobs are the new engine for US GDP growth, replacing the prior two engines – housing/construction 2004-2008 and energy/manufacturing 2010-2014. But I don’t see how you can look at the high yield credit market today or projections of Q4 GDP or any number of credit cycle indicators and not conclude that we are rolling into some sort of “mild” recession.

My fear is that in addition to this inventory-led recession or near-recession, we are about to be walloped by a new financial sector crisis coming out of Asia.

What do I mean? I mean that Chinese banks are not healthy. At all. I mean that China’s attempt to recapitalize heavily indebted state-owned enterprises through the equity market was an utter failure. I mean that China is going to need every penny of its $3 trillion reserves to recapitalize its banks when the day of reckoning comes. I mean that China’s dollar reserves were $4 trillion a year ago, and they’ve spent a trillion dollars already trying to manage a slow devaluation of the yuan. I mean that the flight of capital out of China (and emerging markets in general) is an overwhelming force. I mean that we could wake up any morning to read that China has devalued the yuan by 10-15%.

Look … the people running Asian banks aren’t idiots. They can see where things are clearly headed, and they are going to do what smart bankers always do in these circumstances: TRUST NO ONE. I believe that there is going to be a polar vortex of a credit freeze coming out of Asia that will look a lot like 1997. Put this on top of the deflationary impact of China’s devaluation. Put this on top of an inventory-led recession or near recession in the US, together with high yield credit stress. Put this on top of massive market complacency driven by an ill-placed faith in central banks to save the day. Put this on top of a potentially realigning election in the US this November. Put this on top of a Fed that is tighteningStorm warning, indeed.

So what’s to be done? As Col. Kilgore said in “Apocalypse Now”, you can either surf or you can fight. You can adopt strategies that can make money in this sort of environment (historically speaking, longer-term US Treasuries and trend-following strategies that can go short), or you can slog it out with a traditional equity-heavy portfolio.

Also, as some Epsilon Theory readers may know, I co-managed a long/short hedge fund that weathered the 2008 systemic storm successfully. There were trades available then that, in slightly different form, are just as available today. For example, it may surprise anyone who’s read or seen (or lived) “The Big Short” that the credit default swap (CDS) market is even larger today than it was in 2008. I’d welcome a conversation with anyone who’d like to discuss these systemic risk trades and how they might be implemented today.

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The China Narrative That Really Matters

I’m a China bull, let’s get that out of the way first. But like anything connected with the global industrial and commodity complex today, from Emerging Markets to MLPs to oil prices, it doesn’t matter what the Truth with a capital T might be regarding the real world economic or business fundamentals. The story is broken. The stocks are broken.

I’ve written a lot here in Epsilon Theory about what’s happening in China and what it means for the China growth story to break.

Most directly on the topic, read “When the Story Breaks“. It’s a quick read and introduces an Epsilon Theory perspective for how to think about China.

Most recently on the topic, and why the Chinese currency devaluation kicks US equity markets right in the teeth, read “Storm Warning“.

Most fundamentally on the topic, and why the Chinese currency devaluation is an existential issue for the Beijing regime, read “The Dude Abides: China in the Golden Age of Central Bankers”.

There are other notes on China if you’re so inclined, including: “The Donkey of Guizhou“, “Rosebud“, and “The Power of Why, Exhibit 4,512 in a Continuing Series“.

For a related note on the overall Emerging Market story, read “It Was Barzini All Along“. For an Epsilon Theory perspective on oil prices, read “The Unbearable Over-Determination of Oil“.

Now most stories heal themselves over time, and the China growth story is no exception. Or rather, over time these broken stories evolve into a market-supportive story, for example from a growth story into a value story. You see this in market narratives all the time.

But there’s one aspect of the China story that can’t heal itself or transform into something more benign from a market perspective, and that’s the Narrative of Chinese Government Competence. To quote myself in “When the Story Breaks”:

“This is a completely different Narrative than the growth story, and it’s the story that one-party States rely on to prevent even the thought of a viable political opposition. In highly authoritarian one-party nations – like Saddam’s Iraq or the Shah’s Iran – you’ll typically see the competence Narrative focused on the omnipresent secret police apparatus. In less authoritarian one-party nations – like Lee Kuan Yew’s Singapore or Deng Xiaoping’s China – the competence Narrative is more often based on delivering positive economic outcomes to a wide swath of citizens (not that these regimes are a slouch in the secret police department, of course). From a political perspective, this competence Narrative is THE source of legitimacy and stability for a one-party State. In a multi-party system, you can vote the incompetents (or far more likely, the perceived incompetents) out of office and replace them peacefully with another regime. That’s not an option in a one-party State, and if the competency story breaks the result is always a very dicey and usually a violent power transition.”

So when I read an article this morning in a famous media outlet owned by famously Beijing-friendly Rupert Murdoch that “the impression left on investors is that Chinese authorities are out of their depth” and that “certainly with respect to the stock market, their reputation for incompetence is well-earned”, I get nervous.

I get nervous because the next move in China is going to be a political move, and political moves are never well anticipated by markets. The Beijing regime is going to take steps to defend itself, or at least insulate itself, from the growing Narrative that they are incompetent. Heads will roll. Literally, in all likelihood. But the incompetence genie is very hard to stuff back into the bottle, and depending on whose head is on the chopping block, regime stability can deteriorate very quickly. Now that’s what will make me change my bullish stance on China fundamentals, and that’s what will make the US market swoon of last August look like a gentle spring rain.

From an Epsilon Theory perspective, a collapse in the Narrative of Chinese Government Competence is the biggest systemic risk out there right now, and that’s where I’m focusing my risk antennae.

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Storm Warning

Unfortunately for mariners, the total amount of wave energy in a storm does not rise linearly with wind speed, but to its fourth power. The seas generated by a forty-knot wind aren’t twice as violent as those from a twenty-knot wind, they are seventeen times as violent. A ship’s crew watching the anemometer climb even ten-knots could well be watching their death sentence.

Sebastian Junger, “The Perfect Storm: A True Story of Men Against the Sea” (2009)

[the crew watch emergency surgery performed on the ship’s deck]

Able Seaman: Is them ‘is brains, doctor?
Dr. Stephen Maturin: No, that’s just dried blood. THOSE are his brains.

“Master and Commander: The Far Side of the World” (2003)

[the Konovalov’s own torpedo is about to strike the Konovalov]

Andrei Bonovia: You arrogant ass. You’ve killed *us*!
“The Hunt for Red October” (1990)

Can everyone saying “a 25 bps rate hike doesn’t change anything” or “manufacturing is a small part of the US economy today, so the ISM number doesn’t mean much” or “trade with China is only a few percent of US GDP, so their currency devaluation isn’t important” just stop? Seriously. Can you just stop? Maybe if you were making these statements back in the ‘80s – and by that I mean the 1880s, back when the US was effectively a huge island in the global economy – it would make some sense, but today it’s just embarrassing.

There is a Category 5 deflationary hurricane forming off the Chinese coast as Beijing accelerates the devaluation of the yuan against the dollar under the guise of “reform”. I say forming … the truth is that this deflationary storm has already laid waste to the global commodity complex, doing trillions of dollars in damage. I say forming … the truth is that this deflationary storm has driven inflation expectations down to levels last seen when the world was coming to an end in the Lehman aftermath. And now the Fed is going to tighten? Are you kidding me?

Look, I’m personally no fan of ZIRP and QE and “communication policy”, certainly not the insatiable market devourers they’ve become over the past few years. But you can’t just wish away the Brave New World of globally interlocked, policy-driven, machine-dominated capital markets in some wave of nostalgia and regret for “normalized” days. In an existential financial crisis, emergency government action always becomes permanent government policy, reshaping markets in similarly permanent ways. This was true in the 1930s and it’s true today. It’s neither good nor bad. It just IS. Did QE1 save the market? Yes. Did QE2 and QE3 and all the misbegotten QE children in Europe and Asia break the market? Yes. And in the immortal words of shopkeepers everywhere: you break it, you bought it. The Fed owns capital markets today, like it or not, and raising rates now, as opposed to a year ago when there was a glimmer of a chance to walk back the Narrative of central bank omnipotence, isn’t “brave” or “prudent” or “necessary” or any of the other laudatory adjectives you’ll hear from Fed media apologists after they raise. It’s simply buyer’s remorse. The Fed is sick and tired of owning the market, sick and tired of giving interviews to CNBC every time some jobs report hits the wires, sick and tired of this Frankenstein’s monster called communication policy. So they’re going to raise rates, declare victory, and hope that things go their way.

Am I annoyed by China’s currency actions and their adept use of communication policy to shape the Narrative around devaluation? Not at all. This is exactly what China must do to bolster economic growth while maintaining the pleasant diplomatic fiction that they’re not a command economy. What annoys me is the Fed’s apparent hell-bent intention to force a low-level currency war with China AND whack our own manufacturing and industrial base on the kneecaps with a crowbar, just so they can get out of the communication policy corner they’ve painted themselves into.

Three or four years ago, one of THE dominant market narratives, particularly in the value investment crowd, was the “renaissance of American manufacturing”. Not only was the manufacturing sector going to be the engine of job growth in this country (remember “good jobs with good wages”? me, neither), but this was going to be the engine of economic growth, period (remember the National Export Initiative and “doubling exports in five years”? me, neither). Now we are told that we’re just old fogies to worry about a contracting US manufacturing sector. Now we are told that a global recession in the industrial and commodity complex is well contained here in our vibrant services-led economy. Right. You want some fries with that?

So what’s to be done? You do what you always do in a deflationary, risk-off world – you buy long-dated US Treasuries. Stocks down, USTs up. Of course, if you think that the yield curve is going to steepen after the Fed does whatever it’s going to do this week … you know, because the Fed rate hike is obviously an all-clear sign that we have a robust self-sustaining economic recovery and we’re off to the races … then you want to do the exact opposite, which is to buy stocks and sell the 10-year UST. Yep, time to load up on some bank stocks if that’s your view.

What else can you do? You can read the Epsilon Theory note “I Know It Was You, Fredo” and consider ways to make your portfolio more convex, i.e., more resilient and responsive to both upside and downside surprises in these policy-driven markets. The big institutional allocators use derivative portfolio overlays to inject convexity into their portfolio, and that’s all well and good. But there are steps the rest of us can take, whether that’s adopting strategies that can short markets and asset classes (like some tactical strategies and most trend-following strategies) or whether that’s investing in niche companies and niche strategies that are designed to outperform in either a surprisingly deflationary or a surprisingly inflationary world. The trick really isn’t to choose this fund or that fund. The trick is to broaden your perception of portfolio outcomes so that you don’t have a misplaced faith in either the Fed or econometric models.

I suppose there’s one more thing we should all do. We should all prepare ourselves to perform some emergency surgery on the deck of whatever portfolio ship we’re sailing in 2016. Because with a Fed hike the currency wars will begin in earnest, magnifying the deflationary storm already wreaking havoc in industrials, energy, and materials. No sector or strategy is going to be immune, and we’re all going to suffer some casualties.

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