Un repaso a los mercados

Mark Tinker, AXA IM  - Viernes, 24 de Marzo

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Last week’s options expiry and interest rate change has altered ‘the Greeks’ for markets, increasing the sensitivity of daily moves and undoubtedly fed into some of this week’s weakness. These portfolio insurance events can be meaningful, but are short duration. The approaching quarter end and end of the fiscal year is also likely to be encouraging some profit taking and questions over the ‘reflation trade’ while a dent in the optimism over US tax cuts and infrastructure spend has added to selling pressure. The announcement of a Bond Connect in China and the trend to increasing payouts from cash rich Asian corporates are starting to attract the attention of yield hungry investors to Asia and we believe is an emerging but enduring theme.

Last week we discussed the ‘Ides of March’ and the prospect that the March options expiry might trigger an uptick in Volatility. While the expiry itself seemed to pass relatively uneventfully, the behaviour of markets so far this week suggests that the rollover of options and futures may well have triggered a shift change in market mechanics. The fundamentals remain relatively benign – indeed all the data continues to come in with a strong positive bias – but market pricing often reflects risk tolerance more than economic fundamentals.

 

In this context it makes sense to consider the Vix – the implied volatility index of the S&P500 – not so much as a ‘fear index’ as the press like to refer to it, rather as the price of put options, the cost of portfolio insurance. The price of a put option reflects what derivatives traders refer to as “the Greeks” – the time to expiry (theta), the sensitivity to the underlying instrument (delta) as well as the sensitivity to interest rates (rho). It also incorporates gamma, which is the rate of change in the delta and this in turn will reflect the realised volatility of the underlying instrument – in this case the S&P 500 index. The term for implied volatility is thus reversed out from the price of the options and while realised or actual volatility tends towards this figure they are not the same. The main reason for this in my experience is the balance of supply and demand for options. When there has been an extended period of low realised volatility in equity markets and especially when there has been a slow but steady uptrend – as we have seen since October – then there tends to be a lot of sellers of put options to take in premium and enhance returns. When, as in both December and March, those options expire out of the money, the price of new options remains low as demand drops away relative to supply. However, if as I suspect has just happened, there is a pick-up in demand for puts, then the market mechanics kick in and the price of Vix starts to rise. There is currently significant put positioning between 2340 and 2315 on the S&P500 but the largest volume is currently in the 2350 and 2340 range – exactly where we are right now.

 

As we hit these trigger points, we see the impact of the delta one hedging desks – in effect the banks selling the options hedge their positions in the underlying, so a fall in markets triggers ‘delta hedging’ or second round effects and then gamma rises as the delta becomes higher and so on. At an extreme we get events like the 1987 crash, the rest of the time we get ‘market corrections’. This looks like one happening right now. I also suspect that whereas previously the sellers of puts had been institutions and funds who were effectively ‘covered’, i.e. they have cash and are happy to ‘buy lower down’, most of the sellers at the moment are banks and hedge funds who are using leverage and are thus much more sensitive to small movements in the underlying. This change of actors is what changes the sensitivity to the underlying assets and hence the market mechanics.

 

Of course the other thing that has changed - in addition to theta, delta and gamma – is rho, the sensitivity to interest rates. The Federal Reserve (Fed) raised rates last week as we know, but as chart 1 illustrates the Fed has much more potential impact on the financial economy than the real economy.  Prime lending rates in the US (green line RHS) never went below 3.25% and are now at 4%. The Fed effectively sets the price of money as a raw material and the users of that raw material are the investment banks, hedge funds and financial instrument manufacturers. Last week, the price of that raw material went up (note that the chart shows the effective rate of 0.91% rather than the official target rate) with Libor now at 1.15%, 15bps higher than the December expiry, 30bps higher than last September and 50bps higher than this time a year ago. That might not sound much in absolute terms, but in the case of the last 12 months, that is effectively an 83% increase in the price of your raw material.

The proximate cause for the increase in demand for puts will be a combination of profit taking at financial year end and a swing in the news cycle away from optimism towards pragmatism, if not yet pessimism. The timing is also important, between now and the options expiry we will see the results of the French general elections, now regarded as the chief political risk for Q2. This is not really surprising; market muscle memory is pretty powerful from Q2 last year, when an early buying of put options would have made a big difference to performance.

 

The flip side of the weakness in equities is a rally in bonds and this is leading to the unwinding of the reflation trade looking more symmetrical. Last week we noted that both the long bond and commodities (notably oil) were selling off and that this was obviously inconsistent with a fundamental, inflation linked rationale. Post the options expiry this seems to have normalised. The long bond seems to have found resistance at 2.60%, keeping that as the ceiling for the time being rather than establishing it as a floor for a new range. As to the new floor – well if we look at the charts (including the Fibonacci that markets seemed to be worrying about for a break to the upside on yield) – then 2.33% looks to be the target for testing a floor. Meanwhile the oil price has now broken down through its long term moving average (US$48.5 on West Texas Intermediate - although I notice it is still sitting right on the long term average for Brent crude). 

 

All of this is helping to undermine the consensus ‘reflation trade’ from the beginning of the year as is the ongoing political theatre in the US. Currently, the prospect of the imminent vote on Health Care reforms failing is starting to reduce confidence in the ability of the Trump administration to ‘get things done’. Given the importance to bullish sentiment of reforms in taxation and infrastructure spending, there is undoubtedly a feeling of travelling and arriving here, triggering profit taking and a shift in the narrative, which as outlined above is being magnified by the market mechanics. From Asia’s point of view this is actually somewhat positive in that it is simultaneously reducing the perceived threat of aggressive action on tariffs and trade – something we have in any event assumed to be overplayed.

 

Geo-politics remains a dominant theme in macro discussions and Citi had a conference here in Hong Kong this week with the opportunity for small group meetings with several very interesting macro speakers. First up was Eisuke Sakakibara, or ‘Mr Yen’ as he used to be known. Aside from his view that the yen would strengthen against the dollar over the next twelve months what was perhaps most interesting was his view on Japan itself and the need for change. He suggested that there was no need for change and thus there wouldn’t be any. I found this very interesting in the light of my own recent visit, where as noted, I got the sense of a degree of disengagement with the rest of the world. Apologies once again to my Japanese colleagues, but Sakakibara San’s view on the need for reform in governance (“It’s not that bad”) or the prospect of higher inflation (“1% is enough”) captured something of the sense I got from companies on my last visit. Very much a feeling of ‘it’s not particularly broken, so why try and fix it?’ He believes Japan will struggle to get inflation much higher but that nobody in Japan is that bothered, not even the bureaucrats. As positives he pointed out that Japan has a very clean and green environment – an amazing 67% of land in Japan is actually forest (UK is 11% and that’s mostly Scotland). It is also one of the safest countries in the world as well as the healthiest – certainly in terms of longevity.

 

Harvard Professor William Overholt told some interesting anecdotes about Japan, not least reminding us of the curious set of circumstances whereby Shintaro Ishihara, the then Mayor of Tokyo raised money to buy the Senkaku Islands and how the central government run by Noda turned it into a national issue. This was part of an overall narrative about the region that we find ourselves in situations that began with localised national politics that have then been compounded through agitation from the military. He noted that Prime Minister Abe has an ambition to change the Japanese Constitution to allow an army and he pointed to the military as a major driver of policy across much of the world at the moment.

 

This sentiment was, perhaps not surprisingly, reinforced by former NATO secretary general Anders Fogh Rasmussen. His key takeaway is that the military is very much in the ascendant and that Europe is going to comply with pressure to increase defence spending to 2% of GDP. With the US committed to spending even more on defence, the overall budgets are rising, which probably explains why the US aerospace and defence stocks ETF ITA (black line) is up almost twice as much as the S&P500 over the last year and more than twice as much as the ‘defensive’ stocks index (yellow line).

Again, not surprisingly, given that he now consults for the Ukrainian government, Mr. Rasmussen was very anti-Russian in his remarks, but he also revealed the extent to which the desire to prevent any rapprochement between President Trump and Putin extends within the Washington establishment. He pointed out that Russia is not a priority for Trump, but it clearly is for a lot of other people.

 

One lateral thought about this – and to repeat an earlier discussion. If the US government want to a) reduce the trade deficit b) boost the US consumer c) increase capital expenditure and d) continue to put pressure on Russia, then what better way than to increase the production of US shale oil? As discussed last week, this is now much more of a manufacturing than a mining process, output can be turned off and on rapidly, leaving OPEC as more of a manager of inventory than the marginal price setter. Lower oil and gas prices are good for US consumers and producers (as long as not too low for the marginal energy producer with leverage) and keeping oil below, say US$50, would put a lot of pressure on Russia. Selling more oil (and gas) globally would also reduce the balance of payments deficit.

 

Of course, as a consumer of oil (largely) Asia would be an ongoing beneficiary of this and this is just one reason why I believe that international investors are looking more favourably in this direction once more. However, with our focus on dividend paying stocks in some of our strategies, we would also note some of the bottom up positives that are coming through with respect to higher payouts. The biggest headline of the week was the payout from coal company Shenhua Energy, which paid out a special dividend that was equivalent to a total ‘yield’ of around 20%. In a world starved of yield that is of course hugely significant and triggered the inevitable rush to find ‘more specials’. However, the story is bigger than just State Owned Enterprise (SOE) reform releasing cash, as we have said before around 30% of all dividends paid globally come from Asia and portfolio composition needs to start to reflect that.

Importantly, balance sheets are generally strong and often flush with cash and the payout ratios are starting to rise. For example, insurance giant Ping An just raised its dividend 42%, Indonesian Bank Rakyat just paid a special to lift its payout from 30% to 40%, Sinopec lifted from 33% to a 45% payout ratio and KWG Property from 33% to 51%. There will be more in my view.

 

As a further attraction for yield hungry investors, while last week’s China National People’s Congress (NPC) was examined closely for comments on GDP growth, monetary and exchange rate policy and signs of structural reform – particularly to the supply side in key industries such as steel and coal, what largely passed people by however, was an announcement by premier Li Keqiang on the final day for the Bond Connect. When the original proposals for a stock connect between Hong Kong and Shanghai were floated, most banks assumed that they would provide a channel for capital to flow into the Chinese stock market. Indeed, that was partly behind the speculative bubble that built up immediately following the launch of the Hong Kong Shanghai Stock Connect in late 2014, that and the notion that the Chinese equity market would go into various benchmark indices forcing ‘index trackers’ to buy. In fact, as we now know the flow has largely been in the other direction, helping to narrow the premium between A-shares listed in China and H-shares listed in Hong Kong. The Bond Connect is different however, and is designed to allow long term investors to help set secondary market pricing for the newly emerging China bond markets. In my opinion, China does not need western capital (it has plenty) but it does want western investors to help it create a proper secondary market for securities. In equities, the majority of ‘investors’ remain private individuals and day traders, while in bonds, the majority are simply bought and held to redemption by banks. The new Bond Connect will allow investors to operate through an account held in Hong Kong which should be an increasingly attractive way of participating in the transformation of China’s bond markets.

 

As noted, energy is very important for Asia and it is thus with some concern that investors are observing the mess that the Australian government seems to have got itself into with its energy policy. Rich in natural gas, it appears to have exported so much to the rest of Asia that it has left itself with a domestic shortage and thus sharply rising prices. Indeed as this report points out, Australian gas sold in Japan is now cheaper than gas sold in Australia! At the same time we have South Australia where a headlong dash into renewables and accelerated closure of existing coal plants has led to brownouts and even blackouts that have been highlighted by Tesla and Elon Musk. He has offered to provide a battery storage solution (the acknowledged Achilles heel of a switch to renewables) within 100 days or else do it for free. As I have said in the past, Tesla is a battery company, that just happens to make (extremely good) cars. In the same way, the biggest electric vehicles (EV) producer in China, BYD, is also a battery company making cars. Interesting to see that Chinese automaker Geely is opening a new plant in the UK to make electric taxis, no doubt encouraged by the upcoming Transport for London, TfL initiative that from next year all taxis must have a zero emissions capability of up to 30 miles. In my opinion this simply accelerates the switch away from conventional Internal Combustion Engine technology (note that Honda believes that 2/3^rd of the cars it sells in Europe will have an electric powertrain by 2025).

 

Of course, such initiatives will continue to put pressure on the electricity grids and perhaps the UK government (as well as the Australians) might want to talk to these guys about thorium nuclear power- https://aris.iaea.org/PDF/ARISThorCon9.pdf. Thorium is one of those (proven) technologies that I have written about in the past and keep an eye on and thus noticed that the international atomic energy agency just published a white paper proposal from this company.  It’s worth a quick read if you have time to click the link, but the basic point is that using thorium instead of uranium as a primary fuel means no plutonium is produced, something which we would now regard as a good thing, but back in the 1960s was seen as a negative – production of plutonium for nuclear weapons was actually a key driver for atomic energy. The US ran a thorium reactor for an extended test period and this company, http://thorconpower.com/ - which is by no means the only company looking to operate in this field-  makes the point that this is proven technology that is walk away safe and actually consumes the spent fuel from traditional reactors. What’s not to like? as they say.

 

While talking of energy and technology, the word of the week has to be perovskite. Just as last week we discussed how the new Nissan e-note could act as an interim technology between existing Petrol Hybrid Electric Vehicles (PHEVs) and pure EVs, so perovskite offers the possibility of transforming the ease of use and cost of manufacture of solar electricity. Perovskite is a material that would allow solar cells to effectively be printed or even spray ‘painted’ directly onto surfaces and according to Bloomberg in the link above a British company Oxford PhotoVoltaics  believes the technology will be ready by the end of next year. The implications could be huge. An obvious advantage would be to vastly increase the range of surfaces which could be used to harvest energy – the bodywork of the electric vehicle itself obviously, but all manner of surfaces for more general collection. Not only would it obviously be considerably lighter as well as no longer rigid, but perovskite solar cells use far less energy in their production, not only making them ultra ‘green’, but also significantly reducing their cost. Currently, the perovskite cells are not quite as energy efficient as traditional solar – their efficiency rate (the rate at which solar energy is converted) is currently around 20% compared to 25% from traditional solar – but this is up from only 4% in 2009 and scientists believe the uptrend is continuing. As with any new technology, it is important not to get too carried away, but as the Bloomberg article noted, the sudden switch of research into perovskite cells as a potential replacement for traditional solar reflects the excitement around the technology. Meanwhile, as noted before, Tesla are to produce traditional looking roof tiles that are in fact solar panels, which is a step towards embedding solar technology in all new buildings. Of course, as another lateral thought, were this to become practical there would be a huge increase in demand for inverters.

 

To conclude, this looks to be a week where the fundamentals get better but the markets appear not to like them. In reality this looks very much like market mechanics at play. These are different from technical analysis, where in effect people are trying to anticipate how other traders are positioned, and more about the pricing, leverage and optionality embedded in the portfolio insurance the markets are using – both buyers and sellers. These mechanics can be meaningful, but are rarely enduring. Ultimately the fundamentals come through. To that end, and with an obvious nod to local bias, we believe that the opening up of China’s bond markets and the increased payouts from cash rich and profitable Asian corporates means that Asia should be firmly on the radar of any investor, but particularly those looking for yield.

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