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Impact of Mifid II (the separation of research from execution) on investment research

  • Much larger impact on equity research than fixed income research. Fixed income research cost may actually increase as traditionally research cost is covered by bid-ask spread instead of by commission. Reduction in equity research will likely come from analyst access cost.
  • Reduction of research cost will have largest impact on the research departments of investment banks, then those of independent research providers (IRPs), then the internal research team of asset managers.
  • Research analysts on single stock picking (stock alpha) will be most affected. Quant and macro analysts are least affected. 

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Don’t Rush to Short Saudi Riyal Despite Oil Shock

  • Saudi government’s ample FX reserves/net foreign assets (NFA) has so far provided critical support to Saudi riyal-USD peg. Oil price shock is a double whammy on Saudi NFA. With hard dollar peg in place, lower oil price means lower oil revenue – which leads to slower reserves buildup – and more fiscal spending to offset the economic downturn – which leads to drawdown in FX reserves/foreign assets. The period between 2015 and 2016 represents a perfect example where we saw a sharp increase in fiscal deficit and sharp decline in Saudi NFA.
  • According to IMF Article IV October 2017, the base scenario for the next five years is oil price around $50, which leads to small Saudi current account balance (<2% GDP) and small fiscal deficit (2% GDP) and only gradual drawdown in Saudi NFA. By the end of the 5-year forecast horizon, Saudi NFA should stay comfortably above 20 months worth of import.
  • The downside scenario is where the oil price would stay between $30-$40 over the next five years, which means the economic hardship, large fiscal deficit and drawdown of NFA that were experienced in 2015-2016 would continue over the next five years. Saudi NFA would probably come down to a very low level (5 months of import) around the year of 2022, threatening the sustainability of the dollar peg as well as the Saudi oil-dependent economic model.
  • Therefore, simply extrapolating the 2015-2016 situation to the future is too dire an assumption. That said, only a couple years are left for Saudi to reform its economic model if oil prices stay for a long time between $30-$40.
  • There may be an important twist, however. What if the Saudi monetary authority  SAMA tries all its best to avoid breaking the riyal-dollar peg and – alongside some piecemeal reform – asks for assistance from the Fed and PBoC? More specifically, what if SAMA sets up some kind of bilateral agreement with the Fed (or PBoC) on USD swap (or CNY swap) program? Such scenario is not unlikely given Saudi Arabia’s geopolitical importance in Middle East and the world’s dependence on Saudi oil supply.
  • In other word, even if the downside scenario happens, one needs to think twice if he wants to short the riyal and expects a devaluation of riyal.

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Achilles Heel of the Swedish Housing Market?

  • Australia, Canada, New Zealand, Hong Kong and Sweden have seen their housing prices more than tripled since 2000, according to BIS housing price series. The BIS series does not include Chinese data. Arguably the rally in Chinese property market – particularly those of Tier 1 cities – would comfortably dwarf the countries mentioned above.
  • There seems to be common driver behind the housing price boom of the aforementioned countries, with notable exception being Sweden. And that is the Chinese purchase of housing in China (Mainland and Hong Kong) as well as migration-friendly countries (Canada, Australia, New Zealand). Residential property investment – particularly in Tier 1 Chinese cities and overseas developed countries) – as store of wealth – largely explains the mentality of Chinese buyers.
  • Therefore, the “Achilles Heel” of Chinese housing market is its capital account policy. A radical change in the policy – e.g. allowing Chinese households to move domestic wealth and invest overseas – could significantly cool down the domestic property market, as households would face much more choices to park their wealth. (Btw, the Chinese policymakers know this vulnerability too well, making them reluctant to open Chinese capital account).
  • The next question is, what makes Sweden join the top list of housing market boom without large Chinese investment? What is the “Achilles Heel” of Swedish property market, whose change would drastically weigh on the housing price – and hence policymakers would be really reluctant to adopt in the near future?
  • Broadly speaking, there are three factors driving housing price: supply, people and money. By definition, the “Achilles Heel” is not something that happens only very gradually, such as increasing land supply or reducing population growth. Therefore, the “Achilles Heel” can only be something about money, like the case in China.
  • Notably the total debt as a share of total asset has gone down among Swedish households despite rising level of household debt. What is the money or capital related policy that affects the Swedish housing market? I yet to have an answer about which I am as confident as the one I suggested on China. I will come back to this issue in the future. For the moment, here are the potentially relevant drivers I could think of:
    • Riksbanks’ QE, which increases net financial assets of households, though central banks’ purchase of assets happen across many developed markets.
    • Mortgage interest deductibility, which affects net borrowing cost, though such policy also exists in other countries, e.g. UK.
    • Large current account surplus that increases the country’s wealth, though there are many countries with higher CA than Sweden as a share of GDP, and yet the housing boom is less significant (e.g. Korea, Switzerland)
    • Feedback loop: rising housing price boosts paper value of property and household assets, lowers household debt % household asset, further increases households’ ability to apply for mortgages (taking on more debt). Of course, feedback loop also works when housing prices drop

There may be other drivers that I miss about the booming Swedish housing market, e.g. property tax policy or mass population’s mentality that housing prices could only go up…..I will investigate further.

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Recap of Dan Fuss Speech

[Below is the takeaway from a speech made by Dan Fuss in October 2017. ]

  • Investment view
    • For the very low base of interest rates, most fixed income assets are not compensated for their risks
    • One third of portfolio in cash equivalent (less than 2 years of duration), halved the average maturity of the portfolio
    • Focus on liquidity stress tests
    • EM FX: keep monitoring USDMXN as any early sign of EM stress amid Fed normalization
  •  Peace
    • Less turbulent Middle East and South China Sea.
    • Hot spot in North Korea, but markets have no idea how to price the nuclear uncertainty. [M: it reinforces my belief that every correction in South Korean assets caused by North Korea-US tension is a buying opportunity.]
  • People
    • Aging: Its negative impact on the economy is often talked about. But aging is a two-way street, e.g. rich parents (grandparents) fund the university tuition fee of their sons (grandsons).
    • Migration: adding more stress
  • Politics
    • The divided US congress has been doing very little this year, the lowest activity level since 1974 when Nixon resigned.
    • Little constitutional activity makes investors more cautious in dealing with US assets. More interest in overseas assets (e.g. Asian and EM dollar assets)
  • Prosperity
    • Synchronized global economic expansion
  • Central banks (sitting at the core of the “4P”)
    • Increased interconnection and communication between central banks, increasingly helping each other out
    • Central banks increasingly speak outside of its own mandate, e.g. increase talk about other economies and how they affect the home country.
    • BoJ set up currency swap lines bilaterally with 10 ASEAN central banks in 2013. Given BoJ has currency swap lines with the Fed/ECB/BoE already, BoJ effectively acts as an agent ready dump (in-theory limited, in-practice unlimited) liquidity when ASEAN central banks need it. Similar moves by PBoC with other EM central banks.
    • [M: With currency swap lines set up, FX reserves become less crucial in defending one’s currency, and EM balance sheets become more robust in coping with external shocks]
  • Central banks normalization – rolling back its balance sheet
    • US small banks want the Fed to raise interest rate so that they can offer higher deposit rate to attract deposits – and the Fed branches are listening
    • Draghi/ECB is doing lots of heavy lifting; BoE is absorbed with Brexit; BoJ is also trapped, though with a bit of wriggle room on the back of economic recovery
  • Corporate bond and loans
    • Secular change from a dealer market to an agency market, with low inventory of market makers – not willing to take risks on their principal/capital
    • High liquidity in frequent issuers. Poor liquidity in off-the-run and other issuers.
    • Problem of an agency market (particularly for high-yield): liquidity most quickly dry up when it is needed the most. e.g. High-yield ETF may find it hard to liquidate its assets amid sudden large redemption.
    • Individual loans: covenant light, underestimating potential defaults
    • US corporate – particularly those marginal borrowers with poor quality – may find it out to roll out debt; credit could be withdrawn with quickly.

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Low Risk, High Uncertainty

[The post was drafted in September 2017.]

Trader Smith: “S&P 500 is too expensive; VIX is too low. Hence VIX is to go up big time and am going to long VIX/buy options.”

  • Historically low VIX is a reason  (another one being high equity valuation) often cited to suggest market complacency and the need to long VIX, expecting volatility to go up. Indeed, VIX might seem low relative to the uncertainties facing the world, Brexit, North Korea nuclear threat, Trump, just to name a few.
  • However, (market) risk is not directly comparable to uncertainty. Low risk can sustain amid high uncertainty. It is vitally important to differentiate between market risks – which are trade-able a.k.a “known unknown” – and uncertainties which are often un-trade-able a.k.a “unknown unknown”.
  • Market implication: One should not long VIX simply because he believes that VIX currently looks low relatively to uncertainties. From asset allocation perspectives, relatively low VIX does not necessarily lead to the conclusion of reducing portfolio risks by selling equity and/or overweight gold and safe-haven currencies such as JPY and CHF.

Investors expecting VIX to jump to a substantially higher level usually cite two reasons: the US equity looks very expensive and the VIX currently seems very low relative to the uncertainties we are facing. And they usually like to blend the two reasons together.

However, those are two distinctly different argument. Each of them would open up a large and controversial debate. I will leave the valuation debate for now – there are points arguing for expensive US equity vs those arguing that US equity is fairly valued – and instead focus on the second reason: VIX looks very low relative to the uncertainties we are facing.

In general, the market knows how to trade risks. Uncertainty cannot be traded/insured against. Politics is a prime example that creates uncertainty, not risks; it is hard to put probability distribution towards politics. And political uncertainty is new to developed market, the anchor of pricing for the whole markets (including EMs).

Therefore, market participants often ignore uncertainty and take “wait and see” mode; i.e. react to uncertainty as the events unfold and take investment decisions only when the uncertainty declines. And materialization of uncertainty often leads to market disruption and jumps in volatility.

There are a few things we could do amid low risk and high uncertainty:

  • Worse case scenario planning and decision tree planning, so that one won’t panic when a negative outcome materializes.
  • Track the events as new information comes out to reevaluate outcomes.
  • Hold cash to trade out of events, rather than trade the events.
  • Differentiate between geopolitical risks that fade away easily versus political risks that have material economic impact.

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EM Value Stocks: A Way of Avoiding EM Bubbles

[Originally drafted end of September 2017]

  • Investors are rightfully concerned about the expensiveness of aggregate EM equity following 25%+ YTD return. And there are increasing signs of bubble in certain sectors, e.g. the sky-rocketing technology and Chinese property stocks that are listed in Hong Kong. However, there are compelling reasons to find attractive opportunities in EM equity, notably EM value stocks.
  • The technology sector – containing mostly growth stocks – seems to have done the heavy lifting on the EM rally. It is the only sector that significantly outperformed EM aggregate YTD. Other sectors’ rally looks much less extraordinary.
    • While EM equity has shared some commonality with the US equity this year so far – e.g. outperformance of the technology sector and growth stocks (relative to the market benchmark) –  the number of sectors that outperformed S&P 500 vs those underperformed are more or less equally split.
    • That means the EM investors seem to be particularly optimistic about the technology sector, while attaching less ambitious prospects on rest of the market. Therefore,one could still find lots of value in sectors other than IT, e.g. energy and banks, sectors containing lots of value stocks with low price to earnings and low price to book.
  • Signs of bubble (at least exuberance) in certain Hong Kong-listed Chinese equity, contributing to the strong rally in growth stocks.
    • Related to the IT hotness is the Chinese retail investors’s manic buying of Chinese equities listed in the Hong Kong stock market. Both prices and trading volume surged in Chinese property stocks (e.g. 400%+ return YTD in Sunac and Evergrande) and technology stocks (e.g. 80% return YTD in Tencent), following the Shenzhen-Hong Kong Stock Connect scheme.
    • There are good stories behind those stocks: previously low valuation in property stocks and strong earnings growth in Chinese IT companies. However, every bubble starts with good stories; the substantial surge in price and trading volume in a short period of time in large-cap stocks reflects trend-following behavior of hot money, a typical sign of bubble forming.
    • Surging trading volume makes H shares look more like A shares, and one should not unfamiliar with the bubble and burst stories in A shares, as recent as 2015.
  • In contrast, there are a lot of compelling reasons to invest in EM value stocks:
    • Decent international trade growth that supports EM growth, an environment favorable for EM value stocks
    • Tight labor market in the DMs supports DM inflation, supporting commodity equity such as the energy and material sector, sectors containing mostly value stocks
    • Fed’s balance sheet reduction and ECB tapering provide upside risks in long-term government bond yield and yield steepening, supporting bank equity, another big component of value stocks
  • Therefore, despite high valuation in US equity and certain EM stocks, one can still find attractive opportunities in EM value equity.

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Implication of Negative Chinese Credit Impulse

  • Negative Chinese credit impulse – given its significant impact on Chinese growth and base-metal prices – would probably be good news for DM equity (vs EM equity), base-metal importing countries (vs exporters) and DM non-commodity corporate credit.


This blog post has been partially inspired Trilogy Global Advisors:

I foresaw the negative Chinese credit impulse in November 2016 when Xi sent a very clear signal of credit tightening and regulatory clampdown on the financial industry. That let to my prediction of underperformance of Chinese A shares (vs other EMs) and less bullish outlook on Chinese overseas shares. Looking back at the 1H 2017, however, I have been wrong on three things:

  • The EM equity rally has lasted longer than I thought – I was a bit too early closing the positive call on EMs.
  • Base metal prices have held up better than I thought – they were flat in 1H 2017 as opposed to a decline.
  • There was an argument that the negative Chinese credit impulse creates deflationary forces on the globe, contributing to lower bond yields in 1H 2017 – which I didn’t fully think about.

In retrospect, the market performance again proves the (near) impossibility of market timing, i.e. timing the peaks and troughs of any market.

However, my argument on negative credit impulse end of last year still holds in relative terms:

  • Base metal price underperformed equity
  • Raw material equity underperformed aggregate equity
  • Chinese financial sector stocks (banks and property) underperformed EM equity, both in A-share and overseas markets

Looking forward, what would be the implications of negative Chinese credit impulse? Assuming no systemic crisis (e.g. sudden devaluation of CNY) that would send risky assets sharply down,

  • Base metals should underperform energy
  • base metal-importing markets should outperform exporting markets – opportunity arise in certain DMs; good news for Europe.
  • Within EMs, India and Turkey may continue to outperform EM aggregate.
  • Given the base effect of commodity price in inflation, ECB, BoJ and BoE still need to maintain a dovish tone despite talks of balance sheet reduction: opportunity in DM non-commodity investment grade credit.


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