When an EM changes its exchange rate regime……

If an EM changes its exchange rate regime by notably changing the amount of flexibility/rigidity in its exchange, it usually has important implications on how its local equity would respond to future shocks.

If an EM makes its exchange rate regime more flexible, e.g. from hard peg to crawling peg, or from crawling peg to managed float, or from managed float to freely float, it implies that the currency value would be more sensitive to changes in external environment in the future. Its exchange rate regime should become more of a shock absorbing mechanism, e.g. more currency depreciation in the event of negative shocks to that the economy can regain some (export) competitiveness.

As the currency takes on more responsibility of absorbing external shocks, that means local equity (equity in local-currency term) should be more stable and less sensitive to shocks, even though equity in USD term may still have the same amount of sensitivity as before. That has important implications for equity analysts – when the exchange rate regime becomes for flexible, cross-country equity investment would see more of its volatility coming from FX volatility, rather than that of local equity. Prominent cases include Russian equity since 2011. Chinese equity may be slowly going through the same process as RMB becomes less pegged to USD.

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If the top 1% owns 40% of the stock market…

In the US, the top 1% owns 40% of the stock market, and the 10% owns 80%.

In other word, while company earnings come from nearly 100% of the population (think of Walmart), it is the risk appetite of the top 10% that mostly determines the valuation level of the stock market. And it is the risk appetite of the top 1% that significantly influences where the stock market valuation would end up.

Everyone is subject to fear and greed. So are the top 1%. However, due to their significant amount of wealth (relative to their daily expense) and high savings rate, the way they measure and perceive risks should be different from the median person in the population. But how different?

This question is still a puzzle to me. Wealthy people are usually assumed to be more risk taking than less wealthy counterparts, given their higher ability to sustain loss. But what else? Are wealthy people more or less myopic than others? Are they more or less subject to fear and greed than others? How do they perceive the relevance of diversification? Are they more or less subject to home bias? Lots of behavioral questions come to mind. And I wonder whether those behavioral economists have separate the top 1% from rest of the population when they investigate the thesis.

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Brexit, Trump, French election and the political system

The UK, US and France are all democracies, and yet they have different political systems in which the executive branch executes its power. The PM in the UK is backed by the majority of the parliament and can pretty quickly passes the bills he/she proposes in the parliament – no wonder some call the UK “democratic dictatorship”. The President of the US, in contrast, is constrained by the division of power and greater checks and balances by the Congress and judiciary. Executive orders in the US could be deemed unlawful. France probably stays somewhere between the UK and the US, as the country has a presidential as well as parliament system. When a French president needs to cohabit with the majority in the parliament that is not from his/her own party, obstacles to executive powers are apparent, particularly in domestic policies.

Maybe the difference of the political system contributes the “hardness” of the Brexit and the “softness” of the Trump administration? Maybe the French equity market is correct to be unnerved while the French government bond/CDS is a bit over-reacting to the election?

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Macron vs Le Pen, does it matter?

No matter who wins the French presidency, either of them has to co-habitat with other parties in the National Assembly. That means obstacles to implementing new domestic policies. That implies initial optimism/pessimism with whoever wins the presidency could quickly fade as people gradually discover that new (radical) policies are hard to get through in the French parliament. In that case, investors have to again “forget” about French politics and instead focus on fundamental analysis, e.g. the France/EZ growth momentum, ECB rate path and status of structural rigidity.

The nearer the election is, the sooner we need to forget about politics.

 

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Cyclical or secular bear bond market?

If you believe that income inequality causes low productivity which has led to secular stagnation, then Trump’s policy – tax cut and probably delayed infrastructure spending – seems to exacerbate inequality. Then secular stagnation is not averted. Low (real) bond yield is then here to stay. That means the recent rise in DM bond yield probably indicates a cyclical rather than secular bear market in government bond.

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The ECB “cut the rate” by 500bps, and yet….

According to Wu-Xia ECB shadow rate, https://sites.google.com/site/jingcynthiawu/home/wu-xia-shadow-rates, the impact of the extended ECB QE program since beginning of 2015 is equivalent to a rate cut of more than 500bps. The shadow rate is computed based on (mostly) bund yield curve.

Even though ECB QE has significantly pushed down the bund yield, EURUSD and EZ equity barely moved since 2015. Equity valuation measure such as P/B ratio barely changed from the end-2014 level. This is in sharp contrast with what happened during with Fed QE episodes (2010 – 2014) when US equity prices got a big boost from the unconventional stimulus. Even by ECB standard, a 500bps cut is a substantial cut within a short period of time.

In a word, the result of stimulus is disappointing.

What caused the disappointment? One explanation could be the clogged banking sector in EZ. Credit growth as % GDP has been steadily rising in the US since 2012, while the same ratio has been declining in EZ until stabilizing a bit recently. Despite 500bps easing, the EZ bank lending still does not keep up the pace with the economy.

And yet while EZ needs more credit to boost the economy, headline inflation is fast approaching 2%. Monetary tightening when credit growth is still weak? That would certainly dampen future growth in EZ.

Not jealous about ECB’s job. Draghi is right to be dovish. And the problem with the banking sector is immense – and only monetary policy is not enough.

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EM assets’ downside risks seem to be subsiding…

  • The Chinese and American leaders are going to have a talk, removing a key downside risk for EM trade outlook.
  • That NAFTA is to be repealed is in consensus…anything else bad could happen to Mexico?
  • USD stops rising rapidly, good (at least not bad) news for EM assets in general.

Any new downside risks (mostly unlikely, but who knows…)

  • Oil price back down to $40?
  • Base metal starts to correct as liquidity flows out amid Fed tightening?

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