This page has been archived and commenting is disabled.

Nomura's Sceptical Strategist On Why Correlation Risk Is Rising And What It Means For Inflation

Tyler Durden's picture




 

In his just released piece, Bob Janjuah's partner at Nomura, Kevin Gaynor, makes some quite profound and very contrarian observations on correlations, a topic discussed extensively on Zero Hedge in the past year. While the prevailing thought is that recently cross-asset correlations have actually dropped (in some cases to record levels), the truth is quite different: "While our colleagues in the Macro Strategy team have made a cogent case that price action in several markets reveals a more discerning behaviour and reduction in observed correlations, Bob and I have been coming around to a slightly different view. Many clients with whom we have spoken over recent weeks are becoming aware of the rather narrow sources of market drivers (two we would argue) and consequent similarities in terms of themes that have driven individual asset classes. It logically follows that anything changing the actual or expected state of those market drivers will have an impact on market returns across a range of risk types and geographies. More to the point, given the nature of those themes (mostly one way), we must be aware of the possibility for a non-linear response to linear changes in those market drivers. That's a fancy way of saying that correlation risk is actually rising in our opinion, as two themes appear to be dominating markets – western liquidity injections without leverage or EM FX appreciation and EM as the source of marginal final demand. These two potent forces have come to dominate the return environment. Consider leadership in DM equity indices since March 2009; it is basic materials and industrials and more lately oil and gas. Ex those sectors, western stock market returns would look rather more threadbare. But perhaps more the point in terms of the non-linearity issue is that the beta of the major indices to these sectors has naturally risen over the past 2 years. Whereas in the past, one had to broadly get financials correct to have a decent stab at calling equity returns (a gross oversimplification I know), it now seems to be the CRB sectors you need to get right." The follow through of all this, and it can be read below, is that the 30 year "great moderation" is rapidly ending and the inflationary threat is now very close, and would be EM driven. At that point none of the Fed's emergency tightening policies, no matter what Alan Blinder's textbook says, would have any impact whatsoever.

The Sceptical Strategist: Correlation Collision Part 2, From Kevin Gaynor of Nomura

Strategists love a good tale. The best ones are those that have a beginning, middle and end. Bob and I have been fairly convinced about our understanding of the basic framework of what has been and is driving returns (that's the beginning), felt we had a view on what would happen to those drivers (the middle), but had been missing a key component in the story (the end). We think we've put the final piece of the puzzle in place and as this piece's title hints, it has to do with high potential cross asset return correlations, rather reminiscent of the 2007 and 2008 (some may recall our publication around that time on this issue) period except this time without the high level of private sector leverage. We feel that the recent wobble is a cracking good example of how this works and it deserves serious thought and scrutiny.

My last note set out a framework for thinking about asset allocation from the perspective of EM vs DM growth in which I argued that the two “regions” are still intimately related from a dynamic point of view. Faster domestic demand in the West would, I argued, result in faster aggregate growth in EM, and slower EM capital spending would result in slower aggregate growth in DM.

The question as to whether we ended up in “slower/slower” or “faster/faster” would be answered by how EM policy makers decided to react to a worsening trade off between price increases and growth. Bob and I at the time expected EM policy makers to respond to higher inflation via tightening policy, with a soft landing being the target. This led us to think of the “slower/slower” space as our central case. While we thought this scenario would have generated a correction in markets, it would be a correction one should be looking to buy into reasonably early on, since we felt it would take some of the steam out of the global economy and set western consumption up for continued steady improvement and ease overheating pressures in EM.

Events moved on though during the spring which changed the calculus for politicians in EMs. If we crudely put the policy choice as either higher unemployment or higher food prices, it seemed that the lesson learned from the Maghreb and Gulf was: attempt to accommodate price increases through subsidies and direct price setting in order to minimise the severity of that unpleasant policy choice. In fact, some policy makers seemed to have been comfortable pointing the finger at the Federal Reserve as the primary source of the worsening trade off between growth and inflation, and to underplay domestically generated demand/supply imbalances. In the absence of an increasingly politicised move in currency regime, something had to give.

In the context of our “slower/slower? vs "faster/faster? debate, this put the dénouement back in time but amounted to the “faster/faster” outcome in terms of asset prices. To remind you, that outcome indicated higher risk assets, further quite  substantial increases in commodity prices, higher BEI, curve flatteners and USD index weakness and extensions of carry trades, and volatility declines.

In other words that outcome favoured more of the same but at a faster pace. The attendant risk of a subsequent hard landing in markets and the economy would be that much higher in that scenario. We need to discuss why.

While our colleagues in the Macro Strategy team have made a cogent case that price action in several markets reveals a more discerning behaviour and reduction in observed correlations, Bob and I have been coming around to a slightly different view.

Many clients with whom we have spoken over recent weeks are becoming aware of the rather narrow sources of market drivers (two we would argue) and consequent similarities in terms of themes that have driven individual asset classes. It logically follows that anything changing the actual or expected state of those market drivers will have an impact on market returns across a range of risk types and geographies. More to the point, given the nature of those themes (mostly one way), we must be aware of the possibility for a non-linear response to linear changes in those market drivers.

That's a fancy way of saying that correlation risk is actually rising in our opinion, as two themes appear to be dominating markets – western liquidity injections without leverage or EM FX appreciation and EM as the source of marginal final demand. These two potent forces have come to dominate the return environment. Consider leadership in DM equity indices since March 2009; it is basic materials and industrials and more lately oil and gas. Ex those sectors, western stock market returns would look rather more threadbare. But perhaps more the point in terms of the non-linearity issue is that the beta of the major indices to these sectors has naturally risen over the past 2 years. Whereas in the past, one had to broadly get financials correct to have a decent stab at calling equity returns (a gross oversimplification I know), it now seems to be the CRB sectors you need to get right.

Naturally, to the extent this is being driven by the USD itself, the S&P has developed a rather worryingly strong negative correlation with the USD. A weaker Dollar drives up commodities which in turn drives up the sectors that have become the market leaders and hey presto we all feel better. Well it is sadly not that easy for two reasons; 1) higher commodity prices act as a transfer of income and 2) it now seems that the beta between the USD and commodity prices is RISING. This may be a by-product of a market desperately attempting to clear itself, and/or rank speculative herding as behaviours are adapting to language like “extended period” and extrapolating ultra-loose monetary policy into the far future. Indeed, this is probably a good point to segue for a moment, and relate the latest version of that thinking, which is that the Fed should a) not be fought (standard thinking of course for years), but b) that QEIII will be rapidly implemented if stock values fall by as little as 5-10%. Thus, the Fed put has a trailing strike 5% below the spot price and will, so long as unemployment remains above, say 5%. Therefore don't be so worried, just remain long risk assets in general and commodity assets in particular, and let the bond market go hang.

The logic is, as most fallacious arguments often are, dangerously compelling but sadly specious on three levels; first it assumes that there is no cost to be paid by anyone important enough to matter by pursuing this approach (and this from a team that cheered both QE I and QE II!), second is that the political climate allows the Fed the latitude to just do more, as and when required with impunity, and third is that QE III would be more of the same rather than something fundamentally different in terms of size, or more importantly asset classes bought.

Moving back to the original topic, that rising USD/CRB beta is a problem for EM because it sends the signal that if nothing changes, then not only will their growth/inflation trade off worsen, but it will worsen at an accelerating rate. In other words, the price of delay in terms of the lost output required to stabilise inflation will be larger if the structural coefficients do not return to something more helpful. Now this is clearly a particular problem in economies with wage and rent indexation, since some of that deterioration is being locked in.

The side effect is a relatively rapid real currency appreciation for those EM economies pegged to the USD, for the simple fact that the energy and food intensity of the US economy is lower than the EM economies. So in that regard, the Fed's policy is to some extent achieving the important adjustment in the USD that all seem to want to pin their growth hopes too – an increase in competitiveness as the route to grow GDP sufficiently in order to make debt concerns wane.

One might argue that the “policy” is demonstrably working since charts show that the bulk of US value added growth since 2009 has come from the goods sector. Well, that is true but probably not due to a weaker USD. First, trade balances worsen when you devalue (remember the J-curve?) and second, in most models of trade demand variables tend to trump competiveness variables in the short-term (i.e., up to 2 years).
Instead, the direction of travel of the real USD against these countries is no doubt correct. However, it is the speed of travel as of late that is making both of us nervous, since it appears to be aiding behaviour which is backing EM in to a policy corner at an accelerating rate when global growth is still highly dependent on these countries' fiscal and private sector demand. In addition, it is putting western low and fixed income consumers into a real income squeeze without the luxury of resorting to credit as a temporary boon or asset price appreciation in any way commensurate with commodity and stock price appreciation.

The irony is that EM total factor productivity – labour and tech transfer and FDI sourced capital – has been so strong that it has absorbed the now 10 year boom in commodity prices that have gone hand in hand with the 10 year USD bear market and EM growth miracle. Commodity “shocks” slow productivity down and magnify the worsening growth/inflation trade off even more. For us in the west that have seen rapid margin expansion combined with P/E increases (driven, we argue, by policy), the sweet spot is probably behind in this regard as pass through pressures must be building. Meanwhile the legacy of that margin expansion is modest wage growth to which one would ordinarily be looking as the source of funding for the next round of expansion/consumption.

Naturally, some economies are more exposed to any change in both the key drivers of returns. Those with large manufacturing sectors will fare worse, those with policy flexibility better. This puts some European economies right at the forefront of risk from changes in US, ECB and BoE liquidity (pillar 2 of the global reflation) and tighter policy/slower growth in EM (pillar 1). We would both be very pleasantly surprised if Sweden, Norway, Germany, Austria et al would maintain consensus and official forecasted growth in 2011 and 12. While in the US, it is probably more the case that any aggregate growth slowdown shouldn't be too bad, rather that the composition would look a lot more service orientated than of late.

The reason we wanted to highlight the asymmetric GDP growth risk in Europe is of course in relation to funding maturing private sector commitments in CMBS etc. and some smaller government bond markets. It has been tragic to observe the workings of the actors when there isn't a script but chilling to realise that this play has been happening during what is being described as a German growth miracle. We'd both be intrigued to see how the actors perform when they are having to ad lib and tighten all the Götterdämmerung commando's belts at the same time! At least some euro area governments have long duration markets and strong domestic demand for debt – think Italy.

So where does that leave Bob and myself? To summarise our take:

  • Global manufacturing is late cycle and has probably already peaked.
  • EM policy makers are unlikely to be able to loosen with sufficiently speed to turn the cycle quickly. In any event, more capex really wouldn't be sensible.
  • A soft landing in the EM world would be a fantastic outcome.
  • But positioning has become extended in some markets, and when considered across markets it is probably overextended in the same underlying risk dimensions and themes. This could turn a modest slow-down into a correlation and liquidity rout with substantial knock effects on western demand.
  • The addition of liquidity in the west is coming to an end and we think it is unlikely to return in the same guise unless risks of a hard landing materialise.
  • For the west, two-way volatility in commodity prices could produce another bout of falling CPI – but that could turbo-charge equity market rotation for a while, at least as real consumption relatively benefits – but less so in the EU and UK than in the US.
  • Sector rotation into the real economy related sectors makes sense, but defensive or not is up for debate.

In short, we believe that risk assets do not offer good risk reward characteristics now, whereas quality government bond markets do at least cyclically. And the clear losers would stand to be commodity prices and related assets while the winner initially at least would be the USD and similar currencies.

Looking back it now seems that a fundamental shift happened in mid 2001 to the commodity and currency world, a shift which has been ongoing since and that has affected the global supply side inflation picture around dramatically. This shift has not been analyzed before as far as I'm aware, but in fact, it appears to have dominated asset returns over the period. The US Dollar measured against its broad index shifted from being in a quasi permanent appreciation since the breakup of Bretton Woods, into a depreciating phase which is still going on today. The CRB index, which had been in a broad cycle since the 1960s, shifted into a turbo charged increase phase. Not surprisingly, the basic materials and oil and gas components of the global equity index shifted into a major bull phase at the same time and have together been the two best performing sectors over the period.

This shift coincided with China's membership in the WTO and the outsourcing of production post the equity bear market. This period has seen a substantial move toward a higher headline/core CPI index ratio in the US and other western economies as world commodity prices have trended higher. To the extent that the front end of the US bond is much more correlated to core rather than headline inflation (since the Fed is a core inflation targeter), short rates have not fully reflected this divergence. Considering the funding needs of the US, front end rates are more important than ever for the fiscal balance situation; which is analogous to the cost of funding for a debt stock that is being rolled rapidly.

Why hasn't core inflation tracked headline? We would argue that it is reflected in EM productivity growth and the growing export market share of China (see Figure 6). China's share of US imports is now approaching the peak levels achieved by Japan in the 1980s. As a result, we fell nervous about secular views that rely implicitly on this share rising forever. Truly then, we need to consider whether the twin pillars of market returns since 2009/2010 are not just cyclically extended, and now positionally extended owing to the Arab Spring inspired pause, but coming to a secular shift as well.

 

- advertisements -

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Fri, 05/13/2011 - 11:36 | 1271855 FOC 1183
FOC 1183's picture

intraday correlations have, if anything, increased.  and clearly bob has revrtd to abbrvtns snce they wil not evn let hm wrte anymre

Fri, 05/13/2011 - 11:39 | 1271861 RobotTrader
RobotTrader's picture

Markets are still 100% correlated.

Some mining stocks were up 3% this morning and as soon as panic buying in USDX emerged out of nowhere (The Fed, obviously was buying), the 3% gain in the mining stocks was erased within seconds.

Uncle Gorilla is determined to make sure as many "anti-dollar" hedge funds are obliterated before June 30.

 

Fri, 05/13/2011 - 11:46 | 1271888 centerline
centerline's picture

When the correlations end, it will be the pension funds that take it in the rear.  Those demanding... requiring yield... have been chased into risk assets and leverage.  They have been rounded-up and will be clubbed like baby seals.  That's probably the moment the States will finally roll over.  Until then, party on!

Sat, 05/14/2011 - 17:27 | 1274703 Smiddywesson
Smiddywesson's picture

"Who are you who are so wise in the ways of science?" - Monty Python and the Holy Grail

I'm on board with that 100%  Hedge funds and fund managers in general who live and die by leveraging what worked recently are going to be slaughtered when the manipulators change their game.

Fri, 05/13/2011 - 11:39 | 1271866 machineh
machineh's picture

EM = Emerging Markets

Not clear in the front-page excerpt, due to lack of context.

Fri, 05/13/2011 - 11:42 | 1271876 PulauHantu29
PulauHantu29's picture

But wait just a second fellow, The Bernank just said,"I am 100% confident I have 100% control of 100% of the inflation problem if it arises."

So The Bernank does not see The Inflation as a problem. He is "100% sure" of it.

 

Fri, 05/13/2011 - 12:28 | 1272045 unununium
unununium's picture

He can control it by raising rates in 15 minutes.

Ergo, 15 minutes is an "extended period".

Fri, 05/13/2011 - 11:44 | 1271884 RobotTrader
RobotTrader's picture

The Hubris at the Fed must be near world record levels.

They are confident that inflation has been whipped, and currency-induced cost push hyperinflation will be stopped dead in its tracks with instantaneous margin hikes across the board.

Fri, 05/13/2011 - 12:07 | 1271931 Dr. Engali
Dr. Engali's picture

Margin hikes will only slow the pace temporarily. The money will still flow into commodities. They may win small battles but they will still lose the war. 

Fri, 05/13/2011 - 14:41 | 1272474 DosZap
DosZap's picture

No they won't lose, then comes the "C" edict.

EO, or a PDD.

Turn it in, or else.

See the objective is to make everyone, a Felon.

No rights battles to fight then.

Fri, 05/13/2011 - 12:11 | 1271970 SoNH80
SoNH80's picture

I'll get out the champagne when my grocery bill stops increasing month after month.

Fri, 05/13/2011 - 11:46 | 1271891 TooBearish
TooBearish's picture

Tyler pretty impressive volume in TYM and FVM today

is Pimco capitulating?

Fri, 05/13/2011 - 12:11 | 1271967 Commander Cody
Commander Cody's picture

They were looking for a better entry point.

Fri, 05/13/2011 - 11:54 | 1271907 RobotTrader
RobotTrader's picture

1.2 million block trade just went through on UUP, which just punched to new highs for the move.

XRT is still unfazed, only down about 18 cents.

Fri, 05/13/2011 - 12:00 | 1271920 NOTW777
NOTW777's picture

watch 1.4123 on euro

Fri, 05/13/2011 - 12:07 | 1271947 NOTW777
NOTW777's picture

gone

Fri, 05/13/2011 - 12:30 | 1272054 citrine
citrine's picture

The active contract crossed the 1.4079 Pivot point and bounced back.

Fri, 05/13/2011 - 12:02 | 1271923 dbradsha
dbradsha's picture

Only correlation I see is NFLX, CMG and OPEN. All up, always up. I have visions of all the unemployed booking their Mexican restaurant through Opentable and going home to watch an online movie. As the unemployed grow so do these 3.

Fri, 05/13/2011 - 12:06 | 1271927 SoNH80
SoNH80's picture

This article is fucking gibberish.  Worth posting, to show how "analysis" pumped out by the I-Banks is a bunch of sophistry, using tricked-out jargon to confuse the client.  Trust an investment banker to use 50,000 words when a few will do.  The U.S. has failed to keep its fiscal house in order.  It is printing money to cover a large part of its deficits, and for "mad money" to give to politically favored recipients.  Inflation results. Meantime, the U.S. consumer is overloaded with debt, and faces a bad employment picture.  This is a drag on growth. Using official inflation statistics is a fool's errand.  There, points made, without migrane-inducing run-on sentences.

Fri, 05/13/2011 - 12:32 | 1272051 unununium
unununium's picture

+ unit identity singularity

 

Fri, 05/13/2011 - 12:44 | 1272098 purplefrog
purplefrog's picture

Thanks, I thought it was me.

Sat, 05/14/2011 - 17:39 | 1274718 Smiddywesson
Smiddywesson's picture

I thought it was me too.  Only proves, we are all programed and need to question the Matrix on a regular basis

 

I think this article fell far below the usual ZH quality.  

Fri, 05/13/2011 - 12:10 | 1271964 The Axe
The Axe's picture

Robo is correct about UUP.huge buys..big...feels like NY FED

Fri, 05/13/2011 - 12:15 | 1271988 Boston
Boston's picture

"In short, we believe that risk assets do not offer good risk reward characteristics now, whereas quality government bond markets do at least cyclically."

Ahem,

J. Gundlach: 3

Bill Gross: 0

 


Fri, 05/13/2011 - 12:36 | 1272078 Quinvarius
Quinvarius's picture

Which means any currency induced moves should be faded in PMs and stocks because everyone now thinks they matter.

Fri, 05/13/2011 - 12:48 | 1272127 oogs66
oogs66's picture

perfect timing...gold, eur, oil, es all moving lockstep today

Fri, 05/13/2011 - 13:01 | 1272172 bbq on whitehou...
bbq on whitehouse lawn's picture

I would add that this summer EM will start to raise interest rates but not enough to slow inflation in those countries.

The dollar will strengthen while gold holds its price level or strenghens right along with the dollar.

Only question is degree. Inflation will come on strong in the EM, BRIC and almost everywhere outside the US. Even China may find its currency weakening.

Most of the gold buying happens outside the US so even if the dollar rallies its unlikely to effect the price of gold, as demand increases.

Some EM players will likely welcome their weaker currency to help with exports but they forget commodites will not drop as expected.

Thats my take. We will see.

Fri, 05/13/2011 - 14:59 | 1272513 DosZap
DosZap's picture

Martin Armstrong see's a $1,279.00+/- re-trace.

 www.jsmineset.com

Fri, 05/13/2011 - 13:04 | 1272177 ZOZO Smith
ZOZO Smith's picture

Nice interactive map about food deserts in the US

http://www.ers.usda.gov/data/fooddesert/

Fri, 05/13/2011 - 15:03 | 1272523 Ted K
Ted K's picture

I like this type of post very very much.  This is what makes ZeroHedge worthy to me.  I know the "let's all pee in our trousers Keynesianism is here" gets more vacuous comments (mainly because 90% of ZH idiot commenters haven't yet figured out what Tyler calls "Keynesianism" is really Greenspanism) But this type stuff from Janjuah and Gaynor is real analysis for those who don't masturbate daily to Hayek and those who push panic city button to stimulate gold sales.

Tue, 05/17/2011 - 11:47 | 1283202 SoNH80
SoNH80's picture

If you consider this to be "real analysis", I don't want you to manage my money.

Do NOT follow this link or you will be banned from the site!