I'm increasingly convinced that Japan will be the epicenter of the next financial crisis. It's hard to be surprised by the Bank of Japan's latest QE expansion, because I noted the possibility in a comment to Marketfy subscribers after Wednesday's FOMC meeting. However, the obvious collusion between the BoJ and GPIF, Japan's government pension fund, seems almost devious.
In case you missed it, just hours before the BoJ announcement, GPIF officials approved new allocation targets that will raise the fund's holdings of Japanese equities to 25% of the portfolio from the current 12%. Asset allocation is a zero-sum game, so in order to free up cash the fund will sell longer-dated Japanese government bonds (JGBs). GPIF's allocations are closely watched because a 1% shift means a transfer of more than $10 billion.
Conveniently enough the BoJ's ever-expanding balance sheet will start adding more longer-dated JGBs. The central bank literally can't buy enough T-bills on the open market (at negative yields), so it's shifting to a more liquid part of the curve; effectively subsidizing the public pensions.
Bank of Japan Balance Sheet as a % of Nominal GDP
Oh, and by the way, there are few signs this is working. CPI growth is non-existent even though the BoJ's balance sheet is now 60% of nominal GDP (chart above). The BoJ was already running the wildest monetary experiment in history before Friday's announcement, but now they're operating in a manner that would make Paul Krugman blush.
It's Election Day here in the US, not that anybody cares. The US ranks 120th globally with a voter turnout rate of 66.5%; nearly 30% behind world #1 Australia (94.5%). According to Nate Silver's FiveThirtyEight.com, Republicans have a 62% chance of winning a Senate majority and several gubernatorial races are considered toss-ups.
We made a few adjustments to our portfolio last Friday ahead of the vote. Republican control of Congress would have significant implications for several industries. For example, emerging threats like the Islamic State combined with a Republican Senate could lead to an easing of mandatory cuts in the US defense budget. The cuts aren't due to resume until 2016, but markets are always forward looking and will start to price-in these factors after the elections results.
We're not positioned very aggressively at the moment. I feel good about our uncorrelated bets and the returns have been steady. Heck, we're beating the hell out of most hedge funds this year. And that's just in stocks. I've had a monster year in FX, and not only because of the recent US dollar rally. I'm pressing Marketfy to add FX capabilities, and hopefully they'll be available soon. In the meantime, if you'd like to know what stocks I'm referencing please click here for more info. Your subscription will pay for itself in no time.
Today's letter will cover several topics, including:
- Buffoons in Brazil
- Greenspan sounds off
- Growth in airlines?
- Chart of the Week
As always, if you have any questions or comments or just want to vent, please send me an email at firstname.lastname@example.org.
Until next time, tread lightly out there,
Managing Editor - Cup & Handle Macro
Brazil is Baffling
Brazil is in a major pickle. The country re-elected President Dilma Rousseff last week proving they didn't learn any lessons from her first term. The economy contracted in the second quarter and is expected to do so again in the third quarter, which would make this Brazil's first recession since 2009. The unemployment rate is only 5.0%, but that's being driven by a decline in the participation rate - similar to the US. The real issue is inflation. The Brazilian central bank has an inflation target of 4.5%; a level that's been overshot since early 2010.
Brazil CPI Y/Y
Even in the face stagflation, last week the central bank hiked interest rates 25 bps to 11.25%, surprising analysts who had predicted no change. Throughout her campaign Ms. Rousseff warned the electorate that Aecio Neves, the pro-business candidate, would raise rates so high to quell inflation that he would cause a recession and high unemployment. First of all, the central bank is independent. The President has no control over interest rates. Secondly, Brazil is already headed for recession and capital is pouring out of the country. Alas, Brazilian voters know where their bread is buttered. Since Rousseff's party took control of the Presidency 12 years ago, the minimum wage has increased 84% adjusting for inflation; proving once again that elections can be bought.
iShares MSCI Brazil ETF (NYSEARCA:EWZ)
Rousseff must now convince ratings agencies that she knows what she's doing, which could prove to be difficult. Higher interest rates will help, but the Brazilian Real (BRL) is at risk of falling to the lowest level against USD since 2005, exacerbating the inflation problem in the process. Brazil's stock market has been in a bear market for several years now. Unless you have some reason to be optimistic on commodities, the Brazilian ETF (EWZ) should continue to be a short. If EWZ breaks through the previous low of $38/share it could drop to $30 very quickly.
Greenspan gets it
Even at the age of 88, former Fed Chairman Alan Greenspan still has a firm grasp of markets. Speaking to the Council of Foreign Relations last week, Greenspan said he doesn't think the Fed can unwind years of extraordinary stimulus without igniting some market turmoil. This sounds eerily similar to Julian Robertson's comments from September when he said, "bonds are at ridiculous levels, and the bubble will end in a very bad way."
While the Fed's bond-buying program has been a "terrific success" in boosting asset prices, Greenspan noted "effective demand is dead in the water" and the effort to boost it via QE "has not worked." Asked about opportunities in the market, Greenspan said gold is a good place to put money these days given its value as a currency outside of the policies conducted by governments. I might not buy gold in USD at the moment, but given his rationale, it would be interesting to know what Greenspan thinks about Bitcoin.
The Airline Graveyard
It's one of the most stunning statements in finance: "The airline industry, in its history, has never made money." It seems impossible until you remember the three largest legacy airlines - American (NASDAQ:AAL), United (NYSE:UAL) and Delta (NYSE:DAL) - have all filed for bankruptcy over the past 12 years. Not only that, but each has merged with another large carrier that had also sought legal protection from creditors.
In March 2013, Guggenheim liquidated its Airline ETF (ticker: FAA) after it failed to attract meaningful inflows. Since then, the HYSE Arca Global Airline Index has rallied more than 78% - one of the best runs in the history of airliners.
FAA had $21 million in AUM when it closed, more than 500 ETFs today. If it hadn't closed, it would have been able to cross the $50 million mark - roughly the amount an ETF needs to be profitable - on market performance alone.
NYSE Arca Global Airline Index
Why the turnaround? Airliners have finally started to make money. American and United both announced stock buybacks greater than $1 billion. American also announced its first dividend payment since 1980. As an industry, airliners reported record operating results in the third quarter, and management commentary suggests fourth-quarter results could be just as strong.
The increased profitability is occurring for two reasons. First, continued strong travel demand is allowing airlines to push fares higher. Even the threat of Ebola has had little impact on travel. Second, jet fuel prices, which account 1/3 of costs, have plummeted alongside crude oil. United cut its fuel bill by $135 million compared with last year's third quarter, a reduction of 4.1% on its largest single expense.
Should you get involved? If you think this airliner rally has legs I would recommend using the relative value technique we discussed in last week's note. Specifically, I would try to own airlines operating primarily domestic flights and sell international carriers. Southwest, for example, mainly operates in the continental US; whereas United flies everywhere. It even has a decent chart.
Outright exposure to airlines is risky, especially with a stagnant economy and the potential for higher oil prices. However, on a relative basis there is money to be made here.
Chart of the Week
In last week's Macro Rundown video I introduced a new theme highlighting EM countries vulnerable to a surging US dollar. I still think Turkey is the most vulnerable, but South Africa is running a close second. The unemployment rate is above 25%, CPI is running above 6% Y/Y, GDP growth has slowed to 1.0% Y/Y and the President is a crook. In fact, President Zuma went to court asking that affidavits saying he is a "corrupt crook" be removed. Not that anyone thinks South African courts are legitimate after the Oscar Pistorius trial.
US Dollar / South African Rand
Needless to say I think the South African Rand (ZAR) will continue to fall against the US dollar, but I'd like to highlight this remarkable chart. Since July 2011, USD/ZAR has tested this trend-line (which is more-or-less the 50-week moving average) upwards of six times and never broken through. Trends like this make managing risk very easy, because there is such an obvious stop-level. Some of you might not be interested in buying here after such a strong move, but the chart and fundamentals are indicating this rally is far from over.
**Editor's note: Every week we'll try to answer at least one reader question. If you would like to submit a question, please send us an email at email@example.com. We'd love to hear from you! **
Q: What's your opinion of Bitcoin? - EL
A: I've been meaning to write about Bitcoin for a long time, and will do so eventually. I am very bullish Bitcoin over the long-term. The big obstacle at the moment is an easy-to-use platform that makes Bitcoin transactions simple, but there are thousands of (very smart) software developers working to solve that problem. Millenials, especially those in Asia, are a tech-savvy generation attracted to the concept of a decentralized currency. Everything else in their lives is decentralized. Music, news, even personal relationships are all stored remotely via "the cloud" these days, so why not your savings? Bitcoin is outside the banking system, therefore immune to manipulation (even gold can't say that) and we know there is a fixed supply. That means the price will ultimately be driven by demand, and I think there will be a lot of it.
That's all, see you next week!
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