Moscow Notebook May 2013

My latest four day trip to Moscow sheds some light on the frustratingly difficult situation in Russia this year.

I have been positive about the prospects for the Russian equity market for over a year now, with little to show for it. Since impressively recovering from the desperate lows of the financial crisis, Russia’s market has been trapped in a long-term corridor.

Restrained global growth has capped global commodities prices, impacting both corporate and fiscal cash-flows. Revenues have struggled and the nation’s monetary policy mechanism has stalled as the central bank has shifted from FX to inflation targeting.

GDP Disappoints

With GDP growth declining, the need to restrain inflation became a clear priority, and the central bank is well on the way toward building a credible reputation as an inflation fighter. But, the immediate benefits of such a development might well be capped by the costs, as there are serious questions as to the role of interest rates in setting Russia’s inflation today. It can be strongly argued that inflation is more a function of bottlenecks in the economy and over-reliance on the state sector.

But in fact, beyond the macro debate, investors would do well to note that the situation in Russia is not nearly so bleak as weak economic statistics imply.

A Bustling Vibe

I landed in Moscow, as usual, in the darkest hours. Twenty-four hour culture is one of the great features of modern Moscow, and nowhere is it more obvious than in the city’s airports. Of course, this partly reflects a lack of capacity, but it also reflects Russia’s attractive location between Asia and Europe. There are appealingly timed flights arriving and leaving at all hours of the day.

What was interesting about landing at Domodedevo in late May is that the airport was busier than I’ve seen it for many years. Passport control was completely backed-up, as it regularly used to be ten years ago. Russia’s airports are close to bursting as tourism booms. And reassuringly, despite the crowds, the queuing was orderly, the mood friendly, and frankly the service was swift. I was out and riding into town far quicker than I expected.

The situation at the airport caught my attention in large part because just days before, Russia had reported first quarter economic growth of just 1.6%. Yet another disappointing step down in a protracted cool off, which is heavily impacting international confidence, but bears little relation to what one observes inside Russia.

Political Battleground

That economic growth is struggling, no one denies. The debate about how to fix it is on everyone’s lips, not least because it encapsulates the fascinating political debate about whether or not the Medvedev government can survive, as political challengers step up their campaign against him.

Russians love a good political intrigue, and today they are being treated to one that has broad-reaching implications. Much is changing in Russia, as the rules of the naughties naturally expire. Government is tightening down further on political liberties, but the economic compensation it once promised in return is evaporating. The economic liberals are locked in an ideological campaign with the siloviki, who many now think have the upper hand, and who would further advance the government’s role in the economy.

  

This political showdown might well explain the increasing hesitancy among domestic investors towards starting new projects. Russia’s political future is an overwhelming issue. Even with five years of presidency ahead. And the question of whether or not the government ramps up economic influence, or backs away and gives business the freedom to flourish, is paramount.

Don't Trust the Numbers

But, the present isn’t so bleak either. Being in Russia at the moment is a reminder that the emerging markets story is still alive. Headline economic data are repressed by the dominance of the natural resources sectors. If commodities prices are repressed, so are profits, taxes and investment. Such has been the case lately. But this doesn’t mean the rest of the economy is out for the count, far from it. Russians are locked out of large swaths of the economy, but they are constantly finding opportunities and niches, and continue to believe that the future is bright. Business is flourishing to an impressive extent already, if it could see the future path of political development, it may flourish all the more.

This optimism is in large part because life in Russia, at least in Moscow, continues to improve. Russia’s opposition movement took to the streets when the government cheated Muscovites out their votes in the parliamentary election. (More so than in the presidential election, which the Moscow vote wouldn’t have swayed anyway.) When the Moscow Mayoral vote comes around in 2015, the government will need a clean fair win. Democracy will prevail, because rigging the vote would cause chaos. And the best way to assure itself of a win is to dedicate the next two years to improving the quality of life in Russia’s capital. Hence, even the Muscovites, the most demanding of Russians, are optimistic about the future.

The political issues remain at the forefront, they are impacting investor confidence. And economic policies are an ongoing concern, both fiscal and monetary. But Russia is far from being the lost case that the economic data imply.

Why I'm Not Afraid of QE Ending

Markets dipped at the end of last week, in reaction to FOMC chairman Ben Bernanke's comments that quantitative easing might end earlier than consensus had assumed. Now is a good time then to lay out my view how the ending of QE will impact markets. 

Many are arguing that the equity market rally has been liquidity fuelled, and that its ending can only be bad for investors. As is often my want, I disagree on both points.

First, whilst central bank policies have certainly helped the rally, there is little evidence that they fully explain the current market level. Equity prices are generally in line with earnings expectations. Therefore, arguing that this is a liquidity bubble is tantamount to claiming that earnings themselves have been propped up by QE. I doubt that is true. I think QE has eased debt costs during a painful structural adjustment, and has averted a far worse outcome. But I find little evidence it has directly driven earnings (except perhaps in areas of the housing and real estate financing markets). Importantly, if QE had driven earnings, then surely the Fed would be able to claim its policies had achieved their goal?

Earnings, I think, have benefitted from ongoing global growth and shifting economic balances (such as labour losing so much of its negotiating power). And prices are consistent with earnings.

What about the impact of QE? Certainly it may bring some initial selling, as we saw last week. But such selling is likely to represent a buying opportunity. Why?

First, the Fed will surely learn from Japan and do too much before it does too little. So the economy will likely sustain as QE tapers out. The Fed only went hard into mortgage securities when the housing market was already turning, giving its policy a tailwind. It will surely use the same tactic with the process of winding up QE.

Second, much of the money I talk to is playing cautious. Either on the bench, near to it or still biased to the bear side. The single greatest reason I know for this resistance to engage on the bullish side is nervousness about if or how QE will end. Once the path is reasonably clear, and there has been a steam-venting price dip, I suspect a lot of cautious money will start to get involved. Why? Because the systemic/fiat currency fears will ease, and the economy will be in reasonable shape.

Not to say QE has really worked. It's main contribution is surely having prevented something worse. The Fed still looks to be wrong about the structural impact of the crisis - the US remains on a sub-par growth path with high long-term unemployment, despite sustained government spending (including on benefits).

But if we define reasonably fairly what the Fed's goals were, then it has done ok. Getting out does remain a challenge as recent government finance improvements are unlikely to sustain. But there is little reason to expect the patient to show addiction as the liquidity drug is removed. Longer term relapses are a far higher concern, at least to this analyst.

Consolidation Foretold...

Please note, this week's investment letter was written before Bernanke's testimony. Contact me to subscribe.

The bullish developed world equity market trend continued over the past week, with the S&P 500 rising another 2.1% and European stocks gaining 1.2% on the week. Economic data released were mixed, implying that some of the rally may have come from expectations of continued central bank liquidity. The emerging markets saw prices decline, indicating that the flow of money toward the developed world economies continues.

The global emerging market story is far from ending, and will ultimately benefit further from improvements in the developed world, but reports of Japanese GDP growing at 3.5% in the first quarter support the historical norm of allocation rebalancing at this phase of the global cycle.

It is hard to say that equity prices are excessively high, and we remain confident that the growth cycle will continue. However, the market’s trajectory is beginning to look over-extended once more, whilst economies continue to only slowly digest long-term economic issues.

Short-term capital allocations should be managed very selectively. Entering cheaper stocks is still possible, as valuations remain dispersed. Resource stocks have in many cases under performed, but infrastructure demands remain high globally. There is a strong case for consumer stocks too, as Asian demand is likely to improve and European demand is possibly nearing its low. For diversification purposes this week we suggest to look at gold again. 

Monaco & The Sell-In-May Fallacy

Sell in May, go away. That’s what they say. It has been an effective strategy in recent years, although the date you needed to come back has varied each year. In any case, over the next weeks we’ll get to understand whether this simplistic trading rule will work again this year.

Many are shouting it from the rooftops. To be sure, there are plenty of negatives to point to as triggers, and asset prices do look high, if you can interpret such information from simplistic time series charts. If May does prove to be a down month, then those currently shouting from the rooftops will transform themselves into oracles. They “knew” because it was “obvious.” But they don’t know, and it’s not obvious.

In recent years, financial markets have often been compared with casinos, and the comparison is understandable as in both places economic outcomes are dependent on the uncertain path of the future, and – dare I say it – a degree of chance. Yet, there are some important differences.

Games of chance are defined by a negative probabilistic outcome, the house always wins in the end. And each iteration of the game is fully independent of previous iterations. Thus, in Monaco in 1913, it was possible for black to come up on the roulette wheel no less than 26 times in succession. Each time it happened, players became ever more convinced that the next outcome would be red. They were wrong to believe it; the roulette wheel has no memory so each round of the game had a fully independent outcome. (This event became famously known as the Monte Carlo Fallacy.)

The sell-in-May fallacy is slightly different. Whilst the statistics surrounding this phenomenon can be argued in both directions, depending on your choice of measurement, time period and averaging, there is unarguably a degree of seasonality to markets. And the statistics of autocorrelation tell us that, unlike die, coins or roulette wheels, equities do in fact have some memory. A move up is more likely to be followed by another move up.

The seasonality of May is for higher volatility. Partly this is reflexive – volatility is caused by investors trying to avoid volatility. Other possible triggers are the shifting of the northern hemisphere from spring to summer, which changes the tempo of society at a biological level (see John Coates' research) and the payment of dividends, after which equities naturally tend to decline.

So, May does have a seasonal tendency, but it is not definitively biased towards selling. And even though stocks do have some memory, it doesn’t trump fundamentals. These should be interpreted independently each May. And here we see reason not to automatically sell this May, despite supposedly high prices.

Indexes may look high, but it is arguable that valuations do not. In the latest World Economic Outlook, the IMF notes that when compared to cost of asset replacement, equities actually look cheap. More important, the economic cycle takes longer than a year to play out, so by definition we are not repeating the same part of the cycle this year that we experienced last May.

It is true that Europe is still in recession, but this is not out of line with expectation, and should give way to improvement in the second half of the year. It is also true that US economic statistics have weakened in recent days. This too is in line with expectation. The reason the US economy is slowing is because government spending is declining. This can be read positively. Nations influence economics through fiscal spending and interest rates. When interest rates start rising, financial market volatility initially rises. Then it calms as investors recognize that rising rates are pursuant with a strengthening economy. The same should be expected of fiscal tightening. Initially it causes uncertainty, but ultimately it reflects a healthy aspect of the cycle, even when politics are difficult.

Over in the emerging world, the story is even more clouded. Those arguing that the emerging markets are a simplistic commodities-construction play have been disappointed. China is showing signs of a slowdown, yet the mood in Asia is as positive as ever, few on-the-ground believe the emerging markets story is over – local consensus is that it is evolving.

Chinese growth over the next five years will continue to drive the global economy, supporting a wide range of exporters in the West; and dovetailing with the US growth cycle. Japan has sparked expectations of increased demand too. All of this will ultimately aid Europe. The growth cycle is far from finished.

Sell in May if you will, but don’t claim it’s obvious, it isn’t, and who can say with certainty when is the right time to buy back? The prudent course is to hold quality positions, and continue buying if volatility creates an opportunity to do so.

Cyprus & Systemic Risk, It's Worse Than You Think

In an optimistic scenario, the risk that the Cyprus affair symbolised reached its zenith as leaders raced to meet the ECB’s deadline last weekend, and will continue to fade from here on. This is an optimistic scenario though, as a glance at the headlines shows.

Despite the many powerful waves of financial crisis that we’ve lived through, few issues have elicited as much apocalyptic language as Cyprus, and deservedly so. Even if Cyprus does fade out of the market’s focus now, there is an elevated risk that we’ll come back to it in the future as the event that first underscored how successfully the ECB backstop was suppressing risk within the system. I’ve talked many times about entering a new era, where interventionist policies determine economics and markets. Cyprus goes down in history as the first clear global macro event that demonstrated such policies in action.

The island’s crisis may also come to be remembered as the time that European leaders finally exposed the world to their collective lack of understanding and inability to achieve politically and economically balanced share of responsibility.

In my best judgement, the sequence of events must have gone something like this:

- Europe agrees to help Cyprus, and puts a weighty sum of capital on the table, but refuses to carry the full burden when so much foreign money is parked in Cypriot banks (this money clearly found shelter in Cyprus on the assumption that depositors won’t ever be hurt, be they insured or not).

- Cyprus bulked at the socioeconomic cost of destroying its largest sector by inflicting losses on an investor group that Europe had thus far protected. Responding to Europe’s demand for a domestic contribution, it took the path of writing down all deposits, an understandable move to signal to foreign account holders that this wasn’t something targeted at them. Such a move of course also threatened to unravel the European banking sector. At this stage, Europe should have blinked but didn’t.

- Instead, the Troika then let Cyprus announce an extremely dangerous plan, and the chaos of negotiations in Russia, deadlines from the ECB and readjustment to a more reasonable plan followed.

Cyprus is an exceptional case, and deserves to be treated as such. But, the genie is out of the bottle now, and genii are like toothpaste, very hard to get back in. Uninsured depositors are now at risk. Even insured depositors have had a shot across their bow. When the data is available, expect to learn that deposits reduced across much of Europe over the last weeks, as investors reacted sympathetically.

Europe’s banks were already struggling with capital requirements, even whilst being perpetually bashed by the media. Now they face a new pressure in the danger of depositor retreat. Euro-dollar exchange rates will be a good indicator of how market confidence is holding up going forward. And wholesale funding will become ever more important once more.

Equally importantly, in calling Cyprus’ bluff, the EU once again gave a nod to misapplication of capital structure, allowing bondholders to remain whole. Some of that was officially reversed as Laiki bondholders are finally taking the hit. But in the case of BoC it is not yet clear whether they have skirted the axe. They should not be allowed to of course. There should be a clear legal case against the hit on deposits ahead of senior bonds.

This capital structure point notwithstanding, the messy bailout of Cyprus has reached a reasonable conclusion. The Cypriots knew they were pushing the limits allowing in so much foreign capital, the foreign investors knew they were relying on moral hazard to protect their deposits, and Europe turned a blind eye. All have taken a hit, and a full bailout was neither reasonable nor frankly feasible, given the debt dynamic it would have unleashed.

The problem, more than Cyprus, more than capital controls in the Eurozone, is where things go from here. The ECB’s promise to do whatever it takes to keep the Eurozone whole was noble and impressively designed. But we have seen its dark side in recent weeks. We have now seen how spectacularly far we can drift from economic reason, without markets reacting. Market pricing is an important aspect of risk recognition, we now know it is totally dysfunctional. The open free market era is officially over.

BP Technics

I'm no technical trader, but this is impressive.

Stuck in Cyprus? Head to the Beach Perhaps...

The information below is based on quality media reports made today (March 25th). However, at this stage there is very little official information published about the agreement, so important details may be subject to change.

1. Bank Popular (Laiki) will be closed. Accounts less than Eur100k will go into Bank of Cyprus, which will get support from the ECB. In cases where accounts have more than Eur100k, it is not formerly stated whether the first first Eur100k will be transferred to BoC, but this is a reasonable assumption. Investments remaining in Bank Popular will be written down against its losses. The owners of these deposits will be compensated with equity of the remaining bank, although this will likely have only very low residual value. Bond holds of this bank, should also expect to be written down.

2. Bank of Cyprus will remain open, receiving ECB funding and insured deposits from Bank Popular. As it is also in a very weak financial position, large depositors in this bank will likely be partially written down (estimates maximum 40% loss) to restore the banks solvency. It is currently unclear if bonds in this bank will be written down. Those experiencing write-downs may also be compensated with equity, although again the residual value will be very low.

3. In theory no other depositors in Cypriot banks will suffer losses. However, even when the banks reopen, capital controls will remain in place, it is not clear how or when money will be released from accounts. This will likely depend on how quickly Cypriot banks can liquidate assets themselves. The fact that Cypriot banks will have to sell assets to fund withdrawals explains our caution about the short-term market direction.

Best regards,

James