Mr Risk

14 MAY 2014


Please see important disclosures and
Analyst Certification beginning on page 5

Time Is Running Out
Four Reasons to Say No to the Carry Trade
1. The Feds balance sheet is growing at a slowing rate, just 4.71% over the past 13 weeks
2. Sooner or later, extreme valuations matter
3. Economic Uncertainty is higher now than it was a quarter ago
4. Reduced magnitude of perturbations signals the end is near

SEARCH OF YIELD
Everyone knows that the Feds current policy regime
subsidizes the carry trade. US high-yield investors are getting
equity-like returns with lower risk. The taper scare impact
was more severe for emerging market bonds and FX carry,
but both are once again performing. In line with the 43bp
decline of US yields, AUDUSD has ripped 8.5% higher.
Figure 1 Search for yield

Source: Bloomberg


TWO OPINIONS
The debate is about whether the benign backdrop for carry
continues unabated over the seasonally challenging months.
Opinion falls into two competing camps:
1. Cassandras underestimate the persistence of low
volatility regimes. The Systemic Risk Index shows a
low degree of interconnectedness, implying
resilience to market shocks. While there is little
room left for spread compression, clipping coupons
offers an attractive return relative to safe-haven
assets.
2. Selling volatility at 20-year lows or extrapolating a
benign outcome from the recent past is never a
good idea. Groupthink, high leverage, and
diminished dealer capacity to warehouse risk are a
toxic combination.


WARNING SIGNAL
Fed balance sheet growth over the past 13 weeks is 4.71%,
down from a peak of 11.1%. Note what happened to the
SP500 when this occurred in the past. The definition of
insanity is doing the same thing over and over again and
expecting different results. Dj vu all over again!
Figure 2 Fed Balance Sheet 13-week change

Source: Bloomberg



VALUATION VULNERABILITY
100
120
140
160
180
200
220
240
260
280
300
Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14
G10 FX Carry
EU High Yield
EM Bond
US High Yield
700
900
1100
1300
1500
1700
1900
2100
-10
-5
0
5
10
15
20
25
09 10 11 12 13 14
Fed Balance Sheet
Current Level
SP500

MR RISK

2

One of the signposts of a momentum-driven market is the
willingness to ignore valuation. Notice the divorce between
the earnings revision balance and the MSCI yoy % change:
Figure 3 Earnings not required
Source: Bloomberg
Corporate spreads continue to tighten even as US
nonfinancial corporations boost leverage, contrary to the
historical relationship.
Figure 4 Spreads diverged from leverage

Source: Bloomberg

US high-yield spreads are discounting 60 for ISM. Euphoria
is even more extreme when factoring in non-price features
like covenant-lite.
Figure 5 High yield discounts 60 for ISM

Source: Bloomberg


ECONOMIC UNCERTAINTY
US economic growth is the glue. Solid but unspectacular is
the best outcome for the carry trade. Too fast or too slow is
sub-optimal. One brings the Fed and the other a growth
scare. The Q1 monster miss is now old news. The focus is on
Q2. Yet, the standard deviation of forecasts is much larger
for Q2 today than it was at the end of March, signalling
heighted economic uncertainty.
Figure 6 Q1 GDP forecast disaster

Source: Bloomberg

Figure 7 Q2 GDP Standard Deviation Increase

Source: Bloomberg

Uncertainty is supported by inconsistent forward-looking
reads on the economy. The ISM semi-annual survey question
about CAPEX sent a positive signal for investment. The
rebounds in the Philadelphia Fed and Empire State six-
month outlooks for capital expenditure are consistent with
5.0% annualized CAPEX over the next two quarters.
Figure 8 ISM CAPEX Survey

Source: Bloomberg
-15%
-10%
-5%
0%
5%
10%
15%
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
00 02 04 06 08 10 12
Earnings Revision Balance lhs
MSCI yoy% rhs
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
0
100
200
300
400
500
600
87 89 91 93 95 97 99 01 03 05 07 09 11 13 15
Corporate Spreads ex Fin Net Debt to EBITDA
0
2
4
6
8
10
12
14
16 30
35
40
45
50
55
60
65
J an-98 J un-03 Dec-08 J un-14
ISM HY Spread rhs
0.00
0.50
1.00
1.50
2.00
2.50
3.00
J an-13 May-13 Sep-13 J an-14 May-14
Q1 Consensus Advanced GDP
Really???
0.30
0.35
0.40
0.45
0.50
0.55
0.60
0.65
0.70
0.75
0.80
31-Mar-14 08-May-14
-20
-10
0
10
20
99 01 03 05 07 09 11 13
Info Processing, Equip&Software
ISM Survey

MR RISK

3

Figure 9 Survey-based CAPEX model

Source: Bloomberg

On the flip side, a commodity price shock is set to depress
real incomes. The three-month change in petrol prices
signals a lower services ISM.
Figure 10 Supply shock to hit confidence

Source: Bloomberg

When China sneezes, the US catches a cold. The recent
decline in Chinas PMI, which tends to lead the US by three
months, signals an ISM slide towards 50.
Figure 11 China PMI leads ISM

Source: Bloomberg
The 12-month change in lumber prices (six-month average)
confirms the negative message. Dr Lumber has spoken!
Figure 12 Dr Lumber confirms it

Source: Bloomberg

TWO THINGS THAT SIGNAL THE END IS NEAR
The end of a positive risk run is characterized by two factors
that are currently present:
1. The advance narrows because there is not enough
liquidity to float all boats. The benign interpretation
is one of a market shifting from beta to alpha or
focusing on differentiation. Do not be sucked into
such thinking. The fact that the Systemic Risk
Index is near eight-year lows scares Mr Risk.
2. Perturbations from the trend diminish in
magnitude. Investors grow more confident and
frame each incoming piece of information into
the prevailing heuristic group think. See this in the
smaller three-month peak-to-trough moves for CDX
high yield and the log periodic power law function
fitted to the SP500. The idea is that the SP500 is
a complex system that grinds higher to a
singularity and then undergoes a phase transition
to a chaotic crash. Now, wouldnt that be special?
Figure 13 CDX IG Perturbations

Source: Bloomberg

-60
-40
-20
0
20
40
04 06 08 10 12
Model Equipment&Software&Info Processing
-10
-8
-6
-4
-2
0
2
4
6
8 -100
-50
0
50
100
150
Sep-09 Sep-11 Sep-13
Gasoline 3m changed (3m lead) lhs
Services ISM 3m change rhs
40
45
50
55
60
65
06 07 08 09 10 11 12 13 14
China PMI Nonmanuf ISM
-40
-20
0
20
40
60
40
45
50
55
60
65
Aug-91 Aug-95 Aug-99 Aug-03 Aug-07 Aug-11
ISM
Lumber 6m average (yoy%) rhs
-
10.00
20.00
30.00
40.00
50.00
60.00
70.00
Mar-11 Mar-12 Mar-13 Mar-14
3m Peak to Trough

MR RISK

4

Figure 14 Day of reckoning forecast

Source: Bloomberg

HOW MUCH LEVERAGE IS THERE?
Narrow spreads and low volatility are a problem for asset
managers. If there is little scope for further spread
compression, the answer is more leverage. Sometimes this is
straightforward, other times it is hidden. For example, the
determination to max out on duration or credit risk within a
real-money portfolio can also be called leveraging up. We live
in dangerous times of extraordinary yield-grab groupthink.
Just say No to the carry trade.
Bottom line: There is increased uncertainty at a time when
investors are not being adequately compensated for risk.


900
1100
1300
1500
1700
1900
Dec-09 Dec-10 Dec-11 Dec-12 Dec-13
SP500 Forecast
LPPL

MR RISK

5

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MR RISK

6

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Macro Strategy:
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fgoodwin@statestreet.com