A Storm Is Brewing
A Storm Is Brewing
If You Only Look At One Chart… Time is short, so here is one chart to get you thinking in a new direction.
The Global Population is Shifting to EM
Source: Visual Capitalist
• • •
By 2050 Nigeria could be the third most populous nation on earth. The US is likely to be the only major Western power in the world’s top 10 populations. Europe will be increasingly insignificant as populations decline through aging and falling birth rates.
Right Here, Right Now The best trading ideas of the week from RVP Contributors
Sell China Says Ecstrat
The Chinese stock market looks bearish to Ecstrat in the medium term. A strongly concentrated flow into a narrow range of Chinese tech stocks is propping up a market filled with state-owned enterprises representative of the ‘old economy’. As Jesse Felder observed, these debt-laden behemoths aren’t going anywhere fast. With the 19th Communist Party Congress in October likely to bring reform at the price of growth, the market looks vulnerable.
Chinese Shares Are Riding High – Short Interest Is Minimal.
Source: Bloomberg
There remains the ever-present threat of differences over how to handle North Korea, just to make things a little more perilous: There is a growing possibility that, faced with a strategic policy vacuum among US policymakers towards the relationship with China, Trump will take the opportunity to impose sanctions against SOE’s, an act that Beijing would see as a gross provocation. It’s not an attractive mix going into the second half of the year. What is the catalyst for a bearish move? A renewed strengthening of the USD is the threat, as Ecstrat see it: The external environment has been extremely supportive, with the weak dollar alleviating capital outflow pressures, while the Chinese economy is a prime beneficiary of lower energy prices. We
believe that the dollar weakness is largely played out, while energy prices will remain weak over the remainder of 2017.
Adam’s Portfolio Picks I have picked only the most compelling and highest conviction trade ideas of our RVP Contributors and will track them in a portfolio for you to follow.
No new Portfolio Picks this week.
Note: This is not investment advice. You understand that no content published as part of the services constitutes a recommendation or a statement that any particular investment, security, portfolio of securities, transaction, or investment strategy is suitable for any specific person
The Big Call Legendary hedge fund manager Stanley Druckenmiller said when you see something in the market that really, really excites you, “Bet the ranch on it.” These are the Big Calls, the investment themes that can make or break you. Think differently from the crowd and have a different time horizon, and you have an edge. RVP, with its crack team of financial minds, identifies the Big Calls and guides you through the investment opportunities when they present themselves.
Hurricane Alley Getting into the scary season
The terrible impact of Hurricane Harvey on Texas will be felt for years to come. The damage is likely to be the worst since Hurricane Katrina hit New Orleans in 2005. Such storms have devastating impacts on the lives of those caught in their paths. With Hurricane Irma bearing down on Florida, things could be even worse by next week….
Capital – the resources and time invested in buildings, machinery, vehicles, and lives – is real. The immediate cost of a hurricane is easy enough to calculate and graph but difficult to fully capture in its physicality. Amidst all this human cost of homes and businesses laid waste, what are the further projected impacts for some of the markets affected and the broader Texas and US economies when the clean-up is complete?
The Oil Market Harvey’s path of destruction
Source: The Financial Times
The US oil industry is heavily concentrated in the Gulf of Mexico. The industry has also changed markedly since Katrina in 2005. The shift in domestic production brought about by the shale revolution has completely changed the nature of the US oil market, so that there is now very little dependence on imported oil. Most of the industry for crude production has been relatively unaffected by Harvey, but the logistical problems of moving oil and, crucially, of refining into gasoline have been exacerbated. WTI oil prices fell as tankers came into port ahead of the storm and inventory consumption dipped due to refinery shutdowns – but meanwhile, gasoline prices have soared:
WTI vs Gasoline
Source: TradingView
Shale oil has made US crude oil production far more secure, but the refining system to produce gasoline and other products is heavily concentrated in Hurricane Alley due to historical onshore production in West Texas, offshore production in the Gulf of Mexico, and Venezuelan imports. The existing geography of the US energy market means that this concentration is unlikely to change in the future. Already, though, the majority of Gulf refining is back online – a remarkable turnaround.
The Economic Impact The broader impact on the regional and US economies from hurricanes is substantial. Katrina was so devastating that its impact quite clearly showed up in local unemployment and economic data. After all, when your workplace is destroyed, your employment is simply washed away.
Over-the-year changes in employment, New Orleans, January 2004 to June 2006
Source: Monthly Labor Review, June 2007
The sectors worst-hit by Katrina were tourism and service industries, as the destruction shut the city down for months. As expected, a few select sectors like construction did see a boost, but the overall picture was extremely recessionary:
Over-the-year changes in employment, in employment in the construction sector New Orleans, January 2004 to June 2006
Source: Monthly Labor Review, June 2007
The impact of job losses, some of them permanent, then fed through to consumption and tax receipts, causing a widespread economic downturn. Katrina occurred during a period of generally strong growth in the US. The impact from Harvey and potentially from Irma could be much greater on the broader US economy, given generally weakening momentum.
Source: Federal Reserve Economic Data
The impact on GDP growth is at first negative as economic activity collapses – but thereafter the increase in construction and investment atop a low comparison base means that growth can be extraordinary.
However, there is the issue of the ‘broken window fallacy’ in economics: The cost of the initial destruction of capital is not really offset by the economic benefits of its reconstruction.
Fiscal Stimulus & the Debt Ceiling There is a likelihood of fiscal stimulus to repair damaged infrastructure and rebuild lives in the wake of hurricane season. This stimulus will, however, require additional government borrowing – something that couldn’t be achieved without raising the debt ceiling. The prospect of stimulus may be why the S&P 500 has risen in the past week, despite the capital destruction, while the dollar has fallen. Trump’ striking a quick-fix deal with the Democrats to raise the debt ceiling for three months in order to fund relief and reconstruction is the first sign of accommodative and expansionary policy as the disaster paints the government into a corner. Monetary policy, too, may be impacted. The Fed has been slowing its projected path of rate rises in the recent month because of softer inflation data. With the depressive impact of hurricane disasters looming, another hike this year is off the table, hence the weakness in the dollar. The impact will muddy the numbers on GDP and inflation – and the Fed will explain away any uptick in the latter as a by-product of the disaster. The impact on all kinds of key economic data, including employment, oil inventories, consumer sentiment, inflation expectations, etc, will be a major headache for policy makers trying to determine the underlying picture of the US economy. ‘Each time history repeats itself, the price goes up.’ – Ronald Wright The combined impact from two major hurricanes could dwarf the $160bn cost of Hurricane Katrina. With Harvey’s price tag already estimated at $190bn, or 1% of GDP, the economic punches thrown by two historic storms would significantly dent third-quarter GDP.
Source: NBC
Forty-seven percent of costs for Katrina was covered by insurance, but estimates suggest that only 27% of costs will be covered for Harvey. Those costs will have a big impact on the insurance industry but an even greater long-term impact on the regional economy. With so few households in Houston having flood insurance because of its high cost, the local impact on consumption will be significant. Residents will have
to meet the costs of repairing their homes out of savings and income – damping consumption. Furthermore, with workplaces flooded and jobs lost, what income will be available? The costs may again fall on the government: More than 350k people have registered with the Federal Emergency Management Agency (FEMA), and 37k people have already filed claims with the National Flood Insurance Programme. FEMA has already announced it is down to its last $1bn of funding after Harvey.
What About Irma? If Irma reaches Florida as a major hurricane, as it looks likely to do, we can obviously expect serious damage and disruption. Two devastating hurricanes in a row would be a major headache for FEMA and would increase fiscal costs for infrastructure rebuilding. Florida-exposed insurance stocks such as Universal Insurance and Heritage Insurance have already sold off strongly. Florida is a densely populated state with a huge tourist industry alongside agriculture, logistics, and aerospace, all of which would be heavily disrupted. The state has the fourth largest GDP in the US, not far behind the second largest, Texas. The short-run impact of Harvey and potentially Irma will be depressive, but the scale and cost of restoration may be enough to push the US towards recession – the background macro environment is much more fragile than it was in 2005 with Katrina. Could we see a renewal of stimulus lead to further gains in the stock market? Or will these natural disasters break the back of the market? It is hard to reconcile such massive capital destruction and the washing away of lives and livelihoods with a stock market a few points off all-time highs.
Are You On This Yet? In such a fast paced world staying on top of relevant market news and developments is tough. RVP scours the globe for the most interesting stories and distils them, keeping you ahead of the crowd.
The Everything Bubble We must all be market geniuses
With the prolific supply of cheap money from central banks since the GFC, we have seen significant appreciation in just about everything. For investors concentrating in a particular area, it can appear as if they just keep hitting home runs. A rising tide has lifted all boats, but are we smart investors, or are we just along for the ride? Jesse Felder captured this buying frenzy perfectly when he coined it The Everything Bubble. Whether it’s real estate, FANG stocks, emerging markets, cryptocurrencies, or even gold, everything seems to be in a bull market – the one way to miss out has been to keep your cash on the sidelines.
Trading Motivation To confidently make a trade or an investment, we must believe we have an edge. No rational investor would make a decision to buy or sell a security whilst holding the sincere belief that they know less than everybody else about the asset. We must believe we know some fact, or a particular view, that is more or less unique and that leads us to take action. Yet the proven win records of even the best investors are riddled with imperfect calls.
Right Place, Right Time Warren Buffett famously says he ‘won the ovarian lottery’ by being born a male in the US – a country with enormous economic potential. The US system allowed him to profit from his investing acumen: Had he been born in Bangladesh he might have been the best trader at the spice market in Dhaka, but he would never have become the world’s richest man. The same may apply to being a homeowner in Canada. If Americans thought they were doing well flipping condos on Miami Beach in 2006, then check out the after-party in Canada:
The meteoric rise of Canadian housing has continued unabated since 2006, with house price-to-rent ratios expanding nearly 100% in 25 years. The precipitous state of house prices continues, despite Greg Weldon’sconcern of a bust in the banking system should the bubble be pricked. Continued low rates from the Bank of Canada combined with a strong economy have whipped up a mania for housing that has become apparently self-perpetuating.
Bricks and Mortar or Stocks and Shares? Many investors prefer the tangible benefits of property investing to the perceived ‘high-risk’ market in stocks – real estate has less perceived volatility, and it has clear tangible value. However, like the real estate market in most parts of the world, nearly all stock indexes are up:
Source: Tradingview.com
Since April 2009 all indexes have performed strongly, with the S&P +200%, DAX +188%, FTSE +124%, Nikkei +88%, and emerging +74%. Thus, stock returns, even from emerging markets, have generally kept up with Canadian Real Estate – but has the risk been greater?
Aren't Stocks More Volatile? The really strong returns from the Bubble in Everything is in the short VIX trade. The VIX Volatility Index records the implied volatility of S&P 500 options. When investors’ uncertainty rises, they buy options, driving up the premium on options and thus raising the VIX index. That’s why the VIX is called the ‘fear gauge’ on Wall Street. However, the VIX is also traded by an active futures market, where going short volatility has become an attractive trade due to the positive yield and low volatility created by central bank buying. Peter Brandt has a message for those of you who thought Bitcoin was a bubble:
This graph shows the meteoric pace of gains achieved from shorting the VIX – the trade has gone from zero to here in just 18 months. Perhaps some of this rate of change is due to the exponential nature of potential gains from a nonlinear index like the VIX. This has become a popular trade for ‘volatility tourists’ looking for easy gains:
Source: NYT
Cryptocurrency also exhibits some of this exponential growth potential, given the way that network and capacity growth has increased at a nonlinear rate. To put this phenomenon in perspective, the chance for the Dow US Real Estate Index to grow exponentially is highly limited by the linear nature of real estate and construction.
Leverage – Great on the Way Up… The pervasive factor in all these trades is leverage. Real estate investors are invariably levered. Having 100% equity in one home that is rising in value is much less profitable than having 10% equity in 10 homes that are rising in value – that is how you scale property. The same goes the stock market – when you run out of dry powder in your brokerage account, you take out some margin:
Source: dshort.com
Margin debt has climbed in tandem with the gains in the S&P 500. The rally might be in equity markets, but the backing is debt. However, the short VIX trade has inherent operating leverage from the nonlinear nature of the index – options premiums offer magnified returns over the real returns of the S&P. This is a great way to gain leverage without applying for a mortgage or a margin account. Cryptocurrencies themselves have a similar level of operating leverage, but that leverage is derived from the network effect: As the network grows the value of crypto increases with it. This dynamic helps to explain the meteoric rise of Ethereum over even Bitcoin in recent years – so many new tokens and coin are built on that network.
Terrible on the Way Down… The risk of leverage is always a bust. When housing markets crash 50%, buyers with a 50% deposit lose 100% of their equity. When stock markets plummet, margin calls can drive prices lower in a damaging feedback loop – and if that stock market is the S&P, then demand for put options will send premiums, and the VIX, soaring: An 80% move in the VIX would wipe out the short ETFs to zero. This risk makes crypto gains, built on the network effect, look more appealing than financial leverage does in the mainstream system. But then, of course, crypto leverage is vulnerable to a sudden abandoning of the network in favour of a new and better one.
Where Does That Leave You?
Gold?
Source: Jesse Felder
The recent breakout in gold may be a signal that the Bubble in Everything is vulnerable. Gold bugs have been waiting for this moment for years – but why celebrate? All you are doing is trying to protect purchasing power. With few productive investment opportunities at hand, investors flock to gold. What that says about the wider economy, though, is batten down the hatches.
Speaking of Canada When a bank breaks out from the herd I wrote in The Hack July 6th that the major central banks appeared to be focused on coordinated tightening. However, to date, this has not happened much. Janet Yellen has rowed back from the Isles of Hawkishness to Dove Harbor as inflation data has softened. Draghi too has been very tight-lipped since his minor outburst of ‘Any adjustments to our stance have to be made gradually’. The Bank of England has been dodging the rate-rise bullet, too, fearful of a Brexit upset despite runaway inflation dynamics. That just leaves one bank standing strong – the Bank of Canada.
The Lone Hawk The BOC’s surprise announcement on Wednesday, raising rates for the second month in a row to 1%, shows a significant tightening bias.
Source: Bank of Canada, The Canadian press
It seems that when Stephen Poloz indicated his tightening bias in July, he intended to follow through with it: When you are driving towards a red stoplight, you ease up on the accelerator well before you get there instead of waiting for the last second to stop. I think the same thinking is true in monetary policy, because you must anticipate where the economy will be 18 or 24 months from now. A 1% rate raises the bar back only to the post-GFC-era high – but it has sent a strong signal to the market of the BOC’s hawkish intentions, as this second raise on September 6th was unexpected by the market and not widely priced in. With all the strong forward guidance from the Fed clearly flagging any rate rise or shift in policy, this sudden move signals, in contrast, that the BOC’s governors are not only serious but worried.
Smoke Signals The BOC has the data to back up a hike. Canadian GDP growth has been better than expected; and whilst inflation has been muted, it is within target and not deflationary. Unemployment too remains low at 6.3%, close to recent structural bottoms. As the BOC statement explains: Recent economic data have been stronger than expected, supporting the Bank’s view that growth in Canada is becoming more broadly-based and self-sustaining. Consumer spending remains robust, underpinned by continued solid employment and income growth. If ever there were a time to begin to remove the punch bowl, now is it.
Canadian GDP & Inflation Rate
Source: Tradingeconomics.com
But What About the Canadian Real Estate Bubble? Well, this could be where it gets ugly. Total consumer debt-to-GDP in Canada has assumed gargantuan proportions. Sustained periods of low-interest rates invite increasing complacency regarding debt.
Household Debt to GDP & Canadian 10yr Rate
Source: FRED
Canadian household debt-to-GDP has risen above 100%, and the debt-to-income ratio is nudging 170%. These metrics make any significant rise in rates tough to swallow for consumers. Make no mistake: A 50bps rise in two months from 0.5% is a 100% increase in interest rates. The effects are already being felt in the housing market, with Toronto prices falling 20% from their peak in just a few months: Much of that turmoil is not just down to those who bid at the peak and now want to get out of a deal, but also to lenders tightening credit and property appraisers lowering their valuations. Given how long the housing boom lasted, a retreat was hardly unexpected, but after a nearly decade of bidding wars and swift deals, real estate agents, lawyers, lenders and mortgage brokers struggle
to cope with the new reality. “The big issue is with financing,” said John Pasalis, president of the Realosophy real estate brokerage in Toronto. (Reuters) Where asset prices go, consumer confidence is bound to follow. If the banks are tightening credit conditions, don’t expect a positive reaction to the BOC rate rise. It is difficult in banking to make higher earnings from interest margins when loan growth is declining and asset quality is deteriorating.
Breaking from the Herd The BOC seems to be trying to test the catch-22 created by sustained low-interest rates. The Fed has tried this one and now seem to have failed – weakening growth and a soft inflation picture appears to have put rate rises on hold, although tapering remains on the table. The BOC are giving it a go now – and the question is, how far can they get before something breaks? I have retained a bearish view on Canadian banks since Greg Weldon highlighted their technical breakdowns in May. This is a trade that seems to be slowly coming to fruition, even after the rescue of Home Capital Group by Warren Buffett temporarily injected some pep into the market. These banks remain exposed to extremely high levels of debt relative to income; and unlike in the GFC era, governments are now wary of bailouts – Canada already has a government debt-to-GDP of 92% – so expect losses to be borne by stakeholders.
Staying Ahead There isn’t time each week to discuss everything that is going on in markets. Here we piggyback on previous RVP Weekly Hack talking points and let you explore some stories further.
Waymo – The Secret World of AI Training I highly recommend a read of this lengthy but fascinating article to get an idea of the quality and rigour of the AI that is driving technologies now being developed. The headlines on autonomous driving have generally been captured by Uber and Tesla, but Alphabet’s Waymo is arguably the most advanced in the race to develop self-driving cars. Rather than make customers the primary guinea pigs for their software, Waymo’s researchers have spent countless hours simulating driving conditions for their AI in a system called Carcraft. This is the digitization of real-world driving. Waymo researchers are able to test their AI in simulators against countless thousands of permutations of real-world scenarios in order to finesse the AI much more rapidly than physical testing could. In 2016 they logged 2.5bn virtual miles against 3m physically driven ones – and those miles were modelled to be more ‘interesting’ than highway commuter miles.
Fake News? How about a Fake Journalist? This amusing yarn from PetaPixel details the unlikely story of one Eduardo Martins, a Brazilian photojournalist who toured the world’s toughest war zones, bringing back evocative images of troubled lands. Or did he? It seems it’s not just fake news you have to worry about now, it’s the personalities behind the news, too.
Until next time,
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If You Only Look At One Chart… Time is short, so here is one chart to get you thinking in a new direction.
The Global Population is Shifting to EM
Source: Visual Capitalist
• • •
By 2050 Nigeria could be the third most populous nation on earth. The US is likely to be the only major Western power in the world’s top 10 populations. Europe will be increasingly insignificant as populations decline through aging and falling birth rates.
Right Here, Right Now The best trading ideas of the week from RVP Contributors
Sell China Says Ecstrat
The Chinese stock market looks bearish to Ecstrat in the medium term. A strongly concentrated flow into a narrow range of Chinese tech stocks is propping up a market filled with state-owned enterprises representative of the ‘old economy’. As Jesse Felder observed, these debt-laden behemoths aren’t going anywhere fast. With the 19th Communist Party Congress in October likely to bring reform at the price of growth, the market looks vulnerable.
Chinese Shares Are Riding High – Short Interest Is Minimal.
Source: Bloomberg
There remains the ever-present threat of differences over how to handle North Korea, just to make things a little more perilous: There is a growing possibility that, faced with a strategic policy vacuum among US policymakers towards the relationship with China, Trump will take the opportunity to impose sanctions against SOE’s, an act that Beijing would see as a gross provocation. It’s not an attractive mix going into the second half of the year. What is the catalyst for a bearish move? A renewed strengthening of the USD is the threat, as Ecstrat see it: The external environment has been extremely supportive, with the weak dollar alleviating capital outflow pressures, while the Chinese economy is a prime beneficiary of lower energy prices. We
believe that the dollar weakness is largely played out, while energy prices will remain weak over the remainder of 2017.
Adam’s Portfolio Picks I have picked only the most compelling and highest conviction trade ideas of our RVP Contributors and will track them in a portfolio for you to follow.
No new Portfolio Picks this week.
Note: This is not investment advice. You understand that no content published as part of the services constitutes a recommendation or a statement that any particular investment, security, portfolio of securities, transaction, or investment strategy is suitable for any specific person
The Big Call Legendary hedge fund manager Stanley Druckenmiller said when you see something in the market that really, really excites you, “Bet the ranch on it.” These are the Big Calls, the investment themes that can make or break you. Think differently from the crowd and have a different time horizon, and you have an edge. RVP, with its crack team of financial minds, identifies the Big Calls and guides you through the investment opportunities when they present themselves.
Hurricane Alley Getting into the scary season
The terrible impact of Hurricane Harvey on Texas will be felt for years to come. The damage is likely to be the worst since Hurricane Katrina hit New Orleans in 2005. Such storms have devastating impacts on the lives of those caught in their paths. With Hurricane Irma bearing down on Florida, things could be even worse by next week….
Capital – the resources and time invested in buildings, machinery, vehicles, and lives – is real. The immediate cost of a hurricane is easy enough to calculate and graph but difficult to fully capture in its physicality. Amidst all this human cost of homes and businesses laid waste, what are the further projected impacts for some of the markets affected and the broader Texas and US economies when the clean-up is complete?
The Oil Market Harvey’s path of destruction
Source: The Financial Times
The US oil industry is heavily concentrated in the Gulf of Mexico. The industry has also changed markedly since Katrina in 2005. The shift in domestic production brought about by the shale revolution has completely changed the nature of the US oil market, so that there is now very little dependence on imported oil. Most of the industry for crude production has been relatively unaffected by Harvey, but the logistical problems of moving oil and, crucially, of refining into gasoline have been exacerbated. WTI oil prices fell as tankers came into port ahead of the storm and inventory consumption dipped due to refinery shutdowns – but meanwhile, gasoline prices have soared:
WTI vs Gasoline
Source: TradingView
Shale oil has made US crude oil production far more secure, but the refining system to produce gasoline and other products is heavily concentrated in Hurricane Alley due to historical onshore production in West Texas, offshore production in the Gulf of Mexico, and Venezuelan imports. The existing geography of the US energy market means that this concentration is unlikely to change in the future. Already, though, the majority of Gulf refining is back online – a remarkable turnaround.
The Economic Impact The broader impact on the regional and US economies from hurricanes is substantial. Katrina was so devastating that its impact quite clearly showed up in local unemployment and economic data. After all, when your workplace is destroyed, your employment is simply washed away.
Over-the-year changes in employment, New Orleans, January 2004 to June 2006
Source: Monthly Labor Review, June 2007
The sectors worst-hit by Katrina were tourism and service industries, as the destruction shut the city down for months. As expected, a few select sectors like construction did see a boost, but the overall picture was extremely recessionary:
Over-the-year changes in employment, in employment in the construction sector New Orleans, January 2004 to June 2006
Source: Monthly Labor Review, June 2007
The impact of job losses, some of them permanent, then fed through to consumption and tax receipts, causing a widespread economic downturn. Katrina occurred during a period of generally strong growth in the US. The impact from Harvey and potentially from Irma could be much greater on the broader US economy, given generally weakening momentum.
Source: Federal Reserve Economic Data
The impact on GDP growth is at first negative as economic activity collapses – but thereafter the increase in construction and investment atop a low comparison base means that growth can be extraordinary.
However, there is the issue of the ‘broken window fallacy’ in economics: The cost of the initial destruction of capital is not really offset by the economic benefits of its reconstruction.
Fiscal Stimulus & the Debt Ceiling There is a likelihood of fiscal stimulus to repair damaged infrastructure and rebuild lives in the wake of hurricane season. This stimulus will, however, require additional government borrowing – something that couldn’t be achieved without raising the debt ceiling. The prospect of stimulus may be why the S&P 500 has risen in the past week, despite the capital destruction, while the dollar has fallen. Trump’ striking a quick-fix deal with the Democrats to raise the debt ceiling for three months in order to fund relief and reconstruction is the first sign of accommodative and expansionary policy as the disaster paints the government into a corner. Monetary policy, too, may be impacted. The Fed has been slowing its projected path of rate rises in the recent month because of softer inflation data. With the depressive impact of hurricane disasters looming, another hike this year is off the table, hence the weakness in the dollar. The impact will muddy the numbers on GDP and inflation – and the Fed will explain away any uptick in the latter as a by-product of the disaster. The impact on all kinds of key economic data, including employment, oil inventories, consumer sentiment, inflation expectations, etc, will be a major headache for policy makers trying to determine the underlying picture of the US economy. ‘Each time history repeats itself, the price goes up.’ – Ronald Wright The combined impact from two major hurricanes could dwarf the $160bn cost of Hurricane Katrina. With Harvey’s price tag already estimated at $190bn, or 1% of GDP, the economic punches thrown by two historic storms would significantly dent third-quarter GDP.
Source: NBC
Forty-seven percent of costs for Katrina was covered by insurance, but estimates suggest that only 27% of costs will be covered for Harvey. Those costs will have a big impact on the insurance industry but an even greater long-term impact on the regional economy. With so few households in Houston having flood insurance because of its high cost, the local impact on consumption will be significant. Residents will have
to meet the costs of repairing their homes out of savings and income – damping consumption. Furthermore, with workplaces flooded and jobs lost, what income will be available? The costs may again fall on the government: More than 350k people have registered with the Federal Emergency Management Agency (FEMA), and 37k people have already filed claims with the National Flood Insurance Programme. FEMA has already announced it is down to its last $1bn of funding after Harvey.
What About Irma? If Irma reaches Florida as a major hurricane, as it looks likely to do, we can obviously expect serious damage and disruption. Two devastating hurricanes in a row would be a major headache for FEMA and would increase fiscal costs for infrastructure rebuilding. Florida-exposed insurance stocks such as Universal Insurance and Heritage Insurance have already sold off strongly. Florida is a densely populated state with a huge tourist industry alongside agriculture, logistics, and aerospace, all of which would be heavily disrupted. The state has the fourth largest GDP in the US, not far behind the second largest, Texas. The short-run impact of Harvey and potentially Irma will be depressive, but the scale and cost of restoration may be enough to push the US towards recession – the background macro environment is much more fragile than it was in 2005 with Katrina. Could we see a renewal of stimulus lead to further gains in the stock market? Or will these natural disasters break the back of the market? It is hard to reconcile such massive capital destruction and the washing away of lives and livelihoods with a stock market a few points off all-time highs.
Are You On This Yet? In such a fast paced world staying on top of relevant market news and developments is tough. RVP scours the globe for the most interesting stories and distils them, keeping you ahead of the crowd.
The Everything Bubble We must all be market geniuses
With the prolific supply of cheap money from central banks since the GFC, we have seen significant appreciation in just about everything. For investors concentrating in a particular area, it can appear as if they just keep hitting home runs. A rising tide has lifted all boats, but are we smart investors, or are we just along for the ride? Jesse Felder captured this buying frenzy perfectly when he coined it The Everything Bubble. Whether it’s real estate, FANG stocks, emerging markets, cryptocurrencies, or even gold, everything seems to be in a bull market – the one way to miss out has been to keep your cash on the sidelines.
Trading Motivation To confidently make a trade or an investment, we must believe we have an edge. No rational investor would make a decision to buy or sell a security whilst holding the sincere belief that they know less than everybody else about the asset. We must believe we know some fact, or a particular view, that is more or less unique and that leads us to take action. Yet the proven win records of even the best investors are riddled with imperfect calls.
Right Place, Right Time Warren Buffett famously says he ‘won the ovarian lottery’ by being born a male in the US – a country with enormous economic potential. The US system allowed him to profit from his investing acumen: Had he been born in Bangladesh he might have been the best trader at the spice market in Dhaka, but he would never have become the world’s richest man. The same may apply to being a homeowner in Canada. If Americans thought they were doing well flipping condos on Miami Beach in 2006, then check out the after-party in Canada:
The meteoric rise of Canadian housing has continued unabated since 2006, with house price-to-rent ratios expanding nearly 100% in 25 years. The precipitous state of house prices continues, despite Greg Weldon’sconcern of a bust in the banking system should the bubble be pricked. Continued low rates from the Bank of Canada combined with a strong economy have whipped up a mania for housing that has become apparently self-perpetuating.
Bricks and Mortar or Stocks and Shares? Many investors prefer the tangible benefits of property investing to the perceived ‘high-risk’ market in stocks – real estate has less perceived volatility, and it has clear tangible value. However, like the real estate market in most parts of the world, nearly all stock indexes are up:
Source: Tradingview.com
Since April 2009 all indexes have performed strongly, with the S&P +200%, DAX +188%, FTSE +124%, Nikkei +88%, and emerging +74%. Thus, stock returns, even from emerging markets, have generally kept up with Canadian Real Estate – but has the risk been greater?
Aren't Stocks More Volatile? The really strong returns from the Bubble in Everything is in the short VIX trade. The VIX Volatility Index records the implied volatility of S&P 500 options. When investors’ uncertainty rises, they buy options, driving up the premium on options and thus raising the VIX index. That’s why the VIX is called the ‘fear gauge’ on Wall Street. However, the VIX is also traded by an active futures market, where going short volatility has become an attractive trade due to the positive yield and low volatility created by central bank buying. Peter Brandt has a message for those of you who thought Bitcoin was a bubble:
This graph shows the meteoric pace of gains achieved from shorting the VIX – the trade has gone from zero to here in just 18 months. Perhaps some of this rate of change is due to the exponential nature of potential gains from a nonlinear index like the VIX. This has become a popular trade for ‘volatility tourists’ looking for easy gains:
Source: NYT
Cryptocurrency also exhibits some of this exponential growth potential, given the way that network and capacity growth has increased at a nonlinear rate. To put this phenomenon in perspective, the chance for the Dow US Real Estate Index to grow exponentially is highly limited by the linear nature of real estate and construction.
Leverage – Great on the Way Up… The pervasive factor in all these trades is leverage. Real estate investors are invariably levered. Having 100% equity in one home that is rising in value is much less profitable than having 10% equity in 10 homes that are rising in value – that is how you scale property. The same goes the stock market – when you run out of dry powder in your brokerage account, you take out some margin:
Source: dshort.com
Margin debt has climbed in tandem with the gains in the S&P 500. The rally might be in equity markets, but the backing is debt. However, the short VIX trade has inherent operating leverage from the nonlinear nature of the index – options premiums offer magnified returns over the real returns of the S&P. This is a great way to gain leverage without applying for a mortgage or a margin account. Cryptocurrencies themselves have a similar level of operating leverage, but that leverage is derived from the network effect: As the network grows the value of crypto increases with it. This dynamic helps to explain the meteoric rise of Ethereum over even Bitcoin in recent years – so many new tokens and coin are built on that network.
Terrible on the Way Down… The risk of leverage is always a bust. When housing markets crash 50%, buyers with a 50% deposit lose 100% of their equity. When stock markets plummet, margin calls can drive prices lower in a damaging feedback loop – and if that stock market is the S&P, then demand for put options will send premiums, and the VIX, soaring: An 80% move in the VIX would wipe out the short ETFs to zero. This risk makes crypto gains, built on the network effect, look more appealing than financial leverage does in the mainstream system. But then, of course, crypto leverage is vulnerable to a sudden abandoning of the network in favour of a new and better one.
Where Does That Leave You?
Gold?
Source: Jesse Felder
The recent breakout in gold may be a signal that the Bubble in Everything is vulnerable. Gold bugs have been waiting for this moment for years – but why celebrate? All you are doing is trying to protect purchasing power. With few productive investment opportunities at hand, investors flock to gold. What that says about the wider economy, though, is batten down the hatches.
Speaking of Canada When a bank breaks out from the herd I wrote in The Hack July 6th that the major central banks appeared to be focused on coordinated tightening. However, to date, this has not happened much. Janet Yellen has rowed back from the Isles of Hawkishness to Dove Harbor as inflation data has softened. Draghi too has been very tight-lipped since his minor outburst of ‘Any adjustments to our stance have to be made gradually’. The Bank of England has been dodging the rate-rise bullet, too, fearful of a Brexit upset despite runaway inflation dynamics. That just leaves one bank standing strong – the Bank of Canada.
The Lone Hawk The BOC’s surprise announcement on Wednesday, raising rates for the second month in a row to 1%, shows a significant tightening bias.
Source: Bank of Canada, The Canadian press
It seems that when Stephen Poloz indicated his tightening bias in July, he intended to follow through with it: When you are driving towards a red stoplight, you ease up on the accelerator well before you get there instead of waiting for the last second to stop. I think the same thinking is true in monetary policy, because you must anticipate where the economy will be 18 or 24 months from now. A 1% rate raises the bar back only to the post-GFC-era high – but it has sent a strong signal to the market of the BOC’s hawkish intentions, as this second raise on September 6th was unexpected by the market and not widely priced in. With all the strong forward guidance from the Fed clearly flagging any rate rise or shift in policy, this sudden move signals, in contrast, that the BOC’s governors are not only serious but worried.
Smoke Signals The BOC has the data to back up a hike. Canadian GDP growth has been better than expected; and whilst inflation has been muted, it is within target and not deflationary. Unemployment too remains low at 6.3%, close to recent structural bottoms. As the BOC statement explains: Recent economic data have been stronger than expected, supporting the Bank’s view that growth in Canada is becoming more broadly-based and self-sustaining. Consumer spending remains robust, underpinned by continued solid employment and income growth. If ever there were a time to begin to remove the punch bowl, now is it.
Canadian GDP & Inflation Rate
Source: Tradingeconomics.com
But What About the Canadian Real Estate Bubble? Well, this could be where it gets ugly. Total consumer debt-to-GDP in Canada has assumed gargantuan proportions. Sustained periods of low-interest rates invite increasing complacency regarding debt.
Household Debt to GDP & Canadian 10yr Rate
Source: FRED
Canadian household debt-to-GDP has risen above 100%, and the debt-to-income ratio is nudging 170%. These metrics make any significant rise in rates tough to swallow for consumers. Make no mistake: A 50bps rise in two months from 0.5% is a 100% increase in interest rates. The effects are already being felt in the housing market, with Toronto prices falling 20% from their peak in just a few months: Much of that turmoil is not just down to those who bid at the peak and now want to get out of a deal, but also to lenders tightening credit and property appraisers lowering their valuations. Given how long the housing boom lasted, a retreat was hardly unexpected, but after a nearly decade of bidding wars and swift deals, real estate agents, lawyers, lenders and mortgage brokers struggle
to cope with the new reality. “The big issue is with financing,” said John Pasalis, president of the Realosophy real estate brokerage in Toronto. (Reuters) Where asset prices go, consumer confidence is bound to follow. If the banks are tightening credit conditions, don’t expect a positive reaction to the BOC rate rise. It is difficult in banking to make higher earnings from interest margins when loan growth is declining and asset quality is deteriorating.
Breaking from the Herd The BOC seems to be trying to test the catch-22 created by sustained low-interest rates. The Fed has tried this one and now seem to have failed – weakening growth and a soft inflation picture appears to have put rate rises on hold, although tapering remains on the table. The BOC are giving it a go now – and the question is, how far can they get before something breaks? I have retained a bearish view on Canadian banks since Greg Weldon highlighted their technical breakdowns in May. This is a trade that seems to be slowly coming to fruition, even after the rescue of Home Capital Group by Warren Buffett temporarily injected some pep into the market. These banks remain exposed to extremely high levels of debt relative to income; and unlike in the GFC era, governments are now wary of bailouts – Canada already has a government debt-to-GDP of 92% – so expect losses to be borne by stakeholders.
Staying Ahead There isn’t time each week to discuss everything that is going on in markets. Here we piggyback on previous RVP Weekly Hack talking points and let you explore some stories further.
Waymo – The Secret World of AI Training I highly recommend a read of this lengthy but fascinating article to get an idea of the quality and rigour of the AI that is driving technologies now being developed. The headlines on autonomous driving have generally been captured by Uber and Tesla, but Alphabet’s Waymo is arguably the most advanced in the race to develop self-driving cars. Rather than make customers the primary guinea pigs for their software, Waymo’s researchers have spent countless hours simulating driving conditions for their AI in a system called Carcraft. This is the digitization of real-world driving. Waymo researchers are able to test their AI in simulators against countless thousands of permutations of real-world scenarios in order to finesse the AI much more rapidly than physical testing could. In 2016 they logged 2.5bn virtual miles against 3m physically driven ones – and those miles were modelled to be more ‘interesting’ than highway commuter miles.
Fake News? How about a Fake Journalist? This amusing yarn from PetaPixel details the unlikely story of one Eduardo Martins, a Brazilian photojournalist who toured the world’s toughest war zones, bringing back evocative images of troubled lands. Or did he? It seems it’s not just fake news you have to worry about now, it’s the personalities behind the news, too.
Until next time,
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