All the Makings for a Major Top

August 23, 2013

An unfolding EM crisis, higher Treasury yields, a short squeeze and various market mayhem.

The thesis has been that unconstrained global Credit inherently fuels serial boom and bust cycles. In particular, the dramatic policy response to the 2008/09 collapse of the Mortgage Finance Bubble incited unprecedented financial and economic excess in China and throughout the “developingeconomies. Double-digit Credit growth has been compounding over recent years in China, Brazil, India, Turkey and, generally, throughout Asia and Latin America. I have referred to such a late-cycle dynamic as the “terminal phase” of Credit Bubble excess.

For going on five years now, unprecedentedhot money” has inundated emerging market (EM) financial systems and economies. And as “moneyflooded in, EM central banksrecycled much of this liquidity right back into U.S. Treasuries, German bunds, and sovereign debt around the world.

This massive flow of finance into EM also spurred a spectacular expansion in sovereign wealth funds (SWF), hedge funds and the “global leveraged speculating communitymore generally. The rapid growth in both EM central bank reserve assets, as well as the global pool of speculative finance, solidified the perception of unlimited cheap global liquidity. Repeated – and increasingly desperate - central bank measures over recent years have further crystallized the perception that global markets enjoy a powerful liquidity backstop. Accordingly, speculation has run roughshod through the global markets.

A strong case can be made that recent years have seen the greatest episode of global securities mispricing in history. Global yields collapsed throughout, although nowhere has this mispricing been more pronounced than with EM bond markets. For example, Brazilian (dollar-denominated) bond yields collapsed from above 25% in 2002 to a record low 2.5% last year (currently 4.8%). After averaging about 7% for the period 2003-2011, Turkish (dollar-denominated) bond yields sank to a record low 3.17% in November 2012 (currently 5.6%). After last year sinking to record low 2.84%, Indonesian dollar bond yields have jumped back to 6.12%.

The bullish EM case has been premised on superior fundamentals compared to the developed world. The bear case is that EM markets have been at the heart of historic Bubble excess. I posit that EM securities markets have provided the most extreme case of misperceptions, speculative excess and a general mispricing of risk throughout. I would further argue that the EM Bubble has begun to burst. Moreover, I would expect that global markets have likely commenced a problematic periphery” to “coreCredit and economic crisis – where risk aversion, de-leveraging and resulting liquidity issues gravitate from one market to the next. This dynamic has been held somewhat at bay by massive Fed and BOJ QE and Draghi’s liquidity backstop.

So far in 2013, the Brazilian real has declined 12.66% and the Argentine peso 12.59%. India’s rupee has dropped 13.25%. The Turkish lira is down 10.26%, the Indonesia rupiah 11.44%, the Malaysian ringgit 7.35%, and the Thai baht 3.96%. The South African rand has lost 17.28% and the Russian ruble 7.51%.

Over the past three months, the Brazilian real has declined 12.98%, the Indian rupee 12.32%, the Indonesian rupiah 11.53%, the Malaysian ringgit 8.10%, the Turkish lira 7.11%, the South African rand 6.98%, the Argentine peso 6.42%, the Thai baht 6.09% and the Philippine peso 5.63%.

Market action in recent months has caught many participants by surprise, including some of the most sophisticated market operators. In particular, instead of rallying on heightened EM instability, “coresovereign bonds have been hit by unexpected selling pressure. Treasury yields have surged 82 bps during the past three months and bund yields have jumped 50 bps. Recent atypical correlations between “core” (perceived safe haven) bonds and EM risk markets have thrown a monkey wrench into many investment/speculation strategies (including variations of popularrisk paritymodels).

August 22 – Financial Times (Robin Wigglesworth): Central banks in the developing world have lost $81bn of emergency reserves through capital outflows and currency market interventions since early May, even before the recent renewal of turmoil in emerging markets. The figure, which excludes China, is equal to roughly 2% of all developing country central bank reserves, according to Morgan Stanley analysts, who compiled the data from central bank filings for May, June and July. However some countries have suffered more precipitous drops. Indonesia has lost 13.6% of its central bank reserves between the end of April and the end of July, Turkey 12.7% and Ukraine burnt through almost 10%. India, another country that has seen its currency pummelled in recent months, has shed almost 5.5% of its reserves. ‘It’s a real regime change compared to what we have been used to for the past decade,’ said James Lord, a Morgan Stanley strategist. ‘We saw huge reserve accumulation as emerging markets tried to stem currency appreciation, but now we’re seeing the exact opposite.’”

The flood of “hot money finance into EM spurred years of domestic Credit system excess and attendant destabilizing loosemoney.” The reversal of “hot moneyflows has now instigated a problematic tightening of finance. Importantly, years of historic loose finance created Credit systems and economic structures vulnerable to any meaningful tightening of financial conditions. Over recent months, this latent fragility has been increasingly on display.

I have argued that the dramatic policy measures from one year ago (Draghi’sdo whatever it takes” and the Fed’s $85bn monthly QE) were in response to heightened global fragilities – and that such desperate measures would only work to further destabilize already disorderly global finance. As for EM, unwieldy flows over the past year have, I believe, only created greater fragilities. In Europe, Draghi’s OMT (“outright monetary transactions”) backstop was instrumental in both a loosening of finance and a general political backtracking from financial and economic reform (especially at the troubledperiphery”).

In the U.S., open-ended QE has had minimal impact on the unemployment rate, while exerting dramatic effects on stock prices, corporate debt issuance (especially riskier debt) and home prices (particularly at the upper-end). Going on five years of near-zero short-term rates and bond market interventions have coerced an unprecedented shift of saver assets from the safety of “money” to the risk market wolves. The belief that the Federal Reserve and global central banks would continue to backstop risk markets has been fundamental to epic market mispricing.

Moreover, Trillions have flowed into myriad perceivedmoney-likeproducts, strategies and funds (ETFs, hedge funds, SWFs, “bond” and “total returnfunds, and variousstructured products” and other derivatives) where investors have little appreciation for the degree of associated price, Credit and liquidity risks. The protracted period of massive flows significantly impacted the markets in the underlying securities acquired through these strategies, in particular distorting perceptions of marketplace liquidity (in particular for EM securities and U.S. municipal debt). Misperceptions coupled with significantly inflated securities prices create latent market fragilities.

It’s not difficult for speculators and investors alike in U.S. markets to disregard the unfolding EM crisis along with market risk more generally. After all, ignoring global macro issues has been rewarded handsomely for some time now. Moreover, with the Fed and Bank of Japan (BOJ) combining for about $160bn of monthly QE, ample (developed) marketplace liquidity has seemingly been ensured. And increasingly unstableperipherymarkets also seem to ensure rotation from EM to developed markets, especially U.S. stocks. This is particularly the case with the highly inflated (performance-chasing and trend-following) “global pool of speculative finance.” Indeed, the confluence of acute EM fragilities, $85bn monthly QE and highly-speculative markets has spurred progressively more dangerous speculative excess throughout the U.S. equities marketplace.

August 21 – Wall Street Journal (Juliet Chung and Rob Barry): Short sellers are facing their worst losses in at least a decade, a Wall Street Journal analysis has found, as many of the rising stocks they bet against have only continued to soar. That has stung several high-profile hedge-fund managers, including William Ackman and David Einhorn, who have placed prominent short bets. In the Russell 3000 index, the 100 most heavily shorted stocks are sharply outperforming the average returns of stocks in the index, according to a Journal analysis of data provided by S&P Capital IQ. The shorted stocks are up by an average of 33.8% through Aug. 16, versus 18.3% for all stocks in the index. The gap between the performance of the most-shorted shares… and the market as a whole is wider than it has been in at least a decade ‘It’s actually more painful now than it was in '99,’ said veteran short seller Andrew Left of Citron Research.”

My “Issues 2013 premise was that an increasingly distendedglobal government finance Bubble” was susceptible to significant bipolar risks: an intensified Bubble might either begin to falter or it would become a case of “how crazy do things get.” Well, at this point, there are cracks to go along with a lot of craziness. Comparisons to 1999 speculative excesses resonate. And while it is easy for most to dismiss (or, better yet, relish) the pain being inflicted upon those caught short, the bludgeoning of the bears is indicative of a highly speculative marketplace that has become disconnected from underlying fundamentals.

Global markets have become keenly sensitive to Fedtapering risks. On the one hand, the unfolding EM crisis has sparked de-risking and de-leveraging dynamics. “Hot money” has begun to flee EM, in the process initiating the self-reinforcing downside to what has been a historic Credit boom. EM central banks have been forced to sell international reserves (Treasury, bund, etc.) to bolster their flagging currencies and vulnerable debt and securities markets. Resulting higher yields have forced de-risking and de-leveraging in (“safe haven”) Treasuries, which has worked to pressure U.S. MBS and muni debt, in particular.

On the other hand, Fed QE is fueling major market distortions. The Fed liquidity backstop has provided a magnetic pull for globalhot money,” giving a competitive advantage to U.S. risk assets, stocks, corporate debt and, ultimately, the U.S. economy.

In a replay of the late-nineties, the “king dollardynamic has been exacerbating EM outflows and attendant fragilities. Meanwhile, the supposed inevitable winding down of QE provides an incentive for EM central banks and the speculator community to commence de-risking prior to the withdrawal of the Federal Reserve’s market liquidity backstop. If bonds trade this poorly in the face of the Fed’s $85bn monthly purchases, who is content to wait and see the marketplace liquidity profile when our central bank is no longer a huge buyer.

The unfolding tightening of EM financial conditions portends trouble for the global economy. EM markets have begun to adjust to harsh new realities. Developed markets, if they were functioning normally, would have begun to adjust to mounting risks to global financial and economic systems.

Instead, market players assume heightened fragilities will only extend the period of unprecedented developed central bankmoney printing” and market intervention. This view was bolstered by Bernanke’s comments that the Fed would “push back” against any tightening of financial conditions.

The upshot has been a late-cycle speculative melt-up in U.S. equities, in particular. Popularly shorted stocks have been targeted for “squeezes” the most aggressively since 1999. So-calledhigh betastocks have become market darlings like it’s 1999. Stocks with minimal earnings (hence, little risk of earnings disappointments) have become the target of market game-playing and shenanigans to an extent not experienced since 1999.

The excesses from 1999 set the backdrop for a major market Bubble top in early-2000. Yet the late-nineties Bubble was relatively contained, chiefly impacting a narrow group of stocks, the technology sector and only a segment of the U.S. and global economy. The now well-entrenchedglobal government finance Bubble” has become deeply systemic in the U.S. and abroad. The Bubble essentially enveloped all risk market and myriad strategies. It has fueled conspicuous speculative excess in risky strategies. It has, as well, fueled unappreciated excesses throughout perceived low-risk strategies.

The Bubble has spurred excessive issuance and mispricing in high-risk junk bonds, leveraged loans and risky municipal debt. It has also spurred massive over-issuance of perceived high-quality Treasury securities and “money-likedebt instruments. It has spurred a boom in perceived liquid and low-risk ETF products, funds that loaded up on illiquid securities as “moneyflooded in. It has fueled record assets in hedge funds and sovereign wealth funds. It has spurred incredible concentration of assets in the hands of a group of sophisticated financial operators most adept at playing policy-driven speculative markets.

As an analyst of Bubbles, I readily admit it is impossible to accurately predict the timing of their demise. Even in hindsight, I have no idea why technology stocks put in Bubble highs in March of 2000. It’s not clear why stocks peaked again when they did in 2007. It’s never been clear to me why the U.S. equities Bubble cracked when it did in late-1929.

But all those major market tops were put in after speculative market melt-ups pushed the divergence between inflated securities price Bubbles and deteriorating fundamentals to precarious extremes. And all three speculative melt-ups were fueled in part by powerful short squeezes, squeezes made possible by traders shorting securities in response to deteriorating fundamental backdrops. A similar environment exists for a major top in 2013.

Brazil’s Growth Imperative

Danny Leipziger

23 August 2013
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SÃO PAULOBrazil has lost its swagger. Growth estimates for this year put Latin America’s largest economy above only Venezuela and El Salvador in the region, and the outlook for next year is not much better. Brazil’s currency, the real, has fallen to its lowest level against the US dollar in more than four years, compelling the government to pump billions of dollars into the foreign-exchange futures market and raise interest rates to deter capital outflows – just a few years after imposing a new tax to deter inflows. So what is really happening in Brazil, and what can be done to secure a prosperous future?
To be sure, Brazil has done remarkably well on some measures of economic performance over the past decade. For example, its extensive social programs, combined with past GDP growth, have improved the country’s income distribution markedly.
But, over the same period, annual GDP growth has averaged a modest 3.5%, and productivity growth has slipped into negative territory. Brazil’s labor productivity is one-fifth that of the United States and lower than that of Mexico and Chile. As a result, Brazil may not be as well positioned to take advantage of its demographic dividend (when a rising share of working-age people creates new opportunities for economic growth) as its leaders believe.
One factor limiting Brazil’s prospects is its low productivity, which can be explained partly by an anemic investment rate of 18% of GDPlow for Latin America and paltry compared to East Asia. Insufficient investment has meant inadequate infrastructure. Thus, despite massive spending on stadiums for next year’s World Cup, logistics costs remain high, sapping Brazil’s competitiveness and limiting its growth prospects. Meanwhile, corruption scandals and widespread frustration with the low quality of public services are fueling social discontent and reducing investor confidence.
Brazil’s economic boom was largely a product of skyrocketing commodity prices. Despite a push by Brazil’s development bank, BNDES, to shore up competitiveness and promote the formation of larger, multinational industrial firms, Brazil’s manufacturing position has continued to decline. While the agricultural sector has shown some productivity gains since 2000, high logistics costs have constrained its impact. Brazil is still searching for new drivers of growth.
President Dilma Rousseff’s administration, like that of her predecessor, Luiz Inácio Lula da Silva, clearly has not absorbed the primary lesson of East Asia’s economic rise: while industrial policy can augment economic development, it is no substitute for investment in infrastructure, human capital, and export-oriented industries.
Although Brazil boasts effective tax collection and its central bank has a reputation for prudent monetary policy, fiscal resources are squandered on social programs and on constitutionally mandated expenditures that produce low returns, owing to poor public-sector implementation.
Meanwhile, high domestic borrowing costs are undermining private investment. According to the World Bank, Brazil ranks 130th out of 185 countries in terms of the ease of doing business.
Against this background, Rousseff’s government was perhaps rash to decry the inflow of “unwanted capital” in recent years and to erect import barriers aimed at protecting domestic industry by hampering market competition. A wiser strategy would have been to boost investment by using financial intermediation to allocate these funds to firms that are being crowded out of domestic capital markets by excessively high borrowing costs.
In fact, the government’s approach served only to exacerbate Brazil’s problems of low capital investment, weak competition, and relatively little innovationproblems that have prevented the country from achieving any gains in total factor productivity in the last two decades. Most local forecasters now put Brazil’s growth rates well below potential output. If they are right, it will be difficult to maintain the hard-won economic and social gains of the last decade.
To avoid such an outcome, Brazil’s leaders must increase the efficiency of government spending and use the freed-up resources to clear infrastructure bottlenecks. Success should be measured according to impact on, say, the quality of education and skills acquisition, rather than according to the mandated level of public spending.
Furthermore, policymakers should pursue comprehensive reform aimed at eliminating domestic firms’ privileges and boosting competition, including with foreign firms. In order to enhance Brazilian industry’s export competitiveness, industrial policy must support a transition to high-value products and services. To this end, BNDES loans should be reallocated from incumbents to innovative firms.
Success in all of these areas depends on effective implementation, monitoring, and cooperation between government and business. In the next 10-15 years, Brazil will have a tremendous opportunity to capitalize on its demographic dividend. Unless it has achieved high enough levels of productivity and growth, it will miss its chance.
Manufacturing, which fell from 30% of GDP in 1980 to 15% in 2010, must become an engine of innovation and GDP growth. At the same time, the rapidly growing services sector – which accounts for 90% of Brazil’s newly created jobsmust be made more productive, which requires a stronger emphasis on services linked to manufacturing and exports.
After a decade of reforms and retrenchment under President Fernando Henrique Cardoso in the 1990’s, and a decade of policies favoring social inclusion under Lula, Brazil needs a decade of economic growth. Its government has no time to waste.
Danny Leipziger, Professor of International Business at George Washington University and Managing Director of the Growth Dialogue, was a vice president of the World Bank and served as Vice Chair of the Spence Commission on Growth and Development. 

Weekly COMEX Gold Update: No Relief In Sight For Registered Gold Inventories

Aug 25 2013, 00:35 

by: Hebba Investments

In the last week's report, COMEX gold inventories continued to drop even with the rising gold price, but the declines have been smaller than in past weeks. This week's COMEX data shows that a slight increase in eligible gold inventories, but registered gold continues to drop.
This is something that should be very relevant to investors who own physical gold and the gold ETFs (GLD, PHYS, and CEF) because any abnormal inventory declines may signify extraordinary events behind the scenes that would ultimately affect the gold price.

(click to enlarge)

As investors can see in the chart above, both registered and eligible gold stocks have been declining significantly since the beginning of 2013, though they seem to have begun to stabilize. We will take a closer look at these numbers, but let us first explain the COMEX a little more for investors who are unfamiliar with it.

Introduction to COMEX Warehousing

COMEX is an exchange that offers metal warehousing and storage options for its clients. The list of their silver warehouses can be found here and their gold warehouses can be found here. In the case of silver and gold, the metal is stored at these official warehouses on behalf of banks and their clients and can be used to settle futures contracts, transferred between clients, or withdrawn from the warehouse. This offers large holders of precious metals a convenient way to store their metal with minimal storage fees - very convenient indeed if you hold large amounts of gold or silver and you don't want to store them in your basement.

Silver and gold stored in these warehouses can fall into two categories: Eligible and Registered.

Eligible metals are those that conform to the exchange's requirements of size (1000 ounce bars for silver and 100 ounce bars for gold), purity, and refined by an exchange approved refiner. Eligible metals are stored at COMEX warehouses on behalf of banks or private parties, but are not available for delivery for a futures contract.

Registered metals are similar to eligible metals except that these metals are also available for delivery to settle a futures contract. COMEX issues a daily report on gold, silver, copper, platinum, and palladium stocks, which lists all the metal that is currently stored in COMEX warehouses and how much eligible and registered metal is present.

This information allows investors insight into how much metal is currently backing COMEX futures contracts, what large gold and silver owners are doing with their metals, and how many clients are requesting delivery of their metals. There is a lot more to glean from this information but for the purpose of this article we will focus on the gold drawdown.

This Week's Changes: Modest Decline in Registered Gold as Eligible Gold Rises

Let us now take a deeper look at the gold draw-downs being seen in the COMEX warehouses.

(click to enlarge)

As investors can see in the table above, we have been seeing consistent declines in gold inventories since December. Last week we saw eligible stocks of COMEX gold increase by 43,267 ounces and total COMEX gold increase by a small 14,265 ounces. This negated a little bit of the decline from the previous week.

Now, let us take a look at registered gold stocks.

(click to enlarge)

Even though eligible gold increased on the week, registered gold continued to decline to a new low of 767,232 gold ounces - which was despite a sizable increase in the gold price.

As we have mentioned before, we do not know why gold is leaving the COMEX - but we do know it is still leaving in ever increasing quantities. The steep decline seems to have ended with the gold price rising off of its lows, but until we see gold entering the COMEX in large quantities, this situation is worth monitoring for all precious metals investors.

What does this mean for Gold Investors

It will be interesting to see how COMEX gold inventories respond to the increase in the gold price - will more registered gold come back to the COMEX or is it gone elsewhere for good? Investors should remember that even though the COMEX is not primarily used as a physical market for commodities, the physical gold inventories do provide the underlying foundation for all outstanding contracts.

This is where the very important "owners-per-ounce" statistic (which we have covered before) comes into play. If, as the gold price rises, open interest increases but gold inventories do not, then each contract will be backed by fewer and fewer physical ounces of gold. At a current ratio of around 50 paper ounces to every physical ounce, there really is not a lot of further cushion before we may have players question the situation - which could lead to a COMEX gold run.

Even with the rising gold price, we would not be selling our gold, or advising investors to sell their gold, until we feel that physical holders of gold are selling their physical gold. COMEX inventories suggest there is still quite a ways to go before this happens.

Therefore the situation is still very bullish for investors in physical gold and the gold ETFs (GLD, CEF, and PHYS). Investors interested in leveraging this situation into higher potential profits should also consider buying gold companies such as Randgold (GOLD), Goldcorp (GG), Eldorado Gold (EGO), and any of the other gold miners - though we would caution investors that gold miners have had quite a run so current valuations may be a bit frothy.