A plan for Europe’s refugees

How to manage the migrant crisis

A European problem demands a common, coherent EU policy. Let refugees in, but regulate the flow

REFUGEES are reasonable people in desperate circumstances. Life for many of the 1m-odd asylum-seekers who have fled Syria, Iraq, Afghanistan and other war-torn countries for Europe in the past year has become intolerable. Europe is peaceful, rich and accessible. Most people would rather not abandon their homes and start again among strangers. But when the alternative is the threat of death from barrel-bombs and sabre-wielding fanatics, they make the only rational choice.

The flow of refugees would have been manageable if European Union countries had worked together, as Angela Merkel, Germany’s chancellor, has always wished (and The Economist urged). Instead Germany and Sweden have been left to cope alone. Today their willingness to do so is exhausted. Unless Europe soon restores order, political pressure will force Mrs Merkel to clamp down unilaterally, starting a wave of border closures. More worrying, the migrant crisis is feeding xenophobia and political populism. The divisive forces of right-wing nationalism have already taken hold in parts of eastern Europe. If they spread westward into Germany, France and Italy then the EU could tear itself apart.

The situation today is a mess. Refugees have been free to sail across the Mediterranean, register and make for whichever country seems most welcoming. Many economic migrants with no claim to asylum have found a place in the queue by lying about where they came from. This free-for-all must be replaced by a system in which asylum applicants are screened when they first reach Europe’s borders—or better still, before they cross the Mediterranean. Those who are ineligible for asylum should be sent back without delay; those likely to qualify should be sent on to countries willing to accept them.

Order on the border
Creating a well-regulated system requires three steps. The first is to curb the “push factors” that encourage people to risk the crossing, by beefing up aid to refugees, particularly to the victims of the civil wars in Syria and Iraq, including the huge number who have fled to neighbouring countries such as Turkey, Jordan and Lebanon. The second is to review asylum claims while refugees are still in centres in the Middle East or in the “hotspots” (mainly in Greece and Italy), where they go when they first arrive in the EU. The third element is to insist that asylum-seekers stay put until their applications are processed, rather than jumping on a train to Germany.

All these steps are fraught with difficulty. Consider the “push factors” first. The prospect of ending Syria’s civil war is as remote as ever: peace talks in Geneva this week were suspended without progress. But the EU could do a lot more to help refugees and their host countries.

Scandalously, aid for Syrians was cut in 2015 even as the war grew bloodier: aid agencies got a bit more than half of what they needed last year, according to the UN. Donors at a conference on Syria in London this week were asked for $9 billion for 2016—about as much as Germans spend on chocolate every year. Far more is needed and will be needed every year for several years.

Europe’s money should be used not only to feed and house refugees but also to coax host countries into letting them work. For the first four years of the conflict Syrians were denied work permits in Turkey, Jordan and Lebanon. Recently Turkey has begun to grant them.

Donors should press Jordan and Lebanon to follow. European cash could help teach the 400,000 refugee children in Turkey who have no classes.

Sometimes the answer is no
The next task is to require asylum-seekers to register and be sorted as close to home as possible, probably Turkey, Lebanon and Jordan. Ideally those who travelled by boat to Europe would be sent back to a camp in one of those three countries—to prove that they had just wasted their precious savings paying people-traffickers to take them on a pointless journey. But that would meet legal and political objections, partly because of Turkey’s human-rights record. So, there should also be processing camps in the first EU country they reach, probably Greece or Italy.

The cost of this should fall on the whole EU, since the aim is to establish control over its external borders. Dealmaking is possible. In exchange for hosting large refugee hotspots and camps on its soil, Greece should get help with its debt and budgets which it has long sought to ease its economic crisis.

Refugees will fall in with this scheme (rather than cross the EU illegally) only if they are confident that genuine applications will be accepted within a reasonable time. So the EU needs to spend what it takes to sort through their claims swiftly. And member states ought to agree to accept substantial numbers of bona fide asylum claimants. Some refugees may prefer Germany to, say, France—and there is little to stop them crossing borders once they are inside the Schengen area. But, if they are properly looked after, most will stay put.

The crisis needs a bigger resettlement programme than the one run by the UN’s refugee agency, which has only 160,000 spaces. Countries outside the EU, including the Gulf states, can play their part. Priority should go to refugees who apply for asylum while still in Turkey, Jordan or Lebanon—to reduce the incentive for refugees to board leaky boats to Greece.

Ineligible migrants will have to be refused entry or deported. This will be legally difficult, and it is impossible to repatriate people to some countries, such as Syria. But if the system is not to be overwhelmed or seen as unfair and illegitimate by EU citizens, the sorting must be efficient and enforceable. EU governments should sign and implement readmission agreements allowing rejected migrants to be sent home quickly to, say, Morocco or Algeria. If such agreements are impossible (or if, as with Pakistan, governments fail to honour them), the prospect of waiting indefinitely in Greece will make economic migrants who want to reach Germany hesitate before coming.

Once these measures are in place, it will become possible to take the most controversial step: halting the uncontrolled migrant flow across Greece’s northern border with Macedonia. It has become clear over the past five months that Europe cannot gain control over the numbers or the nature of the migrant stream while border officials wave asylum-seekers through and bid them safe travel to northern Europe.

Since the start of the refugee crisis, we have argued that Europe should welcome persecuted people and carefully manage their entry into European society. Our views have not changed.

Countries have a moral and legal duty to provide sanctuary to those who flee grave danger.

That approach is disruptive in the short term, but in the medium term, so long as they are allowed to work, refugees assimilate and more than pay for themselves. By contrast, the chaos of recent months shows what happens when politicians fail to take a pan-European approach to what is clearly a pan-European problem. The plan we outline would require a big chunk of cash and a lot of testy negotiations. But it is in every country’s interest to help—because all of them would be worse off if the EU lapses into a xenophobic free-for-all.

There is an encouraging precedent, too. When more than 1m “boat people” fled Vietnam after the communists took over in 1975, they went initially to refugee camps in Hong Kong and other parts of Asia before being sent to America, Europe, Australia and wherever else would take them. They arrived with nothing but adapted astonishingly fast: the median household income for Vietnamese-Americans, for example, is now above the national average. No one in America now frets that the boat people will not fit in.

Yellen Punts On State Of Economy

2-10-2016 2-40-09 PM

Bulls hoped Yellen would deliver some dovish rhetoric but she didn’t say much overall.

Pundits struggled to offer something concrete regarding what Yellen had to say this day but could only offer the most diplomatic comments.

Finally, as stocks rallied modestly, early observers could only suggest what she hinted was interest rates would only rise “gradually”, if at all frankly. So that’s what passed for bullish news.

Yellen has another day of testimony before the senate. Given that, she’ll return to her focus groups at the Fed ascertaining what she might say next to push stocks higher. Her client/owners, the primary dealers (appx. 20 large banks), need to be encouraged.

By day’s end traders threw in the towel on the rally, at least for this day, and closed many of market sectors lower. Again, crude oil led markets lower along with materials and other commodities. Gold was higher and the dollar declined overall the Japanese yen rallied. Germany’s Deutsche Bank shares rallied near 10% on hopes a share buyback will come to fruition.

Market sectors moving higher included: Volatility (VIX), Healthcare (XLV), REITs (IYR), Homebuilders (ITB), Europe (VGK), Italy (EWI), Spain (EWP), Ireland (EIRL), Belgium (EWK), China (FXI), China Small Caps (HAO), Russia (RSX), Brazil (EWZ), Gold (GLD), Gold Stocks (GDX), Yen (FXY) and Treasury Bonds (TLT)

Market sectors moving lower included: Financials (XLF), Banks (KBE), Regional Banks (KRE), Energy (XLE), Industrials (XLI), Materials (XLB), MLPs (AMLP), Japan (EWJ), Hedged Japan (DXJ) India (EPI), Canada (EWC), India (EPI), Crude Oil (USO), Natural Gas (UNG) and so forth.
Below is the heat map from Finviz reflecting those ETF market sectors moving higher (green) and falling (red). Dependent on the day (green) may mean leveraged inverse or leveraged short (red).

2-10-2016 2-40-54 PM
Volume was still elevated and breadth per the WSJ was mixed.
2-10-2016 2-42-28 PM
12-17-2015 9-04-44 PM Chart of the Day

2-10-2016 2-42-57 PM NIKK

Charts of the Day


    SPY  5  MINUTE
























































    The NYMO is a market breadth indicator that is based on the difference between the number of advancing and declining issues on the NYSE. When readings are +60/-60 markets are extended short-term.


    The McClellan Summation Index is a long-term version of the McClellan Oscillator. It is a market breadth indicator, and interpretation is similar to that of the McClellan Oscillator, except that it is more suited to major trends. I believe readings of +1000/-1000 reveal markets as much extended.


    The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge". Our own interpretation has changed due to a variety of new factors including HFTs, new VIX linked ETPs and a multitude of new products to leverage trading and change or obscure prior VIX relevance.

Was this just more wasted buying power Wednesday? It looks like it.

Before putting the week in a bust category let’s see how Janet is able to communicate dovishness to an unconvinced audience of investors. She and her focus group will be keeping the lights on at 33 Liberty until late as they craft a new message for senators.

Let’s see what happens.

They Broke the Silver Fix

By: Keith Weiner

Last Thursday, January 28, there was a flash crash on the price chart for silver. Here is a graph of the price action.

The Price of Silver, Jan 28 (All times GMT)
Price of Silver, Jan 28

If you read more about it, you will see that there was an irregularity around the silver fix. At the time, the spot price was around $14.40. The fix was set at $13.58. This is a major deviation.

Many silver bugs are up in arms about how unfair the new silver fix is. That's nothing new.

They were up in arms about the old one. The old one was supposedly manipulated.

One thing is for sure, tactical manipulations can occur. A gold trader in London was found to have pushed the price down in the gold fixing by a few pennies. He had sold a multimillion dollar option, and he wanted it to expire worthless to avoid having to pay. Right after the fix, he bought back the gold he sold, pushing the price back up to where it was. He took a loss on the round trip of the gold, of course, but saved millions on the option which he did not have to pay.

This is not the long-sought proof that nefarious forces are keeping gold from attaining $20,000.

Anyways, because the silver and gold fixes were deemed to be benchmarks by regulatory changes post the LIBOR manipulations, a new process for the gold and silver fixes was implemented. Before we look at what changed, let's consider why there is a fix price. Couldn't they just take the price at 12:00 noon?

No, it wouldn't work because in a live market there is not just one price. There are always two prices: bid and offer. Which would you use as the benchmark? Either price could misrepresent the current state of the market. What's more, those prices are just quotes, not executed trades.

To be useful as a benchmark -- a price that third party contracts and derivatives can be based on -- there has to be a single price based on real executed trades. So they need to get buyers and sellers together, and find the price at which the most metal clears. If there is a better way than that, it hasn't been discovered yet.

This leads to a question. How do two prices that are supposed to track each other actually, you know, stay matched? This occurs in Exchange Traded Funds that move with an index of stocks (such as SPX or GLD). It occurs in gold futures and spot.

It should also occur between the fixing process and the spot market. What use is a silver fix at $13.58 while the spot price was $14.40? We'll get back to market action on that day, in a bit. First, we need to look at the force that keeps two prices close to each other.

It is arbitrage. Let's use GLD as an example. Each share represents a known quantity of gold.

Suppose the price of the share rises relative to the price of gold metal in the spot market, and the metal in a share of GLD is $1 per ounce higher. The arbitrageur buys gold metal, creates shares of GLD, and sells them. This tends to pull up the price of gold metal, and mostly pushes down the price of GLD.

Note that the arbitrageur takes no price risk. He is simply acting to profit from a spread (usually a very small one). Arbitrageurs will keep doing this trade, until GLD and gold metal get close enough that the small remaining profit is not worth the effort.

The arbitrageur is motivated, of course, by profit. He is as greedy as the next guy (admit it, if you could demand a 300% raise from your boss, you would). However, his activity is self-limiting. The more he puts on his trade, the more he compresses the spread. In our example, the arbitrageur buys some gold metal and sells some GLD shares, to make $1. That is the initial profit. However, he compresses that spread, perhaps to 50 cents. He can have another go, but then the spread narrows to 25 cents. Soon enough, he walks away (these are illustrative numbers only for this example).

It's a textbook case of the Invisible Hand described by Adam Smith. The arbitrageur, seeking his own profit, ends up serving other market participants. He keeps two different prices locked tightly together. Everyone else can take for granted that GLD works as it's supposed to.

For example, suppose you run a small gold coin store. You need to hedge your inventory just as a large dealer does. However, you sell gold one ounce at a time. Big dealers might use 100-ounce gold futures, but you use GLD. You can thank the actions of this arbitrageur.

Now let's get back to the fix. The old process was conducted by the major market makers in each metal. They got together in one room, and each had major clients on various phone lines.

The chairman would put out a price, and the market makers would talk to their clients to determine who wanted to sell at that price and who wanted to buy. Then they add up all selling and buying, and see if there's a close match. They would keep moving the price until selling matched buying within tolerance. That was the fix price.

There was just one problem, at least so far as the gold bugs were concerned: the market maker.

Since the first market maker walked into a coffee house in London where shares were being traded, most people have misunderstood the market maker. Back in the coffee house days, all potential sellers would line up on one side of the room, in order from lowest offer price to highest. On the other side, buyers would line up, from highest bid to lowest.

If one had to sell, that meant taking the best bid presented in the room. Likewise, if one wanted to buy right now, one paid the best offer price. As you would imagine, the bid-ask spread could get pretty wide, and perhaps worse yet, it was unpredictable.

Until the market maker walked in. Unlike all the others, he was both a potential buyer and a potential seller. He had an inventory of both shares and cash. He published a better price if you wanted to buy or sell and as it turns out, he was the only one who could consistently buy at the bid price and sell at the ask price.

Of course, the guy with the best bid price -- or what had been the best price until the market maker strolled into the room -- was upset. Who is this dodgy bloke? Why is he allowed to mess about like this? Surely it's unethical, immoral, and maybe even illegal?

In fact, he is serving all market participants (except the few who hoped to sell and make a buyer pay a premium and the equally small few who hoped to buy from someone desperate to raise cash). The market maker is motivated by profit, sure, but in making money he is narrowing the bid-ask spread whilst also reducing its volatility.

Today, the market maker is aka High Frequency Trader, and he uses technology that the coffee house fellows could not have imagined. Nevertheless, he too encounters the same exact suspicion, if not resentment, if not envy and anger.

Now let's tie this to the silver fix. In the old fixing process, bullion bank dealers could place orders in the spot market during the fix. For example, if the fix price looked like it might settle at $14.30, but the spot price was $14.34, the dealers would buy the fix and sell spot, happy to make four cents.

Many objected to this because it looked like information was leaking into the market. They claimed it's so unfair, perhaps even a gateway drug to insider trading? If other market participants can't have this privilege, the bullion banks shouldn't have it either. And besides, they're supposed to be just brokers and not trading their own proprietary positions. The truth was that there was nothing stopping other market participants from also trading in the spot market during the fixing process, it was just that the bullion banks' dealers were more efficient at being market maker.

Well, in part due to the agitation of the gold and silver bugs, government regulators came down on the market makers. They fixed it so that market makers were no longer allowed to arbitrage the fix to the spot and futures markets.

Before you think "yeah, this is what we want," let's revisit one of our favorite and recurrent themes, namely: be careful what you wish for.

As it stands today, if the fix price is starting to deviate from the market price, the market makers' hands are tied. Ross Norman, CEO of bullion dealer Sharps Pixley in London, expressed his frustration with this. "The real problem as we see it is that banks are increasingly unwilling or unable to place corresponding orders where they perceive a mis-pricing because of fears of being accused of abusing a situation and facing the wrath of the regulator or their compliance departments."

The big clients who participate in the fixing process may be freer to trade. However, they don't have the same information. Market making is hard because you're playing for pennies or fractions of a penny, but if you screw up you can lose dollars. The clients may know how many rounds into the fixing process they are, and the order imbalance of each round. But they can't react as quickly as the bullion banks who are making markets in the spot, futures, and ETF markets, and they don't know as much about market conditions either. They can't arbitrage a few pennies. They need a much bigger spread.

A wider spread, much less an unpredictable spread, is to no one's benefit. For example, the mining companies often sell at the fix price, rather than try to time it (or be accused of breach of fiduciary duty by their shareholders if they mis-time it). How much deviation of the fix price will it take before miners are forced to embrace the next-best solution?

"The large discrepancy between the spot price and the fix is very alarming to us especially that it happened twice in a row," KGHM head of market risk Grzegorz Laskowski told FastMarkets.

The next best solution, by definition, is less advantageous than the best.

jueves, febrero 11, 2016



The Golden Age

by: Sober Look

Some people say that gold is dead. They point to deflationary pressures and a bear market that started back in September 2011. The bulls have been wrong for years; however, that may be about to change...
At present, there are multiple reasons to consider gold:
  • Sentiment is very negative, and almost everyone is underweight.
  • Supply and demand fundamentals are positive.
  • Chinese demand continues to rise.
  • Gold is a means to portfolio diversification.
  • The main risks to prices are overblown.
In the next sections, we will examine the bull case for gold and the risks facing it. In conclusion, we will try to answer the following question: Is this the beginning of a new golden age?
Sentiment and Positioning
In the latest Barron's Big Money Poll, only 3% of respondents thought gold was the most attractive asset class. Moreover, 71% were bearish on the yellow metal. Volume traded in the SPDR Gold Trust ETF (NYSEARCA:GLD) has come down dramatically, which indicates a lack of interest in gold bullion. Volume traded in the Market Vectors Gold Miners ETF (NYSEARCA:GDX) and the Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) has been increasing; however, interest in "gold mining stocks" has been falling since mid-2011.
This suggests that traders are trying to catch the falling knife, even though investors are not convinced that gold is undervalued.
In terms of positioning, market participants are heavily underweight materials and commodity stocks. Is this a contrarian buying opportunity? It could be. Especially because the current bear market is getting old. The following table shows the 5 most recent bull and bear markets:
Gold prices fell by 44% over the 52 months from September 2011 to January 7th, 2016. Those numbers match the median length and average cumulative return of the previous 4 bear markets. Gold may continue to fall from here; however, we are probably closer to the end of the bear market than to the beginning... 
Supply and Demand
~46% of gold production is FCF-negative at current prices. In other words, $1100 is not the equilibrium price. If we stay at these levels, then supply will likely decline. Analysts at Credit Suisse are projecting a deficit to begin in 2016. They expect that mine supply will fall by 11.5% from 2015 to 2018:
Even at higher prices, gold miners will be unable to replace all of their depleting reserves. Also, it will be very expensive for them to bring new projects on-line. Lastly, it is important to note that major gold discoveries have become scarce. These trends are negative for supply and positive for prices.
On the demand side, Asia and Europe should continue to support the market. Total bar and coin demand (in tonnes) increased 33% YoY from Q3'14 to Q3'15. Furthermore, consumer demand was up across the board, with exceptionally big numbers in the US. According to the World Gold Council (WGC), "coin sales by the US mint during the quarter were on par with that of Q4 2008." Another key source of demand is central banks. They have continued to buy as they look to diversify their reserve assets. This speaks to gold's utility as a portfolio diversifier. Total demand has been falling; however, the quarterly numbers suggest it could be stabilizing. Going forward, consumer demand is likely to offset ETF outflows.
India and China are the main drivers of demand for gold. In 2014, they accounted for ~1710 tonnes of demand. To put that in perspective, 1700 tonnes = 53% of total consumer demand:
Gold is a big part of both India's and China's culture. As such, it is likely that demand will remain strong.
China's Gold Market
There is an interesting divergence taking place in the physical gold market. China's demand numbers, as measured by withdrawals from the Shanghai Gold Exchange (SGE), are much higher than those reported by the World Gold Council. SGE withdrawals exceeded the WGC's demand estimates by 3,193 tonnes from 2007 to 2014.
The following passage is from Bullion Star's Koos Jansen helps to explain the discrepancy.

"The difference was labeled as net investment (in the CGA Gold Yearbook 2013 at 1,022.44 tonnes), which is calculated by the China Gold Association (CGA) as a residual between what is withdrawn from the SGE vaults and gold sold at retail level (jewelry shops and banks). The WGC doesn't count net investment on its demand balance, but only measures what is being sold at retail level. Net investment, which roughly equals the difference, can only be caused by direct purchases from individual and institutional customers at the SGE that withdraw their metal."
In China, gold imports must pass through the SGE before entering the market place. In addition, bullion exports are prohibited. It follows that Imports + Mine Supply + Scrap = Total Supply = SGE Withdrawals. Said another way, SGE withdrawals are equivalent to domestic wholesale demand. The preceding formula is supported by reports from the CGA and the SGE.
For example, the SGE reported that 2197 tonnes were withdrawn from its vaults in 2013. That is the same number that the CGA reported for total demand in 2013.
The main conclusion is that the SGE's measure of Chinese gold demand is much higher than the WGC's. If the SGE's number are correct, then China is absorbing most of the world's mine supply.
Gold withdrawals from the SGE for 2015 amounted to 2596 tonnes, or 91% of world gold production:
Diversification and Protection
Gold has a negative correlation with US stocks during expansions. More importantly, its correlation with both global and US stocks is more negative during contractions:
As a result, gold tends to rise when stocks fall, which is good for portfolio diversification.
Gold is also an FX hedge for foreign investors. In 2015, it performed relatively well in non-dollar currencies such as the Brazilian real, the Russian ruble, the Chinese yuan and the Canadian dollar. This is important because non-US countries are the main consumers of gold.
Loose monetary policy is here to stay. This cycle, every central bank that tried to raise rates has had to reverse course. That is bad for currencies and good for gold, since no one controls its supply.
Gold can also protect us against a rising cost of living because it tends to hold its value over time. If you look at the CPI, then inflation seems relatively low. That said, the CPI is a utility index, not a measure of the cost of living. Most people would agree that cost of living is rising. For example, education and medical care costs have been outpacing the CPI for years.
Gold's main threats are...
1) A stronger USD
Typically, the US dollar index and gold are negatively correlated. Said differently, when the dollar index does up, gold goes down. Even so, last year, the US dollar (USD) influenced gold prices more than it usually does. In 2015, the correlation between the two was -0.50 in 2015, much higher than -0.36, which is the 30-year average. Going forward, it's likely that the correlation between gold and the USD will revert to normal.
An additional concern is rising rates. One may assume that higher interest rates are good for the dollar. Actually, that is not the case. Historically, the dollar has stopped appreciating when the US raised rates. If the USD index has peaked, then that would be good for gold prices.

2) Rising rates
Despite the Fed's intentions, the yield curve (2s10s) has flattened to its lowest levels of the expansion. The short end has increased, but the long end, which is driven by growth expectations, has not. Basically, the market is not convinced that the era of low rates is over.
Even if rates do increase, gold may perform well. According to Sundial Capital Research, gold actually does quite well in rising rate environments. Gold prices increased by an average of 25.2% in each of the rising rate environments from December 31, '76 to December 27, '13. The median gain was 5.2%, which is much less impressive, but still positive. Low rates are probably better for gold than high ones. That said, it may show good returns either way.
3) Leverage
In the US, the paper gold market is much bigger than the physical one is. In other words, many contracts are traded, but not much gold changes hands. The level of gold dilution has reached unprecedented levels. In a recent blog post, Zero Hedge showed that there are 40 million ounces worth of open interest, but only 74 thousand ounces of registered gold at the Comex. This works out to a gold cover ratio (open interest/registered gold) of 542! The takeaway point is that the amount of gold that is traded is much greater than the amount that actually exists.
The downside risk is that supply in the futures market overshadows demand in the physical market, thereby weighing on prices. Still, there is an upside risk. If demand for physical gold remains strong and inventories continue to fall, then then the Comex may run out of supply. If that happens, then gold prices will rise as market participants start to question the divergence between the paper and physical markets.
Gold should be considered as a contra buy...
  • It is hated.
  • Its fundamentals are improving.
  • Demand from the East is robust.
  • It is negatively correlated with stocks.
  • The benefits outweigh the risks.
Gold is massively under-owned. If sentiment improves, then it could easily outperform other asset classes in 2016…

Up and Down Wall Street

Markets Suffer as China Depletes Reserves

In trying to prop up their currency by selling foreign-exchange reserves, the Chinese are stoking volatility in global stock markets. Also putting pressure on shares: asset liquidations by sovereign wealth funds.

By Randall W. Forsyth

In keeping with the current practice of starting with a scriptural reference, today’s lesson comes from the Book of Genesis, in which Joseph won the pharaoh’s favor by interpreting the Egyptian ruler’s dreams.

Joseph advised that, during seven years of plenty, surplus grain should be stored to prepare for seven years of famine. So, when the lean times arrived, Egypt had ample seed to feed itself and to sell to its neighbors, setting up Joseph as the commodity guru of his time.

Whether this biblical lesson took hold in international finance is hard to say. But some nations that had gone through the fat years of rising oil and other commodity prices did amass huge stores of financial assets in what’s known as sovereign wealth funds. These included oil exporters in the Middle East and Norway, plus Asian powerhouses with big surpluses, such as China, Hong Kong, and Singapore.

Central banks of countries with large trade surpluses also built up big caches of foreign-exchange reserves, although it wasn’t Joseph’s example that they followed. In some cases, as with China, the central banks bought up foreign currencies (mainly dollars) to prevent their own from rising too much.

Some countries also were traumatized by memories of the 1997-98 emerging market crisis, during which a number experienced painful devaluations and what they saw as humiliating bailouts by the International Monetary Fund. To prevent a recurrence, they built up war chests to defend their currencies and economies against future onslaughts.

Whatever their motivations, sovereign wealth funds and central banks acquired large sums of assets during the lush times, no doubt having a positive impact on stock and bond prices around the globe. Now, however, the process is working backward, as they are being forced to sell some of those assets, with the opposite effect.

The suddenly straitened circumstances of oil exporters are making them recycle their petrodollars in reverse, selling stocks and bonds of Western nations that they had accumulated in the past in a kind of vendor financing. Saudi Arabia is even having to borrow in international bond markets and is mulling the sale of shares in its national oil company, Aramco. That would help cover the shortfall in revenues from crude oil in the low-$30 a barrel range, as well as increased expenditures, including for its military.

China, meanwhile, has seen its currency reserves plunge dramatically in recent months. Capital flight has forced the Chinese monetary authorities to spend their rapidly shrinking foreign-exchange reserves to prevent their currency, the renminbi or yuan, from depreciating too rapidly.

This, writes John Brady, who has his highly sensitive ear to the ground as managing director at R.J. O’Brien, a major Chicago futures broker, is the “single largest cloud overhanging the markets.” That’s because the shrinkage of China’s foreign-exchange reserves represents a significant tightening of financial conditions.

Not long after this column goes to press (or the 21st century electronic equivalent), China will release the most important datum, in O’Brien’s view: a tally of its currency reserves. This will show how much the nation’s monetary authorities have spent to offset the exodus of capital seeking to escape the Middle Kingdom, in many cases evading the barriers set up to bar or limit its exit. This number is even more important than the January U.S. employment report released on Friday (about which, more later), he contends.

In the past six months, China has burned through $800 billion in foreign-exchange reserves, which stood at $3.3 trillion as of December, and the total is estimated to have fallen another $120 billion in January. “Street economists, along with the IMF, have written that $2.8 trillion is the lowest acceptable level for China’s forex reserves, so anything below the $3.2 trillion number expected this weekend may add to an increased sense of urgency, as an approach of $2.8 trillion will be seen as undermining global confidence in the People’s Bank of China’s ability to resist currency depreciation and to manage future balance-of-payment shocks,” Brady writes.

For that reason, hedge funds and other investors have been piling into bets that China will be forced to give up its prideful attempt to prop up the yuan, as The Wall Street Journal reported last week. That, of course, contradicts Republican presidential candidate Donald Trump’s assertion that China is deliberately lowering its currency, as noted here previously (“Trump Is Wrong on China,” Nov. 14). Presumably, these hedge-fund managers are also “really, really smart” and “really, really rich,” and yet they come to the opposite conclusion from the Donald, incredible as that may sound. More important are the global implications of China’s vainglorious attempt to try to stem the tide against the yuan by spending billions in foreign-exchange reserves. As Brady explains:

“The spending of forex reserves is in itself a monetary tightening (sell U.S. dollars/buy Chinese yuan/removing yuan from the system), and the Chinese economy isn’t in that part of its economic cycle where it can withstand a dramatic or quick tightening.” Expectations about Federal Reserve interest-rate increases have shifted, he notes, with barely even money on a second hike by the end of 2016. “But it is the pace of reserve liquidation that has the highest potential to keep market volatility and repricing higher than otherwise,” he adds.

And, should you need reminding, higher volatility almost invariably means lower asset prices.

SOVEREIGN WEALTH FUNDS HAVE BEEN LIQUIDATING ASSETS at the same time as the central banks of China and other nations, also with significant impacts on capital markets.
Their sizes give an indication of their potential effects. Norway’s is the largest at about $825 billion, as of last month, according to Statista.com. It’s followed by Abu Dhabi, at $773 billion; the China Investment Corp., at $747 billion; SAMA Foreign Holdings of Saudi Arabia, at $669 billion; and the Kuwait Investment Authority, at $592 billion.

Given the opacity of many of these organizations, estimating their flows is tough, but JPMorgan economist Nikolaos Panigirtzoglou makes a valiant effort. (Thanks to our colleague Chris Dieterich for bringing this to light in his Focus on Funds blog on Barrons.com.)

Lumping together liquidations of the central banks and the sovereign wealth funds of oil-producing nations, Panigirtzoglou estimates that they sold $90 billion of government bonds, $50 billion of public equities, $7 billion of corporate bonds, and $15 billion of cash instruments in 2015.

For 2016, assuming an average oil price of $35 a barrel, Panigirtzoglou estimates that their shortfalls will be covered by liquidations of $220 billion of assets and borrowings of $20 billion.
That would imply the sale of $107 billion of government bonds, $80 billion of public equities, $12 billion of corporate bonds, and $19 billion of cash instruments.

In the equity sphere, he finds, sovereign wealth funds are overweighted in financial and consumer-discretionary stocks and geographically in European markets. Not surprisingly, market watchers infer a connection in the steep drop in European banks, notably Deutsche Bank (ticker: DB), some of which are trading below their 2009 crisis lows. U.S. financials also have taken a battering of late, on concerns about their energy-loan exposure.

THE MARKET TOOK A PUMMELING on Friday from all sellers. The January jobs report provided an inverse Goldilocks effect: some disappointments, but none bad enough to elicit a reaction from the Fed. Nonfarm payrolls rose by 151,000, short of forecasts of a gain in the 190,000 region, and short of the downwardly revised increase of 262,000, originally estimated at 292,000. But the separate household survey showed a 0.1 percentage point downtick in the headline unemployment rate, to 4.9%, although the broader “underemployment” rate held steady at 9.9%.

Broad equity measures shed about 2% on Friday, but the Nasdaq Composite got clobbered by 3.3% as investors saw the bad things that can happen to high-beta, high-multiple tech names. What may be happening, according to Jim Paulsen, chief investment strategist and economist at Wells Capital Management, is that the old leadership groups have become the laggards, and vice versa.

For instance, he notes that the S&P financial, health-care, consumer-discretionary, and technology groups have gone from the top of the leader board last year to the bottom in 2016.
Meanwhile, last year’s low-beta sluggards—consumer staples, telecoms, and utilities—have come into favor in what’s shaping up to be a year of living dangerously.

Perhaps the allure of these defensive groups is being burnished by the further fall in bond yields, with Treasury yields down to 12-month lows (despite steady sales by central banks and sovereign wealth funds). Their dividends also look a lot more secure than those in the energy sector, a situation underscored by the payout cut announced last week by ConocoPhillips (COP).

The 394 dividend reductions in 2015 topped the 295 in 2008, according to Bespoke Investment Group. And this year may be worse, given the deterioration in the high-yield bond market.
“When the credit markets are willing to lend, companies have jumped at the opportunity to borrow and increase their payouts. The flip side is what we are seeing now, and when the credit markets start to turn off the spigot, some companies find they don’t have the cash flows to support their payouts,” Bespoke explains.

Then again, the group rotation may simply be a manifestation of the biblical injunction that the first will be last and the last will be first. Here endeth the lesson.

Oil market spiral threatens to prick global debt bubble, warns BIS

An 'illusion of sustainability' has blinded borrowers and debtors, lulling them into a false of security. The BIS says liquidity is now drying up

By Ambrose Evans-Pritchard

Jaime Caruana, General Manager of the Bank for International Settlements, addresses the participants of the XXIII International Banking Congress in St. Petersburg

Jaime Caruana, general manager of the Bank for International Settlements Photo: EPA

The global oil industry is caught in a self-feeding downward spiral as falling prices cause producers to boost output even further in a scramble to service $3 trillion of dollar debt, the world’s top watchdog has warned.

The Bank for International Settlements fears that a perverse dynamic is at work where energy companies in Brazil, Russia, China and parts of the US shale belt are increasing production in defiance of normal market logic, leading to a bad “feedback-loop” that is sucking the whole sector into a destructive vortex.
“Lower prices have not removed excess capacity from the market, but instead may have exacerbated it. Production has been ramped up, rather than curtailed,” said Jaime Caruana, the general manager of the Swiss-based club for central bankers.
The findings raise serious questions about the strategy of Saudi Arabia and the core Opec states as they flood the global crude market to knock out rivals in a cut-throat battle for export share.

The process of attrition may take far longer and do more damage than originally supposed.
Oil exporters are embracing austerity and slashing government spending, leading to a form of fiscal tightening that is slowing the global economy.


Speaking at the London School of Economics, Mr Caruana said the sheer scale of leverage in the oil and gas industry is amplifying the downturn since companies are attempting to eke out extra production to stay afloat. The risk spreads on high-yield energy bonds have jumped from 330 basis points to 1,600 over the past 18 months, amplifying the effects of the oil price crash itself.

The industry has issued $1.4 trillion of bonds and taken out a further $1.6 trillion in syndicated loans, driving up the combined energy debt threefold to $3 trillion in less than a decade.

While US shale frackers hog the limelight in the Anglo-Saxon press, many of these energy groups are giant "parastatals", such as Rosneft, Petrobras or China National Offshore Oil Corporation (CNOOC).

The BIS said state-owned oil companies increased debt at annual rate of 13pc in Russia, 25pc in Brazil and 31pc in China between 2006 and 2014, much it in the form of dollar debt through offshore subsidiaries. These oil companies do not respond to pure market pressures since they are cash cows for government budgets.

The nexus of oil and gas debt is just one part of an over-stretched financial system, increasingly exposed to the dangers of a “maturing financial cycle” and to punishing moves in the global currency markets.

Mr Caruana said an “illusion of sustainability” has blinded borrowers and debtors, lulling them into a false of security when credit was easy and asset prices were rising. This illusion can die in the blink of an eye. “The turning of the financial cycle can be quite abrupt,” he said.

The BIS calculates that debt in US dollars outside the United States has surged to $9.8 trillion, a fivefold rise since 2000 and an unprecedented level for the global monetary system as a whole.

While some of this dollar debt is matched by dollar assets and dollar earnings, a big chunk has been used to play the local property markets of east Asia, Latin America or eastern Europe, and another chunk has been gobbled up by “non-tradable” sectors that have no natural currency hedge if it all goes wrong.

The BIS estimates that 23pc of every dollar raised in bonds by emerging market companies has been diverted into the “carry trade”, stoking internal credit bubbles.

The average level of private credit in these countries has jumped from 75pc to 125pc of GDP since 2009. Corporate leverage is now more extreme than in the US and Europe. Profit ratios have dropped from 16pc to 9pc in four years, a clear warning sign.

The carry trade was highly profitable in the heyday of zero interest rates and quantitative easing by the US Federal Reserve, when credit was temptingly cheap and the falling dollar generated a currency windfall.

What looked like a one-way bet has proved to be a Faustian Pact now that the Fed is turning off the spigot, especially in countries such as Brazil, South Africa, Turkey, Russia, Malaysia or Azerbaijan, which have seen their currencies plummet. The "broad" dollar index has soared by 32pc since July 2011, the steepest and most sustained rise since the Second World War.

Mr Caruana said there is now clear evidence that this liquidity is drying up. Dollar loans to emerging markets peaked at $3.3 trillion and began to fall in the third quarter of last year, as chastened debtors pared back their exposure. Chinese companies have slashed their dollar liabilities to $877bn from $1.1 trillion in late 2014.

We may be approaching the eye of the storm. “The feedback loop between deleveraging and emerging market currency depreciation presents challenges that should not be underestimated.

The policy room for manoeuvre has been shrinking,” he said.

“The temptation may be to try to keep the financial booms going, or to give them a new lease of life, but this will be just a palliative unless the stock of debt is adjusted,” he said.

The BIS seems to be telling us that reckoning can still be orderly if we face up to reality, or end in a chaotic wave of defaults if we do not. Either way, the debt must clear.