Market Thinking - a view from the equity market


Tuesday May 23rd 2017

  • While the most crowded long trade in January – the dollar - is now flat, the most crowded short trade still appears to be volatility, although the sell-off in the inverse VIX ETF last week should be welcomed if it deflates rather than bursts the bubble
  • US foreign policy initiatives seem to be evolving into the US getting payback for previous support, through defence deals, trade and direct investment into the US
  • Short term supply restrictions in oil have kept it within its trading range, but long term demand issues suggest the very real prospect of stranded assets


Last week ended up as a bit of a long piece around structural change in China, leaving lots of other smaller items for this week. Oil for example has bounced back within its trading range, this time on OPEC (Organisation of the Petroleum Exporting Companies) talk of lower output from Saudi and Russia – although history surely tells us that this is hope over reality and chartists will be watching for lower highs and lower lows to confirm a downtrend. Meanwhile the embedded assumption by OPEC of continued demand growth for petroleum based transportation looks even more unrealistic as even without electric vehicles (EVs), fuel efficiency is rising quicker than miles driven suggesting peak oil has probably arrived, but not in the way that producers were thinking.

In China itself, the authorities continue to try and keep excess leverage from distorting market behaviour. This, rather than debt to GDP ratios is the key ‘problem’ for China. A long term plan to build out physical and monetary infrastructure can easily be disrupted in the short term and while last week I discussed how the shadow banking system is part of the solution rather than the problem, it nevertheless needs containment. The coal, iron ore and steel futures markets in China all stabilised over the last week or so as the People’s Bank of China (PBoC) stepped in to provide liquidity, highlighting the extent to which those markets tell us little about end demand and much more about speculative positions, collateral and other forms of shadow banking.

In the US, markets decided that in the absence of any more drama for the Europeans and not content with a new upset in Brazil, they needed a bit of their own and the Washington echo chamber became feverish last week on the prospects of presidential impeachment. This resulted in markets becoming initially nervous before deciding that there was an awful lot of wishful thinking taking place and deciding to stick with probabilities rather than possibilities. Nerves were also triggered by the cyber-attacks that dominated conversation at the start of last week and certainly worried a lot of people, but one of the best analogies I read was a direct comparison with real viruses. This is not a war we can permanently win, but it is not one we can permanently lose either.

The chart on the dollar index – DXY – now looks horrible for the dollar bulls, looking for a full retracement to last June’s 94 level. To be fair, the index itself is not really traded, rather the major pairs are  and a lot of the ‘damage’ is being done by the euro, which has now rallied 8% from the lows and is back in the middle of the 110-114 range from last summer. The real ‘currency’ winner however continues to be Bitcoin, which has gone parabolic, possibly helped by the need to pay ransom to computer hackers?

Chart 1: Bitcoin goes parabolic – Ransomware?

Source: Bloomberg AXA IM May 2017

However, while the world was focussed on WannaCry and possible impeachment of a US President, the US concluded the first part of a trade deal with China. When Presidents Xi and Trump met in Florida in April, there was a lot of anticipation about trade, but it was overshadowed by North Korea tensions. Now, rather quietly, we see the start of those talks coming into effect. As well as the more standard items such as US beef exports and Chinese cooked poultry exports, we would note the new ability of China to sign long term contracts for liquefied natural gas (LNG) imports from the US. We have highlighted several times in recent weeks the increasing role of LNG in US trade now that the US is moving to be a major exporter. There is still much to do of course on the more contentious areas such as steel and electronics, but clearly ‘The Deal’ is underway. With a capital account surplus, the US needs to attract foreign capital and not surprisingly then the US commerce department has issued a statement explicitly welcoming Chinese direct investment and in a move that must quietly upset Japan and India, the US sent a supportive delegation to the recent One Belt One Road (OBOR) symposium. Meanwhile, as part of a trade-off (again as discussed), the US has been told not to continue its ‘freedom of navigation’ exercises near the Chinese reefs in the South China Sea and arms deals with Taiwan have been put on hold. One interpretation of all this is that the rhetoric in the South China Sea and over Taiwan was part of a geo-political negotiation over North Korea and that the US has now conceded on ‘non issues’ (from a US perspective) in order to succeed in making North Korea ‘China’s problem’. Meanwhile both JP Morgan and Citi are to be allowed to underwrite and settle onshore bonds in China and US rating agencies are going to be allowed to rate them. As we have said many times in the past, the “Chinese don’t need western capital” per se, there is arguably too much capital already ‘trapped’ in China, but they do need western capital markets expertise. At the moment, much of China’s giant bond markets are short dated and rarely traded, in effect they are rolling bank loans. Extending the duration and improving tradability is a key first stage in developing an asset market that can support a proper savings and investment infrastructure (as we discussed last week). This move with the US banks, together with the Bond Connect which is likely to commence on the 20th Anniversary of the Hong Kong handover in July is all part of the process of capital market construction taking place. The fact that it is one step at a time should not obscure the direction of travel.

So the US and China are working out means of mutual co-operation. The US is backing down on some of its original seemingly bellicose behaviour on tariffs and navigation while the Chinese appear to be taking more responsibility for North Korea. Equally, the Chinese are diversifying their energy supply options and building their financial sector with the help of the Americans. Other Asia Pacific countries might be a little concerned, from Australia worried about gas exports, to South Korea worried about the North, Taiwan concerned over a moratorium on US arms sales or India and Japan concerned about the US support for OBOR initiative. However, the reality is that ChiMerica appears to be back.

Meanwhile, this week, President Trump was in the Middle East, where consistency suggests similar deals are being struck. The first of these appeared to come this week, when Saudi Arabia announced a US infrastructure deal with Blackstone as well as the expected arms deals. The timing on comments over Iran to coincide with the election of the new Iranian President could arguably been seen as a message to both sides and I think doubtless we will find that talks over the IPO of Saudi Aramco and diversification of Saudi assets into the US will have taken place.

The most crowded long trades of 2017, the dollar and commodities are now all but flat, marking the end of the so called reflation trade. Meanwhile, the biggest shorts – emerging markets and Europe – are also now flat having been the best performers. The last shall be first as they say. This doesn’t mean that we are just about to reverse the merry go-round and that the market will rotate again, rather than the sharp moves in markets are when risk positions are being closed.  Which bring me to one of the (still) most crowded trades in markets at the moment, short volatility. As discussed previously, I get nervous when derivative tools that have been designed to help institutional investors mitigate risk start to be treated as sources of return for retail investors. The inverse exchange traded notes (ETN) of the VIX is, in my opinion, one such instrument. Offering a return based on the inverse of the VIX implied volatility index, the XIV ETN has delivered spectacular returns over the last five years – up almost 700% - and as such has become one of the most heavily traded ETNs. Indeed, VIX related ETNs count for three of the top traded ETFs based on volumes according to State Street – the straight VIX note, VXX (3rd), the leveraged note UVXY (6th) and the reverse ETN,   XIV (13th). The recent performance of XIV reflects the underlying nature of the VIX itself and the VIX ETN, such as VXX, which is essentially a short dated insurance policy. Investors buy the VXX ETN to hedge against a sharp spike in implied volatility, in effect a form of buying put options on the market. Those buying XIV are on the opposite side, they are effectively selling that insurance. My concern is that they are not really aware of exactly what they are doing. They are merely chasing returns, the long term chart looks great, but the drawdowns can be very large. Briefly, the VIX future is in contango over 80% of the time, meaning that the second contract month (M2) trades at a premium (usually around 5%) to the near term one (M1) and the ETNs reflect a balance of the two. As time passes, M1 expire and M2 become M1 requiring the ETN to buy new M2. Many people assume it is having to buy M2 at a higher price that leads to the loss in the value of VXX and the rise in the value of its inverse, the XIV. However, as this article explains, that is not exactly how it works. Interesting that the article (and its detailed comments) were written at around the time that XIV (the inverse VIX) was suffering very badly. From a market stability point of view, my concern remains that this portfolio insurance is a momentum trade from the ETN market and can disappear just when people need it.

Chart 2 shows how the ETF gyrated wildly last week as the VIX spiked. The gyrations in the VIX last week around concerns over possible presidential impeachment had an interesting effect on the XIV ETF.

Chart 2: Inverse VIX ETF had a wild ride last week

Source: Bloomberg, AXA IM May 2017

In some ways it is encouraging to see the IVX recover from its sell off without, seemingly, causing any collateral damage. When we see bubbles inflating, which they invariably do, it is always best if the air escapes with a hiss rather than a bang. On the other hand, only time will tell if, like the credit default swaps in ‘The Big Short’ the posted price was just defying gravity for a little bit longer. Incidentally, the UVXY is a 2x leveraged version of the ultra-short term VIX. And if that wasn’t risky enough for you, you can buy options on the UVXY. Scary.

At the stock level, Asian results continued to come in on the positive side, with some extremely large sales numbers from the likes of Alibaba, who saw sales rise by 56%, highlighting the power of the Chinese consumer and China 2.0 as a theme. On the flipside old economy, Noble Group the Singapore quoted commodity trading company continues to implode. Having reported a large (and unexpected) trading loss, the running has really been made in the corporate bond markets where the company was a large player. The curious nature of bond indices is that they give the biggest weight to the companies with the most debt – who are often the ones with the least equity. The stock has fallen from a February high of SGD 2.7 to as low as 42 cents (84%) this week before being suspended following a ratings downgrade. Meanwhile the bonds are trading at 43, compared to 98.7 at the end of April.

Finally, last week’s note left little room for a revisit of another old story - to readers here at least – which got something of a new lease of life last week when Tony Seba of Stanford University published some updates to his thoughts on electric transportation. We have been discussing Tony and his ideas for the last three years or so, but his thoughts have gone viral this time not least as they fit in with the green agenda on stranded assets for oil companies. Perhaps not surprisingly the comments below the above linked newspaper articles are nearly 100% sceptical, mainly I would suggest because the readers have no experience of electric cars. Much focuses on range anxiety, which is in one sense valid, but given the average car journey is 20 minutes and 8 miles has already been solved by the 300km batteries.  Others talk about electric cars as being ‘coal powered’ and there being a need for more electricity generating capacity without recognising that firstly the big drive for EVs in China and India is about firstly roadside pollution and secondly reducing dependence on imported oil, while EVs themselves act as a form of energy storage – charging at night when demand is low and operating during the day when it is high. Generation scale battery technology is a separate but connected issue. As I have noted before, the obvious parallel for me is with VHS recorders. When the DVD came out, its all-round superiority as a playback mechanism was touted by tech fans, much as the electric engine is superior in almost every way to the internal combustion engine (ICE), but the users refused to accept it on the basis that “you can’t record”. The interim solution was the hard disk recorder, which displaced the VHS and was then itself displaced by set top boxes recorders and ultimately streaming. For me, the obvious interim solution for replacing the ICE is that provided by the series-hybrid Nissan e-note, already the best-selling car in Japan. By combining an electric motor, with all the positives that entails – great acceleration and torque, no gearbox, regenerative braking delivering ‘one pedal’ driving, smooth, quiet, almost no moving parts so ultra-cheap servicing – with low cost and no range anxiety it is the hard disk recorder for autos, what we used to refer to as “the category killer”. A small battery (therefore cheap) kept charged by a conventional petrol engine which is low but not zero emission delivering 500 miles of range at an efficiency of almost 90mpg. Given the US vehicle fleet is currently averaging around 25mpg, it is difficult to see how miles driven will increase faster than the tripling of fuel efficiency, supporting the overall conclusion that OPEC’s assumptions of further increase in demand for oil for transportation – and thus higher prices – are too optimistic.

Green campaigners have a point therefore about stranded assets and valuations of reserves regardless of whether we believe in the speed of change to pure EV – the hybrid technology is already here. We also have other issues (that Tony discusses in his report). Driverless cars may yet face regulatory hurdles, but I can see driverless buses operating as 24/7 trams in major cities and they would certainly be electric, as will most public service vehicles. One doesn’t have to believe the full blown conspiracy theory advocated in the great movie “Who framed Roger Rabbit?” that the Los Angeles  tram system  was bought up by General Motors and others (which it was) and then deliberately closed down (which is arguable) to see how driverless electric buses could quickly and easily restore  public transportation to major cities. Already we can see how ride hailing (with or without a driver) is going to increasingly focus on fuel efficiency –  the most popular Uber car in London to date has been the Toyota Prius – rather than top speed and style/status. Similarly last mile delivery will likely move to EV or serial hybrid. It is already happening, like VHS video shops starting to stock DVDs. As an aside it is worth remembering that Netflix started out as a business delivering DVDs by post. Alibaba is apparently planning to commission 1m ‘smart trucks’ for its deliveries and you can be sure that as well as smart navigation they will be semi-autonomous and almost certainly hybrid electric.

The other sector facing ‘stranded assets’ of course will be governments. The transportation sector is a major source of tax revenues and while a lot of it is purportedly ‘to encourage a switch to cleaner energy’ the reality is that without it governments everywhere will face a funding shortfall. How they fill this gap (and experience tells us it won’t be with lower spending) will spread the impact of the EV revolution in unexpected and as yet undetermined directions.




Mark Tinker

Head of AXA IM Framlington Equities Asia

-       ENDS  -


Notes to Editors

All data sourced by AXA IM as at Tuesday 23 May 2017.


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