Tuesday, October 6th, 2015

Bear Squeeze

We have spent the last two weeks improving our local risk conditions report and adding coverage of 20 new countries. All equity indices seemed so uniformly awful vs US Treasuries (and all emerging markets so awful relative to a global equity index) that we needed a different perspective. The metrics quoted above are how international investors look at non-US equities, particularly emerging markets. We wanted to see how things would look to a domestic institutional investor which had liabilities denominated in local currency, and who was obliged by law to invest in the local bond market. We need a metric which avoids the distortions introduced by exchange rates, and the ultra-low US yields. So we looked at the total return of the benchmark index in local currency and compared it with the returns from the 7-10 year tenor for of the local bond market.

This report measures the risk-appetite of an Indian institution whose basic choice is between the SENSEX in rupees and Indian government debt. We do the same for Italian institutions who invest primarily in Italian bonds, rather than German bunds, and have a bias towards local Italian equities. The conclusions are as follows.

1. Everything looks awful in local currency as well in dollars. The average recommended weight for equities is 5%, out of a possible 100%. This is a global flight from risk that affects every country and is not primarily driven by the dollar or the US yield curve. 2. The top five countries in order are Ireland, Hungary, Turkey, Israel and South Africa. Some of the countries with the highest equity score (e.g. Turkey and South Africa) have truly dreadful local bond markets. The others, Ireland Israel and Hungary, are at the top of our dollar-based country rankings, but have suffered equity reverses over the last two months. This week Ireland was the last country to be downgraded to underweight relative to local bonds. 3. The bottom five countries in order are Thailand, Taiwan, Korea, Canada and Australia, all of whom have score of zero. This means that if we were allocating purely on the basis of current returns and risk conditions that we would have no exposure to equities. Of course, no large institution would ever take so much benchmark risk, but it is a fair assumption that most are close to the bottom of their permitted equity range.

The message is therefore that equities look equally bad to domestic and international investors. This may seem unsurprising, but this level of unanimity is actually quite rare. And here is where the good news lies. There are some countries where it is hard to see local investors getting any more pessimistic. This category includes the US, and possibly the UK, as well as the bottom five mentioned above. There are also a few countries where the score has improved slightly over the last month – Russia, Malaysia and the Philippines. Unless there is a truly cataclysmic collapse in China, it is hard to see anything which could create new sellers, particularly of emerging market equities. Their currencies have been under pressure for over a year. The flows out of EM equities have made new records. Some countries (possibly Brazil) may not see any sort of equity rally this year, but some of them probably will. Some of them may already be past the worst.

Anybody with a short position in equities in Asia ex Japan or Eastern Europe should think about covering it now.

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