Si vis pacem fac bellum versus Si vis pacem para pacem...investment, legal, and accounting advice...

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August 2018

Si vis pacem fac bellum versus Si vis pacem para pacem

"If you want peace, make war. “ “If you want peace, prepare for peace.”

Trump’s announcement that the United States was withdrawing from the Paris climate agreement marks the

regime change. Trump called the agreement a hoax and had stated previously that: “The concept of global

warming was created by and for the Chinese in order to make U.S. manufacturing non-competitive.”

The world was shocked. How come an American President could behave like that? Well, his critics say that

he has developed an attitude for not being swayed by other governments. I just believe that they are wrong,

he has been all the way the same and his campaign proves it. Conclusion, “Si vis pacem fac bellum” is Trump’s

modus operandi and China was already on the top of his list.

In the SGG July report, I call Trump of “The Resetter” and for the ones who did not have the chance to read

it, peace is the objective. A more peaceful multipolar world requires freely tradable reserve currencies. China

will probably outgrow the United States within the next 10 year and the time has come to force China to move

into that direction. A China which respects the rules of laws as its westerner peers, is a more democratic China.

It looks like that the biggest problem of the US Trade War which China is…. China. On July 20th 2018, the South

China Morning Post was reporting

Yet issues raised by the trade war could be key, including the changes [the trade war] will have on domestic politics, society, foreign

policy and ways the country will be governed,” Deng said.

Business Insider

• The intensifying trade war between China and the US is causing a massive rift within the Communist Party of China.

• Though President Xi Jinping has been clamping down on dissent, veteran party members have expressed discontent about China's image and Xi's handling of the trade dispute.

• Several sources close to the government told Reuters that China's strong nationalist branding had only provoked the US and hurt China's economy.

Reuters : Handling of U.S. trade dispute causes rift in Chinese leadership: sources.

President Xi Jinping vision China Dream 2050 aims at reestablishing the grandeur of the Middle Kingdom.

“China will be transformed into a modern socialist country by 2035 and a more powerful country by 2050.”

Nothing wrong with such a vision but the problem lies within the execution and implementation of such plan.

Will China’s communist party “soften” is modus operandi and become more “democratic”?

Google provides interesting tools (the free versions used to be better…) and it is interesting to observe that

the highest volume of the search expression “Trade War” originates from China. Trump’s trade policy is

definitively resounding as a hard wake up call.

The SGG Report

http://www.stowgrowglow.com/

https://www.scmp.com/news/china/policies-politics/article/2156044/chinas-trade-war-fallout-tipped-be-talk-beidaihe

https://www.scmp.com/news/china/policies-politics/article/2156044/chinas-trade-war-fallout-tipped-be-talk-beidaihe

http://uk.businessinsider.com/trumps-trade-war-causing-rifts-in-communist-party-leadership-2018-8

https://www.reuters.com/article/us-usa-trade-china-politics-analysis/handling-of-u-s-trade-dispute-causes-rift-in-chinese-leadership-sources-idUSKBN1KU0TU

https://www.reuters.com/article/us-usa-trade-china-politics-analysis/handling-of-u-s-trade-dispute-causes-rift-in-chinese-leadership-sources-idUSKBN1KU0TU

http://www.atimes.com/article/xi-outlines-vision-achieve-china-dream-2050/


o He

Search volume

The fate of the world’s economic is very linked to the US and China. The reflation policy undertaken by China in the wake of the 2008 crisis has had very important impacts. Growth, in particular Emerging Markets growth, needs liquidity, trade, reflation and low volatility. The current environment does not bode too well since a close cooperation between the two countries does not seem achievable now. How could this change?

1) The US and China reach a true roadmap which “resolve” their trade war issues. It is in the cards since China has demonstrated his willingness to talk but…. talk is cheap.

2) Recent FED’s bashing by Trump is maybe a signal that the next Jackson Hole statement will provide some hints about a possible softening position from Powell.

3) The EM situation worsens due to contagion effects (Turkey?), USD liquidity tightens further translating into a very strong USD and finally impacting the US capital market negatively.

As said above. Talk is cheap, and Trump is willing on keeping the pressure on.



We need to look at the relative performance of the US (S&P 500) market to the rest of the world (MSCI EAFE index)

Since 1998, the S&P 500 has been outperforming its peers and stands in record territory. The present leg which started in 2008, is the longest and shows that the S&P 500 has been the “no brainer” best equity allocation for the last 10 years. The following chart is interesting. It shows the same but for a time windows of 20 years and the VIX index (volatility) has been included (light grey line) along the USD index (green line)



The great world growth synchronization period (2002-2008) created this above stated “liquidity, trade, reflation (credit growth), weaker USD and lower/falling volatility environment”. The last gasp of that trend occurred in 2009 and since then the US equity market has been the leader.

Massive QE (quantitave easing) programs have been good for the US and EU, driving volatility lower. Observe that the FED was the first to tamper its QE program which coincide with the USD rise. We can point at some reasons for such performance.

1) The status of reserve currency of the USD and the fact that it reigns as the largest liquidity pool is an advantage that all USD bashers should keep in mind. The FED is the central bank of the world!

2) American capitalism is friendlier to capital flows. The quality of the corporate sector offers more opportunities for large M&A and private equity transactions

3) Labor market rules/laws are more flexible than many other peer countries. 4) The tech. industry has been a magnet for attracting talents from everywhere which has translated

into mega huge market caps as the FANG stocks (Facebook, Amazon, Netflix, Google) It seems that nothing can possibly derails such context/conditions. High and low volatility has been good to the US market. PE multiple expansion might find its root behind such conditions. However, subtle changes in conditions will reflect in price and possibly mark a change in trend. Similar situation in the Emerging Markets. However, the S&P recent outperformance (2018) looks a bit more worrisome. An important resistance has been broken easily and might prove to become long lasting.



MSCI Emerging against the MSCI World index (all developed markets ex-US)

Emerging markets outperformance peaked in 2011. It is interesting to observe that for investors (ex US) based in the developed world, EMs were a good bet (2016 to early 2017). Sure, Trump’s trade war has been a trigger to the change, but the Turkish crisis is a much more important factor. My view on Turkey is that a messy default is in the cards. Here is the ratio between the $NQEM Emerging Market (managed by NASDAQ and covers approximately 98% of the market) versus the MSCI Emerging index (which represent about 85% of the market)

A possible understanding of the recent outperformance of the wider market index is that domestic and smaller emerging players have been more resilient. The contagion effect of Turkey is already at play. Investors have started to feel the pain and further wild moves are in the cards.



Brazil is in better shape than Turkey, but the Brazilian economy has gone through an economic depression. Brazil is a country in search of changes which shall crystalize in the next October presidential elections, but the road is still bumpy. The ex-president Lula is in jail for corruption and has announced that he is running for president. Polls show that his popularity is apparently still high, and his fate should be decided shortly. Brazilian laws are quite clear in the sense that he is not eligible. Unfortunately, the Brazilian judicial system is a maze which has proven morally corrupt several times which could lead to higher volatility in the market. A recent publication from the ONU Human Right Committee has heated the debate in Brazil. It states that “

The UN Human Rights Committee has requested Brazil to take all necessary measures to ensure that Lula can enjoy and exercise his political rights while in prison, as candidate in the 2018 presidential elections….”

Human Right Committee should not be meddling in a democratic election process. EWZ ETF: MSCI Brazil The optimism of the rebound is fading away

EWZ ratio with S&P 500: Looks like that a worsening is in the card


https://www.ohchr.org/EN/NewsEvents/Pages/DisplayNews.aspx?NewsID=23464&LangID=E


EWZ versus Emerging (EEM): a falling star with a long tail.

SGG portfolio has been using the EWZ for trading purpose. Fundamentally, Brazil is a country which could crawl back nicely as an excellent investment opportunity. Unfortunately, the election process is very polarized bringing volatility on the table. For speculators, Brazil’s reserve war chest is an interesting target and we need to see how the central bank will manage the situation. So far, FX swaps, settled in Real currency have been the preferred instrument from the BC but the situation could change quickly. Ironically…. Brazilian voter might need to feel some additional stress to make up their mind. As mentioned in the previous report, India should keep benefiting from the China situation. The ratio INDIA versus China confirms it and is now a bit “stretched”, signaling a digestion period is ahead.

India ratio versus EEM: overstretched, signaling a potential pause/consolidation. It looks like that the Indian market is starting a long bull phase.



China (MCHI ETF) and S&P500 SPY (Green)

China versus SPY (S&P 500)



China MCHI versus EEM (Emerging)

The importance of the USD (Green line) for Emerging markets. In red the ratio of EMHY (Emerging market bonds) to EEM (emerging mkt equities). EM bonds outperforms EEM equities with as strong USD.

Powell’s statement at Jackson hole will probably provide some hints about possible softening guidance to the FED’s QT and interest rates policy. Remember…, Emerging markets need: liquidity, trade, reflation and lower/falling volatility! A softer tone like “we are observing closely the developments in EM” could lift off Emerging markets temporarily but let’s not forget that Trump is not willing to compromise much on his trade policy. SGG portfolio does not hold any position in emerging markets for the time being but look at trading opportunities.



PCY ETF (Emerging USD sovereign bonds) vs EMHY (sovereign & Corp Debts emerging). Grey line = VIX

Stress is further building up in the system. Corporates bonds spreads are increasing further than sovereigns. If the situation would worsen, corporates are a large chunk of the market now. HYG (US High yield corp bonds) ratio with LQD (investment grade corp. bonds). Higher 10 TB yield (strong economic activity) offer an interesting correlation with the ratio. The US Equity market is celebrating its longest bull run. Recent underperformance of the HYG is a close watch.

HYG /TLT (long term treasuries) Going nowhere. A sign

that HYG investors might prefer to switch?

SGG’s Portfolio holds a position in TLT. The view is that

record short positions could squeeze out speculators.

Stress building in the market and economy favor lower

bond yields (deflation scare?)



SPY (S&P 500) ratio to TLT (long term USD treasuries bonds). SGG portfolio’s exposure to TLT is a “hedge” against a streched equity market.

XLP (Staples sector) ratio to SPY (S&P500). SGG portfolio has built a position long XLP short SPY (SH ETF).

Following charts: Green line is the S&P index. Yellow line is the SKEW index. Red line is the spread between the Volatility of the VIX index (VVIX index) and the VIX index. This might look a bit confusing, but it is of importance.



The VVIX Index is an indicator of the expected volatility of the 30-day forward price of the VIX or volatility. To make it simple, it is the volatility of the volatility. The Cboe SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk. It is calculated from the prices of S&P 500 out-of-the-money options. An increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the "skew". In simple term, it measures the expensiveness of out of the money PUT options hedging. Ex: the S&P 500 is at 2850 points and you want to buy PUT options at an exercise price of 2500 to hedge your portfolio. Average Volatility (VIX index here below red line)) has gone down and electronic trading of VIX futures has become quite popular. Usually you have a positive difference between a VIX future and the VIX spot (not tradable). I wrote last year a little article about how crowded the selling of volatility trade had become and … how risky it could be too. The steep and short market correction early this year became the Armageddon of the volatility sellers. A few important Short Volatility ETFs got cornered and wiped out from day to night.

On the other side, we can observe in the first chart that the spread between the VVIX and the VIX index has steadily climbed during the whole rally. The gold line (SKEW index), shows a similar pattern. Somehow the whole rally has been driven with the handbrake on all the time (Climbing a wall of worry). A factor behind the increase of the skew index is the necessity (regulatory changes) for financial institutions to hedge some of their risks. However, the cost of hedging is interesting if the market keeps going up at a good pace. A high Skew index tend to avert traders that the risk of a correction is high. However, the Skew index has rarely been a good indicator to time the market, but it is not useless. SGG tends to see a low Skew index as a reading of extreme bullishness sentiment. Conclusion, higher volatility with a market not moving up at a reasonable pace, could become an incentive to reduce equity exposure from traditional hedgers. By analogy, it might feel a bit like riding a slowing down bicycle on a gentle hill while you are getting tired. The chance to step down are high!


http://www.cboe.com/products/vix-index-volatility/volatility-indicators/skew


Yardeni research comes up sometimes with some freebies which provides a good overview. Since 2016, yearly change in total assets has been diminishing. Only recently, stress has been building up within the EM market complex. However, total assets remain at a high level.

The FED is in a much better position than its peers with a 20% Asset/GDP ratio.

China POBC is the question mark at this

stage. Apparently China has already taken

steps for “stealth “ QE through its banking

system.


https://www.yardeni.com/pub/peacockfedecbassets.pdf


Follow up on the Italian situation: 10 years yield in red. Germany in green, Spain yellow and Portugal violet. Italy is a concern and pressure is building up in the system. The good news is that the recent leg up of the 10 years Italian yield has not really impacted it southern cousins like Spain and Portugal.

Precious metal and commodities: China and Russia have been steadily increasing their Gold reserves. Central bankers do not have a great track record in timing the market if you remember the sales of UK reserves (1999-2002). SGG portfolio holds interests in the precious metal complex (Gold, Silver and mining stocks) as a strategic core position. I am not really a gold bug, but I have to say to my credit that I was an early investor back in 2002-2003. One of the reasons was that Gold was the best asset to hold as a proxy for commodities. Investing in commodities is mostly a loser game due to the contango effect of the futures contracts. Western central bankers bashing on gold reserves has been a regular topic and you can find many articles/medias about gold price manipulation. For the ones who believe that price manipulation is fake news, just think about QE. I do not think that gold will become again the anchor of the system, but I view gold as a proxy for trust as it was a century ago. Main street is not much interested into gold for the time being. The conditions for a tremendous price rise will probably occur when trust in governments will erode substantially. How could this happen? When people will realize that governments and their policies are the source of their problems. Are we far away from this? I think that dissatisfaction is growing. Political science defines populism as the concept that society is split into two clashing groups. The corrupt Elites and the rest, the true people, the ones who work hard, have worked hard and are feeling unattended and ignored. The seeds for populism to grow have been planted and the EU seems to be a fertile ground for further advance. However, when we look at China and Russian gold reserves evolution I only can think of one thing. As mentioned above and the previous report, Trump’s trade war has much to do about peace and the Yuan to become a reserve currency. Maybe China will move into that direction, but it is hard to imagine foreign investors holding current accounts and other debt instruments in Yuan for the time being. However, China has been building its own financial architecture with the goal to permeate further its economic and geopolitical influence. The launch of the Yuan crude oil futures is a step into that direction.


https://en.wikipedia.org/wiki/Sale_of_UK_gold_reserves,_1999%E2%80%932002


It looks like China’s plan is to become a financial anchor for a series of “strategic” partner (Iran?). Joining force with Russia is probably in the card. Gold could be the trust factor, as a century ago, which will help develop this new FX and trade plaform. Resuming, SGG portfolios holdings in the precious metal complex has more to do as a kind of hedge which so far, brings a negative contribution to the performance. As I am writing these lines, I find much interesting the news: “Europe needs to set up a payment systems independent of the United States if it wants to save the nuclear deal between Iran and major powers that was abandoned by President Donald Trump, German Foreign Minister Heiko Maas said.” Maybe gold will have a role to play since one the great problem of the EU is the absence of EU debts instruments. Gold and inflation have a long-lasting relationship. The red line is the ratio of the TIP ETF (Treasury Inflation-Protected Securities, or TIPS) with the IEI ETF (3-7 years Treasury Bonds )

The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. We can observe that QE programs drove up Gold prices and inflation expectation. However Gold price peaked earlier. It seems that a replay of this scenario is in the cards. SGG portfolio holds a position in TIP which will probably be discarded.


https://www.reuters.com/article/us-iran-nuclear-germany/germany-urges-eu-payment-system-without-us-to-save-iran-deal-idUSKCN1L61KW


On the radar screen (among many other things…) CMBS ETF (Commercial Mortgage back securities) ratio against IEF ETF (3-7 years Treasury Bonds). This long term divergence and underperformance might signal that commercial real estate is headed for a bumpy road. Kind regards, Renzo

EUFN ETF (Europe Financial sector) vs IEV (Europe 350 index): The ECB will probably need to step in sooner

than expected if the situation does not improve.



EUFN versus XLF (US financial sector) : a truly worrisome trend…

Deutsche Bank versus EUFN:

BNP versus EUFN



EU banks reflect well the underlying problem of the construction of Europe. Mario Draghi is leaving in 2019

and the European Safe Bond initiative will probably remain…. just an initiative. Politicians do not take

unpopular decisions and people are unwilling to open hand of accumulated privileges and or rights (labor

laws, pensions, taxes etc..). How do you resolve such as situation? Stress! It can break the system, but I tend

to believe that the entanglement of the EU members is sufficient to force unpopular decisions and implement

much needed reforms.

To be continued….

Kind regards,

Renzo


Date post:	04-Mar-2021
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Si vis pacem fac bellum versus Si vis pacem para pacem...investment, legal, and accounting advice...

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