As showed in figure 2, the emerging debt daily returns are strongly related to high yield corporate bonds, several emerging currencies, notably the ZAR, TRY and MXN and the Honk Kong Hang Seng. Therefore, the current rally on emerging currencies and equities can be interpreted as a « macro convergence » of assets which are highly connected from a « local » perspective.

Interestingly, figures 3 and 4 depict the leading assets among the emerging complex according to the Radar. While the Asian emerging currencies clearly dominate, the Easter European and Russian currencies are still weak. The trends of emerging equities are improving across the board but remain contrasted: the South African TOP 40, the Mexican Mexbol and the Philippine PSEi are on the forefront whereas the Chinese and Eastern Europe markets lag behind.

Given the various signals on bonds, equities and currencies there is still a significant margin for further improvement in a number of emerging currencies and equities.

Figure 1: Riskelia’s trend indicators on emerging bonds, emerging currencies and emerging equities

Figure 2: Riskelia’s dependencies network of emerging bonds. The numbers displayed below the assets represent the correlations between daily price returns. The arrows coming out of emerging bonds are the markets explained by emerging bonds returns whereas the arrows pointing to emerging bonds are the markets explaining emerging bonds returns.

Figure 3: Riskelia’s recommendations on emerging currencies

Figure 4: Riskelia’s recommendations on emerging equities

• Sectors performance rotated from defensive sectors (Food & Beverage, Health Care) to cyclical and banking sectors (Banks, Insurance, Automobiles & Parts, Basic Resources)
• Emerging equities have started to emerge as performance leaders
• The most cyclical commodities (cyclical precious, base metals) have clearly outperformed energy
• The bullish dollar theme, while still intact in the Radar, has been seriously challenged as the dollar tumbled against emerging and commodity currencies

As a result, the trend-based approach has been challenged in the recent financial environment (figure 1): our bets on US short-term rates, emerging currencies and commodities have failed. By contrast, steady profits have been made longing the risk-on fixed income assets:

• Iboxx Investment Grade in Europe and in the US
• Emerging Bonds
• Iboxx High Yield in the US (note that the radar now has a strong recommendation on the Iboxx High Yield EUR as well)
• Iboxx EUR sovereign debt

From figure 2, we observe that these « muddle-through assets » have gone through the two market trend inversions of Aug 2011 and Dec-Jan 2012 with minimal jitters. These assets are dependent on financial markets liquidity but less so than other cyclical assets such as equities and carry trades. Figure 3 shows the « equity tail dependence » of muddle through assets, defined as the average performance in equities’ worst 10% percentile (measured in numbers of standard deviations): all muddle-through assets except Investment Grade Corporate Credit react negatively to risk-off episodes, but their sensitivities to equity deleveraging is generally moderate, except for high-yield.

It should come as no surprise that these assets have held well in an environment combining sluggish growth and publicly supported financial liquidity. As showed in figure 4, the liquidity conditions have eased on almost every systemic link in the financial system including banks and equities. A continuation of this trend is the most probable scenario given the self-perpetuating nature of liquidity cycles. However, this improvement in liquidity does not bring better growth prospects in OECD countries, as these countries have simultaneously engaged into long-term deleveraging trends. This is the perfect setting for seeing muddle-through assets outperforming any other kind of asset class or trading strategy in the long run…

Figure 1: The tops and the flops of the Radar over the recent month. The performance indicator is normalized at 100% for the best performing bet.

Figure 2: Riskelia’s trend indicator on the « muddle through » assets

Figure 3: Equity tail dependence « muddle through » assets

Figure 4: Riskelia’s Risk Aversion indicator

In figure 1, we have represented a bond total return index since 2000 (composed of Gilt, T Notes of different maturities, Bund, Bobl, Schatz) together with the average bond bubble on the same basket of sovereign bonds and the average equities trend on a basket of European and US stock indices.

We recall that our « bubble » indicator is a signal between -100% and 100%, only based on the past history of market prices and reflecting the regularity of a price signal over different horizons (from a few months to a few years): a bubble indicator above 40% (resp. below -40%) signals excessive regularity in the rise (resp. fall), hence herding behavior and momentum instability.

There are four important messages from this graph:

1. The last decade has seen seven occurrences of bond bubble over 40%:

• Dec 2000/Apr 2001: aftermath of the dot com crash
• Sept 2001/Nov 2001: Sept 11 attack
• Sept 2002/Jul 2003: Enron/WorldCom corporate credit crisis
• Feb 2008/Apr 2008: Bear Sterns’ demise
• Dec 2008/May 2009: Lehman’s fall, interbank market arrest
• May 2010/Dec 2010: first euro sovereign crisis
• Aug 2011 onwards: second euro sovereign crisis

1. Of these seven episodes, six have been associated with negative equities trends, and one (the May 2010/Dec 2010 episode) associated to a neutral equities trend (down from a bubble situation just before the May 2010 euro sovereign crisis).
2. Most of these bubbles have ended with sharp bond depreciations (5% mean fall on peak-to-valley episodes of 110 days in average) coordinated with broad equities rallies (figure 2); however, there are two episodes where the equities rally has largely preceded the ultimate bond bubble burst:

• In Sept 2002/Jul 2003, equities boomed after mid-march 2003 and bond prices peaked only three months after in June,
• In May 2010/Dec 2010, equities rallied from the beginning of Sept 2010 and bonds started their free fall one month after in October

1. We currently are at a critical stage combining a bond bubble over 50% with a seven-weeks-old equities rally

A high bubble score always reflects a castle of leveraged positions which can easily unfold into a cascade of chaotic positions unwinding should the trend reverse, hence the difficulty to predict the exact timing and consequences of the final blow. Nevertheless, if we trust recent history, the bond bubble is probably living its very last moments…

Figure 1: Bond bubble (red), equities trends (blue) and bond total return index (black) since 2000; the periods of bond bubble above 40% are in grey

Figure 2: Some statistics on the six bond bubbles of the 21^st century

• The Radar’s trend is flipping to the positive side on dollar and sterling short term interest rates futures. The reason is not that central banks will further decrease their already nil target rates but rather that the interbank market liquidity is improving.
• The EUR/USD basis swap or the cost to exchange euro cash against dollar cash has noticeably improved going down from 150 bps to 80 bps. The lower cost of dollar funding translates the coordinated actions of central banks to provide liquidity at the turn of November.
• Last but not least, the European banks cost of funding is slowly normalizing, as reflected in figure 3. The improvement in the euro banks credit cost follows the ECB decision to provide unlimited long term financing to banks up to 3 years (the so called « LTRO »). As a result, the European banks almost borrowed 500 Bil euros from the ECB in December.

As depicted in the chart of the ECB’s total balance sheet, the liquidity provided to commercial banks has not been sterilized. Therefore, the LTRO is clearly a type of quantitative easing which consists in increasing lending to -and deposits from- commercial banks. The last chart shows that the ECB quantitative easing has increased the ECB balance sheet relative to the Fed total assets. ECB’s balance sheet has deteriorated both quantitatively and qualitatively as the ECB provides more loans to the banking system, accepting poorer and poorer forms of collateral in return.

This form of quantitative easing, compatible with the German orthodox view of money and the European treaty, is behind the ongoing depreciation of the euro vs. everything (i.e. USD, other currencies, brent, gold, S&P 500…). This has been one of the most prominent themes identified by the Radar at the end of 2011 and is still a promising bet.

Figure 1: Riskelia’s trends in short term interest rates: Eurodollar, Short Sterling, Euribor 3-6 months

Figure 2: EUR/USD 3 months basis swap or annualized cost to exchange dollars against euro

Figure 3: Riskelia’s normalized liquidity indicators on European banks, cash liquidity and equities

Figure 4: Total Balance Sheet of the European Central Banks in Billion EUR (Bloomberg)

Figure 5: Ratio of Fed to ECB Balance Sheets compared with the EURUSD exchange rate (from Bloomberg)

1. The cost of risk in equities markets shows signs of easing while the strain on banks’ funding remains unchanged (Figure 1)
2. Emerging and European currencies are in negative spirals against the US dollar while oil products display strongly positive trends (Figure 2)
3. Some equity sectors, like food and beverage, display strongly positive trends while the trends on other sectors like banks keep their negative orientation (Figure 3)

A similar disconnection has been observed in the recent history: in particular, in Nov 2010- Mar 2011, the equities markets remarkably ignored the problems faced by the banks in their funding, but in June 2011, the banks had the last word and risky assets were eventually reconciled in the summer bearish orientation (Figure 1).

As the fears on euro zone banks’ equity raising resurface (UniCredit slump adds to equity raising fears, Spain sees €50bn of new bank provisions), one may question the long-term viability of the current equities and oil rally, particularly as the level of integration across risky assets approaches its 2008 peak (Figure 4). Does it announce a temporary easing of banks’ funding problems (as in Jan and Feb 2011) or is it a new illustration of the ‘normalcy bias’* in equities volatility market already documented by Artemis Capital Management in this excellent research?

*according to Wikipedia, the normalcy bias refers to a ‘mental state people enter when facing a disaster, causing people to underestimate both the possibility of a disaster occurring and its possible effects’

Figure 1: The divergence of risk perception in equities and banks’ debt markets: the graph represents the normalized VIX and banks’ CDS since Jan 2010. The global stress indicator averages the normalized risk aversion indicators across a large spectrum of cyclical assets.

Figure 2: The divergence of Riskelia’s trends within cyclical assets

Figure 3: Trend divergence among sectors: the example of Food & Beverage vs. Oil

Figure 4:
The level of financial integration plotted below
corresponds to the proportion of the global asset price variations (i.e. the equities, corporate credit, currencies, bonds, interest rates futures, and commodities’ price variations) which can be explained by a common risk factor, viewed as the average dynamics of risky assets against bonds.

Record of 2011’s successful and aborted trends

As showed in figure 1, the 19% return of our « best-of » portfolio in 2011 has been made mostly in the three months of July, August and September, with more than half of the performance generated in the sole month of August. This asymmetric behavior is characteristic of trend-following strategies: trends do not work all the time but when they do, they often do it with full force and you can lose your shirt being against them…

The year 2011 has actually been divided into 3 parts.

Up to the spring 2011, risky assets held on, the dollar tumbled and the markets were blind to the euro sovereign debt issues. The Radar was unable to capture major trends as punctual « black swan » events such as the Fukushima nuclear meltdown have prevailed on long-term developments.

The trend signals have been the most relevant at the end of the spring: everything started with deflationary signals on fixed income assets as early as May 2011, then the recommendations turned negative on a large set of European equities and the global risk aversion signal turned reddish in June as financial markets eventually acknowledged the worldwide repercussion of the Euro sovereign and banking crises. Most of our performance was achieved during the summer months between July and September 2011 where directional trades prevailed.

Then, from September onwards, the cyclical assets were muted. The European equities slightly rebounded whereas the US equities showed impressive resilience in the face of the financial crisis. Eventually, the Radar shifted its focus from the short equities and fixed income themes towards the bullish dollar theme achieving positive performance on selling Emerging currencies and the euro vs. the USD at the turn of the year.

Among our top bets of the year, two thirds are identified as long Fixed Income views; the trophy is awarded to the Emerging Bonds followed by investment grade, UK bonds, inflation bonds and US bonds. The long gold position eventually stands out as a clear winner thanks to the bubble indicator which managed to deleverage the exposure when prices skyrocketed during the summer. The position is presently immunized due to a declining trend towards neutrality. As highlighted in figure 2, the dominant themes of 2011 have been the Fixed Income markets. Meanwhile, many « muddle through » assets such as emerging bonds and inflation bonds have showed impressive resilience, making 2011 sharply different from 2008. Even the oil markets eventually ended up the year in neutral territory.

Among the flops of the year, there are three categories:

• Commodities have been mainly range bound with a good start and a sluggish –though not dramatic- end of year. Therefore, the commodities ended the year with a strong negative consensus as reflected by sharply negative flows from investors, yet not so much loss for the moment apart from the severely hit Base Metals.
• Some equities markets have been hesitating all year long between the « risk on » and the « risk off » modes. In this respect, the Radar recommendations on the Topix were not relevant because of the suddenness of the Fukushima meltdown which reversed the course of the Topix before the financial crisis
• Last but not least, the Radar has been particularly unfitted to capture the binary behavior of the Euro Sovereign Bonds. The August ECB intervention has produced a false positive signal which was later invalidated by the political hesitations of the euro leaders. Then the ECB decision to grant unlimited long term funding up to three years maturity flipped the recommendation back to the positive side.

Year 2012 perspectives

Five themes are presently highlighted by the Radar:

• The bull USD with a specific focus on short emerging bets and short European currencies; it remains to be seen if this theme will survive the probable launch of a QE3 in the first quarter of 2012
• The broad based euro devaluation beyond the dollar side, i.e. short EUR vs. a basket of dollar, US equities markets (S&P for instance), Oil Brent and Worldwide Inflation Bonds
• The downward pressure on specific commodities such as cyclical metals (silver, platinum, copper…) and some grains (corn, soybeans)
• In contrast with other commodities, the good resilience of oil, reflected in the shape of the curve moving to backwardation
• The positive outlook of defensive sectors around the world: STXE Food & Beverage, STXE Healthcare, S&P Utilities, S&P Consumer Staples, S&P Healthcare

A major OECD bonds’ bubble is also on the screen, carrying the threat of an epic bond crash in 2012…

Figure 1: Monthly performance of Riskelia’s best of portfolio

Figure 2: the top bets of 2011: 66% are Fixed Income bullish views

Figure 3: the flops of 2011

These short term dependencies may question the validity of the bullish dollar move as the crude oil is going through a slight positive trend, supported by a curve moving to backwardation. Besides, the US equities have held well in the recent weeks as the Dow Jones for example is close to switching to a positive trend. Yet, these factors are mainly short term drivers and must not hide the long term trend dynamic of the currencies parities. As showed by figure 4, the trend of the driving factors of the EURUSD taken in euro terms (i.e. World Inflation vs. EUR, Crude Oil WTI vs. EUR and S&P 500 vs. EUR) are all in strong positive trend, thus giving some comfort to the strong bearish EURUSD long term dynamic.

Shorting the euro against the dollar, the S&P 500, the Oil WTI and the Worldwide Inflation debt may be the most efficient way to play the ongoing euro broad based devaluation.

Figure 1: Explanatory macro factor of the EUR/USD parity

Figure 2: Explanatory macro factor of the AUD/USD parity

Figure 3: Explanatory macro factor of the CAD/USD parity

Figure 4: Riskelia’s trend indicator of various asset classes vs. EUR

We must not forget that gold has close relatives among inflationary assets, namely Platinum, Silver and Gold Miners. The correlations have been very steady in the range 60%-80% (figure 2). The trends of Platinum and Silver have plunged in September, then Gold Miners followed and now it seems to be the turn of gold to get on board the bearish crew (figure 3). Without any doubt, the gold has lost its safe haven status as a reserve currency and retrieved its status of reflationary bet. The Fed decision not to engage a QE III policy immediately has aggravated the immediate USD funding issues and further weakened the gold play as a currency debasement hedge. As for the ECB, it will be constrained to proceed to Quantitative Easing but not before the euro zone has one feet and a half in the abyss…

Last but not least, the long term gold buyers might temporarily stop piling up the barbarous relic. First, history shows that ETF buyers behave in a pro-cyclical manner as demonstrated by their selling at the end of 2008 (figure 4). As regards silver, they have already deserted the ship and may follow through if gold corrects further. Second, the bubbles of gold vs. emerging countries constitute a worrying sign as major purchasers of gold like India, Mexico and Brazil face a currency crisis which will oblige them to defend their currency against a spiral of foreign outflows (figure 5). This could trigger a decline in dollar and gold reserves. What if insolvent countries, like Italy, the 4^th holder of gold reserves, should sell part of their reserves to pay down their debt?

Gold is still a strategic asset providing incomparable hedge against the looming broad based currency debasement. Yet, for now, the dollar has clearly usurped gold as the ultimate safe haven, which calls for a reduction in gold exposure.

Figure 1: Gold recommendation vs. Price from 2006 onwards

Figure 2: Gold rolling connections with precious metals, gold miners and Dollar Index

Figure 3: Trends of the gold constellation: gold, silver, platinum and gold miners

Figure 4: Total ETF Gold and Silver Holdings (in onces)

Figure 5: Bubbles of Gold vs. Emerging currencies

Figure 6: The bullish dollar trend

• Inflation bonds
• Emerging bonds
• Gold
• Defensive equities (low beta) such as consumer staples and health care sectors

Among the Radar’s 30 top positive bets, six belong to a ‘defensive category’, which can be defined as neither fully connected to safe haven bonds (i.e. US, UK bonds…), nor cyclical assets. These bets, all having recommendations over 30%, are detailed in figure 1. Contrary to safe havens, they offer some good protection against inflation, while behaving better than geographical benchmark equities in periods of financial turbulence.

The dual behavior of inflation and emerging bonds is illustrated in figures 2 and 3. The correlation to commodities is positive for instance whereas the dependence to equities and safe havens is variable over time. These hybrid assets fit well to the current context of negative real interest rates as they can perform well in stagflation or moderate growth environments.

We can build a portfolio consisting of inflation indexed-bonds, emerging bonds, gold and defensive stocks. For example, the following passive allocation is possible:

The currencies are either the dollar or the euro for European sectors. The currency effect may either be passively hedged or actively managed. Note that the current positioning of the Radar is strongly positive on the dollar.

This allocation offers significant upside performance while providing a protection in case of wild deleveraging. Riskelia’s Radar can enhance the portfolio’s properties by replicating a call on each individual asset inside the portfolio. The Sharpe ratio is just a little better but the maximum drawdown is reduced to a very acceptable loss for the investor. The active construction uses some common sense constraints: no leverage, maximum investments are respectively 100% to bonds, 20%to gold and 75% to defensive stocks. Cash is the non-invested part of the active portfolio.

The present allocation of the active portfolio is as follows:

As showed in figure 4 representing the active and passive performances over time, the current crisis looks pale in comparison to the 2008 meltdown as the whole portfolio is much steadier than it used to be in 2008 where all assets prices collapsed like a single man.

Figure 1: Top positive bets among defensive assets

Figure 2: Rolling correlation of worldwide inflation bonds with major assets (Equities, Commodities, Bonds)

Figure 3: Rolling correlation of emerging bonds major assets (Equities, Commodities, Bonds)

Figure 4: Passive and Riskelia’s active portfolios

The first two factors represent monetary effects characterizing the well-established inverse relationship between dollar and inflation. This relationship is due to many converging factors, including the search of reserve diversification from commodity producers, the transformation of commodities as anti-dollar investment asset, and the role of the dollar as a funding currency. This currency effect has also played with other cyclical assets, such as the S&P 500, as illustrated in figure 2. This relationship has been quite robust with a correlation between the single parity and risky assets around 40%.

The last factor of dependency represents the cost of carry associated to a EUR/USD position (EUR short-term rate minus USD short term rate). Last week’s joint central banks’ intervention to provide dollar liquidity to the financial sector was therefore favorable to the EUR. Conversely, the next ECB meeting on Thursday, probably resulting in a further cut of the refi rate, will likely push the EUR/USD downward.

These short-term dependencies and the implied short-term swings along with the risk on/risk off pendulum should not mask the reality of the long-term broad based euro depreciation. As showed in figure 3, the EUR/USD bearish trend is solidly established. For sure, the position is crowded as proved by the CFTC report of Non Commercial net positioning. Besides, a short-term EUR/USD rally is possible in the perspective of the umpteenth euro summit supposed to bail out the euro once again. However, figures 4 and 5 show that the cyclical assets have started to outperform the single currency in the long run. Whereas European investors used to suffer from the EUR over performance up to September, the current EUR/USD negative trend is supporting euro investors’ positions on USD denominated cyclical assets. Gold, oil, equities and worldwide inflation bonds are all displaying a momentum of appreciation against the single currency.

Figure 1: Explanatory factors of EUR/USD returns (apart from other currencies)

Figure 2: 500 days rolling correlation of EURUSD against various financial assets

Figure 3: Riskelia’s recommendation is clearly on the downside

Figure 4: Nasdaq and Brent vs. EUR outperform

Figure 5: Riskelia’s trend indicators are much more stable on cyclical assets vs. EUR