China finds opportunities in oil price drop

This week, Cnooc announced plans to reduce capital spending as the government and large state-owned enterprises respond to the collapse in oil prices. China’s third-largest oil producer said it would cut development spending by 67 per cent and, albeit less dramatically, reduce exploration and production capital expenditure.

At the same time, the Beijing government and refiners such as Zhuhai Zhenrong have increased their purchases of crude oil to record levels. Sinopec, another big state-owned energy enterprise, opened up a tank farm for crude oil on the resort island of Hainan in November.

These apparently contradictory signals reflect changes in the sources of growth in a slowing Chinese economy and show how the government and corporate China are exploiting the collapse to reduce their longer-term vulnerability to price swings in the volatile energy market.

It is easy to understand why Cnooc is cutting back spending. The economy is growing slightly below the level the cadres have commanded and slowed to 7.1 per cent in the final quarter of 2014. Reinforcing that trend is the fact that the energy intensity of Chinese production has gone down. Chinese crude oil demand per unit of gross domestic product has been dropping by 4.3 per cent a year since 2005, according to data from JPMorgan Private Bank.

Moreover, as the sources of growth shift slowly from manufacturing to services and from exports to domestic demand, that drop will probably accelerate, making further oil capex cuts likely — and shareholders happier.

But China is also looking ahead and taking advantage of the speedy and unexpected reversal in the oil price.

The increase in demand for crude on the mainland comes because China is exploiting lower oil prices to dramatically boost its storage capacity for both commercial and strategic reasons. By doing so, it will address one of its perennial weaknesses, its reliance on imported energy, and make itself more competitive.

The move comes at a moment when pessimism about Chinese prospects generally is on the rise. That downbeat attitude reflects chronic excess capacity, an overbuilt property market and concerns about a corporate sector that has borrowed too much, whether in renminbi or appreciating US dollars.

The way China is taking advantage of the declining oil price also suggests that some of the pessimism is unwarranted. The dramatic expansion in commercial and strategic holdings of crude while the price is half of what it was just months ago is only part of the story. The government is also increasing taxes rather than pass on the full benefit of bargain fuel prices to consumers.

Those taxes will go partly to dealing with China’s monumental environmental issues, according to Miswin Mahesh, Barclays’ commodities analyst in London. That spending should be good for China and its neighbours, if the past is any guide.

Up to now, Chinese growth has been good news for the rest of the world. In 1990, China’s contribution to global GDP growth was 5 per cent. Since 2010, the figure has swelled to more than 40 per cent. Its role as a crutch for world growth has become especially important as the growth rate of other emerging markets has fallen. (Last year emerging markets as a whole grew only 4 per cent — the worst figure since 2009 — and this year may even drop slightly below that.)

China’s demand for crude is already lifting the fortunes of shippers and others. Among the biggest beneficiaries of the increase in Chinese appetite for crude is Iran, says Amrita Sen, chief oil analyst with Energy Aspects in Houston and London. Indeed, Chinese demand for oil from Iran accounts for more than India, Japan, and South Korea combined. (All these countries have received specific exemptions from US-imposed sanctions on Iran, and they may also import more than the level the waivers allow.)

Earlier on, before China received permission from the US to procure Iranian oil, the country paid for its Iranian imports in renminbi. But today, Ms Sen says, the Chinese are using dollars. That benefits both sides. Tehran finds dollars more useful than renminbi as there are still controls on what Iran can do with its Chinese currency.

At the same time, China has clearly decided it is better to obtain real assets such as oil with its dollars than to purchase paper securities. Right now, both US Treasuries and the US dollar look attractive, while oil does not. But China always takes the long view — and in the long term neither Treasury securities nor the greenback seem as attractive as they do today — at least as seen from Beijing.

Source: http://www.ft.com/intl/cms/s/0/b083f7b4-ab8d-11e4-b05a-00144feab7de.html#axzz3Qnw9Fh8K

End of QE will test diversification faith

Diversification, the great free lunch of investing, is often taken for granted by investors. Bonds and equities have acted as effective portfolio diversifiers for much of the new millennium because of their different return and volatility patterns. Two of the three main assets in a typical portfolio, cash being the third, moved in opposite directions during financial crises such as 2001 and 2008.

Indeed, portfolio management has become accustomed to this trend and now treats it as an article of faith. But does this faith represent a dangerous cocktail of overconfidence and extrapolation?

The mantra that monetary policy is driving market returns is well rehearsed. Less obvious is the idea that policy is driving the relationship between bond and equity returns.

This year gave a flavour of things to come: a period of high turbulence in May and June as markets took on board the possibility the global liquidity flood was about to abate. Bonds fell sharply and equities stumbled as investors fretted about an end to the Federal Reserve’s emergency asset-buying. Price volatility rose in both mainstream asset classes. Using US equities and 10-year bonds as proxies, the correlation was negative from 2009 to the middle of this year and positive thereafter.

Shock absorbers

Next year could mark a turning point as policy makers exiting the triage phase of recovery from the Great Financial Crisis move away from a material reliance on monetary activism into the potentially more volatile territory of forward guidance.

What does this mean for fixed income? Suppose there is one dominant, price-insensitive buyer (the Fed). Now suppose this buyer has a progressively smaller wallet. All other things being equal, the volatility of prices rises as buyer and seller strive to match each other. Add in another group of (reasonably) price-insensitive buyers (China and the like) downsizing their spending due to slowing growth in foreign exchange reserves, and this risk expands.

Of course, there are shock absorbers. First, the developed world’s ageing populations and their agents (think insurers) have a structural bid for yield. Second, the Bank of Japan is expanding its monetary easing . Some of governor Haruhiko Kuroda’s largesse eventually will pass through Narita Airport as growing shortages of domestic bonds force local institutions to shake off some of their home bias. The conclusion? Do not expect a fixed income bloodbath in 2014 – but brace for more volatile returns.

How about equities? 2013 will probably be known as the Year of Equity. The problem: the numerator of the price to earnings ratio (price) has been driving returns in most markets this year, rather than the denominator (earnings). Higher pricing of the final claim on corporate cash flows – equity – has been aided by the tightest debt spreads on record, insatiable demand from yield-hungry investors, and the ability to refinance and extend fixed obligations at low cost. This works well for a while, but at some point earnings need to come through.

Theory has it the discount rate partially connects bonds (fixed coupons discounted by an interest rate) and equities (fluctuating cash flows discounted by this interest rate plus some variable risk premia). Here is the rub: arithmetically, the lower the real interest rate, the greater the volatility triggered by small changes. If the major driver of returns (policy) becomes more volatile, so do the assets that have benefited from that support.

QE tide turns

Clearly the unprecedented monetary stimulus tide will not last forever. When it dwindles, what will become an effective diversifier of portfolio risk? Bonds or equities? Not entirely; see the drawbacks described above. Cash? Perhaps, but if rates rise for longer-dated bonds and remain anchored by policy for short-dated issues, the diversification benefit of a near zero return is limited.

Challenging the assumptions of the past at a time of regime change is vital in financial markets. This means rethinking fixed income to seek out relative value between bonds, capitalising on rises in volatility and harvesting risk premia. In other words, taking an unconstrained approach. It means a focus on alternative strategies that do not start with the discount rate. Examples are infrastructure and real estate debt, opportunistic acquisition of long duration assets chased off bank balance sheets by regulation and market neutral long-short strategies.

Any reversal in the policy tide involves uncharted territory. A reversal in the 30-year downward trend of rates must, however, involve some different results. 2014 may very well become known as the year in which unwary investors ask: “Who stole my diversifier?”

Source: http://www.ft.com/intl/cms/s/0/0687562c-5e7f-11e3-8621-00144feabdc0.html#axzz2nwa2gnpW

The Challenges in Hedging Tail Risk

If there’s one word investors use to describe the markets over the past few years, it’s unpredictable. Unforeseen events were everywhere.

Last year we had the Japanese tsunami and the Arab Spring, followed by the debt ceiling standoff in the United States and the subsequent credit rating downgrade. Even for a “predictable” event, like the European sovereign debt crisis, each twist seemed to catch investors off guard.

What will take us by surprise in 2012? Will it be military conflict in the Middle East, a slowdown in growth in China, continued stress in Europe, or something else we are not yet thinking about?

This uncertainty is unwelcome to those still recovering from the financial crisis, which not only frayed investors’ nerves, but left many portfolios in a precarious state. Some investors, like underfunded pension funds, have limited ability to withstand another market shock. Given this backdrop and these fears, “tail risk” hedging, or protecting investment portfolios against extreme negative moves in the market, has been a frequent topic of conversation among market participants.

Buying put options is currently the most popular form of “tail risk” hedging. Despite the growing demand to buy long-term put options from both institutional and individual investors, fewer and fewer market participants are willing or able to sell these options. Whereas an option buyer’s risk is limited to the premium they pay, an option seller has much greater risk.

With the coming arrival of the Volcker Rule, which seeks to reduce excessive risk at banks, banks need to decrease the amount of long-dated options they will sell. In addition, regulatory changes have increased the amount of collateral required for these trades, further constraining the number of option sellers. One example is Berkshire Hathaway, which has historically been a significant seller of long-dated put options on the United States equity markets. Berkshire stated in its annual letter than it plans to stop selling options because of regulatory changes.

The increased demand to buy put options (which are priced in terms of implied volatility), coupled with a lack of people willing and able to sell them, has led to excessively high volatility prices, especially in longer-dated maturities.

With the increase in the price of volatility, the cost of portfolio protection has also increased, causing prospective hedgers to often overpay for this insurance. Consider the price of general insurance (home, medical, car, flood, etc.) as a simple example. People buy this type of insurance to protect against the loss from a particular event. Typically, buying it is not expensive because the insurance will be paid out infrequently, if at all.

In the event of the loss, however, the insurance buyer can expect to be paid much more than the annual cost of the insurance. Unfortunately, we cannot currently say the same thing about insuring a stock portfolio against a major loss. For instance, it would cost nearly 4 percent in premium to buy a put option that starts to pay off after the market falls 15 percent over a one-year period. Because of this high cost, the option would lose money until the market fell by 19 percent. And even if the market falls further and the option pays off, the return on premium will be much lower than in the example of general insurance.

As another example of the high cost to buy portfolio protection, consider the price of call options (which benefit from a market rally) relative to the price of put options (which benefit from a market crash). For the same amount of premium, an investor could buy 10 call options on the Standard & Poor’s 500 index expiring in six-months with a strike price that is 15 percent above current levels, or just one put option at strike price 15 percent below the current levels.

For investors trying to reach a certain return target, this high cost can be a constant drag on returns, preventing them from meeting return expectations. As seen in the example above, imagine reducing your returns by 4 percent every year to pay for this down-side protection. These types of investors would be better off finding other ways of reducing portfolio risk. Indeed, there are ways for investors with long-dated capital to sell volatility in a protected manner, thereby earning the high premium themselves.

As we continue to experience bouts of volatility in the market, investors will keep searching (unsuccessfully) for the “silver bullet” for hedging tail risk in the financial markets. But when volatility is high, like it was last year, and options become expensive, investors need to pay attention to the costs of protection they are buying. Otherwise, they risk paying too much and missing their return targets even in a rallying market.

Source: http://dealbook.nytimes.com/2012/04/20/the-challenges-in-hedging-tail-risk/

Financial stability in South Korea: The won that got away

IN MANY respects South Korea looks like a developed economy—if that is not too dirty an expression these days. But its currency, the won, still behaves as if it is part of an old-fashioned emerging market. According to the Korea Institute of Finance, only the Brazilian real and the South African rand exhibited more volatility during the 2008 crisis.

The currency is gyrating again, thanks to grim news from Europe and America. The won lost almost 10% of its value against the dollar in the past month (see chart), although it has since rebounded slightly. At a recent conference held by The Economist in Seoul, one banker labelled it the “VIX currency” in honour of the market gauge that measures volatility.

As one of the world’s most export-oriented economies, South Korea is sensitive to global growth. In good times it can be a magnet for speculative capital, which is why foreign investment has poured into the bond market in recent years. According to Tim Condon of ING, the windfall has produced the highest level of foreign debt relative to reserves in Asia. In bad times speculators can tap those gains to cover losses elsewhere. That does not just hit the currency: the KOSPI stockmarket index lost 11% over three trading sessions last month.

The won’s tendency to weaken when the chips are down is a blessing for the carmakers and shipbuilders who made South Korea what it is today. The Japanese, whose currency tends to strengthen in adversity, seethe with jealousy. But there are costs, too. The Bank of Korea, the central bank, may miss its inflation target as higher import prices drive up the cost of living. On September 23rd, when the won hit its weakest level against the dollar in a year, the Bank of Korea reportedly spent $4 billion propping it up.

The central bank has lots of firepower. Its foreign-exchange hoardings stood at $312 billion at the end of August, which puts it among the top ten of reserve holders. Officials note that this amount is much greater than it was in 2008, and that Korea’s banks are less reliant on short-term, foreign-denominated debt than they were when Lehman collapsed. A string of banking scandals has muffled this message: seven mutual savings banks had their operations suspended in September. But the mutuals account for just 2% of the financial system. They present little real danger, even if they damage perceptions. Much like the won.

Source: http://www7.economist.com/node/21530993