In 2017, I focused less on a personal forex portfolio, and more on other portfolios as capital deposits in the latter reached the same amount as the personal FX portfolio. In this post, I will be discussing three currency portfolios; active trading strategies, carry trade strategy, and cryptocurrencies.
Active Trading Forex Portfolio
Since inception (09/29/2015, I actually started trading in 2011), personal forex portfolio is up 33%. For 2017, it returned 8.39%. For 2016 and 2015, the portfolio returned 32.82% and 117.48%, respectively. So why the big differences in percentages since inception and yearly returns? More money was deposited into the account over time. As a result, I have risked much lesser capital per trade. The portfolio size is 10 times bigger than it was in 2015, or 100 times bigger than it was in 2011. Thus, the returns in % terms are much smaller, but in nominal amounts, much bigger.
In 2017, the maximum drawdown was almost 7%. When the drawdown increased 2% in a week in the middle of the year, I knew I had to change certain positions. 2% move in a week was a big deal considering I was focused less on the personal FX portfolio. Once I closed certain positions and opened new positions, the drawdown went back to its average of 3.5% within two weeks and stayed below that level since then. Risk management is very important!
I don’t have other metrics, such as monthly returns, standard deviation, and Sharpe ratio, as I did for 2016 because the ex-broker who provided me with the useful statistics was banned from the U.S., for defrauding customers and engaging in false/misleading solicitations.
Carry Trade Forex Portfolio
During early 2017, I wanted to create another forex account solely focused on one strategy. I didn’t want the carry trade positions mixed with active positions. So I opened an account with a different broker, Oanda. I initially deposited about 4% of my capital, amount I can afford to lose.
I made some mistakes in the beginning. The first trade was shorting EUR/TRY, whose interest differential is the highest, A.K.A higher yield. I started to lose a lot of money as the only carry trade in the account kept going in the opposite direction of my favor (EUR/TRY kept rising), talks of ECB tapering its balance sheet appreciated the euro and the situation in Turkey depreciated the lira.
Within several months, my unrealized losses were about 30% of the portfolio. I couldn’t do anything about it to manage the risk as my hands were tied due to work. I had to set up the carry trade portfolio in a way I barely have to worry about the fluctuations in unrealized P/L. When work ended for the summer, the portfolio drawdown was its highest, almost 50%.
I learned that the key to successful carry trade is to leave plenty of margin in the account for the pairs to fluctuate without wiping out your account. So I deposited 1% more capital into the account to prevent margin call. Immediately afterward, I changed my positions. I shorted some of the highest yielding currency pairs with negative correlation to EUR/TRY. Within a month, the drawdown went from 50% to 30%. Currently, it is just above 20%. Risk management is very important!
For its first year, the portfolio is up 14%. The 14% comes from the interest returns on the positions as it rolled over to the next day. However, when the unrealized losses are taken into account for 2017, the portfolio is down 23%. Carry trade is a long-term trend following strategy that requires patience and risk management.
This is an instance of humans thinking they can do something well, but things go sideways when they put their actual money, relationships, etc. at risk. I initially believed I could make some money easily with the carry trade. When the time came to have a real money at risk, I made mistakes and learned a lot! This is why I won’t be overconfident in things unless I actually have a good experience in it. Not just for professional life, but also for personal life.
Ahhh. Cryptocurrencies. The hot talk of the moment. Like everybody else, I’m up big time. I started buying cryptocurrencies in July. As of this writing, the portfolio is up 143%. I know I know, 143% is nothing compared to the actual returns of the cryptocurrencies. I currently hold Bitcoin (BTC/USD), bitcoin cash (BHC/USD), Ethereum (ETH/USD), and Litecoin (LTC/USD). If all the cryptocurrencies were to drop 99%, I will only lose 5% of my capital and continue to live as usual. To clarify, I’m not actively trading them.
I bought $ETHUSD (Ethereum) between $135.79 and $142.98. Still holding it. Might buy more (will be tweeted live). Not sure about bitcoin yet
As you may know, I published my forex performance for 2016 and since inception. From now on, I will also share my quarterly performance. March 31st marked the end of first quarter, here are my performance results for FX trading.
Forex Trading Performance – Q1 2017
For currency trading, I was up 2.15%. I know, it’s low (in % terms at least). But, allow me to explain.
Before this year, my currency trades used to be in 1,000 units (or 0.01 lots), lowest I can trade. Since I usually had about 10 positions, each of 1,000 units, the nominal amount was large enough. After depositing more money and getting a clear picture of my Forex performance, I decided to increase my trades to 2,000/3,000 units (or 0.02/0.03 lots) for each position.
Getting a clear picture of my performance – average gain/loss, drawdown, trade duration, the percentage of profitable trades, etc – helped me improve my performance significantly.
This quarter [Q1], I further minimized my drawdowns. By minimizing drawdown, I minimized my returns. And that works for me. Stable uptrending P/L with a low risk.
It is true Forex is way riskier than other assets classes due to its leverage, mostly 1:50. But, that does not mean your portfolio has to include a lot of risks.
While 2.15% return this quarter from Forex trading is low, it’s still big in nominal terms for me and I’m getting a much better understanding of my weakness/strengths as I look through the metrics.
I don’t have the key metrics (besides the returns) and charts to share with you for this quarter for one reason: FXCM was Banned from the U.S. (I’m not even surprised after what happened on January 15, 2015).
FXCM is a retail FX broker and my former broker. They were banned by CFTC for defrauding retail foreign exchange customers and engaging in false and misleading solicitations.
As a result, FXCM customers were automatically changed to a different broker, Forex.com by Gain Capital Holdings, on February 24th. Unlike FXCM, this broker did not offer an analysis of trades. In addition to that, a third-party software did not offer an analysis of trades for Gain Capital’s customers since the broker did not allow the software to be connected with it.
Good news is that I’m currently in process of changing the platform to MetaTrader, which will make it easier for me to track performance metrics. The other platform, ForexTrader made it harder for tracking key metrics.
For the next quarter’s results, you can expect to see more performance metrics for FX trading.
Live On Twitter
As you may know, I tweet out trades/investments I’m making. That’s one of many reasons you should follow me on Twitter if you haven’t already. One of many ways I measure success is through twitter followers, believe it or not.
WHAT A YEAR! Market sell-off. Complete reverse afterwards. Full of surprises, from Brexit to Trump (not for me since I predicted them).
During the global markets crash in August of 2015, I completely lost all the money I made that year plus some more in forex. Witnessing markets free fall – faster than Luke skydiving 25,000 feet without parachute – for the first time ever crushed my account to death. (For the record, I wasn’t trading in 2008 and had absolutely no idea what was unfolding that time).
Thinking euro will go to the parity level by the end of 2015, most of my positions were crowded in shorting EUR (The Big Short). Just when I thought euro would follow the markets, it acted as a safe-haven.
Lessons learned the hard way:
Always keep enough cash for emergency and/or new opportunities (could not make new trades)
Do not keep most things in one place (EUR short)
Do not let the perceptions – media, traders, experts, you name it – fool you (“Euro is not a safe-haven asset”)
Taking all these lessons, I completely changed my strategy and will continue to tweak it to adapt to the current conditions. After taking a break from trading in September (2015), I opened a new forex account.
Started off strongly, with high standard deviations, but enough for me to sit through that. High-risk/High-reward. As I continued tweaking my strategy, I reduced the swings in the P/L.
Starting in August 18 of this year (2016), my returns have been very stable, trending upwards (see Figure 1). It went from 144.49% return to 184.42% as of the last trading day in 2016. Last August, I made a significant chance to my strategy which led to stable returns trending upwards. I continue to tweak my strategy little by little until significant change is needed. Repeat.
Since inception (09/29/2015), I have returned 184.42%. In the second half of this year, I deposited more money into the account. In turn, the % returns you see in the pictures above and below, has a huge difference in nominal amounts.
In 2015, I returned 117.48%. This year, I have returned 32.82%. Since the inception, percentage of profitable trades are 50.70%, with the average gain per trade 3.82 larger than the amount of average loss per trade.
Sharpe ratio is 1.13 (not good yet), with average monthly return of 11.01% and 33.79% standard deviation of monthly return. Compounded monthly rate of return is 7.22%.
I predicted Brexit and profited bigly off it. 30.77% of the profit came from pair GBP/USD. Thanks Brexit. How did I predict Brexit?
Largest loss was 5.21%, from pair AUD/USD. I don’t know what to blame except myself.
As to predicting Trump’s win, the profit was a fraction of Brexit profit, via other pairs than Mexican peso currency. The day after the election, the peso suffered its largest one-day drop since the Tequila Crisis of the 1990s. Too bad I did not have access to peso pair at the time. How did I predict Trump win? Tweet 1, 2.
If you invested $1,000 in me at the inception, that money would have been worth $2,844.23 today.
You can still invest in me. Minimum investment is $1,000. Contact me for more details.
Liquidity is the investor’s ability to buy and sell a security without significantly impacting its price. Lack of liquidity in a security can have its consequences. Post financial crisis regulations, such as Volcker Rule (Dodd-Frank), and Basel 3, has made it more expensive and more difficult for banks to store bonds in their inventories and facilitate trades for investors. Regulations designed to make the system more safer have depressed the trading activity.
Lack of supply is one cause for diminishing liquidity. Banks, the dealers of corporate bonds, have reduced their inventories. According to Bank for International Settlements (BIS), “Market participants have raised concerns that regulatory reforms, by raising the costs of warehousing assets, have contributed to reducing market liquidity and could be keeping banks from acting as shock absorbers during periods of market stress.”
According to BIS, “US primary dealers…have continued to reduce their corporate bond inventories over the past years. Since the beginning of the year 2013, they have cut back their net positions in U.S. Treasuries by nearly 80%.
Another big cause of decreasing in liquidity is technology. A technology that has changed the structure of markets, high-frequency trading (HFT), an algorithm computer trading in seconds and in fractions of seconds, account for much larger share of the trading transactions and it leads to low liquidity. Majority of HFTs, if not all, reduces liquidity by pairing selected (self-interest), leaving out others. According to BIS, 70% of U.S. Treasury trading is done electronically, up from 60% in 2012. For both high-yield bonds (not highly liquid asset), it accounts for more than 20%. About 90% of transactions on bond futures take place electronically. I have no doubt electronic trading will continue to increase.
“Greater use of electronic trading and enhanced transparency in fixed income markets typically comes at the cost of greater price impact from large trades.”, BIS said in the report. Bonds now trade in smaller transaction sizes than they did before, “… large trades seem less suitable for trading on electronic platforms because prices move quickly against participants who enter large orders due to the transparency of the market infrastructure.” “It “discourages market-makers from accommodating large trades if they fear that they cannot unwind their positions without risking a sizeable impact on prices.”
BIS in its quarterly review report (March 2015) stated (source: FINRA’s TRACE data), the average transaction size of large trades of U.S. investment grade corporate bonds (so-called “block trades”) declined from more than $25 million in 2006 to about $15 million in 2013.
This is a sign of illiquidity since “trading large amounts of corporate bonds has become more difficult.” Trades facing constrained liquidity puts investors, especially large investors, to a disadvantage.
Capacity to buy/sell without too much influence on the market prices are deteriorating. Lack of liquidity can causes wild swings in the bond prices, which then can affect the rest of the financial markets. Today’s financial markets are so connected just like the economic domino effects.
They are connected, but let me tell you why they are so important. The U.S Treasury securities market is the largest, the most liquid, and the most active debt market in the world. They are used to finance the government, and used by the Federal Reserve in implementing its monetary policy. I repeat, in implementing its monetary policy. Having a liquid market – in which having no problem buying and selling securities without affecting the market price – is very important to the market participants and policymakers alike.
Examples of high volatility in a low liquidity:
Flash Crash (May 2010)
In a matter of 30 minutes, major U.S. stock indices fell 10%, only to recover most of the losses before the end of the trading day. Some blue-chip shares briefly traded at pennies. WHAT A SALE! According to a U.S. Securities and Exchange Commission (SEC) report, before 2:32 p.m., volatility was unusually high and liquidity was thinning, a mutual-fund group entered a large sell order (valued at approximately $4.1 billion) in “E-mini” futures on the S&P 500 Index. The large trade was made by an algorithm. The “algo” was programmed to take account of trading volume, with little regard, or no regard at all, to the price nor time. Since the volatility was already high during that time and volume was increasing, this sell trade was executed in just 20 minutes, instead of several hours that would be typical for such an order, 75,000 E-mini contracts (again, valued at approximately $4.1 billion).
According to the report, this sell pressure was initially absorbed by HFTs, buying E-mini contracts. However, minutes after the execution of the sell order, HFTs “aggressively” reduced their long positions. The increase in the volume again led the mutual-fund group “algo” to increase “the rate at which it was feeding the orders into the markets”, creating what’s known as a negative feedback loop. That’s the power of HFTs.
This was nearly 6 years ago. Today, there’s no doubt the power of the secretive section of the financial markets, HFTs, are much stronger and powerful and can destroy the markets with “one finger”.
With low liquidity in the bond market and increasing HFT transactions in it, the threat is real. Automated trades can trigger extreme price swings and the communication in these automated trades can quickly erode liquidity before you even know it, even though there is a very high volume. While liquidity in the U.S. bond market is high, it’s not high enough to battle the power of the technological progress.
Let’s not forget. Fixed-income assets such as, corporate bonds, are often traded over the counter in illiquid markets, not in more liquid exchanges, as stocks are.
It’s all about profits. Some, if not all HFTs, act the way they do, to make profit. There’s nothing wrong with that. But, the creators of the algorithms have to be ethical and responsible. It’s not likely to happen anytime soon since profits are the main goal (mine too) in the financial markets. So why should HFT “be fair” to others? I know I wouldn’t.
Taper Tantrum (2013 Summer)
In the summer of 2013, the former Federal Reserve chairman, Ben Bernanke, hinted an end to the Fed’s monthly purchases of long-term securities (taper off, or slow down its Quantitative Easing), which sent the financial markets, including the bond market into a tailspin.
On June 19, 2013, Ben Bernanke during a press conference said, “the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year.” That sentence alone started the financial market roller coaster.
Yields skyrocketed. The gravity took down the value of greenback (U.S. Dollar). U.S. long-term interest rates shot up by 100 basis points (1%). Even short-term interest rate markets saw the rate-hike to come sooner than the Fed policymakers suggested. Borrowings costs increased so much, as the markets was expecting tightening of the monetary policy, it “locked up” the Fed from cutting the pace of bond buying that year.
This raises (or raised) whatever the market prices can handle orders that are executed in milliseconds. It points to a lack of supply (dealer inventories), A.K.A illiquidity. I feel bad for funds that have a lot of corporate-bonds in their portfolio. The struggle is real.
An open-ended funds that allow investors to exit overnight are more likely to experience a run, as market volatility increases. A run on funds will force the funds to sell illiquid assets, which can push down the prices lower and lower. Recently example of that is the Third Avenue (“investors’ money are being held hostage”).
Brace for a fire sale. Coming soon in your area.
Market makers, where are you? Come back. I need to sell the investments at a current price, before it goes much lower.
October 15, 2014
The financial markets experienced – as the U.S. Department of the Treasury puts it – “an unusually high level of volatility and a very rapid round-trip in prices. Although trading volumes were high and the market continued to function, liquidity conditions became significantly strained.”
On October 15, 2014, the markets went into a tailspin again. The Dow plummeted 460 points, only to recover most of the losses. The Nasdaq briefly fell into a correction territory, only to rebound sharply. The 10-year Treasury yield “experienced a 37-basis-point trading range, only to close 6 basis points below its opening level”, according the U.S. Treasury Department report.
According to Nanex, a firm that offers real-time streaming data on the markets, between 9:33 A.M and 9:45 A.M, “liquidity evaporated in Treasury futures and prices skyrocketed (causing yields to plummet). Five minutes later, prices returned to 9:33 levels.” “Treasury futures were so active, they pushed overall trade counts on the CME to a new record high.”, said the report.
“Note how liquidity just plummets.”
Again, as I said, “Today’s financial markets are so connected just like the economic domino effects.” The mayhem in in the bond market can spread to the foreign exchange (forex) market.
These types of occurrences are becoming common, or the “new normal”. As the Fed raises rates, the market participants will be adjusting their portfolio and/or will adjust them ahead of it (expectations), these adjustments will force another market volatility. But this time, I believe it will be much worse, as liquidity continues to dry up and technology progresses.
Recent market crashes and volatility, including the August 2015 ETF blackout, is just another example of increasing illiquidity in the markets. Hiccups in the markets will get bigger and will become common. Illiquidity is the New Normal.
Hello HFTs, how are you doing? Making $$$? Cool.
With interest rates around 0 (well, before the rate-hike in December), U.S. companies have rushed to issue debt. With the recent rate-hike by the Fed, U.S. corporate bond market will experience more volatility. Lower and diminishing liquidity will “manufacture” a volatility to a record levels that the financial markets and the economy won’t be able to cope with it. As said, “Today’s financial markets are so connected just like the economic domino effects.”, the corporate bond market volatility will spread to the rest of the financial markets.
12….11…10…9….IGNITION SEQUENCE START….6….5….4….3….2….1….0….ALL ENGINES RUNNING….LIFTOFF….WE HAVE A LIFTOFF!
The Fed finally raised rates after nearly a decade. On December 16, the Fed decided to raise rates – for the first time since June 2006 – by 0.25%, or 25 basis points. It was widely expected by the markets and I only expected 10bps hike. Well, I was wrong on that.
The Federal Open Market Committee (FOMC) unanimously voted to set the new target range for the federal funds rate at 0.25% to 0.50%, up from 0% to 0.25%. In the statement, the policy makers judged the economy “has been expanding at a moderate pace.” Labor market had shown “further improvement.” Inflation, on the other hand, has continued to “run below Committee’s 2 percent longer-run objective” mainly due to low energy prices.
Remember when the Fed left rates unchanged in September? It was mainly due to low inflation. What’s the difference this time?
In September, the Fed clearly stated “…survey—based measures of longer-term inflation expectations have remained stable.”
Now, the Fed clearly states “…some survey-based measures of longer-term inflation expectations have edged down.”
So…umm…why did they raise rates this time?
Here is a statement comparison from October to December:
On the pace of rate hikes looking forward, the FOMC says:
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
They clearly stated one of the things they look for, which is inflation expectations. But, they also did state that “inflation expectations have edged down.”
It seems to me that the Fed did not decide to raise rates. The markets forced them. Fed Funds Futures predicted about 80% chance of a rate-hike this month. If the Fed did not raise rates, they would have lost their credibility.
I believe the Fed will have to “land” (lower back) rates this year, for the following reasons:
Growing Monetary Policy Divergence
On December 3, European Central Bank (ECB) stepped up its stimulus efforts. The central bank decided to lower deposit rates by 0.10% to -0.30%. The purpose of lower deposit rates is to charge banks more to store excess reserves, which stimulates lending. In other words, free money for the people so they can spend more and save less.
ECB also decided to extend Quantitative Easing (QE) program. They will continue to buy 60 billion euros ($65 billion) worth of government bonds and other assets, but until March 2017, six months longer than previously planned, taking the total size to 1.5 trillion euros ($1.6 trillion), from the previous $1.2 trillion euros package size. During the press conference, ECB President Mario Draghi said the asset eligibility would be broadened to include regional and local debt and signaled QE program could be extended further if necessary.
ECB might be running out of ammunition. ECB extending its purchases to regional and local debt raises doubts about its program.
Not only ECB is going the opposite direction of the Fed. Three weeks ago, Bank of Japan (BoJ) announced a fresh round of new stimulus. The move was hardly significant, but it is still a new round of stimulus. The central bank decided to buy more exchange-traded fund (ETF), extend the maturity of bonds it owns to around 7-12 years from previously planned 7-10 years, and increase purchases of risky assets.
The extensions of its QE are beginning to become routine or the “new normal”.
The move by BoJ exposes the weakness of its past actions. It suggests the bank is also out of ammunition. Already owning 52% or more of the Japan’s ETF market and having a GDP-to-Debt ratio around 245%, it is only a matter of time before Japan’s market crashes. Cracks are already beginning to be shown. I expect the market crash anytime before the end of 2019.
So, what are the side-effects of these growing divergence?
For example, the impact of a US dollar appreciation resulting from a tightening in US monetary policy and the impact of a depreciation in other currencies resulting from easing in its monetary policies. Together, these price changes will shift global demand – away from goods and services produced here in the U.S. and toward those produced abroad. In others words, US goods and services become more expensive abroad, leading to substitution by goods and services in other countries. Thus, it will hurt the sales and profits of U.S. multinationals. To sum up everything that is said in this paragraph, higher U.S. rates relative to rates around the global harms U.S. competitiveness.
Emerging markets were trouble last year. It is about to get worse.
International Monetary Fund (IMF) decided to include China’s currency, renminbi (RMB) or Yuan, to its Special Drawing Rights (SDR) basket, a basket of reserve currencies. Effective October 1, 2016, the Chinese currency is determined to be “freely usable” and will be included as a fifth currency, along with the U.S. dollar, euro, Japanese yen, and pound sterling, in the SDR basket.
“Freely useable” – not so well defined, is it?
Chinese government or should I say People’s Bank Of China (PBOC), cannot keep its hands off the currency (yuan). It does not want to let market forces take control. They think they can do whatever they want. As time goes on, it is highly unlikely. As market forces take more and more control of its exchange-rate, it will be pushed down, due to weak economic fundamentals and weak outlook.
China, no need to put a wall to keep market forces out. Let the market forces determine the value of your currency. It is only a matter of time before they break down the wall.
In August, China changed the way they value their currency. PBOC, China’s central bank, said it will decide the yuan midpoint rate based on the previous day’s close. In daily trading, the yuan is allowed to move 2% above or below the midpoint rate, which is called the daily fixing. In the past, the central bank used to ignore the daily moves and do whatever they want. Their decision to make the midpoint more market-oriented is a step forward, but they still have a long way to go.
China saw a significant outflows last year. According to Institute of International Finance (IFF), an authoritative tracker of emerging market capital flows, China will post record capital outflows in 2015 of more than $500 billion. The world’s second largest economy is likely to see $150 billion in capital outflow in the fourth quarter of 2015, following the third quarter’s record $225 billion.
Ever since the devaluation in August, PBOC has intervened to prop yuan up. The cost of such intervention is getting expensive. The central bank must spend real money during the trading day to guide the yuan to the level the communists want. Where do they get the cash they need? FX reserves.
China’s foreign-exchange reserves, the world’s largest, declined from a peak of nearly $4 trillion in June 2014 to just below $3.5 trillion now, mainly due to PBOC’s selling of dollars to support yuan. In November, China’s FX (forex) reserves fell $87.2 billion to $3.44 trillion, the lowest since February 2013 and largest since a record monthly drop of $93.9 billion in August. It indicates a pick-up in capital outflows. This justifies increased expectations for yuan depreciation. Since the Fed raised rates last month, I would not be surprised if the capital flight flies higher, leading to a weaker yuan.
Depreciation of its currency translates into more problems for “outsiders,” including emerging markets (EM). EMs, particularly commodities-linked countries got hit hard last year as China slowed down and commodity prices slumped. EMs will continue to do so this year, 2016.
The anticipation of tightening in the U.S. and straightening dollar put a lot of pressure on EM. EM have seen a lot of significant capital outflows because they carry a lot of dollar denominated debt. According to the October report from IFF, net capital flows to EM was negative last year for the first time in 27 years (1988). Investors are estimated to pull $540 billion from developing markets in 2015. Foreign inflows will fall to $548 billion, about half of 2014 level and lower than levels recorded during the financial crisis in 2008. Foreign investor inflows probably fell to about 2% of GDP in emerging markets last year, down from a record of about 8% in 2007.
Also contributing to EM outflows are portfolio flows, “the signs are that outflows are coming from institutional investors as well as retail,” said Charles Collyns, IIF chief economist. Investors in equities and bonds are estimated to have withdrawn $40 billion in the third quarter, the worst quarterly figure since the fourth quarter of 2008.
A weaker yuan will make it harder for its main trading partners, emerging markets and Japan, to be competitive. This will lead to central banks of EM to further weaken their currencies. Japan will have no choice but to keep extending their QE program. And to Europe. And to the U.S. DOMINO EFFECT
Why are EMs so important? According to RBS Economics, EMs have accounted for 50%-60 of global output and 70% of global economic growth each year since the 2008 crisis.
Some EM investors, if not all, will flee as U.S. rates rise, compounding the economic pain there. Corporate debt in EM economies increased significantly over the past decade. According to IMF’s Global Financial Stability report, the corporate debt of non-financial firms across major EM economies increased from about $4 trillion in 2004 to well over $18 trillion in 2014.
When you add China’s debt with EM, the total debt is higher than the market capitalization. The average EM corporate debt-to-GDP ratio has also grown by 26% the same period.
The speed in the build-up of debt is distressing. According to Standard & Poor’s, corporate defaults in EM last year have hit their highest level since 2009, and are up 40% year-over-year (Y/Y).
According to IFF (article by WSJ), “companies and countries in EMs are due to repay almost $600 billion of debt maturing this year….of which $85 is dollar-denominated. Almost $300 billion of nonfinancial corporate debt will need to be refinanced this year.”
I would not be surprised if EM corporate debt meltdown triggers sovereign defaults. As yuan weakens, Japan will be forced to devalue their currency by introducing me QE which leaves EMs with no choice. EMs will be forced to devalue their currency. Devaluations in EM currencies will make it much harder (it already is) for EM corporate borrowers to service their debt denominated in foreign currencies, due to decline in their income streams. Deterioration of income leads to a capital flight, pushing down the value of the currency even more, which leads to much more capital flight.
“Firms that have borrowed the most stand to endure the sharpest rise in their debt-service costs once interest rates begin to rise in some advanced economies. Furthermore, local currency depreciations associated with rising policy rates in the advanced economies would make it increasingly difficult for emerging market firms to service their foreign currency-denominated debts if they are not hedged adequately. At the same time, lower commodity prices reduce the natural hedge of firms involved in this business.”
According to its Global Financial Stability report, EM companies have an estimated $3 trillion in “overborrowing” loans in the last decade, reflecting a quadrupling of private sector debt between 2004 and 2014.
Rising US rates and a strengthening dollar will make things much worse for EMs. Jose Vinals, financial counsellor and director of the IMF’s Monetary and Capital Markets Department, said in his October article, “Higher leverage of the private sector and greater exposure to global financial conditions have left firms more susceptible to economic downturns, and emerging markets to capital outflows and deteriorating credit quality.”
I believe currency war will only hit “F5” this year and corporate defaults will increase, leading to the early stage of sovereigns’ defaults. I would not be surprised if some companies gets a loan denominated in euros just to pay off the debt denominated in U.S dollars. That’s likely to make things worse.
Those are some of the risks I see that will force the Fed to lower back the rates. I will address more risks, including lack of liquidity, junk bonds, inventory, etc, in my next article. Thank you.
On October 22, Eli Lilly (LLY) reported an increase in the third-quarter profit, as sales in its animal health segment and new drug launches offset the effect of unfavorable foreign exchange rates and patent expirations. Indianapolis-based drug maker posted a net income increase of 60% to $799.7 million, or to $0.75 per share, as its revenue increased 33% in animal health segment. In January 2015, Eli Lilly acquired Norvartis’s animal health unit for $5.29 billion in an all-cash transaction. The increase in the animal-health revenue helped offset sharp revenue decreases in osteoporosis treatment Evista and antidepressant Cymbalta, whose revenue fell 35% and 34% year-over-year, respectively. Eli Lilly lost U.S. patent protection for both drugs last year, causing patent cliffs. Lower price for the Evista reduced sales by about 2%.
Total revenue increased 2% to $4.96 billion even as currency headwinds, including strong U.S. dollar, shaved 8% off of the top line in revenue. Recently launched diabetes drug Trulicity and bladder-cancer treatment Cyramza helped increase profits, bringing a total of $270.6 billion in the third-quarter. Eli Lilly lifted its guidance for full-year 2015. They expect earnings per share in the range of $2.40 and $2.45, from prior guidance of $2.20 to $2.30.
Despite the stronger third-quarter financial results, I believe Eli Lilly is overvalued. Eli Lilly discovers, develops, manufactures, and sells pharmaceutical products for humans and animals worldwide. The drug maker recently stopped development of the cholesterol treatment evacetrapib because the drug wasn’t effective. Eli Lilly deployed a substantial amount of capital to fund Evacetrapib, which was in Phase 3 research, until they decided to pull the plug on it. The suspension to the development of Evacetrapib is expected to result in a fourth-quarter charge to research and development expense of up to $90 million pre-tax, or about $0.05 per share after-tax. Eli Lilly’s third-quarter operating expense declined 7% year-over-year, mainly due to spending on experimental drugs that failed in late-stage testing trials.
Eli Lilly’s market capitalization skyrocketed over the past five years by 122.76% to $90 billion, but their revenue, gross profit, net-income, operating income, as well as EBITDA, declined significantly. Over the past five years, its revenue decreased 14.61% from $23.08 billion to $19.70 billion (LTM), largely due to patent expirations. Gross profit and net-income declined 26.06% and 53.48%, respectively. Its operating income fell 59.18% over the past five years.
Its operating margin fell a halfway over the past five years from 28.30% to 13.53% (LTM). EBITDA margin, on the other hand, fell all the way to 18.73% (LTM) from 34.05%.
Meanwhile, shares of Eli Lilly gained 144.49% over the past five years. Its price-to-sales ratio too high compared to its history and to S&P 500. Its Price/Sales ratio currently stands at 4.6, vs. at 1.7 in 2010, while S&P 500 currently stays at 1.8 and industry average at 3.9. In addition to the falling revenue, gross profit, net-income, and EBITDA, its free cash flow fell significantly over the past five years by 72.24%, or fell 22.61% on a compounded annual basis.
Not only did their cash flow fall, but their net-debt increased significantly. Its net-debt increased by a whopping 1789.87% over the past five years from $199.5 million to $3.85 billion. They now have almost twice as much of total debt than they do in cash and equivalents. I believe Eli Lilly is at a risk for poor future ratings by rating agencies, which will increase their borrowing costs.
Strong U.S. dollar is an issue for Eli Lilly. Over the past five years, the dollar index increased 26.75%. Last quarter, its 49.2% of revenue came from foreign countries. Its revenue in the U.S. increased 14% to $2.54 billion, while revenue outside the U.S. decreased 9% to $2.42.
Eli Lilly’s dividend yield of 2.55% or 0.50 cents per share quarterly can be attractive, but it is undesirable. From 1995 through 2009 (expectation of 2003-2004), Eli Lilly raised its dividend. Payouts of $0.26 quarterly in 2000 almost doubled to $0.49 in 2009. Then, the company kept its dividend payment unchanged in 2010, the same year when its net-income, EBITDA and earnings per share (EPS) reached an all-time high. About four years later (December 2014), Eli Lilly increased the dividend to $0.50 quarterly. I still don’t see a reason to buy shares of Eli Lilly. The frozen divided before the recent increase was a signal that the management did not see earnings growing. With expected patent expiration of Cymbalta, their top selling drug in 2010, it is no wonder Eli Lilly’s key financials declined and dividends stayed the same. Cymbalta sales were $5.1 billion in 2013, the year its patent expired. In 2014, its sales shrank all the way down to $1.6 billion. Loss of exclusivity for Evista in March 2014 immensely reduced Eli Lilly’s revenue rapidly. Sales decreased to $420 million in 2014, followed by $1.1 billion in 2013. Pharmaceuticals industry continues to lose exclusivities, including Eli Lilly.
In December 2015, Eli Lilly will lose a patent exclusivity for antipsychotic drug Zyprexa in Japan and for lung cancer drug Alimta in European countries and Japan. Both of the drugs combined accounted for revenue of $866.4 million in the third-quarter, or 17.5% of the total revenue. They will also lose a patent protection for the erectile dysfunction drug Cialis in 2017, which accounted for $2.29 billion of sales in 2014, or 11.68% of the total revenue.
Besides the pressure from patent expirations, there is also regulatory pressures on drug pricing. According to second-quarter 10Q filing, Eli Lilly believes “State and federal health care proposals, including price controls, continue to be debated, and if implemented could negatively affect future consolidated results of operations.” During the third-quarter earnings call, CEO of Eli Lilly, John C. Lechleiter, said that price increases reflects many of medicines going generic and “deep discounts” government mandates for large purchasers.
As of October 16, Eli Lilly had two drugs under regulatory review, nine drugs in Phase 3 testing, and 18 drugs in Phase 2 testing. Since the end of July, the drug maker terminated the development of few drugs, including evacetrapib in Phase 3, two drugs in Phase 2, and five in Phase 1. Out of total eight drug termination, only five drugs moved to the next stage of testing. I view the recent termination of evacetrapib as a major setback.
Compared to its peers, LLY’s Price-to-Earnings ratio is too high. Its P/E ratio (on GAAP basis) stands at 38.22 while industry average stands at 17.7. Four of its main peers, Pfizer (PFE), Johnson & Johnson (JNJ), Merck (MRK), and Sanofi (SNY) P/E ratio stands at 24.08, 19.63, 14.41, and 22.38, respectively.
Negative trends, tighter regulations, increasing competition and slowing growth makes Eli Lilly’s current valuation unjustified. I believe it will reach an average P/E ratio of its four main competitors, at 20.12, in the next three years. I expect EPS (GAAP) to contract. With current EPS of $2.21 (LTM, GAAP) and P/E ratio of 20.12, share price would be worth $44.46, down 47.37% from current share-price of $84.47. As EPS contracts, the share price of Eli Lilly will be much further down from $44.46 in the next three years.
Disclosure: I’m not currently short on the stock, LLY, at this time (October 21, 2015).
Note: All information I used here such as revenue, margins, EBITDA, etc are found from Eli Lilly and Company’s official investor relations site, Bloomberg terminal and morningstar. The pictures you see here are my own, except “Eli Lilly Pipeline – Third Quarter Earnings Presentation – Page 16”
Disclaimer: The posts are not a recommendation to buy or sell any stocks, currencies, etc mentioned. They are solely my personal opinions. Every investor/trader must do his/her own due diligence before making any investment/trading decision.
Before we go any further, let’s review what two types of GDP, nominal-dollar terms and real-dollar terms. Current (or nominal-dollar) GDP tallis the value of all goods and services produced in the U.S. using present prices. On the other hand, Real (or chained-dollar) GDP counts only the value of what was physically produced. To clarify the point, suppose a hat-making factory announces that it made $1 million selling hats this year, 11% more than last year. The $1 million represents nominal company sales (or current dollar). However, something is missing. From this future alone, it’s unclear how the factory achieved the extra income. Did it actually sell 11% more hats? Or did it sell the same number of hats as the year before but simply raised prices by 11%? If the factory made more money because it increased the price tag by 11%, then in real (constant-dollar) terms, the true volume of hats sold this year was no greater than last year, at $900,000.
It’s vital to know if the economy grew because the quantity of products sold was greater or whether it was largely the result of price hikes, or inflation. (Source: “The Secrets of Economic Indicators” by Bernard Baumohl)
Real GDP increased at a annualized rate of 2.3%, vs expectations of 2.5%. This is a major acceleration from the first quarter when real GDP increased 0.6% (expansion), revised from -0.2% (contraction). The economy bounced back after a slow start in the beginning of the year.
While first quarter was revised upwards, 2011-2014 was revised lower. The economy grew 1.6% in 2011, down from the 2.3% initial reading; 2.2% in 2012, up from the 1.5% initial reading; 1.5% in 2013, down from 1.7%; and 2.4% in 2014, down from 2.7%. From 2011 to 2014, growth was essentially weaker. The economy expanded by an average annual rate of 2%, below initial reading of 2.3%.
Growth in the second quarter was boosted by consumer spending. Consumer spending grew at a 2.9% rate from a 1.8% in the first quarter. That is a very good sign because real personal consumption expenditures (PFE) AKA consumer spending, accounts for 70% of total GDP. If people are not spending, it spells serious trouble for the economy.
Real exports increased 5.3% in the second quarter, compared to 6% fall in the first quarter. First quarter’s significant drop was due to west port slowdown. The strong dollar has hurt exports but its effects have eased recently…for now. Port delays in the first quarter freed up exports and temporarily increased exports.
Business investment fell 0.6% in the second quarter, from previous 1.6% increase in the first quarter, as energy companies continue to scale back projects amid low oil prices.
Recently, crude oil prices have fallen back to the Earth. On Monday, August 3, crude oil prices hit just above $45 (currently below $45). It will continue to hurt energy companies, causing them to scale back projects and lay-offs. Low gasoline prices, however, would lead consumers to spend money. It’s better to pay off debts first before spending money on “wants”.
ECI, a broad measure of workers’ wages and benefits, increased 0.2%, smallest gain since records began in the second quarter of 1982, following 0.7% increase in the first quarter. Wages and salaries, which accounts of 70% of compensation costs, also increased 0.2% in the second quarter, the smallest gain on record.
The report suggests that slack remains in the labor market. The unemployment rate fell to 5.3% in June – the lowest level since April 2008 – close to the Fed’s target of 5% to 5.2%, which the Fed policy makers consider consistent full employment.
S&P 500’s reaction to both GDP and ECI reports.
Dollar’s reaction to both GDP and ECI reports.
The Federal Reserve are counting on rising wages to boost both the economy and inflation (2% target). On Wednesday, July 29, the Fed said it won’t start lifting rates until there is “some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.”
The Fed will meet on September 16 and 17. I still believe the Fed will raise rates. If employment, inflation and wage reports are not very strong until September meeting, the Fed might raise the rates by little as 0.10% (10 basis points), instead of 0.25%.
I believe the disappointment of ECI is temporary as more companies are starting to increases wages and more people are slowly entering jobs market. I also believe that GDP continues to be strong. In fact, I believe current Q2 GDP will be revised higher. Preliminary (2nd estimate) of Q2 GDP will be released on Thursday, August 27.
On Friday (August 7), important reading data of US economy will be released, non-farm payrolls AKA jobs report. My guess for employment and unemployment rate is 285K and 5.4%, respectively. I believe wages will stay flat at this time and accelerate in the next few months.
I will take advantage of any pullback in the greenback (US Dollar). Greenback has a room to strengthen more. Currency pairs such as USD/JPY, USD/CAD, I would be long, and I would be short EUR/USD. If you have any questions, feel free to contact me and/or leave comments below. Thank you.
Greece had a close call to exit from the 19-member euro-zone (Grexit) following months of uncertainty. Alex Tsipras and Yanis Varoufakis were playing creditors for fools and bluffed too much. Now, they have lost “Liar’s Poker”.
Two weeks ago, more than 61% of Greeks rejected a deal in a referendum that included pensions overhauls and sales taxes. Then on Monday morning, Greece finance minister, Yanis Varoufakis, resigned after Eurogroup participants called for his resign because his absence from its meetings. Before the vote, he said he would resign if Greeks voted “Yes”. He is replaced by Euclid Tsakalotos, who has been involved in talks with European and International Monetary Fund (IMF) creditors.
Then, Euro leaders said that July 12 (Sunday) would be “deal or no deal”. Several days before July 12, Greece Prime Minister Alex Tsipras provided the same type of deal that Greek people voted “No” for, but with little bit tougher austerity. He broke his promise to Greek people.
Over the weekend (July 11-July 12), Euro leaders clashed over the deal. On July 13 morning (Monday), deal was reached. Euro-zone leaders agreed to give Greece three-year bailout up to EUR 86 billion ($93 billion) of aid which Tsipras accepted. This time, he absolutely broke his promise to Greek people.
The deal is much tougher and harsh, for Greece and its people, than the deals in the past few weeks. The deal also includes 30-year, euro-50-billion state privatisation programme. Half of the fund will be used to recapitalise Greek banks, while the remainder will used for debt servicing and other economic needs.
On late July 15 (Wednesday), the Greek parliament approved the deal. In 300-seat chamber, 229 voted to approve the deal and 64 were against it. There was 6 abstentions and 1 absent.
On the same day, the Eurogroup finance ministers agreed to the launch of bailout talks and approved 7.2 billion euros ($7.6 billion) in bridge loans for three months. It will allow the Greek government to pay off upcoming payments. On July 20 (Monday), Greece is due to pay 3.5 billion euros ($3.8 billion) to ECB. Greece also has to pay about 2 billion euros ($2.2 billion) of arrears to the IMF. This bridge loan will “buy” time until the bailout is finalized.
Greek banks are scheduled to open on July 20 (Monday) after a 3-week closure. However, capital controls, or restrictions on cash withdrawals will remain in place. Daily cash withdrawal is limited at 60 euros.
Despite more aid being given to Greece, the country’s debt level is still a major problem. The country has about EUR 320 billion debt ($345 billion), close to 200% of Gross Domestic Product (GDP).
There are many calls for a debt haircut (not what you’re thinking). Debt haircut is reducing the amount of money owned. For example, if someone owns about $10,000, but cannot pay it all. Creditor can try to accept to get paid a fraction of $10,000, say $4,000. After all something is better than nothing.
Some people including Christine Lagarde, managing director of IMF, disagreed on debt haircut. She said debt relief was needed. Extension of Greek debt maturities, extension of grade periods, and reduction of interest rates would be enough, she said.
Even though the deal gets finalized or not, Greece loses. With the deal, life gets harder. Without the deal and exit from euro-zone, life gets much harder.
I learned one important lesson over the past few months. Anything can change anytime. Greece’s current deal might fall through any moment. So much uncertainty has caused EUR (Euro) currency to move around in different directions.
Ever since the deal was announced, EUR/USD has been falling.
I have been short on Euro for some time now and I will continue to be short. Even with deal close, tough challenges remain ahead. ECB might increase or even extend its Quantitative Easing (QE) program, giving support to the European stocks and causing Euro to weaken further. I believe EUR/USD will reach parity level in the next 6 months.
Once the Greece drama settles, more focus will be on the fundamentals in the euro-zone outside of Greece, which accounts for more than 98% of the region’s GDP.
Last Friday (May 8, 2015), non-farm payrolls report was released and it was in-line with expectations. 223,000 new jobs were added in April, and the unemployment rate fell by 0.1% to 5.4%, the lowest level since May 2008. While, this is a good news. March gains was revised down to 85,000 from the prior estimate of 126,000 (-41,000), lowest since 2012. I believe the April number (223,000) will also be revised lower.
Wage growth remained modest. Over the past 12 months, average hourly earnings have increased by 2.2%. As unemployment rate falls, wages should start to pick up speed, which also will push up inflation.
Fed officials are closely watching the labor market and other key economic reports, as they are in a tough spot on raising short-term rates, which have been held near zero since December 2008.
There is a very little chance of rate hike in June. I believe the Fed won’t hike the interest rates, unless over 350,000 jobs are added in May and unemployment rate goes down by 0.2% to 5.2% (which certainly will not happen).
First quarter was very weak due to; strong U.S. dollar, low energy prices, West Coast port strike, and the bad weather. When these four are combined together, it creates a heavy roof to push down economic growth.
Hiring has been strong in many industries, except energy. About 15,000 energy jobs were lost in April, worst month since May 2009. Lower oil prices increased the pressure on the energy sector. Low energy prices has caused energy companies to lose profits. As a result, they had to cut jobs. Recently, crude oil inventories supply were declining, which caused oil prices to rise above $60.
Last Tuesday (May 5, 2015), trade balance report was released and it exploded. The US trade deficit widened by 43.1% to a seasonally adjusted $51.4 billion in March, largest monthly expansion in the trade gap since December 1996 and the largest deficit reading since October 2008. Trade balance is when you subtract imports from exports. In other words, it’s the difference between imports and exports.
A biggest reason for the weakness was the 9-month slowdown at West Coast port due to a labor contract dispute. West Coast ports is back in business. Imports arriving though the West Coast port surged. Imports increased 7.7% in March, the largest increase on record. While exports only increased 0.9% in March, reflecting strong dollar impact. In the past 12 months, the dollar has jumped almost 10%. Strong dollar had made Americans goods and services less competitive in global markets. Bigger imports and smaller exports mean a bigger deficit.
I believe it’s not to worry about in a long term. Once the backlog is cleared, imports will drop and the trade deficit will also drop.
Recently, the dollar has fallen sharply because of weak US economic reports, including Gross Domestic Product (GDP).
On April 29, 2015 (Wednesday), GDP Advance estimate increased at an annual rate of 0.2% in the first quarter of 2015, down from 2.2% in the fourth quarter of 2014 (-2.0%). This is a huge difference. Economists were anticipating growth of 1% in the first quarter.
Again, the weakness was due to U.S. dollar, low energy prices, West Coast port strike, and the bad weather. West Coast port strike disrupted the flow of trade, increasing imports which negatively impact GDP. In the past 12 months, the dollar has jumped almost 10%.
According to the report, Real exports of goods and services decreased 7.2% in the first quarter, from an increase of 4.5% in the fourth quarter. Real Imports of goods and services increased 1.8%, from an increase of 10.4% in the fourth quarter.
I’m afraid that Q1 GDP will be revised to negative number. Second estimate (Preliminary) of Q1 GDP will be released on Friday, May 29, 2015.
First quarter GDP was disappointing. I believe the economy should bounce back in the 3 quarters of 2015.
US markets were very happy with the jobs report, but not with other economic reports. The Dow soared more than 250 points, or 1.5% on Friday. While USD bracket currencies were mixed.
Check out the charts below; Dow Jones and US Dollar. US Dollar has fallen signification after hitting of $100.27 on mid-April. Dow Jones has been in a range. Dow Jones chart includes something “extra”, that’s not included in the post here.
If you have any questions, feel free to contact me anytime by going to “Contact Me” and/or leave comments below. Thank you.