Author: linksweb

How We Tested "The Trump" With Mira

Posted on by linksweb

We extend LINKS Mira to the analysis at a portfolio and asset class levels. Mira enables us to value asset classes and carry out scenario analyses, such as the “Trump-effect”, presented in this issue. To establish credibility of the approach LINKS have consistently taken over the years, we also review the results of our documented recommendations over the 2012 – 2016 period as published in earlier issues of Risk Wire.

The common weakness of conventional stress testing and scenario analysis is their reliance on historical statistical relationships and the assumption of “other things being unchanged”. Unfortunately, in real life there is interactivity between agents, and hence the assumption of “other things being unchanged” often renders analyses futile.
Infrastructure spending is a case in point. Increasing volumes of infrastructure spending, other things unchanged, can result in larger profits in the economy. However, higher demand for workers will put pressure on wages in similar industries (e.g. mining) and result in shrinking profits elsewhere. The combined effect on the economy will depend on the relative size and structure of the economy as well as the size of the initial change.
An agent based model simulates these relationships and treats the global economy as an integrated network. Mira will pass a change in price and/or volume in one industry (the initial event) along the supply network and estimate the total impact on profits generated by all companies in all countries. To explain this in different terms: any event will impact all other economic agents along the supply chain. The cumulative impact of all these (inter-)related changes for all agents is what LINKS Mira measures.

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Putting Economics Back in Economic Scenarios

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Rising complexity in the world and structural breaks across markets require new non-stochastic approaches to scenario generation. The world is also too complex for simplistic ad-hoc assessment. We demonstrate the insights gained by implementing a supply chain agent-based model (LINKS Mira) and run the “China hard landing” scenario with curious conclusions.

As the world goes through a significant economic and political transformation, the number and complexity of risks and opportunities for institutional portfolios increase considerably. Gone are the days when the direction of globalization and integration was unquestionable, the question was just the differences in pace.
Increasing complexity creates additional problems for investment management. How does one manage risk and return in an environment where history is no longer a fair guide? Typically, economic scenario analysis and stress testing are the tools of choice. The common approach is statistical: basic models rely on stochastic processes with a random variable drawn from normal distribution, while more complex approaches involve multiple distributions, decomposition into multiple trend patterns and regime switches. A less common approach is designing ad-hoc descriptive scenarios in the context of the growth-inflation framework. Both approaches fail to deliver actionable results.

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December 2, 2016, "Unarmed and Intuitive: Risk Management Event"

Posted on by linksweb

Join us at our inaugural meetup dedicated to creating impact with risk management.

We misunderstand probability, we’re myopic, we pay attention to the wrong things, and we are just generally very bad at probabilities. The triumph of “heuristics and biases” research pioneered by Daniel Kahneman and Amos Tversky poses a question: how do we stay alive and prosper IF we are so bad at solving problems?

In this session we (together) will identify and manage investment risks, but not as we are used to.
View the agenda and sign-up.

The Unexpected Beneficiaries Of Changing Marine Fuel Standards

Posted on by linksweb
  • It is confirmed: marine transport will have to shift to low sulfur fuels.
  • The environmental mandate creates multi-billion opportunities and risks.
  • The largest impact equivalent to nearly doubling revenues for a number of companies is far down the supply chain.

 
The fuel standard used for the bulk of marine shipping is set to change from 2020. This is yet another seismic shift in an industry already dominated by devastatingly low rates, overcapacity in most categories, the resulting bankruptcies and consolidation across the board.
Although it is difficult to see how the confluence of these factors will impact the industry (for an attempt, see an earlier SA article), there are a few industries down the supply chain that will see revenues increase significantly (possibly by a factor of 2). As the analysis here relies on supply networks, it will take time before the affected markets fully digest the implications of this news item on respective companies.
The International Maritime Organization announced on October 27 that it would go ahead with a global sulfur content cap on marine fuels of 0.5% from January 1, 2020. Up to now, vessels have been using fuel oil (bunker) with a maximum allowable sulfur content of 3.5% everywhere in the world, except in narrowly defined coastal areas (so-called ECA zone), where the limit has been set at 1%. The overall limit as of 2020 will be 0.5%, which is a significant and abrupt move.
Read to full article on Seekingalpha…

The State of the Growth Engine

Posted on by linksweb

Contradictory macro- and microeconomic observations in today’s economy are a norm, and the recent earnings season in the U.S. only adds to the uncertainty. Unfortunately, wishful thinking is not a way out this time either: putting the pieces of puzzle together reveals the state of economy that is not new.
One of the biggest challenges of having a consistent asset return framework is trying to reconcile the assumptions, inputs and returns with the myriad of macro- and microeconomic observations. Often contradictory observations peacefully coexist in the global economy, raising alarms and questions. In this issue of Risk Wire we have tried to take an inventory of key observations (contradictory or not) and tie them together in the context of the Graham Risk framework.
The first observation – the actions of the Central Banks, are clearly the focus of the investment community, with ECB, the Fed and BoE extending unconventional policies. Acronyms like ZIRP and NIRP have become the favourite in the community, as many veteran investors have launched critical attacks of the central bankers. One of the most unrestrained attacks by Bill Gross appeared in an article on October 5, 2016:
“Central bankers have fostered a casino like atmosphere where savers/investors are presented with a Hobson’s Choice, or perhaps a more damaging Sophie’s Choice of participating (or not) in markets previously beyond prior imagination. Investors/savers are now scrappin’ like mongrel dogs for tidbits of return at the zero bound. This cannot end well.”
The second observation, which is hard to reconcile with the first one, is the strong earnings season in the third quarter of this year. Although the season is not over yet, so far a double-digit recovery in earnings is at hand, which is the first positive sign since the late 2014 that corporate America is back to health. Our third observation – higher oil and other main commodity prices can be easily reconciled with stronger earnings season, and with stronger labour market – the fourth observation.
All of the above, however, cannot coexist in an environment of overcapacity in most industries, falling prices for agricultural commodities and the generally deflationary environment. The cocktail of these observations is so inconsistent that a “deeper dive” is warranted in multiple asset categories, geographies and sectors to untangle the web of dependencies.

While earnings numbers are driven by many one-offs and cost adjustments, the revenue numbers are more indicative of what the current state of the economy is. S&P 500 sales are still to recover to the 2014 levels. Large part of the recovery is due to the rebounding oil and materials prices; however, revenues of the energy sector are still down 42% since the peak a few years ago. Materials sector revenues are down 17% and given their combined effect on the industrials sector is large enough to limit growth there, the lacklustre revenue performance of S&P 500 since 2014 is no surprise.

Read the complete paper and download tools after registration…

Read the full paper and download tools:

  • Buy-and-hold and risk-adjusted return forecasts for 16 key assets over 15 years
  • In-depth analysis of trends and their impact on asset returns
  • Description of cross-asset pricing methodology
  • Sample data spreadsheet for sensitivity analysis – European equities and sovereign bonds
  • Historical over- and under-valuation data

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The Small Data Item With Large Consequences For Chemicals And Beyond

Posted on by linksweb
  • In the heaps of Producer Price Data issued by BLS, there was one curious item in September – an unusual price shift.
  • Corroborated by the industry sources, the shift can become a catalyst for many changes beyond petrochemicals.
  • Most of the supply chain will suffer, but there are few companies that might benefit.

Looking for change catalysts can sometimes be frustratingly difficult, particularly in the age of data abundance. In the supply chain investment process, I typically follow commodity price shifts, revenue surprises by major companies, corporate actions – most of these events create aftershocks in the supply chains that can be reliably translated into investment theses.
One such area to pay attention to is Producer Price Indices published by the Bureau of Labor Statistics. Although the purpose of data series is to follow inflation, deep industry level monthly pricing data are an excellent source of change catalysts.
The challenge is of course sifting through the hundreds of industries and finding ones with significant price change; luckily this can be automated – I use LINKS Mira for the purpose. September PPI data show a surprise price increase of 8.1% in the petrochemicals industry. Such a significant price increase cannot leave other industries in the supply chain unaffected. One of the industries that I follow – organic chemical manufacturing, for instance, shows an expected 9.8% profit loss due to the price change.
Read to full article on Seekingalpha…

The Gem In Monsanto's Earnings Announcement And How To Build On It

Posted on by linksweb
  • Earnings season provides incredible insights into global supply chains.
  • Monsanto’s earnings release was by far the most insightful last week in terms of implications for many companies.
  • In many ways, there is no need to forecast – the reliability of conclusions (and trades) is a necessary outcome of what Monsanto disclosed.

The earnings season has begun with its regular treasure chest of valuable gems in terms of supply chain trade ideas and insights. Of course, given the abundance of information and analyses combined with the concerted effort on part of the companies and analysts to “manage” investors, it is hard to pick the most promising (read: profitable) insights from the announcements.
While majority of analysts and market participants focus on the ever important earnings per share number, it is arguably the least informative number in a typical announcement. First, most companies “guide” analysts during the quarter with such fervor that there is little information content left in the final number (the well-documented Standardized Unexpected Earnings, for instance, has stopped working for almost a decade). Secondly, since EPS is the line at the bottom of the income statement, most companies have lines above it with sufficient and often hidden “cushions” to even out quarterly earnings. For this reasons, it is often more rewarding to focus on the top line, particularly if the point is to gain insights about other markets.
Revenue surprises in this sense are a good place to begin. Last week most large revenue surprises were on the negative side, which in itself is quite unsettling. In the table below I have added the end markets of each company to see the pattern. Weakness in the oil & gas, infrastructure and materials industries is not surprising, of course.
Read to full article on Seekingalpha…

Brexit And Pound Decline: Impact From Pharmaceuticals To Jet Engines

Posted on by linksweb
  • The most tangible impact of Brexit so far has been the falling sterling.
  • Near 15% decline of the currency since the vote should in theory create problems for many US competitors.
  • Due to the peculiar nature of the British economy, the outcome is a little more unexpected.

A few months ago, when I was asked about the potential impact of the Brexit vote by our clients, my answer turned out to be half right. I was not worried much about a “no” vote for two reasons. First, I assessed the likelihood of a “no” vote as very low – a conviction that was subconsciously biased due to the precedent of earlier Scottish independence vote of 2014. Secondly, I was not too concerned because I knew a bit about the peculiar structure of Britain’s economy and its potential impact on the rest of the world.
Fast forwarding a few months and here we are, the “no” vote has toppled a government and driven the pound to 25-year lows. But what is the impact on Britain’s key trading partners and why is the British economy so peculiar? More importantly, a large and potentially permanent shift in the exchange rate ought to have created investment opportunities?
Read to full article on Seekingalpha…

From OPEC To Deutsche Bank: Wider Implications

Posted on by linksweb
  • Two very significant events in the week will have implications beyond their immediate markets.
  • OPEC’s agreement to cut production, although ineffective in itself, is a trigger for something more significant.
  • Deutsche Bank was magically saved by accommodating stance of DoJ, yet the episode highlights the vulnerabilities and the mechanism of a global financial distress.

Events that find their way to the daily headlines have direct and apparent impact on many investors. These events move stocks, indices and markets instantaneously. But there are also second and third-degree impacts that become evident only after a while. Understanding these impacts and potentially converting them into trades can help translate the daily events: anything from OPEC’s agreement to cut oil production to the troubles and then the magic rescue of Deutsche Bank (NYSE:DB), into actionable intelligence.

OPEC agreement
While oil traders, analysts and consuming industries are still coming to terms with the unexpected agreement at OPEC to limit production to 32.5 million barrels per day, the oil price is already up by ~8%.
The fact that the decision is not yet implemented and clearly lacks any implementation mechanism (suffices to say that OPEC member countries have not yet agreed an allocation of cuts – that is yet to be decided), scarcely dampened the bullish oil sentiment. Although many are inclined so, it is not wise to chuck it down to the naïve market participants – the wisdom of crowds must have picked up on lack of credibility.
Deutsche Bank
As it appears in the nick of time Deutsche Bank managed to secure a very amicable settlement with the Department of Justice (DoJ) of “only” $5.4 billion versus the earlier requested $14 billion. Good news of course and a remarkably co-operative DoJ stance, but what really just happened and what was averted, and more importantly, what to watch for going forward?
Read to full article on Seekingalpha…

Counterparty Risk: When CDS Spreads and Ratings Are Not Enough

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As the recent Deutsche Bank episode illustrates, counterparty risk management for pension funds and insurance companies should be based on more proactive and comprehensive assessment of all risks relating to the counterparty. Many Boards and investment committees, undoubtedly, have revisited their exposure to Deutsche Bank at some point during the episode and have had to make a quick decision (one way or another) based on limited amount of information. Such a decision would have been made easier with information beyond credit ratings, CDS spreads and rumours.
The situation is of course more complex than a few numbers can suggest: on the one hand, most major counterparty banks have extremely complex balance sheets, with off-balance-sheet exposures significantly more important than what is on the balance sheet. Based on our assessment of major counterparty banks, on the average, assets recorded on the balance sheet are only 65% of all assets that can be traced to the banks. This is possible through the use of special vehicles (SIV, SPE, VIE etc.). Furthermore, due to the so-called Master Netting Agreements, only a small proportion (~ 0.05%) of the total notional value of derivatives is actually included in the balance sheet. All of this creates huge uncertainty, which is not resolved by the politicized and commercial nature of credit ratings.
On the other hand, many banks, and not least Deutsche Bank, constitute a systemically important part of the global financial flows and as such will not only attract greater scrutiny from the regulators but also greater willingness to bail out in case of distress. Certainly the ability and willingness of the government to bail out banks has an implication for the credit risk. But not all home-governments are equally well-off to be able to afford such a rescue. So how does one reconcile all of these factors when dynamically assessing limits to counterparty exposures? Just how risky was the Deutsche Bank episode and what can be done to manage the risks in the future?

To take the example of Deutsche Bank, assessing the extent of the risk as the news flow arrived would have been easier with the insight of what is not on the bank’s balance sheet. Along with all the other major investment banks, Deutsche Bank has a significant derivatives exposure. Based on their 2015 annual report, the notional value of these derivatives is a little below Eur 42 trillion. Large part of this exposure (Eur 32.9 trillion) is in interest rate swaps. To be clear, the bank’s economic exposure is a fraction of this value – only about Eur 20 billion, or about 0.06%. A non-event then?
Not quite. The intricate mechanism of cash (or equivalent) collateral is in place to manage the counterparty risk of all the parties involved. One side of a trade in such a case is usually a pension fund or insurance company hedging its liabilities, while the other side – a hedge fund or bank. When for whatever reason there is distress in the market, such as the one we saw for Deutsche Bank (DB), trades that are unwound in one direction (in case of DB reportedly by a number of hedge funds) are likely to create quite a bit larger open exposure. What is more troubling, if interest rates begin to climb, as they do in these circumstances, there will be a large need for cash collateral from the side that gains, while the side that loses might fail to deliver the required collateral, thus exposing DB.
Judging by unaffected EONIA and LIBOR spreads, however, there is still little cause for panic. A number of factors help mitigate the specific risk. First, Deutsche Bank happens to be in the second group of G-SIB banks (Global Systemically Important Banks), a list that explicitly flags to the governments which banks cannot be left to sort themselves out. Second, the sustainability gap of Germany’s debt is a positive 1.5% (source: LINKS Counterparty Risk Assessment) – one of the few governments able to arrest any negative development, although the size of the (hypothetical) rescue is a whopping 5.3% of GDP.
Having these numbers at hand makes discussion on active management of counterparty risks more tangible and productive; as always, being prepared is the first line of defence.

Counterparty Risk

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