Naufal Sanaullah – January 27, 2014 – [macrobeat.com] macro beat.

Naufal Sanaullah naufal.sanaullah@gm ail.com @naufalsanaullah – January 27, 2014 – [macrobeat.com] macro beat.

I.Introduction 1Market themes 2Executive summary II.Economic analysis 1United States 2Europe 3Japan 4China III.Asset classes I.Rates II.FX III.Equities IV.Commodities V.Volatility IV.Geopolitics V.Special thanks VI.Related reading VII.Disclaimers CONTENTS macro beat.

1Market themes 2Executive summary INTRODUCTION

MARKET THEMES

BullishBearish MARKET THEMES macro beat. US breaking out of deleveraging paradigm US housing remains strong with fixed investment & construction returning DM capex rebounding, boding well for consumers & workers Acceleration in DM labor market recoveries Demographic handoff in the US US fiscal drag materially lessening & fiscal policy risks diminishing Yield curve still very steep to provide a persistent tailwind to markets and reflect low bubble risk Eurozone periphery macro rebound continues Japanese NGDP rebounding Risk of Chinese credit crunch as WMP default risks rise without implicit backstop Eurozone inflation decelerating and risking deflation US & UK monetary policies are no longer massive headwinds to volatility US rates-up impacts DM/global financial conditions Challenging forward guidance in 2014 may spark volatility EMs facing capital account pressures on the back of DM risk-free rates rising Geopolitical risks rising as alliances marginally shift between the US, Russia, Saudi, Iran, & Israel Rebound in labor bargaining power may portend poorly for US profits even as economy accelerates Low risk premia in credit space could bode poorly for rate-sensitive corporates Lack of success of Abenomics in igniting capex- driven inflation feedback loops

 Inflation acceleration in the US & UK and greater CB focus on inflation relative to employment data  Transition toward millennial labor supply & consumer demand  Tougher year for corporate credit and rising headwinds to corporate profits offsetting aggregate demand tailwinds, as “earnings financialization” recedes  Eventual ECB submission to counteract deflation risk  Abenomics recovery falters on the back of tax hikes, driving an asset purchase program increase and declining marginal efficacy of quantitative monetary policy  Rebound in commodities as US/G4 real yields shift to grinding higher instead of spiking like in 2013, with breakevens offsetting some of the rise in nominals  EM rebound with dispersion and differentiated performance within the space MARKET THEMES

1Market themes 2Executive summary INTRODUCTION

EXECUTIVE SUMMARY

 2013 marked a significant transition away from the paradigms characterizing the global economy since 2007  US household sector deleveraging is approaching an end, and private sector growth is robust & accelerating  Persistent liquidity hoarding (and fiscal drag) are now waning, while labor markets are materially tightening in the US & UK  For the first time since the financial crisis, we are seeing a shift in relevancy from demand- to supply-side constraints  Inflation will be much more important to the stance of DM monetary policy at the margin going forward, rather than unemployment, particularly in the US & UK  The US energy boom continues to provide a “dividend” tailwind that should insulate it from external tail risks  The US may have reached “peak inequality” in 2013 and on its way to more equitable national income gains EXECUTIVE SUMMARY macro beat.

 Europe remains in a wage deflation rebalancing process, but the ECB has succeeded in converging periphery yields down to core, in both sovereign and private sector paper  The ECB’s perception of accelerating disinflation leaves Europe open to Fisherian debt deflation risk, but past policy, nascent political shifts, and guidance about their toolkit make policy- driven crises unlikely, even if the path is uncertain  The biggest risk to Europe remains a shift in Chinese rebalancing from stable to instable; rising deflation risk will drive the ECB increasingly closer to an unsterilized OMT  Barring exogenous shocks from China, there is sufficient risk premia still extant for the strong rebound in periphery PMIs to translate further into beneficial asset appreciation & capital flows EXECUTIVE SUMMARY macro beat.

 Japan is ground zero for a massive monetarist experiment, in which the role of expectations will be robustly tested  Thus far, there has been significant devaluation-driven inflation acceleration, but no sign of a capex-linked feedback loop developing yet  The BoJ is unlikely to have the will nor capacity to increase its asset purchases with the JPY at these levels, but a soft patch in growth that drives JPY higher will likely drive a BoJ asset purchase program expansion later this year  With Japanese yields so low, there is very little risk premia for LSAPs to even remove from the market  2013 was the year Japan convinced JGB investors to increase Japanese inflation expectations; 2014 is the year Japan validates or invalidates those expectations  Japan faces a sizable fiscal drag in 2014, which should place a material headwind to monetary policy efficacy  Abe’s nationalist policies should continue to manifest in increased geopolitical tail risks involving China EXECUTIVE SUMMARY macro beat.

 China continues to toe the line between government-assisted growth stability and credit excesses  The policy clampdown on exotic credit products and exporter overinvoicing has sent financial conditions tightening & export volumes underwhelming expectations  Rising tensions with Japan represent a significant tail risk that will likely pervade for a few years to come still  The cessation of Fed-driven hot money flows into China are manifesting in periodic bursts of interbank liquidity crunches  If policymakers can continue to navigate China’s fixed investment/consumption rebalancing in a stable process, asset prices are likely to rebound from their depressed levels  As of now, however, there has been very little actual internal rebalancing and attempts to wean the economy off mini-fiscal stimuli are likely to put policymakers in a precarious position EXECUTIVE SUMMARY macro beat.

UNITED STATES ECONOMIC ANALYSIS

 US private sector growth has rebounded strongly, while fiscal drags are set to lessen materially in 2014  Consumption growth remains solid, although credit growth will be required for acceleration to prior bull cycle rates  Fixed investment growth has strongly rebounded, and as is explained in forthcoming slides, is set for much more acceleration in 2014-16  Government’s contribution to output growth rebounded in H2 as state & local spending outlooks improved, and set to continue to rebound as federal fiscal drag lessens in 2014  Net exports have gone from the persistent drag in the last cycle to slowly becoming a tailwind, much of which due to the domestic energy production boom since 2011 UNITED STATES macro beat.

UNITED STATES macro beat.

 Real GDP accelerated each quarter from Q1 to Q3 last year  An acceleration in fixed investment and lessening government drag accounted for the growth rate’s uptrend  With the tightening labor market, real wage growth should accrue to credit growth, both of which should help accelerate consumption growth to near 2003-05 rates  We expect 2014 real GDP growth around 3-3.5% UNITED STATES macro beat.

 Consumption growth has been solid, but uninspiring, particularly in services spending  Lack of credit growth has been a critical factor in lower consumption rates  As the household sector moves past the deleveraging stage, spending should start outpacing income again  We expect revolving credit growth to ignite services spending, and drive consumption contributions to real GDP growth to above 2% in 2014 UNITED STATES macro beat.

 Investment is the most volatile component of real GDP, and although consumption is the largest share of real GDP, investment is the largest contributor to quarterly SAAR real GDP growth, thanks in large part to inventories volatility  The residential investment rebound began accelerating in 2013, but residential investment as a share of GDP is still at very depressed levels  The combination of strengthening labor markets, particularly in young age cohorts, and general low supply on a flow basis, should provide a strong tailwind for residential fixed investment in 2014 and beyond  Nonresidential fixed investment is also depressed, and its return should ignite various latent feedback loops, as funds flow from low- MPC retained earnings cash coffers to high-MPC consumers UNITED STATES macro beat.

 Nonresidential structures investment has started to accelerate, and although a soft patch in the architectural billings trend suggests a breather in structures investment for a couple months, a nascent rebound in institutional & commercial/industrial sector construction is likely in the works, given the levels of underinvestment this cycle  The average age of corporate fixed assets is 21.7 years, two years higher than in 2000 and over a year higher than pre- crash  As consumer demand accelerates, and with global wage differentials & balance of payments suggesting a tailwind for domestic production this cycle, the aging asset base should provide an incentive for nonresidential equipment & IP investment to finally pick up in 2014 UNITED STATES macro beat.

 Residential investment should have a tailwind from the low 4.6 months of existing housing supply  Given the coming-online of millennials and total population growth, the economy requires approximately 1.5 million new houses per year, according to estimates by Macrofugue’s Matt Busigin and the Federal Reserve’s Andrew Paciorek, compared to the current level of one million housing starts (which Busigin’s model estimates will be closer to 1.3 million in a year)Macrofugue’s Andrew PaciorekBusigin’s model  The Cleveland Fed’s Andrew Dunne estimates a current 2.6 million household shortfallAndrew Dunne  These factors combine to suggest persistent tailwinds to residential fixed investment through the completion of the current business cycle  Nonresidential fixed investment also is running up against capacity constraints, with the total capacity utilization rate having risen materially in H2 2013  The corporate economy is underinvested for the accelerating final demand and demographic handoff to millennials UNITED STATES macro beat.

 Government expenditures & investment have been a persistent drag to growth since Q4 2009, with state & local austerity until 2011, and federal austerity since  With the sharp rebound in tax receipts and repair of municipal balance sheets, state & locals became a net contributor to real output growth last year, accelerating into year-end  The sequester was a massive fiscal drag in Q4 2012 to Q1 2013, with federal defense spending cuts driving a cumulative -1.84% drag on GDP growth since Q4 2012  As the state & local recovery accelerates and federal fiscal drag lessens in 2013 and beyond, we expect government to become a consistently net contributor to output growth for the first time since the recession began in 2007  This is another category that exemplifies the flow of funds into marginally higher MPC hands, increasing money velocity UNITED STATES macro beat.

 After being a persistent drag during the large globalization wave in the late 90s until the recession began in 2007, net exports became positive contributors to growth during the recession, as imports collapsed  Since then, the recovery has been marked by the unique occurrence of flat net impact from trade on output growth  Much of this reflects the shale boom since 2011, which has decreased US reliance on foreign energy imports  The global BoP rebalancing continues in force, with incremental gains accruing to future US labor until smaller Ems build up the capacity to absorb the massive production being displaced at the margin out of larger EMs with sharply risen wages, like China  Going forward, we expect net exports to be a flat to slightly negative contributor to GDP growth, as commodity prices rebound and consumer demand lifts imports, but nothing like the naughts UNITED STATES macro beat.

 The unemployment rate (UER) has declined materially in the last year, from 7.9% in December 2012 to 6.7% December 2013  However, much of this reflects an 80bps drop in the labor force participation rate and going forward, will reflect any expiration of unemployment insurance  This makes the UER a weak metric for monetary policy decision making  The cumulative labor market gains since open-ended LSAPs were announced, along with the low & marginally diminishing efficacy of quantitative policy for jobs growth and rising risks stemming from volatility suppression, justified the taper  Rate policy, however, is constrained only by inflation (and in a similar vein, credit growth) and so forward guidance is still important to the Fed’s reaction function UNITED STATES macro beat.

 Given the composition of the UER decline, the FOMC is likely to lower its UER threshold in its rate policy forward guidance  As former chairman Ben Bernanke mentioned in his final press conference last month, once beyond the 6.5% Evans rule threshold, the FOMC will shift its focus from the UER to labor market internals  Concurrently, demand-side data will give way in relevance to supply-side data as supply constraints & inflation potential gain traction  This makes CPI, wage growth, credit growth, & JOLTS series the most important to watch for rate policymaking  As such, the FOMC may also include a lower-bound inflation floor to its forward guidance, as suggested by St. Louis Fed President James Bullard UNITED STATES macro beat.

 The LFPR debate is much less meaningful than the journalist & analyst community have made it out to be as of late  Much of the LFPR decline is simply a function of demographics, as the populace ages  There is likely a material cyclical component as well, mainly in lower-age cohorts who have been displaced by the weak economy and low labor bargaining power into more school  And the balance is likely due to hysteresis stemming from unskilled, less educated workers who may be poorly trained for the current labor market, many of which have gone on disability  Going forward, the cyclical component should rebound as the echo boomers enter the labor force, while the unskilled cohort struggles to ever reenter the market  As such, we expect the LFPR to converge near to, but still below, levels implied by demographics, with the balance due to hysteresis UNITED STATES macro beat.

 The bigger question for the labor market is how much it is tightening and coming up against supply constraints  Jobs growth in the 55+ years old cohort has started decelerating rapidly, and likely to go negative in the next couple years as retirements accelerate, leaving a large gap of labor to be replaced by younger age cohorts  The most important variable signifying tightening labor markets is a declining labor force mean age against a rising population mean age, reflecting the demographic transition of the labor force as the aggregate labor force’s growth rate goes negative  Meanwhile, the three largest headwinds to labor market strength are set to either neutralize or reverse in 2014-16:  The sharp rebound in housing starts (and likely moderation of price appreciation in 2014) should normalize construction employment, a high-MPC segment of the labor force  State & local municipalities are set to rebuild payrolls as tax receipts continue rebounding and balance sheets move past reparation stage  Federal austerity is set to weaken in 2014, converging public sector labor demand back to private sector levels UNITED STATES macro beat.

 The lower supply, increased demand, and sufficiently strong underlying conditions to drive wage growth higher in 2013 despite a material fiscal drag, all point to continued wage gains in 2014 through the end of this business cycle  The labor market tightening we expect derives from nascent feedback loops  As Guillermo Roditi Dominguez has explained, the higher MPCs of the household & public sectors versus the corporate sector, and the higher effective marginal tax rates of the household versus corporate sector, make wage income carry much more money velocity than retained corporate profits  The rebound in aggregate demand should begin a virtuous cycle, then, as corporate profits get redistributed  Corporate capex effectively “unlocks” money velocity, especially in the current cycle, in which years of underinvestment will drive a sharp “catch- up” period in capex  All of this points to reduced income inequality and self-reinforcing NGDP acceleration, with inflation only mitigated by Fed policy tightening UNITED STATES macro beat.

 Supply constraints are also beginning to show up in industry, as the capacity utilization rate rose by 1.2 points in 2013 alone, thanks to a H2 acceleration  This is inflationary and likely reflects a much smaller output gap than extrapolated pre-crisis trendlines imply (due to the nature of solvency crises)  Fixed investment is set to rebound heavily, and this will ignite a much more “normal” business cycle that will continue until monetary tightening triggers the next recession UNITED STATES macro beat.

 Inflation spent 2013 consistently surprising to the downside, due to three factors:  Public sector wage drag, due to tight state & local finances and federal austerity  Money supply deceleration, due to the payroll tax cut expiration & sequester  Goods disinflation, due to commodity price declines  We expect booming municipal tax receipts, materially lessening federal fiscal drag, and a rebound in commodity prices to alleviate this disinflationary pressures against a backdrop of rising endogenous inflationary pressures from tightening labor markets, rising rents, and rising capacity utilization  Given where the inflation surprise index is, and the December FOMC projections downgrading 2014 core PCE to 1.5% while inflation swaps price in about 1.4% CPI, we expect inflation to surprise to the upside this year UNITED STATES macro beat.

 The chart on the following slide shows the US real GDP, real DPI, real PCE, NFP, IP, and real retail sales growth rates  After decelerating since H1 2011 as the fiscal stimulus impulse and base effect waned, output, consumption, & production all accelerated in H2 2013  The fiscal cliff caused aberrations in the disposable income data, but beneath the noise remains a similar accelerating uptrend  Timely payrolls & retail sales data suggest the consumer entered a mini-soft patch near the end of 2013  But with production accelerating, demand headwinds receding, and material tailwinds coming online, we expect retail sales & jobs data to accelerate as well in 2014 UNITED STATES macro beat.

 Household net credit creation finally began to accelerate in 2013, as mortgage deleveraging slowly reversed and consumer credit growth drove total credit creation  A rebound in household formation should help drive mortgage debt growth higher, although lower homeownership and higher external debt loads (such as student loans) should keep a lid on how high mortgage debt growth can accelerate  As the labor market recovery accelerates and durable goods demand rises, revolving consumer credit should begin contributing more normal levels of credit creation  Auto & student loans have likely reached their peak contribution on the margin, but should continue to drive ample credit creation during this business cycle UNITED STATES macro beat.

 The rebound in home equity values has considerably declined mortgage leverage, allowing for higher labor mobility and household creditworthiness, pushing the deleveraging process in a healthy way  Large swathes of homeowners regained positive equity in the last two years, which was a major factor in allowing growth to accelerate  Owners’ equity is growing at the highest YoY rates of the postwar era, and although home price appreciation should slow in 2014-15, the benefit has already accrued and the negative equity situation substantially alleviated  By the end of 2014, mortgage leverage is likely to have normalized to pre-recession levels, allowing for household leverage to grow again at a more normalized pace UNITED STATES macro beat.

 Wynne Godley’s sectoral balances model highlights how far deficit reduction has progressed since the end of the recession, and accelerated during last year’s fiscal drag  As the shale boom continues, the foreign sector surplus should have headwinds offsetting its usual cyclical rise during expansion cycles, providing incrementally more net surpluses for the private sector  The corporate sector is quickly approaching a return to negative net financial balances, as in previous expansions, which should accelerate as capex picks up  These factors should combine to provide a tailwind to household net surpluses, even as residential fixed investment continues accelerating UNITED STATES macro beat.

 The following slide shows the Kalecki-Levy model of corporate profit decomposition  Given the government (particularly state & local) and household sectors’ higher marginal propensity to consume/invest relative to corporates, the boom in tax receipts and resulting deficit reduction should drive flows from corporate to household net savings at the margin  This is especially the case given the impact on labor markets of increased demand from government & corporate sector spending & investment, since real wages are already accelerating  If corporates were to ramp up nonresidential fixed investment to a pace comparable to government & household sectors’, this could offset the above headwind, but would effectively serve as a flow of profits from investing corporates to the corporate supplying the factors of production for the fixed investment  Applying the Kalecki-Levy model to the current economic environment suggests we are beginning a shift in income from capital to labor, and that corporate profits will underwhelm the aggregate economy’s acceleration, mainly due to higher real wages, lower public deficits, and higher interest expense (which accrues mainly to households) UNITED STATES macro beat.

ASSET CLASSES 1Rates 2FX 3Equities 4Commodities 5Volatility

 We generally favor fading FOMC attempts at strengthening forward guidance, viewing the upside data risks as stronger than reaction function shifts at this point  We expect the FOMC to lower its Evans rule UER threshold and also possibly add an inflation floor a la Bullard to its rate policy guidance, and think rising expectations of that will provide attractive entry points to short Eurodollar reds & greens  If labor markets continue to aggressively tighten as we expect, at some point in Q2 or Q3, whites will get sold as well, providing a buying opportunity to synthetically lock-in any PnL from shorting reds & greens, as we don’t expect any hikes this year as the Fed will use 2014 for “catch-up” inflation  Such a selloff in whites will likely hit equities as well, providing an attractive entry point for collecting ERP in the right places (more on this in the equity section) RATES macro beat.

 We expect tightening to commence as early as H1 2015, with 2-3 hikes next year  Current 2015 year-end Fed Funds rate expectations are:  Median FOMC: 75bps (as of December SEPs)  Mean FOMC: 105bps (as of December SEPs)  Median primary dealer: 50bps (as of December PD survey)  We expect inflation upticks this year to pull forward hike forecasts for 2015, and for this to drive front-end term premia higher as well, sending the Z4Z5 term spread back to its 2013 highs  We are targeting low-98s in EDZ5, to be hit some point in Q2 or Q3 RATES macro beat.

 Mean Fed Funds forecasts from the FOMC’s December SEPs imply 33bps year-end 2014, 105bps 2015, & 195bps 2016  105bps by year-end 2015 puts fair value EDZ5 at maturity at around 98.80, implying a negative term premium at present, using rough 15bps estimate for the FF-90d LIBOR spread  These forecasts include forward guidance expectations and are based on economic estimates which assume inflation doesn’t converge to its symmetrical target until after 2016  An acceleration in inflation, as is suggested by our macro analysis, should make our Z5 fair value in the low-98s very reasonable, given the implied forward rates in the FOMC SEPs  With so much money long this part of the curve, and the December NFPs shaking out short positioning, we believe short Z5 will be a very attractive position to open in Q1 RATES macro beat.

 This view on the path of inflation also makes bear flatteners attractive, particularly in 2s5s or 2s5s10s fly  The belly offers appealing carry/roll down, as well as the best relative risk-adjusted E[r]’s in the curve  2s are mispriced relative to our short rate path assumptions, and have little to no term premia even with more conservative assumptions  With 2s5s over 130bps (very wide historically), the flattener carrying ~6bps/quarter, and spread having widened as the belly sold off, the front-end becomes the more attractive space to short and very rich to the belly RATES macro beat.

 These hawkish views are supported by a FOMC voting base compositional tailwind, as well  Three dovish 2013 FOMC voters will not be among 2014 voters, offset by three new dovish voters this year  However, on the hawkish side, only one hawkish 2013 voter is leaving, offset by three new hawkish voters for 2014  This is displayed in the graphic to the right, courtesy of Financial Times RATES macro beat.

 The marginal shift from CB reaction function to policy data sensitivity last year have created an environment in which majors have become bifurcated based on relative CB expectations, particularly with the behavior of front-end forward yields:  High/rising: USD, GBP, NZD  Low/falling: JPY, AUD, CAD  Because of the nature of this dichotomy, in which persistently-easy money economies are beginning to see NGDP acceleration, while more hawkish ones are seeing labor and inflation data underwhelm  This has driven persistent flows into negative carry trades like GBPAUD, which have started to witness high correlations to general “DM yield” crosses like USDJPY  This dynamic has pervaded across asset classes, and the S&P 500 now has a higher 1mo30min correlation to USDJPY than the Nikkei does FX macro beat.

 We believe that these trade paradigms will be shifting and correlations breaking as the FOMC & BoE lean against unemployment thresholds’ signal value for the path of rates  Meanwhile, we believe the current risk selloff will soon near completion, and set up for outperformance in commodity currencies, whose forwards are already very rich compared to accelerating leading economic indicators  We view carry trades as attractive in FX space for the remainder of Q1, including long AUD & CAD vs GBP & JPY  AUD/NZD is another attractive long, given where forwards have moved to and the technical picture for this pair  Looking further ahead, we expect the eventual inflation-driven rise in US & UK front-end yields to culminate in a risk selloff once the curve repricing accelerates  Given the Japanese consumption tax hike in April and likelihood of DM front-end rates repricing in Q2, we expect the above risk-off scenario to be concurrent to a sharp rise in JPY that washes out the stretched positioning and begins the market’s challenging of the BoJ’s efficacy at reducing real yields FX macro beat.

 JPY positioning is extremely stretched at around 180,000 contracts net short, a level only seen once in the last 20 years (at the multi- year JPY bottom in 2007)  The Japanese breakeven curve continues to be inverted, and the impact of fiscal drag is likely to drive inflation expectations back down, driving real rates higher and making the JPY more attractive  At the same time, given the low inflation and central bank commitment for catch-up growth (i.e. a behind-the-curve tightening cycle) in the US (as well as the rest of the G4), higher US rates are likely to be driven only by inflation driving nominal yields higher, as opposed to central bank reaction function surprises driving, making it hard to repeat 2013’s pattern of higher US reals driving USDJPY higher  We favor JPY longs in Q2, expecting a move to below USDJPY 100 FX macro beat.

 The BoJ will likely push back on any yen appreciation with more asset purchases, so we don’t expect JPY to be a great long beyond Q2  However, longer-term, a failure of asset purchases to spark an NGDP feedback loop in Japan will make investors question quantitative monetarist strategy in environments where risk premia aren’t excessively elevated  In the US, QE2 sparked a speculative “reflation trade” in H2 2010-H1 2011 that drove hot money into buying commodities and shorting USD, which was sharply unwound in H2 2011  Successive rounds of LSAPs had weaker & weaker impacts on inflation expectations, and the open-ended LSAPs announcement in September 2013 drove a spike in breakevens that had completely unwound by the end of the year  Since Japan has already announced the nuclear option of open-ended LSAPs, and can only increase its purchase sizes, any loss of confidence in its efficacy to generate inflation will likely prevent any success in central bank-driven rise in inflation expectations FX macro beat.

FX macro beat.

 EUR is very path-dependent in 2014 due to the wide range of ECB policy outcomes  As long as the ECB continues with its current stance, the euro should have a tailwind, as inflation remains low and the continued periphery rebound offers a rare level of DM risk premia for capital flows to chase  However, accelerating disinflation and/or a debt shock in France will force the ECB to relent to unsterilized quantitative policy, which would send the euro plunging, as the ECB enters LSAPs while the Fed & BoE begin planning their exits from both unconventional quantitative and rate policies  We expect H1 to see EUR rallying until a repricing in US front & belly rates drives a USD rally  We expect H2 to be path-dependent to the variables above, but lean towards a rally FX macro beat.

FX macro beat.

 GBP is vulnerable to a near-term risk correction, as it has become the G4 risk currency of choice and given the recent moves in short sterling forwards  However, we view a correction in GBP to be a buying opportunity, as the labor market is tightening rapidly with December data showing the equivalent of an 800k payrolls print in the US, and inflation likely to be near a cycle low  The BoE reaction function is also more hawkish than the FOMC’s and we expect higher upward pressure in real yields in the UK than the US  The front & belly of the UK curve are likely to face similar headwinds as what we expect in the US curve FX macro beat.

FX macro beat.

 AUD positioning has been this net short only twice in the last two years: at its 2012 bottom and during its sharp 2013 selloff  The RBA has been aggressively talking down the dollar, but with the forwards market pricing in no hikes for almost two years, it will likely have to resort to actual intervention for further depreciation, as more dovish rate guidance will likely be insufficient to drive down AUD  At the same time, commodities appear cheap and poised to rally in a global growth rebound, which would translate into a higher AUD  We expect AUD to witness a material short-covering rally this year, but beyond that, we expect the RBA to be able to talk it back down, leading to a more or less flat year FX macro beat.

FX macro beat.

 CAD has only had positioning this net short twice in the last 20 years: at the 2007 bottom, and at a short-term bottom last summer  2yr Canadian notes yield only 4bps more than overnight rates  Similar to AUD, this commodity currency is facing downward pressure from a weakening labor market, dovish central bank, and low forward rates, causing both AUD & CAD to have become quasi-carry funding currencies  We expect a similar short covering rally and overall flat year in CAD as in AUD, against the backdrop of a commodities rally FX macro beat.

FX macro beat.

 Emerging market currencies have been hit dramatically as a result of rising DM real yields, converging DM/EM growth rate differentials, and consequent capital flows  However, we expect them to be nearing a bottom, as recent volatility has forced even the most market-unfriendly EM CBs, like in Argentina & Turkey, to begin caving to market demands  We view the nascent FOMC & BoE reaction function shift toward inflation to provide the perfect environment for these currencies to reverse upward  However, longer term, EMFX is a tough asset class to own, as US & UK rates have more repricing ahead, especially in the front-end, and because of the accumulated sums of capital inflows in EMs in the last decade reversing now FX macro beat.

EQUITIES

 The S&P 500 equity risk premium (ERP) remains historically wide around 300bps  However, much of this is due to the discount rate risk baked into the UST curve  Matt Busigin’s ERP decomposition model estimates the ERP net of the 2s10s contribution to be around zero  This implies that US equity multiples at present are more or less at “fair value”, with future equity returns more sensitive to EPS vs P/E than anytime post-crisis  As such, buying the S&P offers no real risk premium collection  Although ERP will likely go negative as in the past, given the different demographic & savings allocations dynamics now versus the 1980s/1990s, ERP is unlikely to go beyond -200bps, some of which can come from faster-than expected monetary policy normalization  This sets up for 2014 to be a great year for equity long/short and M&A strategies that rely on microeconomic analysis EQUITIES macro beat.

 The relevance of earnings power over the discount makes the Kalecki-Levy corporate profits equation a valuable macro lens from which to view the current equity landscape  The function states that profits are equal to the sum of net fixed investment and net dividends, net of the sum of household, government, and foreign net savings  With the federal deficit set to continue rapidly shrinking and household net savings poised to materially grow in 2014, this leaves two large equity classes whose earnings will benefit from NGDP acceleration:  Recipients of fixed investment spending  Beneficiaries of a stronger trade balance EQUITIES macro beat.

 As such, we are bullish materials & financials for 2014:  Materials should capture the benefit from global growth accelerating, as well as receive fixed investment spending flows  Financials should continue to have strong earnings power with the yield curve as it is, particularly smaller, non-traditional financials that are subsuming niche vacuums resulting from regulatory developments  Energy names seem superficially attractive based on the improving US energy trade balance, but the restrictions against exporting domestic energy prevent these tailwinds from accruing to earnings power  We are also bullish EM equities, as:  Higher US inflation and rebounding global growth should boost commodities prices from current low levels  Much higher risk premia offer better E[r]’s  The combination of the above two factors should help reverse the persistent capital outflows that began last spring EQUITIES macro beat.

COMMODITIES

 We expect commodities to have a rebound year in 2014, after a devastating 2013  The long-term outlook for commodities remains bleak, given supply increases, Chinese rebalancing, gradual de-financialization of commodities, and end of the “BRIC” and “commodities-as-an-asset-class” investing themes  However, for 2014, rising inflation, accelerating DM demand, and a softer rise in DM real yields should provide a boost to commodities from these oversold levels  We especially like agricultural commodities, for whom a normalization of crop supplies alone should drive them off their lows  Metals are likely to do well in 2014, as disinflation & surging DM real yields risks diminish, but are likely to make new multi-year lows next year, as the Chinese rebalancing accelerates  Crude oil is likely to remain rangebound, facing conflicting pressures from rising US supply and demand, with the potential for intermittent geopolitically-driven spikes COMMODITIES macro beat.

VOLATILITY

 2014 should be a choppy year for volatility, with spikes presenting attractive opportunities to collect income by selling vol  However, with LSAPs (which mechanically, and through investor psychology, drain risk premia and compress volatility) on their way to zero, and real yields on their way up, volatility spikes may be more frequent than in 2013  The reversal of various corporate profit tailwinds should add to the volatility potential, but these can be seen as opportunities  A lower-Sharpe 2014 for equities, with lower returns and higher volatility, should provide great opportunities for tactical vol sellers VOLATILITY macro beat.

1Levant 2Af-Pak 3Asia-Pacific GEOPOLITICS

THE LEVANT

 The prolonged Syrian crisis stems from a breakdown in the UN Security Council, in which Russia’s (and by extension, China’s) veto power deadlocked the only UN arm with binding resolution power from Western policy will  Russia’s economic interest in Syria revolve around quasi-SOE energy powerhouse Gazprom, whose strategy in supplying European natural gas markets hinges on:  Maintaining influence over the recent large natural gas discoveries in the Levant Basin, which underscores the importance of maintaining alliances with Syria’s incumbent leadership,  Preventing competitors from gaining European market share, including proposed gas pipelines by Turkey & Qatar (both of whom are Sunni states against Assad), and  Generally reasserting influence over the Middle East, which it lost as the Soviet Union collapsed (much of which due to Sunni Mujahideen Jihadists)  Last summer’s Ghouta chemical weapons attack in Syria renewed the debate over NATO intervention, with President Obama’s appointment of Samantha Power to UN Ambassador and his characterization of chemical weapons use as a “red line” underscoring likely Obama administration plans to intervene LEVANT macro beat.

 However, Russian President Vladimir Putin brokered a chemical weapons confiscation deal between Syria & the US that prevented Western intervention  The deal isolated Saudi Arabia and other Gulf states, which have been supplying Syrian rebel fighters with heavy weapons, ammunition, and funds  This came two months after a failed secret negotiation between Saudi intelligence minister Bandar bin Sultan & Russian President Putin, in which bin Sultan promised, in exchange for Russia ceasing its support for Assad, to:  Protect Russia’s gas pipeline interests,  Ensure any post-Assad Syrian leadership would be under heavy Saudi influence, which would be wielded to protect Russia’s interests,  Safeguard Russia’s naval bases off the Syrian coast, which are a vital asset for Russia’s energy interests, and  Protect the Winter Olympics in Sochi from attacks from Chechen rebels, which bin Sultan said are “controlled by [Saudi]” LEVANT macro beat.

 Putin characterized bin Sultan’s comments about Chechens as a thinly-veiled threat, and talks broke down  Russia’s strategy was to forego a Russian-OPEC alliance that could boost energy prices, in order to focus on European market share and geopolitical leverage & influence, especially since Saudi’s influence over torpedoing Qatar’s natural gas ambitions is shaky  As such, Russia continues to strengthen its alliance with Iran and other Shi’a/non-Sunni states in the Middle East, who provide a backbone to renewed Russian regional influence, as well as logistical allies for Russian energy export ambitions  In December, bin Sultan met again with Putin, softening his conditions for stemming the Salafist tide in the Levant & Russia, as well as agreeing to the Geneva-2 conference plan  However, bin Sultan also requested a delay in the Geneva-2 conference, an opposition-led interim government to be put in place, and elections to only occur after a new constitution, and Russia appears to have again rejected Saudi deal attempts LEVANT macro beat.

 These dynamics have come against the backdrop of a massive US energy production boom that has:  Reduced US reliance on foreign oil,  Kept a lid on energy prices, and  Set the stage for potential US entry into the global oil trade after a 40-year export ban  This has diminished Saudi leverage in US geopolicy, just as the post- Arab Spring rise of the “Shi’a Crescent” has increased Iran’s regional importance  All of this has combined to begin a US “Shi’a pivot” to:  Ally with the rising “Shi’a axis” in its struggle to fill various Arab Spring power vacuums  Neutralize alliances with Sunni Gulf states, who tend to support Qutbist, Salafist, & Jihadist elements in the region, and subject global energy to cartel pricing  Help prevent the rise of Sunni insurgencies in Iraq & Afghanistan  Check the rising Chinese influence in the region  Capture the advantage of rising marginal leverage against OPEC states LEVANT macro beat.

 The Shi’a pivot has forged an unlikely alliance between Israel & Saudi, with:  Israel now more concerned about Iran & the Shi’a Crescent than Wahhabist elements in the Levant  The Israeli Ambassador to the US recently commenting that Israel has “always preferred the bad guys who weren’t backed by Iran to the bad guys who were backed by Iran”, in regards to the extremist elements within the Syrian rebels  The proposed US-Iran nuclear deal came with much Israeli & Saudi opposition, as it would ease banking & energy sanctions, help stem Iran’s high inflation by boosting the Rial, and bring 1.5- 2 millions barrels per day of crude oil to the market  As such, last summer’s developments involving Syria appear to have driven the US to taking marginal steps away from Israel & Saudi and toward Iran, in the context of a shift in strategy toward supporting Shi’a elements to bring down extremist Sunni cohorts in the region LEVANT macro beat.

 The Islamic State of Iraq & the Levant (ISIL / ISIS) has become the preeminent force in northern Syria, while gaining control of large swathes of southern Iraq, including Fallujah, after staging a successful prison break of many imprisoned members from Abu Ghraib  ISIL has been a major contributor to rising sectarian tensions, attacking Iraq’s Nouri al-Maliki administration (which has favored the Shi’a majority) and Syria’s Bashar al-Assad administration (which has favored Alawite, Christian, and Shi’a minorities), with a harsh sectarian stance  ISIL has now entrenched into Lebanon, including a car bombing targeting Hezbollah loyalists that support the Assad regime LEVANT macro beat.

 ISIL is much more Qutbist than other rebel groups in Syria, imposing strict sharia law immediately after land grabs, focusing on sectarian attacks, and more concerned with establishing rule over conquered territory than defeating Assad  As such, ISIL is likely to become the focal point for the rising sectarian violence in the Levant, and the US & Russia may move to preempt their tide in Lebanon by aiding Hezbollah fighters in Syria  Any Saudi involvement with ISIL remains unclear, although Iranian news has been reporting of a secret meeting between a Saudi intelligence official and a senior ISIL commander shortly before the latter was killed by Iraqi forces LEVANT macro beat.

 The role of Turkey in the Levant’s conflicts remains significant, as it is a Sunni majority country in NATO  However, recent domestic corruption & economic issues have checked Prime Minister Erdogan’s regional geopolitical ambitions as of late  The rise in US interest rates and LSAP taper have affected EMFX more than any other asset class, particularly the Turkish Lira  With a massive share of corporate debt denominated in foreign currencies, the Lira’s slide has had significant impact on the economy beyond just depreciation-driven inflation  Concurrently, Turkey has massive short-term external sovereign debts to roll over, increasing the risk of the currency crisis evolving into a credit crisis  Erdogan and his party are losing political support amid the currency & corruption crises, and the opposition party’s leader is an Alevi (a sort of Shi’a-Sufi hybrid) who is left-leaning and opposes the Islamist ambitions of Erdogan & his party  A continued rise in opposition party approval ratings could weaken Erdogan’s influence (possibly to the point of incumbent AKP party losing 2015 elections), materially strengthen US-Turkish relations, which would be a blow to Sunni Islamists and would be a significant force against ISIL LEVANT macro beat.

 Looking ahead, these dynamics increase the risk of sectarian conflict in the Levant and eastward, as the rise of ISIL underscores  The continued US energy output boom, along with the potential return of Iran & Libyan oil exports (and possibly even US in the longer term) and developments in US-Russian & -Iranian relations should drive Saudi to loosening its grip on Sunni extremists in the region  The tail risk of a Chechen extremist attack during the Sochi Games is heightened against this backdrop, particularly with bin Sultan’s comments to Putin last summer; such an attack would likely impact markets as it would bring out harsh rhetoric from Putin against Saudi  Oil supply shock risks are elevated due to rising sectarian tensions across the region, but are mitigated by US production & the eventual return of Iranian & Libyan exports, unless Iraq descends into crisis  Longer term, this could lead to a decline in Islamist terrorism, as Shi’a cohorts gain regional influence and Qutbist elements aiming for a pan- Arab caliphate (and their supporters) lose geopolitical & economic leverage and influence, materially decreasing oil prices LEVANT macro beat.

AF-PAK

 The future US withdrawal from Afghanistan remains the focal point in the region  The Bilateral Security Agreement (BSA) lays out the terms and timetables for US military disengagement in Afghanistan, and the US set a new year deadline for Karzai to sign it, suggesting the possibility of a “zero-option” withdrawal if he didn’t  Afghan President Hamid Karzai remains skeptical of the US BSA timetable (and its zero-option threat) and is exercising his leverage, including:  Ignoring the US’s deadline for signing the BSA  Ignoring the Loya Jirga (Grand Council)’s acceptance of the BSA  Disinclination to sign the BSA until after April elections,  Making signing the BSA contingent upon the elimination of judicial immunity for American soldiers, peace talks with Taliban leadership, and the release of Afghan detainees at Guantanamo Bay  Releasing 72 high-profile detainees in defiance of US pleas just a week earlier AF-PAK macro beat.

 Karzai seems to pressuring the US to maintain aid and a military presence in Afghanistan, but with increased Afghan sovereignty  Karzai’s interest in pushing signing the BSA until after the April elections partially lies in preventing US interference in Afghan elections, which former Secretary of Defense Robert Gates alluded to having occurred in an attempted 2009 Karzai ousting in his recently released memoirs  Concurrently, the detainee release offers Karzai hopes for restarting talks with Taliban leadership and to assert judicial sovereignty to the US  Karzai is aiming for stronger legitimacy with Pashtuns, in an attempt to retain southern Afghan influence in national politics after he leaves office, and to cement his legacy  Peace talks with the Taliban, although seemingly unlikely thus far, would help ensure Afghanistan’s sovereignty, diminish the risk of mass insurgencies from Pakistan, limit the need for US involvement, and boost relations with India, a vital regional ally and economic powerhouse AF-PAK macro beat.

 India has recently started strengthening relations with Afghanistan, including accelerating development of the Chabahar Port in Iran, which allows Indian access to Afghanistan & Central Asia while bypassing Pakistan  The biggest aims of Karzai, Afghanistan’s Loya Jirga, the US, and India involve diminishing the Taliban’s regional influence without sparking insurgencies or reactionary conflict  This marginally alienates Pakistan, which remains the likeliest link from which peace talks with the Taliban can emanate, and which gains relevance, leverage, and aid because of the insurgency threat  The recent US drone killing of Hakimullah Mehsud, leader of Tehrik-e- Taliban (Pakistani Taliban), in North Waziristan, Pakistan, severely disrupted Pakistani attempts to negotiate with the Taliban, and dampened US-Pakistani relations once more  Thus far, it appears little progress has been made in forging a deal with the Taliban, while Afghani & Pakistani concessions keep piling up, and with both parties covertly trying to use the Taliban to weaken the other’s influence AF-PAK macro beat.

 Going forward, instability in Afghanistan remains a notable risk, especially around spring elections, although these are unlikely to impact markets  The post-US withdrawal experience in Iraq (including the rise of ISIL) bodes poorly for Afghan stability without a peace deal with the Taliban  As long as opium production & trade continues to boom, cutting off extremists’ financing will be difficult  As the US & India make headway with Shi’a groups and NATO begins its disengagement from Afghanistan, Pakistan is likely to attempt to reassert its regional influence and check India’s forays  Pakistan may be a source of geopolitical tail risks in 2014, including threatening to cut off NATO supply routes, moving to limit US drone strikes, rising insurgencies, and acceleration of violence against minority Muslim sects, but such risks are unlikely to impact markets AF-PAK macro beat.

ASIA-PACIFIC

 Strained China-Japan relations are likely the most significant source of geopolitical tension among global powers  Japan’s PM Shinzo Abe is a staunch nationalist whose yen depreciation program has antagonized China, and to a smaller extent South Korea  Territorial disputes between China and Japan over the Senkaku/Diaoyu islands have accelerated in the last two years:  In 2012, Japan purchased three of the islands from their “private owner”, leading to protests and boycotts in China  In late 2013, China declared an air defense identification zone (ADIZ) over an area including the islands  In early 2014, China instituted fishing restrictions in the disputed East China Sea  The islands & surrounding area are home to large undersea oil & natural gas deposits, underscoring the burgeoning economic rivalry  Abe recently paid homage to the Yasukuni war shrine, a tribute to, among others, soldiers who committed war crimes against China in World War II  These dynamics speak to an intentional Japanese attempt to reassert influence in the region, with implicit US backing (perhaps even being a part of the Obama administration “Asia pivot”) ASIA-PACIFIC macro beat.

 The China-Japan economic conflict appears to be developing into a diplomatic clash with rising militarism  The ultimate destination of energy deposits in the East China Sea will likely materially benefit whomever gains control over them, but the path toward that destination is likely to be more relevant in the near-term, especially to markets  Just like with its rising support of Afghanistan against rival & China ally Pakistan, India has strengthened ties with Japan against the backdrop of rising Chinese-Japanese tensions  With declining Japanese-South Korean relations (as South Korean exporters are also facing the brunt of exchange rate appreciation against the yen), North Korea becomes a focal point for regional geopolitics, as Japanese action against the North could rebuild lost ground with the South ASIA-PACIFIC macro beat.

 The US rebounded out of the Great Depression with a massive monetary stimulus campaign (by devaluing the USD) and high- powered fiscal spending including for stimulus and war  Abe has repeated the US’s monetary strategy under FDR, and although he may not actively be pursuing a “war stimulus”, militant nationalism and higher defense spending are cornerstones to his economic & social agenda to revitalize Japan  Many scenarios abound for the future of China-Japan relations, but if tensions continue to rise, Japan may become increasingly vocally aggressive against North Korea  Such a move, whether or not it culminates in military engagement, would likely drive Chinese rhetoric higher as well, to protect its borders from an influx of refugees fleeing crisis and maintain its check against the US ASIA-PACIFIC macro beat.

 Japan’s postwar constitution is pacifist and does not allow military engagement beyond self-defense  In a New Year comment, Abe suggested that the constitution could be amended by 2020 to ease restrictions on military engagement  This came a month after Abe’s cabinet moved to boost defense spending to $240 billion between 2014 and 2019  The largest tail risk comes from the possibility that Abenomics may fail to generate a virtuous cycle of NGDP growth  As discussed in the Japan macro section, the insufficient fiscal measures, low extant risk premia in JGBs, and unmitigated demographic headwinds make it difficult for BoJ asset purchases to stimulate a capex-driven feedback loop  If Abenomics fails to live up to its high hopes, Abe may be increasingly pressured to pivot to defense policy as a way to unite the electorate  Japan has a material fiscal drag in 2014, and if this becomes a significant obstacle to growth, a renewed fiscal push may be in the cards, and would likely revolve around defense spending ASIA-PACIFIC macro beat.

 Thus far, much of the inflation in Japan has been due to rising energy import costs stemming from JPY depreciation  Combined with the perception of nuclear energy since Fukushima, this makes for rising Japanese interest in East China Sea energy reserves, as well as popular support for nationalist defense policy against China  Actual war is unlikely, particularly in the near-term, but the situation is fragile with many possible catalysts for future engagement, such as the increasing military drills (including joint US-Japan naval exercises)  Continued territorial claiming presents catalysts as well, particularly if it brings the US-backed Philippines into the picture, like the recent Chinese threat to seize the disputed Pag-asa/Zhongye island claimed by the Philippines  We expect harsher rhetoric from both parties in 2014, and the potential for short-term market-impacting events particularly from Japanese responses to any North Korean threats  Aggression beyond rhetoric is hard to forecast, but is a real tail risk over the next few years unless the situation markedly changes ASIA-PACIFIC macro beat.

SPECIAL THANKS

 David Schawel, Square One (@davidschawel)  Matt Busigin, Macrofugue (@mbusigin)  Guillermo Roditi Dominguez, New River Investments (@groditi)  Conor Sen, New River Investments (@conorsen)  George “Mac” Robertson (@gmrobertson)  Patrick Brodeur, Uncle Goose (@patrickbrodeur) SPECIAL THANKS macro beat.

Naufal Sanaullah – January 27, 2014 – [macrobeat.com] macro beat.

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Naufal Sanaullah – January 27, 2014 – [macrobeat.com] macro beat.

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