Wednesday April 20

Stocks extend their gains for the week as oil prices continue to put in a strong performance. The S&P500 rose 0.1% to 2,102 and the Dow Jones gained 0.2% to 18,096. The big risk on sentiment today was driven by higher oil prices. WTI crude oil rose 4% to $42.74 and Brent gained 3.5% to $45.38. Oil was driven higher by a report by the EIA that showed slowing production in the US. With stocks now appearing expensive on a price to earnings basis, some decisive and positive factor will be needed to drive prices much higher. The S&P500 is currently just 2% from the record high reached last May. The US dollar enjoyed a strong day. The dollar index rose 0.6% to 94.58. Against the euro the dollar added 0.5% to $1.1298, and the dollar rose 0.6% to Y109.84. As concerns of a hard landing in China subside the correlation between the Shanghai Composite and US indices has eased. The Shanghai composite was down 2.3% today. In the US yields rose on both long and short maturity debt. The ten year yield rose 6 basis points to 1.85% and the two year rose 3 basis points to 0.79%. The Nikkei rose after the BoJ governor hinted at the possibility of expanding QE through buying more equity ETFs.

Defaults in China have been picking up as the government starts to allow state owned enterprises to fail. This may be beneficial for the country’s economy in the long term as it will minimize the dependence on these companies for growth. Instead of propping them up with more debt and relying on bloated manufacturing and industrial companies, the country may begin to shift from the older model to a new consumption and service based model. The near term consequence of allowing these companies to default is unfavorable, as capital outflows may continue and GDP growth may slow. Analysts estimate that public debt in China amounts to around 230% of GDP. At the same time distressed bank assets are estimated to be $196bn with real estate and “shadow banking” both very exposed. In the past the government usually supported these assets and provided the system with liquidity which increases moral hazard. Currently under discussion are debt for equity swaps, and securitization of debt to diversify and spread around risks. The Chinese government has been adopting more open market policies in recent years by freeing up the renminbi, allowing interest rates to float, and opening up the capital markets to international investors. Analysts are therefore hoping that by allowing as much distressed debt as possible to fail that China will be continuing this trend.

Investors have been using derivatives to hedge the risk of a depreciation in the British pound in the event of a Brexit. The cost of such insurance has fallen as the market signals that it is expecting the UK to stay in the EU. Recent polls have shown that the group of voters who want to remain in the EU has risen in size. Various economists and international agencies have warned of the potential negative effects of a Brexit. The Treasury warned that the UK could lose 6% in GDP over the next 15 years. Similarly three month implied volatility has fallen from 16 two weeks ago to 14.79, falling for seven consecutive days. At the same time the British pound has appreciated over the last week gaining 2% since last Thursday to nearly $1.44 now. However each of these measures still remain elevated compared to the start of the year. At the end of December implied volatility was just 9% and the pound was trading close to $1.48. At the same time the three month risk reversal, which indicates the cost of buying downside vs the cost of buying upside protection still remains at a peak. This suggests that investors are still positioning themselves for the event of a Brexit in spite of the changes in the other two metrics. One third of the voting population is still undecided, which could contribute to increased volatility in the British pound as the June referendum comes closer and it becomes more clear what the likely outcome would be.

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Wednesday April 20

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