Friday January 27

Stocks fell marginally today as the Trump trade lost momentum at the end of the week. The S&P 500 and the Dow Jones each fell less than 0.1% to 2,294 and 20,093 respectively. In Trump’s first week as President the S&P 500 rose 1% and the Dow Jones rose 1.3%. The KBW Bank index fell 0.5% while the DJ Utility average rose 0.3%. Economic data today showed that durable goods orders fell 0.4% last month compared to estimates which called for a 2.6% gain. Excluding transportation however durable goods rose 0.5% in line with estimates. Additionally the U.S. economy in the fourth quarter expanded at a rate of just 1.9% while estimates called for a 2.2% gain. The trade balance was a large drag on growth while personal consumption and residential investment were both bright spots. On that backdrop the two year Treasury yield was unchanged at 1.22%. The ten year Treasury yield fell 2bp to 2.48%. 2yr vs 10yr bull flattened to 1.26%. The dollar was mixed on the day against peers. USD fell 0.1% against EUR to $1.0699. USD rose 0.5% against JPY to Y115.13. USD rose 0.4% against GBP to $1.2549. The Mexican peso rose 1.5% against the dollar after the Mexican President and Trump had a phone call after a meeting was cancelled yesterday. Oil prices fell for the second consecutive day. WTI fell 1.1% to $53.20 and Brent fell 1.4% to $55.46.

A default in China and the consequent ripple effects highlight some of the risks and systemic problems in that financial system. Cosun Group recently defaulted on $166mm worth of bonds that were sold to various investors in China. However given the nature of China’s financial system the default is causing problems for investors who didn’t even own Cosun bonds. Retail investors who buy bonds in China oftentimes use them as collateral for personal loans that are made by other retail investors. These transactions all take place through a complex system of online platforms that market bonds and private loans to retail investors through mobile apps. Millions of retail investors in China participate in these types of transactions. Now investors who made loans that were collateralized by Cosun bonds may be on the losing end. Many claim they were not even aware that their loans would be collateralized by bonds in the first place. This is a perfect example of the problems that arise when regulation does not keep up with technology and complexity in the financial system. Ant Financial, which both guarantees loans and markets bonds and secondary loans through a mobile app has more than 13,000 customers that were directly affected by this default and it is unclear how many were affected by spillover affects. These types of loans oftentimes carry high yields around 6% plus.

Brazilian assets are in favor with investors even as growth remains slow. Brazilian stocks outperformed the MSCI emerging markets index last year by 55% and the currency also performed strongly as a pro-business president Michel Temer took office after the impeachment of Dilma Rousseff. So far year to date that momentum has continued rising 9% for equities and the real is up 3.5%. This comes even as GDP growth is slow. After falling 8% over the past two years economic growth in the country in 2017 is expected to be just 0.5% this year according to the central bank. Economist Alberto Ramos at Goldman Sachs referred to the downturn in Brazil as a “balance-sheet recession” meaning that it will take the country longer to recover given the extent of structural changes and systematic delevering that needs to take place. Stock prices in the country have also benefited from rising commodity prices especially oil. Inflation is also ticking lower which means that the central bank is able to lower interest rates. The easing cycle is also supporting stock prices. If all goes according to plan analysts expect that the central bank could bring rates down as much as 350bp this year. Brazil remains an attractive investment destination for foreign investors. While equity valuations may be stretched, fixed income markets are still attractive. Real interest rates in Brazil are still above 6% meaning that investors looking for yield will find Brazil attractive.

Regulatory changes in the European debt markets are creating some concern and uncertainty for investors. During the financial crisis investors in the most senior bank bonds experienced no losses even as governments and taxpayers around the world came to the rescue with billion dollar bailouts. To prevent that issue regulators in both the United States and in Europe imposed the creation of new types of bonds for banks to issue that would create losses for senior bondholders. However the issue is that these debt instruments in Europe have been created in a variety of different ways in different countries which makes the market more complicated. TLAC bonds (Total Loss Absorbing Capacity) push senior bondholders below depositors in the creditor line of preference. These have been referred to with names such as Tier 3, senior non-preferred, and junior senior debt. The nominal value in some of these bonds reduces in times of stress to absorb losses for the bank. That means that a higher supply of debt results in less risk for the investor since losses would be spread out among a bigger number of investors. That is contrary to typical debt market principles where more debt leads to higher risk. This is similar to coco bonds that sold off last year given the uncertainty regarding how losses would be interpreted. European regulators have voiced concerns over the different ways of issuing these types of debt and called for a more uniform approach.

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Friday January 27

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