The Mexican Peso (“MXN”): arriba, arriba, ARRIBA !


Buenos Noches readers.  This article’s purpose is to convince you why the Mexican peso (“MXN”) is going to rise against the almighty U.S. dollar.
As a background, we all know who won the U.S. Election.  The victory of Donald Trump was a seismic event in history.
  • Stocks are rising
  • Commodities and precious metals are stumbling 
  • Bonds are falling                                                                                                                                                                                                                                                                                                                               
  • The smell of inflation is back in the air
  • And the U.S. dollar is within arms-reach of parity with the Euro
Together these changes in Capital Markets are called the “Trump Trade.”  One victim not just in the markets but in geopolitics, has been Mexico.  Mexico has been the “poster child” for everything that has gone wrong with the United States.  According to Trump, the NAFTA trade agreement has taken jobs away from hardworking Americans, resulting in a lower standard of living.  Did you know that 9 out of 10 cars produced in Mexico get shipped to the U.S. (data sourced from UBS)? And then there’s the issue of immigration.  Trump wants to keep Mexicans out.  How’s he gonna do that?  Well I think we are know that answer!
Despite haven’t become President yet, there has been a real fallout on the Mexican economy and the MXN currency.  With every tweet, the Peso keeps declining.  It is now conventional wisdom that the MXN will continue to weaken over the next year.
I don’t believe that to be the case.  While there’s the Trump Trade, and that’s powerful.  There’s also something called the “Madness of Crowds.”  This is when every one of us agrees on something whether or not it’s based on logic.  There have been examples of Manias in the past, of which some were based on faulty-logic.  They include:
·      Tulip mania (1637)
·      Roaring Twenties (1922-1929)
·      Dot-Com Bubble (1995-2000)
·      Real-Estate bubbles (2006-2009)
·      Bitcoin (present day)
Bubbles usually end badly.  The Trump Rally too, will bust. If this happens, it will be the end for the almighty dollar.  I would like to give you five reasons why the Mexican peso will reverse course and RISE against the U.S. dollar.
1.     First, is something called “selling on the news.”  This is a reversal of a market price which goes in complete opposite of what was expected.  One often sees this when a company’s share price declines after reporting excellent earnings.  This is due to the news already being factored into the share price.  Once Trump becomes President, I expect the Peso to reverse its downtrend if rise in earnest by First Half 2017 (think Cinco de Mayo).
2.     The U.S. economy won’t move from 2% GDP growth to 4% just because there’s a different guy in the White House. Running the U.S. government is not the same as running the Trump business empire.  You don’t just give marching orders and have your plan executed.  There’s a whole process to the process, with pushback from Congress, lobbyists, etc.  In fact, according to a WSJ survey of economists, 2018 GDP was upwardly revised by just one-quarter of a percent (to 2.4%).
3.     Differences in real interest rates affect currencies.  The currency with the higher interest rates attracts more investments of which causes an increase in demand for investments denominated in that higher yielding currency. Mexico’s funding rate, for example is nearly double that of U.S 30YR rates.  It is true that a proportion of the higher rate is attributed to inflation, though the Bank of Mexico has aggressively raised rates (in each of its last three meetings) to nip it in the bud.  One can determine whether or not the difference in interest rates is affecting the currency by looking at forward currency rates.  Presently forward currency rates are slightly higher than present rates indicating traders expect to decline slowly.
4.     Oil prices are rising:  After plunging in 2015, oil prices rose 45% in 2016.  Oil prices are expected to remain elevated due to the Nov’16 OPEC agreement.  Mexico’s budget is highly dependent on taxes it receives from PEMEX, the national oil company. PEMEX provides nearly 20% of Mexico’s budget and 5% of exports (mostly to the U.S.). Oil is priced in USD so the net effect could be substantial.
5.     Purchasing Power Parity:  This is an economic theory that determines what the exchange rate should be based on a basket of goods of one country divided by a basket of goods from another country.  The Economist magazine popularized using the price of a Big Macin one country over that of another country to determine the exchange rate.  Its index shows that the Mexican Peso is over 50% undervalued compared to the USD (and its data was before the U.S. election).
Factors working against a stronger Peso are the continuing Drug Warin Mexico and risk to the Current Account surplus with the U.S.  According to the New York Times, in the first 10 months of 2016, there were 17,063 homicide cases in Mexico, already more than 2015’s total and the highest 10-month tally since 2012.  The Drug War has become an almost civil war on the country resulting not only in lost innocent lives but in lower potential economic growth.
Mexican’s trade surplusor Current Account could also hamper a strengthening Peso if Trump initiates trade tariffs onto Mexican imports.  Exports are typically good for the local peso as U.S. importers would have to convert their dollars in order to pay for the Mexican exports, hence more demand for pesos.  However, I believe import tariffs are doubtful as this could lead to a trade war with Mexico.
The currency market is complex and not every factor I have stated to you will affect the Peso.  In summary, I believe the peso will rise due to changing investor expectations, slower U.S. economic growth compared to Mexico, higher interest rates in Mexico, a stronger economy in Mexico due to greater oil exports, and due to Purchasing Power Parity which shows that Big Macs cost just 50% of what they cost here in the U.S.  The peso will reverse its downtrend by 1H’17 – think Cinco de Mayo!

Green Bonds are Giving SRI a BLACK EYE


This article marks my website’s first commentary on the fastest growing trend not only in social investing but ALL of investing.  No, I’m not talking about Enhanced Exchange Traded Funds.  In just the last five years, the emerging asset class of Green Bonds has come from nowhere, growing to $36.6bn (2014) outstanding.

A “Green Garage” courtesy of The Wall Street Journal

Climate Bonds Initiative (a leading London-based research organization in this area) thinks the market will more than double in 2015, to nearly $100bn after tripling in 2014 (see graph).  Total issuance reached $24.5bn year-to-date as of August 2015, so it appears that forecast is untenable. The total addressable market amounts to over $0.5 trillion.

Source: Climate Bonds Initiative, Barclays.


What is a Green Bond?
Green Bonds (aka Climate Bonds) are fixed-income instruments whose proceeds go towards a benefit to the environment.

Green bonds are similar to other bonds. The main types are “Use of Proceeds”, Project Bonds and Securitized Bonds. Use of Proceeds use either dedicated revenue streams as collateral backing the bonds, or are standard bonds which are backed by all of the issuer’s cash flows. Project Bonds, as the name implies, are backed only by specific projects and not the issuer.  Securitized Bonds are asset backed vehicles that are specially-structured and designed

The evolution of Green Bonds is similar to what has been seen for early stage industries. The modern Green Bond “movement” began in 2007 when supranationals, mostly highly-rated banks (e.g., European Investment Bank) issued their first bond. Years later the market broadened to public finance/municipal entities and corporates. During 2014, a corporate name issued the first high-yield bond.  That year, 2014, was a key catalyst for Green Bonds as the market grew deeper and broader. It is very important for the Green Bond market to have corporates in the same manner that the junk-bond market propelled corporate financings during the 1980s (we’ll leave Michael Milken out of this one!)

Proceeds by Issuer Type (source: Climate Bonds Initiative)

The U.S. Green Bond market
The U.S. took a back-seat during the Green Bond market’s early years.  The Europeans have taken the lead due to their socialist nature (see chart below from Climate Bonds Initiative). Several European asset owners and investment managers have signed on to the United Nations Principles for Responsible Investment (PRI) initiative.  Furthermore, European governments have encouraged (via subsidies) socially responsible investing and green projects such as solar power, wind, etc.  Though recently, large liberal States (and cities) of California and Massachusetts have issued municipal Green Bonds.  Given the overall SRI movement in the U.S. and the influence of large pension finds (i.e., TIAA-CREF) corporate issuers are expected to become a larger contributor to the overall Green Bond market.

At this time, the only investment vehicle that focuses in Green Bonds is a mutual fund called Calvert Green Bond (CGAFX). The fund has underperformed, partially due to its high front load (3.7%) though it has underperformed other funds too. It invests 90% of its assets in the U.S. and has an effective duration (maturity) of 5 years.

Recently, Ameriprise Financial subsidiary (Columbia Threadneedle) opened a new muni fund called Columbia U.S. Social Bond Fund which utilizes ESG criteria.

Where do we go from here
The Green Bond market was born in Europe, broadened in the U.S. but it will reach escape velocity in Asia.  During 1Q’14, Toyota Motor Corp. issued the market’s first ABS, backed by auto leases. The proceeds were earmarked towards electric vehicles.  Despite its $1.8bn size, the Japanese market will pale in comparison to the tidal-wave of Green Bonds emerging in China, according to a study conducted by The Intl. Institute for Sustainable Development.

Anyone that has ever visited China or ran the Beijing Marathon could see for themselves that pollution is a BIG problem.  Some observers say environmental costs may be as high as 10% of GDP.  Consequently, the Chinese State Council announced plans to grow a corporate Green Bonds market as part of its Five-Year Plan. There are several drivers that are expected to quicken this pace including:

  • High levels of household savings
  • the movement away from Shadow-Banking towards transparent markets
  • limited financing for small and medium-sized businesses
  • Urbanization and its affect on public health
  • High foreign investor demand
  • Large infrastructure programs that are Green Bond friendly (see below)

Transport, primarily rail, will be a dominant way of reducing emissions in China, according to the IEA. Despite declining rates of rail investments here in the U.S., China recently added 6,000 km of high-speed rail track – which is double the ROW.

Beijing Marathon’14 (Reuters)

Green Standards Need to be Refined Yet Again
There are several standards that define what exactly (or not so exactly) a Green Bond is. The most popular are the Green Bond Principles and Climate Bonds Standard.  There are also Green Bonds indices in which investors can determine if a particular bond is an index component. Both sets of standards are evolving and voluntary. The Climate Bonds Standard was developed by the Climate Bonds Initiative. It is very focused on Green Bonds from solar and wind companies and needs to be broadened to other industries such as transport, water, agriculture, etc.  The Green Bonds Principles were developed by the ICMA and represents over 50 large financial institutions. It is a set of Best Practices for determining what is a Green Bond as well as the process of issuance, management of proceeds and reporting. The Green Bonds Principles were updated on March 27, 2015.  I read them and thought I had mistakenly read the executive summary as they were too general in scope.

When Green Bonds go Bad
There are several ways a Green Bond could turn ugly.  For example, bond proceeds may be diverted from their original noble cause towards activities that are not green. Green-proceeds may also be loosely-tracked and mixed with an issuer’s other bond proceeds.  Reporting may not be transparent enough and assurances may not be objective or from a reputable third-party.  While the above risks are valid, I believe they could be lessened over time. But there is an even greater overarching issue…

Is Green Bond investing really Socially Responsible Investing?
The short answer is a resounding No!

Socially Responsible Investors seek to purchase those companies that are practicing ESG (Environment Social Governance).  These are companies that are striving to reduce their carbon-footprint, treat their employees (and community) well, and become more transparent. Few companies attain five-stars in all three letters, so investors emphasize certain areas.  But overall, SRI asset managers tend to judge the whole company.  The website Socially Responsible Investing, for example, focuses on how companies treat their employees because I believe if you don’t treat your own well you will never treat society well either. Others focus on companies with a mixed track-record that are progressing towards social responsibility. Apple under Tim Cook is a good example of this.  Again, these asset managers are focusing on the merits of the whole company.

The overriding problem with Green Bond investing is that any company (or municipal) could issue such a bond so long that its proceeds go towards benefiting (i.e., less harm) the environment.  With this type of definition, I cannot see a case that a borrower can not issue a Green Bond. So if oil company BP Plc wants to issue a Green Bond to make a new efficient LEED-class building (something it may have been planning anyway) socially responsible asset managers would be allowed to purchase those bonds. (In fairness to the Calvert Green Bond fund, I had conversations with its lead portfolio manager and Chief Investment Officer Fixed Income (Catherine Roy) who understood my issues, but stated that Calvert has experience in SRI and would ensure that it was buying bonds of companies that are socially responsible overall.)

However, the Barclays MSCI Green Bonds Index does address the issue of whether or not the whole company is green-bond worthy in its 90% Rule.  This rule says that a general obligation bond is Green if 90% of its revenues fall under one of its five eligible economic categories.  While I give kudos to Barclays for both addressing the whole issuer and for listing specific economic categories and subcategories, they are too lenient determining whether a whole issuer is Green. For example, using its subcategories, a company is Green if it sells superconductors or building-insulation.

The Case of the Green Parking Garage
In March’15, the WSJ highlighted green bonds sold by Massachusetts (Salem State University) whose proceeds would be used to build a garage with electric-car charging stations. Officials said the garage would reduce pollution by cutting down students’ circling the parking lot looking for spots. However, environmental advocates noted that having a parking garage still encourages people to drive and create greenhouse gases.

Green Bond investing properly executed will continue helping the broader investment world adopt SRI.  However, investors should fully understand the issuer’s core business. Otherwise, these bonds will just be Greenwashing the issuer’s dirty laundry.


A Poem on the Fiscal Cliff


Oh, our feisty Fiscal Cliff,
that bastard child of polarized States.
America, what shall we see upon the new year’s “Dawn’s early light”,
Whose broad stripes and bright stars see us through a perilous fight.
Weeper of the House,
America does not want you to cry,
don’t leave us Dry!
It is America’s resolution to solve the Budget impasse,
Negotiating the return of higher tax-rates,
Is that such a difficult accommodation?
Remember, the U.S. Constitution with its numerous Amendments and Rights was the only truly Great Compromise. 
So, let us put down our muskets,
Besides, there will always be something new to fight,

How about the Debt Ceiling with all your might?

                                                                             – Dominic Lombardo


EUROPE’s reached the “POINT of NO RETURN”

The time is near.  The EU’s game of Chicken is ending.  In fact, Europe’s just reached…

The Point of No Return

When will the European Crises hits its nexus?
According to behavioral finance, trend theory, etc.., I believe this will most likely occur during the second week of February 2012.

Market indices (both equities, bonds and capital markets overall) are likely to have their usual Christmas Rally and January Effect during the next several weeks. Then sometime after January it’ll all be over. 

Background to the Euro-Crises:
Many reasons have been cited for the Euro-Crises, with the “blame-game” starting in the U.S.  (i.e, Wall Street exported it’s derivatives/mortgage mess) to changes in regulations, i.e., the Basel Accords.  Basel II essentially said that Banks didn’t need to set aside any capital for sovereign debt, but lots of capital for most other debt.  This diverted loans from corporates towards Sovereigns.

However, we do not accept these arguments, as most just look to shift blame. We
believe the Euro Crises stems from economic mismanagement and lack of fiscal discipline.  In the same light of weight-gain, we believe the aptly-named PIIGS of Europe were glutenous for debt.

thanks to Mighty Lists blogs!

Individual countries are accountable for their actions.  However, the root cause perhaps came from a “Group Think” mentality, whereby the Eurozone was created with a Monetary Union (i.e, European Central Bank, Euro common currency) but no fiscal union.  We believe fiscal integration and intergovernmentalism is a political impossibility.  The Maastricht Treaty via its “convergence criteria” limits budget deficits to 3% of GDP and Debt to 60% of GDP.  However, this is not legally enforceable, and so failed (see chart).  (All of the charts can be enlarged by clicking on them.)

Source: Eurostat, WSJ

Further, a Monetary union without a Fiscal union is a fundamentally flawed model. This led to many consequences including a large current account (i.e. trade balance) in Germany and negative current accounts with the PIIGS.  Historically, the German D-Mark would have risen, while the others would decline, thus realigning trade flows. Germany is a clear beneficiary of this model’s flaw.

The EU has given the world a daily dose of ideas that increased capital market volatility. Two examples are listed below:

  • Expansion of the EFSF (“European Financial Stability Fund”) which sells bonds to investors and uses proceeds to provide loans to Eurozone countries in need.  Unfortunately, the fund is too small (up to EUR 750Bn including IMF monies) and loan guarantees are too low (20-30%).   Also, note that S&P recently (12/6/11) placed the EFSF on Negative-CreditWatch.  On 12/7/11, it was proposed that the existing or another bailout fund’s ceiling be increased to EUR 750Bn.  Failure to secure backing by all 27 EU (which we view unlikely) nations would likely weaken credibility among investors.
  • Moves towards more Fiscal Integration, as per the 12/8/11 Brussels summit are not feasible.  The 27 EU governments would effectively be ceding greater control of their national budgets including penalties to budget “sinners.” We doubt that all 27 will agree to “fine print” details by March’12.  This is not the United States, where us Americans feel part of one country/culture.  It is doubtful that 27 countries will subjugate their fiscal sovereignty to German rule!

    Below are listed recent data suggesting Europe’s Crises will soon worsen:

    1.) Italy’s Term Structure of Credit Risk has inverted.  That is, Italian short-term sovereign bond yields (and CDS prices) are higher than its long-term yields.  (Note that typically yields/CDS prices rise as tenures lengthen).  So what’s happening?   When ST yields (or CDS prices) are > LT yields this means investors are looking for a near-dire situation short-term, but expecting LT improvement.  This phenomenon is an inversion of the Term Structure of Credit Risk.  See charts below:

    source: WSJ, November 30, 2011

    Republic of Italy:  CDS Term Structure of Credit Risk

    Source: Bloomberg

    According to the table below, Italy’s near-term CDS is trading at approximately the “Ba” equivalent rating, however, note the sample size is small below Baa.

    2.) European banks are insolvent as per Basel III regulations:  This means not only lower capital, but a reverse multiplier-effect (i.e., less lending).  Even officials from the IMF are worried.Article I, Article II.

    3.) Asset Correlations increase significantly during Crises.  This is occuring now.Article.  Higher correlations (and market volatility) typically surround a Crises.  In fact, S&P is now rating European economies in one basket, placing 15 EU nations on Negative-CreditWatch.

    4.) The US equity market declined during Thanksgiving week, the worst since 1942.  (Thanksgiving wasn’t recognized as an official holiday until 1942.)  Such abnormal price-action is usually indicative of worse times to come.

    5.) European Bond Yields and Credit Default Swaps are significantly higher, and rising rapidly.  CDS prices for Europe should be under 100bps.  Italy’s bond yields and CDS are hovering at 7% and 470bps, respectively.  Note that Italy is the third largest bond(Article) market in the world.  Italy is also subject to “hot money” as over 40% of bond market participants are outside the country including Hedge Funds and Asset Managers.  Italy is too big to Bail.

    6.)  The mighty Germany had a failed Bond Auction two weeks ago.  See foxbusiness story.  Again, fundamentally this shouldn’t have happened, indicating cracks in the internals of the market.

    7.)  Austerity plans won’t work as tax revenues are likely to decline due to recent evidence Europe is rapidly falling into recession.  Lower economic growth will cause sovereign borrowing rates to rise,  in turn choking economic growth (i.e, a negative feedback loop). We base this on data provided by OECD and Markit Economics.

    Source: OECD

    8.) Since June’11, liquidity has declined rapidly.  Money Market funds that buy USD commercial paper have changed their purchasing behavior due to new Basel regulations that require they hold shorter-term securities, and that they have higher cash reserves.  (We note though that the recent USD/EUR currency swaps recently set up with Central Banks appear to be temporarily alleviating the situation.)

    8a) Further, Asset Managers, Commercial Banks and other long-term holders of debt are also expected to drain liquidity from the global market.  This is because as part of the Greek bailout (and quasi-bankruptcy)  Greek Credit Default Swaps could not be redeemed, as a Credit Event would not be triggered under ISDA. Click Here for Press Release.  Consequently, professional investors can no longer hedge their European exposure.

    9.) Counting on China as a European savior is no longer an option. China’s “growth-at-all-costs” model is showing signs of fatigue, according to Markit.  The government just lowered reserve-requirements(link) to keep its own Bubble from bursting.  Politicians must also deal with social unrest, especially as its economic growth nears the key 7% level which is needed to maintain social stability, according to Time Magazine.

    While the Euro-Crises has evolved over the last two years, the Crises has worsened to the Point of No Return.  The EU can no longer continue “playing chicken” with the market.  Times have changed – China can no longer afford to save Europe, borrowing rates are unaffordable and the Eurozone is entering recession just as austerity plans are kicking-in.  Europe can no longer save the world from itself !

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