Remain defensive; markets lack sense of direction now: Citi

A sketchy global environment has left investors looking for safe havens. After a troubled month of May, there are now hopes of June bringing in some clarity for markets. Investors are waiting on the sidelines, eagerly awaiting important political outcomes from different pockets of the globe.

In an interview to CNBC-TV18, Mohammed Apabhai, managing director and head of trading strategy - Asia Pacific, Citi says the key events which everyone has an eye on are the Greek elections on June 17 and the Federal policy meet. Taking a back foot on the risk-on trade, investors are now reducing their exposure to risk.

Europe’s economy continues to be stymied by its sovereign debt crisis. The greek election could bring much needed clarity on the future of the euro zone, as voters decide whether they want a political leadership to take the country out of the euro, an event markets fear would destabilise Europe’s banks.

Concerns that Spain's ailing banking sector might worsen the European debt crisis are weighed in on global markets, maybe overtaking worries about Greece. Apabhai says funding stresses have risen after Spanish bank issues. He finds that the market has no clear newsflow to work on, lacking any sort of direction at this point. He advises investors to hold onto their defensive plays.

Below is an edited transcript of his interview. Watch the accompanying videos for more.

Q: What is the mood out there? Are investors bracing themselves for a rough June or do they think that most of the bad news is in?

A: I think investors are very much on the sidelines. We have what we call a ‘super week’ starting on June 15 where there is a lot of news and events that are going to be coming out; the French elections, the Greek elections, we have got the Fed meeting in that week and we have got potential downgrades for US financials. So a lot of things are going to be happening over that period. So for the time being what we are seeing is investors moving very much to the sidelines.

There is no clear view or no conviction in global markets. No real appetite to express a very strong view right here. The trading that we are seeing is very day trading in orientation and markets are generally on hold. We think in the next few days it is probably just the month end position squaring. We had a very turbulent month of May in equities. We are seeing some flows from bonds into equities. We think that’s going to be fairly short-term and markets are probably going to be on hold until June 15 at least.

Q: Some of your peers are putting out worrying reports - one suggesting that Q2 and Q3 of this year is likely to see a very sharp bout of outflows and that that may cause disproportionate under performance for emerging markets, much sharper falls than the developed markets. Is that a concern or an outlook that you share?

A: It is definitely a concern but it’s too early yet to say whether this is actually going to happen or not. Our view is that what is happening right now is that you are seeing risk being reduced. So people are taking benchmark bets off the table and they are reducing overall beta to the market.

In the next phase, we think if the S&P falls below somewhere around 1,285, Asian markets fall below the levels that they were at a couple of weeks ago, if we go down to fresh lows, what you are likely to see then is a liquidation of positions. That could actually be quite sharp. At the moment there is a better than 50% chance of that happening but we don’t actually have enough information in my view to make that a key thesis right now.

We do feel people should be light in terms of positioning on risk. The risk reward remains extremely unattractive for now. There is no point, I don’t think in being a hero right here. You are probably going to get better opportunities to enter into a lot of these markets. If we do get the break of that level and you do get the rise in the funding stress as a result of these events that happen in super week, then it is more than likely that Asian emerging markets will underperform especially on a dollar basis perspective.

The currency markets are selling off. This is a reversal of what we saw in August of 2011, where we saw the equity markets selling off before the currency markets. We are seeing this time around the currency markets going before the equity markets. We are in a very interesting position. People should be using this week, when people are coming into the markets to adjust their portfolios as an opportunity to sell and to reduce risks in portfolios for the first two weeks in June.

Q: How likely is it that any such move would be precipitated by the events in Greece because right now the market is quite focused on political events there? Do you think that will be a make or break or are we making a big deal about something that is a local event or at least limited to the euro zone right now?

A: My view is that in the last two years more effort has been expanded on analyzing the European situation for probably the lowest amount of reward that you could have. What is very important for Asian emerging markets is what is going on in dollar funding and the focus on dollar funding stresses in particular. So for example, what we saw was that after the Greece and French elections, we had dollar funding stresses remaining fairly low. It was only after the nationalisation of Bankia in Spain that we saw the rise in funding stresses and the fall in equity markets that corresponds to it.

So I do think there are other issues in addition to Greece which would be potentially more significant; things like what is going on with the Spanish banks, what is going on in terms of funding availability to US financials, what the impact of credit downgrades is going to be in the US and UK financials as a result of these credit downgrades and what the impact of that is going to be on the overall dollar based funding situation and therefore on the dollar carry trade in global markets.

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Q: What are investors’ positioning now because we keep hearing a lot that people are generally bearish but they haven’t taken a lot of money out from emerging markets? Are you seeing genuine outflows or people being cautious in their outlook but not having acted on that quite yet?

A: I think people are in a view where they really don’t have strong directional buys in either direction. The flows that we are seeing indicated deleveraging of about 40% of the money that they have put into the market since the start of 2012 and from the numbers that we have done, it indicates that investors are about 1-2% under water in a lot of the developed markets and probably about 3-4% under water in most of their EM positions in Asia. That’s an aggregate across the whole market using our client positioning as a representation.

So yes, there has been some de-risking. What has happened is that clients have moved from risk names into more quality names and the view is that what has happened is people have moved in terms of reducing beta, going back to benchmarks but not a systematic liquidation of positions that they have got in equities and we think that is likely to happen if equity markets fall through the previous lows that we set a few weeks ago.

Certainly the positioning is there for a liquidation event to happen at a time when actually liquidity in trading volumes are fairly likely as well and although people will think that it would be the high risk beaten names that will be sold off, there is actually a very significant probability that the defensives could be hit quite hard because there has been a lot of flows moving from the high beta cyclical names into defensive names.

We have also seen outflows from Korea and Taiwan. Interestingly enough India has been one of the markets that has been absolutely rock solid in terms of foreign investor flows and this is a pattern that we saw in 2010 as well that when the equity markets sold off we didn’t see any foreign investor outflows. We think that to force foreign investors out you probably need the Indian equity market to fall by something like 20%, then they’ll probably starts getting very concerned.

But if that happens that you can image what the global picture would also look like. So we are very interestingly positioned. I think the positioning is still there, the market is still longer equities than what most people think but they are hiding out in more of the defensive names right now.

Q: What are you telling your clients to do on India because we are circling around 4,800-4,900, have not quite gone down to last year’s low of 4,500. Do you see those levels being tested and broken in the course of the next couple of months?

A: We don’t have enough information right now. When we look at the levels that are implied by the money markets, it is somewhere around 5,000 on the Nifty. So for the Nifty to break lower what we are going to need is either a fall in offshore markets which again are looking relatively fairly valued, we would need a rise in the dollar, we would need a rise in the dollar funding stress.

Right now it doesn’t appear that there is any risk reward in either being long or being short. You therefore have to take a view on all these events that are happening in super week. I don’t think many people have got an edge on what is happening. Regardless of what the fundamentals might be implying, you get a fall in equity markets and you will actually see deterioration in the fundamentals which could be the premise on which you are buying the markets.

So right here, right now, we are telling people remain fairly defensive, remain very much in cash. If you are going to play the markets, we think we should be playing it through derivatives market but buying puts. Implied Vols (volatility) seems very cheap if you do believe that this liquidation condition is going to happen. What we have seen is number of clients putting on strategies where they have zero or very little cost optionality for example buying Korean or Indian put options and funding them by selling S&P puts. That has been a fairly popular trade as well.

Q: The probability that you attach to a liquidation like event in the second half of the year is not low. What would you say to the chances that markets may have seen the highs for this year in the first couple of months, been there, done that and the second half is going to be either weakness or sort of consolidating in what has already been a correction phase for us?

A: It all again depends on the actions that policymakers are going to take. What is a bit surprising to us is that policymakers are still very reticent about coming forward and providing the liquidity support that we need. We think for example the Fed’s balance sheet is starting to contract which is a bit of a surprise. The Bank of Japan (BoJ) is backtracking a little bit on the amount of stimulus that we thought they were going to provide. The ECB is also sitting on the sidelines.

Even China yesterday, the headlines were very positive at the beginning of the day when they were talking about a new stimulus package by the end of the day. They were talking about the fact that the stimulus was not going to be like it was in 2008-09. So it certainly seems that in terms of pulling out more liquidity from the policymakers, things are going to have to get worse before they get better. So in the short-term at least what you have seen is this divergence in terms of policy between what the politicians are thinking and what the central bankers are thinking.

Certainly at the end of last year what we had was a convergence, we had the politicians turning around and saying – Okay we need to do something here. There is an acknowledgement of how bad the situation is in terms of growth and the policymakers at the central bank therefore being allowed to act. Right now it appears a divergence in opinion.

So it does appear that the market is going to have to go lower from where we are right now to force the policymakers to act. Now the question is really whether they will act when the markets fall 5% or whether it’s going to require something more like a 15% where it really pulls them out. So very difficult to call the probability on that but I still think the fair value is that it heads lower from where we are right now.