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The Knock-On Effects Of A Deleveraging China

Over the last two decades China has been following the Gerschenkron Growth Model to deliver high levels of extended economic growth.

The Gerschenkron model of growth goes like this:

  • Undeveloped countries are plagued by poor infrastructure and have low savings and investment rates.
  • To increase investment and boost development, they lower the household’s share of GDP thus increasing governments and producers share of GDP. This in effect raises the nation’s savings rate, providing more money to invest.
  • This investment is then directed by government into big infrastructure projects and export focused industries.
  • The country then grows by increasing its market share of global exports and investing in high return projects.
  • Eventually the country maxes out the amount of productive investment it can absorb. This results in each new unit of debt having less and less of a positive economic effect.
  • The vested interests who became rich and powerful on the back of the investment led economy aren’t incentivized to rebalance. So they keep adding unproductive debt until, eventually, debt servicing costs exceed the economy’s capacity to service it and the economy inevitably goes through a painful forced or managed rebalancing.

China is now at this last step.

China has to rebalance its economy. It needs to transition from an investment and export led economy to a consumption based one; retransfer wealth from the vested interests in local government and private businesses back to households. In addition, it needs to deleverage by paying down, writing off, or inflating away its debt stock.

The quickest way to resolve a debt problem like this and rebalance an economy is to go through a financial crisis where assets are sold and debt written down. This is what the US did in the 1930s. But China can’t go this route because this path involves high levels of unemployment that bear socio-political risks, which the CCP can’t afford.

A much more likely scenario (which I believe we’re beginning to see now) is one where the CCP takes a gradual and pragmatic approach.

They assign the debt servicing costs to local governments, who are then forced to sell assets in an orderly manner to pay down debt. And then the CCP goes after debt in the most vulnerable areas of the economy, primarily the off-balance sheet / shadow banking sector and P2P lending, while balancing this with leveraging in the visible areas parts of the economy (ie, local government issuing bonds to boost specific investment).

This approach means that we shouldn’t expect a hard landing or financial crisis. It’s likely to look much more like Japan’s lost decade, though China has made it very clear in recent months that they won’t make the same mistake the Japanese did and let their currency strengthen too much. So we should expect the yuan to continue slowly devalue against the dollar.

When I share this China bear thesis with people I almost invariably get the question “Why now? What’s keeping them from kicking the can down the road, again?”

That’s a fair question. Chinese leaders have publicly stated as long ago as 2006 that the country had a serious debt problem and that they’d work to deleverage. Only to obviously do the opposite.

But there’s been a very important change over the last year that makes this time different. And that’s the centralization of power.

Only two types of government have been able to handle and survive a difficult economic and debt rebalancing like this (1) robust democracies with strong institutions (like the US in the 30s) or (2) strong centralized authoritarian regimes (like China in the 80s).

This is what the whole anti-corruption campaign and last year’s 19th Party Congress where Xi became de facto emperor, are all about: Xi consolidating power.

Many people have the misconception that the Chinese government is a well oiled machine, where word is past from on top and carried out at the bottom. But in practice this isn’t the case at all.

The real power and control over debt fueled spending has rested with the vested interests at the local government level; from the provincial on down.

There are two Chinese idioms that relate how things actually work, one is ‘heaven is high and the emperor is far away’ and ‘from above there is policy, but from below there are countermeasures’. Meaning, local government officials are free to do as they please, even if it goes against Beijing’s wishes.

This is why over the last decade we’ve seen leaders in Beijing come out talking about the dire need to rein in the country’s debt but local leaders continuing to borrow, spend, and build.

The vested interests who have become rich and powerful are reluctant to stop the activities that made them so.

The anti-corruption campaign that has punished or jailed over 1.5 million party members since 2012 has been effective in clamping down on dissidence. Xi now has the control and authority to carry out Beijing’s wishes.

The SCMP reported last week that updated party rules “state that failing to implement policies from the top is now officially a breach of discipline that can see cadres lose their jobs or even be expelled from the party. Those who refuse to implement policy directives from the party’s Central Committee, who run their own agenda, or ‘are not resolute enough, cut corners or make accommodations’ in applying them, will be subject to punishment under the new rules, which took effect on August 18.”

That’s why this time IS different

President Xi clearly stated his intentions in 2016, saying “If we don’t structurally transform the economy and instead just stimulate it to generate short-term growth, then we’re taking our future… If we continue to hesitate and wait, we will not only lose this precious window of opportunity, but we will deplete the resources we’ve built up since the start of the reform era.” He finished by stating that the country had until the end of 2020 to make this transition.

Another common objection I hear is, “they’re not deleveraging, they’re easing!” But this isn’t so. This misunderstanding is partly due to a failure to view the data holistically as well as intentional misdirection by the Chinese in order to manage the market’s response.

A recent paper by the Paulson Institute (the Macro Polo blog) helps clarify the recent words and actions out of Beijing. Here’s some highlights from the report with emphasis by me.

Upon a cursory look, the message from the Politburo meeting seems contradictory, emphasizing both deleveraging and growth. But this can be reconciled by clarifying just exactly what Beijing means by “deleveraging” in the current context.

Top policymakers are well aware that they’ve gotten a lot of flak from businesses and investors, as well as local governments, for tightening policies that have dried up credit. The complaints have grown since the beginning of 2018, so the Politburo meeting’s emphasis on deleveraging is meant to signal that amid grumbling among the masses, the central government is holding the line. In other words, Beijing isn’t going to do what’s popular—opening up the credit spigot again—but rather doing what it deems necessary for China’s economic stability. Indeed, the July Politburo meeting readout notably included Beijing’s renewed vow to uphold deleveraging, which was not included in both the April Politburo meeting readout and the December 2017 Central Economic Work Conference.

Even though the emphasis on deleveraging remains fixed, the central government appears ready to tweak its approach around the edges. Based on the readout of the latest State Council Financial Stability Commission meeting, deleveraging in 2H2018 and beyond will be targeted rather than across the board. At least for the time being, deleveraging has been tweaked to mean “structural deleveraging.”

What this means in the second half is that deleveraging will mostly rely on administrative measures targeted at state-owned enterprises (SOEs) and local governments. Meanwhile, the existing financial measures will remain but will not be further tightened, and monetary policy will become more accommodative and be more in line with inflation trends. In other words, Beijing is simply moving from its triple threat on tightening to just a “double” threat.

A more accommodative monetary policy does not necessarily mean that credit growth will increase. In fact, credit growth will likely remain subdued because of the continued clampdown on shadow banking. Even in the absence of additional regulations, the shadow banking sector will continue to shrink in size under the existing policy environment. If Chinese banks remain reluctant to lend to high-risk borrowers, then the disappearance of shadow banking won’t be offset by increased lending through formal channels.

You can find the report here, it’s worth reading in its entirety.

China is deleveraging and we should expect this deleveraging campaign to gain momentum over the next two years. The current trade war with the US gives the CCP even greater political cover in carrying out painful reforms as it gives them an easy scapegoat to assign blame.

Why this matters

The knock-on effects of a deleveraging China will be numerous and far reaching. The increased market volatility, the bear market in EM, the collapse in gold, and the rise of the dollar are all just the start of things to come. There’s no doubt that it’s long and slow deleveraging will be felt everywhere.

And one thing I find interesting is that this is all starting just as the market’s become blind to the China slowdown threat after fretting about it for years. The chart below via BofAML shows that the China tail risk is hasn’t been front and center on investor’s minds in nearly 4 years.

Practically speaking, we should expect EM to continue a slow and grinding descent lower — again, we shouldn’t expect any quick crashes, as global liquidity remains relatively robust. It’s likely that the EEM breakout of last year was just a massive bull trap. Price should continue lower back into its consolidation zone from here.

China’s largest trading partners (shown on the chart below via Atradius) are some of the most exposed to a Chinese deleveraging.

 

 

Why Emerging Markets Are A Dead Money Trade

In our most recent MIR we talked briefly about the growth struggles of EM in the context of the Gerschenkron Growth model, using China as our example.

Our conclusion was that China, and EM in general, is set to be a dead money trade and massive value trap for the remainder of this cycle.

So let’s flesh out a little more why this is likely to be the case.

To start, what exactly separates an emerging market from a developed one? Here’s a good explanation from Eric Lonergan writing on his blog Philosophy of Money (emphasis by me).

Emerging markets are not poor countries, nor are they countries which are making economic progress. They are defined by a very specific set of macroeconomic properties, which financial markets are conscious of, but are rarely clearly articulated.

The overriding characteristic of an emerging market is that a currency devaluation is a tightening of policy. In the developed world, a devaluation is typically an economic stimulus, indeed it often coincides with an easing of monetary policy through lower interest rates or an increase in QE. The post-Brexit policy response of the Bank of England is a case in point – sterling fell sharply and the Bank cut interest rates and initiated more QE.

In emerging markets the opposite occurs. These economies usually have public and private sector liabilities denominated in a currency which they do not issue. So when the Turkish Lira falls against the dollar the burden of finance on many Turkish corporates increases. Due to their US dollar liabilities, the interest payments and capital repayments in Turkish Lira rise. That is the first way in which a devaluation is a tightening of monetary conditions.

The second mechanism is more instructive and carries important lessons for monetary reform in the developed world, and in particular how we should think about the challenges posed by the zero-bound.

Emerging markets suffer from widespread price indexation and significant inflation expectations. In other words, when the currency falls, inflation rises, and when inflation rises the economic system attempts to respond by raising wages, and then raising prices. The 1970s concept of a wage-price spiral has meaning.

Because emerging markets have widespread wage and price indexation and alert inflation expectations central banks cannot exploit ‘temporary’ increases in the inflation rate by reducing real interest rates and stimulating demand, as they do in the developed world. Central banks, as we have seen in Brazil, Turkey and South Africa, have to respond to devaluations by tightening policy in order to prevent an increase in the underlying inflation rate.

EMs have what are called soft currencies, which is one of the three subsets of currencies in the global core-periphery paradigm that we talked about in our Jan 17’ MIR Vicious or Benign? To recap, these are:

  1. The reserve currency which is currently the US dollar.
  2. Hard currencies, that come from countries that can lend to themselves at competitive rates. These tend to be net-importers of commodities. Hard currencies generally act as safe-havens during periods of risk-off.
  3. And soft currencies. Soft currencies tend to be commodity producers. They are countries that have to borrow in other currencies at higher rates. These currencies depreciate during periods of risk aversion.

So… EMs are countries with soft currencies whom have to borrow in foreign hard money (typically dollar or euros) and therefore run into debt repayment problems when their currencies fall AND… due to widespread price and wage indexation, suffer from higher inflation when their exchange rate drops forcing their central banks to carry out procyclical tightening (ie, raising interest rates into a crisis) which causes a spiraling negative economic shock.

These conditions are what lead to the standard balance of payment (BoP) crises that EMs go through seemingly every few years.

A typical BoP crisis looks like this:

  • Rapid economic growth attracts large capital inflows from foreign investors chasing higher returns.
  • This capital flows into equities and hard currency denominated debt.
  • The strong domestic growth leads to a rise in imports which creates a current account deficit (more imports than exports) which then needs to be financed by more foreign capital flows.
  • Eventually, growth slows and debt reaches levels that cause foreign investors to become concerned about the country’s ability to service it and pay it back.
  • This causes the hot money flows to reverse, which drive the currency down, making the hard currency debt more expensive to repay, which causes more hot money outflows, in a crushing positive feedback loop.
  • This goes on until the central bank raises interest rates enough to steady the currency and domestic demand collapses which brings imports back below exports, thus balancing the current account.

This is what we’re seeing variations of occuring in EM now, specifically in Turkey and Argentina.

But here’s why this time is going to be different.

You see, in the past, an EM BoP crisis led to a painful but typically very short, economic contraction where the economies and markets experienced v-shaped recoveries. The 97’ Asian crisis being a perfect example.

They were able to do this because they were rapidly expanding their share of global exports from a low base. A devalued currency meant more attractive exports which meant rising profits and a quickly balanced current account (exports greater than imports). This enabled EMs to deleverage and grow their way out of trouble.

Sri thiruvadanthai of the Jerome Levy Institute wrote about this in one of his recent papers (emphasis by me).

Given this background, it is clear why globalization, especially the period 2000-08, was so beneficial for EMs. Globalization allowed EM exports to DMs to grow exponentially, relaxing the BOP constraint. Moreover, increased capital flows allowed EMs to build their foreign currency reserves, further weakening the BOP constraint. The process of building reserves also fueled demand for safe assets, depressing yields in DMs and extending the unsustainable process of debt-fueled growth in the DMs. However, the EM boom of the 2000s was in part supported by an unsustainable debt driven growth in the DMs. Thus, when the financial crisis of 2008-09 forced DMs to deleverage, it undermined a key pillar of EM growth. The weakness of DM growth post 2008 and the plateauing of offshoring and outsourcing meant that EM export growth hit a wall. Initially, EMs were able to counteract these headwinds by running large fiscal deficits and by turning to domestic profit sources. As we have seen in a previous section, domestic profit source growth requires domestic credit creation. Unsurprisingly, EM credit growth exploded post-2008, and not just in China. The limits of EM domestic demand-driven strategy were reached sometime in 2012-14, and since then EM economies have been struggling.

EM’s structural growth limitations can be boiled down to the following:

  • EMs are BoP constrained. Since they have soft currencies — meaning, they can’t finance current account deficits in their own money — they can’t grow faster than their exports for an extended period of time. Because, a current account deficit leads to a build up of hard currency debt, hot money outflows, and a BoP crisis.
  • EMs have maxed out their market share of global exports. EMs now comprise over 50% of global non-commodity exports (see chart below) and further export share growth will likely be from one EM cannibalizing another. Globalization has peaked and with increasing trade tensions, we should even see a reversal of some of the outsourcing and offshoring that’s occurred over the past two decades.
  • EMs are facing a significant debt burden amid tightening global liquidity. EMs are weighed down by a large amount of debt which they’ve accumulated in financing their current account deficits over the last decade, and much of this debt is dollar denominated. Rising US interest rates and a strengthening dollar will continue to put pressure on EMs going forward.

(Image via Bridgewater)

Then of course there’s a deleveraging China, which has been a big source of demand growth for EMs over the last decade but won’t be any longer.

So EMs are in a tough spot going forward. They need to rebalance their economies and boost domestic demand since they can no longer rely on exports as a serious source of growth. But, until they can get other countries to accept their currencies as payment, they will remain BoP constrained by their soft currency which won’t allow them to grow faster than their export growth. Which, as we’ve discussed, is going to be low.

I see a lot of investors and financial journos talking about how now is a good time to buy EMs. They’re all playing off the old EM playbook and are expecting a v-shaped recovery which is not going to materialize. What will, is a slow moving economic contraction with occasional country specific crisis that will frustrate investors trying to bottom pick.

Select EMs will make for incredible asymmetric investments once the next cycle begins in a few years time. By then, I expect the narrative to have completely flipped from where it is today and EM in general will be a hated and completely discarded asset class. That’s when it’ll be a good time to buy.

Lastly, here’s some good charts that show some of the headwinds EM is up against in the coming years.

A large amount of EM corporate high yield USD debt is maturing in the coming years. As the dollar continues to strengthen, the global dollar shortage will become more apparent and EMs will suffer for it.

(Image via Bloomberg)

Global investors put money in EM stocks and bonds (which are generally seen as riskier) because they are chasing higher relative growth and thus, higher returns. When their growth is declining relative to that of DMs then there’s little reason for investors to invest in EM. This is part of the core-periphery paradigm (charts via MS).

Over the last few years, there’s been a huge amount of hot money flowing into EM equity and debt. There’s still plenty of capital that needs to be unwound.

There’s going to be a reflexive global growth feedback loop in all this. EMs today make up a much larger share of global growth than they did 20-years ago. A slowdown in EM will drive a slowdown in developed markets which will reduce EM export growth, further constraining their ability to grow and so on.

(Image via Bridgewater)

(Image via Bridgewater)

 

 

The Gerschenkron Growth Model

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

On November 18, 1956, during a reception at the Polish embassy in Moscow. Soviet Premier Nikita Khrushchev declared to his audience of Western diplomats that “We [the Soviet Union] will bury you.” This was not a military threat but rather an economic boast. And it was a remark taken very seriously by the West.

The Soviet economy delivered exceptionally high growth rates in the decades following WWII, far outpacing developed Western nations. This growth mesmerized Western academics, policymakers, and intellectuals with its astonishing pace. The Soviet Union was hailed as an “economic miracle” and many became convinced that the Soviet’s Command and Control economy was far superior to the West’s capitalist system… and that it was only a matter of time before the Soviets became the largest economic power in the world.

This was not a fringe belief. In fact, it was the mainstream narrative and accepted as a matter of certainty. Acemoglu and Robinson relate in their book Why Nations Fail, that:

The most widely used university textbook in economics, written by Nobel-prize winner Paul Samuelson, repeatedly predicted the coming economic dominance of the Soviet Union. In the 1961 edition, Samuelson predicted that the Soviet national income would overtake that of the United States possibly by 1984, but probably by 1997. In the 1980 edition there was little change in the analysis, though the two dates were delayed to 2002 and 2012.

Unfortunately for Samuelson, his prediction somewhat missed the mark. Not only did the Soviet Union fail to surpass the US in economic supremacy, it actually went bankrupt (twice!) in the following decades before finally disintegrating as a geopolitical power.  

But in the 70s, while the Soviet economy was beginning its slow descent into irrelevance, another “high growth” country took center stage, quickly becoming Western economist’s new infatuation: Japan.

Japan’s period of high growth lasted nearly three decades. And because of this economic prowess, Japan was also called an “economic miracle”. Economist, politicians, and intellectuals wrote many a books and thought pieces on the superiority of the Japanese economy to that of the laissez faire capitalist system of the West. And once again it became accepted as a matter of fact that the Japanese economy would soon surpass the US in size.

Here’s some excerpts from a NYT article printed in 1991 titled Leaders Come and Go, But the Japanese Boom Seems to Last Forever, that gives you a good sense of what the common narrative of the time was.

At a time when the American economy is struggling with recession, the Japanese economy has just completed its 58th month of uninterrupted growth.

Setting the new record may not have been an occasion for parades or speeches, but economists are calling this one of the greatest booms in recent history, a period that has not only fundamentally altered the Japanese economy but sown the seeds of even greater friction with the United States. Some have taken to calling this period Japan’s second economic miracle, as important as the one that turned a war-devastated nation into an industrial powerhouse.

Japan is a different country today than it was five years ago,” said Kenneth Courtis, senior economist with Deutsche Bank in Tokyo. “It will become even more evident in the 1990’s. The Japanese economy has so much momentum that, competitively speaking, the 1990’s will be over in 1995. The West won’t be able to catch them after that.” As Mr. Courtis put it, Japan has grown economically by the equivalent of one France since 1985, or by one South Korea each year. Its manufacturers invest more every year in new plants, equipment and research than American companies, though the American economy is some 40 percent larger than Japan’s.

This is the change that is likely to make Japan an even more threatening competitor for American companies, many of which used the immense wealth created in the 1980’s to benefit their investment bankers rather than investing aggressively in the future. Japanese companies are expected to increase their capital investment budgets this year… Mr. Courtis estimated that Japanese companies spent about $625 billion on such investments over the last five years, a sum it will take American companies nearly 10 years to spend.

Of course, we know now that “competitively speaking, the 1990’s” didn’t end in 1995… as senior economist Kenneth Courtis so confidently predicted. Instead, 1991 (when this article was printed) marked the peak of the Japanese miracle economy. What followed was the popping of a gargantuan asset bubble followed by decades of painful deflationary economic contraction.

Richard Koo, wrote in his book, The Holy Grail of Macroeconomics: Lessons From Japan’s Great Recession, that falling land and stock prices alone, accounted for the destruction of 1,500 trillion yen in wealth; a figure equal to the entire nation’s stock of personal financial assets or 3-years of GDP. This makes it the greatest economic loss ever in history by a nation in peacetime.

So much for miracles…

Do the economic miracles turned nightmares of Russia and Japan remind you of any similar majority consensus today? Hmmm?

It should, and for good reason. China is following the exact growth model used by both 1960s Russia and 1980s Japan. It’s called the Gerschenkron growth model and China has implemented it to a T, differing only in its intensity and scale which is unprecedented.

And like Japan and Russia before it, China’s economic “miracle” is anything but.

The China deleveraging is going to be the most important macro driver of markets in the years ahead. Emerging markets, commodities, precious metals, the dollar… all be affected by it. Understanding this thematic will help you better understand market moves as a whole. This is what we’re focused on and will be covering extensively in the months ahead.

The above is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

 

 

The ONE Thing…China’s slowdown and the rough road ahead for EM

I think this is one of the more interesting charts in markets right now. It’s a monthly of the MSCI Emerging Market Index (EEM). The chart shows EEM breaking out to the upside of a 10-year wedge last year before reversing back down and testing the upper line of support. It’s down approximately 12% on the year.

The big question is whether this retest offers an excellent risk-to-reward buying opportunity or if this is the start of a larger downward trend.

I believe it’s the latter. Here’s why…

The selloff has widened the US/EM valuation gap, making EM stocks very attractive on a purely relative valuation basis (chart via Topdown Charts).

This notable valuation gap has spawned the popular market narrative that buying the EM dip is the ‘prudent’ to thing to do. Here’s some financial headlines from over the last few months.

This narrative has led to a large amount of capital flowing back into EM following the 2015/16 China scare (chart via IIF).

And here’s the big tell… Capital flowed out of EM from 14’ to 16’ as China was trying to slow its debt growth. That capital then came rushing back into EM as China injected massive amounts of liquidity into its economy in early 2016.

Looking at China’s fixed asset investment (FAI) by state owned enterprises (SOEs) provides a good measure of their fiscal policy, as SOEs are their preferred channel for juicing economic growth by building more high speed rail, bridges, and even entire cities.

You can clearly see the instances where China opened the FAI spigots (orange line) in 09’, 13’, and 16’. Following each of these instances, investment flows came pouring back into emerging markets.

There are two reasons for this (1) China is a large economy and comprises roughly a third of the MSCI EM index and (2) China has become such a large source of global commodity demand that when it slows its leveraging (ie, reduces its frenetic pace of building) that drop off in demand reverberates throughout the rest of the world, hitting EM growth particularly hard.

The graph below via KoyFin shows how Asian, and in particular Chinese stocks, dominate the top 10 weighted holdings of the index.

Knowing how important China is to the wellbeing of EM, it should be concerning that its preferred method of adjusting demand has collapsed from 23.5% yoy growth last year to just 1.5% growth today — its lowest level in 15-years.

This slowdown in China’s leveraging — we can’t call it a deleveraging yet because it appears their rate of debt growth is just stalling and not reversing yet — is largely what’s behind the diverging economic growth projections for the US and EM.

While everybody is focused on the Fed raising interest rates and quantitative tightening— an important variable because of its effect on the USD exchange rate — hardly anyone is talking about the potential impact of a critical drop in Chinese growth and demand.

This is probably because (1) The China bear argument suffers from “Chicken Little” syndrome. People have been calling for China to implode for nearly two decades now and yet the country has managed to keep trucking along and (2) Everyone assumes that China will just keep mainlining credit at each hint of economic instability.

But there’s increasing evidence that things are different this time around. That, in fact, Xi and the CCP are committed to fixing the imbalances in their economy and stomaching the necessary pain that goes along with doing so.

If we’re correct, this will have critical second and third order impacts on the rest of the world.

Hedge fund manager, Dan Loeb, once said that “A key rule in investing is that you don’t necessarily need to understand a lot of different things at any given time, but you need to understand the one thing that really matters.”

China is that one thing that really matters now in global markets….

This month we’re kicking off what will be a three part Macro Intelligence Report (MIR) series where we’ll dive into the investing implications of a wide scale China slowdown, covering everything from its impact on commodities and precious metals, to currencies, and the housing bubbles in places like Canada and Australia.

In this month’s report we’re going to start off by discussing how China and emerging markets in general have exhausted their easy growth channel of expanding their share of global exports. And then we’re going to dissect how China’s economic “miracle” is no miracle at all but rather the result of a standard cycle in the typical “Gerschenkron model” of economic development; one which has occurred time and time again throughout history and which has always, in every instance, resulted in a large, painful, and prolonged economic crisis.

We’re then going to dive into Chinese policy and share with you the evidence from Xi, the CCP, and underlying data on why we think this time is different, and the signals we need to look for going forward.

Then of course, the trading and investing implications… We’ll layout the case why gold is going to $1,000, oil is going to sub $56bbl, and AUDUSD is going to 0.60.

We’re also going to talk about why we are still bullish US stocks and then pitch two beaten down misunderstood US tech companies that offer extremely attractive asymmetric opportunities to the long side. Finally, we’ll cover a highly contrarian short trade on a popular US listed Chinese tech stock.

If you want the scoop on China be sure to sign up for the MIR at the link below.

Click Here To Learn More About The MIR!

There’s no risk to check it out. We have a 60-day money-back guarantee. If you don’t like what you see, and aren’t able to find good trades from it, then just shoot us an email and we’ll return your money right away.

China’s the most important macro situation to understand right now. Getting it wrong can mean years of subpar returns and underperformance. Don’t get caught on the wrong side of the boat! By reading this month’s MIR, you will be prepared for the worst and positioned to profit off of a full out Chinese collapse.

Click Here To Learn More About The MIR!

 

 

Value Investing Is Dead, Long Live Value Investing

Value investing hasn’t performed so well this cycle. Here’s a chart showing value’s relative performance versus that of growth.

The value-factor strategy pioneered by Fama and French, which consists of buying stocks with the lowest valuations and selling those with the highest has produced a cumulative loss of 15% over the past decade, according to Goldman Sachs.

This is the longest stretch of underperformance for the value-factor strategy since the Great Depression.

And as to be expected, this prolonged drudgery has spawned the hyperbolic “Death of Value Investing” narrative that seems to come around at some point every other cycle.

What I find interesting though is that this “death of value” narrative doesn’t seem to be affecting the value fund managers I talk to. They mustn’t have gotten the memo because they seem to be doing just fine — actually, much better than fine with most of them beating the market by a wide margin this cycle.

Which of course begs the question: why the large performance gap between what’s considered classical value (ie, the Famma-French method of buying statistically cheap stocks) and select discretionary value fund managers who’ve been hitting it out of the park?

The answer is two-fold.

  1. Quantitatively arbitraged: Back in Benjamin Graham’s day getting hold of a company’s most basic accounting information was difficult. Figuring out classical value metrics such as price to book and price/earnings required a great amount of effort (the information simply wasn’t readily available). Today, every Joe Schmoe has access to free quantitative screeners that scan, decipher, and rank every stock in the world according to a long list of metrics. If a stock sells for a low price to book or earnings yield then it almost certainly deserves it. Put simply, the widespread availability of quantitative systems has arbed much of the alpha out of looking at the popular valuation metrics.
  2. Asset-light economy: Famed value investor, Bill Nygren of Oakmark Funds, recently wrote that “as the economy has become more asset-light, intangible assets — such as brand names, customer lists, R&D spending and patents — have become more important.” Nygren goes on to note that “the relative importance of tangible assets compared to intangibles has completely flip-flopped from what it was 40 years ago” and that now, intangibles “account for over 80% of the average company’s market value.” The funny thing is, standard GAAP accounting doesn’t even attempt to measure these assets!

So the headlines above decrying the death of value investing are right… at least sort of. Classical quantitative value investing has become a packed house and the edge has been competed away. But value investing still lives on… just in a new and evolving discretionary framework.

The core-tenets of value investing remain the same. The goal is still to buy companies at below the present value of their future cash flows. But the frameworks used for discerning this value have changed.

Value fund manager Joel Tillinghast puts the aim of value investing as this, “I’m looking for companies that are increasing the amount by which their intrinsic value exceeds their accounting values. This difference is called economic goodwill.”

Discerning “economic goodwill” takes discretionary research and deep thinking. It’s not easy and you won’t find a metric for it on any quantitative website, which is largely why it works.

The value managers that are thriving in this environment are the ones who’ve recognized this changing dynamic and have evolved their process along with it. This group of adaptable managers includes the old Oracle himself, Warren Buffett, who has said, “My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely on economic goodwill.”

As a global macro operator I’ve been fascinated with the changing landscape in value investing. Though we don’t ascribe to a certain narrow and rigid approach to markets, such as being strictly fundamental or trend following practitioners etc…Our approach at Macro Ops is, and always has been, to make high risk-adjusted returns by whatever means necessary. And value investing is one of these means.

Because of this, I’ve spent the last few years studying and dissecting the habits, practices, and frameworks of the very best in this evolving value investing landscape.

And in this month’s Macro Intelligence Report (MIR) I’m going to share all that I’ve learned. We will discuss the foundational principles of value investing and then I will walk you through MO’s framework for seeking out and properly analyzing highly asymmetric value investments. We’ll then apply this framework to three deeply mispriced value stocks that I’ve been digging into the last few months.

All three have multi-bagger potential and won’t pop up on any standard quantitative value screens. They are examples of where the quantitative metrics and GAAP accounting numbers obscure their true potential.

If you want access to my top three value stocks for August 2018, sign up to the MIR at the link below.

Click Here To Learn More About The MIR!

There’s no risk to check it out. We have a 60-day money-back guarantee. If you don’t like what you see, and aren’t able to find good trades from it, then just shoot us an email and we’ll return your money right away.

The S&P looks ready to break out to new highs on the back of strong US economic data. I think these three multi-bagger value stocks can start their run as soon as next week. Don’t miss out, sign up for the August MIR by clicking the link below.

Click Here To Learn More About The MIR!

 

 

Has The CCP Turned Off The Tightening?

It looks like China may be folding…

We’ve talked all year about how China is THE largest driver of markets this cycle and their deleveraging was the force behind the widening performance gap between the US and the rest of the world.

The continuation of this trend has been dependent on China’s willingness to stay the course and press on with much needed financial and economic reform. A reversal of policy would be seen as a failure and a direct hit to Xi’s credibility.

Cue recent reports indicating the CCP can’t take the heat and has decided to ease once again. Here’s Bloomberg on China’s policy U-turn (emphasis by me).

China unveiled a package of policies to boost domestic demand as trade tensions threaten to worsen the nation’s economic slowdown, sending stocks higher.

From a tax cut aimed at fostering research spending to special bonds for infrastructure investment, the measures announced late Monday following a meeting of the State Council in Beijing are intended to form a more flexible response to “external uncertainties” than had been implied by budget tightening already in place for this year.

Fiscal policy should now be “more proactive” and better coordinated with financial policy, according to the statement — a signal that the finance ministry will step up its contribution to supporting growth alongside the central bank. The People’s Bank of China has cut reserve ratios three times this year and unveiled a range of measures for the private sector and small businesses.

“It is now quite clear that Beijing has fully shifted its policy stance from the original deleveraging towards fiscal stimulus that will be underpinned by monetary and credit easing,” said Lu Ting, chief China economist at Nomura Holdings Inc. in Hong Kong.

China’s State Council plans to raise local government spending by roughly 1.35 trillion yuan (roughly US$200b) to be spent primarily on infrastructure this year.

And the tax cuts aimed at boosting consumer spending are equivalent in size to the tax cuts passed last year in the US — not an insignificant amount.

Why has China decided to backpedal on what was one of Xi’s and the Party’s top stated goals last year?  

It seems there’s increasing fear at the top of losing control of the economy and this fear is being exacerbated by the escalating trade war. Chinese State media recently warned that China’s judiciary should prepare itself for a possible spike in corporate bankruptcy cases as a result of the trade dispute with the US.

The South China Morning Post (SCMP) recently shared the following (emphasis mine):

In an opinion piece published on Wednesday by People’s Court Daily, Du Wanhua, deputy director of an advisory committee to the Supreme People’s Court, said that courts needed to be aware of the potential harm the tariff row could cause.

“It’s hard to predict how this trade war will develop and to what extent,” he said. “But one thing is sure: if the US imposes tariffs on Chinese imports following an order of US$60 billion yuan, US$200 billion yuan, or even US$500 billion, many Chinese companies will go bankrupt.”

As Chinese courts have yet to have any involvement in the trade dispute, the fact that the newspaper of the nation’s top court, ran an opinion piece – for a judiciary-only readership – suggests concerns might be rising in Beijing about the possible socioeconomic implications of the row.

There’s also been a number of reports (so far, unverified) over the last few weeks of serious trouble brewing within the party. Geopolitical Futures recently shared this.

Last Friday, online reports indicated that gunfire had been heard for roughly 40 minutes in Beijing near the Second Ring Road. The reports claimed it was a violent spasm by groups that sought to overthrow Chinese President Xi Jinping. The following day, French public radio reported it had heard rumors that former Chinese leaders, including Jiang Zemin and Hu Jintao, had allied with other disgruntled Chinese officials in an attempt to force Xi to step down. A Hong Kong tabloid went so far as to suggest that Wang Yang, chairman of the Chinese People’s Political Consultative Conference, might be the compromise leader next in line.

It’s impossible for us to know if there’s any truth to these rumors (China keeps a tight lid on these types of things) but just the fact that they’re circulating are indication of growing unease with the state of the Chinese economy. And it may be why we’re seeing this policy 180 by the CCP.

We also don’t know if this easing will be enough to reverse the negative trends kicked into gear by the initial deleveraging nor do we know how long and aggressive the CCP will be in this round of easing. All we know for sure is that however they choose to carry out policy will continue to have an outsized impact on markets and the global economy.

For our part, we just have to keep a close eye on the data and change up our positioning to account for the new uncertainty created by this shift back to easing.

Two important data points we’ll want to watch in order to gauge the scale of the current easing response are fixed asset investment (ie, infrastructure spending) and China’s M1 money supply (which has a close leading correlation to changes in industrial metal pricing).

 

 

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The Principle of Bubble Rotation

In the book Business cycles: history, theory and investment reality, the author Lars Tvede talks briefly about a cycle phenomenon he calls The Principle of Bubble Rotation. He writes:

There is one further common aspect of all these asset classes. We have seen that business cycles from time to time create monetary environments that are conductive to asset bubbles. However, people will recall past crashes for a while, and this means that whatever asset people bought in the last bubble will rarely be chosen for the next. This leads to a systematic bubble rotation. There was a bubble in precious metals/diamonds in 1980, for instance, and then in collectibles (and Japanese land) in 1990, and then in equities in 2000.

Essentially, what Lars is saying boils down to, “what outperformed in the last cycle will not outperform in the next.”

Since trading and investing is a game of comparisons, we evaluate all assets on a relative basis and then choose to buy one thing over another. Using The Principle of Bubble Rotation we can underweight assets/sectors/industries that may look attractive at first glance but are unlikely to outperform for the simple reason that they did so in the prior cycle.

Let’s look at the outperformers from the last cycle and see how they’ve done in the current one.

The top performing assets/sectors/industries in the 02’ to 08’ cycle were:

  • Emerging markets
  • Homebuilders
  • Financials
  • Commodities

So far each of these assets/sectors/industries have adhered to The Principle of Bubble Rotation.

The reasons why this cycle skip exists are three fold:

  1. Psychological: Investors who were burned buying into a bubble in the previous cycle are likely to be hesitant to buy into those same assets in the next. We call these “event echoes” where the psychological scarring from a jarring market event affects investor behavior well into the future. This usually takes two cycles to reset because most investing careers don’t last much longer than that.
  2. Capital Cycle: Asset bubbles are born from overoptimism. This optimism attracts capital and competition which leads to large amounts of capital expenditure into future supply. This leads to over-capacity which takes the subsequent cycle to clear.
  3. Regulatory: There’s a regulatory cycle that is always fighting the last war and which typically goes into motion following the bust process where many investors were hurt or financial instability occurred. Take banks following the GFC or cryptos following the current bust process as an example. These regulations typically take the completion of another cycle before deregulation occurs.

The Principle of Bubble Rotation isn’t a hard and fast rule. There’s examples where it didn’t hold true and certain industries are susceptible to their own unique capital cycles which affect the length of their boom/bust process.

Still, it’s a useful heuristic to use for filtering down your universe of potential trades. It would have kept you from buying financials this cycle, which has been a popular but dead money trade. Also, it would have alerted you to areas of the market that were more likely to outperform since they underperformed in the previous cycle; the technology sector being a perfect example.

 

 

Trading Is Simple, Not Easy… and a 320%+ oil trade

Good trading is simple, just not easy.

Literally, successful trading can be boiled down to these few words from the original OG, Amos Hostetter.

Cut your losers short, and let your winners run…

This old trading axiom has been repeated throughout time by all the greats. It’s also continuously ignored by nearly everybody.

It’s not that people don’t get it or they don’t think it’s a good principle. Traders talk about how important it is all the time… yet, very few consistently apply it.

The reason why is because it’s incredibly hard to do. It goes against hundreds of thousands of years of our evolutionary neurological wiring.

Evolution wired us to be so risk averse that our instinct is to avoid losses at all costs… even small ones. It’s easier for us to renege on our risk points and let the dice roll in the hopes that price comes back our way; at least until the loss becomes painfully unbearable, our uncle point is hit, and we tap out in despair…  

On the flip side, we’re wired to want to take profits quickly because we count those paper gains as already ours and the psychological pain of losing them instinctively outweighs the perceived value of sitting on the position in hopes of further gain.

This is all part of Prospect theory that was first put forth by Kahneman and Tversky. Wikipedia describes the concept as, “a behavioral economic theory that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known. The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics.”

We’re wired to cut winners short, and let losers run.

We evolved to be bad traders. Trading is simple, just not easy.

You may say, “well, yeah… cutting losers short and letting winners run is important but it’s hardly the whole kit and kaboodle…”

And technically you’re right. Cutting your losers short and letting your winners run isn’t everything… It’s just pretty close to being everything.

You also need to be an independent thinker; be able to develop contrarian ideas; possess mental flexibility, be able to hold multiple opinions and weight them effectively — the whole strong opinions weakly held idea.

But, really, all these mean nothing if you can’t do the basics of cutting your losers short and letting your winners run. And most can’t.

This trading maxim is so important because of the bunchy nature of market returns. Portfolio returns follow a natural power law. This power law exists in all of nature. It’s Pareto’s 80/20 rule… and in markets, it’s more like 90/10.

This means that over time, 90% of your profits will come from 10% or fewer of your trades. For example, if you’re a good trader and you place 100 trades a year, 90 them will be small losers and small winners that will effectively cancel each other out. And just 10 will account for the vast majority (90%) of your nut for the year.

This is an ironclad law. It’s true for everybody. If you study the returns of any of the greats (Buffet, Druck, Soros, Tepper, Livermore etc…) you’ll see the same 90/10 distribution of returns.

Cutting losers short, and letting winners run works because it’s in harmony with this natural power law that’s inherent to markets.

Cutting losers short cuts off the left-tail distribution of losses — yes, losers will follow the same power law if they aren’t cut short. And letting winners run let’s you fully exploit the right tail events; those 10%’ers, the fat pitches, the ungodly asymmetric trades… that only come down the pipe every so often.

But back to this not being easy to do.

It’s not only not easy because we’re psychologically wired to want to instinctively do the wrong thing. But it’s also just really hard to sit and hold through a monster trend.

Take W&T Offshore (WTI). This was a trade that we recently took full profits on. It ended up being one of our 10%’ers for the year — though far from being our biggest winner.

We first pitched our high conviction bullish oil call in August of 2017. It was clear to us that the market and popular bearish oil narrative we’re completely detached from the developing fundamentals.

We bought into WTI in August for around $2.18.

Over the following 8 months, WTI’s stock price increased over 320%, to just under $9…

We 30x’d our risk on the trade. (Our stop was at $2.00.)

This is what we consider a good trade. But sitting for the full gain was not easy. During the 8-month 320%+ rise, we had to sit through two 30%+ drawdowns and countless 5-10% drawdowns along the way.

Meanwhile, we had to endure these large pullbacks all while the majority of the market was telling us a host of very good and smart sounding reasons for why we were wrong; why the correct position was to be bearish on oil — being a contrarian is NEVER easy.

It was tough to follow the foundational trading principle of cutting your losers short, and letting your winners run… specifically, the latter.

But that’s necessary to being a good trader. You have to have the discipline to sit on your winners, ride through the inevitable pullbacks, and weather the storm as long as your reasons (for us it’s always a confluence of macro, technical, and fundamentals) for being in the trade are still valid.

This is the only way you can harness the power law of the markets and exploit it to your benefit.

Chess Grandmaster Josh Waitzkin wrote in his book The Art of Learning that:

It’s rarely a mysterious technique that drives us to the top, but rather a profound mastery of what may well be a basic skill set.

This couldn’t be any truer for trading. The best are the best because they are really good at harnessing the 90/10 power law of markets and utilizing it to their advantage. They do this by cutting their losers short, and letting their winners run.

We were fortunate enough to outperform the market during the first half of 2018. And we did so because we stuck to the basic principles of profitable trading and letting the 90/10 power law play out.

Tomorrow night, we’re throwing a live special event: How We Beat The Market In The First Half of 2018. Tyler, my partner here at Macro Ops, will be showing you guys exactly how we navigated through a tough and volatile year to produce multiples of what the S&P 500 has delivered to passive buy and holders. It’s going live at 9PM EST on June 28th.

Click here to register for this event!

On top of a full breakdown of our 2018 trading, he’ll also be updating you guys on our DOTM option strategy as well as our best practices for drawdown management. Until we hit that big trade in WTI, we had a lengthy multi-month drawdown which would’ve been impossible to endure without our drawdown management techniques.

Finally, you’ll hear how we’re positioning into year-end, and where we expect to find our next 10%’er. You don’t want to miss this!

Click here to register for the live event!

 

 

The Data Says This Bull Market Still Has Legs

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

Over the next 12-18 months we expect the US market to outperform the rest of the world as we head into the final stages of this economic expansion.

Once a quarter we like to review our US macro indicators to see if they confirm or reject our primary macro thesis. Here are the latest readings.


Liquidity:
US liquidity is near its cycle highs (meaning, it’s extremely loose). This is very bullish US risk assets and should prevent emerging markets from going into full-blown crisis mode. This indicator will turn over well before this bull market ends.


LEI (Leading Economic Index):
The Conference Board LEI, which tracks a basket of US economic indicators, is still in a strong uptrend on both an absolute and YoY basis. This indicator will roll over well before we enter a recession.


CLI (Composite Leading Indicator):
Our US composite leading indicator shows the US economy is in an accelerating expansion which should continue into the end of the year.


Inflation ROC:
The 3-month annualized core inflation rate has come down from its Jan/Feb highs, which sent interest rates shooting up. A slower change in inflation eases up pressure on yields and is bullish for stocks.


Advisor Sentiment:
Advisor sentiment has reset from its excessively bullish Jan/Feb highs and is now giving a neutral reading. This is supportive of stocks moving higher.


BAA Yield ROC:
The rate of change in yields has come down from its highs at the start of the year but it still remains elevated. This indicator is in neutral/headwind territory for stocks.


AAII Sentiment Survey:
Bullish sentiment has completely reset since the beginning of the year and is now supportive of stocks moving higher.


S&P 50-day MA Spread:
The percentage of SPX stocks above their 50-day moving averages is in overbought territory. It can and probably will move higher from here but we should be on the lookout for a pullback in the next few weeks as the short-term trend is becoming extended (chart via Bespoke).


Summary:
The US economy is strong and growth is accelerating. All our leading economic indicators are giving positive readings making the odds of a recession in the next 12-months extremely low. Liquidity is still flush which is supportive of the broader trend higher in stocks. Market sentiment has reset from its highs reached at the start of the year. All this means that the primary bullish trend in US stocks is supported by the data and the primary path of least resistance remains up.

However, over the short-term, the trend is overbought and the ROC in yields is elevated. This makes the market more susceptible to a selloff over the next few weeks. A selloff would reset both of these and give us a good opportunity to add risk. There are numerous catalysts that could spark a selloff this week ahead. We have CPI and DPRK Summit on the 12th, the FOMC meeting on the 13th, and June OpX on the 15th.

The above was an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

 

 

Why You Should Be Focused On India & Commodities

In this video we talk about why India (INDA) and commodities in general are the next huge investment trend. To understand why, we need to understand the S-curve. Macro Ops has a detailed article on this topic that I’ll link to in the comments. Be sure to check it out!

As people’s wealth increases, they buy more nonessential goods. As they do so, they consume a lot more commodities, including oil, gas, wheat, copper, and livestock. The growth in commodity consumption is exponential at this point.

We can actually predict when this will happen by tracking the GDP per capita of a country. Once the country hits a certain level, which is around $2,300 to $3,300 GDP per capita, their commodity consumption takes off. This happens in energy, but also in agriculture, where populations begin to increase their meat consumption. Raising livestock is over seven times more grain-intensive than producing for a simple plant based diet. That’s why we also see agriculture explode as well.

We’ve already seen this S-curve phenomenon happen in China (FXI). The last secular bull market in commodities which started in the early 2000’s and ended in 2011, occurred as China hit the S-curve take off point. If you bought the commodity index in 2000, right as the tech bubble was bursting, you would have compounded your money at over 20% annually over the following decade.

India is about to hit that point. Their GDP is exactly where China’s was in 2001, right before the last commodity bull market began. The country also has a population of over 1.3 billion people, just 60 million shy of China’s. Because of this, we think we’re about to enter the largest period of commodity demand growth the global economy has ever experienced.

Watch the video above for more!

And as always, stay Fallible out there investors!