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China’s Deleveraging Continues

We’ve been writing since the beginning of the year that there are two important macro drivers to markets at the moment. These are:

  1. China is actively trying to restructure its economy and end its incessant leveraging.
  2. A growing issuance of treasury paper, driven by a widening budget deficit and quantitative tightening, is sucking up global liquidity and creating a “crowding out” effect in other markets.

The market seems to be firmly focused on the second driver, the Fed. But, for some reason, still largely ignoring the many blaring warning signs in Chinese economic data — at least for the moment. This data is telling us that Xi and company are moving along with their stated goal of deleveraging.

The market appears to be operating on the old assumption that the CCP will just inject lots of credit into the system the moment things get rough. But, as we’ve been noting the last few months, this isn’t going to be the case.

Our baseline needs to be that China will continue to actively deleverage and attempt to reorganize its economy. This will continue to have increasingly profound effects on global markets. We should expect this story to play out until the end of 2019, at the earliest. That’s when the CCP is likely to reverse course and juice its economy so it can be strong in time for the Party’s centennial anniversary in 2021.

Let’s look at the charts.

The YoY change in the Global Manufacturing PMI has turned negative for the first time since 2015, bringing global equities lower with it.

Fathom Consulting’s Chinese economic momentum indicator (blue line), which has a positive leading correlation to commodities, has turned over and is heading lower. If you were wondering why crude oil prices have collapsed recently, this is one of the reasons…

China’s economy is largely dependent on exports. Well, it’s Export Orders Index recently fell to its lowest readings since 2015.

Earnings momentum in China has turned negative and is now at its lowest levels since 2015.

M1 money supply growth is at its lowest levels since… you guessed it, 2015.

There are increasing signs of deteriorating consumer sentiment and spending.

This slowdown is already being sniffed out by investors in US stocks with high exposure to China. Below is a chart that aggregates the return performance relative to the S&P of the 10 US companies with the highest exposure to China as a percentage of revenues. We can see that these companies have experienced massive underperformance as of late — similar to the years from 14’ to 16’. We should expect this trend to continue.

Bloomberg recently noted that borrowing costs for China’s high-yield issuers (most of whom are real estate developers) have doubled this year, and now sit at their highest levels in over four years. In addition, the property sector faces a record $18 billion in maturities coming due next quarter. And according to Bloomberg, “that number is expected to double if investors demand early repayment on some of these notes.”

One gets the sense that “the most important asset class in the world”, as Jim Chanos (and your author) refers to China’s property market, is about to get interesting.

Again via Bloomberg, “soon-to-be-published research will show roughly 22 percent of China’s urban housing stock is unoccupied, according to Professor Gan Li, who runs the main nationwide study. That adds up to more than 50 million empty homes, he said.”

The chart below shows just how extraordinary this is. Nearly everything in China, household wealth, business income, loan collateral etc… is directly linked to the property market — a market which has been used as the primary source of speculation by the masses for the last 20 years… and one which hasn’t been allowed to suffer material losses, ever.

Chanos estimates that Chinese residential real estate represents somewhere around a quarter of the Chinese economy. That’s roughly $3 trillion dollars or 4% global GDP.

Imagine the knock-on effects of an unwinding Chinese property market. Just think what that would do to commodities alone…

Xi Jinping made it clear what he wants when he said “houses are for living in, not for speculation.” We should probably pay attention.

What does all this mean though from a practical investing standpoint?

Well, over the longer-term (next 12-months) we should expect similar macro dynamics to those of 2015, or worse. The last time the Chinese materially delevered.

That means slowing global growth and rising deflationary pressures.

I recently showed the below chart from Ned Davis which is signalling an 80% probability of a global recession. And since 1970, when this indicator has given a reading above 70, we’ve ended up in a recession 92.11% of the time.

There are two main differences though between now and 2015. One is that this time around the US economy is much stronger. Secondly, positioning and sentiment are already fairly bearish on EM assets compared to 2014 when positioning and sentiment were quite the opposite.

Here’s a chart I made which aggregates all net speculative long US and USD synthetic positioning (orange bars) along with the S&P 500’s performance relative to emerging markets (EEM). You can see that when there’s significant spikes in bullish US asset positioning (orange spikes) it often coincides with a near-term top in relative US outperformance.

We recently saw our largest US long positioning spike since early 2016. That means investors are pretty crowded to one side of the boat. It’s not going to take much positive EM/China news (maybe hints at a potential trade deal or anticipation of renewed easing etc..) to cause a position unwind.

Whether this performance reversion lasts a week, a couple of months — or happens at all —  is anyone’s guess. But it’s something to keep note of. And we’ll just have to follow the tape and play the action as it comes.

We’ll consider playing some Chinese and EM names for a swing trade — IF they set up technically. Names like Tencent (TCEHY) and JD.com (JD) which have been obliterated over the last 6-months and are due for a strong bounce. And we’re currently long an Argentina bank (GGAL) with a tight stop.

Longer-term, the primary trade is to continue to be selectively long US assets, long USD positions, and short gold. It makes sense to move more money into defensive sectors, like XLP and XLU as well.

We should expect increasing market volatility in the year ahead and greater dispersion in stock returns (ie, a widening gap between winners and losers).

That’s all I got for now. The macro landscape continues to evolve at a rapid pace and I’ll update my views accordingly. Keep tabs on our research section of the website for the latest updates.

 

 

China Won’t Bail Out Global Markets This Time Around

I believe there are three important drivers to markets right now. Two long-term and one short-term. These are:

  1. China is actively trying to restructure its economy and end its incessant leveraging.
  2. A growing issuance of treasury paper, driven by a widening budget deficit and quantitative tightening, is sucking up global liquidity and creating a “crowding out” effect in other markets.
  3. Consensus long dollar / long US vs. RoW positioning and sentiment has set the stage for an interim bout of EM outperformance; before another reversal and devastating final sell-off.

We’ve written many times over the last few years about why China is THE most important macro variable this cycle. The reason is in the chart below.

China (orange line) has accounted for the majority of credit creation this cycle. They’ve been the global workhorse by leveraging credit driven demand. As a result, China accounts for over 50% of global GDP growth since the financial crisis.

China is now dead set on ending its super-sized leveraging cycle and transitioning to a more sustainable consumer-driven economy. We know this because President Xi Jingping has told us so as he did here in late 2016.

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.

Xi finished the above statement by saying the country had until the end of 2020 to make this transition.

Xi’s moves to finally tackle the debt are also clearly showing up in the data. We’ve been writing about it all year, here, here, here, here, here, here, and here.

This is a very big deal that is still largely being ignored by the market. Investors appear to be operating off of the old assumption that Xi and team will stimulate at any moment. But this won’t be the case. It’s very unlikely we’ll see a reversal in policy until the end of 2019, at the earliest. This will give them time to juice the Chinese economy going into the centennial anniversary for the Chinese Communist Party.

Until this happens, we’re going to see a bumpy road ahead for global markets.

Ned Davis’ Global Recession Probability Model is signaling an 80% probability of a global downturn. As noted on the chart, since 1970 we’ve seen a recession 92.11% of the time there’s been a reading above 70 (chart via CMG Wealth & NDR).

Morgan Stanley’s global Financial Conditions Index is rising and now sits at its highest levels since 2015.

And the Global Manufacturing PMI recently turned negative for the first time since the end of 2015.

Meanwhile, we have strong growth in the US — though it’s likely peaked for the cycle — and near record high equity valuations, combined with rising interest rates.

2019 is going to be an interesting year for markets…  

In this month’s MIR, we’ll be covering the opportunities and dangers that we see ahead. We’ll lay out the case for what we think is the most asymmetric macro trade in markets right now; discuss our process for short-selling and pitch some Icarus stocks we’re adding to our books, and then make the pitch for a Greenblatt style hidden value spinoff trade. If you want access to this research click 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 macro situation has become fast moving and turbulent. If the data continues to head south we can see a swift revaluation of all the high flying stocks that have driven this bull market. By reading this month’s MIR, you will have an idea of how to sidestep a potential collapse and even profit from it.

Click Here To Learn More About The MIR!

 

 

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My Notes on the Druckenmiller Real Vision Interview

Alex here.

The Druckenmiller Real Vision interview is well worth the watch if you have a subscription and 90 minutes to spare. And if you don’t, you’re in luck because I’m sharing with you my notes along with some of my thoughts on what the GOAT said.

Let’s begin…

The start of the interview was by far my favorite part and really blew me away.

Stanley Druckenmiller opened the conversation by looking straight into the screen and then spoke some words I’ll never forget. He said, “Alex Barrow, I am your real biological father…” My jaw dropped even though this was something I’ve always kind of suspected. I mean, just look at the photo of me and my dog below. The resemblance is pretty uncanny. It’s nice to finally know the truth for certain.

Now that I’m done showing off my photoshopping skills, let’s get to the real stuff.

13D founder, Kiril Sokoloff, leads the interview and he and Druck discuss a wide range of topics including his views on the current macro environment, the diminishing signal of price action due to the rise of algorithmic trading, central bank policy, and then my favorite which was his thoughts on trade and portfolio management.

Here’s Druck talking about the difficulty he’s been having in this low rate environment, and how he’s made the vast majority of his money in bear markets (with emphasis by me).

Yeah, well, since free money was instituted, I have really struggled. I haven’t had any down years since I started the family office, but thank you for quoting the 30-year record. I don’t even know how I did that when I look back and I look at today. But I probably made about 70% of my money during that time in currencies and bonds, and that’s been pretty much squished and become a very challenging area, both of them, as a profit center.

So while I started in equities, and that was my bread and butter on my first three or four years in the business, I evolved in other areas. And it’s a little bit of back to the future, the last eight or nine years, where I’ve had to refocus on the equity market. And I also have bear-itis, because I made– my highest absolute returns were all in bear markets. I think my average return in bear markets was well over 50%. So I’ve had a bearish bias, and I’ve been way too cautious the last, say, five or six years. And this year is no exception.

It’s no secret the central bank suppressed rate environment has hurt practitioners of old school macro, such as Druck and PTJ. When these guys began their careers they could park their money in 2-year rates and capture high single to double-digit rates.

Not only did this jack up their returns but higher interest rates and inflation caused more volatility and action in markets. And exploiting volatility is the lifeblood of old school macro traders. Like Druck said, he made his highest returns during bear markets.

The last decade of extremely low-interest rates and dovish Fed policy has suppressed volatility, leading to smoother trend paths. This has led to more capital flowing into passive indexing and less to active managers, which in itself helps to extend the trend of less volatile markets; at least to a point.

Eventually, this low rate regime will reverse. We’ll see higher inflation and a secular rise in interest rates. In fact, this is one my highest conviction ideas for the next secular cycle. The massive debt and unfunded obligations in developed markets, along with the secular rise in populism, nearly ensures that we’ll see profligate government spending and competitive devaluations in the decade ahead.

So we’ll see the rise of volatility and an environment conducive to old school macro once again!

Here’s Druck discussing the major macro thematics he’s been tracking this year.

I came into the year with a very, very challenging puzzle, which is rates are too low worldwide.

You have negative real rates. And yet you have balance sheets being expanded by central banks, at the time, of a trillion dollars a year, which I knew by the end of this year was going to go to zero because the US was obviously going to go from printing money and QE to letting $50 billion a month, starting actually this month, runoff on the balance sheet. I figured Europe, which is doing $30 billion euros a month, would go to zero.

So the question to me was, if you go from $1 trillion in central bank buying a year to zero, and you get that rate of change all happening within a 12-month period, does that not matter if global rates are still what I would call inappropriate for the circumstances? And those circumstances you have outlined perfectly. You pretty much have had robust global growth, with massive fiscal stimulus in the United States, where the unemployment rate is below 4. If you came down from Mars, you would probably guess the Fed funds rate would be 4 or 5/ and you have a president screaming because it’s at 175.

I, maybe because I have a bearish bias, kind of had this scenario that the first half would be fine, but then by July, August, you’d start to discount the shrinking of the balance sheet. I just didn’t see how that rate of change would not be a challenge for equities, other than PEs, and that’s because margins are at an all-time record. We’re at the top of the valuation on any measures you look, except against interest rates. And at least for two or three months, I’ve been dead wrong.

So that was sort of the overwhelming macro view. Interestingly, some of the things that tend to happen early in a monetary tightening are responding to the QE shrinkage. And that’s obviously, as you’ve cited, emerging markets.

We talked about this obvious market mispricing in our latest MIR, The Kuhn Cycle (Revisited). The old narrative of low rates for longer had become extremely entrenched. And this narrative consensus has created a certain amount of data blindness, as is typical with popular and enduring narratives. This data blindness has led to a large mispricing of interest rates, particularly in developed markets.

Where things get interesting is all the corollaries that stem from a low rate narrative like this. Think of the billions of dollars that have poured into private equity over the last decade. The current PE model is predicated on the assumption of interest rates staying low, which is needed for their businesses’ long-term funding needs and justification for their sky-high valuations etc…

A really interesting section of the interview is when Druck talks about the diminishing signaling value in price action. He says:

The other thing that happened two or three months ago, mysteriously, my retail and staple shorts, that have just been fantastic relative to my tech longs, just have had this miraculous recovery. And I’ve also struggled mightily– and this is really concerning to me. It’s about the most trouble I’ve been about my future as a money manager maybe ever is what you mentioned– the canceling of price signals.

But it’s not just the central banks. If it was just the central banks, I could deal with that. But one of my strengths over the years was having deep respect for the markets and using the markets to predict the economy, and particularly using internal groups within the market to make predictions. And I think I was always open-minded enough and had enough humility that if those signals challenged my opinion, I went back to the drawing board and made sure things weren’t changing.

There are some great nuggets in here. I’ve long thought that one of the most important skill sets of a great trader — and something Druck has in spades — is to be extremely flexible mentally; never marrying oneself to a viewpoint or thesis and continuously testing hypotheses against the price action of the market.

Market Wizard Bruce Kovner said he owed much of his success to this, saying:

One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed. You keep trying them on one at a time. Inevitably, most of these pictures will turn out to be wrong — that is, only a few elements of the picture may prove correct. But then, all of a sudden, you will find that in one picture, nine out of ten elements click. That scenario then becomes your image of the world reality.

And Livermore noted the importance of flexibility when he wrote, “As I said before, a man does not have to marry one side of the market till death do them part.”

Now compare this to the “Fintwit experts” who have peddled a doom and gloom outlook for the last 7 years without ever taking a step back to maybe rejigger the models they use to view the world, which have been so consistently wrong.

Anyways, Druck then goes on to lay out the cause behind the diminishing power of price signals.

These algos have taken all the rhythm out of the market and have become extremely confusing to me. And when you take away price action versus news from someone who’s used price action news as their major disciplinary tool for 35 years, it’s tough, and it’s become very tough. I don’t know where this is all going. If it continues, I’m not going to return to 30% a year any time soon, not that I think I might not anyway, but one can always dream when the free money ends, we’ll go back to a normal macro trading environment.

The challenge for me is these groups that used to send me signals, it doesn’t mean anything anymore. I gave one example this year. So the pharmaceuticals, which you would think are the most predictable earning streams out there– so there shouldn’t be a lot of movement one way or the other– from January to May, they were massive underperformers. In the old days, I’d look at that relative strength and I’ll go, this group is a disaster. OK. Trump’s making some noises about drug price in the background.

But they clearly had chart patterns and relative patterns that suggest this group’s a real problem. They were the worst group of any I follow from January to May, and with no change in news and with no change in Trump’s narrative, and, if anything, an acceleration in the US economy, which should put them more toward the back of the bus than the front of the bus because they don’t need a strong economy.

They have now been about the best group from May until now. And I could give you 15 other examples. And that’s the kind of stuff that didn’t used to happen. And that’s the major challenge of the algos for me, not what you’re talking about.

Well, I’ll just, again, tell you why it’s so challenging for me. A lot of my style is you build a thesis, hopefully one that no one else has built; you sort of put some positions on; and then when the thesis starts to evolve, and people get on and you see the momentum start to change in your favor, then you really go for it. You pile into the trade. It’s what my former partner George Soros was so good at. We call it– if you follow baseball, it’s a slugging percentage, as opposed to batting average.

Well, a lot of these algos apparently are based on standard deviation models. So just when you would think you’re supposed to pile on and lift off, their models must tell them, because you’re three standard deviations from where you’re supposed to be, they come in with these massive programs that go against the beginning of the trend. And if you really believe in yourself, it’s an opportunity. But if you’re a guy that uses price signals and price action versus news, it makes you question your scenario.

So they all have many, many different schemes they use, and different factors that go in. And if there’s one thing I’ve learned, currencies probably being the most obvious, every 15 or 20 years, there is regime change. So currency is traded on current account until Reagan came in and then they traded on interest differentials. And about five years, 10 years ago, they started trading on risk-on, risk-off. And a lot of these algos are built on historical models. And I think a lot of their factors are inappropriate because they’re missing– they’re in an old regime as opposed to a new regime, and the world keeps changing. But they’re very disruptive if price action versus news is a big part of your process, like it is for me.

If you’ve been trading for any significant amount of time then you’ve certainly noticed the change in market action and tone due to the rise of algorithmic trading over the last decade. There’s often little rhyme or reason behind large inter-market moves anymore. Moves can simply happen because, as Druck said, algos that run on standard deviation models determine one sector has advanced too much relative to another, so the computers start buying one and sell another.

What we can do as traders now is to evolve and adapt. Work to understand what the popular models are that drive these algos so we can understand when they’re likely to buy and sell.

Also, I love his line about how he works to build a thesis and a position when he says:

A lot of my style is you build a thesis. Hopefully, one that no one else has built; you sort of put some positions on; and then when the thesis starts to evolve, and people get on and you see the momentum start to change in your favor, then you really go for it. You pile into the trade.

This a great lesson in trade management and how to build into a position using the market as a signal.

Druck also talked about Google (one of our largest positions) and reveals how he looks at some of the tech stocks that are popularly thought of as “overvalued” by the market.

I guess, let’s just take Google, OK, which is the new bad boy, and they’re really a bad boy because they didn’t show up at the hearing. They had an empty chair because they only wanted to send their lawyer.

But it’s 20 times earnings. It’s probably 15 times earnings after cash, but let’s just say it’s 20 times. Let’s forget all that other stuff. And they’re under earning in all these areas, and losing money they could turn it off. And then I look at Campbell’s Soup and this stuff selling at 20 times earnings.

And they’re the leaders in AI– unquestioned leaders in AI. There’s no one close. They look like they’re the leaders in driverless car. And then they just have this unbelievable search machine. And one gets emotional when they own stocks, when they keep hearing about how horrible they are for consumers.

I wish everyone that says that would have to use a Yahoo search engine. I’m 65, and I’m not too clever, and every once in a while, I hit the wrong button and my PC moves me into Yahoo. And Jerry Yang’s a close friend so I hate to say this, but these things are so bad.

And to hear the woman from Denmark say that the proof that Google is a monopoly and that iPhones don’t compete with Android is that everyone uses the Google search engine is just nonsense. You’re one click away from any other search engine.

I just I wish that woman would have to use a non-Google search engine for a year– just, OK, fine, you hate Google? Don’t use their product, because it’s a wonderful product. But clearly, they are monopolies. Clearly, there should be some regulation. But at 20 times earnings and a lot of bright prospects, I can’t make myself sell them yet.

Kiril then asks Druck about portfolio construction and how he builds positions, which was one of my favorite parts of the interview.

Kiril: When you worked with Soros for 12 years, one of the things that you said you learned was to focus on capital preservation and taking a really big bet, and that many money managers make all their money on two or three ideas and they have 40 stocks or 40 assets in their portfolio.

And it’s that concentration that has worked. Maybe you could go into that a bit more, how that works, how many of those concentrated bets did work, when you decided to get out if it didn’t work, do you add when the momentum goes up assuming the algos don’t interfere with it?

Druck: As the disclaimer, if you’re going to make a bet like that, it has to be in a very liquid market, even better if it’s a liquid market that trades 24 hours a day. So most of those bets, for me, invariably would end up being in the bond and currency markets because I could change my mind. But I’ve seen guys like Buffett and Carl Icahn do it in the equity markets. I’ve just never had the trust in my own analytical ability to go in an illiquid instrument, which in equity is if you’re going to bet that kind of size on– you just have to be right.

But to answer your question, I’ll get a thesis. And I don’t really– I like to buy not in the zero inning and maybe not in the first inning, but no later than the second inning. And I don’t really want to pile on in the third or fourth or fifth inning.

But even against the dollar, it’s not all-in right away. Normally, I’ll wait for– I’ll go in with, say, a third of a position and then wait for price confirmation. And when I get that, when I get a technical signal, I go.

I had another very close experience with the success of the Deutschmark, which was the euro. I can’t remember– I think it was 2014 when the thing was at 140, and they went to negative interest rates. It was very clear they were going to trash that currency, and the whole world was long the euro. And it would go on for years. I’d like to say I did it all at 139, and I did a whole lot, but I got a lot more brave when it went through to 135. And that’s a more normal pattern for me.

We write a lot about the importance of concentrating your bets due to the natural power law distribution of returns (here’s a link).

This part of the interview was great because it shows how Druck uses a confluence of factors to leg into a trade. He says he develops a theory then waits for the market to begin to validate that theory and he puts a small (usually ⅓ position on). He then waits for further market confirmation that he’s correct (he calls this point the second inning) at which time he piles in and goes for the jugular.

The chart below illustrates perfectly his short EURUSD trade.

Here’s Druck talking about the 2000 tech bubble and what made him turn bearish.

Then there would be this strange case of 2000, which is kind of my favorite, and involves some kind of luck. I had quit Quantum, and Duquesne was down 15%. And I had given up on the year and I went away for four months, and I didn’t see a financial newspaper. I didn’t see anything.

So I come back, and to my astonishment, the NASDAQ has rallied back almost to the high, but some other things have happened– the price of oil is going up, the dollar is going way up, and interest rates were going up— since I was on my sabbatical. And I knew that, normally, this particular cocktail had always been negative for earnings in the US economy. So I then went about calling 50 of my clients– they stayed with me during my sabbatical– who are all small businessmen. I didn’t really have institutional clients. I had all these little businessmen. And every one of them said their business was terrible.

So I’m thinking, this is interesting. And the two-year is yielding 6.04, not that I would remember, and Fed funds were 6 and 1/2. So I start buying very large positions in two and five-year US treasuries. Then, I explained my thesis to Ed Hyman, and I thought that was the end of it. And three days later, he’s run regression analysis– with the dollar interest rates and oil, what happens to S&P earnings? And it spit out, a year later, S&P earnings should be down 25%, and the street had them up 18.

So I keep buying these treasuries, and Greenspan keeps giving these hawkish speeches, and they have a bias to tighten. And I’m almost getting angry. And every time, he gives a speech, I keep buying more and more and more. And that turned out to be one of the best bets I ever made. And again, there was no price movement, I just had such a fundamental belief. So sometimes it’s price, sometimes it’s just such a belief in the fundamentals.

Higher oil, higher dollar, and higher interest rates is likely to eventually lead to a negative earnings surprise for us as well; though that’s probably at least a few quarters if not further away.

Kiril then asks Druck about how he manages a drawdown. What he does emotionally and practically to stage a comeback.

Kiril: One of the great things I understand you do is when you’ve had a down year, normally a fund manager would want to get aggressive to win it back. And what you’ve told me you do, you take a lot of little bets that won’t hurt you until you get back to breakeven. It makes a tremendous amount of sense. Maybe you could just explore that a little bit with me.

Druck: Yeah, one of the lucky things was the way my industry prices is you price– at the end of the year, you take a percentage of whatever profit you made for that year. So at the end of the year, psychologically and financially, you reset to zero. Last year’s profits are yesterday’s news.

So I would always be a crazy person when I was down end of the year, but I know, because I like to gamble, that in Las Vegas, 90% of the people that go there lose. And the odds are only 33 to 32 against you in most of the big games, so how can 90% lose? It’s because they want to go home and brag that they won money. So when they’re winning and they’re hot, they’re very, very cautious. And when they’re cold and losing money, they’re betting big because they want to go home and tell their wife or their friends they made money, which is completely irrational.

And this is important, because I don’t think anyone has ever said it before. One of my most important jobs as a money manager was to understand whether I was hot or cold. Life goes in streaks. And like a hitter in baseball, sometimes a money manager is seeing the ball, and sometimes they’re not. And if you’re managing money, you must know whether you’re cold or hot. And in my opinion, when you’re cold, you should be trying for bunts. You shouldn’t be swinging for the fences. You’ve got to get back into a rhythm.

So that’s pretty much how I operated. If I was down, I had not earned the right to play big. And the little bets you’re talking about were simply on to tell me, had I re-established the rhythm and was I starting to make hits again? The example I gave you of the Treasury bet in 2000 is a total violation of that, which shows you how much conviction I had. So this dominates my thinking, but if a once-in-a-lifetime opportunity comes along, you can’t sit there and go, oh well, I have not earned the right.

Now, I will also say that was after a four-month break. My mind was fresh. My mind was clean. And I will go to my grave believing if I hadn’t taken that sabbatical, I would have never seen that in September, and I would have never made that bet. It’s because I had been freed up and I didn’t need to be hitting singles because I came back, and it was clear, and I was fresh, and so it was like the beginning of the season. So I wasn’t hitting bad yet. I had flushed that all out. But it is really, really important if you’re a money manager to know when you’re seeing the ball. It’s a huge function of success or failure. Huge.

This is perhaps the most important section of the interview. So much of being a great trader is learning to arbitrage time and I mean that in a number of different ways.

First, it means to analyze things on a longer timescale, to be able to pull back and look at the bigger picture, the broader trends, and not get hung up on a missed earnings or the latest news cycle. And secondly, it’s to have enough experience to be able to trust your process to the point that you know returns will eventually come to you if you just stick to your game. This form of time arbitrage means that you’re focusing on having a good return record over a 3, 5, and 10 year time period and you won’t go full-tilt if you’re down for a quarter.

Capital preservation always comes first and a strict adherence to a solid process produces good outcomes over the long pull.

That’s it for my notes. I tried to include all the sections that I thought were worth sharing though I’m sure I missed some stuff. Watch the interview yourself if you can. Here’s a snapshot of Quantum Funds returns; Druck took over in 88’.

 

 

Real Vision’s The One Thing With AK Fallible

Welcome to AK Fallible’s brand new show with Real Vision — The One Thing. Our first episode is called “The Crypto Conundrum”. Make sure to subscribe to our YouTube channel for more! https://www.youtube.com/c/Fallible?sub_confirmation=1

Be sure to check out our China’s Downfall series here: https://bit.ly/2Ig0JZz

Everyone seems to have an opinion on how much Bitcoin and all these cryptos should be worth…. It seems like everyone is in 1 of 2 camps as usual, yet another binary argument…..Either they think it should be the only thing with value in the world or it’s a zero…… Reality as usual is somewhere in the middle.

But how should we know what’s worth when we haven’t really defined what it is! First let’s talk about what it isn’t….

Well as of right now in 2018 it’s not a currency! The name Cryptocurrency is totally misleading! I can’t directly pay my mortgage with bitcoins, the IRS won’t accept Tax payments in bitcoin…

It’s not Gold either! How can you be called a store of value when you’re value gets destroyed at an almost unprecedented rate! Ethereum the world’s second largest Crypto is down over 80% from its January highs! Stability is key component of value storage!!!

It will also be key to see how cryptos do when the stock market hits the skids….. Gold typically acts as a safe haven in times of uncertainty, and catches a bid, will crypto?

Well then what is it were buying! We’re buying a speculative asset with a valuable technology.

The technology behind blockchain, can be a powerful tool for financial transactions in particular but were not there yet. And we don’t know what shape or form blockchain will look like when it’s widely utilized

To learn more, make sure you watch the video above!

And as always, stay Fallible out there investors!

Follow AK on Twitter: https://twitter.com/akfallible

And Instagram: https://www.instagram.com/fallible_money/

***All content, opinions, and commentary by Fallible is intended for general information and educational purposes only, NOT INVESTMENT ADVICE.

 

 

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).