Capital Flows and Asset Markets

Unlike almost anyone else I know, my route to finance was via a currencies. I was working in HK in 1998, when the currency peg came under attack, and was fascinated by the way it affected interest rates and stock markets. I went back to university and wrote my thesis on private currencies (HK is last place in the world where private banks issue banknotes) and applied for a job at UBS. I then built a successful hedge fund business basically arbitraging currency risk via equities, and at the time I imagined the crowning glory was to be heavily short into a massive Chinese devaluation in 2016 - but this was not to be - and ever since currencies have traded in ways that they did not do previously. I will give some examples, and then go into how I think the riddle has been solved.

The Australian dollar used to follow its terms of trade pretty closely. Commodity prices up, Aussie dollar up. From 2016 this relationship has broken down.

This breakdown between the currency and terms of trade led Australia to book huge trade surplus - something never really seen in Australia before.

For many years, Yen was seen as a safe haven currency - doing well as when the S&P 500 was weak - but in 2022 it weakened ever as the S&P 500 fell.

The market was so convinced of this relationship, this led them to record long positions in Yen last last year, which has disappointed again. I refer to long Yen as the new widowmaker trade.

Korean Won used to be highly correlated to SOX Index (a measure that tracks the performance of semiconductor stocks), but in recent times Korean Won has weakened even as semiconductor shares have been on an astounding bull run.

Similarly, Taiwan current account surplus has ballooned.

And yet the Taiwan dollar remains unmoved.

I have been brooding over the markets for the last few days. Something that always happens when I my hedges don’t work quite as expected. And I think I have an answer of sorts. I have previously described the period from 1980 to 2016, as a pro-capital era, when “globalisation” policies - free movement of capital, labour and technology did much to create pools of capital, and a broadly deflationary environment. Politically, was this a grand bargain between the West (Europe, Japan and the US) who were all major oil importers. They all agreed to disinflationary (pro-capital) policies to bring about lower oil prices. By the late 1970s, all three regions were large importers of oil, so politically this was possible.

But around 2016, the US became energy exporter as shale production surged. Currencies stopped working the same way. If pro-capital globalisation policies were designed to give the US access to cheap energy but shale made cheap energy possible, then the US no long needed pro-capital policies, which is exactly where US politics has moved to. The problem, which the Iran War makes clear, is that while oil and natural gas prices are problem for the rest of the world, is it not such a big deal for the US. This is particularly true for natural gas. If you start thinking about currencies as a play on energy security - it gets very hard to be bullish on Yen, Won or Taiwanese Dollar. They are all exposed to natural gas supply issue.

This also answers another currency riddle - while Japanese Yen no longer acts as a safe haven - Switzerland does. Switzerland generates a substantial amount of energy from hydro electricity and nuclear power plants. The Swiss Franc has been very strong.

Thinking about currencies from an energy/geo political point of view also seems to work for currencies like Brazilian Real, which is now energy self sufficient. Historically this has not been a strong currency - but it has been surprisingly stable in recent years.

When I think about currencies politically - I see two outcomes coming. One is a bifurcation of the energy system - where Middle East and Russian output largely flows to China and India, while US and Australia output flows to Europe and American allies in Asia. The second is a huge focus on building domestic power sources - from renewables, batteries and nuclear. A secure energy system is now the route to wealth. Iran War makes this even more obvious. China probably leads most of its Asian peers in having a secure energy system - which probably explains why its currency is is much better shape than anyone else’s in the region.

This probably explains why the “weak dollar” trade has been such a bust. The big currencies like the Euro, Yen, Won and Pound have relatively poor energy security, making sustained dollar weakness difficult. But the relative lack of energy security in these nations probably also helps explain the strength of gold. Ultimately the implication is that Europe and East Asia need to launch huge investment programs to secure energy supply. Cost of capital should keep rising - but that does not mean the US dollar needs to fall.

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It has been plain that a war with Iran has been coming for awhile. The question was what would it look like? Would it be a Venezuelan style coup d’état? Or would a popular uprising sweep away the ancien régime? Or would it become a quagmire. Two weeks in, and the likelihood of the first two outcomes, which would have been ideal, are looking less likely, and a quagmire is becoming more likely. In market terms, this can be seen in the 12mth oil future is now beginning to break out.

Even US January 28 natural gas futures are starting to look a bit perky.

Both these signals are important as they will guide non-middle eastern producers to whether it is worthwhile to increase production or not. As said above, it was clear that some sort of conflict was coming between the US, Israel and Iran, but it was not clear what the result would be. A civil uprising, would mean the world would be awash with Iranian oil in a few years, while conversely a quagmire is plainly bullish energy prices. I generally assume my portfolio would do okay - but the first two weeks has seen some surprising correlation breaks.

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After I closed my last fund, and spent a few years thinking about how the world works, I realised that politics trumps macro. And even when it looks like macro is winning, it just that the politics is allowing it to win. First of all, I recognise that all the doom scrolling headlines on Iran could be true. And maybe its USD 200 a barrel going forward. But politically, Iran looks cooked, and so I feel like taking some shorts off here.

When I look at the Israeli stock market, it is hard to see any signs of war pressure in this market. In fact it is at all time highs.

The Economist has a good article on why Israelis would feel so secure. Iranian offensive ability has been severely degraded, with not only the amount of munitions being launched by Iran falling, the numbers actually making through falling precipitously. They have also resorted to mainly drones from missiles, which are far less powerful.

Israeli does import oil but is self sufficient in natural gas production. The Israeli market fell in 2022 after Russian invasion of Ukraine and spiking energy prices, so market action today seems to reflect a much better security position for Israel. But if Iran is a spent force - why is oil up another USD 12 today?

Clearly, Iran is still able to disrupt shipping in the straight of Hormuz. The question is how long can it do so? Tricky question, but there is some precedent. When Russia invaded Ukraine, it effectively closed off Ukrainian grain exports via the Black Sea. Eventually Russia agreed to some exports, but then withdrew and promised to target any ships carrying grain. Ukraine was still able to export grain through the use of drone and missile attacks on Russian assets. Wheat spiked when the invasion started and then collapsed.

The point of this analogy, is that assuming that the Straits Of Hormuz will be closed for an extended period seems to me to be a very poor bet to make, if Russia was not able to stop Ukraine from exporting grain, why would you think Iran would be able to close this Strait against the military might of the US and Israel for a prolonged period of time?

What I am far more concerned with is that the oil spike creates GFC conditions again. Spiking oil from 2006 to 2008 caused monetary policy to be tightened.

Which then caused credit market to implode and credit spreads to blow out.

Which ultimately created a “DEFLATIONARY” event, which ultimately means the only safe asset is government bonds. That is the question I really worry about. And even post GFC, long bonds and short equities worked well in various deflationary events, like the cratering of the Shale patch story, or fears of Chinese devaluation. But since Covid, the market has said that government policy is set towards inflation. So far 30 year JGBs continue to indicate is an inflation market.

Japan 10 Year JGBs are saying the oil shock is less of a shock that the Trump tariffs in April last year.

To my mind, and as Israeli stock market shows, inflation still is the main trade, which is not necessarily bad for equities. I certainly have a mixed views on equities. But the one assets class that still looks wrong is government bond yields. Why lend to the US government for 30 years at 4.7%? Or Japan at 3.4%?

I am not sure how other people are positioned, but I still can’t see a better way to think about things that seeing a world of rising cost of capital. I think the big problem that Iran has with closing the strait of Hormuz is that it ushers even more “non-carbon” and non-Middle Eastern energy supply on stream, which weakens their strategic bargaining power even further. The OPEC shock proved the power of the Middle East and Soviet Union in the 1970s, I cannot help but feel feel that the 2020s oil shocks are likely to prove the exact opposite.

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It was a war we knew was coming, but had no idea how it would start or end. Would it be one and done like Venezuela, or would somehow this be a new Iraq, a quagmire with no end? The problem with prognosticating on the war today, is that so many players have an interest is spreading disinformation. This mean basing any view on what you hear from other people is a waste of time. Anyone who really knows what’s going on will not be talking anyway. That being said, markets have a way of knowing the truth. So what are markets saying?

Japan and Korea have been by far the weakest markets since the war in Iran started. Nikkei is down 8% this month - but as any day trader or amateur market technician would tell you, so far not even a correction in an uptrend.

Kospi 200 is a meatier 20% this month, which meets the definition of a bear market - but again still in an uptrend.

No prizes for guessing the catalyst. Asian LNG prices have doubled in the last two days.

Kospi VIX is now at 80, which is a level ABOVE Covid shock levels, and in line with GFC levels. No doubt some issues with autocallables are at play here, but that is a very elevated level.

To me it still looks more like a degrossing or margin call issue. Popular/momentum longs get cut, and popular/momentum shorts get bought. With Korea, the big driver has been memory prices. No weakness yet.

In Japan, at least for me, the driver has been a weak yen and rising yields. Yen is still weak.

And 10 year JGBs are still in rising trend.

What you could argue is that Japanese and Korean equities are indicating that the Iran war is going to drag on, and energy prices are going to sky rocket back to 2022 levels. That could be true - but when I look at Israeli equities - they seem to imply that the war is going pretty well.

Israeli shekel is also very strong. In the fog of war, these seem pretty good indicators, as I strongly suspect Israeli knowledge of the war far outpaces knowledge anywhere else.

One lead indicator I have liked for a while is the relative performance of Japanese banks. Again price action here looks corrective more than anything else. And this indicator has regular corrective moves.

Fog of war is the correct term here. But war tends to be inflationary - so not necessarily a negative for what I am positioned for. Also AI which is a big driver of markets can be seen as strategic military asset - so that driver of the market would be unchanged, which also positive for Korea.

For my autocallable obsessed friends out there (you know who you are) - Nikkei divided futures have barely fallen. A real autocallable crisis needs these to tank.

Right now the risk is the war gets worse but there is a risk it gets better too. The Trump game plan is to obviously keep decapitating Iranian leadership until he gets someone who will play ball.

Looking at markets - degrossing is killing winning trades this year. But I dont see any trend changes.

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The current catalyst for a market shift is the war in Iran - and as it is a crisis, the market thinks all moves are temporary. For me, crisis tends to accelerate what the market is doing anyway. In the 40 year bull market in bonds, there were always crises, which would drive yields lower, but that was just an acceleration of what was an obvious trend. In hindsight the deflationary crises of the S&L Crisis, the Tequila Crisis, the Asian Financial Crisis, the Dot Com Bust, the GFC, the Euro Crisis, the Emerging Market Crisis, the Covid Crisis and ever falling yields were two sides of same coin. Economic crisis was welcomed (in a way) as it drove deflation and lower yields.

What I am arguing is that we now have had a political shift from pro-capital to pro-labour shift. What that means is governments intervene to make sure that employment and wages do not fall. And with the obvious increase in defence spending that is required by every government, the political motivation and physical ability is there. That is government can and probably should mop up any excess labour to build out defence and AI infrastructure. This is the new world, and what is exciting about the current “Iran Crisis” is that bond yields are rising, not falling, just as this thesis would predict.

We have now seen this new dynamic in bonds a few times. Under Prime Minister Truss in the UK, and during the Liberation Day sell off under President Trump. To me the old world of falling interest rates and deflation is dead. What is interesting, at least to me is that markets are taking their time to price in this world. Or as I explain to investors, in the old world markets constantly mispriced currency moves. In the new world, markets constantly misprice yield risk.

There are lots of ways to look at this shift, but one of the most profound ways is to think about where pools of capital sit. For 30 or 40 years now, big pools of capital have formed at institutions - be they endowments, retirement funds, sovereign wealth funds or corporate balance sheets. These huge pools of capital drove the cost of capital lower. Central banks acted to encourage this fall. During the worst of the Ben Bernanke led QE mania, central banks literally printed money to give to corporates. This represented the pinnacle of the idea that corporates and corporate managers are the best people to decide how money should be invested. The irony, which almost every man on the street understood, but was seemingly lost on the Central Bankers, was that corporates took all this extra money, and mainly used it for share buybacks as this was a risk free route to wealth, rather than actually risk money to invest. If you look at US durable good orders, the entire QE era was marked my minimal investment. Donald Trump may want a Nobel Peace Prize, but for me giving Ben Bernanke the Nobel Prize in Economics was a true travesty and devalued its worth forever. Not only did his economic ideas directly contribute to the GFC, his ideas led to huge growth in wealth inequality and the rise of populism. I struggle to think of greater failure in public life than Ben Bernanke. I digress. In recent years, as pro-labour policies have take over, investment has surged again, just as QE has receded. And more and more capital should be pooled at households, rather than in institutions.

So if QE did not lead to investment, what did it lead to? Well clearly it led to the “de-equitizaition” of markets. I found this good graph in a Blind Squirrel presentation, so have pilfered it (to be fair, it looks like it was pilfered from Hussman, who pilfered it from S&P. No honour among thieves!).

So with long and short book, I look for ideas that respond well to this new pro-labour world. I think I have found a couple more shorts.

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One of the problems with getting older, is that you see similar market set ups, and you start thinking “uh-oh” I have seen this before. I am certainly getting 2007 deja vu all over again in February. Before I get into all that, let me tell you how we did in February.

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No doubt this will confuse my American readers. I can see themselves saying “Why is this guy talking about a failed short?” Generally speaking my American’s friends advice to me is to talk about how awesome you are, and never show weakness. I have spent enough time in the US to understand why that is sound advice in American cutthroat corporate culture. But my brand, if that’s the right word, is to be straight with people, and to write about what I am thinking about. So here we go.

I shorted a company, because I could see it was involved with CLOs and corporate debt. Generally speaking companies in this area have traded poorly this year, but amazingly, this company has now managed to solicit competing bids to buy it. A bid for a company that I am short is not necessary a failed thesis. You often see bids for companies at the top of the cycle as CEOs can see earnings growth is weakening, and hope to offset that via an acquisition. This almost never works by the way. That is why often an acquiring company can make a good short - and that what we are going to look at today.

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I suspect in a special hell just for hedge fund managers, they are forced to run net short all the time. Making money shorting is tough - and even when it goes well, it can so easily reverse. While stocks can surge higher every day without a correction, I have never known a short not to bounce with perhaps one exception back in the GFC era which just fell 90% in a month.

This year, despite the US being flat year to date, the short book has made money. Should I just cover?