Capital Flows and Asset Markets

I have a lot of time for Brad Setser. In a recent FT article he claimed that China was still buying treasuries, but just via policy banks rather than as official foreign reserves. He provides this chart to support his view. Not the most intuitive chart, but basically the red line goes up when the Renminbi goes up, showing that banks in China buy more treasuries when the Renminbi goes up. The implication is that the banks are trying to slow the appreciation of the Renminbi.

His article claims state banks bought USD 170bn of treasuries in December and January. This is a big number. For context, reported official holdings of US treasuries by China fell by USD 600bn over 10 years, and these number would suggest 25% of this fall was reversed in two months.

To be fair, China is running a USD 1.2 trade surplus, so if they choose to sterilise this flow, then there has to be a LOT of buying of something. Given the freezing of Russian foreign reserves in 2022, I would have assumed that China would not buy treasuries, and just gold. This has been one basis for the GLD/TLT trade - which has worked great.

The FT article is a shorter version of an article that Brad published earlier this year. The most interesting chart would be this one, which basically says that China is back at peak net foreign assets.

I always find China a funny place. Its definitely not an open western democracy, so knowing what exactly is going on is not always easy. But these days, trying to fully understand US economic policy is also not that easy either. But one thing about China is that the government generally tells you what it plans are, and then does it. So I think China is still trying to get out of it US assets - its problem is that it runs a huge trade surplus, and these trade surpluses are controlled by corporations and individuals. When they see the Renminbi appreciate, they want to bring money back to China, which forces the State banks into offsetting trades. And the Renminbi has appreciated this year.

The problem China has is that its currency does look cheap now. If we ignore the US, China’s trade surplus with Europe is at record highs.

But the EURCNY cross rate remains at close to 10 year highs.

By comparison, China runs a trade deficit with Japan.

But the JPYCNY cross rate is at 30 year lows. That is CNY is strong.

To my mind, China might be buying treasuries to offset retail and corporate buying of Chinese Yuan. But this is in part driven by the much bigger macro mystery - why are other Asian currencies so weak? Yen has been weak, but so has Korean Won even as Korean exports of semiconductors surge.

For me, the Chinese numbers I understand. And the Renminbi is strong in an Asian context. But why is the Korean Won or Japanese Yen not stronger? Korean official holdings of treasuries are at new high.

What I think is happening is that big nations of the world - US, Europe and China have turned pro-labour. Which means they want a strong currency. But Korea and Japan, remain pro-capital, which means they want a weak currency. Both have surging stock markets as well. If Japan and Korea ran pro-labour policies, I am sure their currencies and the Renminbi would be stronger too. To my mind, Chinese government has not changed policy - they do not want treasuries - but with such a huge trade surplus, when the Renminbi does appreciate it forces treasury buying by the banks to offset retail flow. The more interesting feature will be when Japan and Korea get serious about raising real wages. Then I think the real fireworks in the Treasury market will begin.

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I have seen various short selling markets in my career. The first one, the dot com bust, was driven by over investment in a huge variety of internet and telecom assets. The second bear market I saw was the GFC - which at its heart was overinvestment in the housing market. The third was the commodity and emerging market sell off, which again was driven by overinvestment. By then, myself and markets had learnt that overinvestment was where stock markets went to die, and so began the great private equity, buy back market. Investors wanted companies to raise prices, cut spending to the bone, and return cash where ever possible. Large corporates did this, and so did private equity. To be honest, I hated this model, particularly in the tech space - how can a tech company not invest? But companies like Broadcom, which were serial acquirers and cash strippers did fantastically well.

Broadcom has kept capex at a ridiculously low level, even as operating cashflow surged.

But when I look at markets now, I think an interesting change is taking place. Companies are getting punished for NOT spending enough in my view.

It is remarkably common to hear 50 something investment managers and strategists to compare the current AI boom to the dot com bubble. For those too young to remember - the dot com bubble burst in 2000, and the S&P 500 had three down years in a row.

There were many poster childs of excess from that period, but perhaps the best was Cisco. Everybody needed to build an online presence, and a thousand start ups were buying equipment. When the bubble burst, the starts up ended up selling their equipment, and there was a huge over hang of equipment. Cisco shares imploded.

Back in 1999, the growth in demand was driven by a surging IPO and equity issuance. That is companies were taking advantage of the high valuations to sell shares and to go buy equipment. When the market tanked, demand tanked with it. While share count of the S&P 500 has risen a bit, it is far less than in 1999/2000.

Alternatively, if I steal a chart from the internet, equity issuance is not driving the AI boom.

In fact, we know that the AI boom is being driven by relatively few companies.

We can and should throw OpenAI and Anthropic into the spenders here as well, but what we know is that these will be big numbers too. In the dot com boom, once investors tired of buying speculative IPOs the capital spigot turned off. But for the AI boom to turn off, you need the CEOs of Oracle, Microsoft, Google, Meta and Amazon to turn off the taps. How likely is that? For a company like Microsoft, and with market views on software, the questions may well be existential. For the first time in a long time, I can see a world without Microsoft in it. That is Microsoft can no long afford to not invest. And this makes it true for all the other players.

In fact the problem for the hyperscalers is that there is not a winner yet. Much like the streaming wars, they all need to spend big until a winner is set. Even though Netflix and Disney shares have been poor, they are still fighting over content. Witness the bidding war for Warner Bros Discovery.

In essence, what I am saying is the dot com bust was driven by a lot of established firms rushing into the internet without knowing what they were doing, and so equally quickly rushed out. The AI boom is being driven by companies that know what they are doing, and cannot afford to lose. I expect the spending to keep coming.

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During my formative years in finance, I learnt to be a “currency first” investor. Basically, I noticed most equity fund managers tended to get currency risk totally wrong, so if I got that right - I should outperform. It has taken a few years to shake off this “currency first” mentality. But I was going through some slides from my friends at 36 South (full disclosure, I am their landlord in London - but I was friends with their head of trading George Adcock, before they became tenants), and was reminded that if I was still a currency first fund manager, I would probably be shitting the bed at the moment. First of all, most currency options are trading cheaply. This implies people are not worried about big moves, just at they were in 2007, 2014 or 2020. (If you would like to see these slides - they are available on Youtube. Link is here.)

People are also bullish.

And cash balances are very low.

And credit spreads are tight across the board.

One graph I liked a lot showed that we are probably at peak dovishness when it comes to central banks. Looking at the top table, the only way seems to be up from here.

And something I have seen many people flag - energy sector is threatening to turn.

From a currency perspective, cross rates like AUDJPY are at levels that would make me worry.

What to make of all this? Well in a free market world, currency led investing works well. But in a government dominated market, currencies are not “free”, and growth is fiscal spend dominated. The question is working out which regime we are in. I still like JGBs as a signal - and even though the 10 year is not above recent highs, it still seems to be speaking to inflation - or a fiscal dominated growth environment.

So what is the bear p@rn then? Well in the final 36 South charts, rather than a bear market, they talk of rotation. Below is signalling short tech, long energy.

And this one is signalling short bonds and long energy.

In currency first regimes, I liked to think about second order affects of currency moves. To me, and looking at 36 South charts, in a fiscal first regime, we should think about second order effects of bond moves. Thankfully, I am already positioned for it.

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I have been bearish on private equity, partly because they stopped returning cash to investors even though markets are at all time highs, and partly because I thought the cost of capital rising would be bad for them. For corporates, cost of capital has not really risen. Over the last couple of years, high yield costs have fallen quite a lot.

Despite falling capital costs, private equity stocks have been pretty weak. KKR is representative.

So what is going on? Well partly, the market has been radically reassessing the credit worthiness of software investments. Like with all things private equity - its not that transparent, but we know there are problems out there. We have had shenanigans in EA bonds, with private equity investors trying to shaft debt holders. Since this purchase, games and software stocks have been hammered.

So is there anyway to judge if private equity really is in trouble with its software exposure? I think there is.

The reason I was known at the most bearish fund manager on the planet back in the day, was that I ran the emerging market bull market all the way up from 2002 to 2007, and was pretty sure emerging markets were going to be a huge waste of time going forward. This view was correct as MSCI Emerging Markets has only recently surpassed the highs of 2007nearly 20 year later. Are Emerging Markets worth chasing from here?

Back in 2007, MSCI Emerging Markets were dominated by banks, commodity stocks and mobile phone stocks. Today, the top five stocks are tech related, with TSMC being by far the biggest constituent. While back in the day emerging markets may have offered some diversification benefit - these days you are making the same bet you are with US stocks - which does reduce the attraction.

The boom in emerging markets from 2002 to 2007 was also driven by spread compression. The Asian Financial Crisis of 1998, the Argentinian and Brazil devaluation crisis of 2001 and 2002 had caused investors to shun EM debt - by 2002, you were getting 8% over treasuries, which fell to 1.5% spread in 2007. Today, EM spread is 2.25% - outside of 2007 the tightest spread I have ever seen.

Some parts of the commodity cycle has boomed but it is extremely narrow. If we look at the Australian Terms Of Trade - we can see very little recent improvement.

While we are all aware of the boom in precious metals, major industrial commodities are still very weak. Chinese steel prices, which was a great proxy for Chinese commodity demand remain at prices first seen in 2003.

Chinese pork prices which drive surging agricultural commodity prices in 2021/2 remain at levels first seen in 2007.

On the currency side, the appreciation of the Chinese Yuan recently does make a positive background for EM assets.

But Chinese interest rates are not sending a confirming message. 12m SHIFOR remains at lows.

Also old currency pairs that have moved with commodity cycles before are back at levels that suggest caution. AUD/JPY is at levels seen before the Asian Financial Crisis, the GFC and China devaluation scare.

Long Emerging Markets does not seem like a slam dunk trade to me. But if you like the argument that AI is shifting spend from software to hardware, then long EM versus S&P 500 makes sense - but that is very different to a traditional emerging market bull market.

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As mentioned in my last post, Eurohedge nominations often happen at inflection points in the market for me. So the recent nomination, has made me nervous that my theory that we are in a world of rising cost of capital could be played out, and it is back to deflation trades. On top of this, an investor I respect wrote to me to say he was going short QQQ, Long ZROZ (QQQ is the Nasdaq 100 ETF, and ZROZ is an aggressive long dated Treasury ETF). Further more, the Blind Squirrel is going long Africa. My first boss back in 2000 told me that when people buy Africa, we are getting near the top. So my anxiety is compounded. The biggest risk I think at the moment, is that I am not wrong, but we have a huge counter trend rally. First of all, we have to recognise that GLD/TLT has had a big move.

It has to be said in recent times, the vast majority of the move above has come from GLD being strong, and not TLT being weak. I was expecting weakness in TLT, but my friend who is shorting QQQ and going long ZROZ, says no one is positioned for a bond rally.

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I am bearish bonds, and I have built a portfolio around the idea that we will have rising inflation, rising yields and a rising cost of capital. The fund has had a good move last year, and a good move this year. So the question that has to be asked, is it done?

Firstly, in my experience, Eurohedge awards can mark the end of a trade. It has certainly been the case the three times I have been nominated before. This is a point of discomfort.

Secondly, the flagship trades for this fund HAVE done well. GLD/TLT has been good.

And Japanese Banks HAVE been good.

So lets sit down, and look at some of the reasons we could think the inflation trade could be over.

I am surprised by this. Performance has been good - but not that good. My nomination probably comes from maybe not that many funds launched last year or I have a great sharp ratio having not had a down month last year. Two other funds have been nominated.

Hunters Moon website says they specialise in financial stocks - so should have done well. Orgueil is run by former colleagues at Horseman, Stephen Roberts and Patric Slama. They had a good year. My only chance of winning will be a superior Sharpe Ratio. More on that later.

I have a long history with Eurohedge. My first fund - the Horseman Emerging Market Opportunity fund was also nominated and won best new fund for 2007 with an 80% return over 15 months (it launched late 2006) and can only be described as concentrated beta rocket. Beta gets a bad rap… but sometimes you want it.

The award ceremony was held in February 2008 and by that time, I had sold my beta rocket positions and started shorting some of them. I remember listening to the other EM fund managers that had won awards saying it was lucky January numbers were not included as many were down hard after big years in 2007.

As it turned out 2008 was a very hard year for EM funds. People were very long EM in 2008 and when the credit market froze, the dollar soared and EM credit spreads blew out. 50% losses where common. I had gone short and made 15% that year - and was one of three emerging markets funds that made money that year. I won the Eurohedge award for best Emerging Market fund for 2008.

If I had followed my strategy of reversing positions at the end of the year I would have made a fortune and would probably still be running that fund and writing this from my own private island. But it was not meant to be.

That year, I took over the Horseman Global Fund. And with a lot of work got it nominated for best long/short fund in 2015, only to lose to another fund on Sharpe Ratio. What's the deal with the Sharpe Ratio? To win a Eurohedge award you need the best performance - but cannot do it with leverage. So if your Sharpe Ratio is much lower than other nominated funds you won’t win. I feel like the Sharpe Ratio tells you more about the underlying volatility of your markets rather than the skill of the manager… but rules are rules.

Does being nominated for Eurohedge mean anything? Like above - should I be reversing my positions? Short gold and long treasuries - a depression trade again? Probably not - but there are a couple of similarities to 2008. First corporate bonds spreads are at very tight levels - just like in 2007.

Also EM bond spreads are also at very tight levels.

For me January and February 2026 performance has been so far so good. But if commodity prices continue to rise - the risk is inflation returns and bonds sell off - and its 2008 or 2022 all over again.

Anyway - thank you Eurohedge for the nomination. And this time, if I win, I will stop my mate from putting the trophy down his kilt at the drinks after ceremony. Good times.

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The Nikkei has been on an absolute tear over the last year or so.

I don’t have many longs, but over half of them have been in Japan.