Capital Flows and Asset Markets

The crappy bank trade has been pretty good for investors. I like it as well as it fits in with my view of a world that is turning pro-labour. This should push up the cost of capital, and benefit banks with large deposit franchises. Generally speaking crappy banks have been centred in countries with weak property markets, and low interest rates, Japan and Germany are probably the stand out markets here. Some banks have been crappy for so long, they attract nicknames. German lender, Commerzbank, has long been known as Comedybank. In the long deflationary funk after the Eurocrisis, I went back to the well many times to short Comedybank, but since 2020, it is up 1000%.

The macro problems with German and Japanese banks was that yields on government debt fell so much after the GFC, it was hard to make money. Movements in 30 year German bunds have pretty much decided where crappy banks like Comedy Bank will trade.

Japanese banks were also a byword for crappy banks, but have also been good places to be in recent years.

Like Comedybank, I would need to see lower JGB yields to be convinced the crappy bank trade is over.

What is spooking the market is signs of fraud in the commercial lending market. If I had to guess, the collateralised loan market, and the private credit market has grown a lot recently, and we are starting to see the fruits of lack of discipline on the lending side come through. The Janus Henderson BBB CLO ETF does not look a happy place.

As someone who has shorted a lot of banks, when a lending cycle goes wrong, it is the banks that grew the balance sheet the most that are going to see the most problems. Comedybank is not a great bank, but they have not been growing their balance sheet that much.

Where the problems are going to be are far more likely in private equity/private credit space. AUM in these areas are up 1000% from the GFC.

As far as I can see, there is a question mark over CLOs and Private Credit, which should impact this area, and it should give cover to central banks like the Federal Reserve to cut interest rates. But will turn into a full blown credit crisis? If oil prices were spiking, then I would be worried, but with oil at new lows, I reckon things will be okay.

The big issue is whether these cases are isolated frauds, or huge systemic issues. By systemic, I would mean the AAA tranches of CLOs were also zeros. So far that is not seemingly the case. The Janus Henderson AAA CLO ETF has held up well so far.

I can see markets selling off from here, as they have had a fantastic run. But an end to an inflation cycle? And the end of the pro-labour cycle? Seems unlikely to me. More likely interest rate cuts embolden politicians to spend. The (voting) public are not ready for an austerity cycle again.

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One of the first things you learn in finance is that VIX is a fear index. When VIX is going up, then markets should be going down. But a combination of AI and autocallables is turning the market on its head. The KOSPI 200 has surged recently, with the AI boom driving both SK Hynix and Samsung Electronics higher - both big constituents of the KOSPI 200.

But we have also seen the KOSPI VIX surge in recent days, with values only seen recently during large sell offs.

What gives? Well Koreans love autocallables, and last month saw record issuance. As a reminder, an autocallable is selling volatility to generate yield. A large issuance, should depress VIX.

KOSPI 200 as are the Euro Stoxx, the Nikkei, S&P 500, Tesla and Nvidia are all popular products. The higher the implied volatility, the higher the yield. A full list of popular underlying is below. The Korean below is for Samsung Electronics.

Autocallables have knock in and knock out levels. My guess is that the Kospi 200 has breached a popular knock out level of 500, which has meant that all the autocallables have been unwound and hence the structural selling of volatility has collapsed and hence the spike in KOSPI VIX. We see a similar thing with the Nikkei, even though it is at new all time highs.

The Nikkei in particular has been driven by AI related stocks - particular Advantest - to outperform the Topix by nearly 15% since the April low.

What does it mean? Well it all depends. If you think the move in AI is sustainable, then the rise in VKOSPI and VNKY is a selling opportunity, and markets will move higher. However, if you think AI is a bubble, then you are likely to see a whole bunch of autocallables get restruck at very high levels, just as the market is about to tank. We have one example of this from 2015, when autocallables got in to trouble after the Chinese market rallied then crashed.

I made money in the 2015 HSCEI autocallable sell off. One sign that things were going wrong was that the dividend futures (needed to structure autocallables) moved the opposite way to markets. I see this with HSCEI Dividend futures again.

And Kospi Dividend Futures.

Who knows, but the spike in VIX in a rising market is sign that the autocallable market is unsettled, and a negative surprise, like the apparent fraud at US regional banks, could drive much lower markets. A Korean, Chinese centred volmaggedon beckons.

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The title of this substack - Capital Flows and Asset Markets - comes from what was a successful use of the idea that capital flows drives asset prices. Long time readers or followers of my work would have seen many charts that looked at Net International Investment Position (NIIP) to explain why China was a short from 2011 onwards, or why Yen used to rally. I stopped using NIIP because US NIIP in my mind signalled trouble in 2016, and yet here we are ten years later, and the US NIIP has continued to explode higher. When a model fails, I move on.

The debasement trade is now all the rage, with silver becoming the focal point. Using NIIP, I would have thought a debasement trade was ready to kick off in 2016 and I would have been too early. What has changed? For me, there is no real difference between US NIIP being negative USD 10 trillion, or USD 26 trillion. So why now?

Long time readers will know that I have liked long Gold/short Treasuries for a while. The basic driver of that was that no central bank wants to hold treasuries anymore - which is more a political than macroeconomic argument. This has been borne out by the data.

And Chinese selling of treasuries.

But I was reading some research from Marko Papic from BCA research, and he pointed out the US primary income has turned negative. I have looked at primary income before, but mainly from the point of view it was always positive for Japan, which drove a bullish Yen view (wrong!). Looking at the primary income data, I am stunned by how large the US promary surplus grew in 2016, and then how much it has fallen in recent years.

Marko has normalised this to GDP, which I could do but as I am a lazy b*****d, I will just cut and paste his graph.

NIIP have become valuation driven. US NIIP is so negative, because US valuations are so high. But income is a cash driven number. It is not hard to work out why income balance has turned negative. Higher US interest rates means the US is paying much more to foreign treasury holders. If we just look at primary income payments, we can see that surge when the Fed raise rates in 2022 and 2004. This makes a lot of sense to me. In many emerging markets, raising interest rates often does nothing to defend the currency, as it just increase payments to foreigners outside of the county. It is only capital flow into assets that can turn a currency around.

Back in 2016, when I was looking at NIIP, and getting bearish US dollar and US assets, the primary income balance was a record surplus. Contrary to my view then, this would be bullish US assets in my view - and this has proven to be case. Also, if I was looking at the S&P 500 as a Japanese investor in 2016, I would think it was a no brainer to buy the S&P 500. It yield vastly more than the 10 year JGB.

But for the Japanese investor today, the S&P 500 looks unattractive, and with a negative primary balance, US assets do not look great. So looking at this together the debasement trade looks pretty good. It implies that the US needs to cut interest rates and/or do yield curve control to get back to a primary surplus, which is bullish gold. Or if interest rates are not cut, then US equities look unattractive, which is bullish for gold. Looking at gold v S&P 500, we still have a long way to move.

For gold bugs, or more sensible people like me that have been both long and short gold, the time to get worried seems to be when the US primary income surplus moves positive, as it did in 1980 and in 2011. We are a long way from there. Maybe I need to buy more gold?

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I have been pushing the GLD/TLT trade for a while. It has been good, even if GLD has been doing most of the work lately.

If we are going back to a 1970s style stagflation market, then we still have more to go - although we would be transitioning from a value trade to a momentum trade I think.

But this year has seen a turn in GLD/SPX, which is now starting to look like it is being confirmed. Over the last 10 years, there has been a few false dawns on this trade. 2016 and 2020 both looked like potential breakdowns in the S&P 500, but this time GLD/SPX bounced hard of the 200 MDA.

On a long term graph, a GLD/SPX move it really only at the foothills. That is a more a value trade than a momentum trade.

SPX has really been driven by the combination of extremely low credit spreads, despite fiscal laxity in the US. As a rule, I never short equity indices as by design, they are meant to go up. So a long GLD/short SPX trade implies shorting more US listed stocks.

About 5 years ago, I bought shares in Rheinmetall AG, as it was trading at or around book. At the time I told my colleagues, it was extremely rare to find a defence stock trading so cheaply. Its cheapness was due to is defence business being unprofitable, and its auto business really struggling. I think we doubled our money, before selling the shares when I closed down the fund. The Russian invasion of Ukraine has radically changed Rheinmetall’s fortunes. It now at 19 times book, and up 3000% from when I first bought shares.

It is not hard to understand why it has rerated. When I look at every part of defence that I like the look of, anti drone defence systems, tanks, ammunition, Rheinmetall is already there and rapidly growing capacity. It also has a CEO who is not afraid of publicity, which in modern markets also helps stocks. Its been a great trade - but are we near peak war I wonder? Without question, Western Europe needs to match Russian output. As a recent Economist article highlighted, Russia has been boosting capacity and can now manufacture around 3m shells.

From an investing point of view, I like explosives as it would generally be hard for greenfield expansion - far more likely that existing areas, and existing producers get contracts for expansion. There are two ways that we could be “Peak War” - the first is that Western European Expansion has already brought parity to Russia, and secondly, the War in Ukraine could be coming to some sort of end. We will look at both of these issues in turn.

In the same article from the Economist it quotes Chris Cavoli, the top NATO Commander as saying Russia would produce 250,000 shells per month, putting it “on track to build a stockpile three times greater than the United States and Europe combined”. One of the problems with defence investing is that companies tend to be tight lipped about their plans - for obvious reasons. But a recent acquisition by Czech listed Colt Group of a producer of a key chemical, Energetic Nitocellulose (eNC), used in munition production gives us some numbers to play with.

Using the numbers above, 250,000 shells a month, gives 3m shells a year. At 6 kg of eNC a shell, this gives 18,000 tonnes of eNC. Russia apparently had access to 13,000 tonnes (mainly from China) last year, so these number don’t match up exactly, but are close enough for me. But the Colt Group lists European capacity of nearly 20,000 tonnes.

It would seem to me that perhaps Western Europe has sufficient capacity, at least at the chemical level. There could be more to do on shell casings etc, but on this metric, perhaps we are peak war. These numbers would suggest at least for ammunition perhaps the investment for peak war is there, even if the production is lagging.

The other risk is that perhaps we are near some end game for Ukraine and Russia? Typically financial markets rally when the worst possible outcome is taken off the table. The Ukrainian Hryvnia is no longer in freefall.

Likewise the Russian Ruble is not as weak as you would expect for a country at war, and the oil price in the US 60 range.

Austrian based, Raiffeisen Bank, which has/had significant assets in Russia and Ukraine has rallied back to pre war highs.

Emotionally, it feels like military spending will keep rising as we are in a multipolar world. And with Russia having a number of incursions into Western Europe, it would seem spending can only increase. But hard numbers seem to be suggesting we are near peak war in Europe at least. Of course a Chinese blockade of Taiwan, or Russia invading another country would change this calculation, but European defence (or at least munitions) does not seem the riskless trade that it was. In my mind there is now potential for over capacity or reduction in fighting. In equity terms, we may be near peak war.

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In the pro-capital/pro-free trade era from 1980 to 2000, we learnt that the Yen was a hard currency. For all the fiat/debasement traders, out there, Japan was a true widowmaker market. With rising debt levels, and a fiscal deficit, and a central bank putting interest rates to zero, you would have assumed gold in Yen terms would have soared at least during the 1990s. You would have been wrong. The gold price in Yen terms fall back to 1971 levels by 2000.

The other mistake that investors made was that they assume bond yields would sell off in Japan. The classis widowmaker trade was short JGBs. As we should all know, this was a massively wrong. JGB yields kept falling, and even when negative on occasions.

And this was not your average retailer they got Yen and JGBs wrong. It was Nobel laureates and head traders and big banks and hedge funds. What did they get wrong? For me it was always Yen. While the BOJ was always desperate to get Yen weak, the government, under pressure from the US, was never too keen to intervene in foreign exchange markets. The Japanese government was committed to free markets, or at least convincing the US government it was committed to free markets. With no inflation in Japan, this meant the Yen would always need to appreciate.

But free markets are not longer. And the BOJ and the Government LOVE a weak Yen, and crucially, the US does not seem that bothered. Probably the move to tariffs makes it hard for the US to preach free market philosophy to its trade partners. This is what makes the Yen so hard to read. It is very cheap, but there is no political consensus that is should strengthen. Despite this, macro managers are repeating the mistake they made with JGBs. They keep expecting yen to appreciate, so early this year were the longest ever in Yen (according to CFTC data).

Their bullishness has been “rewarded” with a chunky 4% sell off in recent days, and a full 9% sell off from peaks in April.

Gold in Yen terms does indeed look parabolic now.

In an interesting twist, the BOJ wants to raise rates, while the incoming LDP leader Takaichi is keen on them not raising rates. When would Japan want a strong yen again? My guess is when the US and/or China put pressure on them to stop. But I also think the Chinese take some measure of pleasure from seeing the Yen weaken.

As I have been writing for a while, macro investors could rely on economics to justify positions from 1980 to 2010s, because political consensus was to allow markets to price everything. In a political world, long yen is a widowmaker trade, and old school macro traders look foolish. The big question is when does the politics change again, and the dogmatic debasement traders look bad again? Its happened before, so I am pretty sure it will happen again. Could be tomorrow, could be after I die. But all I know is to keep an eye on politics.

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Bobby Molavi from GS reckons that 56% of the S&P 500 is now tech or tech related. I have no reason to disbelieve him. For me, the dot com boom, and now the AI boom are all about pricing. The closest thing I have to clear pricing trends is TSMC presentations on ASP, which are still rising as far as I can tell.

Bearish minded people will say that it will revert to weaker pricing, just as it did in 2001. I thought this was possible, as ASML, which is the key maker of equipment for TSMC, was lagging the market badly - a bearish sign I thought. But like many tech stocks this month, it has blasted higher on OpenAI deals.

I have always been cautious on tech stocks as it seemed to me technological changes can wipe out a company pretty quickly, but the market seems convinced todays winners will be tomorrow winners as well. To be fair Microsoft has been around for well over 40 years now, so maybe they are right. That being said, the share prices of quantum computing stocks are implying we are on the threshold of a technological advance. Logically this makes sense - as higher prices for semiconductor chips should motivate research in new areas. Rigetti is popular quantum stock.

I have the trade GLD/TLT as I think we are heading for a rerun of the 1970s. We are getting there. It was a trade that implied that if the US did not run serious monetary policy, then gold would soar. I guess we have our answer.

I did express a very negative view on gold miners in my last post. Mainly because in my investing experience, they have been capital destructive enterprises on an epic scale, and they tend to attract poor quality investors. But my investing time frame is based on 1990s onwards, a period when gold has been relatively poor. Trying to find a chart of long term performance, I found the Barron’s Gold Mining Index. Performance was good in the 1970s, especially on a relative basis, although the mid 1970s sell off was chunky.

But at that time, gold was rising with rapidly rising energy prices. This time, gold is rising independently of energy prices. Gold versus oil ratio is breaking new highs, unlike the late 1970s.

If gold is being driven by the end of the treasury as a reserve asset (and it does look that way), then gold miners may well keep doing well. Semiconductor industry used to be seen as cyclical and dangerous, but has rerated as the have come to be seen as strategic assets, perhaps gold miners are the same. I will keep an open mind on gold miners.

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I originally became interested in gold as an inflation trade. In simple terms I see governments looking to boost wages, which will create inflation. This could be offset by higher interest rates, but it seemed to me to be we were heading for a re-run of the 1970s. The trade I chose was GLD/TLT. On the long term chart, we are really starting to move.

Of the two legs, long GLD or short TLT, the long GLD has been far the better trade. Traders would probably cut the TLT side of this trade, but I am not so sure. For me, there are some thing about gold that make me nervous. One has been the surge in gold miners. I always tell people, you can own gold, but only rent gold miners. If gold mining was a good business, then gold supply would increase radically and the gold price would be weak. With the spike in the gold price this year, the NYSE Arca Gold Bug Index has approached all time highs again.

The question I am wondering is whether the surge in gold miners means its time to sell gold? The time to worry about gold is when gold miners start to spend on bringing projects on line. Newmont has increased capex in the last few years.

Although Barrick Gold (another good gold company) has been more restrained.

But then Agnico Eagle Mines is at peak capex.

As is Chinese gold miner, Zijin Mining, at least compared to the previous peak in 2013.

The increase in CAPEX could of course just reflect how difficult it is to get gold out of the ground, but nevertheless, I prefer gold when gold miners are struggling. Now that gold miners are also doing well, I am a bit more nervous about gold.

When I look at ETF holdings of gold have risen recently, but remain below peak levels. If we saw a huge increase in ETF holdings, then I would get very nervous indeed.

Gold has had two serious bear markets. From 1980 to 2000 and from 2011 to 2019.

Back in 2012 I laid out a bear case for gold in a note that crashed the server due to its “popularity” (read long gold investors getting nervous). For me gold is an Asian asset that happens to be traded globally. If you travel to India and China, which is bit less than 50% of humanity (especially if you count the diaspora), a large chunk of wealth is kept in gold. So why did gold do poorly in the 1980s and 1990s? Because the Chinese Yuan and Indian Rupee was weak, and the average Chinese and Indian person was becoming poorer. And gold soared from 2000 to 2013, when the Chinese Yuan strengthened and Indian Rupee was stable, and then was weak from 2013 when the Chinese Yuan and Indian Rupee was weak. What is great about this analysis is that it explained why gold was weak during the Asian Financial Crisis, and the China devaluation scare of 2015. Conventional western analysis would suggest interest rates cut then should have spurred gold price, but it did not.

But this does raise a problem. Gold has soared without the Chinese Yuan or other Asian currencies being particularly strong (Indian Rupee is very poor). But that can be easily resolved. The Chinese Yuan should be much stronger than it is. Its trade balance has surged in recent years. If we had not moved to a new era of capital controls and tariffs, then the Yuan would be much stronger.

And China does not want to put its trade surplus into treasuries, which leaves only gold as a viable option. Chinese holding of treasuries continues to fall even as its trade surplus surges.

If we assume this is Central Bank buying, then as long as Chinese trade surplus stays strong, China will keep buying gold. It seems a number between 3000 tonnes to 4000 tonnes would be reasonable, looking at other countries holdings.

Using round numbers, that is 1000 tonnes more tonnes of buying which equals 32 million ounces, which is USD 121 billion, or 20% of the annual trade surplus. This seems very reasonable, and would be one third of current total ETF holdings. The risk is more political than anything else - that China decides not to buy gold, perhaps as they perceive it as poor value. But given how the West froze Russian foreign exchange holdings, there seems little they can do. I think a better signal will be if Chinese trade surplus begins to fall. But so far there is no sign of that. It also helps explain the dispersion between gold and oil prices. Lower oil prices boosts the Chinese trade surplus.

Coming back to the GLD/TLT trade, much higher yields would probably cause gold problems, by slowing trade activity, and offering a more attractive alternative - but for the Trump administration has made clear, short term objectives of growth often override long term strategic goals. Gold is probably okay, but a spike in yields could cause problems for gold, but should leave me doing fine.

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September was a very funny month. If you are true believer in speculative tech investing, then you made good money. If you are true believer in gold, then you made good money. If you are true believer in Japan, then you made good money. If you are true believer in bonds, you made money. In such an environment, the only losers would seem to be short sellers, but even here, oddly, there were things to do. It is taken awhile, but I think I am getting a handle on investing, and more importantly short selling, “politically”.