Capital Flows and Asset Markets

I have begun to tire of reading articles about how Trump is changing the world, and everything is going to change. Why? Because it is basically backward looking, and tells me what has happened, not what is going to happen. Reactive research is basically toilet paper, no matter how well written it is. Unless your research produces a clear forecast of the future, please stop bothering me.

What predictive research do I have? My “big idea” was that politics globally was shifting to a pro-labour era. The idea of a pro-labour shift leading to surging inflation is very appealing, as it is very simple. This made me think we were going to see a repeat of the gold/treasury price action that we saw in the 1970s. And so far so good.

What I liked about this analysis was that pro-labour shift gave a prediction that assets markets would not do well. That is that a pro-labour government tended not to be great for stock markets. In Mexico, where pro-labour policy has been implemented has seen its stock market go sideways in US dollar terms.

The UK, which I also feel has moved pro-labour has also had a sideways moving market in US dollar terms.

The logic is that higher wages drives higher interest rates, which means business sees slower profit growth, AND, suffers from a multiple compression. In USD terms, this has not happened with the S&P 500. If anything, the emergence of Trump has been good for the stock market.

Maybe we are beginning to see some change with gold/SPX beginning to break higher - but we have had Trumpian politics since 2016, and this pro-labour shift in asset markets may only just beginning in the US, and even then, only potentially.

I have started to wonder if the move in gold versus treasuries is signalling something other than a “pro-labour” move. In Trump’s second presidency there has been a strong shift to reduce the power and effectiveness of government. DOGE gutted the IRS and other agencies - and there has been cutting of funding to agencies, and now to various elite universities. What we have also seen with Trump second’s presidency most clearly with Section 889 is the US Government acting to make it difficult for foreign governments to tax US multinationals. What I am seeing, and what makes most sense to me, is that the Trump administration is trying to destroy the power of the Federal government. But why would it do that? Well as I understand it, big government came into existence after World War II to counteract two other strong political powers - the rich elite, and religion. The Spanish Civil War was as much a religious war as a progressives versus conservative war. Much of what big government does in terms of social work was carried out by the church before World War II. Destroying the ability of the Federal government to act would benefit both big business and big religion, who often find their ability to act constrained restricted by government agencies (think anti-monopoly investigations, and legal restrictions on religious displays in public spaces). Here is where it gets interesting I think. If you want to destroy the Federal Government, how would you do it? Well the most obvious way would be to make it unable to meet its financial obligations. The first step build up debt levels. Job done.

Second step is make as much US multinational profits tax remote. We can see from the investment into tax haven Ireland, that this has been achieved. Section 889 will make it much harder to access this revenue.

This combined with Conservative tilt of the Supreme Court lead me what will seem an extreme view - but likely true. President Trump and his big tech and religious supporters would probably like to see a the US default on Federal debt, so that the government is forced to shrink. For fans of the Simpsons, the famous “Bart to the Future” episode pretty much predicts this outcome.

What is appealing about this analysis, is that when we go back to long term gold versus treasury chart, it first inflected higher with President George W Bush, and his first efforts at applying the “Starve the Beast” political strategy. The Obama administration saw this trend reverse, and the Trump, Biden, Trump administration has seen this trend take off.

What I also like about this analysis is that it would imply you need to be long S&P 500 and short treasuries, a trade that historically did not work, but has worked very well in recent years.

The ideas that are driving this, and as Peter Theil explains in his essay, Straussian Moment, is that conflict will be good for the US. Certainly World War II cemented the US as the leading power, and this line of thinking is that promoting chaos will weaken the rest of the world and strengthen the US. As someone not living in the US, I would prefer the multilateral approach the US took after World War II. But voters in the US have felt this approach has failed them. The only thing that I would say has changed recently is that the true believers in big government and multilateral organisations now know that they are in a knife fight to the death. Unless they can bring policies that benefit the vast majority of voters, their days are numbered. Meanwhile, its hard to beat long gold short treasuries as a macro trade.

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Even though I am known for short selling, like everyone else in fund management, I have made more money from longs than shorts (its just the nature of the beast). Before I closed my fund in 2022, I did quite like defence as a long theme, and this area has really moved. One stock I owned was Rheinmetall (RHM GY). At the time its defence business was loss making, and its auto business was struggling. It was trading at around book, which to me was amazing. Defence business very rarely trade that cheap. We doubled our money in it, and then in 2021 I closed down the fund and we exited the position. It has continued to trade well, as it has become THE European defence stock.

It has rerated from 1 times EV sales to 8 times EV sales, and market cap has gone from EUR 3.5bn to EUR 87bn today. If I still owned the stock I would be getting nervous - but would probably still hold it, but I would not be adding.

But what Rheinmetall shows is that the market is willing to pay a lot for government protected growth. I also thought Mitsubishi Heavy could be an interesting stock (the maker of the famous Mitsubishi Zero). This has also rerated massively. Whether this is worth chasing or not is hard call, as it has a lot of different businesses.

However, not all my defence stocks have moved. I thought the US would embark on a massive ship building program to try and offset Chinese superiority here. There is only one listed company that builds US navy ships - Huntington Ingalls Industries (HII US). It is also the largest navy shipbuilder. If US suddenly increases shipbuilding orders, this would be the only way to play it. The stock has been a big nothing burger for 10 years. Part of the problem has been margins which have been squeezed (one reason I could not chase Rheinmetall, as you are assuming margins remains good - which is not always the case with military orders).

Another issue is whether ship building is a dead option in a world with drone warfare? I don’t know the answer here, but it is one of the few defence stocks I would define as cheap. Another one is a Chinese one, AviChina. This was one of the first stocks I bought with my first fund at 0.50HKD entry price in 2006 (I did mention I made more money being long). It has been worse than dead money since 2015. Its an unusual stock as most of the value lies in China mainland listed companies. One of its listed subsidiaries built the Chinese fighter that apparently shot down a Rafale jet in the recent India-Pakistan encounter. There are risks to owning this stock - mainly sanctions - but it looks interesting to me for investors that can handle that risk.

And finally, there was one last stock that for years did nothing, but suddenly seems to be moving, so I have decided to take a position in.

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My interest in markets began in 1998 with the Asian financial crisis, grew with the dot com bust, and matured with the global financial crisis. If you wanted to make it, you needed to be the smartest guy in the room - and a sure fire way to win was to keep an eye on where capital had flowed the most. If you could get out and short markets as capital started to leave, this was a winning strategy. Capital flows drove asset markets. A good example of this was using BIS data to see how capital flowed into Ireland, then out again during the Eurocrisis. Below is BIS data on lending flows into and out of Ireland. The red line and blue line should roughly move together - but in early 2000s, capital flows surged before reversing.

Using BIS data, you could see similar problems brewing in China in early 2010s. After the GFC, capital surged into China - and has been trapped ever since.

Capital flowing in then out again to create a crisis was easy to understand. What was unusual was where this capital would flow back to. There seemed to be a set of assets that would always attract flows in crisis: JGBs, Treasuries, Bunds, Yen and Swiss Franc. All of these assets came to be known as safe haven assets. I used to own all of these assets when I thought a crisis was brewing. But why did that work? Well the most obvious reason I think that a very large chunk of the market was pursuing what I would call a carry trade. That would be to buy a high yielding asset, and then short a low yielding asset. If I was to characterise my finance career, it was being long the emerging market carry trade from 2002 to 2007, short it from 2008 to 2016. Why did I stop in 2016? I thought China would devalue, and we would go back to a emerging market crisis - instead, China closed its capital account - and EMBI Bond spreads have behaved pretty well. That is I thought we would have a long period of EMBI bond spreads back at the 800 level rather the sitting at the 400 to 300 level.

For a few years now, we have been seeing now is that the old safe haven assets are no longer safe havens. Long yen has been a widowmaker trade, and treasuries and JGBs have been pretty poor. In April in particular, JGB yields have surged.

Even more unusually, treasuries have traded poorly in periods of market stress. From a macro/political perspective, you could argue that markets are seeing more and more inflationary policies being put in place, so investors are acting like “bond vigilantes”. Its a nice idea - and maybe there is some truth to it. But I suspect there is a far better and satisfying explanation.

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As many people have noticed and commented on, markets have recovered all the losses from “Liberation Day”. In some ways, this is very rational. Trump just showed tariffs was just a negotiating tactic. What tariffs if any will remain in the end is very unknown - but the political aim for Trump is for other nations to spend more and to buy more American products - which is bullish for US. So any trade that was a bet on recession has been a losing trade. A good way of seeing this is the value of leveraged loans. As it is capped at par (100) market is very risk adverse if they get anywhere near 90.

The same with corporate spreads - they barely widened and then came back to near all time lows.

What is clear to me is that the market expects either the Fed or the government to act to overcome any market or economic weakness. The problem is that the US consumer has also woken up to the fact that recessions are now unlikely. Despite low energy prices, US inflation expectations are very elevated.

From 2000 onward, US fiscal and monetary policy has become more and more reckless, and yet the bond bull market continued. This has created a view that deficits do not matter, and in both Trump administrations, and Biden’s Presidency - we saw fiscal deficits expand to ever higher levels. But we now see that long dated bond markets ARE reacting to US policy. 30 year Treasury yields are at nearly 20 year highs. The reasons for this are varied, but long term. I see no reason to expect a bond bull market to start again.

So what I am seeing is that equities are trading in a past that is no long valid. What I am looking for is longs that do well as yields go higher, and shorts that make money when rates go higher.

Moody’s downgraded the US over the weekend. Yields have gone up and down, but we see that the 30 year is only marginally higher than where they were on Friday.

Meanwhile in Japan, the long end of the bond market decided it may as well trade as if it was the one suffering a downgrade. Japan still has a lower credit rating than the US. In contrast, even with the sell off, Japanese 30 year JGBs yield less than the US, so you may well wonder what is the point of rating agencies? (In my view, they could be abolished with little effect on financial markets - other than making a few government agencies actually think about what they are buying - but another story for another time)

Despite Japan having a lower credit rating than the US, its 30 year bonds had a lower yield than the US - and in many ways acted as a lead on 30 year treasury yields. Are JGB yields going to be higher than the US? Or are US yields about to rise as well?

The Japanese often found the rating agencies views to be ridiculous. With the second largest foreign reserves in the world, and huge foreign investment overseas, Japanese found it hard to believe that anyone could think there was any credit risk with JGBs.

Back in the free market period (1990 to 2016) what I found worked best was looking at NIIP to describe the strength of the Yen, and low JGB yields. Japanese NIIP has continued to be strong, as US NIIP has been weak. But Japanese NIIP has not changed, buy JGB yields are rising quickly. A positive NIIP meant that when there was trouble, the Japanese would bring money home, and Yen would rise and yields would fall. This no longer seems to happen.

So why are JGB yields weak? I am pretty sure it is not from foreign selling. I know for a fact that Japanese physical bonds are hard for foreigners to buy. How? Because in my old fund I bought some and had to produce a whole bunch of documents to be allowed to. I can assure you buying Irish, American, Spanish and German bonds was much easier. So the JGB market is dominated by domestic buyers. Helpfully the MOF provides some details on JGB auctions. Demand was very strong until 2017. But from 2017 onwards demand has weakened, and continues to weaken. The accepted/offer rate is taken from MOF data - and is the amount of 30yr JGBs bought divided by the amount that was offered.

I first thought change was coming to JGBs market during Covid in 2020. I thought this was a deflationary event, and yet in 2020 30 year JGB yields never really fell as much as I thought they should. Since then, they have been a in a substantial bear market. We have a longer market history for the 10 year JGB, and one thins we can see is that the amount of 10 year JGBs being offered as been climbing for a very long time.

If increased issuance is the driver of higher yields, then US treasuries should not bee too far behind JGBs. SIFMA show a steep increase in issuance.

When you also notice that Japanese budget deficit is only 2% of GDP currently metrics are very negative for US treasuries on a relative basis. There is only one thing I can find that really stands out for Japan. Food inflation (driven by rice price increases) has continued to surge in Japan.

With the Yen at a super weak exchange rate, the market seems to be trying to tell the BOJ that they should raise rates more aggressively, and strengthen the Yen. Unlike other central banks, Japanese interest rates remain low, and the balance sheet has barely contracted at all.

But while the US does not have a rice problem, it does look like US food inflation looks ready to rise again in my view. Beef prices have trended higher again.

What does it all mean? Well first rating agencies are useless. Secondly, central banks are living in a past that does not exist anymore, and should be raising interest rates, not cutting them. And thirdly, sitting idly by as food inflation surges is a one way ticket to political and likely bond crisis. I suspect US treasuries will also sell off.

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A few years ago, my models were saying the US looked a short, so I started to took for reasons for that to be the case. They were not too hard to find to be honest - the US corporate debt market looked a mess then, and it looks a mess now. But as learnt in the the GFC and Eurocrisis, debt markets can look insane for ages before they break. So lets look at the set up we have first, AND then how the downgrade of US sovereign debt could affect it.

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Before I talk about markets, I would like to thank Sam Knight for providing me with a much better logo for Brumby Capital. If you are looking for someone to help you with strategy and branding - Sam is someone you should get in touch with.

I have been in markets through three big inflection points - the dot com bubble, the GFC and the top in the commodity bubble. What always marked out a top in markets for me was supply. When supply of internet starts ups overwhelmed the available supply of advertising money (every business model back then was based on banner ads) - there needed to be a culling. When supply of housing overwhelmed the number of buyers - we had a culling. And when the supply of mines and oil wells overwhelmed demand - we had a culling. The politics of this is pretty easy to understand - large players are willing to take some short term pain for long term gain (survival). What was true with all of these inflection points was that there was a clear market signal BEFORE the culling. Most internet based retailers perished during the dot com bust - but Amazon peaked in December 1999, well before the market peaked.

Likewise, US homebuilders peaked well before the GFC. Toll Brothers actually peaked in 2005.

And Chinese steel equity started falling well before prices in steel related commodities began falling.

Markets are truth. There are always signs of a top - there are then two questions you need to ask yourself. Am I willing to accept the message that markets are sending me? And am I willing to act on these messages? My personal answer is yes - which is why I have set up Brumby Capital.

Bu I guess for you, dear reader, you are probably asking what message is the market sending?

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A few months ago, I thought semis looked a good short. Bond yields looked to be going higher, and DeepSeek and its collaboration with SMIC had showed that the current model built around OpenAI and Nvidia was probably too high cost. A quick look at the ASP of SMIC compared to TSMC (the fab that Nvidia uses) showed a yawning gap in pricing. My theory was the OpenAI and other big US tech companies had tried to monopolise expensive chips by bidding up the price of cutting edge Nvidia chips to keep competition out. What DeepSeek showed was that using lagging edge chips and clever software you could make a very competitive product at a fraction of the price. It seemed to me that even if Chinese competition was kept out, a US start up would likely copy the DeepSeek methods putting downward pressure on Nvidia and TSMC pricing.

The above data points are to Q1 2025. The good news is that we can get an idea of trends before quarterly reports come out.

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It seemed like Trump wanted a trade war with everyone, then only with China, and in the end with no-one at all. Basically we are where we were at the beginning of April. All the macro strategists and traders look foolish again as they are living in a past that does not exist anymore - but cannot bring themselves to accept. And the sell off then rally has proven this once more.

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It felt so real. I am sure in April we saw the culmination of Trump 2.0, with the repudiation of the trading and security order that existed since the end of World War II. I am sure the two largest economies in the world entered divorce proceedings, and are now in the process of trying to work out who gets what assets, and visitation rights. It felt real at the time, but now today, it feels so much a fever dream.

If I was to push a bullish argument - then the Ukraine policy was pushed to get the rest of the world to spend more militarily and tariffs were pushed to get the rest of the world to spend more domestically. Both policies were aimed at getting foreigners to buy more American goods. If I just focused on these two aspects, then this is bullish - and you should buy equities - and you could point to current equity markets as proof. Certainly, the US trade deficit has exploded higher, so unless their is a recession in the US, you need much more foreigner buying.

For me, where markets went wrong in April was the assumption that there would be a recession, and the Fed would cut rates.