Capital Flows and Asset Markets

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I was born in 1974, and even I have trouble believing that people really wore this stuff. When I first started working in fund management, I used to seek out older fund managers to ask them about previous bear markets were like. Two really stuck out as been brutal. The Asian Financial Crisis was one - where fund managers would tell you that they waited for stocks to fall 90% before buying, only to see them fall another 50%. The had a haunted look to their eyes when they talked about that bear market.

The other was the 1970s in the US. Even back in the early 2000s, there were not too many fund managers who had survived from the 70s, but there were a few. As opposed to the Asian Financial Crisis, which came and went like a storm, the 70s bear market persisted. The most telling comment was from one manager which had avoided the 1974 bear market, bought in at the lows thought he was set for a big bull market, and then saw stocks fall again in 1978. He said that 1978 bear market really broke the fund management community as no one was prepared for it. It was also an era of high inflation and high interest rates, so in real terms, stocks were very very poor indeed.

Why am I interested in this period? When I look at the long term graph of gold versus treasuries, we have basically three periods when this is inflecting higher - 1970s, 2000s and now in 2020s. In 1970s and 2000s, US stocks was not a great place to be invested. So far in 2020s, US stocks have been pretty good. Maybe there are similarities to the early 1970s Nifty Fifty and today? Maybe if I can understand this, then I can understand why my short selling techniques have proved less effective?

When I remembered back to my conversations with old fund managers about the 1970s, I remember them saying the Nifty Fifty ended up being a graveyard for fund managers. And when I look at markets now, there is a strong Nifty Fifty vibe.

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Generally speaking, Americans will always tell you how special America is, even if you don’t ask them. From an investing perspective, US is very special at the moment, with USA making up over 50% of world market capitalisation now. Comparisons of the S&P 500 to other markets confirms American dominance.

If you asked Americans why they are so awesome this would be a (non-exhaustive) list of reasons:

* Work harder - especially compared to Europeans (French in particular)

* Work smarter - especially compared to Chinese/Japanese

* Pro-business government

* Better (higher) education system

* Rule of law

All of the above points are debatable, but if we assume they are true, why were they not true in 2006, when the US fell to less than 30% of global market capitalisation? Was US government particularly bad then? Was the education system not working then, but was working now? I am generally impervious to people’s claims of how awesome they or their nation are. I heard it in Japan in 1991, I heard in again in the US in 2000, I heard in China in 2010, and Brazil in 2014. Generally speaking, claims of awesomeness are generally made to justify very high valuations and generally overvalued exchange rates.

Looking at BIS real effective exchange rates for the US - we can see from 1970 onwards, a weak exchange rate coincided with a low in equities, and high exchange rate a top. Since 1970, a strong exchange rate was never maintained - except in this cycle, where the US dollar has been strong since 2016, and continues to strengthen. What this tells me is that there is something very different in this cycle compared to other cycles - but what?

Lets try a different approach to thinking about US dollar and economic strength.

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The vast majority of people are very easy to analyse. The trick is to pay zero attention to what they say, and pay all the attention to what they do. This is why in-person meetings still remain so valuable, as it is much easier to work out what is motivating them in person, that via zoom. The irony of this approach is that it fails on the person we spend the most time with - ourselves. How often do we tell ourselves we need to go to the gym, or lose weight, or study harder, or read book, when in the end we just doom scroll Tiktok instead. That’s because we are obsessed with what we SHOULD do, and we try and convince ourselves we should do it, when we know that we really want to do is watch another cute cat or dog video. And of course we then go into denial, and try and rationalise our “bad” behaviour away. This is plainly obvious to people on the outside - but somehow lost on ourselves.

Why the philosophical introduction? I gave back money and closed the fund I was running in 2021, and have been writing this substack ever since. It is easy to rationalise from a financial perspective - assets had fallen, I had had a few bad years in the market, and my investment theories (particularly in currency markets) were not working anymore. But that was just excuses I think. I just didn’t want to spend my time managing money anymore. I much preferred spending time with my family, and particularly with my boys. In 2021, they would have been 10 and 7, and the older one was starting to get very serious with his motorsport and the younger with football and cricket. Now in 2025, both boys are going to be in high school (senior school), and both are starting to be men. They both don’t need me to be present in the same way - in fact they both need me to give them the space they need to grow into men. What that means is that this era where I am working from home, spending time with the family, and weekends at sports event all over Europe is coming to an end. Not straight away, but the taper is beginning, I will go from seeing my boys most of the time to just some of the time. And that’s a good thing - as a parent I want our boys to find their own way in life.

I think one of the reasons that I gave back money was that I had ideas on how to turn things around but I knew that it would require the same “nose to the grindstone effort” I had put in from the ages of 25 to 40 to get going again. On some subconscious level, I think I knew I could not do what I wanted to do with my family and with my work life, and so I choose family life. And now, with my family commitments beginning to drop off, I have the bandwidth again. The biggest tell that I am switched on again is that I have started to read investment bank research again! I don’t read this research for opinions but looking for cold hard interesting data points - like panning for gold in a sea of computer generated verbiage. Good, interesting research is vanishingly hard to find - even most “macro armchair thinkers” tend to be pushing some agenda, so the outcome of their “research” is already pre-ordained. I have a friend who keeps asking me to watch Michael Saylor research - but why would I, when I already know the conclusion will be” buy Bitcoin” no matter what point he starts from. Gold bugs fall in the same “pointless to read” bucket. But despite this, I have begun to read research again - which to me is my subconscious starting to warm up the engine of thinking and investing again ( it will almost certainly means I will also get fat again - as reading and thinking makes me snack).

One investing observation that I had back in 2016 or so, which could well have been the basis of running a hedge fund was the observation that most hedge funds (long short equity) are run in a very inefficient basis. Now that I have the energy for it, I think I may try and see what I can do with this observation.

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Energy markets have been one of the most disrupted markets of the last 20 years. As the shale revolution has taken off, the US has both grown production and consumption dramatically. Production growth has been so strong, that the US is now a net exporter of natural gas.

As recently as 2007, it was thought that the US would be importing LNG, but from a standing start, the US has become the single largest supplier of LNG. Shale drilling has truly being a disruptive competitor in the energy market.

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So what the plan, Stan? When I first started thinking about a “pro-labour” shift in the world, one of my first working assumptions was that inflation would be higher than expected going forward. I also assumed that central banks, being backward looking, would be late to the party. What this means is they would be looking to cut interest rates even when the bond market was telling them not to - which is exactly what has happened. The US ten year yield has risen nearly 1% since the first rate cut - in stark contrast to previous cycles.

I thought that higher yields should have a negative effect on the S&P 500 - but this has not really been the case.

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The vast majority of short selling is focused on looking for dodgy balance sheets, and or management doing naughty things. This method has a huge drawbacks in my book. First of all, there is almost no edge in doing this. What tends to happen is that every fund manager and algorithm picks up on the same behaviour, and you end up with a very crowded shorts. Crowded shorts is where short selling goes to die - so I avoid this like the plague. Crowded shorts that have destroyed fund managers includes stocks like Tesla, Evergrande, GME, AMC, Volkswagen among others. With that in mind, I try and short “uncrowded shorts” - or in other words - popular longs. Please bear that in mind in the analysis that is to follow.

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Short selling is fun. And if you can do it well, you will seem like a magician. I like short selling - particularly the way I like to do it - which is to focus on where consensus longs are positioned, and then waiting for the right moment to pounce. Over the years, I have learnt the best shorts are the ones that people will buy all the way down. What I mean by that, lets say an asset or security falls 10%, the owners, rather than being alarmed, buy more! Japanese shares in the 1990s had this feature, as did the dot com bust. The Eurocrisis saw many fund mangers buying Italian debt as it looked so cheap, and in the most recent example, Chinese tech has consistently being bought. Do you remember the FANG era of investing had a Chinese equivalent of BAT - the A being Alibaba? Investors bought this sucker all the way down.

Why do I mention this? Well like everyone else, I saw the re-election of Donald Trump as bullish for stocks and for bitcoin. I think this was partly policy based, but also partly based on what happened to investors who were not bullish in 2016. Career risk is now a big issue for most professional investors - as outperforming the S&P 500 has been very difficult in recent years. But one thought kept coming into my mind. If this was the top in asset markets, everyone would be buyers at lower prices. No one has the guts to short sell this market anymore. Historically, that is the time to short sell - and lo and behold - my short book had its best month for a long time in December.

My American friends have been telling me for years about how bad China and the Chinese Communist Party actually are - how they spy on everyone, how they favour their own companies over others, how they try and influence the politics of others, and most of all, how they don’t seem to trust American government and military. In fact, I suspect most of my subscribers will be reading this and thinking, how could you not see how bad the CCP is - what is wrong with you?

Well let me indulge you in my thinking and why I was not convinced the Chinese government is not as bad as people made out, and why I have changed my mind. First of all, back in the halcyon days of 2000s, people had this idea that China was going to seamless become part of the West. This was never going to be the case. Most Chinese still study and remember the Opium Wars of the 1800s, where the British became so frustrated with a lack of Chinese trade, they forced large numbers of Chinese to become opium addicts just so there was something to trade with China. Of course opium was banned in the UK, but selling it to Chinese and using the might of the British army to achieve this was not a problem for the UK government. With this history, the idea that the Chinese would ever complete trust the UK or the USA is laughable. The average American or British person may have a passing knowledge of the opium wars, but it is burned into the consciousness of all Chinese. To get an idea of this watch Jet Li’s first big film - Once Upon A Time In China - and see the constant references to the Unfair Treaties. Before you write it off as Communist propaganda, the movie was made in Hong Kong, and has a very positive take on Christianity - so even “good” Chinese still remember the Opium Wars.

I also remember that in the 1980s and 1990s, Americans started to get very het up about Japanese economic domination, despite it having no military power and a far smaller population than America. For me, American diatribes against China was another version of this Japanese fear - because nothing defines America more than competition and winning - its a vital part of the American psyche. 1993 film, Rising Sun, starting Sean Connery and Wesley Snipes was a sign of the times. In a similar vein, I had thought of US anti-Chinese sentiment and similar posturing.

Furthermore, when the various accusations of Chinese spying came to the fore, I just remembered how much spying the UK and the USA (and other allies) do on China. I still remember the US spy plane crashing in China in 2001, and thinking that well if China was flying a spy plane that close to the USA, the American would likely lose their minds. In essence, big nations spy on other big nations - always have and always will.

I was also remembering how I felt extremely upset by the US and UK governments statements on weapons of mass destruction (WMDs) back in 2001. When Tony Blair and Colin Powell came out and stated that Iraq had WMDs, I foolishly believed them (I put no faith in George W Bush or Dick Cheney - but I did in Tony and Colin). When no WMDs were found, and the truth of the Second Iraq War came out, I made sure I would never blindly follow politicians ever again.

All of these things have made me extremely distrustful of the US government labelling China as a serious threat. What exactly have they done? What proof can you show me? Which nation have they invaded? Whose citizens have they killed? In all cases, US hostility seemed more driven by the same reason it drove Japanese hostility back in the 1980s - a sense of losing. But this idea that it was also just jostling and politics was broken apart by an article I read in the Economist. I have copied the important part below.

As you can see above, two Chinese ships - Yi Peng 3 and Newnew Polar Bear have been accused of damaging fibre-optic cables and gas pipelines. Why is this a such a big deal for me? Well my experience of China and Chinese people is that they just want to make money - to get ahead. In fact, in general I find Chinese and Americans have a lot in common. So I could understand China retaliating against US tariffs, for example, and I could understand it looking to shore up allies like Russia or North Korea, but I was under the assumption it was doing its best to keep a free trade world going - and to try and copy American free trade policies that were so successful in the 1980s, 90s and 2000s. But how does this fit in with having ships damage vital infrastructure in the Baltic Sea? It doesn’t. A trading focused China would not sanction such an activity in my mind - as all it does is poison a relationship with a important trading partner. For me, this opens up the possibility of various large downside events in the future. Time to have a hard think.

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2024 made a couple of things clear to me. First of all the “pro labour” trade of GLD/TLT remains broadly correct. Even with the virtual corporate takeover of the White House, GLD/TLT continued to perform well. The simple reason is that even with Trump back in the White House, the idea of US politicians enacting any austerity, let alone tax rises remains vanishingly low, at least until the bond market convinces them of the need.

I have been pondering the US and the re-election of President Trump. And in a previous post, I had expounded the idea of we are now in the third era of American policy making since World War II - the “Greed is Bad” era from 1945 to 1980 (high taxes and heavily regulated), to the “Greed is Good” Era from 1980 to 2016 (lower taxes and regulation, but more competition and freer trade), to now the “Greed is Everything” (no taxes or regulation, and using government policy to maximise profits). From a market perspective, this has allowed the value of financial assets as a multiple of GDP, to break out of a long standing range. From 1945 to 2000, having financial net worth of 4 times GDP was a sign of excess - since 2015, it is now more a lower boundary.

I had originally looked at changes in tax and regulations to describe this change to “Greed is Everything”. But I think there is another more intuitive way of thinking about this change. After World War II, the world was a political white space. The old British, French, Japanese and German empires were collapsing. In this void we saw the emergence of two different regimes, the USA and the Soviet Union. For most of the 1950s and 1960s, the march of communism and the Soviet Union was unstoppable. On a population basis (which when you are discussing a system that does not believe or use free market pricing is probably the only valid comparison), Socialism was the dominant political form.

To counteract this, the US (which has always been a reluctant imperialist) offered a deal to the free nations of the world. Military alliances, as long as you supported free trade and free elections (and sometimes the free elections was optional). If you live in the free world, you are never too far from a US military base.

The US led system basically offered wealth and protection to the world, while the Soviet Union led system in the end offered only poverty and oppression. To sign up to a US led system was a no brainer, and eventually everyone did. In some ways, you can think of the US system like the offer to sign up to Amazon Prime. You are getting free delivery AND on demand video AND various other benefits for a very low cost - or even at a loss to Amazon - why would you not sign up? But this is a very common business model - low cost or free to subscribers to build scale, and then once scale is achieved, we move to the monetisation phase. US policy under Trump is now moving to the monetisation phase. Do you want to be in a military alliance with the US? Then you need to spend at least 2% of GDP - preferably on US military equipment.

Do you want to have free trade with the US? Then you need to run a balanced trade with the US, or face tariffs.

In many ways, the US foreign policy has become a carbon copy of many US corporate policies - make switching costs so high, you have no option but to spend. The fact of the matter, is that the switching costs are high, and that these policies plainly help the US at the detriment to rest of the free world. The problem is that where there was no incentive to even have a second option, the US is now creating a strong incentive for nations to counter balance US influence. Just as a smart businesses diversifies suppliers, US trade and military partners are now incentivised to diversify. The first example of this would be the movement away from treasuries and back to gold for foreign reserves. Long gold and short treasuries has continued to work despite the strong equities and strong dollar that America first policies have produced.

The other problem that America first policy has is that is politically destabilises allies. In France, the political centres has been hollowed out, leaving the hard left and and hard right in political driving seat. French- German 10 year bond spread widening implies the end of the EU project. Politically, I find it easier to see this as a benefit to a Russia-China anti US axis, than to the US. Business wise, I can see how the US would see a broken up European Union being less of a threat to US business - although at the risk of Europe falling out of US political orbit.

One thing I have learnt over the last few years is that voters follow the money. I thought the UK leaving the EU was a bad idea, but voters were sold on the idea that we were sending money to Europe that could be used better in the UK. It was only really in the 2000s that the UK became a net contributor after the expansion of EU to the East, and that combined with the influx of people from central Europe that moved the Brexit debate.

The EU became unpopular once the UK became a contributor. US America First policies is asking everyone else to be a contributor. For me, a shift away from the US is possible. I certainly see signs of this in the lack of support for Russian sanctions, and governments hedging their bets with China. The US led system works well for the US, but voters are unwilling to pay for it. Something has to give - and when I look at the world today, it is already giving.

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