Capital Flows and Asset Markets

I recently rewatched “Silence of the Lambs” - fantastic movie. It was with a bit of a shock that I realised I had a lot in common with Hannibal Lecter - I mean other that the killing and eating people part. He has his own moral code, he enjoys analysing people to try and work out what pushes their buttons, has little tolerance for arrogant hacks, and can be very patient in working for his goals. I think I have all that in common with Hannibal, and I really like his analytical work. In the movie Clarice Starling asked Hannibal if he had the courage to analyse himself? Well Hannibal didn’t, but I think I have.

Analysing yourself is much more difficult than analysing other people. Physical clues, particular eye and facial movements tend to betray peoples real motives. Very hard to analyse your own eye and facial, and self-denial is a real thing. So when I analyse myself, I look at my actions and my enthusiasm rather than my words. I might say I want to get fit, but if I can’t be bothered to get out and train, then it is only words. So the question I was asking myself is - why do I keep looking for bearish trades - when I could just buy the Nasdaq, or magnificent seven. All my work says they have locked up the political and economic system to make it almost impossible to either fail, or see valuations drop - so why not just buy it already?

Even more importantly, with my name, reputation and contacts, I could set up an closet index tracking fund for awhile, and get myself a cushy income stream. This is the obvious thing to do, and the financial incentives are there - but I am not interested. Why I am not interested? The simple answer, and a total lie, would be it has gone up so much, and I am waiting for a better entry point. This is not true - but a lie I might tell myself to avoid addressing the real issue.

The hard truth is that I only do things that I can think I can win. And this is true of everything I do. I love basketball, and have only recently stopped playing. My build is not conducive to playing basketball - I should have played rugby - at 182cm (6 foot) and 100kg (220lbs), but I developed a game that was difficult to play against - and every time I stepped on the floor I would be thinking of way to beat the team I was playing. I always played to win, and was very happy to win ugly. I particular enjoy coming up with strategies to win - and I think I may even take up coaching at some point, now that all my joints are beginning to ache. The point is that I always play to win.

When I was a teenager, I started learning Japanese, and by my mid-20s spoke incredibly good Japanese. But in the mid 1990s, I saw that speaking Japanese was not enough to guarantee success - and other good Japanese speakers tended to end up in jobs that did not appeal to me. I also realised that even if I spoke perfect Japanese, I would always be on the outside, and there was nothing I could do about that. I could not “win” at Japanese, and my ardour for it has cooled.

I started this substack, because I thought I could win at it. I am not sure you can definitively “win” at substack, but it has certainly been successful. And because of that I find it very easy to write and publish articles. The “fire in the belly” is there.

So what about markets? Well, I am not particular interested in being another closet indexer, even though that has been the correct call since the GFC. I would be embarrassed to say I was “an innovative and risk taking portfolio manager”, to then invest like an index tracker. What I really want is to be the best, and clearly the best. For me, that route is through short selling, and being bearish positioned consensus long assets. If there was any role model, it would be George Soros, not Warren Buffet. For me, it seemed perfect to focus on short selling. Financial crisis, either currency or debt crisis, seemed to happen every three to four years. 1991 - savings and loan, 1994 - tequila crisis, 1998 - Asian Financial crisis, 2000 - dot-com bust. So when I got my first fund in 2006, I was very long, and then went short in 2008, and raised more money in 2 months in 2008 that I had in 2 years previously. Later on I was short commodities in 2011, MLPS in 2014, Japanese banks in 2015, and even Chinese tech in 2021. I got a lot of short calls right - but markets kept going higher.

In 2018, I thought I had found a career making trade in clearinghouses - and how they systematically misprice risk. The analysis, still looks as good as ever, but every crisis that is caused by clearinghouses gets cleaned up by the authorities. Bearish analysis is not rewarded, and this is what makes it hard for me to get excited about markets. How can I win, if leading stocks never fall?

You are probably asking, why not just win and lose with everyone else, why not just buy the S&P 500 and enjoy the free money the US government is dispersing. Well I could, but it would also take all the joy from financial markets from me. Its a financially stupid, emotional answer - but its the truth. For me its a hard truth. Should I take the easy but financially rewarding route - index investing, or buying quality stocks - or do I keep slogging away trying to find a different more fun way to make money? I already know the answer. I should have stopped playing basketball years ago - I have SOOO many injuries, and yet I keep going out there as its fun. I suspect I will keep looking for that “fun” trade - or eventually just lose interest in markets. Funny - trying to be a winner, has made me a loser. But unlike my knees and basketball, I think I still have the mental capability of finding that trade. That is probably why keep shouting into the void with my substack - just to make sure I am looking around for that long lost “fun” trade.

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Boeing was a frustrating short for me back in the day. In many ways its a very transparent company. Together with Airbus it has a duopoly on the commercial aircraft, enjoying good pricing and margins. The only real driver has tended to be orders from airlines, which tends to ebb and flow with the economy. Airlines may go bust, but Boeing and Airbus would always be there, ready to make more planes.

Around 2017, I thought Boeing looked an interesting short. A third of its order book was estimated to from Chinese airlines. With Trump coming in and the investment climate between the US and China deteriorating, the outlook for Boeing was deteriorating in my view. China was also spending large amounts of money to develop its own aircraft, which would at the very least take some of the Chinese market. From an order book perspective, order backlog did decline over this period. However the stock soared.

The main reason was that management focuses heavily on share buybacks. Shares outstanding fell nearly 20% in this period.

In essence, all operating cashflow was diverted to shareholders. In 2018 and 2019, USD 20bn was used to buyback shares at around USD 350 a share.

While Covid was not particularly predictable, lack of investment into product has indeed comeback to haunt them, as the other side of the duopoly, Airbus has continued to prosper.

For Boeing managers the short term gain of share buybacks was too difficult to resist. For US politicians, the same calculation has taken place, where the gain from spending has outweighed longer term concerns. The most obvious is the inability to raise taxation. 6% of GDP budget deficit with full employment is hard to understand.

Even more mysterious is why the Fed began to cut rates when the stock market and property markets are at all time highs.

The Federal Reserve also cut rates while Boeing workers are asking for a 40% pay increase, and the longshoreman union just won 60% pay increases. The US is flying high at the moment, using its own money to boost growth, but just like Boeing, management seem to be overly focused on short term gains. For me, GLD/TLT points towards the bill coming due.

The question is whether the US government can find it within itself to return budget balance, or like Boeing it waits until crisis before acting?

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One thing that this year has made clear, there is no going back. When Trump lost to Biden, there were some changes in foreign policy, but financial policies stayed pretty much the same, and in the upcoming Harris/Trump face off, whoever wins, financial and economic policy will not change that much. Why? Well ultimately, politicians are more followers than leaders. To win, they follow the crowd. Boris Johnson when he was Mayor of London was ultra-globalist, but when he became Prime Minister, was ultra anti-globalist. The only thing that had changed was that Brexit had shown that non-elite backed policies were vote winners. It is very easy to hate on the standard bearers of the anti-elite vote - Trump, Johnson, Orban, Farage, Le Pen etc. They are all deeply flawed people. But they do politically well despite their flaws tells you that that its the message and not the messenger that people want (as they are deeply flawed people, they believe that people believe in the messenger rather than the message - which is why all populists fail eventually). The key message is that “labour” will not take the brunt of economic adjustment anymore. Initial Jobless Claims remain at striking low levels - and are likely to remain so.

For me this means, unemployment based macro signals will now fail repeatedly. Historically, rising yields worked on the US market by weakening housing and capital good demand, causing unemployment to rise, and a deflationary impulse. This is no longer the case, and much like the late 1970s, the yield curve can become very deeply inverted. Or in other words, old school macro indicators will not work anymore.

The US has run a large trade deficit with the rest of the world. This gives it some huge advantages. Tariffs allow it to exert pressure on trade partners, and incentivises firms to bring factories and jobs back to the US. It also places tax burden on foreigners. If the focus is on maintaining full employment, then I expect tariffs to rise across the board.

President Trump had no intention of ever balancing the fiscal deficit, and has hence boxed in his rivals to follow suit. Perhaps revenue raised from tariffs could compensate, but that remains to be seen. US fiscal deficits are likely to continue.

I think this is clear, and generally understood. And this informs the GLD/TLT trade that is working well.

The more interesting question, if this is the “action”, what is the reaction?

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If you are wondering what a contra is - its an indicator that the market has gone too far, and ready for a tumble. One of the most famous, possibly made-up example, is Joe Kennedy selling the stock market after getting stock tips from a shoeshine boy in 1929. The cover of the Economist is seen as a leading contra indicator - and has been subject of studies. In my working experience, the cover from late 2009 lauding Brazil was as close to a perfect contra indicator as you could get.

And indeed, it marked the top in EWZ US - the MSCI Brazil ETF.

So is this the top in the US? Well unfortunately, there have been plenty of contra covers on the US in recent years - all of them wrong.

Why did the Economist cover indicator used to work? And why does it not now?

As hard as it may seem now, peak oil was a big thing around 2007 or so, as the oil price surged. The idea was that all the easy oil had been extracted, and that oil production was headed for a period of decline and high oil prices would be with us forever.

Of course, economics and finance suggests that high prices will attract capital and innovation, and eventually drive supply. This is exactly what happened as the US shale revolution turned the US into an energy exporter and flooded the market.

The best shorts are cyclical businesses that people believe in are secular stories. Cyclical businesses just need prices to rise high enough to attract competition. To my mind semiconductors and oil seem to have a lot in common. Essential for economic growth, but just need the occasional period of high prices to incentivise supply and capital investment. For me TSMC with it transparent pricing seemed to be a good place to look for signals. And in recent years, pricing has surged. I thought the surge would then see a period of decline like we saw from 2002 to 2011. Now I am not so sure.

Part of me put the recent surge in semi pricing down to the US effectively kneecapping Chinese semiconductor industry. Surely for an industry as innovative and competitive as semiconductors, surging pricing should soon turn to bust, as it did in 2001. However, reading a recent Economist briefing on semiconductors, I realised I was fooled. As a regular reader of TSMC quarterly reports, and the continual movement to lower and lower telemetry, I thought innovation in the semi industry was moving as it had always done. However as the Economist shows, the node names now longer match up with the actual improvements we are seeing. Unlike oil, there has been no breakthrough technology - we have been operating at peak semi since 2010.

And in contrast to the oil industry, the semiconductor sector has been the place to be.

There has been talk of some technological breakthroughs to drive more improvement- switching from silicone to nano carbon or quantum computing, but nothing so far. If peak semi is real, and it looks that way to me, and AI is real, and my interactions with Chat GPT are leaning that way, then absent a recession, semiconductors will continue to do well. What is similar to peak oil is that semiconductor industry requires a new technology to add capacity. While there is plenty of investment, so far no transformative breakthrough has occurred. Perhaps the most interesting thing about “peak semi” is that AI is driving increasing power usage. The performance of US utilities, and particularly nuclear focused utilities shows that a connection between computing and power prices is beginning to be established.

Can surging investment into AI eventually cause power prices to rise to a degree to force much tighter interest rates policy from central bankers? Maybe, but I don’t know. But what I have learnt is that if the best shorts are cyclical stocks that people believe are secular growth stocks, then the corollary is looking true -cyclical stocks that turn into secular growth stocks are the best longs. Nvidia and semiconductors are fitting that bill -and maybe now utilities too?

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I was wondering why US stocks have continued to do well when GLD/TLT is also trading so well. I thought that the continuing boom in tech stocks recalled the dot-com era, but as interest rates normalised, the boom would end. This was the case with a subsection of the tech area - mainly the speculative area that ARKK specialises in.

While I knew that many of the leading tech companies were much better finances than the typical speculative tech company, I also was negative on the larger tech companies due to the experience in China. As regulators broke down switching barriers, and the harvesting of data, the “flywheel” of big tech went into reverse. While the rhetoric from both the Republican and Democratic party has turned anti big-business, the US legal system seems to be working hard to prevent any decisive anti-big business policies to be implemented.

I should define platform businesses to make sure we are on the same page. Platform stocks are businesses that other businesses need to operate, and face limited competition, and hence are able to extract rent. They are either closed gardens (that is you can only use their software and payment systems, and switching cost are high) or have very dominant market share - monopolies or duopolies. Apple, Microsoft, Amazon, Meta, Google, Visa, Mastercard. You could also throw in the rating agencies - Moody’s and S&P Global. You could also throw in other businesses such at MSCI, and Exchanges. Fast food chains like McDonalds also share some similarities. They represent the best of American capitalism, and the pinnacle of globalisation. A large number of these businesses have been subject to antitrust investigations. My biggest issue is that the rise of the platform company and the associated performance of the S&P 500 now has almost a negative correlation with the US budget deficit. Or as share holders get richer, the government gets poorer.

This is mainly, but not entirely, due to falling tax collection. Corporate tax collection is now very low - and at similar levels to 20 years ago.

One of the brutal facts about globalisation was that it was more and more difficult to tax corporates. The temptation for a small nations to cut taxes to attract multinationals that would otherwise invest elsewhere has led to a race to the bottom in corporate tax.

The problem is that US multinationals through various quirks of the tax system pay virtually no tax on foreign earnings - particularly if they run their operations through Ireland. Ireland now runs a fiscal surplus. What is good for Ireland (population 5m), is bad for rest of Europe (population 450m).

Largely driven by corporate tax revenue. Irish corporate tax take in on course to have risen nearly 700% in 10 years. This in stark contrast to everywhere else.

One other factor that disturbs me about US multinational tax arrangements is that it makes it almost impossible for domestic rivals to compete. If you face a competitor that is already larger than you, but they also pay next to zero tax, the chances of competing effectively is virtually zero. This ultimately drives more business to be run and listed in the US. In terms of the flywheel that VC investors are so enamoured with, US tax arrangements drive more and more business to be run out of the US, making it harder and harder for any other country to retain or attract businesses (see ARM in the UK for a recent example). To me, the current political mood of the world is dissatisfaction. Rising income inequality seems to me to be the root cause, and politicians on both the right and left are trying to solve this, or at least appear to do so. This distortion shows up in macro data. One of the biggest macro distortions has been the net international investment position (NIIP) which I have talked about at length. Not only is the size of NIIP deficit of the US without parallel, this should sum to zero across nations, but likely does not due to various structures to shield tax.

The implication is that the bed rock of modern financial theory is probably wrong. Sovereign debt it assumed to be the risk free asset, and US treasuries the ultimate risk free asset. NIIP and tax data would imply US multinationals are the risk free asset (that is the ability of US multinationals to shift revenues and profits as well as globalised production base makes them beyond the control of any government - or in other words, large US corporates are much like bitcoin). The extension of this argument is that the idea of a modern government is broken - as more and more of the economy moves beyond it ability to either tax or regulate. This is the buy case.

The problem with the buy case, for me anyway, is that history is full of examples of a small elite that enrich themselves while ignoring the masses. It always ends with revolution. The idea of modern democracy was to mitigate the risk of revolution by making sure that policy suits the masses. The signs of this revolution is everywhere. Populists are on the rise in the west. China and Russia have broken out of the US orbit, and are replacing US monopolists with their own. US and Western military support is not enough to turn the tide in Ukraine. The Middle East is on fire. And somehow the largest, most profitable organisations to ever exist are happy to continue dig away at the financial supports of western civilisation.

I suspect the best analogy I can make it back to the GFC. Everyone involved in the subprime market knew it was a scam, and that large players like AIG was selling CDS insurance at the wrong price. But it was too profitable for the large investment banks to ignore, so they continued to dance.

Hollowing out the financial support for the West has reduced the political and military power. Everyone assumes someone else should pay, and ultimately the bill will me much larger. This is human nature. Why does GLD/TLT trade so well when US stock market also trades so well? Because both reflect the failure of the US government.

One way or another, governments will reassert their primacy, as that is what voters want, and history shows. My worry is that large US corporations wake up to the risk too late. The movement of GLD/TLT suggests this is the case.

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GLD/TLT has carved out a new high in recent days, which is pleasing.

The original idea behind GLD/TLT is that in a world where governments are becoming more “populist” (i.e. more concerned with raising wages rather than asset prices) - then inflation will be entrenched, and central banks will need run much tighter monetary policy to keep inflation under control. This year has really been the year of gold, as western central banks have really wanted to cut interest rates.

Why the Federal Reserve wants to cut interest rates when house prices are pushing higher from already high levels is a mystery. The decision making and the thought process of Federal Reserve governors is extremely poor for people with that much power. It is pretty much guaranteed that once the Fed governors leave office, no one will have any interest in their ideas. Their power comes from their institutional political power, not their inherent intelligence. They are not Friedman, Hayek or Keynes.

For various reasons, the market had convinced themselves that long term US rates had found a bottom. TLT has been in a range for a year now.

What remains most striking was the sheer amount of investment that has gone into TLT, while gold flows have remained fairly stagnant. As I have mentioned, ETF flows usually follow performance - but for some reason people have convinced themselves that low interest rates are here forever.

A much more typical example is China, where recent surge in shares has also seen a surge in shares outstanding for FXI US (China large cap ETF).

From a market perspective, the strength of the Chinese Yuan is probably the most inflationary signal out there.

My guess is that deflation trades, such as TLT are now in the firing line of the market. Even with the recent rate cut, short TLT generates a positive carry.

The JGB market has also stayed in a quiet bear market, even with the Federal Reserve rate cut, and the recent strength of the Yen.

So here is the trillion dollar question. Was the Federal Reserve rate increases only deflationary for Chinese assets? Was the pressure that it put on the Chinese Yuan leading to weakness in the Chinese property market? The original idea of needing asset price weakness to keep inflation in check was correct - but only in terms of Chinese asset prices? Given the size of the Chinese economy and property market, this could well be true.

If that was so, then rising Chinese equities would indicate rising inflation, and a possible tightening of interest rates in the US, meaning inflation in China leads to tighter monetary policy elsewhere. We are already seeing signs of this, with currencies like Korean Won weakening on Friday - pricing in potential Federal Reserve rate hikes?

It is an interesting idea. And a long way of saying that I think TLT is likely to weaken from here, and GLD could well take a rest.

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To be bullish on China, you have to be comfortable with sanction risk. What I mean by that is you won’t become a forced seller due to sanctions. When Russia invaded Ukraine, sanctions made Rosneft uninvestable. In practical terms, foreign investors (via ROSN LI) who owned Rosneft saw the value of the stock collapse, while domestic Russian investors saw its value maintained. Of course, there is the small problem of getting capital out of Russia. This is what I mean by investable. Getting capital out of China is already a problem, and various semiconductor related names like SMIC are already subject to sanctions, so this is not a hypothetical issue.

The second question is do you have to be involved in China? If you do and are not fully invested, then you are already lagging the market, and are now running career risk.

From that perspective, buy Alibaba and Tencent and you already have 25% of the index, and you are covering the risk of Chinese tech emulating the magnificent seven effect we have seen in the US.

If you believe in the Chinese tech story, you can see that Alibaba has derated from 11 times EV/Sales to about 1.5 today. For long only managers, not owning enough Alibaba would be a problem today.

For what it is worth, in my view Chinese tech will likely remain risky while Xi remains in power. But I do think Chinese authorities are willing to change their view on is the property market. Rather than benefiting tech billionaires, a change in the fortune of the property activity is probably something the authorities could get behind. Floor space built has fallen 75% since 2021.

One high quality company I like plays into this theme.

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Performance was poor this month, and I am left in a quandary. The original inflation trade - long GLD/TLT is trading fine, and just as expected.

But all my attempts to try and build related ideas around this fail. Why is this? I have come up with a number of options:

a) As opposed to when I was started back in 2002, when I would read loads of research and company presentations every day, and be surrounded by other investment professionals, now I tend to work by my own, and don’t have the same inclination of dredging through pages and pages looking for a nugget of useful information.

b) Markets have changed, and the period from 1990 to 2015, which I based my ideas and methods on is never coming back. Could be true - but impossible to answer with 100% certainty.

c) I am running the portfolio with an view to launching a fund, so I am looking for eye catching ideas that will market well (either consciously or subconsciously).

One or all of these things could be true. It makes me wonder if I should just move to and old school retirement portfolio style of investing, where I just buy companies I like, that I know will be around forever? Perhaps I should ditch eye-catching, and go for stodgy? The problem is that I know that change in coming, with the certainty that the Starks knew “Winter Is Coming”.

This may be hard for people a bit younger than me to believe, but in the 1990s, when I was at university, there were still people who believed in communism or, to be more accurate, socialism. There arguments were more or less along the lines of “socialism works, it just wasn’t implemented properly”. It made no sense to me, and I think it was the same for the voting public, and the unreconstructed Trotskyites were condemned to electoral doom. Betting on capitalism (or globalisation) in the 1990s was the winning bet.

When I read politics today, I see more and more articles from the right decrying government and its profligacy. Everything would be better if government got out of the way. Welfare beneficiaries are bleeding the nation dry, and voting should be confined to only those that pay taxes are various ideas I see put around. I think this is a response to hard core capitalist seeing that the standard bearing parties of free market capitalism, the Republicans in the US and Tories in the UK, can no longer win on capitalist policies. Free trade and privatisation are not election winners, anti immigration and anti big business are. When I read these arguments, I think to myself, like the unreconstructed Troskyites, what they are really saying is that capitalism works, we just didn’t implement properly. The implication is that hard core capitalists are condemned to electoral doom. This logic keeps me wanting to put inflation trades on.

The logic of inflation makes sense, but it is not working in my portfolio. Of the inflation trades that I have on, the only one that responded well was gold, up 5% in the month.

On the short side, I was actually pleased with TLT. Even though it rallied a little, the Federal Reserve rate cuts led to a steepening of the curve. The 30 year yield relative to 2 year has gone from being 1% less than the 2 year yield, to now 50bp higher. I could see the 2 year yield flatline from here, and the curve steepen much more. Let’s see.

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The HSCEI has rallied 26% this month.

Is it worth chasing? Well for the technical minded, HSCEI/S&P 500 has completely unwound all the outperformance it achieved from 2000 to 2010. Even with the move this month, its has barely begun to catch up.

One unusual feature of this rally is that it has not been associated with any change in interest rates. The Shanghai Interbank 12m rate has normally risen with markets as expectations of growth and inflation return. Not this time.

What is more common with a rallying HSCEI is a strengthening Chinese Yuan. The recent rally has pushed it to the highest level since 2023. This is bullish and inflationary.

The most bullish thing I could find for Chinese equities is that the authorities are looking to get housing construction back on track. Activity has collapsed back to 2008 levels, which I consider more normal.

Back in 2015, I was short China, when government stimulus sent the market higher before it crashed.

One good lead indicator that the rally in 2015 was unsustainable was that the dividend futures were moving in the opposite direction to the market.