Capital Flows and Asset Markets

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I have always liked the idea of trading a reaction rather than action. For example, if the BOJ commits to a policy to weakening the yen, then Japanese equities will surge. But if the BOJ has a hawkish surprise, then your short yen and long Nikkei trade burns you badly. But lets say after the Yen has devalued, and nothing else changes, then I would expect Korea to be forced to devalue as well, so you can short Korean Won as a “reaction” to Yen devaluation.

GLD/TLT is an extension of that idea. I have no idea whether the Fed will be dovish or hawkish in the future - and neither do the Fed governors. I have long given up expecting logic or consistency from central banks. But in a “pro-labour” environment, if central bank policy is loose (proxied by TLT here) then gold should do well. And if central bank policy is tight, the gold should do badly (or more likely flat). GLD/TLT is on the cusp of breaking out.

All of that has been driven by a move in gold

Harry Hindsight would say to me I should have not bothered with the TLT short - but I lost count of the clients who used to trade over the top of my positions, would ditch hedges and then tell me how much money they lost. The offsetting position is there for a reason. The fact is that the Federal Reserve cut rates by 50bps, and the US 2 year Treasury seems to indicate more cuts to come.

While gold is at new highs, digital gold - bitcoin - is loitering at levels first seen in 2021.

Should we expect a move in bitcoin? Well I always thought the action and reaction in crypto space happened in the stable coin area. If you start seeing an increase in money in stable coins, then the likelihood of a surge in bitcoin and other crypto goes up.

I was deeply influenced by an Economist article written all the way back in 2018, comparing the big tech to the East Indian company. The important paragraph is reproduced below.

A few years later I successfully shorted Chinese tech names, as the government decided to reign them in and regulate them. While this is portrayed very negatively by western media, much of the regulation was extremely sensible. Data harvested from consumers could only be used for the purpose it was given. Platforms could not favour companies they had a commercial interest in. Payment systems needed to be opened up. The Chinese tech sector never recovered. For me, this meant that the “flywheel” for tech companies can go into reverse.

As the Economist article pointed out, profit expectations for big tech were very high 2018, but have been met. But as the article makes clear, Apple in 2018 was getting into comparisons with Standard Oil and the East India Company. I could have added Amazon, Nvidia and Meta into the analysis, and we are apparently living in an era of not just one East India Company, but five or six. Is it possible to have a number of huge commercially dominant companies?

So there are some caveats. First of all, using US GDP probably does not make sense. All of the big tech companies work on a global scale. Using global GDP, it does push them back profits back to 0.1% of GDP, but then amalgamating their profits does push them back to 0.5% of global GDP. So big tech would be on a scale of influence in line with Standard Oil or the East India Company but on a truly global sense. This also makes them more of a comparison with Chinese tech, which have tended to be domestically dominant. I thought the big tech companies would see their dominance ended in one of three ways. One, new technology would come along and disrupt the current system. Two, foreign competition would undercut the US giants. And thirdly, that the US political system would move to restore balance. None of this has happened, or looks likely to happen.

Firstly, the closest thing we have seen to new technology is the appearance of ChatGPT and AI. On current forecasts, Nvidia looks to be joining the “East India Club” in the not to distant future, with profits of USD 120bn predicted for 2026. The AI revolution does not seem to be disrupting the existing players - even though Google search would seem to be most at risk. Microsoft has seemingly been able to join forces with OpenAI. The AI revolution seems to require huge stores of data, which only the incumbent tech firms seem to be able to supply. The only loser from the move to GPU from CPU seems to be Intel.

Chinese tech companies such as Huawei and Xiaomi seemingly offered competition to the Apple model, but have been neutered in the US and other Western nations due to security concerns. TikTok offered competition to both Alphabet and Meta - but again faces security concerns. Security concerns have allowed the US government to try and slow the development of Chinese semiconductor industry, and allow the build up a virtual monopoly position by US firms. The share price of SMIC - China’s semiconductor champion, is more Intel than Nvidia.

Thirdly, and most likely in my view, was that the US political system would move to counter tech dominance. The appointment of Lina Khan to the FTC, as well as Biden’s guidance to regulatory authorities to promote competition all pointed to a Chinese style regulatory backlash. However, in many cases, the legal system has acted to blunt government policy. Courts have become a battleground for politics in the US. Both Donald Trump and Joe Biden has sought to appoint far more judges that their immediate predecessors. Biden has appointed 43, while Trump appointed 53. Noticeably, both Biden and Trump have acted to leave no vacant positions, unlike the usual practice.

Regulatory and judicial stalemate probably suits large US tech companies as they benefit from many policies that were originally put in place in the 1990s to promote tech industry. The only way to make sense of US tech in the same terms as the East India Company is to think of US tech as a branch of the US government - just as the East India Company ruled India on behalf of the UK government. 20 years ago, in European and Asian markets, domestic operators dominated in the media, retail and often electronics space. Now US tech companies dominated in all these areas, and pay little to no tax in overseas markets, just as the East India Company paid little to no tax to India. I do not like this analysis or conclusion, but it does not mean its wrong.

The digital revolution has seen US tech emerge as the dominant players - and have seen them use their influence over tax and regulatory authority to continue to grow profits. This is at one with the idea of shareholder value led capitalism. Corporates are expected to game the system to maximise profits. There are two things that I dislike about this conclusion. First, US tech have an inordinate power over my life, but I, and the UK or Australia government that is meant to represent me has no power over them. This can only end one way - with the rejection of US corporate power also seen as a rejection of US power. Certainly I find high taxes in the UK, and the zero taxes paid by US tech deeply infuriating. Politically, this tension is more and more visible, but can the West survive if it rejects US corporate practice and governance?

Secondly, US corporate dominance has no natural end, only a political end when a coalition comes together to end it, just as happened eventually with British rule of India. The problem I have with this is that I have little faith this happens within the US political system. But the alternatives are grim too. I feel this is classic US business practice - make all alternatives so unattractive so you are forced to stay with a system that does not work for you either. What does this mean from an investing perspective? Well the one trade that has worked me is long GLD/short TLT. Looking at the long term chart, I assumed this was a move to back to a pro-labour inflationary era.

But if I was using an big tech as Empire analysis, the move in GLD/TLT reflect now a political turn towards labour - but the fact that the most powerful government the world has ever known, is in fact unable to control the most powerful companies ever known. Or as I have said before, the S&P 500 is the risk-free asset, and the US treasury is the risky asset. Corporate control of the US government would explain why despite Biden’s best efforts, real wages seem to be going nowhere. I know there is a widely held view in the US that corporates control is better than government control, and the power of the US government and corporates is slowly but surely forcing that view on to the rest of the world. The only place where that is not happening is China, which may be why Chinese government bonds have held their value. Or in other words, shareholder led capitalism ultimately leads to the destruction of modern government?

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For the best part of 20 years, commodity prices seem to ebb and flow with the vagaries of Asian economic growth. The 1990s saw the collapse of the Soviet Union, the busting of the Japanese economic bubble, and the heavy restructuring of the Chinese and Indian economies to free market policies, and then finally the Asian financial crisis. As mentioned in previous posts, I see gold as an Asian asset that happens to be traded globally. The 1990s saw falling Asian wages, and so we saw a falling gold price.

Conversely, rising Asian wages, particularly since 2000 has coincided with rising gold price. While Chinese economic growth has slowed, growth in India and other Asian nations like Vietnam have been able to keep the gold story alive. It should be noted that in 2011 onwards, when it looked like China might devalue, gold suffered, but as China has maintained a policy of keeping real wages high, gold has continued to do well.

Probably the most eye catching move has been weakness in the oil price. Given its importance in inflation and inflation expectations for the American economy was probably the key factor in the Federal Reserve cutting rates.

The reason given for oil price weakness is weaker than expected imports from China. That is demand is surprising to the downside. While that is true, IEA demand forecasts show that compared to the collapsing demand in 2008 or 2020, we are not in the massive economic weakness area.

That other economic sensitive commodity, copper is not collapsing either.

So what gives? Well for me, a pro-labour world, and world of rising Asian wages is a world where commodity demand should remain reasonably solid, but perhaps not the crazy growth in demand we saw in the 2000s. What this means is that supply, rather than demand is a much bigger issue. I think with oil, supply has surprised, rather than demand being weaker than expected. I think this is also true with agricultural products. Corn prices have round tripped.

I suspect many investors, myself included, expected Russian and Ukrainian supply of commodities to be heavily disrupted, if not by the war itself, but by the sanctions imposed on Russia. As the most recent report for the US Department for Agriculture makes clear, there has been little disruption in Coarse Grain (mainly corn) exports from either Russia or Ukraine.

Commodity markets priced in tight supply in areas where Russia and Ukraine are leading exporters - corn, natural gas, oil - and have been disappointed when supply was fine. In other areas like gold, which given the ease of transportation, no real supply disruption was expected have continued to reflect good demand.

Away from Russian/Ukrainian issues, food inflation remains a big issue. In Japan rice prices are surging.

Orange juice prices are at their highest levels since the 1990s.

Coffee prices continue to surge.

Commodity prices seem to reflect changes in supply, with demand remaining robust - which is what the pro-labour theory would suggest. Certainly, when I look at the CRB Food Index, I find myself thinking that interest rates cuts here are foolhardy.

Why has GLD/TLT traded so well? Well gold supply is very difficult to grow rapidly, and or to surprise the market - not the case with agricultural or industrial commodities. It continues to reflect a pro-labour environment in my view.

Commodities that look to have supply restraints should continue to do well. So commodity markets have changed from one where demand was always better than expected, to one where supply is the driver of prices. This is breaking down correlations in my view - and making them seem “screwy”.

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I got my first job as an emerging market analyst because I was cheap. I was a graduate working for UBS in Sydney, and UBS offered a two year program to work elsewhere in the bank with the central office picking up most of the tab. I found a role at GAM in London working on an emerging market fund and away I went. I have been in London ever since. As an emerging market analyst, my boss would ask me to look at banks in a different emerging market every day, so I tried to minimise my work by creating a single huge excel spreadsheet. What I was trying to do was work out if there was any consistency in bank valuations across the world. I created a valuation matrix for each nation, get the average valuation across all banks in that nation , and then compare to various metrics by nation. One result was that market capitalisation to total assets tended to rise with higher return on assets. This should not be a surprise - as valuations and return on assets are different ways of looking at the same thing. I show how it looks today below.

However, I always felt this was a slightly weird way to look at it. During the GFC, and more recently with Silicon Valley Bank, I felt that the quality of the deposit franchise should be where the real value of a bank should be. Or in other words, growing a loan book is easy, but gathering deposits is hard. The problem with this view of course is that deposits are a liability and cost. The relationship between market cap and deposits and 10 year bond yield seems far more random.

This probably sounds abstract. Another way to think about it the value of the top 4 banks in very different markets. I look at Brazil, US, Canada, Australia, UK and Japan. Despite UK and Japanese banks being much larger than Australian and Canadian banks, they are worth less.

The usual argument for this valuation dispersion has to with market concentration. Broadly speaking that seems correct. Overbanked nations like Germany, Japan and Taiwan tend to generate lower returns on assets.

But with the recent failure of Silicon Valley Bank, and my view that politics is turning pro-labour, I wonder if bank dynamics are going to change?

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The short end of the treasury market seems fairly convinced that unemployment is about to rise, and interest rates will be cut dramatically. Since 2000, the 2 year yields have signalled recessions. But in 1990s the two year yield fell dramatically in 1994 and 1998, both years of emerging market crises but were failed recession signals as employment held up.

Its a little hard to find where the bearish view on employment is coming from. the KDP High Yield Daily has seen yields fall - which is normally economically bullish. I would see a spiking rate as a reason to get bullish treasuries - but here we have the opposite.

The leveraged loan market is also not really signalling trouble either.

The Government bond market is not giving me a recession signal either.

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I know I have my own brand of fund management. It is perceived as aggressive, while in my mind it seems conservative, which I guess is just a matter of perspective. One thing I know for sure is that it is not working at the moment. Whenever something is not working for me, I go back to my intellectual foundations, and see if I can find something wrong. If I do find something is wrong in my analysis, then I ditch my trades, and if I can’t, I stick with them. Here is my attempt to go back to the foundations, and see if I can find any problems.

First of all, what exactly is my style of fund management? Well I believe that there is always a megatrend in markets, something that is driving all asset markets. Without understanding that megatrend, then you are just speculating, not investing. If you don’t understand the megatrend, you are better off in cash, and not investing at all. This is the conservative part of my investing strategy.

If you understand the megatrend, then my favourite thing to do is to sell winners and then short sell them as the trend is breaking. This is the aggressive part of my investing strategy, and the bit I love the most. Successful short selling is not only lucrative - its fun. The best work calls I have ever had is when an investor calls for an update and you tell them you have started shorting something you were long of for ten years. Nine times out of ten they will give you more money to manage.

For these reasons, all of my work is centred on finding new megatrends, and trying to call the end of existing mega trends. My themes of pro-labour and changes in fertility rates are all to support the idea that the mega trend of the bond bull market is over. I still think this theme is correct, but it is trading against me currently.

I also thought the theme of food inflation was a good one, with China becoming a food importer, and war in Europe disrupting supply, this seemed like a great megatrend to play. However, Chinese demand has weakened, and Russian and Ukrainian supplies of agricultural products has not been disrupted as I would have expected. This megatrend has not played out as I hoped.

My work on clearinghouses implied that this was a failed reform, and clearinghouses would be at the heart of the next financial crisis. While I think this has been proven to be true, regulators and governments have seemed happy enough to bail out markets and clearinghouses rather than make any changes. So the analysis was correct, but the politics not supportive.

My work on autocallables was that market volatility would have a tendency to spike higher from time to time. This seems to be coming through, but I have no strong view on how to monetise this idea.

The problem with my style is that there is a heavy mean reversion bias to my thinking. Winners become losers, and loser become winners. This thinking comes from my lived experience. I became interested in markets because of the Asian Financial Crisis in 1998, I joined UBS as a graduate at the top of the dot-com bull market in 2000, and I had my first fund in late 2006, just the as the US housing crisis and GFC were beginning to start. In other words, I saw a lot of fund managers fail in my first 10 years in the market. I also first went to Japan in 1991, and property prices are still well below peak levels that I saw back then. It seemed to me, that if you are going to be a fund manager, you need to find an idea that is so compelling, and so big that you can build a fund around it, and have the ability and faith to be able to add when the market moves against you. And that is what I have tried to do. The problem is that the most “winningest” market - the US - simply never loses anymore.

There is a line of thinking that we are in a bubble driven by passive investing. That is investors are taking enormous risk unknowingly. Charts like below are presented as evidence. What I really dislike about this argument, and not just this one, but any related to markets, is that is starting assumption is that market pricing is “wrong”. Also it assumes causation that asset flow is driving pricing, while it is perfectly reasonable to argue the opposite - as passive has done much better than active, investors are going to where the best returns. The passive versus active argument is a dead end in my view.

A far better place to start in my view is the share buybacks.

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August seemed like one of those months that went on forever. It started with the BOJ raising rates, and a weak employment number in the US, driving huge volatlity. We saw a rapid rally in the Yen, and Nikkei VIX top 70.

This briefly caused GLD/TLT to dip, but was fully recovered by the end of the month.

I had assumed that as the BOJ was tightening because Japan was also moving pro-labour. Pro labour policies are positive for Japan in my mind, and this would not have a particularly negative effect on Japanese assets. The Topix in USD terms, finished the month back at highs.

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I like Japanese banks as an inflation trade. Of all the markets I look at it, it seems that changing policies could turn into a long bull market for the banks. I was particularly drawn to the relative trend change in Japanese banks to the Topix.

Of course this is only useful if the Topix is in an uptrend. Topix is down 5% this month, and banks are looking like they might break lower.

In the pro-capital, deflationary era, Japanese banks have been reliable shorts. Even better than that, they have tended to signal trouble well before the market fully appreciates the problems that are coming.

Could Japanese banks be signalling a deflationary move?

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When I got my first fund back in 2006, I had nothing to lose. I had no money, and only one investor. I was bullish on emerging markets, but almost as soon as I got fully invested in April 2006 (100% long) and made a quick 10%. Then the markets dumped, and I drew down over 20%. I remember going home to my new wife and telling her how I had already fucked my one shot. John Horseman was my only investor, he called me over, asked me about my positions (I only had about 10 or 12). I explained them to him, and he said great. He doubled the money I was managing, and kicked off the process to open to outside investors. His timing was great - the fund made 100% from then to end of 2007. I won Eurohedge Best New Equity Hedge Fund.

By 2010, I felt that the China story was coming apart. The government orchestrated housing boom of 2009 looked to me to be a disaster, and the most likely outcome was a China crisis of some sort. This made me bullish bonds, and bearish anything to do with emerging markets. This was good call, but too early. Emerging markets continued to rally until suddenly the markets tanked in 2011, and the short emerging market trade took off.

2010/11 was very tough, as I combined a bearish view on emerging markets with a bullish view on European bonds. I particularly liked Irish bonds, which I saw as having zero chance of defaulting. I bought them when they yielded 8%, unfortunately they went to 12% before rallying.

The combination of bearish emerging markets, and bullish bonds before the trends got going led to horrendous underperformance and redemptions. I was sure I was right, but it was awful.

In 2021, I got very bearish on Chinese tech as I read what the regulators and government wanted to do, and was very correct. But I also thought this would be very negative for US tech, and this was very wrong. Why was I bearish? Generally I view tech as being deflationary (by definition) - and this has been the case in China. But in the US, tech deflation does not really exist. Has anyone seen the cost of using Apple cloud fall? Does Netflix membership fees fall with scale? Is AWS deflationary for users anymore? Despite only incremental improvements in the iPhone, do they get cheaper? The answer of course is no. But I thought it tech deflation would revert for a long time - and suffered because of it. Sometimes you got to know when to hold them, and know when to fold them.

I mention all this, as I am in another moment of existential angst.

For years Japan had a tourism imbalance. Japanese went and travelled the world, but the numbers of tourists visiting Japan was limited. Under Prime Minister Abe a number of policies were implemented to promote tourism. Since 2011, the number of tourist has surged six fold and has recently eclipsed pre-Covid levels.

In Japanese current account data, Japan now receives more from tourism that it spends. As late as 2014, this balance was negative, but is now extremely positive.

There is another imbalance in the Japanese economy that I think may soon be rectified. Japan, almost uniquely among major economies, has never really had any major foreign direct investment flows. What does that mean in plain English? Foreign companies never built any factories in Japan. While the US has had large FDI flows since 1980, Japan has only recently started to see FDI inflows increase, but still lagging the US.

When we look at net outflows, we can see that Japan has very large outflows. Not as large as the US, but much larger than relative inflows. (I don’t know why the US shows a negative print here for 2019 for the US - data is from World Bank)

How does this compare to China? China is almost the exact reverse of Japan. It attracted huge inflows first, which are now reversing. China now has substantial outflows, as Chinese corporates invest overseas.

Using China data, which is more up to date, it has China moving to a negative FDI position. Direct investment into China has moved negative (implying that existing investments in China are being sold). That is production is being moved out of China.

Data from the United Nations Conference on Trade and Data (UNCTAD), we can get a “stock” value of FDI (basically a sum of all inflows). This seems to imply there is USD4 trillion invested in China, with another USD 2 trillion invested in HK, while Japan has only USD250bn of investment.

There is a stock of near USD 3.5 trillion of FDI in China that is no longer growing, and at risk of rising tariffs, at least in the Western World. I do not know how much of the stock of FDI in China is from Japanese corporates - but a reasonable chunk in my view. The current view is that a large part of the investment in China will be diverted to other markets - India, Vietnam, Bangladesh are the most likely names. The problem with these three is that they are not US military alliance members, and never likely to be. South Korea and Taiwan are members of US military alliance, but both are threatened by near neighbours. It seems to me that investing back into Japan makes the most sense from a geo-political point of view. This seems especially true when gross wages in Japan are inline with other developed Asia.

Japan used to have much more expensive land costs than the rest of Asia. Not only has this premium declined, Japanese property prices seem to be moving inline with the rest of Asia now. Japanese property prices are at level first seen in the 1980s.

Japan is still a centre for an innovation, with 3rd most patent applications globally.

The big question here is whether the Japanese government can enact policies to promote domestic production - just as it enacted policies to promote domestic tourism? Historically Japanese government did just that, but under pressure from Washington, and globalisation, moved more and more production off shore. Japanese industrial production is at 1984 levels.

Currently Japanese politics is in a state of flux, with leadership race for the LDP surprisingly open. The room for a “Japan first” style politician seems to be opening up. Will they grasp the nettle?

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