Capital Flows and Asset Markets

Everyone should love Star Trek. It imagines a world without money, where all the different nations of the world work as one. Its continuing mission: to explore strange new worlds; to seek out new life and new civilizations; to boldly go where no one has gone before! But away from the science and the fiction, it was the first American TV show to broadcast an interracial kiss in 1968. Star Trek is progressive to a fault, while Dune is desperately realpolitik.

To my mind, Star Trek follows up on the ideas I expounded in my post on Empire and Politics. In this post, I used John Darwin theory of Empire to delineate three historic empires, a Christian, Muslim and Confucian empires, centred on Europe, Middle East and East Asia respectively. What Darwin’s analysis does it greatly simplify power structures and history. It also solves the conundrum of why does religion, which promotes peace and goodwill, always seem to end up in the middle of all the most intractable conflicts. Simply put, religion is a power structure, more than a belief system.

As he notes, even though Europe was constantly at war, the main nations were also constantly swapping information, technology and culture. European wars were for control of Europe - not to destroy it. I like to think of World War I as a fight between France and Germany for control of Europe, World War II as a fight between Britain and Germany for control of Europe, and the Cold War as a fight between USSR and USA for the control of Europe. Note if you use religion as a way to delineate empire - Europe includes both North and South America as well as Australasia.

In Star Trek terminology, “Europe” is the Federation, slowly but surely adding civilisations to single polity - while maintaining their own cultural identity. Continuing this analogy, then we can see the Russians as Klingons. War like, and enemies for long time, but potential and eventual members of the Federation.

While I doubt US politicians think in these terms, Republicans and Democrats are united in their fear of China, not Russia. And the reason for this is that China operates completely outside of any European empire. I also wonder if this logic still applies to Japan. The nuclear submarine deal that underpins AUKUS deal, would make more sense including Japan in my view, and yet Australia was chosen rather than Japan.

If Russians are Klingons, then what are the Chinese? The best approximation I can come up with is that they are the Borg. I am only became familiar with the Borg because my Trekkie housemate was watching Star Trek Voyager, and the character “Seven of Nine” played by Jeri Ryan made an appearance. My interest was piqued.

Borg, if you are unfamiliar, are enemies of an Earth-based Federation, whose only real interest is the assimilation of other species’ technologies and DNA to improve themselves. Their catchphrase, “resistance is futile”, has entered the popular lexicon. To anyone who has spent time in China or Japan, European ideas being assimilated and made local is very common theme. Japanese curry rice is by definition assimilated and definitely Japanese. And Chinese history, unlike that of Russia, is not of empire expansion through war, but through assimilation. As far as I know, the Federation and the Borg never reached a truce or an alliance, as their value systems are too much at odds. Also in the Star Trek Borg tradition, the US is desperately trying to slow the technology that can be assimilated. But can China/Borg be stopped? Well using the International Innovation Index, China already seems to be one of the most advanced nations in the world.

So will China turn Klingon on Taiwan and invade? Unlikely I think. More likely, China will wait for either the West or other nations to build out alternative supplies of advanced semiconductors. Once this happens, Taiwan loses any strategic importance, and will slow become assimilated. Hong Kong and Macau have both already been assimilated, Taiwan will likely follow - but maybe on a 30 year timeline.

The problem, as I outlined before is that to keep Chinese GDP below the US level implies US policy is aiming to keep Chinese relatively poor. This is a tough policy to push to Chinese trade partners, and like Russian sanctions, it incentivises nations to work around the US system. To quote Data - this is not logical. I suspect efforts to hold back China not to work. I suspect Borg-like assimilation to continue. Resistance is futile.

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They say experience is good, but personally if I could trade experience for youthful dynamism, I would take that trade everyday. Sadly, its not, so we are going to have to settle for experience. And one thing experience has taught me, is that when your subconscious is not settled, then you need to take a beat and try and work out what is wrong. This also works the other way too. I think my subconscious knew that my friend, Michelle, would make a great wife, but it took a long time for my conscious self to catch up.

Working out what the subconscious it trying to say is definitely something that gets easier as you get older. And that’s not even just for myself. Whenever people say one thing, but then do another, its what they are doing that tells you what they really want subconsciously. Working out why they want that subconsciously can be hard to work out, but at least you know what they want.

Lets start with the areas where the conscious and subconscious parts of me are in agreement. It felt to me that political power was flowing back to labour and away from capital. For me this meant that inflation would be higher than expected, and that gold would likely outperform bonds. And the GLD/TLT trade has worked a treat.

What I also thought was that we would transition from credit driven growth to wage driven growth. That is full employment and rising wages would be good for growth, but that the higher interest rates would see credit contraction. From a macro perspective, this has been correct, with US M2 growth turning deeply negative.

My inclination would be that commodities would do well, and that financial assets poorly. That being said, MSCI World has recently hit new all time highs.

Using a macro line of thinking like this, then assets like utilities should also be struggling. But we have recently seen US utilities break higher, I am thinking (in a conscious way) that this type of macro analysis does not really work.

What I am starting to think, and with ample evidence, is that macro does not really matter that much. Industry and politics is the key ultimately. The subprime crisis, was the knock on effect of the US building too many houses.

The Eurocrisis was the knock on effect of Spain building too many houses.

The EM crisis of 2015 or so, was a knock on effect of too much commodity supply hitting the market.

As discussed, GLD/TLT could be working less because of some grand macro play, and rather many governments looking at how the US has tried to use financial sanctions to stop Russia and coming to the conclusion that Treasuries are not a “safe” asset.

I like shorting, but when I look at short ideas that have worked over the last few years, they have been driven by industry not macro analysis. Chinese tech was a good short because I read that the government was going to regulate them properly.

Starbucks has been a good short, because I started to see signs of a price war in the US, and Starbucks was trading by far the weakest of the food chains.

I think what my subconscious is trying to tell me is that macro analysis is fun - but has been generating declining returns for nearly 10 years now. Industry analysis, is really the key. Or buy industries where profits are going up, and short industries where profits are going down (hopefully where supply is overwhelming demand). Keep it simple, stupid.

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Usually I like to make changes at the end of the month, as that just makes everything easier - but I fell motivated to make some mid-month changes. As a rule, if a long or short position is bothering me, then it means its either wrong, or its too big. In this case I think I might just be wrong.

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I have always thought of private equity as a cyclical asset class. There was the famous RJR Nabisco LBO that failed, and formed the basis of the 1989 book, Barbarians At The Gate. I profitably shorted Blackstone soon after its IPO, as the end of the credit cycle appeared.

My negative view on private equity has also been reinforced by the usual dire performance of private equity assets that return to public market, either as an IPO, or as a sale to listed company. So when thinking about private equity, I really saw it as a play on the credit cycle. Get bullish when spreads are wide, such as in 2001 or 208 to 2011, and bearish when they are low.

When I first saw GLD/TLT inflect higher in 2022, I pretty much assumed the private equity and related share buyback trade was done. That is higher inflation would lead to tighter monetary policy, as well as higher spreads. As can be seen above, spreads have moved back to lows, even as GLD/TLT has surged.

My interest in Japan dates from 1991 when I was fresh faced high school exchange student in Kobe. There are no prizes for finding me in the above photo. I was the only “foreigner” in the school, and would go days without seeing anyone else that looked like me or even speaking English. I managed to combine my knowledge and experience in Japan with my other love, economics. I don’t think its too much of an exaggeration to say I owe my career and wealth through studying the Japan experience carefully and then applying those lessons to the rest of the world. One of the most fascinating things about Japanese, economically speaking, is that almost its entire foreign reserves are made up of US treasuries, with almost no gold. As the right hand side column below shows, the share of gold as foreign exchange reserves is highest for the “old world”, while new powers such as China, Japan, Taiwan and Saudi Arabia have relatively low shares.

In absolute terms, China and Japan are by far the largest holders of foreign exchange reserves.

While China has larger foreign reserves than Japan now, Japan basically “invented” the idea of sovereign bonds as foreign exchange reserves. During the gold standard days, if a country like the US wanted to consume more than it produced, it would need to transfer gold overseas. With limited gold supply, this limited consumption. Moving to a treasury based financial system essentially removed this constraint. The only issue is whether other governments would accept treasuries or not.

Why did Japan buy treasuries? Well when the bubble economy burst in the early 1990s, the BOJ cut rates to near zero, but the Yen did not collapse as expected.

In fact in the first stages of BOJ interest rates cuts, the Yen actually rallied. The failure of monetary policy to work as it should lead the Ministry of Finance to intervene to try and help weaken the Yen, and official buying of US dollar assets took off.

In pro-labour terms, when a government is pro-capital it wants to devalue to reduce the wages of its workers. This creates a trade surplus, which should cause the currency to appreciate, but if the governments wants to keep the exchange rate competitive (i.e. keep real wages low), then it needs to buy more and more treasuries. A pro-labour government is happy to see its currency appreciate, and hence does not build foreign currency reserves. What is odd recently is that even as the BOJ remains extremely tardy in its monetary policy response, the Ministry of Finance in Japan has started using foreign reserves to “strengthen” the Yen. As the Economist points out, Japan is currently intervening in the currency market to try and strengthen the Yen.

We don’t know the cost of the foreign exchange intervention at the moment, but as can be seen above, Japanese foreign exchange reserves have not been rebuilt since the last intervention in 2022. Japan also does not run the structural trade surplus that it did from 1980 to 2010.

With falling foreign exchange reserves, trade deficit, and the likely increase in defence spending that the Russian-Ukrainian war implies, BOJ policy looks increasingly wrong. Markets seem to agree, with 10 year JGB yields at 13 year highs.

With either a Biden or Trump presidency in 2025, the chances of an austerity driven fiscal policy or a change in trade policy looks unlikely to me. The Japanese may well be caught in a doom loop, where they need to sell more foreign reserves to prop up the currency, which cause US yields to rise, which causes the Yen to weaken further and so on. Until and unless the BOJ becomes more aggressive, Treasuries look like to have a systematic buyer turn into a systematic seller. China is likely a seller of treasuries and buyer of gold for political and strategic reasons, and Japan is a seller of treasuries for economic reasons. I am still baffled to why retail investors prefer treasuries to gold.

Japan was the key to understanding why treasuries did so well form 1980 to 2020. I think it is now the key to understanding why treasuries are going to do poorly from 2020 onwards.

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Like many economists and investors working today, I learned that “the market” was an unthinking, unfeeling and unavoidable monolith that exerted its influence with powerful invisible hands. Behave appropriately, you reap benefits. Behave inappropriately, and Mr Market would punish you until you learnt your lesson. Or as James Carville supposedly quipped, he wanted to be resurrected as the bond market as you can intimidate anyone.

I have pretty much totally discarded that view. The reason the market was so powerful, was because voters wanted the market to be powerful, and governments to be weak. They had tired of the big government policies in the Post WWII period, and wanted free markets in charge rather than bureaucrats. I believe we are now at an inflection point, where voters favour less market, and more government. As part of this view, I suspect that gold will be a better store of value than treasuries. We have hit new cycle highs on this trade, but history suggests there is a way to go. Below is gold versus a treasury return index.

Even though I think a turn to “more government” is a world wide phenomenon, I have been thinking about what makes countries be more “socialist” in the first place? My first observation is that large scale war tends to make a nation’s politics skew left. Even the hardest nosed, flintiest hearted business person would struggle to argue that a returned and injured soldier was not deserving of some largesse from society. The presence of the “Bonus Army” in Washington, made up of returned World War I servicemen that had not found work during the Depression, was probably a strong factor in the election of FDR, easily the most left wing President the US has ever had. But FDR was elected in the period after World War I but before World War II. The US military swelled greatly during WWII, and stayed large during the cold war. The USSR power peaked in the early 1970s, with the schism between USSR and China. From there on the US has only faced limited military competition, and its politics has skewed to the right from 1980s onwards.

I suspect that just having a large army is not the sole determinant of a socialist trend. If the size of the armed forces, and military spending was the determinant of socialist trends, then the US would be more socialist than France or Canada, which is plainly not the case. I think a bigger determinant is whether a full scale war has been fought IN your country, not BY your country. When the entire population has suffered to some degree, then the chances of leftward move in politics seems elevated in my mind. Of course all of Europe suffered in World War II, while Continental USA was untouched. One thing I like about this line of thinking is that there is an interesting test case in Asia that proves the point. While Japan suffered two nuclear bombs at the end of World War II, there was no actual fighting on mainland Japan. In contrast, the Korean War which lasted from 1950 to 1953 saw the entire peninsula change hands at least twice. South Korea has also had to maintain a much larger standing army to counter the threat from North Korea. The implication is that Korea should be far more “socialist” than Japan. Korea has tended to have far stronger unions than Japan. Using OECD data, Japan has the least amount of strikes, while Korea is close to French levels. Korea has seen its minimum wage steadily rise, while Japanese wages have been stagnant. Korea has regularly seen left wing parties in power, while Japan has had only very limited experience with left wing governments.

My other theory on what makes a country socialist or capitalist probably only really applies to the US. One very distinct feature of the US is that it is built around the car. When we look at the cities of Europe and Asia, they were generally built on pre-car cities, and the cities needed to be adapted to needs of the car as it was introduced. In Europe and Asia, public transport was used to ease congestion.

This is not the case with the US, where most of the growth in cities occurred after the invention of the motor car. Certainly, Los Angeles and Miami do not feel like cities that are easily travelled by public transport. Outside of the big cities, it is very typical to find a chain restaurant located in the middle of a car park. Walking to the restaurant would be a very odd idea. In most of Europe and Asia, public transport tends to be cheap and efficient. In the US, it barely exists. A car culture really does allow someone to live and work in a bubble far away from the travails of your fellow citizen. Using data from the International Association of Public Transport, we can see how much of an outlier the US is in terms of public transport. Oceania (mainly Australia) is probably next closest, and I would argue Australian politics are somewhere between the US and Europe, as its use of public transport.

One interesting question with this analysis is that the US faces no threat of invasion from Russia or China, so there is no issue with that causing a leftward shift in US politics. And US car culture is fully embedded, and with the shift in population South and West, is structurally strengthening. So there would seem to be no structural shift left. But my argument is that leftish moves in the rest of the world forces the US to also shift left. It seems very likely that armed forces will be rebuilt in Western Europe. The question is whether we will see a rise in Armed Forces numbers in the US? I suspect that will need a shooting war with China to break out.

Instinctively the idea of Socialism needing armed combat to spread feels true. Eastern Europe and North Korea become socialist due to the occupying Russian army at the end of World War II, while the Chinese Communist Party had to defeat the KMT to turn China communist. As Chairman Mao said, power comes from a barrel of a gun. So the remoteness of the US, with no military competitors in either North or South America, combined with a strong car culture suggests that the US will always be more capitalist than anywhere in Europe or Asia. But I think there is a second order effect for the US. This analysis suggests that the rest of the world will turn more socialist, which in my view means that global inflation and interest rates will rise. Certainly long dated Japanese bond yields are pointing to a new world. Do bond yield move inversely to peacefulness in the world?

Many people think we should reduce income inequality. But does this only become politically possible in periods of conflict? Is this the ultimate trade off - war with social justice or peace with inequality? Probably.

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April saw GLD/TLT surge to new cycle highs, which was very pleasing.

We also saw general weakness in equities, which was very pleasing. Peak outperformance had the portfolio up 5% with markets off 5%, but by the end of the month the portfolio had moved back to flat, with markets up around 4%. I have started to make some changes to the portfolio.

Back in World War I, the Australian and New Zealand Army Corp (ANZAC) were sent off to fight the Turks in what is known at the Gallipoli campaign. My great grandfather, Lt Col Hubert Harris (above) fought and died and at Gallipoli. He bled out after a Turkish sniper shot down a sniper hole built into the ANZAC trenches from a distance of 20 metres (hard to believe that they were that accurate - but apparently they were). He remains buried at Gallipoli. To cut a long story short, the landings did not go well, many Australians and New Zealanders lost their lives, and after 10 months were forced to retreat.

During Covid I worked on my family tree. I can say without doubt, that Hubert Harris is by far the most clearly recorded family member. The Australian War Memorial keeps extraordinarily detailed records of all the ANZACs, and in 2021 held a memorial event solely in my great grandfather’s honour. Australia’s obsession with Anzacs is driven slightly by grievance. Why? Well it is widely considered that Australians were used as cannon fodder to act as a distraction to allow British forces to land unharmed. For the Australian view of Gallipoli, 1981 Peter Weir film, starring a young Mel Gibson, will give you the gist.

World War I remains the war that saw the most Australians die, despite the growth in Australia’s population since then. Slightly more than 8,000 Australians died at Gallipoli, out of a total near 62,000 deaths in World War I. In World War II, there were 27,000 Australian deaths, despite the fighting coming much closer to Australia. For a more modern context, 60,000 Australians served in the Vietnam war, with only 541 deaths - or less than 1% death rate. But even with these much smaller numbers, the affect on Australian political life of Vietnam was huge. It is also not hard to find studies that show mortality rates for Australian soldiers ran at much higher rates than other allies during World War I. Below is taken from the website “1914-1918 online”. It has a 20% death rate for Australian soldiers. For these reasons, it is easy to see why the Gallipoli campaign still echoes today.

For Australians, who had been granted independence from Britain in 1901, rather than fighting for it, the Gallipoli campaign marked the beginning of an idea of a separate nation with its own identity. And for this reason, Australians mark ANZAC day with our own Australian mix of solemnity and partying. Huge marches take place all over Australia for service men and women, that are very well attended.

And then everyone goes to the pub and play a gambling game called “two-up”. This was a gambling game played by the Australian and New Zealand soldiers in the trenches to pass the time. It is usually illegal, but on Anzac day anyone anywhere can play it. If done right, should get very rowdy.

For many foreigners, the first time they encounter ANZAC day, they are likely to comment that it’s very Australian to turn a remembrance day celebration in to a drunken gambling event. While that is true, it also misses the point. The true point of ANZAC day, in my view, is that no matter how difficult things can be, being inclusive and supportive, and celebrating life, is the truly Australian way. And I am sure my great grandfather would think its fantastic that Australians everywhere remember their dead and then have the freedom to have a beer and gamble in their honour. What’s the point in fighting for freedom if you don’t let you and your descendants be free. For me, having a beer and a bet is probably the greatest homage we can pay to our fallen.

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It is so common in life that dealing with the truth is far harder than just pretending it does not exist. Politically, so many people wonder why people cannot except the truth of climate change, or Brexit or Trump. It is far easier, to accept alternative answers that don’t require you to do anything. Climate change is a hoax, Brexit and Trump lied and are not deserving on their democratic mandates are examples of such thinking.

For me, I have been struggling with the market action in Chinese bond markets. In a pro-labour world, I would expect bond yields to rise everywhere. In China they recently touched new all time lows.

The convenient truth for me is that falling bond yields in China has had no negative effect on my core trade of GLD/TLT, which has recently surged to new all time highs.

So what gives? How can we try and “handle this truth”? If I was a newsletter writer, I could just ignore it, but as I am thinking of launching a fund, the above question is exactly what a high level allocator would ask, and not having a good answer would (should?!?) condemn your pitch the dustbin.

In my recent post, I made fun of the macro community, as the old correlation of gold/copper and US ten year treasury yields had broken down.

However, I would be remiss to not point out that the copper/gold ratio still works quite well when we replace US 10 year with China 10 year bond yield.

And Chinese yields are so low as the domestic property market has been going through a huge slowdown.

If you think China is getting close to cyclical turn, then industrial commodities potentially offer huge upside. I personally have no idea, but it is amazing to see how well commodity prices have held up despite this slowdown.

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