Capital Flows and Asset Markets

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For a number of reasons, I was reminded of 1999. One of my tells for a bear market is when advertising on the Tube in London starts going out of date. It means marketing budgets are being cut. And in late February, I can still plenty of Christmas ads at tube stations. But even more than that has been the stark contrast between a surging US economy and the weakness in China and the rest of Asia. Value investors have constantly been tempted by Chinese shares, and constantly disappointed. The HSCEI is at levels first seen in in 2004.

So what am I seeing that could be possibly construed at bear porn?

Back in the early 2000s, Berkshire Hathaway had a large stake in Chinese oil major, Petrochina. Selling out of the position in 2007, they made 7 times there money in a relatively short period of time.

As so often, he was selling when he could at pretty close to the top. The oil price has been rangebound ever since.

My impression of the time that Buffett was a excellent commodity investor. When I heard the news that Buffett was taking stakes in Japanese trading houses in 2020, I took this as a view that the commodity cycle had decisively turned. The Japanese market has relatively few resource plays, and trading houses were seen as commodity plays. And as the above chart on PetroChina, oil stocks have been “ok” places to put money. But the chart of Itochu, is very different to PetroChina.

Itochu has significant food related assets, an area that I was quite excited by. I thought the Buffett investment was an endorsement of the idea of structural inflation in food. As the VanEck Agribusiness ETF shows, agriculture related stocks have not been a good place to invest.

Even in Japan, agribusiness stocks have disappointed. Kubota, which has a significant tractor business in the US has been disappointing even in yen terms.

For long time Japanese investors, and myself, I found the investments into the trading houses a bit of a surprise. The businesses tend to be complicated, with many subsidiaries. They also have tended to have large amount of debts both at the parent level and at the subsidiary level, and have also been very cyclical assets. So why the interest? Well share counts have of course been falling due to buy backs. Mitsui & Co has seen shares outstanding fall from 1.8bn to 1.5bn. But other commodity producers like Shell have been even more aggressive in buying back shares.

However what does make Japanese trading houses very special indeed is that due to BOJ QQE policies. The BOJ through ETF purchases is estimated to be a large owner of Japanese stocks than the GPIF. Looking at Mitsui shareholder register, this would mean that taking the GPIF, BOJ and Berkshire holdings together, you probably have 25% of the float locked up.

BOJ QQE program also means that yields on Japanese corporate debt is very low by global standards. Mitsui bonds due in 2039, still only yields 1.8%. By comparison Euro denominated Shell PLC bonds of a similar tenor would have double the yield.

One thing this made me consider was whether Buffett’s PetroChina investment was also a similar bond yield to earning yield calculation? Finding an accurate measure of Chinese credit spreads in the early 2000s is a bit difficult, but we do have the JP Morgan EMBI bond spread. In the early 2000s, after the Asian Financial Crisis, Dot Com Bust, and the Argentinian Devaluation of 2001 saw emerging market borrowing costs through the roof. But from 2002 onwards, this spread collapsed.

The thing is that PetroChina represented both a great macro story, as China developed, and transitioned from energy exporter to importer, and a political story, as it joined WTO, saw a surge in investment and had a generally business supportive government. A good earning story, combined with falling emerging market bond yields created a great investment climate, but I can see now it was also following the political winds of the time. This makes sense to me, and helps explain Buffett’s other long term Chinese investment BYD. Not only did it have an attractive valuation when he first invested into it, it was also a key beneficiary of supportive government policy.

It has certainly been true that the Japanese have been extremely “pro-capital” in policy making. And Buffett to his credit has made this work well for Berkshire. What makes this intriguing for me is that rather than seeing as a excellent commodity investor, I have to look at Berkshire is playing the same private equitization game as the rest of the market. Historically I would have bracketed Buffett with Soros, but I think we need to bracket Buffett with Kravis, Schwarzman and other private equity titans. Certainly their respective investment vehicle share prices are highly correlated. I suspect all of them hope the BOJ never tightens monetary policy.

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Free market capitalism is a relatively new phenomenon. Many call the period before World War I as a period of free market capitalism, but that was the era of British Empire, where intra-empire trade could hardly be called free. The post World War II period was the era of Cold War and saw large swathes of the world run on Communist lines, and even in the West policy had a positively socialist bent. Only from 1990 onwards, with the collapse of socialism can we truly say we were living in a free market world, and in a world that is largely run along US political ideals. One thing that is clear, is that US corporates have outsized influence in setting policy. Ask anyone in the world to name famous CEOs, and the list will likely be 90% Americans, or CEOs for American corporation. Google search for famous CEOs pretty much sums up the US dominance.

There are both positives and negatives to having a corporatocracy. It should be fluid, with new blood injected into leadership roles as new business models and industries evolve. Generally speaking, corporatocracy is considered a bad thing. On a positive side, I would say a political system driven by profit seeking/maximising behaviour tends to offer a great deal of clarity, and also tends to keep a society in dominant technical position. When the knowledge that a very successful business will also give you political power, it makes the profit seeking motive even stronger. With artificial intelligence been identified at the next big thing, the private sector investment this is driving by both existing players and new players is phenomenal. Historically speaking, corporatocracies are not politically popular. The Reagan/Thatcher revolution was really build on disillusionment with socialist policy making. Accepting that capitalism is the best form of government (or the least worst), then it follows that political power should follow economic power. In the US, politics has become more and more expensive as political and economic power has fused.

If you accept that US government is run for corporate interests, then it makes sense to maximise the US government balance sheet. That is borrow to the greatest extent possible, both to fund growth, and to minimise taxes to the corporate sector. This is entirely rational in a government run from profit maximising interests.

The logic of capitalism also suggests more and more consolidation, as dominant firms tend to be more profitable. This is also very apparent in modern markets. The concentration of market cap has become very extreme.

US policy making often looks to reduce government competition to the private sector as much as possible and to allow private sector to enter areas that are government dominated. Again a rational policy, which has yielded much success. Take the space industry. Allowing the entry of private sector players into this industry has transformed it. SpaceX now lifts more mass than all other government players combined. The Starlink system that this has allowed to deploy has become a strategic weapon, and a vital part of Ukrainian resistance to Russia.

If you fully accept the above arguments, then cryptocurrencies are just the next privatisation of a government controlled asset. This is not as far fetched as its sounds. The US had many private issuers of currency in the 1800s, but after the mass failure of many of their issuers, the “business of currency” was nationalised. Even today, the Hong Kong Dollar notes are issued by private banks, but backed by the government, who then runs a currency board which pegs it to the US dollar. Next time you are in HK, you can collect notes from the three banks authorised to issue HK dollar - HSBC, Standard Chartered and Bank of China. In the picture below, you can see the name of the issuing bank of the different notes. Cryptocurrencies are tech based version of bank issued private currencies.

The current logic of US markets and crypto implies an ever reducing role for government, which is often been an explicit goal of some leading technology players. Given the global reach of many US tech companies, the idea of a global currency would be compelling. Currently the US can compel any company or even government to follow its regulations, or pay tax by threatening to cut it off from the US financial system. Global usage of a cryptocurrency would greatly reduce the power of the US government to compel corporates to pay any tax, or at least strengthen their bargaining position. And that for me is the most bullish argument I have seen for cryptocurrencies - that it benefits US corporates. If this is true, you need to get long tech and crypto, and stay long. You also need to stay short treasuries, as the loss of tax revenue that crypto implies, combined with the massive wealth effect that crypto creates means much higher interest rates. My gut feeling is that like the 1970s was a time to buy financial assets as policy was slowly shifting from socialist to capitalist, I feel we are now in a period of capitalist overreach, and policy is slowly shifting from capitalist to socialist. That is the period of unfettered corporate power is coming to an end, but I can see how I could be wrong now. For me the real test will come when BOJ raise rates. Bull markets are built on dreams, and bear markets are based on realities. The true reality of markets will only be clear when the lender to the world taps on the brakes.

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Japan has and remains fascinating. For years economists and hedge funds always assumed the yen would collapse, and JGBs were a short. This was based on the history of every other country that had run large fiscal deficits and a central bank that kept interest rates very low. My original thoughts on this was that “free markets” were keeping the Yen strong, and JGB yields low. By free markets I meant that without inflation, Japan should have a strong currency to keep its prices near a “free market” level. Japanese prices have not moved very much since the 1990s, while the US has doubled.

One upshot of this “free market” view was that it made me think central banks were broadly speaking “useless”. They could talk about inflation targeting, forward guidance and all that other stuff, but in a free market world it would be broadly pointless, and possibly even self defeating. Forcing credit and currencies to non-economic levels would just lead to greater deflation when the “free market” worked again. This for me explained the Yen as a safe haven currency phenomenon that existed until relatively

It is fairly widely known that a weak USD dollar tends to be good for commodities and for emerging markets in general. I always thought the transfer mechanism was two pronged. One, US dollar debts become much easier to service, improving credit conditions. And secondly, a weak dollar encourages capital flows out of the US and into carry trades, which also improves capital flows. South Korea has always been a good indicator of this strong currency good, weak currency bad type of scenario. Against the US dollar, the Asian Financial Crisis and GFC are very clear periods of a weak won, and since 2020, Won has been pretty weak again.

This sell off in the Won in 2020 is hard to match up with a bullish S&P 500. Where is the financial crisis? But if we look at Korean won terms in Yen terms, things make a lot more sense. Using the capital flow model, when Yen devalues its also puts downward pressure on the Won. In 1997, this led to Korea having to break its dollar peg, and in 2007, led to another huge devaluation as various credit structures blew up in Korea.

What is odd about the current Yen/Won exchange rates is that its is back at 1997 levels, despite CPI in Korean having doubled in the period, while Japan has maybe risen 8%.

Given the movement in exchange rates, you should not be surprised to see the Nikkei doing better than the Kospi. Since 2013, Nikkei is up over 300%, while Kospi is up 25%.

This affects all of East Asia in particular. Taiwan runs a 12% of GDP current account surplus, and has dominant market share in high end semiconductors. You would expect its currency to be surging. It is not.

The distortions in Yen are truly epic. If I a look at Yen v Mexican peso, it is back at levels seen in 2004.

Mexican CPI has doubled over that period.

Just like Korea, equity returns have been lacklustre.

Historically speaking, the Japanese devaluation policy has been a massive own goal, with huge financial losses in the AFC (caused by Yen devaluation) and the GFC (helped by Yen devaluation). But this time, China has chosen to resist the devaluation pressure that a weak yen other weak Asian currencies is putting on Chinese Yuan. Certain financial types will hyperventilated over the 20% fall in Yuan versus the US dollar, but compared to real currency devaluations this is nothing. Japanese investors I think recognise that a Chinese devaluation does not look like likely, which is why JGBs are beginning to sell off, after almost three decade uninterrupted bull market. Note in 2015, when Chinese devaluation fears were highest, JGB yields collapsed to all time lows.

China and the world have turned pro-labour, which is putting upward pressure on inflation and bond yields. Somehow, the BOJ is still living in the past. When do they wake up and smell the coffee?

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Japan is an unusual country. For decades it defied economic analysis. As Simon Kuznets said, there are four types of countries: developed, undeveloped, Japan and Argentina. And when I started working in finance, Japan was also given special treatment. The Japanese macroeconomic numbers of a large fiscal deficit combined with low interest rates should mean the Yen collapses, and inflation should be running rampant, which lead many funds to short JGBS - a trade that became the original “widowmaker” trade. I spent a lot of time trying to come up with a more “holistic” model of the world, that would explain Japan, JGBs and the Yen. The model, if that’s the right word, is that Japan is the Saudi Arabia of savings, and where it capital flows to booms, and when it pulls its capital you get a bust.

Anecdotally this feels right. In every big financial crisis, Japanese institutions tend to me knee deep in financial crap. But anecdotes are not rigorous analysis, so I set out to try and prove it. One of the first data points I looked at was net international investment position (NIIP). Japan consistently has the largest positive NIIP in the world. And historically speaking, a large negative NIIP was a warning sign, although this has not worked with the US from 2016 onwards.

NIIP data mixes private sector and public sector holdings. In particular, foreign holdings of treasuries tend to mean the US always has a negative number. So I strip out this data from China, Japan and US data to get a “private sector” NIIP. Private sector NIIP tends to shift with asset and currency performance. The long bear market in Chinese assets have pushed this positive. Japan, despite the performance of the Nikkei constantly remains positive, a sign of how flows in Japan tend to only be outwards.

Globally NIIP should add to zero - but it does not. The outlier is the US. Its private sector NIIP used to oscillate around zero, but in recent years has exploded higher. I suspect this has to do with US corporates and their tax avoidance strategies, but will just focus on Japan at the moment. NIIP is a big macro data point that captures relative movements in currency and stock markets, so it is possible just to argue that America and American corporates are awesome, and everyone wants to be invested. While I would not put in that terms, I would say the ability of US corporates to get laws enacted that benefit their own interests are without comparison in the rest of the world. But we can look at different data points to get an idea of Japanese influence. The BIS collect data on location of banks claim and liabilities. Japanese non-banks are the biggest lenders to the world.

If we look at how the Japanese non-bank claims have developed, ever since the Japanese bubble burst, the non-bank sector has rapidly increased claims overseas.

My argument is when the BOJ taps (not steps) on the brakes, all hell breaks loose. Very short rates have only risen occasionally in Japan. 1996 - Asian Financial Crisis; 2000 - Dot Com bust; 2006 - GFC and 2007 was the last time the BOJ raised rates.

Anyway, that’s the background. I will spend the weekend reading BOJ materials to see the likelihood they might actually raise rates, and then try an answer the more difficult question of what that means in a pro-labour world.

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When I first started thinking about a pro-labour world, I tried to imagine how exactly that would look. My thoughts were that wages would rise, and unemployment would stay low. Interest rates would be higher than expected, and long dated bonds would do poorly. I expected financial assets to underperform real assets and commodities. I also expected to see real assets surge if central banks, and particularly the Federal Reserve started to go dovish, and this to cause the yield curve to steepen. We saw this happen in late 2023, and this is when I started to have confidence that my world view was coming into play. But from that point, we have seen a chunky reversal, but still in an uptrend.

However there are a number of things that have not matched up with that world view. I thought higher short term rates would suck money from speculative assets, causing real financial difficulties. While there has been some examples of this, there have been plenty of counter examples. In the crypto space, money has flowed into Tether, supporting the entire crypto arena.

Likewise the Nasdaq has fully recovered from its 2022 sell off.

While China has followed a “pro-labour” cycle in my view, Japan has surged ahead. Many people have remarked on the huge divergence in these two markets.

I have been toying with the idea that semiconductors are a the new oil - and hence have become a strategic asset. This explains the surge in the Nasdaq and the Nikkei to a degree, but does not really explain tether or Bitcoin very well. This would not also explain the continued superb performance of luxury. LVMH continues to trade well.

One thing I agree with Dennis Gartman about is that systems should be kept simple. Simplicity breeds elegance. So is there a simple explanation for why financial/speculative assets are trading so well? There is but I suspect you won’t like it. The Fed had high interest rates all through the 1990s, and dot-com bubble developed anyway. But during that time, the Bank of Japan (BOJ) only finally raised interest rates in 1999 and then the bubble burst. The sub-prime and European debt crisis all developed despite the Fed and the ECB raising interest rates earlier that the BOJ. But when Japan began to tighten in late 2006, everything started to unwind. I could also argue brief attempts raise rates in 1996 also caused the Asian Financial Crisis. If you follow this analysis, with the BOJ still running negative interest rates, speculative assets can continue to do well.

Moving away from policy rates to balance sheets, the BOJ invented QE in early 2000s. By 2006, it removed its QE liquidity from the market, and the subprime crisis began soon after. The BOJ balance sheet briefly contracted in 2022, before expanding again. Markets have seemingly moved more with the BOJ balance sheet than the Fed or the ECB.

The BOJ has maintained super loose policy, despite food inflation taking off in Japan, after decades of doing nothing. This is a surprise for me, but matches how I have been surprised by the performance of speculative assets. For really old investors, loose Japanese monetary policy also explained the bubble economy of the 1980s. BOJ Balance Sheet and S&P 500 have decent correlation in my book.

This also offers a nifty reason for why higher bond yields have not been so bad for asset markets. As JGB 10 yeilds have risen, the BOJ has committed to unlimited purchases to keep it below 1%.

What has been surprising is that wages in USD terms has continued to weaken to levels not seen since 1990. In recent years falling USD wages have been driven by BOJ policy.

The BOJ has continued its QE policy despite food inflation has also taken off in Japan, which is very different to the 1990s and 2000s.

What is great about this analysis is that it says two things. BOJ is the only central bank that matters (as Japan is the biggest international lender that makes sense) and that we need to get bearish the US when the BOJ raises interest rates. Given the moves in bond markets and food inflation, this is a matter of time. Given my plans for a new fund, a bear market would be extremely useful for me. I will be taking a closer look at the BOJ in the near future.

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One of the reasons for an “independent” central bank was the idea that they would not juice up the economy or the stock market to the benefit of incumbent politicians. The reason for this was from the 1970s, when Nixon put huge pressure on the Federal Reserve to make sure the economy was firing. Under the first Trump administration between various other tweets on tariffs and wall building, President Trump was never shy about crowing about the performance of the stock market under his watch. Despite a very good stock market, President Trump lost his re-election bid.

To be fair, President Biden, faces a tough re-election bid as well and he has presided over a pretty good stock market, if not volatile.

Of course, the stock market and the economy is not always the same thing. But unemployment has been at remarkably low levels in the US for the last decade, and yet neither Trump or Biden have ever basked in high popularity. George Bush Senior lost his re-election bid in 1991 with unemployment at 7%, while George Bush Junior won hi re-election bid with unemployment at 5.5%. Obama won re-election with a rate around 7%.

This disconnect between stock market, unemployment and electoral popularity is not just an American phenomenon. In the UK, the Tories are headed for electoral Armageddon with UK unemployment a the lowest level since 1970s.

In Japan, the Prime Minister Fumio Kishida faces a electoral crisis, and very low popularity numbers, despite the Nikkei threatening to break out to new all time highs.

And by recent standards, very low levels of unemployment.

So are there any very popular politicians in the world at the moment? Modi in India is one option, although one wonders what if any lessons could be applied from Indian politics to elsewhere. Another option is President Obrador, who is likely to leave office as the most popular Mexican president ever. As mentioned before, Orbador has been able to raise real wages significantly in Mexico.

Coincidentally, or not, Mexico has done a good job in regulating America Movil (AMX US), which was the source of wealth for Mexico’s wealthiest man, Carlos Slim.

My best guess is that worker’s in the US and UK are not happy with the rate at which wages are rising. Real wages have maybe risen 20% since 1980s, with most of that increase in the last 10 years.

Real return to the S&P 500 since 2008 lows has been close to 500%, which makes the efforts to raise wages seems pointless in comparison.

The road to electoral success lies in raising real wages. Who will grasp the nettle first?

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I have pushing the idea of long Gold/short treasuries to capture a shift to “pro-labour” policies. Like a lot of investment ideas, it is easier to promote this idea as I am looking at the end game of the pro-labour period from 1945 to 1980, which also saw gold massively outperform treasuries. Basically I am saying that we are going to see a repeat of below.

In January I spent two weeks in Australia - catching up with friends and family. As has become the norm, everywhere seems to be very busy, and no signs of a slowdown anywhere. But among this general bullishness, it was noticeable that friends trying to get jobs in finance were really struggling to find a job. I have only really looked for job in finance twice. First, as someone who was hired as a graduate trainee in 1999, and then as an emerging markets analyst in 2002. Talking to people the hiring vibe was closer to 2002 than 1999. But when I look at MSCI World, it looks like 1999 rather than 2002.

From a US equity IPO standpoint, however, it does indeed look more like 2002. Issuance collapsed from very elevated levels in 2021.

Emerging market also remain a dead end, with the market still at levels first seen in 2006.

How about Japan then? Well in USD terms, the Nikkei is not that exciting either, but still better.

So why are investment bank busily hiring warm bodies to do sales or launch funds? I would also speculate that a share buyback driven market like the S&P 500 does not really need many financial professionals. When I joined UBS in 2000 senior management believed we were vital cogs in the allocation of scarce capital. Now stock markets are driven by the return of capital. What need of fund managers or investment bankers?

There is one market, that is sucking in capital and in desperate need of experienced fund managers and bankers. Cryptocurrencies. But would you trust a 50 something crypto fund manager? You could if you want to - but bit like Murtagh in Lethal Weapon - aren’t you getting too old for this s**t? Or to paraphrase another movie title, there are no markets for old men.

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