Capital Flows and Asset Markets

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GENERAL THOUGHTS

When I started thinking about a pro-labour shift in politics, I tried to focus on areas where markets would be surprised. There are many, but in essence growth tends to surprise to the upside, demand is good, but financial assets are weaker than expected. I expected cash and commodities to perform well, long bonds poorly, and equities to be flat to weak.

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Before substack, and even before the internet, fund managers have always liked to read newsletters. Perhaps the two most famous of these old school newsletter writers were Dennis Gartman and Fred Hickey. Gartman wrote the Gartman Letter, and Fred Hickey writes the High Tech Strategist. I never subscribed to the Gartman Letter, but it was not difficult to get a copy, and Gartman basically lived on CNBC, so his opinions were easy to find. Perhaps Gartman’s greatest contribution to finance was his trading rules - which I have filched off the internet and reproduce below.

If Gartman has a problem, it was that he was very reactive to market moves, and tended to have tight stops. He would often buy tops, and sell bottoms. He probably became the most popular “contra” in the market. A contra is someone who reliably gets market moves wrong - so doing the opposite of their market moves it reliably profitable. I often would be filled with dread when my positions would align with Gartman views, and delighted when he cut those positions.

Fred Hickey who writes the High-Tech Strategist is quite different. His strategy tended to be buy and hold. I did pay for his newsletter, but what was odd was that despite the name, more than half of his newsletter became dedicated to precious metal investing, particularly gold. Fred Hickey has been very bearish on tech for a long time. In particular he had a bearish view on Nvidia - based mainly on its 90% drawdown during the dot-com bust. It also fell 80% during the GFC. Obviously, Nvidia is no longer the same company it was. Even more obviously, being bearish on Nvidia has been a huge mistake - probably even worse than being bearish Tesla, which was a common opinion not so long ago.

Lately, I have been suffering from my own Gartman/Hickey like moment.

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The pro-labour model is based on the idea that governments are moving away from pro-business policies to pro-labour polices. This is driven by an electorate that is increasingly disillusioned by pro-capital policies and voting for populist politicians and ideas. At its simplest, its means that demand is very strong, inflation is structurally higher, and central banks are under constant pressure to keep interest rates high. This led me to be naturally long gold and short treasuries (GLD/TLT). My view was that the 1970s would be a natural end game for this trade.

The corollary of this view is that asset prices would struggle. Higher rates would suck the liquidity from asset markets. In particular this should be true of speculative assets. Now if I torture financial market data, I can make this assertion seem true. If I look at equal weighted returns for example, or if I convert Nikkei returns into USD, I can say, “Hey look, assets have not done that well!” But the truth is that outside of China, western equities have done pretty well. US equities do not look to be in a lagging the gold market, one of the best commodities out there.

For the first time in nearly 5 years, I have been back to Australia. The 40 plus hours of flying time (ignoring time spend at airports waiting for flights) give you a lot of time to ruminate. And rumination, has led me to realise I have been too “old man” in my thinking. A fact of life as you get older, its easier to think things will be like the past, rather than allowing your mind to accept changes in the world - and I think I have been guilty of exactly this type of thinking. My pro labour thesis is based on the post World War II period, which definitely was pro-labour. But there was a cold war going on too. How can we think about the cold war from 1950 to 1990, and apply it to the new cold war, starting circa 2015?

For obvious reasons, I have been thinking about whether fund mangers should come out of retirement.   First of all, to answer this question we really need some context.  There are loads of fund managers out there.  The vast majority are closer to product managers than what I would call fund managers.  Their objectives tend to be quite explicit - and the decisions they can take are relatively limited.   This may sound technical but they are pretty easy to identify.  Their communications to investors will talk about tilts, underweights, overweights and sharpe ratios.  Normally, these fund managers are in direct competitions with low-cost index trackers, so have limited pricing power.  As they also paid to be generally full invested, they rarely have contrarian positions to the market.  Outperforming the market with these style of funds, after fees, is extraordinarily hard.  Typically the business is build around a distribution model, and it is very rare these fund managers reach the public recognition that would cause their retirement to  noted by anyone other than their immediate colleagues and friends. Coming out of retirement is rarely an option for these guys.

The second type of fund manager tends to be far more aggressive, and takes extreme views on markets, and will, if they are any good, gather media and market attention.  Perhaps the most famous would be Soros, the man that broke the Bank of England.  But there is a long list of rockstar fund managers.  Chanos, the man who broke Enron.  Paulson, the man who broke subprime.  The upper echelon of “rock star fund managers” is almost always left to fund managers who make money while the majority lost money. This is for the simple reason that allocators not only love fund managers that help them outperform in down markets, they are very likely to save their careers. They also make their money very quickly.

In my mind, and no doubt controversially, in the second tier of fund mangers are the long only fund managers that crush the market.  Top of the list here is no doubt Buffett and Munger.  But there are whole range of other famous investors, such as Peter Lynch, Bill Miller, Anthony Bolton and Mark Woodford who are all extremely successful long only investors.  You might ask how I can rate Buffett and Munger below a Soros.  As businessmen, Buffett and Munger are without peer.  And their successful business acumen, allows them to take risks that no fund manager with outside money could take on.  Fund managers need to raise money, and make money and hold on to money. If Buffett and Munger ran a fund rather than an insurance based conglomerate, they would have seen significant outflows in 2008, greatly hampering their ability to invest. But their insurance business with their float, and tax advantaged situations are fantastic business that no one else seems to have replicated.

Anyway, my concern is whether “rock star” fund managers should come out of retirement?  My list is based on fund managers that have I can remember coming back from retirement, so is a non-exhaustive list.  Soros never really retired, but from what I know is still sharp enough to keep an eye on markets.  Chanos, just retired, but he did launch a very large short biased fund back in 2016, which did not do well.  Paulson, had one big trade in 2007/8 - and basically not troubled the markets again.    You could potentially treat Paulson and Chanos as “one trick pony” - an accusation that I have faced myself from time to time ( I like to think I am closer to a two and half trick pony).

Anthony Bolton was a leading UK fund manager who greatly outperformed the market for many years, with his Fidelity Special Situations Fund - one of the biggest funds outside of the US at its apogee. After retiring from this fund in 2007 he came back to the market with a China Special Situations Funds in 2009. I remember at the time he said he saw a similar set up in China to what he had seen in the UK in the 1980s. I personally had doubts. My experience was that China was heavily driven by government policy, and that trying to apply lessons from the UK would have limited success. In the end, the fund raised significant capital. Ultimately performance was very mixed, and in 2014, he retired for a second and final time.

Neil Woodford did not exactly retire. Woodford left his role at Invesco, where he had been a super succesful fund manager to set up Woodford Investment Management. His big thing at Woodford Investment Management was that UK unlisted tech companies were severely undervalued.  The big risk he faced was that the funds were more liquid than his underlying investments. He ran the risk of facing redemptions before he could realise the value of this speculative stocks. My understanding was that one of his greatest successes at Invesco was convincing tobacco firms to return capital to shareholders after the share prices had been decimated in the 1990s. The performance of British American Tobacco was phenomenal, at least until 2017. Shifting from a more “value” investing to a speculative style was definitely a red flag.

I think perhaps another red flag was that he took to only being photographed in a black jumper, not quite a turtleneck, but close enough to Steve Jobs and Elizabeth Holmes to suggest that perhaps there was a risk of overconfidence.

Generally speaking fund managers coming out of retirement don’t have the best track record, but recently we have seen two former fund managers do quite well. Greg Coffey stepped away from his GLG Emerrging Market Fund in 2008 but has recently reappeared with his new firm Kirkoswald, which seem to be doing very well. Martin Taylor, who was at the very successful Thames River Nevsky, retired from markets in 2010, but returned to markets in 2019 with Crake Asset Management. I cannot tell you how well either are doing, as performance and AUM seem to be private. But as far as I can tell, neither has retired from markets again. My working assumption is that both are doing well.

Given a limited subset of fund managers that have retired and then returned to the market, any conclusions have to be tentative at best. But I think we can look for some red flags. Anything that smacks of a mid-life crisis or vanity driven should probably be seen as a red flag. In particular, when associated with a radical change in investment style of focus. Here I worry a little, as I am thinking in terms of a return to 1950 and 1960s style markets, so I am venturing away from my old style, but with justification I think.

Am I suffering a mid-life crisis? Potentially, but when I look in the mirror and see this, I think I must be fine.

All jokes aside, I do have mixed emotions about potentially coming out of retirement. But the logic of markets seems to say to me that it might be an opportunity too good to pass up.

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Australia, the “Brazil” of cricket, is a fascinating nation. It was not too long ago when Australia was a number one short across the macro hedge fund world.  Australia was, and remains, a significant commodity exporter. A reliance on China economically, while relying on the US militarily always seemed a political paradox that needed to be resolved. The resolution phase of this paradox has begun, with both China and Australia trying to reduce economic contacts, while Australia has signed up to a hugely expensive military pact - AUKUS. I have published my severe doubts about the AUKUS strategy of building nuclear submarines in Australia here. The biggest issue for me is that Australia is not really threatened by China. As we have seen when Russia tried to invade a neighbouring country with a long land border, invasions are difficult. China would not only have to pass through a number of nations, most of the Australian population is protected by the vast desert that is central Australia. New Zealand is even more distant, and is the reason why billionaires buy bunkers there. Why do we need nuclear submarines at a cost of 50% of the defence budget for decades?

Nethertheless, Australia seemed like a perfect short play for the inevitable end to China’s construction boom.  Weirdly, the Chinese construction boom ended, but without commodity prices tanking. This could be one reason why a disconnect between Australia Dollar and commodity prices has opened up.

This has led to the biggest macro change in Australia. It no longer runs a structural current account deficit. These days a surplus is more likely than deficit.

So in that context, Australia is an example of the changing nature of markets. In a free market era, the Aussie dollar would move closely with commodity prices, but in the “political era” that began in 2016, its moves in a very different way. So with these changes in mind, I have come to Australia on family trip - but I am very interested in what changes I can see in my homeland. When I was last here in 2019, Australia had become very expensive. Despite being a significant agricultural exporter, it was very noticeable that groceries and food were much more expensive in Australia than in the UK, a food importer.   Even though Australia had what seemed like expensive food to start with, it has also seen food inflation spike.

However recent food inflation in the UK has been much more significant. As someone coming from London, Sydney now seems cheaper, despite the food being better quality.

I find food in Australia very reasonable in UK terms, however locals definitely feel like there is no respite to the cost of living crisis. More interestingly is that part of my pro-labour view is that interest rates would need to rise to create financial asset deflation to offset rising wages. This seems to be the case in Australia. Despite record low unemployment, my finance friends report a slow labour market, with all the jobs at the more blue collar end of the market.

The problem is that even thought the RBA has raised interest rates from 0 to 4.25% it has had little effect on house prices, which remain at near all time highs.

In a world where politicians are seeking to raise real wages, structural inflation will be much higher than what we are used to. Central banks and markets are pricing in a political world that is gone in my view. When I look at current yields on Australian 10 year bonds at 4.1%, I cannot help but think only a loser would be a buyer at these yields.

Historically speaking, I used to think of Australia as being somewhere between the UK and the US politically. I don’t think that so much. Australia really feels more like an Oceania Scandinavia. Low population density, responsive government, relatively high taxation, but with pretty good public options for things like healthcare or transport. If anything, the UK has drifted further into the US political orbit, where anything free must be socialist, with predictable outcomes in terms of quality of healthcare and infrastructure. Australia has moved in a different direction and for anyone working class, it remains a great place to live - if you can get in. If I am right on the way politics is moving, for working class Australians, things will only get better. For bankers, not so much. But no one cares about bankers anyway.

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Simon Kuznets is quoted as saying there are four types of economies in the world. Developed, undeveloped, Japan and Argentina. In essence, he is saying that rich nations tend to have predictable economic growth, as do poor nations. But Japan and Argentina fit neither of these models. Like Kuznets, I often puzzled over Japanese economic growth. How can I nation that I so admire not have seen wage growth for 30 years? How could a nation that was so technically advanced be so moribund? In 1996 working as an English teacher i was stunned when a colleague said I could have a mobile phone will all calls included for USD 20 a month

Even more amazing was that my next mobile phone in 2000, a Nokia candy bar was heavier, more expensive, and had less functionality. The point was how did a country with such a huge lead in mobile phone technology manage to stagnate? You could argue the same in semiconductors and optical equipment, where Japan was miles ahead of its competition. But Japanese GDP and wages have stagnated since the early 1990s, and its lead in most vital technologies have been lost. For Kuznets and the rest of the economic industry, it is very hard to explain how Japanese nominal GDP today is lower than 1992.

Comparing Japanese GDP to USD GDP over time is also arresting. What is not clear here is that in the early 1990s, Japanese GDP was close to overtaking US GDP.

American will naturally see this as the superiority of American capitalism. Maybe it is. But in the early 1990s, the US was in fear of Japan. Trade friction was a huge political issue. Many films and popular culture represented this fear. Most obviously was 1993 film “Rising Sun” - but even 1982’s Blade Runner represented a future of dominant Japanese culture.

My thoughts on this was that Japan was the Saudi Arabia of capital markets, and they funded growth elsewhere, but this never led to sustained growth in Japan. When credit markets blew up such as the Asian Financial Crisis or the GFC, capital would return to Japan, yen would appreciate and deflation and stagnation would return. The title of this substack, Capital Flows and Asset Markets, comes directly from this theory. But as mentioned in a recent post, perhaps I should change the title from Political Cycles and Asset Markets. This made me think, is there a political cycle that explains Japan’s malaise? Well yes, I think so. First of all, losing World War II was highly detrimental to Japanese growth. Prior to World War II the Japanese economy was rapidly catching depression era USA.

In 1980, as Japanese economic growth surged, again Japan was becoming a threat to the USA. But in 1980s, the bureaucrats and CEOs of Japan Inc would have been men who would have distinct memories of the last outcome when Japan threatened to overtake the USA. For this reason I think Japan agreed to the Plaza accord, which saw the Yen appreciate significantly. With an export led economy, this yen appreciation should have been devastating for the Japanese economy.

Of course the capital flows that this yen appreciation policy caused led to the greatest bubble known to modern economics, it does not take away the fact that Japan agreed to a policy that should have weakened Japan Inc. Another example of Japan choosing weakness was the relocation of substantial parts of the semiconductor business to former Japanese colonies, Korea and Taiwan. For years Japan sold as much as the US in semiconductors.

But as Japan stagnated, Korea and Taiwan have surged. Japan, Korea and Taiwan are as mighty as the US when it comes to semiconductors. And Japan was instrumental in Korean and Taiwanese success. American businesses tend not fund competitors - they usual aim to destroy them.

What I find most intriguing about the political theory of Japanese decline, its that implies that Japan can choose to end decline just as easily, should politics change. My read is that politics has changed, but only incrementally so far. But I can’t help but think even the US would prefer to have a strong Japan to act as a counterweight to China. As a fan of popular culture, this would also fit in with famous South Park episode - Chinpokomon. In this episode, Japan uses anime and constant assurances of their weakness to take over the US. Playing a long term strategy to avoid conflict with the US certainly fits in with my experience of Japanese strategic thinking.

Personally, I am not a fan of conspiracy theories (sorry Zerohedge… I still love you guys anyway), but I think this one is maybe 70% true. If you are bullish Japan, its a good reason to get more bullish - as Japan no longer needs to hide its light under a bushel.

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This is the second post on what I would call investment strategy documents for my idea of a fund. It outlines the business case for what I am thinking of doing. Back when I started in finance in 2000, asset management was a backwater. The area that everyone wanted to be in was investment banking and trading. Hedge funds existed, and had prospered to a degree during the Asian financial crisis, but had gotten severely burnt in the defence of the Hong Kong peg in 1998, and the continuing bull market in US stocks. LTCM was also a major setback for the hedge fund industry. Relatively high interest rates made hedge funds a very niche area of the market. If you were bearish, why not just stick in cash which was yielding 6% in 2000.

Of course as the Fed cut rates after the dot com bust, cash became very unattractive. The hedge fund industry really grew from a (then) misplaced fear of long dated bonds.

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A few months ago I floated the idea of launching a fund. I have had discussions with potential investors and with potential firms to host the fund. Typically I have been talking to institutions that I have had previous dealings with, so have not bothered to produce a strategy document as there has been no need.

Recently I have started talking to an institution that I have not dealt with before, and they asked for a strategy document. Given that the subscriber list for this substack has quintupled from when I first began, I assume there is a great number of people who are also unfamiliar with my background, so I am making this strategy document widely available, but behind the paywall.

Capitalism, as Churchill once said, is the worst possible system except for all the others. The profit motive constant pushes capitalists to get costs as low as possible to drive profit growth, at least in theory. Unprofitable markets cause competition to leave the industry, and profitable markets attract competition, at least in theory. Capitalism should drive deflation.

The Great Depression is seen as a crisis of capitalism. But for me, it is a natural aspect of capitalism and free markets - overproduction and falling prices. Using US CPI data - which offers the advantage of consistency, and avoiding the destruction of the two World Wars which makes economic data unreliable in the rest of the world. You can see that from 1913 to 1945, price levels where virtually unchanged. This was a period that was great for bond holders, but terrible for real assets, corporates and for workers. With so few winners it is little surprise to me that the politics of the world turned viscously against free market capitalism post World War II.

The only equivalent to the Great Depression in modern times has been the experience of Japan. Just like the Great Depression, from 1990 onwards, was great for bond owners, but terrible for asset owners, and for workers. The real mystery of Japan is how in a democratic nation, such policies did not elicit a political response. My guess it did, but hemmed in by US policies was unable to choose inflationary policy responses like massive currency devaluation or tariffs. Obviously the US no longer follows Washington consensus policies, and neither does Japan. Inflation has returned.

In response to the Great Depression politics moved to the left, or what I would call pro-labour policies. For business it was great as demand rose in line with rising wages, and prices rose. Governments spent freely and wages rose. The patsy in this market were commodity producers who saw supply controlled and prices fixed. Bond investors were also screwed over as the purchasing power of bonds collapsed. The 1970s saw the commodity producer and bond buyers rebel against their exploitation by governments, leading to the creation of OPEC and the emergence of bond vigilantes.

The greatest sign that this “post-Depression” policy mix was coming under pressure was the falling level of gold holdings in the US. That is the US government was finding it increasingly difficult to finance these pro-labour policies. In some ways, the US policy was to exploit the huge gold reserves it has built up during the two world wars.

But FDR had also introduced government controlled cartels to curb over production. The Texas Railroad Commission essentially controlled to production of crude oil. This meant that by the late 1960s, US production was beginning to fall.

Crude oil prices were fixed during the 1960s at 1.80 a barrel, while refined prices were set by the market. This was great for integrated US producers, but bad for crude oil producers, which were increasingly foreign.

To satisfy the demands of oil producers and bond markets, a new set of patsies needed to be found. In a return to the pro-capital policies, labour was to become the patsy. Full employment was no longer a political aim, and real wages could fall. Taxation favoured business over individuals and tariffs were cut.

The problem with modern free market capitalism, is that “patsies” are hard to come by. For a brief period after the dot com bust, when deflation in the US beckoned, capitalism exploited inefficiencies in credit markets. When the rating agencies mispriced mortgage backed securities and the related products, the industry grew rapidly. Markets assumed that government guarantees existed for banks, emerging markets, and mortgages that governments only honoured after the crisis. Broadly speaking the investment banks and dealers in MBS knew that the credit markets were wrong, but the limit to growth here was private sector financing of credit guarantees. AIG balance sheet growth was the limiting factor. AIG was a classic “patsy” sitting at a table with GS, MS and other investment banks selling insurance on MBS, making money while thinking they were smartest ones at the table.

Post GFC, the now virtually explicit corporate guarantees have been exploited remorseless by markets, in an era of epic consolidation and the replacement of equity with debt and intangibles. The markets have exploited the treatment of government debt as risk free, even when 5 to 6% GDP fiscal deficits have become the norm. Capitalists have exploited the disconnect between very low interest rates, even though unemployment is very low, and pro-labour polices are sweeping the world. US Federal Government spending tells you exactly who markets are treating as patsies.

Foreigners are not adding to their holdings of treasuries anymore. Of course into this gap have stepped central banks. But this can only be a sustainable model if commodity prices stay low.

The current market bares some resemblance to the 1960s. Growth is good, unemployment is low, but it requires owners of real assets and of bonds to be “patsies”. The GLD/TLT trade is based on at least one of these patsies saying they are not going to take it anymore. This is already happening.

Free market capitalism and democracy are inextricably intertwined. No one wants to be the patsy, but if you don’t have the votes, then you are the patsy. Brexit, Trump, Wilders, Meloni, Obrador, Alternative for Germany are all telling you the same thing. Western workers are no longer willing to be patsies. Bond investors look to be the new patsies to me.

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In hindsight, I was plainly too keen to add to the core trade of GLD/TLT at the beginning of the month. The correction at that point had only moved to 50 DMA. December has seen it reverse further back to the 200 DMA.

The problem has been on the TLT side of the trade. Bonds everywhere have rallied at expectations of rate cuts have been priced in. The US 2 year yield shows clearly the change in view.

As discussed in a previous post, energy markets are really the key here.