Capital Flows and Asset Markets

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I will do a more in-depth post about markets next week - in particular what I have gotten right and wrong in 2023. In this post I will talk about the portfolio performance in November, changes I have made to the portfolio, and general thoughts on the market.

There is very little I am sure about in this market, except that the bull market in bonds is over. A lot of people disagree with this view - but that’s fine by me.

The “chat” from analysts and other market observers was that the change in bond markets, would herald a long awaited change in market leadership. I also thought this would be the case, but after threatening to happen in 2022, 2023 has seen the usual suspects outperform again. Using MSCI definitions, growth stocks continue to outperform value.

The chart above stuck me as odd, as I would have thought a fund like ARKK Innovation ETF was by definition a “growth” investor. But ARKK has not bounced.

MSCI definitions of growth versus value tend to use things like book value. One of the cheapest sectors in the US is banks, and as Michael Hartnett from BOA shows, they are at 80 year lows relative to the market.

Why are banks so poor? Partly because they are forced to hold equity. Share buybacks are relatively rare among banks. But in the broader market, tech in particular, share buybacks are the norm. This is one of the big changes in markets over my investment career has been the transformation of equity markets from a place where capital is raised, to a place where capital is returned. The simplest way to show this is taking the market capitalisation of the the S&P 500 and dividing it by the price of the S&P 500. During the dot-com bubble companies generally sold shares, but in the 15 years since the GFC (with the exception of Covid) shares outstanding has fallen.

The main way that capital is returned is share buy backs. I had two concerns over share buy backs. The first is that in its extreme form, corporates would end up with negative equity. That is debt on the balance sheet far exceeded assets on the balance sheet. McDonald’s, for example, has gone from USD 15bn of equity in 2012, to negative USD 5bn today.

The decline in share out standing started in 1990s, but has accelerated in recent times. It is the acceleration of share buybacks that has driven the decline in equity.

McDonald’s has always been an investment grade borrower even with a much more geared up balance sheet. To simplify, I compare McDonald’s earning yield to US 10 year bond yield plus a 20% premium. In line with analysis on Apple and Microsoft, it did make sense to buy back shares aggressively from 2008 to 2022. But no longer. But just like in the early 1990s, the pace of buyback has slowed, but not reversed. My expectation that higher rates might expose a negative equity McDonald’s to downside risk has been proven wrong.

I am beginning to wonder if the disintermediation of banks, and particularly investment banks means that equity is no longer necessary for large corporates? Or to put in in other words, having banks at the centre of the financial system meant that other participants also needed equity. I am going to refer to my work on clearinghouses, please go here if you want to know more about clearinghouses. Pre GFC, clearinghouses were participants in financial markets, but they were not the main players. Banks much preferred to trade with each other, as it was cheaper, and clearinghouses were given the leftovers. In practice this meant if banks were doing badly, then credit would also do badly. Looking at the S&P Bank Index versus high yield spreads, you can see that falling spreads and bank equity performing well were, and when spreads widened, banks did badly. In 2022 and 2023 banks have been poor, but spreads have barely moved. Why?

Post the GFC, clearinghouses were pushed to the centre of the financial system. This has created a host of other problems, but solved the problem regulators wanted solve, which was having financial problems at banks become problem for the economy. The performance of the Nasdaq in the face of the bankruptcy of SVB probably marks a success for the reform.

Even JP Morgan could not compete with the volumes that major clearinghouses now complete.

Clearinghouses are platforms with government mandated businesses. Unlike banks, which lend and can take losses, and stop intermediating in markets, clearinghouses are only concerned with liquidity. When losses do occur - their losses are very limited (see my clearinghouse work for more detail). Clearinghouses have very serious problems, but as we have seen central banks are happy to provide market liquidity when necessary. The UK bond market (Gilts) is a recent example. LME and nickel is another.

What this implies to me is that large multinationals, which are overwhelming listed in the US, have largely escaped the confines of the international banking markets. By issuing corporate bonds, they can access capital readily, and with the assurance that governments will always provide liquidity via clearinghouses. I can understand why governments have embraced this strategy, as after the GFC and Eurocrisis, voters did not want any more recessions. Voters now want more equality, rising wages and less corporate friendly policies seem a given to me. Smart corporates might want to start building equity again, but that’s just my view.

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I had always marvelled at the awesome ability for the market to mete out justice. Japanese property bubble I experiences first hand when I was 17, and over the subsequent years saw the Japanese deflation take hold of the Japanese economy. I spent 1998 in HK as the Asian Financial Crisis took hold. My first job out of university was with UBS, about a month before the peak in the dot com bubble. Within 6 months of joining half the people on the floor had been let go. One of my graduate friends joined Enron in 2000 - and I had just read a glowing article in the Economist about how Enron was transforming the energy market in the US. I was jealous that she was joining such a cool company.

One year later everything had changed. When we met up again, I asked her if she had any idea Enron was in trouble. She said to me that her area never made any money, they just assumed everywhere else was doing great. Enron’s reported numbers are still on Bloomberg, and don’t particularly scream fraud, although how they grew revenue from USD 13bn in 1996 to USD 100bn in 2000 should have raised some red flags. Chanos built a very successful career and business on the back of discovering the Enron fraud.

But Chanos is hanging up his short selling shooters. There are two reasons in my view. Fund management is about two different things - making money and raising money. To make money in short selling you really want to see bankruptcy. Bear markets are ok, but you really only make a small amount of money relative to the risks you are taking. Bankruptcy, on the other hand, means your short will not only be super profitable, there is very little chance it will rally either. We can get quarterly bankruptcy US Chapter 11 filings back to 1995. We know there were a number of bankruptcies during the 1970s and in the early 1990s, so we can see that initial jobless claims and bankruptcies are closely linked in the US. That is shorting in the US for the last 10 years has been very difficult.

The second reason is that you need demand for short selling. In both the dot com bust and in the GFC, the largest stock and the index fell significantly. This means that allocators that hedged or had allocations to short selling will outperform, and raise money, which will naturally lead to money feeding back to short selling funds. The 2022 bear market, would have helped short sellers for a little while, but with the Magnificent seven and tech doing so well in 2023, demand for short selling would be muted at best. “Buy the dippers” have won again.

So its easy to see why Chanos is closing down - hard to make money, and hard to raise money. Does this mean that short selling is a dead industry? This is an important question for me - as I am thinking of getting back into it. First of all, we should recognise that carry is now positive on short selling for the first time in a long time.

Politically, I think we are entering a new era, where governments are willing to do whatever it takes to raise wages and have full unemployment, which is in marked contrast to the what we saw 1980s onwards. So we need to lookback at the post World War II period to see if short selling could work. From 1950s to 1980s, producer and consumer prices moved together, although the 1970s was marked by government mandated price controls. You can see in this period, the CPI of eating at home or eating out, moved close to one for one. This was an era of cost push inflation - or rising wages driving inflation.

From 1980 onwards, voters (and subsequently governments) accepted higher unemployment and bankruptcy as the price to pay for lower inflation and interest rates. That is the political and business elite accepted the possibility of foreign competition, bankruptcy and default as the cost of lower interest rates and lower inflation. What I am trying to say, is that Chanos and other short sellers like Paulson, or Michael Bury are easy to portray as outsiders fighting a system, that was not the case. This era also reflected an era where economic adjustment fell on workers more than business. An era of profit driven inflation.

It is easy to see in economic data that both CPI and bond yields were kept low from 1980s onwards. Bankruptcy and unemployment was policy, and this is what short sellers thrive on. What we need to work out is whether governments will try and supress profit driven inflation to allow wage inflation to continue? Are we going back to 1950s and 60s policy?

Governments are reducing the power of markets to keep wages low. Tariffs is now seen as an acceptable policy choice. So are capital controls, and reducing the scope of immigration to keep wages down. But taking a closer look at markets, I can see a role for short selling, that works within the political system we are moving to. Rapidly rising minimum wages, progressive taxation, trust busting and higher interest rates are all part of this mix. Areas where governments can directly control price increases are probably areas to look at. Utilities is one area. REITS could be another. Relative to shorting Enron, this is pretty unexciting stuff.

So why did Chanos fail? Governments have moved away from bankruptcy and deflationary policy. The endless economic crisis of the 1980s onwards are largely over (1982 Mexican Devaluation, 1991 Savings and Loans Crisis, 1993 Japan crisis, 1998 Asian Financial Crisis, 1999 Argentinian Crisis, 2000 Dot-Com Crisis, 2007 GFC, 2011 Euro-crisis, 2015 Emerging Market Crisis). Without crisis, Chanos style short selling is largely pointless. Does this make short selling pointless? No. But rather than generating huge returns in short periods of time, it becomes cash + plus type product - somewhere in the 10% return range - but in a potentially sideways moving market that could be attractive. But for a short seller who got Enron right, that would be pretty unattractive I suspect.

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One of the core ideas of a pro-labour world is that governments are now in the position to raise real wages if they so choose. Tariffs, protectionist policies, capital controls, are all back on the policy table. Both China and the US use these policies, so there is no reason why anyone else cannot. In December 2018, Mexico elected Andrés Manuel López Obrador as president. The change in real wages in Mexico under his presidency has been staggering.

Without question Mexico has benefited from the US-China trade war. Mexican exports have surged since Covid.

Despite surging real wages, Mexico has kept inflation under control. The most recent reading of 4.3% is well within some of the lowest readings seen in modern Mexican history.

But to generate real wage growth, you need a strong currency. And for that you need a hawkish central bank. In Mexico, interest rates have risen to over 11%, the highest level since 2000.

But in 2000, Mexican interest rates rose to try and keep the currency stable. In 2023, Mexican interest rates are increasing even as the currency strengthens.

So a strong currency, with rising wages and high interest rates would be negative for profits, but this would be countered by decent economic growth, and rising top line. I assumed this would lead to a stagnant stock market. Which is pretty much what we see.

In contrast Japanese wages have only just recovered to 2008 levels in yen terms

In USD terms, Japanese workers are at new lows, with yearly wages at roughly USD 26,000.

The big difference being that the BOJ continues to run negative interest rates policy, and a weak yen policy. In contrast to Mexico, we would expect the Japanese stock market to be surging. This is what we see.

Japanese policies seem even more extreme when compared to near neighbour South Korea. South Korea like Mexico has been raising the minimum wage.

And to defend the currency has raised interest rates.

Which has led the stock market, Kospi, to be stagnant, just like Mexico.

If Korea has also moved to definitive pro-labour policies do we see any other macro changes? Well for one thing, South Korean holding of US treasuries are starting to fall.

One of the interesting take away from this analysis is that if Japan did enact real pro-inflation policies - like raising minimum wages, or strengthening unions power, the implication would be a strong Yen and stagnant stock market, but rising yields. I wonder if Japanese politics has the capacity to surprise just at the UK surprised the world with Brexit, and the US surprised the world with Trump?

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One of the quiet joys of writing a newsletter is that everyone knows what you are thinking so without any encouragement on my part, I am often told how I am wrong. The trades that I am “wrong” on, tend to be the best ones. And of late, I seem to be inundated with people telling me how wrong I am on bonds. Like the grim reaper, the solemnly tell me the short bond trade is done - and my demise is imminent. Of course many of these same people were screaming that JGBs were shorts through the 1990s and 2000s, but having a memory is a (marketing) hazard in financial markets. The reason that JGBs were a raging buy (and short JGBs were the original widowmaker trade) during the 1990s and 2000s was because wages stopped rising in Japan. Below is the IMF Japan Wages Monthly Earnings tracker.

What happens when population growth is stagnant, and wage growth is stagnant? You get stagnant GDP growth.

In such an environment, the credit cycle is the business cycle, and central banks have to do their best to encourage this by keeping interest rates low. Whenever you have seen credit cycle turn down in Japan, crisis was soon to follow.

Japan is an extreme example as in 1990s Japanese wages were so much higher than the rest of Asia, and with slowing population growth, caused outright deflation. But the same lessons broadly applied to the US as well. When ever the US credit cycle turned, crisis and bond rally returned.

With collapsing mortgage refinancing, I can understand the bond bullishness.

The problem with this analysis is that it ignoring the political and financial priorities of governments. Moving to a pro-labour policy means nominal growth will accelerate. We are already seeing this as work.

There is another huge benefit for the US government to promote wage growth. Individuals pay tax, while corporates have generally found ways to avoid paying tax. US corporate tax take is still at 2006 levels, while individual and social insurance tax take has soared.

What Trump has shown is that custom duties can be collected much easier than it is to collect corporation tax. As the Economist points out Trump’s proposed 10% minimum tariff would collect almost as much tax revenue as corporation tax.

The pro-capital policies of the last 40 years have come to their natural end. The market power and concentration of US markets has led to the benefits of economic growth being concentrated in tax advantaged corporates. Politics and finance concerns all point to pro labour policies and rising wages. What this means is that economic growth can be separate from credit growth. There are already some signs of this change. Very high real rates are having little effect on economic activity.

Technically my favourite idea, GLD/TLT has come back to its 50 day moving average after spiking last month.

I also think that alot of people have put their money where their mouth is, by buying TLT aggressively. Shares outstanding in TLT continues to surge.

For 40 years, short JGBs was the widowmaker trade. I think long TLT is the new widowmaker.

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One of the great things about money is that is really focuses the mind. Now that I am thinking of launching a fund again, I am thinking deeply about the two problems that all fund managers have to deal with. How to make money, and how to raise money. Young and naïve fund managers often have a belief that as long as they make money, then they will be able to raise money. Don’t get me wrong, making money is important, but if you want to have a business you need to raise money. And typically, you need to offer something that institutional investors need. So what are allocators worried about?

Historically, luxury was a bad business. High operating costs, with variable demand meant that luxury stocks tended to act as high beta play on markets. LVMH fell 50% during the Asian Financial Crisis, 60% during the dot com bust, and 50% during the GFC.

However since 2008, LVMH has not really had a sustained fall. In fact it has been a quintessential buy the dip stock, and Bernard Arnault has been the world’s richest person on occasion.

What has changed in luxury? I have tended to use data from the Swiss Watch Federation (SWF) as it seems to match overall luxury data well. We have data on Swiss watch exports going back to 1990, which shows a strong bull market to 2011, and a sideways market since. This makes the more recent bull market harder to understand.

Buried with in the monthly releases from the SWF since 2009 are volume numbers, and we can then separate out volume growth from price growth. Why is this important? Volume growth is much better than price growth. Prices can fall, and if your cost structure has risen with prices, then falling prices will inflict severe losses. I typically look for declining volumes in businesses to short. Seeing falling volumes makes it even harder to understand the success of LVMH.

However, annual data from the SWF points to another trend in luxury. Premiumisation of watches. While watches prices below CHF200 still make up the bulk of the volume, they have become a tiny part of the value. Watches prices over CHF300 have seen their ASP rise by 50% since 2000 and now make up 76% of all value. That is the very top end of the market has seen volume growth and pricing growth, which is ideal condition for any business.

Since 2011, middle to mass market luxury has been very poor, while high end luxury has been phenomenal. Tapestry is the controlling company for Coach, Kate Spade and a few other brands. Hermes is Hermes. Despite US led economic growth, US luxury brands have been poor. Ralph Laruen, Capri (Michael Kors), Prada, Ferragamo, Canada Goose have all been dead money for 10 years or more. That is high end luxury has dominated mass market luxury.

My base view of a pro-labour world would mean I would probably favour mass market over high end luxury. China for me should be the most advanced in this, where the government has taken on pro-capital industries like tech and property development. The problem is there is no sign of a pro-labour move in Kweichow Moutai share price, the most valuable drink firm in the world, with a market cap of over USD 300bn.

Moutai is one of the easiest companies to analyse in the world. It sells Chinese liquor Baiju, and increased volume 7 fold in 20 years, while also raising the price 7 fold in 20 years. USD 200 for a bottle of Kweichou Moutai would seem to be a luxury good in China, but demand remains strong.

In autos, Ferrari has been the stand out stock, recently touching new all time highs.

Taking reported financial data, and adding some estimates for ASP pre 2016 IPO, we see a similar trend - rising volumes and rising prices. Again, the high end operates in a different market to rest of luxury.

So should I short luxury? Well there seems to be two things we need to look for. One would be high end consumer beginning to trade down. Numbers from LVMH and Remy Cointreau shows a slow down in US consumption, particularly of high end spirits. Where cognac goes, does the rest of luxury follow?

As the numbers from Remy show, it was the Americas that was the problem.

The second thing we would need to see is that owners of high end products begin to sell to raise cash. In discussions with friends I thought this was happening already. My friends has tended to indicate that the top end of the watch, car and wine market has come off the boil, with prices off around 20%. The Liv-ex 100 Benchmark Fine Wine Index would confirm that.

So to answer the question, “should I short luxury?” Well from an industry perspective, the best days were long ago. In the post GFC world we saw a big build out by many brands, Prada, Ferragamo, Coach, Hugo Boss, Kors and the mass market stocks have reflected this build out and the rising competition. At the top end, we have seen pricing and volume do very well, and we have seen LVMH be very successful at consolidating this market, with noticeable acquisitions including, but not limited to Bulgari, Tiffany’s and Christian Dior. Ferrari and Lamborghini has built large premiums over other marques such as Aston Martin and Maserati. For these winner brands, I would suggest shorting when we see consumer’s turn against conspicuous consumption. When would that happen? Well with conflict now in Europe and the Middle East - can we be far from “we are all in it together moment”? Luxury strikes me as good area to short. I will take a closer look at the winner stocks.

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The portfolio has been build around the idea of a political shift to favour pro-labour policies. There are numerous repercussions in the investment world, and as it is based on politics, is subject to change. The essential idea is that move to pro-labour policies would mean that inflation would be endemic, and that unless central banks raised rates, inflation would take off. The trade I like to represent this trade off most was long gold/short long dated treasuries. The thing bout gold versus treasury trade, was that there was a decent trend in this from 2000 to 2011, before reversing from 2011 to 2020.

2000 to 2011 also roughly coincided with a period of emerging market dominance over US equities. Strong commodity prices and higher interest rates would seem to be a negative for the US, but in 2023, we have seen the US continue to dominate emerging markets.

Even worse for active managers, US tech continues to dominate, and has moved far past previous eras of equity dominance.

And of US tech, you have needed to be in the Magnificent Seven.

Where macro fails, I have learnt that politics can offer a way forward.

Early October saw a big spike in GLD/TLT which moved it a long way from its moving averages. Over the last week or so, it has come back to a degree, mainly through a rally in TLT.

Just looking at TLT US, a technical minded trader may see TLT rallying back to it 200 moving day average (MDA), which would be around 99. That would another 13% from here and 20% from its low.

What are the bond bulls looking at? Well the rally in TLT is easy to understand. The 2 year treasury yield is indicating that the Federal Reserve is done with raising rates. This makes investors nervous that interest rates are going to fall, and keen to “lock” in the higher yields of 30 year treasury.

I also suspect the bond bulls are looking at lead indicators like the Senior Loan office Survey showing the percentage of loan officers tightening credit standards at levels typical of a recession.

It is interesting for me to see that the professional forecasters for the first time in 20 years think bond yields are too high. They seem to have learnt the lesson of the GFC and its aftermath too late! This is taken from an Apollo presentation, but you can find similar charts at most investment banks. What this says to me, is that economist and forecasters completely missed the bond bull market, and now that rates are higher, they are not going to miss it again. Its this type of mentality shift that tends to lead to sustained bear markets.

I have little faith in Wall Street’s view of bond yields. But I do have faith in the Japanese bond market. The 30 year JGB has been right on inflation and yields for over 30 years (note that until recently, Wall Street was also always bearish on JGBs - so much so that being short JGBs was called the “widowmaker” trade.) JGB market sold off before the treasury market in 2020, and so has good forecasting pedigree. They don’t see a recession coming. What are they looking at?

So what do the Japanese see that Wall Street doesn’t? Well two things I suspect. First neither Biden or Trump have much plans to cut US federal government spending. Federal Government net outlays remain elevated.

And that we are transitioning from a low tariff to a high tariff world.

More and more of the foreign holdings of treasuries are flowing from official holders (read central banks) to private sector holders. To me this implies that pricing should become more important. Central banks are price insensitive. Private sector is price sensitive.

While market forecasters see low inflation or even deflation, the Conference Board is still reporting consumer inflation expectations are very elevated. I have a feeling the consumer has a better feel for this than the economists.

Despite this, flows to GLD and TLT show that market participants are betting on deflation.

For me, with the dividend yield on TLT still well below Fed Funds Rate, short TLT still makes sense to me.

I understand the bond bulls arguments from a macro perspective. But politically what I see is that wage inflation is a political imperative, so the only way to control overall inflation is reducing credit flow. This is the exact opposite of how things have been runs for the last 40 years or so, where wage growth was kept in check, so credit flow was imperative. Investors should expect to see credit indicators flash recession, as this is necessary to get real wages to rise.

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Currencies do not trade the way they used to. In many posts I have pointed out the collapse in old correlations between macro data and currency movements. I have even put forward and new strong dollar model in an old post . It was a step in the right direction, but it still feels somehow lacking. In general most macro analysts also feel like the US dollar is a short, but Brett Johnson of Santiago Capital has been pushing a strong dollar theory, the “Dollar Milkshake” for quite some time. You should have heard of him as he has 260,000 followers on Twitter and RealVision have a video explaining his theory here.

So credit to where it is due, Brett saw divergent monetary policy leading to a strong dollar. And this has been true. The Bank of Japan has keep short term rates negative, and the Japanese Yen has duly collapsed. The question left unanswered in my mind, is that Japan has had extreme monetary policy since 1990, and the Yen was much more overvalued back then than it is today, so why has the monetary policy divergence worked now, and not in the previous 30 years of divergent policy?

As RealVision and presumably Brett point out, US dollar strength is typically associated with financial crises, particularly in emerging markets. Usually tighter monetary policy in the US and a stronger dollar causes financing conditions in emerging markets to tighten considerably. Historically speaking, movements in the Dollar Index and Emerging Market Bond Spreads have been highly correlated. This has not been the case recently, with the dollar trading strongly, and EMBI bond spreads trading at very tight levels.

But there are plenty of other oddities in the currency market. For me, currencies used to be very predictable. When thinking about currencies I almost always started with a hypothetical question. Lets say you needed to keep all your savings in either Canadian Dollars or Mexican Peso for 10 years. Which would you choose? The obvious answer to me would be Canadian Dollars. Why? Political and market history make Canada seem a safer option. Below I provide a long term log scale performance of Canadian Dollar Vs Mexican Peso. I chose Canada and Mexico for very specific reasons. Both border the US, and do the majority of their trade with the US. Both are also major commodity exporters. With all these features netted off, productivity, innovation and sensible fiscal management should determine the relative values of this currency pair. Or to put it simply, no trader has ever gone bust shorting the Mexican Peso.

However over the last three years, the Mexican Peso has been very strong even against the US dollar. This is probably the strongest period of currency strength for the peso is over 50 years.

Japanese Yen/Mexican Peso is even more extreme, with the current exchange rates back at 2008 levels. My observation is that the Dollar Milkshake Theory does little to explain the strength of the Mexican Peso. Historically, tight US monetary policy has destroyed the Peso.

For me I used to short Mexican Peso has an expression of the mismanagement of Pemex (among other sins). This strategy used to work extremely well, with the Peso following Pemex CDS very closely. No longer.

What this says to me is that currency movements no longer reflect movements in macro economics. So why has it become easier for the Mexican Peso to strengthen? And why has it suddenly become easier for the Japanese Yen to devalue? One reason that it used to be hard for the Yen to devalue was that the weak yen would then exert deflationary pressure on other currencies, including the US dollar. That was the Japanese were using a “beggar-thy-neighbour” policy, that continually failed. This was particularly true during the Asian Financial Crisis, in the late 1990s, and during the GFC. Politically, the US was leading the world in opening up to trade and to cut tariffs. A quid pro quo of this was to allow market forces to control exchange rates. Another way to think about this was that Japan has world beating exporters, and falling tariffs would put “upward” pressure on the Yen. The idea was that the currency market would balance out any competitive advantage.

Of course tariffs between the two largest economies in the world are no longer less than 10%. Both have risen to 20%, and probably to the surprise of the Chinese, tariffs have stayed in place even though Biden won the 2020 Presidential election. It should be noted that candidate Trump is mulling a 10% across the board tariff, probably to cut down on the reexport of Chinese goods via third party nations. The logic of falling tariffs being good for Japan, and rising tariffs being bad for Japan is pretty compelling.

Also the idea of friendshoring to Mexico supporting the Mexican Peso is also compelling. I made a lot of money shorting the Mexican Peso from 2011 to 2016, on the principal view that the creditworthiness (or lack thereof) of Pemex was a good guide to the currency. But if Mexico is the preferred export partner to the US (it benefits from being much closer to the US than Japan, and less at risk from disruption), then the strength of the Peso makes sense. As pointed out many times before, macro is really politics, and politics implies a weak Yen and a strong Peso. Currency analysis without political analysis is now worthless.

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