Capital Flows and Asset Markets

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I have been thinking more about individual stocks as I gear up to publish a model portfolio in November. Since I started publishing this substack, I have been mainly focused on trying to understand why macro does not work the same way. The old rules of macro were most pure in currency markets, but do not really work anymore. As I want to talk about stocks, rather than macro I will just show one example. For me in currency markets, carry trades tended to be closely aligned with markets. One classic trade would be Short Yen, long Mexican Peso. In the old macro rules carry trade would always unwind and the Peso always devalue versus the Yen over the long term. Periods of peso strength were great short opportunities. Not this time. The peso has reversed almost all the weakness against Yen since the GFC - the longest period of strength I have eve seen. I understand Mexican peso strength from a political sense, but old school macro analysis would lose you money on this trade. See also Long Norwegian Kroner, short Mexican Peso.

I used to use currency analysis before choosing stocks to short. The idea was to maximise my chances of making money from the short book. Typically, the second thing I would look for was an industry with weakening fundamentals. What has been interesting, is that this area is working (to a degree), without changes in the currency market.

It is pretty easy to be negative on private equity. Their business model seems to be built around the use of leverage to juice returns, while using the cover of private markets to give the illusion of stable returns (which is important when using leverage). That was why I was surprised to see that despite the bond bear market, AUM at Blackstone has hit new all time highs.

Taking a closer look at Blackstone, they obviously have problems with the private REIT, BREIT. My friend and subscriber, George Adcock, passed on some very amusing details on BREIT. A firm out of California, MacKenzie Capital, is offering liquidity to BREIT investors at a 38% discount to stated NAV. To be fair, the entire deal is only USD 15m, so not huge, but is the discount correct? And does this mean Blackstone is in a death spiral?

Again my friend George pointed me in the direction of another Substack written by Warden Capital, which goes in a lot of detail on a USD 4bn investment by the University of California (UC) into BREIT (post is here). This was at the height of redemption requests for BREIT, so UC received much better terms than other investors. Namely, guaranteed return, and also guaranteed liquidity.

That Blackstone can cut deals like this to prevent itself being a forced seller, probably explains why the shares have performed better than expected.

Rupert Mitchell, the writer of the Blind Squirrel Macro substack, is also writing about how investors seem to be paying extra fees to private equity to hide volatility. While this may seem crazy, having talked to many allocators over the years, I can understand why this is attractive to them. In proper bear markets, like the GFC, many funds are forced to sell what they can, not what they want. Allocators want and need (for career purposes) to avoid mark to market events like that. Private Equity allows allocators to avoid that pain. As the UC investment into BREIT shows, this is a structural advantage.

The other problem with shorting Private Equity is that they are benefiting from the flow of funds into private credit. The leading firm here is Ares Capital, which is just off its all time highs. Private credit has the structural tailwind of banks being forced to hold higher rates of capital, and avoid riskier lending, creating space for Private Equity firms.

When I think about all of this, I am reminded of another difficult to short business - Chinese property developers. As far back as 2011, Evergrande was known to be courting trouble with very aggressive financing structure, and for years it was the biggest single short in all of Asia. From its lows in 2015, it then rallied by over 1000%, as government policy supported property markets and property developers. It was only when Chinese government policy moved decisively against developers did the short in Evergrande work, but by then the original short sellers had gone bust.

Private Equity also benefits from a government policy that allows them to use carried interest to reduce their tax bills and juice returns. Reform is often talked about, and yet this tax treatment continues. Private equity expend a lot of political energy on retaining this structural advantage. When, and if, US politicians decide to close this tax advantage will be the time to short private equity. I suspect you need to see the Democrats control both houses for such a change. My views on a pro-labour shift means I think this is likely. But short selling is often a timing game. I am not sure this is the right time, but then again a week is a long time in politics!

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In thinking about portfolio construction, I want to stay close to my core theme of pro-labour politics. The core investment idea is that real assets rise with wages, while financial assets are suppressed to try and keep inflation under control and allow real wages to rise. The key trade has been long GLD (gold) and short TLT (long dated treasuries). It has been good so far.

One of the questions I have been asking myself is whether cryptocurrencies and bitcoin in particular is a financial asset or a real asset (a digital gold). It is a really tough question. Bitcoin got crushed in 2022 when rates started to rise, but has doubled this year.

In a previous post, I stated that I thought stablecoin market cap and bitcoin could be correlated.

The energy markets have been undergoing huge changes. Starting with the shale revolution that saw the US go from producing 6mn barrels a day of oil in 2012, to over 13mn barrels a day today.

A knock on effect is that the US does not need its Strategic Petroleum Reserve (SPR) anymore. In fact much of the stored oil under the SPR was in the wrong place. The Biden administration has taken advantage of the high energy prices since the Russian invasion of Ukraine to run down the SPR.

Some “analysts” claim that this is a one off policy to keep oil prices down, and when the SPR is refilled again, oil prices will surge. US oil inventories are kept as a hedge against supply blockades. IEA recommends keeping 90 days of imports as a minimum. As commercial operators would not hold that much inventory, the US government had to set up the SPR. With the growth in US production, and the fall in imports, US has excess inventory now. The SPR is not necessary. It is very unlikely the SPR will ever be refilled.

US shale oil production has been increasingly dominated by Permian production in recent years. Production in other shale areas has been stagnant.

What is unusual about this is that Permian drillers have been running down the stock of Drilled Uncompleted (DUC) wells. That is they have been completing more wells than they have been drilling.

Why is this a big deal? Well shale oil is a short run method of production. New wells produce 50% of their output in the first year, and then go into decline. To grow production, new wells need to be outpacing the decline in production at older wells, and using data from EIA, we can estimate both. New production looks as if it stalling, while legacy decline is still rising. The chance of US oil production falling is increasing.

I look at January 2028 natural gas future prices to get an idea of whether the industry is still over producing or not. From a low of USD 2.6 in 2020, this rallied to USD 5.5 in 2022, before correcting to USD 4.8 today. If this started to fall again, I would need to change my mind about US supply of energy.

In the renewable space, we have seen problems emerge in the offshore wind industry. This is most visibly seen in the share prices of leading offshore wind producer - Orsted. Orsted has fallen 50% this year, and 77% from its peak in early 2021.

For the more “excitable” analysts out there, this is taken as proof that the offshore wind market is broken, and that government policy to go green is a failure. However, Orsted itself sees no problem in the offshore wind business. It’s most recent capital day still forecasts tremendous growth in the wind industry.

The problems of Orsted and other wind producers are not a failure of government policy but the success. As this Reuters article points out, the auction of rights to seabed in early 2022 saw record amounts raised, as BP, Shell and other big oil names entered the market. The problem for Orsted and other existing wind energy names is that new deep pocketed investors have entered in the industy, increasing competition for offshore wind assets.

Offshore wind suffers some of the same problems US shale suffered. Increasing competition bid up the value of the land, which diminished returns. This has led to reassessment of the returns available, and Orsted to go from being valued at 6 times book value to 1.7. The question is now one of policy. Does the government raise the price paid for offshore wind, so that big oil can earn a return on its investment in seabed rights? Or does it allow market forces to work, and force the value of sea beds lower?

As tradable carbon prices have remained very strong, my best bet is that at some sort of compromise will be reached, and offshore wind generation will continue to grow.

The green energy revolution continues unabated in my view. With investment in fossil energy falling, we should see firm to rising energy prices, and with growing competition for green assets, we will need to see rising prices to keep supply growing. Energy inflation looks set to return.

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The idea I have been pushing for awhile now is long GLD/short TLT to capture the move in politics to pro-labour. It has been working well, with a recent spike.

Without question the short TLT leg of the idea has been the big winner. Falling from 160 to 83 today.

Even as it has fallen, “investors” have been piling into TLT. Shares outstanding has more than quadrupled since 2022.

Over the same period, short interest has remained subdued, so losses to owners of TLT have been very large with very little short seller gains! The middle chart shows shares out short, which has remained stable even as shares outstanding has increased.

Is TLT still a short? Over the last year it has been very attractive as a short, as the yield curve was inverted. That meant that the cash proceeds you got from selling 30 year could generate an interest coupon greater than the cost you would pay to short the 30 year. That is it had a positive carry. If we look at standard yield curves, then this inversion has disappeared (such as a 2yr v 30yr).

The problem is that TLT is not a 30 year treasury. It is an ETF that is designed to remain a long dated treasury forever (i.e. it has no pull to par). A better way to value TLT is its dividend yield versus cash (Fed Funds Rate). On this basis it still looks like a short. Assuming TLT needs a dividend yield of 5% or so, gives another 20% downside.

I suspect yields still have further to rise. The JGB bear market continues unabated.

TLT still looks a good short. If we see a reduction in shares outstanding in TLT or a rise in short interest, a tactical cover may make sense - but I have not seen either of those yet.

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As laid out in a recent post, I think I see an opportunity for a fund. As explained in many posts, I see politics moving pro-labour and away from pro-capital. This makes me bullish on wages and real assets, and bearish on financial assets. The simplest (and so far best) way to express this has been long GLD, short TLT. If central banks shy away from tight monetary policy, then I expect assets like gold to do well, and long dated treasuries to do poorly. So far, the GLD/TLT idea has worked like a dream, with a very big break out recently. I suspect the very big move in recent days is coming from some talk of the Federal Reserve being done with rate hikes. In a pro labour world, this will drive a sell off in TLT and a rally in GLD. Central banks are the only thing that can restrain inflation, and rates will need to keep rising.

For people that do not like the negative carry of the GLD/TLT idea, I suggested the idea of long HYG short TLT. In a pro-labour, rising wage world, credit expansion is unnecessary for growth. So while many macro analysts are calling for a credit contraction driven recession, I doubt we will see one. That means HYG, will do better than expected, and the shorter duration of HYG should see it outperform TLT. This has been the case.

In a pro-labour world, regulations and tariffs are necessary to protect domestic wages. This also means there is little benefit to devaluing the currency, as this just reduces real wages. This makes the exporter led treasury buying unnecessary. What this means is that foreigners are no longer the main buyers of treasuries. And this is what we see (at least in foreign exchange holdings).

If foreigners are not buying treasuries, then who is? Well locals are (the ones getting the wage increases). This can be seen in the surge in shares outstanding for TLT or in the large increase in money market funds.

GLD is representing real assets, namely commodities, while TLT is meant to represent financial assets. The problem is that S&P 500 continues to outperform treasuries. Using long dated Treasury return index, and comparing to the S&P 500, I would have assumed at least some weakness in the S&P 500 this year. This has made short selling problematic.

So the pro-labour “system” makes sense to me. GLD/TLT has been great, but the surprise for me has been how well the S&P 500 has held up. S&P 500 has held its value against gold surprisingly well.

However, the S&P 500 has been dominated by a few mega caps. Getting way from these names, we can see the outlines of a short portfolio. Roughly speaking, this model would suggest a short portfolio of bond proxies and businesses that don’t work at interest rates north of 7%.

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Last time I talked about McDonalds was to cover my short positions. I have talked about the fast food chains at length, as they represent the pinnacle of pro-capital policies in many ways. All the risk is now driven down to franchisees now, while the franchisor collects a royalty no matter the profits of the franchisee. You can read more here and here. Having been short McDonalds for a while, I took the the short off in June. As a number of subscribers have pointed out, this is just before it had a 15% fall.

The question is this just another dip to be bought, or is the beginning of a bigger move to be chased?

If you have been following recent posts, I have been surprised at the continued growth in AUM for private equity. In fact based on AUM growth, alone, I would probably have to pitch Blackstone as a buy.

Dividing market capitalisation by AUM gives a range for Blackstone of between 20% and 8%. At current levels of 11% is not a bad valuation if you believe in the promise of private equity.

However, one of my theories was that rising interest rates would enact a double whammy on private equity. The first was that when investors can get 5% in short rates, they would lose interest in private equity. Using the Q2 2023 Bloomberg Private Equity Chartbook, we can see that publicly reported commitments to private equity has fallen significantly, with 2023 only annualising at USD28.4bn, well down on a peak of USD120bn in 2017.

The fall in public commitments to private equity is hard to match up with Bloomberg numbers that USD 144bn in private equity funds closed in Q2 of 2023 and that Blackstone has just closed a USD30bn fund. Blackstone was the biggest fund to close in the quarter, Blackstone Real Estate Partners X LP at USD 30bn. The X in the name refers to this being the 10th fund in this series. Like movie franchises, private equity, like to continually relaunch the same fund.

The idea is that investors shift from one fund to another fund as one opens and then closes. As Blackstone shows in its presentation, there is always an open Blackstone Real Estate Partners (BREP) fund. The question I wonder here is how much new money went into this. This could suggest that there is a lag to money flows into Blackstone. As well performing funds roll off, there is natural AUM as money is rolled in. This would imply that if interest rates remain high for a few more years then we will begin to see this AUM fall.

Taking a closer look at Blackstone, the first thing to note is that there is a very big difference between total AUM and Fee-earning AUM. Over 25% in Blackstone case, with total AUM at USD 1 trillion, while fee earing AUM is USD731bn. The second thing to note is that Real Estate is a much bigger AUM on a fee earning basis.

Blackstone has a number of permanent capital strategies which have tilted the firm even more aggressively towards real estate. The Blackstone Property Platform (BPP) with USD71bn and Blackstone Real Estate Income Trust (BREIT) with USD68bn make of 20% of fee earning assets, and half of the fee earning assets for Real Estate. Blackstone Infrastructure Partners (BIP) is listed and is down 16% this year

The Blackstone Property Partners Platform is not particularly transparent to me. I can see there is a USD 15bn European part of the platform with listed bonds. Predictably these bonds have been poor, which I would assume should be negative for this business. Most listed European property funds have been extremely poor over the last year.

The Blackstone REIT with USD 67bn of assets, which would make it one of the largest REITs in the world. Why has Blackstone entered the REIT market? Well a quick look at the fact sheet provides a pretty clear reason - they have been able to jack up fees. Listed REITS have no performance fee, BREIT does - at 12.5% of annual return.

Blackstone has been aggressively pursuing the idea of taking listed REITS and making them private. Blackstone M&A in the REIT sector includes PS Business Parks for USD5bn, American Campus for USD 13bn, Preferred Apartments for USD3.6bn, Bluerock Growth for USD2bn and QTS Realty for USD 5.3bn. Not all of these have ended up in BREIT - in particular QTS Realty looks to be in a different fund. BREIT has large exposure to rental (including student) housing in Florida and Texas.

One of the selling points of private equity is that valuations are more stable. So in the case of REITS, by taking them private pension investors have no need to mark to market. For this “benefit”, Blackstone is able to charge a performance fee. The weird thing about this, is that investors are charged a fee for reduced liquidity. When BREIT was hit with redemption requests, the fund gated.

Looking at the performance of listed apartment REITS, I find it hard to believe that redemption requests are likely to go away.

Bloomberg Private Equity data shows slowing flows to the sector, and Blackstone’s two largest permanent capital structures should be seeing financial pressure and/or redemption pressure. So how can AUM still be rising? And why are Blackstone shares holding up so well. Well it seems that underlying collateral values remain strong. Despite rising interest rates, US house prices have risen to new all time highs.

To be fair to private equity, part of their appeal is that the stability of their valuations is an attraction. And as property prices and collateral values are still rising, its hard to argue that the valuations of their funds have necessarily taken a hit. But rising property prices imply still rising inflation pressure in my mind, and hence rising interest rates. To my mind a short Blackstone position makes sense as either inflation and interest rates keep rising, or collateral values start falling. Neither of these will be good for Blackstone.

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The Hamas attack on Israel creates a level of geo-political uncertainty. The most concrete example was the 4% rally in the oil price.

Theoretically you would also think VIX would spike. War and potential for a spike in the oil prices is bad no? You would be wrong. VIX ended Monday close to where it was on Friday.

Why no fear?

So the trade I have been recommending for a while now is long GLD/Short TLT. It has been trading great, and I suspect it will continue to trade great.

Now typically in fund management, managers and allocators rely heavily on back testing as a way of working out the riskiness of a trade. This back testing would currently be suggesting that either the dollar is too strong, or bonds are oversold (which is exactly what the macro community is suggesting) The dollar appreciation from 2001 to 2015 coincided with GLD/TLT underperforming.

Separating out the performance of GLD and TLT, would lead you to think that gold looks overvalued. In this case, back testing would highlight that gold has held up well despite bonds being weak. In particular, when TLT was weak in 2014, gold got destroyed.

The combination of strong gold price and a strong dollar leads to the most arresting chart (for me in anyway), gold in yen terms. What I find extraordinary is that in 2001, gold in yen terms was the same price it was in 1978. No wonder Japan felt so wealthy in the 1990s and 2000s, but feels poor today. In 2016, I would have assumed a collapsing Chinese Yuan would drag down gold prices, but Chinese policy has been very pro-labour which is about supporting wages, not asset markets.

How do I fit all these contradictory signals together? Politics provides a much better way to understand this. In 2016 with the election of Trump, and 2020 with the election of Biden, we have had two “pro-labour” presidents. 2024 will most likely see the third straight “pro-labour” presidency (either Trump or Biden again). Pro labour policy in the US is a combination of tariffs, Buy American provisions, and low unemployment. I also see pro labour policy as being “strong dollar”. Why? Workers know when their wages buy less, so keeping real wages strong implies a strong currency. Also until 2016, free markets would push up undervalued currencies (and labour), and push down overvalued currencies (and labour). In a free market world, Japan with its deflation and constant trade surpluses would see a Yen rally. In a world where the US has tariffs and domestic production subsidies, the Yen is weak.

In a protectionist world pro-labour world, a trade surplus is a sign of economic weakness, not competitive strength. All of these are good for the US, except for one area. Treasuries. In the new world, where trade surpluses are weaknesses, why would anyone buy treasuries as a foreign reserve? Both economically and politically it makes no sense. Official holdings are beginning to reflect that reality.

So treasuries are a short - but why hold gold? Going back to Japan, in 2013 Abenomics was launched and is an extremely pro-capital policy. With the US moving to pro-labour, this has led to the break out of gold in yen terms. For me, if the Federal Reserve moves to pro-capital policies then I would expect a similar move in USD terms. Gold is held in place by tight monetary policy, and should the Fed go back to old habits, we should see gold move higher. GLD/TLT is what I call a “correlation break” trade, and is one of my tools for running net short. You can read more about it here. In essence a correlation break is when a macro relationship reverses, and catches the macro community out. What that means you can be long and short trades that should be positive correlated, and then make windfall gains when the correlation changes. GLD/TLT offers a template for this trade. As mentioned previously, I think private equity is probably the industry that dies in this correlation break.

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