Capital Flows and Asset Markets

As the Western world deals with uncomfortably high inflation, China has been cruising along at inflation levels that could even be considered too low. Its latest print it only just above zero. In recent years, US CPI has been above China - allowing the US economy to grow much faster than China in nominal terms.

Almost all market participants have been surprised by the lack of a “reopening” trade in China - that is surging demand that pushes up the price of everything. On a pure revenge travel style Covid boost, we can see that flights to Macau for example have recovered to the highest level since Covid. So why has the reopening trade not worked?

The biggest difference in my mind is that the Chinese authorities have taken the opportunity of Covid reopening to move away from the property led economic model that has dominated since the GFC. There is a better chart showing the surge in property development after GFC, and it now returning to that level - but I am on the road, so this will have to do.

In contrast, the US is still building houses at near peak levels (ex pre GFC).

In my mind, China has spent the last few years teaching the market that the government will not guarantee all corporates - in fact, bigger is not better in China. Investors in Asian credit would have done much better in Chinese government bonds than in corporate bonds. Singapore listed Asian High Yield bond ETF is a good proxy.

In the US, all bonds have been not so good - but what we have seen is that corporate bond spreads have remained tight. My read of this is that the Federal Reserve offering to guarantee all bonds during Covid has taught the market to treat corporate debt similarly to treasury debt. I am using the KDP High Yield Debt Index and 5 year treasuries to generate the spread here.

Oddly enough, China is probably the country most closely following economic orthodoxy but is considered uninvestable. The uninvestable part of China is policy making that aims to maximise real wages not profits - but by doing so, is keeping inflation low. China does show it’s possible to have low inflation - it’s just that corporates don’t like it.

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When I listen to market commentary, you would think strong dollar was “the macro trade” of the day. Chinese Yuan has breached 7 - and the world is about to end - again. And yet, for me strong dollar is strangely present in the places it shouldn’t be, and totally absent in place where it should be. Commodity prices have been weak this year, and in a strong dollar/weak commodity environment, shorting Mexican Peso historically has been a no brainer. Not this year. Mexican peso has seen significant strength against the US dollar. Not something I associate with a strong dollar environment.

One thing I learnt from my American friends over the years is that the profit incentive is the only thing that can be relied on in the US. And there is a lot to be said for such a system. It is transparent, it rewards effort, and when money is the centre of a political system it allows for concessions and agreements (you can always buy off your opponents). Broadly speaking, when I talk of pro-capital policies, I talk of policies that favour corporates over workers, and more generally corporates over governments. Privatisation was the transfer of public assets to the private sector. But it was not only the transfer of assets, it was the removal of government controlled competition from the private sector. The “problem” with this theory was that government controlled institutions could not fail by definition. As more businesses were privatised, the business cycle became more brutal, and governments needed to spend ever more to keep the cycle going. So despite strong growth and wealth creation, the US government has become ever more indebted.

In the UK and the US, public wealth is now negative. That is the combination of privatisation and then government spending has led the net assets of government to be negative. This seems to be the obvious end game for pro-capital policies. The question then, what is the basis for government bonds being risk free assets? The obvious answer is that should governments need or want to, then they can easily nationalise or tax as need be to pay off debts. But here is the paradox of the US. Both major parties seem committed to increasing spending, and not raising taxes (well both parties love increasing spending, and the Republicans are committed to cutting taxes). And that is the mystery of US treasuries. They are a government obligation, but the political ideology of the US is for an ever smaller state - and ever increasing corporate sector. And absent some crisis that causes a sea change in domestic politics, it is hard to see how tax rates for corporates might ever rise (the movement in people from California to Texas suggests a secular trend to lower tax collection).

The market has picked up on the political winds in the US. During the recent debt ceiling negotiations, the 5 yr CDS on the US has risen to 54. Not high by emerging market standards, but very high by US standards. And very odd if you consider that with high house prices, and full employment, the US should be a very safe sovereign credit.

The problem for holders of US treasuries is that the market does not price in problems for US government debt default into corporate issuers. If we look at Apple, its 5 year CDS has barely moved even as the US looks more likely to default. The market is probably rightly saying that the US may well default on its debt, and leave corporates be. Can I imagine a scenario where the US decided to default on it debt, but Apple continues to pay its debt? Well I can.

This change in risk pricing is probably correct. Apple operates globally, and famously avoided paying tax in Europe for many years. It could probably avoid any tax grab on its resources if push came to shove, or pay lobbyists enough to avoid paying tax. The market seems to waking up to the fact that the US does not really face any strong disincentives to defaulting on its debt. The way markets have evolved over the last few years makes this even more likely. Talk of debt default has not seen the US dollar weaken (which is a way of defaulting on debt to foreigners).

Also big owners of treasuries are the Federal Reserve and Central Banks (China still has nearly a trillion in US debt). They are easy to default on than the US public. What makes this more likely is that US corporates saw neither bond weakness or equity weakness during the debt defaults talks. If they see no downside to US debt default, then why would they accept higher taxes? Treasuries are hard to understand as risk free assets with the current US political set up.

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The US led free world (Western Europe, Japan and Australia) during the cold war were offered a pretty good deal. Mutual economic access (to a degree) and US military protection. In return the US got to set the majority of the economic terms. This was a very good deal for all involved. With the collapse of the Soviet Union and communism, this deal was extended to more countries. Eastern Europe, rest of Asia, and most notable from 2000 onwards China. The problem is that the US is reneging on its part of the deal.

As the War in Ukraine drags on, it’s increasingly clear that the US cannot guarantee security, a continuation of the problems in both Afghanistan and Iraq. As pointed out in the note on Australia, the US is now asking Australia to spend 50% of its defence budget for the next 30 years to supply the US with a nuclear submarine refuelling station in Perth. This has two negatives. Firstly it risks Australian access to the Chinese market, which is far larger than the US market for Australia. And it starves other parts of the Australian military of funds.

Secondly, the implication is that American defence spending, despite being larger than the next 10 nations combined, now requires its allies to spend more. That is the “implicit deal” for a country like Australia is getting worse. The biggest problem with this for me is that the basic assumption is that as an autocratic state, China is dangerous. That as President Xi is likely to be president for life, we need to build out military power for when, not if, China begins to take offensive military action.

The obvious problem with this logic, is that it is not applied to either Saudi Arabia or even Turkey, with the latter being a key member of NATO. Even India is beginning to show signs of single party domination with Modi, but the threat of China leads to this inconsistency to be overlooked. Close US allies, Japan and Singapore have had virtually single party rule since World War II. Even if the fear of Xi is correct - the appearance is that this is a China specific policy. That is even if China was democratic - US policy would still be focused on containment.

So the US is now asking allies to reduce exposure to China (the largest trading partner is most cases) and spend more on military to protect themselves from China. To compound the unattractive mess of the current US deal, the US has adopted industrial policy, offering heavy subsidies to attract new business to the US at the expense of its allies.

Why is the US treating its allies so badly? I have two reasons. With the advent of shale oil and gas, the US really does not need the rest of the world anymore. That is US policy can be completely geared to domestic needs, and ignore foreigners wishes with little negative consequences. The oil shocks of the 1970s showed the US it needs to pay more attention to the world, and to make the US dollar more attractive. With the US no long a net importer, there is no impetus to care about the rest of the world. If anything the pressure on China to reach out to other nations is rising.

The second reason is that income inequality is now so extreme in the US, domestic politics has become poisoned - and any concessions have become politicaly impossible. In essence US policy becomes “what can you do for me?” President Trump personifies this view, and is very popular with the US voting electorate. His chances of becoming President again have been rising lately.

The other way to look at US policy is that it is driven by corporate interests. US corporates love the access to Chinese markets, and to Chinese manufacturers, but are extremely uncomfortable with Chinese competition in leading industries. Hence Chinese tech needs to be disparaged as dangerous to stop it taking market share - see Huawei, TikTok, semiconductor investment etc. No doubt threats to the payment systems of Visa and Mastercard will portray WePay and AliPay as security threats. Or as BYD will be seen as a security risk if it begins to threaten Tesla’s position in the US. And yet the Chinese still run a large trade surplus with the US, as corporate America still needs the low cost manufacturing. Politically the US position makes no sense, but from a corporate profitability point of view it makes perfect sense.

The real problem that the US faces is that China is getting to a position where it could offer the deal that the US used to offer. Military protection, and access to a vast domestic market, but in return only asking to use a China based financial system, it at the very least, a non-US centric system. All the other pretenders to the US crown never had the military might to give security guarantees. Germany and Japan had the economic might in 1970s and 80s, but lacked the military might.

In this case the US seems to be helping the Chinese. The attractions of a non-US based system increases every time the possibility of US debt default rises. The problem is that the political logic of a debt default in the US is hard to escape. Republicans are committed to cutting taxes and spending, and Democrats are committed to raising spending. The main cost of the debt default would be born by foreigners, either by the US dollar falling or the value of debt falling.

Weirdly, if the US really wanted to damage China, a return to the tight monetary and fiscal policies of the 1980s and 1990s would probably be the best possible reaction to China’s rise. This policy combination led to the Asian Financial Crisis, as it destabilised the financial markets of Asia. But can US corporates bring themselves to endorse a policy that could see profits and valuations fall?

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When Ben Bernanke and the other central bankers started talking about QE after the GFC - I really wondered why they thought it was a good idea. The long experience of Japan showed that it did nothing for creating inflation, and in my mind made things worse. My understanding of boom and busts in a free market capitalist world was that capital flows would create a boom, and then its reversal a bust. Looking at Japan, we can see the how flows in the 1980s, followed by either contraction or stagnation. All data taken from BIS locational banking statistics - A3.1 9 (here).

The stagnation of Japan was a real outlier in the 1990s and 2000s, as the rest of the world went on a credit boom. But from 2007 onward, global flows have taken on a very Japanese flavour.

The US BIS data share a passing resemblance to Japanese data in the aftermath of its bust. A rapid rise in claims and liabilities, that then leads to a long period of stagnation.

Is there a way to forecast when the growth of liabilities and claims could end? In my view, liabilities and claims should move together, and when they become unbalanced, there was a risk of a market shock. Both Japan and the US have multinational corporates that muddy the BIS data, but BIS data does suggest both are at extremes in terms of claims over liabilities. Ireland shows more clearly how extreme capital flows can be caught in BIS data.

You can see that both Japan in late 1990s, and the US in 2007, claims and liabilities moved apart before coming the crisis. If I was looking at the current net positions of Japan and US, I would say that imbalances have built out again, and a deflationary period beckons again. That is long TLT and short GLD would be the trade.

What about China? As you would expect financial flows boomed post GFC, and from 2014 onwards fears of Chinese devaluation of deflationary bust have stalked the market.

Using BIS net data, China has the same extremes between claims and liabilities that we saw before Ireland, Japan and US deflationary busts, but China has managed to defuse that bust without either devaluing or seeing a collapse in asset prices. This for me is the game changer in inflation terms.

So one way that the extreme net positioning we see in Japan and US could play out, is the same way it has played out in Korea. South Korea has had three extremes in Net BIS Data, 1997, 2007 and today.

All three periods have been market by currency weakness.

So what does it all mean? China has balanced its BIS position, while Korea, Japan and the US have extreme net positions. The most likely outcome is that the Chinese Yuan will likely strengthen, which will be gold positive and treasury negative. Long GLD, short TLT still looks like the right trade.

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The strength of the dollar has generally been a surprise to macro investors (in my view). It did not weaken materially during the surge in commodity prices in 2021, and the old theory of twin deficits (the addition of current account and fiscal deficits) has also broken down in recent years.

I have also pointed out that terms of trade changes also used to move currencies has broken down.

I was a heavy user of Net International Investment Position (NIIP), which worked well for Japanese bubble, the Asian Financial Crisis, Eurocrisis, the problems in EM since 2011 onwards (please see my other NIIP posts). In recent years, the NIIP model has been saying both the US dollar and US equities were problems.

How can we explain the failure of these macro indicators? Recently, I have been thinking about the concept of an American Empire. When we say Empire, we typically think of an invasion of some sort, followed by direct political control. But almost all Empires had some sort of financial aspect. The East India Company was definitely focused on profitable trading. Post World War II independence, and anti-imperialism has been the norm, which has seen the number of independent nations bloom. 1945 there were 50 members of the United Nations, now there are 193. But if the idea of invading a nation to control it is largely gone (assuming Russia’s invasion of Ukraine fails), how else could we think of an empire? Could we use the idea of wallet share? I look at my current life and compare it to twenty years ago. Today is essentially impossible for me to operate without using and paying US owned corporations. Substack is based in the US, as is Stripe that handles the payments. All of the software I use is US owned, and even though I use a Samsung mobile phone, it uses Google software. I do most of my banking with a US bank, and my credit cards are all US payment systems. I watch the majority of my TV through either Netflix, Disney+ or Amazon. Even my favourite football team is majority owned by Americans. American corporations control a large amount of the food and beverage companies I use.

Is there some sort of historical comparison to corporate domination leading to currency strength? The best I can come up with, in the globalisation period which began in 1980, is Japan. For people of a certain age, corporate Japan basically dominated the auto sector, the gaming sector, the semiconductor business, medical and photography business, music (think Walkman and TDK), and basically destroyed incumbents everywhere. What was also very noticeable again Japan was the almost total lack of success that foreign brands had in penetrating Japan, with perhaps the exceptions of Coke Cola and McDonalds, but even there they faced strong domestic competition (I highly recommend Pokari Sweat and MosBurger if you ever make it to Japan). There were two big differences between Japan in the 1980s and the US today. First of all, Japan exports were goods heavy, and Japanese corporates tended to pay tax. So, as Japanese corporates dominated global trade and took market share, this turned up in a very healthy trade surplus, and in a budget surplus. So corporate domination appeared in a twin surplus and drove a stong yen.

When we look at the US today, we see similar domination, but much of the domination are in what would be called service based indices. US multinationals also make heavy use of tax arbitrage to reduce tax bills substantially. There is a reason so many pharmaceutical and technology companies are based out of Ireland. If we think about US corporate domination and the profits it brings, but they are only visible in the stock market, not in trade data, or even in tax receipts, does the record NIIP deficit make more sense? Probably.

It probably also explains the relative strength of the Chinese Yuan, as China would be the one market where US corporates face competition in all areas from payment to hardware. Also China is far more in control of tax than the US (you are tempting jail or worse in China by attempting tax avoidance). China has also been very good at taking market share in other emerging markets against US corporates, threatening long term dominance. The financial commentary is constantly talking about how Chinese innovation is probably done. And yet, TikTok destroyed Instragam by being both better and cheaper. Same with Hauwei and Cisco. Alipay and Wepay offered far better and cheaper payment systems than Mastercard and Visa. Huawei and other mobile phone operators in China also dominated in emerging markets by offering better foreign language technology and cheaper take rates on their app stores (15% compared to 30%). I always thought the security angle of attacking Chinese business was a smoke screen to protecting profits, but this analysis suggests that profits and security are flip sides of the same coin.

This analysis points to a better way to think about macro. Macro is actually driven my corporate profitability and market share. This would certainly explain some of the unusual weakness we have seen in oil exporting nations relative to the oil price. They are using old technology, while the US is developing the short cycle shale oil cycle.

Does this mean in a capitalist free market world, there is is no macro or credit cycle? Just corporate profitability and market share, which probably explains when nations with weak innovation such as Mexico or Philippines continue to have weak currencies. It certainly makes understanding the macro world easier. An area for further research.

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In a recent post I recommended reading the Economist backwards. I pointed out that the science and technology section often had good (or interesting) investment ideas. A recent article talked about ispace - a recently listed company that just saw its moon lander crash while trying to land on the moon. As most of its material is in Japanese I have put some English analysis below.

I recently posted about the Economist as a contra. I highlighted how the front cover of the Economist often marks peaks and bottoms in various economic and financial cycles. Hence the recent front cover on the success of the American economy was somewhat concerning.

What I should highlight is that the Economist is, despite its “contra” status, a very good “newspaper” (I think of it as a magazine, but for regulatory purposes it insists that it is a newspaper). I have been reading the Economist since I was 16. My mother was always keen on her children reading well, and there were always copies of the Economist, the now defunct Bulletin and Far East Economic Review (FEER) lying around. The Bulletin was sort of like an Australian focused Economist, but with more Kal style cartoons, while the FEER was an excellent publication, and far better at covering Asia than the Economist, but sadly no longer with us. For Japanese readers, I was a big fan of Toyo Keizai 東洋経済 - but I have not read it for over 10 years, mainly due to laziness on my part.

The problem with the Economist, is that same reason it is has survived while the Bulletin and it FEER are no longer with us. The Economist knows how to sell to the biggest English reading market - America. As far as I know, US subscriber base make up 50% of all Economist subscriptions. And certainly in recent years, this domination by US subscribers has influenced the “leader” section of the Economist. As noted above, I can’t blame the Economist for pandering to its client base. In an era that has been extremely harsh for many “newspapers” and magazines, the Economist has thrived.

To get the most value from the Economist these days, I would recommend most people to read it backwards. Start with the obituary, where all sorts of interesting and inspiring people’s lives are detailed. Not all of them would be considered “good” people, but all were exceptional. One of my life’s objectives it to have my obituary in the Economist - which has actually given me two objectives in life. One is to be very interesting (I would only classify myself as interesting so far) and the second is how to fake my death for a month or so to see if I made it to the obituary. This is by far the hardest part, but I will wait until my life becomes “very interesting” before worrying too much about that. I have also realised faking my death to try and make it to the Economist obituary pages, would probably be enough to get my obituary published after I really die - but that would require faking my death twice…. Which is probably a bridge too far.

The majority of Economist readers I expect to be middle aged men (I would be delighted to be wrong about this), and so the temptation to skip the culture pages would be strong. I would strongly advise you not to do this. In my experience too many men become overly focused on business and career success, and forget that you should “work to live” not “live to work”. Reading the books, seeing the movies and going to the theatre recommended in this section will make you a better person, while reading another annual report will not.

The science and technology pages will often provide good ideas for either investing or for setting up a business. The most recent one that I read, details a new technology for cement that reduces CO2 emissions, and calls out for more research. There are also details of a listed moon launching business in Japan, that could be a huge, and finally it details efforts to reduced redundant pill consumption. Which could offer a great short selling opportunity, if there is a commonly taken pill that is largely redundant. All fantastic business ideas, yet for some reason buried in the science and technology section.

Going backwards, you then get to the finance and economics section. To be honest, while this section is better than the leader section of the Economist, it is the weakest of the back sections. If you follow the markets reasonably well, it is unlikely you will learn too much from this area, but there are the occasional nuggets.

The business section is very good. Mainly as it is largely devoid of opinion. The recent article on Chinese unicorns was fascinating, as it shows that the Chinese government rather than stifling innovation as most investors predicted after it slapped down Alibaba and Tencent, it has been able to direct more capital to the areas that China needs, namely semiconductors. And this section leads to a much more nuanced view on the China-US confrontation. The leader section would have you believe that China is stumbling under the sanctions that have been placed on it. The business section shows that China is getting its act together to replace many US technologies.

International section is relatively new, and I have found hit and miss so far, so will not pass comment.

You then get to countries section. The order of this section depends on where you are reading the Economist. I have the UK version, which writes about the UK first, then Europe, followed by the US, Middle East and Africa, America, Asia and then finally China. If you are actually interested in where the world is going, then this is probably exactly backwards. What is even more infuriating about this order is that very few people need to know “more” about the UK, Europe and the US. These are the most extensively covered news markets in the world. People need to know more about where China, India, Asia, Middle East and Africa are going, and these are the areas where the the Economist adds most value, but of course has the least number of subscribers.

Recently the Economist has had added “By Invitation” section, which I usually skip, as I don’t need more opinions in my life. The letters section I read religiously, not because I usually learn that much, but mainly for amusement factor as various people write into say how much the Economist is wrong on some subject. My brother, curse him, once a got a letter published. (This is one reason I need to get my obituary into the Economist so I can outdo him. The Economist once wondered why Australia’s best selling magazine, Women’s Weekly, was only published monthly. My brother wrote a letter pointing out that it used to be a weekly publication, but when it changed to a monthly publication, even Australian publishers blanched at the idea of calling a magazine “Women’s Monthly”. My various efforts at getting a letter published in the Economist have totally failed).

And the finally you get to the leaders. Typically once you have read the title, you know exactly what the rest of the article is going to say. Is Keir Starmer Ready For Office? Probably. The West Should Supply Ukraine With F-16s. Agreed. The Power And Limits Of The US Dollar. Boring. You get the idea.

To be fair to the Economist, I still read it every week, even as I have given up on other newspapers and magazines like the FT, The Sydney Morning Hearld, Private Eye and GQ. More power to it. And hopefully my advice to read it backwards will help boost its subscription base - and maybe even get the leader section to be improved. I live in hope and hopefully die in the obituary section.

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When I talk about a political shift from pro-labour to pro-capital policies, I have tended to talk about the Thatcher/Reagan revolution beginning in the 1980s. This was more out of convenience than anything else, as no one is going to argue with dating a pro-capital shift to the rise of Thatcher. However, the reality of political revolutions is that they start out small and then seem to happen all at once. For me, I think of the real beginning of the shift from pro-labour policies to pro-capital was the decision to leave the gold standard. From the moment FDR instituted a minimum wage in 1939, until the moment the gold standard was abandoned, an increase in the minimum wage was a “real” increase. American workers could afford more gold at the very least. From when FDR began using a Federal Minimum wage until 1980, it rose over 1000% in 40 years.

But as gold left the US, and flowed back to Europe, it required higher and higher interest rates to maintain the link between the US dollar and gold prices. At a certain point, Nixon decided the economic pain of higher interest rates was not worth it, and decided to devalue. Still powerful unions and labour interests saw it for what it was, a wage cut and to push for equivalent increase in wages, and the era of stagflation and misery index was born. But eventually by the end of the 1970s, workers (or production worker’s) hourly wages had fallen back by 90% in gold terms. The 1980s then saw an era of much slower wage increase, but tight monetary and fiscal policy. Wages in gold terms rose again, but with a substantial fall in the gold price. But with advent of Ben Bernanke and his policies of continual stimulus and QE, we have seen worker wages plummet back to 1980s lows, and remain there for 10 years. As an explanation for why central bankers garner such visceral hate, you could not find a better chart. House price to incomes tell a similar story.

Broadly speaking, maintaining positive real interest rates will keep your currency strong, and allow real wages to increase. Volcker in 1980s did exactly that. Ben Bernanke did the exact opposite.

Since the GFC, and driven by Ben Bernanke idea, devaluation has become the default policy of central bankers in the rest of the world, with the notable exception of China, which I have written about extensively. One of the mysteries of this policy position, is that I have yet to find a nation that has devalued itself to prosperity. If currency devaluation was really the panacea it was made out to be, then surely Italy would be the richest nation in the EU and not Germany? Or Mexico should be more successful than the US? The Asian financial crisis saw many nations devalue, and perhaps with the exception of Korea, it is hard to see how this benefited these nations in any way. In fact in 1990s, central bankers knew that devaluation was a failed policy, and actively raised interest rates to stop the currency from devaluing. Somewhere along the line, it was decided that sacrificing real wages for higher profits was a good strategy. Back when I was running money, I would try to avoid being long countries that I thought would devalue, which outside of the 2000 to 2008 period was almost every emerging market, which is why this period was so good for emerging market investing. It is also the main reason I remain lukewarm on investing in India.

And here is the rub, China is not devaluing, and has a number of policies that is slowing the property market, and anti-cartel policies that are good for the stock market. But as mentioned in previous posts, luxury stocks do not seem to be indicating any great slowdown in Chinese consumption. The Western World has been emphasising profits and pro-capital policies, and weak real wages until recently at least. China has been focusing on raising real wages, and a strong currency. And as mentioned, I have yet to see a country devalue its way to propserity - and this it probably one reason I keep wondering if China is winning….

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How do you stop a country from developing? That is the question that is confronting US policy makers. At the moment, the US is adopting a number of policies including stopping technology transfers, tariffs and other regulatory barriers. The US has used this type of policy against North Korea, Cuba Venezuela and Iran, and these policies have indeed l…