Capital Flows and Asset Markets

This is a free preview of a paid episode. To hear more, visit www.russell-clark.com

Emerging market investing (at least on the long side) always seems pretty easy. It almost always centres on some sort of “catch up” trade. A classic example is the auto market, where developed markets will have somewhere between 400 to 800 cars per thousand people, and an analysis will look at an emerging market an assume that it will catch up in 20 years, and then model a likely growth potential. A chart like below would be a classic starting point - showing auto ownership per 1000 people and comparing to GDP per capita.

The premise behind this is that Emerging Markets like China, Indonesia and India will catch up to developed world standards. This is standard template for pretty much all emerging market bull stories, and features heavily in any long bias emerging market fund. The implication is that you should always be bullish emerging markets. Despite this, emerging market have been a sideways markets since 2007.

Despite the many emerging market crises over the years, most fund managers are very unwilling to short emerging markets. The reason is that there is a belief that there will always be underlying growth. The problem with this is that it assumes poor countries will become rich (convergence). As we can see from manufacturing labour cost (read as wages). The former Tiger Economies such as Philippine, Malaysia and Thailand all saw their best growth in 1990s, and since then it been pretty poor - but with the glaring exception of China.

My observation with emerging markets was it was not the stocks that gets you (although frauds in emerging markets are pretty common) its the currency that gets you. Or to be put it another way, wages always rise nominally in market like Malaysia, Thailand or India, but then currency weakness pushes the wages back in US dollar terms. In a “pro-capital” world this meant that you basically needed to buy emerging markets when their relative wages looked cheap against the US. The best way to measure relative cheapness (and adjusting for productivity etc) was to look at the trade and current account balances. One way to think of pro-capital policies is that they actually REDUCE income inequality BETWEEN countries. Or to put it another way, there used to be no billionaires in China in 1980, and now there are plenty. Or all Chinese were poor in 1980, but now the majority of Chinese (or any other emerging market) are only relatively poor.

From 1900 onwards, WWI and the collapse of various Empires saw policy focus on reducing “within-country inequality”.

In my first post, “What To Do About India?” On January 4th of this year, I highlighted that India was severely overrepresented in the richest people in the world list, AND, that their wealth relative to the size of the Indian economy really stood them out as the sort of people that should suffer in a swing away from pro-capital to pro labour policies. I reproduce the original table. At the time, I suggested that the Adani net worth really looked excessive. A few weeks later, Hindenburg Research published a note, that saw a large decline in some of the Adani company share prices, and the latest figures has his net worth at closer to USD58bn.

For those of you unaware, Adani share prices rose dramatically in 2022. With the Hindenburg report, they have fallen by some 50%. It should be noted, Adani Power was falling well before the Hindenburg Report, and are still well up on where they where a couple of years ago.

If you have not read the report, basically it claims the company’s have lots of debt, there is lots of cross ownership between subsidiaries, claims of share price manipulation, and aggressive use of Mauritius shell companies to maintain corporate control. But this is how business works in India. I was a bit surprised that anyone really cared that much to be honest.

The whole experience of the Adani group, really sums up the broader experience of Indian investing. Lots of excitement, lots of potential, but after adjusting for currency, pretty disappointing. Buying the MSCI India ETF (INDA US) has not really done anything for you for the last 5 years.

Having returned to Bangalore for the first time in 10 years, there definitely been development, and some improvement in infrastructure. But as someone who was in China in 1998, I still marvel at the differences between the two nations. In 1998, the Chinese government was massively overbuilding. Empty highways that would stretch forever, massive airports with only 3 scheduled flights, even as even the best hotels would be rather shoddy. If I had to categorise it, it was that public assets were great, where as private assets were not so good. India was, and remains, the opposite, where public assets remain shoddy, while private assets (hotels, shopping malls, IPL teams) can be world class. While India gets compared to China mainly due to its size, a better comparison feels like Malaysia to me. Diverse populations, English as a lingua Franca, and an overly close relationship between business and government. For non-dedicated Emerging Market investors, you are probably wondering what does comparing India to Malaysia mean? Back in the day Malaysia was the single biggest market in emerging markets, but since 1998, it has been probably the worst value trap of all time.

The comparison is not perfect, but it is also not that bad either. And it does some up my feeling towards investing in India - it is far more risky than most people realise. One thing that I do take from my visit to India, is that if I am wrong, and India thrives, then expect the gold price to continue to trade well. And this makes me want to stick with my GLD/TLT trade.

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit www.russell-clark.com/subscribe

(Housekeeping - I post about my son’s karting exploits here now : Jarrett Clark Racing please subscribe if you are interested)

One of the biggest headwinds the hedge fund and alternative industry has faced in the last few years has been the consistent outperformance of the US, and particularly large cap stocks. Who needs hedge funds, when you have FANG, or SPY? Why pay fees to an investment manager when you can buy the most liquid assets on the planet for virtually nothing? For me, my working assumption was that US stocks could go up forever, but only if the US dollar was weak. That assumption proved to be wrong. Using BIS measure, the US dollar is was very strong over this period, and remains strong.

Now the Economist has a long and illustrious career at a “contra”. A good recent example was Brazil. In November of 2009, the Economist ran this cover on Brazil.

Brazil has tended to do well, when its currency does well, and the cover of the Economist marked pretty close to a high for the Brazilian Real. It peaked at 1.5 Brazilian Real to the USD, and got close to 6 in 2020.

For me, there are many similarities between the US now, and Brazil then. I went to Brazil at that time for a capital raising conference, and the hotel in San Paolo was USD 500 a night and everything seemed pretty expensive. I met potential Brazilian investors, and said to them, just get your money out of Brazilian Real, and you will be fine, and the response was that the US dollar did not pay enough for them to sell Brazilian Real. One of my favourite indicators Net International Investment Position (NIIP) also flipped very negative in 2010 (and has remained negative). Typically NIIP should go positive if you devalue enough.

I have not been to the US since Covid, but most of my basketball team are North Americans and have been recently, and come back with stories of hotel rates of USD 1000 a night in Miami and New York. From a purely macro position, I have been a fan of NIIP and this has been screaming sell the US Dollar since 2016. As I am travelling, I will be using old charts from a previous post, but recent data has not changed too much - with the most recent number being USD16.7 trillion. For context, I have never seen another country get past USD 4 trillion before getting into trouble.

The US is not like other countries, so I also look at it in terms of its own history. Here I strip out the treasury holdings of other countries - to try and look at “Private Sector” alone, and then divided by GDP, to try and make a comparison over time. The Dot Com bust happened at 10% of private sector NIIP to GDP, while in 2020 we got to 40%. I personally went bearish on USD in 2016 on the back of this analysis, and was wrong.

What has changed to make US NIIP get so extreme? Well the US bulls have been right in a way, it’s the best of a bad bunch. China has capital controls, and both Japan and Europe until recently ran negative interest rate policies, with almost explicit policy objective of keeping the currency weak. This was one reason I have focused so much on food inflation, as this seemed to me the one type of inflation that could prompt real change from central banks. If Europe and Japan raised rates to strengthen their currencies, could this lead to capital outflow from the US? I don’t know - but the Economist cover could prove a top again. And in hindsight it would be easy to say it was obvious.

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit www.russell-clark.com/subscribe

This is a free preview of a paid episode. To hear more, visit www.russell-clark.com

I have been fascinated by the US shale oil and gas industry for years now. It is almost a perfect example of the US economic model. First, a new technology is invented, and then secondly there is a huge rush of capital and participants all seeking to grow as fast as possible (land grab), and then there is the fall out as prices crash, and eventual consolidation. But even today, as the industry has consolidated, I still struggle to understand the economics of shale. I am using the EIA Drilling Productivity Report which gives details on shale drilling in the US. The economics of one well is easy to understand. A well is “fracked” and the trapped natural gas and oil can then rise to the surface. Unlike a conventional well that might produce hydrocarbons over 20 years before declining, shale wells go into decline very soon after being drilled. As a rule of thumb, half of the hydrocarbons are produced in the first year. The EIA Productivity Report shows this by separating out “new well” production (ie just drillled wells), and legacy decline (the fall in production that are not new wells). Here are the exact definitions:

So what this means is that for the “industry” to grow production, you need be adding new production at a faster rate than old wells are declining. And of course, as you add more new production, the decline will be even larger than before, requiring even more wells and so on and so forth. It seemed to me shale drilling was like trying to run a marathon but where you needed to have a faster pace every mile. Sure you can do it, but why would you?

One of the upshot’s of this sprint/marathoning of shale drillers, is that the industry has an almost insatiable need for land to drill new wells. This has meant that drillers have put most of the capital they raise, and the profits from drilling back into acquiring land. It has been much better to be a land owner than a driller, and there are very large oil and gas private equity firms that have focused on acquiring land and wells to then on sell to listed shale producers.

My focus on food inflation has been looking at the connections between pork prices and grain prices, as well as natural gas prices and fertiliser costs. The reality of both these areas is that recent price action has been more deflationary than inflationary. Chinese pork prices have fallen back to levels that were seen before the problems with African Swine Flu.

Fertiliser prices have also fallen back from the levels seen during the initial stages of Russia’s invasion of Ukraine.

With pork prices and fertiliser prices falling back, upward pressure on grain prices should have reduced. This should lead to less upward pressure on bread prices and food prices in general.

So the core idea of food inflation continuing looks challenged, and in particular by the fall in Chinese pork prices. But bread and pork are food items that Westerners can easily relate to. But while bread is the key food in the west, rice is the key food for Asia. And as the Economist infographic highlights, increasingly important in Africa and Latin America.

As you would expect, with the largest populations and largest per capita consumption, India and China dominate production of rice.

However, on an export basis, Thailand and India are the biggest producers, but with Thai exports declining recently, and Indian exports increasing.

China has also quietly become the world’s largest importer of rice.

And unlike other grains over the last 12 months or so, rice prices have been gently rising.

What makes rice far more interesting for food inflation is that it is much more closely linked to wage inflation. Rice farming tends to be done at a small scale, and is far less mechanised than wheat, corn or soy, which are the only other products that approach the scale of rice farming. So rising manufacturing wages in China should have very strong effect on the cost of rice in China.

If China is having problems with rice production because it has high wages, the longer the Chinese Yuan stays stronger, the more likely we are to see wages rising in other rice producing nations, making it even more likely rice prices keep rising. Does this analysis mean that food inflation is likely to remain an Asian problem? Probably not. Despite weakening wheat prices over the last year, China has become the world largest importer of wheat.

The destruction of the Soviet Union ushered in a period of commodity oversupply. Unless China can be similarly destroyed economically, either through major recession or currency devaluation, food inflation looks like it is here to stay.

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit www.russell-clark.com/subscribe

I am going to talk about McDonald’s which I thought looked a good short about 10% lower than where it is today. But before that, just a quick explanation for the slightly different format. I am about to enter the karting season, which means I will be on the road with my oldest son a lot more. It will be much easier for me to do this on an iPad rather than lugging my laptop everywhere. So this is my first effort to see if I can produce a decent post via laptop and mobile exclusively. Please do comment on any problems you find with this post.

McDonalds. There is a paid post that goes into detail why I like McDonalds as a short (full disclosure - I am short). As a rule, I do not like being short stocks that have taken out all time highs. One of the first trading rules any fund manager learns is that strength should be bought, and weakness sold.

There is a lot more detail on why I want to short McDonalds - and you can see it at the “What to Short Sell - Part 3”. But one key part is that US wages (as proxied by minimum wages) has not kept up with the price of a Big Mac. My belief is that this is turning higher, and that fast food chains are entering a period of structural decline.

There is plenty of evidence that this is indeed playing out. McDonalds for years had very good relations with its franchisees, but in recent years it has moved to a move aggressive profit seeking behaviour.

This week has also seen McDonalds announce layoffs, at the corporate level rather than at franchisee level. All of this would seem a business that has a few problems, and yet it trades at all time highs. When a stock does not fall on bad news, this normally means it’s a buy. So what is going well for McDonalds? A rally in the bond market and compression in spreads has seen the McDonalds 30year bond fall from 6% late last year to 5% today. Given that McDonalds aggressively buys back stock - this is very supportive of its equity valuation.

The McDonalds corp as it is currently structured is not affected by the profitability (or lack thereof) of its franchisees. In fact, it is deliberately structured to benefit from sales growth, not profit growth. In an inflationary environment, this makes McDonald’s very attractive. The core of the short idea is that politicians and regulators will seek to “share the pain” of franchisees with McDonald’s corporation. After recent bail out of Silicon Valley Bank corporate depositors, and various shenanigans at clearinghouses, I have my doubts that regulators even know how to punish corporates anymore.

So what to do? Well the two trading rules mentioned above, would tell me to cover the position. But I have one rule that I have yet to mention. If a position if going against you, but the portfolio as a whole is making money, then be patient. I have many inflation trades held against my short book, which are working surprisingly well. The idea was that if US regulators and politicians continue to bail out Wall Street, then inflation would rear its head again. And so far, so true.

Ironically, a collapsing McDonald’s share price would make me much more optimistic about the US, as it would show a political system that is still capable of acting in the interests of the majority, rather than the few. I still have hope that the US can turn things around - so I will hold on a for a bit longer. But this really is hope winning out over experience.

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit www.russell-clark.com/subscribe

This was published last week - but now getting out of date - so moving it to free

The S&P 500 has bounced and VIX has dropped back to 20 over the last week.

Unusually, this rip higher in equities has not coincided with a bounce in high yield bonds (HYG is a high yield bond ETF).

Also the spread between spot VIX and 6 month generic VIX (UX6) has moved back to close to 5, suggesting VIX is too low. The combination of very low VIX and not confirmation from HYG still suggests selling the rip here.

In my last note, I did not explain why VIX could be mispriced, which I will do now for paying subscribers. Free subscribers will get the full note next week.

Long time readers will know of my interest in the autocallable market. This is a product popular in Korea and Europe that sells volatility to produce a high yielding product. It is a very countercyclical product, with issuance strong when VIX is low, and very low issuance when VIX is high. Autocallables sell VIX - but have to buy it back if it rallies to much against them. Hence the safest time to buy the dip is when the autocallables have blown up - like in 2016 and 2020.

Below shows the relationship between VIX and autocallable issuance. The big fall in issuance in 2015 was due to a blow up in the HSCEI market, while 2020 is obviously COVID. Issuance is still strong, suggesting that a VIX sell off could go much higher than what we have seen so far.

Looking at the relationship of high yield and VIX, current VIX levels look too low.

With commodity prices still firm, and inflation pressures not abating, it still looks like sell the rip to me.

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit www.russell-clark.com/subscribe

As everyone should know, the US has a very unusual mortgage system. I am not going to go into the details, but the key upshot of this mortgage system is that it is relative easily for homeowners with mortgages to refinance when long term interest rates fall. Offered rates on mortgages went as high at 18% under Volker, and fell below 3% under Powell recently.

Since 1982, the average rate on outstanding mortgages has rarely risen, and when it has done so, it has been for brief periods. Periods of offered mortgage rates above outstanding rates have been associated with US economic weakness, which of course has then led to long term bond yields falling and refinancing beginning again. Other than 1970s, the period from 2005 to 2008 saw the longest period of offered rates about outstanding rates - but the heavy usage of adjustable rate mortgages in this period means offered rates are probably overstated from 2004 to 2007. The late sell off in 2018 in US equities also coincided with offered rates rising above outstanding rates.

Despite mortgage rates that are still low by historical standards, the University of Michigan survey is finding prospective home buyers as current markets as some of the most unattractive markets to be a buyer since the early 1980s.

Since 1990, the Mortgage Bankers Association have produced a refinancing index that allows us to see the trend in refinancing. As can be seen, its has a strong countercyclical nature, as lower interest rates tends to drive stronger activity, most recently seen during Covid in 2020. However, both new buyer interest and refinancing seems to be dropping off at the same time.

The fall in refinancing is fairly easy to understand. Bankrate.com gives us daily updates of mortgage rates. We can see in 2022, mortgage rates are rising rapidly, and far more quickly than in 2018.

One very negative aspect I think about quite a lot, is that for most of my adult life, US demand has been the key driver for commodity prices, but in 2022 China seems to be far more dominant driver. What if the Federal Reserve is aggressive with rate hikes to combat commodity driven inflation, but it makes no difference to commodity prices? What happens then?

I am going to start experimenting with adding paid bits to this website.

Why? I have enjoyed writing the website as I have been winding up other parts of my life, but I have other options that I could take up. Unless I can put some monetary value on doing this website, I will have to focus on more lucrative uses of my time.

How? I think I will give paying subscribers early access to my posts. Particularly those that could be used by financial professionals. That will mean for non-professionals who are not time sensitive, they should see no meaningful change in access.

When? I will start playing around with paywall options now.

What should I do? If you find my writing useful, and can afford it, then pay up. If you like my writing, but don’t want to pay, become a free subscriber today. You will still get access, but with a delay.

What else do I get? Well if you pay me some money, then I will very happy take on requests at anything you want me to look out - with the proviso I will only actually publish anything if it actually interesting.

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit www.russell-clark.com/subscribe

It is hard to overstate the awesomeness of the bull market in semiconductors. Using the Philadelphia Stock Exchange Semiconductor Index (SOX Index) as proxy, the semiconductor industry has appreciated over 200% from the Covid low.

Unlike some other tech industries, semiconductors are a Capex heavy industry. During downturns, it tends to underperform dramatically, and conversely in upturns it outperforms dramatically. If we look at the performance of the SOX Index relative to the Nasdaq it outperformed in 1998 to 2001 during the dotcom bubble, and again from from 2012 onwards.

Finding a real world indicator of this not very hard. The biggest component stock of the SOX Index is TSMC. TSMC is the dominant foundry, and makes almost all the high end chips for companies such as Nvidia, AMD, Apple among others. TSMC is also an extraordinarily transparent company, allowing us to to track wafer shipments and average selling price (ASP). As can be seem below, somewhere around 2013, pricing inflected higher for TSMC, and the industry has been booming ever since.

The improvement in pricing is evident in sales for the entire industry. Where we can see growth has inflected much higher in recent years, just as it did in the late 1990s. Data is taken form SIA.ORG and WSTS.

As a rule, per capita usage of semiconductor will rise going forward hence volume tends to always rise. The bigger issue is the pricing of semiconductors. When the dot com bubble burst, reducing demand for semiconductors just as a huge amount of capacity came online. If we look at the revenue of the two largest US semiconductor equipment makers, Applied Materials and Lam Research, we can see that there has been increasing orders for equipment, just as there was in 1999.

So if supply is coming on line, where could we see a drop off in demand? One area of demand for semiconductors has been cryptocurrency. When the profitability of mining bitcoin (or other cryptos) rise, this creates strong demand for high end equipment. Theoretically, the rise of cryptocurrencies changes the pricing dynamic of the semiconductor industry, meaning that the trend change in ASP seen above at TSMC is permanent, rather than temporary. While I have no view on the long term outlook on bitcoin, the rise in energy costs seen in 2021 and 2022, combined with recent weakness in bitcoin should reduce the profitability and demand for mining equipment. US electricity prices broadly follow the price of natural gas, which is beginning to break out.

Rising natural gas prices, should drive higher energy costs, which should drive tighter monetary policy. This should make life much more difficult for speculative assets such as crypto. If this was true we should see semiconductors begin to trade as an inverse to the oil and gas industry. We are beginning to see that.

The above chart suggest markets are beginning to price in the reduced investment into oil and gas industries, and the potential excess capacity in semiconductor industries.

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit www.russell-clark.com/subscribe

Since 2016, it has generally made sense to buy the dip. For dip buyers, a VIX around 30 has proved to be a good dip buying opportunity, which is roughly where VIX is today.

However, it has also tend to make sense to buy equities when the high yield (junk bond) market is distressed. Even with the recent sell off in high yield, it is still at levels far lower than seen in previous sell offs.

One reason why the VIX and high yield are saying different things, is that long dated volatility has become much more expensive over the last year. Below I show a rolling generic 6mth VIX future. Pre Covid, it traded between 15 and 20, post Covid it has usually been above 25.

Why this is important is that the level of the VIX is a better buy signal when it trades well above the 6mth curve, typically a premium of 10, as seen in 2009, 2012, 2018 and 2020. Currently we are well short of that level, mainly due to the elevated long dated future.

Finally, the weakness in US equities seen in 2022 is the first time since 2016 when equity weakness has not coincided with weakness in the oil price. 2008 was the last time we saw rising oil prices and falling equity markets.

Risk reward would suggest to still sell the rip in equities.

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit www.russell-clark.com/subscribe