Capital Flows and Asset Markets

The most dangerous place to be long invested is a cartel that is about to get disrupted. Payments, and fintech more broadly, seems a good place to look. Typically, a cartel member will have fantastic financial positions, and will generally be considered as either a “quality” or “compounder” stock. One recurring feature of investors in broken cartels is that they tend to buy all the way down as think they are buying at a discounted price. Payments strikes me as area full of competition and ready for disruption.

As mentioned in my post “Is the US taking on the Credit Card Cartel?” there are changes afoot at the FTC in how they regulate the payment system. What we have also seen in China is the forcible opening up of the Alipay and Wepay payment systems to the detriment of their owners, Alibaba and Tencent.

While Tencent and Alibaba fell for a variety of reason to do with increased government regulation, the fact that they were forced to open their payment ecosystems is very interesting. With the imminent launch of the eRMB, China’s payment system should be fully digital, and fully backed by the state. The cost of transactions in China, which is already low, should fall even further. Looking at Visa financial data, it has been losing competitive position in Asia Pacific market for the last few years.

In the “olden days" (think pre GFC), the combination of weakness in competitors share price and declining competitive position would lead to a derating of a stock. This has not happened with the US payment sector, in fact it has rerated higher. This in particular has been driven by Visa and Mastercard. Like many large cash flow generative US corporates has taken to issuing bonds and buying back shares.

A company like Visa does not need to issue debt, as it has minimal capex. But by having a bond outstanding, it can have a fixed income security to help justify its equity valuation and share buybacks as “value creating”. That is large cap US corporates use the price insensitive bond buying of central banks to help rerate equities higher.

Both Visa and Mastercard trade on close to 20 times EV/sales - but as pointed out above, this is a valuation driven by share buyback and bonds that currently yield 5% below US inflation rates. However the very high valuation of Visa and Mastercard has pulled the entire financial technology sector higher. The Factset Financial Technology Index has been an excellent performer in recent years, but is beginning to face some significant weakness.

Visa and Mastercard make up a significant part of this index, but among many of the smaller names, there has been significant weakness. I find usually small cap weakness precedes large cap problems.

From experience, when a company has three different negative angles that could play out, it is very unlikely to prosper. Payments in the US fit that criteria. Competition from blockchain, rising inflation and bond yields, and increasing regulation from the government. Given the large amount of VC money in fintech, is the above comes true, then I imagine VC are will also be troubled. Payments look a place to avoid or sell.

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Typically, the spread on high yield bonds and VIX follow each other. Both are measures of risk or fear. The rise in VIX this year has not been accompanied by a widening in high yield spreads. This would place the S&P 500 in a buying opportunity scenario as seen in 1998 during the Asian Financial Crisis, and in XIV induced sell off in early 2018.

Historically speaking, the VIX was purely a simple measure of implied volatility on near dated S&P options. The higher the VIX, the more traders believed that the S&P could be volatile. However, in the long period of ultra low interest rates “selling volatility” has become a popular trade with retail investors. XIV ETF, that spectacularly blew up in 2018, is one aspect of this popularity.

The biggest single market for “volatility selling” globally is Korea. The retail market is always short volatility, and has a tendency to “roll” its exposure. This has two main effects on volatility. First, this has moved VIX from an independent observation of market sentiment, to a product that drives market sentiment. In plain words, it used to be that if market fell, then VIX would go up. It is now possible to VIX to rise, and this to cause the market to fall. This tendency is partly caused and exacerbated by Korean autocallables. Issuance is high when VIX is low (putting pressure on VIX to fall more) and issuance collapses with VIX spikes. As of December 2021 data, Korean issuance is back at highs.

The collapse in autocallable issuance in 2020 was obviously driven by Covid. The 2015 collapse in issuance was driven by weakness in the HSCEI market, which at the time was the most popular market for Korean autocallables. The HSCEI had been driven higher in 2014 and early 2015 in a liquidity induced rally, but as liqudity ebbed, falling HSCEI levels led to a collapse in autocallable issuance and a large spike in VHSCEI (the HSCEI equivalent of VIX).

Could we see a similar autocallable led spike in VIX and similar 40% decline in the S&P 500? Covid induced liquidity rally has reduced short interest in US stocks to very low levels.

High yield debt now yields well below inflation. Any more to reestablish a premium to inflation would put downward pressure on equities.

If the Federal Reserve does remove market support to combat inflation, then the combination of large short volatility positions, very low yields and rising inflation could lead to a substantial volatility spike, and a severe sell off in the S&P 500.

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On most measures market and macro indicators are at extremes. S&P 500 vs MSCI World captures the major extreme. US assets have massively outperformed, even more so than during the dot com bubble, which would mean a “reverting to normal” trade implies shorting US equities.

When combined with my own preferred measure of extreme capital flows, net international investment position (NIIP), the US private sector has been at dot com extremes since 2016, and pushed beyond that level. (I separate out foreign reserve holding of US assets, as the private sector position has historically offered a better read on leverage and asset flows). This again implies shorting US assets.

However, this analysis misses the major change in financial markets over the last ten years. US corporates have become the price setters for equity through their use of share buy backs. This is stark contrast to the dot com era, when corporates issued equity.

Outside of the US, only the Nikkei has followed the S&P 500 in reducing share count considerably. This probably explains why the Nikkei is the only other index that is above its 2007 high.

The US Federal Reserve since the GFC has constantly acted to reduce the cost of corporate debt. This has caused the relationship between HYG (Blackrock High Yield Bond ETF) and the S&P 500 to be quite strong.

Where we are today, you can make a bullish and bearish argument. The bearish argument is that over the last year, loose monetary policy has coincided with rising inflation. With US CPI running at 7%, high yield corporate bonds only yield slightly more than 4%, the risk is that corporate bond yields normalise to some level above inflation, and take equities with them.

On the bullish side, if we look at the ECB where inflation recently topped 5%, the highest level since the creation of the Euro, the ECB balance sheet continues to grow, and talk of raising interest rates remain non-existent. That is central banks really don’t care about inflation, and hence share buy backs will remain supported.

If you take the view that central banks do not care about inflation then this sell off is purely driven by the “fear” of of the central banks raising interest rates. This fear becomes self reinforcing through the VIX index and volatility targeting strategies, that must sell when volatility rises. At current levels of 30, have been buying opportunities previously.

In a free market, I would suggest the risk reward of shorting US equities as excellent. But with central banks buying bonds with yields below inflation, and corporates selling bonds to buy back equities, any analysis of markets needs to incorporate central banks response. With the ECB and the BOJ both declining to even move interest rates positive, short selling will remain tricky.

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There are many reasons given for why interest rates have been so low. In my posts, I have been coming more and more to the idea that if wages are not rising, then it is very difficult to have inflation. That is wages drive inflation, and the relative power of “labour” then determines inflation rates. Thinking about inflation this way has some benefits. It easily explains the post World War II inflation, as governments set policies to target full employment and rising wages, and also explains falling inflation, as labour markets were opened up to global competition. It also helps to explain how the last 60 years has seen the Bank of England set both the highest and lowest interest rates in its 300 plus years of setting interest rates.

Can we quantify labour competition? And if so, would it gives us a guide to where inflation might be going? Japan was the first market to suffer from deflation, and very low bond yields, so is a good candidate to look at first. Using the IMF Wage Tracker, we can see that Japanese wages began to inflect lower in the early 1990s.

After the Plaza accord of 1985, the Yen doubled in value against the dollar. This meant in USD terms, GDP per capita rose significantly. This put Japan at a significant disadvantage against then competitors South Korea and Malaysia, a disadvantage that was compounded by the currency devaluations of the Asian Financial Crisis. The problem for Japan workers was then further compounded by the entry of China to WTO in 2001. Given the relative population size of China, this would have had an even more negative effect on wages than the Asian Financial Crisis. Looking at below graph, and the rising GDP per capita of Korea, as well as Chinese GDP passing Malaysian levels, it is hard not to believe that the worst of the deflationary pressure on wages has passed by.

We can look at the EU and North America to gauge at what levels of income do low cost manufactures stop exerting wage deflation pressure in advance economies. The EU provides a good test case. Spain was a low cost manufacturing destination when it first joined the EU in 1986, and Poland is now a low cost manufacturing destination after joining the EU in 2004. Given freedom of movement, I would suggest labour deflation pressure in Europe are more intense in the short term, but can adjust quicker than Japan due to internal migration. Spain joining the EU seemed to put intense pressure on German wages, but Poland joining the EU seems to have affected Spain far more than Poland. Given the unlikelihood of any other nation joining the EU, it would seem that the worst of the deflationary labour pressures are over.

Mexico joined NAFTA in 1993, which should have put pressure on wages in the US. Compared to Japan and China, the relative populations would suggest much less wage pressure. Also without the free movement of labour that underpins the EU, you would expect the adjustment to be much milder. In GDP per capita terms, its hard to see any influence of NAFTA on the US. Even more intriguing is that Mexico GDP is flatlining around USD 10,000 for the last decade, with seemingly no negative effect on US GDP per capita.

To me it looks like wage competition in Japan and Europe are coming to an end. This is making the chances of rising wages and GDP in Europe and Japan much more likely in my view, after 30 years of stagnation in Japan and 10 years of stagnation in Europe.

It seems to me that in 1970s and 1980s politics and trade combined to create an environment that sought to weaken “labour” which has continued to this day. Both Europe and Japan had to make much bigger adjustments to collapse of socialism, given much closer trade links to Eastern Europe and China. From a trade perspective, the rising wages in outsourcing nations suggest the worst is behind us for labour deflation. The tendency towards nationalist and populist policy making suggest politics is also changing. Rising wages and inflation looks likely to me.

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Professional fund managers will often worry about whether they are on the slope of hope, or are climbing the wall of worry. The slope of hope refers to the awful position of being on the wrong side of the market, and holding on in the “hope” that your position will come good. The wall of worry is that you are worried markets might fall in value, but never do. Back in the early 2000s, you could only really guess by reading stock broker morning emails, and perhaps looking at other funds positioning.

However the advent of ETFs have made the slope of hope/wall of worry discussion much easier. QQQ - the Invesco Nasdaq 100 ETF - was one of the first popular ETFs, and remains one of the biggest. As can be seen below, in 2001 shares outstanding and performance went in very different directions. A classic sign of riding down the slope of hope. By contrast, even as the Nasdaq has broken to new all time highs in 2015, shares outstanding has only risen slowly, a classic climbing the wall of worry, until recently anyway.

What is very surprising about the QQQ is that for the first 10 years of its life, the average investor had lost money. We can use two data points, the price of the the ETF and the shares outstanding to breakdown the market cap of the ETF into flow and price appreciation. For dot com era for the next 10 years, all of the market cap for QQQ came from flows, as the average investor had lost money on QQQ. For me this, is classic, slope of hope investing. However from 2014 through to 2018, the QQQ was climbing a wall of worry, as new highs in the QQQ was not greeted with rising inflows. However 2021 has seen the first new high in QQQ with a new high in shares outstanding since 1999.

One observation I take from this is that ETFs seem to have a wonderful countercyclical nature, that they take in flows even when in a bear market. This is probably shown in the fabulous performance of the world’s largest ETF manager - Blackrock.

But what can ETFs tell us about retail sentiment particularly in tech? If we get away from QQQ to other high profile ETFs, we see much clearer signs of a trend change. The ARKK funds was a leading fund for many years. However in early 2021, the fund saw underperformance early in the year, but was still greeted with further inflows, that have only slowly begun to turn to outflows. That is investors moved to a slope of hope, which has been borne out in 2022 so far.

Much like the QQQ in 2001, the average ARKK investors is now underwater on their investment.

Adding to concerns for tech investors would be the performance of the Grayscale Bitcoin trust (GBTC). In the first big bitcoin boom, share outstanding in GBTC barely grew, but in the most recent bitcoin boom, inflows into GBTC have been large. Perhaps even more disconcerting is that inflows have continued even during the recent weakness in bitcoin.

Looking at the market cap of GBTC from inflows and capital appreciation we can see the composition of gains now is in stark contrast to the boom in 2017.

Taken altogether, it would seem that the tech space is getting very close to entering the slope of hope phase of capital markets.

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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

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Comments are welcome.

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