Capital Flows and Asset Markets

For various reasons I have been having discussions about gates. A gate for an investment fund is pretty common these days - as it seen as a way to protect investors from themselves. It is so common that is just usually added into many investment fund articles. Personally, I hate gates. I have on occasions had opportunities to impose gates, and have turned them down. When I took over the management of the Horseman Global fund, we had redemptions of well over 80% of assets - but chose not to gate. The only time I can think a gate might make sense maybe in time of total crisis, like GFC or Covid, when there is no liquidity anywhere - but even then your investors will likely have other concerns so a gate makes little sense. But gates tend to be standard parts of most funds these days - but my advice is for most fund managers to be extremely cautious in using them.

In the midst of the on/off war in Iran, and an epic AI boom, and all sorts of other shenanigans, you may have forgotten that private credit funds have been gating their clients.

And this gating has been why the Invesco Listed Private Equity ETF (PSP US) (many private equity firms do private credit as well) has been poor on both an absolute and relative basis.

For me, once you gate a fund, it pretty much a dead product. Fund management is a trust game - and if people want their money back you should give it to them. And once you gate, you create terrible incentives for other investors. Gating means or implies you have a bunch of assets that cannot be priced or sold. And for investors who have not asked to redeem, they start asking themselves some difficult questions. Will the fund manager have to sell the liquid positions to meet redemptions, leaving the fund only with illiquid assets? The answer is almost certainly yes in my experience. And does anyone want to then invest into this fund, with only illiquid assets that cannot be priced? Not really. Cliffwater is a good example of this phenomenon.

And with more money going out that coming in - you would wonder if that NAV is correct.

Cliffwater has capped redemption at 5% of assets, despite have 17% redemptions. Following the logic laid out above, this looks to be a dead product. Who would put money in this now? The one thing I find very odd about this is that Cliffwater is getting into trouble when high yield spreads are at all time lows.

For reference - Blackstone listed in 2007, just before credit spreads blew out - and fell 90%.

One wonders what private credit would actually do in a recession?!?

Anyway, the point of this notes are gates are bad, and there is almost never a good reason to use one, and using one will likely make a bad situation worse.

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I was cleaning up some files from my laptop, and I found a stash of my oldest research I first published back in the early 2010, when I was trying to convince everyone China was going wrong (tough sell back then). I am just going to put it here for posterity, so I can easily reference going forward. Enjoy. Three notes, first is on iron ore, second on mining, and third on Brazil - all from 2011 and 2012.

A follow up note on mining.

And a note on a potential Brazilian debt crisis.

And in conclusion, yes, I have always been this boring.

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If you wanted to get bearish on the whole AI trade - then you could look at Meta, Microsoft and Oracle share prices and say that the market is taking a dim view of AI. All have been lacklustre recently.

There is no mystery to their share price weakness. All are investing heavily in data centres, and so free cash flow after capex is falling. Microsoft it a good example.

All of the above is factual. Share price has been weak as investment has grown. What does it mean - well that is where the analysis comes in. There are various options. The first I would call the traditional Wall Street MBA version - “Maximum Bullish Always” which would centre around exploding demand, and capex is needed to keep up with demand, and would see current share price weakness as a buying opportunity.

The second style of analysis is also MBA, but a macro/short seller interpretation so “Maximum Bearish Always”. In this analysis, the weakness is hyperscalers is direct analogy to the dot com bubble, where the internet stocks weakened first. The analogy here is internet stocks like Amazon topped out late 1999, and then hardware stocks like Cisco followed with a lag, as the internet stocks cut spending. In this analogy, now is the time to be shorting memory stocks, as hyperscalers have topped out.

For me, both these analyses seem wrong to me. What I see is that AI is booming, but it is also a threat to existing tech companies. Probably the biggest threat comes from SpaceX. Elon Musk has been a disruptive entrant in payments (PayPal), autos (Tesla), rocket launch (SpaceX) and telecommunications (Starlink). If I saw Elon entering my industry, I would also become super defensive as well. In this case, I would be trying to push up the cost of entry AND secure infrastructure to try and keep xAI from becoming a serious competitor. Unfortunately for the existing players, SpaceX was able to list, and Elon will about to keep investing. As a reminder, Tesla invested far more than cashflow and was the biggest short in the market for years before finally taking off.

So Russell’s non MBA read of the AI market is that hyperscaler’s shares are weak not because AI is a failure, but because a powerful new player has entered the industry. I admit the rise of leveraged semi ETFs, like MUU make memory stocks volatile - its hard for me to get too bearish when TSMC is near all time highs.

Or when Taiwan listed wafer company, Global Wafers is at at all time highs.

If Microsoft, or Meta or Oracle were suddenly to cut capex - yes that would be bearish for semiconductors, but it would probably be even more bearish for these hyperscalers. It would be boosting short term cashflow at the expense of long term market share. What I think is very telling was that in the dot com boom, credit spreads starting rising in 1998, but the dot com bubble did not burst until 1999/2000. Currently credit spreads are at all time tights - which suggests the cash will keep on flowing to drive the AI trade.

If you want to be bearish, legacy hyperscalers are probably the best bet - not AI infrastructure.

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In my first stint as a macro hedge fund manager, I used to obsess over capital flows into and out of Japan. When the capital was flowing out - you wanted to buy, and went it was flowing back, you wanted to sell. I now realise I was studying the symptoms of a pro-capital world, but having only lived in a pro-capital world, how would I know any different? But now we live in a pro-labour world, and symptoms have changed. Capital is no longer getting build, up but being run down.

I think the easiest way to understand it is that in a pro-capital world, we were creating huge pools of capital, and Japan was creating the largest pools. In fact, Japanese pools of capital were so large, the BOJ and the government had to go out of their way to force capital out of Japan. Hence, NIRP, QE and YCC were all invented in Japan.

One feature of this was that whenever US 10 yields fell, the spread to JGBs would fall, and the Yen would rally. This was a feature of markets from 1994 to maybe 2020. But since then, the spread between JGBs and treasuries have collapsed, but Yen continues to weaken (see my posts on “long Yen as new Widowmaker”)

If we break out the spread line above in to its components, then what we have is the yield on the Japanese 10 year rising rapidly.

While Japanese yields are rising, the US 10 year has been stuck in a range since 2023 now. This seems a bit odd, as Japanese have far more savings than the US. It feels like higher Japanese yields should drive higher US yields. But over the last two years, nothing.

If you believe in my pro-labour theory, what the market is saying is that inflation, and the rise of populist politics is causing investors to reduce idle cash balances to a minimum. Another big change is that governments do not buy treasuries as foreign reserves, but buy gold instead. Corporates do not hoard cash, but spend it. And so capital is getting scarce. For Japan, I think we are getting ready for the other shoe to fall. And that is, Japan needs to start selling treasuries if it wants the currency to appreciate. Japan holds the majority of its foreign reserves as US treasuries. It is the largest holder at USD 1.2 trillion.

If you wanted just one graph to explain the new world order, the BOJ foreign intervention graph is a pretty good one. They used to have to sell Yen and buy USD. Now they need to sell USD and buy Yen.

The Ministry of Finance has a similar graph, although not loaded on Bloomberg. In 1998, during the Asian Financial crisis, Yen was weak against the USD, but very strong against other Asian currencies - which is why we see some Yen buying then. But the flip from USD buying to Yen buying in recent years is extreme.

So the shift from a pro-capital to a pro-labour world is leading Japan to sell foreign assets. It is also leading to rising interest rates in Japan. You could argue that Japan now runs an overall trade deficit, and so this is why we are seeing a changing dynamic. The problem with that view, is that Korea, a country that has similar economy to Japan has record trade balance.

This record trade surplus has not seen the Korean Won appreciate. In fact is has a record weak exchange rate. What is bad about this for US treasuries was that when Korean Won or Japanese Yen used to appreciate from having a trade surplus, they became buyers of treasuries. Now that currencies do not follow trade flows, there is no natural buying of treasuries.

For me, everything seems to be working in reverse, which means that the next economic surprise should be higher yields - the opposite of what happened in the 1990s and 2000s.

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Before the Nasdaq - there was the Nikkei. I was lucky enough to first live in Japan in 1991 as a high school exchange student. If you had told me at the time, that Japan was heading for 30 years of relative decline, I would have not believed you. But that has been the case. MSCI Japan versus MSCI World is a tale of neglect and decline.

I have a great deal of respect for Japan and Japanese people. But the Japanese economic story since 1991 has constantly felt like one of missed opportunities. Japan led the mobile phone market in the early 1990s. In 1996 I got my first mobile phone in Japan was cheaper and better than the Nokia brick I bought in 2000, and yet, Nokia, Apple and Samsung dominated this market. Going back even further, the Japanese OWNED the semiconductor market in 1980s, generating more sales than the US. But since then, they have been in decline.

For an old report, I made a very nice chart, showing the relative performance of Japanese sales compared to the US, pretty much tracks Nikkei underperformance. In a way, it links semiconductor sales to market dominance - something we are seeing again today.

For a long time, I like many other people, blamed the Japanese for their monumental economic fumble. But in this new era we live in, my thoughts on Japan are changing. I am starting to think Japan committed a form of corporate harakiri, mainly to placate the USA. In 1986, Japan basically agreed to stop competing with US semiconductor companies.

It was also around this time, Japan agreed a steep appreciation of the Yen in the Plaza accord.

In many ways, it seems that Japan chose to accommodate the US by choosing to stop investing in Japan. Given the outcome of the last time Japan had confronted the US, this is entirely understandable political, if not economic, decision. But there are two things, I want you to take from this analysis. First off all, its was politics, not markets that bought Japan undone. And secondly, the political agreement of 1986, and the Yen appreciation of 1984 should have stopped the Japanese market stone dead, but the Nikkei did not top out until 1989, as Japan unleashed a credit bubble to offset its now obvious industrial problems. The reason I am talking about all this, is that I see a similar set up in the US. I know many people see the US “value creating” machine as unstoppable, and that is totally understandable if you look at just current business and economic trends, but when I look at political trends, the top looks in. I know I am going to regret writing this, as I will be inundated with email and charts showing how dominant the US in tech, market cap, and all other markets. But that is all backward looking. I will start with the easiest areas to see US topping, and move on from there. First of all, is the rejection of US treasuries as reserve assets. I continue to see the weaponization of treasuries as a huge own goal by the US. And this can be seen in the divergence of treasury yields from Swiss bond yields.

Under the Trump administration, NATO allies can no longer take it for granted that the US will offer military security. This has led to allies greatly increasing military spend, which was a Trump administration aim. The huge long term downside for the US is that allies are now developing competing and often cheaper technologies. The DAPRA model that has served the US so well, is now being rolled out globally. In my view, stocks like Lockheed Martin reflect this long term deterioration in their outlook.

Finally US policy on taxation, AI and other issues have revived industrial policy in the rest of the world. As mentioned in a recent post, the most ardent free trading nation in the world, the UK, will no longer allow its tech companies to be bought by the US. DeepMind would not be sold to Google today, and ARM would not be sold to Softbank. Politically, these changes are being made today, but it will take some time to feed through the system, just as it took time to feed through to Japanese asset markets. But they will come. For those with a sense of history, the rise of Socialism felt unstoppable post World War II, but slowly but surely the US and other free nations worked to undermine the USSR. The normalisation of relations between the US and China probably marked the beginning of the end, which started in 1970s, but took until the end of the 1980s to be fully realised. The rest of the world can see that reliance on the US is no longer a tenable political model, and are beginning down the road to sovereignty. If the political process has begun, when does the market recognise it? Maybe it has already. Japan seems to be outperforming US equities again, bond spreads are widening against Switzerland, and gold is still doing better than treasuries. The irony is that the US forced Japan into decline. The US seems to have chosen decline - but perhaps that is why US politics is so febrile. The liberal trade order than made the US so successful it no longer a vote winner, and so nationalism is the political driver of the day. But US nationalism drives nationalism elsewhere, and undercuts the system that has made the US the leading nation it is today. In my thirty years of adulthood, I have seen Japan top out, and now bottom out. I wonder if I will still be around for the bottom in the US.

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As mentioned in a recent post, I have liked gold since 2022, because when Russian foreign reserves were frozen, I assumed most central banks would stop buying treasuries, and start buying gold. Data has confirmed this view as correct.

If central bank buying was the only variable, then there would be no reason to be particularly bearish on gold. Looking at shares outstanding in GLD, the biggest gold ETF, retail did not seem that frenzied in their buying.

Buy going through the data on the World Gold Council website - Chinese retail went bonkers for gold bars in Q1 this year. At 200 tonnes, Chinese retail alone bought more than all central banks in Q1.

I also realised the Bloomberg measure of total gold ETF holdings did not include Chinese Gold ETFs. Given the above, I thought I should try and get a better idea of Chinese retail gold flows, both physical and ETFs if I was going to judge gold price risk accurately.

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Market moves in June could convince you of any and all of the following set ups:

* Deflation is about to return, and market will implode

* Inflation is here to stay, and market will keep surging

* AI is a failure

* AI is a winner

That is markets have become a Rorschach diagram, and you can see whatever you want to see.

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Gold has been pretty weak this year since it peaked back in February. I liked gold ever since Russian foreign reserves were frozen. For me, this would drive other big nations to diversify away from treasuries, and for China this could only mean gold. I also took the view that gold would do poorly if US yields rose enough, so have been bearish on TLT. This trade did look overbought earlier this year, but has smashed through the 200MDA.

The idea that central banks would buy more gold has been borne out by the data. And to be brutally honest, nothing has changed in the US to change this dynamic.

People talk that Warsh has ended the dollar debasement trade, but the funny thing is there has been remarkably little dollar debasement to end. Gold tends to do well when Asian currencies are strong - something we have seen relatively little off. Asian currencies remain at low points, and look distinctly undervalued.

A more valid concern was that retail investors were overly bullish and leveraged long. I could see that more clearly in silver than in gold. Silver does not have central bank buying behind it, and is a much more easily manipulated market. But I did worry that a top in silver tends to mark a top in gold as well.

The problem was when I looked at gold ETF holdings, I did not really see any frenzy at all. Holding were still below levels seen in 2020.

Plainly something did not add up. And over the weekend I had a think, and I think I have worked out what’s going on.

I get asked who in financial markets do I read? The answer is not many people. For some reason, people with not much to actually say will pad out their comments with all sort of superfluous gunk (quoting ancient Greek history or alluding to some esoteric science are classic signs of a time wasting financial writer). But if I do read someone, and they made me money, then I will keep reading their stuff. GS research has made me money, and Chris Woods out of Jefferies, have both made me money. As of the moment, they are on opposite sides of the AI trade - so I will lay out the bull and bear case for you.

The AI boom is driven by a huge increase in Capex by the AI scalers. Bloomberg has provided an estimate of the spend.

Basically we are in peak acceleration of AI spend, with 2026 seeing capex rise by USD344bn to a total of USD 833bn. But the forecasts still have capex rising to 2032.

But GS are arguing that market may be too bearish, and capex grows even more in 2027.

And essentially saying big capex booms have been larger in the past.

AI is a transformative technology, so capex can be even larger than market expects. And that is the bull case.

Chris Woods has come out with the bear case. He looks at OpenRouter data, which is a website that allows you to access multiple AI models. What Chris is saying is that Chinese AI models are now dominating US models.

Or in essence, what “free markets” have always done, let the low cost producer take market share. And this has been highlighted by numerous people, that Chinese AI models are very cheap. The cheapness of Chinese AI is in part driven by the cut throat competition of Chinese tech companies. The Hang Seng Tech index bares no resemblance to the Nasdaq.

The key point that Chris is making is that half of OpenRouters users are in the US, which implies that US customers are opting for Chinese AI models. Here are the most recent top 10 models.

So Xiaomi, Tencent and minimax are all listed, and their shares are near cycle lows. And that is your bear case - cutthroat Chinese competition in AI will undercut the big US models.

So now time for a wealth warning. I thought Chinese EV competition would hurt Tesla earnings. And it has, earning expectations for Tesla in 2026 have fallen from USD 7.50 a share in 2023 to less than USD 2.00 a share today.

Collapsing earning expectations have had almost no effect on Tesla stock price.

Politically, I understand this paradox. President Trump has based his electoral success around defending American businesses. Chinese AI might be cheaper, but how many big US businesses can realistically use Chinese AI? And it seems at odds with the revenue numbers we are hearing out of Anthropic.

And here lies the problem - I respect GS, and they are bullish, and I respect Chris Woods, and he is bearish. What I will say, is that the amount of leverage being applied to the AI trade means you probably need the market to price in some of Chris Woods bearishness first. Or what I am saying you can be tactically bearish - but you would need some other signal to get really beerish on AI. You need one of the hyperscalers to quit - and cut capex. That might happen - but usually the market forces this by crushing share prices. Only Microsoft comes close to fitting that description.

And my guess is that Microsoft is suffering from its software business looking exposed, rather than its Capex. If politics in the US has not changed - my guess is that Chinese AI will comes under more political pressure going forward. And perhaps that is why Chinese AI is trading so poorly.

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One thing I love about being a in the markets is you develop and idea, and then apply and you are almost immediately told if you are right or wrong (or too early or too late). GLD/TLT has been such a good trade, I am surprised its managed to be as weak as it has this year. Down 26% from the highs, and down 8% this year.

This has indeed focused my mind. What could have changed in markets to drive such a move? I like GLD/TLT because it fits in with the political world that I see, and which continues to be nationalist, populist and inflationary. If anything the politics is getting more populist, not less so. But markets have not reacted to this. I look at 30 year Gilt yields, and with the elevation of Andy Burnham to Prime Minister in waiting, I would expect yields to spike higher. But actually they have fallen.

My guess is that the markets have looked at Kevin Warsh, and decided that the US is going to run tight monetary policy, and this is going to be deflationary. So sell gold, buy TLT, and strong dollar. So here is EXACTLY where I differ from the markets. I don’t think central banks have any control over inflation, and never have. Central Bank independence coincided with an acceleration in globalisation - so they looked really good. Now central banks are trying to control inflation in an era of political populism. They are doomed to fail in my view - but it does excite me that Kevin Warsh is going to try and control inflation. This should drive the next leg higher in interest rates and yields in my view. While I worry about gold, I should mention I am happy with my bearish view on Private Equity. The Invesco Private Equity ETF is at new lows.

So the real mispricing in markets is now the 30 year bond market, which has rallied because they think central banks will bring inflation under control. I just don’t see it, although I understand their logic. Where we are now is the reverse of the bull market in bonds from 1980 to 2020. Then, after every rally, bonds would sell off, and everyone would be waiting for them to keep selling off - but instead yields went lower. Now, I think people are worried that with a new Fed, long bonds may rally again, but politics tells me they go higher. GLD is acting as it should, but I think TLT is going to trap some bulls. The next big move in 30 Year Yields should be higher.

Finally, in my last note, I used the CRB Food Index to say food inflation was not an issue. A very sharp subscriber pointed out this was discontinued in March. My bad, but when I had looked at other food indicators, they said the same. Urea prices are back at lows.

And wheat prices are subdued.

I still come back to the same conclusion. Either politics pushes up inflation despite the efforts of the Fed, or the inflation will undershoot in the short term, and Fed will seem more dovish sooner rather than later. That is, no need to chase recent move in markets. If you still like gold - you can hedge that position with a good short book potentially - but there are not many good short sellers left out there.

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