Not everyone has time to read the lengthy, boring letters that I write, so I thought I’d summarize and simplify.

Current economic data is indicative of a global synchronized slowdown. Looking behind the numbers we find a more healthy US economy, a recovering UK economy, a chronically ailing Eurozone, and slowing emerging markets. The US economy has seen some short term weakness, most of it coming from a slowdown in government expenditures; the private sector economy continues to grow at not 2.5% but closer to 4% YOY. The UK economy is emerging from recession after taking austerity earlier rather than later, and lower corporate tax rates. The Eurozone has a chronic structural problem with the EUR which is failing to allow for price discovery in factor markets. Emerging markets struggle with capacity constraints, productivity limitations, mostly as a result of technological limits. Japan’s QE is the latest in the world and the first in a long time domestically, hence it is reaping economies of scale and is likely to ignite a self sustaining recovery. China’s economy I have discussed in previous posts, the latest export data is not only highly dubious but corrected for FX arbitrage volumes is quite poor.

I like US and UK equities. I like US housing even after it has risen as strongly as it has in the past year. I don’t like China and the Germans are levered to China.

Bonds look overvalued, especially investment grade. High yield trades more like equity and so is preferred. Given the volume of issuance, defaults will be postponed for some time. Companies are paying dividends and buying back stock releasing cash to investors who are seeking returns and who therefore are likely to redeploy to to equities, and given the resulting reduction in float, is likely to push equities higher. In fixed income I like bank loans for their seniority and floating rate coupon. I also like US RMBS for the housing exposure and security of good collateral.

Industrial metals are likely to suffer as growth redistributes to more efficient producers. Agricultural commodities are likely to do well on current dietary and demographic trends. Technicals are also supportive.

Gold remains a conundrum but which now reveals much about other asset markets. Gold is a hedge against QE but not any kind of QE, it is a hedge against unsuccessful QE. If QE is successful, gold is a less useful hedge as risky assets begin to react to improved fundamentals. The great rotation, may be out of gold.

Official trade data for China showed exports growing YOY by 14.7%, ahead of forecasts of 9% and imports of 16.8%, ahead of forecasts of 13%. Closer inspection of the data reveals interesting themes. Notably, the bulk of the rise in exports was to Asia, as was the bulk of imports. Ex Asia, the numbers for imports and exports were less exuberant, particularly for exports.

What’s going on?

China Exports by Destination

China Imports by Source

It appears that there has been a lockstep rise in exports and imports. What plausible explanation could there be? Here is one.

1. Companies in China buy RMB for USD at the onshore rate of 6.20.

2. Companies in HK sell RMB for USD at an offshore (CNH) rate of 6.18.

What are the implications?

1. Exports in all other regions were weak. They may have even shrunk YOY.

2. The strength in RMB is hurting China exports. So also is the re-shoring of manufacturing to developed markets.

3. This could signal continued weaker growth in China.

4. What is interesting is the rise in imports from North America, strengthening the thesis that the US is becoming a competitive exporter.

The game of chicken is played when two cars are driven at each other at high speed. The one that flinches first, loses. The one that flinches last, wins. If neither flinch, they both lose. 

Fundamentals are improving in the US and UK. Europe remains in poor shape and will do so as long as they remain on the EUR. The crisis of 2008 did not cause any of the ills in Europe; it just exposed them and removed the tailwinds that allowed Europe to maintain its economy under a suboptimal currency regime. Where central banks are able to monetize debt and print money, quantitative easing has allowed time for healing and ‘animal spirits’ to be revived. Emerging markets growth remains above developed markets growth but a more complex dynamic is brewing. Developed markets technology is allowing them to catch up with emerging markets where cost pressures and an inability to match the West in generating proprietary technology is hobbling their potential growth. Frontier markets are growing on the back of an advantageous demographic and low cost labor at the expense of emerging markets which are being squeezed from above and below. These are generalizations of course, which mask a richness of detail necessary to make more specific forecasts for the prospects of each country.

The implications for risk assets are even less clear. As companies are increasingly global, a country based analysis of macroeconomic prospects is less helpful in the analysis of companies’ prospects. We cannot but generalize despite the risk of losing resolution.

The role of interest rates and liquidity in the current rally in risk assets is important. Interest rates have been unilaterally suppressed across the term structure across most of the major currencies while monetary bases have been substantially increased. Private sector companies which can, have taken the opportunity to liquefy their balance sheets through bond issuance. Smaller companies with no access to debt capital markets have found banks unable to supply adequate financing due to their own inadequate capital positions. This has been a partial contributing factor to the chronic unemployment as smaller companies are more likely to hire while larger ones are in rationalization mode. This structure is also likely to confound central bank efforts to target employment in the conduct of policy. It also creates an opportunity for providers of growth capital to small and medium sized enterprises.

As ‘animal spirits’ are revived, and or inflation begins to accelerate, an exit plan from QE will be sought and implemented. This poses a risk to risky assets. The question is how big a risk. If rates rise as a result of stronger economic growth then one can expect an orderly slow down in risk assets followed by a resumption of growth, which has been empirically supported in previous tightening cycles. The complication here is that the size of the money base is of unprecedented scale, asset sales may need to follow the raising of interest rates and the current level of interest rates introduces a high level of non linearity in private balance sheets which may prove unmanageable. Central banks will have to telegraph their intentions well in advance to help wean the private sector off easy money.

For now, the point of higher interest rates is likely far off, some 3 years at least. Yet yield curves may still steepen while central banks keep short rates low. Given that inflation is likely to be under control in the developed markets, their term structures will likely stay flat or at least relatively flat. Emerging markets, however, may face a less tractable problem, that of rising inflation, partially the product of developed market central bank policy, and slower growth, again partially the product of a less profligate developed market consumer and the growing trend of re-shoring of manufacturing. Already some such countries have begun to cut rates as growth has slowed.

Unfortunately, the purpose of this letter is not to advise on a particular trade or portfolio positioning but to highlight some of the current issues. The reader may extrapolate their own trading and investment strategies. We now end with the last bit of an old song…

Last thing I remember, I was

Running for the door

I had to find the passage back

To the place I was before

“Relax, ” said the night man,

“We are programmed to receive.

You can check-out any time you like,

But you can never leave! “

Having borrowed heavily in the bond markets in the past couple of years. If interest rates should rise substantially, a corporate CFO might be tempted to buy back their company’s debt at below par and retire its debt. Its an interesting way of making money without producing a single widget.

One wonders how significant this impact could be. It certainly won’t hurt to own the equity.

The sudden weakness in gold is intriguing given the acceleration in global QE most recently by the Bank of Japan. Gold has always been thought as a hedge against inflation and deflation. In fact most gold bugs would have one believe it can cure physical ailments. It is established wisdom, however, that gold is a hedge against the debasement of fiat currency. Now this thesis at least sounds plausible and I can accept it. But why then, in the midst of rotational, global, wholesale currency debasement, is gold weak?

Perhaps we are missing a particular nuance. Perhaps we need to modify our thesis and restate it as: gold is a hedge against ineffective quantitative easing and the debasement of currency. The subtlety here is that gold is a good hedge against QE assuming QE doesn’t work. If, however, QE begins to work, that QE does more than inflate away debt, that QE does more than monetize sovereign debt, that QE in fact manages to stir ‘animal spirits’ and induce a self sustaining cycle of growth, then perhaps gold becomes much less valuable as a hedge.

This thesis would imply that the market as a whole is beginning to embrace the reality of a more durable economic recovery, led by the US, the UK, and bits of Europe. Surprisingly, the weakness now seems to originate from the emerging markets where central banks have begun to cut rates despite inflation rates that while not raging, are not entirely trivial. The developed markets, ravaged by poor sovereign balance sheets appear to be pulling themselves up by their bootstraps. If the thesis about gold is to be supported, we need to see more consolidation of the meagre growth that we have seen in the US and even better, a resurgence of growth after the summer. And further weakness in gold.