Friday, 25 October 2019

The late 1960s curve inversion...

Late 60s were interesting. The economic framework since Bretton Woods was starting to become unbalanced. The start of the so called Second Turning.

The Fed went through several hiking cycles trying to stop inflation and the inversion in the late 60s saw equities fall, the curve invert, CPI roll over, no recession, only a small fall in equity earnings. The Fed had only hiked to 5.76%, then the Fed cut and everything rebounded. Oct 66 was the turning point. 
The Fed then had to hike from May '67 into the end of '69 to over 9% causing the 1970 recession. This time markets fell 30% as earnings fell 13%. But the market peaked 9 months in advance in Dec 68.  The Fed then cut rates through July 1972 and the markets bounced. Nixon closed the gold window in Aug 71 and devalued causing an equity bounce followed by more inflation, the Fed hiking over 12% and an even bigger recession in '74 where earnings fell 15% or so but the market fell 50%. Gold also fell heavily in this recession. 
After that the stock market didnt perform well until Volcker killed inflation in the earning 80s. 
The USD vs the DEM went from about 3.4 under Bretton Woods to 1.74 in 1980. 
So the question is, if 2019 is about rate cuts, will 2020 be about hikes? 

Trump's MAGA economics of full employment, fiscal stimulus and pushing wages as a percent of GDP up via inflation and on-shoring outsourcing, is likely to put upwards pressure on inflation in his second term.

Tuesday, 8 October 2019

Some thoughts on China, the US trade dispute and the Hong Kong protests

China is one of the most important economic stories as it and the US have been the main contributors to global GDP growth in this cycle.

As we know, Trump has been driving his trade agenda and has forced China to negotiate; but discussions are stuck on three key points:
  1. Forced knowledge and technology transfer in exchange for Chinese market access
  2. IP theft
  3. State subsidies for key industries
So why are these the key points and why is China so unwilling to negotiate on them?

The answer is that China is an authoritarian state, ruled by the Chinese Communist Party. Their 'pact with the people' has been growth, peace and stability in exchange for one party rule. It has worked pretty well for the economy, albeit with large imbalances built up.

As China recovered from the Cultural Revolution, the first stage of growth was in basic industries, then more advanced industries, then high tech and now aiming to be global leaders in new high tech industries.

So how do you make the leap from basic industries to high-tech? You put state resources into education and you invite foreign tech companies to set up manufacturing bases to access cheap labour. You also force knowledge transfer and allow domestic IP theft.

That growth strategy has brought China to the upper level of middle income status with median wages of around $12k a year. Below is a chart showing China's progress relative to the US from 1960 to 2008 (the most recent one I could find). While China has moved up, relative to the US, its still in middle income status and there are a large number of other countries that are stuck in the middle income trap:


Targeting high-income jobs and industries
If we set aside development issues like corruption, capital flight, inefficient SoEs, lack of basic rights; in order for China to keep growing and avoid the so called middle income trap and get to high income status, China needs to generate hundreds of millions of higher income/ high productivity jobs, mainly in domestic services, but a significant number in goods producing and globally competitive export industries.

Put simply they need global leader companies that can compete in their markets. The problem is the global technology/ pharmaceutical/ biotech/ high end industrial markets are protected by patents and trade secret laws and the owners of those patents are US/ EU/ Japanese companies. To survive without subsidies in most mature global industries you need to be in the top 3 of each segment and while Chinese companies can achieve that domestically, they usually can't globally.

So China needs to target the new industries where they can register patents and achieve scale and competitiveness. So the government provides state subsidies to companies like Huawei to help them become global leaders in the new markets as they open up. These are the same new markets that US/ EU/ Japanese companies want to compete in. But the Chinese companies can operate at break even or a loss for as long as it takes to drive foreign competition out of a new market. They can also invest whatever it takes in R&D for these new industries.

Trump is pushing back against this development model. But the problem the CCP has is their growth pact. They have to deliver higher standards of living and productivity to avoid falling into the middle income trap and these three core policies are their strategy to deliver it. Without these policies, it is not clear to me how they will create the numbers of high income jobs they need in order to escape middle income status. Then China would become little more than a large market for high end western goods, similar to Russia or India.

So overall it seems unlikely that China will make a full compromise on these areas and for now they are saying these key principles are non-negotiable. I suspect that next year they will try and position a compromise that is in their interest and does not effectively stop this development model.

If Trump does not really want a deal and just wants to make it look like he tried hard before ending negotiations and putting more tariffs on, he has the excuse already. I think this outcome is likely, but that Trump wants the bad news to come out in stages. Partly to not roil markets and partly as it takes years to reposition supply chains. 

Hong Kong protests, could they spill into China?
The Arab Spring came about because a baby boom of young men born in the 1980s came of age, couldn't find work and saw no future. It seems that the Hong Kong protests have similarities. Young Hong Kongers, who have no allegiance to the CCP, live in what is a developed market, but cant afford property and lack the basic self-determination rights.

The Hong Kong authorities can act to bring down real estate prices, but giving democracy and greater rights seems to be incompatible with the Mainlanders not having those same rights. My former colleagues, who are Chinese and based in Hong Kong, are expecting a ruthless crackdown on the protesters by the CCP at any time.

The risk is that leads to more protests and more loss of control or even the protests starting in China itself. My former colleagues are fairly sceptical of this spillover happening, given CCP brainwashing and control of media and communications. They also think the CCP would ruthlessly end any initial Mainland protests, out of sight of the global media.

But I think this comes back to the common issue. If the CCP fail to deliver their growth pact and China starts to stagnate in middle income status, with many economic imbalances built up or starting to unwind, perhaps there can be protests in China as well.

If that happens and the CCP start to lose control, it would trigger a 1997-style Asian and EM meltdown as commodity prices and the flow of USD's to EM collapse. While China runs a large trade surplus with the US and EU, it runs almost a $200bn goods deficit with Asia and EM.

I don't know how likely it is that Mainland protests start and my former colleagues are confident they would be ended ruthlessly, as the CCP's primary aim is survival, but given the potential of this scenario, its worth considering the possibility and the impact it could have.

Tuesday, 24 September 2019

Corbyn plots a Marxist revolution; could he win the election by accident?

I don't think Corbyn can win outright. However, with the constituency system of 650 MPs and votes split often three or four ways in each constituency, he could get in via a coalition with the SNP or LibDems. He is currently only 41 MPs behind the Tories. With a Lab/ LibDem/ SNP coalition he only really needs 270-280 seats vs 247 now:

You Guv 9th September voting intentions:

I think a lot of it will resolve to what the Brexit Party does to the Tory vote in Tory marginals vs how many votes Labour lose to the Brexit Party in the northern heartlands. Its unlikely the Brexit Party will win any seats outright.

Farage does not believe the Tory Party will exit the EU by itself, or at least will only exit via the Withdrawal Agreement which leaves the UK closely tied to EU rules, taxes and regulations. If Farage does campaign against them, he risks splitting the leave vote in Tory marginals. This would boost both the Lib Dems and Labour numbers in Parliament. Its unlikely the Brexit Party could cause many Labour marginals to become Tory seats.

Corbyn's conference speech

The speech can be taken as a trial balloon for the manifesto in the coming election.

I would summarise it as planning to take capital away from successful people, who would invest it and giving it to unsuccessful people, who will spend it.

In the short term 'free money for all' policies boost the economy via upfront spending, but medium term it will be a disaster, as centralised state socialism always is.

My understanding of Marxism is as follows; the proletariat rise up and overthrow the 'bourgeois' capital owners and bring about a revolutionary socialist system. Marx predicted this is most likely to happen when the capitalist economy is in crisis. In other words; socialism is born out of capitalist failure and crisis.

I think its fair to say capitalism has been in the Third Turning since 2008 (in fact I think the Third Turning was 1997-2016), The Unravelling, whereby policy has aimed to continue the prior framework (credit super cycle supporting final demand in the face of large imbalances, global platform company labour arbitrage, concentration of assets and profits and falling wage shares to GDP).

Strauss-Howe predict that in the Fourth Turning reformist leaders emerge (which I see as happening since 2016), who break down the prior institutional framework and implement a new one, during which time there is a chaotic environment. Clearly our reformists are Boris Johnson and Jeremy Corbyn.

Viewed from this perspective, of Marxist theory in a time of struggle and reform, Corbyn's speech tells you he sees himself as that revolutionary socialist leader and he intends to lead that revolution now.

Below are a summary of his key speech policies:

Economic control:

He described the economy as 'a tool in the hands of policy makers'
  • So command and control and a return to centrally agreed 'five year industrial plans'
  • He is unable to understand that the 'capital and labour' economic framework from 150 years ago has been displaced by a complex, high skilled service and innovation driven economy. 75% of our economic output is now non-industrial. 
  • His understanding of economics and business is defined by the prism of worker vs capital zero sum conflict  
He will scrap the Trade Union laws and nationalise rail, national electricity grid, water and mail.
  • The Trade Unions will just push for extortionate wage increases, which is a tax on consumers, is inflationary and pushes up the IRR hurdle on new private investments
  • In terms of nationalising certain complex, large, low RoE utility sectors; Im not so against it, if they are well run (which they wont be by the party bosses). We have had coordination and investment problems with rail and the national grid needs investment for electrical transportation in the coming years  

Pharmaceutical IP theft:

'Using compulsory licensing to secure generic versions of patented medicines. We’ll tell the drugs companies that if they want public research funding then they’ll have to make their drugs affordable for all. And we will create a new publicly owned generic drugs manufacturer to supply cheaper medicines to our NHS'
  • He seems to have missed the part where the drug company gambled billions in developing the new drug and going forwards will make sure they don't do any valuable R&D within the UK in order to protect their product IP and patents but will probably still use government money for early stage, primary scientific research
  • Hs also doesnt understand the difference between biotechnology drugs which involve an organic chemistry process (that is usually secret) and pharmaceutical drugs that are made in a traditional factory and can be more easily generically made

Government sponsored education programmes: 

'Free education for everyone throughout life as a right not a privilege. No more university tuition fees. Free childcare and a new Sure Start programme. Free vocational and technical education. And free training for adults.'
  • It has to be paid for by taxes, so why does he think he can spend this money better via centralisation than the tax payers organising their own education and training? 
  • Child care has already been regulated to the point of unaffordability. Pre-school nursery costs on average £12k a year, the highest cost in the world, vs around £5k per child school place.
  • Scrapping tuition fees would cost about £20bn a year, or 1% of GDP. 

Wealth redistribution:

He will give the workforce a 10% stake in large companies, paying a dividend of up to £500 a year to every employee. He will increase the minimum wage by almost 20%.
  • Large companies by definition have been the most successful ones and are essential for productivity/ volume of GDP, but here he wants to increase their cost of capital through basically a form of a shared ownership tax and rising the wages of the least productive workers
He wants to tax the top 5% and big companies.
  • While big companies drive GDP volume, its often small, entrepreneurial ones that come up with the breakthroughs that drive productivity growth
  • All higher taxes will do is increase the before tax IRR hurdle on a project and reduce investment
  • The Tories would cut taxes in an effort to bring in investment and jobs, which in turn see taxes through payrolls and sales taxes

5 year central plans:

UK industrial output is about £500bn a year, or 25% of GDP. He announced he would spend an unbelievable 25% of GDP, or 5% of annual GDP if spread over 5 years, on two large scale sets of new spending programmes. Corbyn is a Unions & QUANGO workers wet dream.

He will spend £250bn (£50bn a year/ 10% of UK annual industrial output if spread over 5 years) on energy, transport and broadband infrastructure.
  • In comparison parliament found a need for just £3-5bn of telecoms subsidy in rural areas. The private sector can deliver fast charging stations. The Tories are spending single digit billions on other areas of transportation plus the white elephant of HS2. 
  • Its not clear at all what the £250bn would be spent on, why the private sector cant and whether it would pay for itself. 
He will spend £250bn on 'capital for businesses and co-ops'
  • No details, but could be the nationalisation programme or some other government/ union/ company forced union.
With £500bn without doubt you can solve some problems, but if that is low RoE or negative RoE and crowds out private sector investment it will just lead to less economic growth in the long run. Its also likely to be a massive union boondoggle and very beneficial to party and union connected businesses.

It might also be a bigger fiscal boost for German goods producers than anything the German government will agree to.

Who will pay for this?

We already have a near record trade deficit and need to rebalance that via a careful strategy of higher wages, higher savings, higher investment, more domestic production and more exports and less imports. I have argued the case before for a private sector, investment led, economic boom after Brexit.

UK Current Account as a percent of GDP:

UK Capital flows, Qtly in £bns:

Corbyn simply sees the problems and plans to spend enormous amounts of money, but he cant know where the money will come from to pay for it. The external sector has been willing to finance UK deficits for some time as the economy rebounded and grew and while the UK represented a liberal safehaven. For a while it will also probably finance Corbyn given his policies are pro-cyclical and will offer higher returns/ yields for a period. However, longer term, given the high tax, stagflationary policies, it seems very unlikely the external sector will pay; so crowding out the domestic private sector is the only possible alternative. This is the stuff FX crisis are made of, but only a few years down the line.

The first five years could see a significant boost to GDP, maybe longer, but later on the negative effects will show more prominence, probably when there is a recession. 

Two details were outlined however, those were that he will build large scale solar plants, battery hubs and wind farms and he will also ramp public house building. All of this is great for well connected, high-wage, unionised companies and QUANGOs.


He will withdraw from US/ NATO military interventions in favour of diplomacy.
  • In effect he will weaken the ability of organisations like the UN and the ICC to enforce basic human rights onto rogue states and allow China's sphere of influence to grow. That is the opposite of his stated foreign policy intention.


His fence sitting policy on Brexit it to; negotiate a better deal, put it to referendum and carry out the referendum result. Its a Remain party, but as an ardent Brexiteer he is calculating the referendum result will be to leave with whatever deal he has negotiated.

He would then be relatively free to implement his policies; he has no intention of reducing taxes or regulation (and therefore maintain the level playing field requirements) and having left the EU would not be as bound by EU state subsidy rules in his nationalisation and 'investment' programme.

Corbyn was never meant to be leader, after a career as a campaigner, he lucked into the role due to failure by mainstream career politicians. In the last several years he has been forced to become an expedient politician. His reformist agenda is also popular with the party grassroots.

Question is can he now luck into No. 10?



The Guardian has a good summary of his conference speech statements:

Tuesday, 3 September 2019

Small caps lagging large caps, 2018 redux?

With a sell off into the latter part of the year. Maybe after CB disappointment later this month.


Monday, 2 September 2019

Why do CAT Bond funds keep losing money on 1/25, 1/50, 1/100 year US windstorms?

It’s pretty simple, those probabilities are based on historical storm instances, but as global sea temperatures have risen, it makes the likelihood of major storms higher.

According to NOAA July was the hottest July on record. The mid-Atlantic where the US south east storms gain force was also significantly above average.

So any pricing model based on historical datasets might underestimate the future level and frequency of reinsured losses from major US hurricanes.

For UCITS funds that have a 25-40% risk concentration exposure to US windstorms; this raises additional questions over risk concentration, risk/ reward disclosures to investors and liquidity/ pricing of impaired bonds in the Sept-October period.

Sunday, 1 September 2019

Are the Leading Economic Indicators predicting a recession next year?

The LEI has leveled off. By my count this has happened 11 times in this chart associated with 7 recessions. If it goes flat YoY that usually leads to a recession.

2 of the false signals were in the 90s. I guess driven by the events of 97/98 in one of them.
5/10 LEIs are causing the weakness. While the 5 not contributing are mostly financial market/ jobs linked

Further tariff escalation or a slow down in the consumer might be enough to push the US into a recession next year

Here is a link to Ed Yardeni's report.

Monday, 12 August 2019

Why the Fed has to cut 100bps, but will only do so after a market crash

I have previously argued that QE repatriation, which I thought would be driven by QT, is a new Plaza Accord that would put the Yen and probably the Euro into 2-3 year structural bull markets.

It seems we are now there, via a different driver. With USD Libor above the yields of Treasuries and other fixed income securities, financial and other investors are incentivised/ forced to take profits and it seems repatriation is going on. This is also causing the Euro to now rally in risk off days and the USD to sell off. That's the opposite of prior relationships and shows just how much the US has been dependent on external funding in this cycle and on an ongoing basis, given Trump's deficits.

You can clearly see the repatriation in the Yen. The Yen bottomed in Q4 as US 10 year yields peaked and has tracked the US 10 year lower (stronger Yen). Recently the US 10 yield going below USD Libor has accelerated both the Yen rally and the fall in yields; they seem to be reinforcing themselves on a reflexive basis.

In my opinion the Yen could go to 65 before it has any real valuation problem, but I expect that will take several years. It has until recently been one of the cheapest majors on a REER basis.

I also think the JPYCNY rate could go over 7.5c and perhaps over 8.5c later, which would represent a full unwind of Abenomics and a much more competitive CNY.

According to the headline Fed figure, US banking system excess reserves are $1.37Tn.

However JP Morgan, BaML and others have argued that true excess liquidity is now tight and that amongst other factors a few banks hold a lot of excess reserves, while others are struggling to fund themselves, such as primary dealers who are holding what seems to be an ever growing pile of >$200bn of TSYs.

To finance which they have added about $125bn of net repo financing since Trump cut taxes last year.

Into this mix we see the US Treasury increasing Treasury issuance significantly over Q3 and Euro and Japanese investors liquidating fixed income.

In summary then, we have catalysts for USD liquidity to tighten a lot in Q3 and for US investors who buy the Treasuries being sold to have to sell other assets to fund those purchases. To rectify this dynamic JP Morgan and BaML conclude that the Fed will have to restart OMO/ QE.

However that doesnt resolve the fact that US Libor is higher than TSY yields. To fix that the Fed will need to cut about 100bps, assuming the curve doesn't fall further before the Fed cuts.

However the Fed/ Powell have said they will only cut rates on a lagging basis to data/ markets. So they wont pre-empt any move. Instead financial conditions will have to tighten significantly and the fastest way for that to happen is equities and credit crash into September.

It goes without saying that both Trump and Xi have the geopolitical equivalent of 'sell buttons' that can be pressed at will.

This whole dynamic of liquidation causing market falls and then Fed rate cuts is hardly positive for the USD bulls aginast the major currencies, albeit the USD is likely to rally against EM FX particularly as countries like Brazil slide into recession and South Africa gets downgraded.