Market Thinking

making sense of the narrative

Market Thinking November

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In Equity Markets, the near 5% rise in October effectively reversed the equivalent selloff in September as the market mechanics unwound, while bond markets saw the month close with sharply higher volatility and some very aggressive flattening of the yield curve at the front end, seemingly as central banks stopped buying in short dated bonds as part of a ‘tapering’ exercise. Meanwhile commodities bounced as the market negativity on ‘all things China’ reversed somewhat and the reality of the ‘China Price’ as a concept started to become clear – whatever China buys goes up in price and whatever it makes and sells goes down in price. Splitting between short and long term demand/supply from China is thus key to inflation pressures and means different things for different countries as a result. The west is far more dependent on China than it cares to admit. Meanwhile, the emergence of the MetaVerse as a concept should alert us to the way that, post Covid, high price/low productivity local services such as Health and Education are ripe for major disruption by Internet 3.0. Financial Services too, we might find that just as we onshore manufacturing, we effectively offshore services.

Short Term Uncertainties

In September, a whole series of what we refer to as Market Mechanics triggered a sell-off in equity markets, principally centered around the quarterly options expiry. As usual they were ‘over-explained’ in terms of economic fundamentals, principally around a stagflation narrative. While this is still a possibility, we continue to prefer the reflation rather than stagflation or sustained inflation outcome, mainly because we see the root cause as being from the supply side. The other two outcomes would be most likely to occur from policy error – so can not be ruled out. True to form, as the market mechanics of September unwound in October, equity market basically regained all their lost ground and the strength of commodities once again flipped the narrative back. The Vix dropped sharply, while Bitcoin, perhaps now thought of as a ‘risk on’ indicator, soared again, helped in part by the new Bitcoin futures contract. It may also be picking up some interest as a new ‘bond’ as well as a new ‘gold’, in that there are signs that people are acquiring a modest amount of bitcoin or Ethereum as a long term buy and hold strategy, a form of tail risk insurance. To date, Crypto has only really been in the ‘short term uncertainties’ bracket, but as it moves out to ‘Medium Term risk’ and indeed ‘long term themes’ its price behaviour will change.

On the Geo-political side, after the fraught US withdrawal from Afghanistan in late August and the associated rise of the Shanghai Cooperation Organisation as a political and economic force, western focus shifted once again to China as ‘a threat’. The announcements on AUKUS in September are still causing tensions between Australia and France/EU while the start of October saw a ratcheting up of tensions over Taiwan, not least when the Chinese airforce were accused of frequently violating Taiwanese airspace and the armchair generals in the west were, once again, predicting/demanding actual conflict. The fact that the flights were many kilometres to the South West of Taiwan and only violated an ‘identification zone’ that also happens to include a large slice of the Chinese mainland was not mentioned, indeed the flights were nearer to Hong Kong than to Taipei. Nor was the fact mentioned that they were actually flying over a 17 strong fleet of western warships carrying out ‘freedom of navigation exercises’, on China National Day. It is not too cynical to say that this is currently Pentagon Budget time of year and there is a seasonality about the ‘threats’ we are told of. Without China as an enemy, there is no need for the majority of the US navy for example, just as without Russia as a threat there is no need for the majority of NATO troops stationed in Europe. As such the sabre rattling is more the sound of the collection tin rattling and is likely to dissipate once funding has been allocated. Having said that, the very real prospect of the pro Beijing KMT party winning power and thus putting Taiwan’s vital chip industry ‘closer to China’ was only avoided in 2020 by the coincidence of the Hong Kong protests leading to a huge turn around in the DDTs fortunes. As such there is a geo-strategic angle on Taiwan that means it will not easily go away as a topic even if it dissipates for now.

In the meantime, the attention switched to the bond markets as volatility jumped sharply at month end. The dramatic front end flattening of global yield curves towards the end of the month was triggered by the Australian Reserve Bank not coming in to buy short dated bonds, followed shortly by a similar ‘tapering’ move by Canada. By contrast, the long end of the US yield curve rallied, probably down to deleveraging and collapsing of curve trades. rather than any strategic re-assessment of economic fundamentals. We have argued many times that the shape of the yield curve tells us far more about the Bond markets themselves than it tells us about the economy, however hard trading-desk economists try and spin the narrative wheel between boom and bust ‘forecasts’. Nevertheless it places bond market fragility and the associated disruption to the risk parity quant funds, as the key short term uncertainty for markets.

Medium Term Risks – The China Price

While the technicalities and curve positioning drive short term trading noise, asset allocators are struggling to determine what signals there actually are out there. As is often the case, we see China as central to this and the impact it has depends on where you stand in relation to Chinese demand and supply and thus what is sometimes referred to as The China Price.

If China is buying from you, you are likely seeing near term price weakness but long term strength, while if it is selling to you then you are seeing the opposite.

The concept of The China Price is that, due to their enormous scale, whatever China is buying goes up in price and whatever they are making and selling goes down in price. This simple demand and supply model goes a long way to explaining inflation trends and subtrends around the world in recent years. In terms of ‘What China is buying’ suppliers of raw materials, such as Australia, Canada and Brazil have benefitted hugely, while the former two countries were also recipients of trade flows from the invisibles side of the balance sheet as well, in terms of large amounts of cash flow into the tourism, education and housing sectors. By contrast, the main beneficiaries of ‘What China is selling’ have been the US and Europe, where the cost of China sourced consumer products has been declining steadily and consistently for many products for many years. Thus as the graphic of a basket of consumer goods in the US shows, there is a clear divergence versus average earnings that could easily be explained by The China Price. Indeed, Alan Greenspan took the argument even further with the concept of Hedonics, arguing that we should also adjust for the improvements in quality and productivity arising from the new technology.


Note that the way an average index works is that, if the things that ‘normally’ get cheaper every year cease to do so, then all else being equal, the average price level will start to rise. This doesn’t necessarily mean inflation – that likely requires a wage price spiral driven by government intervention (actually one of the main medium term risks) – rather it means a step change in the price level to a new (higher) equilibrium. In this it is the equal and opposite to the step change down in prices in Japan after the corporate demand destruction in the 1990s. Everything went from being bought out of pre-tax corporate expenses to being bought out of post tax private income and the prices had to adjust accordingly. This focus on private sector cashflow also explained why Japanese consumption was so sensitive to the changes in consumption tax back in 2014 and also why monetary policy was counter-productive, when you have no appetite for debt and it is your assets in cash, cutting interest rates reduces your ‘other income’ and requires you to spend less and save more. Indeed, western governments and their think tanks could do worse than look at the real life lessons of Japan rather than just the theoretical models.

We also have to allow for some deliberate action by China, certainly on some of its import costs. China is very aware of its role as the main buyer of coal, iron ore and copper, as well as other commodities and is also aware of the entire ‘industry’ built up speculating around its end user demand. As such, rather like the Japanese used to do with the Yen, it is not above ‘managed intervention’ in the spot and futures markets, especially in the less liquid markets like coal and iron ore. Thus countries supplying raw materials to China – Australia, Canada and Brazil for example – may see short term falls in demand for their exports, but the idea that China doesn’t need coking coal, iron ore, copper, Uranium, lumber etc is clearly misplaced. Watching prices fall in speculative markets is not the same as saying there is a structural shift in demand versus supply.

The importance of this is to not get swept up in the narrative that Chinese demand is dropping structurally when looking at medium to long term investment. Predicting stock prices off GDP forecasts and high frequency economic data like China PMIs is to confuse trading with investing; they can be self fulfilling in the short term, but ultimately are often good contrarian indicators. It is perhaps not then a coincidence that all three countries selling to China have been tightening domestic monetary policy recently, anticipating a resumption rather than a collapse of Chinese demand for goods and services.

On the other side of the equation, those countries only seeing the supply side of the China price are seeing price rises as China exports drop and the damage that Covid policies have wreaked on the global supply chain puts an additional restrictions on exports. Also Zero Carbon policies (see the revenge of the deadly Trinity of Zeros) have compounded the problem. For example, when China recently decided to join in with the Zero Carbon project and started limiting electricity production (also hit by the weather), there exports dropped further and the west got a sharp taste of what might be to come if there is a more permanent supply adjustment, let alone a price increase due to higher energy costs.

Long Term Trends – Law of Unintended Consequences

From our earlier price chart, two things stand out – Education and Health care. While these are hot button issues for politicians – and also, no coincidence, some of the more heavily unionised areas in most advanced economies, meaning it is difficult to reform from within – the scale of the price inflation is triggering some private sector supply side response, much of which has actually been facilitated by the Covid Crisis. In the UK for example, with both GPs and teachers ‘working from home’, Covid has forced widespread adoption of technology such as Zoom/Microsoft teams etc for diagnosis or lessons/lectures. By insisting that these are ‘just as good’ as In Real Life (IRL) the unionised practitioners have actually removed barriers to entry and recast their own industries and probably not in a way they would like. Building Back Better in General Healthcare for example may well mean that your online consultation will be with an Amazon AI – probably one that you can connect to your wearable device – and Amazon can then deliver any necessary prescription. Equally, we are already seeing pharmacists offering one on one consultations for a fee that includes the prescription. If you are going to promote the idea that the future of medicine lies in mass diagnostics combined with online consultation and subsequent drug delivery, then it is difficult to also argue that the NHS has any expertise in this area. In effect, the internet is doing what it always does, which is to eliminate a layer of middle men.

Similarly with teaching. If a lecturer is simply going to put their notes online, then why wouldn’t it become like any other online publisher, where the very best authors attract the majority of the readers? Why indeed for a standard school syllabus would there not be a standard set of online lectures? This then reverts to the old idea of ‘homework’ being the time when the information is ‘absorbed’ and ‘schoolwork’ being where it is discussed and practised. Much more of a tutorial system. This can also be extended online. One only has to look at how, already, private tutors are making money online helping the relatively well off from all over the world fill in the ‘gaps’ in their education, almost like mentoring in many ways. The internet is already helping Generation Z graduates (Zoomers) earn cash through tutoring teenagers in multiple countries. Once you start working from home, does it really matter where home is? It is not a great stretch to put together a hybrid school system that blends the best of in person socialisation and tutoring with the best of online information and resources.

Running behind all of this of course is the emerging trend of the MetaVerse. Facebook has woken people up to the word at least, if not the detail, by changing its name to Meta, but in fact it is part of a broader thread of Internet 3.0, that brings together the Blockchain, digital currency and Virtual Reality/online gaming. While currently the idea of a 3D VR headset is similar to the ‘Brick’ mobile phones that the yuppies of the early 1990s carried around, it wasn’t long before we had moved to the flip phone and in 1998 the iconic Nokia 5110 (as featured heavily in the Matrix) the following year. Just as mobile phones were a combination of consumer products and back end infrastructure, so too will be the integration of VR and AR into the consumer sector via the fact that online communities will be able to act as online ‘economies’ that will interface with IRL. As blockchain and stable coins allow payments and transaction to take place in a separate economy, but one where ‘coins’ can be traded back into conventional money, there is going to be a large displacement of conventional ‘agents’ and gatekeepers. Obviously parts of health and education, as discussed, but also Financial service, where custody and transaction charges can largely be eliminated by the blockchain.

While tens of thousands of politicians, lobbyists, middle men and marketing types are gathered at ESG Glastonbury this month, to discuss a problem that has already been ‘solved’ (we already know that we are going to embrace new nuclear), hundreds of thousands of creatives, developers and innovative people around the world are using the digital tools now at our disposal to remake things from the bottom up. While the millennials are busy talking, the Zoomers of generation Z are busy getting to work.

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