Just before Christmas, I was delighted to have the opportunity to chat with Angelo Robles, founder of the US based Family Office Association about a wide range of subjects, but in particular how we at Market Thinking saw the coming year in markets
Thanks to the kind efforts of an old friend and former colleague, David Talbot of Synchrotab and sponsored by Accordia Group and Ruby Carbon Asset Mangement Group, this has been turned into a video for Angelo’s YouTube channel, which you can see in its entirety (c 20 mins) by following the link below. Alternatively there are some much shorter (2 or 3 minute) clips linked further on.
The Whole Thing
The conversation was wide ranging and lasted a couple of hours, but David has edited it down to a more usable 20 minutes or so and overall I think he has done a great job of capturing all the key points, even allowing for the poor-at-times internet quality from my end (weather in the Alps!) and overall I thought was pretty good for a first effort – on my side, that is, the other guys are pros!
For shorter clips, (2 or 3 minutes) here are two – the first on asset allocation for a family office in 2023.
A Clip on Asset Allocation for a Family Office
And the Second, on a subject we have written on before and which is also dear to my good friends and colleagues at Tosca Fund is Why for European Banks, it really is different this time!
A Clip on Why for European Banks, it really is different this time.
Times are changing and as the saying goes we need to change with them and while we will continue to blog and appear on Bloomberg, CNBC etc, we recognise that this slightly longer form style has its many merits (and its many advocates) and we will be aiming to do a lot more. Watch out for more innovation as we move into the New Year and of course the New Chinese Year of the Rabbit!
Old School Q+A
Meanwhile, in ‘old form’ we thought it worth adding in the written commentary we prepared in advance for Angelo’s great set of questions.
Q: Your blog at Market Thinking claims to make sense of the narrative. How would you characterize the prevailing market narrative in 2022, and how is it shifting as years’ end nears?
A: We try and make sense of the narrative! For us, the prevailing narrative of 2022 has been one of ‘normalising’, in practical terms after Covid two years of Covid, but also in financial terms after 14 years of QE and Zero interest rates, with a particular ‘perfect storm’ over the last two years, when an unprecedented fiscal stimulus was met with Central Banks dramatically expanding the money supply; indeed in 2020/21 the Fed printed more $s than in the entire history of the United States.
This increase in MS finally delivered the high street inflation that had failed to emerge over the previous decade or more, building on the ‘temporary’ inflation that arose due to the supply chain disruption around first the shut down and then the rapid opening up under covid – remember all the congestion in the Port of Los Angeles, the ship stuck in the Suez Canal? That was all indeed temporary, Shipping prices are now way down, and most energy prices (except gas) are also normalising. The dramatic rise in commodity and particularly gas prices after the invasion in Ukraine was caused by the sanctions the west imposed on Russia and was another bout of ‘temporary’ cost push inflation – the portrayal of inflation as ‘Putin’s Price hike’ is disingenuous.
However, the Fed has acted to deal with the real issue, which is the money supply growth. That has now gone firmly negative and will deliver the recession with a 12 to 18 month lag in an equal and opposite manner to which the boost to the money supply delivered the inflation we have experienced this year.
It is important to recognise that rates normally lead the expansion in the MS and are thus used as early warning signals, but that we normally expect a lag. Because of QE lasting so long, they got out of synch, ultra low rates led to a huge distortion of capital markets and deflation (excess supply and Zombie companies, cheap working capital funding extended global supply chains etc), they only lead to inflation when the MS expanded to facilitate the Covid fiscal expansions. Collapsing the MS, as the Fed did from April onwards has coincided with higher rates, they are no longer lead indicators.
Thus the narrative has shifted from inflation to recession, but we would disagree with the consensus that the Fed has to finish raising rates before markets can respond. This is because the second way in which rates lead the economy is that they lead markets through the yield curve setting the discount rate. Long duration assets – long bonds and growth stocks have both ‘tanked’ this year because of the shift in the discount rate. The Fed adding another 50bp here or there won’t affect discount rates any longer – although they will, likely, affect the dollar (see later)
Q: You bring many years of developed market experience in your observance of China, as the country’s economy seeks to harness the benefits of capital markets. Is China still committed to a market economy and can this coexist with an autocratic CCP?
A: Yes and yes, but we need some context. When Xi took over in 2012, one of the first things he said as part of his reform agenda was that ‘where the market can set prices it should be allowed to do so’. This remains the case and is very important as we believe this is the key source of ‘misunderstanding’ of China in the west.
Too many in the west viewed China as simply the largest emerging market due to follow the template of the rest, ie the Washington Consensus model of open exchange rates, western capital to build and own factories and labour migration from farms to provide cheap factory labour to produce cheap consumer goods for sale to the west. (See for example, Diary of an Economic Hitman).The agriculture sector was then transformed into a ‘plantation’ providing exports to the west while depending on western imports of basic foods. Subsequently, factory workers were encouraged/allowed to borrow from local banks (who had in turn borrowed in $ from the west as there were insufficient domestic savings) and buy higher value added consumer good from abroad – but from countries where the west also owned the factories. This was part of so called screwdriver industry approach where each ‘new’ emerging market provided the cheap components to the next one up the chain. As the economy grew, capita markets arrived, offering debt and equity in local companies to overseas investors; these companies were usually public or quasi public goods – telecoms, utilities, energy companies, banks, constructions etc – and an ’emerging market boom’ occurred as western investors piled in and resulted in too much money chasing too few goods. This almost always resulted in a spike in the exchange rate making exports uncompetitive and undermining growth as well as CPI inflation, where the prescription from the IMF was always to raise interest rates. This resulted in a blow-off peak in the exchange rate and then a collapse as the consumer sector was crushed by high debt payments and rising unemployment as western companies relocated to the next emerging market down the chain. Cue default on debts, paid by US tax payer and Wall street picking up key assets at cents on the dollar. Then the circus moves on. Rinse and repeat.
The reason for this long explanation is two-fold, one that the west went into China expecting a similar outcome and two that the Chinese saw them coming. We might add a third, that the Chinese told us what they were doing (or not doing) but we chose not to listen. Thus the Chinese have not opened up their exchange rate, nor do they allow the west to own the factories. They have not allowed $ funded consumer borrowing – not least because they have a huge pool of domestic savings. They have allowed migration from the farms, but it is strictly controlled by the Hukou system, precisely to prevent the Favella/Shanty town problems seen elsewhere in Emerging markets. Nor do they do plantation farming for export. Their approach has been to be more mercantilist and to go steadily up the value curve within China – which is of course the source of most of the tension with the west.
China hasn’t changed course, it’s just that our understanding of it has. Xi’s first five years were characterised as the China dream, which we misinterpreted as them wanting ‘the American Dream’ and the first stage of the Washington Consensus – even though it was clear that the Chinese were not going to let that happen. His second five years have been about Common prosperity, which is basically a socialist approach to industrial capitalism. Here again, we thought China ‘wanted’ western Financial Capitalism, ie the second phase of the Washington Consensus where the western financial markets get to own all the public goods. Last year, with the Education stocks and calling time on the magical thinking behind ADRs, we suddenly realised that wasn’t going to happen either. Thus we now describe China as ‘authoritarian, autocratic and anti free market, when in reality it is simply rejecting our Financial Capitalism/rent seeking model (which is why Soros et al complain about it). China remains happy to co-operate to allow markets to price efficiently, but it will not allow the west to exploit it (in their view).
One good way to think of China is as the EU would like to be; China is approximately the same size as Europe, with similar diversity of geography, climate and even dialects. We can think of the provinces as being semi autonomous like Europe’s nation states -China has 23 Provinces, 5 Autonomous regions and 2 SARs (Special Administrative Regions) in Hong Kong and Macau. In comparison, the EU is 27 countries, with 3 in the EEA and two that are effectively SARs (in that they have separate legal administrative and judicial systems) in UK and Switzerland. The difference of course is that the unelected body that administers China has ultimate central control over the regions, whereas the EU does not, which is why it is able to do central planning – particularly of infrastructure – high speed rail, airports energy and other infrastructure as well as have, ultimately, one government balance sheet.
Bottom line, China doesn’t need the west, but is happy to co-operate
Q: Are you a bear on the USD and if so, why?
A: We believe that the $ overshot last year due to a variety of technical reasons, mostly to do with the financial markets. Most obviously as the Fed started to tighten we had a relative interest rate effect, but this was enhanced by a widespread de-leveraging across multiple strategies, particularly carry trades – almost all of which were funded by a short US$ position. We also had situations early in the year, where the Yen fell sharply as the big life companies found themselves over-hedged. As US Treasuries fell in value, the short $ cash positions in the life companies had to be bought back in sufficient size as to stimulate a big momentum trade. The war in Ukraine catalysed similar problems for the UK and the Eurozone needing to print more pounds and Euros to buy more expensive energy while being initially reluctant to raise short rates due to greater economic sensitivity to the short end. Ultimately the problem for the US $ is that it has huge twin deficits that it needs to fund and thanks to the ‘freezing’ of Russian FX assets, the current account surplus countries are reluctant to buy US bonds. Thus we need to look at the US$ relative not just to the Yen, Euro and Pound (the DXY) but increasingly the Sing$, SK Won and of course the Rmb. Longer term the other big issue for the $ is that ‘The Rest’ – as opposed to ‘The West’ are going to use cross exchange rates rather than the $ for trade, which will have an impact equal and opposite to the Petro $ impact in 1971.
Q: Are you in the Russel Napier camp that sees inflation as a necessary solution to over-indebted government balance sheets?
A: Russel is a great economic historian and rightly identifies the way that ultimately this situation will be resolved, but it also ultimately involves a reduction in government spending. One might argue that a lot of what is going on with NATO right now is a way to shift a lot of the Military Spending of the US onto the shoulders of the rest of NATO to reduce its budget deficit, while forcing Europe to buy highly expensive LNG to help reduce its current account deficit.
Q: Which parts of the Chinese market may provide the greatest upside for Families with long term investment horizons.
A: Families need to view China as collaborative, it is building out its own savings infrastructure and will allow the west to help ‘set prices’ for assets. Thus it will allow you to own shares or bonds, but not the whole company, in the same way it will allow entrepreneurs to become rich, even very rich, but not to use that wealth to buy political influence. Thus back companies that add value, but not those whose ultimate aim is a monopoly and excess ‘rent’. China is also building lots of infrastructure, both inside and outside of the country, participating in funding that will provide a lot of interesting opportunities. It is also important to think of China as an Industrial Capitalism economy, rather than a Financial capitalism one, thus strategies that involve leverage, illiquidity and carry trades are inherently more risky
Q: You have written extensively about the three zeros, Interest rates, Covid and Carbon and how such policies have wrought havoc on investors. As at least the first two are receding, what policy mistakes worry you most going forward?
A: Sadly, almost all government policy in recent years has only had the unintended consequences and never the intended ones.
The lock step of western central bankers imposing the same short rates on the upside is a big risk as consumer balance sheets are very different, while the power of lockdown remains a powerful draw for way too many officials, but yes, the negatives of those two are working their way out.
Zero Carbon remains a big concern as it combines rent seeking with crony capitalism and lobbying, but it has become a huge industry and a quasi religion in the west. In practical terms it is unprecedented that economies can grow sustainably with more expensive energy inputs, most likely they will simply yield to competitors who aren’t following this prescription. In the west, financiers are, quite literally manufacturing money out of thin air with products like carbon credits which until now they were able to ‘purchase’ from emerging markets and sell to western economies, thus allowing western politicians to buy influence in Emerging Markets with western corporates’ money. This has been tolerated thus far, not least because by selling their credits, the Emerging economies could not manufacture themselves. Now, with One Belt One Road and Chinese capital, the Emerging Markets may be reluctant to limit their economic growth in this way – in turn putting huge pressure on western manufacturers.
Q: You recently raised the idea that “this time may actually be different” for European banks, and indeed compared the unloved sector to the energy industry in November 2020. What makes it different?
A: It does seem a bit counter-intuitive as we are expecting rates to stay high, go higher and a recession, but we need to return to the idea that interest rates are no longer a lead indicator of either the economy or the markets thanks to 14 years of ZIRP. Traditionally markets view banks as winning from higher rates as their net interest margins expand, but losing on bad debts as the higher interest rates bring about a recession. This time however, rates are rising from a level where banks couldn’t make any money to a level where they can and while there will be a recession (we think) the level of provisions is already very high – and made higher during covid with government help. In addition, since the Financial Crisis, banks have not really been allowed to make loans and where they have, they have faced challengers from a shadow banking system funded on cheap money. It is they who will bear the brunt of the write downs and they who are no longer eating the traditional banks’ lunch. For the European banks in particular, they have until now been prevented from paying dividends or doing buybacks – this is now changing and is a key reason why, along with valuation and a diversification from US$ assets, they look extremely interesting.
Q: You frequently comment on the noise traders. Explain to our listeners what you mean and where are the voices currently rising.
We view the markets as being driven by three ‘tribes’ – short term traders, medium term asset allocators and long term investors. When they are all aligned, market movements can be powerful, but much of the time they are in conflict, so understanding who is driving markets at any time is key to making sense of the narrative. Short term traders tend to be absolute return focussed, leveraged and predominantly in currencies, short dated bonds and commodities and their modus operandi is to put on a trade and then generate a lot of ‘noise’ to get others to follow in and take their profit. This is why we hear so much about short term indicators like the Non Farm payrolls or the Oil inventories or anything else on the financial TV channels. If they can they will try and generate momentum such that the medium term allocators are forced to buy in order to ‘close out underweight positions against a benchmark and here the noise gets louder and louder and is most compelling just when it reverses – think Sterling in September. This year has been a great year for CTA traders as they have turned shorts in bonds and equities and a long in $ into very profitable strategies. These all closed around Thanksgiving (effectively their year end) and at the moment there is no strong consensus. We do sense an emerging short dollar, perhaps long gold trade and also a China opening up trade.
Q: Volatility risk metrics have featured widely in the investment process of many large and previously successful multi-strat hedge funds. You have been a vocal critic of risk parity strategies. Why do you consider this approach invalid?
We have primarily been critical of the institutional approach of claiming to minimise investment risk for long term investors via two variables – benchmark risk and volatility risk – since they ignore other sources of risk, in particular liquidity risk and leverage risk. Part of this is because of the Peter Drucker maxim that ‘what can be measured will be managed’ and traditionally benchmark risk was used to judge medium term fund managers while volatility risk was used to judge/manage short term traders. Long term investors should be collecting the reward for taking volatility risk rather than having it suppressed and should not be focussed on short term tracking of a benchmark. By contrast, they should not be taking hidden leverage risk (think LDI) and while they can take liquidity risk, they should be rewarded for it (which currently they are not).
Q: Do you consider the years ahead may become characterized as another commodity super cycle?
A:Yes, see below
Q: What are the dominant macro themes you see for 2023?
A: China re-opening is likely to be a dominant theme for next year, which will likely give another bout of cyclical commodity inflation – as well as a boost from Chinese visitors. This will merge into a commodity super cycle, particularly for mining and metals and energy where, thanks to net zero policies, there has been significant under-investment.
A related multi year theme is that China is now going to be using the Rmb to buy commodities, especially oil, which means that not only is there is less demand for $s to trade (which will deleverage the FX market) but also that China no longer has to earn $100bn every year via exports to buy oil, it can just print the currency and divert its economic resources to the domestic economy. This will have big implications for supply chains and consumer goods in the west.
On the downside, the short rate sensitive economies – peripheral Europe, Aus, NZ will see significant slowdown in consumers (other than Chinese tourists!), which will combine with the slowing of money supply to make economic background gloomy – except ironically for European banks as previously discussed.
