Markets has a good Q3, especially the broader based equity indices, which caught up a little with the narrow MegaCap driven benchmarks. Nevertheless, idiosyncratic or stock specific concentration risk remains extremely elevated and the wobbles in August highlighted how fragile these benchmarks can be, whereby any move is rapidly escalated by passive benchmark effects. Markets are always nervous in October, but especially in Election years, wary of ‘The October Surprise’ and with October year ends for Mutual Funds and Hedge Funds having de facto year ends after Thanksgiving, an Election right between the two suggests to us at least that both traders and investors may retreat to the sidelines, ready to react rather than predict.

Short Term Uncertainties

Elections, October Surprises and what to do about China

The short term uncertainties are obviously focussed on the upcoming US Presidential Election, although we would also watch out for the BRICS+ conference coming up in October, where there might be an October Surprise announcement of the new BRICS+ currency trading basket called the UNIT – we know they are actively working on this and it is a 60:40 basket of BRICS+ currencies and Gold. This is not to replace the $ as the world’s Reserve Currency, but to remove it as the currency of much of the world’s trade accounting – in effect to reintroduce J M Keynes’ idea of the Bancor, but on the blockchain. See more about this in a recent post here.

The notion of an October surprise in a Presidential year is a function of recentcy bias, things are announced in order to influence the Election, which obviously means that something could happen in either of the two theatres of war either to influence the Election or to act before a potential regime change. As such geo-political uncertainty is likely to spike this coming month.

While the policies of the two Presidential Candidates might best be described as pro Business versus pro Consumer (voter) and both sets continue the flawed economics of trying to fix prices to control outputs, they are largely domestic issues. It is difficult to see how either side will deal with the mess that is Foreign Policy.  

Meanwhile, the latest news out of China which was neither a bazooka nor the start of a co-ordinated monetary stimulus (see ‘Not a Bazooka’) led to a dramatic spike in the China stock indices at the end of the month/Quarter which was in our view not unconnected with this chart (courtesy of our friends at Redburn).

As traders scramble to cover shorts, the spike has led those who are able/allowed to invest in China to consider whether it is finally time to look at how to do so. Meanwhile, although we suspect that the Chinese retail investor may get rather excited as they come back from Golden week, we think this is more of a long term opportunity appearing here and if this is indeed a new bull market for China, we would rather be buying the dips than chasing the rallies.

Medium Term Risks

Concentration risk, diversification risk and $ risk

One of the biggest risks in our view remains the concentration risk embedded in the US Market as passive flows have chased the MegaCap stocks and is best summed up in this great chart from the team at Invesco.

Passive investors have effectively increased the risk for everyone else and active investors and real return investors are having to calculate how much idiosyncratic risk they are prepared to take. A passive investor suffers no ‘loss’ if the index drops sharply, but an active investor is deemed to have failed in their mandate if they don’t outperform an index incorporating increasing levels of stock specific risk. Hugging the benchmark or monitoring low volatility ticks the box for low risk passives, or closet trackers, but in the real world, where loss of capital is the real risk there is a trade off. FOMO investing is not investing, it is trading, but the two are often mixed up.

We continue to see the other main medium term risk as a weaker $ through a combination of continued lack of fiscal control and a narrowing of interest rates differentials. Also, and perhaps more importantly, we see the risk of significant capital flows as investors diversify away from a huge over-exposure to the $ markets. Domestic US cash ear-market for bonds is now moving down the yield curve, but cash currently sat in equities as a barbell with MegaCap tech is starting to move into quality and yield stocks. In the US that means equal weighted SPW is out-performing market cap weighted SPX, but for international investors that cash is going to look closer to home and that means selling $s. We need to watch the flow into and out of Money Market Funds closely.

Even though we have long had a contrarian view that the glass in China is half full, we would look to fade this sharp rally, (note this is not investment advice, please do your own research and speak to a financial advisor) which we see as short covering by traders, rather than a meaningful change of opinion by allocators and log term investors. We continue to see China as in the process of deflating a real estate developer bubble, through deliberate creative destruction, which simultaneously building out Made in China across a wide range of high tech and strong valued added sectors. (See here and here for previous discussions, or just search the substack for China) It is not going to follow the Western Bailout model of encouraging leveraged demand to maintain high prices (and producer profits). Rather this latest round of initiatives is about providing enough liquidity for markets to clear at lower prices.

The latest moves by China are about building a Capital Market with Chinese Characteristics

Having said that, we also note efforts to put a floor in China markets, not because there is a Wealth Effect to worry about (Chinese consumers own less than 5% of the market), nor because they need markets to provide investment capital (corporates have large and liquid balance sheets and most external funding is currently from Banks), but because thee aim is to build large scale stable financial markets as a source of wealth and pensions as well as a source of efficient capital allocation. We call this a Capital Market with Chines Characteristics, which essentially means it is to be built for the borrowers and the lenders, not the brokers and the middlemen.

China currently has over $40trn in bank deposits, more than the US and the EU combined and four times the size of the Chinese stock market.

Currently China’s savings are in cash, Gold and Real Estate. The authorities don’t want that cash remaining on the sidelines, or going back into speculative real estate, they want them going into productive investment. Deploying them into the real economy via a coherent set of capital markets is the real goal.

Long Term Trends

The UNIT transforming trade and Investment

Thus, as we discussed in the October Surprise , the biggest long term trend we see in financial markets is the transformation of Asia in general and China in particular into a non $ based system for both trading and investment. This is not about replacing the $ as a reserve currency, it is about replacing SWIFT as a settlement system with an apolitical unit of account, but it is also about redefining a Savings and Investment culture through the development of capital markets for long term investment, not just for short term speculation. Back in 2021, Xi reminded people that houses were for living in, not speculation. A similar point could be made about Social Support; pension funds and insurance products are about long term cash flows and reinvestment in the productive parts of the economy through equity, not debt. It is not about short term speculation.

After the Controlled Demolition, the rebuild.

Within this framework, we can see the deliberate controlled demolition of the China ADR market in 2021 as all of a part with the controlled demolition of the speculative bubble in housing developers around the same time. Western ‘investors’ were horrified and called it a massive failure, but we would suggest they were looking through the wrong lens. Their own. From the Chinese authorities’ point of view we might see this as shedding the last vestiges of the western system, to replace it with one with Chinese Characteristics. As such it is not a failure, nor yet a success. It is a work in progress.

This obviously ties in with the BRICS+ currency and Gold backed method of exchange known as the UNIT coinciding with the end of the Petro$ and the recycling of Sovereign Wealth Funds into assets other than US Treasuries.

In effect not only are BRICS+ and specifically China hoping to take the Banks out of the capital allocation process, but by extension they are also taking the US itself out of the process. The Middle East in particular is launching multiple initiatives to allocate their surpluses across both public and private markets making for a new and significant set of long term absolute return investors and having a common accounting unit for both trade and investment is highly attractive.

Obviously, the other key long term theme for investors is the resolution of the ‘forever wars’ in Europe and the Middle East, which brings us back to the US Presidential Election and any possible change of direction in US Foreign Policy - which is frankly the key variable in all this. Obviously this is a more visceral example of demolition and rebuild, but any resolution would offer a large real world opportunity set for long term capital - likely further crowding out claims by US Treasuries and in both cases would likely be vey positive for significant energy consumers like Europe and Japan - yet another reason for diversification from the US$.

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