Mean Reversion

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January 22, 2023
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Kung hei Fat Choy!

Firstly, a Happy Chinese New Year to all our friends and colleagues in Asia, for as we pointed out in a post this time a year ago Chinese New Year is celebrated not only in Greater China but across much of Asia. Indeed, we would estimate that close to 2bn people are celebrating this week, and after the disruption of the last two years, there is enormous pent up demand for travel and social interaction. Enjoy!

s year is the year of the Rabbit, or more specifically, the Water Rabbit, as each of the 12 signs of the Chinese Zodiac rotates through a cycle of five elements, nicely described in the annual (tongue in cheek) investment guide from CLSA on the Feng Shui Index . And yet, as we noted in our year ahead piece,(January Market Thinking) despite over a billion people travelling in a short two week period, billions of dollars in cash being handed over in red envelopes known as Lai See and large amounts of expenditure on celebrations, the majority of the 2023 market commentary barely mentioned the re-opening of China as a factor for markets this year, instead largely obsessing over the Fed (as usual). While year on year comparisons are somewhat meaningless due to the restrictions (overseas bookings up 1000% for example), estimates suggest that travel will be back to perhaps 70% of 2019 levels.

Not much social distancing at Shanghai Train station

At least as hundreds of millions of Chinese crowd the railways (including their 40,000km of high speed rail) they won’t encounter the same problems in the UK (with its 115km of high speed rail) as NotWork rail continues to keep people (not) Working From Home.

Having said all that, it is interesting to see how this narrative is now shifting, even in the last two weeks. The fact that this week the FT editorial board has caught up with the China re-opening story means it’s fair to say that it has almost certainly been on the Agenda at Davos, albeit with the predictable knee-jerk response from the usual suspects that this will require central banks to raise interest rates to prevent more inflation. It won’t of course, for the exact same reason it didn’t in 2010 when China also caused a boom in commodity prices, but the orthodoxy is as busy insisting on rate rises now as it was demanding rate cuts to cause inflation a matter of three years ago. In our view, the most likely outcome is a prolonged pause, no over-tightening and no ‘pivot’ to revisit the madness of QE.

To us, this belated recognition of the impact of China is somewhat reminiscent of the time when the US markets realised that the biggest spending day of the year in the US, Black Friday, was dwarfed by the Chinese equivalent , where AliBaba alone exceeded the US total. As the saying goes, you can ignore (Chinese) economics, but it won’t ignore you.

Taiwan Elections need watching closely

More interesting (for us at least) from the FT this week was the discussion about the Taiwan Presidential Election, coming up in January 2024, where, as the FT puts it, in recent opinion polls, Lai Ching Te, (the new candidate for the ruling DPP Party) is slightly (their words, actually 6%) behind Hou Yu-ih, the popular mayor of the country’s largest municipality from the Kuomintang (KMT), the more China-friendly opposition party. Lai is taking over following the resignation of Taiwan President Tsai Ing-Wen last November after a heavy defeat in the local government polls. Tsai would not have been able to stand for the next Presidential Election in any case as only two terms are allowed, but her tactic of making the local polls all about a strong anti China stance clearly backfired. Interestingly, something similar happened in local elections four years ago and it was only the ‘fortunate’ timing of civil unrest that occurred in Hong Kong in 2019 that enabled Tsai to exploit anti Chinese sentiment over Hong Kong and produce a remarkable comeback in the polls to win a second term.

The interesting twist from this otherwise largely unremarked upon article is that according to the FT, in the same polls, DDT man Lai is seen as the clear winner of a presidential race if instead of Hou Yu-ih, the KMT instead nominates its chair, Eric Chu. As we saw 4 years ago, a pro Beijing Party is seen by many in Washington as a strategic risk for ‘the west’ -until they have built their own Chip foundries that is, so we would expect a lot of pressure from the US to ensure the latter happens, with counter pressure from the mainland to ensure it doesn’t. One to watch.

Short Term Uncertainties.

Commodities up, Dollar down, Bonds and Equities range bound.

With the narrative starting to shift on China re-opening, the commodities space has picked up again, with Oil rebounding from the early attempt to play the ‘US Recession’ card, while Copper and other metals have rallied 10% or more. We should remember however that these markets are all leveraged and relatively short term in nature and their volatility is often as much about market positioning as anything fundamental. Gold, too, has broken up nicely, helped by discussions about a Gold backed currency basket (see below). Part of this is also down to continued weakness in the $, with the DXY heading down below all its major moving averages towards the 100 level again.

Both Bonds and Equities remain range bound for now as the traders concentrate on their preferred ground of FX and Commodities. The S&P 500 continues to struggle to break to the upside, leaving a broad + or – 5% band from around here. Going into reporting season, a number of traders will be looking for strategies like put spread hedges, not only for the S&P, but also the Nasdaq, where there is a raft of big tech companies reporting, both of which suggest some uptick in volatility in coming weeks. This is not unusual for January, although it is worth remembering the recent history is distorted not only by the Covid related spike in 2020 but also by the late, and not much lamented, XIV Exchange Trade Note from Credit Suisse, which pulled in a huge amount of money as a ‘short’ on the Vix in late 2017 and early 2018 before imploding in February 2018 causing VIX to spike dramatically. Another CS triumph, for the lawyers at least. By contrast, non US markets have all caught a bid so far this year as the medium term asset allocators return to their desks and have their investment meetings.

Medium Term Risks

Diversification, benchmark risk, currencies.

The views on China opening up are not only percolating through to Davos, but also to the Medium Term Asset allocators, encouraging some flows into commodity related areas – like Mining stocks and Oil companies -but also into Emerging Markets generally. This latter move, as demonstrated through ETF flows, may in the immediate sense, however, have more to do with the $’s continued weakness, as well as that perpetual bugbear of the risk averse asset allocator, benchmark risk. Last year, when there were big macro trends in play, taking benchmark risk by being underweight, say, the FTSE or Europe or Japan was easy to justify by referencing the ‘groupthink’ being promoted by the noise traders and also delivered a useful currency related gain, given the extreme outperformance of the US$. Without that ‘free lunch’ from the currency, there is going to be a return to hugging the benchmarks.

We see the old habit of a return to benchmark, as Asset allocators buy things, not because they like them, but because they are going up and they are underweight.

Reuters report that European ETFs saw over $7bn of inflows, while the US saw $3bn of outflows last week. Emerging markets saw around $1.2bn. A similar pattern is emerging in Bond ETFs, suggesting that this is more of an allocation shift away from a strong bias toward US assets versus international assets. As we noted in our year ahead commentary, a lot of international money has been ‘hiding’ in US assets, notably cash for the last 12 months, which delivered a very helpful return in local currencies for many of them. However, with the $ breaking back down from its September overbought position, flows have started to move back (probably just to neutral) into a lot of non US markets. As far as Europe is concerned the four biggest European ETFs are all up around 10% year to date, on a combination of valuation ‘catch up’ and a weaker $/stronger Euro.

Long Term Trends

The announcement this week that the Saudis would now consider receiving payment for Oil in currencies other than $s was pointedly made in an interview with Bloomberg at Davos, where, as we noted earlier this week, there is also a creeping realisation that the New Normal is not going to be the one they planned for us all. At the same time as the Kingdom’s finance minister announced a multi billion $ investment in Pakistan. This undoubtedly caused some shockwaves in markets, but, frankly, simply confirmed what many already accepted – that, after 50 years, the Petro $ is effectively dead. We have been discussing for almost a year now, essentially since the US ‘froze’ Russian FX reserves, how this unprecedented move by the Biden administration would now mean that $ surplus currencies (China plus all commodity exporters) would not only seek to recycle their $s elsewhere, but also they would seek to reduce their need to use the $ as a trading currency other than with the US itself.

Last week we discussed some interesting comments by both Pepe Escobar, an independent Journalist and Zoltan Posnar, formerly of the US Treasury, Fed and now Credit Suisse, about the prospect of a commodities backed trading currency to replace the $, not so much as a Reserve Currency, but as a trading account currency. This originated as a variation on the SDR basket (we ourselves discussed last March in Is it time for the Bancor?), but as Escobar points out in his latest piece, this thinking is evolving into some form of Gold Backed Currency basket.

Losing ‘The House’?

We can think of the $ as being a bit like gambling chips in a casino, where the players buy the chips at the door and can move between tables and games using those chips, only turning them back into ‘currency’ when they leave. Currently, the US owns ‘The House’ and can create as many chips as it likes without causing inflation as the rest of the world needs those chips to play (trade). If however, the players in a casino decide they are happy to play with a different set of chips, then the US loses that position. Crucially, when the US came off Gold in 1971, the US$ in the form of Petro $s really was the only alternative – in effect they owned the casino. Not only is that no longer the case, but, to extend the analogy, the ‘House’ has just evicted a major player and refused to cash his chips, making the rest of the players wonder what would happen if they were deemed to be breaking ‘House Rules’.

Pepe Escobar is perhaps being more than a touch hyperbolic when he suggests that a Gold backed Ruble would leave the US$ in a position similar to FTX (!) but it certainly concentrates the mind of the long term investor on the need to diversify.

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Political Cicadas - no change in the product, just the sales team

The habit of spending long periods underground before re-emerging is not limited to the Cicada, for while this year sees the coincidence of the 13 year year Cicada cycle and the 17 year one, something that last happened 221 years ago, it is also 17 years sine Tony Blair was last in power and 13 since Francois Holland (likely PM in the French Hung Parliament) was. Both now look to be re-emerging to ensure continuity of policies that never really went away. The key sources of protest across Europe - crippling expensive wars against Russia and Climate change as well as uncontrolled immigration have only been addressed in the doubling down - the first thing UK PM Starmer did was fly to Washington to offer more money to NATO, while his Chancellor promised more money for Net Zero. Meanwhile, the left alliance put together to thwart Le Pen is even more pro immigrant than Macron. For markets, there is no prospect of lower spending and every prospect of higher taxes - the only 'Change' visible but not the one promised. The Technocrats and Globalists expecting this 'democracy' means that the populous will go quietly will be disappointed, especially with the arrival in the Autumn (once the Cicadas have gone) of the great populist, anti open border, anti net zero and anti war populist Donald Trump.

Market Thinking July 2024

The scorecard for the first half puts Equities, commodities and Gold in the top half of the table, with cash and fixed income in the lower half. This is consistent with the steady but uninspiring macro backdrop and positioning ahead of a tricky H2 from a political perspective. The anomaly of the Market Cap weighted SPX out-performing the equal weighted SPW by over 10% points tells us both that the SPX is no longer telling us anything about the US economy and that this excess return is for taking (considerable) concentration risk. Meanwhile, with Bond analysts 'pivoting from the Pivot' the fixed income markets have calmed down a little and leaving The Donald' rather thna 'The Fed' as likely the biggest policy influence on Markets over the next 12 months. In particular, we would look out for a 'Trump Plaza Acord" early next year, 40 years after the last one- something the FX markets aren't talking about, but the asset allocators seem to be (at least subconsciously) pricing in.

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