As usual, Hugh Hendry pro­vides a pro­foundly insight­ful view of the global econ­omy and mar­kets, and this month's let­ter is a must read:

Eclec­tica Asset Man­age­ment –Let­ter to Investors — Novem­ber 2009

by Hugh Hendry
Port­fo­lio Man­ager, Eclec­tica Fund

"The power to become habit­u­ated to his sur­round­ings is a marked char­ac­ter­is­tic of mankind."

John May­nard Keynes
The Eco­nomic Con­se­quences of the Peace, 1921

This month I will attempt to answer the entrance exam­i­na­tion for the Chi­nese civil ser­vice. That is to say, I will attempt to tell you every­thing that I know. In doing so, I will argue that this year's rally in infla­tion­ary assets, from emerg­ing stock mar­kets to indus­trial com­modi­ties to the fall in the US dol­lar, could be a FAKE. Let me explain why.

But first, I am indebted to Scott Sum­ner, pro­fes­sor of eco­nom­ics at the Uni­ver­sity of Bent­ley, and his essay on the eco­nomic lessons that can be drawn from time­less­ness in art (see http://blogsandwikis.bentley.edu/themoneyillusion/?p=2542). It is a theme that I will con­stantly revisit in my argu­ments below.

Sum­ner is able to take us from the Flem­ish forger, Van Meegeren, and his hor­ren­dous repro­duc­tions of the Dutch painter, Ver­meer, to the notion that every reces­sion seems unique and spe­cial to its pro­tag­o­nists. So just how did Van Meegeren fool the Nazis with paint­ings that today look so awful, so un-Vermeer? Jonathan Lopez, the noted art his­to­rian, argues that a FAKE suc­ceeds owing to its power to sway the con­tem­po­rary mind. Or in other words, the best forg­eries tend to pay homage to the tastes and prej­u­dices of their time. The present is so seductive.

How­ever, for­get the art world. Con­trol­ling the psy­che of this gen­er­a­tion of investor is the indeli­ble mark of the falling dol­lar and the asso­ci­ated fear of infla­tion. Mon­e­tary infla­tion has been the dis­tin­guish­ing fea­ture of the last ten years, and it is now firmly embed­ded in the con­tem­po­rary mind. I am sure I need not remind you that gold, along with just about every other com­mod­ity, has at least quadru­pled in price since 1999. You already know my expla­na­tion for why this has happened.

The spec­tac­u­lar rise in the Chi­nese trade sur­plus, pre­dom­i­nantly with Amer­ica, to $320bn per annum at its peak in 2007, and the mer­can­tilist desire to pre­vent cur­rency appre­ci­a­tion drove the Asians and the sheiks to buy Trea­suries and print their own cur­ren­cies. The abil­ity of frac­tional reserve bank­ing to lever­age this liq­uid­ity many times over pro­vided the mon­e­tary mo-jo to insti­gate ever higher com­mod­ity prices. In other words, quan­ti­ta­tive eas­ing, mas­querad­ing as a cheap but fixed cur­rency régime, has suc­ceeded where Japan's ortho­dox ver­sion has failed. The QE suc­ceeded because, amongst other fea­tures, it raised the veloc­ity of mon­e­tary circulation.

How­ever, it was not always like this. As an exam­ple, ten years ago it was unthink­able that the dol­lar would prove so frag­ile. Recall that back then, when the euro was first launched in 1999, it promptly lost 31% of its value against the green­back. The sub­se­quent recon­struc­tion of mod­ern China, though, inter­vened. In order to finance the emer­gence of a new eco­nomic super­power, an abun­dance of dol­lars was needed. Have no doubt that had we not had the dol­lar as a reserve cur­rency, the rise of China would not have been as swift nor as decisive.

Adver­tise­ment

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The Yel­low Brick Road
Con­sider another econ­omy need­ing to be rebuilt: that of the United States in 1865, the post Civil War era. The rebirth of the Amer­i­can econ­omy was funded from the mon­e­tary rec­ti­tude of the gold stan­dard, not from the gen­eros­ity of a for­eign and infi­nitely expand­able paper cur­rency. How­ever, all of this occurred before the dis­cov­ery of cyanide for heap-leaching and the open­ing up of the huge South African gold fields. In other words, hard money was in tight sup­ply and the recov­ery was nei­ther swift nor deci­sive. Indeed, 30 years later, dur­ing the pres­i­den­tial elec­tion cam­paign of 1896, Williams Jen­nings Bryan was still hotly con­test­ing its mer­its. He railed against the per­sis­tent price defla­tion and argued that the econ­omy was bur­dened by a "cross of gold" (see The Eclec­tica Fund Report, Decem­ber 2005).
Per­haps I Should Stick to the Twenty-First Cen­tury?
My pre­vi­ous invest­ment let­ter attempted to explain the sub­tleties of the Trif­fen dilemma and the dollar's pre-eminent role in regen­er­at­ing mod­ern day economies. Let me repeat once more: lots of dol­lars were required, and duly deliv­ered, to build mod­ern China. They did not have to wait on the vagaries of a gold dis­cov­ery to pro­mote and sus­tain their eco­nomic engine. Instead, they required the will­ing­ness of their trade part­ners to run trade deficits. The US deliv­ered and, partly as a con­se­quence, the Fed's broader trade weighted dol­lar index has now fallen 20% since its peak in 2002 (the nar­rower DXY index com­piled by the Inter­con­ti­nen­tal Exchange has fallen more, but excludes the ren­minbi and over­states the role of the euro). In return, the world has a new $4trn trad­ing part­ner: China.

Heady stuff, but not with­out prece­dent: recall the Mar­shall Plan, a water­shed Amer­i­can aid pro­gram that assisted the recon­struc­tion of the West­ern Euro­pean econ­omy dur­ing the 1950s and 60s. This was fur­ther aug­mented by America's will­ing­ness to run trade deficits, the mod­ern day equiv­a­lent to a gold dis­cov­ery, which became nec­es­sary to sus­tain the emer­gence of the new eco­nomic trad­ing bloc. This resulted in the dollar's huge deval­u­a­tion ver­sus gold in the 1970s. How­ever, back then, the broad trade weighted index kept ris­ing. This time it has fallen sharply.
What an Ungrate­ful Lot We Are?
The dollar's role as the world's sole reserve cur­rency has both assisted and accel­er­ated the devel­op­ment of world trade. America's trad­ing part­ners have come to rely upon the bounty of dol­lars nec­es­sary to recy­cle their trade sur­pluses and thus finance their grow­ing pros­per­ity. This was done even at the expense of domes­tic Amer­i­can job losses. Replace the dol­lar with IMF spe­cial draw­ing rights; I hear your retort. Sure, but have you ever bought a cup of cof­fee with an account­ing iden­tity? And, fun­da­men­tally that argu­ment still suf­fers from the dearth of any other major econ­omy show­ing any will­ing­ness to sac­ri­fice its short term eco­nomic stand­ing for the longer-term mutual ben­e­fit of hav­ing enriched trad­ing partners.

Do not for­get that the Chi­nese could repli­cate equiv­a­lent cur­rency bas­kets to SDRs at any moment. Instead, they con­tinue to recy­cle almost three quar­ters of their trade sur­plus back into dol­lars. This is not coer­cion but sim­ple com­mer­cial prag­ma­tism. They know full well that nei­ther Europe nor Japan nor Britain nor Switzer­land nor the rest of Asia are will­ing to sac­ri­fice the implicit loss of man­u­fac­tur­ing jobs. They under­stand that it is only the US that is will­ing to embrace the ben­e­fits of com­par­a­tive advan­tage that arise from inter­na­tional trade. Have you ever asked your­self why car prices in Amer­ica are so low com­pared with those in Europe? This is my point.

I keep hear­ing that a dol­lar deval­u­a­tion would help mat­ters. I agree; it has. Let me say it again; we have already had the deval­u­a­tion. That is what the last five years were all about. Now with China rebuilt, and the trade deficit in full retreat (note the –47% con­tri­bu­tion from net exports to China's GDP growth in the first 9 months of this year), there are less dol­lar bills being exported over­seas to ungrate­ful recip­i­ents. Is it not time we drop our fas­ci­na­tion with the present and con­sider the future? Is it really incon­ceiv­able that the dol­lar could now strengthen?
Women in Love, Investors in Love. What's the Dif­fer­ence?
Of course this is a minor­ity view. Investors have reacted to last year's defla­tion­ary trau­mas by insist­ing that it is busi­ness as usual. They behave like D.H. Lawrence's coal miner Ger­ald from the novel Women in Love, who, just days after his father's funeral, steals into his for­mer lover's bed­room and, "...into her he poured all his pent-up dark­ness and cor­ro­sive heat, and he was whole again." Or was he? The trou­ble is that we are so anchored to the recent past. Investors are fear­ful of what now seems so famil­iar and recog­nis­able; at what they per­ceive as the reck­less behav­iour of our mon­e­tary author­i­ties. "Infla­tion is a mon­e­tary phe­nom­e­non" is their Fried­man­ite dogma. Their sal­va­tion can only be found in the safe sanc­tu­ary of gold and the embrace of risky assets, but are they truly safe?

This is my home. Don't be so sure about any­thing, Big Horace. Not about any­thing in this world.

Adver­tise­ment

The Orphan's Home Cycle
Hor­ton Foote

And so, just as the Church of Eng­land com­mis­sion­ers became con­vinced by the cult of equity way back in the whim­si­cal days of 1999 and went 100% long the stock mar­ket, investors today recant a new mantra of, "any­thing but the dol­lar (A-B-D)". Infla­tion bets are all the rage. Some would insist that it is their fidu­ciary duty to pro­tect their clients' cap­i­tal; I say tell that to the Church of Eng­land pen­sion fund, whose assets today are just £461m against lia­bil­i­ties of £813m. Aus­ter­ity beck­ons for the cler­gy­men; heaven will have to pay their stipend.

But the spell cast by a con­tem­po­rary cult is hard to resist. Take another august body, the Har­vard Endow­ment Fund. Not typ­i­cally renowned as a hotbed of reac­tionary fer­vour, the fund is nev­er­the­less rad­i­cal in its con­struc­tion and has come to typ­ify the A-B-D stance.

Harvard's posi­tion could well be con­strued as a one-way bet. Almost half of the fund is invested in emerg­ing mar­ket equi­ties, com­modi­ties, real-estate, pri­vate equity and junk bonds. It is as though the rap artist 50 Cent has taken over the advi­sory board. The fund is going to, "get rich or die tryin'".

We, on the other hand, approach risk by con­sid­er­ing the worst pos­si­ble out­come. For a cur­rent pen­sion scheme the great­est tor­ment would be a repeat of last year's final quar­ter when 30 year Trea­suries yielded just 2.5%. This would require a CAGR of 20% or more from the fund's riskier assets at pre­cisely the time that their future returns would seem most ques­tion­able; insol­vency would beckon. And yet, they blithely run the risk of ruination.

Of course, they are not alone. Another pop­u­lar argu­ment is that the emerg­ing economies have to urgently diver­sify their immense dol­lar reserves. And so the Chi­nese are colonis­ing the African con­ti­nent in the pur­suit of com­modi­ties and the Indian gov­ern­ment has just agreed to buy 200 tons of the IMF's gold hoard.

Is this not a rein­car­na­tion of the 1980 trade of the broth­ers Hunt? It is hardly an exag­ger­a­tion to sug­gest that China, for all intents and pur­poses, is already the com­mod­ity mar­ket. For despite pro­vid­ing less than 8% of global GDP, China accounts for more than half of the world's steel pro­duc­tion and more than half of global seaborne iron ore freight. Indeed, this pecu­liar­ity is cir­cu­lar in nature. Con­sider that a mod­ern alu­minium plant requires 25% of the project's cost to be spent on buy­ing alu­minium in the first place. And remem­ber that invest­ments in fi xed cap­i­tal for­ma­tion (think new alu­minium plants et al.) have made up 95% of Chi­nese GDP growth this year. China Inc. is Com­modi­ties Inc.

Accord­ingly, China shares the same risk as the world's largest pen­sion schemes. An over– lever­aged Amer­i­can con­sumer does not return to his/her manic buy­ing of old. As William White, for­mer chief econ­o­mist of the BIS, has argued:

Many coun­tries that relied heav­ily on exports as a growth strat­egy are now geared up to pro­vide goods and ser­vices to heav­ily indebted coun­tries that no longer have the will or the means to buy them.

Surely, the Chi­nese stash of Trea­suries is a pru­dent elim­i­na­tion of the fat tail risk that pri­vate sec­tor delever­ag­ing in the west ends up killing the golden goose of the trade sur­plus. But instead, in exer­cis­ing good ol' Texan tra­di­tion, they have opted, like the Hunt broth­ers did, to dou­ble up. It is the old dice game, Mort Subite, played by the employ­ees of the National Bank of Bel­gium in the busy lunch time cafes of Brus­sels in 1910. If the play­ers didn't have time to com­plete their busi­ness, they played a final round with a sud­den end­ing where the loser would be pro­nounced dead.

Much is made of the com­par­i­son between today's bal­ance sheet reces­sion and Japan's demise back in 1989. Despite their bub­ble never com­ing close to match­ing China's promi­nence in indus­trial com­modi­ties, the loss of Japan­ese eco­nomic growth in the 1990s was nev­er­the­less a major fac­tor in the water­fall crash in com­modi­ties. This plunge ulti­mately saw oil trade for as lit­tle as $10 per bar­rel in the next decade. Just con­sider how much more dev­as­tat­ing the expe­ri­ence would have been had they gone very long the com­mod­ity mar­ket in 1989 rather than golf courses and Rock­e­feller Cen­tre. At least the Har­vard endow­ment scheme did not share their enthu­si­asm for golf. But, this time around, I fear a Mort Subite beck­ons for the losers in Asia and the pen­sion mar­ket.
Last Orders: Infla­tion or Defla­tion?
If a poet knows more about a horse than he does about heaven,
he might bet­ter stick to the horse... the horse might carry him to heaven.

Charles Ives

I am now going to return to the tor­tur­ous and binary debate con­cern­ing infla­tion. As you know, I am in the defla­tion camp for now, and we own a mod­est amount of gov­ern­ment bonds and a series of asym­met­ric bets which would receive a boost from a return to some form of risk aver­sion. You could say that I am stick­ing to my horse.

My intel­lec­tual foes, on the other hand, are adamant that long dura­tion gov­ern­ment bonds are a short. I even hear that some Wall Street leg­ends are so con­vinced of the argu­ment made by the likes of Niall Fer­gu­son that they per­son­ally own Trea­sury put options and are actively coun­selling oth­ers to do the same. The argu­ment can be con­densed into just two fears.

First, they will sug­gest that 4.5% is not an ade­quate return for lend­ing your money to the prof­li­gate United States for 30 years. I agree whole­heart­edly. Again, I fear it is my accent, but let me stress once more that I do not pro­pose that any­one adopt a buy-and-hold pol­icy for the next thirty years in bonds. How­ever, a nom­i­nal rate of 4.5% might prove very prof­itable over the com­ing year should breakeven infla­tion expec­ta­tions head south again.

Sec­ond, the bears con­tend, a lower Chi­nese trade sur­plus will elim­i­nate a very large source of Trea­sury buy­ers at a time of bur­geon­ing sup­ply. Again, we find our­selves agree­ing vig­or­ously. How­ever, it is our con­tention that US sav­ings are head­ing north over the months and years to come. And an Amer­ica that saves is an Amer­ica that does not run a cur­rent account deficit. It is an Amer­i­can that can finance its own spend­ing domes­ti­cally. The US pro­duced a small sur­plus back in the 1990–91 reces­sion, so why not again?

As a con­se­quence the Chi­nese sur­plus is set to fall fur­ther and, with fewer dol­lars need­ing to be recy­cled to main­tain the cur­rency peg, their demand for Trea­suries will con­tinue to shrink. Now this is poten­tially a huge headache owing to the mas­sive pro­jected Amer­i­can bud­get deficits for this year and next, and the Treasury's desire to extend the matu­rity of the exist­ing stock of gov­ern­ment bonds which is becom­ing per­ilously short dated. Some esti­mate new issuance of around $2.5trn for the upcom­ing year. Per­haps, it is bet­ter that we buy those Trea­sury put options after all?
Amer­i­can Gothic
Or is it? I have quoted Don Coxe's def­i­n­i­tion of a bull mar­ket before and I intend to do so again. "The most excit­ing returns are to be had from an asset class where those who know it best, love it least." On this point, Amer­ica has fallen out of love with its own cur­rency and bond mar­ket. For­eign­ers own over half of the out­stand­ing Trea­sury stock. But, like I said, I think events could reignite some of the natives' old amour.

It is almost like declar­ing an enthu­si­asm for Say's Law. Think of it this way, a greater sup­ply of Trea­suries would be a very obvi­ous by-product of weaker than antic­i­pated eco­nomic growth. And in this envi­ron­ment risk aver­sion stim­u­lates the invest­ment desire for risk free assets. So, in a round about way, there are cir­cum­stances when sup­ply and demand can match in the bond mar­ket. But weaker eco­nomic growth? Surely the gov­ern­ments' inter­ven­tions this year have reme­died the economy?

The sur­prise might con­cern the role that ris­ing lever­age has played in boost­ing GDP and in anchor­ing investors' expec­ta­tions to an unre­al­is­tic level of nom­i­nal GDP. Over the last decade, each mar­ginal dol­lar of debt has gen­er­ated less and less mar­ginal income. We knew that there would be a "zero-hour" for the econ­omy when the cre­ation of new debt would not con­tribute to GDP growth. The government's reac­tion to last year's demand shock has been to increase its own lever­age. But, with the econ­omy oper­at­ing at its zero-hour, we believe this incre­men­tal lever­age will actu­ally have a neg­a­tive impact. That is to say, the pub­lic sec­tor will fail in its attempt to bring the econ­omy back to its pre­vi­ous level of nom­i­nal GDP. In this sce­nario, the out­come will dis­ap­point the market's expec­ta­tions, which are ram­pantly bull­ish as evi­denced by this year's dra­matic re-pricing of risk assets.

This zero-hour for Amer­ica has per­haps arrived sooner than many had antic­i­pated. It was her­alded by the Japan­ese expe­ri­ence. Japan is the bogey­man that con­fronts all aca­d­e­mic thinkers, regard­less of creed, from Krug­man to Fer­gu­son, as well as all who would choose to inter­vene in the work­ings of the econ­omy. In a debate I had with Mr. Fer­gu­son in Lon­don last month, he claimed that Japan was an extreme out­lier and could be ignored. Really?

No sex, no drugs, no wine, no woman, no fun, no sin, no won­der it's dark
Every­one around me is a total stranger.
Every­one avoids me like a psy­ched loan-ranger
That's why I'm turn­ing Japan­ese,
I think I'm turn­ing Japan­ese,
I really think so

The Vapors, 1980

Adver­tise­ment

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Japan has cham­pi­oned both Fried­man and Keynes. They have built bridges to nowhere and dropped Yen notes from heli­copters for twenty years and still they have noth­ing to show for it. Clearly the addi­tional return from Yen debt in Japan is close to zero and it exposes the night­mare of inter­ven­tion­ists every­where: it may just be that there are no pol­icy reme­dies for a debt defla­tion. So to elab­o­rate fur­ther, our chances of finan­cial suc­cess are great­est under con­di­tions where investors believe gov­ern­ment spend­ing will suc­ceed but in real­ity it fails.

How­ever, where will the demand for all of this addi­tional gov­ern­ment debt come from? Let us review the Fed's Z1 num­bers. The US has house­hold wealth of some $67trn. Of that, $20trn is accounted for by real estate and is per­haps out of bounds for our pur­poses. But $8trn is held in the form of pri­vate pen­sions and insur­ance funds. And yet, remark­ably, these insti­tu­tions presently allo­cate just $630bn to Trea­suries et al. House­holds have a fur­ther $22trn in time deposits and other finan­cial assets. But again they own just $500bn of Trea­suries, and com­mer­cial banks own a tiny $130bn or, 1% of their total asset base of $12trn.

Con­sider that in 1952, at the very end of the super­nova bond bull mar­ket formed from the ashes of the Great Depres­sion and the Lib­erty Bonds that financed the Sec­ond World War, US banks held 40% of their gross assets in Trea­suries. That is a poten­tial $5trn of demand from this one source alone, albeit spread out over a num­ber of years. And again, the Japan expe­ri­ence lends sup­port. Japan­ese finan­cial insti­tu­tions have quadru­pled the per­cent­age of their assets held in JGBs. Fur­ther­more, their house­holds have lifted their gov­ern­ment bond weight­ings five-fold over the last ten years. Should the same pat­tern repeat itself state­side, Amer­i­can house­holds would need to buy another $2.5trn, but again, over ten years.

And let us not for­get that a trend of ris­ing prices allied to the most basic human emo­tion of avarice encour­aged com­mer­cial banks and other finan­cial insti­tu­tions to buy $3.2trn of ques­tion­able mort­gage backed secu­ri­ties in 2004, $1.9trn in 2005, $2.2trn in 2006 and $2.1trn in 2007. So it is not incon­ceiv­able, at least in my mind, that finan­cial insti­tu­tions, and notable amongst them the nation's pen­sion and endow­ment schemes, could be moti­vated by another basic human emo­tion, namely fear for their own sur­vival, to snap up all these new gov­ern­ment bonds. Per­haps in the end sup­ply will cre­ate its own demand.

Again, it all really comes down to your take on the ratio of total debt-to-GDP. If you believe, like I do, that it peaked in 2007 then the reper­cus­sions are enor­mous. The lever­age does not nec­es­sar­ily have to come down (after peak­ing in 1932 at 300% it troughed 20 years later at 150%). Rather, it may well be that low inter­est rates allow the moun­tain of debt to con­tinue to be ser­viced. This has been the Japan­ese expe­ri­ence to date. How­ever, every­thing in our eco­nomic life exists at the mar­gin, and the con­se­quences of just main­tain­ing the lever­age con­stant would be a very low delta in nom­i­nal GDP growth. Con­sider that the Japan­ese, under these very cir­cum­stances, have man­aged to grow nom­i­nal GDP at just 1% com­pound since 1990.
In Bernie We Trust?
This is why China's mad dash for com­modi­ties and its invest­ment splurge this year is so wor­ry­ing. In my mar­ket­ing pre­sen­ta­tions I show a pic­ture of Mad­off super­im­posed on a dol­lar bill and ask, "...in Bernie we trust?" My point is that if the hedge fund fraud­ster had been given the respon­si­bil­ity for US GDP account­ing, he would surely have over­stated the fig­ure. And in a sim­i­lar way, the rise in lever­age has prob­a­bly mis­rep­re­sented the truly recur­ring nature of nom­i­nal GDP. Now, if we repeat the Japan­ese expe­ri­ence then it is pos­si­ble that nom­i­nal US G DP will rise from $14trn today to per­haps just $16trn in ten years time. Along sim­i­lar lines, the Ger­man gov­ern­ment does not antic­i­pate its econ­omy exceed­ing its pre­vi­ous GDP high until 2014. And yet it is as though the other sur­plus coun­tries are behav­ing like Bernie's for­mer investors who, believ­ing in the stated NAV and its promise of more of the same (i.e., pre­dictable and attrac­tive com­pound growth rates), were happy to spend lav­ishly. The Chi­nese are build­ing capac­ity to meet a world where US nom­i­nal GDP is $25trn in ten years time. I fear they could be in for a nasty shock.

What Do I Mean?
Con­sider the steel mar­ket. The homo­ge­neous nature of steel, as well as other fac­tors such as its price-to-density, allows for the export of the fin­ished good across trade bound­aries. Now with China hav­ing been on such an expan­sion­ary tear, it may not sur­prise you to hear that fin­ished Chi­nese steel prices today trade below their pro­duc­tion cost. Fur­ther­more, import license appli­ca­tions to sell steel in the US, the world's largest export mar­ket, rose 24% last month. Now, mostly this comes from Mex­i­can and Korean pro­duc­ers, but clearly there is the implicit threat that their Chi­nese com­peti­tors might also be tempted.
But the Econ­omy is Grow­ing?
Clearly it would be inap­pro­pri­ate to annu­alise the pro­duc­tion of the US steel indus­try in the fourth quar­ter of last year when capac­ity util­i­sa­tion plum­meted to just 32%. So con­sider, instead, the annual run rate this year from Jan­u­ary to August. This was a period of sta­bil­i­sa­tion in tan­dem with the cash-for-clunkers pro­gram, which boosted the industry's largest cus­tomer, the car sec­tor. It is quite chill­ing to note that steel pro­duc­tion in Amer­ica is on a par with out­put back in 1938, when GDP was a mere 7% of its cur­rent size. The industry's run rate dropped to a pal­try 13% dur­ing the Great Depres­sion. How­ever, out­put only troughed at its 1908 level; a twenty year retrace­ment that is a far cry from our 70 year retrace­ment. So the phys­i­cal devel­op­ments in the west­ern steel mar­kets should raise some con­cern. How­ever, with an active steel futures mar­ket in China turn­ing over $15bn a day (con­sult the Bloomberg page <RBTA CMDY CT>), spec­u­la­tive fears con­cern­ing the dol­lar have over­come the paucity of indus­trial demand in the west.

Adver­tise­ment

Of course, it is not just steel. Con­sider the alu­minium mar­ket. We recently had a very bear­ish meet­ing with the Nor­we­gian com­pany Norsk Hydro. Admit­tedly, their strong petro-currency does not help and you have to dis­count the solace I seek in find­ing peo­ple even more mis­er­able than myself. Even so, the alu­minium sit­u­a­tion mim­ics that of steel, but with an even might­ier inven­tory over­hang. Four and a half mil­lion tons reside at the Lon­don Metal Exchange, per­haps 20% of world ex-China annual capac­ity. It is prob­a­ble that 75% of this sur­plus stock is accounted for by finan­cial play­ers exploit­ing a contango.

Does Life Imi­tate Art?
The advo­cates of Prechter's socio-economics would not be sur­prised to hear that the Roman­ian writer Herta Mueller has been awarded this year's Nobel Prize for lit­er­a­ture for her work depict­ing "the land­scape of the dis­pos­sessed". In a Los Ange­les Times review of her book, The Appoint­ment, they noted,

"...it is some­times dif­fi­cult to tell whether we are read­ing about peo­ple dri­ven mad by a mad régime or peo­ple who may not have had all their mar­bles in the first place."

My part­ner, Mr. Lee, reflected on this as he sat in the chilly offices of Norsk Hydro last week watch­ing the snow fall out­side. The Nor­we­gians con­tin­ued with their tale of woe: a cou­ple of mil­lion tonnes of inven­tory remains unac­counted for on the world stage and are believed to be hid­den in cheaper ware­houses in Rus­sia. The ratio­nale behind this is the same as the ratio­nale used by LME spec­u­la­tors. Fur­ther­more, the big Russ­ian play­ers like Rusal are under intense pres­sure from Putin not to cut capac­ity (check out 'Putin bitch slaps Deri­paska' on http://www.youtube.com/watch?v=PprlM5R3Hbg), and are rumoured to be sur­viv­ing only by not pay­ing their elec­tric­ity bills.

To make mat­ters even worse, the Chi­nese have stopped import­ing and are eager to ramp up domes­tic alu­minium pro­duc­tion. They havethe capac­ity to pro­duce another 13mt annu­ally, which is equiv­a­lent to 52% of global pro­duc­tion. Lastly, there is the fact that Rio Tinto bought Alcan right at the very top of the cycle, though they dare not admit it is a ter­ri­ble busi­ness.
Poor Old Norsk Hydro?
Who would want to share a stage with so many mad vil­lains? The Nor­we­gians noted that con­struc­tion demand had just taken another leg down as build­ings started pre-crisis are now fin­ished whilst no fur­ther pipeline exists out­side of China. Even Ryanair are talk­ing about sus­pend­ing their aggres­sive growth plans and may delay the pur­chase of more planes.

The Nor­we­gians suf­fer the most pain at present, but if the dol­lar were to strengthen Alcoa could con­ceiv­ably go bust. Their dol­lar cost is the company's only com­pet­i­tive advan­tage. Let us not for­get Alcoa has the most expo­sure to air­craft con­struc­tion and still has $10bn of gross debt lord­ing over an almost equiv­a­lent mar­ket cap. Imag­ine that we have not even con­sid­ered their pen­sion lia­bil­i­ties. Yet the Alcoa CDS trades at 200 basis points, down from its high of 1200 ear­lier this year. Why?!

"May sor­row break these chains of my suf­fer­ings, for pity's sake"

Las­cia ch'io pianga
Handel

Now remem­ber I have been describ­ing a pos­i­tive macro sce­nario: a world in which low inter­est rates make the debt load man­age­able and that we mud­dle through with lower growth rates in nom­i­nal GDP. But clearly the con­se­quences for cor­po­rate prof­itabil­ity are very poor. The alarm­ing thing is that my oppo­nents (see Fer­gu­son et al.) believe that gov­ern­ment bond yields are going much higher. Effec­tively, the world's bond vig­i­lantes are going to pun­ish the Fed and tighten mon­e­tary pol­icy. It is almost as if the world's great­est spec­u­la­tors are agi­tat­ing for their own demise. It is my con­tention that the lever­age of the econ­omy is only ten­able if inter­est rates stay low and yet, whilst I believe some of them agree, they still fer­vently expect a rise.

Je con­sens, ou plutôt j'aspire à ma ruine.

Pierre Corneille
Polyeucte, 1642

Do not for­get that the US does not share the dis­tinc­tion of the British or Aus­tralian hous­ing mar­kets. Accord­ing to FSA data, 55% of UK mort­gages are fixed rate and 45% are float­ing. The lat­ter have, of course, col­lapsed and have proven a boon for dis­pos­able income. We must remem­ber, how­ever, that British fixed rates are deter­mined by two and three year swap rates; so effec­tively the entire stock of UK mort­gages are deter­mined by the cen­tral bank and could be thought of as float­ing. In the US, how­ever, things are very dif­fer­ent. Total single-family mort­gages out­stand­ing are $11trn but $9trn is fixed to the pre­vail­ing 30 year Trea­sury yield. Banks just do not offer vari­able rate or teaser mort­gages any­more. You might say that the Amer­i­can hous­ing mar­ket hangs by the ten­der threads of the bond market's gen­eros­ity. Lose it, and let us say that the mar­kets demand 6% yields on 30 year dura­tions and mort­gage rates would then shoot back up to 7%. And, I would argue, the econo my would come to a crash­ing halt. Do spec­u­la­tors really want this to happen?

Per­haps I am describ­ing a pres­sure cooker. The pri­vate sector's debt may be sus­tained by main­tain­ing low nom­i­nal inter­est rates.But the pres­sure from so much issuance at a time of great reluc­tance from finan­cial insti­tu­tions to pur­chase bonds could break the stale­mate. And with it the omi­nous prece­dent of 1931, out­lined in our Feb­ru­ary report, when a back up in ten year Trea­sury yields from 3.1% to 4.4% undoubt­edly accel­er­ated the rate of defla­tion in the US economy.

Con­clu­sion and Invest­ment Review: The Augus­tus Gloop Song

Oompa loompa doom­pety doo I've got a per­fect puz­zle for you Oompa loompa doom­pety dee If you are wise you'll lis­ten to me What do you get when you guz­zle down sweets Eat­ing as much as an ele­phant eats What are you at, get­ting ter­ri­bly fat What do you think will come of that...

Oompa loompa doom­pety da If you're not greedy, you will go far Char­lie and the Choco­late Fac­tory Roald Dahl, 1964

I now return to Japan. Some­times I find myself sound­ing like an apol­o­gist for Bernanke and big gov­ern­ment. In my debate with Mr. Fer­gu­son it was expected that I would rep­re­sent Paul Krug­man (yuck!) so let me attempt to clear any mis­ap­pre­hen­sions. I think our present lot of politi­cians and gov­ern­ment offi­cials are "filthy". There are no lim­its as to how far they are will­ing to go in order to pre­vent a mar­ket inspired liq­ui­da­tion of all the economy's rot­ten apples. After all, that is what defla­tion is all about. The gov­ern­ment insists it under­stands the pol­icy gaffes of the 1930s and has assured every­one that these will not hap­pen again.

I want to pun­ish them for this mon­strous non­sense and their intel­lec­tual arro­gance as much as you do. I want noth­ing to do with them. I want to watch them squeal as higher and higher gold prices rebuke their inter­ven­tion­ist ways. But I also want to make money; lots of money. I sim­ply do not want to do this in a man­ner in which my errors could cost the Fund a great deal of money and heart­break. So I fall back on my old argu­ment. It is per­haps too sub­tle, but at its core lies today's most per­ti­nent ques­tion. What if Bernanke, the Chi­nese, Putin, Obama, his Con­gress, and all the other inter­ven­tion­ists, are sim­ply impo­tent? What if they do not mat­ter? Per­haps it is the debt, stu­pid. Per­haps the incre­men­tal GDP from all of this addi­tional stim­u­lus spend­ing is zero. And, as Japan has fore­told, per­haps all of this year's inter­ven­tions will be unable to lift the global econ­omy from its funk. If this is so, you will not require all those infla­tion hedges; you have been sold a FAKE.

But first, it may require the spec­ta­cle of see­ing Japan implode and so we have been actively posi­tion­ing the Fund to profit from such a sce­nario. As many of you know, the fis­cal sit­u­a­tion in Japan is rapidly ris­ing out of con­trol. Gov­ern­ment tax receipts are down 14% over the last 12 months; gov­ern­ment spend­ing is twice the receipts and the trade sur­plus appears struc­turally impaired. We have to go back to 1991 to find the last time they ran a pri­mary sur­plus suf­fi­cient to meet their national debt's inter­est pay­ments. Today they would need the equiv­a­lent of 4.4% of GDP. Fail­ing this, and assum­ing they do not shorten the debt matu­rity of the JGBs that they sell to the pub­lic, then the ratio of pub­lic debt to GDP is guar­an­teed to rise fur­ther. It is cur­rently 196% of GDP with the IMF esti­mat­ing that it will rise to 234% by 2014.

This sit­u­a­tion has not gone unno­ticed. The sov­er­eign dol­lar default swap has dou­bled to 75bps since August, and Japan is now the most expen­sive credit to insure against a dol­lar default in the G10. How­ever, we have been active buy­ers of cor­po­rate debt default swaps. We find it remark­able that one can insure highly lever­aged util­i­ties at 23bps despite their con­sid­er­able yen debt. Con­sider the Tokyo Elec­tric Power Co. (9501 JP) with a mar­ket cap­i­tal­i­sa­tion of $32bn and net debt of $81bn. The debt is 7x EBITDA, the inter­est cover is 1.9x, and the aver­age inter­est cost for now is thank­fully just 1.9% p.a.

The Japan­ese gov­ern­ment has been sen­si­ble in one area; two thirds of all their JGB issuance has been in matu­ri­ties of ten years or more whereas the US has a skew to shorter dated issuance. How­ever, it is prob­a­ble that the pub­lic sec­tor in Japan is crowd­ing out the pri­vate sec­tor from the long end, for whilst only 24% of the gov­ern­ment debt is of 2–5 year matu­rity, the cor­re­spond­ing fig­ure for the util­ity com­pany is 57%. Fur­ther­more, they are depen­dent on 70% of their debt being sourced from non-banking sources, i.e., from the mar­ket place. Clearly there are two promi­nent risks: debt rollover and higher inter­est rates. The "cheap" risk is a nor­mal­i­sa­tion of inter­est rates brought about by a dearth of buy­ers at these lev­els. Should Tokyo Electric's inter­est cost dou­ble to 4.6%, the company's EBITDA-less-CAPEX would just cover the inter­est bill. What cost would credit under­writ­ers insist for the CDS in this scenario?

We have a notional expo­sure rep­re­sent­ing almost 40% of the Fund's NAV. It rep­re­sents a large notional risk expo­sure with a quan­tifi­able and man­age­able down­side loss of just 9 bps of the Fund's NAV every year for five years. How­ever, the poten­tial return to the Fund in the event of a default would be 23% of NAV, or 250x our annual out­lay. Whilst we would still make 1% point of NAV should it trade in line with the sov­er­eign credit risk, or 1 0x our annual cost. We might get rich but we cer­tainly will not die tryin'.

The above is typ­i­cal of our port­fo­lio today. Gone are the cav­a­lier days of large gross expo­sures across mul­ti­ple asset classes and large monthly volatil­ity. Instead we own a bas­ket of cheap sov­er­eign and cor­po­rate default swaps and the asym­me­try of inter­est rate option pack­ages which enjoy high pay-offs should the enor­mous debt load of the pri­vate sec­tor keep rates lower for longer. I began this lengthy let­ter quot­ing from Keynes' Eco­nomic Con­se­quences of the Peace. With the ben­e­fit of hind­sight, future his­to­ri­ans might con­clude that the major blun­der of last year's bailout was the fail­ure to reduce or even address the economy's debt bur­den. If this turns out to be the case, I believe that the Fund is well posi­tioned to make money.

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