The 2nd Half of 2016: Nationalism & Political (In)stability

It’s a beautiful, blue skied Saturday morning where I am. Yet I can’t shake off a general sense of unease I’m feeling… It’s not the Turkey coup situation or the French mass murders (on Thursday) alone… for me, it’s a (growing) pattern of incidents I loosely see as symptomatic of the rise of nationalism and political instability.

The fruit of my labor is not a result of merely my own labor

It almost feels wrong to be enjoying life, and living in a land that is so abundant (relatively) in peace and prosperity, while my fellow human being suffers so much. I did not choose where I was born; I did not choose WHEN in history I was born; I did not choose my parents, the household  conditions…and so on, and so forth. No one has. It seems quite unfair that all these characteristics – that I had no control over – account for most of who and where I am today. Yes, I have worked hard (sometimes). Yes, I have been smart/skillful (less than sometimes). But who am I kidding? My success is not merely my own – it is the sum result of many factors, most of which I had no control over.

And so I find it difficult to be enjoying myself when so many other human beings – fellow brothers and sisters of the human race – are suffering for reasons beyond their own decisions.

I have actually felt this sense of unease for the last 5-6 years…I would occasionally tell friends that I fear that a good portion of our remaining adult lives may be filled with far more human tragedy. That we face high risk of war, that the peace/tranquility we Americans have been blessed with for the last 30 years is not the norm, at least from the vantagepoint of human history.  A certain financial/political researcher I follow correctly anticipated the rise of political instability / war risk, specifically pointing to 2015 Q3 as the beginning of a cycle.

Being right does not bring comfort. I hope I am wrong.

Growing Unease, Nationalism, Political Instability and Financial Markets

I feel almost wrong thinking about how this growing unease impacts financial markets. Should I not mourn for those in suffering? Perhaps. But in times like these, I also feel a responsibility to live life abundantly – to live life with a sense of gratitude, purpose and meaning.

it seems the best way to honor the deceased and the suffering.

The sum result on financial markets is not immediately clear, especially as it relates to US financial markets. What is clear(er) to me is the growing importance of global macro, or at least understanding how global macro impacts one’s investment strategy. Specifically, I will be surprised if the following are NOT true, going forward:

  • (Continued) Record-breaking bi-directional macro volatility
  • Confusing, inconsistent, and sometimes outright non-sensical correlations between headline political instability/violence versus financial markets price activity

The 9/11 Risk

A friend of mine who has been a global macro speculator since the mid 1990s considered 9/11 far scarier than 2008. 2008, at least from a global macro perspective (in his view), was predictable. 9/11, as it pertains to financial markets implications, was not.

Another friend (an ancient whose career precedes the macro friend’s by more than a decade) described October 1987 in similar terms – he was not sure if his fund’s positions would clear that week. He feared that his brokers/banks would fail.

Perhaps Brexit was that for us in 2016 (except that it was a very well broadcasted event). Or perhaps Brexit is a sneak preview.

Either way, here are the implications I see:

  • 9/11 and October 1987 are not predictable. Outright positioning for one seems a waste of time and capital. Mental preparation for one seems a good use of time.
  • Their impacts on medium/long term fundamentals and financial market trajectory afterwards is similarly unpredictable.
  • Namely, 9/11 eventually was followed by recession/equity bubble crash. 1987, on the other hand, was a blip in the continued US bull market. Bottom-line: the 9/11, 1987 risk is not long-term bullish or bearish for risk assets.

 

2016 so far has been quite the year of statistically significant price action:

  • All-time highs in the quantity of negative yielding bonds. All-time lows in interest rates, record-breaking YTD capital appreciation.
  • Greatest GBP one day decline in history.
  • The S&P500 and USTs tested record highs and lows (yields) respectively on the same day…for the first time in history.
  • multi strategy hedge fund performance – see January/February period.
  • Various records broken in rapid changes in volatility.
  • Top 1-3 peak to trough declines in oil (through late January).
  • Greatest one-day decline in Spanish equity market history

I expect the 2nd half of 2016 to continue with record breaking market activity.

Parsing Soros’ comments on Europe

Yesterday, George Soros published an op-ed titled: Brexit and the Future of Europe on Project Syndicate. As Soros’ public statements tend to be

  • Misquoted or taken out of context
  • Misunderstood
  • Even occasionally dismissed as the rabble rousing of an old man

I will document my interpretation – a parsing – of his latest comments. The purpose of this writing is for my own benefit – as a journal of sorts (so I can look back in the future to see if was right or wrong) … and to benefit anyone who has eyes and ears to learn.

And yet that was not enough to stop the United Kingdom’s electorate from voting to leave. Why? The answer could be seen in opinion polls in the months leading up to the “Brexit” referendum.

Translation: You morons completely misinterpreted or dismissed my Guardian Op-ed that I wrote days before the Brexit vote. The likelihood and risk of a Brexit were evident to those dispassionately paying attention to the ground level realities. In fact, I wrote: “My 60 years of experience tells me the pound will plummet, along with your living standards.” But you arrogant fools dismissed me as a “has-been” octagenarian. And those of you inattentive to detail ignored my explicit prognostication. You arrogant fools also ignored the fact that, like 2006-2008, this time I turned off the “auto-pilot” program running Soros Fund Management – and I switched back to manual.

Now the catastrophic scenario that many feared has materialized, making the disintegration of the EU practically irreversible. Britain eventually may or may not be relatively better off than other countries by leaving the EU, but its economy and people stand to suffer significantly in the short to medium term. The pound plunged to its lowest level in more than three decades immediately after the vote, and financial markets worldwide are likely to remain in turmoil as the long, complicated process of political and economic divorce from the EU is negotiated. The consequences for the real economy will be comparable only to the financial crisis of 2007-2008.

Translation: The EU has been in a fragile state for several years – the 2010-2011 volatility in European sovereign debt markets were a very clear warning sign. But those EU-related concerns abated at the end of 2011 (though not fully disappearing)… in all likelihood, Brexit is the needle that will “break the camel’s back” (i.e. lead to disintegration of the EU). Contrary to the doom and gloom media headlines (and even some of my earlier rhetoric in the Guardian) claiming that this will destroy Britain’s economy, Britain’s economy may actually be relatively better off long-term by leaving the EU. The immediate consequences, however, appear negative for its economy and its people.

The odds that financial markets globally remain in turmoil exceed the odds they do not; however, like 2007-2008,  this may lead to counter-intuitive market price levels – and very violent, unpredictable paths – across all assets.

That process is sure to be fraught with further uncertainty and political risk, because what is at stake was never only some real or imaginary advantage for Britain, but the very survival of the European project. Brexit will open the floodgates for other anti-European forces within the Union. Indeed, no sooner was the referendum’s outcome announced than France’s National Front issued a call for “Frexit,” while Dutch populist Geert Wilders promoted “Nexit.”

Translation: My Guardian Op-ed may have been a bit deceiving (though not intentionally), in that my fears have always been about the risk of EU dissolution, not  fear of the UK’s future.

But the implications for Europe could be far worse. Tensions among member states have reached a breaking point, not only over refugees, but also as a result of exceptional strains between creditor and debtor countries within the eurozone. At the same time, weakened leaders in France and Germany are now squarely focused on domestic problems. In Italy, a 10% fall in the stock market following the Brexit vote clearly signals the country’s vulnerability to a full-blown banking crisis – which could well bring the populist Five Star Movement, which has just won the mayoralty in Rome, to power as early as next year.

Translation: Yes, I believe Brexit will hurt the UK’s economy in the near term. However, if Brussels has a punitive attitude/approach to Brexit (i.e. try to “make an example” of the UK for purpose of deterring other EU countries), that will actually backfire against Brussels. Case in point, Italy. Brussels, you better be careful not to treat the UK as you did Greece.

All of Europe, including Britain, would suffer from the loss of the common market and the loss of common values that the EU was designed to protect. Yet the EU truly has broken down and ceased to satisfy its citizens’ needs and aspirations. It is heading for a disorderly disintegration that will leave Europe worse off than where it would have been had the EU not been brought into existence.

Translation: Some of you conspiracists may see me as an elitist, “New order” puppetmaster, blind and callous to the plight of the masses. Actually, I am fully aware that the EU has and is not acting in the interest of most its members’ citizens. It does not make me happy at all…don’t forget I am a survivor of a far darker period in Europe’s history. I am concerned that the EU’s member nations and its citizens may end up worse off in coming years, versus the counterfactual scenario where the EU had never existed. Yes, to put it bluntly: the EU may end up a failure.

But we must not give up. Admittedly, the EU is a flawed construction. After Brexit, all of us who believe in the values and principles that the EU was designed to uphold must band together to save it by thoroughly reconstructing it. I am convinced that as the consequences of Brexit unfold in the weeks and months ahead, more and more people will join us.

Translation: Yes, the EU might prove to be a mistake. It is inherently a flawed construction. But it is still worth fighting for. I may not have specific policy prescriptions, but recall that I earlier implied that a punitive approach by Brussels will be counter-productive. That is the wrong approach. It would not be consistent with the values and principles the EU was designed to uphold.

I’m cautiously optimistic that if the aftershocks of Brexit don’t dissipate in coming weeks/months – rather, escalating(i.e., in financial markets, the real economy, and overall peace) – more people will seek to preserve/reconstruct the union, but with more conciliatory attitudes and approaches. A punitive approach by Brussels will lead to the dissolution of the EU. A conciliatory one may lead to a EU 2.0.

Additional Thoughts:

  • I found a certain Vic Niederhoffer’s public heckling over Soros (few weeks ago) rather amusing and…ironic.
  • Soros’ comments must be analyzed from global macro and game theoretic lenses.
  • This past week is a key inflection point in attitude of the casual Soros bashing market participant – their knee jerk reactions up to now might have been to ‘fade’ (i.e. bet against) any Soros related headline (without reading/listening to his actual words). The behavior may now switch, until there is some sort of market climax/resolution.

Black Friday: Spain’s Biggest One-Day Drop in its History

Yesterday, Spain’s equity market – as measured by its IBEX-35 – experienced its largest single day decline in in its history (the index was launched in 1992). The IBEX-35 fell 12.4%. The previous record (for largest daily decline) was 9.14% in 2008. Italy’s equity market fell by similar magnitude, but it is not clear if yesterday’s decline broke the record for a single day decline in Italian equities.

The decline in Spain’s stock market wasn’t quite as steep as Black Monday’s crash (Monday, October 19, 1987), when the Dow fell 22%. But a 12.4% decline is most definitely a rare event…a statistically significant event.

 

2016: The Halftime Report – Purchasing Power & the Case for Active Management

“On one point only were economists agreed. Without exception those consulted say: ‘There is no sure hedge against inflation.’ ” – Hedging Against Inflation

2016’s midpoint is fast approaching. The following has occupied my mind for the first half :

INFLATION, DEFLATION, AND PURCHASING POWER

The “Inflation” vs “Deflation” trade(s) – January 1 through early February of this year was (largely) defined by the “deflation” trade(s)…indeed, if you examine the hedge fund performance figures through early February, you see that the best performing funds had high exposure to “deflation” trade(s). Since mid-February, the “inflation” trade(s) have been where capital has been (mostly) rewarded…that is, until the last 2-4 weeks.

At this juncture, the inflation bulls believe we are experiencing a pause/counter-trend before the inflation trade(s) resumeth. The deflationistas, on the other hand, appear to believe the February – April rally in the “inflation trade(s)” was largely driven by a pro-longed short squeeze coupled with explicit/implicit coordination between US and China (specifically as it relates to fx).

Either way, I see only one truly superior risk/reward trade (and the rest are terrible in comparison), with respect to the “inflation” and “deflation” trade(s). That is where I should and/or will devote most/all my energies/capital when it comes to the inflation/deflation framework.

This “truly superior risk/reward trade” I mention may prove to resemble going long the JPY in 2014.

Purchasing Power – In terms of trading/speculation, ‘inflation’ and ‘deflation’ hold concrete/actionable meaning for me. In terms of economics, I don’t know what ‘inflation’ nor ‘deflation’ mean anymore.  The economic measures of inflation/deflation don’t make sense to me.

For example, the medical care component of CPI only shows an aggregate increase of 15% since 2011…yet I know for a fact premiums have risen far more than that over the last 5 years (more like 10% CAGR over 5 years!).

On the other hand, ‘Purchasing power’, makes sense to me.

 

Purchasing power erosion

I know that the overall (domestic) purchasing power for most individuals/families in America is lower today versus 10 years ago, and 20 years ago. I know that the purchasing power of most residents in New York and San Francisco have dramatically eroded over the last 5 years.

Purchasing power accretion

I also know that most Americans’ purchasing power with respect to buying foreign goods/services have dramatically improved over the last 1-2 years (due to the strength of the $).

Technology has also improved purchasing power for us all, in some specific ways (e.g. smartphones). Yet the economists call this ‘deflationary’ (almost as if it’s a pejorative). I consider this ‘progress’.

I estimate that ‘purchasing power’ will matter in more obvious ways in coming years.

I believe that “they” want inflation… the “they” I’m referring to are government and central banking officials with fiscal and monetary policy responsibilities. The following lead me to believe that “they” want inflation:

  • “They” know that debt is a problem.
  • “They” know that history suggests that large (but not excessive) inflation is the least socially disruptive means to address the debt, so long as the inflation concurrently increases cost of living and wages in similar orders of magnitude.
  • “They” probably would prefer relatively steady 5-15% true inflation, versus 2%-3% they claim as objectives, so long as the 5%-15% inflation doesn’t spiral upwards.
  • “They” don’t mind eroding the balance sheets of savers and the wealthy, so long as they can preserve / minimize damage rendered to real wages.

The question remains whether “they” will succeed in “creating” inflation…I for one don’t know. Inflation is not inevitable, as “they” can elect (instead) to severely raise taxes, severely cut spending, debt jubilees, etc. No path is inevitable. Also, on a more optimistic note, further innovation/technology advances may improve productivity in coming decades, which would only help the real economy.

THE CASE FOR ENTREPRENEURIAL ACTIVE MANAGEMENT

 

I’m uber-bullish Active management…and concurrently bearish the current hedge fund paradigm – The sentiment towards active management, specifically (but not only) aimed at the 2/20 crowd, is (justifiably) very negative. Alternative investors have performed rather poorly over the last few years.

The incentive fee component does not seem the problem – it’s the management fee component. Perhaps limited partners should demand a refund for all the management fees paid for abysmal performance, a la a ‘clawback’.

Yet I see the seeds for future active management outperformance. The “risk/reward” in going “long” active management is skewed in favor of active management. A key driver (i.e. a necessary condition) for active management seems to be firmly in place.

Returning to Hedge Fund Entrepreneurial Roots

While I consider myself (uber)bullish active management, I doubt the extraordinary returns will originate from the well-known, worshipped, investment conference-frequenting, mult-billion $ aum hedge funds. Rather, they will hail from the:

“crazy ones. The misfits. The rebels. The troublemakers. The round pegs in the square holes. The ones who see things differently.”

My belief is not without precedent: recall that hedge funds were defined by the misfits, troublemakers, etc. until fairly recently (i.e. the last 10-15 years). For example:

  • A sociologist turned diplomat turned journalist became the ‘father of hedge funds’ (Alfred Winslow Jones)
  • English major turned taxi driver turned macro hf manager (Caxton)
  • Academic/professor turned trader turned greatest investor (Rentech)
  • Academic turned casino ‘gambler’ turned hf mgr (Thorp)
  • A crew of high school + college dropouts turned alpha machines (Feshbach)
  • Medical student dropout turned excellent/exceptional investor (Icahn)
  • Medical resident dropout turned message board legend turned investor

The “institutionalization of hedge funds” have only served to place returns in institutional strait-jackets.  The institutionalization of hedge funds have castrated hedge funds of their very essence, replacing them with sterile qualities that bureaucrats would love, e.g.:

  • Accreditation/pedigree vs aptitude
  • Pro-cyclical behavior
  • Mediocre / loser mentality, i.e. hug the indices and think like mutual funds…but get paid like hedge funds.
  • Dis-incentivizing long-term decision-making, and true investment-oriented thinking and behavior.
  • Dis-incentivize those with entrepreneurial leanings, incentivize those with bureaucratic leanings.

“I think you are like us. You are one of the pirates, and I’d like you to join my ship.” – Crispin Odey

 

Regime Change(s) in Financial Markets and Politics

The phrase ‘regime change’ appears apt when describing the present state of financial markets and politics…worldwide. A few considerations that come to mind:

Financial Markets

  • The Federal Reserve / Janet Yellen would like to lead the US and the world out of the post 2008 monetary maneuvers (e.g. QE, ZIRP, NIRP, etc). The Fed’s wishes have been complicated by the BOJ, ECB, market reactions to the BOJ, ECB.. and other forces. Monetary regime change (?)
  • The on-going construction and related credit bust in China remain on-going…coupled with counter-cyclical policies e.g. tax cuts, market liberalization, etc. Forced/necessary/desirable economic rebalancing, i.e. regime change (?)
  • Record level of NIRP-related debt outstanding, as well as record-breaking negative interest rates. FX considerations aside, the marginal non-Central Bank buyer may at some point question the notion of providing negative-carry debt capital to governments that refuse to structurally reform. Not to mention what to make of insurers, pensions, etc. that require payouts.
  • Calls for banning cash by… non-law enforcement figures, such as Larry Summers, Mario Draghi, etc.
  • US housing in NYC/SF/DC face downside risks due to notable affordability problems. Housing in rest of the USA, and demographic drivers,look reasonably healthy. Real estate is local again? Regime change
  • Private tech/VC valuations marked down, but deal volumes remain at same (if not higher) levels versus YoY.
  • “only 1 of the 10 largest banks in Texas survived” re: late 1980s …something to think about, especially coupled with fact that banking/credit/employment related implications of energy bust have LAGGING EFFECT. (I’m not necessarily fixated on Texas per se…it’s a case study/analogy on causation).
  • “Trafigura estimates that the world’s 10 top commodities hedge funds now manage $10 billion altogether, a fifth of what they did in 2008.” Yes, as the joke  “what is down 80% can go down 90%, as the joke what is a stock that has been cut in half?
  • Wages are rising. Signs are widespread. This is a significant paradigm shift… concurrently, usage of automation/robotics something to watch.
  • The market has been experiencing the ‘other side’ of a bear market in recent weeks. ‘Leadership’ has differed from prior years.

Politics

  • Rise of Nationalism. Pretty much everywhere.
  • Trump is winning. Bernie Sanders Super Tuesday results disappointing. The loudest Trump critics appear to misunderstand him and his fans. No matter, both point to regime change. Note that “regime change” in Asia and Europe before the modern era, were often accompanied by executions.
  • Supreme Court, replacement for Antonin Scalia.
  • Regulatory enforcement is rising (after decade-low levels of white collar fraud enforcements through 2013/2014″ e.g. Valeant Pharmaceuticals. Regime change.
  •  Europe – Brexit, Spain (Visca Catalunya), threats to Schengen, etc.
  • China – Xi regime gives off the impression of a more nationalistic tone.

 

The above lead me to believe that we are transitioning from one state to another… methinks the ‘regime change’ may resemble the transition from the dot com bubble/bust to housing bubble/bust. We’re somewhere in between two different regimes.

China Government Bonds

The following got my attention:

  • The People’s Bank of China said in a statement on its website Wednesday that most types of overseas financial institutions will no longer require quotas to invest in the interbank bond market, which accounts for the bulk of debt in the nation.
  • Commercial lenders, insurance companies, securities firms and asset managers were included on a list of those eligible and the authority said it also hopes to attract long-term investors such as pension funds and charities.
  • Hedge funds were not included, while foreign central banks and sovereign wealth funds won access in June.
  • Bonds outstanding in China totaled 48.8 trillion yuan ($7.5 trillion) at the end of December, according to the central bank.
  • The interbank market totaled 35 trillion yuan at the end of January
  • Foreigners held less than 2 percent of this, ChinaBond data show.
  • China’s 10-year sovereign yield of 2.87 percent compares with 1.69 percent in the U.S., the world’s largest bond market, and sub-zero in second-ranked Japan.

source: http://www.bloomberg.com/news/articles/2016-02-24/china-opens-bond-market-to-foreigners-as-outflows-weaken-yuan

George Soros and 1987: when your longs & shorts BOTH go against you

I can relate to situations where all my positions went against me…and I’m sure some participants can relate to that as well YTD. So imagine the following scenario:

It’s 1987 and you’re the Quantum Fund:

  • Soros’s team was up ~60% by the end of September, 1987
  • Quantum was positioned short Japan but long the U.S. market.
  • On October 14 Soros published an article in the Financial Times reaffirming his view that the crash would arrive in Tokyo.
  • That day, followed by the 15th and 16th, US equities declined precipitously.
  • October 19, went down in history as Black Monday. The Dow Jones index lost 22.6 percent of its value. Soros, having been short Japan (Nikkei index fell too), was hedged.
  • US equities rallied Tuesday and Wednesday.
  • Later in the week (Wednesday) however, the nikkei-related short (structured via futures in HK, due to greater liquidity in that market) position INCREASED in value by 9.3% (its biggest one day gain since 1949). He had wanted to get out of these contracts, but HK halted them.
  • US Futures declined on Thursday…and Soros sold us futures.. his position sizing was too large, exacerbating the move down.
  • In roughly a week, Quantum had gone from being up 60 percent for the year to being some 10 percent down; $840 million had vanished.

 

A week or two after Black Monday, Soros spotted an opportunity to short the dollar, and he put on a gutsy, leveraged position as though nothing untoward had happened. The dollar duly fell, and the gamble paid off. Quantum ended 1987 up 13 percent, despite having languished in the red only two months earlier.

Source: More Money Than God by Sebastian Mallaby

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