• Embed Doc
  • Copy Link
  • Readcast
  • Collections
  • CommentGo Back
Download
 
THE ECLECTICA FUND
FUND MANAGER COMMENTARY 
JUNE 2009
Warning, I am about to repeat myself
I have been keeping a low profile and have reduced the length ofmy reports. There has been little to note: my favourite assetclass is long duration bonds; not index linkers. These have performed poorly so far this year. I have not fought this trendaggressively. By March I had rebuilt a modest sized position owing to the severity of the weak economic data. However this was mostly eliminated by the first week of April out of respect for the formidable price correction that was ongoing. As a resultthe Fund is down modestly on the year to date following last year’s surge. However, with the long bond yield in America nownot far off 5pc, it is my contention that the trend may be approaching another extreme. I therefore thought it appropriate toonce more outline my thoughts: what if the trend in the charts below continues; what if this year is a re-run of last year? The decision to reduce the book in April reflected an unpleasantseasonality in our preferred trade. The second quarter in four out of the last five years has simply not been kind to risk aversion. Furthermore, markets continue to swing from the binaryoutcomes of inflation and deflation. At this point last year inflation was in the ascendancy. Backwards, forwards, since July oflast year the same investors had to adjust to profound deflationary forces as all risk asset classes fell precipitously. Can webe any more confident that the market has it right now?
Let's swallow a frog
I do not have the requisite level of confidence to make such a commitment. Better I would contend to always have a vividimage of the worst that might happen in our uncertain future andhave this shape our behaviour today. So let's consider the"bad things" which might initiate another dramatic rotation towards deflation.My greatest angst is reserved for the four-fold rise in private sector, non-financial, leverage in America. In just 60 years, theprivate sector increased its debt from 43pc of GDP to 175pc. To put this into perspective, the UK is on the verge of havingits formidable tax raising franchise downgraded because its debtmay reach 100pc in two years time. And yet, until last year,there was little hand wringing about the private sector having borrowed more than 4x the public sector’s then debt.Don’t get me wrong, I am sympathetic to the plight of America’s debtors. I understand why they came to believe that they were invincible. In truth, something without precedent occurred earlier this decade. Fearing the fall out from the tech bubble,businesses across all sectors of the economy set about cutting costs and laying staff off to prepare for the impending deeprecession. Unemployed workers should have cut back on spending and rebuilt their savings. Instead they leveragedthemselves against appreciating home prices to maintain their spending habits. Corporate revenues should have fallen.Instead, with disposable income boosted by home equity extraction, sales rose and profits boomed like no time before. Today, by comparison, the corporate sector is threatened not so much by its own debt but rather by the loss of spending inthe economy from the debt laden workers it has fired. Businessesare slashing costs and letting staff go. Americanunemployment is at a 26 year high of 9.4pc and total nominal wage payments have fallen for the first time in at least 50 years. This time around the economic orthodoxy is reasserting itself. Companies are discovering that in their quest to containcosts (by firing the economy’s consumers), they are suffering from a loss of revenue in future quarters; because of this I am wary of most prospective profit forecasts and not tempted by trailing 10 year earnings multiples.
Crude Oil ($) 2008 v. 2009 YTDMSCI World (£) 2008 v. 2009 YTD
60708090100110DecMarJunSepDec
Source: Bloomberg - Data SeriesRebased to 100
MSCI World 2008MSCI World 2009
 
20406080100120140160DecMarJunSepDec
Source: Bloomberg - Data SeriesRebased to 100
Crude Oil 2008Crude Oil 2009
 
THE ECLECTICA FUND
FUND MANAGER COMMENTARY 
JUNE 2009
My second concern relates to the willingness of governments to use their own leverage as a remedy for asset deflation. Policymakers seem to believe that the only way to reverse the tide in asset prices is to issue vast sums of ‘money-like pieces ofpaper’, aka government bonds. In doing so they are mimicking the previous decade when investment banks were able toboost the housing market by issuing trillions of dollars of mortgage backed paper, or the 1990s when it was new internet shareissuance which drove the TMT bubble and so on back to John Law and his endless printing of BanqueGénéralecertificates which financed the Mississippi stock bubble.However there is a glaring flaw. Government debt is very visible; certainly more so than the paper previously issued byinvestment banks. Increase the issuance of mortgage backed securities, from $0.5trn in 1996 to $3.2trn in 2003, and no onebats an eyelid; house prices boom. Suggest issuing a corresponding amount of Treasuries and the bond market quickly fearsinflation and frets over who will possibly buy all these bonds. Today bond prices are falling and there is the possibility thateconomic activity may be subdued by the rising cost of money. USmortgages are now dearer than at the end of last year.
Stimulus, what stimulus?
So prices are falling on the high street, total nominal wages are in retreat and yet the sovereign debt markets are in open revolton the premise that “inflation is always and everywhere a monetary phenomenon”. Panic has taken over. Marc Faber isasserting that the US will definitely have hyper-inflation, one investment manager recommends an 89pc balanced fundallocation to inflation-proof Treasuries and CLSA’sChristopher Wood is recommending that US pension funds hold 40pc oftheir portfolio in gold. In other words people are convinced that inflation is the future. What is less certain is when rising government bond yields beginto remove credit from the mortgage market and so close thedoor on the exit route of cheaper refinancing; today this is still seen as a distant prospect. The other pertinent question is whether “deficit nations”like the US and UK will be forced to moderate their ambitious spending targets. No one likes criticismand the reprobation of the German Chancellor and the Governor ofthe Bank of China must produce some soul searching;after all, central bankers are not renowned for their non consensual habits.I keep thinking that it would be ironic if history were to show that US policy makers were right to fear the prospects of a $54trillion debt deflation and that they should have been more ambitious in their monetary expansion. The bond vigilantes believethat the double dip deflation of the 1930s will ensure that the Fed will be slow to raise interest rates this time around. But whatif the economy stalls because the credit markets are premature in tightening monetary policy for them?I am beginning to sense another paradoxical twist. What if the Fed is right and Angela Merkel, Zhou Xiaochuan, Warren Buffetand James Grant are wrong? And that contrary to their inclinations the American authorities are forced to moderate their monetary expansion in order not to undermine the confidence of the international community. Whilst at the same time the bondmarket pushes long rates higher.Under such a scenario the debt reduction efforts of the private sector would usurp the government’s attempts at stimulus; theeconomy would falter once more. Back in 1931 the same thing happened. Bond prices dropped and yields rose to the levelthat had prevailed for the previous ten years; a feeble economy lapsed back into a deflationary spiral. Perhaps if this were tohappen again, and we were once more confronted by a truly dire economic outcome, then it is conceivable that the authoritiescould gain the vital legitimacy necessary to engage in an unquestionably large monetary response which finally purges thesystem of deflation. That is when I would choose to let rip on buying commodities and cheap equities. The key is the economy’s sensitivity to bond yields. Russell Napier argues that it would require ten-year yields of 6pc (vs. 4pctoday) to knock the economy and stock market from their perch and reassert the deflationary trend. But he bases his assertionon observations taken since the early 1960s. My quibble is that today’s leverage is unprecedented and prices are falling.May’s American CPI is forecast to contract by 0.9pc YoY; they fell in April. We never had falling prices in the 1960s, 70s, 80sor 90s. I therefore maintain that it is feasible that some unquantifiable but certainly lower nominal rate could choke theeconomy.Regardless, it is my contention that many are investing in risk once more almost oblivious to the notion that a heavily indebtedeconomy is confronted by a very real tightening of monetary policy. It is not inconceivable that the macro compass could swing violently towards deflation and wrong foot them again. Will it happen? As I suggested at the beginning, it really comesdown to whether we are trading in a groundhog version of last year. By last summer, oil had been bid up to $147 per barrel andmarkets were anticipating that central bankers like the Bank of England would be forced to raise (not cut!) rates by 200 basis points. The pressure was intense. I recall philosophicalconversations regarding short sterling; what did it really represent? And with oil spiking I was taking my gross long positiondown but replacing it with $200 call option premium; not $50 putstrikes. As Robert Prechterreminds his readers, “the news atturning points is just too strong for most people to act contrarily to it…fundamentals so intensely support the continuation of atrend just when it is ready to reverse”; meaculpa.
 
THE ECLECTICA FUND
FUND MANAGER COMMENTARY 
JUNE 2009
I have had cause to think long and hard about what caused the turnaround last July in the commodity spectrum. I believe thepersistent and government approved appreciation of the Yuan played a prominent role. Forget quantitative easing, I believe this was the printing press that propelled risk asset prices higher. Chinese speculators could borrow in dollars knowing that their loans could be repaid for less in their local currency. And whenthe US entered the global recession first, and began cuttingrates, the Chinese were emboldened to ramp up their overseas borrowing further; they had to buy something and as we knowoil went parabolic. But then the Yuan stopped appreciating. Perhaps the central planners didn't like spending so much oncommodities? I suspect it was more that they became fearful of their competitive position vis-à-vis the Koreans and other mercantilist trading countries. Whatever the reason, it is clearthat since last July their currency stopped appreciating vs. thedollar. This provoked an immediate response: speculators rushed to reverse their trade and we immediately went from inflationto deflation.Since early March the price of risk assets has again risen considerably; the Yuan has gone sideways. Perhaps the Chinesedon't want to re-price their scarce exports amidst the economic weakness? I see this as a non-confirmation of the move inequities and commodities and it reinforces my bearish slant on the year. However, I happily contend that should the Yuan beginto appreciate once more and establish a new high vs. the dollar then I am just plain wrong with risk aversion and I will changethe Fund’s posture; but so far it has been almost a year and nothing.
Rapidly Decreasing Pessimism?
I have been very fearful of fighting this stock market rally, taking the view that we could see something vigorous enough toconvince the majority that we were in a new bull market. I did not expect anything like new absolute highs; more like 1930 whenthe Dow Jones rallied 52pc from its 1929 bottom. I was thereforeheartened to hear, “History says fill your boots, sell your wife,dive in…”from David Schwartz, the self styled stock market historian, inan article from The London Times on the 9th of May,one day after the European stock futures had completed a 50pc rally from their intra day lows back in March. Furthermore, it was taken from a piece entitled, “Investors bet that worst of recession is over and predict new bull market”. These are earlydays but clearly the process of social herding and higher pricesis succeeding in tempting many investors to risk their capitalagain.I have written previously of life imitating art and continue to take inspiration from Will Self’s collection of short stories, “TheQuantity Theory of Insanity”. In one tale a plucky undergraduate succeeds in locating his missing college professor bydetermining a pattern from a collection of integers copied from homosexual graffiti lifted from the cubicles of London lavatories.But it’s just a lucky coincidence. This got me thinking about Soros andPaul Tudor Jones plotting where the Dow might trade in1987 from the entrails of the Dow in 1929. They thought the “great crash”of 2008 was due in 1987. They were wrong. Buttheir pattern of integers, by coincidence, matched perfectly andTudor Jones made 50pc in October 1987. In this business itdoesn’t matter if you get lucky; just stay lucky.
RenminbiStrengthCrude OilCNY/USD
Source: Bloomberg
of 00

Leave a Comment

You must be to leave a comment.
Submit
Characters: ...
You must be to leave a comment.
Submit
Characters: ...