The Eclectica Fund
Manager Commentary, April 2012
n fact, no one can enter a strong man's house and carry off his possessions unless he first ties up the strong man. Then he can rob his house.”
price restructuring looks to us as if it is creating yet another historic turning point. By embracing his inadequacies and leaping on his luck, the strong man may have finally broken the binds that had previously held him back. We are also more pessimistic on Chinese growth than ever. This makes us bearish on most Asian stocks, bearish on industrial commodity prices, interested in some US stocks, a seller of high variance equities and deeply concerned that Japan could become the focal point of the next global leg down. On the plus side we also believe that we are much closer than before to the beginning of a bull market of perhaps 1982, if not 1932, proportions. We just need the last shoe to drop. US First, EU Second, China Last “China's economic growth is unsteady, imbalanced, uncoordinated, and unsustainable.”
I have not written to you at any great length since the winter of 2010. This is largely because not much has happened to change our views. We still see the global economy as grotesquely distorted by the presence of fixed exchange rates, the unraveling of which is creating financial anarchy, just as it did in the 1920s and 1930s. Back then the relevant fixes were around the gold standard. Today it is the dual fixed pricing regimes of the euro countries and of the dollar/renminbi peg.
Premier Wen Jiabao, March 2007 press conference following the annual meeting of the National People's Congress. Let us start with that final shoe, China. For a decade the bureaucrats in Beijing attempted and managed the seemingly impossible, keeping their currency undervalued and maintaining domestic price stability. How? From the mid 1990s to 2005 the renminbi was pegged one-for-one to the dollar. For most of this period the greenback was strong (the dollar appreciated by roughly 3.5% p.a. through 2001). Investors were infatuated with American TMT stocks and China was yet to mount its assault on the rest of the world. The dynamic meant the US current account surplus was held in check (around 2% of GDP). Dollar strength worked to keep a lid on Chinese inflation. Soon after several things changed. China got accepted into the WTO, America set a course for a weaker currency post the NASDAQ crash and the dollar's real trade-weighted value took a nose-dive. This was initially great news for the Chinese. Net exports as a percentage of GDP doubled in the two years from 2005. Then they doubled again. The overseas sector contributed less than 5% of GDP growth in the four years to 2004 but 20% between 2005 and 2008. At the same time the current account surplus reached its zenith at almost 10% of GDP. According to the rights of economic principle at this point the renminbi should have appreciated
The former is common knowledge – everyone wonders whether the Greeks have a political economy that can work with the euro. The second system is less understood. But I believe we might soon come to question whether China is going to be able to maintain its currency peg with the dollar. It has long seemed to us to be the case that this economic crisis would start in the US and make its way to Europe. That has happened. However, we also think it will end in Asia.
This might be the year everyone else notices this; the year panic over Chinese economic growth comes to replace the market's morbid fascination with the travails of the European continent and the year in which we see that the US is not giving way to China in terms of global economic leadership. There is a near consensus that China will supplant America this decade. We do not believe this. We are more bullish on US growth than most. The momentous nature of recent advances in shale oil and gas extraction and America's acceptance of the unpleasantness of debt and labour
Manager Commentary, April 2012
considerably. This was not allowed to happen. The scale of Chinese FX interventions became legendary as bureaucrats sought to maintain the cheap currency. The level of FX reserves rose to unprecedented heights for any country at any time in history. China was on a roll. However the boom came at a cost. The Chinese government had effectively printed money to purchase vast amounts of Treasuries. This was akin to shorting their own currency. In time the new money began to overwhelm the domestic money supply. The American economy was three times the size of China’s economy yet Chinese broad money exceeded that of the US. And of course waves of credit such as this are not just about money, they are about temptation as well. In any other economy that would have meant runaway inflation. In China it did not. Instead, the rate of consumer price increases averaged just 3% p.a. How Did They (Almost) Get Away With It? The Chinese did it with a cultural revolution; they did it through financial repression on a gigantic scale. The central bank kept the deposit rate low, incredibly low. On February 21st, 2002 the monetary authorities set the interest rate that banks could pay on demand deposits at just 0.72% and then kept it unchanged for a remarkable six and a half years. By the first half of 2008, inflation was running at 7.9% and the real rate of return on demand deposits had fallen to -7.2%. This appalling rate of return on bank deposits probably accounted for 20% of the decline in household disposable incomes as a share of GDP over the period 1992 to 2008 and significantly contributed towards the consequent collapse in consumption relative to GDP. Having averaged more than 50% of GDP during the 1980s, consumption had fallen to just 34% by 2010. This was a record low for any nation and, to my mind at least, a very potent sign of the disequilibrium created by the currency peg and the repression required to maintain it. Unintended Consequences… It must have all seemed devilishly clever to the authorities. Unfortunately they failed to take into account the law of unintended consequences. Chinese households mounted a rearguard offensive action against this repression. Instead of accepting low rates on their money in the bank, they became a nation of property speculators. There was temptation in all that
newly printed money after all and the populace gave in to it. Investment in residential real estate averaged only 2.4% of GDP back in the years before the financial repression. As deposit rates became more and more unattractive and the People’s Bank shorted more and more of its own currency domestic speculators lit the torch paper under residential real estate investment. It grew to 9.1% of GDP by H1 2011. Chairman Mao must have been turning in his grave.
Household Consumption (% China GDP)
60% 55% 50% 45% 40% 35% 30% 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: Bloomberg/EAM Research
The Mother of All Housing Booms? At first the scale of this speculation was hidden under the guise of an entirely plausible argument based on mass urbanisation. China, we were told, was merely investing as peasants moved en-masse to the coastal cities. Perfectly plausible. But perfectly wrong. During the period 2000 to 2003 mass migration to the cities peaked at 24 million people per annum. At the same time residential investment expanded to 4.1% of GDP and housing starts rose from 240m sqm per year to 440m. After that the urban population growth rate decelerated (to an average of only 19 million people per year) but residential development did not. Instead, housing starts went crazy, rising from 490m sqm in 2004 to 1,290m sqm six years later. It is also worth noting that by the time all this happened the sharpest rise in home ownership had already passed. In 1983 the home ownership rate in China was a mere 10%. By 1998, thanks to the authorities' commendable privatisation of the housing stock in the mid 1990s, it had reached 80%. Its growth since has been, by comparison, unspectacular.
Manager Commentary, April 2012
So it was not urbanisation that drove residential investment. And it wasn’t levels of home ownership rising from a low base. Rather, it was house price appreciation. Before 2004 bank deposit returns had exceeded average house price gains across the country. After that money printing and financial repression propelled house prices higher and higher. Annual returns from residential investments beat term deposits by a whopping 5% p.a. in real terms. At the same time first time buyers found they could borrow at a discount of 15% to 30% to the benchmark rate for the life of a mortgage. There was no property tax so the carrying cost of owning an empty flat was modest. Housing investment was a no-brainer.
The market went ballistic. On official numbers, households raised their borrowing by $400bn and then $460bn in 2009 and 2010. That was an annual average increase 4x the increase seen in 2008. By 2009, individual mortgage borrowings where growing 6x faster than the year before as banks lent out a third of the total mortgage stock outstanding. By mid-2010, the share of residential properties purchased across Chinese cities as an investment hit an extreme peak of 40% and even the central bank estimated that 18% of households in Beijing owned two or more properties. Many of these lay vacant. It should not be surprising to learn that as a result of all this the ratio of household debt to income rose by almost 20 percentage points between the end of 2008 and the end of 2010. This was an incremental change greater than the one witnessed during the wilder years of the US boom. China has spent twice as much as the US relative to the size of its economy on its property bubble. Given that American mortgage underwriting standards completely collapsed during the bubble, that is quite an achievement. The scale of the surge is, we think, without precedent in emerging markets. Consider Taiwan. It is an island
nation with land in short supply and, like the UK, it is susceptible to housing bubbles. But when Taiwan had its China moment of rapid growth and mass urbanisation, investment in residential housing peaked at just 4.3% of GDP (in 1980). In other words, half of where it was in China last year. The Chinese Buy in Cash? Nonsense… You do not read as much about a residential bubble as you should. China's banks are instructed to demand 40% down-payments on new mortgages and official numbers have China's household debt-to-GDP ratio at the end of 2007 as just 20%. Ergo, Chinese households are thought to be unleveraged so there can be no bubble. This just does not fit the facts. To really understand what is going on we must look to the shadow-banking system and how the financially repressed, caught in the tyranny of negative real interest rates, use it. These underground lending and investing networks are estimated to total $1.3 trillion. This rivals the size of the U.S. government's budget deficit. I suspect that we will also find in time that it has financed a large number of the deposits apparently prudent investors have put down on new build flats. Want a House Deposit? Ask a Shipbuilder… This is just the beginning. All this might have started with informal loan desks at underground train stations in Wenzhou but, as ever, it was not long before everyone wanted a piece of the action. Societe Generale's Yao Wei estimates that China's entire shadow-banking system totals $2.4 trillion, so around one-third the size of the official loan market and equal to the entire stock of US consumer debt. Wei's larger figure includes $1.1trn in outstanding "wealth management” products from the official banking sector. These products enjoyed a three-fold increase in 2010 alone as banks and other corporates desperately sought to compete against the black-market loan flyers on the streets promising to pay as much as 0.5% a day. The banks responded by offering 2 to 31 day term deposits with annualised returns of 8%. But perhaps with too much zeal. China's Banking Regulatory Commission recently had to insist that they refrain from selling such "wealth" products (I use this term in its loosest possible sense) which are not based on market analysis, have no risk measurement and cannot be independently appraised.
Manager Commentary, April 2012
There is more. Consider the $3.7bn, Singapore listed, Chinese shipbuilder Yangzijiang. One could argue that when there are huge financial returns to be made it makes sense for shipbuilders and other capital intensive businesses – ones in which customers make large upfront payments – to use their core businesses as loss leaders in order to take in cash and then lend it out. Even today, with ruinously low shipping rates, Chinese yards offer new builds at prices not far from the distressed resale value of second hand vessels. However they also have quite a loan business on the go. YZJ purport to have $2.7bn on the balance sheet, of which around $1bn is real cash sitting (presumably) in a real bank. The other $1.7bn is lent out in the form of fixed term loans to various SMEs deemed unable to access funds from the banks and thus forced to pay interest rates of over 10%, and in certain cases in excess of 20%. Of course, Yangzijiang’s executives exude business élan and I am sure their intentions are honourable. They certainly say all the right things. For instance, they insist on borrowers having at least three times the value of the loans in collateral, and will accept only land and Chinese A-shares. In reality, of course, they represent a team of shipyard managers building new ships at a price barely above that of second hand ships and lending hand-over-fist during an unprecedented credit boom using a plethora of financial techniques from rural micro finance to venture capital. This $1.7bn loan book is about 80% of the group’s NAV. That is not something you want to be invested in. Perhaps the moral teachings of Confucius will have to expand to include the doctrine that "wise shipbuilder not invest in mortgage lending"? Rich Sister, Poor Sister As you can imagine the bureaucrats don’t like this much. But their real fear - the inflationary consequences of all this over lending - can be seen in the spate of death sentences meted out to hapless individuals such as the 28 year old Wu Ying (now commuted), otherwise known by her banking moniker, Rich Sister. Rich Sister raised $122m between May 2005 and February 2007 from savers eager to escape the tyranny of negative real rates. All was well as long as China's legions of risk takers could borrow from her and then flip their purchases to pay her back. But unbeknownst to Rich Sister a distant empire was about to strike back and she would get caught up in the fallout. America’s QE2 seems to have prodded the Chinese monetary authorities to remove the
punchbowl. In a sequence of steps ending in June 2011, the reserve ratio was raised from 15.5% to 21.5%, making Wu Ying’s profitable game of pass the parcel less and less desirable.
Wu Ying aka “Rich Sister”
From Spend, Spend, Spend to End, End, End Wu Ying was caught out by matters of state - by QE2 and the way China had to raise interest rates in response to it. The Fed's program of QE2, announced in the second half of 2010, was an attempt to restore the potency of US monetary policy. It had become obvious that attempts to reduce the long term rise in American unemployment had failed, in part thanks to the Asian mercantilist policy of the previous ten years. Despite the unprecedented monetary easing to that point, American unemployment in 2010 was still stubbornly high and politically contentious. Something had to be done. That something was more QE. We warned at the time that with money creation already so vibrant in China, American QE2, while likely to achieve its aim, would do so at the expense of setting creditor nation policies against those prevailing in debtor nations.
The New Economic Order: The Empire Strikes Back
Fed QE US rejects globalisation
High sovereign debt restricts fiscal stimulus
US rejects China Gaming FX
Zero lower bound restricts monetary policy
A Vicious Circle: Producing Dollars to Stop China
US seeks to create domestic price inflation overseas
US and Germany slow
US seeks to revalue China et al FX real vs nominal prices
EM growth slows
Debtor countries raise rates despite high unemployment a la 1931
Creditor countries tighten monetary policy
Manager Commentary, April 2012
That is, to say it would draw to an end the famous unity displayed at the London G20 summit in April 2009 when China promised to spend, spend, spend to get us all out of trouble. At the time China effectively offered the world a credit bubble. It set out to build a bridge, the idea being to stabilise the world economy until such time as the recession in western economies receded from the system. The result? Investment spending sky rocketed. The rail network, for example, saw spending rise by 67% to over $100bn with 50% of all bank lending directed by the state towards infrastructure projects. And whilst global output fell by more than 2% in 2009 before recovering by a pallid 3.9% in 2010, in China it grew by 9.2% and 10.4% respectively. This year such state directed spending could contribute 60% of the economy's expected 8% growth rate. The problem is that China is no James Bond. Some might think that its brand of state capitalism would have saved the world. But it has not.
G20 Summit London, 2009
The Descent of Money Let me explain by taking liberties with Professor Niall Ferguson's excellent depiction of the German descent into Weimar hyper-inflation from his book The Ascent of Money and using it to draw comparison with contemporary China. The parallels are inexact but I believe they may prove illuminating. If China is ever to suffer a monetary crisis QE2 will rightly get some of the blame. But the roots of the crisis will lie more in the domestic Chinese political and economic decisions made over the last four years. The truth is that while many still think of China as being financially stable, the state’s finances are increasingly imperiled. The decision in 2007 to cut corporate tax rates from 33% to 25%, which reduced tax revenues by $21bn a year was in some ways commendable. But given that social spending has risen 22% a year between 2004 and 2010
it was also pretty risky, particularly given public sector wage settlements are not far off the 15-20% rises seen in the private sector. How much debt is there in China? We know that local government debt had expanded considerably since the end of 2005. And we know that it is thought to be about 25% of GDP. Less is known about the murky world of central government finances. However we have sympathy with analysts who suggest a total figure around 80% as China's central government deficits, which averaged only $23bn between 2006-08, have risen five-fold in the past two fiscal years. Ominous stuff. We also know that the result of the 2009 spend, spend, spend policy was to funnel huge amounts into worse-than-useless job creation projects via a broken financial system which thanks to negative real interest rates provided little financial incentive for rational behaviour. The anecdotes have entered modern mythology. Think municipal water companies that have lost money every year since the mid 1990s; 175 new airports whose aircraft landing fees and other revenues don't come close to covering the operating costs of the (or the 50 more to come). Think rail transit box revenues that do not remotely cover subway systems' operating costs; and of course the new rail lines on the outskirts of the city of Changsha, the latest poster child of absurdity. They lead directly onto open farmland.
Which brings me to Mr. Ferguson’s argument. He postulates that those in charge of Weimar economic policy in the early 1920s felt little incentive to stabilise Germany's fiscal policy. Why? Because any inflationinduced boom would be corrected by an export led boom as the US and UK economies emerged from their post war recession and gobbled up cheap German goods priced in a depreciated currency. You can almost hear the Chinese economic tacticians arguing similar lines. Any investment spending folly from 2009 onwards would be corrected for by undermining the west's incessant pleas for a stronger Yuan. When the Yuan was no longer appreciating and western economies were on the mend, the positive stimulus from China's export dependency would once more bail them out.
It Never Works Out Quite Like You Think But just as the post war recession of the early 1920s
Manager Commentary, April 2012
rumbled on longer than the German political elite had envisioned, so the austerity travails of contemporary China's largest customer, the EU, have busted their calculated gamble. Perhaps China miscalculated: its leaders mistook a prolonged period of balance sheet deleveraging in the west, a rare bird, for a typical recession. China’s modern German counterparts, chastened by the Weimar experience, are yet to be persuaded by cries to spend, spend, spend. As a result they currently only have to wrestle with the operational leverage of their manufacturing led economy. The Chinese, on the other hand, are double cocked. They have compounded the dangers from their operationally leveraged economy with a financially leveraged sovereign. And in doing so they may have jeopardised their country's economic future. Creditor, or serial current account surplus nations, are always caught out by the pro-cyclicality embedded in their growth rates. By exporting surplus savings to the rest of the world and importing excess demand, the mercantilist leverages its GDP growth rate as the world expands. But when world trade stumbles they are always surprised by the severity of the resulting slump. When Britain Was America Consider the paths of the UK and US economies in the early 1930s. The British, playing the role America plays today, as an empire in decline, suffered just an 8% correction in peak-to-trough GDP whereas the tiger
economy of the US, role playing today's Chinese economy, suffered the indignity of a 23% nominal GDP decline in 1932 alone. In a downturn, the debtor nation mitigates the economic shortfall by importing less. It then captures more of its own GDP domestically and cushions the fall in GDP. The strongest looking economies can sometimes prove the most vulnerable. A Prize Fighter in a Corner is Told Hit Where it Hurts, Yep, Silver and Gold...¹ At the beginning of this letter I said that the key to the next stage of the crisis is the currency peg. Back to this, and how it makes the story I have told so far even more worrying. Look back to 1935 when the US Treasury introduced an earlier version of QE, buying silver to help its domestic miners by boosting the price. Unwittingly it simultaneously caused an outflow of "hot-silver" from China, creating a contraction in domestic Chinese credit and producing domestic deflation. The economy sagged disastrously and the Chinese had to break their currency peg. Inflation later peaked at over 1000% p.a. in 1947. Might the contemporary dollar standard go the same way? Bernanke's quantitative easing program, buying Treasuries not silver this time around, has succeeded. It has generated wage inflation in mainland China to the extent that a renminbi cost base is no longer the sine qua non for manufacturing re-location that it was a few years back. Add this to the fact it is entirely possible that (for the reasons cited in my first few paragraphs above) the trade weighted dollar could rebound sharply. The competitiveness quandary confronting China would then become monumental. China would now no longer have a cheap currency. At the same time Europe, its largest customer, would remain locked in a perpetual cycle of austerity. What then for China's exports? And what value for those worse-than-useless investment projects, the vintage of the 2009 credit cycle which have always struggled to cover even their operating costs (capital costs will never be met)? It seems to us that under these circumstances hot money would depart China in droves. This has probably already started. What would China do then? Sell Treasuries? Unlikely. Remember this is the end game for mercantilism, the point where the country’s capacity to produce has outstripped that of western consumers to borrow and
¹U2._Joshua Tree_Island Records, 1987.
Manager Commentary, April 2012
spend. China purchased Treasuries so that it could run a trade surplus and create the estimated 80m plus domestic jobs that now service the overseas sector. But should it have to sell these same instruments in order to address its own ballooning fiscal deficits and explosive growth in its sovereign debt (as net exports turn negative and domestic bubbles pop), the renminbi (despite the economy’s poor fundamentals) could have to rise (as dollars were sold and yuan repatriated). The export sector would then be utterly annihilated. It seems to me then that they would have little option but to keep their Treasuries and absorb the private sector's escalating debts à la Japan. Their public debt has risen 10 fold since 1990. That has not yet been a disaster for Japan for the simple reason that until recently it was isolated in its misery. Thanks to the booms/bubbles elsewhere its current account stayed in surplus and it hung on to the means available to pay for this transfer of wealth to the household sector. China may not enjoy this luxury. I am not saying that history will repeat itself or that China will necessarily end up with the hyperinflation that followed the 1935 break with silver. But with their largest overseas customer, the Europeans, in a funk just as the domestic economy is rolling over, I am very pessimistic on the Chinese authorities' grounds for manoeuvre. This makes me fearful of the future value of the renminbi.
Concentrate on China
It also means that when we look at where the next market crisis will come from we should be looking to China. When the liquidity cycle turns adverse again, as it did in 2008 and 2011, the market will find a weak spot. The Spanish/Portuguese axis might attempt to rival the dislocations rendered by the collapse of Lehman, Greece and Italian BTPs. But would such an event register as profound a surprise as those which previously set off margin calls and delta hedging? It might, but I am not convinced. I would argue that investors will have already bought protection for such an inherently possible outcome. Crises are usually more left-field than this. They also tend to occur against a bullish consensus that has leveraged the status quo by selling a lot of cheap option volatility to enhance carry. It seems to me that with all the problems I have outlined in China, something bigger is to hand in terms
of investments. Something that is not well looked at - a new pricing regime as the world fumbles to imagine a world less reliant on China's breakneck pace of economic growth and cuts the price it will pay for a large group of stocks. From the pulpit of a ten-year bull market, those businesses servicing the tigerish growth of China have, by way of consistent share price outperformance, become the stalwarts of institutional equity portfolios. Former sceptics have become confirmed zealots of the perpetuity of continued serial Asian urbanisation. But have their portfolios become dangerously out of sync with changes on the ground? Consider the case of the Brazilian, Eike Batista, and his very, very ambitious iron ore and port projects. A devastating combination of charisma, the enigma of China's insatiable appetite for commodities and G7 pension fund money will, so he believes, make him the world's richest man in three or four years time: "Just look at the assets. Jesus, by 2015 we will be making $10bn. Between 2015 and 2020 that will double or triple. And those are discounted numbers..."
But this is hardly a given: prices and marginal trends are telling a different story. Whisper quietly, but the bull market may have passed. Those taking big bets on several more years of rapid Chinese investment growth are vulnerable to big losses. And Short Japan… It is not my intention to scaremonger. I simply wonder why at this juncture one would consider buying stocks too exposed to Asia and in particular China?
Manager Commentary, April 2012
Wu Jingling, China's leading academic economist was close to the mark in 2001 when he characterised the stock market in China as a casino in which households would inevitably lose money owing to front running, insider trading and other dubious practices. There is arguably little value to western shareholders in the majority of these state listed stocks. Note that even as growth has been running at 10% and there has been a bubble everywhere, Chinese stocks have only gone down. To repeat Jinglian's prophetic advice, at worst, these are frauds run for the benefit of the insiders, not for pensioners. At best there is so much debt and sovereign interference that the equity stub is almost worthless.
Tactically we find ourselves short many of these Asian names. However to stay the course we have had to be slightly obtuse (I daresay this surprises you). We have used single-name Japanese credit protection to procure some of the cheapest priced volatility anywhere (we have taken short positions via credit default swaps). Yes, Japanese not Chinese. Why? Because Japan is the most industrially exposed economy there is to a Chinese slowdown. I have always been intrigued by Benjamin Anderson's financial history of the US between 1914-46. In it he refers to the Japanese policy of the time – “propping up the inflated wartime price level”. The result? “Instead of the deflation the policy-makers feared, Japan suffered 7 years of stagnation, punctuated in 1927 by a devastating financial crisis...Japan lost 7 years only to incur greater exaggerated losses at the end."² I think that, thanks in good part to China, this is about to happen to Japan once more. There have been 20 lost years. Now there is to be an exaggerated loss at the end. Think back ten years when former Prime Minister Junichiro Koizumi was hailed as an Elvis styled king of reform. But most of the pretty minimal growth during his premiership (starting in 2001) came not from his policies but from the surge in mainland China's economic growth rate. That boosted Japan's exports and created a surge in corporate capex to meet this new demand. It seems to us that the Lehman shock exposed this disproportionate sensitivity – it explains why nominal GDP has fallen 8% peak-to-trough since and why things are likely to get much, much worse.
For Japan is not out of the woods yet. Whilst the west may have paid a few corporate titans and bankers way too much money, corporate Japan, along with much of the rest of Asia, is guilty of paying too many redundant quasi-state employees anything at all. It is a ruinous policy, symptomatic of a failure to face tough decisions, and it is slowly but surely eliminating all of the residual equity value in far too many businesses. Hitachi: Too Fat to Diet? Consider Hitachi. It has a new CEO, one who has committed to improving operational efficiency. That has made the market happy but we do not think the market is concentrating. Let us leave aside for a minute the sheer opaqueness of their balance sheet (try asking management about that $18.5bn of “other assets”) and let us ignore the fact that, whilst people might tout the company’s cash flow record, its net debt in FY11 was much the same as it was FY03 despite a purported $10bn of free cash flow in the intervening period. Instead let us look at the fact that the firm has 376,000 employees and that what truly moves the needle on margins in these slow moving mega-conglomerates is the ability to reduce headcount. People are calling Nakanishi-san, the new CEO, Hitachi’s Jack Welch. Jack got rid of nearly a quarter of the workforce of GE in just over five years. By coincidence, Hitachi employs 25% more people than GE today. So is Nakanishi-san a Jack Welch? Using Sony's recent restructuring cost as a reference, it looks like it would cost Hitachi between $75k and $100k per redundancy. That is an implied liability of $8bn. No one calculating book value for Hitachi takes this into account. So book value is hugely over stated.
² Anderson, Benjamin. Economics and the Public Welfare. New York City: Liberty Fund, Inc: 1980.
Manager Commentary, April 2012
This is crucial because when consideration is given to the $25bn of existing net debt and pension liabilities (to say nothing of the potential for other unknown liabilities nestling within project finance and other SIVs) the debt-to-equity ratio would easily surpass the 1.5x ratio that usually makes Tokyo’s bankers queasy. With a market cap of $29bn Hitachi is not cheap. It is far too expensive. Fabless, not Fabulous Another example is Renesas, the slightly less commoditised semiconductor sister of now defunct Elpida. It has some merits (largely that it has outsourced rather than heavily invested in capex) but it still has 44,000 employees. With a market cap of just $2.9bn, this is surely way too many workers. By comparison, note that Qualcomm has a market cap of $114bn, but employs just 21,000 people. Does Renesas have any equity value? We do not think so. This is not the world that most macro economists see. Instead they tend to cite the de-leveraging of nonfinancial companies from 130% of GDP in 1990 to 80% by 2005, and like Edward Chancellor writing in the FT, they proclaim the balance sheet recession is over. But it is not. Let us examine another Japanese behemoth, Toshiba. Toshiba has 212,000 employees. It also has net debt of over $10bn, a number which more than doubles to $22bn if one includes pension liabilities and operating leases, and one we could certainly push higher if we had full disclosure: the presence of hard to track off-balance sheet finance schemes and indecipherable accounting techniques makes it tough to be sure. To add to the concerns Toshiba does not file accounts with the SEC and it has been very dependent on deal making (goodwill and intangibles representing 47% of equity). Recall the shares fell 8% (the Nikkei dropped 3%) immediately following the Olympus scandal as investors pulled back from all but the most redoubtable names. But our real bugbear with this company relates to its purchase of the nuclear power manufacturer Westinghouse for $5.4bn, or 3x prior year sales, in 2006. The deal added $3.0bn of goodwill and $2.5bn of other intangibles on to Toshiba’s balance sheet. This year we have watched the share price of the French nuclear group Areva drop below where it was in
the aftermath of the Fukushima disaster and we now worry that nuclear reactor growth is unlikely to match the rosy assumptions underpinning the pricing of huge intangibles and could, we think, prompt a significant downgrade from the domestic rating agencies. This concern is strengthened by two additional factors. First, US based Shaw Group is exercising its put and selling its remaining stake back to Toshiba. The Japanese now have to come up with $1.6bn. Second, Toshiba has a large debt roll-over risk: almost 40% of the group's long-term debt comes due over the next two years. What is mentioned above explains why the Fund has purchased credit protection on Toshiba's senior debt. The price of the 5 year CDS has widened to just over 200bps. That is a level we believe fails to adequately reflect the credit risks arising from the many liabilities, the high operational leverage, the potential for goodwill and deferred tax asset write downs, the roll-over risk and the long shot of a fraud revelation. The Tranquility That Could Rock the World Something else we are watching is the short selling of volatility by Japan's major banks through single name corporate credits. The market is very short on the premise that the country’s financially over-leveraged and Asian export sensitive industrials are perfectly safe. After all, investment grade credits do not default. Like Alice in Wonderland, they do not believe in impossible things...and US home prices cannot fall nationwide. We know this not to be true. But there are omens out there for all Japanese carry junkies to see. First, there was the TEPCO-led price implosion in their domestic electric power utility bonds (some $150bn of notes and bonds are outstanding). Many of TEPCO’s now trade at 60% of par. Six months later they had to suffer the ignominy of seeing their largest European holdings, Italian BTPs, decline sharply in price. Now it is the commercial disasters hitting Japan's formerly renowned electronics sector with household names such as Sharp, NEC and Sony producing earnings reports that numerically illustrate just how they have been left high and dry by a devastating combination of American technology, Korean ingenuity, an ongoing failure to tackle costs and the withering debilitating of the yen. The CDS spreads are blowing out under the pressure of credit downgrades from Japan's own rating
Manager Commentary, April 2012
agency. It is hard to escape the impression that Japan's blue-chip companies are teetering on the brink of extinction.
Sharp 5yr Snr CDS
400 350 300 250 200 150 100 50 0 2006
I can hear your anguished pleas. You say that the yen has recently weakened and the BoJ has now declared an inflation target. You think all will be well. But go to Tokyo as I did at the end of February and you will see there is too eerie a sense of calm. I maintain that the central bank will only seek to destroy the value of the currency after the next leg down in the struggle for corporate profitability that we are currently witnessing. The central bank will require a full blown crisis before it engages in all out financial anarchy. Wait until Chinese growth has unmistakably faltered. Wait until the next credit downgrading, the bit when the companies no longer can issue any more “cheap" equity to their much abused shareholders. Then we will have entered the crisis and resolution chapter.
We are not yet there but we are getting close. Things in Japan are happening faster than they usually do. Deferred tax write downs are increasingly common; profits are not returning and the auditors and ratings agencies are insisting that assets must be written down to reflect that reality. As a result, shareholder funds are taking a battering and debt to equity ratios (DERs) are moving higher. Typically, three years of consistent losses and a DER greater than 1.5x will prove sufficient for the domestic credit rating agencies to remove investment grade status. There is no future for such fallen angels. That means that their management, in an attempt to stop it happening, will turn instead to the stock market for heavily dilutive rights issues.
This is exactly what occurred at Mazda, a company that
does nothing if not confirm our Japan thesis. Confronted with net debt of $7.4bn (2.6x times its market cap), a DER of 1.9x and a second consecutive year of large net losses, the company's bankers, SMFJ, tapped the directors' shoulders and instructed them to dilute equity shareholders again. This time it was a $1.9bn rights issue which increases the number of outstanding shares by 60%. This comes uncomfortably close to their last dilutive issue three years ago. Back then they sold the shares at a price 65% above today's level. Who buys this stuff? For Japan's corporate zombies it is evident that equity serves only as a sop for the banks and other debt holders. Mazda trades for just 11% of sales and at a 40% discount to book. That might make it look cheap, but it has little relevance if company management has to persistently issue more and more shares to keep the bankers from pulling the plug. It might be that Ben Graham's value style of investing only worked so well in the 1930s because American firms had purged themselves of debt liabilities. It is my contention that value does not mix so well with debt. Perhaps the most remarkable aspect of the Mazda deal, and the part which has received least attention, has been the more realistic pricing of the additional $860m of 60 year subordinated loans at TIBOR +475bps, rising to +575bps after 2017. Are the banks finally getting it? Are they about to re-price credit to reflect risk? I certainly hope so. However the travails of the likes of Mazda have so far served merely as a precursor to the announcement of one of Japan's largest post war bankruptcies, Elpida. It is noteworthy that this immensely capital intensive and cyclical business (think of a steel company that has to write off its blast furnaces every 5 years!) had $5.5bn of debt at the time of bankruptcy having posted a $1.5bn ebit loss on $3.3bn of sales in the year to March 2009. Japan Airlines, another capital intensive and operationally leveraged business, had to restructure $7.4bn in 2009 and remember Japanese companies do not default? It is simply impossible! Do you see a pattern here? I do. That is why we are using single named Japanese credit protection to short China. The Easy Bit. And the Hard Bit. These are all vexing issues so I want to include in this long letter a few personal insights I have picked up over
Manager Commentary, April 2012
the years both about investing and about our industry. As you know, I have a proclivity to make money in a bear market. The Fund's ten-year NAV progression demonstrates this survivorship bias; when bad things have happened, we have made money. We are very robust. Last year was no exception. Despite the challenges confronting speculators, I am much relieved that we succeeded in making 12% in a rather disciplined manner, and the Fund has now posted a CAGR of almost 10% for the last nine years. Maybe that was the easy bit. The question now is just how we can make money in the tough business of global macro investing this year. As I am sure you by now know, I am nothing but a worrier. I have, I think, a soul mate in the prolific but often misunderstood Italian soccer player Pippo Inzaghi, the second highest scorer in all European club competitions. He has 70 goals behind him but he recently noted that, “the tension is always the same...I hoped to become less agitated with time, but this is also my strength”. I suspect he would have made a fine macro manager.
I meet a lot of inquisitive and extremely intelligent people in this business and I have come to think that maybe this is something of a problem. Perhaps they are just too smart. Perhaps they just try too hard. Rightly or wrongly, the highest return on intellectual capital of any endeavour in the world today comes from the management of other people’s money. So it is entirely rational (especially if you have never met a hedge fund manager) to assume the industry attracts the brightest, smartest minds. The beautiful mind, if you will. But I am not aiming to outsmart George, Stan, Julian, Bruce or the others. I do not think it is logical to try and outsmart the smartest people. Instead, my weapons are irony and paradox. The joy of life is partly in the strange and unexpected. It is in the constant exclamation "Who
would have thought it?" Why did ten year treasuries yield 14% under the vice like grip of iron-man Volker but yield just 1.8% under the bookish and most definitely Weimar-like Bernanke? Why does France in 2012 flirt with the notion of electing a socialist president intent on reducing the retirement age, imposing a top rate of tax of 75% and increasing the size of the public sector? Why do we hang on the every word of elected politicians when Luxembourg’s prime minister Jean Claude Junker openly admits, "When it becomes serious, you have to lie"? You cannot make stuff like this up. It is simply too absurd. That is perhaps a long way of saying that existentialism is alive and well in the 21st century. For, if the last ten years have taught me anything, it must be that the French philosopher Albert Camus, in his search for an understanding of the principals of ethics that can shape and form our behaviour, may have surreptitiously provided us with three basic principles for macro investing. I am perhaps doing him a gross injustice, but I would summarise as follows: God is dead, life is absurd and there are no rules. In other words, you are on your own and you must take ownership of your own destiny. For me this has always meant being detached from the sell-side community. It is not a question of respect, it is just that I prefer not to engage in their perpetual dialogue of determining where the “flow" is. I cannot be reached by telephone. I suspect that I am one of the few CIOs who does not maintain daily correspondence with investment bankers and their specialist hedge fund sales teams. Not one buddy, not one phone call, not one instant message. I am not seeking that kind of "edge.” Eclectica occupies an area outside the accepted belief system.
Manager Commentary, April 2012
“I have striven not to laugh at human actions, not to weep at them, not to hate them, but to understand them” Baruch Spinoza, Tractatus Politicus, 1676 I attempt to cultivate my own insights and to recognise the precarious uncertainty of global macro trends. I attempt to observe such things first hand through my extensive travel (I promise no more YouTube videos), and seek to understand their significance by investigating how previous societies coped under similar circumstances. But first and foremost, I am always preoccupied with the notion that I just do not have the answer. I am not blessed with the notion of certainty. Someone once said we should think of the world as a sentence with no grammar. If we do I see my job as putting in the punctuation. But above all, my job is to make money. In keeping with this theme, I want define the three ingredients that I believe make for an outstanding macro hedge fund manager. These are, in no stringent order: 1. Successful but contentious macro risk posturing. 2. The need to choose the asset class offering the highest probability of payout should the conviction hold true whilst offering an asymmetric loss profile should the original premise prove unfounded/ 3. A best in class risk technique that stop losses the narrative and responds early with loss mitigation procedures (i.e. a method of staying solvent, rational and disciplined under pressure). I have always figured that the first is the real key. That success was simply a matter of contentious macro posturing. In other words, going long very rich risk premium or buying cheap stuff. It is my assertion that what makes a great fund manager first and foremost is the ability to establish a contentious premise outside the existing belief system and have it go on to become adopted by the broader financial community. Bruce Kovner expressed the idea more eloquently when he said, “I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine...that the dollar can fall to 100 yen”. I am sure you are nodding in agreement, except Bruce was saying this when the USDJPY was well over
200, not today's rate of 80! That is the kind of guy I want to be when I grow up. Recall that I have the kind of imagination that can conceive of the yen trading closer to 60. Similarly, if we look back and reminisce about previous years, the Fund's 50% return in 2003 was derived from a legitimate but certainly contentious view that China's WTO entry was set to boost the cyclical "old" economy of the West and that fiat hyper-management of the financial economy could propel gold into a super bull market. To think these views were once contentious; plus ça change! Such pay-offs are very good but like the Bible's warning that a rich man to reaching heaven is like a camel passing through the eye of a needle, I ask just how many of us have this power to cultivate and truly believe in the unexpected? I know I do. Today the key contrarian point I am trying to make is that hyperinflation is not possible without short periods of hyperdeflation, in this case possibly as a result of the death of Asia's mercantilism. The second characteristic of excellent macro managers is evident in the tale of Jesse Livermore's tragic demise. In 1929 his trading and macro convictions had made him as rich as John Paulson. By 1932 he was declared bankrupt, and by 1937 he was scribbling “I'M A LOSER!" on the wall of a hotel lobby before blowing his brains out. This was one super smart guy. He was in possession of what might have been the original beautiful mind.
Jesse correctly anticipated that the US economy of 1929-37 would experience that very rare occurrence, a depression and balance sheet recession. But volatility killed Jesse. You see, in a balance sheet recession volatility becomes pathological and one needs to be prepared. A game plan is needed for all contingencies. What is more it is not necessarily the high volatility that
Manager Commentary, April 2012
is so daunting but rather the great oscillations from high to low that keep wrong footing investors. Volatility is something that perhaps separated the financial winners from the losers last year. It is simply imperative to stop-loss the narrative. One can have an inflation portfolio. One can have a portfolio stuffed with deflationary pay-offs. One might even be a masochist and own banks (or God forbid, Japanese cyclicals) because of cheap price-to-book values. Best of luck; I will not argue. But in this environment of pathological price volatility one must stop-loss the portfolio's narrative. The second hallmark of the successful macro manager is the ability to conceive of and map the price fluctuations of flight path determinacy. This is because economic developments (sadly) do not progress steadily toward unique points of conjecture. Instead, the probability of making money can depend not on the end game but on how we get there: the starting point and transitory events in between have a significant bearing on whether one can ultimately profit from the envisioned outcome. The ongoing rally induced by the ECB's generous 3-year loan programs to the European banking sector is a case in point. Europe has always had its quacks and Mario Draghi's monetary experiment reminds me of Guillaume-Benjamin-Armand Duchenne de Boulogne, the French physician (what else?) who believed that expressions of the human face could be the gateway to the soul. Using galvanism Mr. Duchenne made the legs of dead frogs jump. He wanted to introduce the facial symptoms of fear. Draghi, on the other hand, is more benevolent; he just wants to make us smile. So far it is round one to Super Mario but I fear the patient, like the frog, is dead.
Given the frequency of these monetary interventions, I spend a great deal of time wrestling with pre-trade
analytics to determine the asset class that enjoys the highest ex-ante probability of making money with the lowest variance should our macro convictions play out as expected. As the table of our Fund's return attribution demonstrates, our initial years emphasised long/short equity strategies to capture bullish world views. However, from 2006 onwards we adopted a cautious or bearish macro posture as we anticipated a deflationary fallout from a correction in US housing. Experience quickly led us to dislike equity risk representations of our view since they called for naked shorting of positive risk premium. Remember, Jesse's demise was down to his shorting of the stock market. Without a doubt, as our transition starting in 2007 testifies to, bearish macro calls are better expressed through the use of fixed income strategies. There is a higher probability that such bets will pay out should the narrative be vindicated. One is long, not short, risk premium and the lower volatility enhances the persistency of the trade. For the last four years our fixed income profits have dominated our return attribution.
The Eclectica Fund: Performance Attribution
Equity 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002* Total 2.4 0.4 -0.2 -5.6 -5.5 1.3 26.1 14.2 39.9 -3.7 113.0 FI 10.9 8.9 1.9 35.2 3.9 -2.6 -0.6 5.9 0.5 -1.6 75.7 Comms 0.4 1.5 -0.9 6.9 7.6 -2.4 4.3 4.2 2.1 0.0 25.8 CDS 3.4 -5.5 -5.4 0.4 0.0 0.0 0.0 0.0 0.0 0.0 -7.2 FX -1.3 -1.0 -1.9 3.0 -2.5 1.3 -10.6 -12.7 18.0 1.9 -8.4
* From 30 September 2002. Gross figures based on EAM internal estimates.
On n'a pas Besoin de Mourir Idiot! But for the moment, let us forget the chances of a hard landing in China. Forget the drama of Europe's big-top circus of gross political inspired economic incompetency. Forget that the good news of the US economy's succession of positive economic surprises is really bad news (because fixed income managers have sold copious amounts of volatility and because it has made equity investors bullish and sent stock market
Manager Commentary, April 2012
volatility tumbling back to 2007 levels). There is, in terms of our parochial world of hedge fund investing, a bigger issue. I fear that our no longer small community has been compromised. Funds are neglecting their hard portfolio stop limits. Last year was generally very tough for long/short strategies and I commiserate with all concerned. But last year witnessed too many world class funds lose over 15% in the space of just two months. Of course today they are celebrated once again for making double digit returns in the quarter just ended yet they still languish below high water marks and their Sharpe ratios are busted. You could probably live with that if you are a pension scheme or a large, sophisticated fund-of-fund because you have a global macro sub-sector that is typically long gamma (just look at our credit tail fund's 46% gain last year). The unfortunate thing is this group exercised its stop losses somewhere between 2009 and 2010. That is to say, they honoured the pact they had with clients. They adhered to the terms of their risk budget. I fear that owing to this nasty experience, today no one in macro is running much risk. I suspect daily VaR budgets are anchored at 50 bps or less. That is to say, I fear the financial world is in danger of harvesting a monoculture of fund returns that could prove less than robust should the global economy suffer another deflationary reversal. Everyone is pursuing the same, seemingly low risk, strategy and it might not be the right thing. The Cavendish Club - Members Welcome
To my mind the situation has parallels with the plight of the everyday banana. Today the world eats predominately just one type of banana, the Cavendish, but it is being wiped out by a blight known as Tropical Race 4, which encourages the plant to kill itself. Scientists refer to it as Programmed Death Cell Destruction. In stressful situations bananas fortify themselves by dropping leaves. They kill off weaker cells so that stronger ones may live to fight anew. They operate a stop-loss system.
But modern mass production of single type bananas has replaced jungle diversity with commercial monocultural fields that provide more hosts to harbour the blight. The economy keeps producing stressful volatility events. Good managers keep shedding risk and
monetising losses and are duly fired and we are left with a monoculture of brazen managers who will never stop loss. In the past diversification has proven the most robust survival mechanism against failures of judgment by any one society or hedge fund manager or hedge fund style. But what if we are now a single global hedge fund community afraid to take stop losses and convinced of an inflationary outcome? Let me conclude this piece by sharing with you my fascination for that second rout in US treasuries way back in 1984, long after the inflation of the 1970s was met head on by Volker's monetary vice and a deep recession. How could ten-year treasury yields have soared back to 14% and how could so many investment veterans have been convinced that a second wave of even more virulent inflation was to descend upon the global economy? Psychologists tell us the explanation is embedded deep in the mind. They refer to the availability heuristic. Back in 1984 Mr. Market asked investors every day to guess at the frequency of high prospective inflation rates. But goaded by the proximity to the last dramatic event investors over-exaggerated and over-reacted to the news that the US economy was pulling out of recession in 1984. They saw high inflation where there was none. With this in mind, we would contend that it may take several more years before the threat of debt and deflation can be successfully exorcised from investors' minds, even if the global economy were not set on such a perilous course. Such is the potency and memory of 2008's crash that anything remotely resembling the scenarios I have outlined above could be met by a sudden and severe reappraisal to the downside.
Manager Commentary, April 2012
Should such an event send 30-year Treasuries yields back to their 2008 low of 2.5%, we believe enlightened investors, and their best interests, might better be served by thinking the opposite. That is to say, another huge spike in the VIX above 80 would probably herald a once in a lifetime buying opportunity in risk assets. As it is, a modern millenarian group-think seems to hold sway in the stock market right now. The prospect of another change in world order continues to fascinate the majority. And, whipped up by the failures that led to the collapse of 2008, the west and its current rulers, especially the US, are charged with being corrupt, unjust, and otherwise just wrong. They are therefore believed likely to be replaced by a powerful new force of China-led Asian dominance. We firmly reject this hypothesis for the reasons cited earlier and would remind others that it was the countries with the worst inflation problems such as the UK and US that benefited most from Volker's determination to tame inflation. It was Latin America, whose commodity fuelled current account surpluses funded a surfeit of grandiose infrastructure projects in the 1970s that was really the group laid low by the new pricing regime ushered in by falling inflation. So there you have it. Eclectica have worked very hard to build a formidable fortress of low variance packages within the Fund such that we can take the courage and insights from our analysis to position ourselves. We are, as a result, long the debt saddled west and short the vastly over vaunted and over owned BRICs. Let the games begin!
Manager Commentary, April 2012 Historic Return Correlation Map (2011)
Long Risk Premium
S&P 500 Nikkei Oil EUR v USD
USD v JPY
USD v KRW
USD v AUD
The Eclectica Fund - Strategy Bucket Breakdown IVaR 95% = 47bps VaR MC 95%
49bps 41bps 36bps
Long Risk Premium 10bps
Bull Disc 13bps
Tail Risk 13bps
Bear Disc 11bps
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German 10y Bonds Australian 10y Bonds US 10yr Bonds
0.60 0.50 0.40 0.30 0.20 0.10 0.00 Long RP
Data at 20 April 2012
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