PS to We’re not in Kansas anymore

The table above is not made up; it is a snip from Bloomberg taken a few minutes ago. We may not have reached the “End of History” but we certainly have reached the end of financial markets, as some of us knew them.

This may well be the best example of all that is wrong with Quantitative Tightening. Fixed income markets are broken. You may observe that 2-year Brazil sovereign debt in US dollars is trading through 2-year US Treasuries! As strange as this may be, it is no more unusual than Portugal 2-year trading through France or Germany! Either repo markets are in disarray or there is no liquidity in PGBs or both.

As weird as these prices are, they are not a source of concern in themselves, conversely as we keep pointing out, China is a concern. The reminbi cannot keep its floating peg to a basket of currencies with such a large interest rate differential for very long. China has to ease monetary policy as all its trading partners are tightening. The only outlet for this to be sustainable is to let the currency depreciate. This will have largescale repercussions in trade and financial flows.

If in addition, the Central Bank of Japan abandons its yield curve management sometime next year, US Treasurys and other G7 government bonds may lack an important buyer as JGBs yields rise. This will not be a good development for the euro area periphery, then again what event ever is?

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We’re not in Kansas anymore

The peculiar sense of humour that one develops as an investor is one of the few joys of this profession. Over the past thirty odd years, we may not have seen everything under the sun, but certainly, we have heard a good number of truly unique stories. Take for example the plant manager at a London Stock Exchange listed Russian-oligarch-owned copper smelter in Kazakhstan in the 1990s, who after being unable to answer a single question during a plant tour justified his ignorance with the following pearl of wisdom: ‘around here the less you know, the longer you live.’ As good as this anecdote may be, it comes a distant second to a South Korean sovereign CDS trader who, when questioned on a remarkably small widening of the sovereign credit spread following news that North Korea was testing a nuclear warhead-mounted missile, said impassibly that ‘the risk of thermonuclear war had already been largely discounted.’ We may soon see what exactly it is that markets today are ‘largely discounting.’

Slowly but surely, the water temperature is rising as we are inured to the horrors of war in Ukraine. Over the last few days, pundits are reframing our expectations by openly and candidly discussing the growing probability that Putin may use tactical nuclear weapons in this conflict to regain the initiative. It would appear that Russia is losing the war with conventional forces. Britain’s chief of the defence staff believes that Putin ‘is failing on all his military strategic objectives.’ Retired US four-star General Wesley Clark, in an interview in The Economist this week, goes even further as he predicts that the use of nuclear weapons would not dent the resolve of the Ukrainian army!

Something tells us that, if indeed that scenario plays out, the markets may not take it in stride. If a variant of the common cold virus brought the world to its knees in a panic, God only knows how people may react to the sight of a nuclear mushroom over a Ukrainian city on Tik Tok.

Russia’s army: “low morale, gauche leadership and subpar equipment”

Disinformation and propaganda are always important factors to control in a war. The Russian military do not appear to be as competent nor as resolute as advertised at the outset of the conflict. Rather they seem to be afflicted with low morale (especially among conscripted soldiers), a gauche leadership, and subpar equipment. This may not come as a surprise to those familiar with the horror stories of conscripted military service in Russia. Commanding officers often bully, beat, extort, and starve recruits. Widespread corruption in all spheres of public and private life there may explain the state of apparent disrepair of military equipment.

Napoleon found out how difficult it is to rule over easily conquered territory in the Peninsular War (1807-1814). In 1812, the Emperor of France found out that the Russian winter was the fiercest enemy in the world. Putin, an avid student of history by his own accord, seems to have ignored these lessons. While most people in Europe fear energy shortages this winter, the occupying forces in Ukraine should be far more concerned as their supply lines appear to be faulty.

Luckily, a good friend of ours wrote an article this weekend on Ursula von der Leyen’s speech on the State of the European Union; otherwise, we would have remained ignorant of such a momentous event. European Union supporters believe that the Union grows stronger with each crisis. We do not see any evidence of that. On the contrary, we see the union getting weaker by the decade. The loss of the UK’s membership is irreparable for both parties. The potential loss of members such as Hungary, which do not comply with rule-of-law guidelines, may be less dramatic, but it would remain a move in the wrong direction.

Decommission the European Commission

Counterintuitively, we believe that the EU should get rid of the European Commission to survive. This fourth power assigned to unelected officials selected on a country quota basis is shockingly inept. Its incompetent attempt at reorganizing the market for electricity in the current crisis is but the latest episode in a long-running series of catastrophic decision-making informed by political agendas that clash with reality. To cap the price for the lowest cost electricity producers at €180 per MWh does not solve any problems. Italy for once has a much better plan when it capped renewable energy sales at €60 per MWh, which is close to twice as much as new renewable energy installations require to be profitable. What the EU should urgently do is re-regulate electricity production. In this perhaps temporary scheme, electricity producers would earn their cost of capital on invested capital, no more no less. Those who protest should be reminded that we are at war.

Capital votes with its wings in China

If things were not bad enough in Eurasia, tensions are rising in the South China Sea as the Chinese economy is decelerating to a standstill. We expect a continued depreciation of the renminbi, especially following the October leadership meeting that should ratify Xi’s third term (or maybe even his appointment for life). The renmimbi exchange rate is one of the key prices that has been wrong for longer. For many years, one of the most frequent questions we keep getting from Chinese nationals is whether we knew how they could get their money out of the country, bypassing capital controls. The Net Errors and Omissions line item of China’s balance of payments is gigantic ($1.7 trillion in 2021 alone). It is a reflection of the magnitude of capital flight. Such a situation is not sustainable over time. It is also alarming that President Biden seems to be unsure of what would be the US’s policy if China were to make a move on Taiwan. Thrice he has said that the US would come in Taiwan’s defence, while US official policy remains one of ‘strategic ambiguity’.

Battling inflation: Rates remain in record negative territory

Inflation is a new problem to add to the long list of ills we are suffering. Ray Dalio believes that current inflation expectations, at 2.6%, are too low. Certainly, real rates do not appear to be high enough to destroy demand. Even with the recent rate hikes, short-term real rates remain in record high negative territory in both the US and the euro zone. With markets concerned about the debt sustainability of Italy and other periphery countries as well as that of many corporate issuers, the received wisdom is that neither the Fed nor the ECB are willing to hike rates beyond a level that is considered safe for debt sustainability in general, which Mr Dalio estimates at 4.5%.

We shall soon see how that these predictions work out. On the one hand, a rapidly ageing population in China and Europe support Mr Dalio’s higher inflation target as we may have seen peak employment in both currency areas. This depressing reality has been afflicting Japan for many years. On the other hand, Artificial Intelligence allegedly poses a real threat to employment. Some of you may remember economists and policymakers discussing taxes on robots to compensate displaced workers. While it is true that self-driving vehicles have not become commonplace, as futurists expected a decade ago, it is no less true that incrementally technology is displacing many workers.

Globalization’s flaw: Free movement of everything but labour

We have argued for years that the flaw in globalization is that while the international order incentivised more free trade in goods and services as well as more open capital accounts, labour markets remain closed to large migration movements. Between 1820 and 1920, approximately 34 million immigrants arrived in the US, helping decisively the growth in US population from just under 10 million in 1820 to 106 million by 1920. It is impossible to understand the US’s rise from a smattering of agricultural colonies to a global empire without accounting for the demographic contribution of these huddled masses. Yet, today, even as the US economy needs to fill millions of jobs, immigration reform is regarded by the country’s political leaders as too toxic to handle.

We do agree with Mr Dalio that it would be very salutatory for the yield curve to shift up to yields closer to 4.5% across tenors. This normalization of the cost of money nearer the “natural rate of interest” will eventually prove to be healthy. In the transitional period, there will be both new costs and benefits. Millions of families who had no particular interest in becoming investors will again be able to save for retirement with some visibility on the outcome of their frugality in nominal terms.

Winners and losers as the tide goes out

As with all Minsky moments, there will be winners and losers as the long period of financial repression unwinds. The usual suspects will have to restructure or liquidate. Creditors will start focusing on EBITDA coverage of interest instead of debt-to-EBITDA ratios. The most solvent creditors will be able to get debt relief by buying back their bonds at a discount to par. In general, credit markets should widen while mortgage prepayment speeds may slow down to a crawl. Investors generally expect banks to make higher profits. While banks may post higher pre-provision earnings, their internal models may underestimate the cost of risk in the new higher rates environment.

Equity markets may suffer another leg down. Punters in the stocks of unprofitable declining businesses may end up regretting their hubris. As offensive as their defiance of financial economics may be to some, their bets at least contained an unlikely, yet plausible, scenario where they could make a nice return. This was not the case, and remains not the case, with hundreds of billions of bonds yielding close to nothing. The professional investment managers of these positions may soon have to answer for losses that imperil the solvency of many a pension fund and insurance company, especially in the euro zone.

With all this in mind, it should be no surprise that we remain cautiously constructive on a few investments and very concerned about pretty much everything else.

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