Author: viennacapitalist

On this blog I want to share my thoughts on topics of interest. Although my academic background is in financial economics I have been an ardous student of austrian economics for more than a decade. I observe that the school is frequently misunderstood in the mainstream press, mostly stemming from a lack of in-depth-knowledge of the field. On the professional side I have been managing money for hedge funds, family offices for more than twelve years. I would consider myself a value investor with a macro bent.

Capital Flight from China continues

From the FT,

(…)Chinese investors have made their first foray into English football, snapping up a 13 per cent stake in Premier League leaders Manchester City just weeks after President Xi Jinping visited the club’s academy(…)

USD 400mln for a 13 percent stake in ManCity!

And why?

(…)We see unprecedented growth opportunities in both its development as an industry, being China’s most watched sport, and its inspirational role bringing people of all ages together with a shared passion(…)

You see: they are taking their “rebalancing” seriously…

Whenever I see old football pics, I cannot fail to notice how a lot of the sponsors at the time were representative for a certain bubble period. This is especially true for British clubs, as it is easier for foreigners to have a say in a club in Britain than on the continent. For instance, a lot of British top clubs in the 80ies and 90ies were sponsored by Japanese firms. With hindsight we know this was the peak and investing in the sponsors would have cost you dearly  – think Japanese electronics industry (Sony, Sharp, Panasonic etc.)…

Although I am no fan of British football, below is probably one of the most representative pics, taken somewhen around the GFC in 2008…

FootballRonaldo

…you could say that AIG and Northern Rock were certainly part of a bubble industry back in the days.

So will the investment in Manchester City help diversify the Chinese economy?

Count me sceptical…

Disclosure (short CNH and short AUD)

 

Renewing the CNY short

Tomorrow my CNH short option will expire – worthless.

I bought it two years ago when implied vols were around 5 percent. Three weeks ago I already renewed my commitment and had to pay 10 percent. Thus, my greed for not paying up for one more year has cost me money. I should have known that the Chinese will try very, very hard to save face and only devalue when the cost of that will be unbearable. I had been told many times that this is an important element of Chinese culture.

Lesson learned!

I still think that the CNH puts are cheap :

  • the Renmimbi spot is way overvalued
  • 10 percent is still a low vol compared to what is typical for EM.

The absence of historical volatility doesn’t mean there is no uncertainty. On the contrary, history tells us that there might be a negative relationship between historic vol and future vol. This is the forest fire analogy Mark Spitznagel uses and which I find enlightening.

Because of that, I am also looking for ways to short the Saudi Rial…

Surprising Jobs Data from Down under

Since I have been short the AUD for the past 2.5 years I have been watching the news from China/Australia every morning (here for instance) with great interest. Given my bearish view on China and seeing it slowly being accepted by the consensus, I think the AUD has further to fall – nothing has really happened yet!  Thus I was surprised when I switched on my computer this morning to learn that the jobs number down under came in way better than expected. Here is the FT for more color:

(…) Thursday’s data, which showed 58,600 jobs were created in October, beating expectations of 15,000, looked to quash any further talk of a rate cut and pointed to resilience in the economy in the face of the slowdown in China, Australia’s biggest trading partner. It took the unemployment rate to 5.9 per cent, a shade under the RBA’s forecast range of 6 per cent to 6.35 per cent that was issued just last week  (…)

How can this be, especially given the recent news about collapsing exports in South Korea and the Philippines as a result of the China slowdown? If anything, the commodity bear market has gained traction over the past months.

I was immediately reminded of the events in April when a similarly good jobs report resulted in a 6 percent gain in the AUD and caused great losses for Crispin Odey, the famous macro manager. Here is what I wrote back then,

(…) To be honest: I have no clue why the job data for February came in much better than expected. Macro data are backward looking anyway and do not help much in assessing future outcomes. Interestingly, the RBA also doesn’t believe that this is sustainable, since they did cut the benchmark rate further (…)

Yeah, right: single point “real-time” Macro data are should not be relied upon too much, especially when the outcome is completely counterintuitive.

Now I learn on Zerohedge (here), that there have been serious questions about the data quality of the seasonally adjusted jobs number in the past,

(…) The ABS is itself cautions against placing too much credence on the monthly figures, which are based on a changing sample, particularly the seasonally adjusted data. The statistician encourages people to focus on the trend estimate (which had the unemployment rate unchanged).

And, after a series of stuff ups, revisions and methodological changes over the past year, there is even more room for caution.

Last year, the ABS was forced to abandon seasonally adjusted labour force numbers for a period after conceding they were unreliable. The former chief statistician recently said the data was not worth the paper it was written on (…)

Lesson: it is probably not just China massaging the numbers that are most watched…

 

Disclosure: short CNY, short AUD

Stan Druckenmiller Interview

Stan Druckenmiller is one of my favourite managers. I always listen to what he has to say and I usually agree with most of his views (I disagreed with his bullish China call a few months back, obviously). This week he gave an interview at the NYT Deal Book Conference and I recommend it to everyone. Here is the link,

http://www.valuewalk.com/2015/11/stan-druckenmiller-dealbook/

The interview is worth listening to in full, but I just want to share my spontaneous thoughts on two of the topics he touches in the interview: Larry Summers and Amazon.

Larry Summers and what’s wrong with modern macroeconomics

Druckenmiller is of the opinion that the Fed has been overdoing it with ultra-low rates and QE and thereby encouraged investors, governments and corporates to engage in risky and irrational activities such as stock buybacks near record highs instead of business investment. Andrew Ross Sorkin, the host, notices that in a recent WSJ article, Nobel laureate Michael Spence has echoed a similar view.

The Spence article is interesting because it has triggered an angered response by Larry Summers, the outspoken former Treasury Secretary to whom it is completely inconceivable that lower interest rates can be responsible for reduced business investment on the margin. Therefore he calls Spence’s claims nonsense. When asked about his opinion on the dispute, Druckenmiller states that the real world differs from Summers`s classroom models and that in the real world “short terminism” coupled with low interest rates leads to gambling, rather than investment.

How to make sense of that?

Without knowing for sure, it is likely that Lawrence Summers bases his view on some macro model (given that he is a macroeconomist) that looks at the world in terms of aggregates. In these models there is usually only one “price-level” – the aggregate price level – that matters and the dynamic effect of changes in variables is analyzed evoking the famous “ceteris paribus” assumption. In these models a lower interest rate always leads to higher investment “ceteris paribus” – all else equal. Macroeconomists are so convinced of their models that when they see falling business investment and falling interest rates at the same time, it must be because the interest rate is not low enough. Hence the “liquidity trap” chatter and the call for negative interest rates.

Needless to say: this is utter rubbish!

The interest rate is not equally important for all industries. It depends on whether the industry is early stage or late stage (see the famous Hayekian triangle). An economy that is dominated by early stage industries such as Australia and Canada will show more interest sensitivity in aggregate investment spending than those that are dominated by late stage industries. For a complex economy such as the US it is difficult to say what dominates, but the evidence could mean that later stage industries (services!) dominate. Those industries that are early stage, such as shale gas and real estate, have experienced a boom in the US, it just was not big enough to raise aggregate investment which is what Keynesians and Monetarists are obsessed with.

Given that Stocks are long-term assets, stock buybacks decisions too are very sensitive to interest rates. By lowering interest rates the relative attractiveness of stock buyback vs. capex in early stage industry increases. It can be argued that buybacks “crowd out” business spending.

What’s more, in the real world, it is never “ceteris paribus”. When the fed lowers the interest rate or engages in large scale bond buying, it is changing the expectations and relative prices of individuals SIMULTANEOUSLY and not sequentially – which is precisely why economics does not lend itself well to mathematical modelling. In other words it might well be that the benefit from lower rates is offset by some other factor that matters for the investment decision. The aggregate price level does not matter to corporates – just ask the oil industry.

Conclusion: Lawrence Summers is a man with a hammer and Michael Spence is right.

Amazon

Druckenmiller likes Amazon and thinks that Jeff Bezos is a great entrepreneur who is not focused on the short-term. He notes that Amazon has much more misses in quarterly earnings than for instance IBM (a heavy buyer of its own stock) which he sees as evidence that Bezos does not care at all about meeting short-term targets. I like his way of reasoning and will try to incorporate that metric into my stock screener.

When confronted with the fact that Amazon is barely profitable, Druckenmiller retorts that Amazon has pricing power and could show positive margins whenever it so desires. This is similar to an argument I made recently (here), but I still would like to see some numbers behind Amazon’s pricing potential. Would be interesting to know his detailled thoughts on that.

However whereas I agree that Amazon has pricing power, I do not think that is true for a lot of the “unicorns” who are often priced off traded tech companies like Amazon and Facebook. So what is a justifiable triple digit PE for Amazon might be sheer fantasy in most cases….

 

Jim Chanos on Tesla and Glencore

Jim Chanos was on Bloomberg TV this week and shared his thoughts on recent developments in the markets.

I recommend to watch the whole thing here:

http://www.bloomberg.com/news/videos/2015-10-12/jim-chanos-explains-his-short-of-tesla-solarcity

His main point on Tesla was that it is much more difficult to become a profitable car manufacturer than be innovative, something which I also pointed out in my post a few months back:

(…)Red bull, an energy drink producer (!), decided a few years back to enter Formula one for marketing reasons. It hired the right people, has spent a meaningful amount of money and competes successfully with the likes of Ferrari and Mercedes ever since. No question, Red Bull’s execution was excellent, and good execution is rare. But, I reason that if Red Bull can dominate the most competitive racing series, building a single good car is doable (…)

Obviously, I fully agree with him. However, he also pointed out that BMW is already selling more electric cars in the US than Tesla, albeit smaller and cheaper ones.

If Tesla ever becomes a large-scale manufacturer of electric cars – as implied by its valuation – its returns are likely to be meager due to the absence of a true “moat”.

Chanos also indicated that he might be short Glencore, the troubled commodity trader.

http://www.bloomberg.com/news/videos/2015-10-12/jim-chanos-i-m-a-potential-purchaser-of-glencore

His main argument is that the company that used to be 20:80 (hard assets vs. trading) has basically become the opposite as a result of its Xstrata acquisition at the end of 2012 (at the top of the commodities boom)…

But it’s not just the changed business model that is worrying, Chanos expresses doubts about the company’s trading acumen now that Glencore tries to shed assets to generate cash for debt repayment. Chanos observes,

They were buying assets at the top and selling them after the crash, does this sound smart to you?

I have expressed my doubts about commodity traders acumen in the past and I have no doubt, given the lemming like behavior of most boardrooms, that other commodity traders suffer from equally bad judgement…

The Euro and the Austrian view (Part IV: Why joining the Euro can be dangerous)

In my last post, I tried to define the “Europroblem” more accurately. This was necessary because the topic is usually discussed in generalized terms that prevent us to see the root cause of the crisis. I argued that a common monetary unit for the Euro zone does not constitute a problem per se. Indeed common monetary units were the norm in much of the past and are still used in much of the world without having the same negative effects as in the Euro zone. The causes for the crisis lie elsewhere. I claimed that what makes the Euro zone situation unique in history is the fact that when the Euro was created, many countries that had “EM-type” banking systems joined a fractional reserve (DM-Mark) currency block virtually overnight thereby triggering a boom-bust cycle.

In this post I will analyse the problems that arise from this process, first by looking at it deductively and then looking at a natural experiment case study for empirical evidence.

The difference between dollarization and joining the Euro

First, let me clarify what I mean by dollarization and why it is fundamentally different from what happened in Greece and the PIIGS. Dollarization occurs when a country – typically and Emerging Market experiencing high inflation – adopts the USD (or the EUR in which case it is euroization) as legal tender within its borders. The fact that the country changes its legal tender laws doesn’t mean that USD (or EUR) have to be procured, since in most cases the currency in question will already have circulated for quite some time in the country and will be readily available. The government merely stops pretending it can continue to issue widely accepted medium of exchange on its own and acknowledges the facts on the ground. This has happened many times in history, more recently in Ecuador and in Montenegro. Currency boards – a slightly watered down version of the same phenomenon – are even more common.

Note that dollarization is unilateral, i.e. it doesn’t require the approval of the central bank that issues the reserve currency, i.e. the Fed or ECB. No Maastricht treaty or any other document of cooperation has to be signed and there is no discussion about fake budget numbers and “shared values”.

Why?

Answer: no treaty is required, since there is no privilege conferred by abandoning the local currency. Life goes on as before for the citizens or even improves as the transaction costs of switching between the (undesired) local currency and the de-facto medium of exchange disappear. Not much changes for the local bank manager either: he has to keep a high enough liquidity reserve against FX deposits just as before and credit growth is strongly tied to savings growth. The bank looses FX conversion fees though a substantial source of revenue for EM banks, which is why currency boards are more common, I suppose.

Joining the Euro(system)

When a country joins the Eurosystem, however, the situation is fundamentally different. There are long negotiations, there are criteria and transition phases etc. Whereas the focus is usually on the free movement of goods and people, the biggest change – as we will see – actually happens in the banking system. Why, because the government debt of the country in question will be eligible for tender at the ECB virtually overnight – a huge privilege and a game changer. Access to the reserve currency via a central bank, in turn, incentivize the banker to run down his “uneconomic” liquidity reserve which before, as a proportion of deposits, had to be much higher than for his peers in the Eurosystem. He now can afford to be less cautious courtesy of the new (marginal) lender of last resort (the ECB). Consequently, underwriting standards are lowered, liquidity cost goes down and a boom bust cycle is set in motion.

For illustration, below is a chart with the evolution of the equity ratio in the US banking system. I use this ratio as a proxy for balance sheet expansion, i.e. credit/money creation. As you can see, the equity ratio experienced a sharp fall twice in the last century. First, after the founding of the Federal Reserve in 1913 which enabled bankers to run down their prudent reserves as there was a “lender of last resort” and another time in the 1930ies with the introduction of the FDIC which reduced the probability of bank runs. Both events set in motion huge multi-decade credit bubbles.

USequityratio

My hypothesis: when a country with a non-reserve currency joins a reserve currency block it is akin to the introduction of a central bank with all the consequences. This is because the local central bank’s role is now enhanced: whereas previously its capacity as “lender of last resort” was limited by its FX reserves, it becomes virtually unlimited once it is part of a reserve currency block such as the Eurosystem.

In the next step I want to test my hypothesis with a case study.

A natural experiment: the Euro introduction in Slovenia

Slovenia became a full member of the EU in 2004 and a member of the Eurosystem in 2007. Its immediate neighbour Croatia (the capital cities are 120km apart), however, has become a member only recently and to this day has not joined the Euro. The two countries are as close as you can get for an experiment in the social sciences.

They have:

  • comparable degree of development
  • similar culture, shared history, close economic ties
  • both banking systems historically DM/Euro-based
  • local currency after independence pegged to Euro
  • 80 percent of the deposits Euro based – characteristics of EM-type banking system
  • Comparable legal system

So if my theory is correct, we would see a relatively higher degree of credit creation in Slovenia after 2004 when it became clear that the country would join the Euro in 2007. As markets tend to act in anticipation, it is to be assumed that a large part of the credit creation predates the formal Euro entry.

Indeed, this is the main reason why I prefer this case study to looking at actual data for the PIIGS. Most of the PIIGS joined a long time ago and at different dates, with long transition phases as the Euro project was work in progress during the 90ies. Further, I prefer to use bottom-up single bank data, rather than macroeconomic aggregates and it can be quite hard to get reliable data from more than a decade ago.

I will use the loan to deposit (LTD) ratio as a proxy for credit-money creation, since it does not suffer from some shortcomings the equity ratio has over shorter time spans (loss recognition, different equity definitions etc.). The analysis will focus on the two largest banks respectively: Nova Ljubjlanska Banka (NLB) in Slovenia and Zagrebacka Banka (ZABA) in Croatia. The latter is majority owned by Austrian Bank Austria Group. Here is the chart that depicts the evolution of the LTD ratio for each bank,

LTDratio

As one can see, the credit growth for NLB (blue) really took off with Slovenia’s EU membership (shaded area) with its LTD ratio rapidly rising from under 90 percent in at the beginning of 2004 to more than 130 percent until the financial crisis. No doubt, international credit conditions were generally easy, a trend which allowed Croatian ZABA (dotted red line) under foreign ownership to expand its LTD over the same timeframe as well. Now, the interesting thing is if we compare this to Postanska Banka (green) the biggest domestically owned Croatian bank whose LTD ratio rises slightly over the period: cut off from direct access to the Eurosystem or indirect access via foreign ownership, it had to adhere to much more conservative liquidity policies, just as my hypothesis would predict.

Thus, both Slovenia and Croatia have experienced their own version of ABCT. The specifics were different (they always are) but the results are the same. Credit growth in Slovenia was driven by local banks and their direct link to the Eurosystem, whereas in Croatia it was predominantly foreign banks that transmitted loose international credit conditions to the local economy via group loans, probably in anticipation of a future EU membership and adoption of the Euro. You will not be surprised to hear that both countries experienced serious real estate bubbles that have now busted.

It is clear that similar dynamics must have played out all over Europe when the Euro was finally introduced in 2002. Indeed, looking at the following chart one gets the impression that the introduction of the Euro acted like an aphrodisiac on the continent’s bankers,

LTDratioEurozone

Of course, the average masks the all-important regional differences,

LTD_ratioEurozone

As one could expect, credit growth was much higher in the PIIGS (here the example of Spain and Ireland) than in the Eurozone overall. This however is entirely explained by the fact that the introduction of the Euro was a game changer for the bank managers in the PIIGS whereas nothing really changed for the Germans, the Dutch, etc. Most discussions focus on differnces in culture and mentality, but this misses the point: there is no need to resort to cultural differences when looking at phenomena caused by abnormal credit growth.

Conclusion

The Europroblem is the result of faulty design, as opposed to irreconcilable cultural differences between member states. This is not to say that cultural differences do not matter – far from it – it is just that they are irrelevant when discussing questions of currency.

The faulty design lies in the fractional reserve nature of our banking system which is known to generate boom-bust cycles on a regular basis, irrespective of whether we are talking about American, German, Greek or Spanish bank mangers or whether banks are privately or state owned. The stark heterogeneity in performance between the core and the periphery is thus not due to some cultural factor, but rooted in the fact that EM-type banking systems existed in the periphery from whom access to the reserve currency via regular tenders was a much bigger shock than for banks operating in “the core” – the starting point matters.

Thus, the discussion of whether Greece should retain the Euro or not is futile and unnecessary and is repeating in a way the mistake made before: ignoring path dependency and the starting point. Consequently, any viable solution has to start with the fact that Greece currently “has the Euro” and this specific banking system.

In the next and last post of this series I will look at how a sensible solution for Greece could look like (and why it is unlikely to happen)….

Very interesting post on risk parity

Longshorttrader with interesting thoughts on risk parity:

  • Why is Ray Dalio making more media appearances than even Warren Buffett? Arguably, Cliff Asness too, though his/AQR’s appearances seem a bit more measured. Both seem highly defensive of risk parity. Why? If you’re in a position of strength, why be defensive? Does not pass the “sniff test”.

  • Why does Bridgewater “backtest” returns without factoring in the impact that their and other RP funds’ presence would’ve had on markets in those past periods? http://www.bwater.com/Uploads/FileManager/research/Our%20Thoughts%20about%20Risk%20Parity%20and%20All%20Weather.pdf

  • Why is it that some obscure outfit called Renaissance Technologies seems to obsess over modeling expected profit potential of a strategy as a function of its size?

  • If Bridgewater and other RP funds’ AUM went to zero, would the world care? Would the world be any worse off?

  • Assume I am wrong. Examine the claims of the RP proponents.

  • Compare/verify/test the proponents’ claims with evidence.

  • How much AUM is dedicated to RP strategies? How much EXPOSURE do these funds have (i.e., how much leverage)?

  • The Leon Cooperman / Omega Advisor quotes regarding Risk Parity are a distraction…the reality and truth are perversely ironic. Time will reveal all.

  • Why should the immediate and more distant future resemble the past, when the immediate past and present wildly differ from most of history?

  • The best “risk-adjusted” way of implementing “Anti Risk Parity” will likely be quite…boring. Though immensely profitable.

I share his concerns. Although I used to admire Ray Dalio when I started investing more than ten years ago for the breath of his analysis and curiosity, I am much more sceptical of him now. I mean how serious can you take a guy who calls this,

Area-chart-of-Total-US-Debt

a “beautiful deleveraging“…

And of course and as regular readers know, I fully disagree with him on China…

So what has happened to the combative, truth-seeking manager of ten years ago?

I think that Ray Dalio has to be very balanced in his public comments – a direct consequence of Bridgewater’s huge size. No doubt, he has many clients (sovereign wealth funds, pension funds, foundations etc.) who are very wary with whom they associate. As a consequence, he is obliged to balance a hundred considerations at once in every public appearance. His position is understandable from a profit-maximizing viewpoint, just be aware that the obligation precludes intellectual honesty (and don’t take his statements at face value)…

 

 

The Euro and the Austrian view (Part III: Formulating the Problem)

This is the continuation of my series on Greece’s and the Euro (click for part I and part II)

There is little doubt that Greece and the rest of the PIIGS have been experiencing a credit induced boom-bust cycle. According to the mainstream view, the main culprit is the Euro which before the crisis imposed a “one-size fits all interest rate” that induced the southern countries to take out too many loans, whereas now it’s a “one-size fits all monetary policy” that acts as “a straightjacket” on the struggling economies in southern Europe, as it doesn’t allow them to conduct their own monetary policy. If you believe in this narrative, you will also believe that “a Grexit” is the only viable solution for Greece.

(The other narrative, mostly told by Eurocrats, is that the reason for the Greek crisis is the result of a “lack of political union” and that it is not the Euro per se that is faulty, but the lack of political centralization. Since this opinion mostly stems from bureaucrats’ wet dreams, rather than any theory known to me, I will not explicitly discuss it here for the sake of brevity)

Problem is: the story is (way) to simplistic and its implications somewhat confusing.

For, how can it be that the Euro led to uniform interest rates before, whereas since the start of the crisis rates have differed between the core countries and the rest? Apparently, it is possible to have the Euro AND different interest rates at the same time. And doesn’t a market that differentiates according to credit risks improve capital allocation anyway? Isn’t that how it should be? After all, that’s what one learns in Econ101 and that’s also what happens in the Eurobond market every day. Finally, why is interest rate heterogeneity across the Euro zone bad now, whereas it is precisely the homogenous interest rates before 2009 that are considered a major cause for the current trouble?

Is this bunch of inconsistencies really the best economic science has to offer? Is it any wonder that everybody is confused by the advice of these “experts”?

Now, the typical Keynesian/Monetary economist would probably defend his position citing Keynes, “…when the circumstances change, I change my mind…” an attitude which will bring him a lot of sympathy – especially among market participants – since flexibility of mind is, no doubt, a laudable goal. However, I do not see how the attractiveness of a flexible mind translates automatically into flexibility in monetary arrangements as a desired outcome. For, as we are currently witnessing, entering and exiting a currency union is no trivial matter and the costs are enormous. It is certainly not feasible to change your monetary system whenever a supposed “external shock” hits the economy and you need some kind of “painless” adjustment mechanism – it doesn’t work.

The confusing statements of mainstream theory arise from a tendency to focus on the present, disregarding intertemporal dynamics. Since the dysfunctional state of the Greek economy has roots in the past, it CANNOT be properly analysed by models that do not account for path-dependency and changes in time, or that leave out the financial sector entirely, as most macro-models do. This leads to conflicting and often nonsensical prescriptions of mainstream economists who fail to come up with something that could work.

The path dependency of an economy arises from a complex capital structure as we typically find in large-scale societies based on the division of labour. In other words, past (investment) decisions do matter and it’s the balance sheet, i.e. decisions made in the past that ail the Greek (and many other) economy. That there is something wrong with the allocation of capital in Greece and the rest of the PIIGS is obvious even to the casual tourist: empty highways and golf courses in the south of Spain, a huge and overpaid bureaucracy in Greece etc. I am sure everybody can come up with some example.

But what, we have to ask, does the EURO have to do with it?

Well, it turns out the answer to this question is a little tricky. For, as I have argued before, the fact that there is a common currency is not problematic per se – see the gold standard, or the various dollarized/euroized economies in the world. Rather, it’s the specific design of the Euro zone and how it has been implemented that are faulty. Now, we all know that the current monetary system characterized by the absence of an automatic and continuous rebalancing mechanism for capital flows, differs radically from the 19th century world gold standard. However, that’s not what I want to focus on here as it is a problem shared by every other economy in the world, not just the Euro zone. Don’t get me wrong, this is a huge problem, but it is not Euro-specific.

Therefore, I want to reframe the question somewhat:

Why has the Euro had a disproportionately negative effect in the PIIGS (and not in “the core”)?

Europe pre-Euro

Before the introduction of the Euro (and its predecessor the ECU), every European country had its own currency “printed” by the local central bank. Since the breakdown of Bretton Woods in the 70ies most currencies had been freely floating. Many countries in Europe still adhere to this model: Scandinavia, the UK and most of CEE. The results of these freely floating currencies were mixed. Whereas southern Europe experienced high inflation as a result of generally more statist inclinations, currencies of “the core” performed better (or worse if you are Keynesian :-)) notably Germany, Austria and the Netherlands, the latter two pegging their respective currencies to the DM-Mark, arguably the most stable fiat money in the world, in the late 70ies.

By the way, while in Southern Europe statist policies led to regular depreciation and high interest rates, the formerly outright communist countries of Eastern Europe experienced bouts of severe inflation and hyperinflation. For instance, two of the worst hyperinflation in recorded history happened in the 80ies (Yugoslavia) and 90ies (Romania) in this geographic area (here).

In an inflationary environment, the best way for individuals to preserve wealth was to store it in the relatively most stable alternative available: the DM-mark. And that’s exactly what most people did. Indeed, the communist government of block-free Yugoslavia even permitted citizens to open FX deposits in foreign currency providing the elite (together with neoliberal IMF loans) with precious foreign exchange letting them to kick the can down the road somewhat longer.

Regardless whether we are talking about communist Europe or the Euro periphery, the respective banking systems were similar, i.e. characterized by high interest rates and low complexity. At high rates the demand for loans was naturally limited to short maturities and lending was done mostly to connected (read: government related) parties. Private debt levels and experience with financial products was low. Since savings occurred mostly in the form of real estate (hence the very high home ownership across southern Europe and CEE) and FX deposits, but rarely in local currency (exception: Italy) it was critical for bank management to keep a sufficient reserve in FX as a cushion against bank runs. In short, the situation for Greece, Spain, etc. was akin to what we find nowadays across Emerging Market banking systems adjusted for local specifics.

To make a long story short: what actually happened in Greece was that an EM-type banking system (Greece) joined a reserve currency block (the Euro) more or less overnight. This is a highly unusual thing to happen and to my knowledge has not happened anywhere else in this form in history – it is indeed a specific Euro problem…

In the next part I will show how this event caused most of Greece’s current problems by first analysing this phenomenon deductively and then have a look at a truly natural experiment – a rare case in economics. Stay tuned…

Is it time to buy Emerging Markets?

The recent sell-off in many Emerging Market currencies and bonds has led to a sizeable outflow from EM funds. As this article in the FT points out, the bad performance has lasted since 2011 and the JP Morgen EM currency basket which tracks the 10 most important EM currencies has reached new historic lows.

Is this a new secular low and therefore time to pile into EM assets?

Not so fast. While it is true that I have taken the opportunity to accumulate RUB assets in the recent sell-off (here) and I start to see value in places like Brazil, it is also true that many Emerging markets have yet to crash (notably: Turkey, Nigeria, China…). These things usually end with a bang and there has been no bang yet, merely weakness

In other words, I believe this to be a relative value market environment, not a secular bottom which is why I prefer to trade around positions while keeping a sizeable portion of cash.

There are two reasons for my scepticism:

  1. The unresolved external debt problem of many EMs (estimated at USD 9-10 trillion)
  2. The technical market positioning

While there has been much focus on the former and there is no need to dwell on this topic (see my short post from last year) now, the article has opened my eyes as regards the latter.

Just look at this chart,

EMCarryTrade

The red line depicts the development of the spot rates comprising the JP Morgan EM currency index. It is at an all-time low and suggests an undervaluation of historic proportions. As usual, you have more and more “experts” coming out and explaining how this is a “historic” buying opportunity. I have no doubts that many a private banking client is shown a version of this chart by his financial advisor as I write this piece.

The second line (rose/orange) shows the performance of a carry strategy applied to said basket taking the interest rate differentials into account. I observe that despite recent disappointing performance, most carry traders are either sitting on long-term gains or on small losses such that making them up must still feel feasible for most.

Carry trading has historically been a highly volatile strategy. But having a healthy risk appetite is merely a necessary not sufficient condition in investing. In order to be long-term successful, one has to be able to avoid the “permanent loss” disasters such as devaluations and sovereign defaults that characterize many of these markets. It is not to be expected that buying and holding a basket of high yielding currencies will positively compound capital in the long-term, as it has since the start of the millennium. This is consistent with Interest rate parity theory which suggests that on average, no returns from holding high yielding currencies can be expected.

Now we know that as a result of its “success” until 2011, carry trades have gone mainstream with many retail investors and institution piling into financial products promising to escape low DM interest rates in recent years. Experience tells us that these newcomers neither have the stomach for high volatility, nor the ability to successfully differentiate between markets. Most of them are starting to experience the high volatility nature of carry trading. You will know the market has bottomed when permanent losses are realized…

 

Buying the Ruble again

The developments this week have been very exciting. I would never have thought that I would see a EURRUB above 80 that quickly again, but WTI below 40 has helped. I took the opportunity to increase my RUB exposure once more at what I believe are attractive levels, despite the fact that I believe this week’s rout is just the beginning.

A few facts: (for my stance on Russia see for instance here, here and here)

Russia’s external debt has decreased from USD 680bn at the beginning of Q4 2014, i.e. the beginning of sanctions and the Ruble crisis in December, to USD 556bn at the end of the first half 2015. At the same time, its foreign exchange reserves have dropped only by USD 60bn over the same timeframe and currently stand at comfortable USD 360bn. Further, Russia’s current account is in surplus, despite the significantly lower oil price enabling it to pay down external debt further. It can be said that from a financial perspective, its financial position is improving, despite lower prices for its export commodities.

I know, I know: you didn’t read that in the NYT or the FT.

As many readers are aware, I have been short the CNY and the AUD for more than two years, since I believe China is unraveling (and commodities with it). My bearishness on all things commodity related and my bullish Russia view might sound inconsistent to some and it probably is, but I believe that demand for the bulk of Russia’s commodities exports (Energy) is less dependent on the China story than for others such as iron ore, or copper. Relative strength if you will.

Further, in many commodity sectors, Russian companies are the low-cost producer enabling it to sit out a market downturn much longer than global competitors. Add to this their usually conservative capital structure (with the exception of Rosneft) and you probably recognize why I am less pessimistic about than most market participants (to say nothing of journalists and our “leaders”)…

And do not forget that the main export market for Russian energy is Europe, not China which should at least keep volumes constant…

This is not a recommendation to buy Russian assets, do your own research.