Bringing it all Back Home

The cover of Bob Dylan’s album of the same name features a Plato’s cave of treasures, all his influences, from mundane to downright strange. And as I write this I’m listening to Bob Dylan’s Theme Time Radio Hour on BBC Radio I-player. It’s brilliantly odd – this week the theme is walking. Nietsche apparently said – great thoughts can only be achieved by walking.

It’s hard to walk and type at the same time – so you’ll have to accept some less than great thoughts as I switch seamlessly to talking about investment.

One of the reasons I don’t hang my hat on one particular style of investment or any particular asset class is that it disobeys a fundamental tenet of investing – kind of obvious really – always maximise performance. And to do that, Buffet and Munger will tell you – you have to maximise your risk/reward on every trade.

Now the best performing investment style over the last forty years has been to buy stocks with a top quartile earnings yield, and a top quartile spread between the return on invested capital, and the cost of capital. In the UK, BHP Billiton, Rios and Xstrata all fitted the bill at the start of 2007. They were the year’s big winners.

And it makes a huge amount of sense. If the stock is relatively cheap, but it can compound good returns, well, someday the share price will come to reflect those underlying fundamentals. You can make money just by being patient. But that’s not enough for me. Because, forty years of outperformance is no guarantee of future returns, however sensible the underlying philosophy.

And that’s because the trade got way too crowded. Credit Suisse’s cash flow return on capital almost became dogma among fund managers from 2002. And this and other similar gauges of value saw the biggest outperformance from 2000-mid-2007 than at any time over those 40 years. And then, from mid-2007 to mid-January 2008, it all came crashing down. Value got punked so badly in the first two weeks of 2008 that many value managers may struggle to get their heads above benchmark for the year as a whole. Q108 was, I understand, Bill Miller’s worst ever quarter.

So, the advantage of running global multi-asset money is that you can walk away from trades that everyone else is on. And, if you are like me, you can go actively short.

And right now, I think the big opportunities to play against crowded trades lie in the currencies.

Last week I wrote – in Dollar Bill – why I have turned fundamentally bullish on the dollar.

But the more I’ve been thinking about the role of currencies in the current system, the more I’ve come to think that the monster trade is to short the Euroyen cross.

When I wrote about why I was fundamentally bullish the dollar, I highlighted that the shrinking US current account deficit was step one – as it reduced the flow of dollars into the rest of the world. Step two was a sharp reduction in the banking multiplier applied to those dollars. And step three was slowing growth and falling rates outside the US.

The FT earlier this week reported on a study into why the Libor/base rate spread has remained so elevated, despite the best efforts of the central banks. The answer was the positioning of the European commercial banks. They had raised US dollar borrowing by $500bn from 2003-2007. And you can bet your bottom dollar that this borrowing funded all manner of convergence trades and purchases of other exotic structured products. The spread will remain elevated throughout the great unwind.

My view is that these positions will be the European Banks’ undoing.

Yet another example showed up last week. When Trichet hinted at a rate hike, we saw an extraordinary 80 basis point flattening in the curve between the 2s and 30s. That, to use the technical term, is totally mental. Why did it happen? The obvious answer is that too many punters were sitting on steepeners. But that’s not enough - there’s another answer. It turns out that the European banks had bought a particular structured product. What this thing did was pay out an income whenever the yield curve was steeper than, say, 10 basis points. It would pay out nothing between, say -10bps and +10bps. And then it would cost you if the curve inverted more than 10bps. Now, this trade was a no-brainer. The curve hadn’t been inverted since the advent of the Euro. And at certain times; 2001-4 for instance, it was massively lucrative.

Only problem – it caused a fantastic increase the Banks’ risk in extremis – as their regular businesses also deteriorate when curves flatten and invert. So when the curve inverted last week, they all started unwinding their positions at once. Welcome to the house of pain.

What’s in store now? Well, my view is that The European Banks will sell-off, over the next two to three years, the vast array of structured products and convergence trades that they built up over the past decade. Losses will be enormous. And as they do that, they will be buying dollars to repay the $500bn of loans that they took out to make these trades. A Euro won’t buy $1.55 when they’re done.

And what of the other side of the trade; the yen? The yen has recently weakened from around 95 to the dollar in mid-March, to 107.50 this morning. I am now betting on a return trip, at the very least. Now, there is no question that there has been a relentless pressure on the yen to weaken from 2003. It came from the massive portfolio diversification of the Japanese housewife, and to an extent, the banks and corporates too. They bought bonds in Australia and New Zealand – all yielding attractively relative to Japanese bonds– and then adding a currency kicker to boot (as everyone got on the trade). But perhaps the notable event is the Indian equity madness. Japanese private investors own more Indian stocks than they own European stocks, a market many times larger.

Now, emerging market inflation throws a spanner in the works of this particular trade. Inflation disrupts the real returns from holding bonds outside of Japan, it also disrupts the currencies – the rupee is now falling. And, yes, it also causes trouble for the stocks – the Indian market is getting whacked. At the same time, we’re seeing some reflation in Japanese property – so the prospects for domestic investment are maybe improving. My bet is that the emerging market inflation, and the general pressure on risk assets, will bring those yen back home.