Pin-up

Marilyn is an unlikely pin-up. Marilyn von Savant that is. She writes a syndicated agony aunt column in the US, which she’s done since 1986. But her real claim to fame was that she was for many years recognised in the Guinness book of records as having the highest IQ ever recorded – 242.

Leonard Modinow tells a story about her in ‘The Drunkard’s Walk’ – a fantastically engaging book on randomness and probability. Anyway, one of her readers asked about the Monty Hall problem. In the game show, there are three doors. Behind one a car, behind the other two; goats. The contestant guesses a door, then Monty, knowing what’s behind all the doors, opens one of the other doors to reveal a goat. The contestant is then asked – stick with your current door, or switch to the other closed door.

So are you best served sticking or switching to win the car? Marilyn said switch. There followed a storm of protest, from the public and from maths professors alike. 92% disagreed with her (either saying it makes no difference, or stick). But Marilyn was right.

Why? Because the chance of not picking the car first go, and instead picking a goat, is 2/3. Then, when the other goat is eliminated, the chance of picking the car if you switch is 1. So you have a 2/3 chance of winning the car if you switch. But a 1/3 chance of winning the car if you stick.

What is amazing about this is how simple, yet unintuitive it is. Even Paul Erdos, the preeminent mathematician of his day, got it wrong.

Now one thing I like about global macro is its ability to generate counterintuitive results. Why the dollar likely goes up, and US stocks likely outperform when the US falls into recession - that’s a classic – but unfortunately now pretty widely known.

But here’s a new one; I think Hungary, an oil importer, will collapse if oil prices continue to fall. And I’m betting that oil prices continue to fall.

Why? Well, it’s precisely the reason that Hungary hasn’t collapsed yet (the forint recently hit new highs against the dollar and Euro). Now I’ve been negative on banks with Eastern European exposure for a year – and I’ve made some good money. But the forint hasn’t cracked and a lot of people have asked me why. Especially during the latest bout of risk aversion from mid-May through to mid-July.

The answer is petrodollar reflows. Oil’s move from $100/bbl to $145/bbl from April through June racked up the oil exporters’ reserves. And those reserves flowed through European banks into emerging Europe.

And heaven knows Hungary needed them. Its current account deficit stands at 17% of GDP. It gets nine percentage points of financing from FDI, and another six from remittances from Hungarian workers in Spain and Italy in particular. The remittances are likely slowing fast (remittances to Mexico have collapsed over the past year) – as the Spanish housing market collapses, and as Italy slides back into the doldrums. So Hungary sure needs the capital.

Johannes Wiegand has just written a paper for the IMF comparing the current funding in emerging Europe with events leading up to the Latin American debt crisis. He’s used BIS data on bank flows to measure petrodollar outflows into bank deposits, and then he’s looked to see where the banks have then lent (he’s used a bunch of complex correlation analysis to get there, and as I’m not prepared to rework his many equations on such a sunny day, I’m going to have to take it on trust that he’s done it right).

And what he comes up with is that;

First, petrodollar reflows into bank deposits are significant – accounting for around a quarter of oil exporter surpluses.

Second, Russia, Libya, Nigeria and Angola have put a lot more on deposit than the Middle East.

Third, most of it has gone into European based banks.

Fourth, those European banks have funnelled over half of their resulting emerging market loans to Eastern Europe.

So the danger for Hungary is that a sharp slowdown in deposits at European banks will lead to a similar sharp slowdown in lending to Hungary. Something the broader process of restricting loan growth across Europe will reinforce. And this just at the point that remittances from the rest of Europe to Hungary will likely collapse.

Now, the problem with this process is that it will become self-reinforcing. Downward pressure on the forint will lower the value of the bank assets in local currency, and reduce the ability of Hungarian borrowers to pay interest. Falling real estate prices will do the same. The banks will become more and more unable and unwilling to lend. Consumers in Hungary with Euro or Swissie denominated mortgages – the majority of them – will see their incomes squeezed.

This is fantastically toxic. And it happens because oil goes down. Just as the Latin American debt crisis did, and despite the fact that Hungary has seen no great resources boost. And this just at the point investors might be thinking ‘well, Hungary survived the May-July sell-off, maybe it’s robust after all’.

My own view is that we will get a full blown crisis in Hungary over the next 18 months. And that falling oil and a rising dollar will precipitate it. I am currently long the dollar against the forint. Further down the track, should equities rally as I expect and shorts in these names get squeezed, I will use the opportunity to return to my short positions in the banks with Hungarian and broader emerging European exposure.

I’m heading down to the New Forest with the family for the coming month, so my posts will likely become a little less frequent. But, I hope, the ‘end of inflation’ theme will remain the same. It’s working so far, and the fund hit a new high watermark for the year today, up 46%.

The Matrix

My theme for the next six plus months is ‘The end of inflation’. And that has some pretty big investment calls riding on it. Short oil, copper & gold, long US stock indices and long specific US and Asian consumer stocks. Long the dollar, long Australian rate futures, short Eastern European banks and currencies.

What’s notable here is that this is completely at odds with the broad investment themes of the past few years. I’m calling for a reversal of the six year commodity bull, the five year dollar bear, and the one year drop in stocks.

Now, what is plain is that these kinds of tectonic shifts are not going to happen without some serious market tremors.

So it struck me during the last week or two that I needed to do a lot of work to prepare myself for trading the next six months.

Brett Steenburger, of ‘psychology of trading’ fame has some classy advice. He has identified frustration as the primary enemy of the trader. Trade when you’re frustrated, and you pretty much guarantee you lose your edge and blow your performance. And to avoid it, you’ve got to visualise ahead of time your successes and failures, and how you will deal with them. It’s all about emotion – the visualisation gives you a control over the situation you didn’t have before – it stops you getting frustrated and it kicks out a lot of bad trading.

So what I visualised was three outcomes;
1) I’m right in size from day one.
2) Several of the markets I think will reverse will see double or treble bottoms/tops
3) It isn’t the end of inflation, oil and gold start to recover from recent corrections and punch to new highs. Or instead, we get a full on deflationary bust.

How do I deal with 1)? I don’t increase the bet size. Why? Because I need to be sitting on a decent profit so I can wear the inevitable correction that follows.

How do I deal with 2)? I make sure I’m not running too levered a book, and I run wider than usual, but clearly defined, stop limits. Even worse than losing money because you’re an idiot, is losing money when you’ve got the call right. Why? Because it means you’ve come in low against Puggy Wilson’s three rules of gambling;

1) Know the right end of a 60/40 proposition.
2) Know yourself.
3) Know how to manage your money.

If you lose money when you’ve got the call right it means you’re short on 2) and 3). And that’s too short by far. So how do I deal with this? By not running too leveraged a book I mean 300% gross, rather than my 500% limit. And by wider limits, I mean 3x normal, which is ok given my performance to date. In other words, I do it by being ready for the loss. A loss unexpected is fantastically frustrating. A loss planned for is a cost of doing business. So my attitude to it is completely different. I’m sinking 5% to make 20%. It’s an investment.

The next one is much more difficult.

What do I do if I’m wrong? And how will I know I’m wrong, rather than, say, buffeted by volatility. There’s the nub. The first point is don’t make the decision when you’re frustrated, which means don’t make the decision after you’ve lost money. Make the decision before you’ve lost money, in the cold light of day. And to make the decision, you’ve got to enter the Matrix.

Now the Matrix is an idea, or a way of doing things, that comes from Richard Heuer, the ex-CIA research man who wrote ‘The psychology of intelligence analysis’. When I talked about this book last, I said that when I get to run a fund, I’d buy a copy for every analyst and fund manager there. That’s what I did when I started my own private fund – I bought the book for myself.

So here’s how he does it. He gets a bunch of analysts in a room to chew on a problem – the more diverse the better. And he creates ‘the matrix’.

Along the top; four or five views, or hypotheses. Along the side, loads of ‘evidence’. For markets, this would be everything from sentiment, through positioning, market moves, all the way to actual, er, fundamentals.

This is very different from the usual way of doing things. Mostly, we create a view – our best guess of what’s about to go on. And then we subjectively decide whether each new piece of evidence supports or undermines our call. The question – how likely is that to be the best way to get at the truth? Er, not very likely.

So, before you ‘go deep’ on a call, you’ve got to look at evidence. You can’t say ‘Hey, I’m a genius, I’m right’. What you’ve got to say is ‘that knocks out theory three and four, it fits with my number one theory. But theories two and five, well, they could still be right. They could still be better, more moneymaking, theories than mine.

All my time in markets, I never heard anyone talk like that.

So the best competing hypotheses with mine are;

1) A total deflationary bust wipe-out. The banks become unable to lend. Cash rich corporates and debt laden consumers become unwilling to spend.
2) Inflation a-go-go. Central banks might have acted a bit, but cash rates are still low against inflation. Inflation is always and everywhere a monetary phenomenon – so inflation here we come.
3) Peak oil. Oil supply has peaked. So, from here, weak global growth gets little oil ‘price relief’. Improving global growth gets outsized oil price gains and crowding out.

For brevity, I’ll stick to the big four. Here it is, and I hope you can read the chart.

So, three things to say.

1) It’s pretty easy, physically and mentally, to enter the data into the matrix.
2) It’s actually quite hard to do, emotionally. I almost persuaded myself that I just had to write about it – without actually doing the work.
3) It’s surprisingly hard to eliminate competing hypotheses.

The hardest to eliminate of all is peak oil. That suggests that I need to keep ‘peak oil’ on the backburner, as a potential major trade down the track. Deflationary bust isn’t that easy to dismiss either. If oil, copper and gold keep going down, and the dollar up, but stocks fail, I’ve got to keep my discipline and cut the stocks.

So I’m hoping that my awareness of the matrix does for me what it did for Keanu; lets me fly around in a full length leather coat and kung foo the bad guys.

Coke break

One thing I got out of the book I read on John Templeton was a sense of how he got into hated stocks and held his nerve.

Buying the airlines after 9/11 was an example – he knew they were despised, he didn’t believe it was the end of travel, and he was convinced that the government would not let them go bust in the wake of a terrorist attack – that would mean that the terrorists had won. It was also clear that once he made the decision, he could stomach a lot of volatility on the way to making money.

So it wasn’t enough for something to be cheap but shunned. He needed an angle.

And there is no doubt that, if you’re out to buy consumer discretionary stocks or financials right now, you need some kind of angle. Last Tuesday was a great time to buy consumer discretionary and distressed financials just because they were hated. Short interest in individual US financial names, at 11% was more than three times the short interest in tech names in 2001 & 2002. And I’m sure the long onlys were one way only.

But if you bought then because everyone hated them, you might have sold yesterday on the US correction, or today on the National Australia Bank announcement. NAB didn’t just chuck out the kitchen sink – it tossed the whole kitchen.

So this is where the ‘angle’ comes in. And getting the angle is, I think, the difference between fast money trades and quick profits (and I’m not knocking quick profits) – and serious compounding returns. My view is that ‘the angle’ makes you three or four times the returns you get on correctly timing a quick sentiment call.

And the angle here is falling inflation. Now that’s a big change from the world as we know it. Ever since early 2002 we’ve seen building inflationary pressure and rising resource prices. Believe it or not, 97 of the 100 commodities that make up the broad Goldman Sachs commodities index were up in 2002. That was one thing that told you, before the equity rally from March 2003, that the world economy might be on its way back up.

It’s quite hard to back up the truck from the kind of inflationary pressure that we’ve seen build over the past five years. What with concatenating resource and infrastructure shortages and with powerful wage pressure in the oil producers and the currency manipulators. There’s an awful lot of evidence out there that inflationary forces are strong.

But that’s the point. You get the biggest payoff from an anti-inflation call when there’s lots of inflation, but the pressure is turning.

And turning it is. First off, the Fed is holding money tight – we’re seeing very little base money growth in the US – despite all the talk of ‘printing money to bail out Bear Stearns’ etc. Next we have the aggressive shrinking of the US non-oil current account deficit – that effectively reduces bank deposits in the rest of the world. Then we have the massive unwinding of the bank multiplier – as the shadow banking system folds in on itself. It all leads to a major reversal in global bank reserve accumulation.

All this is generating deflationary pressure across the world. And from a point of maximum tightness, we likely see logistical and resource bottlenecks loosen across the world. We also see a reversal of the incentives to hoard resources. We may well get Europe, the UK, Australia and New Zealand in recession in 1H09, a dip to lower growth in the US and a collapse in Eastern Europe.

Now, if I’m right, and this causes a major fall in energy, food and metals prices, we’ll start to see a powerful play-through to headline inflation. Even if oil just stopped going up, US headline inflation would fall back from 6% to 3% by next June. If oil falls back sharply, we could get a zero headline CPI reading, even negative numbers.

1975 can tell you a lot about how markets behave when inflation falls fast – and thanks to Teun Draaisma of Morgan Stanley for the data on this. Because headline inflation is the single most powerful driver of PE ratings (see chart). In a period of high and rising inflation, ratings get crushed – as they should. Because no one knows their cost of capital, and there are huge incentives to run companies inefficiently (ie with high inventories). That’s why, when you see inflation coming to a sector’s prices – always buy the small inefficient companies. That worked for housebuilders in 2000, and it worked for miners in 2003.


But when inflation falls, it’s a different story. Teun points out that US EPS fell 40% from December 1974 to April 1976. A disaster story – and the expectation of falling earnings is something many people are using to remain bearish now. They may be right, on the outlook for earnings that is. But inflation fell from 12% to 6% through 1975 as food and fuel prices fell-off. And the market was up 80% over the period. It was re-rating a-go-go.

So what should an investor do, if he thinks we are due an inflation break? The first thing he should do is sell all the small stocks in the inflationary sectors. Small cap oil and junior miners are toxic in a world like this.

The second thing he should do is buy big and low cost. Big sales to market cap, big economies of scale, lowest costs in the business. Companies that win with scale. In Asia it is stocks like Tsingtao Breweries and China Mobile. In the US it’s the Cokes and Walmarts. GM doesn’t win on costs, but it hits the ball out the park on sales to market cap.

Perfect Swing

There are loads of reasons I trade global macro. Rather than, say, specialist commodities money, European long/short, asset allocation or, heaven forbid, long only regional cash.

And probably the most important is that it puts me in a much better position to control risk.

At its simplest, global macro trading is all about working out which quadrant the market will pass through over the next six months.

If you believe it’s a disinflationary boom (growth with diminishing inflationary pressure – or more likely here, slowing growth, with surprisingly rapid diminishing inflationary pressure) – then you buy the biggest, lowest cost producers, you buy US and Asian consumer and insurance plays, Asian and Latam real estate, you buy bonds, the dollar, and you sell commodities and resource stocks – and you buy the best bombed out bank.

Deflationary bust; buy bonds, sell equities & commodities. Inflationary bust; own commodities, sell stocks, bonds and rate futures.

Now, the beauty of this construction is that if you make a call – for disinflation (as I did two or three weeks ago) – and you put all the trades on (not just your favourites) – you can afford to be a fair bit wrong and not lose. If it’s a deflationary bust, the gains on your long dollar, long rate futures, and short commodities should offset losses on your long equities.

If, instead, it’s an inflationary boom (growth and inflationary pressure), your gains on stocks, offset some losses on commodities, rate futures and the dollar. And, at the very least, it should buy you some time to change your mind.

If you’re right, the market will still flit between segments, even during a sustained disinflationary phase, this spread of assets will reduce your volatility, increase your sharpe ratio, or, in words I understand, it will help you preserve your equanimity, and all that good stuff.

And this works because it’s pretty hard for the economy to lurch from corner to corner – from disinflationary boom to inflationary bust, for instance. It tends to go from side-to-side, or up & down.

So, when I set up my fund to play disinflation two or three weeks ago, I went with the same ‘double sized’ risk I went with into the ‘inflationary bust’ trade in mid-May. I was standing +35% three weeks ago and, in line with my trading rules, that allowed me to increase exposure and widen loss limits. But when I take on more risk, my risk discipline remains unaltered, if I hit a stop, I cut, period.

What happened next was highly unusual. The market flip-flopped between disinflation and inflationary bust. Corner-to-corner. And this took away the automatic macro hedge in my portfolio, with a vengeance. Either every position won, or every single thing lost. I think this happened because the accelerating moves down in the banks and the accelerating moves up in coal and oil were big on momentum and positioning, but mutually exclusive.

So I started seeing some intense volatility in the fund. Maybe three times what I’m used to. After a 9% drawdown in the week to Monday last, the fund recovered aggressively and now stands at a new high, up 44% for the year.

Now I’ve trained myself to deal with some decent market swings. But this degree of movement suggests to me that I risk breaking my only golden rule of investment; never blow yourself up. Or, to be more accurate, never get into a drawdown doldrums that puts you off making money.

So I took advantage of the moves yesterday morning to take a third of my risk off the table.

Now, I would never put as much risk on the table, a-priori, as it turned out I did, ex-post. But as Gavekal is wont to say, fund managers are paid to adapt – and I think that reducing risk now is right – even during a good run, in a market prone to acute macro schizophrenia. Even if I think that the good ‘disinflation’ personality in the market will win out over the evil ‘inflationary bust’ persona over the coming weeks and months.

There is another way to run global macro money that helps with what I call ‘real risk’. Not the VAR type measures that missed every one of the 31 listed hedge fund blowups over the last 12 months. But the real risk when positioning is extreme and fundamentals reverse.

And it is to watch what I call, for want of a better phrase, behavioural correlation. Now, what I do is look at the big, long in the tooth themes. And this is for me a bit more of an art than a science. Basically, I look for long running theme, with a lot of historic P&L, chunky positioning, and loads of front page coverage.

So you have three types of theme – loved, hated, and ignored. And what I do is create an index of each. So, as an example of a theme, peak oil, I wouldn’t just use the oil price as the index. I’d use the uranium price, the coal price, the deep sea drilling day rate, oil drillers shares etc.

Then I look at each instrument I’m trading, and I run a correlation with the index. I then work a weighted correlation for the fund against the theme.

So the idea is – be non-correlated/negatively correlated with the ‘heavy’ themes. And be happy to be positively correlated with hated themes, and sneakily involved with ignored themes. If you make a mistake, cut.

So what I’m trying to get at is what the difference is between real risk/reward, volatility risk, and mistake risk.

Each requires a different attitude. I use stop losses to guard against mistake risk. I use volatility adjusted gross limits to guard against volatility risk (my fund’s volatility was higher than I thought it would be over the last two weeks, so I cut my gross). I use ‘behavioural correlation’ to make sure I’m running good ‘real’ risk reward.

Now, that’s all good, but there’s another type of risk. What I’d call extreme thematic risk.

I’m only just beginning to deal with this sort of risk in my macro fund. The attraction is that plays are often micro thematic – they’re opportunities to make money when something unusual happens. And if you’re early enough – they are ‘ignored’ on my behavioural correlation tests. When I’ve bought some time in the fund, I’ll go looking for some ‘extreme themes’ to make me some extreme, unusually uncorrelated returns. My first trade, four months ago, was Pico holdings. Macro, schmacro, in a major West Coast water shortage, Californian water assets are the wrong price.

What not to wear

I mentioned on Monday that I’d read a book called ‘Mistakes were made, but not by us’. As books on the human condition go, this comes out of the top draw.

The central idea is that we all invest ourselves in our views. Of what kind of people we are. What kind of people yous are, the right way for society to treat its rich and its poor. Whether the US is debasing its currency and gold is heading for $2000/lb. Or whether the implosion of the banking system is to send us into debt deflation and Dow 2000.

When we get invested in a view, it becomes part of us. I’m a caring person – because I say that society should subsidise its poor. I’m a libertarian and a realist, because I say that society should allow extreme wealth, because that creates the opportunity and motivation for people to better themselves. And so on. When you have an internally consistent global macro view, it’s very easy to start thinking you’re smarter than the average bear.

And then something happens that doesn’t agree with your call – it creates a dissonance. Not just with your view, but with your view of yourself.

So it’s natural, it’s a self-esteem survival instinct, to diminish in your mind data that undermines your view and you with it. And to accentuate the positive – to bolster your own standing.

Now this is all very well, you might say, and I can see that people do this, but it doesn’t happen to me. That is one of the clever things in the book – that’s exactly what you would say, in spite of evidence to the contrary, to preserve your self esteem. And damn it if I don’t see myself do it, and the people around me do it, every single day.

Now, in my view, it’s just this resistance to mental change that causes the building feedback loop of price change, P&L and popularity that is at the heart of boom & bust.

It’s one reason I’ve got some sympathy with Robert Prechter’s theory of socionomics – that it is changes in social moods that govern markets, that then feed back to economies, and then to broader social developments (like the rulers we choose, and their tendency to start wars).

Now one implication of Prechter’s view is that social moods move in waves - it’s the most efficient way for a natural process to organise itself. Woody Dorsey, who wrote ‘Behavioural Trading’, also talks about the lifecycle of themes, and he carries out surveys to find out how prevalent, or out of favour, themes have got.

So the situation up to last week – with financials going asymptotic down(ie the trend accelerating) and oil going asymptotic up – well that got the bahaviouralists to fever pitch. Both themes have been trending for the last 18 months, and accelerating for the past year. On the one side, oil was running out – and the oil price was heading for $200/bbl. On the other, the financials were heading for zero. But it’s dangerous to extrapolate these themes – because ultimately, I think, they become mutually exclusive.

And the behaviouralists would say that both themes have gone so far, and become so widely accepted, that the natural move now is for oil to fall and financials to rise.

That brings me back to my point about dissonance. A lot of people are heavily invested, personally and professionally, in the ideas of a falling dollar, rising oil & gold, and falling financials.

But I think that there is a big dissonance out there – and that is the shrinking US current account deficit, the shrinking banking multiplier, the rising cost of capital and the falling returns in the developing economies.

That kind of stuff can loosen bottlenecks pretty fast. It can also generate extreme credit stress in poorly managed peripheral economies.

So my call here is that we move forward in waves of disinflation and deflation. When oil starts to fall, and markets are oversold, it’s right to buy disinflation; US autos, global airlines, Western and Asian consumer stocks, even bombed out financials.

Then, when markets have bounced, it’s right to bet on the next wave of debt deflation – this time in Europe, especially Eastern Europe.

And through the whole thing, if I’m right, it’s right to be long the dollar, and short commodities. So far, the call is working nicely, and I’ve just hit a new high of 41% up for the year.

In my next piece ‘Perfect Swing’ I’ll talk about some unusual aspects of the current market action – that has caused a surprising (at least to me) spike in volatility in my fund – and what I’m doing to control my risk.

Dirty

I didn’t kill myself worrying about the market over my holiday last week. What with rowing the kids over to the island, cooking barbecues, fishing for mackerel (good) and pollack (er…), and dog days on Howe strand.

Things had already got tricky the Friday we were leaving for Ireland. By that time I’d hit an 8% drawdown from my 38% high – the biggest drawdown of the year. And when I said I was going into the holiday with high conviction, I wasn’t ready to blow myself up. I halved my risk before we got on the plane. As a day trade that was just as well – at the close that day I was a fraction shy of 10% off my peak.

Now, as it happens, I was reading two books while I was there; ‘Amarillo Slim in a world full of fat people’ that I picked up in the gambling section of the Books etc at the airport, and ‘Mistakes were made, but not by me’ by Carol Tarvis and Elliot Aronson. Both were easy to read, and they got me thinking about how to deal with my trading.

So what I was thinking about in the downtime from the kids & family was how good a bet it is to bet on disinflation/deflation from here. Falling commodities, rising bonds, a rising dollar, and in the short term – a higher Dow.

Was I simply justifying my decision, because I’d made it already, and told everyone what I thought? Or did I still think, in the light of day, that the call had a great risk/reward payoff?

In short, I thought the bet was good. Early last week I put the risk I’d taken off the Friday before back on. The only other trade I made was to cut some of the long rate futures Thursday as oil fell apart (high oil, in my view, has been deflationary of late) and put it into long stocks.

Make no mistake, I’d have cut my losses in a New York second if I thought I was misreading the market; justifying a decision I’d already made, and misrepresenting the opposite view.

Now one of the best ways of analysing how good a trading view is, is to ask, dispassionately, how strong an alternative view is. And the strongest alternative view is that shortages in energy resources will continue to worsen. If that is right, then I will likely lose money. The dollar would struggle to rise, global recession would loom large, and high headline inflation numbers would help de-rate stocks further. Pretty much all my trades would fail.

The thing about the long energy trade is that it’s very convincing. The fundamentals in coal and oil are the tightest they have been in a generation. And my argument against them is, well, a little tentative.

My main consolation is that the best selling opportunities for commodities come when people think that they are running out (oil) – and the best buying opportunities come when people think the commodities will stay free forever (like, say, water).

I have been reading a bit of technical analysis on how long blow-off bull markets end. And this has been a long blow-off for oil– lasting 365 days to the high early last week. It’s rare for a major market to go asymptotic for longer.

The major macro reason for believing in deflation/disinflation is that the non-oil current account deficit has collapsed – from 5.5% of GDP in 2006, to 2.5% now. As I mentioned in a previous blog ‘Decision Three’ – that is the equivalent of reducing global base money supply. But that’s not the only deflationary effect. Global banks – especially those in Europe – will reduce their bank multipliers aggressively, as they seek to defend their balance sheets against further capital destruction. So the main source of inflation is the spending from the oil states (about 7% of world GDP) – the oil deficit rose from 2% of US GDP in 2006, to 3.5% now. My view is that this inflationary pressure is getting increasingly narrow.

The counter to this is that it is energy supply that has been the major factor behind the tightness. I struggle with that argument – as we have just seen the five strongest years both for global growth and for the intensity of commodity use in several generations. What I would agree with is that energy supply has been exceptionally unresponsive to that demand growth.

I don’t buy the idea that financial speculation has forced energy prices higher. I think financial speculation has simply followed the fundamentals. But I do think a couple of temporary factors have added the exceptional tightness this year. One was China’s aggressive moves against small/unsafe coal mines over the past two years. Moves that caused 11,000 mines to close, and which helped precipitate a major coal and energy shortage in the wake of China’s twin earthquake and big freeze disruptions earlier this year. I understand that 4,000 of the bigger mines are now reopening, and that China is now pursuing an active policy of reducing the energy intensity of exports, and growth in general. We’ll likely see a large reduction in diesel use for generators, and an easing of energy supply constraint in the months ahead. I then think slowing global growth will help to ease these constraints further over the next two years.

A few other things factored into the call;

1. The Fed and Paulson have said that they will seek to bail out Freddy & Fanny. The Fed has not said that it will let money rip – it isn’t, nor has it done over the last two years.

2. Aren’t folks bearish? On all sorts of sentiment measures, and across the mainstream media and the financial press. The VIX finally broke 30 early last week. And short positioning in financial stocks hit an all time high at the same time.

3. The European banking system is in a far worse state than the US banking system. Subprime exposure is similar, but the Europeans have an order of magnitude greater exposure to real estate in the UK, Ireland, Spain, Greece and Hungary, and to European convergence trades in general.

4. Two weeks ago I bought three stocks; BA, GM and Lloyds. And I have to admit – I felt a little bit dirty after buying them. After all, the fundamentals really are shocking. But these stocks were still up come Monday, after the Friday panic low.

And with a bit more disinflation (the commodity markets look to be breaking down) – and these things could really move. GM is now up 21% from when I bought it. BA is up 17%, and Lloyds is up 18%. Sometimes it’s good to be dirty.

Golden Years

Back in 2003 I used to bicycle down to Hatton Garden every payday and use a quarter of my salary to buy Krugerrands. I kept buying until gold broke through $400/oz.

This week I sold my first tranche back. I also went short gold last week in the fund – to the tune of 40% of NAV.

In short, I think we’re at a major turning point for the commodities here, and I think gold is in trouble. Gold is the talisman of the commodity complex – and my bet is that where gold goes, the rest will follow.

But before I start, it’s worth stating my basic view on gold. It’s not a hedge against inflation. It’s not a defence against doom. It behaves as an index of reflation. My view – reflation is over. From here on in it’s either disinflation or deflation.

The very big picture call is that the US non-oil current account is collapsing. It’s fallen from 5.5% of GDP in 2006 to 2.5% now. It’s heading for zero, or beyond, in my view. That is yanking deposits from foreign banks, who are anyway cutting back their banking multipliers. That kind of pressure goes beyond disinflation and into deflation.

The first way this affects the gold market is that foreign central bank reserves will stop growing as fast, and then stop growing at all. As part of that reserve accumulation was going into gold, that will strip away some demand at the margin.

The second effect is from the dollar. If the dollar rises in response to the deflationary forces described above, and my bet is that it does, then gold production gets cheaper, and consumption more expensive.

Another way deflationary pressure affects gold is via the production function. Deflationary pressure is going to push down utilisation rates in a lot of places. I think recessions are due across Europe, in Australia, New Zealand, Pakistan, Vietnam, Iceland, in the UK and in the US in 2009. I’m expecting deep cyclical downturns in China and India. And I’m anticipating outright collapse in Hungary and several other Eastern European reflator states. Over the next year, that’s going to take the pressure off production globally. Shortages will become less frequent, and bottlenecks will loosen. In a roundabout way this will ease production constraints across the whole commodity complex. Gold will be no exception.

And then we have the crowding out of consumption from higher food prices. We’re seeing that across the emerging economies. Indian gold imports fell 50% YoY in May. The same stresses on emerging market consumers is causing a large increase in scrap supply, as people sell back their coins and jewellery to help make ends meet. Scrap supply hit 300t in Q1, from 200t in Q307.

And finally we are drawing to the end of dis-hedging. Back in the 1990s, when producers sold forward, it involved, via a convoluted mechanism, a spot sale of gold out of reserves. When the producers started to buy back those hedges in the early 2000s, it effected a repurchase of gold back into reserves. That’s added around 300t, or around 8%, to global demand in the last year. But there aren’t many hedges left to dis-hedge. Over the next year we’ll see that demand fade away.

Now, the likely outlook for mine supply over the next year is for a 2-3% fall – given the problems in South Africa. But the bounce in scrap supply will likely bring that number back to zero. And if you look at net sales from Central Bank reserves – that will likely increase – not because of greater sales, but just because of fewer purchases.

But if we look at demand, my guess is we’re facing something like a 10-15% decline. Gold should be at $600/oz, not $945/oz. In a year or two, I think it will be.

Tomorrow I’m heading to Kinsale, Ireland for a week with the family. So the next blog will come out early the week after next. It’s always a tough call what to do with the portfolio when you’re away. I’ve got a high conviction call on, so I’m not inclined to pare my positions. What I’m doing instead is to put stops in place that will guard me against the worst possible event – and for the current portfolio that would be an Israeli attack on Iran, and a full scale disruption of shipping through the Straits of Hormuz. If that happens I’ll be stopped out 7% down from here, and I’ll be drowning my sorrows in an ice cold pint of Magners.

Timequake

Well, that was one heck of a trading day.

When we were watching the Wimbledon I told my wife that I’d rather be a trader than Roger Federer. Because at least I don’t have to talk to freaking Sue Barker at the end of each trading day.

And I was in no mood to talk at 7pm tonight. I what was by far my most volatile trading day to date, at one point I was up 4% - which would have been my best day – only to give it all back in a little more than an hour. Big swings indeed.

Benoit Mandelbrot equates volatile periods with an acceleration of trading time. And that hour lasted at least a week, by my watch.

So the rumour was that Bill Miller finally capitulated on his Freddie Mac position. Miller owned about 8% of Freddie. And if Q108 was ugly for his particular brand of financial ‘value’, I imagine mid-May to the end of June was genuinely gruesome. I’ve got huge respect for Miller, even if I never bought his buy case on Citigroup for the past year. Or the US housebuilders for that matter. And I suspect that the rumours of his troubles, true or otherwise, likely carry some real information.

The last time a major ‘value’ investor capitulated was when Julian Robertson exited the world of ‘mouse clicks and momentum’ in March 2000. Robertson’s portfolio at that point – stuffed with gold stocks and old economy stalwarts – would have gone on to shoot the lights out over the next eight years. That outperformance would have started the day after Robertson closed Tiger.

I have a central view about panics. At the moment of a panic, volatility spikes. More volatility means less visibility. Less visibility means more perceived risk. It means that the risk premium is at unnatural highs. It means that the market is paying you more than at any other time to take the risk of owning stocks.

The irony of panics, then, is that they are the safest time to buy stocks. Because no one wants them – you have the biggest margin of safety when you buy.

Now I’d already got long of stocks last week, including a 5% chunk of NAV long GM. And what I did during the panic today was, er, nothing. I ended 1% up for the day, with all my positions unchanged.

Decision Three

I take a general view that there are around five decisions to make a year in global macro. And if you catch them right – if you move decisively and in size in the week or two before the turn, then have the patience to see them through, then each decision is worth maybe 20-25%.

So running global macro money is all about training yourself to be ready to make those decisions, and then maintaining the discipline to hold them for several months, despite the intervening volatility. The quote, supposedly from Confucius, sums up the call; ‘I have always known that I would take this path, but yesterday I did not know that it would be today’ – well, something like that anyway.

Decision one was to buy resources stocks in mid-January. Back in mid-Jan the equity investor sentiment was at a 15-year low. But if you reverse engineered a different outlook – ‘if the S&P is up 15% by June, how would it happen?’ – the answer wasn’t so hard to see. A big tax boost and an end to destocking could get the ISM back towards the mid-50s by Q3, bit of a short squeeze etc. It actually looked quite likely.

And then the call to play resources stocks in particular came from the view that everyone was bearish resources, on the assumption that the credit crunch would do for global growth. But my view then was that growth in the BRICs was self-sustaining. For the economies as a whole, the return on capital was 700 bps higher than the cost of capital. That meant investment, profit, and self reinforcing growth. And if the BRICs were going to grow, my work on resource intensity showed me that commodities demand was going to run above trend, even with weak growth in the developed world. Supply growth was likely to be below trend – due to the concatenating bottlenecks and shortages – shortages which were just then showing up in South Africa. That call – which I put in place as soon as I restarted my fund in mid-February, was good for 22%.

Decision two was to go short risk, and especially European and UK financials from early May (My angle was to be short financials with Eastern European exposure). By then, investors were bullish, but the wholesale banking market was still broken – Libor rates were well above base, inflation was rampaging and oil was exploding. I thought the set-up was so strong I doubled my potential risk exposure to play the call. Then Trichet came out hawkish, effectively contradicting Bernanke’s pitch to strengthen the dollar, and oil spiked in response. That’s when I took the short position to the max – around 180% of NAV. That was good for 15%.

Decision three was last week. I didn’t realise before last week that it was coming time to make a major call. But the more I’ve looked at the dynamics of the US current account deficit, the more apparent the call has become.

The call is to be long rate futures – I’m long Europe and Australia. Long the dollar – I’m long against the Euro, Sterling and the Kiwi. Short commodities – I’m short gold, silver and copper. Long some risk – I’m long Dow Jones – and I’m considering a sneaky long position in GM. And finally, long the yen as a hedge.

Why this call? Because I think inflation is done for this cycle. The key point is what’s happened to the non-oil deficit. From 2006, the US non-oil current account deficit has shrunk from 5.5% to 2.5%. That is a powerful disinflationary force.

In a sense, a rise in the US current account deficit works as an addition to global base money (it adds to global bank deposits). And the banks ramped up these deposits aggressively to generate loans – the velocity of money went stratospheric by mid-2007. But there’s a kicker. The European banks borrowed a further $500bn from the US on top of this from 2003-7. My guess – this went to funding convergence trades and esoteric credit structures.

So, yank the 3% of US current account deficit, yank the credit growth on the top of that, and then return the $500bn to sender and what have you got? An incredibly powerful deflation and a massive flow of capital back to the US. I disagree with Joachim Fells’ (of Morgan Stanley) call that low real rates will drive further inflation. Not if we’ve got debt deflation it won’t. That’s what’s got me short the Euro and long Euribor.

Australia’s fate also looks sealed. Australia’ housing marking is trading at 8x income or so. The mortgage rate is 9%. The rental yield is 3% (Buy to let anyone?). Corporate lending is down 35% in the three months to May. Consumer confidence is at a 16-year low. Retail sales are off sharply. But capacity utilisation rates are high, and the RBA is holding the line on rates to stifle inflation. My bet is that Australia is doing a swallow dive into recession. I’m long Australian rate futures. The outlook for New Zealand is equally precarious. I think the Japanese will soon pull their funding for New Zealand bonds and credit. I’m short the Kiwi against the yen.

Now, the big question about all this is how the oil trade plays out. The oil deficit has expanded from 2%-4% from 2006. That’s set off a self reinforcing boom in infrastructure spending and capital deepening in the oil producing states – which in turn has led to an accelerating boom in oil consumption in those regions.

My view is that this process is becoming increasingly narrow; the growth, the inflationary pressure, and perhaps its influence on the world. An even bigger oil freak-out is the risk I’m going to have to take to make the next 20%.

Gentlemen vs Players

The more I’ve proselytised about playing the short side of late, the more I’ve felt like I’ve been forcing the issue. And forcing the issue is rarely a ticket to riches.

Back in early May, the short call felt to me like a cracking trade. Investors were bullish again. But the wholesale banking model was as bust as ever (as judged by base rate to libor spread). The banks weren’t intermediating between savers and borrowers. Oil was skyrocketing. Inflation was running out of control, and policymakers were becoming increasingly fractious and unpredictable. The set-up was so good I doubled my risk exposure.

Six weeks later and everyone is bearish. A friend told me that his favourite contrarian indicator, the hacks in his morning meeting, had capitulated; they were all selling. Now everyone knows about emerging market inflation. Yet the central banks in the UK, Europe and the US have all stepped away from further hikes. Something is changing.

And if we get a bit more fundamental, global inflationary pressure has probably peaked. US monetary growth has remained well contained. And there’s no doubt that we have seen a veritable collapse in the velocity of money globally this year. As Gavekal point out, it’s interesting that the dollar didn’t break to new lows while oil broke to new highs.

I’ve been reading a great little book by Ed Smith called ‘What Sport Tells us About Life – Bradman’s average, Zidane’s kiss and other sporting lessons’. And in it he discusses the disappearance of the amateur in sport. Sport is so serious, so professional, that many players have tied themselves up. They’re unable to ‘play’; to experiment, to take the risks you have to take to learn new skills, to get better.

Ed Smith compares the career of Kevin Pieterson, who seems to have fun playing, and who doesn’t appear to give a toss about whatever anyone – selectors or crowd – thinks of him – and Mark Ramprakash. Ramprakash had an incredible county record – including 100+ averages in 2006 & 7. But come to the tests, he was a Muppet. Why? Because he took it all way too seriously.

My feeling, being bearish right now is taking it all too seriously. It all seems entirely logical. You’ve finally marshalled your arguments and convinced the asset allocation committee. Er….

So, anyway, I’ve gone long. Long the dollar, long Euribor, and long the Dow Jones. And I’m due to go long the rate contracts in Australia and New Zealand – it’s just I’ve got to wait up to do it.

My idea is pretty simple. The inflation showing up in the developed world is a lagged effect of the blow out in the US current account deficit from 2002-6, and the massive expansion of credit from 2003-7. From 2006, the current account deficit in the US has started to shrink. But in an odd way. The oil deficit has actually expanded – from two percentage points to four. So Gulf spending has accelerated as an inflation pressure. But at the same time, the non-oil deficit has collapsed from 5.5% of GDP to 2.5%. It means that, outside the oil states, we have a massive deflationary force. And without a doubt, the collapse in the shadow banking system in Europe is compounding this pressure.

In short, global inflationary pressure has become very narrow. And those emerging markets, like India or Vietnam, where local monetary authorities allowed inflation to get out of hand, well, they’re now acting to control that inflation.

Now, if you wanted a major recession in Europe – what would you need to achieve it? Er, a major inflation scare just as the leading indicators, money growth, and housing were collapsing and the banking sector was shutting up shop. That’s if you wanted to be dead sure of a recession. But it’s been a rough couple of months for those who believed Europe was heading for the macro morgue – and decided to buy rate futures to play it. But I think the trade has turned. And I’ve gone long Euribor. A year from now, the ECB will be cutting aggressively. And all the while, there will be fewer dollars from the states to stimulate growth, and the banks will be gearing those diminishing dollars less aggressively. The banks will struggle to intermediate between savers and borrowers across Europe. My bet, these pressures deliver a European crisis in a year to two years time. By then, I suspect that the Euro will be back through parity.

So I’m long Euribor, and long the dollar against the Euro. But why long the Dow Jones? Well, no two ways about it, it’s a punt. A punt on the idea that everybody’s bearish now, that there’s money in the wings, but that market inflation expectations may just have peaked. I’m not married to the trade – but I might just sneak a cheeky single or two before the opposition catch on.

The Oil Nexus

Yes, commenting on oil when the price has gone ballistic is a perfect set-up for looking dead stupid. But that’s never stopped me before…..

Now, the first thing to say about oil is that oil price spikes are dreadful for stocks. I’ve got a model that uses the six-month change in oil prices and the six-month change in US mortgage rates to predict stock sell-offs. As a model, it’s near pitch-perfect back through the 1960s – the only thing about it – you need some patience – you’ve got to keep your positions in place for at least three months to make it work. Right now, the model is screaming sell, even with stocks back to their March lows.

The process at work is that the oil spike sucks the air out of the US consumers’ lungs. Sales falter, consumer inventories build, producers cut production, utilisation and profits fall back. That’s what’s in store in the US this autumn. That’s part of the reason I think stocks break to new lows in the coming weeks.

My call on oil is simple; the fundamental pressure is for higher oil prices. And it will stay that way as long as the Fed maintains negative real rates.

Now the problem, as I see it, is that the Fed is dealing with oil, and to a lesser extent food, as a shock, rather than something endogenous to the current system. I think they have that wrong.

Don Kohn’s recent speech likely sums up the thinking; in an environment with a negative price shock – oil in the 1990s springs to mind – the Fed can keep rates lower than they would have done otherwise, unemployment and inflation are also lower. No worries. In the current price shock, Kohn says, we see a shift in the Phillips curve – so inflation is higher, unemployment is higher, and rates higher than they would be otherwise.

Well, yes, that’s correct in theory. Except that the rates aren’t higher. So the Fed’s hope is that they can ‘wait out’ these higher oil prices, and when prices stop rising, then, well, inflation will collapse and all will be good again. Indeed it would. Even I’d get bullish on risk. But the Fed has been hoping for this for four years. It’s not exactly global macro leadership. My guess, the Fed doesn’t get what it wants, unless it is prepared to take some pain.

The Fed in the 1990s was an inflation capper – always keeping rates a little too high through a downturn until energy prices and inflation expectations fell off. Each cycle, inflation peaked and troughed lower than the cycle before. It was the most benign possible environment for risk.

Now the Fed is an inflation booster. Each cycle it lets inflation expectations fray a little more than in the cycle before.

What we’re left with is a Fed just as worried that it sees further structural pressure on the banking system as it is about inflation. By leaving real rates negative it is encouraging oil consumption. Not just in the US but globally.

Now, you might well argue that the deflationary forces at work in the global banking system will destroy oil demand. Indeed, lots of people have argued just that all year. But that misses a big issue. And that is that the credit crisis did not happen on its own. It is itself a victim of crowding out.

Basically, the spending at the oil producers has lagged oil prices by 12-18 months for the past five years. It meant that there was excess capital available to depress yields and spur the credit boom from 2003-2007. All good.

But the oil producer’s spending is catching up now, as ambitions for infrastructure spending and capital deepening have built. If we combine that with the fact that utilisation rates in the BRICs are all at 20-year highs, it spells a very different environment.

There are three aspects to the crowding out. The first is financial. As the oil producers ramp up spending in the face of high global utilisation rates – it crowds out financial investment globally. Spare cash goes into physical assets, pushing up costs, rather than into bonds and credit. Yields rise (compared to where they would have been). Profits fade. And if the previous period had been one where credit had multiplied aggressively, then the deleveraging phase can be particularly acute.

The second type of crowding out is of Western consumption. This is the type my model picks up – higher oil prices take spending power away from the Western consumer.

And the third type of crowding out is of Western production. As the oil producers build out their infrastructure and capital base, costs rise and profits fall in the west for the same activity. The hurdle rate for an investment goes up (with rates), and the payoff goes down (with higher costs and lower growth). The willingness and ability to invest in production in the West is reduced.

So what we’ve got, in the end, is some oil demand destruction in the West, but active demand creation among the oil producers. They’re tiny, you say? Well, yes, they account for less than 10% of world GDP. But they now account for 60% of global oil demand growth.

Nowhere, in this environment, do we have absolute, all encompassing oil demand destruction. In my view, demand is growing not shrinking. That won’t stop the oil market rising.

And if you then look at supply, there is little positive there. Oil supply is flat from May 2005, despite the extraordinary rise in prices. We have structural declines in place in the North Sea, in Cantarrell in Mexico, and in Burgan in Kuwait. Russian production is in decline. And there is a growing sense that the oil states are not unhappy with this state of affairs. With 70% of production globally in government hands, there is an increasing disconnect between higher prices and the motivation to raise supply.

Which brings me back to square one – the Fed has to raise rates – and induce disinflation in emerging markets – if it is to break oil. Otherwise, it is just engaged in wishful thinking. My bet; that wishful thinking will go unrewarded.

My plays on this are net short equities, but long Patterson, the US natural gas driller, Petrobras, the Brazilian major, and Vallourec – the specialist steels producer.

Trouble Trouble Trouble

‘These are troublous times’
Charles T Barney
Knickerbocker Trust Company, October 21, 1907

Mr Barney didn’t last too long after that statement. Neither did the Knickerbocker Trust Company. Indeed, it was the first in a long line of trust and bank runs in New York that season.

‘The Panic of 1907’ by Robert Bruner and Sean Carr does a decent job of explaining the background to the panic. The excessive monetary inflows into the ‘emerging market’ of the United States, the credit and investment trust boom that accompanied the economic expansion, the rise in food prices, a failed corner in the copper market, the steady tightening of the money supply earlier in 1907 and then…….the panic.

The thing that struck me about all this was that it all seemed, er, pretty tame. Compared to what we’re facing now, that is.

Over the weekend I got chatting to a CEO of a multinational, while our kids were playing tennis. And he accused me of ‘talking us into a downturn’. Now, I’m not entirely sure what that means – especially as I’ve trying so hard to be positive. After all, I’ve developed a roadmap to the next bull market – the only issue with my roadmap – it needs a major dollar rally, and a global recession, before it can happen.

But, I’m in the business of making money, so there’s no sense in seeing the world though rose-tinted spectacles. And the problem with my roadmap, so far, is that the Fed hasn’t stood up to the oil market. And as a twist on the phrase I used on Friday; if the Fed doesn’t control the oil market, then the oil market will control the Fed.

Now it seems abundantly clear that Paulson and Bernanke want a stronger dollar. And it is highly likely they want it because a stronger dollar would spread disinflationary pressure around the world. And that, they hope, would break the back of the oil bull market.

The problem is that talking won’t get them there. Bernanke needs to raise rates to create a credible threat.

But while Bernanke has got one eye on the dollar, he’s got another eye on the banking system. And in particular, he’s focussed on bank credit intermediation. In his book of essays on the Great Depression, Bernanke majored on the role of the banks is turning a common & garden downturn into a full blown meltdown. And it is the banks’ role as an intermediator of credit between consumers who save, and consumers who borrow that he thought critical. This is exactly the problem the US, and the developed world as a whole, is facing right now. The banks are offering savers relatively paltry rates – savers are losing money after adjusting for inflation. But they’re offering high rates to borrowers, with much more strenuous lending conditions.

One of the things about credit and wealth effects is that they take an awful long time to work through, but when they do, their power is relentless. This is why I’m always bemused whenever anyone says the US has avoided recession. No, it hasn’t. It has delayed it’s recession with one mother of a tax break. Come the autumn, we’ll see how the consumers are doing as the tax break rolls off.

I’m also bemused that anyone is forecasting anything except for a deep recession in Europe next year. There may be a dual speed Europe – with Germany showing strong exports. But if Eastern Europe is in as much trouble as I think it’s in, and with Asia now fraying under the threat of inflation, my guess is that German exports will lose a good deal of their sparkle.

So how am I playing it? My positions are;

Equities; 140% gross, 60% net short. This position is smaller than it was a month or so ago, when I thought that the risk/reward on the short call was fantastic. Now, the call is more consensus, and we are seeing forced selling by the insurance companies. It might be fun, but it’s increasingly dangerous. I will be reducing my net exposure further as the market falls. In terms of breakdown, I am 40% long in a range of stocks including Patterson, the US natural gas driller, and Pico holdings, the Californian water company, as well as Petrobras and CVRD in Brazil. Of the 100% short positions, I am short of Erstebank, Allied Capital and a UK insurer or two, plus short FTSE, CAC 40, Eurostoxx and S&P. I’ve taken profit on several names over the past couple of weeks, including shorts on Swedbank and the Indian Nifty.


So far my currency calls have been less than spectacular. I’ve been banging on about the yen for three or four weeks, but only after the last couple of sessions have I had any joy – and I’ve built the yen long up to 80% of NAV (mostly against the US dollar, and partly against the Kiwi). I still think the yen will break 95 when the market lurches into full capitulation mode – and I don’t think last week was full capitulation. I don’t mind hanging around for the yen move – it repaid my patience when I went long last June – and it wasn’t until that August that it skyrocketed (the NZD/JPY cross did 8% in one day!).

At risk now is the entire unwinding of Japan’s home bias. For all the talk of Chinese reserves and the Bretton Woods II system, it has been the sea change in the distribution of Japanese savings that has done the most to raise the risk profile of global capital flows. There have been massive purchases of Kiwi and Aussie bonds. And, as I rarely tire of repeating, the Japanese have gone mad for Indian stocks – now owning more stocks there than in Europe - a market an order of magnitude larger. But these are troublous times for emerging markets. Joachim Fells of Morgan Stanley has come up with a cracking stat – that 42% of the world’s population is facing double digit inflation. Gerard Minack, also at Morgan Stanley, pointed out that emerging market rates are well below their level in 2000, despite the fact that utilisation rates, and inflation rates, are much higher. Japanese investors with overseas stocks and bonds are now at risk of double trouble – falling asset prices (both equities and bonds), and weakening foreign currencies. There’s no greater excuse for bringing your yen back home.

But it’s the Pound and the Euro that’s bothering me most. I think that the basic problem with the UK and Europe is that the intransigence on rates by the MPC and the ECB is causing an inverted curve, which in turn is destroying the banks’ ability and willingness to lend. Both regions will be deep in recession and cutting heavily within 12 months. But…. Whenever the market sees increased concern over credit conditions – as it has over the past couple of weeks (and even though credit troubles are greater in the UK and Europe than in the US) – it assumes that the Fed will be the first to act. So the dollar comes under pressure. I think this is all setting up a sudden ‘reversal’ of order. That will come when investors realise how precarious conditions in Europe really are. I’m 80% long the dollar against the pound, the euro and the Kiwi. That’s smaller than it was before – I’ve taken some losses.