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%.