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%.