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.