A bout de soufflé

I don’t know if using French in a blog title has the same effect as using an equation in a book – that of guaranteeing to halve your readership. But I guess I’ll find out later today. It’s the title of the classic new wave Jean-Luc Godard movie from 1960 – starring Belmondo and Jean Seberg. And it translates as ‘breathless’.

That strikes me as just the right phrase to describe a bunch of emerging markets nowadays, and probably a bunch of hedge funds too. They’ve got so big, they are struggling to breathe under their own weight.

I like to watch how the average hedge fund manager behaves. It doesn’t matter how eclectic they all are, whether they’re trying to shoot out the lights, or to hug low volatility to gain assets under management. From 2003 to October 2007, the aggregate hedge fund performance indices all behaved in a certain way. They behaved as if they were a mechanical leveraged long position on the S&P 500, with a trailing stop.

Now, when I discovered this in early 2006, I thought it was ridiculous. Why pay 2&20 for something you could run with a two line spreadsheet model? But lately I’ve thought about it some more, and I’ve changed my mind.

There’s a good book by New Yorker columnist James Surowieki called the ‘Wisdom of Crowds’ – that I’m sure many of you have read. In it he describes how that, if you average out the responses from a group of random people at a fair guessing the weight of a cow, well, you get a more accurate result than if you ask a individual expert; a farmer or a butcher.

And so with hedge funds over the period. The most efficient way of trading the market from 2003-October 2007 was leveraged long stocks with a trailing stop. Amazing really, that all the thought, all the emotion and all the complexity in markets over that period could be reduced to such a simple formula.

That changed in November 2007, when hedge funds held up, despite a fall in the market. That was very interesting – it was the first sign of a change in behaviour in over four years.

Then we had Q108. And the funds got toasted. It was the worst performance quarter on record – as equities collapsed, rebounded, collapsed and started to rebound again – all in three months. But, according to Hedge Fund Research, Hedge funds have now made up, in April and May, all their losses from Q1.

So on average this year, the funds are back to leveraged long with a trailing stop. The way they’ve been for around 61 of the last 62 months.

Now what all that tells me is that funds are struggling to adapt. They’ve got a tendency, on average, to revert to the lucrative behaviour of the 2003-7 years. And that’s probably why, when I got cautious a little over a month ago, the market kept running for a few weeks, even as the risk/reward of going long had deteriorated. Funds were reverting to the leveraged long trade, stops on short positions were getting hit, and there was a tendency to get on the momentum, to make up the losses of Q1.

But like any organism that has taken such massive advantage of its environment – the funds have grown to the point that the environment can no longer support them in their present form. Returns have been falling. Hedge funds, on average, will now have to adapt or die.

My own view is that, with the weight of money – and the likelihood that the overall pool of funds will shrink – it is very unlikely that leveraged long with a trailing stop will prove the most efficient way to run money over the year ahead. The adaptation I expect is this; funds will end up doing the opposite. Leveraged short with a trailing stop. And the earlier they do it, the larger they’ll get. Indeed, I suspect some of the funds that have blown the lights out – and gained assets over the last twelve months - are predisposed to behaving this way.

And that got me to thinking about what to look for in this environment.

That comes back to my title at the head of this post. When the global economy was recovering from a point in 2003 at which resources, globally, were grossly underutilised (we were back at 1982 lows) - everything could reflate. Housing, property, resources. Everything. And capital flows from East to West and the convergence of Eastern Europe helped to prolong and exaggerate the process.

But that dynamic – which generated an incredible uniformity of performance across risk markets - hid some profound differences.

Don’t laugh, but I like to keep things simple. I think a good way of categorising countries (and sectors if you like) – is to split them into inflators and reflators. An inflator is a country that’s pulling in large resource dollars for fundamental reasons (described in my presentation – crowded house). A reflator is a country that has pulled in large amounts of capital for investment in local bonds, credit, commercial and residential real estate.

Obviously, there are shades of grey. If an inflator country allows its credit to expand rapidly – say above 3x GDP – then it’s a wild inflator. Russia, Dubai and the UAE fall into this category. If a reflator still has good returns on capital, a current account surplus, and credit growth of less than 2x GDP – then it is a conservative reflator. China is a clear example. If a reflator has blowout current account deficits and rip-roaring credit growth – like the Ukraine, Vietnam, Latvia and co – then they are wild reflators.

And the reason these distinctions are useful, is that all these countries are going to have to adapt to the current environment in very different ways. The first to run out of breath will be the wild reflators. My view is that the oxygen is already scarce.

Not just financial oxygen either. The inflator nations aren’t just selling high priced oil. They are using the funds to subsidise a massive expansion of domestic oil consumption and growth (oil exporting countries, that make up less than 15% of world GDP, account for more than 50% of oil demand growth). Smells like a self-reinforcing process to me – one that starves consumers and corporates of air in reflator nations.

On the principle that two shocks are more than twice as bad as one – we now have to deal with – I’d say – five major shocks;
1) The original structural problems with the winding down of bank disintermediation and deteriorating asset backed securities in reflator nations.
2) The breakdown of the wholesale banking model as libor/base rate spreads widened.
3) The self-reinforcing crowding out of consumers in reflator nations by inflator nations – and a subsequent slowdown.
4) The deterioration in credit generally and property loans in particular in reflator nations as a result of 1, 2 & 3.
5) A reversal of speculative funding in assets in reflator nations due to 1,2,3,4 and due to a change in fund behaviour.

In my experience, markets can and do price in bad news. But markets are very bad at pricing in self-reinforcing negative processes like the ones described above. There’s still a long way to go on the short side.

Short Shrift

I’ve been talking for over a month now on why I was getting cautious. And for the past week, I’ve been explaining why I’ve gone net short. As of Friday I was 150% net short. About a third of that is against the FTSE, and the rest is distributed between shorts on the Dow, the CAC 40, the Indian Nifty, Swedbank and Erstebank. I also bought some US treasuries along the way.

Now this is a decent sized position – and larger than I would normally go. Deliberately so. I’m up 22% from my start in mid-Feb and I’m ready to bet half my gains on the short trade.

I have a rule about changing the rules by which I trade. First, I’ve got to change the rules in advance – rather than altering my game plan after a loss. So – in advance of any losses - I’ve doubled my normal risk tolerance. Let me make myself clear. If I was down 5% to date, I’d be running half normal risk, not double. But this is no hubris driven momentum trade. I made money this year long resources and infrastructure – and from here I plan to make money short.

And I’m fully aware – at 150% net short, I have a lot of risk on board. But the risk I’m taking is not the risk most people suppose.

It’s not the risk that the market will go up, and I’ll blow up. I know, if the market rises, exactly how much I will lose. That’s deliberate – I made the commitment to lose that money when I put the bet on. If I lose, will I regret it? No. I think, a priori, this is one of the best risk/reward bets I’ve made.

The risk I fear is that I’ll chicken on my call. That I’ll make a few percent, then walk away.

So I’m steeling myself for that commitment. And the only way I know how to do that is to get intellectually involved. So I’ve switched from focussing on opportunities for compounding returns – which has made me a bundle over the past four years – to looking for stocks that will fall over 50%.

I’ve halved all my long equity positions bar Petrobras and Pico holdings. And I’m prepared to take everything, bar Petrobras, down to zero. Petrobras is the only stock I’m holding for the kids. It’s the only stock I’m prepared to watch halve, and stay invested.

So what’s going to go down more than 50%? That’s no idle question. It takes some serious changes to fundamentals and to sentiment to take a stock down that far.

As I write this – Heidi Couch of Bloomberg TV is telling me that small cap ozzie resources are up a lot. Fortescue has gone mental. So it would be tempting to suggest that these stocks will tumble.

Of course, that’s not impossible. And the risk/reward of a short here is pretty good. But I’m always a bit worried betting against self-reinforcing fundamentals in China – and the potential for self-reinforcing resource shortages. I’d still rather go hunting among the banks with Eastern and Southern European exposure.

Starting in November 2006 I was short Irish banks and domestic Spanish banks (I wanted to avoid being short the Brazilian businesses of the major Spanish players) – a painful 10-15% too early. I was short them through 2007, and I added shorts on the investment banks, US real estate and Eastern European property during the year. I’ve been in and out of shorts on Erstebank, Swedbank, and the Greek banks since I restarted in mid- Feb. Erste hasn’t made me any money of late. Swedbank looks set to break below its January lows – and from there….

So what are the key themes here?

The first one is the morphing of the credit crunch. Round one was a combination of unwinding bank disintermediation, the deterioration of asset backed securities (ABS) and the pressure on the wholesale banking model in the developed world. But remember – that all happened in 2007, before there was any real macro stress. Round two - macro stress - is a whole different ballgame.

And my guess is that it’s a much bigger problem than what we saw in the early 1990s and early 2000s. There are two reasons for this. First, it’s because the commercial banks have got themselves deeply unbalanced. In the UK, I understand that 80% of bank lending by the majors is property related.

The second reason is that inflation is staying the hand of the MPC, the ECB, the Fed and many Asian central banks. That means yield curves will be flatter than normal – for longer than normal – in the downturn. It’s going to be very tough for the banks to recapitalise – especially here in Europe.

Now this makes for a classic vicious circle. A friend of mine has a pat line; bankers always lie. So when the banks started to realise the trouble that they were in last Autumn, they did what they do best. They were economical with the truth about the deterioration in their asset quality, and they shut up shop. They stopped lending to other banks as their own balance sheets exploded, and as they realised that those other banks could be in a bunch of trouble too.

So first the demand for ABS collapses, and so therefore does the issuance. That means fewer and tougher loans on property in Spain, Ireland, the UK and the US. Then the breakdown in the wholesale banking model (as Libor base rate spreads blew out globally) meant these banks had to collapse lending too. That’s why we saw the sudden fall in commercial property valuations in the UK late last year, and that’s why we’re seeing the lagged crunch in residential property here as well. And clearly, as these assets deteriorate, the banks’ willingness and ability to lend will weaken further.

But so far, much of the trouble is with the lenders. We are only now seeing the weakening of labour market conditions – which will reduce demand for commercial property, and raise residential defaults in the US and across Europe. And that will get the vicious circle started again.

So much, so obvious. I think a key point to hold onto is that the central banks have much less room to operate than in previous recessions – due to inflation and due to the fact that it will be rock hard to reflate commercial and residential property now, in 2008, that the property is so overvalued.

I think a second key point is that the commercial banks are now much less able to recapitalise and grow loans given the potential for flat curves, and the fact that their assets have deteriorated so aggressively before the usual macro hit in a downturn. Betsy Grassek, the Morgan Stanley financials analyst, estimates that bad loan provisioning in the US is due to have a bigger negative impact on earnings than the subprime write-offs.

But, if you’re looking for trouble, it’s worth going the whole hog. And that’s why it’s worth looking for macro trouble. If you add a macro breakdown to a vicious cycle in bank lending and property prices, well – it gets real exciting. And the past several weeks, we have seen that macro trouble emerging. We’ve got stagflation – proper stagflation – in India, Pakistan, Vietnam, the Ukraine, Latvia, Hungary, Bulgaria, South Africa and Iceland. We’ve seen pressure on the rupee, the rand and the Icelandic krona.

I’ve taken the chance to go short the Nifty. Not only is inflation and slowing growth ugly in its own right, it’s downright hideous when you realise the amount of Japanese money in the Indian market. Japan currently invests more in Indian stocks than those in Europe. It’s been a huge trade for the Japanese housewife over the past five years. My view is that it could unravel fast – and that it will be exacerbated if, as I expect, the yen starts to move up hard against the rupee.

Then there are the Eastern European economies. Now I’ve already said I thought these guys were in trouble. They have inflation and their economies are rolling over. So far, so bad. But they also have massive current account and budget deficits. Then they have almost all seen credit growth above 20% for the past four or five years – and all have seen massive property booms. That’s a pretty good benchmark for trouble in a slowdown.

And yes, it gets worse. They have borrowed from abroad – in many cases loans, even domestic mortgage loans, are denominated in Swissies and Euros. If you look down the list of big lenders in Eastern Europe, you find Erstebank, Swedbank and the Greeks. These guys are facing the same pressure as the rest of the European Banks – they are pulling in their lending horns as they try to protect their assets, and stabilise their reserves. The problem is this leads to a vicious cycle in emerging Europe similar to the one I described for the UK above.

But in Eastern Europe, falling currencies will likely reinforce this vicious cycle (as less capital comes in, and more flows out). And that’s when the going gets genuinely tough. Because inflation worsens, spending power falls, defaults rise and the banks’ assets in the region collapse in local currency terms – forcing another round of loan reduction. I think we now have a higher than 50% chance of a full on financial crisis in Eastern Europe. The bankers involved may not be saying much in public, but I’ll wager that, behind closed doors, they’re panicking.