Things from my Newsblur; 2024 Part I

OM aims to publish six Newsblur posts this year instead of waiting to accumulate numerous articles. Thus, expect shorter posts with 4-5 articles but with more timely content.

The Best Day.  The Very Best Day.
OM loves football (aka soccer), especially his team - AFC Wimbledon. Recently, they faced their hated rivals in a heated match, echoing John Green's sentiment that "football is the most important of all unimportant things."  I’ll spare you all the details, but this is a short 5min video that OM will come back to whenever he needs a pick me-up!

For those who don’t want to watch it; as OM tells his kids – prepare, give your best, and control what you can.  Success isn’t guaranteed, but sometimes – just sometimes – you will score a 94th minute winner in front of your fans, the roof will be lifted off and everything will make sense for a little while.   
(John Green/@vlogbrothers on YouTube)

The Profile Interview: Rob Henderson on Why We Hold ‘Luxury Beliefs’ and Develop ‘Status Anxiety’
A slight departure from the norm but I think a good one;  I have read Rob Henderon’s blog for a few years now and I’m working my way through his just released memoir (Troubled: A Memoir of Foster Care, Family, and Social Class).   I like them both a lot but it’s not for everyone, amongst other things it requires holding conflicting views of the author and some of his ideas at the same time.  For those who are curious, The Profile’s (also a good read) interview is a good starting point.

The most interesting of Henderson’s ideas is the term he coined, ‘luxury beliefs’, which he defines as “ideas and opinions that confer status on the affluent, while often inflicting costs on the lower classes and everyone else.  A core feature of a luxury belief is that the believer is sheltered from the consequences of his or her beliefs.”
(The Profile)

Things I Don’t Know About AI
There is no shortage of opinions on AI, but this is an interesting way to think about what we don’t know.   Written by a Founder/VC, the opening sentences sum it up; “In most markets, the more time passes the clearer things become. In generative AI (“AI”), it has been the opposite. The more time passes, the less I think I actually understand.”
(Elad Blog)

Can Trade Intervention Lead to Freer Trade
OM believes that there’s something wrong with the version of ‘free trade’ today, and that the next 50-years are likely to see something quite different from the last 50-years.   Michael Pettis article delves more into this, and his introduction sums the issues up well!

“A well-functioning trading regime would permit neither the large, persistent trade imbalances that characterize the current global trading system nor the perverse flow of capital from developing economies to advanced economies. Global trade needs new rules that encourage a return to the benefits of free trade and comparative advantage.”
(China Financial Markets)

Half-Baked Idea: Chinese A-Shares

[Quick thing: OM changed the provider that sends these emails out, so hopefully you’re all receiving this.  I’d say holler if you’re not, but err…hopefully, the new ‘advanced’ software will let me know you’re not (or at least didn’t open this email) else this bit is all a bit moot!]

This is something OM has been pondering for a couple of months; though, he thought (and still thinks, even with the big move in A-Shares) that it would be a late 2019/early 2020 trade.  

This idea is all about pattern recognition, backed up by a collection of circumstantial evidence so it will always be a more speculative idea.  That doesn’t mean OM won’t take a position in it at some point, though it would likely be a 6-18mos trade and thus not a huge position.

The above is a long-term OEW technical chart of China.  If you look at the lows (05/06, 08/09, 13/14, and now 18/19….even back to 94/95) – all down 50%+ from prior peak.  All were followed by sharp rises in the following years.  If history is a guide, or at least could rhyme a little, this C-wave should last ~2years and if the last few bull markets are anything to go by, the IRR could be spectacular.  For comparison, post-06 the market was up 500% in ~2yrs, post-08/09 it more doubled in about a year, and after the 13/14 low it almost tripled by mid-2015.  In the case of both post-06 and after the 13/14 lows, the rally started off slowly before going exponential towards the end.

So the technical perspective is that we potentially saw a new major low at the end of 2018.  In the short term, MSCI’s recent announcement of mid-2019’s large increase in China’s weighting in the MSCI Emerging Market Index has helped the new bull market establish itself.

Given this good news, why does OM like the ~2 year time frame?  Well, he rather suspects it fits well with the Communist Party’s incentives.  Consider the following timeline:
- 2021 is the Centenary of the Communist Party of China's founding, marking the start of the “two centenary goals”*.  The goals were put down in writing at the 18th National Congress (in 2012) when Xi Jinping became leader.  Xi has subsequently linked them to the “Chinese dream”.
- 2022 sees the next National Congress where Xi likely to be the first leader to run for a 3rd term.

The Party has a strong incentive for China to go into those two events with a strong economy.  That means using 2019 to sort out some of China’s imbalances - and the trade dispute with the US provides great cover/excuse for this, whether there a deal or no deal!  This will prevent overheating when China stimulates and allows them to stimulate aggressively in 2020 to ensure a strong 2021-2022. 

So now you know the half-baked idea, expect an update if OM is putting it into the book.




*The other centenary is that of the founding of the People’s Republic of China in 2049.

Portfolio Update

Given there were a number of new additions to the portfolio at the end of 2016 and in early 2017, this seems like an appropriate moment to look at the various books/themes in the portfolio and talk a little more about them.


Technical: 22.7% NAV (all sizes are as of March-end) 
The positions are unchanged and are relatively evenly split between DDM, SSO, and QLD, which represent exposure to the major US indices   Currently Our Man’s technical model is strongly in “Buy” territory, and while it indicates there are possibilities of 5-8% pull backs in the near future barring a much more substantial reversal in markets it seems unlikely that its recommendation will change.  Thus, Our Man’s not expecting much to change here for a while.


International:  20.1% NAV 
This book currently has positions reflecting themes in Argentina, Brazil, and Europe (Italy).
- Argentina (8.9%) is the largest theme, though this was reduced during Q1 as OM exited PZE (Petrobras Argentina, which rallied strongly in late-2016) and reduced the size of the PAM (Pampa Energie) position.  The remaining exposure to the theme comes through Pampa (6.4%) and Adecoagro (AGRO, 2.5%).  It’s now been over a year since President Macri took office, and he’s made a remarkable number of changes to help Argentina transition towards a more market-based (vs. government driven) economy including the removal of capital controls, allowing real independence to the Central Bank (which has since decided to target inflation), settling with bond holdouts opening the way for Argentina to raise USD debt, and reducing government subsidies and price caps.   While these things are only now starting to impact the economy, they have already improved investor sentiment which is highlighted by the prospect of Argentina returning to the MSCI Emerging Markets Index this summer.   While OM hopes to see the benefit of the increased liquidity and flows, the position is likely to be one that declines as Argentina continues its move towards normalization.

- The recent additions of Brazil (7.6%) and Europe (Italy 3.7%) were discussed in the year-end review.  Both positions are likely to increase in the future, especially if the recent pullback in Brazil continues.

- Finally, at the start of the year, GVAL was removed from this book and added to the new Funds book (see below)


Equities: 19.3% 
The equities book is made up of broadly evenly sized positions (~3.5%) in JD.com (JD), Vipshops (VIPS), the Nasdaq Biotech ETF (IBB), Dollar Tree (DLTR) and Liberty Broadband (LBRDK).  JD (which Our Man re-entered in January at a mildly better price than he sold it at last year) & the long-held VIPS position are both plays on the Chinese Consumer; think of them as companies that one day could be Amazon & an online TJ Maxx respectively.   Both Dollar Tree and Liberty Broadband (mainly Charter Communications, whose services fellow New Yorkers see as the new “Spectrum”) are exceptionally well run businesses which would also would be beneficiaries of tax reform in the US.

There is also a much smaller position in Fannie Mae (FNMA, 80bp), which along with the position in IBB was discussed in the year-end review.


Funds:  9.9% 
This represents a new book/theme in the portfolio; all of the exposure is expressed through ETFs (or potentially funds).  These ETFs have something about them that has piqued OM’s interest and are why I think they’ll outperform markets over the long-term.   Given that this outperformance is expected over the long-term, the changes to this book are expected to be extremely small.  Currently, there are 3 broadly equally-sized positions in the book:
- GVAL and CAPE are both based on applications of Shiller’s PE Ratio (aka Cyclically Adjusted Price Earnings, CAPE).  GVAL applies it to International stocks (finding the cheapest stocks in the cheapest countries), and CAPE applies it to US sectors.  To Our Man’s mind Shiller’s PE Ratio/CAPE is a tool that is poorly applied in finance with too many trying to use it as a timing mechanism or reason for a short-term decision, whereas it’s real value is as a very long-term measure of relative value.  The intent of both ETFs is to buy things that are cheap on a relative basis (compared to other countries/sectors) and Our Man’s wager is that over the long-term this will prove to be more profitable than the market.  The GVAL position was moved from the International book/theme as it seems to better fit here.
- CWS:  Our Man has read the Crossing Wall Street blog for most of the last decade, and this ETF is based off that blog.  CWS publishes an annual “Buy List” of ~25 stocks at the start of each year, which are equally weighted and then no changes can be made during the year.  Each year only 5 stocks from the Buy List have been replaced, with the others carried forward (with any additions) onto the new Buy List.  This longer-term focus (typically, 4-5 years on the Buy List) leads to a bias towards quality and value and if the process can remain disciplined this can lead to out performance over time.


Commodities: 3.4% 
This book was changed from Precious Metals to better encapsulate the things that might go into it
- The Uranium stock ETF (URA) was added during January, and is the sole position in this book.  OM will likely go into the thesis on Uranium in greater detail at some point, but the cliff notes are:
1). Supply: 70% of supply comes from 2 producers (Cameco, a North American company, and the Republic of Kazakhstan) and both have cut supply in the last 12months and announced their intention to keep it down.  It takes a really long-time (5-7years+) to permit, build, and develop a mine so this capacity constraint has limited offsets.

2). Demand: The primary demand for Uranium is from nuclear power plants.  Post-Fukushima the demand fell substantially as Japan (and other countries like Germany) closed down their nuclear power plants.  Over the last year+ we’ve started to see some of these Japanese plants being updated and come back online, while other countries have approved and are building new (typically Generation III/III+) nuclear plants.  The building of new plants takes time (5-7 years to the plant approved, built) and will likely be slow (as countries wait to see how the new Generation III plants operate) but represents positive incremental change.  In the short-term, contracts for uranium supply are long-term (2-10yrs) with a significant percentage coming due within the next couple of years.

3). Price/Technical:  URA is down 80-90% from its 2011 peak and hit a low of $11.31 in mid-Jan 2016.  Subsequently, it held above this low in early November ($11.74) and confirmed a yearly uptrend in early 2017 (it’s price in 2017 closed at a level higher than any price in 2016!).  OM’s technical model suggests that the future path of URA is more likely to be a bear market rally than the start of a new bull market, but also that this could well be a particularly vicious bear market rally (to $40+!!!) given the depth & time of the decline.

Given this combination of supply/demand factors and the price/technical lining, OM believes that URA currently represents an attractive risk/reward.


Currencies: -47.6% 
OM continues to remain very long the US Dollar, with short positions in the Euro (via EUO) and Japanese Yen (via YCS).  The Euro short is around 2x the size of that in the Yen, with OM continuing to believe that the Euro will comfortably break par to the Dollar within the next 12-18mos.


China Thesis: 2.3% 
There are two components to OM’s China thesis; (i) that the Chinese are seeking to transition their economy to a Consumer-driven one (like the US/Europe/etc) and away from a Fixed Investment one, and that (ii) that they will provide as much monetary support as they’re able to in an attempt to smooth this transition.  To some degree, the Chinese internet positions (JD and VIPS) in the Equities book incorporate the view described in part (i) but in the China Thesis book it is expressed via a small short position in the Australian dollar (42% of Australian exports go to China, in particular commodities used for Fixed investments).  This short position has been substantially larger than it is today (10%+ vs ~1.5%). Part (ii) of the thesis is expressed through a position in Chinese A-shares (~3.5%) with OM believing that much of China’s monetary support will end up finding its way into the local stock market and that 2007 and 2015’s highs (50%+ above here) will be eclipsed before the market finally peaks. 



Disclaimer:  Nothing above represents a recommendation in any way, shape or form so please don’t even think of trying to take the above that way.  For added clarity, while Our Man is invested in all of the securities mentioned that’s a terrible reason for anyone else to do so.  Our Man also holds some cash and a few other securities (of negligible value).  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you given your own circumstances/risk tolerance/etc. 

Portfolio Update – February & March 2014

February & March saw the some changes to the portfolio in some time, so it seemed sensible to use an entire post to explain what’s going on.

China Thesis 

As you all know, Our Man has been bearish on China for some time and this has been expressed intermittently in the portfolio, primarily through this sleeve of the book.  For the last 6-12mos, the chosen expression of this theme has been a Short Australian Dollar position, where the risk of potential stimulus in China has been partially offset through a Long Chinese A-Shares position.  It has broadly worked reasonably well, with the China Thesis book contributing >50bps+, over the last 6-12mos and both sides of the trade contributing to performance.  However, with the decline in the Australian Dollar from above parity (A$1>$1.04) in Q2-14 to well below parity (A$1 <$0.87) in early 2014, and the public discourse (read: breathless CNBC discussions) surrounding the fears of weaker China growth, Our Man decided to reposition this book.  This was done through substantially reducing his Short Australia Dollar position, with the hope of being able to rebuild it later in the year at a better price (i.e. just below parity), while retaining the Long Chinese A-Shares position (in case there is any government stimulus to help the economy).

Equity Book:  

Those who know Our Man, know that he’s fascinated by India as a potential investment arena for the next decade or two; it’s a country (and market) that comes with vast opportunity (demographics, size, consumer behavior, education/technologically advanced workforce, solid legal process, etc) as well as many challenges (governmental issues, slow legal process, a bifurcated market between large/small cos where foreign inflows can exert too much influence, etc).  Our Man was hoping to find a suitable ETF or Mutual Fund to express this view through but was unable to find anything of great interest, though the search did lead to a some interesting stock ideas (US-listed ADRs), which resulted in 2 new positions for the fund. 
- Dr Reddy's (RDY):  Dr. Reddy’s has achieved meaningful scale as a manufacturer of complex generic drugs, many of which have limited competition (it’s focus is largely on delivery forms other than solid dose/pills).  At year-end, the firm had a strong pipeline with 62 drugs pending FDA approval (39 are in the 180-day exclusivity bracket, and 9 were first to file products), and the US already generates 40% of sales (c$800mn) having grown almost 20% in 2013.  These all hint at some useful future traits (pricing power and growth) to supplement a strong existing business (60% gross margins and 20% EBITDA margins, on average over the last 6yrs) 
- Tata Motors (TTM):  Tata Motors is known as the manufacturer of the cheapest car in the world (the Nano) and one of the largest commercial vehicle manufacturers globally.  Most people don’t realize that it is also the holding company for 2 very well-known luxury banks; Jaguar and Land Rover (JLR), which represent the vast majority of revenue and all of the group’s profits.  With new models and refreshments of existing lines being key drivers of car sales, Our Man likes that JLR has a half-dozen+ coming out in the next couple of years, the reduced risk of cannibalization (Jaguar’s sales are 450K units/year) and the opportunity for JLR given the huge holes in JLR’s line-up (no convertible till the F-type came out, no station wagon/estate product in Europe despite it being 60% of the sedan market, no all-wheel drive Jaguar, despite all-wheel drive being 40% of North American sedan sales, etc).  These new launches, coupled with the ongoing rationalization of manufacturing (starting factories in China and Brazil) helps create interesting operating leverage.  With the business being profitable as is (Jaguar is too small so breaks even, but Land Rover is exceptionally profitable) and at an attractive price (10x this year’s earnings), Our Man has started a position. 

- Internet Names: The recent sell-off in markets has been centered on those stocks that (i) are primarily growth stories (i.e. a large part of today’s value comes from what investors expect to happen over the next 5-7years) and (ii) have performed very strongly over the last 6-12months.  Numerous reasons have been posited for their decline including the prospect may increase rates earlier than previously expected (meaning a $ of profit 5-7 years in the future, is worth less today than it was before), increased risk aversion (blamed on Russia-Ukraine), that the names were over-owned and suffered from profit-taking and the lack of natural new buyers.   While there are certainly elements of truth to all of these factors, and the valuations of this group of companies is still rich, there’s likely some opportunity to take advantage of the very negative sentiment and hold some of the names (at least for the next 6-12mos).  As such, Our Man started positions in PNQI (an ETF of a number of large well-known Internet names, think Amazon, Facebook, Ebay, etc), P (Pandora; online radio), and TWTR (Twitter; though OM doesn’t tweet) in the US.  OM also bought 2 US-listed, but more internationally focused named within the group, QIWI (QIWI; a provider of payment services in Russia and the CIS, which interests OM given the low trust in Banks in the region…think a complicated mix of Visa/Mastercard, MPesa, Moneygram, etc) and VIPS (Vipshop Holdings; a Chinese online discount retailer…think the online TJ Maxx of China).  In total these new positions represent c12.5% of the portfolio, with the PDXI being the largest component of this (and the others being roughly equal in size).

International Book 
Our Man has long been a fan of CAPE (Cyclically-Adjusted PE ratio) as a good signpost for whether a market is cheap and where one should look for ideas.  Thus, Our Man was very excited by the launch of the new Cambria Global Value ETF; Meb Faber and Cambria have done some of the better CAPE work on global markets and this ETF takes advantage of that…buying the cheapest ($200mn+ market cap) stocks, in the cheapest (CAPE) markets globally.  Given the small size of the ETF, the initial position has been restricted to 2.5% (+/- 0.75%, meaning Our Man would be a buyer if it fell to a c1.75% position and would take profits if it grew to c3.25%).

Absolute/Bond Funds 
With the possibility of higher rates (at the short-end at least) in the coming months, and the fund’s exposure to tighter credit spreads (and gold/gold miners in the case of HSTRX), Our Man decided to reduce his weighting to the 2 bond orientated funds in the book.

NCAV 
The NCAV screen was run, and found no names that met the eligible criteria.  Furthermore, with IMN having been in the NCAV portfolio for over a year since it last came upon the screens, it was sold (as per the NCAV book’s rules).  As a result, the NCAV book currently has no positions.

Technical Book 
The initial sell signals we saw in late January were invalidated by the subsequent rally in February and so, despite the market weakness of the last week or two, we wait for new initial sell signals.  While the Dow and S&P may show one (after a rise to new highs), the Nasdaq is the furthest away despite being the epicenter of the recent downturn in the market. 

Disclaimer:  For added clarity, as indicated in the post, Our Man is invested in almost all of the securities mentioned.  He also holds some cash and other securities too.  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you.

Perception & Reality

“It was six men of Indostan
To learning much inclined,
Who went to see the Elephant(Though all of them were blind),
That each by observation
Might satisfy his mind”

- Verse 1 of Blind Man & the Elephant, John Godfrey Saxe

Our Man’s father is likely quite disappointed that he's quoting the John Godfrey Saxe poem (rather than say the version in Persian Sufi poet Sania's "The Walled Garden of Truth"), since the parable about “the blind men and an elephant” is of Indian origin.  The story tells of how 6 blind men come upon (or are introduced to) an elephant and each touch it to learn what it is like.  The men touch a different parts of the animal (side, tusk, trunk, knee, ear and tail) meaning that when they compare notes, each of them have a completely different (and incomplete) opinion of what an elephant is like.

The markets and global economy have offered a similar conundrum over the last 4-6 weeks, and like the blind men, there’s some evidence to support most perspectives. 

For example, the advance estimate of Q1-12’s real GDP growth (in the US) came in at +2.2%, a healthy enough number but beneath analyst estimates (of +2.5%) and the previous quarter (Q4-11: +3.0%).  On the surface, we should be pleased, after all GDP has now grown for 11 consecutive quarters.  Things seem less rosy when we consider a little more data and realize that the economy has only now returned to its 2007-peak and that historically-speaking, the pace of our post-recession growth is exceptionally slow.  This disappointment becomes clearer yet when we consider the extraordinary measures, including a zero-interest rate policy, massive budget deficits and the numerous attempts at unorthodox monetary policy (including QE1, QE2, QE-Lite, Operation Twist, etc), which have been used to try and stimulate the economy and drive growth.

And what to make of Europe?  The initial success of their unorthodox monetary policy (LTRO – where the ECB flooded European banks with cheap 3-year loans, and encouraged them to buy European sovereign debt with the money) was undeniable, silencing talk of potential crises in Italy and Spain by helping drive long-term bond yields substantially lower.  For example, Spanish 10-yr yields fell from over 6.7% in December to under 5% when the LTRO ended on 29^th February.  Yet, barely 6-8 weeks later the same bond-yields are rising slowly back towards their pre-LTRO level and the worry is that LTRO has failed to buy enough time.  Furthermore, if the (admittedly British-centric view that) Euro was a political creation rather than an economic one, then the political carnage bears noting.  Every one of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) has seen its government swept away, or replaced by unelected EU technocrats (e.g. PM Mario Monti in Italy, or PM Lucas Papedemos in Greece), irrespective of the previous ruling party’s history* and achievements.  Additionally, with politicians working not for their citizens but focused on defending the “Euro project”, nationalism (and the hard-Right and hard-Left) is on the rise not just in the PIIGS but in the core countries.  The last fortnight has seen Netherlands’ government collapse after the Freedom Party’s Geert Wilders brought down the coalition after openly calling for defiance against the "Diktats from Brussels".  Then there is France, where the National Front recorded their best ever election performance (17.9% of the vote) in the first round of voting and the recently formed Left Front (11% of the vote) almost doubled their share of the vote.

Finally, there’s China.  The last few weeks have seen a divergence between the different manufacturing PMI (Purchasing Managers Index) readings, with HSBC’s showing a continued slowdown and the official government one showing a decent bounce-back.  These readings followed the weaker than expected Q1 GDP Growth (+8.1%), which was the lowest reading since the end of the 08-recession.  While it’s clear that China’s growth has slowed, the prevailing attitude remains that the government remains accommodative and that the slowdown is contained and being managed with limited risk of a hard landing (GDP growth of <3%).  For the skeptics (including Our Man) however, the worries of falling house prices and the impacts of non-economic credit-driven investment continue to mount.

What does this all mean for Our Man?  Not much, as observers of the portfolio would recognize.  The opportunity to generate strong investment returns is at its peak when; (i) your perception of reality diverges significantly from the mainstream, (ii) you have high conviction that your perception accurately reflects reality and (iii) reality is likely to be acknowledged in the markets (or instruments you’re trading) within an acceptable time period.  This allows you to take risks that others feel imprudent and to do so in size, with some faith that if you’ve sized the positions appropriately (and in the right instruments) you can hold them until reality conforms to your perception (or your perception adjusts).  Today, Our Man’s issues is primarily temporal; I have a more bearish medium-term view of global growth (especially Chinese) than most and reasonable conviction in it, but more limited faith that the markets will conform to this view in the near-term.  As such, the portfolio continues to hold smaller (than optimal) positions that reflect my views and will allow it to participate should things change quickly, but also substantial amounts of cash that waits for greater clarity before being invested.



* To put this into context consider:  Ireland’s Fianna Fail, the largest party in the government in every election from 1932 to 2011, lost over 1/2 of its share of the vote and 3/4 of its seats in 2011.  Greece’s PASOK, which has dominated Greek government since the collapse of the country’s military dictatorship in 1974, are polling at 15% (vs. having never won less than 38% of the vote since 1981!) for Sunday’s election.

 

What to do about China?

In the past, Our Man has opined a lot on the difference between opinion and execution, and how it is vital to consider this difference whenever you hear someone stating an opinion (especially when it’s on a disreputable source, like CNBC) on financial markets.

To this point, just last week, Our Man shared his strongly-held skepticism about China’s economic miracle.   This skepticism hasn’t done much for the portfolio, with the China thesis being a consistent negative contributor since it was added to the book in mid-10.  Fortunately, the execution has been somewhat better; despite the persistent losses, the thesis has cost a mere 50bps since its inception.  This is a result of the small amount of capital that’s been allocated to the trade due to Our Man’s acceptance that the timing factors haven’t fully aligned, yet…

However, there are some signs that the timing signals are finally coming around.  As you will no doubt recall, a couple of the key timing signals that Our Man was waiting for were the arrival of inflation and some signs of Bank/Credit tightening (see he said it, right here).  Well, as the pretty little graph (from The Economist) down below shows these elements certainly seem to showing up, with both inflation and the banks’ reserve ratio steadily climbing!

Given this, you won’t be surprised that Our Man is starting to look to increase his exposure to the China thesis and here’s a recap of the ways he’d consider doing so.  As a brief reminder, Our Man can only go Short through longer-term put options (12mths+ for companies, 3-6mths+ for various ETFs) and is limited to solely investing in US-listed ETFs and companies.  This eliminates a number of the more esoteric positions, which have far better risk-reward, out there in fixed income world (I’m talking Australian interest rate swaptions, CDS on Japanese industrials, etc).  This inability to execute as efficiently as Our Man would like is also why the China thesis, despite Our Man’s strong opinion, will never be as large a position as it could be (given that strong opinion).

- Commodity (and Commodity-related) Companies

The argument for betting against these names is simple; China is both the major and the marginal buyer of their products.  For example, China represents over 40% of the global demand for copper, or over ½ of global demand for Steel (and thus directly and indirectly Iron ore).  Furthermore, much of the shenanigans to circumvent the credit tightening at the banks is through the use of commodities (originally copper, now it has allegedly progressed to other commodities following a government crackdown on using copper) as collateral, meaning the behavior of real demand is less clear than it appears.  As such, should a slow-down happen in China… the likely impact will be larger on commodities and related companies than people expect.

- Australia

Not much has changed in Australia, since Our Man talked about it at length a year ago.  The economy continues to benefit from its large supply of raw materials and households continue to pile on more (largely mortgage) debt.  Much like the rest of the China thesis the timing factors have improved, most notably home prices have started to slide, which has resulted in an increase in the number of homes for sale.  This has a certain similarity to the 2006-7 period in the US, and we’ll see if the Australian Banks’ claims that they have been better at underwriting mortgage risk than their US peers holds true.  Unfortunately, the only real way Our Man can play Australia remains EWA (an ETF) and some Australian-listed commodity companies that have US ADRs.

- Brazil

The one region that has become vastly more interesting as a potential short over the last year is Brazil.  Brazil has a similar underlying story to Australia; it’s a vast producer of raw materials (especially iron ore and soy products) and thus exports a great deal of this to China (though it lacks Australia’s proximity).  However, despite these large exports to China the country remains a net importer overall.  What’s more (and spot the trend here) there are signs of potential credit issues looming, after a strong period of credit growth (credit doubled between 2002 and 2010) and an infrastructure that’s not yet developed for such credit growth (i.e. Banks can’t see a customer’s total credit outstanding, just their credit outstanding with the bank).  What’s yet more interesting, is that the timing factors are also lining up well, with the Brazilian yield curve becoming inverted (see here) – while this is no guarantor of recession, it’s typically a sign that the market expects one in the coming year or so (e.g. the US yield curve became inverted in mid-07).  The final benefit of a potential Brazilian position is the ETF, which is large and liquid and largely consists of commodity-related and financial firms.

Some More Observations on China...

Our Man has long been skeptical of the “China story” and the seemingly commonly held view that China is the panacea, since GDP growth there will never slow down.  So in this glance at China, rather than give you a regurgitation of his earlier posts (in case you wanted to know, here’s why Our Man is skeptical), Our Man thought he’d just blithely refer you to various bits in them as he meanders through some observations of the last few months.  

A few months ago, Our Man motioned in the direction of the weakening Chinese PMI’s which suggested that the pace of Chinese growth was slowing and this trend continues with the PMI’s preliminary reading for May falling to 51.1 (from 51.8 in April).  Our Man also mentioned the various shenanigans that were going on in the copper market (where copper was being used as collateral to help obtain financing, i.e. as a way around credit constraints).  

The last few months have seen a whole new spate of shenanigans featuring Chinese companies that are listed in the US.  No fewer than a dozen Chinese-based companies currently have seen their shares suspended or halted from trading in US, predominantly as a result of accusations of fraud.  There are a lot of companies listed in the US, yet the vast majority of those whose shares are suspended are Chinese.  What is more surprising is that many of these companies were ‘supposedly’ blue-chip names like China Media Express, which reached c$1bn market cap, before allegations of fraud led to its CFO and auditor to resign.  Or Longtop Financial, a multi-billion dollar darling of the hedge fund crowd, whose auditors resigned saying their previous audits weren’t to be trusted as management and the local banks were complicit in the fraud after the firm was exposed in the impressive Citron Research blog.  The most recent example is Sino-Forrest, a $4bn+ market cap company that has lost 80% of its value since a report by research firm Muddy Waters alleging fraud came out.  Muddy Waters aren’t the only ones who have been skeptical and now even the mainstream media are cottoning on to the various issues surrounding Sino-Forest.   Now, Our Man’s not saying that everything you hear from China and every company there is a lying crock of ****, but hopefully if you’re a believer in the China story you have got your eyes wide-open.

Now, Our Man was pointing this out to a Sinophile friend of his, when the friend very politely suggested that these were private companies and hence while there were shenanigans, the private Chinese companies were merely suckering naive or lazy American investors who bought into their story.  Lest that you fall for such clap-trap, Our Man thought it only fair to point you in the direction of some public-sector shenanigans.  Remember when everyone was so impressed by China’s high-speed rail?  Well, unfortunately, the man-in-charge Liu Zhijun was arrested for embezzlement and that his ministry managed to rack up $271mn of debt (or 5% of Chinese GDP!) and that numerous others are being investigated after safety concerns cropped up (the result of using low quality concrete and other materials).  That said, needing to bail out high-speed rail links isn’t unique to China (see Japan’s bullet train, Taiwan’s high speed trains and the lack of profitability of France’s various high-speed lines as examples) though it’s normally takes longer before you need to quietly shutter high-speed lines because no one wants, or perhaps it's can afford, to travel on them.

However, this wasn’t the public issue that caught Our Man’s eye over the last few months.  Imagine there were a bail-out of local state debt that represented >10% of GDP (i.e. we’re talking bigger than California or Greece)…that would make major news, right?  Well, apparently if it’s a US state or a European country it’s good for 24/7 coverage…but not if it’s China bailing out its local governments.  Interestingly, most people thing that the Chinese government tackling this problem head-on is a good thing and certainly acknowledging and quantifying the problem is.  However, what matters is who eventually has to pay the bill not who carries the liability.  The Chinese have some form with determining who pays from their banking crisis in the 90’s which was a glorified version of extend and pretend.  Back then government-backed Asset Management companies bought the impaired bonds from the Banks, issued the Banks new ones and made the interest payments by liquidating the impaired bonds over time.  Obviously, when the principal came due the Asset Management cos didn’t have the capital and so rolled the bonds into a new bond backed solely by…a Ministry of Finance letter!  Hence the eventual cost was borne by the household sector which through taxation and negative real interest rates helped provide this subsidies to the banks.  Don’t be shocked to see a similar thing happen this time.  There are of course other ways for the State to pay for this debt that it's taken on; perhaps the state will sell-off some assets to meet these debts, or they will confiscate wealth from the wealthy/SME’s/etc but Our Man suspects that they will continue to rely on the household sector to bear the burden as they’ve done for the last 20years+.   The identity of the ultimate payer matters, especially if it's to be the household sector, since one of the primary aims of China’s much lauded latest 5-year plan is the aim of increasing consumption by 2-3% of GDP…and thus starting to reverse the trend of the last 20years.

All very interesting, I’m sure you’ll agree, but the real question is what is Our Man doing with all this information and data that he’s seeing.   For that, you shall have to wait till next time.