Wednesday, March 18, 2009

Race to The Bottom

The Federal Reserve's announcement to buy longer term Treasury and mortgage securities is its way of telling the world: "We are going to create money out of thin air; we mean business." Unlike the US Treasury Department, which has to fund operation through through taxation, the Fed simply clicks a few buttons on its computer, and viola! unlimited amount of new money is created to do whatever the Fed desires. The immediate reactions include the sharp decline US dollar against other major currencies, price run-up in financial and physical assets. It appears that it reflects more of the market fear on inflation pressure rather than an approval on its attempt to jump start the economy.

Currencies are of relative value, so the ones with less prudent monetary and fiscal policies depreciates against those with more cautious policies, everything else being equal. What if everyone decides to conduct ultra-loose monetary policy at the same time, as we see with the US Federal Reserve, Bank of England, Bank of Japan, Swiss National Bank? Then these currencies are in the race to the bottom. They might not depreciate against one again very much, but no so in other currencies or in real terms. Currencies linked to commodities, such as Australian dollars, will likely fare better.

We often hear that economists dismiss the concerns on the size of US debt, arguing that as a percent of GDP it is not a big deal, comparing with other developed nations. But they seem to forget one important fact - the US is the largest economy in the world. With 20% of the world GDP, it outsizes the second, third, fourth ... economy by a great margin. By modest estimation, increasing new US debt from 45% of GDP to 65% means the world has to generate 4% more cash to absorb debt issued by US Treasury. That's 2.8 trillion US dollar. Can the world grows 4% annually and invests all the money earned towards US Treasuries? Can China and Japan cough up more cash for the 2.8 trillion when their main source of income, export, are shrinking sharply? Considering the amount of US debt supply the world has to absorb, I reckon that it's the absolute dollar that matters, not the percentage against the US GDP. The Fed is trying to defy gravity in vain.

Another implication on buying long-term bonds is that it will take longer for the Fed to unwind the money supply. Surprise! When the economy picks up or inflation kicks in, the Fed will have to sell these securities before maturity and/or raise short-term interest rates. Either way, investors in the long-term bonds get killed.

Monday, March 9, 2009

Gold as a Currency

If you cannot eat it, drink it, or use it (for economic purpose), it ain't really an commodity. Although gold is traded on commodity exchanges and regarded by many as a commodity, it's both historically and intrinsically a currency. The distinction is important when it comes to invest in gold.

The main use of commodities, such as oil or cotton, is for production, not for store of value. Buyers and sellers are mainly individuals and organizations that take them as input or output in the production process. Profit and loss are results of production marginal costs and prevailing market prices. A few low-cost, efficient producers make the most profit.

On the other hand, the marginal cost of currencies is negligible comparing with its market price, i.e. the face value. Currencies are instruments to store value. They don't have any intrinsic value without considering the amount of economic goods and services they may use to exchange. The purpose would be undermined if vastly more currencies are created than the actual goods and services. We know that as the threat of inflation.

Theoretically, anything can be used as currency as long as it people put their faith behind it. And such faith is instilled in government's paper money. When faith runs out of on a particular paper currency, people flee to another government's paper money, traditionally the hard currency like the US dollar. What if people lose faith in all government papers? They turn to the currency has the highest marginal cost of production - gold, because government cannot simply print gold, rather they have to dig it out of the ground.

So when it comes to invest in gold, we should think of it as making a currency trade rather than buying a cash-generating asset. The subtlety lies in the nature of relative-value and zero-sum in currency trade. In other words, even if you made the right decision, you only made money in your base currency, and in nominal terms. It does not necessarily mean that you can now effort more goods and services. It's likely that the goods and services now cost more as your base currency depreciates. That's often a puzzling aspect in currency trading.

As government around the world create paper money at a fanatic pace in an attempt to inflate the economy out of the current slump, hedge funds and big money managers around the world are piling into gold, essentially a bet that all paper currencies are losing value relative to gold. Again, even if they are right, they are merely preserving the purchase power of their money, though they might have a good profit in their base currency. Personally, I am not quite sure about that. When governments and central banks outside the US really face cash crunch, they are more likely to sell their hard currency reserve, such as gold, to finance import purchases, therefore depressing gold prices, at least in the short-to-medium term. Physical commodities and commodity producers, despite the lower demand from the economic recession, seem to be a better place to invest, given that they actually create value through the production process.

Thursday, April 24, 2008

Have Your Cake and Eat It Too

The smartest guys in the room just had another field day.

In the height of the leveraged buyout boom, financial intermediaries like investment banks hungry for deals were hawking around with cheap and "covenant-lite" loans as investors could not resist a few extra basis points in interest they would earn with these loans. They all seemed to conveniently forget what might happen to the principal if things went wrong. Or they were simply caught up by peer pressure and crowd behavior? As former Citigroup CEO Chunk Prince said, when the music is playing, you have to get up and dance; and you don't know whether you would have a chair when it stops. Private equity firms were too smart not to take advantage of the greed (or stupidity) of the capital market, and borrowed mountains of these cheap, loosely-underwritten loans.

Now time has changed. With the credit crunch, banks are dumping their leveraged loan holdings in an attempt to repair their capital base and balance sheet, often at a significant discount. And that presents a unique and unusual opportunity to the borrowers. By buying back its own debt at a discount, a private equity portfolio company pays down its loan with less money than originally required. The debt reduction boosts the company's equity value, in turn benefiting its shareholders. Guess who are the shareholders? The private equity firms that used cheap loans to buy the company in the first place. Typically a private equity firm uses two schemes to increase its equity value: 1) selling a portfolio company to another firm or the public at a higher price than what it has paid (known as multiple expansion in the industry); 2) paying down the debt through operating cash flows. The new practice is similar to the latter scheme and the difference is that the gain is now from clever financial trading rather than operating.

So far the losers are the banks that had to mark down their loans and sell them off. Of course, they are not happy about being the loser. In the TDC story reported by FT, the banks were alleging that TDC, the borrower, violated the loan agreement by buying back its own debt at a discount. Whether the banks can recoup some of their losses through legal challenges is yet to be seen. Right now, private equity firms seem to outsmart their counterparts.

Monday, April 21, 2008

Forget Recession, Think Inflation

The Inconvenient Truth

While the media and policymakers are fretting over recession of the U.S. economy, commodity prices are sending a very different signal. Steady rising commodity prices historically stem from robust economic growth and increasing inflation pressure. “Not this time,” some argue. They think that the current soaring prices are consequences of speculative money flow and point to the dismal U.S. GDP growth and benign expected inflation as evidence. What they have missed are: 1) Commodity prices are determined by the aggregate world economy. As a percentage of the total world GDP, the U.S. economy has been declining for years. A U.S. slowdown would have a lesser impact to the world demand in commodities than previous recessions. 2) The U.S. economy is growing at 6% in nominal terms, not a bad figure if the inflation had been kept under the Fed target of 2%. Unfortunately, the Federal Reserve is misguided in making inflation judgment using the core PCE deflator, which excludes food and energy and currently stands a little above 2%, instead of the headline CPI, currently at 4.3%. 3) The traditional measure of expected inflation, which is the spread between 10-year Treasury and 10-year TIPS, is severely distorted under the current market condition. The credit crunch has led to a massive flight-to-quality – investors seek safe heavens in Treasury securities, pushing yields down. According a study by the Cleveland Fed, after adjusting for the liquidity distortion, the expected inflation has in fact shot up 45%.

Consumers have a real reason to worry about inflation. At the end of the day, they pay the headline inflation, no matter how central bankers are unwilling to recognize that.

Figure 1: Inflation expectations and commodity prices

Inflation Tax

You can make money in a bull market by riding the rising tide. You can also make money in a bear market by betting against it. But you can hardly make money in a market of high inflation.

Inflation is an implicit form of tax, imposed on not only investment profit but the principal. When taking income taxes into consideration, investors need to earn a higher rate of return than the rate of inflation to break even (See Table 1). As the current U.S. headline inflation reaches 4.3% in 2008, investors in the 28% tax bracket, for instance, would have to earn 6% just to preserve their real purchasing power.

Table 1: Breakeven return adjusted for inflation and income tax.

Investment Strategies

Steepen U.S. Treasury Yield Curve: When the yield on 10-year U.S. Treasuries dropped below 3.4% and the corresponding liquidity-adjusted expected inflation rose above 3.2%, something is seriously wrong here. Along the yield curve, we have a real interest rate of -2.1% at the frontend and 0.2% at the backend. Not only will the overall real interest rise back to its long-run rate, but the spread between the short-dated and long-dated treasuries will widen to reflect the soaring inflation expectations.

Long Commodity Currencies: The robust and lasting commodity boom also brings widely fluctuations in commodity prices, making it difficult for investors to hold outright commodities in their portfolio. Exchange rates of small open commodity exporting economies, such as Australia, Canada, South Africa, Chile, and Brazil, are the present values of expected commodity prices and tend to move more gradually than commodity prices. Empirical studies have shown that commodity prices Granger-cause exchange rates. An investment example is to long the Brazilian real by investing in the risk-free Brazilian treasury securities. With the Brazilian CPI at 4.66% and the policy fund rate at 11.75%, this strategy can generate a real income of 7% plus capital appreciation in the currency.

Sideline U.S. Equities: A recent study indicates a negative growth in consumer expenditures when excluding spending on food and energy. As 70% of the U.S. domestic economy relies on consumer spending, this is not good news for Corporate America. When consumer spending slows, earnings slow. We have yet to see the reported earnings drop, but it is important to remember that historically corporate earnings are significantly overstated in periods of rising prices as they are reported in nominal terms.

It’s the inflation, stupid!

Wednesday, January 23, 2008

More on Decoupling: Real Economy vs "Mr. Market"

I was recently challenged by market professionals why I would still argue for the decoupling theory while the global equity markets all suffered huge losses in the threat of imminent U.S. recession. Some clarifications are necessary. First, when referring to "decoupling", I meant real economies rather than equity markets. Second, I don't think the global economy operates in a binary fashion - coupled vs. decoupled. The argument is not "this time is different" because there has never been a first time, but rather I view that real economy and stock market each follow their own separate paths, up or down. However the paths might resemble in shape, they are distinct. For those more physics inclined, these cyclical waves have different phase velocity and wavelength. George Soros, the legendary Quantum Fund founder, made such a reference when interpreting boom-bust cycles in his book "The Alchemy of Finance". He called it the Theory of Reflexivity.

Without a fancy name like Reflexivity or other quantum physics mumble jumble, we could understand this notion intuitively. Imagine a father hiking on rolling hills with his 4-year-old son. The trail moves up and down gradually as the landscape changes. The father follows the trail at a predictable pace and in one direction; the son run back and forth around his father, getting excited sometimes and running ahead, and then getting exhausted and falling behind. The father and son travel along the same trail but the path patterns they travel are unique. Sometimes in the same direction and other times opposite; sometimes the child runs too far ahead and other times falls far behind. Now think the father walks the path of real economy and the erratic child walks the path of the market. Ben Graham more vividly described this manic-obsessed childish character "Mr. Market" in his book "Intelligent Investor".

In today's Financial Times, Mohamed El-Erian, the co-chief executive and co-chief investment office of PIMCO and former president and CEO of the Harvard endowment, also made the clarification on "decoupling": while markets might be highly correlated the economies might not.

Can other countries "decouple" from the problems of the US? Here, it is important to distinguish between market valuations and economic trends. An increase in the overall level of risk aversion around the world makes it hard for markets to decouple. Economic decoupling is a greater possibility, supported by underlying productivity trends and the larger degree of policy flexibility in some other key countries.

Interestingly, the FT editors also put a commentary from George Soros right next to that of El-Erian, where he refers to reflexivity:

Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral.


Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.

Tuesday, January 1, 2008

On Decoupling: Could China Save the Day?

For many years, the U.S. economy has grown through expansion in private consumption, absorbing excess output from emerging economies. As the financial system and households are experiencing the credit crunch, many economists and market players see rising odds in recession, but they are divided whether emerging economies, China in particular, can “decouple” from the largest economy in the world and sustain their growth. U.S. Treasury Secretary Hank Paulson recently called on China to live up its global responsibility by maintaining growth while relying less on exports and more on domestic consumption.

By examining the key contributing factors to the economic growth in China, I will weigh the impact of reduced U.S. demand to the Chinese economic and suggest that decoupling could occur to a large degree but it is unlikely that it would provide a meaningful boost to the U.S. economy. Lastly, I will discuss some high-level investment considerations based on the analysis.


For the past four years, it’s widely known that export has been a key driver in China’s economic growth. With a 11% plus annual growth in GDP, export accounts for more than a third of that growth. Based on the estimate from China’s central bank, every 1% drop in U.S. economic growth translates into a 6% fall in Chinese exports. Suppose that the U.S. economy grinds to a halt, the impact to the Chinese export sector would be devastating, but the Chinese economy as a whole would well weather the downturn. This might be surprising to those who have much anecdotal experience about Chinese exports. What people tend to overlook is that China imports almost as much as it exports, so the contribution to the overall GDP from net export accounts for only 10%. Excluding export growth, China would still have more than 7% growth in real GDP year over year, a rate that any country would be happy to have.


Fixed investment, on the other hand, is the largest component in the GDP, accounting for 40% of the overall GDP and another third of the economic growth. To cool off investments, the Chinese government has been taking aggressive administrative measures to tighten liquidity, such as lifting commercial bank’s reserve ratios and lending rates many times this year, and clamping down non-bank lending. However, companies are finding ways to circumvent the tightening policies and plowing back cash earnings into new investments at a record level. The companies affected are mostly private businesses that rely heavily on bank lending to run business, such as real estate developers and small-to-medium businesses. Besides domestic sources, foreign private equity funds and Gulf petrodollars are also eager to get their hands on hot investment opportunities, intensifying the problem of excess liquidity.

It is quite possible that investment could become an even bigger factor driving the economic growth in the near future. On the other hand, if the flood of investment mostly goes into building out the export sector, this investment-led growth is unlikely to be long-lasting.

Private Consumption

Household consumption in China is the lowest among countries in the region. Most Chinese policymakers agree with Secretary Paulson that on balance consumption should play a bigger role in economic growth, but it is unlikely that consumer spending will pick up much pace in next few years. In fact, as a percentage of GDP, it dropped from 46% in 2000 to 36% in 2006 and its contribution to growth remains muted. Despite very-low-to-negative real interest rates, consumer savings have actually increased. This counterintuitive phenomenon reflects the social economic changes undergone in China in the last decade, which receive little attention from outsiders but fundamentally affect how Chinese consumers make budgeting decisions. Gone are the cradle-to-grave social welfare programs, and consumers are forced to save large sums for uncovered or unexpected expenses. For instance, only 17% of the population are covered under any basic government pension scheme, while only 14% have unemployment insurance. Without much confidence in the social supporting systems, the saving rate will remain elevated for the foreseeable future.

Furthermore, growth in consumer spending would provide limited relief to the U.S. economy, because most consumer goods manufacturers in the U.S. have either gone out of business or moved their operations to low-cost countries, like China. In the latter case, the economic output is counted towards the countries that manufacture the goods rather than the U.S., because firm ownership is irrelevant when calculating GDP.

Decoupling, Yet Not Saving The Day

Not until the last decade, China had been a rather closed economy as a result of the decades-long “self-sufficient” economic policies. The astonishing growth in export largely stems from a very low starting point. Meanwhile, China has to import large quantities of capital goods, energy, and raw materials to feed the export growth. In fact, import offsets most of the economic growth that export contributes to. The slowdown in the U.S. economy will lead to contraction in Chinese export, but at the same time China needs to import much less to produce these goods. On the margin, China’s economy will decouple from the U.S. slowdown to a large extend and continue its growth as other economic drivers remain in place.

One way to reinvigorate the U.S. economy is to boost its export, particularly in industries that the U.S. still has a comparative advantage, such as high-tech goods and services. Unfortunately, many such high-tech goods and services are off-limits to China for political reasons. Without structural changes in the U.S. export, it’s unlikely that the U.S. economy could benefit much from China’s continuing prosperity and its increasing appetite for imported goods.

Investment Considerations

U.S. Capital Goods Companies
The large growth and weight in fixed investment as a percentage of GDP presents a lasting force that drives demand in capital goods, particularly industrial equipment and infrastructure. U.S. firms that offer superior engineering products and expertise could benefit from it.

European and Japanese Consumer Brands
Consumption growth follows similar paths among developing countries, evolving from basic household needs to the pursue of diverse life styles. With more disposal income, Chinese consumers will start shifting from what they need to what identify them, buying more electronics, cars, and luxury goods. Strong European and Japanese consumer brands have long been viewed as high-quality, high-fashion, and leading-edge by Chinese consumers.

Agricultural Chemical and Natural Gas
More disposal income also naturally leads to more consumption in protein and other food on the top of the food chain. We have seen that the demand in meat and dairy products has been increasing faster than people expected. While it is difficult for average investors to invest in farms or commodity futures, it is possible to invest in companies along the value chain. To feed more stocks, we need to plant more crops, which in turn need more fertilizer. And it takes a lot of natural gas to make fertilizer. Agricultural chemical companies and natural gas producers appear to be the beneficiaries in this macro trend.

Monday, December 10, 2007

Definition of Risk

In the Modern Portfolio Theory, the risk is defined by beta or volatility, theoretically simple and graceful but largely flawed and irrelevant in reality. The most dangerous aspect of this definition is that people more often than not mistake low volatility as low risk. Low volatility gives people the false sense of security, encouraging excessive risk taking. Throughout the history, we have seen repeatedly that long periods of low volatility often precipitated major market crisis, like the Savings & Loans in the 80s, LTCM in the 90s, and the subprime crisis that we are currently experiencing. Other popular quantitative models that measure Value at Risk (VAR) also suffer large degrees of deficiency because of unrealistic input assumptions. For instance, the variance-covariance model (VCV) assumes that risk factor returns are always normally distributed. Nassim Taleb has since proven that the tail risk is far greater than the bell curve can predict. The output is only as good as the input.

Warren Buffett considers risk as “the possibility of loss or injury from an investment,” a honest but certainly unsatisfactory definition for academics and investment bankers who seek precise measurement in risk. The truth of the matter is that such precision might not exist at all. Rather than defining risk in some sort of uniformly objective fashion, I think that risk is a subject of the observer or bearer of the risk. In other words, risk is how much a person is willing to and can afford to lose. If one considers 10% the maximal willingness-to-lose on his investment, a 10% drawdown should signal the exit on the investment when possible. This risk management measure is not uncommon among investment practitioners, but the real difficulty is to have the discipline to stick to it when losses accumulate. After all, most people suffer loss aversion: when facing large potential losses, people exhibit risk-seeking behavior rather than risk-averse behavior.