The game of chicken is played when two cars are driven at each other at high speed. The one that flinches first, loses. The one that flinches last, wins. If neither flinch, they both lose. 

Fundamentals are improving in the US and UK. Europe remains in poor shape and will do so as long as they remain on the EUR. The crisis of 2008 did not cause any of the ills in Europe; it just exposed them and removed the tailwinds that allowed Europe to maintain its economy under a suboptimal currency regime. Where central banks are able to monetize debt and print money, quantitative easing has allowed time for healing and ‘animal spirits’ to be revived. Emerging markets growth remains above developed markets growth but a more complex dynamic is brewing. Developed markets technology is allowing them to catch up with emerging markets where cost pressures and an inability to match the West in generating proprietary technology is hobbling their potential growth. Frontier markets are growing on the back of an advantageous demographic and low cost labor at the expense of emerging markets which are being squeezed from above and below. These are generalizations of course, which mask a richness of detail necessary to make more specific forecasts for the prospects of each country.

The implications for risk assets are even less clear. As companies are increasingly global, a country based analysis of macroeconomic prospects is less helpful in the analysis of companies’ prospects. We cannot but generalize despite the risk of losing resolution.

The role of interest rates and liquidity in the current rally in risk assets is important. Interest rates have been unilaterally suppressed across the term structure across most of the major currencies while monetary bases have been substantially increased. Private sector companies which can, have taken the opportunity to liquefy their balance sheets through bond issuance. Smaller companies with no access to debt capital markets have found banks unable to supply adequate financing due to their own inadequate capital positions. This has been a partial contributing factor to the chronic unemployment as smaller companies are more likely to hire while larger ones are in rationalization mode. This structure is also likely to confound central bank efforts to target employment in the conduct of policy. It also creates an opportunity for providers of growth capital to small and medium sized enterprises.

As ‘animal spirits’ are revived, and or inflation begins to accelerate, an exit plan from QE will be sought and implemented. This poses a risk to risky assets. The question is how big a risk. If rates rise as a result of stronger economic growth then one can expect an orderly slow down in risk assets followed by a resumption of growth, which has been empirically supported in previous tightening cycles. The complication here is that the size of the money base is of unprecedented scale, asset sales may need to follow the raising of interest rates and the current level of interest rates introduces a high level of non linearity in private balance sheets which may prove unmanageable. Central banks will have to telegraph their intentions well in advance to help wean the private sector off easy money.

For now, the point of higher interest rates is likely far off, some 3 years at least. Yet yield curves may still steepen while central banks keep short rates low. Given that inflation is likely to be under control in the developed markets, their term structures will likely stay flat or at least relatively flat. Emerging markets, however, may face a less tractable problem, that of rising inflation, partially the product of developed market central bank policy, and slower growth, again partially the product of a less profligate developed market consumer and the growing trend of re-shoring of manufacturing. Already some such countries have begun to cut rates as growth has slowed.

Unfortunately, the purpose of this letter is not to advise on a particular trade or portfolio positioning but to highlight some of the current issues. The reader may extrapolate their own trading and investment strategies. We now end with the last bit of an old song…

Last thing I remember, I was

Running for the door

I had to find the passage back

To the place I was before

“Relax, ” said the night man,

“We are programmed to receive.

You can check-out any time you like,

But you can never leave! “

Having borrowed heavily in the bond markets in the past couple of years. If interest rates should rise substantially, a corporate CFO might be tempted to buy back their company’s debt at below par and retire its debt. Its an interesting way of making money without producing a single widget.

One wonders how significant this impact could be. It certainly won’t hurt to own the equity.

The sudden weakness in gold is intriguing given the acceleration in global QE most recently by the Bank of Japan. Gold has always been thought as a hedge against inflation and deflation. In fact most gold bugs would have one believe it can cure physical ailments. It is established wisdom, however, that gold is a hedge against the debasement of fiat currency. Now this thesis at least sounds plausible and I can accept it. But why then, in the midst of rotational, global, wholesale currency debasement, is gold weak?

Perhaps we are missing a particular nuance. Perhaps we need to modify our thesis and restate it as: gold is a hedge against ineffective quantitative easing and the debasement of currency. The subtlety here is that gold is a good hedge against QE assuming QE doesn’t work. If, however, QE begins to work, that QE does more than inflate away debt, that QE does more than monetize sovereign debt, that QE in fact manages to stir ‘animal spirits’ and induce a self sustaining cycle of growth, then perhaps gold becomes much less valuable as a hedge.

This thesis would imply that the market as a whole is beginning to embrace the reality of a more durable economic recovery, led by the US, the UK, and bits of Europe. Surprisingly, the weakness now seems to originate from the emerging markets where central banks have begun to cut rates despite inflation rates that while not raging, are not entirely trivial. The developed markets, ravaged by poor sovereign balance sheets appear to be pulling themselves up by their bootstraps. If the thesis about gold is to be supported, we need to see more consolidation of the meagre growth that we have seen in the US and even better, a resurgence of growth after the summer. And further weakness in gold.

The Japanese stock market is up some 40% year to date while the JPY has gone from 86 at the end of 2012 to 101 today. Wow. Is it too late to invest in Japan? I think not, but at the same time, it pays to be more circumspect.

The obvious trade has been in the exporters. These have rallied hard and its likely that the weak JPY impact on earnings for exporters has been efficiently priced in. It is time to look at domestic businesses as the impact of monetary and fiscal policy gain traction, in a more self sustaining recovery, than a mere export driven shot of morphine.

This time is different. Monetary policy in the past 24 years has been half hearted. Quantitative easing was always sterilized while the BoJ has been almost apologetic for their perceived irresponsibility. The independence of the BoJ and the need to maintain the semblance of independence has meant that the BoJ has never really been able to align itself with the government, even if it fundamentally agreed with it. Fiscal policy, meanwhile, will be kept loose. In the meantime, the two step increase in the consumption tax will do two things, it will front load expenditure thus compensating for some of the effects of deflation and it will raise revenues from a larger tax base. On the other hand, the cut in the corporate tax rate, more generous depreciation accounting and employment subsidies will help businesses. Beyond their material impact, the confluence of these initiatives will have a positive impact on ‘animal spirits’.

What are the risks? The obvious ones are that Japan’s fiscal position is untenable in the long run. Its demographics will result in the eventual inability to fund its debt domestically thus exposing it to international standards of credit appraisal. This can be quite far away. Less obvious is that a weak JPY is a crutch, not a cure, and it is a weak crutch. Inflation has many faces. Cost push inflation with weak demand could result, we have a word for that, its called stagflation. Also, if successful, the BoJ’s 2% inflation target could spark a sell off at the long end of the curve. A steeper term structure would raise debt costs for the government and probably require the BoJ to monetize even more debt.

In short, the prospects for a higher Nikkei are good, and I can see the market continuing for a good 12 months, maybe even more. How Japan resolves its structural issues is another question, currently unasked and unanswered.

Our methodology is simple. Its getting it right that’s difficult. First of all, we observe, all the time, data, anecdotal evidence, trends, events and developments, everything. Then we postulate theses, what we think all the information evolving before us means. From these theses come predictions about the evolution of investable asset markets. This is the hard part. The next part is easy. We sit back and see if our predictions come true. If they do, we still ask ourselves if it is a coincidence or pure dumb luck, or if it was a consequence of our theses. If they don’t, then we revisit our theses to see if they are still sound or valid. If they are not, then its back to the drawing board. We almost never rely entirely on the price evolution of the asset markets we are interested in. That’s like forecasting the weather by looking out the window. We are not going to wait for a 20% drawdown in the market to inform us that we are in a bear market. That type of signal is ever so slightly late.

Since early October 2012 we have had an overweight on US (the S&P is up 13% from then till now (9 May 2013)), and UK equities (the Footsie is up 11.77%) and an underweight in German (DAX +6.12%) and China domestic listed equities (SHCOMP +5.23%). These were not based on drawing straight lines or smoothed lines through charts but our expectations for the performance of the respective economies, the psychology that transmits such fundamentals to markets and an analysis of the flows of capital to the underlying companies, most of which are global in nature and which thus confound traditional country delineated asset allocation techniques. Happily this view has worked and I have no reason to change the view so far.

The slowdown in the global economy is as expected. In China, it is the continuation of a longer trend, of an economy maturing and facing growing pains, and growing linearly without addressing speed limits and the instabilities that come with growth. In Europe, the EUR continues to sap the vitality of the region, and I expect more misallocation and under-employment of factors such as labour and capital, with associated impact on growth, profits and asset prices. The US remains a bright spot precisely because post 2008, its equilibrium growth rate has halved, so that the meager growth it managed last quarter was an overshoot (by my count) rather than an undershoot (by consensus’ count.)

As the world becomes more mercantilist and less cooperative, the emerging markets will excel in some areas and lag in others. The developed markets hold the cards in technology, intellectual property and productivity and in the case of the US, cheap and domestic energy, and the emerging markets hold the cards in natural resources and cheap labour but could face energy inflation. Central banks will continue to try to engineer as much inflation as they can safely and covertly do so as to erode the debt pile of their sovereigns as well as improve their terms of trade. This can descend into hostilities if they are not careful.

Basically, the problems of 2008 have not been addressed, but global growth and progress has slowed to a rate that we are happy to coast at given the lack of visibility. Normally, this level of uncertainty over unresolved problems would trigger panic attacks but we have been under the Sword of Damocles so long that few even notice its presence any more.