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Manager Commentary, December 2016

End of year macro observations on a Trumpian bonds over the last forty years can be construed as the
new world order hijacking of the market economy by creditors. The
advent of hawkish inflation targeting by central bankers
was a response to the exceptional inflation of the 1970s
Right Here, Right Now? which had bestowed an embedded inflation risk
premium into the term structure of interest rates.
As you know, back in late 2014 we were more However, the disinflationary forces of globalisation and
constructive on risk taking opportunities as Europe the internet a decade later arguably meant that interest
prepared to launch QE, finally resetting monetary rates were set too high for the period and creditors
policy on a necessary looser course. And by early 2015 were overcompensated. This mispricing of credit
European stock indices had rallied 30% from their effectively established an enduring rent transfer from
October low, despite the pervasive market view that QE the debtor constituencies of the household and
had passed its sell by date. But the momentum passed corporate sectors to the rentiers, which is most clearly
and the continent’s equities have performed woefully manifest in the outperformance of government bonds
ever since, giving back their entire advance. We use the over the period (see our May 2015 Commentary for
discipline of time to regulate our risk taking behaviour; further explanation).
our thinking was re-appraised over the summer and we
were out of the position completely by October. Following the crisis of 2008 the central bankers had no
choice but to abolish this rent transfer, a challenge
Chart 1: Euro Stoxx 50 vs S&P 500 – Relative given the scope of their traditional role controlling
Performance since January 2015 short term rates. The advent of QE was an attempt to
push the impact of monetary policy further along the
120
curve, explicitly targeting lower 10-year rates. Many
investors were and are sceptical as I believe they are
largely ignorant of the policy objective: to eliminate the
110 debilitating inflation premium embedded in real yields
which was making it impossible for households and
100
corporates to maintain spending and repay debts in the
period from 2005 onwards. By driving 10-year rates
close to zero the central planners hoped to re-price risk
90 and thereby enable the debtors to keep spending whilst
repaying more of their liabilities. The table below,
80
comparing the real interest cost incurred by debtors in
the economy with real GDP growth, demonstrates that
this policy has succeeded: since 2010 real GDP growth
in the US has exceeded the real interest cost, meaning
Source: Bloomberg/EAM
that debtors have been able to earn enough from their
Here is what I think happened… economic activity over and above the cost of debt to
reduce their liabilities. I wish a QE-sponsoring central
My team and I have grown tired of the demonisation of banker would use this narrative to explain their policy
QE. We believe that the timely adoption of this policy in intentions…
the US back in early 2009 was successful in that it
staved off the very real prospect that the US economy Real Cost of Transfer to
Real Rate Total Debt/ Real GDP
Debt/ Creditors
would endure the hardship and misery of an economic (US 5yr) GDP (%)
GDP (%)
Growth (%)
(%)
depression comparable to that of the 1930s. 2002 2.20 270 5.9 2.0 3.9
Nevertheless the shock therapy of this radical new 2003 1.10 285 3.1 4.4 -1.3
2004 0.97 310 3.0 3.1 -0.1
policy intervention had nasty side effects. Think of it as
2005 1.49 322 4.8 3.0 1.8
the financial equivalent of chemotherapy where the side 2006 2.29 335 7.7 2.4 5.3
effects of treatment can initially make the patient feel 2007 2.15 350 7.5 1.9 5.6
worse before allowing them to live longer. It’s just that 2008 1.34 360 4.8 -2.8 7.6
Europe, by steadfastly refusing treatment for so long, 2009 1.11 370 4.1 -0.2 4.3
2010 0.27 365 1.0 2.7 -1.7
may have irreparably weakened itself to such an extent 2011 -0.43 360 -1.5 1.7 -3.2
that the side effects might end up killing the patient, in 2012 -1.20 353 -4.2 1.3 -5.5
this case the EU project. 2013 -0.74 350 -2.6 2.7 -5.3
2014 -0.16 350 -0.6 2.5 -3.1
2015 0.11 350 0.4 1.9 -1.5
Let me explain. Our interpretation of the miserable
performance of risk-adjusted equities versus sovereign Source: Bloomberg/EAM

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Manager Commentary, December 2016

Regardless, the pinnacle of this policy was probably which continues to defy the Brexit Armageddon
reached earlier this year when almost $11trn of naysayers. So I am beginning to think the world is
sovereign 10-year money was priced at zero or negative healing and in 10 years' time we will look back and see
nominal yields and the Bank of England's benchmark that stocks have outperformed government bonds on a
ten year interest rate fell to its lowest level in 322 years. volatility-adjusted basis, similar to what we saw with
This much you know. What is less commonly gold versus the S&P at the turn of the century.
understood is that this summer, in the aftermath of the
surprise Brexit vote, nominal US Treasury yields 140
converged with the rest of the world. Vol.-Adjusted Gold vs S&P (1996 to 2012)
120 Vol.-Adjusted S&P vs USTs (2007 to Present)
Real 10-year treasuries reached zero but this was 100
nothing new as they had been deeply negative back in
2013 prior to the taper tantrum. The unreported and 80

new factor was that nominal Treasury yields converged 60


to the lower Japanese and European levels on a
currency-hedged basis. That is to say international 40

investors, who typically hedge their foreign exchange 20


exposure, found they could no longer achieve a yield
uplift relative to their domestic bond market by buying 0

Treasuries as the widening of cross currency basis and Years


dollar libor rates made hedging more expensive. This Source: Bloomberg/EAM
was probably the point when the great multi-decade
bull market in bond prices reached its climax, when the
economic ascendancy of the creditor class reached its “I’m mad as hell, and I’m not going to take this
high water mark and when the shackles on global anymore!”
macro performance were finally released.
The Network (1976)
Chart 2: Nominal Sovereign 10yr Yield
Convergence However I fear this may not prove the case in Europe in
2017 owing to the afore-mentioned harmful side-effects
3.5 10yr USTs 10yr JGBs
on the political economy. In reality few debtors have
10yr USTs (JPY hedged) 10yr OATs been able to access this wealth transfer in the shape of
3.0 10yr USTs (EUR hedged) cheap credit, whilst other assets re-priced higher to
2.5 reflect zero yields. So the rich got much richer and
2.0 ordinary folk became really annoyed, setting in motion
1.5
the (thankfully) bloodless revolution of Brexit and
Trump.
1.0

0.5 Trump succeeded by seizing on this discontent. He has


0.0 now set out an agenda of fiscal expansion, exploiting
-0.5
the low rates. In other words, America has just elected a
debtor president who will direct the government to
borrow on behalf of his household and corporate
Source: Bloomberg/EAM
constituencies at the rates previously only made
available to the privileged few and the Fed will be
For those fortunate to borrow at such low real rates the pushed into a slow and predictable series of rate hikes
levy has reversed. Large businesses with solid ideas can that keeps real rates very low for years to come.
now borrow money at the wrong price; creditors have Spending on infra-structure and financing substantial
no choice but to transfer their wealth to the economy’s tax cuts is the chosen route to expand and accelerate
entrepreneurial and household sectors. I think this is this wealth transfer. I suspect the American patient is
likely to persist. The benefits of this pivot have already well positioned to recover from the political fissures
taken root in the US where, with the wealth transfer brought on by QE.
now running in reverse as per the table above,
economic growth has been superior to the rest of the The unknown factor is how the current phase of private
world. sector tightening of monetary policy will conflict with
this ambition. We have often pointed out how difficult
Likewise it is evident in the other early adopter, the UK, it is for central planners to generate inflation. The
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Manager Commentary, December 2016

problem is the colossal size of publicly traded sovereign inflationary zeal of the central bankers: by front
bond markets and freely floating exchange rates; the running the bureaucrats and raising bond yields at the
private sector tightens monetary conditions in response earliest indication of inflationary pressure, the markets
to an expected pickup in inflation. Previous periods of have successfully kept a lid on such ambitions despite
hyperinflation many decades ago occurred owing to the huge central bank bond purchases. But in comparison
absence of such constraints. The power of this with Europe, Japan is an oasis of political consensus
automatic stabiliser can be seen when 10-year rates and stability. In five short years the country’s elected
almost doubled during 2013’s taper tantrum, closely leaders have removed hawkish Bank of Japan
followed by a 25% rally in the US dollar index. I believe governors, wound back fiscally regressive tax hikes and
this pernicious repricing of credit almost certainly now have ‘sacked’ the bond market. Their inflationary
contributed to the US economy’s subsequent sluggish intent is now almost unencumbered.
performance and the continued slide in inflation
expectations. There will surely be a debate as to So if Trumpian policies lead to higher inflation globally,
whether something similar might happen again. this could be the long-awaited moment when inflation
However, this time the market’s hand brake is likely to finally makes an appearance in Japan. And with
be less effective given the imminent tax cuts, nominal bonds yields held at zero, the outlet valve
repatriation of stranded corporate cash balances from would be a sharply weaker yen.
overseas and fiscal spending. In short, the US seems to
have the political resolve and capacity to generate some In short, a European macro storm is brewing and the
momentum in economic growth. yen slide seems likely to persist.

Sadly the same cannot be said of Europe. The low Mad Policy, Mad Men or Mad Max?
growth and high government debt of significant
European nations such as Italy requires decades of "Tomorrow we wake up - I mean, I would jump out of
financial repression to be resolved. Instead, the hotel window if this was the scenario - but we
government bond yields have been dragged higher with wake up and China has devalued 20%. The world is
global rates and, what is more, the German dogma of over..."
‘good deflation’ seems as entrenched as ever with the
first steps towards an exit from QE having just been This is how I rather colourfully elected to share my
taken as the ECB announced a reduction in the monthly thinking in an interview on RealVision back in
asset purchases from April next year'. February. My usual hyperbole aside, why was I so at
odds with market fears that a renminbi devaluation was
And last but by no means least, there is simply no imminent?
political resolve at the core of Europe to embrace a
fiscal expansion to offset the dangers of this tightening Largely it was the severe implications of such a
on the continent’s weaker territories. The major unilateral step. I felt aggrieved that those pursuing the
northern countries tend to look at government budgets logic of a large one-off devaluation were ignoring some
similar to households and favour balanced budgets; serious and negative consequences. The big issue was
high spending policies involving more debt issuance political. China is officially monitored annually by the
from the core nations are simply unpopular with voters US Treasury department, on behalf of Congress, to
already angry about immigration and the effect of QE determine whether at the prevailing rate of exchange
on the yields achieved on their savings. So I fear that the country is deemed to be a currency manipulator.
Europe looks to set to flounder once more. And with That is to say, the US government stands constantly
Brexit, and now President Elect Trump, offering an vigilant and ready to impose trade tariffs should it
appealing nationalistic growth alternative the fear must deem that China is using an under-valued exchange
be that the popular vote in Europe’s busy election rate to support its exports. It is therefore inconceivable
timetable will be galvanised into producing more to us that an immediate and sharp devaluation from
shocks in the year ahead. Remember, as we discussed officially designated "cheap" levels would not be met,
in our July 2016 Commentary, it was the successful even by the liberal style of the outgoing Obama
precedent of an alternative economic policy following administration, by harsh new tariffs on Chinese exports
the UK’s decision to leave the gold standard in the early making redundant most of the trading advantages from
1930s that led to the demise of the previous regime. a lower renminbi. Most likely US allies such as Japan
and Korea (and maybe even the ponderous Europeans)
Japan is a different proposition. The Bank of Japan’s would follow suit resulting in an inevitable tit-for-tat by
momentous decision to target zero 10-year JGB yields the Chinese who would in turn impose import tariffs on
was itself an open admission that the private sector access to their lucrative domestic market and make it
pricing of sovereign bond markets can scupper the much more difficult for foreign businesses to operate in
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Manager Commentary, December 2016

China. Global trade would tank, the WTO would likely money into the offshore market at will to take
collapse and fresh waves of nationalism would sweep advantage of higher rates, causing a shortfall of
over the global political landscape, pulling the world liquidity offshore. This phenomenon will only become
economy into a deeper contraction than last seen back more acute should pressure on the renminbi intensify.
in late 2008 and early 2009. In such a world, a trade paying offshore CNH rates
carries positively and acts as a long volatility position
Taking a step back from my incendiary comments made should market fears about China re-assert themselves.
in February, I think it was not necessarily the
magnitude of the purported devaluation that upset me So, to conclude, you might say that we are running a
so much but rather the "how" and "when" it would Trumpian portfolio. With the economy’s debtors finally
happen. For as we have seen this year, with the fine- in the ascendancy Eclectica is positioned for an
tuning of the prevailing capital controls, and perhaps anticipated mean reversion, being long the US debtor
the officially sanctioned weakness in the renminbi community and short the rest of the world’s creditor
versus a basket of its global trading partners, a class. The portfolio hangs on this one narrative with
moderately weak yuan is proving far less contentious or three thematic risk expressions.
dangerous to the world than the swift one-off
devaluation envisaged by the markets at the turn of the • In Europe we anticipate further duress in the
year. political commitment to the European project as the
success of Trump’s economic stimulus plan keeps
Perhaps the macro risk from China is less to do about US growth humming along leaving the continent
leverage and more about the scale of uneconomic badly exposed as a politically fractured economy
lending? China and the West dealt with the slack that without the resolve to implement successful growth
arose from the Great Recession in different ways. China strategies.
was defiantly Keynesian, over building infrastructure,
whilst the West chose to scale back on capital spending. • The combination of Trumpian economics producing
It might be argued that the West subsidised people to the long sought-after lift in inflation expectations
do nothing, leaving itself with a huge government globally and Japanese 10-year nominal yields being
burden, whilst China subsidised people and companies trapped at zero by the Bank of Japan should mean
to build capacity, some of which will be used to further the yen continues to weaken.
expand the economy and some of which won't. The
optimum position is probably somewhere closer to the • And finally, there are appealing opportunities in
middle but to say that China got it more wrong than Chinese fixed income markets arising from the flows
other countries seems premature. Indeed I suspect in of liquidity between the onshore and offshore
our post-Brexit Trumpian world, we are all moving markets, trades which generate positive carry should
closer to the Chinese doctrine and so once more I find I the status quo persist yet remain long volatility
have no appetite for the Chinese apocalypse narrative. should pressure on the renminbi intensify in the face
of a strengthening US dollar or slowing Chinese
As I see it, we are in a long term cycle where Chinese economy.
GDP growth decelerates from 10% per annum to the
current 6% regime and then inevitably to low single Long live the revolution…in Europe it will almost
digit rates of expansion. Today, within that longer term certainly be political!
cycle, China is approaching the end of a mini cycle of
monetary and economic expansion; if anything I believe
China is in the midst of shifting to a tightening bias
rather than further easing. And I do not anticipate a Hugh Hendry, George Lee, Tom Roderick
sharp sell-off in the renminbi; a currency devaluation
would be politically counterproductive, especially in
light of Trump’s contentious trade posturing.

Instead I can envisage a situation where the PBOC


prefers to keep the currency relatively stable. However,
in a new Trumpian world with a rising US dollar, the
mechanics of their supporting the renminbi will yield
profitable trade opportunities. Government
intervention will remove liquidity from the offshore
market, whilst the incomplete capital account
liberalisation prevents onshore Chinese moving their
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Manager Commentary, December 2016

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