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Implication of Negative Chinese Credit Impulse

  • Negative Chinese credit impulse – given its significant impact on Chinese growth and base-metal prices – would probably be good news for DM equity (vs EM equity), base-metal importing countries (vs exporters) and DM non-commodity corporate credit.

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This blog post has been partially inspired Trilogy Global Advisors: https://www.trilogyadvisors.com/1066040.pdf

I foresaw the negative Chinese credit impulse in November 2016 when Xi sent a very clear signal of credit tightening and regulatory clampdown on the financial industry. That let to my prediction of underperformance of Chinese A shares (vs other EMs) and less bullish outlook on Chinese overseas shares. Looking back at the 1H 2017, however, I have been wrong on three things:

  • The EM equity rally has lasted longer than I thought – I was a bit too early closing the positive call on EMs.
  • Base metal prices have held up better than I thought – they were flat in 1H 2017 as opposed to a decline.
  • There was an argument that the negative Chinese credit impulse creates deflationary forces on the globe, contributing to lower bond yields in 1H 2017 – which I didn’t fully think about.

In retrospect, the market performance again proves the (near) impossibility of market timing, i.e. timing the peaks and troughs of any market.

However, my argument on negative credit impulse end of last year still holds in relative terms:

  • Base metal price underperformed equity
  • Raw material equity underperformed aggregate equity
  • Chinese financial sector stocks (banks and property) underperformed EM equity, both in A-share and overseas markets

Looking forward, what would be the implications of negative Chinese credit impulse? Assuming no systemic crisis (e.g. sudden devaluation of CNY) that would send risky assets sharply down,

  • Base metals should underperform energy
  • base metal-importing markets should outperform exporting markets – opportunity arise in certain DMs; good news for Europe.
  • Within EMs, India and Turkey may continue to outperform EM aggregate.
  • Given the base effect of commodity price in inflation, ECB, BoJ and BoE still need to maintain a dovish tone despite talks of balance sheet reduction: opportunity in DM non-commodity investment grade credit.

 

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The bright side of the UK snap election

  • The probability of “soft Brexit” (relative to “hard Brexit”) has increased.
  • Even though domestic political uncertainty weakens UK’s Brexit negotiation power with the EU, a soft Brexit would be relatively good news for the UK economy.
  • The sterling weakened to 1.27 vs USD, but it was not a sharp correction as some expected (1.23 consensus before the election) for the scenario of a hung parliament.
  • Political uncertainty has compressed gilt yield. And yet a softer Brexit should support the UK economy and brings upside in UK gilt yield.

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How to hedge Trump Impeachment

  • Buy Mexican equity, Mexican peso, Japanese yen
  • Sell copper, UW US equity and EM equity

One can find people’s mood/nervousness of Trump impeachment at https://trends.google.com/trends/explore?date=today%2012-m&q=trump%20impeachment

 

 

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Two things where I disagree with GMO’s quarterly letter

Very interesting and pleasant read of GMO’s Quarter Letter “This Time Seems Very, Very Different” . However, two things on which I disagree with Jeremy Grantham:
1) Globalization and branding help to drive high profit margin?
Globalization and branding may sound a plausible explanation for high profit margin of S&P 500 companies. After all, with globalization those companies can now easily tap into international customers. However, according to S&P,  “S&P 500 Foreign Sales at 44.3% in 2015, Lowest Level Since 2006”. That looks at odd with Jeremy’s assertion.
2) Benefit of real interest rate being competed away?
Jeremy dismisses the effect of real interest rate on equity valuation (see the screenshot below), saying that the benefit of real interest rate will be competed away. I disagree. Reducing real interest rate is exactly a policy tool that many central banks use to boost the economy (after they boost the stock markets…). While individual firms might compete away some benefit of lower interest rate, the market as a whole benefits from it. In fact, the GMO paper seems implicitly highlighting the effect of real interest rate on equity valuation.
Inline images 1

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Political events vs markets – not linear

If one had a crystal ball end of 2015 and knew in advance that British would vote for leave in June, Trump would get elected in November and Renzi would resign in December 2016, then he probably would buy gold and sell equity. And unfortunately that person would lose money even with perfect foresight of political events.

However, if he did the same exercise end of 2016 and knew in advance that May would trigger Article 50 end of March and call a snap election in April, the defeat of the anti-euro party in the Dutch election, Erdogan’s win in the Turkish referendum, and Macron’s win in the first round of the French election, would that person sell gold and buy equity? Probably so……and that would have made him decent gains.

At the end of the day, in your opinion, should one trust a crystal ball that predicts political events?

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Forget about France; Focus on Italy now

As the 1st round of French election delivers an unsurprising result, the ECB has lost another reason to continue its monetary easing. Political instability is subsiding in the eurozone, forcing the ECB to pay more attention to underlying economic fundamentals, such as inflation dynamics.

If one assumes the ECB sets its pace of monetary easing with regard the the weakest (major) member of the EZ, then one should now turn to Italy. The pace of ECB easing could be particularly sensitive to any inflation surprise from that country. If inflation continues to surprise to the upside, then euro may continue to strengthen, and we are nearing the beginning of the end of the period of ultra-loose monetary policy in EZ.

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Why new technology (e.g. AI) does not necessarily result in lower inflation

New technology lowers average/marginal cost of production. Lower average/marginal cost leads to either higher productivity or lower inflation, or both. And I believe technology has a larger role to play in raising productivity than in reducing inflation. Here are a few examples to illustrate the point.

  • The cost of producing a loaf of bread has gone down substantially from the Victoria era to now, with the benefit of machines. That has certainly led to a higher productivity in the bakery industry,. The price of a loaf of bread has also gone down, helping drive down inflation, but its contribution may not be as large as one may think, because the weight of bread in the CPI basket has also gone down substantially.
  • The cost of computer memory halves almost every year, which in theory should make IT equipment cheaper and cheaper. However, at the same time we demand higher and higher computer memory to run in our laptops, desktops and mobile phones. iPhone 1 is substantially cheaper than 5 years ago, but many people have already upgraded to iPhone 6/7 which still costs quite a bit. Again, technology leads to better goods, but not necessarily lower expenditure on certain goods (e.g. IT equipment).
  • There is new demand that was not foreseen 100 years ago or even 10 years that helps push up inflation. For instance, the CPI basket 100 years ago wouldn’t include computers. 50 years from now, the CPI basket may not include any desktops, but rather new products – which deserves a premium in its price – built on new technology.

Another (monetarist) angle to explain why new technology does not necessarily lead to lower inflation (or by the same argument lower government bond yield): inflation is probably a monetary phenomenon. Why broad money supply – driven by growing narrow money or higher monetary/credit multipliers – increases beyond people’s estimate, unexpected inflation occurs and leads to inflation overshoot.

At the end of the day, it is much easier to generate hyperinflation than moderate inflation (with decent growth in the background).

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