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.
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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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When an EM changes its exchange rate regime……

If an EM changes its exchange rate regime by notably changing the amount of flexibility/rigidity in its exchange, it usually has important implications on how its local equity would respond to future shocks.

If an EM makes its exchange rate regime more flexible, e.g. from hard peg to crawling peg, or from crawling peg to managed float, or from managed float to freely float, it implies that the currency value would be more sensitive to changes in external environment in the future. Its exchange rate regime should become more of a shock absorbing mechanism, e.g. more currency depreciation in the event of negative shocks to that the economy can regain some (export) competitiveness.

As the currency takes on more responsibility of absorbing external shocks, that means local equity (equity in local-currency term) should be more stable and less sensitive to shocks, even though equity in USD term may still have the same amount of sensitivity as before. That has important implications for equity analysts – when the exchange rate regime becomes for flexible, cross-country equity investment would see more of its volatility coming from FX volatility, rather than that of local equity. Prominent cases include Russian equity since 2011. Chinese equity may be slowly going through the same process as RMB becomes less pegged to USD.

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If the top 1% owns 40% of the stock market…

In the US, the top 1% owns 40% of the stock market, and the 10% owns 80%.

In other word, while company earnings come from nearly 100% of the population (think of Walmart), it is the risk appetite of the top 10% that mostly determines the valuation level of the stock market. And it is the risk appetite of the top 1% that significantly influences where the stock market valuation would end up.

Everyone is subject to fear and greed. So are the top 1%. However, due to their significant amount of wealth (relative to their daily expense) and high savings rate, the way they measure and perceive risks should be different from the median person in the population. But how different?

This question is still a puzzle to me. Wealthy people are usually assumed to be more risk taking than less wealthy counterparts, given their higher ability to sustain loss. But what else? Are wealthy people more or less myopic than others? Are they more or less subject to fear and greed than others? How do they perceive the relevance of diversification? Are they more or less subject to home bias? Lots of behavioral questions come to mind. And I wonder whether those behavioral economists have separate the top 1% from rest of the population when they investigate the thesis.

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