Outside the Box

Questions for the Coming Year

January 10, 2018

Today, in week 5 of our 8-week SIC Speaker Series, I give you Louis-Vincent Gave, the Hong Kong-based CEO and founding partner of Gavekal. Louis always brings an abundance of fresh, actionable insights to the Strategic Investment Conference, and you’ll get a taste of what’s in store as Louis shares his “Questions for the Coming Year” with us in today’s Outside the Box.

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A big question this year is what will become of Bitcoin (and its crypto-brethren), and Louis leads off with a telling anecdote about an encounter that Federal Reserve Bank President Neel Kashkari had in LAX a few weeks back. Then he shifts the perspective back to Asia, where China, South Korea, and Japan are dominant global Bitcoin forces. (Did you know that in Japan there are about 1 million Bitcoin day traders and that some 300,000 shops accept the crypto-coins for payment?)

Speaking of Japan, the Bank of Japan has been the world’s most aggressive central bank, but with Japanese banks and insurers hitting the wall, Louis asks whether this could be the year the BoJ backs off in a big way and the short-yen trade craters.

Since Louis launched Gavekal in 2001 with his father, Charles, and Anatole Kaletsky, the firm has always had a broadly deflationary view of the world (and again, that view was largely formed by Louis’s being on the ground in Asia). But now, Louis asks, “What would happen to companies whose sole purpose is to optimize excess capacity (i.e. half of the world’s unicorns) if and when that excess capacity is used up?” He’s referring to massive shifts underway in China’s labor pool, demographics, and excess industrial capacity. And if the outcome is pricier Chinese exports, will they fan the embers of inflation that are already beginning to glow in the US, Japan, and Europe?

Well, those are just the first three of Louis’s perceptive questions; and you’ll have the chance to toss questions his way, too, at my upcoming Strategic Investment Conference, March 6–9 in San Diego. You can reserve your seat right here.

Next week my SIC Speaker Series will feature David McWilliams, the redoubtable Irish economist, writer, broadcaster and journalist, and academic, and raconteur (not necessarily in that order). He is not to be missed.

The question about the direction of the yen is of particular interest to me, as I have had my mortgage in short yen options. I still have about six years to go along with that trade, so there is plenty of time for the yen to collapse. But I am beginning to lose faith.

I have asked many of my economist friends, and so far have found none (and I mean none!) who would have thought that Japan could monetize 140% of its GDP and the yen would actually strengthen. This has never happened in the history of the world. Ask Zimbabwe how it worked out for them. Or Argentina. Forget Weimar Germany.

Our plane kept getting delayed on our return trip from Hong Kong, so I am barely awake as I write this final note. It may be that my body is still in Hong Kong. This was supposed to be a working day, but I’m not sure how much work is actually going to get done. With literally 600 emails in my inbox, I’m going to have to do a lot of ketchup. Hmm, make that “catchup.” But I can’t tell you how good it was to be in my own bed last night.

Shane and I got to spend a lot of time with Lacy and JK Hunt, not to mention Ajay Kapur, our host from BAML in Hong Kong. We could not have had a better time. And my friend Peter Churchouse took us all out on his 65-foot racing yacht in the harbor when it was just a tad bit windy, and I think he said we got up to around 40 knots as he took us through his tacks. It was my first time to be on a sailboat that was listing at a 60° angle –quite an interesting experience. Shane might have gotten a tad nervous. She was worried about tipping over – imagine that. I promised her that after 65 years Peter knew how to keep the boat upright, which he brilliantly accomplished.

At the end of this weekend’s letter, I’m going to tell you a story that I think is great fun (though Shane and JK may not quite appreciate it) about the next adventure we had in HK.

And with that I will punch the send button and turn you over to Louis. Have a great week.

Your working around the edges of major jet lag analyst,

John Mauldin, Editor
Outside the Box

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The Questions for the Coming Year

By Louis-Vincent Gave, Gavekal Research
December 15, 2017

Like obscenity and modern art, bitcoin price charts will mean different things to different people. Take for example this recent tweet from the Federal Reserve board’s “uber-dove”, Neel Kashkari.

This tweet startled me for various reasons, namely:

a) Central bankers really do embrace their role as party-poopers whose mission is to take away the punch bowl before things really hot up (note, there will be no central bankers at my annual Christmas Eve party, so if you happen to be in Whistler, you should come along!).

b) The above was tweeted by the most dovish Fed governor, so if Kashkari is scratching his head over bitcoin developments more hawkish governors are presumably pulling their hair out.

c) And if dovish policymakers in the US are publicly pondering the impact of crypto-currency speculation, central bankers in markets where such activity is rampant must be properly concerned.

Indeed, a recent Bloomberg article noted that 40% of bitcoins are owned by around 1,000 or so individuals who mostly reside in the greater San Francisco Bay area (the early adopters). Sitting in Asia, it feels as if at least another 40% must be Chinese investors (looking to skirt capital controls), and Korean and Japanese momentum traders. After all, the general rule of thumb in Asia is that when things go up, investors should buy more.

Asia’s fondness for chasing rising asset prices means that it tends to have the best bubbles. To this day, nothing has topped the late 1980s Taiwanese bubble, although perhaps, left to its own devices, the bitcoin bubble may take on a truly Asian flavor and outstrip them all? Already in Japan, some 1mn individuals are thought to day-trade bitcoins, while 300,000 shops reportedly have the capacity to accept them for payment. In South Korea, which accounts for about 20% of daily volume in bitcoin and has three of the largest exchanges, bitcoin futures have now been banned. For its part, Korea’s justice ministry is considering legislation that would ban payments in bitcoin all together.

At the very least, it sounds like the Bank of Korea’s recent 25bp interest rate hike was not enough to tame Korean animal spirits. So will the unfolding bitcoin bubble trigger a change of policy from the BoK and, much more importantly, from the Bank of Japan in 2018?

The aim of this paper is to look at this and other important questions whose answers may have a significant impact on the price of financial assets over the coming quarters.

1 — Will the BoJ change course in 2018?

In recent years, the BoJ has been the most aggressive central bank, causing government bond yields to stay anchored close to zero across the curve, while acting as a “buyer of last resort” for equities by scooping up roughly three quarters of Japanese ETF shares. Yet, while equities have loved this intervention, Japanese insurers and banks have had a tougher time. Indeed, a chorus of voices is now calling for the BoJ to let the long end of the yield curve rise, if only to stop regional banks hitting the wall.

So could the BoJ tighten monetary policy in 2018? This may be more of an open question than the market assumes. Indeed, the “short yen” trade is popular on the premise that the BoJ will be the last central bank to stop quantitative easing. But what if this isn’t the case? There are, after all, pros and cons to keeping an uber-easy monetary policy, as shown below.

So all in all, we seem to be on a knife edge, and any number of events in the coming months may force the BoJ’s hand.

2 — Will inflation surprise on the upside?

From the very first Gavekal paper to the first book we wrote up to my more recent offerings, we, as a firm, have taken a broadly deflationary view of the world. A key factor for this over the past 15 years has been excess manufacturing added by China, together with millions of workers leaving the countryside year after year to try their luck in cities. In a sense, spending the past 15 years talking about deflation had less to do with being visionary than simply being observant.

But is the situation now changing? In a recent piece, I asked what would happen to companies whose sole purpose is to optimize excess capacity (i.e. half of the world’s unicorns) if and when that excess capacity is used up. Again, simply by being observant rather than visionary, we know that:

a) Migrant workers are no longer pouring into Chinese cities. With about 60% of China’s citizens now living in urban areas, urbanization growth was always bound to slow. Combine that with China’s aging population and the fact that a rising share of rural residents are over 40 (and so less likely to move), and it seems clear that the deflationary pressure arising from China’s urban migration is set to abate.

b) Reduced excess capacity in China is real: from restrictions on coal mines, to the shuttering of shipyards and steel mills, Xi Jinping’s supply-side reforms have bitten. At the very least, some 10mn industrial workers have lost their jobs since Xi’s took office (note: there are roughly 12.5m manufacturing workers in the US today!).

To say that most “excess investment” China unleashed with its 2015-16 monetary and regulatory policy stimulus went into domestic real estate is only a mild exaggeration. Very little went into manufacturing capacity, which may explain why the price of goods exports from China has, after a five-year period, shown signs of breaking out on the upside. Another part of the puzzle is that Chinese producer prices are also rising, so it is perhaps not surprising that export prices have followed suit. The point is, if China’s export prices do rise in a concerted manner, it will happen when inflation data in the likes of Japan, the US and Germany are moving northward.

Indeed, for all the talk about how inflation is harder to find than morals in a movie production company, a sizable chunk of the recent inflation data is starting to point towards a creep higher in a number of prices.

3 — Why does inflation matter?

Forget the fact that higher inflation typically leads to lower P/E ratios (as firms are forced to keep more inventory, thereby exposing themselves to the economic cycle), while lower inflation tends to lead to higher P/Es. Forget also that equity market valuations around the world, but especially in the US, are decently high by any historical gage, and thus arguably discounting a low inflation/low interest rate environment for years to come. The real reason I worry about inflation today is that inflation has the potential to seriously disrupt the happy policy status quo that has underpinned markets since the February 2016 Shanghai G20 meeting. And here, a historical parallel may be relevant.

Back in the early 1980s, foreign exchange volatility wreaked havoc on business spending plans and countries’ ability to repay foreign currency debt. To remedy this situation, the world’s key financial policymakers got together, first at the Plaza Hotel in New York in late 1985 and then in early 1987 in Paris to agree on a plan for coordinating monetary policies. The idea was to reduce currency volatility and so limit the scope for financial shocks. And so were born the “Plaza accords” and the “Louvre accords”.

Unsurprisingly, global investors loved the idea that they would no longer get sucker-punched by large currency swings. Almost all risk assets ripped higher. Gold and silver miners were especially big winners as silver prices more than doubled between the summers of 1986 and 1987 (today, bitcoin has that easily beat!). Deep cyclicals rallied hard, as did emerging markets (Hong Kong equities more than doubled in the period, while Taiwan (where 10% of adults were day-trading) started to redefine what a bubble looked like. These go-go years came to an abrupt halt after a rise in bond yields through the summer of 1987. In response, the Bundesbank (which back then was a genuine inflation hawk) panicked and in October 1987 raised short rates. US Treasury Secretary James Baker responded: “We will not sit back in this country and watch surplus countries jack up their interest rates and squeeze growth worldwide on the expectation that the United States somehow will follow by raising its interest rates”.

This statement made on a Sunday morning television show made it clear that the Louvre Accord was dead and buried. The next day, the Dow Jones Industrials opened down 27%.

So why re-hash ancient history?

Because careful readers will have noticed that for the past 18 months, I have espoused the idea that, after a big rise in foreign exchange uncertainty – triggered mostly by China with its summer 2015 devaluation, but also by Japan and its talk of helicopter money, and by the violent devaluation of the euro that followed the eurozone crisis – the big financial powers acted to calm foreign exchange markets after the February 2016 meeting of the G20 in Shanghai.

Since then, markets have lived under the calming influence of the “Shanghai agreement” (such an agreement may or may not exist, but the fact that market participants think it does has minimized the required intervention!). And, as in the post-Louvre accord quarters, risk assets have broadly rallied hard. It’s all felt wonderful, if not quite as care-free as the mid-1980s. And as long as we live under this Shanghai accord, perhaps we should not look a gift horse in the mouth and continue to pile on risk?

This brings me to the nagging worry of “what if the Shanghai agreement comes to a brutal end as in 1987?” (back then, the Hong Kong stock exchange closed for a week as it could not handle a tsunami of sell orders).

For that to happen, one would need someone to play the role of Karl Otto Pohl who headed the Bundesbank through the 1980s. Now today, Mario Draghi is about as well suited to play that role as Ben Affleck is to play Batman. And frankly, in spite of the concerns expressed above about regional Japanese banks, Haruhiko Kuroda at the BoJ is also unlikely to upset the Shanghai understanding. So it is easy to conclude that, with everyone now happy to be on the back foot against inflation, there is no risk of a 1987 denouement of the established international order.

Except that this overlooks the single most important economy: China (let’s face it: the last two upswings in global growth, namely 2009 and 2016, were triggered by China more than the US). Indeed, the People’s Bank of China may well be the new Bundesbank for the simple reason that most technocrats roaming the halls of power in Beijing were brought up in the Marxist church. And the first tenet of the Marxist faith is that historical events are shaped by economic forces, with inflation being the most powerful of these. From Marx’s perspective, Louis XVI would have kept his head, and his throne, had it not been for rapid food price inflation the years that preceded the French Revolution. And for a Chinese technocrat, the Tiananmen uprising of 1989 only happened because food price inflation was running at above 20%. For this reason, the one central bank that can be counted on to be decently hawkish against rising inflation, or at least more hawkish then others, is the PBoC.

And this is why a rise in inflation could end up dealing the markets a triple body blow. First, rising inflation would lead to lower valuations for most asset prices. Secondly, higher inflation would likely trigger a tighter monetary and fiscal policy in China. Thirdly, a tighter China threatens the cozy “Shanghai Agreement” which has prevailed since 2016. And how can one hedge against this threat? In 1987, bunds ended the year among the world’s best performing asset classes. Of course, history never repeats itself; but if it ends up rhyming, owning short-dated renminbi-denominated bonds may be an obvious “portfolio cushion”.

4 — What will the Fed do?

Answering this question has always been an important driver of performance, yet this year the general level of “stress” regarding the Fed’s upcoming decisions has been remarkably low. Almost every conversation I have had on the topic has been a version of the following:

a) The differences between incoming chair Jerome Powell and departing chair Janet Yellen are marginal.

b) In any event, Powell’s policy choices in the near term are constrained by the “dot-plot” and the path that Yellen has traced out. For Powell to depart from the plan would require significant upside/downside surprise for the economy and markets.

c) So bottom line, unless there is a shock to the system, we will just have more of the same.

d) And more of the same seems fine, thank you very much!

Needless to say, the above makes ample sense; and indeed, the path that Powell will follow is likely that offered by Yellen, and so discounted by the market. Yet, imagine a parallel universe, such that within a few months of being sworn in, Powell faces a US economy where:

  • Unemployment is close to record lows and government debt stands at record highs, yet the federal government embarks on an oddly timed fiscal stimulus through across-the-board tax cuts.
  • Shortly afterwards, the government further compounds this stimulus with a large infrastructure spending bill.
  • As inflationary pressures intensify around the world (partly due to this US stimulus), the PBoC, BoJ and ECB adopt more hawkish positions than have been discounted by the market.
  • The unexpected tightening by non-US central banks leads other currencies higher, and the US dollar lower.
  • The combination of low interest rates, expansionary fiscal policy and a weaker dollar causes the US economy to properly overheat, forcing the Fed to tighten more aggressively than expected.

The base case must remain that the Fed will follow broadly the path that it has set for itself. That said, the above scenario does not look far-fetched. Which means that looking into 2018, four scenarios seem most likely.

In the first scenario, events unfold fairly predictably and the Fed stays on its promised path. In this case, global currency volatility stays muted. In the second scenario, the US embarks on a huge stimulus, prompting the Fed to tighten monetary policy aggressively. Meanwhile, other central banks continue to sit on their hands. is triggers big capital inflows from the rest of the world into the US and pushes the dollar higher. The third scenario sees the world experience some kind of shock (take your pick from a bad Italian election, a bank crisis in China, a Saudi-Iran war, a North Korea war or a political crisis in the US) and the Fed responds with more QE. Finally, the fourth scenario sees the Fed deliver the promised monetary policy tightening, but inflation accelerates and the rest of the world tightens more aggressively than expected.

In the first two scenarios, the US dollar will likely rise, either a little, or a lot. In the latter two scenarios, the dollar would likely be very weak. So if this analysis is broadly correct, shorting the dollar should be a good “tail risk” policy. If the global economy rolls over and/or a shock appears, the dollar will weaken. And if global nominal GDP growth accelerates further from here, the dollar will also likely weaken. Being long the dollar is a bet that the current investment environment is sustained.

5 — The other threat to the current environment: oil prices

For ease of math, assume that the world consumes 100mn barrels of oil a day (the real number is around 97mn bpd). Then further assume that about 100 days of inventory is kept “in the system”, whether in pipelines, boats or reservoirs. Now, funding these inventories takes money, which is how a US$20/barrel move in the oil price can have a big impact on the global liquidity situation. After all, if the price of oil is US$60/bbl, then oil inventories will immobilize around US$600bn in working capital. But if the price drops to US$40/bbl, then the working capital needs of the broader energy industry drops by US$200bn.

The point is that an environment of rising oil prices and tightening Fed policy is usually bad for financial assets. Simply put, the more money the Fed sucks out of the system, and the more that is tied up in the energy complex, the less is available to push up asset prices. On this score, it should be noted that excess money supply in the US is decelerating (see chart below).

Should oil prices continue to rise, the resulting change in the liquidity situation could leave markets vulnerable. It follows that energy stocks may be a decent hedge for portfolios. To be sure, if oil prices head lower, then energy stocks will underperform, as the freed-up excess liquidity will flow into the likes of tech, emerging markets and bitcoin. But if oil prices do creep higher – or worse still, some kind of supply shock unfolds due to a Saudi-Iran confrontation or perhaps another collapse in Venezuela’s output – then energy stocks will provide a buttressing effect against a very different investment environment.


To many investors’ surprise, the past year was characterized by:

a) Massive outperformance of growth vs value

b) Massive outperformance of tech

c) Solid globally synchronized growth with low inflation

d) Low equity market volatility

e) Low bond market volatility

f) Low foreign exchange market volatility

g) Oil mostly range-traded, though breaking out on the upside towards the end of the year

h) Yield curves flattened/stayed flat

What are the odds that 2018 produces more of the same?

When I was a boy, I went to Jesuit school in France. And there, I was taught to answer every question with another question. Or better yet, with several questions (if only to ensure that one’s conversation partner ends up too confused to press a point). So the quandary of whether 2018 will unleash “more of the same” to me comes down to five questions:

1) Is the recent oil price breakout a sign of more strength to come? My fear is that the recent upside stems from strong, global, synchronized growth and a lack of investment in the past few years. This lack of investment is important, as the energy industry has become far more capital-intensive in recent years due to the rapid depletion of fracking wells compared to traditional wells and the associated faster wear and tear of equipment. Thus, I am inclined to own energy stocks as a hedge against a further rise in oil prices; a rise which will suck up excess liquidity and so cap gains in hitherto “hot” asset classes. I also like energy stocks as a hedge against a big geopolitical shock as I worry that Saudi and Iran are one big terrorist event away from going at each other’s throats.

2) Will inflation surprise on the upside in 2018? There is little doubt that most of the world’s structural trends (the digitalization of everything, robotics and population aging) are deeply deflationary. Yet, what strikes me as odd is that everyone in every investment committee meeting these days is a deflationist. Gone are the days when at least one or two people may argue that central bank printing would lead us down the path of Zimbabwe or Weimar Germany. The inflationists have either been fired, or beaten into silence and submission. Which probably means that the “deflation forever” thesis is, by now, most likely fully baked into most asset prices? So much so that, even as inflation data around the world start to rebound, no-one seems to care! It should also be acknowledged that since the eurozone crisis of 2011-12 few modern economies have added much productive investment capacity. Sure, real estate has been on fire almost everywhere and it is hard to go to a major city and not see a number of large construction cranes scar the skyline. But beyond real estate, and beyond tech, where have the marginal investment dollars gone? Not into steel mills, petrochemical plants, oil refineries, cement factories, or new tankers; not even in China, Korea or Japan (which could usually be counted to invest regardless!). So if global growth continues on its current synchronized path, isn’t the risk that this lack of investment in new capacity ends up causing demand to outstrip supply? If so, then a sell-off in global bond markets is likely, along with all long- dated assets (especially growth stocks with limited profits). Fortunately, hedging against such an event is fairly easy as financials around the world should, in this eventuality, see steeper yield curves rapidly translate into better profits.

(3) Will China tighten more aggressively in 2018? The main reason I am worried about inflation is that this would likely trigger a far tighter stance from Chinese policymakers. And let’s face it, the world is more fun when China steps on the accelerator than when it steps on the brakes. At the very least, it is easier to make money when China steps on the gas. Now this doesn’t mean we can’t cushion portfolios against a tighter China. And today, the most obvious hedge would be Chinese government bonds, denominated in renminbi, yielding 4%. In case of further Chinese tightening, such bonds may be as useful to portfolios as bunds were in 1987. As Charles often likes to highlight, he came into October 1987 with 30% of the portfolio he managed (against the World MSCI) invested in long-dated German bunds. In early October 87, he thought this might be too much. By late October 87, he had realized it wasn’t enough.

(4) Will Japan tighten monetary policy? The lack of inflation in Japan makes this seem a fringe possibility. Yet, there are three reasons why a policy change may occur. Firstly, at some point policymakers will need to be seen doing “something” in response to the bitcoin mania. The second is that Japan tends to play ball with American requests and [though] a mercantilist president wants wins on trade, that won’t be easy with an under-valued yen. The third is that regional banks are starting to really struggle, with the simplest fix being a yield curve steepening. Thus, while a change in monetary policy is not likely, it is a risk for the coming year and one that is currently “unpriced”. With that in mind, investors who, like me, fear a BoJ policy reversal should (i) remove yen hedges/short positions, (ii) rotate equity portfolios from high flying exporters to long-suffering domestic financials and (iii) press bets on Japanese domestic real estate.

(5) Will the Fed continue to tighten monetary policy? It has been said that Keynesians think governments should expand their balance sheets when an economy heads south, and shrink it once an expansion is under way. Meanwhile, Republicans think the government should expand its balance sheet when a Republican is president and shrink it when a democrat is president. I used to take this adage in jest, but today, the joke is on us as the GOP seems intent on proving the premise with gusto.

Concretely, this means that the US investment environment may be set to change. Specifically, between 2010 (when the GOP took over the House) and 2016, the US experienced a tight fiscal and loose monetary policy. As Charles has shown over the years, this is the best combination for equity markets, as tight fiscal policy and loose money almost invariably leads to far higher P/E ratios. Alas, the opposite is true for the reverse: loose fiscal policy and tight money typically trigger a de-rating of equity markets. And this is the policy mix we seem to be heading towards.

So pulling it together, investors who responded “no” to all five of the above questions with confidence should stick with the winners of recent years. In this eventuality, the investment environment in 2018 should not prove too different from the one that prevailed in 2017. However, investors who answered yes to the above questions may want to start building cushions in their portfolios against shocks. These cushions may be a greater exposure to energy stocks, financial stocks, renminbi bonds, the yen, rotating away from US growth stocks and towards value stocks, or simply buying puts on US equities.


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