in this edition - the global macro investor this edition: • introduction ... understand fully ......

Monthly Publication No.126 January 2015 _________________________________________________________________________

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© The Global Macro Investor 2013 2

In this edition:

• Introduction – The January 2015 Think Piece

• Happy 10 th Anniversary!

• A Recap

• Forecasts (Sort Of…)

• 2014

• My Thoughts on Markets

• The Economy

• Things to make you go ‘Hmmm…’ 2015

o The EU

o A Better Understanding of Currency

o China

o Crash Patterns

o The Death of the Listed Markets The GMI iPad App is available to members. Please go to the Apple Store, search for The Global Macro Investor and download it. Please remember to allow your iPad to FULLY load all the documents before using the Application. This may initially take some time. It is a great way to read GMI; I hope you enjoy it.


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The January 2015 Think Piece

Introduction Welcome to 2015 and welcome to GMI’s January 2015 Think Piece. The purpose of this monthly is to offer something different to the usual monthly publication. Our objective is to provide some great new thoughts and concepts in order to develop your understanding of the world and to spark new ideas. I think and hope you’ll find some very interesting articles within. Enjoy. I wish you all the very best of luck, health and happiness in 2015.

Happy 10 th Anniversary! I’m not sure where the time went but this publication is the tenth annual Think Piece I have written in January. It has been one hell of a ride thus far. The longing… Back in January 2005, I had just ‘semi-retired’ and had bid a sad but fond farewell to old colleagues and mentors from my life running a global macro fund at GLG Partners (now Man Group) such as Noam Gottesman, Ben Gill, Pierre Lagrange, Lex Van Dam and Greg Coffey. I was delighted to declare myself ‘semi-retired’ and leave behind the inherent stresses and constraints of monthly NAV, capital raising and all the other wonders of running other people’s money. I longed for the old world of macro, with longer-term position-taking and in-depth macro thinking to create consistently better longer-term returns (with higher volatility obviously – not only on the downside but, more importantly, the upside too). The absolute premise behind writing GMI was to prove that old-school macro investment techniques were still the way to superior performance. I wanted to use the experience and knowledge I had gained from the previous fifteen years of working with some of the greatest-ever investors, many of whom I would speak to on a daily basis at Goldman Sachs and at GLG, and also use the experience of learning from my mistakes and victories in running a sizeable (at that time, anyway) macro fund. I hoped that I had something to offer. You bought the ticket; you took the ride. Some of you kindly bought the ticket and took the ride. My first four subscribers are still subscribers to this day. I knew two of them previously and two were new to me. I am slightly in awe that I still count them as subscribers and friends to this very day; I must have done something right. One of them is here on Little Cayman over the New Year and is building a house next to mine, here on the beach. I didn’t know him at all before this great journey commenced and I now count him as a close friend and mentor.


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Lucky boy When I first started writing I decided to move to the side of a mountain just inland from a small fishing/tourist town on the Costa Blanca in Spain. I now write from the beach on a small but perfect Caribbean island with a population of 150 people, where life is simple yet delicious and I have space to think, write and create opportunities. I am a lucky boy indeed. I think I’ve always been a lucky boy, regardless of the ups and downs of life and markets. Long may that last. Maybe we make our own luck. Who knows? But GMI is not the place for philosophy… Death of G7 Macro I have just looked back at the first publication and at my thoughts then on my big macro framework. I think I done good. I said that bond yields would never be 4.2% again (in our working careers) and that deflation and demographics were the drivers that no one would understand fully (hence the desire for most market participants to short bonds and get stopped out!). I also feared that G7 macro would be on its way out as interest rates drifted towards zero. Additionally I suggested that the periods of high returns for macro players would diminish as monthly NAV and volatility targets killed returns. I suggested that secular themes move asset prices over the long run and that the business cycle created the gyrations within those trends. A Recap Let’s take a look at what has happened to some major asset prices over the last ten years: bond yields have fallen…


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Equities have risen strongly. They managed to tack on a 6% annual rate of return, which is not far from average. Emerging markets wildly outperformed up until 2011 – and have pared back gains since then – and have produced roughly the same returns as the SPX…

MSCI World has not performed so well and only managed a 3.8% annual return…


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The Dollar managed a 1% return over the last ten years…

Oil produced a 2% annual return…


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Base metals managed a decent 5% annualised return…

Gold crushed everything else with 10.5% annual returns (yup, a big surprise for me too!)…


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And Ags also managed a 6% return…

Perspective I find it useful looking back like this. It allows me to evaluate. I quickly gain the perspective that this is a low return world for the pension funds that buy and hold huge baskets of assets. I think anyone trying to reach a hurdle rate of more than 5% will have struggled. Hmmm… not sure It does however, show me that a global financial crisis of some magnitude didn’t do much for long-run returns, except dampen them a tad. It’s not clear in my head if that is just the way things are (the natural return of markets), or a function of the need to invest in financial markets by pension funds and other baby boomer retirement vehicles, thus keeping asset prices elevated, along with massive central bank intervention. I think the latter is probably more correct and unsustainable, but time will tell… The Business Cycle is the key to better returns However, even if we know that secular cycles have led to slower asset price growth, we know that trading the business cycle can clearly enhance those returns. In 70% of the last ten years, GMI has produced strongly positive returns. It had one very bad year (2009) and two flattish/small down-years (2012 & 2013). I’ve managed to produce a few years with over 100% returns and almost every single up-year has likely had returns well above 20%. I think that is a track record to be proud of.


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I’ve made more than a few good calls I managed to nail many of the big themes of the last ten years. I called the bottom of the soft commodity market, got the bond market right, got EM stocks right, Monsoon markets right, got both the down and the up move in the dollar, the up and down move in oil, industrial metals and gold. I got Bitcoin and got the move in pharmaceutical and healthcare companies. I also managed to predict the global financial crisis and its recession, the excess capacity bust in China and the EU crisis (although not early enough). I am proud of what I’ve achieved and I hope I have helped you make some good returns as well as keeping you entertained over the years! And a few bad ones… I totally fucked up the power of central banks to elevate asset prices, got topped and tailed in India (as well as a few other markets), and gave back most of my profits from the EU divergence trade. I also learned that agricultural commodities are never a buy and hold! Lessons learned are always good, and I’ve learned a few! Still learning… I am still learning that the business cycle drags on longer than anyone expects, but that its power to drive asset prices is still undiminished. I’m still trying to figure out how the central banks get out of the mess they create. And I’m trying to figure out how a debt super-cycle ends in a way that is not catastrophic. I’m also still struggling to understand why no one ever predicts a recession and why economists don’t understand or even use the Business Cycle. Thank you, thank you, thank you… I cannot thank you all enough for allowing me to get paid to think. This is one of the most flattering and beautiful things in life. I hope my thinking has been worthwhile. There have been ups and downs but I sincerely hope that I have proven myself to you many times over. I continue to strive for that each and every month. Deflation Another interesting thing I have noted is how deflation has crept into GMI. In the early days I produced monthly publications of some twenty-five pages, while nowadays GMI averages at well over seventy pages. The price has never changed. It now takes me three times longer to write, for the same price. That is deflation through the back door. I think companies all over the world suffer similar dynamics. It is a sign of the times. Forecasts (Sort Of…) What do I think is going to happen over the next ten years? Well, I do think things are much less predictable now due to the huge manipulation of markets and the retirement of baby boomers, but as ever I’ll stick my neck out a little…


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• Monsoon countries will, on average, grow faster tha n others.

• Africa will begin to emerge.

• India will likely do better than almost any major e conomy.

• Developed market equities will produce a decade of negative returns, and the cult of equity will die.

• Businesses will primarily fund themselves via priva te equity capital and private

debt capital and not via public markets.

• Most emerging markets will underperform developed m arkets.

• Gold will do extremely well.

• Bitcoin will thrive.

• There will be opportunities to buy bombed-out marke ts such as Russia (and maybe later China) and produce 100% plus returns ov er a two- or three year period. The same will be true in Oil at some point.

• I think that central banking will not survive as we know it and that belief in the

voodoo of monetary policy will collapse.

• There will be a financial crisis bigger than the la st one.

• Keynes and Friedman will both be consigned to the d ustbin.

• The system of big government will collapse under it s own weight and the trend will continue for smaller countries and potentially smaller government in big countries. People will be forced back into voting t o make this finally happen.

• The pension fund industry will die and individuals will actually have to save

money and not expect people to make money for them instead.

• Shunning debt will be the norm.

• Countries will thrive in the trend towards higher s avings and lower participation in public markets, and corporations will finally be able to use excess savings to invest in building better businesses, rather than u sing debt to goose false returns. Low debt growth will actually perversely g ive higher returns in capital.

• The dollar will be king for the next few years and the final attempts at reversing

that by the Fed will ultimately bring about the col lapse many fear, and the rise in bond yields and inflation. This will be the last shoe to drop.

• The faster we get The Big Reset , the quicker we can get to a situation where

risk-taking and allocation of capital pays off trul y incredible returns. In a nutshell, it’s all to play for. The next ten years are going to see some massive secular shifts occurring. What we know about the recent past (the last 30 years) is not going to help us predict the next decade. I think it’s time now to zoom in a bit and look at the last year…


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2014 Forgive me, but I’m feeling pretty smug about how GMI performed in 2014. In January 2014, I restructured the portfolio and it allowed me the opportunity to be able to focus on how to think about risk, opportunity and longer-term themes. Tail Risk My tail risk portfolio did exactly what it was supposed to do. The losing hedges lost peanuts while the two big winners: copper puts and calls on USD 30-Yr bonds paid out returns of 2400% and 1000% respectively! Core Themes My core trades, which included Indian bonds, Russian bonds and US bonds, all made money – except for a very small loss in being short the Euro early in the year. I closed out all the risk ahead of the back-up in yields in the US and before EM blew up (phew!). Risk On balance, my short-term risk portfolio lost money because of the big drawdown in Bitcoin, but in terms of winners versus losers evened out at 50:50. I held very few core positions as I didn’t think it was an easy buy and hold year… and correctly so. Long-term The long-term risk portfolio of Bombed-Out markets and Monsoon markets was a home run. Out of twenty-one trades, only four lost money and those losses were dwarfed by the gains in the other investments in that portfolio. But all in all, the thing I was the proudest of was the fortuitous timing in seeing that the dollar strength was about to change everything and I therefore closed out the entire Monsoon portfolio and core portfolio at the highs and then reversed and took the other side (but to a smaller extent). Many of those Monsoon markets have fallen 40% from the point that I took them off.

Just tallying up the total winners versus losers, t he end result was pretty impressive 70% winners – and with the winners outperforming th e losers by a massive margin. This was a good year for GMI by any yardstick. GMI’s 10-year track record stands now at 7 winning years out of 10, with the winners massively outperforming the losers (although, granted, 2009 was shit by any measure). Oil and the Dollar I think in the midst of the usual cut and thrust of markets, I managed to isolate two of the biggest trades of the year – short oil (which I have been writing about since late spring) and long the Dollar. The latter may well be the biggest driver of asset class returns over the next several years.


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No laurel resting here… As ever, now is not the time to sit back and ponder how my shit may well now smell of roses. Now is the time to focus because there is a lot going on and there are plenty of opportunities and also plenty of potholes to lose one’s arse in. I come into the New Year with three long-term investments outstanding: long Bitcoin, long Bank of Cyprus (trading was suspended nearly all of last year) and long 1-Year USD/RMB call options. All other positions are automatically closed at year-end. However, with immediate effect I will re-instate my short on EEM, short on ADXY, short on AUD. My Thoughts on Markets In January last year, I wrote that I expected a low volatility environment for most of the year. That played out almost exactly. The SPX did better than I expected but I was still positively biased due to the business cycle and low volatility. I expected bonds to do well, which played out as hoped; I anticipated the stability in the dollar with the acknowledged risk that it may strengthen later in the year and that the dollar strength, when it arrived, would be a big deal. Hmmm… not bad. I also expected relatively weak economic growth but no recession, which pretty much came to pass. Growth will average out somewhere near 2.6%, a tad better than anticipated but below trend still. This year I expect a very different year. I think that the balance of probability is for volatility to increase over the year. This time I think volatility will be led by currency vol. As you know I am very bullish on the US Dollar and very bearish on most global currencies. Currency vol has broken out. I think it will trend higher and maybe explode over the course of the year…


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I think that currency volatility will spill into equity volatility…


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I also believe that 100% of analysts are going to be wrong when they expect a +5% year for the US equity market. I think that the equity market is likely to fall sharply early on in the year and then possibly rally, and I suspect we will see a real bear market start this year, although it will only reveal itself fully in 2016. Demark indicators are giving a second 13-top here on the monthly chart; I would not preclude the rally from the coming fall to count to another monthly 9 before finally giving up, i.e. this year is going to be volatile in the SPX but unlikely to trend lower all year…

It would not surprise me to see the SPX fall from the beginning of the year back to 1800 before rising again. Weekly Demarks have topped. At some point the bloody fabled failed rally I have been expecting will occur! I think this is going to be the year…


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I also think that the balance of probabilities is for Emerging Markets to fall sharply. The EEM is about to take out its last major support around 36. Then the next stop is 20…


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The dollar is again the big driver. It is pricing the EEM ETF at near 20 already…

In terms of currencies, I have devoted a whole section to this, but I do think that the DXY will continue to weaken although will soon bounce for a while, maybe on US economic weakness. The DXY is close to putting in a monthly 9 signal…


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Even if it doesn’t, the weekly Demark 13 may well stop the rally here…

This correction and the subsequent recovery from it is the final piece of evidence we need to move the dollar bull market thesis from extremely likely to certainty. I will address China later but I think that there is a real risk that China devalues its currency as part of a more strategic geopolitical and economic play.


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In terms of other collateral damage from the big picture, copper strikes me as having a high probability of collapse…

Over in bond world, I fully expect the yield curve to continue to flatten. It appears that the bear flattening will continue for a bit before the bull flattening will start with earnest. The bull flattening will usher in weak economic growth. I think that somewhere around 1.2% is roughly a flat yield curve in the old world (when we used to have interest rates.) A break of that would be significant. I do not expect it to break without bouncing first (i.e. a back-up in 10-Year bonds at some point, probably lower than here)…


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I do think however that the next move will see 10-Year bonds breaking the wedge, with a huge collapse in yields; after that we can have a correction…


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Gold has a 50:50 chance of finding support. I am itching to start to accumulate gold but I need to see how it trades with a stronger dollar. It is right at key levels here… I just don’t know if it holds or not…

I also think that Bitcoin is now getting interesting … but it too is a bit 50:50 for my liking…


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I am however getting close to accumulating both Gold and Bitcoin for the long-term portfolio. A break lower in price would be a gift. But gifts from the market gods have a habit of not occurring! The Economy The economic situation is the least clear aspect of 2015. As expected, the ISM has been topping out in this mini-cycle…

Momentum in ISM is falling fast…


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The CESI Cycle has remained shifted to the right (meaning that the timing has extended and is slightly out of phase) and thus should top out soon and fall into April or May, i.e. economic data is soon going to come out weaker than expected again in Q1, and yet again we will play the, ‘it’s a seasonal trend’ game, until it isn’t…

Let’s however, never lose focus that this is the slowest-ever recovery in the history of the USA…


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And don’t lose sight in the fray of the markets that inflation is almost certain to fall to deflation with the stronger dollar…

The Fed would love to raise rates so they have a bullet or two left when deflation comes and the next recession arrives. Will they even manage one rate hike? I very much doubt it. The next recession – probably starting in 2015 – will test central banking to the limit. Why do I think there is likely to be a recession starting in 2015? Well the average trough-to-trough recession length is 25 quarters. The last economic trough was 22 quarters ago. The trough-to-trough prior to that was 30 quarters. Let’s assume that it takes at least two quarters to go from 2.7% growth to 0% and if it takes another two to three quarters to trough, then this expansion is going to last 28 quarters. Even if I were wrong by a quarter or so, it would still appear that the balance of probabilities is for the US to begin its inevitable move towards the next recession trough. I think this trough will be in 2016 and we hit 0% GDP growth this year. Only time will tell… Another idea we have to test is the performance of equity markets in local currency terms if the currency collapses. Japanese investors have bought into the idea that Japanese stocks should hold their value in the wake of a very weak JPY. Chinese investors are following suit. Russian investors have taken the opposite approach. (Wrongly? Rightly? Who the hell knows yet!) In the Asian crisis, equity markets collapsed along with currencies. So my conclusion thus far is that the economy has to collapse along with a collapsing currency to erode equity returns, but I just don’t yet know. It is something I’m mulling over, as it will likely become rather important. Again, best of luck for 2015. It looks like it is going to be an interesting one and, more rewardingly, a macro one.


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Things to make you go, ‘Hmmm…’ 2015

1. The EU

I purposely didn’t discuss Europe earlier. It is not an easy call as to how Europe plays out. We just don’t know enough about what the ECB can and will do and how much Germany will allow things to develop.

But the intention of this annual Think Piece is to get us to start pondering issues that may come up now or in the future. The first thing we need to get a grasp on is that the Euro has broken down. The break of the massive head-and-shoulders (an albeit convoluted one) would suggest that the move in the currency over the next few years should be to around 75c (US). I know the market is somewhat positioned in the short Euro trade, but any pullbacks are to be shorted…


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Just to remind you what currencies are like when they trend, cast your mind back to 2002 when the Euro bull market started... From February 2002 to July 2002, the Euro moved 19% and then corrected only 5% over a two-month period. It then moved another 15% into March 2003 and then corrected only 5%. The total cumulative move had therefore been 29% with only two 5% corrections. The Euro then tacked on another 14% before finally seeing its first major correction of 10%. It then rallied another 20% (for a now cumulative move of 55%) before another 9% correction. Then a 16% move and a 14% correction. Finally, after that big refresh, the Euro went on another rip with very limited correction, tacking on another 38% move and a total cumulative bull market of 92%! The lesson is that the corrections are not to be feared. Buy dollars, sell Euros into any pause. The currency can move 50% without any major correction more than 5%. The other issue we need to think about is that some of the stock markets are looking concerning (much more on this later). The MIB in Italy has formed a giant head-and-shoulders top…


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And this to me is likely to complete the top of a larger GMI Crash Pattern (below)…

But the thing that is becoming clearer is that the recent vote in Greece is, as I have been pointing out for some time, a precursor of political change to come. I know Europe well, having lived in Spain for ten years. I understand that the youth is, all over Europe, disconnected from the political parties. I also understand that they are not going to take to the streets because they are still safe since they live at home and claim benefits. But I do know they have a MASSIVE distrust of authority and given the chance would rally behind a cause to oust the current political parties. In Greece, it looks like Syriza will take power and they will listen to the people and walk away from their debts, or at least from austerity. The people have had enough and the Germans uncompromising stance has led to this. But the picture is bigger than that. Spain is where my real focus lies. I think the groundswell of support from the youth for Podemos is almost unstoppable. The better the party does, the faster Podemos attracts more support. The chart below documents the rapid rise…


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Just remember that 91% of Spaniards in recent polls suggested that the current political situation is either ‘bad’ or ‘very bad’. 2015 will see a triple election year in Spain with local, regional and general elections. The Catalans also want a referendum. No one is thinking about this. Everyone is slow to think ahead. I prefer to walk where no one treads. In the next month or two, I’m going to buy Spanish CDS. I think at 65bps it is as close to a free bet as you could possibly make. The chart is suggestive of an inverse head-and-shoulders bottom…


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Finally, I’ll leave you with the following chart - the chart of the Eurostoxx. The probability is rising that we have a potential major crash pattern forming. It is not certain but it is becoming more likely. The chart looks messy but it shows a series of failed rallies, and the potential to break the only key support. The structure of the chart pattern would suggest that if that support goes then this index is going to fall very fast indeed…

Keep focused.

2. A Better Understanding of Currency So much is currently being written about currency wars, Dollar strength, Euro weakness, Yen trashing etc. and, as you know I’m never one to accept anything on face value I thought I’d do a little digging into the subject matter to really understand the lie of the land. I looked at five different major currencies versus an evenly-weighted basket of other currencies. The five currencies were the US$, Euro, KRW, CAD and JPY. I compared each of these to a basket of EUR, AUD, CAD, KRW, JPY, SGD, Gold, GBP, NOK, SEK and BRL to give a broad, global spread, but purposely excluded the US$. The results are somewhat surprising…


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• The Euro is actually up 1% versus the basket, but down 2% if we strip out the very weak NOK, SEK and BRL.

• The Korean Won is up 5.3% versus the basket, but only up 1.75% ex-NOK, SEK,

BRL.

• The Canadian Dollar is up 4.3% versus the basket, but only up 0.7% ex-NOK, SEK, BRL.

• The Japanese Yen is down 3.9% versus the basket and down 7.75% ex-NOK, SEK,

BRL.

• However, the US Dollar is up 13.7% versus the basket and up 9.8% ex-NOK, SEK, BRL.

And there’s more There is even more information in these performance numbers than initially meets the eye: Firstly, they tells us that the dollar is seeing generalised strength, not due to any external factor such as economic weakness in Europe or Japanese QE. The dollar is strong against every major currency on earth. Clearly, a large part of the dollar strength is policy divergence, or probably more accurately, the relative outperformance of the US economy. As you know, I think once this process of a strengthening dollar gets underway it will gain its own momentum. I also think that economic weakness globally, should it occur, will add fuel to the strong dollar and capital will flee emerging markets and other economies. It’s kind of win/win for the US Dollar right now. Secondly, the weak currencies of the Yen, BRL, NOK and SEK are all trading roughly in line with each other, give or take a few percent. Thirdly, the other major currencies are also roughly trading in line with each other. The Euro is not weak necessarily because of anything structural, yet. Fourthly, Gold is the second strongest currency in the world (no, I didn’t guess that either). Revaluation, not devaluation My summary of this is that we are seeing a dollar revaluation. This is not a devaluation of other currencies. The weaker currencies are generally carry trade currencies that are being unwound, plus oil-related currencies. Clearly, the JPY is different and that is the result of central bank action. All things remain equal Thus, if all global trade remains equal, then there will be no large terms-of-trade shock for anyone except the US. All the other countries can continue to trade amongst each other and roughly see prices remain stable, and thus profits stable. Clearly, dollar-earning companies will do better unless they sell commodities…


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Dollar funding is at risk However, those countries that have larger amounts of dollar loans can get into trouble as their funding currency (the dollar) skyrockets. This is where my focus will mainly lie ahead. The BIS now estimates that there is some $9 trillion in the US carry trade. That is beyond massive and has the potential to cre ate a shock of epic proportions. It is in fact the largest speculative trade in history . China – the big deal However, the big standout in all of this is China. The RMB, which is essentially pegged to the US Dollar, is extremely strong versus other countries. This is a big terms-of-trade shock and something that will need to be addressed in due course by China. China’s economy is weak. They are export led. Their currency is up some 14% versus all other currencies. I expect the dollar to go much, much higher. China will have to devalue or face massive economic weakness. That leads me neatly on to the next section…

3. China China is getting my full attention right now. A Chinese devaluation is a black swan event that very few are pricing in, or even understand. China’s second-largest export market is the USA. The RMB has weakened 3.4% versus the USD in the last twelve months. That’s all fine, right? No.

• China’s largest export market is Europe. The RMB is up 14.5% versus the Euro since June.

• China’s next largest market is Japan. The RMB is up 18.3% versus the JPY since

June.

• Then it’s Korea. The RMB is up 10% versus the KRW.

• Then Taiwan. The RMB is up 7.15% versus the TWD.

• Then Australia. The RMB is up 14.5% versus the AUD.

• Then Malaysia. The RMB is up 11% versus the Ringgit.

• Then Brazil. The RMB is up 23.5% versus the Real. That’s an average rise of 14% versus its major export partners. Now, that magnitude of rise is not something an economy the size of China should be concerned about… yet.


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There may be trouble ahead… But my job is not to look at how things are now, but how things could be in the future. If we look back at the two previous dollar bull markets, we can see that dollar rallied in the 1980s around 16% per annum for four years and in the 1990s and early 2000s it rallied around 7% per annum. That would give us an average annual dollar bull market pace of around 10% per annum. Last year the DXY rallied 10%. So, if we were to see an ordinary dollar bull market we should see another 10% gain in the dollar and the RMB (due to its rough peg). That alone would be an exchange rate shock of nearly 30% versus the JPY from June 2014 and 25% versus the Euro. Then if that bull market continued for another year, it would compound. That, dear reader, is China out of business. But we need to take into account the facts that we have available. We know the dollar has broken the largest chart pattern in fiat currency history… it is now a confirmed break too…

This chart pattern is suggestive of a very rapid and long-lasting move in the dollar. If we then add to the fact that there are some $9 trillion of carry trades tied to the US Dollar, then we can imagine that the pace of the rise might be beyond anything we are currently expecting or have seen before. If we look back at the Euro bull market of 2002 and 2003 when the Euro finally reversed its initial fall, the Euro managed to tack on nearly 20% a year for two years. I think it is possible that the dollar move in 2015 even exceeds this.


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Take a look at the current trend in the USD, which I have extrapolated further to the end of 2015; it projects a 22.5% rise…

Thus, just based on these facts alone I have to imagine that China cannot and will not stand by and let this happen. If we then factor in that some $3 trillion of the carry trade is short US Dollar and long RMB we can see that the risk is for a break in the RMB and trades get closed out or go bust. Take a look at the 12-month forwards in the RMB overleaf; a confirmed head-and-shoulders top…


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Whaddya think? However, where most people get stuck is figuring out if it makes sense for China to devalue or allow a free float. Here I think people need to think a little harder and put together more parts of the jigsaw. Swap it We know that China has been busy putting together swap agreements and lending agreements in RMB with other countries. In fact, since 2008 China has made bilateral swap accords with 29 countries and deeper strategic trade agreements with many of these also. Take a look at this map of the swap agreements made so far…


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That is pretty impressive, but why are they doing this? Well, already the RMB has overtaken the Euro as the second-most widely used currency for trade. The more countries that use the RMB, then the less foreign exchange risk that China has to deal with. And that’s the important bit. If China allows its currency to free float, it too will devalue against the dollar (or in more correct terms, the dollar will revalue against the RMB). Sure, it might overshoot due to the excessive US borrowings in the massive carry trade, but would a 30% devaluation by the end of 2015 be out of line with any other currency except the US Dollar? No. And that’s the point I tried to make in the last section. All other major currencies are trading in line with each other, give or take a bit. If China were to allow their currency to weaken it would just realign itself with the rest of the pack, especially if its float was a dirty float versus a basket of currencies including gold. Policy divergence China has no interest in following US economic and central bank policy. It diverged its policy path by cutting rates in November when the US was suggesting a tightening. You can see the massive policy divergence when you look at this graph of Chinese and US rates normalised since June 2014…


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Currency and economic war What China does have is an interest in weakening its currency against its largest trading partner – the US – and allowing its own currency to remain more stable amongst other nations, with whom it wishes to garner favour, i.e. to create a global trading block away from the dollar that in effect allows the dollar to revalue dramatically higher, whilst other countries are relatively unaffected in trade terms. (Yes, yes, there is the huge blow-up risk from the carry trade – but that is going to happen anyway, regardless of China.) This has the effect of subtle economic warfare against the US – making the US open to more imports (prices are cheap in dollar terms), subject to deflation (cheaper imports and lower commodity prices) and uncompetative with exports – and then allowing China’s trading partners to fund themsevles in RMB (using the currency swaps) which is going to be much more stable than the US Dollar. If you want to kill the US Dollar’s influence then this is the way to do it. OK, I do realise that $3 trillion of carry trade unwind plus a shattered banking system is going to play havoc in China, but think about this: if the Chinese allow a 30% devaluation they will automatically have reserves that are worth more RMB, and that alone can paper up all the holes left from the credit wipeout that China is heading towards. In the end, China can cement its role as a partial reserve currency, regain competitive advantage, rebuild a shattered internal economy fro m the excesses of the credit boom/bust AND put the US at a rather large disadvan tage. What would the US answer be to this? The most likely outcome would be more QE to try to weaken the US Dollar. The size of the QE would have to be in the trillions in order to offset the carry trade unwind. That may well risk the creditworthiness of the US. Central bank intervention of that magnitude could cause absolute chaos and a loss of faith. Game set and match to China. It is going to be pain ful for China but the end result is potentially a rather nice win. SCO a-go-go In the meantime, China is building on the Shanghai Cooperation Organisation. The result is that China is essentially further expanding its sphere of influence all across the Asian landmass. The economic power of this group cannot be understated especially if India, Turkey and Iran join, as is slated. Now, clearly again it is in China’s interest for the RMB to be more aligned with these trading partners as opposed to with the US Dollar…


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Win/Win Think of it like this: If, for example, China and Russia increase their trade and China lends Russia RMB, then Russia has less need to borrow dollars and can remain solvent. They can sell those RMB for dollars or, if they wish, they can just use them for their trade with China. If the RMB then devalues, Russia would need to pay off less RMB. China doesn’t care because it will still get the same amount of RMB back. China can repeat this magic trick across all nation s in need of non-dollar funding. They end up with those debtor nations in their favour an d the power of the US is diminished. Gold is in the mix Somewhere in this mix is the constant chatter from those more knowledgeable than I, that many of these nations are hoarding gold in huge, undeclared quanities to create a new, more robust currency system at the end of this. A formidable trading block with currencies backed by large amounts of gold will make the US Dollar look incredibly unattractive indeed. Go on, just use your imagination… Now just for a second imagine the scene in a couple of years’ time, when the US is in its next recession, the dollar is screaming higher, the Fed needs to undertake massive QE in an attempt to weaken it and the SCO and/or BRICs announce a new SDR backed by gold… … that would be The End Game. It’s not the most probable event, but it’s certainly possible. We live in extreme times, my friends. Anything is possible.


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4. Crash Patterns It’s not a cheery Think Piece this year, but we play the cards we are dealt with and this year it’s all about markets, as opposed to a more abstract discussion as is more usual. I would like to run through some of the chart patterns that are out there in the world in order to make everyone realise that the risk of bad things happening is as high as I’ve witnessed it since 2007… arguably this is one of the worst sets of charts I’ve seen ever. In the US, there is no fear. Positioning is high. Confidence is high and the stock market is near all-time highs. Hurrah!

But elsewhere things are a little more concerning…


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The FTSE is completing a massive rounded top…

The IBEX is close to testing the key level in a giant GMI Crash Pattern…


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The entire EU energy sector is about to get flushed down the toilet in a monster head-and-shoulders top (yes, behold in awe… that is a 16-year top pattern)…

The KOSPI is about to break the key support of a multi-year GMI Crash Pattern…


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The Hang Seng is also at key levels…

Russia has gone…


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Poland is at risk…

Brazil is close to acceleration point…


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Canada, with its two big failed rallies, is at risk of a GMI Crash Pattern…

I think South Africa has a high chance of a crash…


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The entire EM ETF is heading for a crash…

Dubai has gone…


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Saudi has gone…

Oil has gone…


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Copper is in freefall…

Ally is in freefall…


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Iron Ore has gone…

Lead is falling like… well, lead…


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Corn is done for…

Beans are bust…


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Sugar is melting…

High yield… on its way down…


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So… I’m worried. Very bloody worried. We are close to the very precipice. We’ve been saved before. Will we get saved again? I doubt it. Ho hum. I’ve been spectacularly wrong before. I can be wrong again. I remain lightly positioned but firmly negative.

5. The Death of the Listed Markets For many years now, I have been discussing how publically listing a company in the developed world makes no sense unless you can sell it for too high a price (the greater fool theory) or you need accounting tricks and buybacks to goose your stock price in order to make the managers rich. A nice story Many years ago, when I was meeting potential investors at GLG Partners, the principal of a very large European family business (foodstuffs, if I remember rightly) came in for a chat. I believe this was in 2000. I jokingly asked the guy why he didn’t float his company, which was probably valued at the time at something like $10bn. He laughed. He then explained that his business had been in his family for well over 100 years. All his family were rich because of it. The business generated enough profits to keep them in the lifestyle they wanted and piled up enough cash for expansion or a rainy day. He pointed out that if his company had gone public, invariably they would have seen their profits at certain points move down 30% or more, or even turn to losses with swings in the cycle. His share price would have collapsed and the family would have been forced off the board. He explained that within a private company no one could take control. You have no share price to worry about. And if the business is well run and makes enough money you can ride out any downside in the profit cycle without any real concerns. He then pointed out that even if he sold the business, he would not be able to generate the same returns with the cash he was given, so why not just keep the company private and live happily? He also enjoyed the privacy of not being in the public eye. Hmmm…. that changed my outlook completely. What he said made total sense. It used to be that the other main reason for listing was to gain access to capital, but that reason has disappeared. I came across a statistic last week that was fascinating – 50% of the assets of the wealthiest 1% of Americans are now in unincorporated equity and real estate. That is amazing. The wealthy have given up the stock market. They access new companies directly, fund them directly and take direct equity stakes. They also buy existing non-listed businesses, grow them and hold them for cash flow and yield and never take them public. Take a look at the chart of SPX annual volumes overleaf; they are down 70% from peak…


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Personally, I think this is a good thing on many levels. Bunch of crooks I think how stock market listed corporations play with their accounting is crooked. Their focus on short term EPS is simply ludicrous, deceitful and destructive. I think issuing debt to buy back shares to raise EPS and thus share prices and the value of stock options should be illegal. It is fraud. I think the game of raising private funding for start-ups and then progressively taking in funding at higher levels of valuation to eventually hoist a valueless company on the unsuspecting public at crazy valuations should be illegal too. It is plain old pump and dump. I know it is tough to figure out what is a real valuation and what is not, but there should be at least a warning that asks, “Do you understand that before you buy these shares at IPO that this company has never made a profit and may never make a profit?” No investment I also note that due to accounting tricks and focus on short-term earnings, that corporations in the developed world are simply not investing in fixed assets. This means that the older businesses just become more and more obsolete and cannot compete with newer businesses. This is part of the holing out of the manufacturing base that has been such a key trend over the last couple of decades. Without this sort of investment, productivity tends to decline and GDP tends to sag from lack of returns from business investment.


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The decline in US Business Investment is simply incredible…

But there is light at the end of the tunnel… Yay USA! I spend a lot of time now in the USA, travelling all over the country for work and for pleasure, as it is now on my doorstep from here in Cayman. One thing I’m totally amazed at is how high tech the US has suddenly become. The last tech boom in the US saw very little rub off on the country as a whole, but now the US is so far in advance of other countries that is amazes me. As long-term readers know, I’ve never said that before… Back in 2000, the tech boom was in every country and most countries capitalised on it better than the US did. Their companies invested in better technology and the US got left behind, particularly when compared to Asia. Asia just looked like a different world in the 2000s. It looked like the future. This time the tech boom is almost entirely a US phenomenon. And the US is the future. I think the reason for this dramatic change is that private investment in the US has piled into tech start-ups. The investment in Bitcoin-related businesses alone is equal to all the money that went into the Internet back in 1996. Everyone I speak to is engaged in helping build technology-related businesses (even I am building a disruptive internet TV business!). Many of these businesses are not actually social media, loss-making junk but businesses like Uber that revolutionise an old business and are actually making plenty of money.


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This trend towards private investment, precision directed at the very best technology, is creating some magic in the US: the magic of free market capitalism and the reward that it can create. This private investment also created the shale oil boom via technological advancements. It is creating the biotech boom too. This is how capitalism should work. It is pure, it is targeted and it creates cutting-edge, world-leading businesses. Now, not for a second does it mean investors won’t lose money. Of course they will. Hopefully the money they lose from the bust of the shale boom or the bust in tech funding will only be a giveback of some of the profits they have made. That’s fine. We are all big boys. Just don’t buy many of these companies when they come to market. Then you will lose everything and will have had none of the benefits. The listed markets are dead. Long live capitalism!


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Background

Raoul Pal has been publishing The Global Macro Investor since January 2004 to provide original, high quality, quantifiable and easily readable research for the global macro investment community. It draws on his considerable experience in running a hedge fund and advising many more.

The Global Macro Investor has one of the very best, proven track records of any newsletter in the industry, producing extremely positive returns in 7 out of the last 10 years.

Raoul Pal retired from managing client money at the age of 36 in 2004 and now lives in the tiny Caribbean island of Little Cayman in the Cayman Islands.

He is also co-founder of Real Vision Television, the world’s first on-demand TV channel for finance: www.realvisiontv.com.

Previously he co-managed the GLG Global Macro Fund in London for GLG Partners, one of the largest hedge fund groups in the world.

Raoul moved to GLG from Goldman Sachs where he co-managed the hedge fund sales business in Equities and Equity Derivatives in Europe. In this role, Raoul established strong relationships with many of the world’s pre-eminent hedge funds, learning from their styles and experiences.

Other stop-off points on the way were NatWest Markets and HSBC, although he began his career by training traders in technical analysis. Should you wish to receive information about membership please email us at [email protected] . The number of members is STRICTLY limited, with only a few free spaces coming up each year, as the membership is full. If there are no free spaces available, a waiting list will apply. Except for use granted to the named subscriber, this publication may only be reproduced, stored or transmitted in any form or by any means, with prior permission in writing from the publishers. Raoul Pal, The Global Macro Investor, Little Cayman, Cayman Islands 6th January 2015

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