Saturday, August 28, 2010

Would raising competitiveness solve the world's problem?

In the new world of globalization, a fashionable phrase after the financial crisis is raising competitiveness.   A lunch tale from my own experience exemplifies how catchy this phrase is.  As the European sovereign crisis unfolded in April, I was having lunch with a large group of financial industry professionals, many of whom have master and Ph.D. degrees and at least a few years of experience in the financial industry, as well as the CFA designations.  At the time, the Greek sovereign CDS shot out of the roof, and our discussion inevitably touches on the crisis in PIIGS countries.  The sentiments at the table are that these countries deserve to suffer unless they can raise their competitiveness through internal deflation and that these countries are too small to affect the global economy and we can just leave them alone. 

I was the lone dissident.  I tried to explain that in today’s world of deep globalization, “no man is an island.”  When the bell tolls, be prepared to help instead of standing aloofly.  I also tried to explain that the problem for the world today is not a lack of competitiveness, but an unbalanced growth.  In fact, a lack of competitiveness cannot exist for the world as a whole.  After all, competitiveness is always in relative terms. 

A few days later, the unfolding events quickly proved that we couldn’t stand aloofly while the crisis spreads.  At the time, the possibility of contagion started to shake up the whole European markets, as well as the U.S. markets. 

It is the other point that is more difficult to prove, and I think it deserves some explanations.  Take Europe as an example.  It is well known that Germany raised competitiveness related to the other European countries during the last decade after a painful post-unification digestion period in the 1990s.  As a result, the unit labor cost, which is the most important cost for most developed countries, is lower in Germany than in other European countries.  As a result, even though Europe has a largely balanced trade with the rest of world, countries like Germany run a large trade surplus against the rest of Europe.  The unbalanced trade and growth within Europe is the root cause of today’s European crisis. 

Even though PIIGS countries could catch up the German standard of productivity, it does not solve the world’s problem.  Rising competitiveness in these countries might balance the trade within the Euro Zone, which is currently the biggest problem.  However, it also would transform the Euro Zone as a whole from a region with balanced trade with the rest world to another East Asia.  That would be a nightmare for the whole world. 

In nominal terms, the Euro Zone GDP is close to that of East Asia as a share of the world’s GDP.  Combined at today’s exchange rate, these two regions produce close to half of the world’s GDP.  Intuitively, for the whole world, we know that the total amount of exports and imports should equal to each other, and the total amount of trade surplus should equal to that of trade deficit.   Thus, if the Euro Zone were to run a level of trade surplus as a percentage of its GDP similar to that of East Asia due to their newly gained competitiveness, the rest of world will have to consistently run at least as high a level of trade deficit as a percentage of GDP.  In the long term this is mathematically impossible, unless we can export to Mars. 

More importantly, a single-minded focus on raising competitiveness would threaten the current globalization process, which has been largely peaceful to date.  The first half of the 20th century is a period when nations focus single-mindedly on raising competitiveness.  We all know that the outcomes were trade wars and World Wars.  Instead, for globalization to stay its course going forward, the fashionable phrase, and the only solution, should be balanced growth. 

What is important in global macro investing?

Global macro investing has a few unique characteristics (This will be a continuously updated post given the importance of this topic and the difficulty to be complete at one shot. Looking for updates in the future):

1.    It would be silly to talk about t-statistics in global macro investing.  The breadth, or the times that you can place bets, through global macro investing is very small.  Generally, there is no way to measure statistical significance here.  Instead, you have to do thorough investigation to magnify the odds of winning in each situation.

2.    As a result, unless you are really sure of the probability of winning (e.g., 90%), it helps not to place the bets, even if the alternative is zero yield cash investments. 

3.    As another result, you should not be overly greedy by leveraging up too high.  If a strategy with limited leverage can make 20% during a short period of time within a year with little or even negative correlation with the market returns, stay with this strategy instead of leveraging up n times.  Otherwise, a sudden market swing against you could deal a disastrous blow, and you may lose a lot of money instead of making a lot of money, even though you get the strategy perfectly right.  After all, a consistent 20% each year would easily put you within the category of legendary investors.

4.    Global macro investing requires patience.  Once committed, you should give it at least six months to a year to work out.  And you should leave yourself the flexibility to hold the line in any reasonable cases in this horizon.  For the same reason, you should also resist the urge to time the market by increasing the bets substantially within a short period time in the hope of achieving astronomical returns.  This is related to the discussion in point 3.

5.    Determining the right instruments, as well as the right leverage, is at least as important as determining the right strategy. 

6.    If you are doing both longs and shorts, you do not have to rewind the positions at the same time. 

7.    Global macro investing is more about the ability to analyze and interpret the information than collecting new information.  After all, most of the relevant information is publicly available and is released to most people at the same time.  The ability to synthesize the information and draw the correct conclusion is crucially important and is a personal gift. 

8. Debate and discussion are very helpful in global macro investing to certain extent.  At the end of day, you have to put the money at where your mouth is.  Frequently you will find people all hold on to their own believes, right or wrong, without ever being able to be persuaded.  And most people are all cheap talk, with no ability to invest and make money.  It is better to force them to make the investment decision according to their believes and see about the outcomes.  After all, you should only invest when you have strong believes in global macro investing, and at the same time, you cannot always miss opportunities while others can consistently make money. Too much debate is a total waste of time. There is an old Chinese saying: whether it is a horse or mule, the easiest way to tell is to take it for a ride. 

9. People who make correct global macro calls are generally generalists, not specialists or experts.  In the last two years, there was a bit soul searching in the annual meeting of America Economic Association why few economists foresaw the Great Financial Crisis.  The investment industry should have done the same thing.  But the fact of life is that those few economists may be able to call the Crisis even if they are not economists.  They are just insightful generalists with common sense who can synthesize information well and be courageous enough to point out the nakedness of any emperors, and they just happen to be economists.  In general, people’s tendency to consult experts, unless there are generalist experts like Roubini, would yield nothing valuable in terms of preparing for global macro events, be it risk management or speculation. 

How do these characteristics fit in the context of the simple global macro strategy that I advocated a couple of weeks ago?  There I suggested investing 100% in long-term U.S. Treasury bonds and short selling 100% equities.  Let’s use ETFs to illustrate.  iShares has TLT for long term T-bonds and IVV for S&P500 index.  When I suggest the strategy, TLT is at about 104 and IVV is at about 110.  If you have 1 million dollars, you can buy 1 million dollars of TLT and short 1 million dollars of TLT. 

People may ask what information that I have that other people do not have.  My response, related to point 7, is that all the information that I have is available to most people.  But information cannot tell its own story, especially to the people who are blind to it even if it is under their noses.  For example, in March, I have already told many people that double dip is almost a sure thing by the end of Q1 2011 without substantial further stimulus.  The pundits have only come out recently to argue for a likely double dip.  I have only less, not more, information than them, but that does not mean that they can predict better. 

I would not place this bet until very recently after I am quite confident about the direction of stock markets in the next six months.  Once getting into position, do not necessarily try to leverage up further, even if markets seem to drop quickly like at the start of the last two-week period.  No markets go up or down in a straight line and the reversal effect could be quite nasty if you leverage up too much at the wrong time, like on last Friday of August 28, 2010.  Limited leverage would help you hold the line and wait patiently for the expected returns in the next six months.  I choose the above two instruments because they do not have minimum investment requirement, are fairly liquid and have plenty of short availability, and can help leverage up to a reasonable amount without excessive risks.  Whenever TLT appreciates by about 10% from 104 or whenever IVV drops by about 10% from 110, you can start to rewind either position depending on your judgment and risk appetite.  Of course the chances are that much higher returns may be achieved than 20%.  So you can wait to rewind either position at much higher returns. 

So far, you would have made about 4% returns from this position, which is not too bad for two weeks of time.  There will be more to come in the next few months.  The GDP is quite in inline with my prediction of a range of 1.8-2.2 and then subtracting some for the reasons that I mentioned in my global macro call. Fed has very limited effective options (other than inflation targeting) by now and the market just wants to find an excuse to relieve itself at some point.

Even though I have had the luck to predict the market direction correctly in the last few years, it would impossible to get a significant t-statistic from my calls unless I keep doing this until maybe my death.  And even there, it is just a MAYBE. 

Sunday, August 22, 2010

Why you may be interested in my blog?

As a new blogger, I guess that I have to do some advertising for my blog.  However, this blog space allows only minimum flexibility in terms of adding anything other than blogs.  So I apologize for using a blog for the purpose of self-advertisement.  Here I list a few reasons why you may be interested in my blog on global macro and quant equity.  I always wonder what if any entity could have provided the opportunity for me to implement any of these insights.  The entity aside, I could certainly have retired by this time.  Even though I feel that credential shingles are far less important than actual insights, I find that many people just feel more comfortable with shingles on the roof.  When I have more time and space, I will put up some credential shingles somewhere on the blog.


§    Predicted the market crash at the start of 2008.
§    Predicted the bear rally from March 2009.
§    Predicted quant equity underperformance for >2 years at the start of 2008; reconfirmed the prediction in early 2009. The experience of 2008-09 has confirmed these predictions.
§    Recommended remedies to quant models and processes at the start of 2008. The experience of 2008 confirmed the correctness of these remedies.
§    Predicted significant underperformance of momentum factors and features in the subsequent five years at the start of 2009. The experience of 2009 has confirmed this prediction so far.

Here I list a few finance related professionals who should be able to testify for some or all of what I list above, if they have a little honesty. There are many more people who can vouch for me. But as I said, people generally believe in credential shingles. So I only list a few people with reasonably impressive shingles in alphabetic order. (If you need formal references, you should let me know directly.)

Malcolm Baker, Professor, Harvard Business School
John Chisholm, CIO of Acadian Asset Management
Peng Fei, Head of North American Equity Research at SSGA

Huiyu Huang, Researcher at GMO
Tie Su, Associate Professor, University of Miami
Rodney Sullivan, Head of Publications at CFA Institute, Editor of Financial Analyst Journal
Charles Wang, CEO of E Fund Management (Hong Kong subsidiary), Formerly co-head of research in Acadian Asset Management
Zhijie Xie, Professor, Boston College

It is still not too late to join the party: Simple global macro strategies to make at least 20% in the rest of year

About 2-3 months ago, while I was having lunch with a few friends who are on the investment side of large asset managers, I find myself being the only one who would buy long term T-bonds.  Quickly they wedged me to bets against them.  I smiled and said that while I am sure I will win the bet, I am not going to bets against you guys.  First, the bets placed on lunch table will likely be very small compared to the large sum that I will put where my mouth is.  Second, if I made a good amount of money from my investment, I do not feel good to take more money from you guys who would miss the party or even lose money.  At the time, the price of the long term T-bond ETF from iShares, TLT, is about $95, and I said that there would be at least 15-20% upside in the next 6 months.

Last Monday, I wrote to my friends again, urging them to join the party, because I think it is still not too late.  By then, TLT is already up by about 10%.  By the end of last week, TLT was about $106.  I mentioned to them that a simple strategy of buying long-term T-bonds or related funds while shorting stocks, be it U.S. or international markets, will easily yield at least another 20% at some point before the end of Q1 2011, and more likely it could be another 30% before the end of this year. 

I have predicted that this scenario will happen in the second half of 2010 all along (since the beginning of 2010).  Many people with strong financial expertise, including professional investors, can testify for it.  I hope that I have made a good impression on them, especially because some of them heard my predictions while they were still holding stocks for more gains to come at the end of Q1 2010.  I guess the more curious question is how I made this call?  Was it all out of thin air? 

Obviously, I would not bet a large sum of my own money on thin air.  As an example, let’s take a few simple numbers to which every one has access.  After the seemingly phenomenal GDP growth in Q4 2009 and Q1 2010, all that we see is a paltry of about 2% of private demand among the total growth.  The rest are from economic stimulus.  Even among that 2%, a large portion is inventory restocking.  Naturally, we know that economic stimulus and inventory restocking would have zero and then negative impact on GDP growth at some point.  (The only exception is when we have another large dose of stimulus, especially fiscal stimulus, which seems infeasible unless we are already in a double dip, given the madness of bond vigilantes who get it all wrong.)  For example, if you put in $200 billion stimulus into the economy in Q4 2009, the economy will grow by some percentage from stimulus.  If you were to have the same impact on GDP growth from stimulus in Q1 2010, you would have to put in at least $400 billion.  By many estimates made even at the end of Q1 2010, the impact on growth from stimulus and inventory restocking will likely be zero in Q3 2010 and be negative in Q4 2010.  What that means is that even without too much sophisticated help from economists (who also tend to be quite overly optimistic), you can figure out that we will have a GDP growth of about 2% and 1%, respectively, in Q3 and Q4 2010.  That is still the estimate before you taking into consideration the slowing growth in China today, the ongoing sovereign debt crisis in Europe, and the exploding trade deficit of the U.S. with China that will persist and keep exploding (See an explanation why this trade deficit will explode and persist here  So even if the initial announcement of Q3 2010 GDP is 2.4%, the revised number to be announced this coming Friday will be more likely to be below 2% than above 2%. 

Although it may still make some sense to speculate for equity market rallies in Q1 2010, armed with these realistic numbers, one should know that that the party for equities would have been long over and the party for T-bonds would have long started by this time of year.  But if you have been absent minded until today, it is still not too late to step away from the rail track of the equity train and join the party for long term T-bonds while shorting equities.  Most news that we will get from now on will be negative news, and markets will be down at least until they incorporate these negative surprises.   At the same time, the Fed has only turned the doorknob for a certain QE2.  Even if they let the door half open eventually in comparison to 2008, say in 2-3 months of time, the upside of TLT is still substantial. 

You may want to say that I just get lucky this time.  However, I have advised many people to take this same strategy before September 2008.  On March 11, 2009, I start to advise many people to take advantage of the bear rally.  I have also always stick to my description of the rally since March 2009 as a bear rally.  I guess that I have to be really lucky in all these historical occasions. 

Saturday, August 21, 2010

The fixation on nominal exchange rates and what I really fear for China

While most of the developed world is pondering a possible double dip, China is in the seemingly enviable position of fighting excessive growth.  Although some commentators are concerned about the quality of China’s growth, the overwhelming majority is charmed by its formidable growth.  Then why should I fear for China? 

To explain, let’s start with an introduction of real exchange rate (RER).  RER is nominal exchange rate (NER) adjusted for inflation rate and is more important in determining a country’s current account balances with another country.  However, the current debate on rebalancing global trade, especially Sino-U.S. trade, has focused on appreciating Yuan, the Chinese currency, against USD in terms of NER. 

In China’s situation with the U.S., its NER with the U.S. is largely fixed in the last few years.  Rebalancing global trade can only be achieved through internal inflation relative to the U.S.  Since it is difficult to control internal money flows, internal inflation frequently leads to asset bubbles, which is the reason for the bubbly real estate prices in many Chinese cities and the excessive growth in China today.  However, in China’s situation, internal inflation process may also lead to some peculiar dynamics that effectively depreciate Yuan in terms of RER.  These dynamics are little noticed by now and are what I really fear for China.  I discuss three of the prime examples.  

The first dynamic is related to real interest rates.  The real interest rates in the U.S. today have dropped significantly [i.e., 5-year Treasury bond rate was 1% at the end of 2007 and is 0.17% at the end of July 2010].  In comparison, the real interest rates in China are likely to have dropped much more and are often negative, due to the inflation reacceleration from the massive stimulus in 2009-2010 and largely fixed nominal interest rates.  Despite higher inflation rates in China, this dynamic effectively depreciates Chinese Yuan in terms of RER.  Because investments are above 65% of Chinese economy, much higher than their 35% share of the U.S. GDP, this dynamic means that the relatively more reduced investment costs in China would give a very strong monetary stimulus particularly to China’s investment growth.  This impact on investment also means even faster productivity growth in China, which effectively depreciates the RER of Yuan against the USD, given the largely fixed NER.  As a result, this dynamic would push China backwards on the track to rebalance its economy and trade. 

The second dynamic is related to the first one.  Wage growth relative to productivity growth would also affect RER.  Even if the productivity in the U.S. have been growing at a faster pace than wage growth in the post-crisis period, the productivity growth is likely to be so fast in China that it is growing even faster relative to wage growth during the same period when compared to the U.S.  Despite media attention on workers successfully gaining significant concession from some foreign owned factories, that is still the exceptions instead of the norms.  Most organized labor movements are likely to be prime targets of being crushed. 

The third dynamic is also related to the first one, with the twist of financial repression.  Even if real interest rate are often in the negative territory, with few investment options, Chinese households can only put most of their savings in the bank.  Since this dynamic constitutes substantial erosions in the personal wealth of Chinese households, it keeps consumption in check very effectively. 

These three are just some of the prime dynamics.  The overall impact of these dynamics means that even though China seems to be doing something to rebalance the global trade, they are always behind the curve, and Yuan consistently depreciates against the USD in terms of RER.  To be ahead of the curve, China needs to raise real interest rates drastically, provide many more investment options to its households, substantially appreciate Yuan against the USD in terms of NER, and award its workers much higher wages. 

These dynamics are among the fundamental problems facing China today.  In comparison, things like bubbly housing prices in many Chinese cities are just symptoms of these dynamics.  For example, the bubbly housing prices are due to a combination of negative real interest rates, few investment options, and extremely low carry costs in terms of property taxes and maintenance fees.  Put another way, these prices are a result of internal inflation process and financial repression. 

Without taking the suggested prescriptions, the continued unfolding of these dynamics would yield a few predictions, with some actually being pretty counterintuitive to what most commentators think.  First, Chinese current account surplus and the U.S. current account deficit are likely to explode instead of shrink, as some in the U.S. have wished, even with some mild appreciation of Yuan in terms of NER.  These explosions will happen even if the U.S. consumers retrench significantly by consuming less and saving more.  Because the open border of the capital and trade flows in the U.S., as long as things are getting cheaper and cheaper in relative terms in China, China will be able to force China-made goods down the throat of the broken American consumers. 

Second, China will invest more money into the USD assets, instead of less, because this is only way for them to avoid significant upward pressure on Yuan.  This will likely keep the yields on U.S. Treasury bond low as long as China runs huge trade surplus against the U.S.  This prediction follows from the accounting identity stating that the sum of current account balance and capital account balance should be zero to keep the exchange rates intact.  This identify is taught in any MBA international course but many commentators seem to miss it and still worry about China stopping the purchase of U.S. Treasury bonds. 

The third prediction, which is my fear, is that China is increasingly cornering itself by reducing the RER of Yuan while they should have been doing exactly the opposite.  Given the preoccupation of the current debate on the NER between Yuan and USD, one day, the continuously exploding trade deficit, coupled with likely persistent high unemployment rate in the U.S., means that the only outcome will be the threat of trade war, or trade war itself. 

China’s action against appreciating the RER of Yuan relative to the USD is out of necessity.  Its employment problem has always been the most important political problems.  However, solving employment problem by growing the economy through persistent current account surplus is at the expenses of its trading partners.  In good years, no trading partners get really bothered by it.  However, since the start of financial crisis, the U.S. suffers from sustained and elevated unemployment levels (8 millions of jobs lost) with no end in sight, which is likely to evolve gradually from an economic problem to a political problem.  By then, I am afraid that China may have hit the wall in terms of depreciating the RER of Yuan through the above dynamics, while the pre-occupation of almost every one on NER means that Yuan has to appreciate significantly in terms of NER, with the alternative being a trade war.  This will not be pretty for the whole world but it will probably be even worse for China. 

By then, China will be in a very precarious position, especially because the above dynamics means that China probably has become more dependent on investments and current account surplus to grow its economy instead of less.  I suspect that China may yet become another Japanese growth story with a collapse of its economy or its economic growth rates.  If China has trouble, the most commodity driven economies, which are often emerging markets, will likely experience subdued growth rates as well.  In comparison, the U.S., which control the final demand and may finally realize that this control gives it much stronger bargaining power, may end up as the relative winner.  

The future intellectuality of the stimulus debate in the U.S.

We are at zero interest bound and the economy is in the liquidity trap.  The greatest problem facing the world is a severe lack of final demand.  There is a wall of overcapacity (the output gap between trend and actual growth of about 8%).  The grim employment picture is the worst in the last six decades and will surely last for years to come given that fewer jobs are generated than population growth, which also pose long term risk to the country by making a large percentage of population permanently lose their productive skills.  Central bankers are still burnishing their inflation fighting credentials while the median core inflation is showing a stubborn trend of heading south short of a future catastrophic shock.  Meanwhile, bond vigilantes seem to live in a world in where up is down and down is up (or maybe they keep making the rudimentary mistake of confusing bond yields and prices).  They tirelessly exert gravity on long-term government bond yield to the extent that the real cost of stimulating the economy is trivial if we could actually jump-start the economy to a sustainable level.  With these facts in mind, the argument for “austerity now” in countries such as the U.S. is intellectually naked.  Irish experience is a recent example of “austerity now” gone poorly.  We shall take care of the austerity issue when the economy is on a sound footing. 

Even with the intellectual nakedness of the “austerity now” emperors, this debate is far from a forgone event.  It is important to keep pointing out their nakedness, because they are emperors and thus are in power to make life and death decisions for all of us and because they often think their power means that they have wisdom .  It is important to educate the population to be imaginative enough to get accustomed to seemingly big numbers in the short term (say, e.g., expanding Fed balance sheet to US$10 trillions and another couple of trillions of fiscal stimulus) and to organize pushes for more stimulus from grassroots level.  It is important because the consequence is dire without drastic actions.  Without doing much, we are lucky to be bouncing around in the disinflation or mild deflation environment for a long time with no end in sight (think Japan, the most likely scenario).  If we are really unlucky, we could have severe deflation.  It is also important because once people start to get used to this new normal, it will require even bolder actions to eradicate the deflationary expectation. 

At the same time, however, those of us who agree with substantially more stimulus need to ponder the unthinkable, “If we could obtain enough fire power to attempt jumping start the economy, can we surely generate sustainable growth within foreseeable future and how long that would take?”  The answer may be just as long as it takes.  After all, the greatest problem facing the world now is a severe lack of final demand.  Also, in the aftermath of the current balance sheet recession, households are bound to struggle to save and pay off debt, and the approach of whole-sale bail-outs for most stakeholders guarantees that we are not in a 1930’s world in which households have escaped debt prison through defaults by this time of economic cycle.  In addition, we should not expect another World War to wipe out and suck up all the overcapacity.  Further, short of a trade war, the beggar-thy-neighbor tendency of global governments also makes the coordinated global rebalancing, which should be part of the plan for sustainable future growth, nearly impossible. 

We have to identify the linchpin for sustainable long-term demand growth and plan for its attainment.  I certainly hope it is not another bubble as in the last two decades.  It seems that we need something else in addition to the stimulus (which likely will involve reducing the massive unemployment) and figuring out that something else probably lies in the core of the future intellectuality of the stimulus debate (Forget about China rebalancing its economy soon. Though it should be an important part of the solution, it will probably be too little and too late).  I understand that many times we may have no choice but to improvise as events unfold, and we can attempt navigating the uncharted water with measures such as persistent pursuit of an inflation target.  However, it helps to at least identify and think about the issue.  At this point, figuring “it” out seems to be at the center of the intellectuality of any future stimulus debate.  This shift from the debate with “austerity now” emperors will become much more evidence in the next few months, when the Fed, and maybe even the Congress, starts to injecting stimulus again in the face of certain faltering of economic growth.