Everyone seems so grumpy and full of foreboding. Large institutional investors have had to endure so much in the last 15 years, and scarred by this they are demonstrating a predilection for great caution spurred on by countless gloomy scenarios. I met one recently that had an annual budget of $200m to spend on hedging against extremely low probability bad events, whilst one of Brazil’s largest pension funds describes its new investment strategy as “wait, see and pray”.
Whilst it is understandable that sentiment in a commodity producing nation should have reversed, on a global basis this caution seems odd. For at the macro level there are always winners and losers and we are very much more upbeat at the prospect of participating in the winds of change that are spurring new winners.
This of course represents quite a change. Our flagship fund was born exactly 13 years ago. Back then in the fund’s infancy I was far more concerned about the world outlook, especially the prospective returns from stocks. As an active discretionary investment manager I sought the widest possible investment parameters so that the fund might escape what we thought might prove the penury of the equity market. I chose to begin life emphatically on the outside, bullish commodities.¹
Hedge funds count time in dog years and by our adolescence we had grown wary of the threat of a deflationary financial shock and had pivoted from commodities to the security of the fixed income markets and safely rode out the turmoil of the Great Financial Recession. It is only as adulthood has beckoned, and we can look back and see that on a volatility adjusted basis the S&P has under-performed Treasuries by c. 75% since our launch, that we now feel more comfortable contemplating an economic path that is less daunting and, dare I say it, more rewarding.
In these monthly updates we have attempted to chronicle our shifting stance. It began out of mercantilist Asia. Since the turn of the century China’s policy support for investment-driven GDP growth led, intentionally or otherwise, to a repression of the consumer. However, ten years later, as marginal returns on incremental investment collapsed and world trade slowed, the old model alone could no longer sustain the desired level of GDP growth and the authorities relented, allowing the working population the right to share more evenly in the bonanza their toils had produced; wages have been rising above and beyond productivity gains ever since.
Long Consumers versus Producers
It is the linkage with the rest of the world which concerns this month’s narrative as growth in emerging markets has shifted to a less commodity intensive consumption model. The ensuing decline in the price of commodities over the last eighteen months may be catastrophic for some parts of the global economy, but it has produced a significant windfall for hard pressed households around the world whose real incomes are no longer in retreat.
We have constructed a relative value FX trade that seeks to benefit from such a shift. On the long side we have focused on countries which have a low dependency on external trade and have not experienced large negative terms of trade shocks owing to the collapse of commodity prices. We have also avoided developed nations where in the presence of deep capital markets relative monetary policy swings tend to drive capital flows and hence FX movements much more than trade flows.
This brings us to emerging markets, where FX moves still tend to be more dominated by trade flows. Currently the major distinguishing non-dollar trend in currency movements seems to suggest that being a consumer nation with a large non-tradeable goods and services component of GDP, and being an importer of commodities and so enjoying a large positive terms of trade shock, are paramount.
There are only a lucky few that have not seen large negative impacts on the trade balance in this category. The more obvious names are the Asian ‘consumer’ nations of the Philippines and India, which have performed well on a carry adjusted basis. Both are populous with large domestic markets and room to grow with low penetration rates of consumer credit. They are major importers of energy and other commodity raw materials and so have just received a large improvement to their terms of trade. Finally, exports are below 30% of GDP, and both feature a heavy weighting towards services sold to customers in developed markets. The only caveat is that the position is fairly consensual. And so to counterweight this factor we also include Indonesia in this group. Investors tend to concentrate on the high weighting of heavy metals in the country’s export basket. The reality however is that commodity exports represent c. 14% of GDP with the vast majority of GDP accounted for by Indonesia’s vast internal economy of 250 million people who are not particularly exposed to global trade; a fact seemingly supported by the 40% recovery in the country’s current account since 2013 to just 2.1% of GDP.
On the short side we have not focused on large exporters of raw commodities: the price adjustment may have further to go but it is hard to argue that this is not a fairly mature trend. Instead we reach higher up the supply chain to developed Asia where exports to GDP are higher than anywhere else in the world. The price shock and resulting deflationary pressures should continue to inch closer to the markets for more complex goods where overcapacity has also been seen. Currently these nations have performed OK thanks to raw material prices falling quicker than finished goods, but pricing pressures are now feeding through directly to the factory gate as can be seen by the extremely low PPI in developed Asia.
As the world shifts to a new regime of localisation of the supply chain embedded within large end markets and as China builds out its Silk Road, offshore developed Asia seems likely to suffer the most. The likelihood is that they will capture less of the value-added than previously as the chain consolidates and highly engineered products and sophisticated services migrate to onshore China. In short, we believe nations without large domestic markets of their own are likely to be the most at risk. In this category we place Taiwan, Singapore, Thailand and Malaysia. They are currently experiencing chronic disinflation which is likely to persist, and as their end consumer markets are not huge there is little to be gained from running tight monetary policies to support their currencies.
And with the Fed seemingly intent on couching any rate hike in very dovish language, or quickly aborting any attempt at tightening should the dollar surge, we are less keen on owning the US dollar outright against Asian currencies at this point in a market where popular trades are falling prey to vicious mean reversion. However, I do believe this divergence between the world’s consumers and producers is likely to continue and accordingly, and similar to the theme that stretches across the rest of our risk assets, we continue to favour less obvious, idiosyncratic, trades that capture the likely enduring trend of favouring consumers over producers.