Odey: Oz at centre of looming global crash

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Macro Afternoon

From Crispin Odey, the $12 billion hedge fund manager, and his latest newsletter:

The themes I have been outlining since the second quarter of 2014 are now establishing themselves:

A faltering Chinese economy with growth ultimately slowing down to 3%. A hard landing for those countries plugged into China’s growth – especially Australia, South Africa and Brazil. A fall in commodity prices bringing with it pain to those heavily exposed. For oil this is the Middle East, Venezuela, Argentina, mid-west USA, Canada, Norway and Scotland.

No one forecast how fast and how far those commodity markets would fall. However, the same people who singly failed to see this coming are the first to say that the benefits of falling prices will outweigh the costs. My problem with such a hopeful outcome is that, in my experience, those that lose out from a fall in their income are quicker to adjust than those that benefit. In that intertemporal space lurks a recession.

For me, the slowdown/recession finds a secondary downturn thanks to the immediate closing down of any discretionary capital expenditure in the affected industr es and countries, something we are only just seeing. This obviously has knockon effects for incomes and employment. At that time the exchange rate is likely to be falling to give some support. In my world this slowdown in the commodity producer’s economy is felt via falling exports back in the beneficiary’s economy, which finds external markets weaken. Again, if I am right on timing, the effect can be great because it is not yet affected by a pickup in spending in the beneficiary’s economy.

As always, that is the theory and markets will show whether it works in practice. In my world, this hit to the world economy is the first experience of a business cycle since 2008. Most investors do not believe we can experi-ence such a downturn. They rely upon Central bankers who they think have solved the problem.

However, let’s also deal with three counters that I currently have to field:

1. ‘How long dare you be wrong?’ 2. The opposite. ‘Do you think after a good quarter, this is all in the price?’ 3. ‘But isn’t a downturn in the world economy leading to massive counter-measures in terms of liquidity, as en-visaged by Draghi and the ECB, which will push mar-kets and assets higher?’

My answers are as follows:

1. The performance of the fund since I decided that the world would end differently to my previous thinking, which was in March/April 2014, reflects that I have not been especially early in this call. It would have been rather nice to get the fall in oil spot on, but we didn’t. 2. No change in cycle lasts for nine months. This down cycle is likely to be remembered in a hundred years, when we hope it won’t be rated for “How good it looks for its age!”. Sadly this down cycle will cause a great deal of damage, precisely because it will happen despite the efforts of the central banks to thwart it. 3. We need to go back to 2008. We had seen reckless spending and reckless borrowing, fraudulently obtained credit advances and overvalued housing. And yet, de-spite the banks losing a great deal of money and house prices in the USA tanking, we hardly saw a recession in 2009. Why? Because when the Anglo-Saxon central banks lowered interest rates from 5.25% to effectively zero, they put the equivalent of 30% of net income into the hands of the overborrowed. There were other QE measures taken but this was the important one.

Today we get excited about what Draghi is going to with his QE plans for Europe. However, buying government bonds yielding 1.2% does not move the dial for European borrowers. Moreover it is almost impossible with negative short rates of 0.2%, because why would anyone sell a bond to the govern-ment, even if the yield is only 0.4%, to get a –0.2% yield on their cash? It looks like Draghi’s measures will disappoint markets. Faced with a deflationary bust, monetary policy will prove to be but “pushing on a string”.

There will be a strong temptation for individual countries to act independently of each other to soften the downturn. In this regard the story looks like it is only half way through. Russia will necessarily have to introduce exchange controls, and that really quite soon. Australia, where the average wage is over $70,000, while the USA is creating jobs at $28,000, will have to allow the currency to fall further. Japan has shown, under Abe, how it intends to react. ‘Everyman for himself’ puts enormous stress on a world trading system which has watched world trade rise from 12% to 32% of world GNP in little over 20 years.

So, where am I placing my money?

  • Firstly, I think equity markets will get devastated. Un-announced business cycles ensured Japan’s stock mar-ket rating fell by two thirds over 20 years.
  • Equities are priced for perfection, pushed up by SWF and high yield investors looking for higher yields and better covenants than high yield bonds.
  • Commodity-related sectors look unappealing and dangerous.
  • International consumer companies look overexposed to EMs.
  • Fund management companies look overexposed to the wrong assets, especially EMs.
  • Volatility is rising. Not every trade will work.
  • Australia is still to see rates down to 0.5% at the short end, 1.5% at the long end, down from 2.5% currently.
  • Currency trading is still to make the money. It made money last year as it was where the ‘tyres hit the road’ – equities are just the residual.
  • Equity markets will struggle to understand the quarterly translation and transaction effects of these currency moves on corporate profits, starting with Q1 2015.

We have seen though some strange things, with economics 101 turned on its head. We’ve seen that falling prices produce more supply, as the biggest producers see that they can take market share and use the opportunity by reducing average costs through excess production. We’ve seen that in the oil, minerals and iron ore industries. We have also seen in the last couple of years that as bond yields fall, governments are able to issue more debt.

But this time round the problem we have as well is that politics will start to rear its head and we are left to deal with politi-cians who are increasingly critical of the capitalist system’s ability to allocate capital and provide for society.

For me the shorting opportunity looks as great as it was in 07/09, if only because people are still looking at what is hap-pening and believe that each event is an individual, isolated event. Whether it’s the oil price fall or the Swiss franc move, they’re seen as exceptions.

After the 1987 crash, a friend of mine, then a young Director of Sotheby’s, was sent to consult an old Partner who had been at Sotheby’s during the 1930s and was still alive, albeit in a nursing home. My friend asked the question “What was it like in the 30s?” and the man replied “It was like being bitten by a tarantula.” My friend didn’t really understand that, but later on in the conversation the old Partner said“A spasm of activity followed by a death.”

My point is that we used all our monetary firepower to avoid the first downturn in 2007-09, so we are really at a dangerous point to try to counter the effects of a slowing China, falling commodities and EM incomes, and the ultimate First World effects. This is the heart of the message. If economic activ-ity far from picks up, but falters, then there will be a pain-ful round of debt default.

We already have volatility across asset classes and as I say, equities are the residual. There is a precious little earnings growth ex-Japanese exporters and we have now reduced our US cyclical exposure as we expect the commodity-induced recession in the mid-west to effect the resilience of the greater US economy. In Europe, we are half way through the write-off process, having written off half as much as the US. Draghi will disappoint and this may cause the first Euro rally given the fall from €1.25 to €1.15 in a month.

We are in the first stage of this downturn. It is too early to see what will happen – a change of this magnitude means the darkness and mist is very great. We will make some mistakes but with our thinking we won’t make the major mistakes. The problem is where you stand – I am amazed to see so many are fully invested given that equities are already fighting the downtrend. Mid and smallcaps have moved into bear markets and much relies on large caps to keep the whole thing going and they are very exposed to international trade.

Can’t say I disagree. It’s all about timing.

Houses and Holes
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  1. HnH, any wonder I said I was not as sanguine as some about the commodity complex unwind.

    An ill wind blows. And I feel very uncertain. Timing and/or can kicking remain the unknowns.

    • Anyway, it was awesome that we put all our eggs in the commodities basket instead of investing in the capabilities that will be required for the future. The party was worth it, eh 2d?

      • Hell yeah.

        We weren’t going to invest in ‘capabilities’ so just as well we invested in commodities. Gave us decade and more of good times.

        A generation has reached adulthood with no experience of recession, we’ve paid ourselves handsomely and enjoyed Australia is Different 😉

        Wel’ll have fond memories in hard times.

      • Commodities were great to produce those eggs but the basket that we put those eggs into is every home purchased in the last 10 years. Thats the problem.

      • I’m not sure being heavily invested in the commodity complex was a bad idea per say. when you have a good wind, run with it.

        Leveraging that into home loans by the banks, aka, going all in leveraged on a (in the end) strong AUD story leaving the country uniquely vulnerable to a TOT disaster, that was maybe not such a great idea.

        Doing everything exactly as we did, but with a land tax and no land price inflation, we would be sitting pretty. still, good party while it lasted…

      • Should have mentioned of course the fact that we also threw more or less every existing value-adding industry under the bus for the sake of “making room” for the mining boom. Not looking so clever now.

    • Mate, it may be that should Abbott be removed, the incoming may tell the public just what is the real state of the Nation, a sort of cleansing statement.
      Business may then take the opportunity to cut employment, (based on the fact they have been mislead for all this time) and the ball starts rolling downhill from there. WW

      • My response got ‘spammed” 🙁 Never mind.But here’s a plan after my own heart !

        ” One day, somebody sets himself on fire, then thousands of people are in the streets, and before you know it, the country is burning. And then there’s no time for us to get to the airport and jump on our Gulfstream Vs and fly to New Zealand.”


    • I will be sure to tell my children and their children (and so forth) of the reign of the FIRE beast and how it was ultimately slaughtered.

      • We should be more ambitious, we should be the case study in future text books, and be synonymous with policy failure. The chapter ‘Aussie Hubris’ (or something similarly named) has a nice ring to it.

  2. What he said about consumer companies kicked off in q3 14 with unilever’s sales volume down 20% in China. This has rocked suppliers all over Asia as Unilever budgets were slashed accordingly. WPP should be bricking itself as it scurries for business and I am seeing this happen right now.

  3. It seems to me that there is a cycle of about 100 years. It is long enough to make who ever is alive not naturally realise we are repeating a cycle.

    The cycle is caused by demographics. A baby boom leads to a flood of adults 20 odd years later. Then about 60-70 odd years later they retire. At approx baby boom+20 years they flood the economy causing stress in the economic infrastructure (oil shock of the 1970s), then as they retire, the economy has over capacity leading to price falls and ultimately depression.

    We are at that part where the over capacity begins showing up in the face of falling demand and the economy falls out from under the infrastructure. Technology/automation adds extra damage by removing additional employment opportunities. Ironically this has occurred because of the extra brain-power caused by the baby boom. Businesses in the face of this falling demand automate even more to lower prices to recapture demand, but the demand is retiring and not interested.

    The EU fracturing is the equivalent of the European fracturing in the world wars. The internet and computers is the equivalent of the production line and Henry Fords car. The Great Depression II then is our future.

    Our current baby boom retirees is not a single baby boom group but 2 overlapping baby booms. The Great Depression left energetic men not working and little opportunity for fun and entertainment so they were more eager to have sex with the wife for the cost free benefits leading to a baby boom. WW2’s completion also caused its own baby boom. Both together overlapping make a baby boom of about 40 years wide, the majority of which is still to leave the economy in the coming decades.

    This has other consequences, less economy means less taxes, less taxes means gov debt becomes a problem.

    Baby booms ultimately cause depressions which then cause baby booms. Technology exacerbates the up and therefore the subsequent crater.

    The mining boom pre-GFC was caused by a baby boom in China in the 1980s causing a bulge of adults in the 2000s needing housing and investments. This was about 10 years wide. A mild baby boom in China is a huge event for much smaller Australia hence the huge economic spike here.

    I believe demographics fluctuations is the root of most of the economic ups and downs. If true the world wide demographic fall (relative to the average exponential curve of population/adult growth) is the equivalent of economic fall. This then leads to a new baby boom. Repeat.

    I am not an expert and so I might be delusional 🙂 but events keep matching my hypothesis.

    • C.M.BurnsMEMBER

      I’ve never heard that thesis before but it sounds / feels right.

      Have you done research into this (uni or investment related) ?

      • After the GFC I spent years reading the internet on finance. I eventually came across Martin Armstrong who gave me the idea of cycles. But he never explained the origin of them but was making accurate predictions. In my own research I could find reasons for stock market dips but was unable to find the reasons for spikes. I came a cross one site that explained the 1950s economic expansion in the US being due to house building and infrastructure government programs to accommodate the extra adults. I set about comparing population booms to stock market spikes. (Thanks ABS.)

        I found a good correlation at 40 odd years after the fertility rate spikes. This puzzled me greatly! Then I realised this might be the maximum/middle of the adult productivity/consumption age.

        This then made me change my view from a simplistic fertility boom to the slightly different worker boom/bust hypothesis for both ups and downs.

        I converted the All Ordinaries chart to a compound percentage improvement per annum chart (Using Stooq’s back calculated All Ords which goes back to 1875! See ‘All Ordinaries’ in Wikipedia) then pattern matched the fertility data from the ABS. It correlates to the low points of my new All Ords p.a. percentage chart from 1959 (ABS data starts at 1921 and my offset was 38 years = 1959) through to about 1999. The mining spike was found to correlate with the Chinese new adult boom taking us to 2008. From that point the All Ords stays higher than the expected fertility rate+38 years expectation.

        Recognising the fertility rates and markets correlate with a time delay its logical to assume a repeating cycle. Looking back at history events do look the same just the tech is different.

        I expect that habit/faith and government manipulations and hopium are holding the world stock markets up post 2008. But when this runs out of ability to continue the market then falls back to the base defined by the fundamental worker demographic.

        Visually the drop in the worker demographic pulls the All Ords/economy down from year 2008 through to about year 2017. Calculated back onto the All Ords Index this is a drop from year 2008=~3000 to year 2017=~1500. Obviously the All Ords was not 3000 in year 2008 but that is because Chinese influence is not included. It seems that China will be less of an uplifting influence in the future and so it risks the 1500 number being more realistic (and scary!) in 2017. The effect of the worker demographic recovers back to the year 2008 numeric level at about year 2033. (Martin Armstrong has interesting comments about the year 2032.) Post year 2033 a new exponential curve upwards of workers begins terminating back at roughly year 1959-2008 trend in year 2045.

        Overall the hollowing out of the worker demographic pulls the economy down below trend between 2008 and 2045. The low point being 2017. This doesn’t include the effects of the drag caused by the retirees themselves, who consume about 2/3rds less, move from risky to safe investments, produce nothing and get sicker, or other outside influences.

        This baby boom was global because the Great Depression and WW2 was global so the worker bust is also global.

        Can images be dropped in posts??

      • Interesting stuff amateurish.

        Pictures can’t be posted unless you’re one of the blessed two(?) but it’s easy enough to upload them to http://tinypic.com/ and then put a link here for people to click on.

    • On the money. The main difference with this cycle is that it might be the largest one of its kind ever.

      Edit: Unfortunately for all, the zeroth law of economics seems to be that people are irrelevant.

      • migtronixMEMBER

        That’s the zeroth law of central planning, the one in which entropy is magically wished away with the “well of infinite contracts”.