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Capitalist Exploits is a team of globe-trotting professionals dedicated to seeking out and investing into unique, undiscovered, and profitable opportunities worldwide. This could be an asymmetric trading opportunity in the global currency markets, seeding a tech startup in Israel, or... More
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  • Can You Hear The Fat Lady Singing? - Part III

    I love what I do! A recent get together found me subjected to talk about "work at the office":

    "What did you do at work today?"

    "Oh, nothing much, tried to look down the new girl's top for a bit then I made some phone calls, you?"

    "Oh, much the normal, searched the web for our next vacation and found I can get a Filipino bride for a grand."

    After only 10 minutes I was ready to leave.

    I then received a call from a friend which snapped me back into my world and cemented my decision to leave. This friend has been extremely successful trading Asian credit and I was eager to get his perspective on emerging market debt and in particular China.

    This brings me to my thoughts on emerging market currencies and debt, which I'd like to share with you today.

    It all starts with the dollar bull market which we've discussed previously at length. As Brad mentioned earlier this year:

    So while the US current account deficit continues to narrow there is absolutely going to be a shortage of USDs. There is $9 trillion of dollar denominated debt outstanding, well considering that it took a number of years to build up this debt, it is going to take more than just a few months to unwind, more likely a couple of years at least. If the US Federal Reserve were to raise rates this year it sure wouldn't help the cause, rather it would throw accelerant on the smouldering liquidity fire!

    After a brief breather, the dollar (NYSEARCA:UUP) looks set to take out new highs:

    (click to enlarge)

    This time around the dollar looks set to take out 100 on the Dollar Index. My thoughts today lie in what this may mean for various emerging market asset classes.

    Take a look at the MSCI Emerging Markets ETF (NYSEARCA:EEM):

    (click to enlarge)

    Support sits at 36 and we're getting close!

    This is a function of a stronger dollar. The larger question lies in where the leverage in emerging markets may lie, remembering that the unwinding of the carry trade will be particularly severely felt where leverage is highest.

    Taking a step back for a minute and thinking about the events in Europe recently and the events we've just witnessed in China, it's clear to me that central banks are out of control.

    Risk lies in with the fact central banks believe themselves omnipotent. This is only half of the problem. The majority of investors believe the central banks are actually omnipotent and that is the other half of the problem. Central bank omnipotence is at an all time high... or is it?

    If we look back in history, it's littered, not with successful central bank intervention, but with central bank failures. For every action there is a reaction. Everything is connected. You can't throw a stone into a pond and not get ripples. Similarly you can't have central banks buying assets, or slashing interest rates or any other such action, without consequences for those actions.

    Last week I looked back at how the Asian crisis unfolded. That particular crisis was only 18 years ago, yet market participants seem to have forgotten the lessons. We know that central bank intervention in the face of a levered market which is unwinding can often be the precursor to an outright rout.

    I then spoke about China earlier this week and how easily and quickly the Chinese central bank stepped in to attempt to stabilise the stock market. That they acted so aggressively is far more concerning to me than the actions themselves. The consequences of this are ultimately a weaker remnimbi, and a weaker remnimbi threatens to exacerbate losses for investors that have been participating in the USD carry trade.

    Furthermore, as Chinese growth slows the temptation to slash interest rates and devalue the remnimbi, should it happen, puts additional pressure on competitive emerging market currencies. Countries such as Korea, Malaysia, Thailand, even India. Once again, a stronger dollar vis-à-vis these respective currencies threatens any levered capital invested in the bond markets to seek first to reduce exposures. This means selling the respective currencies and buying back dollars. This self-reinforcing cycle can quickly force margin calls and the global carry trade unwind threatens to get particularly "exciting".

    It's not difficult to imagine a scenario where as the dollar bull run gathers steam we may well see more and more emerging markets looking like Greece.

    Right now a number of emerging market currencies are looking like they're getting ready to roll over. The repercussions could well be an emerging market bond rout. As such, we've been dipping our toes into shorting the iShares JP Morgan Emerging Market Bond ETF (NYSEARCA:EMB) with some long dated options.

    If nothing else, it's a heck more interesting than boring cocktail parties...

    - Chris

    "It amazed her how much people wanted to talk at parties. And about nothing in particular." - J.D. Robb, Holiday in Death

    Aug 02 12:36 AM | Link | Comment!
  • Industry Standard Be Damned!

    Some 12 years ago, on my first trip to China, I found myself pleasantly surprised by almost everything I saw. The high quality and low cost of accommodation, the fantastic roads, and overall infrastructure.

    I found a friendly people with a truly surprising level of wealth. It was a country I knew very little about; a country which, had I been listening to the brain-dead media, was "Red China", a commie outpost suffering an armageddon type battleground, overpopulated with grovelling, poverty-stricken, half dead villagers eating dogs when they couldn't find a foreigner to feast on.

    Nothing could be further from the truth, though less pleasing was the pollution in the cities, me being fussy about wanting to breathe air rather than chew it, and the surprisingly poor quality of food in general. Since that first trip the food has gotten much better while the chewable air has gotten worse.

    I bring up China since it popped into my mind recently while conducting due diligence on a deal. I was reminded about an experience I had in China which I'll tell you about in a minute...

    While looking through the term sheets and shareholder agreements, we questioned some of the elements and were told that they were "industry standard."

    "Industry standard," together with "standard procedure" are probably two of the most overused, loaded phrases in business, as they denote a certain sense of authority where the recipient is meant to find themselves as an outlier if in disagreement.

    What may be considered industry standard in one country can be completely unusual in another, and even within varying parts of the business cycle. Right now the S&P is trading at roughly 20x earnings. One could argue that is a type of 'industry standard." Does that make it right?

    A handful of examples that come to mind from recent deals we've been working on:

    • "Why is this clause in here?" - "Oh, it's Industry standard." (which never answers the question).
    • "Why is the CEO paying himself $xxx.xxx per year when the company is pre-revenue?" - "Oh, that's industry standard."
    • "Why are the founders also on a consulting agreement with the company they own?" - "Oh, that's industry standard."

    I wrote an entire post around stacked notes and how investors are getting royally screwed by companies raising money (especially in Silicon valley), and today it's considered... you guessed it - "industry standard."

    The hell with industry standard!

    To put "industry standard" in perspective let's go back to China...

    Whenever traveling to a new country there are always new norms to adjust to - driving on the correct side of the road, ensuring you use the correct means of greeting people, dressing appropriately (the UAE) and so on. We're adjusting to a new set of "industry standards" in an unfamiliar place. Nobody thinks it peculiar in their home territory. It's just the way things are done.

    One of the things that is "industry standard" in parts of China which is... ahem, different is the way they potty train toddlers.

    I was violently introduced to this while dining in a restaurant in Xian. Sitting a few meters away was a family with a toddler. The toddler, feeling the urge, proceeded to defecate all over the restaurant floor. The parents continuing to enjoy their meal, watched the process much in the same way you'd watch pigeons scoffing breadcrumbs, in other words, completely unperturbed.

    I, on the other hand, clutched for the anti-nausea medication which should have come standard as condiments on the tables. I'd seen toddlers walking around with the "slip pants," but thankfully had yet to see them being put to use. My first time was to be while eating my lunch. Lucky me...

    In Western society toddlers wear nappies/diapers and are trained to "go potty." As nasty as changing nappies tends to be, they do serve a dual purpose: as punishment to parents everywhere for bringing little brats into the world; and, more importantly it sure beats cleaning up excrement out of kids clothing, or off the floor of restaurants.

    Thank God then for disposable nappies, clearly one of mankind's best inventions, right up there with antibiotics, the Internet, quantum physics, electricity and the string bikini.

    In parts of China the use of a nappy is clearly NOT "industry standard." Having specially designed pants to enable "going potty" anywhere at any time is considered "industry standard." It's considered legitimate even if you don't agree with it.

    In business this terminology is used frequently to provide legitimacy. It can be dangerous and is certainly annoying. Just as I wouldn't let a toddler defecate on my living room floor, so too I don't want investments poorly structured, whether considered industry standard or not.

    Just remember what is industry standard today may well be looked at as completely ludicrous tomorrow. Remember the deals put together in the dot-com boom? Yeah, so much for "industry standard!"

    The difference between having human excrement on your restaurant floor or not comes down to industry standard. Next time you are reviewing business agreements and have questions, just to be told they're "industry standard," be sure to remember the crap on the restaurant floor... and make sure not to sign up for that.

    - Chris

    "The hell with the rules. If it sounds right, then it is." - Eddie Van Halen

    May 09 11:12 AM | Link | Comment!
  • This One Thing Has Killed Before And It's About To Kill Again

    While on a weekend hike with my family a few weeks ago I bumped into a very experienced alpine climber and we started chatting. This guy had climbed some of the most treacherous alpine mountains that the planet can chuck at you.

    I've never had the inclination to climb like this guy climbs. Firstly, I'm not great with heights and while I enjoy being outdoors, I like doing so without being convinced that I'm going to die. It spoils it for me.

    I was curious to know what the real risks of falling when climbing treacherous terrain were like statistically. He then told me an interesting fact: most climbing accidents involving falls happen NOT at the riskiest part of a climb, but rather in sections of terrain which you'd not expect to see the highest casualties.

    What happens is that climbers come out of very risky terrain and subsequently think they're out of the "high risk zone" dropping their concentration, and not realising they are still in a risky environment. This lack of attention kills more climbers than anything else.

    You see the same sort of thing on long stretches of straight roads. Drivers simply get lazy and stop paying attention. Next thing they know they're upside down and the airbags have been deployed (or worse, they were driving a Lada and there are no airbags).

    One of the lessons I learned when trading for a living was that when I was "cruising" I would inevitably make stupid decisions. I would be the equivalent of the climber who has just finished a really treacherous section of a climb and thinking he can "relax". I'd do something stupid, forgetting that I was still "on the mountain".

    This complacency is a killer and right now we have complacency in a number of markets, not the least of which are the debt markets, both sovereign and corporate. Our Global Debt report highlighted the truly astonishing state of our global debt markets. The data shocked even me when I first reviewed it.

    Today the situation in the corporate bond market is even worse. In a minute we'll take a look at it but before we do, what is important to know is why corporate bonds are so overvalued. To answer this question we need only look at government bond markets which have been hijacked by central bankers intent on injecting ever more liquidity into the world economy.

    Slowly but surely, government bond yields have slipped away (source: CLSA)

    The above graph is really indicative of what has driven capital into the private corporate bond market, creating in the wake of a sovereign debt bubble yet another bubble. Most notable is the junk bond market.

    Since 2008, high yield debt has gone from $300 billion to $900 billion. This is but one side effect of QE which has forced sovereign bond yields into negative real territory and sent yield hungry investors into the high yield market.

    While investors, mutual funds in particular, have been scrambling into junk bonds like fat kids after that last cupcake, the fundamentals in this market have been collapsing. The ratio of dealer inventory to fund/ETF holding has collapsed as shown above. Remember that banks act as the intermediaries between buyers and sellers providing liquidity to the market, and their holdings have gone from $286 billion to $96 billion - a mere 9% of inventory.

    Dealer inventory to US corporates has careened from 8% down to just 1%. In case readers aren't 100% clear what this means let me explain with one word: LIQUIDITY. Banks and dealers provide liquidity in any market and this one is no different. That liquidity cushion has collapsed by over 88%.

    Liquidity is so very important, especially at market extremes. Elaborating on the concept of liquidity, the ever brilliant Howard Marks of Oaktree Capital recently put it this way:

    It's often a mistake to say a particular asset is either liquid or illiquid. Usually an asset isn't "liquid" or "illiquid" by its nature. Liquidity is ephemeral: it can come and go.

    Come and go indeed!

    Bonds, unlike equities are non-linear. A bond market can, will and does go "no bid". Let's take a look at my old employer:

    What to do?

    Knowing that an event has a high probability of arriving and failing to position accordingly is like getting Scarlett Johansson into the sack and promptly falling asleep. A terrible shame! There are a number of ways to deal with this. I'll list a few that pop into my head:

    • Cherry picking the worst of the worst junk bonds and going short.
    • Shorting an ETF such as HYG (NYSEARCA:HYG) and JNK (NYSEARCA:JNK).
    • Placing bids right now for the best corporate debt out there expecting an event that drives sellers to sell high quality bonds. (I'd suggest beginning a hunt in the bonds that are populating LQD (NYSEARCA:LQD), the iShares iBoxx $ Investment Grade Corporate Bond ETF). If I'm right then the good will be dumped along with the bad for a short period of time and alert investors will be well positioned to build themselves a solid quality corporate bond portfolio which you'll likely not have to look at for another 20 years.

    Our very own Brad trades the asymmetry discussed here using optionality which is our favoured method, but who am I to tell you what to do with Scarlett in bed?

    - Chris

    "Liquidity can be transient and paradoxical. It's plentiful when you don't care about it and scarce when you need it most. Given the way it waxes and wanes, it's dangerous to assume the liquidity that's available in good times will be there when the tide goes out." - Howard Marks

    May 06 6:24 AM | Link | Comment!
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