We ended the last post (the first part of a discussion with Harris Kupperman - "Kuppy") discussing Mongolia and then Cambodia. In this discussion Harris and I moved on to the state of the world economy, and Japan in particular.
Chris: We're living in a very unique investing environment at present. Frankly when I look around at what our monetary system looks like I'm terrified. Credit expansion by central banks has gone parabolic. For reference we're in a period where worldwide debt to GDP is the highest its ever been…EVER…and this in peacetime!
As an investor, trader and speculator these setups typically make me stand up and take notice. Any parabolic move when one is long, deserves a rapid exit and a potential to take the other side of the trade. Couple this with markets which move largely due to some bureaucrats decision, rather than due to any fundamentals and we have a very very difficult investment environment. Personally, though it may sound counter-intuitive, over the last decade or so, I've been led deeper and deeper into private equity and in particular emerging and frontier markets while keeping a solid position in precious metals and ag commodities.
I find that the risks in developing markets tend to be risks which are in your face. Corruption exists for example, yet is "in your face", easily identifiable and quantifiable. I can no longer quantify risks in the developed markets, and when I can't quantify the risks I'm not comfortable investing my capital. What do you think of this and how are you positioning your hedge fund in this environment?
Harris: US equity markets have more than doubled since the lows in 2008. I see no bargains. We're mostly in cash and when I say cash, I mean gold. I'm waiting for new opportunities. The real money isn't made by guessing if a 13 PE should be a 15 PE. It's by finding those shakeouts that are supposed to happen every hundred years, but seem to happen about every 5 years.
Chris: (laughs) Indeed, we have Ben and buddies to thank. You and I've spoken at length before about Japan and the Yen. I dived in a little before you I believe on the short side. Right now I'm waiting for a Yen bounce, but who knows, maybe we don't get it. I mean a 14% move in such a liquid currency market is a substantial move, however when I look back at currency markets over the last 30 years or so, volatility is increasingly part of the new game. The new normal. A 15% move is no longer what a 15% move used to be.
Japan as I've mentioned before has the unique ability to have a seriously disorderly move in both its currency as well as its bond market. People tend to forget that government bonds are really just long-dated currency. I've seen arguments where analysts are trying to make the case that JGB's can remain at present interest rates while the Yen goes beyond 100 to the dollar. Am I missing something here?
Gold in Yen (photo credit to xe.com)
Harris: I booked my Yen short. I was a bit early, but that's life. I don't see how the Koreans or Chinese can let the Japanese continue to weaken their currency. It's a race to the bottom by all three.
That said, the Japanese cannot afford to allow interest rates to rise. I think that the same can be said for all central banks. Wouldn't it be perverse if interest rates stay at historic lows even while everyone prints money? I could see a world where the central bankers succeed beyond their wildest dreams in terms of cornering the bond markets of the world and also stoking epic inflation.
Chris: Yes, you know it's surreal to think about it but then again I find it surreal that we're at this stage in the game across the indebted (read "developed") world. If Government bond markets are drugs then Japan has the crack cocaine of the lot. It's one uniquely unstable financial environment, and now it would seem increasingly unstable geopolitically. Abe is taking steps to beef up the military. History is replete with examples of bankrupt nations fomenting war. We both speak to people from all over the world on a daily basis, what is your sense of the threats on this front?
Harris: I don't think we're ready for war yet. Young nations start wars. Japan, China and Korea are mostly made up of senior citizens. Seniors worry about their health care-they're not thinking of fighting. The politicians may try to start wars, but the wars will be in the Middle East and other young countries.
Chris: Still I wonder about the societal impact when the Yen takes out 200 or 300 to the dollar and the bond market cracks. It was fascinating and horrifying to watch it take place in Zimbabwe, and you would have had some insights on your trip there as to what life was like, but you know, Zimbabweans for the most part where poor people to begin with and still they suffered massively. Much of the progress will be reversed, of that I'm confident, as we need only look at how it has played out previously.
I'm all for lithe, young Japanese girls draped in loin cloth riding horses…essentially reversing 100 years of progress. Do you think this could be a catalyst for central bankers to re-examine Keynesian policies?
Harris: Young girls on horseback?? You must be talking about a Japanese government bond marketing campaign… lol. For JPY to take out 200 or even 300, you need the USD to strengthen. Do you think the US is in much better shape than Japan? It just won't happen. The world will collapse in a very inflationary round of money printing - but it will trick most people until the final, dramatic stage when you cannot ignore it any longer. People will see the various currencies acting relatively stable and not think that their currencies are in free-fall - because they won't be in free-fall against other currencies, but rather, they will be in free-fall against "stuff".
Central bankers won't re-examine Keynesian policies because they're not paid to do that. They will continue to print, because that's all that they know how to do. Communism only ended when even the guys at the top, realized it wasn't working any more. The same will happen with Keynesianism. You need these countries to consume themselves from within, and it won't be quick. It will take decades before it finally collapses. Most of the Western world is still quite wealthy. This wealth needs to be destroyed first.
Chris: Sobering…long horses, loin cloth and gold then! Until next time. I'm going to get a stiff drink.
Harris: Maybe I'll join you.
"Gold may be a standard asset-class in the portfolio of Japanese pension funds as Abe's target is realized." - Itsuo Toshima (Advisor to Japanese Pension funds)