On China, Japan, Gold, Long-dated Treasuries, QE policies and the China Study – Part IV!

From: Aditya Rana
Date: Sat, Nov 3, 2012 at 2:54 PM
Subject: On China, Japan, Gold, Long-dated Treasuries, QE policies and the China Study – Part IV!


A key requirement for successful investing over time is to pay heed to iconoclastic views on markets and asset classes and there are few people who can match Hugh Hendry (who runs the hedge fund Eclectica Asset Management) and David Einhorn (who runs the hedge fund Greenlight capital) in that regard. Both are successful and well known hedge fund managers, having anticipated the2008 financial crisis and making contrarian bets on unloved assets which subsequently performed well. To highlight a few – gold (Hendry in 2002 and Einhorn a few years later) , long dated treasury bonds (Hendry in 2006), short Lehman (Einhorn in early 2008) and short Europe (Hendry in 2009).They both spoke a recent conference organised by the Economist (http://www.livestream.com/theeconomist/video?clipId=pla_36cbc150-b893-4af6-b820-0570d08fd4da – Hendry at the beginning and Einhorn at about 56 minutes) and I summarise below their views on a wide range of topics like China, gold, long dated treasuries and the impact of QE policies :

Hugh Hendry:

A crisis event is usually required to bring about a repricing and rebalancing of assets and economic variables which have moved to extreme values – for example, the TMT crisis in 2000 was needed to reverse the multi-decade trend of stocks dramatically outperforming real assets like commodities.

-Hendry went long gold in late 2002 in anticipation of this relative outperformance of stocks versus commodities to reverse itself – the bet paid off handsomely and his fund was up 50% in 2003.

-Hendry switched focus from gold to long dated US treasuries in 2006, in anticipation of another crisis to correct the imbalances which had built up since the TMT crisis and the resulting likelihood of central bank intervention to support the markets. His fund was up 50% in October 2008!

-Hendry currently thinks that the next big crisis is likely to emanate from Asia with the mercantilist export model (i.e. exporting savings and importing income) being in a death spiral , causing immense pain to the creditor nations like Japan and China.

-Japan and China have amassed huge foreign currency assets of about $3 trillion each (in Japan’s case it includes the net assets held by the private sector) by effectively shorting their currencies in order to keep them cheap and support their mercantilist export models.

-This era is now coming to an end and he would not be surprised to see a massive appreciation of their currencies through a “short squeeze” process bringing the $/yen level to the late 50s or the early 60s. This would precipitate widespread corporate bankruptcies in Japan.

-China is currently playing the role of the US in the 1920s by being a creditor nation, while the US is currently in the position of the UK which was the global hegemon then. Severe downturns hit creditors nations harder than debtor nations – the UK economy declined by 8% from peak to trough while the US economy declined by 23% in 1931.

-China’s GDP growth has been fuelled by massive investment with negative marginal real returns and therefore does not have the income to pay off the debts incurred to finance this investment. With the developed world not recovering fast enough to buy goods from China, a crisis event is likely to correct this imbalance.

-It would be possible to correct this imbalance through reorienting the economy towards domestic consumption – but that is a long and painful process as Japan has shown over the last two decades.

-Hendry has been long gold and short the S&P for a while – the trade has been profitable but less than expected as the S&P has been supported by QE policies of the central banks. He is also long gold and short gold mining stocks, as mining stocks are subject to confiscation risk if gold prices move higher.

David Einhorn:

-QE policies by central banks have reached a point where they are detrimental to economic growth and have significantly increased the tail risk in markets. This is contrary to the reflexive group think currently prevailing in policy and economic circles which supports further QE.

-Zero interest rates have curtailed consumption by forcing people to save more for retirement as their interest income has dramatically come down. Lowering interest rates can only be stimulative to the economy when rates are high.

-The view held by the Fed that QE policies boost growth by inflating asset prices as the discount rates to value them are lowered is not necessarily true as that effect may not counteract the negative impact on savers. In addition, by boosting commodity prices they have further reduced the income levels of consumers.

-The unprecedented increase in balance sheet by the Fed have significantly increased the tail risk in the markets and economy, making businesses more cautious in investing and consumers more cautious in their spending.

-A carefully telegraphed policy by the Fed to increase interest rates will be beneficial to economic growth rather than a continuance of the current QE policies.

As I mentioned earlier, it is always interesting to hear the views of these two men even though one might not agree with them! Hendry makes the deeper and more interesting points (and as is usual in his case) puts the current situation in a historical context. As I have argued in previous newsletters, I agree that China has a serious problem to tackle in the future in terms of its malinvestment, but it is unlikely to result in a crisis event as: 1) China has successfully implemented a policy of financial repression through the low interest rates its pays on its massive domestic savings, 2) China does not have a mark-to-market system and its banks can therefore work-out the bad assets over time – and carry them at a very low interest cost. In addition, slowly improving developed economies will provide gradually improving demand for its exports. So yes, a decade of sub-par growth (7-8%?) in China is likely as it works out its problems, but a hard landing remains a remote possibility.

David Einhorn’s views on the negative impact of QE policies unfortunately make the standard arguments against QE policies, and while perhaps true in a narrow sense, are not supported by historical experience and hard analysis of economic data. QE policies, by making real rates negative, have clearly shown to have a positive impact on the economy as a whole via the wealth impact and also boosting consumption and investment via lowering the real financing cost. While they may have a diminishing impact, it is a far stretch to hold the view (ideological rather than based on hard anlaysis) that the impact is actually negative!

The China Study – Part IV (Prof. Colin Campbell, Cornell University):

To follow-up on last week’s summary of the second-half of the chapter on cancer, I present below an introduction to the chapter on “Lessons from China”:

-The landmark China Study began with study visit to Cornell by the deputy director of China’s premier health research laboratory in the early 80s. The study leveraged the monumental work initiated by premier Chou Enlai in the 1970s (as he lay dying of cancer) which involved a survey of 2,400 counties across China (880 million people) by 650,000 workers! The end result was the China Atlas which displayed the geographical incidence of cancer and other diseases across China in the form of a colour-coded atlas.

-The atlas made clear that cancer in China was geographically localized, and while cancer incidence has been known to vary across countries, the geographical variation in China was much greater even though 87% of the population belonged to the same ethnic group.

-The question to be answered was why was there such a massive variation in cancer rates among people with similar genetic backgrounds – might it be that cancer was largely determined by environmental and lifestyle factors?

-A team was formed including Professor Campell, Professor Peto from Oxford University (a world renowned epidemiologist) and the Chinese Academy of Medical Sciences to utilise the disease mortality data from the China Atlas for a variety of diseases, and conduct a survey of 65 counties across China (in rural and semi-rural areas) which included blood and urine tests, questionnaires on food and lifestyles and careful survey of daily diets and food sold in the marketplace.

-The focus on rural and semi-rural areas was intentional as they wanted to study people who mostly lived and ate food in the same area for most of their lives – 94% of the people in the study lived in the same area as they were born. One half of the population was male and the other half female and were aged between 35 and 64 years.

Statistical analysis was conducted on the vast amount of data to compare diet, lifestyle and disease characteristics in the sample population. Average values of the county populations was compared rather than individual to individual comparisons.

-The study was, and still is, the most comprehensive of its kind ever conducted with a study of 367 variables including 48 diseases, 109 nutritional, viral and hormonal indicators in the blood samples, 24 urinary factors, 36 food constituents (nutrients, pesticides and heavy metals), 36 specific nutrients and food intakes measured in the household survey, 60 diet and lifestyle factors from the questionnaires and 17 geographical and climatic factors.

-A unique aspect of the study (being an ecological study) was to study as many dietary and lifestyle factors and their impact on diseases rather than try and isolate a cause-and-effect relationship between single causes and outcomes, as nutrients work through multiple channels and chemicals acting together, as in foods.

To be continued!

Here is to being iconoclastic – with regard to markets, food and life in general!



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