“The superior man, when resting in safety, does not forget that danger may come. When in a state of security he does not forget the possibility of ruin. When all is orderly, he does not forget that disorder may come. Thus his person is not endangered, and his States and all their clans are preserved."
-Confucius
While our Confucius (Keith) is on T.V. this morning, I’ve been handed the pen on the Early Look. The real Confucius is, of course, the ancient Chinese philosopher whose writings have influenced China in varying degrees for the last 2,000 plus years. They espouse a practicality and logic that can be transferred readily to many types of societies. The quote above suggests that the superior man, or government, will proactively plan for the future. In money management, we call that a Risk Manager. These are typically the guys or gals with long careers.
The United States continues to be the global leader in GDP market share, but its share has consistently eroded over the past ~35+ years. Based on current and projected GDP growth rates, and GDP growth capacity of nations, it will not be long before China surpasses the United States. While this may be shocking to some, the reality is that this is really Back to the Economic Future in terms of economic market share as China had a larger economy than the United States for most of the 1800s.
Many astute short sellers are incredibly bearish on the prospects for China. Jim Chanos, an investor who we hold in regard for more than the fact the he roomed with current Yale Hockey Coach Keith Allain in college, is at the top of that list. Having never spoken to Jim about China specifically, what I can surmise from reports is that his thesis is primarily based on the inaccuracy of government data (“they make it up”) and that there is serious risk to the banking system in China due to writing a lot of bad loans.
Even if Jim is correct, we would be remiss to believe that China’s GDP market share gains will slow for the longer term. As Kenneth Rogoff and Carmen Reinhart write in their must read book, This Time Is Different:
“China’s four large state owned banks, with 68% of banking system assets, were deemed insolvent. Banking system nonperforming loans were estimated at 50%.”
They were referring to the epic bank failures in China in the late 1990s. When 68% of your banking system is insolvent, it can’t get much worse. But guess what happened over the ensuing decade? China recovered and continued to take massive GDP market share. This centralized communist government led the nation back from the financial abyss.
While our financial crisis is largely behind us, the reality remains in the United States: healthcare needs reforming, the longer term impact of entitlements needs to be addressed, mounting national debt issue needs to be resolved, and our financial system needs better regulation. Absent a permanent super majority in congress, which seems unlikely to happen, the only way anything will be accomplished is if the parties work together in the spirit of a true constitutional democracy.
For that to occur, it will require a willingness of whomever the President is at the time to reach across party lines and work with his or her political opponents. The four issues outlined above need solutions and if they aren’t addressed the longer term outlook for investment in the United States and in United States government debt (especially at current prices) is a lot less compelling than other nations.
With the startling victory by Scott Brown in Massachusetts, one would hope that that both the President and the Democrats realize that while they have the power, they need to respect the middle and independents it they have any hope to effectively govern and solve any of the major problems facing the nation.
We have been writing to our subscriber base that we expect to see a shift in politics in the coming years. A shift to more independents and independent candidates, as the electorate continues to lose faith in the partisan political system. A recently poll from Rasmussen suggested that Americans unaffiliated with either party is now at 32.3%.
The immediate term market reaction to this shift in the character of political and government leadership is a continued Buck Breakout. This morning the U.S. dollar is breaking to 5-month highs based on recent political events and the anticipation of continued change. This change will come in the form of politicians whose core qualification for being elected is not already having been a Washington Weasel (an elected politician).
Our current political system is beholden to the attempts of both parties to implement a tyranny of the majority. In the Federalist Papers, Publius defined the tyranny of the majority aptly:
“. . . a number of citizens who are united and actuated by some common impulse of passion, or of interest, adverse to the rights of other citizens, or to the permanent and aggregate interests of the community."
This quote embodies our current age of politics. Yesterday, President Obama was out pumping that this remains, “the second largest Democrat majority in a generation.” While this is factually correct, that emphasis is not exactly what the Founders had in mind. The reality of continued attempts at tyranny of the majority in the United States is political deadlock and Back to the Economic Future for global GDP market share. China gains, we lose.
Keep your head up and your stick on the ice,
Daryl G. Jones
Managing Director
LONG ETFS
XLK – SPDR Technology — We bought back Tech after a healthy 2-day pullback on 1/7/10.
UUP – PowerShares US Dollar Index Fund — We bought the USD Fund on 1/4/10 as an explicit way to represent our Q1 2010 Macro Theme that we have labeled Buck Breakout (we were bearish on the USD in ’09).
EWG - iShares Germany —Buying back the bullish intermediate term TREND thesis Matt Hedrick maintains on Germany. We are short Russia and, from a European exposure perspective, like being long the lower beta DAX against the higher beta RTSI as well.
EWZ - iShares Brazil — As Greece and Dubai were blowing up, we took our Asset Allocation on International Equities to zero. On 12/8/09 we started buying back exposure via our favorite country, Brazil, with the etf trading down on the day. We remain bullish on Brazil's commodity complex and believe the country's management of its interest rate policy has promoted stimulus.
CYB - WisdomTree Dreyfus Chinese Yuan — The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.
TIP - iShares TIPS — The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are mispriced and that TIPS are a efficient way to own yield on an inflation protected basis.
SHORT ETFS
EWW – iShares Mexico — We do not want to be net long Latin America (Brazil) anymore. Mexico short is a solid compliment to our short position on oil and our concerns about sovereign debt risks.
USO – United States Oil Fund — We have been waiting, patiently, to short the US Oil Fund on an up day, which we got on 2/2/10. We are bullish on the Buck and bearish on China right now. These factors contribute to our multi-factor (bearish) intermediate term stance on the oil price.
EWJ – iShares Japan — We shorted Japan on 2/2/10 after the Nikkei’s up move of +1.6%. Japan's sovereign debt problems make Greece's look benign.
UNG – United States Natural Gas Fund — Macro DJ (Daryl Jones) and I remain bearish on Commodities. Natural Gas had a healthy price pop on 2/1/10, prompting us to short it.
XLE – SPDR Energy — The Energy ETF was up +1.7% on 1/29/10 and we remain bearish on both oil and commodity prices for the intermediate term. Shorting green.
SPY – SPDR S&P 500 — The SP500 broke our intermediate term TREND line earlier this week and remains broken. The 4Q09 GDP report confirms that Bernanke has to raise interest rates. ZERO is not a perpetual policy unless the USA wants to become Japan. We shorted SPY on 1/29/10.
GLD – SPDR Gold Shares — We re-shorted Gold on a bounce on 1/25/10. We remain bullish on the US Dollar and bearish on the intermediate term TREND for the gold price as a result.
IEF – iShares 7-10 Year Treasury — One of our Macro Themes for Q1 of 2010 is "Rate Run-up". Our bearish view on US Treasuries is implied.
RSX – Market Vectors Russia — We shorted Russia on 12/18/09 after a terrible unemployment report and an intermediate term TREND view of oil’s price that’s bearish. Russia’s GDP fell 7.9% in 2009.
EWJ - iShares Japan — While a sweeping victory for the Democratic Party of Japan has ended over 50 years of rule by the LDP bringing some hope to voters; the new leadership appears, if anything, to have a less developed recovery plan than their predecessors. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.