The Gavekal Ethos

Financial Mirror (Cyprus) - - FRONT PAGE - By Charles Gave

In re­cent days a num­ber of our read­ers have ex­pressed sur­prise — even be­wil­der­ment — at the dif­fer­ence of opin­ions within Gavekal on some im­por­tant top­ics. “What,” they ask, “is the Gavekal house view?” This is a per­fectly le­git­i­mate ques­tion, and as chair­man of the firm, it is my duty to ex­plain our po­si­tion.

The sim­ple an­swer is that as a firm, we try to avoid “group-think”, al­ways en­cour­ag­ing in­di­vid­u­als — whether part­ners or an­a­lysts — to present well-rea­soned, ar­gued, and doc­u­mented points of view on their own mer­its. The rea­son for this is sim­ple: we be­lieve that through de­bate and by chal­leng­ing each other’s views we can best re­fine our own ar­gu­ments, and so present more in­ter­est­ing ideas to our clients. Oc­ca­sion­ally this process can lead to pub­lic dis­agree­ments that may dis­con­cert some read­ers. But, as Ana­tole Kalet­sky likes to say: “Our clients are not chil­dren, and we are not their par­ents. We needn’t feel obliged not to fight in front of them”.

The present, as our clients have ob­served, is one of those times of dis­agree­ment. The di­ver­gence of views has been build­ing for a while. Un­til a year or so ago, al­though we may have dif­fered on the fun­da­men­tals, we were able to agree eas­ily enough on the struc­ture of the port­fo­lios that we would rec­om­mend: over­weight the US, ex­pect­ing the US dol­lar to rise, the price of oil to fall, in­fla­tion to re­main either low or very low, and long rates to de­cline. Those days are over.

As I wrote in June, quot­ing the great Yogi Berra: “When you come to a fork in the road, take it!”

So, what is the fork now in front of us? To the right, we have what I would call the re­turn to a nor­mal cy­cle. The great dis­tur­bance of 2008-2009 has fi­nally been ab­sorbed. The US econ­omy con­tin­ues to grow, al­beit more slowly than be­fore. The US dol­lar has made its high, and long yields their lows, to­gether with US in­fla­tion. If the world fol­lows this road, it is now time to un­der­weight Amer­ica and move cap­i­tal out of the US.

By con­trast, to the left we have the risk of some­thing un­ex­pected: a mas­sive rise in the value of the US dol­lar, sim­i­lar to the one which fol­lowed the last great Key­ne­sian ex­per­i­ment ini­ti­ated in the 1970s by Fed­eral Re­serve chair­man Arthur Burns. Most of the time, peo­ple an­a­lyse cur­ren­cies on a flow ba­sis, look­ing at dif­fer­ences in in­ter­est rates, cur­rent ac­counts, cap­i­tal flows, pur­chas­ing par­i­ties, and so on. For 90% of the time this ap­proach works. How­ever, once in a while, a prob­lem of stock arises. By 1981 the short po­si­tion on the US dol­lar — the dol­lars bor­rowed in­ter­na­tion­ally — was greater than the US money sup­ply. Tech­ni­cally the mar­ket had been cor­nered, and the dol­lar went bal­lis­tic. In 1985, in what amounted to the first great quan­ti­ta­tive eas­ing in his­tory, the Fed ex­tended mas­sive swaps to the world’s ma­jor cen­tral banks to al­low them to break out of the cor­ner. Some­thing sim­i­lar hap­pened in 2008.

My con­cern is that we could be in a sim­i­lar sit­u­a­tion again to­day. If we are, then the US dol­lar will go through the roof, US in­ter­est rates will fall by at least half, and US in­fla­tion will turn neg­a­tive. I am not say­ing that the world econ­omy def­i­nitely will take this left hand fork; I am say­ing that it could. So, for in­vestors, the so­lu­tion is not to bet on one or other out­come, but to build a port­fo­lio which will de­liver ac­cept­able per­for­mance which­ever hap­pens.

This is dif­fi­cult, be­cause the two sce­nar­ios are clearly not com­pat­i­ble with each other. The only hedge against the sec­ond sce­nario, which would dev­as­tate coun­tries and com­pa­nies with US dol­lar debts and neg­a­tive cash flows, is for in­vestors to hold a siz­able pro­por­tion of their as­sets in US zero coupon bonds, with a pref­er­ence for con­stant du­ra­tions of seven years or more, which would rally even as eq­uity mar­kets tanked. In par­al­lel, in­vestors should buy far out of the money US dol­lar calls to pro­tect their port­fo­lios against a six sigma event, pray­ing that th­ese calls never move into the money.

On the eq­uity front, if we are mov­ing into de­fla­tion, in­vestors should own only the shares of com­pa­nies sell­ing goods and ser­vices elas­tic to prices. Th­ese are eas­ily iden­ti­fied, be­cause to­day they are the ones with ris­ing sales. In­vestors should elim­i­nate com­pa­nies which have fall­ing sales from their port­fo­lios, as th­ese com­pa­nies are ob­vi­ously sell­ing goods and ser­vices which are in­elas­tic to price. In the sec­ond sce­nario, they would get killed. Dur­ing the lat­est earn­ings sea­son fewer than half US com­pa­nies re­ported ris­ing sales, so eq­uity port­fo­lios in­vest­ing only in com­pa­nies sell­ing goods and ser­vices elas­tic to prices will have mas­sive track­ing er­rors against the in­dexes. This is the price you will have to pay if you want to sur­vive.

At best, this is a com­pro­mise port­fo­lio. In sce­nario two, it will not get de­stroyed; but in sce­nario one, it will un­der­per­form. It is, how­ever, the prod­uct of Gavekal’s ethos of free and open de­bate.

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