The Gavekal Ethos
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.