What We Don't See - July 2005 From GaveKal Research Our favorite economist, Frederic Bastiat, used to say that economics was all about weighing "what one can see" against "what one can not see'. And while we realize we have used this quote repeatedly, we never get tired of it. Indeed, more than anything, it best summarizes what most investment professionals in their daily routine try to do; answer the question of "what do I know that the market does not?". We felt it might be interesting to review what we see, but we believe the market does not. What The Market Does Not See: the Euro Carry-Trade Every now and then, central banks fall asleep on the job and allow their currencies to achieve very overvalued levels. In turn, this slows down the underlying economy, a fact which then forces the central bank into cutting rates aggressively to counter-balance the tightening done by the FX markets. When such a turn of event occurs, financial market participants jump on it with both feet; all of a sudden, financiers are given an opportunity to borrow in a currency which a) goes down and b) whose borrowing costs keep falling. What we are describing above is not theoretical. In fact, it has happened twice in the past decade. And it is about to happen again. A fact with important investment consequences. Between 1995 and 1998, a number of investors participated in the great "Yen carry trade". For three years, it was fantastic: whatever one bought with one's borrowed Yen, one made money. Until one did not; and then the unwinding of the Yen carry trade was both violent, and painful for those involved in it (Tiger, Sumitomo...). From 2001 to 2004, we experienced the great US$ carry trade. As we tried to show in a number of reports in the past couple of years a large number of people borrowed US$ on the premise that a) the US$ could only go down and b) borrowing US$ was nearly free (1% interest rates) and likely to stay that way for a very long time. Needless to say, the US$ carry trade is no longer working. For a start, the US$ is no longer falling, and borrowing US$ is no longer free (the Fed just raised rates again). In turn, this raises an important question: will the unwinding of the US$ carry trade prove as painful as the unwinding of the Yen carry-trade? As our readers know, we have argued in recent months that the unwinding of the US$ carry-trade could lead to some short-term dislocations in the financial markets. However, so far this year, the US$ on a trade-weighted basis has risen +11% in a straight line, and the impact on financial markets has been mild. So have our fears on the effects of the unwinding of the US$ carry-trade been excessive? One explanation for the good tenure of markets in the face of the US$ rally is that most investors short the US$ (save the ones who got in the game late) are still positive on their short US$ trade. Meanwhile long-term bearishness on the US$ remains prevalent (i.e.: the belief in the "unsustainability of the US current account deficit), and so panic has not yet hit the market. As the reality of the US$ bull market sets in, we will of course witness a change of behaviour in financial market participants. Will this change be a panic? Or will the change be a hunt for new opportunities? We use to believe it would be the former. We now believe it could be the latter. Indeed, all around the world, it is becoming increasingly obvious to investors that there is one currency which remains grotesquely overvalued, and whose interest rates can only go down: the Euro (though the AU$ also qualifies). So borrowing Euros to buy whatever else now makes a lot of sense. The US$ carry trade is in the process of being replaced by the Euro carry trade. This means, of course, that we should expect European monetary aggregates to accelerate rapidly (as they have done). After all, if the whole world starts to borrow Euros, then there will be a lot more of them around! The question then becomes: what will investors do with their borrowed Euros? So far, investors have been buying a lot of European government debt and a little b it of European equities. So what could trigger a change in this behavior? Option #1: A real political crisis in Europe (i.e.: a threat by Italy to return to the Lira, or worse, by Germany to return to the DM) leads investors to shy away from EMU government bonds, or at least, to put a "risk premium" on EMU government bonds (European governments are the only governments in the OECD issuing debt in a currency that they can not print at will - a fact which should lead to some "risk premium"). Option #2: The ECB caves in and cuts interest rates aggressively. All of a sudden, European equities and real estate look far more attractive than EMU bonds. Option #3: Returns on European assets start to lag returns on global assets because of the weak domestic growth environment. Investors then start to borrow Euros to buy assets elsewhere (i.e.: real estate in the US, Asian bonds...). The bottom line on the Euro carry-trade: So far, the Euro carry trade has mostly benefited the European government bond market. To us, this seems unlikely to continue. And this for a simple reason: either European economic growth starts to accelerate, in which case borrowing Euros to buy European equities (especially exporters) makes sense and owning government bonds does not. Or European economic growth deteriorates, in which case questions will start to be raised on the ability of European government to meet their obligations; if of course, European governments don't decide to abandon the Euro experiment even before the market forces them to! As we look at the situation in Europe, borrowing in Euros makes a lot of sense. Buying European equities with the borrowed Euros also makes sense (especially if one is bullish on European or global economic growth). But buying European bonds with the borrowed Euros is a risky bet on the belief that things in Europe will stay as "we see them". But can Europe stay on the edge of the abyss without either falling, or walking back? What The Market Does Not See: Asia & US$ Leverage We will never forget the summer of 1984. All over France and Britain, every street corner was mobbed by a hundred American tourists. Why were they there? Because one US$ was equal to one Pound, and ten French Francs! How did the US$ get to be so expensive? Because in the late 1970s and early 1980s, European banks lent US$ aggressively to borrowers in Latin America (Brazil, Mexico...), Africa (Nigeria, Zaire...) and the Middle East (Saudi Arabia, Iran, Iraq...). And the loans seemed safe enough. Weren't all these countries large commodity exporters, and, as such, steady US$ earners? And couldn't commodity prices go only way (up)? And couldn't the US$ only go another (down)? So how could lending US$ one did not have (since one was a European bank) to Brazil or Nigeria not make sense? The answer soon became clear. It would not make sense if a) commodity prices started falling (because of the excess capacity put in thanks to the new debt), b) commodity producing countries started to default and c) the US$ started to rise. As all of the above started to happen, European banks were forced to write off the US$ loans they had made. This implied going into the market to buy back the US$ they themselves had borrowed to lend. In essence, European banks were "short-squeezed". And this US$ short-squeeze triggered the first major US consumption boom of the modern era (and coincidentally kicked off the first sirens on the frivolous US consumer, the unsustainable US trade deficit at The Economist, the Financial Times, etc...). Why are we re-hashing this? Because while History rarely repeats itself, it often rhymes. And in the past few years, we have witnessed a large increase in US$ borrowing through non US$ banks.