Thursday, January 11, 2018

2018: Images from the crystal ball

As 2017 draws to a close, it is time to peep into the crystal ball for 2018. But before that let me just quickly give a brief prelude.

What a year!
2017 was supposed to be a dramatic year. Back in 2011, from the extent and nature of QE, I expected around 2017 to be the year when the shit hits the fan. How wrong was I! In the intervening period I was caught off guard by a smallish slowdown, a central bank response that far outweighed anything we have seen and an unprecedented surge in valuations.

Asset prices have increased over this period since 2013. In 2017, they have reached their all times highs. The valuations of all the asset classes increased almost linearly. Many are more expensive than 2007. The art market has gone up substantially. Bitcoins are the new game in town creating large price changes on an almost daily basis.

Inflation, on the other hand, has been relatively benign. Not much is happening in food prices. Oil and Gold, the two special 

The dichotomy between these two is quite important. In Subverting Capitalism and thereafter on this blog I have maintained that when you pump money while watching the inflation basket, it leads to non-inflation basket asset price inflation. This relative price discrepancy gets corrected as prices can flow through two central asset classes - oil and homes. Oil is on its way to becoming irrelevant. But not homes.

In 2018
Some of the important events that are likely in 2018 seem as follows:

Home prices, however, continue to rise till they break inflation.
Home prices across the world rallied between 2003-04 till the peak in 2007-08. The rise of the home prices was at an unprecedented rate. There was a lull in 2008-2010 period. While prices crashed, the house price to median income ratio was high. Since 2010, the housing prices have started rising. The rise has been documented by IMF here and by Economist here.

So how higher can these go? Well, they will go till they break inflation on the upside. There is a condition. The prices may not go up if artificially cooled. Singapore has done it, Canada is considering it and others are monitoring the house prices. In effect, house prices are almost included in the inflation basket. When that is the case, the excess money has to move somewhere before Fed and other central banks can suck it out. Commodities - gold and oil offer such bets.

Oil touching $100 then retracing back to $40-$45
Not many are pricing oil beyond $70 at present. Apart from one call from Goldman, there seems to calls for high Oil prices. Oil is also becoming irrelevant. It has now been established that "peak oil" is more peak oil demand rather than peak oil supply. The decision of Saudi Aramco to go for IPO is an acknowledgement of this reality. These days, IPOs are an exit for promoters not call for investment with promoters.

Oil is surprisingly inflexible in the short term and almost surely irrelevant in the very long term. It is possible for short-term geopolitics to drive a supply squeeze to push prices up. At present geopolitics is in a stalemate. As much as Saudi Arabia likes higher oil prices, those will help Qatar and Iran too. Further, the real target of low oil prices - US Shale producers have turned out to be more resilient than anticipated. Thus quagmire will solve itself gradually. With Russia entering the picture in the Middle East, you can be sure Oil price will rise in short term. The higher oil price beneficiary group is bigger than the low Oil price beneficiary group. Higher oil price will also ease pressure on Venezuela.

At the same time, I do not foresee Oil sustain at $100/bbl. After the $100 rendezvous, oil may recede back to $40-$45 range. So at present, I would like to be long oil right all the way till $100 and then short oil right till $55.

The story of 2017 is the breakout of bitcoin. Where will bitcoin go in 2018? More important than that question, what effect will bitcoin have on the main economy?

Return of Japan
2018 should be the year when Japan makes a comeback. There are a bunch of quality companies that have been stuck because of Japan's economic stalemate. I think Japanese companies will see some traction this year. Japans social re-engineering is going to be the thing to watch for. If Japanese women truly join the workforce and are allowed to operate at their potential then we could see something remarkable. It is possible that whole new segments of the economy may be created to support the working women. It will be stimulus twice over.

Europe - See-Saw?
Eurozone is basking in a bit of sunshine this winter - good news flowing all around. The French are putting their house in order with labour reforms. There is a decent amount of growth and banks are more healthy than ever before. There are some weird signs though. The Greek and Portuguese bonds seem to be too cheap. With these indicators what can go wrong?

Not much this year it appears. Europe should perform well in first half and the worries may appear only in late 2018. The ECB and SNB have bought substantial amounts of corporate bonds. This is not a great sign if you ask me. In a recent podcast, Felix Zulauf highlighted this. I was struck by his assessment impact on future of bond markets such moves are making. 

Impact on Politics
The response to the financial crisis of 2008 has left many befuddled. Mark Yusko, in his letter points to the very same issue - the actual behaviour of markets is at odds with the fundamentals. It is indeed. But aside from those issues, we must assess the other slow-moving forces this has unleashed - particularly in politics. Politics has become increasingly expensive because of this central bank policy.

That means we do not get the reform that is necessary. Thus, we have an enormous tax compliance process that is weighing the growth down. Yet, Democrats won't acknowledge that. Conversely, the Republican tax proposal does not simplify or ease that burden but complicates it even more.

What we also get are politicians who are increasingly out of touch with the citizens.

Coming War?
The combination of out-of-touch politicians, economic interests at loggerheads, economic and policy stagnation, distrust and fake news is a potent powder keg searching for a spark. My scenario for war now looks likely.

China's policy with One Belt One Road and lending-driven quasi-colonisation is also bound to create dissidence. The US and developed world will put pressure back on China by reducing demand for its factories which can service almost entire world's demand (maybe twice over) using robotics and automation. Automation, it is my belief, is the result of the prolonged low cost of capital. In that sense, China's communists will get a taste of Marx - Capital V Labour.

Add the uncoordinated US strategies in the Middle East, the fundamentalist strain of Islam and we have making of a world war. This Middle East angle de-escalated a bit after Iraqi victories against IS in Iraq and Syria. Yet, the threats continue. Iran may not be the problem area it appears now. The wildcard could come from Af-Pak area.

In Sum
We may be looking at an interesting year in 2018. 

Knowledge improves Risk Mitigation

Improved knowledge of business domain: A person who has better knowledge of the nature of risk is better placed than person without any knowledge.  What you want to know is - where are the bargaining power centres, do you understand them and who owns them and whether you can change those. Given my knowledge of pharma and allied sectors, I do not invest in pharma.

Improved knowledge of parties involved: If you know the founders well, you may be able to take higher risks than otherwise. You may also "know" competitive landscape - what they think, how they act.

Mechanisms to hedge risks are available and known: Hedging mechanisms are not always obvious. Not always "options" will solve your problem. Your knowledge must be comprehensive enough to determine what are the hedging mechanisms involved. Sometimes you can create an alternate product line to improve your bargaining power. 

With knowledge, you can better understand the risks. For you, the risks will be lower than others.