The Quants Live On
Stateside, the "quants" -- quantitative hedge funds that have survived the initial panic -- seem to have survived with some remaining assets, if not dignity.
Two Goldman funds, JPMorgan's Highbridge fund, AQR, Tykhe, Renaissance Technologies, and other quant funds have been badly hurt by the subprime mushroom cloud, but seem to have rebounded sharply in the last couple of days. However, there is a new concern on the horizon: inflation.
Inflation on the Rise
China announced yesterday that its core inflation rate had surged to 5.6 percent. As I predicted in July's newsletters, Chinese inflation has been dramatically understated for a long time. For China to admit that its inflation has gone from about 4 percent to 5.6 percent in one year not only understates the extent of their problem (you have to realize that authoritarian governments, particularly Asian ones, understate any and every problem until the last possible moment), but also tacitly admits that the Chinese government has completely lost control of its monetary policy.
More evidence of understated inflation comes from Chinese capital flows. In the past three months, as global equities markets have begun a significant (and incomplete) retreat, Chinese equities have barreled ahead to even more ridiculous levels. Insane? Of course. But as insane as keeping money in Chinese banks? Definitely not. Chinese investors are picking up their savings deposits and running to the Shanghai and Shenzhen exchanges, because nominal interest rates on their deposits are not changing as real interest rates on their deposits, already negative, are only getting more negative.
All this has to be putting enormous pressure on the Chinese banking system [sic], which already groans under a colossal and unknown weight of bad debt. If the Chinese act as they previously have, they will announce their own banking problems shortly. The Chinese government doesn't look particularly incompetent in admitting mistakes if the international financial system has already made the same mistakes.
However, inflation is getting worse around the world. The European Central Bank (ECB) has injected some $270 billion into the world economy over the past several days, the Fed over $50 billion, and smaller central banks about $20 billion more. The ECB's monetary stimulus has easily exceeded the stimulus it provided on September 12, 2001. While that did stop a worldwide equities free-fall on Friday, the central banks will have to remove that stimulus over the next several months. The European-American monetary base has probably grown 15 percent during this timeframe, even as the economic base has probably fallen.
At the same time, the financial markets are howling for a rate cut at the Fed's next meeting. This will be "Helicopter Ben" Bernanke's first major test, and if he reinforces the Greenspan Put (bailing out financial firms with interest-rate cuts every time they screw up), the dollar will go into freefall, and gold will go up.
The Golden Safehaven
Gold is a very good place to be right now. Many quant funds have been unwinding long gold positions to cover bleeding short positions, making gold cheap regardless of fundamental factors (inflation expectations and macroeconomic factors) -- which are as favorable to gold as they have ever been. If the Fed does not bow to the investment banks' squealing, money will flow out of stocks and into safer assets (usually good for gold). If it does, inflation expectations will rise significantly, which will be very good for gold. I simply don't see how anyone can be bearish on gold at the moment.
Oil is trickier. Two weeks ago, I predicted that oil would go down as the subprime contagion spread and economic growth expectations fell to more realistic levels. And lo, oil has come down (slightly).
Higher inflation expectations will mean more medium-term economic activity, and more expensive oil. However, the overall macro outlook will remain flat at best, which means cheaper oil.
As the central banks necessarily withdraw some of the huge financial stimulus they have provided recently, quant funds' correlation matrices will swing out of whack again, forcing smaller reruns of what we saw last Thursday and Friday. Furthermore, mergers and acquisitions have simply collapsed. Feverish M&A activity had been a major boon to US and European equities valuations, and the "M&A Put" is gone for the foreseeable future.
Markit.com's ABX, CDX and CMBX credit spreads have halted their vertical trajectory, but they haven't exactly reverted to historical levels, either. To wit:
The CMBX spreads in particular do not inspire confidence that "the crisis has passed".
The Bottom Line
In summary, I am long gold. I am neutral on oil and assorted industrial commodities (which will be more driven by short-medium term macro factors, aka Fed activity). I am short equities--European equities in particular. I am short Treasurys. Going long corporate bonds would be risky, but might well pay off a year down the road.
And, of course, I am long cash.
--Alex Forshaw,
http://www.bestwaytoinvest.com
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