Monthly Investment Letter – October 2010

Das Boot – Super Goldilocks – Super Cycle

Leave it to the French: “The looming recession will spur a 60% drop in stocks. The unfolding liquidity-driven Emerging Markets (EM) and commodity bubble will burst just as it did in the second half of 2008.” Albert Edwards, Chief Strategist, Société Générale S.A. – last week.

But certainly the great majority is still not convinced. It seems obvious from our vantage point that the market is merely in a historical continuum of the boom-bust cycle. A 360-degree 3D observation at month-end in October confirmed that at present, we are in the dead centre of the sweet-spot for the risk-trade, EM equities, commodities and Russia-related assets characterised by:

  • the weak US dollar
  • real rates at near zero
  • low valuations
  • high EPS growth
  • surging commodity demand
  • largely benign inflation
  • broad-based global GDP expansion
  • co-ordinated central bank stimulus
  • peak debt pricing
  • and, perhaps best of all, persistently high unemployment in the G7.

Blue skies forever…but “oh mon Dieu,” one of the biggest and most respected banks in Europe is forecasting a 60% stock market crash – a bigger fall than 2008! EM equities and commodity exposure? Is Monsieur Edwards talking about us? After twenty months of hoping for the next leg down, defeatists and misanthropes are becoming martyrs. Way out in the California of days gone bye, men used to say: “If the horse is dead, get off it.”

What is especially fortunate, and hence the opportunity, is that the consensus is still in denial – pessimism remains high, cash is king, bond yields crash, and gold rallies.

Q4 – Das Boot

The year-end “Boat” scenario plays out like this. Bearish sentiment is at its highest level since the long trough of the crisis during summer, as both institutions and private investors saw stocks climb the “Wall of Worry” and watched from the safety of the bond market. One after another, the will o’ the wisps of the 2010 misplaced market panic recede into memory: Greek contagion, global deflation, demise of the Euro, end of Chinese commodity demand, a double dip in the United States derailing the global recovery and “currency wars”. While walking a lonely road for much of the year and standing friendless on the high side of the boat since 15 April 2010, we sense that we are now no longer alone.

Das Boot. The markets remain supportive in November and at year end, money managers and retail investors alike try to play catch-up. Portfolio managers cannot show year-end cash in a rising market or they’ll lose their mandates. Having been underweight the market for most of the year, these managers may be forced to chase return, throwing money at the market by Christmas to avoid being seen sitting on their hands while the world trades higher. Greed will trump fear, driving retail flows. We anticipate the market consensus will join us on the starboard side just in time for the Santa Claus Rally.

All Aboard. We believe that the “Goldilocks scenario” of weak but provisionally positive growth and the longest, most protracted period of anaemic job creation in the United States is optimal for current portfolio construction. That’s because from the perspective of the “risk-trade,” asset appreciation is being driven more by an extended period of near-zero real rates, the possibility of additional Fed stimulus and, most importantly, the declining USD, than by any modest near-term improvement in the US employment numbers.

That has played out nicely for the last 120 days, culminating in the latest round of QE2 last week. Please take your seat – there is plenty of room on the bandwagon.

Citibank has joined the party, with their chief emerging markets strategist Geoffrey Dennis upping the rhetoric in a variation on the theme: “The weak, but not recessionary, macro situation in developed countries is a ‘Super-Goldilocks’ environment… The underlying conditions that have driven markets higher over the past few months remain in place and are likely to do so for several more quarters.”

Super-Goldilocks

Even better, we see the super-goldilocks scenario and have brought “Super-Cycle” – a term not heard since May 2008 – back into the lexicon of Russian hedge fund investing.

Last month, the world’s attention was on the fate of 33 miners trapped in the world’s largest copper mine at Escondida in Chile, where 20 years of digging have left a hole the size of downtown Manhattan. The mine accounted for 10% of global production in 2007, but has since reduced output by 25%.

As consumption of industrial metals increases in China, India and other high-growth economies, production and output capacity are falling below demand. The best resources in the world, like oil, are developed, and the costs/risks of maintaining global production will only escalate.

The confluence of industrialisation, urbanisation, EM population growth, resurgent demand, rising extraction costs and a relatively scarce resources suggest that commodities have entered a “super-cycle”: a decades-long period of higher prices driven by the emerging middle classes, rising living standards leading ultimately to American-style individual consumption levels. This represents a one-directional shift in power, prestige and demand from West to East. But the trend is not limited to base metals. There is only a finite amount of oil and other commodities in the ground, while population will grow and demand is virtually unlimited.

The China story

This paradigm remains largely, but not entirely driven by the China story.

China’s copper consumption has quadrupled since 1995, rising from 10% of global demand to 40% in 15 years. With Chinese demand expected to double again by 2020, the implications are clear.

More than 700m of China’s 1.3 billion people live in the rural interior, which represents over 75% of the country’s total area. China’s leadership is committed to developing the interior over the next 15 years, and this will require 150-200 mass transit systems, 50,000 skyscrapers, and high-density urban apartments for a minimum of 400 million people.

So expect the market to double for just about everything – for materials and basic resources, infrastructure, conumer durables, cars and clothing. And with farmers using 70% less commodities than urban dwellers, demand here will rise sharply too.

In August 2010, China’s y-o-y electricity demand grew by 18%! Not nuclear, not solar, not wind; this is all about coal.

This month, China bought an entire mountain in Peru’s Morococha District, which is estimated to contain up to $50bn in copper ore deposits, for just $810m. And that’s just part of the $11bn of pending Chinese mining investments in Peru alone.

But such investment doesn’t come without a cost. The Chinese plan to relocate the entire indigenous population living on the peak, that’s three villages and 4,680 villagers, and completely level the mountain. Not in Marin County!

…and the Indian version

With 1.1bn people, India has a 200m souls fewer than China, but its population is growing faster, its infrastructure is significantly less developed and it has an even higher percentage of the population in the agricultural interior.

We therefore anticipate a multiplier effect significantly beyond current estimates. It is no accident that COMEX December Copper futures represent one of the largest line items in our portfolio. Recommondation? Hoard!

Still no hope of a double dip

U.S. manufacturing expanded more than forecast in October to a five-month high – 56.9 vs. 54.4 consensus. It’s just one indicator, but readings above 50 signal growth, and 57 is consistent with >4% GDP growth.

Manufacturing in China expanded in October at its fastest pace in six months. A China purchasing managers’ index released by the logistics federation rose to 54.7 last month from 53.8. A second PMI, from HSBC Holdings Plc and Markit Economics, jumped to 54.8 from 52.9.

Korean exports rose 30% in September y-o-y.

U.K. factory growth unexpectedly accelerated as hiring and export orders improved. The Chartered Institute of Purchasing and Supply Index rose to 54.9 last month from 53.5 – again, anything above 50 indicate expansion.

The ISM’s U.S. new orders climbed to 58.9 from 51.1, while the production index jumped to 62.7 from 56.5. >50 = expansion.

Slow consumer spending (YES) and high unemployment (YES) mean real rates near zero for an indefinite period, a weak dollar, commodity appreciation and killing fields for risk assets like Russian stocks. There should be QE of $600 billion in asset purchases over six months, and some forecast as much as an additional $2 trillion in eventual asset purchases.

Side bet: OPEC will raise the oil/bbl target to $100 in 2011. We put our money where our mouth is – we have this very bet with the head of research at CA Cheuvreux.

Fed surveys last month showed Empire State (New York-region) factories expanded in October at the fastest pace since June, while those in the Philadelphia area grew after contracting in the previous two months.The Institute for Supply Management-Chicago said its business barometer unexpectedly rose in October.

On employment, we anticipate a modest continuation of private payroll job creation with a persistently high a headline number.

But high unemployment and positive markets are poorly correlated, and portfolio construction is all about a weak USD and low rates. Any unanticipated spike in job creation would represent a meaningful negative to Fund investors. Meaningful job creation in America will signal an end to “bad news is good news” and likely lead us to deleverage our aggressive portfolio construction and start a sector rotation out of industrials and cyclicals into consumer related stocks.

We see no change in the macro fundamentals since the “Sell in May” and “June Swoon”. Only now we may have found some company. Anecdotal: Ma and Pa Kettle are not dead. USA Halloween spending was +20% y-o-y, and we expect a Christmas shopping period shocker. As consumer spending is around 70% of GDP, this bodes well for a Q4 GDP surprise on the upside.

Even better, with so many naysayers in the industry still employed, it is easy to find somebody to take the other side of our trades! The bears have not gone into winter hibernation. Memo to Harvard University professor Martin Feldstein: the adage goes that if you are wrong long enough, eventually you will be right. But as always, booksellers and academics without investor capital in harm’s way will be given the appropriate mark down.

But some bears manage huge investor capital! Last month, Mohamed El-Erian, Pimco’s co-chief investment officer, raised his projection of the “new normal” to a 55% chance of coming true. That sounds to us like he is also saying that it has a near 50% chance of his projection not coming true. Coin flip? “Like all our analytical work, the new normal scenario is subject to continuous refinement to incorporate new information and analysis.” Hmm.. a 50/50 proposition … subject to change and we won’t be wrong either way. So that is what makes dog fights and marriages; a difference of opinion. And in our opinion, they are wrong.

With nod to Paulson, Soros, and Mobius, we credit this month’s sanity check to Ken Fisher, who manages $38bn at Fisher Investments. “The next 10 years are going to be just as good as the 1990s. The problems in this current environment we think are so different, and so new and so unique. It’s the same stupid old normal we’ve always had. We’ve got a great future,” Fisher said at the Forbes Global CEO Conference in Sydney. “The new normal is idiotic. We are chimpanzees with no memory.”

We hold to our view since March 2009 that we are in the midst of a post-crisis global recovery which is largely consistent with historical post-crisis recoveries.

The investment case for Russia

Russia’s investment climate may be fairly characterised by

  • global growth
  • inventory restocking
  • urbanisation
  • industrialisation
  • associated increased commodity consumption

Were it not for our Risk and Compliance Department, we would say that the probability of a global double-dip recession is zero.

So we are actually increasing exposure to EM equities (current 147.0% net long) and commodities (current 21.8% net long), while at the same time building short positions to 47.1% in FX derivatives (28.5%) and credit markets (18.6%).

Amerika Redux Part Deux

In the short weeks following the distribution of our “All-American Edition” September newsletter to investors, we received a number of intelligent and well intentioned queries as to the relevance of our expansive global macro process.

Why, they wanted to know, do we, as a Russia fund, pay so much attention to the world beyond Kaliningrad and Khabarovsk? But then, in the subsequent weeks, it seemed that all anybody wanted to talk about was capital creation “ex nihilo” (out of nothing) and QE2.

This seems a reasonable encapsulation of a quandary. The database folks and their fund-of-fund cousins want to dumb-down a complex and irregular world into no more than one or two, easy-to-swallow coated gel caps.

But the real world of investing is convoluted and in constant flux. Why do we focus on America? For the same reason we focus on China. For the same reason we focus on credit markets, consumption, commodity demand, currencies, crude, the consumer and Greek contagion, not to mention all the other drivers of Russian asset appreciation/deprecation which do not start with the letter “C” – dry bulk and tankers, interest rates and inflation, the Kazakh Tenge and the Korean Won, industrial production and world trade.

Investing in Russia represents “Terra Infirma” and significant risk. But it also offers perhaps the highest return profiles in the investible universe.

While there should be little debate that Russia is the least integrated major market in the world, it is a disservice to investors to pretend that looking at company specifics, without understanding the drivers of asset price movements, is sufficient. But this exactly what we see from the investment community.

“We are stock pickers” – mere barnacles on the ship. Alpha generation:

  • 50% of the capture is the direction
  • 30% of the capture is asset allocation
  • 15% of the capture is invention
  • A mere 5% of the capture is splitting hairs between MTS vs. Vimplecom.

How often has one heard: “well we just don’t make bets on the direction of oil price or on what the Russian government may or may not do regarding the next tax regime. Shucks, we just focus on fundamentals, we just keep our eyes on the ball here in Russia, we meet twice a year with management, and boy, we really know our companies.” Have you heard this pitch too?

But these very same people are perfectly happy to make a bet on the price direction of a stock like Surgutneftegaz based on a three-page EV/DACF which calculates the potential output of every Russian wellhead from the Caspian to Sakhalin, while professing to have no opinion on politics, OPEC, tanker volumes, Chinese demand, inventories, the USD, global GDP, capacity utilisation, Russia-specific risk, or the very price direction of the underlying commodity! What could be more fundamental?

Back to America. The fact is that in the three months since we took the then heretical stance that the US would surprise the markets on fundamentals and not fear, and spelled out in significant detail exactly why, the S&P 500 staged a near 20% unprecedented rally.

It is simply fantasy to imagine that a single security in the portfolio from long December Palladium futures, to Bank of Georgia ADRs, to short FX GBP/KRW, to Hyundai Mipo Dockyard swaps, was unaffected by the tides in New York.

Even long-only, Russia-only, stock-only funds (significantly all of the competition) will ride the swell… or swill. Investors: if they are telling you that they do not care what is happening in New York (or Shanghai or London or Singapore), then they do not know what is happening… Buy the ETF and don’t pay them 2/20!

Top performing stocks for the October reporting period

  1. Xinyi Glass 868 HK China +28.35%
  2. Bank of Georgia BGEO LI Georgia +17.99%
  3. OTP Bank OTP HB Hungary +17.82%
  4. Sundance Resources SDL AU Cameroon +17.76%
  5. Orascom Development ODHN SW Suisse +15.73%
  6. International Container ICT PM Philippines +15.13%

We remain long and leveraged to Russia-related assets, the risk trade, basic materials, and emerging market equities. Our fund is selectively short long-dated bond futures and G7 and safe haven FX.

Our largest long holdings include February Brent ICE futures, January Comex Platinum, December Palladium and December Copper futures.

Favoured stock sectors remain metals, industrials, shipping, coal, financials, and agriculture.

As such, we have zero exposure to defensive sectors of healthcare, consumer staples, telecommunications, food retail or electrical utilities.

Slava Rabinovich is CEO and CIO of Diamond Age Capital Advisors Ltd. and the Diamond Age Russia Fund, a hedge fund run from Moscow.

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