My naive and fishy view on deleveraging

I'm writing this in response to a Barron's piece about Ray Dalio. I'm writing this because I'm puzzled about the 3 strategies for deleveraging that I heard about over the years. To me, there is only one strategy. (I'm not sure if the Barron's article is behind their paywall. If so, you can also find a snipplet quoted at Frank Voisin's blog.)

* * *

In the distant land of Asgard, the currency unit was "cans of sardines". And sardine hunting was Asgard's major economical activity.

One day, an entrepreneur called Loki visited the Central Bank of Sardines. He wanted to borrow 1/2 of the nation's sardine reserve, which had been accumulated as a preparation for the next ice age. He had this grand vision. He wanted to use the proceeding to employ many engineers and scientists to create an automatic sardine harvesting machine.

Loki eventually got his loan. But on his way back to his office, he bumped into a gigantic green monster and all the sardines were lost.

Now, after this incidence, Asgard didn't have enough sardines for the nation to go through the ice age. What could they do? What were the options?

Could they "inflat" their way out? They could repackage each can with only 70% of original volume of sardines, and they could repeat doing this every year. That inflated the number of cans. But, it didn't address Asgardians' hunger... 30% less sardines was 30% stomach unfilled.

Could they go on austerity?

Well, I think austerity = hunger.

It's apparent that the only sensible option was to ramp up their sardine hunting or improve the yield (by really inventing a harvest machine!) to make up for the lost.

This means they had to grow, to improve their productivity.

Did inflation have a place? Probably. If Asgard labour and goods were cheaper, they could probably sell more stuff to other nations and thus accelerated the build up of their sardine reserve.

Did austerity have a place?  Probably. For one thing, sardines (i.e. money) should not flow through Loki's hands anymore. In other words, austerity should be applied selective at the places where waste would occur.

But, without growth, austerity and inflation were useless.

* * *

I don't have any rigorous economic theory to back up my story. I am pretty sure you can poke holes in this "analysis". I am looking forward to comments on the fallacies of my reasoning.

(Don't ask me why "Asgard" and "sardine". I just had these random thoughts in my head while I was writing this.)

Next leg of the crisis

It's instrumental to learn the financial history. Technologies advance, companies come and go, but human psychology doesn't change. While the boom and bust cycles don't unfold in the same way each time, studying the past gives us two important insights:

• a sense of the time scales
• the severity and magntiude of the events

The next leg

One thing that I learned is a financial crisis unfolds over more years, at different pace in different countries and can have many many legs downwards.

It looks like we are now entering the next leg of GFC originated in 2007.

At the moment, France and Greece are throwing tantrums. On one hand we have France threatening to disintegrate the Euro core when its new president François Hollande, rightly so, wants to reset the fiscal and monetary agendas of the Euro zone. On the other hand, we have Greece on the brink of leaving Euro.

I wrote in February this year in my private blog:

...I just can't help thinking the financial world now has some kind of "Euro zone fatigue", sick of hearing bad news from the region and has basically switched off, not to pay any attention anymore for a while. I still reckon there is a good chance Greece will default [disorderly] this year. On the top of that, we have also the possibility Isarel may attack Iran and the mess in Syria. Not to mention the China bubble is looming behind the scene. We know from high school math, to calculate the probability of "at least one bad thing will happen" is to add the probabilities up. (And this hasn't taken into account this kind of stuff is not mutually independent.)

Greece did default but in an orderly fashion. Since then, the market sentiment has been calm until 2 weeks ago. Now we have another real possibility that Greece will "default again" and send another shockwave throughout our financial systems.

What is it for value investors?

What does this mean for value investors?

How bad the situation will get? When will be the market bottom? No one knows. The key is not to time the market. The key is to price individual companies.

At a minimum, we should all be prepared. The volatility is on the rise. When Mr Market presents us with opportunities, we need to act swiftly and decisively, deploying meaningful amount of money to buy mispriced companies -- companies with wonderful prospects for the next 15 years but priced only for the outlook of the next quarter.

Learning the history

Back to the issue of studying the financial history.

There are classic like Devil Take the Hindmost, Manias, Panics, and Crashes and  Extraordinary Popular Delusions and The Madness of Crowds.

However, these two are my favourites:

•  In an Uncertain World - This is Robert Rubin's memoir of his life as the Secretary of the Treasury in the Clinton era. You will see how the Asian Crisis, the Mexican Crisis andthe Russian Crisis unfolded through the eyes of a policy maker. Besides, this also touches on Rubin's probabilistic thinking style, which is vital for decision making under uncertainty. (Isn't that what investing is all about?!) This is quite a page turner. I've actually read it twice. This book is particularly relevant in the context of the current Euro crisis.
• Anatomy of the Bear - Russell Napier documented four greatest bear periods in this book. This book is relatively dry and the analyses get a bit repetitive. However, it gives you a lot of charts, statistics and newspaper vignettes, showing you how different asset classes performed, what the central banks were doing and the how market sentiments turned around those four market bottoms. It uses Tobin's Q-ratio has a barometer of the market valuation and it draws the conclusion that the return of price stability of commodities is a key indictator of the bottom of the market. They are interesting perspectives. But being a bottom-up investor, I personally won't use these indicators to time the market. To me, the real value of this book is in the historical facts Russell has compiled.

Hedge fund manager Hugh Hendry reckons "we are single-digit years away from the most profound market clearing moment". Will the final leg in the next couple of years be a China fallout or a Japan collapse or something else? There is no way of knowing. But we better be prepared.

China and the Australian Dollar

I follow Michael Pettis' writings. Michael Pettis is a finance professor at Peking University’s Guanghua School of Management. His analyses of China's financial market are always insightful and thought provoking.

Last month, he published a piece titled "When will China emerge from the global crisis?" It follows up on an argument that he has made in the previous years: The impact of the GFC will affect United States first. It will spread to Europe, and eventually Asian countries and China, but with a delay. The States will also be the first economy recovering from the crisis. The delay is the result of different fiscal policies and monetary policies adapted by different countries

(Pettis' piece worths reading even if you are not interested in Australia's economy.)

We haven't seen the impact on China yet. But it appears we are now at the point of inflexion. China has just  reported their largest trade deficit in two decades. It also announced last week it would lower the growth target to 7.5% which is more symbolic than anything. Besides, there are more and more accounts reported in the Western media in the recent months about China's shaky financial status. (Examples are here and here and here.)

Even if there is no hard landing, a slowed down China will hurt Australia's economy. It looks like many people in Australia, including the politicians, pay no attention to it. They either pretend that won't happen or don't know that will happen. Australia has suffered from the Dutch Disease for some time. The economy has been buttressed solely by the resource and mining exports. Excluding the resource sector, all other industries have lost their competitiveness because of the high Australian dollar and are deteriorating fast. Since the GFC, China has accelerated their infrastructure investments. They've brought forward many of their infrastructure projects in order to keep the economy going. That's what keeping the resource sector strong. But such acceleration must come to an end at some point. By that time, it will be a major slowdown (recession?) in Australia.


One way to "short" the Australia economy is to bet against its currency. And the simplest way to do so is to buy USD. When resource exports slow down, AUD has to come down. The Economist's not-too-scientific Big Mac Index says it's about currently ~20% overvalued with respect to USD.


You got to wonder what Forex has to do on a value blog. I'm wondering that too. :-) There are so many factors influencing a currency. Macro economics, carry trades, geopolitical factors, to name a few. There is no way to predict its short term and medium term movements. However, I just can't help but think the underlying fundamentals is pointing to only one direction in long term. Given the pace how the impact of GFC unfolds around the world, when I say long term, the time scale I'm thinking of is 1-3 years. 


Probably the relative high 6% interest rate one can easily get in AUD$ bank accounts is the biggest hurdle. The way I see it, when I have a significant portion of my assets in Australia, moving some money into USD is a reasonable hedging strategy and the 6% is one has to pay for such hedge.


By the way, for Australian readers, I found one can get the best exchange rates at HSBC. The buy/sell spreads at the major banks like Westpac are just ridiculous.