Stalking Horse


[Jeremiah and Bear Claw hunt elk]

Jeremiah: Wind’s right, but he’ll just run soon as we step out of these trees.
Bear Claw: Trick to it. Walk out on this side of your horse.
Jeremiah: What if he sees our feet?
Bear Claw: Elk don’t know how many feet a horse has!

– “Jeremiah Johnson” (1972)

epsilon-theory-stalking-horse-july-21-2014-livre-de-chasseGaston Phoebus, “Livre de Chasse” (1387)

In war, truth is the first casualty. 

Aeschylus (525 – 456 BC)

I honestly believe that people of my generation despise authenticity, mostly because they’re all so envious of it.

Chuck Klosterman, “Killing Yourself to Live: 85% of a True Story” (2005)

I began my time as Chairman with the goal of increasing the transparency of the Federal Reserve, and of monetary policy in particular. In response to a financial crisis and a deep recession, the Fed’s monetary policy communications have proved far more important and have evolved in different ways than I would have envisioned eight years ago.

Ben Bernanke, “Communication and Monetary Policy” (Nov. 19, 2013)

The stalking horse is a hunting technique that goes back thousands of years, where a hunter finds it much easier to get a drop on wild game by hiding behind an animal or a representation of an animal that the prey finds more familiar in its natural environment than a human. My favorite description of how the stalking horse technique works comes from the 1972 Robert Redford movie, “Jeremiah Johnson”, where the old trapper Bear Claw patiently explains to newbie trapper Jeremiah that they can walk behind their horses to get a good shot because “elk don’t know how many feet a horse has”. Of course Bear Claw is right, and he and Jeremiah eat well that night.

Today’s markets are chock-full of stalking horses, not for something as trivial as setting up a hostile takeover (which is how the phrase has traditionally been used in investment circles), but for setting up politically-driven macro-economic goals. Whether it’s the use of words to create a representation of a stalking horse or a direct investment in a security to turn it into a stalking horse, governments today are more manipulative (and I mean that in the technical sense of the word) than at any time since the 1930’s. Very little is as it seems in modern markets.

And yes, we’re the elk.

Here’s a great example of what I mean. This past Wednesday the WSJ published an article titled “China Plays a Big Role as US Treasury Yields Fall”, pointing out that the Chinese government bought US Treasuries at the fastest pace in the first five months of 2014 than at any point since this data started being collected more than 30 years ago. China added $107 billion to its Treasury holdings over these five months, almost 10% of its total Treasury holdings of $1.27 trillion, which is itself about 10% of the total $12 trillion US Treasury market. As the article points out, these massive purchases go a long way towards explaining “the mysterious US bond rally of 2014”, where, for example, yields on the 10-year note fell from 3% at the end of 2013 to about 2.5% over this five month period, despite widespread expectations at the start of the year by both market savants and investor public opinion that rates were on a one-way path up, up, and away.

The reason I characterize China’s purchases as a stalking horse rests on both the meaning of the purchases for the Chinese government and the perception of the purchases by market participants.

China is not buying US Treasuries for the same reasons that, say, PIMCO buys US Treasuries. China is not an economic buyer of US Treasuries, making an asset allocation decision based on some evaluation of fundamental global growth prospects. No, China is a strategic buyer of US Treasuries, purchasing US dollar-denominated assets in order to weaken its own currency and spur domestic growth by boosting exports. I’ve written about this sea change in Chinese monetary policy a lot (herehere, and here), and what we are seeing in China’s acceleration of US Treasury purchases is part and parcel of this existential political calculus and its challenge to the Western “rules” of global economics.

What’s really interesting to me – and this gets to the market perception question – is that this “explanation” of the 2014 US bond rally is just now being promulgated by one of the major media arbiters of taste. I mean, China’s Treasury purchases are no secret. The data is published monthly with about a 6-week delay. In April (data released more than a month ago) China bought more Treasuries than the US Fed, but there was hardly a peep about it in any major financial media outlet. What’s interesting about the perception by market participants of China’s accelerated Treasury purchases is that there was essentially NO perception of these purchases as an explanation of falling rates. It’s as if China were invisible or something, which, of course, is EXACTLY how China wished to be perceived in these actions. The market’s inability to recognize that China was buying massive amounts of US Treasuries to weaken the yuan is exactly like the elk herd’s inability to recognize that Jeremiah Johnson was standing on the other side of his horse to get a cleaner shot. The market has access to all the data, just like the elk can see how many feet are under Jeremiah’s horse. We see six feet under the horse, but we can’t comprehend the meaning of six feet under a horse. This is the secret of the stalking horse.

To be clear, I’m NOT saying that there is some grand conspiracy between financial media and China to keep their actions and motives hush-hush. Even if, to use a purely hypothetical thought experiment, Rupert Murdoch were perfectly willing to carry Beijing’s water to the ends of the Earth, the simple truth is that the Chinese regime doesn’t need to resort to these Citizen Kane tactics to carry out a stalking horse operation.

Also to be clear, I’m NOT saying that China’s Treasury purchases are the only reason for falling rates or that there are no fundamental economic reasons for continued strength in global bond markets. On the contrary, I’m firmly in the camp that global growth is structurally challenged, miserable as far as the eye can see, and that Western monetary policy is part of the problem, not the solution.

What I’m saying is that in the Golden Age of the Central Banker it is impossible to distinguish fundamental economic reasons for asset class price movements from politically-driven strategic reasons. Are European sovereign bonds so strong over the past few months because growth remains pathetically weak or because Draghi is promising his own version of QE? Answer: yes.

What I’m saying is that:

  1. Just as the elk is hard-wired to trust a horse standing in a field no matter how many legs it has, so are we wired to watch stocks go up and down and think about fundamental economic explanations for market outcomes no matter how many signals exist that non-economic game-players are really calling the shots.
  2. Government actors, from the Fed to the ECB to the White House to the Chinese Politburo, understand how we are wired and strategically use that understanding to further political goals such as market stability (US) and trade regime change (China). They stand behind their horses – stocks and bonds and fundamental economic explanations – in order to hunt down their true quarry without spooking anyone.

Once you start thinking about what’s happening in markets and the world as an inextricable weave of fundamental events and political efforts to shape our interpretation of those events to achieve a political end, you start to see stalking horses everywhere. A Fed QE program ostensibly to reduce unemployment and help Main Street? Stalking horse. A regulatory Big Data program ostensibly to identify brokers who churn accounts? Stalking horse. A Chinese banking program ostensibly to liberalize currency exchange rates? Stalking horse.

And it’s not just actual programs or actual market behaviors like the Chinese purchase of US Treasuries. When words are used for strategic effect rather than a genuine transmission of information you create a virtual stalking horse. This, of course, describes every use of words by every politician and every central banker. This is what Bernanke and Yellen and Draghi and Abe and Obama and Merkel mean when they refer to communication policy. Communication policy is the strategic use of words to shape perceptions and expectations. It’s a focus on how something is said as opposed to what is described. It’s a focus on form rather than content, on truthiness rather than truth. It’s why authenticity is as rare as a unicorn in the public world today.
Look, I understand why politicians and bankers have completely abandoned authenticity, an uncommon quality even in the best of times. The Great Recession was a near-death experience for the global economy, and slamming a syringe of adrenaline into the patient’s heart – which was basically what QE 1 did – doesn’t happen without long-term side-effects. To switch the metaphor around a bit, this was a war to preserve the System, and as Aeschylus said 2,500 years ago, the first casualty of war is truth. I really don’t think Bernanke or Draghi came into office thinking that their public statements would become the most powerful weapon in their arsenal, or that they could train markets to respond so positively to words presented strategically for effect, but there you have it. This is what worked. This is how the war was won.

So … I understand why politicians and bankers have adopted a stalking horse technique to shape market expectations and behaviors, but that doesn’t mean I have to like it. And while I am happy to condone the use of emergency powers to win a war and save the world, I am not at all comfortable with their continued use once the crisis is over. Unfortunately, I believe that is exactly what has happened, that “strategic communication policy” has mutated from an emergency measure designed to prevent an economic collapse into a standard bureaucratic process designed to maintain financial stability. Is this banal assumption and routinization of power a natural bureaucratic response to a crisis, something we also saw in the aftermath of the Great Depression? Yes, but I’ve got examples going the other way, too. Lincoln suspended habeas corpus in 1861, and good for him. But in early 1866 – less than a year after Lee’s surrender at Appomattox – the US government stood down and restored Constitutional protections. I am really hard-pressed to understand how the exigencies of recovery from the Great Recession, now more than 5 years on, are somehow more deserving of ongoing emergency policies than the immediate aftermath of the freakin’ Civil War.>

Wait a second, Ben. Are you seriously equating the government’s use of “strategic communications” to a suspension of Constitutional protections? Doesn’t that seem a tad over the top? Yes I am, and no I don’t think so. The bedrock assumption of limited, representative government is that we, the people have an inalienable right to make an informed decision about who will make policy decisions on our behalf. Of course this is an imperfect process, and of course the information we use to make these decisions will be mediated and skewed by all sorts of competing interests. But it makes a big difference if the government itself is fully committed to mediating and skewing this information. And it makes all the difference in the world if relatively apolitical institutions like the Fed and various regulatory authorities – institutions which have been granted a vast array of powers over the years precisely because they have been viewed as relatively apolitical – now embrace the highly political act of mediating and skewing information in service to their own particular visions of stability and status quo preservationThis is the danger of strategic communication policy. This is the price we pay for a loss of authenticity within our most important institutions.

Whew! Okay, I’ll climb down from the soap box for now. What is the practical investment adaptation to all this, where historical market patterns based on economic principles can and will be turned on their heads by government “hunters” determined to capture their non-economic goals? I believe that now, more than ever, a portfolio based on what I call profound agnosticism is in order. It’s not easy to admit that your crystal ball is broken, that you have no idea what will happen next or when it will happen, but that’s the required mind-set, I think. Importantly, however, this mind-set does not require hiding under a rock or going to cash or playing defense all the time. Is the Golden Age of the Central Banker a time for investment survivors rather than investment heroes? Absolutely. But as I’ll discuss in Epsilon Theory notes over the next few weeks, a wily elk can still do pretty well for himself if he recognizes the hunters’ games and sticks to the ground he knows. If you’re not already a subscriber, I hope you join the herd.

In closing, I thought I’d share one more illustration from the 14th century “Book of the Hunt”. Here we see a method of trapping wolves that involves a long circular corridor with a one-way door forming a concentric circle around a holding pen where the bait (a live sheep and a blood trail source) is placed. It’s important to use the concentric lay-out for three reasons. First, the circular outer wall is hard for the wolf to escape if he gets wise to the trap, and the circular inner wall keeps the live bait … alive. Second, wolves expect to hunt and track their prey. By establishing a longer trail that must be navigated successfully the wolf becomes more committed to the trap the farther he goes. Third and most importantly, the design prevents the wolves from seeing each other until they get to the end of the blood trail, at which point it’s too late to escape what they now know is a trap.

Gaston Phoebus, “Livre de Chasse” (1387)

In many respects this  medieval wolf trap is an even more effective metaphor for modern markets and  the Narrative constructions of politicians and bankers than the stalking horse.  So for all you investors and allocators who see yourselves as solitary wolves  rather than as an elk or some other herd animal, just remember that these hunters  have a plan for you, too. You can learn a lot from an old book…

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The Red King


“He’s dreaming now,” said Tweedledee, “and what do you think he’s dreaming about?”
Alice said, “Nobody can guess that.”

“Why, about you!” Tweedledee exclaimed, clapping his hands triumphantly. “And if he left off dreaming about you, where do you suppose you’d be?”

“Where I am now, of course,” said Alice.

“Not you!” Tweedledee retorted contemptuously. “You’d be nowhere. Why, you’re only a sort of thing in his dream!”

“If that there King was to wake,” added Tweedledum, “you’d go out — bang! — just like a candle!”

Lewis Carroll, “Through the Looking Glass” (1871)

Never trust the storyteller. Only trust the story. 

Neil Gaiman, “The Sandman, Vol. 6: Fables and Reflections” (1994)

He felt that his whole life was some kind of dream, and he sometimes wondered whose it was and whether they were enjoying it.

Douglas Adams “The Hitchhiker’s Guide to the Galaxy” (1979)

In dreams begin responsibilities.

W.B. Yeats “Responsibilities” (1914)

What happens to a dream deferred?

Does it dry up
like a raisin in the sun?
Or fester like a sore —
And then run?
Does it stink like rotten meat?
Or crust and sugar over —
like a syrupy sweet?

Maybe it just sags
like a heavy load.

Or does it explode? 

Langston Hughes, “Dream Deferred” (1951)D)


We’re all familiar with the Queen of Hearts from Alice in Wonderland, less so with the Red King. He’s sleeping all the while, and when Alice goes to wake him up she’s warned off by Tweedledee and Tweedledum, who tell her that everything in Wonderland – including Alice herself – is perhaps just the dream of the Red King. Wake him up and maybe, just maybe, everything goes … poof!

Europe is once again nearing a potential Red King moment, something last seen in the summer of 2012. Then the wake-up call was a series of national elections, particularly in Greece. Today it’s a restructuring of the European financial system, a process started in 2012 with the recapitalization of Spanish banks, continued with the depositor bail-in of Cypriot banks, and now at a tipping point with the imminent ECB regulatory control over all large EU banks.

Mario Draghi is Alice, and the dream is a unified European identity triumphant over individual national identities, symbolized and crystalized in a single currency, the Euro. 

The Red King? Well, that’s us.

A quick recap of our story so far. The European sovereign debt crisis of both the summer of 2011 and the summer of 2012 was also a banking system crisis. In fact, you really can’t separate the two. European sovereigns in the South and the periphery are, as a general rule, poorly capitalized and highly levered, and so are their banks. The massive spike in sovereign rates we all witnessed in countries like Portugal, Spain, Italy, and Greece was exactly like a run on the bank, just on a national scale. It’s a collapse in confidence in the solvency of the sovereign, manifested as a liquidity crisis. This is the Red King having a nightmare.

Front and center in this nightmare are the actual banks in countries like Portugal, Spain, Italy, and Greece, which suffer actual runs and massive deposit outflows. These banks must be recapitalized to survive, but who exactly should be on the hook for this recapitalization if it ultimately fails? It’s all well and good to say that Europe as a whole should create a common fund to accomplish these recapitalizations, but is it really fair for German taxpayers to pay the price for a Spanish bank’s insolvency, particularly when those taxpayers (or their representatives) have zero insight into how bad the mess really is and zero oversight over efforts to get out of the mess? But if you make the Spanish government a guarantor of the Spanish bank’s recapitalization, all you’re doing is adding to the debt burden of the Spanish sovereign, which just makes the nightmare worse.

Everyone agrees on the best recapitalization solution – an EU banking union, where all the big banks, regardless of nationality, are guaranteed by the entire EU – but you can’t just go straight to a banking union in one fell swoop. First you need an EU banking regulator, someone who the German taxpayer trusts to take a hard look at the Spanish bank’s books, to force changes in the Spanish bank’s management and balance sheet if warranted, and to watch the Spanish bank like a hawk to make sure that this new German money doesn’t fall into the old Spanish rat hole of bad loans and highly questionable banking practices. This super-regulator is the ECB, or at least that’s what Draghi promised as part of his “whatever it takes” pledge in 2012, and now here we are, two years later, and it’s time for Draghi to make good on that promise.

So what makes the summer of 2014 different from the summer of 2012? If Draghi sang a lullaby to the fitful Red King two years ago with his “whatever it takes” pledge, why won’t he do the same today by following through with a no-muss-no-fuss ECB regulatory take-over of major EU banks?

Odds are he will. But what’s different today is that it’s his own institution on the line. What’s different today is that a heartfelt speech and a mythical OMT program – pure Narratives, in other words – are not sufficient. The ECB actually has to assume responsibility for these banks if Draghi is to move forward with the next step of the Grand Plan, and there’s nothing intangible or mythic about that.

I think that the best way to understand the recent spate of write-downs and default notifications from European banks (Erste Bank on July 4th, Espirito Santo on July 10th) is in the context of this regulatory unification of big EU banks. For the first time in decades these banks are being examined for real. No more patsy national regulators with their revolving doors and inherited culpability, but a highly professional independent banking bureaucracy looking carefully at every bottle and tin in the pantry because they’re scared to death of swallowing some poisonous balance sheet.

The problem for the ECB, of course, is that Espirito Santo and Erste are not isolated incidents, any more than Laiki and Fortis and Anglo Irish and WestLB and BMPS and … should I go on? … were isolated incidents. The problem is that no amount of public scrubbing and show trials can change the fact that the entire European banking system has been an enthusiastic accomplice to domestic political interests for the past 30+ years, stuffing their collective balance sheets to the gills with loans in direct or indirect service to domestic political demands. What? You mean that 6 billion euros lent to politically-connected business interests in Angola (a Portuguese colony until 1975) were maybe not such a good idea for Espirito Santo? I’m shocked! But precisely because the politically-inspired rot is so widespread, taking a bank like Espirito Santo into the street and shooting it in the head no more solves Europe’s systemic banking crisis than executing Bear Stearns in March 2008 solved the US systemic banking crisis. As Dorothy Parker once wrote, “beauty is only skin deep, but ugly goes clear to the bone.” That’s the European financial system: politically ugly, clear to the bone.

No one understands this sad state of affairs better than Draghi. I mean … the guy was the head of the Italian central bank, for god’s sake. You don’t think he was there for the initial unmasking of BMPS? You don’t think he is only too aware of the tentacles, excuse me … I mean board seats, that private companies like Mediobanca have throughout the sector? But this is just the skin-deep stuff. The ugly that goes clear to the bone is the manner in which the modern Italian banking system was designed to carry out political missions. This was the entire idea behind Berlusconi’s successful privatization of the banking system in the early ‘90’s: he and his pals got control of the really big banks – Unicredit, Intesa, etc. – in order to fund the Italian State, and the Left got control of the next tier of banks – the credit unions – in order to fund their local politically-connected small-to-medium businesses. It might not be crony capitalism at an African level of expertise, which certainly remains the global gold standard, but it’s not too shabby, either.

So with apologies to Lewis Carroll, here’s the choice facing our modern-day Alice – does she sing a lullaby that keeps the Red King sleeping for a few more years, albeit at the cost of drinking a terrible potion that will turn her into a hideous giant … or does she let the Red King wake up, shattering the dream and risking the existence of everything, herself included, but preserving the story of her beautiful face and form?

If I were a betting man (and I am), I’d wager on Draghi drinking the potion and keeping the dream alive, no matter how complicit it makes him in preserving a very ugly and very politically-driven status quo. But there’s a non-trivial chance that it’s just too much to swallow, that becoming the public face of a European banking system that will ultimately come undone in national political elections over the next cycle or two establishes a personal and professional legacy Draghi is unwilling to accept. There are no easy choices here. Does Draghi postpone what I believe is an inevitable day of reckoning over the politically bloated balance sheets of the European banking sector? Or does he accelerate that time table so that he can (perhaps) better control its unwinding? I suspect he’ll take the former course and choose delay. But maybe not. This is one of those unlikely events that no one will anticipate in advance and everyone will claim was obvious in retrospect, which makes it a perfect item to examine through an Epsilon Theory looking glass. Curiouser and curiouser …

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The Donkey of Guizhou


There were no donkeys in Guizhou until an eccentric took one there by boat; but finding no use for it he set it loose in the hills. A tiger who saw this monstrous-looking beast thought it must be divine. It first surveyed the donkey from under cover, then ventured a little nearer, still keeping a respectful distance.

One day the donkey brayed, and the tiger took flight and fled, for fear of being bitten. It was utterly terrified. But it came back for another look, and decided this creature was not so formidable after all. Then, growing used to the braying, it drew nearer, though it still dared not attack. Coming nearer still, it began to take liberties, shoving, jostling, and charging roughly, till the donkey lost its temper and kicked out.

“So that is all it can do!” thought the tiger, greatly pleased.

Then it leaped on the donkey and sank its teeth into it, severing its throat and devouring it before going on its way.

Poor donkey! Its size made it look powerful, and its bray made it sound redoubtable. Had it not shown all it could do, even the fierce tiger might not have dared to attack.
Liu Zongyuan (773-819 A

A quick note to follow up on last week’s big note “The Dude Abides: China in the Golden Age of Central Bankers.” A number of readers asked if China’s accumulation of physical gold played a significant role in China’s current and forthcoming challenges to the Western monetary policy status quo. Absolutely! It has exactly the same meaning as the recently announced dollar-free natural gas trade agreement with Russia. It’s a fang. It’s a claw. It’s a tool in the construction of an alternative monetary policy regime structure.

Gold has meaning to China in the same way that gold has meaning (or should have meaning) to Western investors. Not as an inherent store of value or some timeless monetary standard … if you’ve gotten nothing else out of Epsilon Theory over the past year I hope it’s a recognition that there’s nothing eternal or timeless about anything that the human animal does, particularly in social practices like trade or commerce … but as a symbol of failed confidence in Western central bank control over market outcomes. To both investors and China, gold is an insurance policy against Western central bankers losing control of their massive monetary policy experiment. The difference is that China has the power to do something about it.

What will China do and when will they do it? Other than pointing you to what China is already doing – weakening the renminbi, pushing against the dollar denomination of international trade in every possible venue, acquiring technology by any means necessary, claiming vast tracts of energy-rich territory – and suggesting that these behaviors will accelerate and expand … I have no idea. But this is exactly why it’s possible to find asymmetric risk/reward opportunities for trading on future Chinese-led challenges to the Narrative of Central Bank Omnipotence. If this were simply a matter of identifying the outcomes and odds of known policy initiatives, then we wouldn’t be talking about the possibility of a Big Trade. Identifying that potential in an environment of uncertainty as opposed to mere risk, whether it’s a bet on gold or – my choice – a bet on the hard peg of the Hong Kong dollar and US dollar coming undone, is where game theory can really shine and what gets me up in the morning.

How should the US respond to the “shoving, jostling, and charging roughly” that the Chinese tiger is starting in the economic realm? Coolly, with no braying or kicking out in anger. So long as China perceives the US as another, larger tiger – as opposed to a donkey – this is not an inevitably apocalyptic Great Power confrontation. To switch metaphors from animals to poker, China will not put the US all-in unless it believes that it knows the cards everyone is holding. The careful use of intentional ambiguity is extremely useful in these situations, but unfortunately that has not exactly been the US forte of late!Understanding this sort of strategic interaction and communication is what game theory is designed to do, and it’s an analysis that I hope you’ll look to Epsilon Theory to provide.

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The Dude Abides: China in the Golden Age of Central Bankers


In approaching a problem a Marxist should see the whole as well as the parts. A frog in a well says, “The sky is no bigger than the mouth of the well.” – Mao Zedong

Jake Gittes: How much are you worth?

Noah Cross: I have no idea. How much do you want?

Jake Gittes: I just want to know what you’re worth. More than ten million?

Noah Cross: Oh my, yes!

Jake Gittes: Why are you doing it? How much better can you eat? What could you buy that you can’t already afford?

Noah Cross: The future, Mr. Gittes! The future. … You see, Mr. Gittes, most people never have to face the fact that at the right time and the right place, they’re capable of ANYTHING.

Chinatown (1974)

Deng Xiaoping was a survivor. That’s why I love this picture of the man, here 80-something years old, looking for all the world like Emperor Palpatine of Star Wars fame, still dying his hair jet-black and chain-smoking his Panda cigarettes. Purged not once but twice. Wife and daughter dead in childbirth. Friends mowed down by the Kuomintang. Eldest son tortured by Red Guards before being thrown out a 4th-story window. 

You think this veteran of the Long March, who lived in caves and ate rats … when the war was going well, wasn’t willing to do ANYTHING to set the future course of the modern Chinese State? You think that Tiananmen Square kept this guy up at night?

Deng Xiaoping and his ally/mentor, Zhou Enlai, are the architects of modern China, of China as a Great Power. For 30 years Zhou tempered the Maoist ideology of permanent revolution, preserving the kernel of a stable army and stable government bureaucracy, setting the stage for a pragmatic successor to Mao. But it was Deng who was able to out-maneuver the Gang of Four and seize control of the Army and the Party after Mao’s death (and Zhou’s) in 1976, replacing that Maoist ideology of permanent revolution with a market-driven ideology of modernization and economic growth. Deng wasn’t interested in political purity, but in economic results. It’s not the color of the cat, as he famously said, but its ability to catch mice.

Deng’s political genius – the core attribute that made him such a consummate survivor – was his ability to sell his vision of economic modernization and growth as an end in itself to other political and military leaders. Permanent revolution is … tiring … and doesn’t really pay that well. Deng offered a vision of stability and wealth, and by 1979 that vision proved to be enormously successful in uniting what Clausewitz called the iron triangle of a Great Power – Army, Government, and People, acting as one for a common goal. Economic growth was, to paraphrase “The Big Lebowski”, the rug that tied the whole room together.

Importantly, Deng’s unifying vision of economic growth and modernization was socialist and nationalist in nature, not liberal and individualistic. Deng was no petty oligarch, stashing away billions in foreign bank accounts during his tenure as Paramount Leader, and this was a big part of what made his transformation of the Chinese nation so successful. Deng was authentic. He was a survivor and he was a patriot. He was a Dude, enforcing at the highest levels of the Party and the Army an understanding that economic growth was (primarily) in the service of the nation rather than (primarily) in the service of personal aggrandizement. Sure, there might be the occasional provincial governor egregiously lining his family’s pockets rather than kicking up to the central authorities in Beijing, but this has only been a problem for the Chinese government for … oh, the past 3,000 years or so, and it’s nothing that a few show trials and public executions can’t bring back in line. No, the important thing was that China’s top political and military leaders shared Deng’s vision of market-oriented AND socialist/nationalist ideologies existing hand-in-hand. And for a while there, they did.

Today, however, the Chinese State faces two existential threats, each stemming from or accelerated by the Great Recession and Western policy responses to that crisis of market confidence.

FirstQE and other “emergency” Western monetary policies of the past five years threaten the grand political unification of Deng Xiaoping from without. 

Second, massive wealth inequality and concentration driven largely by those same monetary policies threaten it from within.

The external threat to Chinese political stability comes from the explicit purpose of recent monetary policy: to paper over anemic real economic growth with financial asset inflation. It’s a brilliant political solution to the political problem of low growth in the West, because our political stability does not depend on robust real economic growth. So long as we avoid outright negative growth (and even that’s okay so long as it can be explained away by “the weather” or some such rationale) and prop up the financial asset values that in turn support a levered system, we can very slowly grow or inflate our way out of debt. Or not. The debt can hang out there … forever, essentially … so long as there’s no exogenous shock. A low-growth zombie financial system where credit is treated as a government utility is a perfectly stable outcome in the West because our elections and political powers don’t hinge on strong economic growth. They hinge on social issues and notions of identity. They hinge on the preservation of wealth, the preservation of benefits, and the preservation of rights. All good and important things in the Western political context. But for China? Not so much.

Chinese political stability under the unified coalition formed by Deng Xiaoping depends on robust and real domestic economic growth. Not the veneer of economic growth as can be constructed within capital markets. Not the liquidity-driven asset price inflation of Western monetary policy. Chinese political stability depends on the actual production of actual things by actual people working in actual factories, and the prospects for that real economic growth are made significantly worse the longer the West persists in favoring financial asset inflation and the ossification of a low-growth status quo. Why? Because the domestic Chinese market is not advanced or rich enough to support the politically necessary rates of Chinese economic growth. I’m sure it will be one day, but that day is not today. That day will not be with us for decades to come. And until that happy day for China arrives, real economic growth will depend on developed world export markets in the US and Europe. Those export markets are more uncertain and structurally weak from a Chinese perspective than at any point since Deng Xiaoping forged his coalition, and that’s a risk that the Chinese regime will do ANYTHING to redress.

The internal threat to Chinese political stability is even more destabilizing and pernicious than the external threat. I don’t care what you think about the specifics of Thomas Piketty’s book, if you don’t recognize that the growing concentration of global wealth within a tiny set of families is a big problem and getting bigger worldwide, you’re just not paying attention. No country in the world is more vulnerable to the political problems caused by wealth inequality and concentration than China. Why? Because socialism may well be, as Deng said, fully consistent with free market practices on a nationalist, mercantilist level, and it’s mostly consistent (or at least can co-exist) with a free market ideology focused on individual advancement and individual wealth creation in the 99%. But wealth creation and wealth accumulation in an era of massive and coordinated central bank liquidity is a totally different animal than wealth creation and accumulation when Deng consolidated power and struck his grand bargain in the late 1970’s. The unfathomable riches available today to the very top of the economic pyramid – the 1% of the 1% of the 1% – are so enormous that they threaten to obliterate the links that Deng created between Army, Party, and People.

Have there always been rich people and rich families in China? Of course. But the scope and meaning of “rich” is so different today in 2014 than it was in 1984, or 1994, or even 2004 as to be a laughable comparison. It’s not just that concentrated private wealth in the modern manner has created an entire class of hyper-privileged Chinese families with the ability to bypass State control. It’s not just that these hyper-privileged families wield political power independently of any State apparatus.  Most importantly – and most damagingly for Deng’s political coalition – these hyper-privileged families largely arose from personal aggrandizement of positions within the core Chinese political institutions of Party and Army. The meaning of Party and Army has changed in China, from one of unquestioned political legitimacy as THE guardians of Chinese socialism to one of highly questionable legitimacy as a vehicle for personal wealth.  For the majority of Party and Army office holders – those who did not make vast fortunes from their office, those who seek a patriotic return to the unquestioned political legitimacy of these institutions – this is an entirely intolerable development and they will do ANYTHING to change it back. Even among those Party and Army leaders who have managed to acquire great fortunes, there is a widespread recognition that – while the West may be able to accept, even celebrate, unlimited private wealth – China cannot. Not if it wants to remain a politically unified Great Power.

The common thread between the external and internal threats to Deng’s stable political architecture is Western monetary policy and its support of a particular system of global market liberalism. What does China intend to do about it? I believe that Chinese leadership increasingly sees itself as the turtle in the old fable of the turtle and “the compassionate man,” where the system is the pan of boiling water that the compassionate man (the West) sets up to turn the turtle into turtle soup. Through incredible focus and an application of all its resources the turtle walks on a narrow rod to cross the pan of boiling water, but having crossed once is now required to cross again. It’s the system that requires changing from the turtle’s perspective, and I believe that’s exactly what China will seek to do.

Changing the system does not mean withdrawing from the system or blowing the system up. Remember, China MUST continue to sell stuff into developed world export markets as a bridge to a more stable economic growth path based on domestic markets. Changing the system means changing the rules, the “correlation of forces” to use a good-old-fashioned Leninist phrase, so that China can still sell lots of stuff to the world in order to support its domestic factories and generate capital to build its domestic infrastructure, but in a way that can be controlled by the State and not usurped by these hyper-privileged families that have popped up over the past few years. China doesn’t want to be the turtle; it wants to be “the compassionate man” who sets out the pan of boiling water for other turtles to cross. China wants to control its own future, and to accomplish this, strong actions must be taken domestically and internationally.

Domestically, I expect two things.

First, the backlash against the privileged families, particularly those politically active second and third generation inheritors of both a mantle of authority and a vast fortune from Mao-era Party and Army leaders, will widen and grow. This is the right context for understanding the Bo Xilai “scandal” and trial. Murder a British “banker” who helped you quietly funnel more than $100 million into personal overseas accounts? No problem, and thank you for not stealing more. Use your control over a vast domestic fortune (billions of dollars seized from “organized crime” in Chongqing) to fund a personal political machine with national aspirations, in effect becoming a Chinese conflation of Michael Bloomberg and Rudy Giuliani? Sorry, Bub, time for you to go.

Second, and relatedly, the backlash against these Princes will be driven by a domestic media Narrative that China is engaged in an economic “struggle” with powerful outside forces, and that these hyper-privileged families are in effect siding with the enemy. Of course, the Princes can read the newspapers, too. Not only is the message loud and clear that you should keep your domestic wealth hidden and totally segregated from political purposes, but also that you’re only as rich as the wealth you can remove from China entirely. Hold that thought.

Internationally, I expect three things.

First, to construct the domestic Narrative of an economic struggle you need a foreign enemy, but it’s too risky (for now) to cast entire nations in this light. The next best thing? Japanese and American companies that sell expensive, industrially advanced stuff into China, and by “stuff” I mean both manufactured items and services. Recently companies like IBM and Cisco have reported a distinct slowdown in their Chinese business. My view? You ain’t seen nothing yet. As powerful as the “Buy American” marketing slogan has been in this country, the “Buy Chinese” slogan in China will be 100x more powerful.

Second, if there’s one historical lesson that all Great Powers know – particularly up-and-coming Great Powers like Germany in the 1890’s, Japan in the 1930’s, or Russia in the 1950’s – it’s that the only way to win the Great Game is to control enough natural resources so that the incumbent Powers can’t squeeze you dry. Resource independence isn’t a sufficient condition to change the rules of the system, but it’s certainly a necessary one. The resources that matter today are energy and technology, period, and this is the context in which we need to understand China’s actions in the South China Sea, in cyber-security, in Africa, and in its diplomatic relations with Russia. Achieving energy independence and technological parity – or at least reducing its vulnerability to being fatally suffocated if that’s what it comes to – is not a matter of choice to a China that sees itself under assault from the West within and without, but a matter of necessity.

Third, since Western monetary policy is the root of all evil from a Chinese perspective (okay, that’s a bit of poetic license, but not as much as you might think), the primary weaponry for China’s rule-changing efforts will also be monetary policy, particularly currency exchange rate policy. Here’s a chart that illustrates what I mean, and why I think that China is already embarking on the paths outlined above.


First, take a look at the price level ratio of the Chinese renminbi and the US dollar (dark blue line above) to see what I mean when I say that the rules of the global trade system pose a structural challenge for China, and that the Chinese government is starting to challenge those rules. From 2005 through 2007 China strengthened the renminbi versus the dollar by more than 20%, assuaging US political pressure that the Chinese currency was too weak and created “an uneven playing field” in international trade. This was an easy concession by the Chinese regime, as domestic growth remained plenty strong and their domestic stock market rocketed higher. Not coincidentally, vast fortunes were built by the most politically connected and powerful Chinese families over this 3-year period. But then 2008 happened, plunging all markets and all economies into chaos. China decided that discretion was the better part of valor during the Great Recession, so the renminbi was kept steady against the dollar until the end of 2009. At this point it looked like domestic GDP growth and global markets were in the clear, and so China returned to the exchange rate policy that had worked so well for them in the 2005-2007 period. Oops. In a QE dominated world … in the Golden Age of the Central Banker … renminbi strengthening has been an unmitigated disaster.

How so? Take a look at the HSCEI/SPX ratio (red line above). Measured from the beginning of 2004, the broad mainland Chinese equity market rose to a price level 2.5x greater than the broad US equity market by March 2009 and the initiation of QE1. Since then, the US market has done nothing but go up and the Chinese market nothing but go down, so that the Chinese market’s price level is now only 50% higher than the US market in 2004 terms, down more than 80% from its peak relative price level.

Similarly, Chinese GDP growth (green line above), after a brief recovery along with the rest of the world in 2009 in response to the Fed’s adrenaline shot straight into the flat-lining heart of US capital markets, has done nothing but drift down in an alarming and totally unprecedented way. I know, I know … Chinese GDP data is terribly untrustworthy and is largely constructed out of whole cloth. But that fact just makes this chart even scarier! If the manufactured data is this steadily disappointing, imagine what the real GDP growth rates look like.

So what is China’s response? Since the beginning of this year, China has forced the renminbi down in value, making the currency weaker and making exports cheaper, in effect administering their own shot of adrenaline to the heart of their economy. I think this is just the start of a multi-year weakening of the renminbi, a sea change in Chinese monetary policy that will inevitably create broad political tensions with the US and make Japan’s devaluation/inflation course infinitely more difficult to achieve. For more than 40 years China has been willing to accept the lead of the US in determining the rules of the road when it comes to international trade. Now China is looking to call the shots. Modern trade wars are not fought with tariffs and quotas, but with exchange rates, and what China is doing with their currency is the modern-day trade regime equivalent of firing on Fort Sumter.

Okay, Ben … interesting enough, but I’m not a forex trader. What does all this mean for portfolio construction, asset allocation, and risk management?

It means everything. It means that China intends to challenge the current system of global trade by forcing change in the monetary policy rules and relationships we have known for the past 40+ years. It means that ANYTHING is possible and NOTHING is off the table as the Chinese State combats an existential internal and external threat.

To use Mao’s phrase, the Chinese regime is not a frog in a well, seeing the limits of the sky in what the mouth of the well defines. If we want to be effective investors or allocators in the difficult years to come, we need to look beyond the mouth of the well, too. What’s beyond the mouth of the well? What are the specific policy choices China could make to restore political legitimacy to Party and Army while also driving real economic growth? Beyond forcing the renminbi down, staking out energy-rich geographies, “acquiring” technological know-how by any means necessary, and aligning with Russia on all of these issues … I have no idea. But I am certain that there is more to come, in both scale and scope. I am certain that whatever these policy choices may be, they will be outside every macroeconomic model, every sell-side report. I am certain that some historical correlations we treat today as ironclad market laws will be turned on their heads, wreaking havoc on portfolios that insist on treating the past as some immutable Truth with a capital T.

In this environment I think the most useful response from a portfolio construction perspective is to adopt what I call “profound agnosticism” about what the future holds. Or expressed with fewer $10 words, what’s required is to accept that no one has a working crystal ball right now. If ever there was a time when it makes sense to structure a portfolio in an adaptive fashion, where you start with a balanced allocation to a wide range of asset classes and then let the market tell you what’s working and what’s not, today is the day. I’ve said it before and I’ll say it again: the Golden Age of the Central Banker is a time for investment survivors, not investment heroes. China’s challenge to the Western status quo reinforces that claim 10-fold.

I’ll close with an observation of a less defensive sort, because the forthcoming Chinese challenge to the current monetary policy rules will present opportunities as well as dangers, and because a good risk manager is always looking for asymmetric risk/reward ratios in either direction. Here’s a 40-year price chart of 1 US dollar expressed in Hong Kong dollars. The vertical axis (number of $HK = 1 $US) is inverted because a higher number of Hong Kong dollars reflects a weakening of that currency.


For the past 30+ years, the HK dollar – the world’s eighth most traded currency – has been pegged to the US dollar with rock-solid certainty. In the world of international trade, the HK dollar hard peg is the equivalent of the law of gravity, with all the certainty for future economic transactions that implies. As you can see clearly from the chart, there has been essentially zero volatility in the exchange rate since October 1983 and the creation of the currency board system.

To use a geological analogy, the Hong Kong dollar is the most stable tectonic plate in all of global economics, and the fault line between the Hong Kong dollar tectonic plate and the US dollar tectonic plate hasn’t had a tremor in 30 years.  But here’s the thing. The stability of the Hong Kong / US dollar fault line is entirely due to politics. It’s stable because the Hong Kong government says that it’s stable. There is zero reflection of fundamental economic pressures in this exchange rate, because it is entirely a political creation. And if the politics change at a deep enough level, such that it is no longer in Beijing’s interest to maintain the hard peg, you will have a massive earthquake.

Very smart guys have predicted either an end to the hard peg or an end to the Hong Kong dollar altogether, and they’ve been entirely wrong. In 1995 Milton Friedman predicted that the currency could not survive the 1997 handover of Hong Kong to Beijing, a prediction that Jim Rogers has adopted as a policy prescription since 2007. In 2011 Bill Ackman famously went long the Hong Kong dollar, arguing that the fault line between the Hong Kong dollar and the US dollar could not withstand the inflation Hong Kong would be importing from the US (you can access a copy of Ackman’s 150-page slide presentation here). In investments as in comedy, timing is everything. So why do I think it’s different this time? Why do I think the clock is now ticking on an earthquake in the fault line between the Hong Kong dollar and the US dollar?

It’s different this time because China is under greater pressure, both externally and internally, to change the international rules of the road than at any time since Deng forged his domestic political coalition. It’s different this time because there are specific catalysts – the weakening of the renminbi, the creation of a domestic media Narrative that trumpets an economic “struggle” with the West, the claiming of vast swaths of strategic offshore territories, the acceleration of cyber-espionage, the strengthening of ties with Russia to create a new economic axis – that are forcing the Great Powers of the 21st century onto a collision course. It’s different this time because the hyper-privileged families of modern China need to get their wealth out of China ASAP, and parking it in Hong Kong (or in Hong Kong dollars) is no longer safe enough. I can’t tell you the timing, the odds, or the form of this or that earthquake-provoking event. My crystal ball is just as broken as anyone else’s. But I think where Epsilon Theory is useful is in providing the right lens for evaluating these events as they occur, and that this monitoring function can help investors and allocators alike interpret environmental risks as part of an adaptive framework.

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