Crescat Capital letter to investors for the second quarter ended June 30, 2016
See more great hedge fund letters here – also Crescat’s whole letter is great as always but the stat on China in the headline is mind-boggling – check it all below.
The markets have been turbulent in the wake of the unexpected Brexit vote. Crescat’s hedge funds were well prepared for the shock based on our diversified global macro themes, well hedged long/short positioning, and disciplined risk model. As evidence, our Global Macro Fund posted gains on both Friday and Monday when the S&P 500 was down 3.6% and 1.8% respectively. Crescat Large Cap, our long-only strategy, was also well prepared for Brexit with its large cash position, precious metals exposure, and ample defensive equity holdings. Even after the sharp snap back rally on Tuesday and Wednesday, all three Crescat Strategies are ahead of the S&P 500 in June month to date through yesterday’s close with the S&P 500 down 1.1%.
Far and away, our best performing macro theme year to date remains Global Fiat Currency Debasement, our long precious metals theme across all three strategies. Gold, the world’s perennial reserve currency, remains near a historically low valuation relative to the global fiat monetary base. Meanwhile, silver remains near a historically low valuation relative to gold. The problems caused by debt-to-GDP excess in Europe, China, Japan, and elsewhere auger well for further global central bank fiat money debasement and substantial future hard money, i.e., gold and silver, appreciation. Brexit is just one of the catalysts.
Despite a broadly rallying market in April and May, we also saw positive returns in the hedge fund strategies from our short-oriented China Currency and Credit bubble theme. We believe that this theme, along with our New Oil and Gas Resources and Asian Contagion themes represent significant opportunities for the second half of 2016. In addition, our Yahoo/Alibaba Spread trade has continued to be a low volatility and high return winner for the hedge fund strategies. We think this has much further to play out in our favor as we show below.
Crescat Capital – Three New Macro Themes
We are now introducing three new themes: Rise of the Machines, European Disunion, and Asian Contagion. Rise of the Machines has been carved out of our Digital Evolution theme and is focused on companies at the forefront of developing and capitalizing on artificial intelligence (AI) technologies. Our new AI theme is fortified by one of our long-term core holdings, NVIDIA, a highly profitable, high growth, low valuation company with over 7,000 patents in visual computing. NVIDIA invented the graphics processing unit (GPU) and enjoys a leadership position in the development of an entire computing platform for artificial intelligence.
European Disunion is a spin-off from our Global Debt-to-GDP Resolution theme and currently houses our newly fortified short exposure to the euro and British pound in our Global Macro Fund. Euro and pound sterling had long been Crescat shorts relative to the dollar. We had covered this exposure ahead of the UK vote due to heavy bookmaker odds of a Bremain vote. The surprise Brexit vote has provided the confirmation for us to reenter these positions. These, along with our other currency shorts, including Chinese yuan, Japanese yen, Australian dollar, New Zealand dollar, Canadian dollar, are also a means of diversifying our long precious metals exposure in the Global Macro Fund.
Our new Asian Contagion theme is a reformulation of our Aussie Debt Crisis theme. It includes countries that have their own unique set of problems, such as the Australian housing bubble, but are also highly likely to be affected by the crisis that we see unfolding in China.
Below is a summary of results for Q2 2016 through May and since inception for the three Crescat strategies. Please note our substantial, persistently high risk-adjusted returns compared to the market and other managers across all strategies over the long term. We will have preliminary June and Q2 performance out soon.
More information on each strategy can be found on our website. In the remainder of this letter, we discuss three of our high conviction macro themes: China Currency and Credit Bubble, New Oil and Gas Resources, and Yahoo/Alibaba Spread.
China Currency and Credit Bubble
The Chinese economic bubble is poised to burst and continues to represent an even bigger risk to the global financial markets than European Disunion.
In July of 2014, we wrote about the huge imbalance with respect to China’s M2 money supply and nominal GDP relative to the US. At the time, China’s M2 money supply was 71% higher than the US but its economy was 56% smaller, which we said was an indication of the overvaluation of the Chinese currency. Since that time, the yuan has fallen by only 6.8% relative to the dollar. We haven’t seen anything yet.
Today, the circumstances have significantly worsened. Money supply has continued to grow faster than GDP. With over $30 trillion of assets in its banking system and an underappreciated non-performing loan problem, we are convinced that China is headed for a twin banking and currency crisis. Money velocity has reached historically low levels which reflects China’s extreme credit imbalance and its crimping impact on its ability to generate future real GDP growth.
Just as worrying as the immense amount of credit built up, China has been reporting major downward revisions in its balance of payments (BoP) accounts. For more than a decade, China had been reporting an impossible twin surplus in its BoP accounts. When we wrote about this issue in 2014, we emphasized the likelihood of massive illicit capital outflows that not been accounted for. At that time, according to the State Administration of Foreign Exchange of China (SAFE), China had accumulated a BoP imbalance that was close to $9.4 trillion surplus since 2000 which we believed represented capital outflows that should have been recorded in the capital account.
The same accumulated BoP number today, revised by SAFE several times since, is now a deficit of about $2.8 trillion. Essentially, with its revisions, the SAFE has acknowledged even more capital outflows over the last 16 years than we had initially identified.
On the capital account side, there was a downward revision of $10.1 trillion – from a $4.2 trillion surplus to a $5.9 trillion deficit. On the current account side, the revisions show that Chinese exports have not been as strong as initially reported over the last decade and a half. China’s current account surplus has been reduced by $2.1 trillion– going from $5.1 trillion to $2.9 trillion over the last 16 years.
What we initially considered to be a $9.4 trillion imbalance has been more than proven by a $12.2 trillion revision.
In continuation of our analysis, we had previously pointed out how the purchase of assets by the People’s Bank of China (PBOC) was actually quantitative easing (QE) or outright money printing and was larger than any other major central bank in the world. With China’s year to date cash injections this condition has only become more explicit.
The PBOC has injected over $1.6 trillion of