James Aitken, one of Australia's sharpest macro minds, says bank stocks have peaked, China will devalue and investors must conquer 'factor risk' and impatience to triumph. Jonathan Shapiro reports.
There have been few bigger weeks for Australia's economy; the Coalition government will present its budget hours after the Reserve Bank contemplates a sub-2 per cent cash rate, while four of the nation's five largest banks announce their half-year profits, in the most intense political climate in years.
For a nation gripped by the property market and the "financial complex" that drives the economy, the budget may be of secondary importance. But for James Aitken it holds the key to our prosperity, as central banks pass the baton to governments.
Aitken, an Australian expat, advises many of the world's largest hedge funds, institutions and policymakers on the consequences of their interactions. And he charges top dollar for a subscription to his newsletter, Notes from a Small Island, which he dispatches from his base in Wimbledon. 
But once a year, the elder brother of fund manager Charlie and stockbroker Angus shares his insights with The Australian Financial Review on the state of his home nation, the frailties of financial markets, and the predicaments of anxious global policymakers. This year he has much to say about Australia.
"Beneath the macro risk headlines there are some good things happening," he is keen to stress. And he's echoing a point global policymakers, and Reserve Bank governor Glenn Stevens, have been at pains to make; our prosperity will be a function of fiscal, not monetary policy.
On Tuesday, Treasurer Scott Morrison hands down the federal budget, which Aitken says he hopes will be inspired by that delivered by Canada's fresh, popular centre-left government, led by Prime Minister Justin Trudeau.
"The whole thrust of the Canadian budget was investing in infrastructure to create prosperity and jobs for the middle class. I guarantee you that Turnbull and others have studied this with interest," he says. "As Trudeau said: 'infrastructure is un-sexy, but we're going to get on with the un-sexy stuff first because the multipliers are real'."
The multiplier effects of infrastructure spending were touted by Tony Abbott and Joe Hockey but Aitken says Malcolm Turnbull is doing more to make sure it happens. A well-considered infrastructure program isn't going to lift growth back to 4 per cent, but it's "welcome, necessary and unambiguously positive," he says.
For a nation obsessed with housing and banks, it is time to pay more attention to the way the government is going after key infrastructure projects and articulating how they should be funded. This is being led by Turnbull and NSW Premier Mike Baird, along with federal Assistant Minister for Cities Angus Taylor and Major Projects Minister Paul Fletcher.
At the heart of the Coalition's vision is unlocking the potential of western Sydney - a region that embodies aspirational Australia. "Turnbull is going for it in terms of unlocking its potential and getting its infrastructure, transport and hospitals right, and releasing land for development which, to be fair, is more to do with Mike Baird at the state level," Aitken says.
"Making Parramatta a true second CBD has been discussed for three decades, but it is now happening. It's impressive and real and improves the livelihood of all those residing in what is the heart of aspirational Australia - western Sydney."
The budget is the headline event of a Super Tuesday for finance and economists. A Reserve Bank cash rate decision has unexpectedly become "live" after a soft inflation reading. Aitken is not as convinced as some that an RBA cut is inevitable but it does remove any and all hurdles for it to do so.
And as if a budget and a rates decision weren't enough economics action, three of the big four banks will present their half-year profits. Just months before a general election, they have once again become a political target.
The conduct of the banks is now a major election issue thanks to irresponsible lenders, stingy insurers or wealth destructive financial advisers.
This, Aitken says, is a function of the pressure on bank management do deliver double-digit returns on equity in a low single-digit interest rate world and "feed the great fully franked dividend machine."
"In that environment, mistakes tend to get made and so I would expect further revelations to come. We are not talking about anything systemic, just embarrassing sloppy accidents."
The other political debate centres on property prices and housing affordability. When it comes to housing, which constitutes the largest asset for most Australians, a "proportionate" debate is nigh on impossible. The Prime Minister knows that.
His steadfast refusal to contemplate changes to negative gearing has more to do with pragmatism than any true reflection on a policy that encourages households to take on more debt than they should, Aitken speculates. Turnbull has an election to win.
"He understands markets, he understands economics and the last thing he wants to do is add to that uncertainty in the near term by fiddling with negative gearing," Aitken says.
As for the big banks, they will have more to do than absorb the political punches. With the "capital-raising cycle far from over" and bad debts ticking upwards, bank chiefs will be tested. Aitken believes bank share prices have peaked and will ultimately de-rate into valuations more akin to their global peers.
The lingering issue, however, is a systemic reliance on foreign capital. Limitations are being imposed on US short-term "prime" money market funds, which are multibillion-dollar financiers, while more generally global liquidity is being more constrained. "It may be unwise to assume that Australian banks continue to roll their wholesale funding with impunity. To be fair, this is something Wayne Byres [APRA boss] has zeroed in on.
"On balance, it, and higher deposit rates, means higher mortgage costs will be passed on by the banks but, prudentially, is that a bad thing?" Aitken built his reputation by being at the front line of the worst financial crisis of this generation.
He served time at AIG's infamous Financial Products group, whose contagious credit derivatives contracts placed it at the heart of the pending 2008 credit crisis.
That experience gave him the insights to anticipate and articulate what was occurring beneath the surface of the financial system when he joined UBS, before he set up his one-man consultancy.
The Financial Review interviewed Aitken last week on the eve of a central banking version of "Super Tuesday" - 24 hours of major policy decisions from the US, New Zealand, and Japan. He wouldn't have been shocked by the Bank of Japan's non-action that sparked a fierce rally in the yen.
"The No. 1 change in 2016 has been a hardening of the view in Washington about currency games," he said.
"I don't know the exact cause but I know there have been strong words exchanged, publicly and privately, between US and Japan authorities and the former has said in the strongest possible terms, we will no longer tolerate you playing games with the yen."
"All hell will break loose," he warned, if Japan started or kept "playing silly buggers" with the currency. The overriding point is that BoJ governor Kuroda may be more constrained than many in the market realise, which calls "Abenomics" into question.
Markets appear to be confused as to the intentions of the People's Bank of China with regard to the renminbi. A big hint was dropped by the second in command at the Peoples Bank of China, Yi Gang, at a recent panel discussion in Washington, he says.
Yi was asked about China's new policy of managing a basket, or index, of currencies - rebased at a value of 100 in   December 2014 - rather than the US dollar. How could the objective be stability when the renminbi has declined by an annualised rate of 12 per cent against this basket?
"He started talking about why they calibrated the market, why they chose an end of   December 2014 value of 100 for their new RMB basket - but he then started talking about three and five-year moving averages - and it was like 'wait a minute, this guy wants the RMB way lower'," he says.
Those "moving averages", Aitken explains, implies an index level of 80 versus the current basket value of 97 or 98.
"Their intent is clear" but with China holding the rotating G20 this year and a highly charged US presidential election, he's not expecting a sudden move, let alone the one-off devaluation many are betting on. The Chinese will, however, "unhesitatingly weaken" the renminbi if the yen weakens, the euro weakens or if the US dollar strengthens.
Aitken says there has also been a "remarkable lack of coverage, anywhere" of the "breathtaking scale" of Chinese monetary stimulus laid out in a document jointly signed by nine ministries on   February 26, which has been implemented through various measures.
"I still don't think the market appreciates the scale of what the Chinese are doing. They are absolutely going for it," he says.
But these measures, which Aitken said exceed the level of enormous liquidity injection of 2009, have come with complications.
"As we have seen when China turns on the spigots, the animal spirits rise up and an outlet is needed for the speculative juices."
His advice for any "resource company that has made it this far," is that the speculative spike in the iron ore price is unlikely to hold and that "now is the time to nail your balance sheet to the floor".
This brings us to the current perplexing state of financial markets. They are now no longer being characterised by asset classes but increasingly by "factors" - the binding characteristic behind the performance of an investment, or its risk premium. Equities, bonds and credit are asset classes. "Value", "momentum", "growth" and "volatility" are some of the "factors" investors use to manage and drive exposures.
"For many long-short hedge funds, the first quarter was the worst of their careers and it wasn't about leverage but about understanding their true factor risk," he says. "Too many investors think factor risk equals factor exposure. It doesn't: factor risk equals factor exposure multiplied by factor volatility."
That may sound like serious hedge-fund speak. It can be translated to mean that investors just haven't realised what underlying unified force is influencing the performance of their trades, until it is too late.
In many instances, one factor has dominated performance more than others - the upward momentum of the US dollar which, as it has reversed, caused havoc as it stalled.
But the shake-out in the first quarter has created buying opportunities, particularly in resource stocks and Asian equities, which have traded at their lowest valuations since the Asia crisis of 1998.
Investors that bought back then had a "very average 1998, but spectacular 1999 because of what they bought in 1998."
There is one key difference this time, Aitken says. "If you were buying certain Asian equities in 1998 your thesis was validated by central bank activity - a massive forceful response."
That's not going to happen this time. The central banks have "expended their bullets", "are pulling on a string" and from here on in, something else needs to change to close the valuation gap.
His advice to those brave enough to buy resource stocks and other beaten-up investments applies as much to investors that have been made to look good by monetary policy as it does the governments of the day. Central banks no longer have your back.
"We are going back to old-fashioned investing, where you partner your capital with hard-headed, disciplined management who focus on their balance sheets and are able to pick up good assets ahead of the cycle. It's old-fashioned patience and discipline."