The history of our planet is replete with extinctions. As our planet’s environment and conditions evolve, and as the various species which live upon it evolve, speciation and extinctions occur. At the point of writing there are an estimated 8.7 million different types of life forms of which animals number between 1 to 2 million and plants just below 400,000. These are rough estimates of course, given the difficulty of discovering and numbering the vast number of living things in the world. There is a natural rate of extinctions in a dynamic system such as our planet, and a natural rate of mutations resulting in new species. Most species do not alter their habitat significantly or significantly quickly to alter the balance of creation and destruction. One species defines itself by its ingenuity, ability to use tools, ability to organize itself to achieve macro sized impact, and ability to intentionally change its environment to suit its own purpose. Humans. Humans do not set out to systematically cause mass extinctions within or across species. They may do so out of neglect or inability to foresee the collateral consequences of their actions. One of the most damaging impacts of humans is that their actions, by reason of their macro influence, correlate the extinction phases of multiple species. They also interfere with the duration of speciation and extinction. This loss of temporal diversification is damaging. In addition, human’s colonization of greater areas of the planet also reduce geographical separation and impedes speciation. The result is a net reduction in bio diversity as speciation is slowed relative to extinction. The actions humans take to encourage bio diversity have unpredictable results. Any systematic approach to encourage bio diversity could introduce systematic biases which miss the point of temporal diversification and balance between speciation and extinction.

Following a pretty bad final quarter in 2018, markets had a good first quarter 2019. The reasons for the rebound included a) the fact that markets overreacted in 2018 to growth fears and the US Fed sending too hawkish a signal, and  b) the US Fed retracting its hawkish message and aligning with the Chinese and European central banks in accommodative policy. The global economy continues to cool as trade tensions maintain a damper on growth, loose monetary policy faces diminishing returns and loses some of its impact, and the natural fatigue of a long period of growth sets in.

Many factors can drive markets but only one or two do at any one time. Earnings growth may be slowing and valuations may have recovered but the U turn of the Fed in signalling policy from hawkish to dovish, and the ECB finally caving to evidence of weak Eurozone growth, together with the PBOC making large scale liquidity infusions to address slowing growth in China, all together represent significantly expansionary liquidity conditions. These have driven and will continue to drive markets higher. That growth and earnings will moderate mean that valuations will get richer and there may be more caution in the markets as it heads higher. This is no bad thing in the short term.

Since the driver of equity returns has been looser monetary policy, bonds have rallied in unison. Also, since the momentum behind returns has also been due to a rebound from an overreaction to bad news, we can explain the relative performance of certain markets. The most liquid and retail investor populated markets suffered the most volatility, fell most against their valuations and rebounded most. Chinese equities were priced for recession in 2018 when reality was a moderate slowdown. The actions of the PBOC to supply liquidity and cut funding costs have buoyed the Chinese equity market and are likely to continue to drive that market up. European equity markets have also done well as the ECB has back tracked on its intentions to raise rates. In fact it has replaced QE with repo operations that represent quasi QE. The Indian market, which did well last year, has fared less well this year as political risks loom with the elections already underway.

Liquid credit did very poorly in Q4 2019 and subsequently rebounded strongly. The initial sell off was triggered by fears of tighter policy and slowing growth hitting both duration and credit spread simultaneously. The sensitivity of credit to liquidity exacerbated the impact. Both the ECB and the Fed backtracked on normalization. The ECB had been too optimistic on Eurozone growth and had to replace QE with a similar policy while the Fed signalled a pause in rate hikes and balance sheet normalization. The rebound was equally as sharp as the declines the past quarter and occurred in both duration and credit. As a result, floating coupons underperformed fixed coupons. The liquidity impact was also reversed. Basically, CLOs and loans suffered smaller losses and experienced smaller rebounds  compared with the bond market which fell harder and bounced higher.

What does the rest of the year hold for markets?

The expectations for slower growth are well founded and telegraphed. This will validate looser monetary policy which will continue to support asset markets. However, as slower growth becomes more evident, the strength of the rally should fade. On a net basis, liquidity should beat slower growth and markets should trend upwards albeit at a slower pace. In equities, this favours more levered companies. In debt markets, this favours duration over credit. Given the extent of weakness in Europe, this theme will be more pronounced in EUR and Eurozone issuers than in USD or US issuers. Already there has been rotation from loans and CLOs to bonds and this should continue further into the year.

A word about oil. The collapse in the oil price in 2014 was due to the Saudi’s flooding the market in reaction to increased US shale production. The collapse in the oil price in 2018 was due to the Saudi’s over producing beyond their quotas in reaction to the recovery in US shale production. The market is highly manipulated or managed if you are more diplomatic and strong short to medium trends can result from these interventions. In the longer run, that’s 3 to 5 years, the industry hasn’t invested in sufficient capacity and shortages will result. In the longer term, the rotation to cleaner energy sources will limit the demand growth for oil.

At some point the markets will turn and fall but there will be specific triggers for this. I cannot, of course, see what these triggers are, but can guess at the conditions necessary for this to happen.

Interest rates head higher. This could be because of inflation, which is unlikely, causing central banks to reassess their policy. Central banks might reassess their policy because of a rebound in growth prospects as well but this is equally unlikely. Rates could head higher if fiscal positions weaken and sovereign issuance rises relative to demand. This is more likely.

Politics could be a trigger and is always unpredictable. Europe has elections, India is in the midst of them, the US will be preparing for them. Inequality continues to sustain populism, no bad thing unless that populism takes on a lazy, cynical and later aggressive posture. Politics would have direct impact on risk assets as well as sovereign rates. The list of potential political dislocations is long and deserves separate comment.

A crisis in a specific market such as Chinese debt, US loans, corporate bonds, is unlikely. We are more likely to face a whole host of smaller problems, although they might coincide in terms of timing. The banking system has always been the coordinating factor in financial crises and the reform and regulation of the past decade have made banks safer and less of a systemic threat to the economy.

The level of debt in the global economy is high and rising and a problem but it is a latent one. It requires a catalyst without which it is likely to grow quietly in the background. We have found various innovative solutions to funding this growing debt and avoiding a disruptive repricing. Anything that threatens the debt service, which is most sensitive to interest rates, will catalyse the repricing. So while the level of debt is a problem, it is already too big for us to worry about, we should focus on the level and path of interest rates. Given the structure and organization of the economy, society and politics, it is unlikely that the debt level will be significantly addressed or reduced for some time to come.

It is clear that the global economy is slowing, most acutely in Europe, but also in China and even in the US. This much is quite obvious from slower moving economic data. Yet for the first quarter, risk assets from equities to high yield credit have done well. This has mostly if not entirely been down to central bank policy, real or perceived. We know the ECB had been ignoring weak data to its peril and had to retract its optimistic appraisal, we know that the PBOC had been tight last year before loosening in the final quarter 2018 and following through this last quarter. The Fed, which miscommunicated in Sep 2018 has since made a radical turn and signalled loose policy.

I think there is a serious weakness in the global economy and financial system, which is excessive debt. Its not a forgone conclusion and there are serious arguments why chronic and high debt may be sustainable. I just don’t think it is, and if you agree with me, then there is a day of reckoning somewhere in the future. Predicting this day is difficult given the efforts of central banks to defer, hopefully indefinitely, this event.

However, if I’m right, then a crisis must coincide with a sharp rise in interest rates, and FX volatility, which we do not see at this point or indeed in the near future. The volatility in the last week, is therefore most likely to be a short term phenomenon without much depth. It could signal a cap on market levels or it could see further declines, but not a bear market, and not a crisis. Such dips are tradable. It may even be possible, in less volatile asset markets, to sell with a view to re-buying in 3 to 6 months time. In fast moving markets like equities, its not so easy. I don’t even think we are in a Q4 2018 magnitude correction.

China is important. Its population and its fast paced growth, even as it slows, is a significant factor in global demand. China’s situation is not so bad. It certainly has over-leveraged corporate and local government sectors but household debt and central government debt remain well contained. The slowdown is also engineered and self inflicted, most importantly, it is a controlled demolition. The CBIRC and the PBOC are trying to regulate the non bank sector and to do it they need to first divert credit away from it into the regulated banks. This will take the burden off the non bank sector which they can then begin to regulate before allowing credit back into the newly regulated channel. 2018 saw a wobble as the regulators struggled to manage the deleveraging of one sector and the leveraging up of another. Deflating a more highly leveraged structure while inflating a less leveraged one led to net deleveraging at a faster rate than they expected. This has been corrected and the capitalisation and liquidity provision to the banking system has increased significantly.

India is in the midst of crucial elections which could determine its long term trajectory. India’s growth spurt in the last 5 years has been down to having a simple majority in the Lok Sabha for the first time in over 30 years, under a business friendly Prime Minister. If Modi’s management ceases, the risks to India are substantial. At 2.2 trillion USD nominal value, India is a significant player in the global economy, but its linkages are nowhere as ubiquitous and influential as China’s and poses less of a threat, or boost, to global growth. India is a domestic risk and opportunity.

The US has been the only country able to normalise monetary policy for any length of time in the last decade. The recent pause by the Fed is unfortunate, as it signals a Fed beholden to the President, investors, and asset owners, to the subordination of longer term stability and prudence. I do not deny that a slowdown looms but a recession is still a small risk. To back track on normalization because of a slowdown which appears to be a cyclical slowdown, one which should be expected in the normal cycle, is disappointing and could store up risks for the future. Moral hazard is the first and biggest risk, but the lack of latitude in policy is the other big one. The Fed should take the opportunity to normalize so that it can cut more effectively when the depth of recession necessitates it.

And finally, Europe. This is possibly the weakest link, not for Brexit and Italian debt but for the latent political tensions and dynamics that are likely to break cover at this year’s European Parliamentary elections. The Far Right is gaining foothold across Europe, German leadership is in flux, Italy is beginning to sway rather too easily to the League and Spain’s upcoming elections (end April) could easily see another hung parliament. In the meantime, the ECB has been too sanguine and too late and is also about to see a change of Chair. The focus on fiscal and monetary policy has distracted from balancing the economy away from exports, a position which is precarious in the wake of a Chinese US trade war.

So, some serious concerns on the horizon, but the markets should refocus on liquidity for the rest of the year while fretting about growth occasionally. A range bound market at worst, or at best, depending on your point of view.

Capitalism and democracy are fundamentally bound. So it is with some trepidation that we witness the evolution of capitalism post the financial crisis of 2008. Without Communism as a nemesis and a guide it was also a risk that capitalism would make unexpected detours. The reaction to the crisis and its pragmatic prescriptions were done perhaps without considering the deeper ideological implications. Bailouts of particular institutions, industries and of whole economies are not capitalist concepts but the acuteness of the situation at the time called for extraordinary measures and a temporary suspension of principles. Unfortunately, such is human behaviour that a palliative once discovered is difficult to wean off. So it would be a good 7 years before QE would be tapered and then only in the US. No sooner had the rest of the world signalled a return to normalcy that economic growth has begun to slow and policy makers appeared to relapse into accommodation.

The emergency economic measures involved as a side effect the transfer of wealth from labour to asset owners. This will later prove to be a dangerous side effect with far ranging social and political consequences.

The development of capitalism and a welfare state was a deliberate solution to the Marxist threat. The West, recognizing that Marx was possibly right in his observation that capitalism leads to inequality and to the roots of its own demise, rightly pre-emptively addressed this by establishing social safety nets. The cynic may call this appeasement or worse, a capitalist narcotic, but it is prudent risk management.

With the downfall of Communism, Capitalism lost an important part of its raison d’être. Capitalism, communism, are ideologies governing how the organization of society and how it can harness resources to improve its welfare. One important pillar is the avoidance of war. Democratic societies are less likely to seek war, since the masses pay the price, the rule of the masses are likelier to avoid it. Dictatorships are more likely to wage war since the price is not paid by the ruling class who declare war.

The flavour of democracy and capitalism that evolved to meet the communist challenge was always one of balance, against communism and the forces that give rise to it and sustain it. Capitalism post 1990 was designed to check itself, lest its unfettered progress gave rise to the conditions ripe for revolution. For capitalism to persist, the threat of communism was necessary. Without communism, there is no superior economic and social model to challenge it. Without capitalism, there is no inequality to address. You could say capitalism and communism were one and the same, the two faces of Janus.

The world that Marx envisaged and the polarization of the post war years saw clear borders between these two worlds, Russia and China on the one side and the West on the other. The situation today is more complicated. We are still two worlds, but no longer are they geographically distinct. They are among us. Whomever they may be.

However, the deprivation of opportunity is as powerful a force for change as hunger and physical deprivation. The rise of the European Far Right, of populists, of strongmen, are symptomatic of this disaffection for the status quo. It threatens to escalate.

One mitigating factor is the ageing population. Discontinuous and turbulent change tend to be precipitated by the young. The old have invested too much in the status quo to seriously challenge it; they have too much to lose, not a long horizon left to accrue the benefits of that change, less energy and less aggression.

Still, the current type of capitalism persists. It encourages inequality of wealth and income, it often transfers wealth from poor to rich, it fails to address the underlying causes of slow growth, it fails to address fundamental weaknesses in the economic system, and it is increasingly seen as unfair and unjust. In Europe, and elsewhere, it is beginning to incite incipient constitutionally compliant revolt. The democratically sanctioned rise of populists is an example.

What is an alternative investment? With growing popularity among investors, the question of what exactly constitutes and alternative investment is becoming more important. In investment circles the definition of what exactly constitutes an alternative investment is pretty wide and vague. Since we use the name alternative investment, the logical question is, alternative to what? What are traditional investments? It depends a lot on the sophistication of the investor. To a sophisticated investor, many investments might be considered traditional. One definition of traditional investment is by asset class. Bonds and equities are considered traditional investments. Anything besides, is an alternative investment. An extension of this definition is to add that any other way besides buying (holding a long position in) a bond or equity, is an alternative investment. It isn’t too much of a stretch to look instead at the properties of traditional assets and how they are traditionally invested in.

Traditional investments:

• Equities
• Bonds
• Long only
• No leverage
• Liquid markets only

Where do we put these?

• FX
• Commodities
• Real estate
• Infrastructure

Alternative investments:

• Hedge funds
• Private equity
• Private debt
• Structured credit – sophisticated investors would classify these as fixed income
• Asset backed securities – sophisticated investors would classify these as fixed income
• Insurance linked investments
• Litigation claims
• Freight derivatives
• Asset leasing
• Anything an investor can dream up that provides a return that is potentially uncorrelated to equities and bonds.

To be useful an alternative investment should address a weakness or a gap in traditional investing.

• A positive expected return over the cost of capital or financing.

Its not much use investing in something with a negative expected return, after cost of capital or funding. Even in a portfolio context, such an investment would not be a diversifyer or a hedge, it would be an offset.

• A low or negative correlation to traditional investments.

In the quest for diversification, its not much use investing in something which was highly correlated to other investments in the portfolio. If a set of investments were highly correlated, you could replace one of those investments with a combination of the others. It would reduce the complexity of managing the portfolio since there would be fewer items to monitor.

Investor concerns regarding alternatives:

• Illiquidity. Some alternative investments are illiquid. Some are by nature illiquid and some just happen to be illiquid when you want the liquidity. Investors should demand higher returns for poorer liquidity. Liquidity is a complex subject related to mark-to-market valuation. Sometimes, liquidity limitations can be a good thing if they prevent the investor from crystallizing losses at the wrong time. This is especially the case when mark-to-market pricing is not representative of true value and underprices the  an investment.
• Leverage. Leverage is neither good nor bad but amplifies positive and negative returns. However, in most cases, the application of leverage transfers the control of the investment over to the provider of said financing. This can be a risk if the provider of leverage withdraws funding at an inopportune time.
• Complexity. Some alternative investments are complex and difficult to understand. Investors should always understand what they invest in if nothing else so that they can make the right decisions in response to profits and losses.

Beware. The investment industry is full of plain vanilla investments labelled alternative investments when their purveyors seek to justify their higher fees. Investing in these can be a waste of time and money and provide a false sense of comfort. The investment industry is also full of alternative investments dressed as simple, traditional investments when their purveyors seek to satisfy investor demand for simplicity and transparency. Investing in these can hold unpleasant surprises. Try to approach all investments with the same innocent curiosity of a ‘tourist’ and question everything and anything you wish until you are satisfied.