1. Recent market action
2. Is there a fundamental weakness?
3. Inflation
4. QE dependency
5. Market expectations over next 12 months

Recent market action:

I would never advise anyone to look at market movements on a daily basis. At these time frames what we observe is noise and not signal. With this caveat, let’s have a look at what has happened.

US markets ended last week with a sharp fall on Friday (Feb 2), ostensibly triggered by strong employment and wage data fuelling fears of inflation and more aggressive policy reaction. After the weekend we saw a week of very high volatility. From peak to trough in over the last 2 weeks, the S&P500 was down over 10%. VIX rose from below 10 to over 50. One inverse VIX ETF has been liquidated. Commodity prices have been falling in sympathy with bond and equity prices. Even the gold price has fallen. As risk assets have sold off, the USD which had been very weak as the risk assets rallied all last year, rallied, behaving like a haven asset.

The 10Y UST has traded from a yield of 2.6 to over 2.8 and the 30Y from 2.93 to 3.1. The USD yield curve steepened, the 2 – 10 steepening 17 bps. The HY bond market has seen spreads widen from 3.00 to 3.31. The IG spread has been volatile but has generally tightened as the duration element has dominated pricing leading perversely to spread tightening. Loan spreads have begun to widen but have so far lagged and been stable.

The blame for the initial sell off has been inflation expectations and a more hawkish Fed. 5 year 5 year breakevens, the market pricing of inflation have jumped from 2.15 to 2.26. But PCE Core inflation hasn’t seen 2% since 2012 and at 1.5% still has room to rise before it even reaches the Fed’s target. Eurozone inflation is even further from target. If inflation is really a threat, the market is being very forward looking, and jumpy.

Is there a fundamental weakness?

The reasons there is not:

• Global growth is strong, accelerating and broadening to include more regions and countries.
• International trade has rebounded and is growing.
• Inflation is rising but is well below central bank targets. (More on this later.)
• Emerging markets have their balance sheets in order with less USD liabilities.
• Interest rates remain low. Among the majors, only the US Fed is tightening and even then is doing so very gently. All other majors remain accommodative.

The reasons there is:

• The global economy has lived off 10 years of QE. While the ECB and BoJ continue to operate QE, there are fears that they may taper their programs. Already the US Fed is raising rates and shrinking its balance sheet. We are about to discover if global economic growth can be sustained without QE.
• Global debt levels are high. Debt levels have increased significantly in the last 10 years. Debt has not been paid down but has been transferred from private balance sheets to public ones. And why not since everyone including central banks are such willing lenders. Non financial corporates have been the most aggressive borrowers followed by governments then the financial sector with households trailing the lot. 
• Inflation may be rising. The US labour market is showing signs of tightness with higher wage growth, lower unemployment and higher quits rates.
• Political risk remains. While the US seems to be surviving a Trump White House, the French have eschewed National Front politics, the UK continues to limp ahead with the ruling Conservatives split down the middle. Germany will have a grand coalition but also the AfD in the Bundestag. Italy goes to the elections in early March.

When markets rise the public focus on the good fundamentals. When markets fall sufficiently they will once again focus on the bad fundamentals. In a sense, the market influences how we look at the world.

Inflation

At this time inflation seems to be to blame for the market sell-off. The strong labour market data in the US on Feb 2 triggered fears that inflation would rise and that the rates market and possibly the Fed might be behind the curve and have to compensate. Since equity market valuations were high, and being justified by low interest rates, the threat of higher and rising rates naturally caused a re-assessment of equity valuations.

Inflation in the US is 1.5% (core PCE, the Fed’s benchmark measure.) The Fed’s target is 2%. Inflation in the Eurozone is 1.4% (HICP). The ECB’s soft target is 2%. China’s headline inflation’s recent peak was 6.5% in 2011 from which it has steadily fallen to the current 1.8%. Japan’s inflation is only just in positive territory and barely merits mention. It seems premature to fear an overshoot of inflation when current measures are significantly below targets.

Is the inflation threat real? If trade protectionism gains momentum, it would add to inflation pressures. So would a fiscal deficit, a weak USD, rising energy and commodity prices, and a tighter labour market. We think that rising interest rates itself will spark inflation for technical reasons. So I do expect inflation to rise and for the rise to accelerate, but I also see that inflation levels will only be a concern over a year from now. Has the market become so forward looking? We do not think so.

QE dependency

The global economy has survived on QE for 10 years. Like any painkiller, it is difficult to give up. QE has done a lot of good, it has given regulators time to restructure and recapitalize the banking system. It has cushioned the blow of recession and shortened the duration of the slump. It has cheapened cost of debt and helped the economy to find its feet and recover. On the other hand it has strengthened moral hazard, it has distorted prices, not least the price of money (interest rates), not only at short maturities but at all points along a 30 year yield curve. It has inflated asset prices and exacerbated inequality resulting in over saving. By intervening in the market mechanism for pricing assets, we now do not know the right price of assets without QE. And we may be quickly discovering what those prices may be.

The US Fed has begun to shrink its balance sheet and no longer buys the quantity of bonds it used to. The ECB will stop expanding its balance sheet Sep 2018. The BoJ looks like it will continue QE for the foreseeable future. The PBOC manages towards domestic objectives but is trying to risk manage a financial system which has leveraged itself up acutely. It is not the level of liquidity that matters but the rate of change, and the Fed’s actions will have significant impact.

Market expectations over next 12 months

We’ve had 9 years of uncertainty over global growth punctuated by mini crises and growth slumps, patchy recoveries and tepid growth and how did the market react? With a 9 year bull market. Earlier this year asked how markets would react to a growing consensus of confidence and optimism and appear to have found my answer.

In order of confidence

Interest rates will rise.

The Fed is not just reacting to inflation expectations but has to reset its primary policy tool in case it has to be deployed again. The strength of the economy gives the Fed a window of opportunity to do so. I am quite confident that that the Fed will stick to 3 hikes this year with a small risk that they may do four. What could confound my expectations? So far the market volatility has been most felt in equities. If the yield curve steepens too quickly or if credit spreads widen too much, this could do the job of the Fed for them in which case they might slow down.

Credit spreads will widen.

Corporate credit spreads are very tight relative to history and it is very difficult to see spreads tightening further. Also, as we are in a late stage growth phase I would expect to see increased leverage and with rising base rates, rising debt service. Default rates are likely to rise and recovery rates to fall. The credit market is a fairly rational one and will likely price these dynamics in.

In mortgage bonds, however, I see continued improvement in collateral and in debt service with a stronger labour market.

The yield curve will steepen.

In addition to rising rates we also see inflation picking up. I think that this is a slow but steady process and that the curve will steepen to price in the inflation. Not only that, the US budget and tax reform will increase the borrowing requirements of the US government resulting in greater issuance. Add this to the Fed normalization and the uncertainty on whether China will remain a big buyer of treasuries and the recipe for curve steepening is set up. What could confound the view? Inflation hasn’t even reached central bank targets in any of the major economies and if the current trend in rising prices might not gain momentum.

USD will recover.

The weakness in the USD all of 2017 was somewhat of a mystery to us. The Fed was the only major rolling back accommodation, the economy was strong and continues to be strong. Experts cite the stronger growth in Europe and the risk that the ECB might taper QE thus favouring EUR but the USD was also weak against JPY and the BoJ is in no danger of tightening anything soon. Our view is that the USD is a haven asset and that a heightened risk aversion will support the currency. Or at least re-focus investors to the fundamentals of the US, a net importer trying to be more protectionist, a strong economy, with a central bank pulling back the liquidity reins.

Equity markets will continue to rise.

With a strong economy and wide spread upward earnings revisions it is unwise to bet against a rising market. However, if a market rises to X% above fair value and it corrects you can be sure it will not stop at fair value but can easily fall to X% below fair value. On average and over the long run, I should expect markets to track growth and earnings.

Volatile markets with a trend represent an opportunity. It allows the active investor to rotate between being long the market via the underlying stocks to being short put options to being long call options, and to take advantage of volatility.

The USD has been weak all 2017. In early 2018 its weakness has worsened acutely. With the US economy in good health and printing growth numbers like 2.6% annualized in Q4 2017 and with interest rates rising, its difficult to understand why the USD is weak.

Some have attributed the weakness to the pre-emptive nature of markets and that investors are looking for a turn in monetary policy at the ECB and BoJ and that a change in policy has greater impact on markets than a continuation of policy, however determined. Others point to the trade deficit which has begun to widen again, but the US is a chronic deficit nation.

What is more likely is that the USD is a safe haven currency. For the last 8 years we have had fear and trepidation which has buoyed the USD. Sure, there have been bouts of USD weakness coinciding with JPY strength but these are not because JPY is a haven currency but that it is a funding currency. The same could be said about EUR.

If the USD is indeed a safe haven currency, then the current exuberance about global growth prospects and equity markets explains the weakness as investors diversify into riskier assets and currencies. If correct, the USD could be a cheap hedge to equity risk, and could be an interesting value play in itself. Sooner or later, risk manifests itself as damage.

8 years of recovery

We have now had 8 years of economic growth since the financial crisis, with a little turbulence along the way, the European banking crisis 2011/2012, Taper Tantrum 2013, the China stock bubble in 2015. China has clearly matured and growth rates decelerated as one would expect from an economy of its size. The US has grown steadily albeit at a slower pace than in previous decades. 2017 witnessed a deepening and broadening of growth most notably in Europe and Japan. India’s potential remains good but has been held back by some necessary policy adjustments. Generally, it has been 8 years of prosperity, punctuated by few moments of stress.

In the last 8 years, the major actors on the economic stage have been the central banks. When crisis struck they were quick to respond with liquidity infusions and rate cuts. As with all painkillers, QE and ZIRP are addictive and hard to wean off. Currently, the US Fed is the only major central bank which is raising rates and normalizing balance sheets. The People’s Bank of China is trying to manage the credit transmission in the economy, not really tightening policy but putting an unruly system in order. The ECB remains accommodative at least up till September 2018. The Bank of Japan at last sees a growing economy and may be able to shift its QE program down a gear. One thing is clear, the need for extraordinary policy has passed and it is time to reset policy for when the next downturn hits us.

The global banking system, found wanting 10 years ago, has been put in order. US banks were recapitalized some years ago and now the European banks are also in good shape. Regulations and capital requirements raised in the years following the crisis may even be relaxed. But though their period of expiation has passed banks face new challenges in the shape of Fintech and the shadow banking system. This evolution of financial intermediation poses challenges and opportunities. Regulators will have to change and expand their remits accordingly.

Tech has had a resurgence that has already well surpassed the heights of the Dot Com boom of 2000. Innovation has progressed by leaps and bounds, in hard as well as applied tech. The potential for the likes of Amazon, Tencent, Ali Baba, Facebook and Google appear limitless. But the high profile  of the tech sector invites scrutiny and regulation, adding an additional dimension to tech investing. On top of that no investor should forget the limitless potential of Nokia, Ericsson, and the telcos in the late nineties.

To answer the question of whether equities can keep rising we need to understand the future of central bank policy and inflation. History tells us that central banks don’t raise rates very far before the next problem arises. However, if the pace of rate hikes is sufficiently slow, and inflation muted, interest rates should not rise enough to threaten the expensive valuation of equities. This appears to be the broad consensus, however, it also assumes that there are no other factors which may cause them to accelerate their tightening. Inflation has been surprising low given the tightness in some labour markets and the pace of growth. One factor is the rise of innovation which increases productivity and efficiency. Another factor is inequality which leads to a surfeit of saving and demand deficiency. If central banks can maintain the glacial path of normalization, and inflation remains subdued, then equity markets are likely to continue their ascent. However, given recent performance, future performance is likely to be more subdued.

If inflation rises, and it may do so if commodities and energy prices rise, or if rising interest rates should reduce slack in the economy, or if the Neo-Fisherian view (that real interest rates are slow to adjust and hiking nominal interest rates can lead to inflation) is right, then the outlook for equities could deteriorate. Valuations will be harder to support with higher interest rates and steeper yield curves.

Topical Areas:

China is no longer an emerging economy. With over 11 trillion USD nominal GDP, it is unsurprising that growth has slowed. The last 8 years have also presented China with several major challenges. One of them is how to deal with a more insular, protectionist world. China’s response to this global trade (cold) war was to become more reliant on domestic demand, a continuing project. The reshaping of its economy, especially while trying to maintain stable growth has been capital intensive and has led to massive credit creation, through the banks and the shadow banking system from the bond market to more exotic financing structures such as LGFVs. Today, China is trying regulate and manage this complex credit intermediation system. Investors have watched developments with some concern but it is likely that the regulators have matters under control. The 19^th National Party Congress has cemented President Xi’s position which will give him more power to pursue his agenda of integrating China into the international community, building bridges while the US builds walls, and developing a Chinese hegemony. Simultaneously the Party is encouraging rule of law over rule of party, ironically, so it can extend its reach more effectively.

India is one of the most interesting economies in Asia. The country has not seen a simple majority in the Lok Sabha since Rajiv Ghandi led Congress to victory in 1984. Current PM Narenda Modi’s popularity is buying him a lot of patience to conduct a long overdue campaign of reform of the Indian economy. Demonetization in 2016 and GST in 2017 slowed economic growth and imposed short term brakes on growth but the rebound is gaining momentum and the long term benefits of greater banking participation and a common market across Indian states should not be underestimated. A newly drafted insolvency law (2016) has been followed by regulators encouraging banks to deal with non-performing loans and most recently by a plan of recapitalization of the banking system. These measures will unblock credit intermediation which will boost investment. Indian equities are expensive, and inflation is a threat, but the long term prospects are positive. A young demographic, a population fast catching up to the size of China’s and a nominal output only one fifth the size of the Chinese economy frames the opportunity. India is a long term play with great potential.

Japan’s Topix flirts with the 1800 level, a major resistance which had been tested before unsuccessfully in 2007, 2000, and 1996 in Japan’s lost two and a half decades. Economic growth has been steady and corporate profits growing. Various steps in reform such as easing of visa requirements, getting more women and retirees into the labour force, improving corporate governance have joined infrastructure investment, fiscal expansion and ultra-loose monetary policy in propelling the economy and the stock market. There is a palpable revival of animal spirits in Japan, the economy is not only growing but confidence has returned which will translate into an improved business investment cycle lifting the economy further. On a per capita basis, GDP growth is already competitive with the US. For investors, what Japan offers is a glimpse of the future, an ageing population, high national debt, low inflation and clues as to the sectors and businesses which thrive under these conditions.

While equities have done well these past years, on a risk adjusted basis, it is hard to compete with credit. Fixed income markets have performed remarkably well since the crisis, powered by falling interest rates as well as tightening credit spreads. Today, bonds are more overvalued than equities. With central banks shifting towards normalization, (the Fed is already underway,) duration will be a headwind. As for credit spreads, the thirst for yield has led to a consistent tightening of spreads, more pronounced in investment grade but also in high yield. That economic fundamentals are healthy is not in question but there is a price too high and credit is near that. The duration factor can be addressed by trafficking in the floating rate sectors of the market but even these face tight spreads. Structured credit provided cheaper access to the market for more sophisticated investors but even some of these avenues are being exhausted. Mortgage bonds which were areas of value are becoming more expensive. The dearth of value in fixed income will encourage asset allocators to shift exposure over to equities further crowding the space.

Banks. 2017 marked a turning point in banking regulation. The Basel 4 framework has been agreed and will be implemented in the next few years. In the US, a new Fed Chair and a business friendly government will likely begin to soften banking regulation. European banks, some 2 years behind the US in the recapitalization cycle, are now adequately capitalized. New capital rules will require all banks to further strengthen balance sheets, but not by much more. Banks should become more profitable as CEOs will now focus on return on capital, not the raising of it. In China, regulators are perhaps half a cycle behind but are now busy reining in reckless credit practices and stabilizing the banking and financial system. They will likely succeed. In India, a newly inked (2016) insolvency law is being enthusiastic applied with some encouragement from the RBI, followed by a generous recapitalization package. A decade of banking sector underperformance from QE and increased regulation will soon be behind us.

Hedge funds and other alternatives. The era of QE and central intervention saw correlation rise and volatility fall creating very challenging conditions for hedge funds to operate in. Hedge funds thrive on dispersion of returns among assets. High correlation makes it difficult to find winners and losers as assets rise and fall in unison. Low volatility also lowers returns requiring hedge funds to raise leverage but may either find investor resistance or reluctant prime brokers, (who have their own capital requirements to consider.) Indeed equity long short managers have lost market share to event driven and private credit managers as investors seek alternative sources of yield. This may soon change as central banks pull back from ultra-easy policy. Expect volatility to increase and correlation to fall implying easier operating conditions for hedge funds. This coincides with decreasing investor appetite for hedge funds and active managers in favour of passive and index following investing. As investors flock to passive investing, it can pay to move in the opposite direction.

Risk appetite and aversion. Investors have been accused of complacency as the market has risen. Evidence is found in the weak VIX, in high PE multiples and in tight credit spreads. The reality is more balanced. It is true that absolute PE multiples are high on a historical basis but this is less acute once one considers the low treasury yields. The equity yield gap still suggests that equity valuations are not at an extreme. They are expensive but not exorbitant. Then we have credit spreads and here the high valuations are less defensible since they are already expressed as a spread over treasuries. Credit markets are indeed expensive, at least where senior unsecured bonds are concerned. The leveraged loan market is tight, but this is explained by demand from investors seeking floating rate exposure. With the underlying economy in good health, the arguments against loans may be more technical than fundamental in nature. As for the VIX as a complacency indicator, it shows but half the picture. A closer look at the options market reveals that skews have been elevated in the last 8 years, indicative of investor caution. This healthy caution has, however, recently been eroded as the market continues to inch higher.

Generally, FX is sufficiently flow and sentiment driven to confound the best of fundamentally based forecasts and 2017 was no different. In late 2016, a strong consensus developed for a strong USD. The Trump Presidency and the promise of more protectionism and tax breaks coupled with an already stable and growing economy propelled the USD to a high on Jan 2 from which it spent the whole of 2017 falling (the DXY losing 10%.) The improving European economy and the signals that the ECB might begin to normalize policy boosted the EUR more than hard data would have suggested. The long term picture for the USD remains good, however; the economy is stable and growing, the Fed has already turned the corner, and fiscal policy is finally turning the President’s way. The ECB may well end accommodation in October this year and the BoJ might even signal some moderation of its QE, but rate differentials are still substantial and the inflation prospects also still favour the US. The protectionists tendencies will also boost USD prospects over the longer term. While we have long held a bullish USD view based on fundamentals, we see significant interference from flows and sentiment that we had not taken significant currency views in 2017. The long USD trade is one which we think will pay off but which also requires patience and pain tolerance and it is one which we avoid in our more conservative portfolios.

Strategy:

Our asset allocation is advised by the relative valuations between equities and fixed income. While we expect equity returns to slow in 2018 from 2017 levels, we expect the deceleration to be even more pronounced in fixed income. In the past we have always managed to find niche markets within fixed income to provide us with a superior risk return than either equities or traditional bonds. These opportunities are becoming more difficult to find.

We have a disciplined risk allocation process which takes into consideration the potential returns and the risks of each investment we make. Generally speaking, we will be increasing equity exposure slightly while de-risking our fixed income portfolio. On a net basis, this should maintain the overall risk level since equities are riskier than bonds. We will be deploying more risk to hedge funds given our optimistic outlook.

In equities, we will focus more on Asia given the opportunities we see in the region. Our position in Asia also gives us an edge and greater insight into the markets in the region. We expect to allocate more actively to India, Japan and China. In the rest of Asia, we are cautious as the giants pursue their national agendas, potentially to the detriment of the smaller countries in the region. Globally, we have an optimistic view on developed market banks, especially in Europe. Asian banks are probably a year or two lagging developed markets and we will monitor the situation with a view to capturing the catch up when it occurs.

In fixed income, we are understandably cautious on duration. The USD curve has flattened significantly over the year and we do not see much further scope for flattening. The economy is too strong to warrant an inverted curve. That said, the 2 year will continue to reflect Fed rates policy and continue to climb. This implies that the long end should sell off. We will focus our exposure in floating rate paper and may opportunistically hedge USD duration at longer maturities. We maintain the same level of caution on EUR rates which may move in sympathy with the USD curve. In terms of credit, we see more value in high yield than in investment grade corporates but generally regard corporates as expensive. The leveraged loan market is not cheap either but rising rates will bring us some yield. Investment grade CLOs are relatively attractive on a loss adjusted basis and we will dedicate capital to this segment. Generally we are witnessing corporate issuers increasing leverage, in some cases to pay dividends, and see the sector as expensive on a loss adjusted basis. We find better fundamentals in the US MBS market where households’ leverage remains moderate. We also find value in subordinated financials and contingent capital as part of a wider banking theme where we expect the reversal of QE and regulation to be positive for both bank equities and credits.

We have Italian elections in early March. The Germans still haven’t formed a government, and the AfD have 13% (the fictional TV series Berlin Station predicted a 13% vote for the fictional analogue PfD). All the data is good and synchronized. It really can’t get any better than this. Investors are more bullish than at any time in the last 10 years. What could go wrong?

Well, we’ll see.

The Fed is hiking, and no longer buying as much, the ECB’s QE could be running down, the BoJ is the last bastion of super loose money and facing a stronger economy, the PBOC is tapping the brakes on the financial system in China. If you believe that QE had little to do with asset price inflation then you can sleep easy.

Markets did very well in 2017 and are off to a very strong start for 2018. Are you happy with conditions?

The economy is as strong as it has ever been in the last 10 years. We’ve had bouts and pockets of strength but the current expansion is as broad as it is deep. Europe is growing at a rapid pace, America is growing at a stable pace. Developed markets growth is surprisingly strong. Emerging markets have shrugged off trade worries and commodity markets are rising.

It doesn’t seem to matter that the Fed is raising rates and shrinking its balance sheet, that the ECB is not far behind, that the PBOC is increasing regulation and curbing credit expansion. There is widespread optimism.

Conditions look very good indeed. Is there anything that causes you concern?

Markets are driven by inflexions and rates of change, not by levels. A synchronized expansion is vulnerable to change, to a country or region slowing down, to a deceleration. General conditions are so good now a deterioration will elicit a stronger response than an improvement.

We spent the last 10 years being cautious and facing a European crisis, a China stock bubble, various turns of QE and then its taper, all manner of political turmoil – mostly yet to be resolved, and what we got was a raging bull market. What will optimism bring? The market has not been this bullish since 2003, and before that 2000. It was right to be in 2003 but not in 2000. In 2003 it was coming off a recession, in 2000 it was coming off a high.

Valuations are high in both equities and credit. They only look reasonable in the context of low interest rates. If interest rates climb, financial assets could look very expensive indeed. Since we have a correlating factor, a common factor, the risks certainly have risen. You have to get your interest rate call right.

Financial market performance has correlated quite well with the monetary accommodation of the Fed, the ECB, the BoJ in the last 8 years. The Fed is done with QE, the ECB could be done with it soon. We will soon discover how dependent financial markets were on QE. I suspect they were but nobody knows for sure until we reverse the experiment.

There is a small risk that inflation reacts perversely to interest rates according to the Neo Fisherian view. If so, the Fed could be creating inflation with its rate hikes. In any case, inflation could pick up as base effects take effect. Also, commodity and in particular, energy prices are rising. If inflation rises significantly it could change the interest rate outlook on which so much hangs.

So we should be taking risk of the table?

The market can stay irrational longer than you can stay solvent, said a great man. I wouldn’t underestimate the power of the herd and currently the sentiment is with the bulls. Markets over shoot when they rise and when they fall. They’ve already overshot reasonable levels but there is momentum and the overshoot could go further.

Buy some protection. Options are cheap at the moment and it makes sense to remain long the market, but buy some put protection. If you are a value investor, there is no value in sight except for the options market. Implied volatility is not realized volatility, it’s the market’s best guess of what the realized vol will be going forward and it is acutely low at the moment.

As for fixed income, I’d certainly be hedging duration. The market is probably underestimating the determination of the Fed to normalize and raise rates. It’s also probably underestimating the potential for inflation to rise as well. With the breadth of the economic growth we are experiencing, I wouldn’t be betting on lower EUR or JPY rates either. Credit is another matter. The corporate bond market is as tight as a drum and there is certainly very little value there. If you want to invest in credit you have to find cheap conduits, cheap vehicles, to access corporate credit, and there just aren’t that many.

We hear that equity valuations are near historical highs and credit spreads are extremely tight. Are markets really expensive?

In absolute terms, equity markets are very expensive and credit markets are acutely expensive. You can find cheaper access vehicles to credit but you’ll have to accept some complexity and illiquidity. There are pockets of value in ABS, in particular in RMBS. But generally markets are expensive. The only way to justify valuations is to compare them to sovereign bond yields. It’s cold comfort because all that says is that sovereign bonds are even more expensive. Further, it means that one should expect markets to be very sensitive to the sovereign bond market and to interest rates.

So in summary, general conditions are healthy, good even, but markets are expensive and investors are complacent. Is that a fair characterization of the market? How would you invest under these conditions?

I think that sums it up quite well. That the underlying economy is growing is a comfort, so one should be long the market, not short. That markets are expensive means you should be cautious and therefore look to buy put protection. There are some fairly valued markets around such as the US mortgage market, but you can’t have all your eggs in one basket. Banks and financials are cheap, and facing a more forgiving regulatory outlook. And if you have to buy something expensive, it better be growing fast, so selected emerging markets like India, or Vietnam, some turnaround economies like Japan but you don’t want to over pay for pedestrian growth just because that economy happens to be in a cyclical upswing. It has to be a more durable growth than that.

But caution means you will miss some upside and some opportunities. If you are unwilling to miss out, you have to capture all the upside, you will inevitably capture a good part of the downside, when it comes. If you are lucky, the end comes late and you will have compounded a sizeable return by then. If the end comes soon, then, not so lucky and it will take some time to recoup losses. It depends on how reliant you want to be on luck. There’s certainly an element of it in everything.

Tell us what you make of Bitcoin and all these crypto currencies. A fad or the real thing? Will they last and are they worth that much?

Honestly don’t know. And yet, they have strong parallels to fiat currency. Fiat currency, the USD, the EUR, have value because an authority said so and we accept that it is so. Cryptocurrencies have value because a group of people say so and because sufficient people accept that it is so. Bitcoin is too volatile to be a medium of exchange because no one would ever pay with it as it is rising. Its not really a good numeraire since its value changes by so much in so short a time. It is a good store of value because it’s been rising but the since late Dec 2017 till mid Jan 2019 we’ve seen a lot of volatility. If you paid 18,800 USD for a Bitcoin, you’re store of value has fallen by over a quarter and then rebounded some. Is it a fad or will it last? I really don’t know. There will be insufficient coin to facilitate trade as long as the speed of mining is artificially handicapped. It’s tempting to say that cryptocurrencies aren’t real, that their value is arbitrary or dependent on the greater fool, but the same could be said of fiat currency. Perhaps the greatest thing about cryptocurrencies will be what they teach us about our perception of the financial assets and objects which we are so familiar with. Familiar to the point that we fail to examine them objectively.

What are your best investment ideas for 2018?

A portfolio is not just a collection of investment ideas. At all times a portfolio should be constructed so that it has the desired exposures and diversifies or hedges away unwanted exposures. I am invested in US mortgages, residential and commercial. I have non agency exposure and I have agency CRTs as well. I have a little emerging market hard currency credit exposure, not currency or duration exposure. I access corporate credit through CLOs which cheapen the access a little and also provide better diversification and credit enhancement. One of my main themes is banks and I have a significant exposure to bank’s contingent capital, especially in Europe. The result is that the credit book is quite risk on. What little duration there is is hedged not with swaps or futures but with long bank equity positions. Beyond a hedge, I expect banks to outperform the broad equity market and so have a significant overweight position. I am optimistic about India and Japan and am overweight their equities. Tech may come under pressure from increased regulation so I am underweight. The equity allocation is roughly neutral but I own put protection as implieds have been cheap and it makes sense to own some vega. I have a tactical trade in a 2 and 30 USD curve steepener betting on the flattening of the curve being overdone and inflation being underpriced. I’m watching the Italian elections closely to see if there might be an opportunity to buy BTPS against shorting bunds.