Our methodology is simple. Its getting it right that’s difficult. First of all, we observe, all the time, data, anecdotal evidence, trends, events and developments, everything. Then we postulate theses, what we think all the information evolving before us means. From these theses come predictions about the evolution of investable asset markets. This is the hard part. The next part is easy. We sit back and see if our predictions come true. If they do, we still ask ourselves if it is a coincidence or pure dumb luck, or if it was a consequence of our theses. If they don’t, then we revisit our theses to see if they are still sound or valid. If they are not, then its back to the drawing board. We almost never rely entirely on the price evolution of the asset markets we are interested in. That’s like forecasting the weather by looking out the window. We are not going to wait for a 20% drawdown in the market to inform us that we are in a bear market. That type of signal is ever so slightly late.

Since early October 2012 we have had an overweight on US (the S&P is up 13% from then till now (9 May 2013)), and UK equities (the Footsie is up 11.77%) and an underweight in German (DAX +6.12%) and China domestic listed equities (SHCOMP +5.23%). These were not based on drawing straight lines or smoothed lines through charts but our expectations for the performance of the respective economies, the psychology that transmits such fundamentals to markets and an analysis of the flows of capital to the underlying companies, most of which are global in nature and which thus confound traditional country delineated asset allocation techniques. Happily this view has worked and I have no reason to change the view so far.

The slowdown in the global economy is as expected. In China, it is the continuation of a longer trend, of an economy maturing and facing growing pains, and growing linearly without addressing speed limits and the instabilities that come with growth. In Europe, the EUR continues to sap the vitality of the region, and I expect more misallocation and under-employment of factors such as labour and capital, with associated impact on growth, profits and asset prices. The US remains a bright spot precisely because post 2008, its equilibrium growth rate has halved, so that the meager growth it managed last quarter was an overshoot (by my count) rather than an undershoot (by consensus’ count.)

As the world becomes more mercantilist and less cooperative, the emerging markets will excel in some areas and lag in others. The developed markets hold the cards in technology, intellectual property and productivity and in the case of the US, cheap and domestic energy, and the emerging markets hold the cards in natural resources and cheap labour but could face energy inflation. Central banks will continue to try to engineer as much inflation as they can safely and covertly do so as to erode the debt pile of their sovereigns as well as improve their terms of trade. This can descend into hostilities if they are not careful.

Basically, the problems of 2008 have not been addressed, but global growth and progress has slowed to a rate that we are happy to coast at given the lack of visibility. Normally, this level of uncertainty over unresolved problems would trigger panic attacks but we have been under the Sword of Damocles so long that few even notice its presence any more.

‘Abenomics’ isn’t particularly innovative. Keynesian spending funded by central bank debt monetization was popularized by the Bank of Japan as an ineffective tool to raise output since before every Western Central bank and its accessories multiplied their balance sheets post 2008, with some surprising success. Japan has tried this before with little success, so is this time different? Yes and no. Past attempts at QE by the BoJ were sterilized so that while on the one hand it was buying assets, on the other it sold to maintain a moderate balance sheet expansion. You cannot have a semi-responsible central bank. Irresponsibility is best overdone if one decides to do it. In previous QEs, the current account and the JPY strengthened confounding efforts. Today we see the reverse. So large is the scale of asset purchases by the BoJ that the JPY has lurched down while the current account has deteriorated. Good job!

The liquidity infusion and the improvement in market sentiment has caused the stock market to surge. Most foreign investors are naturally skeptical after two and a half lost decades. Domestic investors, normally the more morose of the two, surprisingly, are the more upbeat. Th current mood and liquidity are such that a continued rally in the stock market is not only possible, it is probable. This, however, is a trade and not a secular trend. Still, such a trade can last a good 12 months or more. 3 to 5 years down the road, the picture is very unclear and rather concerning. For now, however, the trade balance has improved on an accounting basis from JPY weakness, it remains to be seen if the terms of trade will have a more leasing effect on trade flows, consumer sentiment has surged, and the JPY has been allowed to weaken and will be given more latitude by trading partners. That the BoJ has lagged it’s Western counterparts in balance sheet expansion has bought it some forbearance as it eases policy and weakens its currency.

An inflation target if 2% is laudable since Japan has been mired in chronic deflation. However, this deflation is a consequence of demand deficiency in large part due to a rapidly aging demographic, and not productivity. Since Japan is heavily dependent on imports for its energy, oil and gas, a sufficiently devalued JPY will provide cost push inflation, even without a recovery in demand. Is like building a nuclear reactor for the radiation but without the power.

Second, how will Japan pay off its massive debts? The government is accumulating debt faster than it can repay. With a slow economy and an aging demographic Japan will run out of domestic savings to fund itself. A weak JPY will further discourage foreign lenders. It will be left to the BoJ to monetize Japan’s debt as it refinances itself into the future with no end in sight.

Now lets take a detour into the truly unconventional (never never land). I don’t much like central banks for their meddling in the money market, unilaterally declaring short term interest rates and more recently trying to manipulate the entire term structure. So for me, seppuku, is the preferred path for a central bank. What would happen if a central bank made the ultimate sacrifice and destroyed itself? It’s quite unthinkable and quite frankly, if private commercial bank deposits and reserves with the central bank were not protected we would quite quickly descend into barter and social chaos. However, a slightly less chaotic route would be to create a bad central bank and a good one. Before this happens the central bank will make its ultimate sacrifice. The sovereign would issue special bonds at negative nominal interest rates for purchase by the central bank and any other self destructive investors (there are always a few). The government would receive positive income the more it issued and help its fiscal position. The central bank would face guaranteed losses which it would fund out of money printing. At some stage the central bank would become insolvent but given its ability to print money this is not an obstacle. Appoint of acute stress would no doubt come when the central bank would have to reorganize itself and hive off a bad bank holding these ridiculous negative coupon bonds with just enough capital at it would simply amortize to thin air in a finite time frame. But here is the thing, if you we’re trying to get 2% inflation, it is likely that this little stratagem will decimate your currency and deliver you several thousand % inflation. Would you call that a rip roaring success?

The US economy is currently in a slowdown. How significant is this?  If we assume that trend growth for GDP is 4%, as was widely believed to be the case pre 2008, then 2.5% GDP growth would have indicated an economy failing to recover fully in its latest cycle, which would be quite negative. If, however, trend growth is 2% as I believe it is in a post 2008 world where the economy is not only no longer fueled by credit creation but also attempting to gradually deleverage itself, then 2.5% growth represents an overshoot, a cyclical high from which the US economy is currently climbing down, and therefore to be expected. It would be indicative of a normal recovery, albeit along a so-called ‘new normal’ equilibrium path of lower growth. 

Caveat: A strong economy does not always imply a strong US stock market. Companies are global these days and need to be appraised individually on their peculiar merits. Many US companies are exporters and derive their income from markets which are slowing down, such as the emerging markets, or in depression, such as large swathes of Europe. Since the recovery from the depths of 2008 the right plays were exporters, today one should be sifting through US domestic businesses for opportunities. One asset type which is particularly domestically driven is residential real estate. US housing is on a steady path of recovery. Non agency mortgage backed securities provide senior claim as well as income together with upside to house prices.

Corporate balance sheets have been significantly repaired since the crisis of 2008. On the other hand, sovereign balance sheets became and remain in poor condition. Most countries have addressed this problem by instituting programs of debt monetization with, as an associated bonus feature, artificially low interest rates across the relevant term structure.

This lowers costs of debt capital for private businesses, if they are able to access credit, and has provided businesses the opportunity to raise debt and of refinance existing debt at lower rates improving margins thus simultaneously improving liquidity, profitability and this solvency. Equity valuations are also enhanced as discount rates are reduced and comparisons of earnings yields to alternative sources of return such as treasury or corporate bond yields are also improved.

While there is real improvement in corporate solvency and profitability, much depends on interest rates. The questions are, can central banks keep rates low, for how long can they keep rates low, and, how robust are balance sheets and profitability to rising interest rates.

How long will central banks maintain low interest rates? For as long as it takes, seems to be the universal answer, which is reassuring. At least mostly. Interest rates represent a hurdle rate when making an investment. Artificially low interest rates can encourage excessive risk taking or simply ill advised investment leading to misallocation of resources. Also, in a market economy, it might be hoped that the price of capital, arguably the most important price in the exhaustive set of prices in the economy, should be determined by the market and not a central planner unilaterally declaring a price. Academic issues are quickly subordinated to more practical concerns in times of crisis, and yet it seems that the practice has predated and survived the crisis. Let us assume, therefore, that low interest rates are good, thereby transforming a thesis into an assumption.

How are central banks achieving low interest rates and why might they fail? Central banks are able to set short rates by declaring their own short term rates at which they will lend or borrow. The banking system transmits this through their deposits at the central bank by pricing loans as a spread over this base. At longer maturities, the central bank may either do the same and provide credit at longer maturities or it can buy government bonds, simultaneously setting a rate and funding the state. There are some limitations to this strategy. Inflation may accelerate. While a little inflation is a good thing, excessive inflation is not, and runaway inflation tends to be the product of a loss of confidence rather than a continuous erosion of purchasing power. With a money base as inflated as most central banks have, one has to question how this money base will be shrunk when the economy recovers. Also, since the velocity of money multiplies the money base in the measurement of nominal output, a small pick up in the velocity of money could lead to a jump in inflation. Also, asset sales by a central bank which has crowded out the sovereign bond market could make for a very unstable term structure. Confidence can also affect the currency which could force a damaging defense involving higher interest rates.

How robust is the economy to higher interest rates? With interest rates at such low levels, interest expense is highly convex to interest rates. Household debt service is therefore quite sensitive to higher interest rates. Households appear to be aware of this as they increase their savings and reduce debt. The same can be said for corporates which have raised significant levels of fixed rate debt to lock in current interest rates. Corporates cash hoard will also probably mitigate some of the impact of higher rates.

PS:

It is a peculiar time for investing. Investors cannot see beyond low interest rates, reasoning perhaps that the implication of higher rates is simply too dire for governments or central banks to bear. Under a regime of low interest rates, now that the yield has been wrung out of bonds of almost all regions and issuers, equities shine as good value. Investors seem to even have forgotten the volatility of equity investing, seeking yield in the form of dividends. (One could say that dividends dampen the volatility of stocks but the other argument is that yields are far too low for an asset of infinite duration.)

As for hedge funds, the mass of them provide some equity correlation, some spread duration but for the most part generate a negative alpha. As one would expect in the opaque world of hedge funds, a small group continue to generate very attractive returns without taking excessive risk, certainly taking less risk than the garden variety long only mutual fund, unfazed by the macro vagaries of the market, engaging in arbitrage or relative value or trading in niche markets where they have an edge. Most investors will not have the access to these managers, or the resources or faculties to make sense of their activities, keeping them relatively compact compared to their long only brethren, keeping them hungry and nimble. As the growth of the size of the pie slows, it is increasingly important to engage managers most able to take a bigger slice of it on one’s behalf.

The first quarter of 2013 has ended with risk assets mostly higher than at the end of 2012. It would seem that the optimism that greeted the new year was well placed. Indeed many of the problems in the world have been solved, patched or postponed.

The big picture remains very much the same as it had been in the past 4 to 5 years. A credit bubble had been inflated with inflated collateral. The bursting of the bubble was precipitated by falling collateral values which led to a nasty feedback loop exacerbated by excessive leverage. So acute was the problem that governments were forced to step in and bail out the bankrupt, meaning mostly the lenders to the borrowers whose collateral was no longer sufficient to cover their debts. Most of this collateral was residential real estate. The impact was a retrenchment in consumption and thus profits and thus investment and thus employment. These were the effects on the private sector. For the public sector, bailouts are not free and as a result fiscal positions were severely impacted. This meant questions about sovereign solvency which were answered by successive rounds of debt monetization, an apparatus quite indistinguishable, and conveniently so, from quantitative easing, a perceived lesser evil.

With the private sector largely bailed out, a real economic recovery has taken place in most places except where structural impediments have confounded efforts by the private sector operating in market economies to heal themselves. No where is this more apparent than Europe, where the Euro suppresses price discovery and coupled with sticky prices in some markets, such as the labour market, result in a failure of such markets to clear. Elsewhere, the healing takes place, at least in the private sector. The public sector, however, languishes in a risky state of uncertainty and personality disorder.

Absent a strong ideological compass, public sector policy has been pragmatic, itself a laudable quality, but lacking conviction, lacking vision and ultimately, lacking firm theoretical basis.

Where government is weak, indecisive, divisive and chaotic, the private sector has moved on. Some reservations remain, which may constrain longer term investment, but by and large, market mechanisms allow the private sector to move on. These economies correlate with poorer fiscal positions and lower growth.

Where government is more pervasive, invasive, authoritarian and has historically been relied upon to lead the private sector, recovery is slower, less firmly entrenched or unbalanced. These governments, correlate with countries with better fiscal positions and higher economic growth.

A caveat over the government finances. If bank balance sheets are hard to read, country balance sheets are mostly indeterminate. Strong accounting standards can mitigate some of this risk but mostly the problem lies not in accounting standards but in risk management. If either the intention or the ability to manage risk is compromised then so is the endeavor.

The desperate throes of the developed markets’ central banks in their efforts to support their sovereigns, revitalize their moribund economies and inflate away the public debt has led to a number of side effects. Most of all, the expected inflation has not surfaced at home, but rather has manifested abroad, where economic growth is less somnolent. In a world with open capital accounts, this was bound to happen.

Globally open capital accounts and having a currency widely used as a reserve asset together make for effective quantitative easing / debt monetization. It affords the central bank good control over the entire yield curve. Relaxing any of the above assumptions endangers this thesis. Widespread recognition of this phenomenon may also trigger vigorous resistance, most likely by a limited restriction of capital mobility, hopefully not much worse.

A global economy also spawns global businesses or global companies. When investing in businesses, whether it be in their equity or debt, sweeping macro considerations are best replaced by the bottom up analysis of the multinational, multiregional nature of these companies.

This does not mean that macro investing is not useful. However, the tools of macro investing are more often than not currencies, interest rates and sovereign bonds. Equities cross too many borders to yield to macro analysis. Real estate, whether its equity or its debt, is also another highly locally driven asset class. But here, the line between macro and micro is nothing more than a factor of magnification.

Very often, what is and what should be do not converge. This is often a source of opportunityy. The Euro is an interesting example. Its use to the investor lies in its inefficiency and inappropriateness. Forcing a single currency upon a region with differing factor productivities and sticky prices must create imbalances which tend to gradually build and then break. This creates trading opportunities for the astute investor with an eye for fundamentals and a sympathy for the rhythm of market psychology.

A more fearful divergence lies in the very model of our economy. Capitalism. Mathematically elegant, it has become diluted and perverted, by the absence of a nemesis, ever since the fall of Communism. Moral hazard taints all capitalism today. The asymmetric treatment of gain and loss invalidates all the mathematical underpinnings of efficiency of production and allocation under a free market. The arbitrary bailouts mounted by central banks and governments have only served to enhance the reputation of interventionism and big government. Government involvement in an economy should only be to provide contingent measures when the free market is unable or unwilling to supply a good or service. Yet current public opinion, and indeed, the opinion of conventional economists, is that governments need to do more. This has serious repercussions in the longer term. Understanding the motivations of economic agents and macro economic behavior will require new models and new insights.

Finally, before I sign off, there is still a vast amount of debt which remains to be repaid, defaulted upon or inflated away. So far, it has just been moved about and refinanced in rather creative ways.

There are some specific strategies that arise from the above:

Overweight companies with intellectual property and brands. These are more easily found in the US and Europe. They will confound their own countries’ macroeconomic ills.

Buy the US housing recovery. This continues to be best expressed through the non agency mortgage backed securities market.

Avoid Chinese financial risk. The Chinese shadow banking industy is not bad for being a shadow banking system but for its opacity and the resultant difficulty of assessing the priority of claim. The risk that any default or run on the system could turn out to be disorderly is high. By extrapolation, one should be cautious of any associated risks in the real economy and its businesses.

Overweight hard duration in developed markets like US, UK and Germany. Inflation created by QE is surfacing in emerging markets where
one should expect yield curves to steepen relative to developed market term structures.

Overweight the USD. The trade position of the US has changed for the better. While the Fed continues to operate QE, so does the BoJ, BoE and the ECB. At the same time, China isn’t exactly tightening monetary policy and is accumulating debt at an alarming pace.