Interest rates will stay low for a long time. The implications for higher interest rates are sufficiently dire that policy has no choice but to ensure low rates across the major currency curves for the foreseeable future. OK, longer than that.

Stocks look undervalued on a yield gap basis. The implication of yield gap analysis must be either that stocks are cheap or that government bonds are much too expensive. From our thoughts on interest rates above, we must conclude that stocks are cheap.

Stocks look undervalued relative to corporate bonds. A corporate bond yield to equity yield gap analysis leads one to the conclusion that either stocks are cheap or bonds are very expensive. The rationale for corporate credit has been that since governments have basically bailed out the private sector, it pays to invest in the private sector instead of in government securities. Since risk aversion is still high, investors seek a senior claim on corporate earnings and assets. Hence corporate bonds and in particular high yield.

The interest rate policy and the parlous state of sovereign balance sheets has led to a perplexing phenomenon. Credit could be a bubble relative to stocks and treasuries. Corporate yields are too low and equity valuations are even lower, but only if interest rates continue to remain low for a long time.

What could change all this? The major developed world central banks will likely keep interest rates low until they cannot. They will be able to continue unless inflation confounds the strategy, and the only threat to inflation (for various reasons I shall defer to another article) is the exchange rate. Japan has had low rates for this long in great part because inflation has been so low, and in greater part because the high savings rate internally funds the public sector. A weak JPY would require a costly defence which would see higher rates and bankrupt (further) the country. Without a high savings rate or foreign reserves, the currency would have weakened and rates would rise, all other things being equal.

All major economic regions therefore need to be able to keep rates low to avert a major repricing of equities and bonds. To do so, exchange rates cannot trend too far from where they currently are. Stationary volatility, even if elevated, is not a problem.

Exchange rates are therefore as important as LIBOR to the central banks. How much more transparent are FX markets than rates?

The problem with the wholesale and long term suppression of interest rates is that it can be inflationary, costly, distort funding markets, and plays fast and loose with relative prices in the economy. It also encourages excessive leverage, which was one of the fundamental problems leading up to the financial crisis in the first place.

The coherence of policy must be questioned. We began with excessive debt which we transferred to more stable hands and which we now hope to pay down over time. As we pay it down we want interest burdens to remain low, so we suppress interest rates. For all the public and private pensions and any institution with long term liabilities which it needs to fund, or indeed any investor wishing to preserve future purchasing power, this creates a yield drought which drives them into riskier investments for a given level of return. In 2001, the Greenspan induced yield drought drove the financial industry to create the instruments tailored to the yield junkies, triple A high yield. In less than a decade these instruments have failed. In the current yield drought, human ingenuity will without a trace of doubt find a way and a product to feed the yield junkie.

In each yield drought, the correct response and indeed the initial intention was to delever the system. The final result, once the symptoms of the initial condition were addressed, has been either a resumption or acceleration of credit creation. Because this time its different.

In these treacherous times the degree of macro risk in markets is substantial and it is tempting to try to capture these opportunities. The confident macro trader will certainly argue for the opportunity while the fundamental investor may be confounded by factors beyond their considerations. One of the more controlled ways of investing in the current environment is event driven strategies.

The current environment is characterized by weak or erratic economic growth, poor sovereign balance sheets, disparity of financial strength and commercial prospects across businesses, policy risk, political risk, and liquidity risk, to name but a few. The macro or fundamental investor is well advised to assume the specific risks they seek and to avoid or hedge the risks they do not. The event driven manager is already predisposed to this approach in the best of times and is well positioned for these erratic markets.

The current climate is certainly fertile for event driven trading. Businesses of varying financial strength make for interesting and active mergers and acquisitions. The strong have the wherewithal and currency for acquisitions, while the weak are motivated sellers or targets.

Private equity LBO activity is conspicuously quiet, yet strategic transactions continue to take place. Post 2008 PE funds continue to struggle at raising capital in the traditional buyout space and many GPs have turned to high yield, direct lending, distressed debt, and structured credit secondaries. The result for M&A is better quality and less highly levered transactions.

The differing fortunes of countries and regions encourage cross border deals with their concomitant complexity, not least from the political angle.

The difficult operating environment is also prompting balance sheet reorganizations (to stave off defaults or hostile takeovers) and defaults. The current environment encourages asset divestitures and capital raisings. In the case of default and or reorganizations, distress investment opportunities present themselves, for example in buying fulcrum securities or providing debtor in possession financing.

Event driven investing is a perennial strategy which excels in hard times and coasts comfortably in good times. The key is selecting a manager with the requisite skills. Unlike macro and fundamental investing, event driven managers require not only investment and trading skills but legal, regulatory, and strategic skills as well.

The garden variety event driven manager assesses the terminal prospects for an event. The textbook risk arbitrage trade is highly levered and has negatively skewed returns meaning that success is rewarded slightly and failure is punished acutely. However, by assessing the probability of deal break, or deal completion, and diversifying over a number of deals, a positive expected return can be achieved.

For the most part, merger arbitrage is expressed in the equity of the companies in play. There is no reason why the same event cannot be capitalized upon in the debt of the relevant companies. Some mergers feature unlisted companies which almost always have debt securities. Differential treatment of claims under change of control can cause different claims to price differently creating arbitrage or trading opportunities. Few managers have cross capital structure expertise to take advantage of these situations. Managers able to trade in the c
redits benefit from participating in less crowded trades.

A wealth manager, asset manager, multi-family office or private bank intending to service the wealthy should first and foremost begin with empathy. Too often the agent seems to be looking at themselves when they talk about what they can do for their clients.

Empathy is very important. The rationale is simple, how can one be trusted to consider what the client has not considered if one has not considered what the client has considered?

It is no wonder that the industry’s self prognosis is not optimistic. The wrong approach can only be repeated so many times after which, one’s sophisticated client being as sophisticated as their agent believes they are is bound to adapt. It is no wonder also that the industry is in decline. In many ways the family office is the high net worth’s defence against the corporate onslaught.

The wealthy are not homogenous and they each have their own particular needs. While bespoke solutions are sought and service providers strive to provide them, there are general principles.

The wealthy are not interested in short term gains. They may appear to be for recreational reasons but in the end they want purchasing power preservation plus a spread, compounding over the long term.

They worry about their future just like everybody else. Human beings adjust to being rich and the rich may not feel as rich as one thinks they feel.

They worry about loss. Some clients are happy to take a guaranteed finite defined loss (a cost) over the chance of gain with the associated chance of unquantified loss. They may just want safekeeping and banking services. They understand the concept of diversification of custody in addition and as opposed to diversification of investments. In these uncertain times, bank failures cannot be ruled out.

Often they are, understandably, suspicious of the motives of those who come to service and advise. But here the issue is complicated. They are naturally suspicious of services and advice which are provided for free, and yet are unwilling to pay for advice, from poor prior experience, of unpaid advice and services. And around and around it goes.

Relationships are all important for the wealthy. Staff turnover is not only damaging to the building of lasting relationships they are also a metric of failure. As an industry, staff turnover in wealth management is remarkably high. A consequence is that long duration or gestation strategies or products are purposely and successfully under-represented, despite the importance of long term strategy. Instead, product providers complain that investors are not long term enough in their outlook precisely with regard to their daily, weekly or monthly liquidity products. Staff retention is closely related to staff compensation which is in turn closely related to agency behaviour. Ideally, staff should eat their own cooking, as demonstrated by the chefs who cut the fugu (the poisonous but delicious puffer fish.)

The wealthy are not responsible for their agent’s budgets. Organizations run to quarterly sales targets and financial results. This is a wonderful way to run a business facing the wealthy, a wonderfully poor way of representing the client properly. Front line relationship managers may, if they are good, understand this and keep a relationship at risk of losing a trade. It is simply irrational to do the trade and lose the relationship. Unfortunately not everyone in an organization, particularly large, complex ones with interdependent stakeholders and constituents, understand this simple principle. Clients aren’t always active. Sometimes when the going gets tough clients understandably reduce their risk. Sometimes, when the going is easy, they may likewise reduce their activity. To earn their keep, advisors need to provide investments which are robust under various environments, which means turning to alternative investments which obtain their returns from sources other than passive, directional exposure. And even then, sometimes, the right advice is to reduce risk and do less. Advising a client appropriately builds trust and will likely get you fired.

The corporate connection:

Many rich families have strong relationships with the banks originating from their business activities. This relationship is beyond the scope of this discussion, but the information asymmetry is less acute in that relationship. The entrepreneur knows their own business far better than they do an accumulator or a CDO Squared. They engage the bank as equals or partners.

Any executive must see the obvious synergies of managing both private wealth needs as well as corporate ones. This is sometimes if not often the raison d’etre of a private bank.

Here truly is a synergy and a strength if it is properly executed. The agent must engage the client as an equal, a strategy that may involve providing training, at the behest of the client, potentially to both current and future generations.

The outmoded merchant bank model is suddenly relevant, aligning principal and agent objectives. Basel 3 is a potential impediment, of course, as it is to so many parts of banking. In fact, the implications of Basel 3 have already driven some of the more cynical banks into the co-opting of client capital to provide the regulatory and equity capital to quasi-principal trades which place the bank in a senior position with recourse and not a small proportion of the profits. Such perversions will eventually alienate further the principal from agent.

The better way is to foster co-investment in a transparent and clear way, where regulation only governs disclosure and is otherwise neither prescriptive nor intrusive.

For Agents:

* understand the client.

* represent the client first.

* align the interests of the firm with the client.

* be transparent about fees, expenses and economics of the relationship.

* keep the relationship, lose the trade.

* be prepared to educate the client.

* the client is the ultimate payer.

For Clients:

* pay for independent advice.

* conduct due diligence on your advisers.

* ensure alignment of interest between your advisers and your own objectives.

* be transparent about your objectives and clear in your instruction. Require your agent to be similarly clear and transparent.

* trust but verify.

“The truth? You can’t handle the truth.” Col. Nathan Jessep (Jack Nicholson), A Few Good Men. In times of war, such as when we fought off the spectre of financial collapse, when banks quivered in fear and markets shuddered in despair, a few good men got together and did what they had to do. Is it right that we now question the manner in which they provided that solution? Well if you didn’t then you end up with the guns once trained on the enemy being used indiscriminately on any convenient target.

Interest rate manipulation almost certainly extended beyond LIBORs, beyond Barclays and beyond London. The banks may have stood at a point when price discovery would have doomed them to liquidation and the manipulation of LIBORs seemed justified, but the thing about morphine cures is that they’re not, and morphine is addictive. Market manipulation is never justified.

Its not just LIBORs. Think of all the times we stood on the brink and large sums of money hung in the balance. What bargains were struck last December between the banks and the ECB before the unexpected LTRO. What grubby deals must have been done in the prelude to each dose of government largesse and money printing? Is it even remotely conceivable that the central banks were not privy to the manipulation of LIBORs, if not actively encouraging it? Anyone who thinks otherwise is simply naïve.

Its not just banks. Tobacco had its day in the sun, this time its banks, tomorrow its pharma or IT or some other big business.

Capitalism has failed. Without its old nemesis, without A nemesis, capitalism has lost its foil, lost the competition that improves the breed. Even ideologies must compete to improve and to be kept hones.

Imagine you wanted to issue bonds but no one would buy them from you. Now wouldn’t it be clever if you bought them yourself, but now you didn’t have the money to buy them, at least not until you issued the bonds. There is a way.

 There is certainly no way you could do this in USD or GBP or any (barely) credible currency, but you could do it if the bonds were denominated in gift vouchers issued by you. Remember that if no third party will buy your bonds, you can only buy and pay for the bonds you issued with something else you issued. If, you did this in scale, however, at some point, you’d have more gift vouchers than inventory stock. At that point, the gift vouchers purchasing power must come under severe doubt.

How do you pay down a debt that is 7 times your nominal GDP? Well, first you have to reorganize it. But you have to do it without calling it a reorganization lest the cost of rolling the debt becomes too high. You have to reorganize it first by monetizing it. In a private enterprise in trouble, the first thing to do is to file a plan of reorganization, in consultation with the creditors, stop all interest payments on existing debt, reorganize the business, and reorganize the debt. No such orderly process exists for countries. The crucial step that has no analog for countries is the business reorganization. That’s where factor prices are realigned with productivity, lots of job descriptions get rewritten, lots of benefits get cancelled and lots of people take to the streets. You can’t sell off a division of a country, although airport services, or banking supervision, might be good places to start.

Assuming that, after long discussions with unions, interest groups, political parties, serious men in suits from the IMF, and yes, even creditors, a business reorganization is agreed, there remains the reorganization of debt. 

Interest expense needs to be cut. This can take the form of charging the interest on depleted notionals, or suppressing interest rates. One is a clear default, the other can be structured to avoid default. So far in the brand of capitalism that has evolved to reward success and forgive failure, suppressing interest rates is the preferred solution.

Ideally, most, if not all the debt is refinanced at these lower interest rates. As most of the debt will be purchased by a connected party, a local bank, the central bank, some hapless state or federal pension plan the effect on the banking system will be an inflated balance sheet which eventually invites inflation. Before the bulk of the debt is refinanced, interest rates will be suppressed at all cost. Once the bulk of the debt is refinanced, the balance sheet inflation will very likely result in inflation and rising interest rates. To keep interest rates low, the issuer’s opcos would have to maintain its purchasing of the associate’s debt. This seems clever, except that it will ultimately crowd out any external lender and place potentially catastrophic downward pressure on the currency.

This is the plan, by the way, for the US, UK, Japan and Europe. Some emerging market countries have already executed this trick decades ago, so everybody has a go.

Europe has been discussed ad nauseum so I shall not devote any serious analysis to it, just some naïve observations.

If you have a chain of restaurants and they have differing profitability, either the underperforming ones are ‘reformed’ or shut down. Or, the profitable shops must subsidize the unprofitable shops. If in aggregate the whole is unprofitable then the prospect of the profitable subsidizing the unprofitable is simply not sustainable.

If the unprofitable ones seek credit lines to continue their operations, lenders will likely say no, or demand a huge premium. Left on their own, no one will lend them money. Everyone is happy to lend to the profitable ones of course but the returns will be understandably low.

The weak shops may of course call upon the group or holdco to help them finance themselves. One would expect the strong shops to protest or block such a funding strategy since it is clear where the cash flow to service the debt will come from. Now if the holdco was ultimately forced to assume the funding responsibility, the cost of its funding would certainly not be as low as that for a strong shop. Lenders would take into account the profitability of the weak and the strong in aggregate in pricing the debt.

If in aggregate the whole was unprofitable, then its cost of funds must rise impacting its ability to pay down the existing debt of the group as a whole.

This brings us back to the initial problem and its less than perfect solution of print-to-pay.

Shops may decide to spin-off and leave the group. The shops with the highest motivation to leave must be the strong, not the weak, since the weak have the most to gain and the strong, while there may be synergies to being in the group, will have to support the weak.

A sum of parts analysis would advise disaggregation of the shops.