If anyone believed that the proceeds of the LTRO were meant to be spent buying bonds in the secondary market, they have misunderstood the raison d’etre of the LTRO. The ECB has made available this 1 trillion EUR so that banks may purchase new issues of their respective sovereign debt. They will not be making SME loans, or buying sovereign debt in the secondary market, or other sovereign’s debt within the Eurozone. The ECB is not refinancing the banks; it is refinancing the sovereigns. Once this is understood the high cash balances of the banks with the ECB generating negative cash flow is explained.

The risk of sovereign default is therefore low, at least in the next 12 months. If the risk should rise, the ECB will find some way of helping these countries refinance themselves, either through direct bond purchases at auction or further LTROs. The foregoing is therefore academic but it may be amusing to look at the refinancing risk in the next 12 months anyway.

All eyes are on Spain and Italy. Spain’s 5 year CDS spread is now 510bps, an all time high, rising from 350 bps in early February. Italy’s 5 year CDS is 470bps, from 350 bps in mid March. This year, Spain will need to refinance 46 billion EUR of debt, and plans to issue 87 billion EUR of new debt. Italy on the other hand has 193 billion EUR to retire in 2012 and a planned issuance of 245 billion EUR. Which country would you worry about more?

Well don’t worry. The ECB has been and will be the lender of last resort, directly or indirectly, to the European sovereigns. In many ways, this takes central banking to its roots. The world’s second oldest central bank, the Bank of England was established to fund William III’s military expenditure in rebuilding the Royal Navy.

Singaporeans are obsessive about real estate, much like Americans and Britons were before 2008 burst their bubble. However, while other countries’ housing markets have failed to recover fully, the housing markets of the emerging markets have rebounded and surged past old highs.

What makes Singapore housing special? Housing is all about demand and supply. In Singapore, supply is limited by the fact that it is a tiny island. Demand is dependent on the desire and the ability to buy. A booming economy and overcrowding have fuelled both factors.

There is a two segment market in Singapore, both heavily driven by government policy.

Affordable housing is provided by the Housing Development Board (HDB), which offers subsidized apartments for sale under strict conditions of eligibility and restrictions on the secondary market. At last count in 2010, some 82% of households lived in HDB flats. The HDB’s raison d’etre is creating affordable, quality housing and encouraging vibrant towns and cohesive communities.

Private housing accounts for a small minority, therefore, of households, and represents luxury and high status of its households. Some 11% of households live in private apartments while the remaining 6% or so live in landed properties.

Land supply is tightly controlled by the Singapore Land Authority. HDB supply of apartments is tightly controlled as well.

Singapore housing prices have grown steadily since records were kept in 1966. However, the time series exhibits considerable volatility. 1985 – 1989, 1997 – 2000, 2001 – 2002, and 2008 – 2009 being notable bear markets with drawdowns of 25 – 30%.

The long term drivers of Singapore housing prices include 30 yrs of declining interest rates and the impact on an extremely long duration asset, improving demographics in terms of a rapidly increasing population mainly as a result of an open door policy encouraging foreign talent and wealth immigration, rising wealth and wages of incumbents and immigrants alike, low taxation across income, capital gains, inheritance, consumption and property taxes, easy access to mortgage credit, robust economic growth and a fixed, finite and small stock of land.

The risks ahead include, an end to secular declining interest rates (which impact on such long duration assets is potentially serious), the low level of interest rates which effectively lengthen the duration on assets, the absence of fixed rate mortgages and an overdependence on adjustable rate mortgages, a slowdown in global economic growth in general and in the Asian region in particular, political backlash against government immigration policy which has resulted in proactive anti-housing inflation and anti-local labour displacement policies (such as the additional 10% stamp duty on foreigners’ purchases of real estate, and a tightening of work permit approvals), the advanced age of the Father of the Nation and the transition and political risks when the inevitable happens, the high sensitivity of prices to immigration (in either direction) due to the high proportion of foreigners resident in Singapore (in particular Asian buyers who seek safe haven shelter in Singapore and who thus are especially sensitive to political risks), and space and infrastructure limitations to immigration.

Of the above, the most important driver of property prices are low interest rates and continued strong employment; and the greatest risks to property prices come from rising interest rates and political risks.

Non-financial issues:

While the primary residence has been the most significant source and store of wealth for most Singapore households, it is questionable if household welfare is sensitive to housing values. Even as housing prices rise, replacement values rise, negating any mark-to-market gains since monetizing these gains require the household to replace their primary residence. Sentiment, however, is and should not be underestimated as an economic driver.

As Singapore continues to develop, overcrowding becomes an increasingly important issue with profound implications on society if not the economy. It may be possible
to house an ever increasing stock of humans, however, supplying their subsistence and recreational requirements, as well as transporting them from residence to workplace and other locations is another matter. Already the subway system, the vaunted MRT system has come under pressure and system failures have increased in frequency. Even if infrastructural issues can be addressed, intangible but no less material factors have become an issue.

One can argue that apart from rule of law, security, employment, social security and shelter, a maximum level of population density is a basic human need if not right. Below a certain level of population density, humans seek company (an increase in population density), but beyond a certain level, they seek to reduce it. The threshold is evidenced by increased anti-social sentiment, intolerance of other ethnicities, minorities or other social groups, increased stress levels, and elevated incidence of crime. All of which are manifest in Singapore today.

One could argue that to maintain a certain level of cohesiveness in the community, the government, through its immigration, economic and housing policy needs to target a certain level of population density, both locally and at the national level, a level which has been clearly exceeded by now.

Conventional economics recommends growing the economy by unbounded growth of the population, a strategy clearly impracticable for an island state of such acutely limited land area. Such theories were built in lands where space was not a practical constraint. Even there, concentration issues have rendered the metropolises such as New York, London, Hong Kong, barely habitable. For Singapore, this strategy is not viable in the long run. Moreover, density levels are so close to undesirable levels that the long run is here today.

Fortunately, or unfortunately, population density can grow further still, perhaps by some 20%, with increased investment in construction and infrastructure, before the social externalities render Singapore uninhabitable.

Forget about correlations. Here are the conditional probabilities between equity market monthly returns and hedge fund returns as represented by the MSCI World Equity Index and the HFRI Hedge Fund Index respectively.

Since Jan 1997, over 183 months,

• Hedge funds were positive when equities were positive 98 months or 54% of the time.
• Hedge funds were negative when equities were negative 54 months or 30% of the time.
• Hedge funds were positive when equities were negative 24 months or 13% of the time… And
• Hedge funds were negative when equities were positive 7 months or 4% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 54 out of 78 or 69%.

And, when equities are up, the chances of your hedge fund losing money are 7 out of 105 or 7%.

However:

Since Jan 2008, over 51 months,

• Hedge funds were positive when equities were positive 24 months or 47% of the time.
• Hedge funds were negative when equities were negative 21 months or 41% of the time.
• Hedge funds were positive when equities were negative 5  months or 10% of the time. And…
• Hedge funds were negative when equities were positive 1 month or 2% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 21 out of 26 or 81%.

And, when equities are up, the chances of your hedge fund losing money are 1 out of 25 or 4%.  

Post 2008, the markets have begun to behave in a very volatile and erratic fashion that has confounded many hedge fund managers who had previously navigated market crises such as 1998 and 2001 successfully.

In investing and trading, easy to identify strategies are rare. Asian convertible bonds in late 2008 are an example, the QE2 liquidity infused rally of 2010, the first LTRO rally, the rebound in RMBS in 2009, are others. The massive relief rally on early 2009 was harder to identify and caught most investors off guard. The rally in US treasuries in the last 3 years, the rally in gold, the implications of the second LTRO, all have been diabolically hard to call and trade.

Even worse, what is obvious to one investor is unclear to another. And of the events listed above as ‘obvious’, most were only obvious well after the fact.

In the best of times, markets are risky places for investors; in the worst of times they are treacherous waters, graveyards of fortunes lost.

1. Directional investing is vulnerable to market risk. Whether it is in equities, credit, commodities or FX, taking directional bets on asset prices exposes one to the general direction of markets. Even the multi-directional nature of global macro investing is not spared. Fund managers express directional views on asset prices based on their understanding and analysis of macroeconomics and policy. Most fail to deliver consistent returns, but some are uncannily consistent. These rise to become the premier global macro hedge funds we come to know. Soros, Brevan Howard, Caxton, Tudor, Moore, et al. Long only funds are examples of directional funds where one direction (short) has been denied them.

2. Relative value investing is less vulnerable to market risk but exposes one to idiosyncratic risk. In relative value, basis risk is actively sought. The manager seeks to express a view on one security doing better than another, one company, commodity or currency outperforming another. Market risk is reduced, not eliminated. It is also transformed into a more complex risk. The relative value manager seeks to assume a specific risk, while hedging out other risks. Buying GM and selling Daimler is a bet on the quality of management, but it also includes bets on the relative fortunes of luxury versus regular automobiles, the relative strength in the economies of Europe, or Asia or North America depending on the relative exposures of each company to each area. Some risks can be hedged away, some cannot. Be that as it may, relative value represents a more targeted way of assuming risk, and seeking returns, than making open ended long only wagers on the fates and fortunes of companies, commodities, or countries.

3. Arbitrage is the Holy Grail of investing. Most of the time it does not exist. On those rare occasions when it does, it is hideously difficult to identify and capture. Most arbitrage trades are quasi arbitrage in that there are risks, but they are remote or have been missed by the arbitrageur. True arbitrage involves buying something, simultaneously selling it or its equivalent for less and picking up the difference without assuming any risk. Most of the time, risk in quasi-arbitrage leaks into the operational, settlement, delivery, legal and regulatory aspects of the trade.

The financial crisis of 2008 is now 4 years behind us. Yet its ripples haunt us over time. This period arguable represents one of the most important turning points in recent history. The main themes surrounding this turning points are:

A. Reversal of US current account and trade balance deficits.

B. Reversal of the falling savings rates in the West.

C. Reversal of weak USD.

D. Reversal of falling USD interest rates and bond yields.

E. Global wide debt reduction with implications for economic growth.

F. Regulatory and Policy responses to the past abuses of the Principal Agent relationship.

The short term perturbations around these reversals will confuse and confound investors. It is necessary to have a specialized skill set in asset market in order to navigate these difficult investment conditions. The logical implication is to outsource investment decisions to experts, to dedicated fund managers.

Even here there is a dilemma.

1. Private investors who are not full time dedicated investors often lack the expertise to invest in certain markets, or indeed the expertise to asset allocate across a range of investment opportunities. Professional fund managers have the experience, expertise and resources to invest money in their areas of expertise. This is the strongest argument for investing in funds. And yet…

2. Professional fund managers are restricted in their function. There are certain norms and accepted practices in fund management which create certain biases in manager behavior even if they are sub-optimal. One example is that managers feel that they need to be fully invested even when conditions are unclear or they are unable to find sufficient compelling investment opportunities. The behavior of investors in the past (who believe that managers should earn their fees) have driven managers into this type of irrational behavior. A rational investor may decide to refrain from investing for not insubstantial periods of time if the outlook is unclear or there is a dearth of investment opportunities.

The choice of manager becomes extremely important.

The erratic path taken by macro economic data and by asset prices such as stocks, bonds, commodities etc are the confluence of long, medium and short term cycles. The long term cycle took a turn in 2008 and remains decidedly poor.

 A substantial relief rally in 2009 and an LTRO and BoJ morphine induced rally in the last 4 months do not indicate a healthy global economy. They are indicative of a poorly global economy, one which is over-levered and still in the process of being de-levered, which policymakers have kept afloat by further credit creation, much like putting a fire out with gasoline, and infrastructure build in emerging markets. The long term picture is the following: we have collectively spent more than we earned and created a disproportionately large hoard of debt which will need to be paid down over time. Given the strange way we measure and account for GDP, credit creation adds to GDP growth and now as we reduce the size of the global balance sheet, credit destruction will detract from GDP growth. The long term is therefore fairly simple to understand and remains gloomy.

Does the short or medium term cycle reinforce or contradict the long term cycle? Large scale debt monetization and fiscal reflation can and has buoyed the economy and asset markets for short periods of time and can be credited for the local bull markets in 2009, 2010 and 2011. The last significant reflationary policy was the 3 year LTRO operated by the ECB in Dec 2011 and Feb 2012. The liquidity injection has supported sagging asset markets and indeed propelled some of them to local highs. This is likely to have run its course.

The economic recovery in the US which took everyone by surprise, and which began in Sep 2011 if you were watching closely, was triggered and driven by exports which indirectly can be traced to the infrastructure binge undertaken by China as its export markets dried up. China’s credit driven infrastructure binge is over. This will reveal local weaknesses in the Australian economy, weaken demand in the resource economies, and with a lag, depress the US economy once again.

Long Term Prospects

• The long term trend in economic growth is weak.
• A significant part of this is due to the need to de-lever stretched private and public balance sheets across the globe.
• Asia’s balance sheets are not as healthy as many believe if shadow banking statistics are consolidated. That is, off balance sheet credit creation has been more than we understand it to be.
• The West will be in savings mode for longer than many expect. Also, the West will evolve into export economies while EM countries evolve into consumption economies. This will put upward pressure on the USD.
• An international shortage of USD and the lack of external demand for US government debt will likely place upward pressure on USD interest rates. A 30 year bull market in bonds is likely over.
• Risk is likely to decline generally as carry trades and leveraged investments decline due to rising costs of debt.

Medium term view:

• Equities remain cheap but valuations are sensitive to bond yields. Equities are therefore vulnerable. High yield is also vulnerable on both duration and spread bases. The risk reward in any case is poor. Sell.
• Carry trades are riskier now than ever since the mark to market impact on borrowing short and lending long is likely to be negative. Pull in duration.
• China’s economy is slowing and will have global impact via commodities. Sell.
• China may not have room to lower interest rates as much as the market expects due to food price inflation. Don’t count on a rally in Chinese stocks.
• Commodities likely to suffer from a slowdown in China.
• Prospects for a US QE3 rise but it is not clear how the Fed will expand its balance sheet. The most likely asset is US treasuries. This could delay rising rates. Sell receivers.
• The ECB is likely to be done with its QE. Sell receivers.
• BoJ has begun its cycle of QE and Japan equities likely to outperform.
• USD likely to strengthen against majors as well as EM currencies.
• USD curve to steepen relative to EUR, GBP and JPY curves.

Who knows if the above will work out. But here I can time stamp my own expectations. And this serves me more as a aide de memoire than anything else.