Insanity

• The US credit rating gets downgraded and US treasuries rally.

• The ECB shoots morphine into an insolvent European banking system and it is the banks that rally most.

• China leads global economic growth and its stock market performs most poorly.

• Europe is in a serious recession whereas the US is in a mild recovery, yet European stocks rally as much as US stocks.

• Global risk levels remain elevated and investors are increasingly jumpy yet VIX and other measures of risk aversion signal calm.

• Italy, Spain and Greece are still on the Euro. And the currency is appreciating despite a massive round of quantitative easing. Its even more surprising that Germany is on the Euro.

• With the BoE, BoJ, ECB all frantically monetizing debt and printing money, gold has weakened. And inflation has not accelerated. Since output has not recovered, this must imply an acute deceleration in the velocity of money.

For the global macro trader and the fundamental investor alike, these are confusing and treacherous times. The logical thing to do, is often to do nothing. Go to cash and hold mostly one’s accounting currency, with a small allocation to gold and a bigger one to USD.

The professional money manager, however, very often cannot or is not incentivised to hold cash. Do investors want to pay fees to a fund manager to carry cash? Would investors pay fund managers for their decision to carry cash? Yet investors are often happy to pay fund managers to carry consistent, chronic negative levels of cash. This is effectively what one gets in a levered investment fund or product.

In the meantime investors become ever more disenchanted with professional fund managers who seem to be as confused as everybody else.

In the long run markets cannot stray too far from fundamentals. Yet there is a paradox. The further we look forward, the less certain is our view of the world.  And in the short term, psychology, greed and fear, errors in judgment, conspire to drive markets in chaotic fashion…

Hedge Fund manager skill versus the rising tide lifting all boats: We all understand how a rising market can make a long only equity fund manager look like a star. But what about a hedge fund manager operating an equity long short strategy? Sometimes, a long term, non-directional theme can provide a hedge fund manager with an edge. What initially starts out as skill can with time become a repeatable strategy. Take the Euro for example. Since the early 1990s, European rates began to converge and European stocks began to trade along industry and sector lines more than national ones. This has been a
20 year theme which has only unraveled in the financial crisis and only when European country risk began to dominate idiosyncratic and sector risk.

An even longer term theme has been the 30 year trend in (falling) interest rates and bond yields. Yield curve dynamics around this secular theme have provided hedge funds very profitable opportunities over the years. Again, what began as skill in identifying the trend, and recognizing its underlying causality, over time has become a repeatable strategy.

The risk to these strategies arises when a significant or important secular theme ceases or wanes and a new one begins. Initially, fund managers who traded in blind ignorance to the causality of the old theme, but who understood the local trends and dynamics around it, lose money. Their returns at best are likely to become highly inconsistent. This is because they never understood the environment they used to be in, they only knew what it looked like, or had a feel for its rhythms.

The world post 2008 certainly looks like this for a great many fund managers. At the same time, there is an emerging group of managers who ‘get it’ and whose returns will gain in consistency over time.

Identifying these new managers is the key to a successful alternatives investment program. Sticking with the establishment is likely to result in poor risk adjusted performance.

The skills and the approach to finding new talent are uncommon. The current approach of interviewing managers ad nauseum, digging into their track record and their past careers is of limited use. By definition, if a new theme has taken hold and one seeks the best new managers to monetize that theme, past track record is of limited relevance. Being able to detect new talent requires an open mind and a closeness to markets and an understanding of economics at the level of the managers one engages.

In Nov 2011 I warned that the Chinese economy was headed for a slump. This is an update. In the past quarter, manufacturing data has supported the view that the Chinese economy was decelerating rapidly.

 The much watched inflation numbers have come off as well providing policy makers room to ease. However, despite recent weakness, food prices remain elevated and may stay the hand of policymakers from outright interest rate cuts.

The real estate sector has also cast a pall on the economy. Here, the slump is the result of government policy to cool an overheating housing market. Rising house prices do not increase welfare; to the contrary, at lower levels of home ownership, they decrease welfare, something surely not missed by a Communist country. Policy has therefore been steadfastly tight on the real estate sector resulting in falling land and property values. The flipside to this policy is that the value of collateral falls and the construction industry slows.

The most interesting sign that China is in the grip of a serious slump, however, lies in the anecdotal evidence that the number of factory workers returning after the Chinese Lunar New Year to work in the coastal cities and traditional manufacturing centres has slumped. What is interesting is that this has been interpreted as workers having found employment in the provinces and therefore not returning.

By speaking to a number of businesses and investment managers in the mainland, the feedback I received late last year was that the slump in workers returning to work after the Chinese New Year was to at the time expected, but for a different reason. The expectation then was that employers would take advantage of the annual pilgrimage to lay off staff.

Laying off workers at any other time involved paying for their train ticket home. Moreover, the risk remained that workers would picket factories instead of going quietly. During the Chinese New Year, workers pay their own fare home to meet with family. If they were let go then, they would also be less likely to travel back to their factories to demonstrate their disaffection. This thesis having been built last October / November has seen empirical support.

The performance of stock markets has been instructive. In the last quarter, Japan stocks rose because the BoJ is printing funny money. European stocks are also rising because the ECB is printing funny money in vast quantities. US stocks rallied since 4Q 2011 in a delayed reaction to economic recovery begun in 3Q 2011. Of the BRICs, China and India have underperformed despite rallying early in the year. In India, political parties attempt mutual and often self destruction with the private sector as hostage. China’s problems are similarly difficult with a change of management on the near horizon as the economy begins to look slightly unhinged.

China suffers from rising wages, rising food prices, an overleveraged shadow banking system established to finance the massive Keynesian infrastructure binge just post 2008 and export partners who are retrenching and increasing their savings rates. Economic growth based on investment and government expenditure can only go so far. And it appears that it has.

Some people believe that whatever happens anywhere in the world tends to impact Asia, sometimes disproportionately. Given the rise of China in the past decade the converse is also true. One has to question the robustness of the US recovery if it has been based on capital goods exports to resource countries supplying Chinese infrastructure build. The US equity bull market may last a bit longer on momentum in new orders on the back of backlogs in inventory restocking but it is hard to see a broad based recovery based on internal consumption. The US bull market is unlikely to persist more than a further 3 to 6 months. How you trade it, is a matter of personal trading style.

The last 30 years have been defined by falling interest rates across the USD curve. Since Volcker defeated inflation in the early 1980’s short term rates and long bond yields have tracked lower and lower. Inflation has similarly been trapped in the 3% to 5% range as Greenspan was celebrated for creating a Goldilocks economy, in reference to porridge that was neither too hot nor too cold. Since 1980, the US current account has also trended down into severe deficit until late 2006. During this time, the trade weighted USD has weakened by roughly 50%.

The ability of the US to maintain robust economic growth with low inflation and falling interest rates may be attributed to their outsourcing their manufacturing capacity abroad whether it was to China, Mexico or Japan. The policy would involve exporting US intellectual property and technology to less developed and emerging economies where labour was cheap and diminishing returns were not yet acute. US consumers then imported finished product while exporting USD. The efficacy of this approach would be evidenced by an accumulating balance of trade and current account deficit and a weak USD. The balancing of the current account took the form of a sort of vendor financing in the form of foreign central banks recycling surplus USD by buying US treasuries, keeping USD interest rates low and the US consumer accustomed or addicted to cheap credit. US household’s savings rate has steadily declined from 12% in 1981 to 1% in 2005. Inevitably the savings rate has rebounded to around 4.5% today and it appears will need to improve further due to the confluence of a dearth of easy credit, excessive debt levels and impaired collateral prices (read housing prices).

Reversing these imbalances will result in a higher rate of inflation at each level of economic growth as cheap production is less available. Inflation expectations are likely to put upward pressure on long term interest rates.

A shortage of USD internationally will also put upward pressure on rates.

This is independent of the parlous state of government finances. Taking additional account of the fact that US treasuries are effectively PIKs, that total public plus private debt levels (if one includes entitlements) are at some 7 times nominal annual GDP, and the rise of the RMB as a potential additional reserve currency, and the risk of higher interest rates suddenly becomes quite material.

How will the world cope with rising USD interest rates and falling bond prices?

• Interest rates around the world are likely to rise in sympathy since the USD is the de facto reference risk free currency.

• Leveraged trades and businesses will suffer. Banks may face some interesting balance sheet issues. Carry trades will become more viable as curves steepen, although existing positions will face mark to market impact.

• Real estate which is typically highly leveraged will see higher cap rates. In the residential sector, affordability will be affected adversely. Note that many Asian countries are significantly exposed to adjustable rate mortgages. These countries’ banks may suffer losses and rising provisions.

• Generally, rising rates are likely to encourage higher savings rates and lower marginal propensities to consume.

• On the positive side, investments will face a higher hurdle rate and there will be less frivolous investment.

• Equity market valuations which are currently highly attractive will seem less so in a higher interest rate environment. The (negative) correlation between interest rates and equity markets is remarkable and rather ominous. See the chart below. During the 1960s and 1970s the S&P 500 traded in a band as interest rates rose to combat inflation. While an acutely high inflation scenario is not as likely inflation can be expected to be more elevated and rates higher than currently prevailing.

• The search for yield. The past 3 decades has seen an insatiable thirst for yield that has depressed yields across asset classes and increased yield asset valuations. While on the one hand this has created a problem for pensions seeking to match liabilities, and driven investors into some questionable investments like AAA ABS tranche securities, the dynamics of a rising yield environment are interesting and not so easy to pin down. New investments will see higher yields but current ones, particularly longer duration assets will face markdowns through lower capitalized valuations.

The above observations are associated with high and rising interest rates. The scenarios we have looked at only consider rising interest rates. They could take some time to get sufficiently high for some of these themes to take hold.

Look for a moment at the deal struck between the US and China in the past decade. China has effectively agreed to hand over a thousand pairs of cotton underwear in exchange for an iPad 6 somewhere down the line.

 Unfortunately, somewhere along the line, those thousand pairs of cotton underwear came to be worth a paltry half an iPad 6. The USD, that generally accepted accounting currency came to be not quite so generally accepted.

A whole bunch of shopping vouchers issued by the US treasury had been debased.

In the past decade, or more, the US had managed to keep economic growth humming at low inflation rates because the US was able to outsource its manufacturing to China. China as a willing accomplice was happy to provide vendor financing via the PBOC which bought US treasuries with its surplus USDs.

This trade dynamic was happily tolerated by all as it fueled China’s growth and investment and accumulation of intellectual property. (Yes, mostly others’). The US was happy to live on credit as long as interest rates were low and collateral prices (read home prices) were rising. A key performance indicator of this policy was a rising current account and trade deficit which confirmed both hopes and fears.

This has come to an end. Negative savings rates in the US are no longer viable and therefore will rise. The trade deficit that the US runs with China and the rest of the world will shrink perhaps into the black.

A country that imports stuff, exports its currency. As the export of USD slows and contracts, the pressure will be on the USD to rise. The pressure on USD interest rates will also be to rise.

A decade of negative savings and wholesale export of USD has led to a weak USD. Yet no one has accused the US of being a currency manipulator. The weak USD has now resulted in pretty advantageous terms of trade. Also, US companies remain the strongest holders of patents, owner of trademarks and brands and holders of intellectual property.

The world has always had strong demand for US brands. For a long time these brands were made outside the US. This trend is reversing.

US exports have therefore rebounded and are likely to be the driver of growth going forward.

A country that exports stuff, imports currency. As the import of USD accelerates the pressure will be on the USD to rise. The pressure on USD interest rates will also be to rise.

The US policy of badgering the Chinese to let the CNY strengthen is not reasonable. If the Chinese float the CNY, the Americans may be in for a surprise.

Mario Draghi has been a genius. And I am sure he realizes that all he has done is bought the politicians more time to sort out the fundamental issues surrounding the Eurozone crisis. In the first 3 year LTRO 489  billion EUR was allotted. In this, the second, 529 billion EUR has been allotted, apparently to a great many banks, some 800 of them.

I have written at length about the effects of the first LTRO.  It recapitalizes the banks out of retained profits from their carry trades, it separates and realigns national debt by country thus reducing external debt, it encourages the banks to become the ECB’s proxies in monetizing sovereign debt thus it keeps rates low and allows sovereigns to refinance at reasonable rates. This we already know. The market reaction then was relief and thus a rally in risky assets, particularly the banks, the Euro, irrationally yet understandably, and just about anything you could shake a bid offer spread at.

What it doesn’t do is fix fundamentally inefficient economies. It just allows these economies to refinance themselves, essentially in the continuing issue of PIKs, in de facto voluntary exchanges. This can now go on until at some point when questions are asked of the fundamental soundness of the Eurozone’s member countries’ fiscal viability.

It is a risky strategy for the ECB. They are now accepting practically any collateral, subject to haircuts. One of the world’s largest and most important central banks has become a pawn shop; one charging a paltry 1% to its deadbeat debtors. If the politicians and bureaucrats do not keep up their end of the bargain in executing some fundamental reform, some of this collateral may default. Quite what the consequences are of such a default, I have not yet considered carefully. Presumably, the ECB will require further collateral to be posted. This would impair the balance sheets of the banks further and at a time when their assets, which are presumably similar to the collateral they have posted already with the ECB, are being further marked down, in what would effectively be an ECB enforced cram-down.

The first 3 year LTRO caught everyone by surprise and its implications for simply addressing money market liquidity and banking system stress was clear. Therefore risky assets rose.

This second 3 year discount window operation is less predictable. Why? People were expecting it and had sufficient time to confuse themselves. Markets have already recovered. If the first one worked a treat, why did 800 banks queue at the window hats in hand with their bric-a-brac? Was a big number good? Was a small number good? (The market was expecting 500 – 1000 billion EUR, they got 529 billlion.) What will these banks do with the money? This is the trillion EUR question. What could the banks possibly do with the money?

1. Well lets see. If they deposit it with the ECB this is a clear sign of problems in the banking system beyond the current expectations of man and regulator. This would be a negative carry position since they would pay 1% and collect 25 basis points. This is a clear danger sign.
2. They could lend it out to the private sector. Yeah right. Any economist expecting this should be given an umbrella, a colorful tie and made to predict the weather on national TV. They would have better luck. Basel 3 pretty much ensures that no self-serving, error-fearing, creatively challenged bank CFO or CEO would ever do that.
3. Lend it to your sovereign. That’s what they did before and look where it got them. Yet this is capital efficient, most sovereigns, even downgraded ones still issue securities that attract no capital encumbrances under Basel 3. Which really is an indictment of Basel 3 and not the hapless banks. It’s the carry trade all over again. And its doubling down. If the sovereign folds, its all over anyway. But there is an advantage as well. If the Euro breaks, at least assets and liabilities will be denominated in the same sea-shells and lollipops.
4. You could give it to the prop desk to try their luck at the tables, but wait, the Volcker Rule says this is a very very naughty thing to do and by the way the traders have all fled and joined or set up their own hedge funds. 
5.  Or, you could invest it in hedge funds and private equity. But Basel 3 says that that too is very very naughty and as a result you’d have to provide a lump of capital equal to 4 times the investmen
   t in said hedge funds. You might make some money but there is that hefty capital charge. But wait, there is one hedge fund you could invest with which bears a zero capital charge. And which one is that? Why the ECB of course, but that trade will earn you, let see, 0.25% – 1.00% = -0.75%. Its cheaper than paying XYZ Capital Partners 2 and 20 in fees, and it does guarantee you a return. A guaranteed loss of 0.75%.