If as I expect, the economy goes into recession on normal metrics, the yield curve will flatten all the way to flat or inverted, the trade to do is a flattener over 2s and 10s or 2s and 5s. The trade in the 2s and 10s shows more mileage but the really interesting trade is at longer maturities. This benefits from Operation Twist. If the Fed is going to get behind my trade, so be it.

Markets have been volatile and political and economic news from across the globe have been very confusing. How do we make sense of this?

Europe:

It is useful to understand that Greece cannot remain in the Euro. It can only do so if its economy can deflate and withstand a deflation of 30-40% in an abridged time frame. This is not going to happen. With their own currency they could do a one time devaluation. Any reorganization of debt without addressing the currency is a waste of resources and scarce capital. The Eurozone core will not allow Greece out of the Euro easily. 60 over years of history and cultural baggage make it very hard for Germany to even allow any weakness in the Euro experiment. As a result markets will continue to be buffetted by hope, whenever the Eurozone leaders meet to discuss bailouts, restructurings and other fantasies, and despair, as when they realize that the Eurozone governments have no clear solution. This makes for a lot of extreme and often times untradeable volatility but it can at times establish a trading rhythm. Sell into hope and cover into reality.

US:

The US economy is in worse shape today than it was a year ago, yet the Fed’s response was weaker, not stronger, medicine. One has to suspect that the Fed has simply run out of viable policy tools. Ex-debt, the US economy is well in recession. The housing market weakness needs to be stemmed once and for all. It is the largest repository of wealth in the economy and falling house prices simply create a negative wealth effect. That said, note that last year 75% of the profits of the S&P companies came from outside the US.

China:

The real estate market and the local governments are heavily levered. The SIV lite like structures (LGFVs and trust firms) used to channel this leverage is unstable. As long as growth remains on track these structured credit vehicles should pose little problem. Given that the government is aware of this problem, it is unlikely that they will allow the economy to slow to a degree that will impact these structures. Be that as it may, land prices have fallen precipitously as inflation fighting policies reduce the availability of credit which is the life blood of real estate. One bright spot is that inflation is likely to recede, possibly below 5% by year end on base effects. This could create a year end rally, although selectively since most of the listed companies are banks, insurers, resources and exporters.

The global investment approach:

For the last 2 over years it has been profitable to invest globally, buying companies with emerging market revenue sources and shorting those with developed market exposure. This approach still holds in the long term but current levels and valuations make even this approach vulnerable. Typically one would establish a portfolio gradually, buying long as the market dips and selling short as it rises to accumulate gross exposure in a low market beta fashion. As profits rise, gross risk is increased and as losses increase, gross risk is decreased. If the market is also rising, a gradual increase in net market beta can be taken, but not too aggressively. If the market is trending down, a net negative beta can be accumulated. Gross risk should be a function of the underlying stock’s volatility, so that target fund volatility (or VaR) is kept relatively constant. Given the current high volatility, this implies a very low gross exposure. Given valuations of the bull trending stocks, the long book is getting hard to justify. The short book remains opportunity rich. This allows the bottom up stock picking to drive the net exposure into a slight net short positioning. Shorting is tricky business. The banks are an obvious long term fundamental short since they are being regulated as utilities and ROEs will fall in line with utilities in the long run. In the short run they are short of capital and many are insolvent. That said, shorting bans, bailouts and unilateral government action can confound the most fundamentally justified short. It is time for guerrilla trading and stock picking. In stocks, unfortunately, there is no arbitrage. The opportunities in credit are getting very interesting. For example, in some Asian names you can buy a convert wide of the straight bond, short the bond and gamma trade the equity option. The option is cheaper than free… In the vol space, the implied curves are inverted meaning that you can buy the long dated vol and fund it with short dated written options.,,

The US economy is clearly weaker now than it was a year ago. Why then is the Fed’s response to use weaker medicine (Operation Twist) than the previous rounds of QE? I can think of one reason; it has no other viable policies which are politically acceptable or that do not come with unacceptable side effects.

Operation Twist puzzles me a bit. Buying longer dated US treasuries while selling shorter dated ones is not full blown QE in that it doesn’t really print money. Instead it is likely to flatten the dollar yield curve further and depress the cost of long term funding, assuming that the credit transmission system is functioning. But the curve was already flat and flattening even before the Fed’s announcement. For the US treasury, OpTwist is effectively a refinancing exercise where it swaps short term debt for long term debt. For that, the treasury owes a debt of debt to the Fed. Yet why was the Fed needed to effect this given how well US treasuries are bid? The problems in the US economy lie elsewhere.

While the yield curve is quite flat, there is easily a good 50 – 100 basis points more of flattening that could occur. And 400 billion usd is not a small number. The easy trade is to front run the Fed and get ahead of the curve flattening further.

The trade in equities is harder to see. OpTwist is likely to increase the cheapness of equities relative to bonds and may provide some boost to equities but this is grasping at straws. The fundamental drivers of equities are likely to dominate any interest rate effects.

The gold trade is interesting. Gold has always been an inflation hedge and protection against the debasement of fiat currency. The previous round of quantitative easing had clear implications for currency as it was an outright debasement. The current nature of OpTwist is different. It lengthens duration but it does not actually inject more money into the system and is therefore not likely to translate into a direct substitution away from cash to gold. To the extent that gold may have priced in a more aggressive stimulus, it could have run ahead of itself and thus need to correct further than the already sharp decline to below 1600 seen in the past few days.

A Crumbling World

I think the market agrees that the Fed has no more bullets left. The curve is flat, rates are near zero, mortgage rates are low, and still the economy is weak.

The mortgage market is broken so no matter how low interest rates are prepayments are slow and the transmission of lower rates through to household wallets doesn’t work. Is the market right in its indictment of the Fed and the government? I think it is.

I think the market agrees that the Euro doesn’t work, at least not for everyone and is voting Greece and possibly Italy or Spain out of the Euro. That governments are not heeding this vote is creating turmoil. The market is also voting that Greece eventually defaults and that bailouts will ultimately fail. Is the market right? Again I think it is.

As the highest up the food chain the US and Europe are important to the emerging market’s listed economy. And emerging markets on that basis are voting against any easy or quick recovery in the developed markets.

Are there patches of strength in the global economy? Emerging markets domestic economies appear to be fine. This is reflected in market prices of developed world companies exporting to emerging markets as well as emerging market domestically exposed companies. Is the market right? I think the market may be underestimating the risk in emerging markets.

Emerging markets have primarily been export economies. Since developed world consumption and thus demand for emerging market exports was decimated in 2008, infrastructure spending, a form of fiscal stimulus, has replaced exports as the engine of emerging market growth. Domestic consumption remains weak. Conspicuous consumption, however, is a different matter. Crossing borders, the divide between rich and poor has grown and remains persistent. This has been reflected in the market prices of luxury companies. Returning to infrastructure spending, this has been financed out of credit. A big dollop of it. Let’s hope the liabilities match the assets. In China for example, in the 2.1 trillion USD SIV like Local Government Funding Vehicles, they do not. At some stage there may be a need for the federal government to backstop the funding. This will swell the public balance sheet in quick order.

The world has seen roughly 7 years of plenty, OK, slightly less. Its payback time. Literally. And this is without even considering the underfunded status of many a corporate, or government pension plan, or social security, or public medical insurance. Its mostly looking pretty bad.

So what can we do in a world that is crumbling around us? We could buy gold but even that has its risks depending on what form the exposure takes. And buying gold is a bit of a cop out. You buy the most useless material because everything else is crumbling. Surely there are more intelligent ways to turn a profit.

Trading

Uncertain markets exhibit volatility. Often, though not always, this volatility can be traded. The problems in the world are colossal. And solutions exist. However, governments will always seek to convince the people that less painful and less protracted solutions exist than actually do. When markets are persuaded by these devices, they rise, and when reality bites, they fall. The ability to read when governments lie and when they tell the truth is helpful. So is the ability to read the psychology of the herd. Markets are voting mechanisms after all. Knowing how to manage risk and how to manage one’s own emotions are important in trading. This is not the time for dogmatic investing unless one has the long term capital and appetite for pain to do so.

Secular trends

• I do believe that the inequality of income and wealth will tend to increase up to a point of discontinuity. It is the primary motive of humans to gain at the expense of others. The concept of relative welfare is not lost on our species. And since we are defined by our intelligence, the bulk of human ingenuity is dedicated to increasing inequality. Inequality is only addressed as a constraint, which in the breach results in revolution. Buy luxury businesses.

• Inflation is another secular trend. Not the kind measured by CPI but the real kind that captures the debasement of fiat currency. The scale of debt in the world today needs not only to be paid down but to be eroded by inflation. Human ingenuity will be deployed to engineer an acceptable or undetectable inflation. This is the case for buying the useless yellow metal. It is so useless as to be priceless; it cannot be priced for its marginal product in any useful production. It is just the alternative to paper money which is devalued in its oversupply. TIPs and curve trading can also be used to express a view on inflation.

• Invest in the shadow banking industry. The banking industry will henceforth face increased regulation more commonly applied to utilities. Expect ROEs to converge to that of utilities. Yet economic growth needs more desperately than ever to be financed by innovative means. The private finance arena will pick up the slack. This means venture capital, private equity, hedge funds and asset based lending. While the private finance industry will not escape regulation entirely, the regulation is of a different nature, and will not impair their ability to generate robust returns over the long run. The logic is the following: Banks are not just providers of credit, they are the safe custodians of the assets of the masses. This safe custody aspect is what will limit their ability to continue to generate high ROEs. Provision of credit remains crucial to economic growth and the world needs economic growth. The shadow banking industry provides an alternative financing route for growth and will achieve the ROEs that banks used to achieve when regulation was less draconian.

Short term opportunities

• Convertible bonds have been acutely weak and represent good value both outright and hedged. Some Asian issues are trading wide of the straight bonds and CDS presenting arbitrage opportunities. While valuations have not approached late 2008 levels, they are attractive. They are likely to get weaker though so the window for execution is fairly wide.

• Capital structures are heading for dislocation again. Senior versus subordinated arbitrage opportunities are beginning to appear where a trade can be constructed with positive to non negative carry while having positive jump to default. Even where a pure arbitrage is not available the relative pricing between senior and subordinated liabilities is such that implied recoveries and default rates are inconsistent across capital structures. Relative value intra issuer trades are presenting very attractive risk return opportunities.

• European equities are presenting very cheap exposure to emerging markets. I like scavenging in distressed equity markets. Europe is replete with companies that do significant proportions of their business in the relatively resilient emerging market economies and yet may have been sold down due to misunderstanding of where those companies’ risks lie. Companies which sell to China, India and Latin America but who are listed in Spain, France or Germany are attractive risk return opportunities.

• The US yield curve is pretty flat, particular at the long end. The curve is likely to continue to flatten over all sectors, even with the short end pinned at close to zero. Bank buying provides the base line demand and periodic panics when investors realize that governments are in less control than they (both) think, provide the rallies.

Hedge funds have had a tough time, but not quite as tough as equities or commodities. Bonds have continued to outperform, much to the bewilderment of investors.

On a risk adjusted basis, hedge funds trounce equities and commodities but still lag bonds.

Year to date hedge funds have been nearly flat whereas equities have lost some 6%. This masks some very poor performance in emerging markets and European equities. US equities have proven more resilient than expected but then 75% of the S&P500’s profits originate outside the USA.

It is interesting to note that in 2008, until July, the HFRI had dropped -3.6% while the MSCI had dropped 16.3%. From July to December 2008, the HFRI fell a further -16% while the MSCI world fell -34%. What happened from August to December? A liquidity crisis exacerbated and related to risk of a major counterparty default. In those days, investors waited sleepless weekends to see if the likes of Morgan Stanley, Goldman Sachs and Lehman would open for business on Monday. Eventually Lehman fell.

Hedge funds traded not only against each other. They traded with their prime brokers and it was the prime brokers who faced each other as counterparties. When the market cast doubts over the solvency of prime brokers, lines were pulled and redemptions poured in.

What about today? While markets trade continuously and in liquid fashion hedge funds will continue to outperform and more than that, limit losses substantially. To assess the risk of a drastic drawdown in hedge fund investments, one has to assess the risk of counterparty default among the prime brokers.

There is an irony when investors fret about hedge funds that are levered 2X and have independent administrators performing valuations that borrow from institutions which tend to be levered 20X and where nobody seems to be able to value their assets.