Financial markets began 2018 with a surge. Equity markets closed on or exceeded historical highs, credit spreads tightened and sovereign bonds sold off. Commodities rallied with emerging market currencies as the USD sank. The first week of 2018 appeared to indicate continued risk appetite and exuberant sentiment, with some good reasons and some cautions.

1. We have a benign economic environment with a broadening and strengthening of growth. Despite the Fed raising rates and normalizing balance sheets, global liquidity conditions remain very accommodative. The change in fiscal stance in the US adds another boost to growth potential. As far as the economy is concerned, all is well.

2. Most investors agree that assets are expensive from equities to corporate bonds. The only justification for asset valuations comes from comparing them relative to interest rates. This makes interest rates an important factor in calling the markets.

3. Risk aversion is low. VIX index, an indicator of market participants’ perception of future volatility, is near all-time lows. Options are a form of insurance policy and one buys insurance when one can, not when one needs.

4. As asset returns have outrun economic growth, investment opportunities have become scarcer. Combine this with the massive liquidity infusions of the past 8 years and witness the global rise in asset valuations. Old opportunities continue to creep up and new opportunities become inundated with capital.

5. One response to the rising valuations is to invest with hedge funds. Hedge fund returns have been pedestrian in the past 8 years compared with their passive long only competitors but this has in part been due to central bank liquidity dampening volatility and increasing correlations. As central banks normalize, it is expected that dispersion and volatility will return to the markets providing hedge funds a more fertile hunting ground. However, investors have a tendency to allocate to the most recently best performing funds and, in the last year at least, these have tended to be the more beta driven funds.

6. The liquidity risk premium has also been compressed as investors give up liquidity for returns. Private equity and private debt valuations are near (and sometimes beyond) public market valuations reducing the liquidity premium.

7. As the Fed raises rates, even from such low levels, there comes a point at which it is not impractical to hold cash.

8. There are no immediate or apparent threats to economic growth or financial markets that investors can see. It is always difficult to identify catalysts to end a bull market. In 2000, the Dotcom bubble was only recognized by a few. In 2008, only a few investors recognized the bubble developing in the US real estate and mortgage market. Since the crisis, the market has shrugged off political risks (such as Brexit, Trump, the far right in Europe, North Korean missiles, and populism) as well as economic risks (QE taper, China’s debt levels, Japan’s national debt, Fed rate hikes and normalization). It is impossible to foresee what could derail this bull market but conditions are indicating a rise in exuberance and complacency.

How should one invest when growth is already robust and may plateau, expected returns are lower as assets are expensive and the central banks are beginning to turn from extraordinary accommodation? There are several approaches. One is to maintain a fixed target return and increase the level of risk required to achieve it. The other is to maintain the level of risk and do one’s best, accepting that returns may be lower.

What happens when investors target a level of returns? They get creative. In 2000, the Dotcom bubble had burst and taken the rest of Wall Street with it, the economy was suffering, and the Fed cut interest rates aggressively, from 6.50% to 1.00% in the course of two and half years. While this saved the economy, the stock market and the bond market, it meant that in 2003, investors seeking yield were finding it difficult to find any. Investors had to reach further for yield shifting weight from IG to HY, allocating more to junk, and then when returns have been squeezed out of traditional bond markets, turning to leveraged finance and ABS. CLOs, CDOs, SIVs, and other leveraged structures produced highly rated securities with arbitrage spreads which investors could take advantage of. The securitization of mortgages provided similar opportunities to benefit from diversification and leverage. When unlevered returns fall, returns targeting implies that leverage must rise. As leverage rises, demand for the underlying investment opportunities rises, at some point outstripping supply. When willingness to lend or invest outweighs willingness to borrow, or raise capital, the dynamics of the market change. Investors are no longer effectively policing markets and enforcing efficient price discovery. Subprime loans, liar loans, teaser rate loans, option ARMs, were inventions to encourage borrowing to feed the production of securities to satisfy investor demand. We know how that story played out.

For most people, a simple investment strategy is best. Complex investment strategies with ambitious objectives, whether they are loss reduction, returns enhancement, volatility targeting, alpha generation, et al, are luxuries with associated cost. Here are some simple rules that investors of all levels of sophistication should follow. 

1. Invest early and keep it simple. Take more risk when young and reduce your risk with age.

2. Diversify over time. Apply dollar cost averaging to reduce the impact of market volatility. Diversify over assets. Don’t have all your eggs in one basket.

3. Manage your costs which include both transaction as well as ongoing fees. Don’t trade often as it is expensive and does not add to performance in the long run.

4. Learn about economics, politics and finance but not so much that you feel you can break rules 1 to 3 above.

When you are young and just earning an income, say in your early twenties, set some income aside and invest it all in equities. A diversified ETFs is the most efficient way to invest. As you get older, put some portion away in bonds. Again one or two diversified ETFs or a single diversified mutual fund is best. At age 70, or 90, or whatever the retirement age has become by then, have no equities and should only have low risk, high quality bonds. In between, just do a straight line pro ration to figure out how much you need in bonds and how much in equities for any given age you are.

Exchange traded funds (ETFs) and mutual funds are useful investment vehicles. They give the investor instant diversification and reduce the investment amounts to manageable sizes for those who don’t have a lot to invest.

Stock picking is a difficult thing to do. Too much concentration in a single stock is risky, and too little exposure per stock means that the time and effort spent identifying that stock is diluted. Have a diversified portfolio.

Market timing is difficult to do. The best of professional traders fail at market timing, an amateur should not even try. Nor should they delegate market timing even to professionals. Apply dollar cost averaging, spreading investments over time to smooth the impact of market volatility.

Fund picking can be easy or difficult. Don’t make it difficult by trying to identify so-called alpha generating fund managers. Alpha is hard to find and can be variable. Often an ETF is the most effective investment instrument. When selecting an ETF, check that it indeed gives you the exposure you seek, check that you are comfortable with the cost (total expense ratio, not just management fees), and with the liquidity in case you need to cash out.

Sometimes, ETFs are not available for the investment you are trying to make. This is rare if you are keeping it simple, but some investors are a bit more sophisticated than others. In this case, a mutual fund could be the answer. Again, check that the fund gives you the intended exposure at a reasonable cost and liquidity.

Find a cost effective execution and custody platform. Most banks offer all of the investment solutions you seek but can be expensive. If all you seek is execution and safekeeping of assets, you should be acutely cost sensitive and risk conscious.

If you have lots of money, many financial institutions will try to advise you. If you have little or less money, fewer people will be willing to advise you. You should be clear what advice you need or want and seek it.

If advice comes looking for you, it is likely to be expensive. It is generally expensive to provide investment advice and so that advice comes at a price. Financial advisors have to find you. This is expensive as they have to spend money on advertisements or hire salespeople to seek you out. These costs are borne by you directly or indirectly, they are not borne by the financial advisor. Investment advice is expensive to deliver. The financial advisor has certain duties and responsibilities which raise their costs. They have to get to know you, your financial circumstances and objectives. The collection and maintenance of data is expensive. They have to provide suitable advice. This process involves finding the right products and selling them to you in a proper way, meaning that apart from telling you the benefits, they have to tell you the risks, and the costs. Financial firms have people who check that their salespeople are behaving properly and following procedure. They have investment professionals seeking out suitable products and doing research for you. All this costs money, and of course has to be paid for by you.

Small investors pay the highest fees because they do not have bargaining power and yet are not very profitable to the firm as their investment amounts are too small. To make servicing small investors profitable, costs have to be cut. Automation and other systematic asset allocation models are a potentially efficient solution.

Big investors are very price sensitive and often haggle over fees and shop around. To make servicing big investors profitable, service levels have to be raised, often raising costs further. The provision of increasingly sophisticated investment advice and products can be like an arms race, but the cost often rises to meet the benefit.

The TPP was President Obama’s trade pact designed to be a counterbalance to the surging influence of China. It was designed to exclude China. When President Trump decided to turn away from TPP he provided China with a strategic opening. China has been building bridges as the US was busy building walls, or trying to anyway.

China could wrongfoot the US easily by joining the TPP and help in driving it to conclusion. It would win as much prestige as the US would lose. Then perhaps President Trump will see that an insular and nationalistic policy is counterproductive and opt for a more open and engaging stance. If it did, it could spark a wave of competitive engagement which would be more productive than the current competitive insularism.

Of course, China’s SOEs present the biggest practical hurdle to China ever joining the TPP. For now at least, SOEs are an important policy apparatus in the management of the Chinese economy. Yet with time this may change as China continues to reform and deregulate. Already it has decided to open its banking and asset management industry to foreign ownership, which is a big step in the right direction. If China could find itself ready to procure that its SOEs comply with international commercial standards, there is a chance.

A decade on from the Great Financial Crisis and all is well. Multiple rounds of extraordinary monetary policy campaigns have boosted asset prices and stabilized economies across the world. Intermittent turbulence from Europe (2011), Greece (2014), and Brexit (2016) have failed to derail the recovery.

The political landscape is changing as well with the rise of the Far Right in Europe, newfound stability in India and Japan, Brexit, nationalism in the US, and China under Xi, still not well understood. Social media have brought people together to share their divisions and create a more polarized world. Inequality seethes beneath the thin ice of the status quo.

Strides in technology make today seem like the science fiction of only a decade ago. The promise and threat of Artificial Intelligence beckons. A post scarcity utopia looms in the distance threatening dystopia on the way.

The most effective way to invest is to start early and keep it simple. Start with maximum tolerable risk and decrease the risk you take over time. Start early because you will need time to make up for mistakes, time to compound returns and patience for investments to mature. Trading tends to be more profitable for your broker than for you. And then keep it simple. Complexity works for specialists whom perhaps you may wish to hire (by investing with them), but this is more luxury than necessity. Common sense, patience, and a healthy disconnect from emotion are necessities.

Without the benefit of time and a long runway, we face today, fairly good fundamentals, synchronized growth, the beginnings of central bank policy normalization, a slight lull in the political agenda but expensive asset prices.

In the US, the pro-business President has struggled to get any policy passed despite Republican control of House and Senate. A significantly pro-growth tax reform package is the Republicans’ only hope of showing progress for the year. Otherwise, growth is robust, sentiment buoyant, inflation conspicuously absent, and in markets, equities are on the expensive side and credit spreads are as tight as a drum. The Fed is already on its 4^th rate hike, is almost certain to hike again in December and has signalled 3 more hikes in 2018, something markets place a less than one third probability of happening. The market has been right in the last few years in being sceptical about the Fed’s hawkish intentions but is likely to be wrong this time. The Fed appears determined to normalize both interest rates and its balance sheet.

Some risks surround this policy normalization. Inflation has been weak, partially from weak energy prices but also at the core. Energy prices are on the rise but core inflation has been chronically and inexplicably weak. That said, we believe that the relationship between interest rates and inflation, at these low levels and at a turning point, could have anomalous effects, namely that raising interest rates could lift inflation. This finds some basis in the Neo Fisherian view as well as some microeconomic effects of cost of capital. From a liquidity perspective there is the risk that as QE inflated markets more than output and prices, perhaps the retraction of QE or quantitative tightening (QT), might have the reverse impact. This should also counsel caution on emerging markets exuberance as liquidity can drain from anywhere due to open markets and capital mobility.

A reluctant and boring consensus is building that returns from US equities should moderate to circa 5% p.a. over the next two to three years. The outlook for credit is less optimistic given where spreads are, slightly over 3% OAS for HY and 1% for investment grade. Taking into consideration duration, the outlook for bonds is not very rosy indeed. There are, however, pockets of potential if not outright value. Mortgage bonds and CLOs remain attractive but sourcing and selection are key in these highly idiosyncratic markets.

Until recently Europe has been the most problematic major developed economy. Weak peripheral sovereign balance sheets, Greece, Far Right populism, under capitalized banks, and then Brexit serially buffeted the European economy. More recently we have seen a resurgent economy, still with no inflation, but improving PMIs and sentiment, and more buoyant stock and credit markets. A weak EUR has played a part in this prosperity. How long can it last?

The longer term picture presents headwinds. The single currency is inefficient at clearing factor markets leading to unemployment and underemployment, and leads further to misallocation of resources. Inflation should pick up but thankfully has not. Unemployment has receded but is still painfully high in places (over 17% in Spain.) There is common monetary policy but alignment of fiscal policy is still a challenge.

Brexit looms. Both the UK and the EU have appeared to weather the impact of Brexit, but only because it hasn’t happened yet. The EU will lose its largest trading partner and its pro-business lobby. The UK will lose an arm and a leg.

The rise of the populist Far Right did not die with the French elections earlier this year, they only went to ground. Despite Le Pen’s and Wilders’s losses, both expanded their parties’ representation and influence. In Germany, the AfD, previously unrepresented in the Bundestag managed to win over 12% of the vote and 94 seats. Elections are due in Italy in 2018. More immediately are regional elections in Spain where the Catalonian will try to legitimize its secessionist plans.

In the shorter term, the momentum is strong. The ECB’s exuberance was premature and it was forced to extend QE till 2018, even if at half strength. The ECB is likely to remain in accommodative mode for the foreseeable future, impacting the EUR adversely, and stocks and credit positively. One area of particular opportunity is bank capital. Tightening regulatory standards, IFRS9, Basel IV, and ECB NPL treatment, will be a tailwind for subordinated capital (and a headwind for equity).

For equities in general, the continuing easy monetary conditions, steady growth, and lack of political noise coupled with lower valuations relative to the US will support markets, especially if the EUR is also weak on interest differentials. The outlook for credit is less positive given how tight spreads have become but general conditions remain benign.

India. With almost as many people as China, two thirds of whom are of working age, a per capita GDP (at PPP) 2.3 times smaller and a nominal GDP nearly 5 times smaller than China’s, India’s potential for growth is significant. The problem is realizing that potential. The political stability and the popular support enjoyed by Prime Minister Modi, whose party in 2014 won the first simple majority in 30 years, could help unlock this potential. The reform agenda has been packed and the pace frenetic. The implementation of GST replacing local and state taxes is analogous to the creation of a common market like the EU. The demonetization effort while bringing long term gains has short term costs in the form of slower growth as the informal sector is assimilated. The Indian economy is currently growing through consumption and government expenditure but private sector investment has been moribund. To animate private investment the government needs to clean up the banking system which has accumulated a growing mass of non-performing assets. A new insolvency and bankruptcy code was established last year which the RBI is encouraging the banks to use aggressively. Only when NPLs are addressed can the recapitalization of banks occur which will give them the capacity to finance the economic growth potential in India. In the meantime, government investment in infrastructure, in road and rail, telecoms and the financial system continue apace, investments which address directly one of the main difficulties in India. In the short term there will be volatility as rising oil prices and the large agrarian sector of the economy faces more uncertain monsoons arising from climate change. This will impact inflation and RBI policy as growth claws back from the demonetization and implementation of GST. In the long term if India just catches up part of the way with China, its growth and development will increase significantly.

Japan. Japan is a country with poor macroeconomic conditions and strong microeconomic fundamentals. It has one of the highest per capita GDP levels, nominal or PPP, it is one of the most modern and technologically advanced countries in Asia, the current government is stable and Abenomics has reinvigorated Japan’s economy and boosted sentiment amongst consumers and businesses. Balancing this is a rapidly ageing population the result of falling birth rates and rising life expectancy, a national debt which is over 2.5X GDP, a central bank that is increasingly the lender of last resort to the sovereign, albeit indirectly, and a propensity for propping up inefficient zombie companies which sustains overcapacity and suppresses inflation. Where there are problems there are opportunities. Japan’s ageing population and shrinking labour force encourage private sector solutions to problems which the rest of the developed world are facing or will soon face. Japan has an oft overlooked technology sector which is domestically focused and which foreign investors struggle to navigate. Often these are small and mid-cap companies which are little covered by sell side analysts and little known outside Japan. The advantages of understanding and investing in these areas is not just the returns they might bring but the lessons they hold for the rich, ageing, developed world. Demographically and fiscally, Japan could well be our future. Opportunities exist in companies at the centre of labour reform, technology, gerontology and healthcare. But beware as over 80% of the companies in the benchmark indices are old economy laggards.

China. At the recent 19^th National Congress of the Communist Party, President Xi’s Thought on Socialism with Chinese Characteristics for a New Era was enshrined in the constitution, solidifying the President’s position in the party and China’s history. While this appears to be the building of a cult of personality, China is complicated. China intends to consolidate its progress and standing international community. It seeks to integrate itself into more global institutions and standards and engage the world in generally accepted terms. Of course it aims to shape those terms but gone are the days when China would go it alone. That distinction appears to be the preserve of the US. China builds bridges, as the US attempts to build walls. In its path to maturity and international integration, China precipitates a number of contradictions, not unique to China but certainly of note. China wants to open its markets and capital account but at the same time wants to retain control over the path of liberalization. The President seeks to inculcate rule of law over rule of party, but seeks to consolidate his control over the institutions and policies that shape China. Asia is replete with strongmen but successful ones have tended to co-opt rule of law to their side, cosmetic or real, rather than rely on outright repression.

Within more practical time frames, growth is expected to slow for no other reason than the size of the economy. A 6% growth rate in the next 3 years would not surprise. The surge in credit creation over the past few years will need to be managed carefully. There are concerning signs that regulators may not have this completely under control. As banking liquidity growth has moderated, total social financing, a measure that includes the shadow banking system indicates continued growth. The PBOC will continue to tinker (or meddle, if you are a sceptic), to maintain a neutral macro stance while redirecting credit to direct growth and leverage as it sees fit. One Belt One Road will need a lot of credit to finance its investment. Local governments will be encourage to continue deleveraging. The profusion of conduits (LGFVs, trust loans, wealth management products) will be challenging to regulate and modulate.

The economy has already become less export dependent, a stated objective some 5 years or more ago, and more domestically oriented. This is a piece of risk management despite the continuing drive to build bridges to deal with a more protectionist USA. The US has been more protectionist since well before Trump when reshoring was championed by former President Obama, as evidenced by campaigns such as SelectUSA and Manufacturing USA. Export sector companies globally remain at risk as trade as a percentage of GDP has fallen steadily over the last 5 years.

In spite of potential for reduced trade, China is a populous country with enough resources and technology to be relatively self-sufficient. Its growth rate would be quite high for an economy of its size and complexity which would provide support for equity markets. In the more immediate term, the relative outperformance of the HK H share market relative to the onshore A share market could be unwound. Local A shares look better value.

As always, there are threats we have chosen to ignore, at least for now, mostly for good reason. We highlight such a threat, which is an academic oddity. The past decade has been characterized by economic recovery, strength even in some quarters, coupled with low inflation. To some this has been a concern and to central bankers it is a puzzle. Aggressively cutting rates and depressing bond yields has had little impact on inflation. This is even more acute considering the large weight in the CPI of owner’s equivalent rent, a non-cash flow item. Central bankers operating according to the Taylor Rule when in fact a Neo Fisherian process exists would quickly converge to the zero lower bound, as observed in practice. If the Neo Fisherian model is valid, a gently path of rising interest rates would encourage inflation and a central bank continuing to operate under the Taylor Rule could push inflation steadily higher. Markets are not prepared for this and have an overly sanguine view of inflation and interest rates. The consequences for fixed income investors and for borrowers would be serious. The impact could also be exported through FX as countries try to maintain some stability in their exchange rates, resulting in rising cost of credit. There would be consequences for developed market equities as well as valuations are already stretched and low rates are required to justify elevated multiples.

Sep 27, the Big Six presented a draft tax proposal representing President Trump’s tax plan. This is a long awaited piece of reform with high market impact.

Trump Tax Plan:

Probability of House and Senate approval:

• The plan is the result of negotiations between the White House, Treasury, House Ways and Means Committee and Senate Finance Committee, so it has more weight than a unilateral White House proposal. Some of terms presented have therefore been pre-negotiated.

• The plan could increase the national debt by 1.5 trillion USD, or over 10% of GDP over the next 10 years. This could face opposition from fiscal hawks.

• The plan is less progressive and favours corporate America and the wealthy and will face opposition from the Democrats in the Senate. There is a risk of a filibuster.

• Generally, the Republicans are united behind this plan and while details are missing on some issues, there is sufficient detail and content to suggest that the Republicans have been presented and considered the plan. It is unlikely therefore to find resistance or suffer from friendly fire.

• It is late in the year and almost all of President Trump’s attempts at policy have failed, most recently the attempt to repeal Obamacare. The Republicans and the White House will be motivated achieve at least one major policy agenda item in 2017.

• That there are areas of great detail and areas of remarkable vagueness suggests that these areas will be open for negotiation.

• Expect that the tax plan will be approved in some shape or form with the broad characteristics largely intact.

Potential impact if passed:

It is too difficult to both envisage how the plan may be amended amidst negotiations as well as forecast impact on the economy and markets. We have to assume that the tax plan is adopted without modification in our assessment of impact.

• The loss of tax revenue will be expansionary and inflationary. Growth will be boosted in the medium to long term.
  • A tax cut boosts aggregate demand and raises interest rates. Coupled with the Fed’s rate hikes and balance sheet normalization, expect duration to underperform.
  • Higher growth and higher rates are supportive for the USD.
• The immediate impact will be a one-time boost to S&P500 corporate profits of circa 11% FY2018 (according to Goldman Sachs).
  • To see who gains most consider tax rates by sector in the chart below.
  • In addition to the current effective tax rates, Transport, Utilities and Energy are the most capital intensive and likely to benefit.
• Bad for rates but good for credit:
  • The inflationary nature of the tax cuts will force the Fed to hike rates more aggressively.
  • Reduced supply of corporate bonds. Companies will be incentivised to pivot to equity financing. High equity valuations and rising rates also favour the pivot. Interest expense deductibility repeal is a real risk to callable bonds.
  • Increased demand for yield. The less progressive personal tax code will increase savings rates and capital seeking investments in yielding assets.
  • Floating rate debt instruments will be in demand. Issuance will fall just as demand rises.
• Could even be good for bonds:
  • Repatriation of foreign profits needs to find a home. Dividends are one avenue. Share buybacks will be limited given valuations. Debt buybacks and reduction will be the most likely path given rising rates and thus interest expenses. This means reducing leverage as well as reduced issuance if not a significant rise in par calls.
• Strong USD and rising rates.
  • Negative for emerging markets, especially those with high USD debt.
  • Negative for commodities. US is not a high intensity consumer of industrial commodities and displacing growth towards the US will weaken support for commodities.
  • Positive FX impact on European and Japanese equities as hedging costs are low.
  • Neutral to negative impact

Tax Rates By Sector: (note that the Energy sector ETR is pulled down by MLPs. Big 4 Oil and Gas ETR is circa 24%.)

For information I include the proposed changes to personal tax: