China growth is also stabilizing but this has a cost in credit creation. The natural growth rate is slower in the new regime but the government cannot allow the economy to function there. As a result it is overstimulating the economy with side effects in commodities and real estate. These sectors will be very sensitive to Chinese policy and timing these markets will be quite difficult.

Japan is back in a difficult position. The sales tax has been postponed but this will not be sufficient. An outsized fiscal package is likely but this will only worsen the balance sheet. The BoJ will be drafted into more debt monetization. If the inflation target is to be achieved, another round of concerted fiscal and monetary policy will be needed.

The US economy is fundamentally on sound footing and we expect a pick-up in growth as spreads have stabilized. We also note that the manufacturing sector appears to have completed its pivot to a domestic audience. The poor employment number in May was an indication of a skills mismatch and not weakness in the economy. Wages are holding up, quits rates have recovered, initial claims have been subdued. Manufacturing PMI has been over 50 for 3 months now.

Oil prices have done very well this year. Oversupply peaked in January and has receded a little. At these levels we are seeing now a 3rd week of increasing rig counts. Oil prices should not rise any more from here. At these levels, however, HY defaults will still rise although the headline correlation will be reduced.

FOMC: Fed could not have moved even if it wanted to. The Fed’s control is the Fed funds rate but the real economy funds itself at market rates. Sell offs lead to spread widening and de facto tightening. Is a rate hike on July 27? It all depends on the market price of credit. If markets are well behaved, the Fed can act, if they are not, then the Fed cannot act.

The EU referendum is on the agenda. The polls have Leave in the lead by 43 to 42. The bookmakers have Remain in the lead by 65 to 35. We believe the bookmakers. Polls pick up what people want to do but bookmakers pick up what people intend to do. Negative voting has been prevalent in recent elections which have led to inaccurate polls.

Europe also looks to have been stabilized by the ECB but growth is fragile. A Brexit is going to hurt the EU. The UK is 17% of EU exports but the force of sentiment will have more immediate impact and could derail the recovery. We expect the impact on Europe could be greater than the impact on the UK. The UK economy is relatively strong compared with the EU and better able to absorb the shock of disengagement. If sterling weakens more, it could improve the UK’s competitiveness. If the euro is also weak, and there are reasons to expect this, Europe may benefit also. This might achieve what QE could not, which was to weaken the euro.

Peripheral spreads will widen on Brexit but France and Germany and the ECB will most definitely move to strengthen the union. This would see peripheral spreads snap back quickly.

Liquidity is low in the summer and we have a number of events including EU referendum, Spanish elections, Republican and Democratic conventions, Japan upper house election, and the run up to the US presidential election.

Equity valuations are high. Apart from the US, fundamentals are still fragile. Credit spreads are tight. Sovereign yields are too low. The margin for error is very small. There will be some who hope the financial press can keep the Brexit flame alive, and even hope for Brexit, to bring markets lower. At current prices there are few opportunities and one almost needs to shake the tree.

Is Brexit a globally systemic event?

• How immediate is the problem? 2 year holiday.
• Contagion risk? European problem. Could escalate. EU exports to UK 17%. UK exports to EU, 45%. Exports to ROTW should not be affected. UK is 2.36% of world GDP. EU ex UK is 13% of world GDP. UK is not part of Eurozone. Not part of TARGET2.
• Sentiment risk? High in the short term.

For those with a high cash holding it is time to add some risk, pre EU referendum.

The latest Yougov poll on the EU referendum has the 42% voting to Remain, 43% voting to Leave and 11% undecided. The result in any case will be unpredictable because the voting intentions are not driven by commercial interests but by political, social and emotional ones, and the material consequences of leaving the EU are to a great extent, unknown. Bookmakers odds paint a different picture with odds of exit at mid-30s percent. One explanation is that the polls reflect what people want to do, whereas the odds reflect what people realistically intend to do. Opinion polls have become more inconsistent as negative voting has become prevalent. If this thesis is true then the UK will vote to remain in the EU.

Depending on how acute the fear of Brexit becomes before June 23 and the extent of damage in the markets and sterling, the rebound could be significant. The bond markets have been fairly resilient even controlling for the compensating impact of duration. Last week, Euro investment grade outperformed euro sovereigns although investment grade did also outperform high yield. The commencement of the ECB’s corporate securities purchase program had some impact on the euro IG market. The euro leveraged loan market lagged with a flat performance. As we approach June 23, don’t expect credit markets to remain resolute. They will likely also experience volatility.

Notwithstanding the bookmakers’ odds favoring Remain, the situation is very volatile and a geopolitical or security event could easily overturn the odds in an instant. Even without an event, the words and actions of the players in the theatre could spark market volatility as well.

The consequences of Brexit are difficult to quantify. The UK is the EU’s single largest destination for exports representing 17% of the total while the EU accounts for 45% of UK exports. The UK runs a goods trade deficit (-66 billion GBP) against the EU but a trade surplus (+10 billion GBP) in services. For both sides, the rationale for a trade agreement is therefore strong, however, a liberal agreement on services may be more difficult to obtain. The impact on sovereignty will depend on the UK’s intentions regarding maintaining trade access and could involve retaining compliance with the majority of EU legislation while losing the ability to influence its formulation. Trade access would also mean continuing to contribute to the EU budget. Broadly, the UK can leave the EU for reasons of budget contributions, sovereignty, immigration and benefits arbitrage, but it would have to forego trade access. To obtain trade access it would have to reinstate contributions to the budget, compliance with EU legislation, open its borders and provide access to benefits. This would be analogous to a switch from a contractual telephony plan to a pay-as-you-go plan. Complete replication will neither be desired nor achievable. The EU will want to discourage other members of the EU from leaving and would have to impose costs upon the UK to set an example.

Any analysis will be inadequate because only the instantaneous effects are the least bit predictable. The impact on sovereignty, trade, immigration and politics will vary as each agent’s behavior evolves in reaction to the actions of other agents. In the best case, one could hope that the UK economy is sufficiently flexible that the new degrees of freedom are used wisely and growth is enhanced. In a more sober scenario, the event of Brexit is a Y2K event, a non-event, where an omnibus relationship is replaced with a series of specific ones which largely replicate the pre Brexit status quo. In the worst case, the UK either cannot or will not negotiate to reinstate trade access and goes down the path of trade war to the detriment of both the UK and the EU. Given the already fragile economic condition of Europe, this is a scenario they can ill afford and the region plunges into a protracted recession. In a scenario which is hard to classify as good or bad, the UK example emboldens other members to leave the EU which ultimately threatens the Eurozone and the single currency is abandoned.

The reaction functions of players in this game are non-linear. But the range of our vision allows us only to extrapolate.

It is unlikely that the UK will vote to leave the European Union.

If it does, the consequences will be short term instability and long term gain on both sides simply based on the adaptability and resourcefulness of humans.

It is now difficult to see more than 10 seconds into the future. What was chosen for a laugh as a blog title has become a reality. Central banks have led the markets if not the economy for the last 8 years out of crisis and are now losing some credibility and control. A quick survey finds weak but positive growth across most countries with the exception of Brazil and Russia in 2016, and positive growth across all countries in 2017. It also finds inflation mercifully low, and positive, even in Japan and the Eurozone. This does not appear to be a dire environment. However, aggregate data hide less tractable problems. If the averages are poor and the inequality is acutely high, it means that the majority of the population are experiencing declining wealth. Mercifully, inflation has been low.

It is always a difficult time to invest. In the 90s we fretted about inflation which in the end failed to materialize. We inflated a tech boom bubble which burst. We inflated a housing bubble which burst. And since then we’ve been led by the nose by central banks cleaning up the debris of the last bust while trying to strengthen the financial system which proved not so robust and simultaneously trying to spur economic growth which sputtered in no small part because of those very efforts at financial market reform.

The US economy is out of the woods and on a stable path of positive if rather tepid growth. The European economy is not far behind. The inefficiencies of the Euro are something they will live with regardless but so much liquidity is bound to spur some growth. China was actually first to lead with unconventional policy. It saw external demand shut down in 2008 and continue to fade as countries engaged in trade war. China is arguably ahead of the cycle in terms of policy, priming the pump quickly, smoothing the downturn, then tightening prematurely, hopefully not a lesson for the Fed, and finding itself needing to turn on the taps again. Japan is perhaps way ahead of everyone else. Demographically, Japan is the future. We can only hope that it is not also the future in terms of economics and policy.

Policy has targeted an arbitrary rate of growth and in doing so introduced more imbalances which drive delayed oscillations in market prices. At the micro level we already observe that asset prices can deviate from fundamental value for longer and gyrate more substantially as they converge to intrinsic value. Long duration assets are all the more risky in that there is no deadline for convergence. Finite and shorter maturity assets are not immune to volatility. Policy, sentiment and capital flows are the prime determinants of price discovery. Markets fail to bring convergence to intrinsic value quickly and efficiently.

There are several reasons for this. In the past, relative prices were brought into equilibrium or no-arbitrage pricing by traders or groups of traders who traded across capital structures. Most of this capital took the form of bank proprietary trading desks. With Basel III, Dodd-Frank and the Volcker Rule, the capital dedicated to these activities has shriveled. Some of these traders have sought new homes in hedge funds. However, the scale of capital in hedge funds pale in comparison with the practically bottomless pits of capital commanded by prop desks in the past.

In the search for yield, retail investors, through their regulated and sanitized vehicles like mutual funds and ETFs have ventured into markets normally traded by professional investors. The herd mentality and the artificial liquidity created by retail capital has led to more momentum driven markets where undervaluation soon becomes overvaluation and overvaluation becomes undervaluation in a cyclical and volatile fashion. Prop traders accustomed to leveraging small, predictable deviations now face large, unpredictable deviations, and in their hedge fund formats, face prime brokers who cannot extend the scale of leverage they are accustomed too, or the valuation forbearance of the investment banks of old. Therefore, they struggle. This is the new market, at least for now.

One could play the long game, identify good businesses and invest for the long term. To do this, one needs not only to be right, but one needs stability of capital and the faith of investors. With the current uncertainty, investor loyalty is understandably in short supply. Uncertainty is high. When economic growth is low, small deviations can lead to negative readings. The acute inequality of wealth is slowly translating into the feeling of injustice, and society seems heavy with social tension. Between political factions there is more civil war than inter party conflict. Policy has been deployed bearing such low marginal fruit that it has taken extreme efforts to have an
y effect. The risks of unforeseen side effects proportionate to the scale of the effort, not the effect, are high.

The inescapable reality is that markets have become more volatile and fickle. The patient investor can take advantage of this volatility but this can often be a test of stoic patience. Markets like this also require the investor to be more informed, even if they are outsourcing their investing decisions lest they make mistakes in their capital allocation plans. For investors who need to be invested many opportunities remain, and some very good ones at that. Investors should be careful not to overreach in their thirst for yield. However, there are areas of the market which remain beyond the reach of retail capital and other hot money and where price discovery remains linked to fundamentals. Some of these markets are the way they are because of legacy issues from the 2008 financial crisis, some even performed well through those periods but through guilt by association will not be revisited even by some institutional investors. Under-owned, under-researched, misunderstood assets represent good opportunities. But even here, markets may not be sufficient to bring price discovery; patience, and duration matching of capital, is necessary.

Below are a series of pictures depicting the US labor market. We highlight a number of points.

1. The weak payroll numbers in May are significant in that

1. 1. they were well below even the lower bound estimates,
   2. prior month numbers were revised down significantly,
   3. temporary non-farm payrolls were also below estimates,
   4. there were no special mitigating factors

1. Average hourly earnings and quits rates remain in an uptrend indicating a tight labour market.
2. Falling participation rates can be explained by factors other than economic growth such as increased school and post graduate enrolment and the better health of new cohorts in the over 55 segment. We do not see falling participation as evidence of a weak economy.

1. While the non-manufacturing PMI has weakened recently it remains above 50 (52.9) and the manufacturing PMI has turned over 50 in the last 3 months. Recession risk is low.
2. We conclude that the labour market is at an inflexion point and is failing to adjust quickly enough to the evolving economy and that the May number is not a sign of a weak economy.
3. The Fed is likely to look beyond the weak May data in their assessment of the economy. We maintain our outlook for a July rate hike. Our initial thesis for not expecting June was based not on the economy but rather the UK EU referendum due Jun 23, just 1 week after the Jun 15 FOMC.

With the exception of the 1990s, whenever labor productivity fell, unemployment fell. This is consistent with a model where labor’s share of output increases to compensate from lower labor productivity when technology could not pick up the slack. The 1990s was the era of the PC and internet which led to higher productivity even as unemployment fell.

The fall in labour participation is not a post 2008 phenomenon, it is a post 2000 phenomenon. The largest falls have been in the 16-19 year segment, presumable due to higher school enrolment. Post 2008, we have also seen declines in the 20-24 year segment with smaller declines in the 25-54 year segment. The falloff in the 20-24 year segment could be due to increased enrolment in post graduate education which was particularly popular in the post dotcom bust years. The 55+ segment has seen participation increase, presumably due to healthier populations. The trend of falling participation rates can therefore be explained mainly by demographic and non-economic factors ruling out the hypothesis of a weak economy.

The latest non-farm payroll numbers were quite poor, at 38K they fell below the lowest professional estimate of 90K and far below the average 160K. Taken as a percentage of the total labor force the number does not look better.

Two areas of strength, albeit not too much of it. One is the quits rate which is steadily climbing, although it has yet to reclaim the levels pre 2008. Quits rates are consistent with a tight labour market. Second is average hourly earnings which continues to recover. It also has yet to reclaim pre 2008.

Charts data source: Bloomberg and BLS

The Singapore economy is in a bit of a rut. A space constrained, population constrained economy like Singapore needs to look to unconventional economic models for growth. It cannot target population growth, capital accumulation and technological innovation without bound. Population growth meets space constraints and population density issues sooner or later. By all accounts, it already has. Capital accumulation faces fewer limitations but by far it is technological innovation that will liberate Singapore’s economic growth from conventional constraints.

Population constraints imply domestic demand and output constraints. Singapore has to supply the world in a scalable and dematerialized fashion. This is even more so given that the world is evidently engaged in a trade war which is impacting material goods far more so than services.

Beyond using or being associated with innovation, Singapore needs to be generating innovation. Whether Singaporean’s or immigrants or indeed transients generate the innovation is immaterial as long as the innovation is retained as Singaporean intellectual property.

Singapore needs to become a centre for research and development. It needs to be a central node in the global knowledge economy. This means it needs world class schools and research facilities. Red tape and over-regulation are the mortal enemies of innovation. Rules and regulations have to be streamlined to encourage innovation.

One area of potential development is financial technology. At one end of the spectrum is the cutting edge technology which the industry expects to disrupt the current financial system by changing how customers, counterparties, debtors, creditors, and regulators interact in the financial market place. This is so-called Fintech, which is highly topical. The other area of financial innovation is a slightly older technology that though useful has been demonized by the 2008 financial crisis.

Singapore is privileged to have two sovereign wealth funds with considerable financial firepower. One of them, Temasek Holdings, has significant investments in banks such as DBS, a national champion with Asian regional reach and services from investment banking to retail and consumer banking as well as wealth management. As the Western world struggles to regulate their banks and insurers in the aftermath of 2008, Singapore’s relative resilience emerging from that crisis is an opportunity to go back where others failed and salvage valuable technology. It has the opportunity to work around Basel III and demonstrate its weaknesses by reviving securitization and structured finance and making a success of these technologies.

The West’s experience with Shadow Banking began well, was overdone by Wall Street and ended in disaster. Through this all Asia was such a late adopter that it had not the opportunity to overextend the technology to disastrous end. There is not the political and cultural baggage surrounding structured finance in Asia to prevent it being revived in an improved form for the good of all. Where Basel III is highly restrictive, the Shadow Banking system can be a useful conduit to direct savings to investments more efficiently than a banking system hobbled by overly reactive regulation. The world has sufficient potential economic growth left in it, and central banks the means to finance it, but the plumbing is broken.

Singapore’s SWFs have the capital to capitalize innovative credit structures to enable economic growth, not just in Singapore but in Asia. It has banking relationships which in can draw upon to provide the intellectual basis. One example would be to encourage a bank like Standard Chartered to engage its credit underwriting machinery without consuming balance sheet. Standard Chartered’s new boss is an old hand at leveraged finance and is well placed to turn Standard Chartered’s investment bank into a tranched
credit manufacturer. Temasek could very well sponsor such activity and anchor the equity of such investment vehicles. DBS could be similarly engaged. Both banks could become examples of how banks can work hand in hand with shadow banks in a capital efficient, profitable and regulation-compliant fashion directing capital where it needs to go and pricing risk appropriately.

If done properly, Singapore could reap a Wimbledon Effect, at least in Asia, reintroducing a technology there that went out of fashion in the West for not entirely good reasons, and which can do a lot of good in bank capital constrained regions.

If and when Singapore decides to go down these roads the institutions leading the way will need to have appropriate leadership. CEOs and CIOs will need to be familiar with these technologies. Generalists briefed by specialists only to approve or validate the specialists’ decisions and recommendations will not do. These armies will need to be led by battle scarred fighting men and not HQ bound generals.

The SWFs will have a much wider responsibility. Not only must they generate sufficient returns for the nation to augment the budget, they must actively and aggressively drive development both of industry and nation. They must shamelessly attract expertise with capital and latitude, they must attract coinvestment both financial and strategic and they must create a brand which can extend beyond the shores of this tiny island. This brand will stand for integrity, transparency, efficiency, innovation and excellence. It must demonstrate a new model for countries constrained by size and resources, that once again a small force can achieve more than a big one. Its going to take some leverage.