Last week the FOMC finally raised interest rates, the first time in 9 years. Risk markets rallied in relief before falling back on concerns in commodities and credit markets.

Equities

Year to date MSCI World is -3.45%. The S&P is -2.6%, FTSE is -7.8%, MXAPJ  is -13.6% and MSCI Emerging Markets is -15.3%. In China, H shares are -19.6% and Shanghai Comp is +10.6%. In positive territory, the Eurostoxx is +3.63% with CAC and DAX both up over 8%. The Nikkei is +8.8% and Topix +9.2%. A cursory glance observes that the weakest economies have the strongest stock markets.

Fixed Income

The Barclays Agg is -0.5%. On   the positive side, Euro sovereigns are +2.25%, China corporates are up, local IG and HY +2.95% and +6.83%. USD IG and HY are +3.45% and +10.55%. US Non Agency RMBS is +9.55%. On the negative side, US and EUR IG are -0.59% and -0.27%. US HY and loans are -6.17% and -0.94%.

FX

JPY traded within 116 – 125 in the year before settling at 121.33, or -1.30% YTD, largely flat despite weak data, as the BoJ holds firm.

EUR is -10.2% YTD, depressed by QE and the ECB’s inflationary efforts.

JP Morgan’s Emerging Market FX Index is -15.2% YTD.

Gold traded in a +-10% range YTD most recently trading at -10% YTD at 1065.

Commodities

Crude oil is -35% as supply continues to outstrip demand.

Nat Gas is -36%.

Industrial metals are broadly -30+% YTD.

Looking forward:

There is not much to look forward to really. One bright spot is the Eurozone where QE is young and PMIs are still buoyant. Still there is much uncertainty as flash PMIs have weakened, Spain will have a new government but it is not clear of what composition, Greece is still running a significant budget deficit and has signaled reluctance at further IMF support and the UK considers exiting the European Union. Fortunately the ECB’s last expansion of QE was sufficiently half-hearted to warrant a further augmentation.

The US was slowing already ahead of the rate hike. The Fed says 4 hikes in 2016 the market 3, so investors are already more optimistic about markets and less optimistic about the economy than the Fed. Without an expansionary Fed, equity markets will have to rely on earnings growth, which has been weak and hitting peak in recent quarters. At least the Americans are repacking their parachute back into the bag.

China continues to slow at a steady rate and has dragged its entire Emerging Market supply chain with it. The rebalance towards consumption and services looks to be on track, at the expense of the old economy industrial machine. The PBOC will continue to send liquidity where it is needed in copious quantities but will be careful that it does not drive asset bubbles. The H share market, already cheap keeps getting cheaper as fundamentals catch up to valuations.

Emerging markets have been in a 5 year bear market and valuations are approaching attractive levels. The problems they face are, however, not high valuations or rising interest rates or strong or weak currencies. Supplying China and the US or standing between them is no longer a viable business model when the two giants turn from one another.

Commodities’ current cycle is already very mature. However, it takes a catalyst to reverse the 5 year bear market. Such a catalyst could be a supply side shock, new legislation, previously unidentified demand.

A few spots of value may be exploitable.

Energy is evidently distressed and will soon present opportunities for restructuring. It’s probably too early and buying performing debt is probably ill advised but swaths of the industry will be headed into Chapter 11.

US high yield was overvalued but the tide has turned and not so much on credit quality than on concerns over liquidity. The HY bond market and the leveraged loan market already presents good value. However, the very nature of the mis-pricing, that is concerns over illiquidity, portend a volatile market. Risk management will be important.

Success sews the seeds of its own demise. Adversity improves the breed. Human beings are dynamic and adaptive, which means they adapt to hardship by growing stronger, becoming more resilient and more resourceful, and they react to comfort by growing lazy, complacent and vulnerable.

A society which has won success and comfort through toil, enterprise and resourcefulness is strong. Even as success matures remnants of strength remain. Subsequent generations also observe the path to wealth and security lie in effort and enterprise.

Extended periods of success can lead subsequent generations to lose the memory of the path to success leading to lazier generations with a culture of entitlement.

When a significant proportion of a population finds success not solely by effort and enterprise, there is a significant risk that subsequent generations do not associate success with enterprise and effort but seek more comfortable factors to attribute the success.

Asset inflation is a particularly risky form of wealth creation, as opposed to accumulation of skills or capital. This is particularly acute in the case of housing booms because home ownership is likely more prevalent than other forms of asset ownership. Real estate booms result in a wide ranging and highly inclusive growth in nominal wealth. Absent multiple real estate asset ownership it is arguable if utility is improved since replacement value rises with asset value. The increase in wealth is disassociated with effort and enterprise, and this is signaled to subsequent generations. Populations which have insufficient history to observe asset busts as well as booms will have biased assessments of risk, generally underpricing the risk in the relevant asset class.

The ubiquity of the wealth effect results in a widespread accumulation of wealth which is disconnected from effort and enterprise. The impact on labour is that it discourages effort, encourages a sense of entitlement, and a sense of financial security, which together increase the propensity to shirk, since the penalties to unemployment are low.

Successful economies signal a strong causality between effort and enterprise, and success. They are sufficiently unequal in wealth to incite effort yet not so unequal that the probability of an individual moving upwards between wealth percentiles is unrealistically small. Everyone should be seen to have a fighting chance to get ahead. They have a sufficient proportion of households with sufficient accumulated equity to maintain aggregate stability in the economy and they have a sufficient proportion of households with insufficient accumulated equity to incentivize effort and enterprise. The rules of commerce and finance are sufficiently fair, and corruption is sufficiently low, to incentivize participation.

Hedge funds and their prime brokers should get more creative with their business development.

One area is illiquid side pockets which can be used to house either illiquid assets or long gestation strategies. These strategies should ideally not be in the main liquid structure of the hedge fund but carved out as a side pocket. The side pocket would be capitalized separately by investors who opt in, and or be separately offered to investors at arm’s length (that is to investors not investing in the main liquid fund.) The financing of such a side pocket would best be served by term financing or term securities lending. These liabilities might be offered to credit investors on a senior secured basis. Prime brokers could help in placing these liabilities for a fee.

Another area of development could be asset backed commercial paper issued by hedge funds. These would be shorter maturity secured paper backed by hedge fund assets. The maturities would need to be matched against the redemption frequencies and lock ups of the fund. Again, prime brokerage can facilitate the issue of these securities.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

It is important to correctly define what is meant by private banking, especially in the context of Asia.

Many private banks in Asia struggle despite asset growth because of margin and cost pressures. One reason for margin compression is the failure to distinguish between private banking, brokerage and lending businesses. A typical private bank may have 5% – 10% of AUM under discretionary management, and a further 15% – 40% in annuity fee paying AUM. The rest are deposits which are mined for transaction income.

A significant proportion of annuity income takes the form of retrocessions from managed product providers. This model too is under threat from regulation which is encouraging the industry towards greater fee transparency. Regulators are also encouraging a proper alignment of interests and guiding banks towards charging clients directly rather than charging them indirectly through the receipt of trailer fees paid by fund managers but ultimately funded out of the net asset value of investors’ capital.

Mining deposits for transaction fees is not true private banking. That is a brokerage business. Asian clients are highly fee sensitive and tend to compress brokerage fees very quickly. A bank can mitigate this by offering unique product but this is difficult as regulation encourages product providers to seek multiple distributors leading to competitive pressures on transaction fees. In the retail segment, products are bought on-line or through low cost bank branch generalist sales staff. Private banks relationship managers are too expensive to be so deployed.

Many private banks react to this margin compression by trying to grow AUM at a rate to compensate for the margin compression. In the limit this takes the form of consolidation, a dynamic already well underway in Asia. In the long run there are limits to this business strategy.

As transaction fees compress private banks have turned become leverage providers. This is a very different business as the bank now has capital at risk. Systems, processes and people have to be deployed to properly manage the risk. Essentially this is a prime brokerage business for private investors. Witness the margin compression in the prime brokerage business servicing hedge funds where sub scale clients (hedge funds) are turned away. The analog has not happened and private banks continue to compete for AUM driving down underwriting standards. Clients can shop around to find the cheapest and most leveraged offerings. It is questionable if the loans are being properly priced in terms of capital consumption. In Asia it is still possible to obtain leverage at cost of funds + 0.60% for good clients.

For clients, leverage may not be optimal, it may, but the advice around crafting a leveraged portfolio seldom revolves around risk. Clients are encouraged by relationship managers to maximize leverage. Client and relationship manager are often negotiating on the same side against risk managers. And private bank credit and risk managers are not quite as sophisticated as their counterparts at prop desks, the investment bank or prime brokerage. Very often their credit modelling is rudimentary, that is if they are not calling around to their peers on the street to align lending values. Relationship managers under pressure to perform can be persuasive and influence senior management to relax lending standards for good customers. And senior management often accommodate for the sake of quarterly revenues.

 

Leverage is not a bad per se. It magnifies upside as well as downside and when interest rates are as low as they are now, leverage can be a very attractive tool. However, private bank investor loans are rarely term loans and have strict loan to value covenants which may trigger margin calls. When leverage is not matched to either the duration of the asset or the gestation of the investment strategy, the investor crucially loses control of the strategy.

To summarize, Asian private banks define their remit as, discretionary and advisory management, which is traditional private banking, and then more innovative activities such as brokerage and leverage. That brokerage and leverage income represents the majority of income by a wide margin is not ideal. Brokerage is highly cyclical and volatile while leverage involves capital at risk.

Rightsizing a private bank like most businesses begins with self-awareness and defining the nature and core strengths of the private bank. It involves defining clearly what businesses it is in, and what businesses it will not engage in. Failure to do this will lead to over-resourcing and wastage.

The future of brokerage can be seen in the history of equity sales. Low single digit basis points commissions. The future of leverage provision can be seen in prime brokerage where only clients of a critical size are entertained as their scale and profitability pay for sophisticated risk management and engagement. In 2008, Lehman was the only major prime broker to fail but the credit worthiness of almost all of its peers were sorely tested. They survived, but only after many of their hedge fund clients were decimated.

 

The future of Asian private banking is clouded. One hopes it matures and clients engage private banks as trusted advisors and fiduciaries. Unfortunately the private banks mostly live by a quarterly revenue target which necessitates pressuring clients to transact and to leverage up. Cost pressures also discourage private banks from hiring high quality investment and risk managers and competent advisors. Faced with the painfully evident quality of advisor facing them, the client reacts rationally and eschews passing discretion to the bank. And so the cycle of mutual mistrust perpetuates.

 

 

The Fed has form. When it wants to take away the punchbowl, it usually telegraphs its intentions well in advance so partygoers have time to go buy their own moonshine. So it was with QE taper, signaled in 2013, executed in 2014. By the time the Fed stopped net purchases of bonds the market had digested the eventuality and 10 year US treasury yields ended 2014 lower than at the beginning. The idea behind this is simple; the Fed wants to give the economy time to prepare for tighter policy, and constantly communicates with the market, managing expectations until when the move comes, the reaction is one of indifference. As we have seen in September, sometimes, the expectation becomes so entrenched that failure to act as signaled results in disappointment.

Forward guidance was meant more narrowly to mean central banks promising to keep interest rates lower for a longer period than signaled by traditional reaction function, an augmentation to policy once the traditional and the traditionally extraordinary have been exhausted, a last resort. Today, could it be interpreted as a more detailed statement about the intended objectives of the Fed, not just at the front end of the curve but across the curve as well? The Fed wants to hike rates, but it doesn’t want 10 year or 30 year yields to rise excessive or at all. Hence the numerous signals that the path of rate hikes will be slow, that inflation risk is de minimis, that treasury bonds will be in short supply, and so on.

Surely today, the Fed has once again engineered conditions to its tastes. The market expects a rate hike of 25 basis points, and little impact if any at the long end of the term structure. Quite in line with what the Fed intends.