Inequality has decreased globally, yet this aggregate phenomenon hides a more disturbing picture. As countries have become less unequal, the distribution of wealth and income within countries has become more unequal. If the material and commercial motivation for conflict between nations has receded between nations, it has certainly risen within each country.

A disinterested flavor of capitalism both requires and promotes inequality. Absent some form of social safety net, the juggernaut of capitalism crushes the weak and exalts the strong. Diversity feeds the system, and natural selection drives aggregate efficiency and productivity.

There are two reasons why social safety nets have been enacted in many developed capitalist countries. One is human charity and an innate sense that all life is precious and the neglect of the weak is too cynical a position. The other is that a sustainable system, however capitalist, requires a sustainable underclass. A parallel argument supports the saving of the environment as well as the diversity of animal and plant species. You never know when you might need them. The need for an underclass is clear and present.

To take the less cynical view, progress requires that effort and results are rewarded and sloth and failure are not rewarded. A certain level of inequality encourages effort. It is hoped that such effort promotes the common good as the profits of the successful are spent and reinvested leading to the distribution of wealth. This distribution is not always equal. It tends to concentrate business and industry rather than diversify. And marginal propensities to consume fall with higher income and wealth resulting in a wealth trap. It is possible that overly unequal economies over save. One could envisage such a definition of over saving. Another measure of over saving is to define the optimal level of savings as that amount that will allow a person to smooth their consumption over their life, with allowances for uncertainty, to a target terminal wealth of zero. Inheritance becomes topical. Is it fair to target zero inheritance? Would acutely high inheritance taxes be useful or practical?

The accumulation of wealth for wealth’s sake is an important motivation that should not be totally discouraged. Thus, a target terminal wealth of zero may be undesirable. However, inheritance taxes can still transfer some wealth without impairing ambition too much. Practicality is another matter as high inheritance taxes only encourage tax avoidance strategies such as pre mortem transfers.

It seems that while a certain level of inequality encourages progress, inequality is neither an unmitigated good nor an irredeemable bad. As long as inequality is not synonymous with unfairness, then it is a good thing. Fairness would require that each new entrant into the economy does so on equal terms. But what does equal terms mean and how far does it go? Does it require equal initial endowments of wealth and capital? Is equal access to education sufficient? Is the limiting or prohibition of extra curricular education too far to go?

The cynical view would maintain and encourage inequality subject to the constraint that such inequality does not threaten the status quo. A minimal level of social security and welfare would be provided to appease the middle to lower classes to prevent a revolt. In the meantime policy would focus on maintaining the wealth accumulation of the influential and wealthy. Bailouts of asset markets, ostensibly to avoid damage to Main Street at cost to employment and household income and consumption, support the cynical view. The increased inequality post crisis is further evidence.

Unconstrained free market capitalism tends towards extreme inequality of wealth. The accumulation of physical and intellectual capital makes wealthier households more productive than others in a perpetual cycle. Eventually inequality becomes acute and needs to be addressed. Current solutions are overly complex and politicized and treated as a necessary evil. They only slow the rising inequality without establishing basic principles and facing the primary issues. Is inequality to be embraced or tolerated? Is inequality a bad to be actively reversed? On what basis is inequality measured and what are the metrics? What are the side effects of whatever route and policy is chosen and what is acceptable?

The divergence between the US treasury market and US equities can be accounted for.

1. US treasury yields are held down because.
   1. Floating rate note issuance is expected to be circa 180 billion USD. This will substitute away some of the fixed coupon issuance. This means less supply of fixed coupons.
   2. Tax receipts are up which will also slow the issuance of treasuries.
   3. Major trading partners such as China and Japan are seeing a reduction of trade surpluses or an increase in trade deficits implying slowing supply of USD offshore and thus weaker demand for treasuries.

1. US equity markets:
   1. Economic growth remains robust. There was a speed bump due to the harsh winter but this has passed.
   2. Trend growth is not 3% but 2%. Given this, any ‘fail’ of the 3% mark is not a risk of reception but a cyclical slowdown within a global rising trend. Since 2010 GDP YOY has oscillated around 2%, which I regard as the new trend growth rate. Why is trend growth lower today than before? This is not an easy question and there are no definitive answers. One possibility is that credit creation has become impaired. Despite efforts to inflate the monetary base, bank regulation and scarcity of bank capital are constraining credit creation. The 3% average growth rate from 1980 – 2006 was probably boosted by a full 1% due to the early 80’s boom in junk bond issuance, the securitization of debt in the late 1980’s and the surge in securitized and tranched mortgage bonds in the last 15 years. Absent this credit innovation, trend growth would have been 2% as it is now.
   3. Given the above view of a secular recovery, US equities are in a secular bull market. That said, we could be at a cyclical peak given that price levels have run ahead of earnings.
   4. The continuation of the current cyclical bull requires a recovery in corporate investment which has not yet happened. The growth of the past 5 years has been driven by consumption and housing. Corporate profitability is now at a cyclical high and household savings rates have fallen from mid 5’s to low 4’s. While US equities remain fundamentally sound, a continuation of earnings growth now stands on a single pillar, corporate investment. I believe this will happen given the average age of the capital stock…

1. Conclusion:
   1. I expect the US treasury market to be more resilient than consensus for reasons of demand and supply.
   2. I expect the US equity market to be in the early stages of a secular bull market.
   3. However, I do feel that the US equity market is currently vulnerable as fundamentals have yet to catch up to valuations.

One of the commonly accepted models of economic growth is one where economic growth is determined by capital accumulation, innovation and growth of the labour force. The growth of the labour force quickly translates into growth of the population and particular age groups which are regarded as particularly productive. This is all fine, if you can grow the population without bound. The weakness of this assumption is most apparent in the case of small islands. Singapore is a good example. Progressive immigration policy has helped growth not just in population growth but also in capital accumulation and innovation. Lately, however, the limits of immigration have been tested. The storage and transport of labour has become difficult. Incumbents have come to regard further increases in population very negatively. The government, on account of the last election’s poor result, has begun to listen to the people, to an extent. They have tightened immigration policy in sympathy to the people’s preferences. These measures are not sufficient. If the government is serious about avoiding and reversing the momentum of overpopulation, it must cut back on the creation of storage of labour. This it has not done. One can only speculate that a longer term strategy still pursues rising immigration but that an interim solution has been formulated to manage the people’s expectations. Here is how one such plan could work:

1. The people regard the country as over populated and register their objections.
2. The authorities tighten immigration rules to slow population growth.
3. The authorities continue to increase population storage by land sales and the approval of building permits, etc.
4. The stock of housing increases.
5. The authorities can then at a later stage present a housing oversupply to the people.
6. They authorities can present also a strategy for preventing a crash in housing prices by allowing more immigration thus increasing the demand for housing.

Thus, it would have been possible to achieve the desired population growth to sustain economic growth with the acquiescence of the people. It is a clever gambit but it fails to address the limitations faced by the island state. Population cannot be grown without bound anywhere let alone on a small island. New goals and new strategies need to be established towards a more viable society. We can only hope that the authorities have the vision to see this.

The current volatility in global markets is unremarkable. What is remarkable is the lack of volatility in the past two years. The macro conditions envisaged in mid 2012 continue to hold. For details see:

Investment Strategy In a Crazy World April 2012

1. Long term global growth rate has stabilized along a slower growth path, mainly due to moderation in credit creation.
2. Developed Markets (DM) rebalance towards a neutral trade balance. Emerging Markets (EM) also rebalance towards neutral trade balance. Generally this is the rebalancing of economies towards better balance between investment, consumption and trade.
3. Aiding the resurgence of exports and manufacturing in DM is an entrenched technological or knowledge advantage.
4. Trade flows are supportive of USD.
5. Trade flows are raising true cost of funds for hard currencies.

1. DM growth to accelerate. EM growth to decelerate.
2. DM currencies to strengthen relative to EM.
3. EM curves to flatten relative to DM curves.
4. Bearish for commodities as DM are more efficient users of commodities relative to EM.
5. Much depends on EM response to current volatility in FX and rates. Raising short rates may not work in defending currencies. Side effects include depressing local currency bond markets as cost of FX hedging rise. Hard currency bond financing faces obvious problems. Selling hard currency for local is an analgesic with poor long term prospects as foreign reserves are exhausted.
6. EM risk is likely to be continuous rather than catastrophic. Crises are unlikely. Steady underperformance is likely.
7. credit crisis risk has been postponed by the opaque bailout of the Credit Equals Gold product but refi risk is significant.

1. Avoid macro trades. Allocate to well hedged, idiosyncratic risk strategies.
2. But if you have to invest in macro fashion, invest in DM.
3. Overweight US risk assets.
4. Neutral, not underweight, USD duration.
5. Overweight European duration.
6. EM is weak, but there is a price at which EM can be bought.

1. ’s shadow banking system remains opaque and leverage is high once you include corporate credit to the infrastructure finance.
2. is in a feel good mode at the moment but much of the structural issues remain. The ECB will soon be banking regulator which is a positive, however, Glass – Steagall type legislation needs to be enacted. In the meantime, bank balance sheets remain opaque.
3. The Euro fails to clear labour markets. Employment is stabilizing but structural employment is likely to persist. Witness the recovery of labour markets in countries with a sovereign currency such as UK and US.
4. Man made risks such as risk pooling. Risk can be pooled in vehicles such as mutual funds, structured credit vehicles like CLOs, or more insidiously, through conventions and systems. Common risk metrics and common risk systems are a significant risk to financial stability.
5. Non commercial risks. In a slower growth environment, human beings are less inclined to share, the propensity for unhealthy competition is raised. Risk of martial conflict is raised.

1. For every asset there is a price too high, and a price too low.
2. If there
   is no reason to invest, don’t. Every extension of risk requires a sound thesis. Where ends the thesis, where ends the trade.
3. Fundamentals are necessary but not sufficient. Psychologically susceptible investors are an important element to market pricing.

Barely are we into the end of January 2014 and the emerging market debt markets are once again showing signs if weakness.

1. Emerging markets are suffering from a slow down in exports relative to imports relative to the US and other developed markets. This is a long term trend stemming from a technology deficit.

1. The supply of hard currencies, USD and EUR will be constrained. This will raise the effective short term interest rates for these currencies, LIBOR and other benchmarks notwithstanding. This is likely to also drive currency appreciation.

1. The demand for emerging market debt cannot be taken in isolation. The real money investor will want to minimize or at least manage FX risk. The high yield of an Indonesian government bond or a Brazilian government bond needs to be taken in the context of either FX volatility or the cost of hedging such FX volatility.

1. The cost of hedging the FX volatility is the short term interest rate of the currency of the respective bond. An important metric for assessing the economics of an emerging market sovereign bond is therefore the spread between the yield of the bond and the  short term interest rate. Ceteris paribus, in particular ignoring inflation expectations, the flatter the yield curve, the worse the economics of owning the bond. For example, a 10 yr Brazilian government bond yields 11% but costs 10.75% to finance. A 10 year US treasury yields 2.8% but costs 30 basis points to finance. In addition, given that US treasuries are good collateral in the repo market, a 10 yr can in practice be financed at circa 6 basis points.

1. With Basel 3 and Solvency 2, US treasuries capital treatment and declining issuance could make them the surprise outperformer this year.