The world is witnessing renewed economic strength. Generally, fundamentals are strong(er), especially in the developed markets. Policy, however, remains nervous and uncertain and drives financial market volatility. Equities in the performing markets seem fully priced. Credit continues to perform in the face of potentially higher interest rates. What can we make of all this? Let’s do this back to front…

Implications:

Slower global growth means less cooperative counterparties. Expect more mercantilism, currency wars, and control of cross border movement of intellectual, financial and human capital. Reward national self sufficiency.

US short term interest rates likely to be pinned at close to zero for multiple years. The longer end will be driven by market expectations. Its reasonable to expect the USD curve to be steeper than EUR and GBP term structures on both growth and inflation expectations.

EM inflation is a problem; sovereign finances may add fuel to the fire. Expect EM term structures to underperform.

In the US, high yield and credit may continue to perform despite the QE taper talk. Growth is self sustaining but weaker than the market expects. Hold with high yield now. If QE taper becomes more probable, a switch to equities may be useful.

In Europe, high yield and credit are likely to continue to perform. Equities look cheap in aggregate but when controlled for quality, equities are fully priced. EUR denominated high yield, even of non Eurozone issuers, is attractive as credit is priced off the EUR curve which is likely to outperform.

Growth:

The global economy will face slower long-term potential growth compared with before 2008. Cyclically, the developed markets of the US, Europe and Japan are experiencing a recovery. Emerging markets are slowing down, albeit from higher rates of growth.

It appears that, overall, the fundamental economy is healthy and on its way to self sustaining growth. Over the longer term, emerging market growth must reasonably be expected to moderate as those economies mature.

Post 2008, a global rebalancing is underway, which is natural after every crisis. Whereas the late 1990’s saw emerging market crises which led them to repair their balance sheets, the most recent crisis was rooted in excessive debt in the developed markets. This has been met by efforts to manage the existing stock of debt, to provide relief to poorly underwritten credit, and to scale back indebtedness. Some of these efforts will be mutually confounding.

For the developed markets the rebalancing will involve a revival of manufacturing, a reorganization and reduction in private debt, a resurgence of exports as a driver of growth, and stricter regulation of the financial system. Emerging markets will have to rebalance their economies away from exports, this will be done for them by the developed markets anyway, towards a more consumption led engine of growth. This will tend to weaken emerging market private and public balance sheets.

Emerging markets, which weathered the 2008 crisis relatively well, now face a more difficult reality. The immediate impact of the credit crisis on emerging markets was a quick reversal in their balance of trade, due to the sudden dearth of trade finance, then due to the competitive devaluation of developed market currencies, re-shoring of manufacturing, and competitive intellectual property strategies. Emerging markets have had to operate equally loose monetary policy to support their export dependent economies. They have felt able to do so due to their generally strong foreign reserves and as falling interest rates have helped to offset weak developed market currencies. At the same time, emerging markets are being rebalanced toward more consumption led growth, almost by default, as developed markets become more export competitive.

Earnings:

In the US, the economic recovery there has probably achieved escape velocity. The innovation and efficiency of US companies is driving a sustainable, secular trend in earnings. The distribution of growth is, however, uneven. Capital remains expensive and debt, while cheap, is not widely available. Small and medium businesses rely on bank credit, which remains impaired. Companies with access to debt capital markets can fund cheaply and profit from the increased demand for yield among investors. For these, a simple balance sheet restructuring in favor of debt financing is accretive to earnings per share.

In a positive but low growth environment, compounded by political uncertainty, (over the debt ceiling for example), financial engineering dominates business expansion, and employment. The dearth of bank capital also limits growth capital for small and medium businesses who tend to be more important for employment growth.

The European experience is similar although Europe is a step or two behind the US on the path to recovery. That said, Europe continues to suffer from over-capacity, as evidenced by its lack of inflation, and could profit handsomely from any uptick in growth as operational leverage remains high. Europe, however, suffers from a more acute form of funding shortage. Its banks are well behind the rest of the world in recapitalizing and SME lending is moribund. Recent signals from the ECB indicate that the problem is being addressed. The Asset Quality Review initiated just now is a good example.

As emerging markets rebalance towards more consumption and less investment and saving, the fortunes of companies will rotate accordingly. Current index heavyweights like banks, resources and exporters will likely see increased risk or weaker earnings.

Prices

Emerging markets are suffering from inflation. Inflation measures are imperfect and anecdotal evidence indicates inflation is running faster than official numbers suggest. Additionally, inflation is higher in non-administrative goods markets. This implies higher potential inflation should these goods or services markets be deregulated. What are the sources of this inflation given that emerging markets are in fact facing slowing growth? One is the inflow of capital as a result of QE in developed markets. This argument is weakened by the fact that inflation in the economies printing the money is muted. Asset prices such as real estate are rising but goods and services inflation is decidedly muted in developed markets. As the world becomes less globalized, and economies less open, the sources of inflation are increasingly domestic. Policy tools such as the exchange rate become ineffective. Interest rates on the other hand are a blunt instrument and ineffective under stagflation. Generally, trade enables price discovery and market clearing and a less globalized world encourages inflation.

Inflation in the developed markets is more complicated. Whereas central banks like the Fed have been purchasing assets and growing the money base, inflation has been surprisingly low. And yet, the risk of inflation is high. If the money multiplier or the velocity of money were to accelerate, it would multiply through a massive money base to inflate nominal output. If capacity is tight, the risk for a spike in inflation is significant. The US therefore is poised between low inflation and a spike in inflation. This is one reason that the Fed needs to reduce the
size of its balance sheet as soon as practicable. In Europe, the UK excepting, deflation is the greater risk. German influence is likely to keep the ECB tighter than it otherwise would be, even as the ECB maintains its easing stance.

Financing:

Developed market regulators are sending conflicting signals to banks, encouraging to lend more and take less risk. The Basel III capital rules have certainly reduced the amount of credit available per dollar of bank capital. With investors still hurting from the losses of the last crisis, private funding may have rebounded but have yet to fully recover to pre crisis levels. Debt capital markets are a bright spot, however, as low rates and demand from retail investors and mutual funds have driven bond issuance. Structured credit issuance and thus demand for collateral has recovered slightly overall but remains weak outside the US. With less bank capital and still sub capacity shadow banking sources, credit conditions remain constrained. Larger, developed market issuers, not necessarily better credits, will face easier credit conditions through access to bond markets.

For credit to fully recover and grow, the shadow banking industry needs to be further developed. Regulation has so far focused on banks. Some efforts have been made to bring shadow banking under the purview of regulation but the complexity of the system has so far confounded regulators’ efforts.

Policy:

The US treasury will need to continually finance itself despite cash flow insolvency. The US Fed lost its independence the day it stepped in to rescue the markets and the economy and will continue to fund Treasury. It is likely that the Fed will keep rates floored for multiple more years. Attempts by Treasury to extend its funding with low duration issues like FRNs are evidence that rates will be kept low.

QE will be moderated. The question is one of timing. The Fed needs to control its balance sheet soon or risk a spike in inflation. It has tools such as reverse repo to reduce liquidity but these are temporary measures. It is simply not prudent to maintain a balance sheet of this size. The most likely scenario remains that QE moderation will be conducted, but that sufficient noise will surround the incidence to desensitize the market. The goal remains to reduce the size of the balance sheet without steepening the term structure excessively.

Europe is significantly behind the US in terms of policy. The European recovery is still in its early stages and significant tail risks remain, notably in France, whose economy is weaker than its CDS spread suggests. The EUR continues to impede market clearing in the labor market creating chronic unemployment across the region. The ECB will likely continue its LTRO to maintain liquidity in the system while the banking system undergoes its recapitalization exercise.

Slowing growth and rising inflation plague parts of the emerging markets. Countries with sound balance sheets may spend their way out, within limits. Current account deficit an or budget deficit countries will be very constrained in what they can do. Brazil and India are the main examples, and there are more from Asia to Lat Am to Central Europe of countries where currencies are vulnerable, reserves are thin and efforts to support currencies could choke off growth.

China’s efforts at rebalancing its economy are commendable and also a sign of strength. Recent initiatives to reign in credit and to audit the shadow banking industry point to responsible management and imply strength of the financial system. Much will rest on the shoulders of the central government, though, as local governments have been impoverished and the banking system lives on very optimistic appraisals of their balance sheets.

Risks:

If it is written here, it is not a serious risk. The most serious risks are the ones that only become clear once the damage is done. But anyway…

Almost all asset pricing is dependent on some kind of discount rate. Central bank policy dictates interest rates, the most natural discount rate in any asset pricing model. One mistake and all asset prices will be mispriced. We’d better hope that central banks are able to wean the market off interventionist policy in an orderly fashion.

A corollary to the above is that nobody knows the correct price of any asset as long as quantitative easing and other unconventional monetary policies are in force.

Inequality. We have witnessed inequality fall across the globe as poorer nations got richer more quickly than richer nations. Within countries, however, the reverse was true; inequality worsened within each given country. Sufficient in-country inequality can be destabilizing socially, politically and economically.

A small pick up in inflation too soon can be difficult to manage when a central bank’s balance sheet is over inflated.

Long maturity, low interest debt is very long in duration, and very convex.

I reiterate what was said at the start of this article. Slower global growth means less cooperative counterparties. Expect more mercantilism, currency wars, and control of cross border movement of intellectual, financial and human capital. It is not a stretch to extrapolate such competitiveness to armed conflict. All it takes is a little bit of paranoia.

Treasury is reducing issuance of T bills. At the same time they are starting issuance of 2 – 3 year FRNs. Why?

There is a strong consensus among investors that rates will rise and therefore they should reduce duration. As a result they are buying shorter and shorter maturities.

This trend is hurting Treasury’s ability to issue notes and bonds. The only way Treasury can issue outside of a year is to offer a short duration, long maturity instrument. Enter the FRN.

Now, in order for Treasury to control debt service the Fed Funds Rate will have to be kept at 0.25% for much longer since the FRN’s coupons are benchmarked to short rates.

This only confirms what I’ve already expected, that regardless of QE tapering or not tapering, the FFR will be kept low for multiple years. 

Strategy:

Don’t expect floating rate credit to profit from rising rates, the short end will not move. Be that as it may, USD duration will still get punished, just not as soon as we thought. We still need USD floating rate funds.

European duration will likely be unaffected. That means you could even buy the EUR or GBP debt of a US issuer. This is interesting. The need for a Euro floating rate fund is perhaps not that urgent as in EUR, you want duration.

EM duration remains bad news. Outside of price controlled goods, inflation is actually a problem. I expect BRIC term structures to underperform. If ever floaters worked, they would work in EM, unfortunately, EM bank debt doesn’t trade.

With consistent central bank asset purchases, the term structure of interest rates cannot find its natural market clearing level. It is difficult to know if asset bubbles are being inflated or not, and it is hard to tell if the economy is yet on a self sustaining growth path. The only way to tell, to discover the price of things, is to wind down the asset purchase programs. 

The constant feeding of liquidity into the financial system has failed to revive labour markets even if it has revived markets for equities, bonds and real estate. GDP growth while positive has fallen short of expectations.

Asset purchases may be stifling credit market liquidity. As more market liquidity has migrated to secured lending markets, the availability of eligible collateral becomes more important. As the Fed does not lend out its assets for collateral, it is possible that the Fed is in fact starving the credit markets of suitable collateral with which to lubricate the flow of short term credit. This mode of liquidity injection definitively precludes any sort of multiplier effect since it creates no bank capital to be multiplied. For this reason, the velocity of money falls almost in perfect reaction and in inverse proportion to the magnitude of balance sheet expansion.

By suppressing interest rates, central banks are making it more attractive for companies to finance themselves with debt instead of equity. In the US, share buybacks have reduced the free float of equity markets even as high yield issuance remains robust. Equity market capitalization growth has lagged the S&P index level growth by almost 3% per annum since 2005 for a -30% lag. The economy seems preoccupied with equity returns rather than growth of income and employment. The Modigliani Miller theorem’s assumptions are certainly violated by the convoluted US tax code which generally favors equity finance, for the businesses, and equity investment, for investors.

The benefit of lower interest rates favors large companies with access to debt capital markets. Small and medium businesses which rely on bank loans for financing continue to be starved of capital as Basel III and a lack of bank capital impedes bank lending. As employment tends to be created in small and medium enterprises compared with large businesses, which on balance tend to consolidate, the impact of low interest rates do not encourage job creation.

What then does QE do? It does inflate asset and house prices and supports consumption through the wealth effect. It supports equity and debt valuations by suppressing rates across the term structure. It monetizes debt which may not obtain sufficiently robust bid to cover ratios thereby maintaining confidence in the treasury and agency MBS markets. It supports co-investors in treasury and MBS assets.

It would be unfair to say that QE wasn’t working, employment has improved, manufacturing has rebounded and growth has stabilized, but the improvements have been small and slow to gain traction, and the side effects are potentially serious. Given that the economy has stabilized, there are grounds for the withdrawal of QE simply to understand the distortionary effects of having QE in force.

Our system of politics and economics is very much a product of history, so much so that some basic questions about fairness and efficiency remain unresolved.

Why is income taxed more vigorously than capital gains? Why are the gains from gambling not taxed more aggressively?

In a meritocracy, what is to be done with under performers? More importantly, in a meritocracy, how should underperformance which is due to bad luck, or indeed outperformance which is due to good luck to be considered? Is the outcome more important than the route?

Does a sovereign country expect to repay its debts within a finite time period, by which is meant, achieve a net cash financial position?

A prudent way to run a business is to increase its equity over time. How should a business plan its capital structure? Should a business plan to achieve a net cash position within a finite time period?

A prudent householder should plan to accumulate equity over time while it is productive and to build an asset base to provide for retirement. Is it prudent to draw down equity during the retirement phase and if so how should it plan to do so? If a generation within a household is deceased with a positive equity, how much discretion should the deceased have (through their wills), over the distribution of the excess equity?

Markets are generally efficient in aggregate and over time. Markets can be inefficient in parts or for periods of time. Do I really believe this? Yes, provided they are proper markets by which I mean that there are sufficiently numerous independent participants, neither of which has sufficient individual influence over pricing.

Most of the familiar asset types exhibit these properties. Equity markets are a good example. So are corporate credit markets. The persistent performance of a small group of hedge fund managers, and the disappointing performance of the significant majority of their competitors is instructive. Successful equity hedge fund managers are rare. Credit managers tend to display more persistent out performance. The liquidity, symmetry of information, completeness of markets in equity markets tends to level the playing field. They also make inefficiencies small, relative to background noise, complicating the job of the equity investor. Here is another point. Every market has a level of background noise. Inefficiencies have to be larger and more persistent if they are to be captured by an investor. If the inefficiencies are too small or last too short a time, then by definition these markets are too efficient. This could be one measure of the efficiency of a market. That some investors are able to repeatedly beat the market implies that there are inefficiencies but that they may not be obvious enough for the majority to identify or capitalize on.

Cross asset inefficiencies are an example of how apparently efficient markets can be inefficient because they are in fact incomplete. Capital structure arbitrage is evidence of such inefficiencies. Because efficiency in equities and bonds are policed by different constituents whose pricing models do not look across asset classes, the valuation between different parts of a company’s capital structure may be mispriced and provide the suitably equipped investor arbitrage or relative value opportunities. This strategy is especially topical under the current cosh of increased regulation in the form of Basel 3, Solvency 2, Dodd-Frank and the Volcker rule. The best policing of capital structures used to be the proprietary trading desks of the investment banks. With increased regulation, prop desks are being shrunk or closed, reducing the amount of capital policing cross asset no-arbitrage conditions in the markets. The opportunities for arbitrage and relative value are greater now than ever before. In other words, markets are a lot less efficient these days.

There are other reasons why a market may be persistently inefficient. The existence of one or a group of participants with disproportionate influence can distort pricing. A simple example is a regulator or central bank. Under what was apparently regarded as normal conditions, central banks may unilaterally determine or influence the level of short term interest rates. While this is already a deviation from the assumption of market determined prices an even greater departure is if the said central bank additionally influences other maturities along the yield curve, for example through the open market purchases of government bonds we have come to call Quantitative Easing or QE. Under these conditions the market is far from perfect and no-arbitrage pricing should not be expected to hold. Investors trading on the assumption of efficient pricing are likely to be confounded.

Extending the complete markets argument for inefficient markets, one could argue that price distortion in one market can affect prices in other markets. A current example is equity markets. Investors consider equity valuations reasonable on an equity yield gap basis, that is relative to US treasuries. If, however, the yield curve is being artificially suppressed by the actions of the central bank, such as under the unconventional monetary policy we call QE, then equities are vulnerable if the central bank were to reduce or stop their purchases of US treasuries and the yield curve was to find its natural level.

Another instance where markets are temporarily inefficient are times or high uncertainty and turbulence where information is insufficient for the market to digest and interpret. Times of crisis and near crisis often lead to the inversion of credit default term structures, for example, making it more expensive to insure against default over a shorter period than over a longer period. US treasury bills may at times trade at higher yields than the unsecured LIBOR market in a recent example, when default by the US treasury seemed possible, albeit highly improbable.

In some markets, imperfections are more prevalent or persistent. Securitized markets such as mortgages, auto loans, student loans, and credit cards are a good example. Complexity of products, market conventions, market culture and regulation make the securitized products market a highly peculiar one. The highly contrived nature of the products being traded are the root of the overall complexity of the market, if it can even be called a market. The highly politicized nature of the underlying assets in which the derivative products are based also invite complex and confusing regulation driven by the confluence of politics, socio-economics and commercialism. One of the results is one of the largest, most liquid asset markets in the world: agency mortgage backed securities. Yet size does not an efficient market make. The best traders in mortgage markets are those who have been involve in the regulation or the industry, the production of the securities, the distribution of product and the origination and management of the underlying assets being securitized. They are bonds indeed, but not as we conventionally know it. Fixed income investors uninitiated to the peculiarities of the MBS market but lured by the high yield, high ratings, often struggle to trade an entrenched club of insiders.