Economic growth in the developed markets appears to be in a general if tepid recovery. The US continues to exhibit steady recovery in economic growth supported by a robust housing recovery and manufacturing which has even now widened to a slightly healthier labor market. Tempering this is a falling participation rate, which is troubling since the unemployment is in the younger cohorts, and the increasing proportion of temporary work, which is more likely a consequence of Obamacare, which requires employers to provide health insurance to full time employees.

In Europe, a nascent recovery is underway, a first quarter of positive growth after six negative ones, led by Germany, and featuring, surprisingly, France.

It is perhaps surprising that the weak spots in the world have come to be the emerging markets, although the emerging markets are far from homogenous. China’s weakness seems the biggest threat given the size of its economy. India is unnerving with the acute weakness of the INR and the shortage of USD unsettling markets.

The last 5 years have been marked by the importance of policy intervention. Central banks have reduced short term interest rates and multiplied their balance sheets to fund their respective governments in the face of bailout bills and flagging tax receipts, as well as to inflate liquidity in the hope of stimulating demand. Success must imply a rollback of such policies if nothing else than to reset their policy weapons, but more importantly to wean the economy off life support. QE tapering can thus be viewed of evidence of strength and not weakness. Currently only the US Fed is contemplating a moderation of QE. Most other central banks still face weak economies and continue to be dovish. But the US Fed faces another problem, if indeed it can be called that. As the economy recovers, tax revenues have recovered also and the US Treasury will not need to borrow as much. At the same time, despite a housing recovery, securitization has slowed compared to pre crisis levels. This presents a supply problem. If the Fed were to continue to purchase a fixed proportion of new issuance, it would be forced to slow its buying anyway. Perhaps to manage market expectations the Fed has telegraphed its intentions well in advance. No such luxury exists elsewhere in the major economies.

I am comfortable with the nature of the recovery in the US, that it is sustainable in the long run. The volatility in US assets is a consequence of the withdrawal of stimulus which should signal strength. Be that as it may, US asset markets have rallied hard and it is time for a breather. Tactically, buying put protection or outright neutralizing the beta may be a good idea. Longer term, the prospects for US assets remains good. Europe is not out of the woods but could, and I emphasize the could because nothing is certain, be 9 months behind the US in terms of recovery. If so, European assets are a good buy, in particular corporate debt, especially high yield since we appear to have good corporate performance coupled with low growth.

While China had me concerned for a while I am a bit more sanguine on her prospects now. While I still regard the innovation deficit in China to be a serious drag on the economy, and I expect growth to moderate further, valuations are sufficiently low to warrant buying. The one impediment was the health of the financial system, in particular the shadow banking industry. It now appears that the government is serious in facing the issue by measuring the risk and then managing it. In some ways, the Chinese economy, while slowing from a frenetic pace, is, at least in the view of policy makers, sufficiently robust to warrant a restructuring which has certain parallels to QE tapering. This is a good thing.

It is perhaps the strength in developed markets that poses the largest threat to emerging markets.

1. The USD and EUR have been stable to strong with expectations for further strength in the USD.
2. The US economy is expected to extend its recovery and Europe appears to be stabilizing.
3. Developed market corporate balance sheets have been rehabilitated quickly.
4. The Refinancing Wall, a trillion USD and change in Europe, a couple of trillion USD in the Americas, is likely to displace demand away from emerging market debt and perhaps even equities.

So far the nascent sell off in emerging markets has found no trigger, no single factor. However, I would not underestimate the impact of competing sources of capital on EM assets as capital first reallocates and next flees away from emerging markets.

The wall of refinancing in the developed markets presents a high risk to emerging market fixed income assets as they divert capital away from these markets.

A couple of thoughts on risk…

In a portfolio consisting of assets of varying complexity, liquidity and aggregation structures (such as mutual funds, structured credit and structured products), the problem of risk measurement and management becomes a bit more complex.

Instantaneous and econometric risk:

Econometric risk is the risk measured by the historical time series of the portfolio over time. It is relevant particularly where the portfolio contains mutual funds with varying liquidity terms which limit the investor’s ability to alter the portfolio in real time. The risk here is that of the fund manager’s ability to alter the risk profile of the component fund hence confounding instantaneous risk metrics. In this situation the econometric risk is a more useful metric for risk measurement as it internalizes the manager’s behavior.

Instantaneous risk is a simple concept and is simply the risk to the portfolio at any single point in time. It is based on the instantaneous risk of the individual portfolio components and their interrelations (proxied by their correlations). Instantaneous risk is more relevant where managed products with lower liquidity are present and where the investor can immediately trade the portfolio.

The concepts of instantaneous and econometric risks cannot easily be unified into a single or simple measure. Portfolio risks are bests measured using both approaches separately as each provides different and useful insights to portfolio risk.

A portfolio of mixed assets including liquid direct securities and liquidity constrained managed products:

While econometric risk is relevant to the managed product portion of the portfolio, the mixture of self directed, advisory and discretionary strategies in a portfolio make econometric risk very hard to measure. An investor may make withdrawals or injections to the portfolio and without unitizing the portfolio for each unique investor’s econometric risk is not measurable since there is no NAV time series to speak of. Instantaneous risk is more tractable for such portfolios, which incidentally are the mainstay or private client portfolios. We shall therefore focus on instantaneous risk.

We aim to describe as completely as we can the risks in a portfolio while maintaining as much parsimony as possible. Some risk methodologies attempt to reduce the risk metrics to a single parameter. This is not possible as there are several orthogonal risks and orthogonality by definition precludes linear combination without serious loss of information.

We begin with the convertible bond as it includes elements of equity, credit, duration and optionality in a single asset. A convertible bond’s risk measures will include equity metrics such as delta and beta. It’s bond metrics include yield(s), duration(s), spread(s), and convexity. It’s option metrics include the usual Greeks such as gamma and vega. If one is so inclined, credit ratings may be included. A risk system capable of decomposing a convertible bond into its component risk metrics will be able to also handle equities and bonds and indeed most of the capital structure of a corporate or so sovereign security. The above metrics should therefore be available at the minimum. In the econometric risk domain, price history should be taken in and the usual moments calculated.

Aggregation vehicles introduce further challenges to the complete description of risk. In the simple case we have a mutual fund. Since the mutual fund may contain both equity and credit instruments, transparency is necessary to the underlying strategy, mandate or portfolio of the fund in question before it can be correctly decomposed in the risk system. This is usually but not always available. Here econometric metrics need to be used. Sophisticated systems may be able to decompose a fund by risk factors which can then be used to describe the instantaneous properties of the fund. The usefulness of such a scheme is not entirely clear. The risk metric frequency needs be no higher than the liquidity frequency of the fund since any output is not actionable in between dealing dates. We can deal with the varying dealing frequencies of the various different assets in a portfolio and adjust the moment estimates appropriately by borrowing from option implied volatility corrections for liquidity (the subject of another article.) Aggregation vehicles such as asset backed securities and tranched securities will have more complex characteristics which may require augmentations.

Note that in our portfolio, each line item whether a single asset or an aggregation of assets such as a fund, the econometric metrics can and should be used to quantify the volatility and correlations across the portfolio. This is one of the few instances where econometric metrics imply instantaneous metrics. The accuracy and more importantly the validity of the estimators and the subjective adjustments thereto are crucial in arriving at useful portfolio implied moments.

Most risk systems focus on this area of risk as the reduction of risk the first four (implied) moments is very convenient. The implied moments are certainly useful summary metrics but are not a substitute for the orthogonal risk factors such as the Greeks. Both sets of metrics should be presented.

Note that implied moments are not entirely behavioural. They may be at the asset level but not at the portfolio level. This is the one instance when we pass from the econometric to the instantaneous and the resultant metric is most definitely instantaneous and not behavioural.

Let us consider a model for philanthropic, development finance. An interesting model for development philanthropy is one which provides equity capital to target low income groups to finance and encourage enterprise .

Principals from a target group are invited to submit business plans for approval. Approvals will be based not purely on charitable criteria but on commercial and developmental criteria as well. The aim of these projects is to allow poor communities to develop self sustaining, commercially viable enterprise to provide growth and employment. Hence, funding costs will be aligned with commercial rates; aligned but not identical as barriers to entry may need to be mitigated in the initial stages. Commercial viability is an important criteria as such businesses need to be able to survive and grow once the sponsor capital has been repaid and the sponsor has withdrawn from the operation of the business. The businesses will focus on providing employment to the communities in which these businesses are established. Employees will be awarded equity as part of their compensation to promote an owner operator culture.

Sponsors will actively help principals in the management of the business providing training in best practices in operations and financial management while also providing corporate governance at board level and mediating between employees, minorities and management.

Capital is provided initially as equity. As profits are generated, a proportion is used to pay down sponsor equity and the remainder is used to create new equity capital, this new equity accruing to the local community owner operators. Once all sponsor equity is repaid and a target multiple or IRR is achieved, the sponsor exits the business almost entirely, relinquishing operating control entirely to the principals while maintaining board representation only insofar as to maintain standards of corporate governance. 

In summary:

1. Funded business plans are expected to be viable going concerns at the minimum.

2. Capital is provided on a semi commercial basis. Cost of capital will be benchmarked appropriately so as to avoid funding non commercially viable businesses.

3. Principals earn in their equity. All staff also earn in their equity.

4. The philanthropic sponsor eventually exits but maintains a corporate governance role by way of board membership.

5. Sponsors impart international best practice in operations and finance as much as start up capital.

6. A terminal date is set for the withdrawal of sponsor equity, and thus a target date for commercial viability is built in to each project. The initial funding needs should never become perpetual.

7. The deal resembles equity that converts to debt. Capital is provided in the form of equity. After a period of stabilization, the equity is converted to debt. Excess returns are capitalized and shares are awarded to all staff at all levels.

As the world recovers slowly from the Great Recession of 2008, employment has lagged, particularly youth and new graduate employment. Why is this? Employing new graduates and the young is a longer term investment involving money, time and resources towards future productivity. Employing older, experienced workers is an investment in current productivity. Any future productivity must be subject to discounting by variability depending on general business conditions. In times of uncertainty, it is rational to invest in fixed capital, for which there is ownership over a potentially transferable, marketable asset, and experienced workers. Only when there is less uncertainty, or sufficient comfort from current success will businesses invest in future productivity, which incidentally may be mobile with the benefits accruing to the employee, not the firm. Business investment is likely to be a leading indicator, therefore, for a recovery in youth and new graduate employment. Evidence supporting this conjecture can be found in the recovery in part time employment, while full time employment has lagged. The thesis that education derives more value as a signaling device is also supported here. Employers prefer a hard signal, that is, actual and relevant work experience over an indirect and soft signal carried by a college degree. This does not suggest that a college degree is unimportant; workers without a college degree with similar years of (in)experience fare even worse.