I have a dream. A dream of a different wealth management model. A model where the interests of the staff, the firm and the clients are aligned. Where the reward relies on the minimum of subjectivity. Where the people are at the top if their field. Where the infrastructure is adequate and efficient and supports the client and the business. And where there is mutual and universal professional and personal respect.

I dream of a private wealth management model where the client comes first, and where the concept is not mere rhetoric but a commercial reality. This is the first principle. The Client Comes First. This will be achieved through the co-investment of both the firm and its people into the same products it expects its clients to invest in.

The firm and its people shall be aligned to the interests of the client. To do this, a portion of the firm’s capital will be invested in the products offered to its clients. The impact of Basel 3 will be an unavoidable cost of business and no longer a convenient excuse to not invest in what is offered to clients. The firm’s capital will be invested based on the Model Portfolio.

Staff bonuses shall be formulaic and contractual and designed to reflect the particular job function. For example, some roles will be based on commissions while others will have bonus caps with bonuses reduced for underperformance or high error rates and exceptions.

There shall be intellectual integrity in investing. Conflicting views are permitted. A house view will be published which will form the basis of the Model Portfolio. The firm’s capital shall be invested in the model Portfolio.

Staff bonuses shall be subject to a holdback (based on seniority and relevance). The remainder will be paid out in cash. The holdback will be locked up for 3-4 years and may be invested in the various products offered by the firm or in cash. The aggregate allocations of the staff will be published so that clients can observe the revealed preference allocations of the staff as a group. This shall be called the Principal Portfolio. Staff redemption execution will be sufficiently delayed so clients have an opportunity to act first ahead of staff. Staff will invest on the same or at least no worse terms as clients and at similar fees, liquidity and transparency terms.

A very useful way of approaching investing is to first assess the underlying prospects for a particular company and then to find the best value and risk reward in its capital structure to buy. Often, however, we tend to assess macro conditions, then market implications and asset allocate between equities or bonds before we look at companies. This approach often fails to discriminate between the diverse geographical sources or revenues and costs. Unfortunately, the force of habit is so entrenched that mainstream investment strategies will find it hard to adjust to the more targeted approach, and so we march on with the old tools. One has to be cognizant of the existing methodology since it will drive current capital allocations and fund flows which move the market.

It has now become consensus that the US economy is in a sustained recovery, so much so that the Fed is considering slowing down the pace of unconventional policy. I think this is correct. The market expects Europe to also recover but has failed to provide any causal explanation. I see the Eurozone in continued and regular weakness due to its common currency. The emerging markets are now feeling the strain of mercantilist developed markets withholding demand, credit, free transfers of technology and other charitable acts on account of their own weakness. With an innovation deficit, China, India, Brazil et al will face a hard time growing, while facing inflationary speed limits. I hope the Japanese economy makes it sufficiently far as to ignite a self sustaining recovery but the prognosis for the longer term is poor.

I like US equities. A recovering economy, low interest rates, strong balance sheets, high operating leverage, a shrinking float on account of share buybacks bode well for US companies. They also remain the most innovative, the most important owners and generators of intellectual property and innovation. And between debt and equity, there is no question that the value lies in the equity of US companies relative to their bonds.

I like European companies. The weak European economy will delay any risk of monetary tightening by the ECB, labour costs will remain suppressed for a long time as employment switches out of the mainstream to contract hire, and material costs remain muted. European companies deriving revenues from emerging markets have a goldilocks operating environment of low costs and high growth. The underperformance of European markets has also resulted in attractive valuations. Whereas in the US over exuberant credit markets have made bonds expensive, European high yield is an attractive prospect paying higher yields and providing stronger covenants. In Europe therefore, the better approach is to assess a company then its capital structure for the optimal trade expression. For allocators who are unable to do so, buy a balanced exposure to Europe; buy equities and buy high yield.

I like Japanese equities. Tactically, the prime minister and the BoJ will need to ramp the market higher towards the elections. There, depending on the result, one should make a binary choice to double up or cut. My bet is that the elections will be positive, even if the majority is insufficient to gain unilateral control, and that the three prongs of policy will buy sufficient time for animal spirits to take hold in Japan. In the longer term, I believe that the demographic will be unable to fund the fiscal deficit and default or unconventional reorganization is inevitable. That, however, is too far down the road for our purposes and I would buy Japanese equities.

I like equity long short in Asia. Asia will see lots of winners and losers. Asia ex Japan is not as resilient as investors believe. Lack of innovation and a weakening Chinese economy will hamper the region. Much depends on China. Asia ex Japan remains a supply of resources to China or an entrepôt or a satellite to China’s hub. The lack of world class brands or technologies is a serious gap in Asia ex Japan. Pockets of innovation in Korea and Taiwan may emerge but so far the norm has been repackaging or contract manufacturing. Stock picking will be crucial in Asia. Particularly in China, where the economy is clearly evolving towards a more balanced one between consumption and investment, the differential fortunes between industries and companies will emerge. I don’t recommend a macro blanket approach to Asia. Certainly on a macro blanket basis, I am very cautious about China’s prospects. The US is re-shoring manufacturing capacity and withholding the transfer or sharing of intellectual property and until China is able to invent, produce and market its own innovations, I think it will struggle. The same argument holds to any country which cannot innovate.

I have a definite view of inflation. Indeed it is a case of Fire and Ice. Massive balance sheet expansion in the developed markets in a world of open capital accounts has led to inflation flowing to where capacity is constrained by productivity and growth is relatively strong, in other words, the emerging markets. I therefore expect the US, UK and German term structures to outperform (steepen slower or less) than emerging market term structures. In the US, UK and Europe, rates are likely to rise, but this rise will likely come from strengthening economies. In the emerging markets rising rates are likely to be the result of rising inflation. As a result, in developed markets, bond yields will likely see negatively correlated duration and credit spreads whereas in emerging markets they will see positively correlated credit spreads. This leads me to prefer developed market high yield over emerging market high yield.

I like European senior loans. I liked US senior loans. Generally, the floating rate features of loans make them attractive if one believes that interest rates have bottomed. With 3M USD LIBOR at 27 basis points there isn’t much room to fall. While I do not expect short rates to rise in the next 12 months, floating rates provide important diversification. The structural seniority of the claims, the maintenance covenants, all make senior bank debt a good asset to be in when in times of stress. The US loan market, however, has become pretty tight with the revival of the CLO market
and the return of some covenant light issues. In Europe, however, the CLO market is only just coming back to life and one could argue that the timing is ripe to invest in bank loans in anticipation of demand from a structural buyer.

I like the USD. As the US becomes more export led it will import more USD creating a shortage of USD which will likely support the USD. Otherwise, the continuing phoney currency wars make FX forecasting a very difficult game indeed.

Buy European equities. There will be no roll back of easy monetary conditions in Europe in the short to medium term. Domestic economies remain hampered by the common currency and unemployment. Labour is getting cheaper. Inputs are getting cheaper. Companies have deleveraged balance sheets and are in a position to releverage cheaply and as required. Many European companies are exposed to high growth emerging markets. Despite a palpable slowdown in emerging markets and rising inflation in many of them, European companies represent an arbitrage since they face deflation domestically and thus low interest rates across the term structure where they finance in EUR, while they reap the benefits of increasingly more consumption driven emerging market economies. Valuations are also attractive. In a world where the crowded consensus trades have hurt investors it pays to be ahead of the curve.

The Fed will roll back QE gradually and will telegraph its intentions well in advance. This is clear. And it has begun. The Fed will continue to keep QE tapering in the news maintaining a ‘will they won’t they’ stance until the market begins to get tired of the message and accept QE tapering as a reality. Only then will the Fed roll back its asset purchases. By then, the market won’t care. It will be focused on fundamentals such as earnings growth, cost of capital, balance sheet quality etc. Correlations will have slowly leached out of the system.

Economic Growth

In the decades prior to 2008, rising credit allowed most economies, even inefficient or unstable ones, to grow and prosper. 2008 marked a turning point in the long term credit cycle. With global deleveraging, weak and strong economies have been revealed for what they are.

Countries hardened by previous crises which have learnt from their past mistakes have emerged stronger. Most of the emerging markets fall into this category. North America, in particular the US with its flexible economy has recovered with renewed vigor. The innovativeness and entrepreneurial nature of the American people, coupled with a free and open market, have allowed prices to adjust and resources to be reallocated more quickly than elsewhere. The result is a self sustaining and stable recovery, even if a modest one. Europe‘s experiment with a common currency has been less successful. The rising tide pre 2008 hid the serious inefficiencies introduced by the common currency, the EUR. With sticky wages and over-regulated labour markets, the Eurozone structural unemployment is currently acutely high. Witness the Swiss and UK economies which unfettered by a common currency have been relatively robust compared with the Eurozone. Asia like Latin America, has had the benefit of severe crises in the 1990s which taught hard lessons about fiscal prudence and balance sheet management both in the private and public sectors. The relative strengths and weaknesses of the North American, European and Asian economies are now revealed by the withdrawal or reduction of credit on a global scale.

Inflation and Interest Rates

Inflation expectations can be similarly extrapolated from the different underlying efficiencies of each country. Massive money printing by the world’s central banks have surprised by not producing the expected levels of inflation. Globalization is an important factor. Open capital accounts allow capital to flow to where it is most welcome or where it obtains the best returns. As a result, capital has flowed to relatively robust emerging markets, creating inflation there, while in the developed markets, capital has gone into asset markets most notably into the equity stock of global companies. If long term interest rates reflect inflation expectations, steeper yield curves are likely to follow. In the meantime, while vast QE irrevocably implies rising interest rates, developed markets long term rates can be expected to rise relatively more slowly compared with inflationary emerging markets. Globally, rising interest rates are almost inevitable. The question is which countries will outperform and which will underperform. The factors driving relative performance will include inflation expectations, public finances, and the current account. With lower inflation expectations and improving terms of trade and trade balances, it is likely that developed markets will outperform, this despite much worse public finances. Fiscal austerity has been deployed to address this issue and is likely to bear fruit down the road. The UK is a case in point where the early application or austerity is currently paying off.

Equities

What are the prospects for equity returns? As companies become more global, national aspects become less important. Is GE a US company or a Chinese one? Is Caterpillar a US company or a Central / Latin American one? Esprit sells more in Europe than it does in Asia. Santander has more balance sheet deployed in Latin America than it does in continental Europe. From 2007-2008 equity markets were correlated as they fell sharply, driven by fear. From 2009-2012 equities remained highly correlated as they recovered, driven by liquidity and relief. Correlations have fallen sharply since late 2012 as equities began to price in the relative and idiosyncratic fortunes of companies. This has created a stock picker market. This is likely to persist. The potential alpha, and it is potential since ex post alpha can be negative as well as positive, is high. The analysis of a company is complicated by their global reach and exposure, by their disparate geographical as well as priority of funding. Interest rates not only represent a cost of business, they are important in valuations as well. The coming rise of interest rates will create different winners and losers.

Besides fundamentals, equity investing requires an understanding of the demand and supply of equities. The supply side is impacted by IPOs, secondary offerings and even share buy backs. The demand side is driven by the nature of the investor base, by psychology, by cultural and historical behavior and by taxation.

For these and other reasons, self directed investment portfolios will be disadvantaged versus the professional investor. Investors are well advised to rely on professional fund managers to invest on their behalf.

Credit and Fixed Income

Interest rates have spent the last 30 years falling. This is unlikely to continue; in fact rates are very likely to rise. In some countries the rise of interest rates will be precipitated by improving economic growth and moderate inflation. In others, rates may rise on inflation expectations. In yet others, rates may need to rise to defend a weak currency. The US is most likely to see rates rise as growth consolidates and QE is gently withdrawn. Initially rate volatility will be high, as when any sort of analgesic is withdrawn. The outlook for the Eurozone is complicated. Emerging markets with high inflation are likely to see higher rates in a less benign light.

Higher interest rates will impact equity risk premia in the respective markets. Where higher rates are the consequence of higher growth and profits, the equity risk premium and thus valuations can be preserved. The US is most likely in this camp. Europe is not only complicated but interesting. European companies are very much global. If disinflation or deflation takes hold in the Eurozone, companies may find their cost of debt remaining low while profits improve. Of course this would require and might imply some sort of mismatch in funding currency. The prospects for emerging markets are similarly complicated. The reader is invited to extrapolate the above line of argument.

Corporate bonds are mostly fixed rate securities and will find it hard to escape the effects of rising interest rates. Even high yield, where the yield is a composite of duration and spread will be affected to some extent. If we think of the spread as being correlated to the equity risk premium, interesting inferences can be made as to the relative fortunes of different issuers’ bonds depending on their currency and country of issue. Where rates rise due to a stronger economy, the spread is likely to compensate for the duration. Again the US is likely to be in this camp. Where rates rise due to inflation the impact of duration may be exacerbated. Readers are left to make their own inferences regarding the regional relative prospects for corporate credit.