The first quarter of 2013 has ended with risk assets mostly higher than at the end of 2012. It would seem that the optimism that greeted the new year was well placed. Indeed many of the problems in the world have been solved, patched or postponed.

The big picture remains very much the same as it had been in the past 4 to 5 years. A credit bubble had been inflated with inflated collateral. The bursting of the bubble was precipitated by falling collateral values which led to a nasty feedback loop exacerbated by excessive leverage. So acute was the problem that governments were forced to step in and bail out the bankrupt, meaning mostly the lenders to the borrowers whose collateral was no longer sufficient to cover their debts. Most of this collateral was residential real estate. The impact was a retrenchment in consumption and thus profits and thus investment and thus employment. These were the effects on the private sector. For the public sector, bailouts are not free and as a result fiscal positions were severely impacted. This meant questions about sovereign solvency which were answered by successive rounds of debt monetization, an apparatus quite indistinguishable, and conveniently so, from quantitative easing, a perceived lesser evil.

With the private sector largely bailed out, a real economic recovery has taken place in most places except where structural impediments have confounded efforts by the private sector operating in market economies to heal themselves. No where is this more apparent than Europe, where the Euro suppresses price discovery and coupled with sticky prices in some markets, such as the labour market, result in a failure of such markets to clear. Elsewhere, the healing takes place, at least in the private sector. The public sector, however, languishes in a risky state of uncertainty and personality disorder.

Absent a strong ideological compass, public sector policy has been pragmatic, itself a laudable quality, but lacking conviction, lacking vision and ultimately, lacking firm theoretical basis.

Where government is weak, indecisive, divisive and chaotic, the private sector has moved on. Some reservations remain, which may constrain longer term investment, but by and large, market mechanisms allow the private sector to move on. These economies correlate with poorer fiscal positions and lower growth.

Where government is more pervasive, invasive, authoritarian and has historically been relied upon to lead the private sector, recovery is slower, less firmly entrenched or unbalanced. These governments, correlate with countries with better fiscal positions and higher economic growth.

A caveat over the government finances. If bank balance sheets are hard to read, country balance sheets are mostly indeterminate. Strong accounting standards can mitigate some of this risk but mostly the problem lies not in accounting standards but in risk management. If either the intention or the ability to manage risk is compromised then so is the endeavor.

The desperate throes of the developed markets’ central banks in their efforts to support their sovereigns, revitalize their moribund economies and inflate away the public debt has led to a number of side effects. Most of all, the expected inflation has not surfaced at home, but rather has manifested abroad, where economic growth is less somnolent. In a world with open capital accounts, this was bound to happen.

Globally open capital accounts and having a currency widely used as a reserve asset together make for effective quantitative easing / debt monetization. It affords the central bank good control over the entire yield curve. Relaxing any of the above assumptions endangers this thesis. Widespread recognition of this phenomenon may also trigger vigorous resistance, most likely by a limited restriction of capital mobility, hopefully not much worse.

A global economy also spawns global businesses or global companies. When investing in businesses, whether it be in their equity or debt, sweeping macro considerations are best replaced by the bottom up analysis of the multinational, multiregional nature of these companies.

This does not mean that macro investing is not useful. However, the tools of macro investing are more often than not currencies, interest rates and sovereign bonds. Equities cross too many borders to yield to macro analysis. Real estate, whether its equity or its debt, is also another highly locally driven asset class. But here, the line between macro and micro is nothing more than a factor of magnification.

Very often, what is and what should be do not converge. This is often a source of opportunityy. The Euro is an interesting example. Its use to the investor lies in its inefficiency and inappropriateness. Forcing a single currency upon a region with differing factor productivities and sticky prices must create imbalances which tend to gradually build and then break. This creates trading opportunities for the astute investor with an eye for fundamentals and a sympathy for the rhythm of market psychology.

A more fearful divergence lies in the very model of our economy. Capitalism. Mathematically elegant, it has become diluted and perverted, by the absence of a nemesis, ever since the fall of Communism. Moral hazard taints all capitalism today. The asymmetric treatment of gain and loss invalidates all the mathematical underpinnings of efficiency of production and allocation under a free market. The arbitrary bailouts mounted by central banks and governments have only served to enhance the reputation of interventionism and big government. Government involvement in an economy should only be to provide contingent measures when the free market is unable or unwilling to supply a good or service. Yet current public opinion, and indeed, the opinion of conventional economists, is that governments need to do more. This has serious repercussions in the longer term. Understanding the motivations of economic agents and macro economic behavior will require new models and new insights.

Finally, before I sign off, there is still a vast amount of debt which remains to be repaid, defaulted upon or inflated away. So far, it has just been moved about and refinanced in rather creative ways.

There are some specific strategies that arise from the above:

Overweight companies with intellectual property and brands. These are more easily found in the US and Europe. They will confound their own countries’ macroeconomic ills.

Buy the US housing recovery. This continues to be best expressed through the non agency mortgage backed securities market.

Avoid Chinese financial risk. The Chinese shadow banking industy is not bad for being a shadow banking system but for its opacity and the resultant difficulty of assessing the priority of claim. The risk that any default or run on the system could turn out to be disorderly is high. By extrapolation, one should be cautious of any associated risks in the real economy and its businesses.

Overweight hard duration in developed markets like US, UK and Germany. Inflation created by QE is surfacing in emerging markets where
one should expect yield curves to steepen relative to developed market term structures.

Overweight the USD. The trade position of the US has changed for the better. While the Fed continues to operate QE, so does the BoJ, BoE and the ECB. At the same time, China isn’t exactly tightening monetary policy and is accumulating debt at an alarming pace.

The cool thing about the Euro is that it doesn’t really work, and yet, the politicians in Europe insist on having it. This creates periodic buying opportunities. Here is an indirect Euro ‘we’ll hold it together come hell or high water’ trade.

The uncertainty surrounding the fate of the Italian government is destroying bank stock prices. An interesting ‘lets ransom the European banking system’ trade is to buy a bunch of Italian banks. Ideally, one would choose the smallest banks which are systemically important and whose demise would take the whole lot with them as well. At current prices, one doesn’t have to be too fussy. Any bank too important to fail will do. A basket is convenient. Many of the candidates are insolvent but it won’t matter. The trade here is to stare down the ECB. Banks like Unicredit, Intesa San Paolo, BMPS and Banco Popolare are just as good as any for the trade.

• Unicredit, 3.33
• Intesa SP, 1.142
• BMPS, 0.1875
• BP, 0.9835

The latter two banks are more interesting because they are smaller and weaker and will price bettter on entry and on exit. It brinksmanship to be sure, but Europe doesn’t have the stones to let Italy under, and that means rescuing all her systemically important banks.

Disclaimer: I do not have any position in the above stocks nor do I intend to take any. This post is purely an academic speculation and not a recommendation or solicitation to trade in securities.

• Inflation is an emerging market problem created in the developed markets.
• Equities are being boosted by factors other than fundamentals, which is fine.
• We invest and spend in nominal terms, it pays to stay invested and it costs to not be invested.
• Uncertainty prolongs trends, consensus ends them. Until bullishness reaches an extreme, the trend will continue.
• Its not useful to think of equities or companies along national lines. Most businesses are global.
• Developed markets have an intellectual property advantage. In trade wars, exchange rates are the first salvo. Intellectual property is the next.

Is the rally in risk assets sustainable? Central banks have held nominal rates at close to zero and thus real rates in negative territory and will keep doing so for the foreseeable future. At the short end they are able to unilaterally declare rates and at longer maturities, open market transactions allow central banks to cap rates using printed money. Fundamentally this is irresponsible behavior being highly inflationary. However, in a globalized world with open capital accounts ultra-loose monetary policy creates inflation not domestically in the weaker economies but abroad, in higher growth emerging markets.

To hedge against higher inflation, emerging market investors need to diversify by investing in developed markets risk assets, particularly the ones operating ultra-loose monetary policy.

Another phenomenon, which we have discussed before, is developed markets, particularly the US ability to generate and monetize intellectual property more effectively than most emerging markets. Falling energy costs at home and rising labor costs abroad are encouraging the re-shoring of manufacturing to the US helping strengthen the USD and reverse current account imbalances.

Another phenomenon supporting equities is the appetite for yield and thus bonds, fuelling high volumes of issuance. Companies are on aggregate issuing more debt to finance dividend payments and more importantly, share buybacks, reducing the float significantly. Institutional investors maintain highly stationary or constant bond to equity allocations and therefore reinvest the proceeds of capital repayments into the stock market further supporting equity markets in a virtuous cycle. 

In the US, the housing recovery provides further support to the economy through the wealth effect. House prices are in their 7th month of recovery putting the recovery in its early days as house prices are typically serially correlated with strong momentum factors. The shortest housing bull run has been 6 yrs in duration. Rising house prices are the result of improved employment and wages, higher levels of savings and lower mortgage rates. They also result in improved home equity against which home equity lines of credit can be drawn driving consumption and retail sales.

Is it possible that the world has healed, has latched on to a new growth path, markets have stabilized and are in a new secular bull market? Well, yes and no. Problems remain. Mostly, these problems have to do with debt levels that remain stubbornly high, growth levels which are depressingly low, so much so that any moderate growth looks like a spurt, imbalances have been transferred from one place to another or transformed from one form to another.

Inflation is a problem. But not for the central banks causing it. It hurts those most frugal and it helps those most profligate.

Risk of the shadow banking system in China blowing up is not insubstantial.

The Euro continues to plague us by its existence.

Low interest rates make debt service highly convex and could lead to credit crunches in unexpected faraway lands.

In the meantime, however, we make money in nominal terms, not real terms. With inflation rearing its ugly head, particularly in emerging markets, it pays to invest in risk assets. Just not always those at home. In a globalized world, thinking of assets along national lines is not useful. One has to think as globally as the world.

When you keep your money in a bank, you are basically a general creditor to a business that is typically leveraged by about 10 X to 50 X, even today after the deleveraging post 2008.  Fortunately, most countries have some form of deposit insurance. Unfortunately, the guarantees are limited. In the Eurozone, which includes Cyprus for example, the limit of deposit insurance is 100,000 EUR. In Switzerland, it is 100,000 CHF, in the UK it is 85,000 GBP, in Hong Kong it is 500,000 HKD, in the US it is 250,000 USD and in Singapore it is 50,000 SGD. That’s not a lot.

If one buys a security from a bank and or appoints the bank to hold such security in custody, then the risk that the client bears is on the security and not the custodian (in this case the bank.) For example, if I buy a US treasury bond and have it held in custody with Barclays, my risk is on the US treasury, with its duration, default and FX risk, and not on the credit quality of the custodian bank. The bank simply holds the security on my behalf. If the bank is subject to a run, I can transfer custody of my security to another custodian bank. There is no need to camp out in front of an ATM trying to physically shovel cash into a bag to carry precariously to another bank.  If the bank should default before I have time to transfer the security, no problem. The security is not part of the assets of the bank and no creditors can lay claim to it. I am safe.

So, as a precaution, I keep a list of money market funds which I may use for this strategy of insulating myself from bank risk. If I see stress in the banking system, I can quickly move cash on deposit into these funds, transforming myself from being a general creditor of a highly levered business to an owner of an asset merely held in custody on my behalf by said highly levered institution. It is important of course, that the fund I choose is insulated from the problem creating the bank stress. Due diligence is necessary to ensure that the asset one buys is not itself highly levered (avoid hedge funds for this purpose) or invests in highly levered or risky assets (avoid equity funds, high yield funds, commodity funds et al). Try to invest in funds that invest in short term debt, preferable secured, if not secured then issued by well capitalized companies, and most important of all, a diversified portfolio, because you won’t think of everything. That’s why a fund, which gives instant diversification, is ideal even though any other security will do. Concentration is undesirable when the banking system gets stressed.

So, the next time the world gets its knickers in a twist about liquidity and the banking system… break glass, fish out list of fixed income and money market funds, subscribe. Get your hard earned money out of the way of the balance sheet of the bank.

Today, equities, bonds, FX and most asset classes are driven by one thing. Central bank policy.

Equities are cheap when compared to treasuries. Investment grade yields are low in absolute terms but not so much when compared to their historical spread over treasuries. The same goes for high yield, not cheap but cheaper than treasuries.

The world has placed a whole bunch of bets on various assets, hoping for diversification, yet their bets can be reduced to a single highly dependent (a stronger condition than correlated) bet. They are betting that central banks will be successful at keeping interest rates low.

Poliicy rates, discount rates, repo rates, can be unilaterally declared low. Market rates like swaps and LIBOR cannot, but so far have played ball. It would take a liquidity disruption like 2008 to cause significant divergence, as much in speed and magnitude. Perhaps when the time comes, central banks would like to hire the LIBOR fiddlers to help them bring convergence.

Long rates have traditionally been market driven based on inflation expectations, pension demand for liability management, hedging of other long term products and to a lesser extent collateralization of derivative contracts. That is until the distribution mechanism was disrupted and the Fed intervened under the guise of quantitative easing. The same act can serve different objectives. Various forms of QE have involved manipulation of long rates in the open market. 

The equity markets, recently so serene and buoyant, are sensitive to rates. This was demonstrated at the end of each of QE1 and QE2. It is no coincidence that QE3 has no expiry date. The equity markets appear unable to stand on their own without the aid of QE.

As the VIX falls to an all time low below 12, and the MOVE follows after, one cannot help feel uneasy. Risk measures like VIX which are representations of the second moments of stock returns are bounded above and below (by zero) and are therefore mean reverting. The nature of the options market (an insurance market) means that vols tend to spike and decay, and repeat that pattern over and over. It seems that a spike may be due if not overdue.

The observations above are not technical but neither are they fundamental. I’ll talk about fundamentals later, but for now observe that:

Europe is in recession. China’s recovery is slightly wobbly. Emerging markets are also looking increasingly uncertain. The US, however, has solidified its recovery, albeit towards a long term potential rate of 2%, half of what we assumed it was pre crisis. Corporate profits have soared and margins have been maintained, at the expense of labour and employment. Corporate investment is moribund. An exuberant bond market has allowed CFOs to eke out efficiencies simply in capital structure optimization, borrowing in the senior unsecured claim to lock in cheap financing, pay dividends and buy back stock. This has helped buoy equity markets.

But how long and far can equities and corporate bonds go in this environment of lacklustre growth that discourages investment in future productive capacity and technology?

We can’t keep buying luxury stocks forever. The non agency MBS trade is a distressed debt strategy that will run its course and MBS are callable and thus can’t trade far above par. Leveraged loans in the US have fully recovered.

We have a strategy for today, but what about tomorrow?

In long only, macro, traditional strategies, we will eventually run out of rope. I expect equity long short to recover somewhat as a strategy, but this period of post crisis insanity has created great dislocations across corporate capital structures, for example in inconsistent recovery rates intra issuer, across their junior to senior securities. The same can be said about tranche securities. In M&A, consolidations have begun and risk arbitrage will be a very exciting strategy. At the fringes, banks will continue to try to be too clever about Basel 3, Dodd Frank and other Glass Steagall offspring. Where there is explicit regulation there is opportunity for circumvention. Credit strategies involving bank balance sheet optimization such as ‘asset reclassification’ and regulatory capital relief are lucrative but may later attract public scrutiny, just like the Magnetar Trade of 2008. A word of caution about FX strategies. In a phoney war, the tensions underlying the market which are not captured in realized or implied vols and correlation make FX especially tricky, and risky. I expect FX to trade away from lognormal thus confounding options pricing models.

Then there is distressed investing. A bit of patience goes a long way.