With the ECB warrantying that it will be lender of last resort to Euro zone governments it seems that the risk of a break up of the Euro is no longer. Be that as if may, as each day passes the cost of maintaining the Euro becomes more and more apparent. The charge is not one of market turmoil, sovereign funding cost, financial sector imbalances or fiscal discipline but a more fundamental issue of price discovery and factor and goods market equilibrium. If a single currency is to persist, domestic prices of all things, goods, services and inputs, need to be flexible so that markets clear. Yet we know that for various reasons wages tend to be sticky upwards, that is, wages are easier to raise than to lower. Labour laws and unions are the main reasons for this asymmetry of wage friction. As a result, the labour market fails to clear and we have Euro zone unemployment close to 12% with youth unemployment substantially higher and Club Med countries running at double the zone’s average.

Taken together the common currency and current labour market regulations fail to clear the labour market.

 

More generally, a common currency requires factor price flexibility to achieve market clearing efficiency. The price of capital and land are less problematic. Land prices in Spain and Italy have been correcting since 2008.

 

This may impoverish home owners and impair consumption through a negative wealth effect but they are less debilitating and political. And the downward adjustment is economically a good thing. If governments then try to prop up housing values or interfere in markets for capital then the inefficiencies that plague the labour market will be replicated in these other factor markets. Capital markets already face inefficiencies arising from Basel rules and the Eurozone’s own efforts at financial sector regulation that they need not be exacerbated in the Euro zone. Land is already facing its own analog of unemployment. This is the true cost of maintaining the Euro.

 

Now we are told of all the trade barriers that would automatically materialize should the Euro be dismantled. This need not be. It is, only because we make it so. Any new impediments would be political constructs which had been enacted and not some natural behavioral phenomenon.

 

Today, it seems the Euro is safe from fission, saved by the ECBs backstop. How long will it be before Euro zone leaders, economists and people realize the true cost of maintaining the Euro? It may not be an instantaneous, financial market crisis type event that breaks the Euro, just too many people unemployed for too long.

 

 

 

The VIX index has sunk to remarkably low levels, as has the MOVE index. Yields on bonds from treasuries to investment grade to junk have compressed significantly. The market is now more optimistic about the prospects for a recovery in China, a more robust US housing market and the ability of the Europeans to hold their common currency together. All is well.

Time to worry. Risk is highest in calm waters. Once the iceberg hits, its just damage. The best asset can be priced sufficiently highly to be a poor investment, and the worst asset can be priced sufficiently lowly to be a good investment.

MOVE Index

VIX Index

 

 

Q&A with Burnham Banks

Q: There appear to be consensus that most of the tail risk has been resolved and that investors should be overweight risk assets. So the question is, is the world still broken or has it been fixed?

 

A: Much of the world remains broken, some things have been fixed but most things have just been patched. It’s perhaps useful to classify things that way. What’s still broken? Principal agent relationships which were unresolved remain unresolved. That’s a bit vague and general but it is important nonetheless. The interests of shareholders, customers and employees often conflict and this is an unresolved conflict. I don’t think it’s an easily investable theme but it bears keeping in mind in the greater scheme of things. And it extends beyond business to include governments and their people too.

 

The transmission of capital between savings and investment is definitely broken. Regulation is squeezing out banks creating the need and opportunity for non bank financial institutions. The free market is slowly reorganizing itself around this theme but I don’t think the macro economic implications have been sufficiently researched and understood. One of the better solutions is a revival or a reboot of the shadow banking system with its structured credit infrastructure, but recent experience will probably complicate developments in that area.

 

Moral hazard and the role of regulators and government is a question that no one wants to address. Interested parties have gained too much or have too much to gain, or too much to hide, to seek clear, ideological, fundamental bases for defining the role of government. Interference in interest rate markets and unilateral intervention based on expediency don’t fix a problem they only patch a problem. Beyond the moral hazard or fundamental rigor there is the question of long term efficacy. Our solutions to problems seem to spawn further problems down the road.

 

One area where strong ideology underpins a system is the Euro. Unfortunately, the one place where we find strong ideological basis is where it is fundamentally misguided. The Euro is inefficient; its raison d’être is based in history, politics and culture, mostly superstition. An efficient Euro zone would require considerable domestic price volatility which is something no one, not even the ECB wants to see. The Europeans are wedded to their Euro and will maintain it at all costs. If we have a single currency AND we impose sticky or slowly adjusting factor prices, then imbalances MUST accumulate somewhere.  

 

 

Q: So what has been fixed? We’ve done so much since the crisis in 2008, surely we can’t not have made any progress.

 

 

A: You’re quite right; some things have been or at least are being fixed. The shadow banking system has organized itself at the boundary of regulation to be a more efficient conduit of capital. It is still early days and more capital needs to be diverted away from the banking system but it is a start.

 

The ECB finally formally accepted the role that was inevitable, to act as lender of last resort. This is required if you insist on keeping the Euro. I am not suggesting that the Euro is a good thing but if you want to keep it, this is how you go about it.

 

China’s macro prudential management has been quite deft. There is a significant debt pile in China’s shadow banks where the risk management is questionable, but the macro prudential policies to cool areas of overinvestment such as real estate and infrastructure have worked. With inflation under control China has sufficient latitude to address its slowing economy. This could be one of the main themes for 2013, a resurgent Chinese economy. Trade expression may not be as simple as buying
a bunch of Chinese listed equities, however.

 

The US fiscal cliff is a non event. Just like the budget ceiling was a domestic altercation the fiscal cliff is of more political than economic consequence. If 800 billion of fiscal stimulus failed to lift the real economy I don’t see how 600 billion of fiscal tightening is going to materially damage the economy, especially since the issues have been tabled so early and expectations are so low for a resolution. Sure, it’s not good for the economy but it isn’t catastrophic. So, a non event I think.

 

 

 

Q: With most of the thorniest issues addressed, would you expect risk assets to rally in 2013?

 

A: Its not a certainty. We barreled into late 2011 with nothing but headwinds and bad news and ended 2012 up with double digit returns in equities and junk bonds. The investor has to consider two things, one is the long list of unresolved or unaddressed problems, and the other is, even if these issues don’t manifest in the current year and fundamentals turn out to be benign, what is the right trade expression.

 

Q: We see professional investment advisers counseling more equity exposure for 2013, yet equities are vulnerable to higher interest rates, so are corporate bonds all the way from investment to junk, and also by definition, so are government bonds. If so much is dependent on interest rates it implies that future correlations will be high, what then is the right investment strategy?

 

 

A: Its interesting you noticed the dependence. So much is dependent on rates that one might be tempted to trade rates and nothing else. But there is an asymmetry. Rates can’t fall much more, another 25 basis points and we are at zero. But rates can rise quite a bit. So the short side is easy and cheap to express. CFOs all over are putting on this trade by swapping equity for debt. Bond issuance in 2012 has been remarkably high. The question then on the long side is, how do I profit from continued low interest rates without taking too much risk. The answer is, there aren’t many ways. All of them involve some form of playing the game of chicken, staying on long enough but getting ready to bail. Vols are cheap so one might be tempted to buy puts, but the period of low interest rates can outlast your options. Outright risk on positions with tight stops can allow you to capture more upside than downside for a given move in the market and is my preferred alternative at the moment.

 

 

Q: Global debt levels remain elevated, having simply been transferred from private to public balance sheets during the crisis. As debt repayment dampens economic growth, where will earnings growth come from and how should one invest?

 

 

A: Sometimes it is useful to think in aggregates but at the security level, idiosyncratic risk can swamp macro issues. Its true that global economic growth has found a much lower long term trend rate, however, within that long term cycle are short term cycles which can be traded. Also, the fortunes of industries and countries and regions can differ greatly. Also, fundamentals and pricing can be disconnected. What it does mean for the investor is that broad based macro views and trade expressions will miss a lot of upside potential while exposing the investor to unintended risks. One has to be specific in buying just the risk one wants while hedging out the risks one doesn’t want. Also, there is no need to be invested all the time. When one is uncertain or has no view, it is perfectly alright to be in cash. Not for too long. The point is that one should only invest if one has a reason and a thesis. This was not the case when we had plain sailing credit infused bull markets but in the current post crisis workout, guerrilla investing is the right strategy.

 

 

Q: How do we invest around the risks of Eurozone member defaults? The ECB has promised unlimited asset purchases and the beginnings of a banking union have emerged but it is not clear if Greece, Italy and Spain will be able to find long term solutions without seeking bailouts or defaulting. Markets have taken courage from the short term fixes by the Eurozone but what should one’s longer term investment strategy be?

 

A: First we should establish the sacred cows. The Euro will be held together. That’s the be all and end al of Euro zone policy. The rest are small details. It would take a default of a country like Italy or France to threaten the Euro. Greece and Portugal are big enough to cause substantial financial damage but not big enough to derail ideology. I would continue a convergence trade between Italy, France and German spreads. Greece will eventually default (it effectively has already) and get restructured (again effectively, it has). A more explicit reorganization may be on the cards so despite the massive rally in Greek debt, I would take my winnings and leave. There are lower spread but higher certainty trades in the larger Club Med.

 

 

 

Q: Inflation or deflation? The scale of banking system balance sheet expansion should suggest that inflation will soon set in and that central banks will struggle to rein in such inflation when it occurs. At the same time the velocity of money has shrunk to sterilize the balance sheet expansion almost completely leading to near deflationary conditions. What is the verdict on inflation and how does one invest in such a climate?

 

A: Here again is a game of chicken. Two closely related issues plague the bond markets today. First, when central banks print money at the rate they have, they place the economy in a precarious position. The risk of inflation is high, yet this is not the only risk; since central banks’ primary mandate is price stability, there is a simultaneous risk of deflation as central banks are more likely to pull back credit at the first sign of a pick up in prices or the velocity of money. The second is that there is a run on the currency stemming from a crisis of confidence. When central banks print money, they don’t guarantee inflation, they place the economy on the edge, in an unstable equilibrium between inflation and deflation. How does one play this? Floating rate instruments such as leveraged loans provide the positive correlation to higher interest rates with a senior secured position in the capital structure. The risk reward profile of this asset class is quite attractive for this knife edge scenario our central banks have placed us in.

 

A less crowded view is that irresponsible developed market central banks create inflation in emerging market economies. While market consensus has been that developed market yield curves would steepen and one should overweight emerging market duration, this slightly contrarian view argues for steepeners in emerging markets and flatteners in developed markets, which goes slightly against consensus.

 

Q: Corporate bonds have done exceedingly well in 2012 and yields have compresses to acutely tight levels. What are the prospects for corporate bonds given the slowing world economy and where are we in the credit cycle? Are ratings downgrades and increased defaults around the corner?

 

A: Corporate bond yields have indeed compressed significantly over the past couple of years. However, corporate bond yield spreads to US treasuries have not shown the same acute compression. Thus, corporate bonds are not over-valued, compared to US treasuries. If there is a bubble it is not in equities or credit but in the artificially supported US treasury market where yields have been artificially depressed by all the myriad rounds of quantitative easing. Absent QE, the US equity market and corporate bond market cannot stand on its own. The US Fed, however, has the means to maintain QE nearly indefinitely and without bound. This alone supports equity and credit markets in the US, and by extension, elsewhere. The fear is not in fundamentals but in capital flows. So much capital has poured into bonds from investme
nt grade to junk that when capital flows abate, spreads could widen significantly simply because the market has required large volumes of inflows just to maintain spreads and soak up issuance. A reversal of capital flows could catch the market on the wrong foot.

 

 

Q: At the end of 2011 investors were expecting a poor year ahead to risk assets. 2012 turned out to be one of the better years for asset returns. At the end of 2012 we hear about China’s economic growth recovering, a rebound in US housing and employment, a more accommodative Japanese government, an end to the risk of the Euro breaking up. It all sounds good. Where might we get it wrong if indeed 2013 turns out to be less positive than we expect?

 

 

A: We can see where the problems are, we can see where all the leaks and cracks in the hull are, but what is going to precipitate a retracement, or a bust? That has never been easy to see. To stay uninvested is one response, but for the rich, with luxury inflation running well ahead of CPI, it may be preferable to play the game of chicken, which is to get invested having checked all the exits and unlocked all the doors. There is a cost to being uninvested and you can quantify it as the negative real interest rate. This cost can be likened to an option premium paid to stay out of risk assets. In the past there was a cost to being invested, these days there is a cost to not being invested. It is a cost that has been created by governments and central banks to get private investors, savers, to fund the massive debt piles that they have amassed bailing out the private sector. Unfortunately, by being arbitrary and unilateral, governments’ efforts have led to a potentially unfair reallocation or transfer from savers to borrowers. This we all know and can see. But if I am being asked to pay in order to be uninvested, then I am doubly careful how and if I invest. I’m sorry I cannot be more specific than that. My vision is the average, despite the belief that we are each unique and better than others at whatever it is we do. I am the average and I am Joe Public. I cannot foresee what they cannot foresee. My trading style is to understand Joe Public and pre-empt their behavior by just a bit, just a short space of time. Anything too long and I am trying to be too much smarter than Joe Public, which given that I am Joe Public, is quite risky.

 

 

 

Q: What is your favorite strategy at the moment?

 

A: Since macro economic trends have been so difficult to understand and policy action introduced a major element of tail risk to traditional macro strategies, one of the better opportunities is in direct lending. Direct lending circumvents banks and Basel 3 legislation, plugs a persistent gap in the transmission of capital and is well compensated for the risk it assumes. There are various expressions of this theme. Real estate mezzanine finance is one. The shortage of bank capital is making solution capital very attractive for lenders. Balance sheet optimization enablers such as sale and leasebacks are also attractive. At the lower risk lower return end of the spectrum there are factoring and trade finance. One controversial area which is quite lucrative is bank regulatory capital relief trades. Here a lender provides subordinated capital for a pool of assets bilaterally agreed with a bank in return for a high, often senior coupon. The bank avoids equity dilution and releases capital at the same time. The risk in these is how they are ultimately regarded by regulators.

 

Stepping in where old structures have failed is another potentially a good idea. We talked about bank capital and Basel 3 but the ruins of structured credit are also replete with opportunity. While bonds have rebounded sharply and are beginning to look like a bubble, loans remain interesting especially in Europe where CLOs remain moribund. CLOs were the largest buyers of loans and with the 2008 crisis and with current regulation stacked against securitization European loans have not seen the same recovery as in the US while balance sheets remain healthy.

 

Mortgages are still interesting even after a 3 year rally. Agencies are fully priced given they were the target of the Feds QE3 and the smart money mostly front ran that trade and is now reducing exposure. Non agencies are still good. It’s a pretty idiosyncratic market and you need to be able to pick your points, geographically, demographically, and within the capital structure, and asset types, but non agencies still hold good value. Not as good as before, but better than in other fixed income markets.

 

I won’t get started on arbitrage, which has become available again, as many investors just don’t trust arb any more. But its there for the intrepid investor. Merger arb, capital structure arb, fixed income arb, its all come back as the markets get more and more unhinged, despite lower vols and higher levels. Its all good.

 

In the age old children’s story of persuasion versus force, the sun and the wind compete to remove the traveler’s coat to prove their power. The wind’s efforts only make the man wrap his coat more tightly and securely while the sun’s heat eventually drives the man to voluntarily remove his coat.

The taxmen of the world should pay heed to this children’s parable. Desperately stretched governments across the globe are seeking to raise tax revenue by raising marginal tax rates and closing tax loopholes. This is misguided. Closing loopholes is a good if it simplifies the tax code and makes for a more level playing field, as well as discouraging the over allocation of human intellect to the avoidance of tax.

 

Where once the friction against labour and capital mobility made tax revenue relatively inelastic the current globalized world where companies operate across continents and countries, capital flows freely in search of safety and returns, and individuals are increasingly mobile in their search for employment and opportunity, tax revenue is more elastic than governments would like to believe.

 

As a country tries to capture more tax dollars by raising tax rates, while there taxpayers react by attempting to flee or dodge taxation, a trivially obvious strategy is to make it more attractive to pay tax in one’s country. This can be done by lowering, not raising, marginal tax rates.

 

Don’t forget that it is almost always possible to legally avoid paying tax by simply walking away from a particularly unfriendly tax regime. The French are already doing this to avoid the hefty 75% top marginal tax rate, fleeing to places like Belgium.

 

Perhaps a better banner to wave than “its your duty to pay taxes you scum” is the more welcoming one “Sale! Low marginal tax rates over here.”

Model Portfolio and Strategy Review:

 

 

It’s time to review our investment outlook and strategy for 2013. It is remarkable how have arbitrary time intervals when we review and make our plans but that is how we humans have chosen to behave and so any study in human behavior or endeavor should reasonably respect these arbitrary wavelengths. We begin with a review of the investment strategy for 2012.

2012:

We were of the view, and remain of the view, that the world economy remains badly wounded, that the plots and purposes of regulators and governments remain misguided, and that the main ailments remain undiagnosed and unrecognized. However, we recognized that markets are the confluence of popular psychology, driven by the collective decisions of the masses, which provides no guarantee that fundamentals would be heeded, or that rationality would prevail.

 

In equities, we were risk on into the beginning of the year on two events, one was the recovery of the US economy which was already 3 months old, and the ECBs LTRO. Our trade expression was to overweight a clutch of European banks, likely insolvent but one cannot be dogmatic about these things. We were also selectively long US banks. We were chronically overweight luxury brands, a longer term theme which we think will persist beyond a couple more short term cycles.

 

 

We had been very negative on the prospects for China’s economic growth since Nov 2010 where we anticipated a hard landing. This did not stop us from being overweight exporters to China’s infrastructure building efforts as we saw a need for China to shore up growth at all costs, even further debt accumulation, in a changeover of management year. European and US industrials and selected consumer goods companies represented the bulk of our trade expression. We were short Chinese banks, exporters and consumer cyclicals.

 

 

The second half of 2012 saw a similar positioning. The arbitrary wavelengths hide an active tactical trading strategy that saw us long, then short, then long European banks purely on news flow of ECB policy action. We reiterate our view that the majority of European banks are fundamentally insolvent, even the blue chip names. The only chronic exposure we maintained was an overweight long position in luxuries, a theme that has served us well despite a few bumps along the way from the likes of Burberry.

 

Our shorts in Chinese banks generated losses as we were more wedded to fundamentals in this sector than we should have been, so compelling were the balance sheet issues. These positions were cut, even as we maintain our view that the accounting standard, or lack thereof, allow China’s banks to print their own numbers with impunity. This has now become an issue for the SEC more generally regarding the accounting standards governing Chinese companies.

 

 

Generally, the first half saw better returns on the back of more event driven trading, such as our interpretation of the first LTRO (to go significantly long), and the second LTRO (to trade short). The second half was disappointing as we were too slow to react to the change of psychology in Asia, which eroded the gains made in Europe and the US.

 

 

 

2013:

 

Macro is a guide and sometimes a poor one. The post crisis world we live in confounds macro in so many ways as policy collides with fear and relief. Fundamentals are always important as they provide the trend around which the noise ebbs and flows. We continue to believe that we are in a trading market and that psychology remains overwhelmingly important. Be that as it may, investors always want to hear the macro story so we shall not disappoint, although our story might, as might our accuracy ex post.

 

 

At a very high level we continue to exist in a post crisis world. Global economic growth will now be on a slower long term potential trend due to the repayment of accumulated debt. Policy will be focused on the short term (within the electoral cycle) pain management of that debt rather than seeking long term solutions. This will create trading opportunities in the form of local trends. Tail risks remain since the fundamental flaws of our economic system have not been addressed. A fundamental principal agent divide has emerged which has manifested at the country level as well as the company level. Hung parliaments, revolutions, conflicts, shareholder revolts, board mutinies, all the manifestations of principals trying to realign their agents, will intensify. In an age of lower growth, expect protectionism, trade war and perhaps the odd spat here and there. Tail risks remain high, except where protection is proffered.

 

 

 

Europe will try to muddle through as they believe that is the best they can do. There is little risk at least in the near future of a Euro break up simply because of the political resolve to keep the Eurozone together. Any small economy threatening to fall out of the Euro will be rescued. The Germans have already lost in the game of Chicken. It would take a country the size of Italy or France to break the Euro, which could happen, but not in the next 2 years. It is the consensus view that Draghi has removed the tail risk from the Eurozone but the definition of tail risk is that it is unenvisaged. Technically therefore, Draghi has addressed one major and evident risk. Given that all solutions thus far have been analgesic, one might suspect that the best that has been achieved is the transmission of risk from one area to another, usually less apparent area. While the politicians fiddle, and I mean no allusion to a smoldering Rome, private enterprise has picked up and moved on. So have private investors. European companies are some of the most global. Centuries of conquest and colonization have given Europe cultural access to Latin America, Asia, the Middle East and Africa. (While Vodafone struggles in Europe, Vodacom (65% owned by Vodafone) thrives in Africa.)

 

 

The US economy is a resilient one, yet it is plagued with high debt and even higher unfunded liabilities once welfare and healthcare is factored in. This will cap growth. The fiscal cliff is likely to be a nonevent given its scale. 800 billion USD of injections did little to lift the economy, 600 billion USD of withdrawals will not sink it. Never bet against the US consumer, however. Even in an environment of slow growth, the US consumer has dipped into their savings, lowering the savings rate further, in order to spend. The Fed is bent on facilitating this. In QE3 it is buying MBS in an effort to support the housing market, a gambit that appears to have worked, in expectation that US households will be able to refinance (which requires positive equity), or obtain new HELOCs (which also requires positive equity), so they can go shopping. Employment has been slow to recover as the economy evolves. It takes time for labor supply to adjust to the new face of demand. The slow economy will periodically spook the markets providing some useful tradable volatility. US corporates remain the largest repository of brands and intellectual property and their export capabilities should not be underestimated. It is not clear how a more protectionist world will impact US companies. Significant repatriation of productive capacity has already begun and will continue. The identification of winners and losers will have to take place at the company level.

 

 

It has been our view since Nov 2010 that China’s economy was slowing aggressively and that it was headed for a hard landing. While the macro data has suggested otherwise, domestic stock prices have supported our view. We are now of the view that China’s economy is bottoming or has bottomed. This is not a forward looking or particularly clever view, but a naïve inspection of current, coincident data. We are also of the view that the Chinese economy is already significantly consumer driven, and that it is the general weakness of the consumer economy, and not a slowdown in the evolution that has been responsible for the weakness all this year. China has engineered a deft strategy of rebalancing its economy while maintaining economic growth through investment and government spending. The cost has been an accumulation of long term debt in its shadow banking system which currently resembles the SIVs of post crisis Western capital markets. The most accurate characterization of China is that it has good continuous risk characteristics with substantial tail risk.

 

 

 

 

Trade expression:

 

 

Now for the hard part. We certainly sound more sure of our macro views than we actually are. In truth, our macro view directs our search for ideas, it does not dictate it. Very often our macro views are either wrong, in which case our trade expressions are negated, or our macro views are right but our trade expressions are wrong in which case we adjust them. This means that our trade expressions may be good one quarter out, but are otherwise very much subject to change.

 

 

Rates:

 

 

It is safe to say that all central banks will keep rates as low as they can for as long as they can until they are unable to do so. Unfortunately, low interest rates create an unhealthy dependence that is difficult to wean off, hence our view. The consequences of higher interest rates are just too painful for most economies to absorb in the near future.

 

The USD yield curve has flattened from 2010 and is likely to continue to do so. The same can be said of the Bund and Gilt curves. The JPY yield curve is ominously flat and is indicative of recession. The risk to central bank policy is where they are no longer able keep rates low. There is therefore tail risk from inflation which could cause long rates to gap.

 

 

FX:

 

 

We do not understand currencies. For correlated exposure we tend to allocate a portion of money to be fully expensed and hit the tables in Macau.

 

 

 

Fixed Income:

 

 

While we do not expect interest rates to rise, it pays to diversify some significant portion of the portfolio into leveraged loans which offer floating rate coupons and a senior claim in the capital structure. This is perhaps our strongest theme for 2013. We have previously highlighted a relative value argument, and a potential arbitrage pricing anomaly between loans and bonds arising from the thirst for yield among retail investors and their unfamiliarity with the loan asset class.

 

 

We like European corporate credit. There are a number of trade expressions depending on the investors’ liquidity tolerance. We see exceptional value in European CLO equity, however, the leverage and illiquidity may not suit many investors’ liquidity profiles. European loans are the liquid expression of our view on European corporate credit. One has to be selective of course but Europe is a good place to be hunting. Even in high yield which we generally feel is overvalued, European pricing and covenants make them relatively more attractive. We do not expect a sell off in US high yield but we don’t see a lot of value after the protracted and robust rally. High yield is expected to keep on paying with risk of defaults deferred, perversely, by the ongoing volume and ease of issuance. This game of chicken continues to be viable but one has to be prepared to exit quickly when rates rise. By extension we think that investment grade credits are expensive. Yield hungry investors have been overenthusiastic in this asset class. An interesting trade expression is to be long equities and loans and short senior unsecured bonds in the middle of the capital structure. This is a relative value way of investing in a company through the cheaper parts of the capital structure while shorting the overvalued portions which have been bid up by over zealous investors.

 

 

Emerging market debt is a hard one to call. We are cautious. There is considerable momentum in the asset class as investors diversify from developed market debt. Fundamentals are strong but yields have fallen to within less than a percent of the 2007 summer lows. Inflation is a risk as is the risk on risk off cycle which has a greater influence than fundamentals. Fundamentally, LatAm economic growth is slowing and likely to disappoint as their consumption cycles peak. Debt levels and the DM experience will moderate the likelihood of a significant pick up in investment. Russia continues to live off oil and agriculture with little in way of economic reform to balance its economy. Asia too is quite patchy. India’s experience is instructive where attempts at reform are expensive and face significant internal frictions. As a group EM fixed income has rallied hard and 2013 will likely see more dispersion and require more country specific analysis. We like Russia, Venezuela and Mexico and are underweight Indonesia, Philippines, Brazil, Turkey, South Africa and Ukraine. On the whole, however, EM debt is at that point where investors are more willing to lend than EM borrowers are willing to borrow. This is usually a tipping point much like in 2007 when demand for mortgage debt outstripped demand for houses.

Equities:

The current environment favors equities over bonds. Companies have rushed to raise debt capital to replace equity financing through share buy backs and to pay dividends. This is evidence that insiders regard equity finance as expensive and debt finance as cheap. For investors this is a signal that equities are undervalued relative to corporate bonds. The problem with this thesis is that it makes equity valuations particularly sensitive to US treasuries since equities are cheap on a yield gap basis as well as on a discounted cash flow basis. A sell off in treasuries could create a correlation-1 sell off across corporate credit and equities.

 

 

We continue the emerging market/ developed market relative value theme where we previously sought long ideas among European and US companies deriving revenues from Asia and in particular China’s investment binge, and short ideas among expensively valued Asian companies facing a difficult export environment in Western developed markets, this time by taking the reverse of this theme by seeking long ideas in European and US consumer stocks with Asian and China exposure and short ideas in Asian and Chinese exporters of consumer goods. The specificity of this theme makes it not very robust so expect us to trade around the theme. The general principle remains true, we would rather track the source of revenues of a company than its domicile or country of listing. We expect China and Asia to become more consumption led and less investment led. The global wealth inequality theme remains intact and we continue to favor luxury stocks and continue to rotate between the high price point cyclicals like Coach and Tiffany and the ultra high price point defensives like Hermes and Richemont. Thematic ideas will also likely feature such as grain / grape alcohol substitution or rotation trades, commodity themed trades where we may short downstream companies unable to pass on higher raw material costs against longs in upstream producers. Kellogg’s high sugar and corn costs are a case in point.

 

 

We expect most of the stock ideas to be idiosyncratic bottom up situations where macro factors merely tells us where to look. There are few broad brush themes although we do see Europe improving faster than expected and showing good value. China’s economy may be recovering but we are wary of expressing our ideas in the domestic A Share listings as the companies are mostly SOEs with a record of poor stewardship pf capital and dividend payment. Moreover, the high retail participation makes that market particularly sentiment driven and most investors both retail and institutional have only know a bear market (since volumes only picked up in 2007) and the market remains a
net destroyer of value. We are long China, just not through China listings.

 

 

Summary:

 

 

Arbitrage opportunities will continue to present themselves to investors with sufficient patience and a tolerance for less liquidity. The inefficiencies will present in credit capital structure arbitrage and in event driven strategies. In liquid strategies such as macro and equities, dogmatic reliance on fundamentals is likely to be confounded by the exogenous interference of regulation and policy with all their unintended consequences. For these markets we recommend ‘guerrilla’ trading based on opportunistic forays, tactical trades and event driven trading.