Happy Friday

• China is going to have another bad year. Time to short German exporters.

• The CLO trade in the US is done. Apply similar recipe for Europe.

• The trouble with central banks trying to inflate asset prices is that eventually, hedge funds start shorting something real.

• Austerity for fiscal balance is like giving up your right arm to be ambidextrous.

• Governments lie and cheat. So does everyone else but governments do it with impunity, and its part of their standard process.

• Buy the USD. Every central bank is debasing their currencies but the US have the better print quality.

• You can rely on human nature. On that basis, expect the economic crisis to escalate into war.

• The Japanese and Taiwanese have descended into a spitting match in the East China Sea. They do not stand a chance if the Chinese get involved.

• Consensus in government means you can debate all you want but the final decision is mine.

• The world’s oldest central bank was a failed bank.

• The world’s second oldest bank was a distressed debt hedge fund.

• All the world’s central banks are now pawn shops.

Hedge funds are now more useful than ever now that many investors have given up on them.

Since the trauma of 2008 when some funds gated redemptions, side pocketed their ugly skeletons of illiquid securities, suspended NAVs altogether, only US institutional investors have resumed investing in any scale. European investors who were significant investors in hedge funds never quite recovered from the Madoff scandal and the general disappointment of what they thought was a bullet proof investments. And yet, hedge funds, even on average, and one should never invest in the average hedge fund, did well relative to equity investments. On a risk adjusted basis, over a multi decade period, they’ve outperformed a balanced portfolio of equities and bonds. Yet Europe turned its attention towards regulated hedge funds, or UCITS III funds, there is now a UCITS 4 directive that extends the already convoluted UCITS III rules… These have also disappointed as me too managers jumped on the bandwagon in the hope of gathering assets. The higher quality managers simply dove underground, eschewed UCITS and me too investors and went about managing partners’ capital. It was a return to the old days. Asia, a late adopter of hedge funds, whose investors had a net negative return in the asset class all told, have simply given up. They turn to real estate and private equity, moving up the risk scale by seeking directs instead of funds, and applying as much leverage as their relationship banks will give them. Given the asset inflationary efforts of the central banks, these investments have worked, thus far. Its not clear if these investors are aware of the levered beta exposure they have assumed. Indeed its not clear the leverage providers are aware of the same. Doomsayers are sidelined as naysayers, who will one day publish their memoirs or tell them in bars.

The hedge funds that have found capital tend to be the larger brand name funds with a strong recent track record. Beware. A strong track record is the confluence of skill and luck and discerning the relative contributions of each is not easy. The risk arbitrageur who suddenly gets lucky in mortgages can generate such a remarkably strong track record that investors throw money at them, which they subsequently halve in their attempt to reinvent themselves as global macro managers. Investors still chase returns, fall for the institutional pitch, the legions of staff, the bold offices, the glossy presentations, and the references of old investors for whom the trade is already done.

As a whole, the hedge fund industry has done a poor job. At least that’s what the HFRI indices indicate. But this was always going to be the case. In an unregulated industry seeking absolute returns, not benchmarked relative returns, more will fail than succeed. Hedge fund detractors claim that hedge funds don’t add value, and they are right. The average hedge fund doesn’t add value, it quite definitely detracts from value, especially with the high fees. There is no question that in this highly talent dependent industry, the average is decidedly poor. The good managers are decidedly good, and decidedly in an acute and elusive minority. How do you find them?

It is not entirely useful to try to pick outperforming strategies. The winds of fortune come and go for each strategy. There will be times when a particular anomaly arises which presents glaring arbitrage opportunities. However, when such opportunities have been harvested, what is an investor to do? Redeeming his investment would not be an unreasonable reaction. The talented hedge fund manager weathers all conditions, except the catastrophic ones. Beware managers who survive catastrophes but are otherwise unspectacular, this is a warning sign of good luck, something the investor is well advised to avoid.

Picking outstanding managers is not easy either but it is much more useful. The dispersion of returns of hedge funds around their peer index is significantly higher than one will find for mutual funds, and understandably so. There is no clustering around a benchmark, no place to hide. Successful managers are expected to make money all of the time. It is therefore important to identify these talented managers and to distinguish between skill and luck.

Of the managers in the portfolio, 7 out of the 10 managers have done significantly better than their peers, and generated strong returns. Year to date August, the merger arbitrageur is up 18%, the credit alternatives fund is up 12%, the credit long short is up 7.5%, the event equity fund is up over 16%, the multi strategy capital structure arb is up over 13%, the Asian carve out by the same manager is up over 7% and finally the credit and converts fund is up 5.9%. Slightly discouraging were the fixed income arb fund at -0.06%, the fixed income relative value and macro fund at 0.13% and  the Asian multi asset at 3.58%. The HFRI Index has only managed 3.52% year to August. The portfolio as a whole is up 9.29% gross year to August and 8.63% net.

None of the managers is a megasized brand name manager. All of them were found after extensive research, analysis and due diligence.

For the US, UK and Germany, a small window remains to raise long term debt. Take the UK for example. They need to issue 30 year debt in quantities sufficient to remove refinancing risk for the next 5 yrs, and then cut tax rates.

Usually in a distress refinancing, creditors want to see a plan of reorganization before they will agree to buy the new debt. The distractions from Southern Europe mean that the UK and Germany are being given the opportunity to refinance themselves even in the absence of a credible plan of reorganization. They should not look a gift horse in the mouth. They should refi now for the long haul and then use the time borrowed, for that is precisely and all that it is, and cut tax rates, reform the entire economic system, address moral hazard, sclerotic labour markets, anti-competitive policies, clean up the financial system and get the country back on its feet. Time is running out.

I’d like to understand the causality between lower MBS yields and unemployment. I’m sure there is a correlation, but I’m not sure that the dependence is so high.

 So if mortgage rates are low house prices will rise leading to lower lending standards, more mortgage lending, rising house prices, which lead to improved sentiment, better credit and the increased propensity to consume leading to an economic recovery. There are too many ifs, too many conditions which might not hold. We’ve had low mortgage rates for a while now, yet no significant rebound in house prices. The Case Shiller index is showing only nascent signs of improvement but this is probably a consequence of QE1.

For QE3 to work, house prices have to be rising independently of the MBS buying. Also, lower mortgage rates do not necessarily lead to more lending unless the securitization markets are open. (Unless of course the Fed intends to be the sole buyer of MBS.) Lower mortgage rates, absent securitization may drive banks to lend less as their returns from mortgage lending become less attractive relative to their cost of capital under Basel 3.

House prices have to rise at least until households face positive equity otherwise they will not be able to refinance under any mortgage rates. If they cannot refinance then they cannot take advantage of lower mortgage rates, which the Feds QE was supposed to produce.

There is also existing debt to be repaid. Any refinancing activity that improves household’s cash flows may not result in increased discretionary spending as household’s are likely to first pay down existing debt. This has to happen with or without QE and so is not an argument against QE, it just means that the impact of QE3 may take much longer than intended. US households need to save more and consume less, not the converse. I wonder if the Fed has this in mind. 

Demographics. What if the demand deficiency is a structural consequence of demographics? What if this generation is done with its big spending ways? 2007 coincided with the peak consumption age of the average Baby Boomer. Growth cannot come from unbridled consumption alone. And consumption certainly should not be financed out of debt; it should substantially be funded out of profits and cash flow. And what about exports? Unfortunately the world currently faces a synchronized slowdown and it simply isn’t possible for everyone to be a net exporter. Over the longer term, but not the long term, emerging markets’ demographics will mean that they will have to take on the mantle of consumer of the world. What does that imply for the US economy and other developed markets? Does the Japanese experience beckon? Does an ageing population lead to deflation and recession? (Not necessarily as Japan has different problems.) In the meantime a period of non-cooperation and self sufficiency appears to be emerging, as one would reasonably expect in a global recession. How long will this period of self sufficiency last? What are its consequences on the path of history.

Does QE increase or decrease the amount of debt? It seems a little bit strange that the proposed solutions to  a problem precipitated by excessive debt seem all to involve the creation of more debt. In a bankruptcy reorganization of debt is a necessary step but this comes with a credible business plan. Without fundamental changes to the cash flow generation plan, it is not possible to make an insolvent business solvent simply by shuffling the debt.

QE is a debt reorganization. It is silent about the cash flow generation model of the economy and the government. That part of the problem is equally if not more complicated. Being a macro debt reorg it does not address bottlenecks and agency issues at the micro level, but one could argue that it is sufficient, as a debt reorg.

A culture of entitlement hobbles the world. We want free medical care, free education, free everything, but we don’t want to pay the high taxes. Nothing is free but everyone wants it to be. People want others to pay for their stuff. Basically they are either don’t understand or don’t want to abide by their constraints and demand more than is available to them.

Our political systems ensure oppression by the majority, populism and cynicism. Where there is democracy, governments have not the strength of resolve to present to their people the hard truths. Where there is no democracy, governments simply trample on the will of the people. The democracies therefore hurtle towards disaster while the undemocratic profit handsomely at the expense of both the West and the haplessness of their own peoples.

The people need to wake up. In the West they need to realize that they cannot have their cake and eat it. The culture of entitlement must be forfeited. In order to get borrowing costs down, some level of austerity is necessary in the form of poorer social security, medical benefits, free services. Governments need to reduce marginal tax rates. This is a commercial reality. As purveyors of tax domicile, they need to cut prices and that price is the marginal income tax rate for individuals and corporates. It is a less contentious alternative to trade war. In order to balance their profit and loss and cash flow, the size of government needs to be reduced. This is not an ideological objective but a practical one.

Undemocratic countries will continue to attract and harbour illicit businesses and capital. This time of economic crisis and ill advised government policy has only exacerbated the exodus of capital away from regulatory scrutiny. Western democracies need to address this in two ways; first, by reducing the tax arbitrage by lowering taxes, and second by pursuing with extreme prejudice, illicit capital and its custodians. Poor economic management can be condoned but willful misconduct must face punitive and if need be destructive consequences. Capital needs to be out in the open if it is to do any good.

Capitalism needs to be restored from its current incarnation. Since the fall of communism, capitalism has become adulterated with myriad forms of moral hazard, adverse selection and agency inefficiencies. Addressing moral hazard is all important. Capitalism needs to be allowed to punish as well as reward. If not, excessive risk taking will always occur with the final bill being visited on the public balance sheet. This pushes up the tax bill and inflates government. As part of this effort, the role of central banks needs to be examined. Unilaterally setting interest rates distorts relative prices as much as the arbitrary purchase of US treasuries or agency mortgage backed securities. The very existence of a lender of last resort is anathema to capitalism. Airbags and seatbelts save lives but increase the incidence of accidents.

Its Friday and its been a long week…

• When risks are high one reasonably expects the risk free rate to be low.

• Buy when interest rates are high, sell when they are low.

• ‘Tis calmest before the storm. ‘Tis very calm. Corollary: risk is high when VIX is low.

• Markets are attached to fundamentals by psychology, a very elastic couple.

• When the pie shrinks, people are less happy to share. There is a point when economic considerations give way to strategic considerations.

• ‘You got to know when to hold ’em, know when to fold ’em’. Kenny Rogers, The Gambler.

• “My options are decreasing mostly rapidly.” Gordon Sumner, Seven Days.

• Money can buy almost anything, even and especially experience. But pay as you go, there is no need for a retainer.

• Often the way to an efficient portfolio is a short memory.

• Often the way to successful trading is a long memory.