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Greece Referendum. Analysis and Investment Opportunities. PDF Print E-mail
Written by Burnham Banks   
Friday, 03 July 2015 07:07

 

Greece will conduct a referendum on July 5 regarding a creditor plan of reorganization. The referendum is framed as a Yes/No vote to either accept or reject the creditors’ proposals.


1. The vote as it is framed is strictly about accepting or rejecting the creditor proposal. However, the consequences of either a Yes or a No go beyond the creditor proposal, they go to whether Greece intends to be a part of Europe, or not.


2. There are a number of scenarios:


a) Yes. Tsipras government resigns. A new government will have to be formed which is happy to comply with the referendums implications. Financial and liquidity support will resume and details of a bailout will be finalized and implemented.


b) Yes. Tsipras government does not resign. Syriza has campaigned for anti-austerity and recommend the people vote No so a Yes vote would destabilize the government. It is unclear how the creditors will proceed in negotiations with Syriza. Syriza would have to honour the implications of the Yes vote and negotiate accordingly. The ECB may not be as quick to lift the suspension of ELA and negotiations would have to continue to finalize details. These negotiations could be problematic if represented by Syriza.

 

c) No. Tsipras government will have a strengthened mandate. The ECB would certainly ringfence the Greek financial system and maintain suspension of the ELA. Greece may be explicitly removed from TARGET2 which would isolate its financial system. There are many possibilities under a No vote since it would imply chaos and a likely exit of Greece from the currency union and perhaps from the European Union as well.

 


3. Short term effects: Equity markets will likely react well to a) above. The uncertainty of b) above means that any upside is likely to be fragile. Volatility could persist until a clear deal could be reached. In c) above the immediate impact will likely be a sharp sell-off as investors seek to de-risk and avoid any potential Black Swan events. “We know how bad it is and it ain’t so bad, but we don’t know what else we could have missed…” would be the likely thinking. European markets are still on average about 10% in the money year to date and investors will want to protect that.


4. European equities will correlate closely with BTP and BONOS spreads versus Bunds in each of the above scenarios. For 30 year BTPs, spreads could tighten below 100 under a) or languish in a 100 – 150 range under b). Under scenario c) the immediate impact could be big. Spreads were over 400 in 2011 but with the ECB’s OMT, QE and LTRO operations a widening to 200 would be extraordinary and would be a trigger to buy the spread. A similar analysis applies to 30 year Spanish spreads.


5. Longer term positioning.


a) Scenario a) provides Greece a lifeline. Depending on the final nature of the bailout the outcome could be long term negative for Europe, if for example, the creditor plan was unrealistic, draconian and would cause Greece to require another bailout in a few years’ time. A realistic deal would see some form of debt write-down with conditions to rehabilitate the Greek economy. Such a scenario would be long term positive.


b) Scenario b) could not realistically play out over the long term since the raison d’étre of Syriza was anti-austerity.

 

c) Scenario c) presents the most interesting long term investment opportunities.


I) The Greeks might soften their demands but the probability of this after a No vote is small. The probability that the Eurozone would soften their demands following a no vote is similarly remote given the contagion risk of moral hazard to Spain, Italy, Portugal.

 

II) Greece is already de facto in default and a No vote would formalize this. Negotiations would begin, or in this case, resume, with creditors. In this case, creditors would be quite powerless to negotiate for anything except to eject Greece from the union and suspend all aid. Keeping Greece in the greater union but not the Euro would provide a template for subsequent member exits and is therefore unlikely to be supported by Germany or France.

 

III) Greece would have to mint its own currency, which would probably depreciate some 40%-50% instantaneously. Some form of capital controls will be needed to ensure the success of the new currency.

 

IV) At this point but not before, Greek assets and legacy debt might present value.

Last Updated on Friday, 03 July 2015 07:17
 
China Equities. Fundamentals Positive. Valuations High In Places. IPO Activity Sapping the Market. PDF Print E-mail
Written by Burnham Banks   
Friday, 26 June 2015 04:22
  • Long term positive China on reform and liquidity.
  • Medium term volatility from valuations and IPO issuance.

 

  1. There are reasons to be optimistic about the Chinese economy in the long run due to structural reform. Current growth rates will slow but China is reorganizing itself to a more durable model.

    1. Political reform, notably the leaning away from rule of Party to rule of Law. The renewed importance of the Chinese constitution.

    2. Economic reform. Refinancing the local governments, lowering debt service costs. Rebalancing leverage away from over leveraged local governments and corporates towards households and central government.

    3. Financial market reform. The introduction of market discipline such as fewer bailouts and thus more use of the bankruptcy code.

  1. The PBOC is in the midst of expansionary policy.

    1. QE lite via LTROs with muni bonds as HQLA collateral.

    2. Cutting interest rates

    3. Cutting RRR.

    4. General deregulation of the banking and savings industry.

    5. This will favor the banks.

  1. The stock market has been very volatile.

    1. Valuations in parts of the market have overshot fundamentals.

    2. The market has simply run up too high.

    3. IPOs are sapping fund flows.

  1. Not all parts of the market are overvalued.

    1. HSCEI is trading on 9.4X 2015 est earnings.

    2. SHCOMP is trading on 17.5X

    3. Shenzen is trading on 36.9X

    4. ChiNext is trading on 97.2X

Today we take a look at IPO activity.

  1. Market capitalization is rising faster than SHCOMP due to the increased volume of IPOs.

  2. June MTD China announced IPOs total over 75 billion USD (as at 26 June). This compares with an average of 27 billion per month for the last 12 months.

  3. We estimate the 12 month cumulative IPO volume as a percentage of market capitalization in the second chart below*. IPO volume is definitely diverting capital away from the market.

Chart 1: Normalized Market Cap, SHCOMP and IPO issuance. 

 

 

 

Chart 2: IPOs as a percentage of Market Cap. 12 month moving sum.

 

 

 

Last Updated on Friday, 26 June 2015 04:38
 
EUR: Perspective on daily volatility and market rationality PDF Print E-mail
Written by Burnham Banks   
Wednesday, 24 June 2015 23:17

The behavior of the EUR may have been confusing. If we look at the daily volatility since the Greek situation began its crescendo we have seen the EUR weaken on good news (of a deal) and strengthen when there was bad news (of no deal.)


This is not so irrational. Notwithstanding any plan for retaining Greece within the Euro, Greece’s business model is not working. Current plans for reorganization from both creditors and debtor do not present Greece as a going concern. Therefore, retaining Greece in the Euro must be negative for the EUR and lead to weakness, while a Greek exit would remove a source of uncertainty, inefficiency and cost from the Eurozone which is positive for the EUR.


How rational are markets? We often expect markets to react to bad news badly, regardless of the underlying logic. Could this be a case where the market is being remarkably rational?

Last Updated on Wednesday, 24 June 2015 23:23
 
Responsible Financial Behavior Punished. Rich Bounce Back as Poor Stagnate. PDF Print E-mail
Written by Burnham Banks   
Monday, 22 June 2015 07:15

If you were careful, responsible and diligent and didn't overextend yourself buying that big apartment in the prime central area and the second apartment to rent out, but maintained a reasonable debt to income and debt to equity ratio, you did OK but you certainly didn't do as well as the guy who bought bigger than he could afford, was less than candid on his loan application for his buy-to-let in prime central, levered himself to his eyeballs and got bailed out when central banks the world over cut rates and did whatever they possibly could to ensure that a free market selection process for weeding out imprudent risk takers was confounded and conservative and responsible investors were disadvantaged.

The interventions and bailouts were entirely unfair. The bailouts were sold to us by the governments that the investment banks had the world over a barrel and that Wall Street had Main Street as hostages and human shields.

And now we are told (in a Bloomberg article Jun 18, 2015) that As the Rich Bounce Back, the Middle Class Stays Stagnant.

When income and wealth inequality are moderate, there is less motivation to challenge the status quo. However, at some level of inequality, when the bottom half of the population by wealth ask themselves what the probability is that they and their children might progress to the top half through diligence and effort, and the answer is pretty low, then change may come.

 

 

 

 
India Equities Look Interesting. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 17 June 2015 07:32

India is an interesting market. Modi's election success boosted equity markets but lately delays in reform have stalled the market which is some 10% of its 2015 highs.

 

Growth:

  • Near term the economy is slowing but long term potential remains strong.

  • India has strong demographics with the working age population rising as a percentage of total and is expected to peak only some 20 years from now.

  • The urban population in India is rising at an accelerating rate and per capital income is rising.

  • Current GDP growth is 7.5% YOY. Inflation is 5%. With a 2 trillion USD nominal GDP economy, India has plenty of room to grow.

  • India has for a long time had strong growth potential but was held back by excessive bureaucracy, corruption and inefficiency. A reformist government may unlock this potential.

Government:

  • The Modi government has a strong mandate with 282 out of 543 seats in parliament making it the first simple majority government since the Congress government in 1984.

  • Modi’s mandate is growth and development. He has been a good Chief Minister of Gujarat with 4 consecutive terms and has shown talent as a strong CEO.

  • The government is addressing a number of areas for reform:

    • Ease of doing business, moving to on line licensing and rationalizing other administrative functions.

    • Improving the investment climate, for example increasing FDI limits in selected industries like insurance, defense and railways, circumventing potential for corruption through more transparent processes, and more government co-investment in infrastructure.

    • Fiscal policy, to continue fiscal consolidation and removal of price distorting subsidies, for example in energy and transport, and to make government expenditure more efficient.

    • Taxation, simplifying the tax code, consolidating state and federal taxes into a single GST, expected to be circa 20% - 22%, also lowering corporate taxes from 30% to 25% over the next 4 years.

    • Banking and financial services, take for example the roll out of formal banking services to the general population (target circa 110 million new accounts), and the further augmenting of the bankruptcy law (last week creditors were granted rights to wrest control of management of defaulting companies.)

Corporate sector and Markets:

  • RBI has made 3 rate cuts this year, most recently 2 weeks ago to take the repo rate from 7.50% to 7.25%.

  • The Indian market is dominated by private sector business with SOE’s conspicuously absent. Companies are entrepreneurial and therefore capital and asset efficient.

  • Long run ROEs are 17% compared with 11% for the rest of the world and 12% in emerging markets.

  • Current ROEs are circa 15% and EBIT margins are around 10% which are cyclical lows.

  • Market PE is 16.3X which is at the long term average. The market is relatively cheap considering that corporate profitability is at cyclical lows.

Risks:

  • Things always take longer than planned or expected in India. This is one of the consequences of India’s democracy and bureaucracy. For example, the GST bill is facing opposition in Parliament and will only be reintroduced in July. It is expected to be passed during the monsoon season.

  • While bureaucracy is being rolled back and even civil servants are optimistic about the progress legacy issues remain. Take for example the retroactive nature of the Minimum Alternate Tax which has caused much confusion and is still in resolution.

  • Inflation may yet rise. The monsoon can affect near term inflation through food prices. India is energy dependent and affected by the oil price. We expect the oil price to remain capped and that long term the oil price will not appreciate significantly.

  • Infrastructure remains poor despite the stated aims to increase infrastructure investment.

  • INR exposure is difficult or costly to hedge. Interest rate differentials imply FX hedging costs between USD and INR to be circa 7%.

Last Updated on Wednesday, 17 June 2015 08:00
 
Greece Needs To Focus On The Longer Term. PDF Print E-mail
Written by Burnham Banks   
Thursday, 11 June 2015 06:23

If the Greek's were hoping for a bailout, their approach to obtaining one is novel. One would have expected a more conciliatory approach. Their current approach suggests that they are unwilling or unable, probably the latter, to comply with the creditors plan. It seems therefore that the choice before the Greeks is austerity in Euros or austerity in Drachmas.

The choice for the creditors is receiving fewer Euros or more Drachmas.

You can't lend a debtor into solvency. Greece needs to find a long term solution and to do that it needs to decide what it wants to be, not simply what it wants to do. I think that it may be in Greece's interest to exit the Euro and face the austerity that it will face in any case, in Drachmas, where it will at least have freedom over its monetary policy, although it will be constrained in the international capital markets. As it is, it has no control over monetary policy and it is constrained in the debt markets.

Varoufakis' game theory experience must advise him that Greece needs to leave the Euro before it is ejected, just as the best strategy for the Eurozone is to eject Greece before it leaves lest other members see exit as painless. The fact is that the pain is not because it is the Eurozone that Greece is leaving but that it is Greece that is leaving the Eurozone. The Eurozone will want to preserve the former myth and the Greeks will probably want to avoid the latter inference. So everyone is served in some way.

The only legitimate complaint the Greeks might have is that the Eurozone suppressed their cost of debt, an analgesic that allowed the country's deficiencies to persist and accumulate without symptoms for so long. Only the return of country risk in the wake of 2008 awoke the various countries to their conditions as sovereign spreads diverged to reflect individual members' default risk.

Last Updated on Wednesday, 17 June 2015 07:34
 
Central Bankers Are As Lost As We Are. And They Can Do What? PDF Print E-mail
Written by Burnham Banks   
Tuesday, 09 June 2015 06:09

I guess central bankers are human too and don't have a crystal ball. So they don't know with certainty how the economy will evolve and they have to make decisions which impact the economy in a way that is imprecise. They also have to consider how their actions will impact the economy, in this imprecise way, and how the economy will react, unpredictably, to their actions, as they decide what to do. It is amazing they even bother trying. Its like trying to control a yo yo at the end of a yo yo at the end of a yo yo.

I'd have just decreed that money supply shall be some function of output, and left it at that, being silent about rates, money supply, inflation, output and all of it. If we went back to defining the use of money, and been dogmatic about supplying enough of it to serve those very functions, store of value and transaction enablement, and nothing more, perhaps we'd spend less time trying to second guess central banks in our business and financial investment decisions, believing that central bankers knew what they were doing.

They are just as lost as the rest of us, but far more powerful in affecting the economy in all kinds of unpredictable ways. The wise central banker would quit.

 

Last Updated on Monday, 15 June 2015 06:36
 
China. Markets and Economy. An Updated Overview. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 02 June 2015 08:27

 

  • China is moving from Party rule to rule of law: The constitution and anti-corruption

  • China is deregulating markets and increasing greater market discipline: Testing enterprise bankruptcy law and allowing defaults. Credit is becoming more an alpha market.

  • The credit markets are being stabilized through macro prudential policy: New formation of LGFVs banned. Muni bond market open. Systemic risk is reduced.

  • The PBOC is firmly in easing mode. MLF and PSL = LTRO = QE lite. Risk assets to rally for some time to come.

  • The PBOC will try to sterilize the side effects of its easing: Curbing excesses in equity markets. Buy the dips.

  • China intends to internationalize the RMB via the SDR: QDII2. PBOC is counting on outflows being balanced by foreign accumulation of RMB reserves.

  • China wants to deleverage local governments and corporates and leverage up consumers. Municipal bond markets supported by commercial banks, consumer sector supported by consumer credit.

  • Just a reminder, this is NOT a democracy.

Over a 12 month period the Shanghai composite index has risen by 2.5X and the Shenzen composite index by 2.7X. Equity valuations which were among the world’s cheapest are now among the world’s most expensive. China’s stock markets are reflecting an interesting period of reorganization in the underlying economy.

Political reorganization:

At November 2014’s Fourth Plenum, the Chinese government signaled the importance of rule of law drawing attention to the constitution and establishing a series of circuit courts independent of local government influence. This, together with the anti-corruption campaign that has been deeper and wider than expected can be taken as a sign of a very significant shift in policy. The drivers of this policy are likely pragmatic rather than ideological, yet even so, the reforms that we are witnessing are likely to be durable and positive in the long run. We are under no illusions that China’s party wishes to cede control to democratic rule. However, the government has seen what Western democracies are good at, and bad at, and are currently choosing positive elements of Western democracy for its own use. Conceptually, the central government remains a central planner which has chosen to outsource certain parts of the political and financial system to the market where they believe the market provides a better solution than central planning.

A growing middle class, an increasingly fluid flow of information through social media and the evolutionary demands of this growing middle class present to the government significant new challenges in governing the country. The scale of the problem has led the government to conclude that central government is not feasible and that management needs to be decentralized and localized. The government also recognizes that decentralization requires two elements, the first is that policy needs to be driven by rule of law, and that corruption needs to be minimized. The pursuit of these two objectives are evident.

Economic Restructuring and Policy:

In a global trade war a valuable asset is a large and engaged consumer base. Also, as the marginal returns to exports are eroded, it pays to focus efforts on areas of the economy that are less mature hence the desire to de-focus exports and fixed asset investment and encourage consumption and accumulation of intellectual capital (R&D). In 2005, China was 45% of global new patent filings, in 2010 it was 72%. China recognizes it lags in innovation and is investing in R&D to compensate.

The past 5 years have also seen a surge in credit in particular in local governments and corporate businesses. Local governments were previously prohibited from issuing bonds and instead financed their investments through local government funding vehicles, in effect SIVs. LGFVs are now prohibited; only refinancing of existing assets are allowed. Eligibility of LGFV liabilities as general collateral has also been shut down. Instead, local government has been directed towards the issue of municipal bonds, made available through new legislation. To accelerate this great refinancing, currently estimated at 1.7 trillion RMB, a fluid number likely to be increased serially over the coming years, the PBOC has established repo facilities analogous to the ECB’s LTRO, designating municipal bonds as HQLA for collateral purposes, and discounting risk weights to minimize bank capital consumption. On the corporate front, the government is removing implicit guarantees and seeking to slow the accumulation of corporate debt while Imposing greater market discipline into the market. China has an enterprise bankruptcy law enacted in 2007 which is largely untested. Expect it to be tested this year. There have been 4 defaults to date. The first was effectively bailed out, the second and third are entering litigation. The fourth happened last week.

Where is China expanding credit, if it seems to be trying to reign in government and corporate borrowing? Consumer credit needs to be unfettered if China is to successfully engage its consumer base. The life cycle of income generation makes consumer credit an important necessary condition as house prices grow and as consumer tastes develop and mature. SME lending is another area where credit can be extended. While the Chinese banking system serves SMEs relatively well compared with other countries on access, cost of financing is another matter. The PBOC clearly seeks to lower cost of debt for SME as the economy slows. Banks also have a disproportionate propensity to lend to SOEs which bear implicit state guarantees rather than risky private loans. Deposit caps artificially suppress interest expense boosting margins on low yielding loans. The PBOC has recently signaled it may remove deposit caps altogether exposing commercial banks to higher costs of debt and force them to move down the credit quality curve thus spurring SME lending.

Policy:

The PBOC’s efforts at expansionary policy to address slowing growth, to reduce borrowing costs, to encourage SME lending and consumer credit, have side effects on inflation and asset markets. The PBOC will seek to mitigate some of the asset inflationary impact of its reflationary policies. The CSRC in January limited the pace of creation of margin accounts and most recently in May, brokerages have been tightening margin requirements evidently at the behest of the regulator.

These periodic interventions to cool possible asset bubbles will create volatility in asset markets but are unlikely to prevent a bubble from inflating. Capital finds a way. The credit restructuring efforts of the PBOC will likely lead to credit expansion and asset price inflation. It will likely lead to inflation in the services sector as well but this is a different story. Current valuations are already stretched but the potential expansion of system wide credit will likely carry to stock market further. Eventually, over valuation leads inexorably to correction but under current conditions this is some time away.

RMB and SDR

China will seek the inclusion of the RMB in the SDR. The RMB is the 7th largest reserve currency and 7th most used trade currency in the world. SDR inclusion notwithstanding, the RMB will become an international currency. China will soon launch QDII2, a scheme which will open up its capital account even further by allowing qualified investors with over 1 million RMB in financial assets to invest internationally. The calculus expects the opening of the capital account to help the RMB into the SDR and that the resulting foreign demand for RMB reserves will compensate from the domestic capital outflows for investments. This capital will seek a home by the way.

Reality Check:

I am pretty sanguine about the prospects for China. China is embarking on QE or QE lite on an ever increasing scale. This will fuel the asset inflation. The asset inflation will be punctuated by efforts to deflate any asset bubble, although it will likely be futile. The end game is a bust, but one that is far away.

The risk is political. The government appears enlightened and is pressing reform in many directions. One thing, however, has not changed and will likely not change. China is not a democracy and if it ever does, will not become one in a continuous or smooth fashion. While markets are being liberalized, personal freedoms are being limited. This may have little bearing for foreign investors who have but a commercial interest in China, however, there is a way in which the failure to reform the political system may be asynchronous with the economic reform. There is that old communist fallback of redirecting internal tensions into external tensions.

Last Updated on Tuesday, 02 June 2015 08:55
 
Autonomous Automobiles and Shared Mobility. The Possibilities Are Endless. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 26 May 2015 09:22

With the coming of autonomous automobiles and with Uber’s current exploratory steps into shared mobility, the future of the automobile is becoming interesting. From a central planner’s perspective one would like encourage better productivity of capital. As it is, people who drive to work end up parking their cars for hours a day. This is inefficient use of capital.

Roads are a scarce resource and need to be rationed. Road pricing is an efficient way to ration road usage. This tax should be levied specifically on the beneficiaries of using the respective road, not bus or taxi drivers, unless the meter is running. A form of this is already in force in Singapore.

Car ownership can similarly be rationed through taxation. The stock of cars on the road should be calculated based on the expected use of cars by a given population for a given set of road infrastructure. Redundant features beyond reasonable thresholds such as excessive vehicle size, engine displacement, engine power output, noise output, and the cost of the vehicle, should also be factored into the tax. Public transport vehicles should be granted preferential treatment. A form of this is also currently in force in Singapore.

Cleaner and more energy efficient cars should be encouraged again through taxation. This is done in many countries.

Cars should be encouraged to be put in use as much as possible. With autonomous cars, car owners can rent out their cars when they are not using them. Dedicated limousine services like Uber, taxi companies and private car owners would compete in a market for private car transport. Different markets and services will evolve which will defy efforts to predict them. Examples include using an autonomous car as a courier, as a surveillance drone, as a decoy or as a third party pick-up service.

Last Updated on Tuesday, 26 May 2015 09:24
 
Ten Seconds Into The Future. Investment Outlook 2H 2015 PDF Print E-mail
Written by Burnham Banks   
Monday, 25 May 2015 08:09

Outlook 2H 2015

 

Behind every forecast is a melee of competing ideas and arguments. Behind the veil of confidence is a dialectical process of self-questioning and reinforcement, and often, self-doubt. Behind every investment strategist is a risk manager acting as goalkeeper, and a trader dodging and weaving around short term volatility, avoiding the thousand cuts that often derails a sound strategy.



Economics:

 

Table 1.1

 

Economics

Expectation

Positives

Negatives

US

· Stable growth

· Slower equilibrium growth rate

· Inflation likely has troughed.

· Secular intellectual capital advantage.

· Domestic demand base and credit channels to enable it.

· Less reliant on outsourcing to cheap EM producers.

· Low savings rates and flexible labor market.

· Growing energy independence.

· Slowdown of globalization affects productivity.

· Inflation has probably bottomed. Energy prices have stabilized, labor markets are tight and the housing market appears to be reaccelerating.

Europe

· Unstable growth

· Slower equilibrium growth rate

· Inflation likely has troughed.

· Intellectual capital advantage.

· Failure of EUR to clear markets leads to inter-member cyclicality.

· Inflation is likely to pick up as the weak EUR inflates input prices.

· EUR single currency is a structural self-inflicted inefficiency.

· Subordination of economic rationality to political reality.

· Preoccupation with fiscal probity.

· Greece is insolvent and needs to be bailed out or default.

China

· Steady slowing of growth rate

· No hard landing.

· Inflation likely has troughed.

· Political reform towards rule of law.

· Economic reform towards greater market discipline.

· Macro prudential management of credit markets.

· PBOC easing to accelerate.

· Economic slowdown is clear and present.

· Intellectual capital deficit – albeit being addressed.

· Social development lagging economic development – leads to social dislocation.

· De-globalization hurts export dependent countries.

Japan

· Unstable growth

· Loss of export sector as a driver of growth.

· Inflation likely to undershoot.

· Weak JPY improves terms of trade.

· Demographic drag.

· Debt levels too high. Even with monetization policies.

·

EM

· Non Asia EM faces stagflation

· Demographic dividend.

· Second mover advantage in development.

· Major beneficiary of globalization will be impacted as globalization slows.

· Inflation risk.

 

 

 

Long Term:


The long term equilibrium trends for the various major economies remain intact. The US economy is growing steadily albeit at a lower rate than in in the preceding 30 years. Its drivers are a structural advantage that include such factors as strong institutions, deep markets, financial innovation, technology and intellectual capital. That the equilibrium trend growth rate is slower than before and slower than the market expects will lead to policy errors and allocative errors as cyclical growth is mis-estimated by econometric models.


Europe has much of the strengths of the US; however, it has a single currency, cultural differences, and partial and incomplete unification in important parts of legislation and regulation. These fractures will cause market failures from time to time. For example, the single currency causes market failures to manifest where local prices are inflexible, such as in labour markets where wages are sticky. Unemployment is some 23% to 25% in Spain and Greece, yet labour markets are tight in Germany.


China has been touted as the most important economy because of its size of economy and pace of growth. Despite having a smaller nominal output, China’s pace of growth will generate more incremental nominal output than the US, this while slowing to a still respectable 7%. The importance of China goes beyond its economic impact. China is in the process of an important political, social and economic restructuring. China is seeking a mechanically and logistically tractable way to govern the country which leads the Party logically to adopt rule of law over central control. It seeks to rebalance its economy by encouraging consumption over investment and exports, partly out of the reality that countries will become increasingly mercantilist, self-sufficient and insular. China also recognizes that rule of law implicitly requires that markets are subject to market discipline and not central planning.


India’s restructuring is less radical but will have no less significant impact on its economy. India seeks to unclog the plumbing of commerce, to simplify and rationalize its legislation and regulation so that a conceptually open economy can become a practically open economy.

Japan is also a reform story with new management promising change. So far the efforts on the monetary and fiscal side have been significant but structural reform has been slower to follow. One would argue that the pace was reasonable given the historical caution of the Japanese.

As countries all over restructure their economies for the new reality, globalization continues to slow and retreat. The financial crisis of 2008 is now 7 years behind us but the realization that trade was one of the few avenues left to drive growth has led countries to engage in a global cold trade war. The weapons deployed have included debasement of currency and FX manipulation to re-shoring and the development and protection of intellectual capital. This era of contentiousness will persist for some time to come. A side effect will be reduced global productive and allocative efficiency lowering the non-inflationary speed limit. The short term evidence does not support this view but inflation is a real risk.

 

Medium Term:


The US economy experienced a period of economic softness in the first quarter, attributed in part to the weather and to a port shutdown on the West Coast, and in part due to the natural metabolism of the economy. This period of softness is likely over. The labour market appears tight and while wages have lagged, they are likely to be dragged along. Manufacturing and services PMIs remain robust.


The European economy has been aided by a remarkable improvement in terms of trade through a much weakened Euro and disinflation. The natural metabolism of the European economy has turned in favor, however, and just when the ECB has initiated its QE program. The immediate effects are understandably optimistic but the structural inefficiencies of the single currency and a host of political challenges on the horizon may temper data and sentiment in future.


China’s stimulus efforts are evident and look set to continue. Market reforms in particular in the credit markets are positive in the long term but in the short term can lift credit default rates. The PBOC will ensure that system liquidity and solvency are unquestionable during the restructuring process. A side effect will be the risk of inflating bubbles in asset markets. To address this, the PBOC operates targeted macro prudential policies to direct the flow and cost of capital. Notwithstanding the efforts of the PBOC the basic tradeoffs between control and state variables mean that policy will continue to have unintended consequences which may present opportunities.



Policy:

 

Table 1.2

 

Policy

Expectation

Tight

Loose

US

· Fed expected to lift off Sep 2015.

· Less aggressive rate trajectory. However, expect a series of rate hikes.

· Possibility of July lift off cannot be ruled out.

· Inflation turns out to be stronger than expected.

· Oil prices stabilize to rise.

· Labor markets tight, lead to rising wages and costs.

· Reduced trade deficits provide less USD to be recycled into treasuries.

· US treasury debt service costs

· Weaker than expected long term growth trajectory leads to policy error.

· Erring on the side of loosening – 1930’s experience of being too tight.

· Global economic weakness.

· Strong USD hurts terms of trade.

Europe

· ECB QE just underway.

· Rate hikes are not expected soon. This could change if inflation expectations recover.

· Tight fiscal policy and loose monetary policy will cap inflation and output.

· Inflation is stabilizing and could pick up.

· ECB may consider tapering QE ahead of Sep 2016, although this is highly unlikely at this point.

· Fiscal policy will be a persistent drag on output.

· ECB QE is recent and is scheduled to run to Sep 2016.

· Credit transmission is only just recovering. Bond issuance has recovered but loan and structured credit issuance still slow.

China

· PBOC likely to continue to loosen and may accelerate stimulus to compensate for slowing economy and reforms.

· Current liquidity operations may be extended to QE at a later stage.

· Macro prudential policies to direct credit away from overleveraged industries.

· PBOC is vigilant over equity market and real estate inflation.

· PBOC to continue to suppress cost of debt.

· Current policy includes a host of open market operations.

Japan

· BoJ may have to loosen policy further to compensate for fiscal constraints.

· Japan is in a liquidity trap.

· Fiscal policy is tight.

· Sales tax hike delayed till 2017.

· BoJ remains loose but is running out of options as output and prices sensitivity to policy is reduced.

· BoJ may have to compensate for tight fiscal policy.

 


Strategy:

 

Portfolios should be positioned for the long term and traded and adjusted for the medium term while being aware of the risks.


US:


In the US stable growth will support corporate earnings and cash flows. With the Federal Reserve no longer expanding its balance sheet, the correlation between duration and equities, distorted to the positive for the duration of QE will revert to the historically negative. While we remain exposed to US equity risk we prefer to express this in US high yield corporate credit. We obtain these risks in two ways, in traditional high yield bonds, which we are underweight and in senior, secured, floating rate bank debt which bears little duration. At the same time we obtain domestic US economic growth exposure via the housing market through credit sensitive non-agency residential mortgage backed securities.

 

Europe:


We are in the early stages of implementation of the ECB’s QE program. We do not see significant probability for an early taper despite the current cyclical uptick in activity. While QE is in force, correlations between equity and duration will likely be positive. We are therefore long hard duration in the peripheral countries while being underweight duration in the core of Germany and France. A related trade expression is available in the sovereign CDS where we would be long protection France and Germany and writing protection on the periphery.


We find an efficient trade expression in banks’ capital securities such as contingent convertible bonds and perpetuals where improving balance sheets and capital positions encourage spread compression. While it seems reasonable that high yield corporates should tighten in this environment increased volume of issuance and lighter covenant standards increase the risk in these securities. The demand and supply environment for high yield corporates may cap the returns potential for European high yield.


In European loans we find better underwriting standards, tighter covenants and wider spreads, however, the duration protection is not something we require at the moment and the liquidity of the European market is much poorer than in the US. We do not feel compelled to invest in this area yet.


China:


In China the conditions are positive for risk assets and the most accessible and liquid trade expression is through listed equities. In the medium term, Hong Kong listed H-shares have a valuation advantage which can be exploited. A-shares on the other hand are more directly impacted by improving local liquidity conditions, but valuations are significantly higher than their HK listed counterparts. RMB bonds are another area where the prognosis is positive but here, the government’s reform efforts are likely to drive up default rates as they test insolvency law.

 


Less Liquid Strategies:

 

For investors with a tolerance of less liquid investments the prognosis is good. The common thread running through all these strategies is the increased regulation of banks and the vacuum they leave behind.


Hedge funds:


Public data about hedge fund performance is incomplete and misleading. The hedge fund industry has evolved into one where talent is global but source of capital is predominantly US based. Europe had beaten the UCITS path and Asia had almost eschewed hedge funds altogether. In the meantime, talented managers have tightened liquidity provisions to stabilize their capital base and businesses. Illiquid strategies which may either have illiquid assets or liquid assets but long gestation strategies have done well. Examples are complex agency RMBS arbitrage involving arbitraging the relative valuations between mortgage derivatives and the underlying pools. Event driven managers have profited from the surge in M&A activity. Some hedge funds have coupled risk arbitrage with activism to operate highly successful strategies. Generally, with greater regulation and higher capital requirements for principal activities, banks have reduced their principal activities in exchange for agency businesses. The lack of cross market, cross capital structure trading by banks removes an important source of capital policing the no-arbitrage pricing of markets and securities resulting in greater price dislocation that hedge funds can take advantage of. The strategies we favor include cross capital structure arbitrage, merger arbitrage and agency MBS arbitrage. We are less confident that quant driven strategies like statistical arbitrage or trend following price data driven strategies will be able to generate consistent, repeatable performance.


Private Equity and Private Debt:


Private equity and debt strategies are the natural beneficiaries of the dearth of bank capital. However, the weight of capital flowing into private equity in the past 3 years has led to a surfeit of capital seeking deals. Certainly PE secondaries are trading at high valuations and there is a shortage of quality secondaries on the market. The shortage of deals is also leading to deals circulating between funds at increasing valuations.

The private debt market is more interesting in particular mezzanine lending to mid market companies. Restricted access to debt capital markets and a shortage of bank capital coupled with disadvantageous Basel III risk weighted capital treatment make lending to SMEs attractive. One area of low volatility returns is trade finance. Properly structured, trade finance provides very stable returns with low default rates and high recoveries. Private trade finance funds profit from the dearth of credit from bank consolidation and shrinking credit limits.

 


What are we not positive about? Is there anything we are not buying?

 

The face of capitalism was unmasked in the aftermath of 2008. Moral hazard reigns supreme. Central banks will not allow any systemically important entities to fail, and will generally err on the side of easy conditions. Fundamental health of the economy notwithstanding, central banks will be supportive of risk assets and indeed any assets with a positive wealth effect. Be that as it may, we are cognizant of the risks in the world economy today.


Broad picture:


The most important risk investors should consider is how central banks will reduce their large scale asset purchases and eventually return their balance sheets to a more manageable size, the implications will be for the real economy and for markets.

 

Central bank balance sheets cannot be maintained or indeed expanded for too long. A pick-up in the velocity of money can quickly multiply through the money base to result in high inflation. With interest rates at such low levels, central banks may struggle to contain an unexpected increase in inflation. At some point central banks will need to shrink their balance sheets. Not even the US Fed has entered that stage and no one is quite certain what the repercussions will be. The Fed will understandably want to be gradual, probably allowing the assets to pay down and avoid selling assets in open market transactions. When the European economy achieves a durable state of recovery, the Fed will hopefully provide a template for exit.


A by-product of low interest rates is that they impair the functioning of the savings and pensions system. There is a limit to how long interest rates can be artificially suppressed. Liabilities are inflated as much as assets by low discount rates and unfunded liabilities with time become a sizeable current problem.


Tangential to the health of the savings and pensions industry are the fortunes of banks. The future for banks is unexciting. A number of banks operated in potentially disingenuous fashion both during the 2008 crisis and after leading regulators to questions the conduct of these banks. The role of banks in transmitting and amplifying the credit crisis in 2008 added to regulators concerns about the systemic risk posed by the commercial banks. Regulation has understandably swung in the direction of excessively prescriptive policies. Banks have henceforth been regulated like essential utilities, a position they are unused to. Banks may still provide short term thematic trading opportunities, especially in respect of their continuing, albeit diminishing role as the infrastructure of finance, however, for the long term investor, better alternatives exist in the value chain between savings and investments.


Medium term:


In the US, the stability and eventual recovery of inflation recommends an underweight in duration. Curve trades may be available to trade supply and demand driven flattening but outright duration longs should be avoided.


In Europe the temptation to front run the ECB’s QE program is strong. Tactically, the ECB provides a backstop for the investor to maintain a long duration profile, especially in the peripheral member states. Greece can be excluded as the ECB backstop excludes non-investment grade sovereigns. The safer trade expression is to fund the longs with shorts in core Europe. That said, the QE backstop is compelling. We will adopt a long bias to peripheral duration with a keen eye on potential risk off selloffs as happened in the second quarter.


While we have a general preference for equities the return per unit risk of equities and the relative valuation of equities encourages us to find alternatives or proxies to equity risk which suppress volatility or realign the valuations. Where no viable alternatives are available, we will not shy from investing in equities but we will size positions based on the risk of the underlying instrument. Examples are non-investment grade corporate bonds and leveraged loans where we buy credit sensitivity as a correlated asset to equities.


Commodities are ever a volatile asset class where despite having an opinion, we do not have an edge. Oil had been exceedingly weak in 2014, surprising all including the most experienced and dedicated energy traders. Since then, the price has stabilized. Oil has significant impact on inflation expectations and can impact the direction of term structures. While we do not explicitly trade energy and energy related corporates, we monitor the market carefully. Notwithstanding the current rebound and stability in oil markets, the fundamental balance is not supportive of the oil price and we are not convinced of a durable recovery. The actions of the Saudis are illuminating. The Saudis, behaving purely as merchants, clearly regard the future value of oil in the ground inferior to the cash value of what they can sell, all the way down to circa 45 USD. This is a significant overhang.


We have in the past invested in agency mortgages where we sought additional yield over our intended long duration positioning. For one, we are no longer seeking to be long USD duration and for another, agency spreads over treasuries have tightened considerable so that the compensation for prepayment risk is no longer adequate. Tactical opportunities may arise depending on issuance and demand and supply but we are otherwise underweight agency mortgages.


Table 1.3

 

Strategy

Equities

Fixed Income

Other

US

· Earnings growth slowing.

· Valuations high.

· Long term positive.

· Short term limited upside.

· Downside risk from higher rates.

· Prefer cyclicals to defensives.

· Long duration trade is over.

· High yield to benefit from slow, positive, growth environment. However, duration will detract.

· Leverage loans provide credit exposure with floating rates and little duration.

· High conviction call on non-agency RMBS as housing recovery matures into a sustainable long term trend.

· M&A activity elevated. Allocate to event driven M&A hedge funds.

· Agency MBS relative value opportunities. Rate volatility generates dispersion and dislocation which can be harvested.

· Trends are turning and have not been established. CTA’s may suffer.

Europe

· Equity and bond correlation will be positive under QE.

· Equities cheap relative to bonds and credit.

· Convergence trade in Eurozone sovereign debt, long Spain, Italy, Portugal, short France, Germany.

· Long financials capital securities.

· European equity long short opportunities.

· M&A activity elevated. Allocate to event driven M&A hedge funds.

China

· Equities supported by PBOC liquidity policies.

· H shares cheap to A shares.

· High yield preferred to IG

· In real estate, prefer size and IG to HY.

·

Japan

· Domestic pension funds are increasing allocations to Japanese equities.

· Economic reform encouraging firms to focus on shareholder value.

· JGB market liquidity reduced to BoJ activity.

· Activist hedge funds may find more opportunities.

 

 

 


Risks:

 

Table 2.0

 

Risks

Equities

Fixed Income

Other

US

· Significant demand is coming from buybacks. Buybacks tend to be a poor indicator of timing.

· Valuations are neither cheap nor expensive. There is no advantage in equities.

· Inflation could surprise on the upside.

· Growth could slow to the extent that the Fed is unable to raise rates.

· The US Fed is first in line to taper QE and to eventually reduce its balance sheet. How will it do this and how will markets react?

· As the US becomes more insular what will become of its allies?

· How will the US react to a challenge to its hegemony by China?

Europe

· Equities are being supported by the bond market as QE remains in force. Correlation to bonds is positive and optimistic bond markets currently support the equity market. This could change when the QE program matures.

· The debate over the solvency and liquidity of Greece continues on with only tactical solutions, not long term structural solutions.

· Political risk. Syriza’s win in Greece has demonstrated the consequences of populist parties and policies. Spain’s recent local government elections are a portent of the potential risk at the Spanish parliamentary elections in December.

· The UK will have an In Out Referendum on Europe by 2017.

China

· Valuations are very high and downside risks are substantial.

· Event risk. The Shanghai Stock Connect had a few false starts. Fortunately it is now functioning well. The Shenzhen Stock Connect is expected later this year and could introduce more volatility.

· PBOC policy is academically sound but implementation is inexperienced. Mistakes can happen.

· The promotion of rule of law will likely increase default rates, albeit limited to systemically unimportant issuers.

· Political risk is the most significant risk. Tensions in the South China Sea are unlikely to abate absent a comprehensive solution which no one appears ready to engage in.

· The inclusion of the RMB in the SDR and the ascension of the AIIB are examples of matters which challenge the US hegemony and can become contentious.

Japan

· Equity markets are quite stretched. Much depends on BoJ stimulus efforts and a weaker currency.

· The BoJ appears to be in a corner. On the one hand it expects a slow economy and on the other it expects a rebound in inflation. If both occur it could pose a new set of challenges for the BoJ.

· Japan is a test case of extreme debt monetization and debasement of currency in the hope that growth will recover before bond markets fail. A high savings rate and a captive source of funding can delay the day of reckoning for a long time, but not forever.

 

 

 


In Closing:

 

The investment landscape is risky. The world has not yet healed from its credit binge and bust, and debt levels remain high, growth is slower than before and countries have become more protectionist thus reducing economic efficiency. And yet, central bank policy is either deliberately or unintentionally inflating or backstopping asset prices. The question is, in this environment, can the rational investor ignore markets and refuse to play the central banks’ games?


One, we are mindful of valuations as we invest. Finding cheap assets or cheap trade expressions provides us with a cushion for when markets correct. Currently asset markets are buoyed by monetary policy. Buying cheap non agency RMBS to capture growth is an example of a targeted trade to capture domestic US growth. Buying leveraged loans is a way to obtain exposure to strong corporate cash flows without exposure to duration.


Two, because central banks have such strong influence in the economy and markets today we watch them closely to understand their objectives and limitations, and the propensity for policy errors. We focus not only on what central banks are doing and thinking but we study the mechanical processes by which they effect policy to gain a head start on policy and to find opportunities from operational aspects of policy. For example, when the Swiss National Bank announced an end to the currency cap, it signaled to us the near certainty of the ECB announcement to undertake QE and allowed us to buy bonds before the announcement. Another example is where we focused not on the directional aspect of the ECB’s QE but on the risk sharing by the member states’ central banks to construct a Eurozone core-peripheral convergence trade.


Third, fundamentals and asset prices are joined by an elastic couple which can result in perverse phenomena. Weak economies can spur loose monetary conditions that drive asset prices. Strong fundamentals on the other hand can signal tighter monetary conditions that might choke off an asset rally. Being too early in to a trade can be costly, just as overstaying a theme which has run its course. We keep a close eye on that elastic couple, psychology, which drives markets, even as we maintain conviction in our fundamental views.


The problems that face the global economy are many, but human ingenuity is great. We are acutely aware of the problems and we relentlessly trade the efforts of regulators and market participants to address these problems until a point when market prices are no longer as acutely distorted by regulators and policy and markets can return to pricing assets according to their intrinsic value.

 

 

 

 

 

 

 

 

 

 

 

Last Updated on Monday, 25 May 2015 08:29
 
China's QE Lite II. Jiangsu Successfully Issues 52 billion RMB of Muni Bonds PDF Print E-mail
Written by Burnham Banks   
Thursday, 21 May 2015 00:37

On Monday, 18 May, Jiangsu province successfully sold 52 billion RMB of municipal bonds.

 

Recently, the Chinese government has accelerated a municipal bond program that effectively is a debt swap for some 1.7 trillion RMB of existing local government debt. Cost of debt for the local governments is expected to fall by some 250-300 basis points.


There is some logic behind what is effectively a system wide restructuring. The municipal bonds yield less than the maturing or retired debt, however, they also have a lower risk weight of 20% or less and thus consume a lot less capital.


For a bank seeking to maintain profitability, it would have to extend more loans for every dollar notional of restructured debt. The municipal bonds are financed at highly advantageous rates and haircuts. Naively, if risk weights were reduced to 20%, a bank could make 5 times the loans it used to with the same capital and fund itself cheaply, not with deposits where reform is raising rates, but with medium to long term repos with the PBOC, namely the MLF and PSL. Impact on bank profitability would be neutral, balance sheets would expand, loan growth would rise, credit quality would improve, and the impact will likely be felt across the economy as a whole and drive the stock market even further.


At the same time, the Chinese regulators have relaxed funding conditions by allowing banks to refinance existing LGFVs in respect of projects started prior to the end of 2014. This is likely a stop gap measure as the PSLs are unlikely to be able to absorb the volume of refinancings of what is essentially the substantial majority of local government debt in the system.

 

 

 

 

 

 

 

 

 

Last Updated on Friday, 22 May 2015 01:25
 
Why Did German Bunds Selloff and What Opportunities Are There in European Sovereign Bonds PDF Print E-mail
Written by Burnham Banks   
Thursday, 14 May 2015 07:09

Why did German bunds selloff so violently?

When the ECB announced QE, traders attempted to front run the program. The program would buy bonds according to the capital subscription of the national central banks to the ECB. On that count, bunds would see an 18% allocation of the budget, France 14%, Italy 12% and Spain 9%. Traders reasoned that bunds would see the biggest allocation not only in absolute terms but relative to the stock of bonds available. The problem with this thesis was the investors who had over 2 years of profits ready to crystallize.

A less volatile trade expression for QE was to realize that with risk mutualisation, 20% explicitly and 100% implicitly through TARGET2, it made sense to sell protection on Italy, Spain, Portugal and to buy protection on Germany and France.

When the Maastricht treaty was signed, peripheral spreads over bunds were much wider than they are today, some 4%-5%. They spent the best part of a decade converging, in the case of Italy, to a negative spread to bunds... In 2012, spreads widened to pre Maastricht levels as country risk reasserted itself in the European sovereign bond market. Since the ECB's "all it takes" policy, spreads have converged again. We are currently still well wide of zero and convergence remains a logical trade.

 

Last Updated on Thursday, 14 May 2015 07:15
 
Greece. No Way Out But Exit? Example Solution From Corporate Workout. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 12 May 2015 00:59

A business cannot borrow itself into solvency. On the other hand there will be a cost of debt beyond which no business model can survive. What Greece needs to do is examine its business model to get a handle on its revenues and expenses (including unfunded liabilities), examine its balance sheet (including state owned assets) and find a viable business model (from a cash flow and profit perspective) and balance sheet.

A rational creditor would work with Greece to maximize the value of the loans they have already extended to Greece. This could very realistically involve extending more credit to Greece, at easier terms. A rational creditor would only agree to this if there was a formal business plan.

In order that any such business plan was sufficiently reassuring to Greece's creditors, cash flows from tax and other revenue might have to be directed to escrow accounts where a waterfall of priority of cash flows directed cash so as to satisfy basic needs of the Greek government and people, then creditors, then less high priority Greek interests.

Last Updated on Friday, 22 May 2015 01:25
 
EUR and Greece PDF Print E-mail
Written by Burnham Banks   
Monday, 11 May 2015 00:23

A short EUR position has been a consensus trade for most of 2014. Recent EUR volatility and the contentious negotiations about Greece's finances challenge the consensus.

If Greece manages to stay in the Eurozone it will be by postponing its problems and continually deferring default and exit. The Euro would be weak under this scenario. Volatility would remain elevated with bouts of strength at each narrow escape. This is not rational but markets are often not rational. Greece's membership of the Eurozone should cheapen the EUR not strengthen it.

If Greece is removed from the Euro it would be positive for the currency. While short term reactionary price action is difficult to predict, one would expect a Grexit to promote EUR strength with the EUR heading perhaps to 1.30 to the USD. This could hurt European exports and growth.

Herein lies a trading strategy.

 

 

 

 

Last Updated on Monday, 11 May 2015 00:39
 
Equity and Bond Correlations. Inflation. Commodities. Implications. PDF Print E-mail
Written by Burnham Banks   
Thursday, 07 May 2015 03:49

In 2014 we saw stronger equity markets and falling bond yields. In 2015 we see slowing equity markets, slower growth and rising bond yields. The 2014 correlation went against historical correlations but could be explained by equity valuations being supported by falling discount rates and thus rerating. Also, despite a stronger economy, bond yields fell as a result of demand and supply conditions. Corporate tax revenues were strong, defense spending was receding and the US treasury started to fund with 2 year FRNs for the first time reducing supply at longer maturities. This explains the unusual correlations in 2014.

In 2015 we have a weaker US economy, low inflation in Q1, a Fed seeking to raise rates but confounded by data, and rising bond yields.

1. Is the correlation between equities and bonds reverting to their historical levels?

Equity Bond correlations are widely accepted to be negative. In fact they are highly variable and often change sign. They are also sensitive to short term interest rates and inflation. Correlations were negative in the 1950s through 1960s, and from the late 1990s to the present. They turned positive in 2014. And, they were positive throughout the 1970s and 1980s. In 2015 correlations appear to have reverted to negative although the time frame is too short for statistically significant estimation.

Focusing on recent behavior, it is possible that with the multiple asset purchase programs of the central bank, bonds have come to be regarded as a risk asset held for return and not for safety. In that respect, bonds would have become a risky asset and correlations with equities would have turned positive. This would explain 2014 behavior. With bonds falling and equities holding as the economy slows, there is a risk that either the correlations have reverted to negative, or one of either the bond or equity market is lagging the other.

Scenario A: Let us assume that correlations have indeed reverted to negative. Let us assume that the US economy is in a phase of stable but low growth with a moderate cyclicality around it. This should be moderately supportive of equity markets. With negative correlations, bonds should weaken as investors substitute away from the safety of the reserve asset to the risky asset. The current cyclical weakness in the economy and the weakness of the USD seem to contradict this scenario. If this scenario is in fact valid, the USD would have to recover and the economy rebound. There are expectations for both so time will tell if this scenario is valid.

Scenario B: Let us assume that bonds are a risky asset and that correlations are therefore positive. Let us assume again a stable, low growth economy with moderate cyclicality. In this environment cyclical weakness might trigger a selloff in risky assets leading to weak equity and bond markets. The relative weakness would depend on the weight of capital in each asset class attempting to exit. Given the leveraged nature of bond holdings one might reasonable expect a sharper sell off in bonds than equities. The reserve asset here would no longer be bonds but cash. The bond purchases of the central bank would have led to private investors front running the central bank rendering bonds a speculative asset instead of a risk-free asset and at the same time impairing price discovery so that the efficient market price of the bond was unknown. If at the same time as the cyclical weakness the central bank was considering raising rates for other than economic reasons, such as resetting a policy tool for example, the coincident impact on bonds could be exacerbated. Even if weak data delayed central bank action bonds would remain volatile with a downside bias. In this environment, equities would be vulnerable.

Equity Bond Correlation

Positive

Negative

Strong growth

Equities positive

Bonds positive

USD positive

High yield positive

Short duration credit neutral

USD curve flattens

Agency and Non Agency RMBS positive

Equities positive

Bonds negative

USD positive

Short duration credit positive

Long duration credit negative

USD curve neutral

Prefer Non Agency to Agency RMBS

Weak growth

Equities negative

Bonds negative

USD negative

Investment grade neutral

USD curve steepens

Agency and Non Agency RMBS negative

Equities negative

Bonds positive

USD negative

Investment grade credit positive

Short duration credit negative

USD curve flattens

Prefer Agency to Non Agency RMBS

 

2. What are inflation expectations?

Inflation is a significant risk. Inflation expectations have been stable except for the 2008 crisis. In 2014 inflation expectations, as indicated by the breakevens, fell, mostly on the back of weak commodity prices. Commodity prices have stabilized in Q2 2015 and may well recover. This would lift bond yields.

Apart from the recovery in commodities, the monetary base remains very much inflated and any acceleration in the velocity of money could result in a strong increase in nominal growth. This risk is tempered by capacity utilization retreating from the 80 level in recent months. Also, the Fed has tools at hand to absorb liquidity should prices accelerate. The cost, however, would be higher repo and short rates.

3. If money is coming out of equity and bond markets, where is it going or how is it being absorbed?

The default reserve asset is cash. Investors will not stay long in cash if inflation accelerates and alternatives will be sought.

For yield seeking investors who are unwilling to raise cash, they may seek alternatives such as ABS, leveraged loans or commodities or gold. Most investors, especially ex US, are unfamiliar with ABS and loans. The complexity of ABS will deter some but loans could absorb significant capital. Currently retail investors are reducing exposure as institutional investors are adding to loans. Recent experience in commodities has been volatile and investors may take some time to return to the asset class. Gold is an asset class that will likely benefit from inflation but will also require that investors exhaust the set of viable liquid alternatives before large scale inflows can be expected. If correlations are in fact positive, which is a strong assumption, the set of viable alternatives could shrink very quickly. However, all that is required is that one or two alternatives are found which are more liquid with lower transaction and storage costs.

 

* This analysis does not consider the possibility of investing internationally to simplify the analysis. Cross border investing will be considered separately.

Last Updated on Thursday, 07 May 2015 04:05
 
Greece. Yes No. What Then? Tsipras and Merkel At Last Agree. PDF Print E-mail
Written by Burnham Banks   
Thursday, 02 July 2015 23:48

I was undecided before but the rhetoric from Berlin has now convinced me that for once, Merkel and Tsipras agree. They both want the Greek people to vote No in the July 5 referendum on creditors’ terms.

Greece has been on explicit financial aid since the first bailout in 2010. In 2015, since Syriza won the general elections, all Greece has been trying to do is renegotiate the terms of its aid. It is not a bailout or a refinancing or debt reorganization, its aid. For the Eurozone, its members already struggling fiscally, with the exception of Germany, aid to an unproductive member was never sustainable. That the Greeks did not have a commercially acceptable business plan exacerbated the situation. Reprieve (for the EZ) came in the form of Syriza. Under ND, austerity had failed but its effects would only manifest will past the elections. Had Greece failed under a compliant New Democracy the effectiveness of the Eurozone’s austerity programs would have come into question. Rather fortuitously, ND lost to a strident Syriza intent on tearing up the status quo became a convenient pawn in a gambit designed to see Greece out of the Euro, by its own hand, and facing painful consequences – as a warning to Portugal, Spain and Italy, that exit has a price too high.

Unfortunately, for the Eurozone and Syriza, the vote will likely be Yes. Quite what happens after such a vote is another matter but, polls notwithstanding, the human tendency is to go with the devil you know. A Yes is more probable because, Greeks do want to stay in the Euro, they receive aid from the Eurozone, their borrowing costs are or were held down by the Euro, but most of all, they cannot envisage life without the Euro, or life with a Drachma. More immediately, the banks are closed and pension disbursements are drying up. Greece and her banks are short of cash. In the short term only Emergency Liquidity Assistance can restore the flow of cash and the ECB will certainly not raise the ceiling on ELA if there is a No vote. By imposing capital controls and a bank holiday, Tsipras may be encouraging his people to vote Yes just to free up the flow of money.

A Yes vote will mean a loss of mandate for Tsipras and his Syriza since he has recommended to his people to vote No. Tsipras may have to resign, triggering fresh elections. If so, a new government will need to be formed during which time it is not clear what the position of the Eurozone will be, they will have no one to negotiate with. The position of the ECB will be similarly unclear. Should they provide relief and lift the ceiling on the ELA? If they did, cash would start flowing again while Greek default risk would still be ring-fenced within the Greek financial system. So it is likely they would. Tsipras may not resign. A cynic might expect him to hold on to his position and resume negotiations with the creditors. He has already shown sufficient flexibility in between the time he called for the referendum and when the referendum would be held by attempting to negotiate terms with a softer stance. In any case, a Tsipras government or another government would have to respect the result of the referendum in negotiations with the creditors, basically accepting the terms of the initial creditor plan. The latitude for any government to be obstructive is significantly limited by a Yes vote. Very likely a deal will be struck and bailout disbursements would follow. Given the draconian terms of the creditor plan, Greece would limp along until the next crisis.

A No vote would keep Syriza in place but could well put Greece out of place. While it appears that anything is possible, if we are to believe the myriad official voices from Brussels to Berlin to Athens, Greece would probably be forced out of the Euro. Theoretically it could default and remain within the union, since membership does not explicitly preclude default, but the going concern status of Greece would be in question and there might be sanctions regarding Greece’s access to the European TARGET2 payments system. Another possibility might be Greece being removed from the currency union but not the European union in a similar way that the United Kingdom is part of the EU but has its own currency. In any case, Greece has for all intents and purposes already defaulted on the IMF loan due June 30. The IMF would simply formalize this by changing its status from being in arrears to being in default.

Under a No vote and default, could Greece remain in the Euro? Theoretically it could. Greek debt in Euro would default and face writedowns in the usual fashion that defaulted dollar debt faces writedowns. A plan of reorganization could still be formulated with Greece within the Euro that would restructure its debt. Creditors would still impose conditions, and Greece would negotiate for leniency, in fact the negotiations might look very much like what we have experienced in the past 5 months. The negotiations thus far have not only been ineffective, they have been irrelevant. Now it may be that the Eurozone then decides to remove Greece from the currency union. It may keep Greece in the broader union, or it may also eject it altogether. That is a separate analysis which would involve longer term strategic considerations as well as historical, cultural and emotional factors. The logistics of default are another matter. Upon default, Greece would have to be prevented from creating further liabilities, which it can do within TARGET2. Shutting Greece out of TARGET2 or limiting its access to it would be the equivalent of Europe unilaterally and exogenously imposing capital controls on Greece, which surely would encourage Greece to leave the Euro.

What other alternatives does Greece have? Tsipras has evidently approached Russia. Russia, however, is not entirely in shape for such extravagance. While the Russian economy has stabilized somewhat rates remain elevated and the currency may yet begin to weaken again and the budget has already begun to deteriorate again. Putin might be happy to spend some money on entertainment and Greece would be a source of worry in NATO’s backyard but so far Tsipras’ overtures don’t seem to have borne fruit. Unless they are waiting for a more opportune time to come out.

The polls have been all over the place beginning with favor for a Yes, to a more even balance to favoring a No. Polls tell you what people wish they could do, not what they will do. And even when the votes are counted, a new uncertainty will have begun.

 
Bondification. The Quest For Yield And The Turning Point. PDF Print E-mail
Written by Burnham Banks   
Thursday, 25 June 2015 05:49

When we buy an equity or a bond we buy a claim on a business but with differing payoffs, rights and obligations. The rational investor would first decide if the business in question was something they wanted to own before deciding on whether to own it through the equity or the debt. If indeed the business was attractive then the analysis would progress to which claim to buy, an analysis which would take into account the prospects for the business, the riskiness of the business and the available claims. The assessment would be made on a risk adjusted basis and not on the absolute attractiveness of the claim. I say this because if it was decided that the most senior claim was the right one, leverage could be used to scale the investment to the right size. If for example equity was the right claim but the investor was targeting a low risk, then a deleveraged position could be taken (that is pairing the position with cash).

We apply this methodology with the prices before us. Its really the best we can do. The methodology may well drive us to hold lots of cash for example if equity was the more attractive claim, yet our desired volatility was lower than the unlevered cash equity. In this case we would hold a deleveraged position, meaning a portfolio of positive cash and positive equity.

Current valuations are quite balanced. Looking at aggregates, equities are cheap compared with government bonds but they are fairly priced on a historical basis when compared with corporate bonds. The spread of investment grade corporates to treasuries is moderately attractive and at this point at least, a comparison of high yield to investment grade yields is equivocal.

The investment problem is that government bond yields are too depressed. Valuations made against government bonds are a risky practice since yields are likely to rise and could render reasonably priced assets expensive quite quickly.

It was low interest rates in 2003/2004 of 1% in the US, now a princely level, which saw the reach for yield in that decade which was sated by ratings arbitrage, necessary because institutional investors were constrained by ratings requirements. The ratings arbitrage resulted in clever constructs like CLOs and CDOs. Demand for yield drove demand for CLO origination which in turn drove demand for ABS and in particular RMBS origination to the point that the banks were more willing to lend than the homeowner was to borrow. This was the tipping point.

As we reach for yield today we should be aware of the balance of enthusiasm between lenders and borrowers. When lenders are more motivated to lend than borrowers are to borrow it is usually a sign of a credit bubble.

 
When Will The Fed Shrink Its Balance Sheet? In The Long Run The Fed's Balance Sheet Will Probably Grow. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 23 June 2015 09:26

Analgesics are addictive. Since interest rates were deployed to manage the economic cycle we have seen the Fed Funds Target Rate decline, making lower lows and lower highs (1980, 1984, 1989, 1995, 2000, 2007) as the Fed has been repeatedly enlisted in the bailout of asset markets and the economy.

Now that a new policy tool has been invented it will doubtless be counted upon to support further crises and excesses. This is the nature of moral hazard. We cannot un-discover QE.

With Fed Funds at 0.25% there is no room for cutting it any further. We will be fortunate when the Fed finds itself in a position to reset its policy tool higher but should another crisis or recession occur, with Fed funds at these low levels, the Fed's balance sheet can and will be deployed. While the balance sheet may shrink in the next 7 to 8 years, one can reasonably expect it to expand over a longer time frame.

Last Updated on Thursday, 25 June 2015 05:51
 
Investing In Mutual Funds. Rationale, Costs and Benefits. . Mutual Fund Distribution and Other Issues. Asian Fund Distribution PDF Print E-mail
Written by Burnham Banks   
Thursday, 18 June 2015 07:32

Some Issues In Mutual Fund Investing.

 

1. One of the problems in mutual fund investing is how they are sold to investors.

 

a. High front end commissions. Mutual funds typically charge a commission to invest in them. This commission is paid to the distributor of the mutual fund, such as a bank or an independent financial adviser. Just like any other product marketing has a cost. Mutual funds can charge up to 5%, sometimes more, in commissions. Distributors receive these fees ostensibly for providing advice. Perhaps, but if so, why are the fees charged by the funds and rebated to the distributors and not paid directly by clients to their bank. By accepting payment from the fund manager instead of the investor, distributors work for the fund manager, not the investor. How about sophisticated investors who do not require advice but are faced with subscription commissions wherever they turn? In a low yield environment even a 1% commission can eat up 3 months’ worth of gross returns.

 

b. High management fees. Mutual funds charge different clients different fees. Institutional clients pay half of what retail clients pay, sometimes even less. The primary reason for the difference is that retail funds' fees have to be shared with distributors such as banks and IFAs in what are called trailer fees. A fund charging 1.5% per annum will pay its distributor 0.75% per annum on the assets raised. Fortunately there are some banks who eschew this practice and either invest their clients’ money in institutional share classes, which incur much lower fees, or rebate any trailer fees they get on to their clients. In certain markets like the UK, it has become illegal to pay trailer fees to distributors. In Asia trailer fees are the norm.

 

c. Opaque fee structures and conflicts of interest of distributors. The payment of trailer fees to distributors creates a conflict of interest. Distributors have a strong incentive to sell funds with high trailer fees or commissions. Whereas fund distributors claim to represent the interests of their investors they are in fact being paid by the fund managers. Low volatility funds often also have low expected returns and fund managers scale their management fees accordingly. Since trailer fees are usually a cut of management fees distributors prefer to sell investors high risk, high returning funds which charge high fees to low volatility funds. Investors are allowed to believe that their banks are working for them when in fact they are working for the fund managers as their distributors.

 

2. Underperformance of benchmarks is addressed below under “When ETFs are more effective.”

 

3. Mutual funds are aggregation vehicles when it comes to market systemic risk. As more capital comes to be controlled by fewer independent decision makers, systemic risks are raised. CLOs and CDOs dominated the demand for loans and bonds in the years prior to the 2008 crisis.

 

a. The size of a fund should be seen in the context of its market. A fund which represents too large a proportion of total trading or total holdings in a particular market is risky from a liquidity aspect.

 

b. The aggregate size of mutual funds as a percentage of total market size is another risk factor since mutual fund managers and their investors are likely to behave similarly.

 

 

There are a number of reasons for investors to invest in investment funds.

 

1. They are a practical and convenient tool and component to deploy a diversified global portfolio. Regional, country, sector and asset class funds allow the investor to construct a portfolio to their own requirements.


2. Investment funds offer a diversified portfolio within a defined investment objective. Funds diversify the idiosyncratic risk while retaining the thematic risk so a single security or issuer cannot derail a sound thematic investment strategy.


3. Outsource investment strategy to experts in their particular fields. Funds allow investors to delegate investment strategy to professionals of a particular focus and specialization.


4. Related to point 2 above is divisibility. Some securities can only be traded in large values. If an investor’s portfolio is too small it may be impossible to invest in such securities or to invest in such securities with sufficient diversification.


5. Access. Certain instruments and markets are not easily accessed by retail investors. Catastrophe bonds, asset backed securities, structured credit, freight futures, commodity derivatives, etc are examples of instruments which are traded by institutional investors and not retail investors but which can be accessed through funds.

 

 

When Exchange Traded Funds Are More Effective.

 

1. One of the criticisms of mutual funds is costs. Mutual fund managers charge annual management fees, and some even charge performance fees. In order for a manager to return the same as their benchmark on a net basis, they must outperform their benchmarks by the quantum of their fees on a gross basis. Empirical evidence suggests that on average, mutual fund managers are unable to compensate for the fee drag. An exchange traded fund or ETF may be the solution to the fee problem. Due to scale and the mechanical nature of the portfolio construction ETFs charge very low fees. In some cases, the index replication strategies are sufficiently clever that they even recoup the little transaction, administration and custody expenses incurred by the fund.

 

2. Highly efficient markets are difficult to outperform. The US equity market is a good example where very few active managers outperform the index. In such markets, an ETF is more efficient.

 

3. Highly liquid and efficient markets are easier to replicate in an ETF. In illiquid markets.

 

4. ETFs can be traded at any time during the trading day. Mutual funds are typically traded at the NAV at the close of the day. Some mutual funds have poorer redemption liquidity which may be weekly or monthly.

 

5. The cost in trading ETFs is normal trading commissions which have seen significant compression over the years. Mutual funds can and often do involve paying a hefty up front commission to the distributor of the funds. Commissions can be as high as 5% or higher in certain markets.

 

 

When Mutual Funds Are More Effective.

 

1. There are some markets which are simply not tracked by indices or ETFs. An example is the non-agency MBS market. While there are a number of large and well known MBS (mortgage backed security) ETFs these invest entirely in agency mortgages. The non-agency MBS market is simply not represented by any ETF.

 

2. There are some funds which have a theme or strategy that is not represented by any index or ETF. Hedge Fund Research, an index compilation company has compiled investable indices called HFRX so that even hedge fund strategies are replicable and can be accessed through an ETF but there remain some areas which ETFs have not reached. ETF providers are, however, trying to complete their shelf and are constantly evolving new strategies.

 

3. On average, by definition, mutual funds make a gross return equal to their benchmarks, which after fees and expenses, is below the benchmark. There are, however, mutual funds whose managers consistently outperform their benchmarks. The incidence of these managers is in part determined by the efficiency of the market. More efficient markets like US equities, are more difficult to outperform. Less liquid and less efficient markets enable active management and outperformance. They also enable underperformance.

 

 

Bottom Line:

 

1. As with all things investors should know the product at least as well, if not better than, their advisors.

 

2. Regulators should address the conflicts of interest in how mutual funds are offered to end investors. Regulation in the UK for example has been enacted to address the trailer fee issue.

 

3. Investors should be aware not just of the fees, costs and expenses in fund investing but of who are the beneficiaries of these fees, costs and expenses so that a judgment can be made as to the quality of advice they obtain from the various parties.

 

4. There are circumstances under which actively managed mutual funds can be used and circumstances under which ETFs should be used. One is not always and everywhere superior to the other.

 

 

 

 

 

Last Updated on Thursday, 18 June 2015 23:55
 
FOMC Meeting This Week. What To Expect. The Fed Wants To Raise Rates. PDF Print E-mail
Written by Burnham Banks   
Monday, 15 June 2015 06:15

Since the last FOMC meeting in April, economic data have improved. Most recently US payrolls and average hourly earnings have picked up and retail sales have rebounded. Only inflationary pressures have been conspicuously missing. Yet inflation is but one consideration for the Fed. As rescuer of last resort to the economy and the financial system the Fed is now about 7 years into a recovery with all its emergency bail out policies fully deployed. It needs to reset some of these tools in case of another financial or economic crisis. Granted, it also has to do this without precipitating a financial or economic crisis.

The bottom line is that the Fed wants to raise rates. It may not be able to. It has already signalled that it wants to raise rates and it that the path of rate hikes will be gradual. We can see why, the incremental interest expense to each 25 basis point hike (assuming it flows through the rest of the term structure uniformly) will be of the order of tens of billions of USD per annum, not large but not insignificant either.

The Fed has prepared the market for a rate hike for some time and the focus and attention on the next rate hike suggests that the market is prepared for it. What the market may not be prepared for is further delays which could signal a weaker economy than previously thought.

 

Last Updated on Monday, 15 June 2015 08:02
 
RMB Internationalization and Inclusion in SDR. Implications For US Treasuries. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 09 June 2015 06:26

There is some concern that with the internationalization of the RMB and its eventual inclusion in the SDR, that China's demand for USD and US treasuries will fall. There may be other reasons why China's demand for USD and US treasuries may fall but the SDR inclusion and RMB internationalization is not a primary concern. China's decision to hold USD and US treasuries is not determined by the RMBs reserve status. As far as China is concerned, the RMB has reserve status since this is China's own sovereign currency.

A tighter trade surplus may result in lower demand for treasuries.

 
Greece Needs To Exit The Euro For Its Own Good. PDF Print E-mail
Written by Burnham Banks   
Monday, 08 June 2015 05:21

For there to be reform one has to quantify the problem. Under any form of bail out or support, the size of the problem is hidden. That Greece is in the Euro is already an impediment to price discovery and the quantification of the problem. The Greek economy needs to discover its marginal product for all factors and inputs. Inclusion in the Euro means that locally sticky prices perpetuate misallocation and mispricing. Since some prices will always be locally sticky, it is necessary to have an external adjustment. A Drachma is the additional degree of freedom the Greek economy requires. Under a freely floating Drachma, and there will certainly be volatility, the Greeks will be able to determine efficient factor prices, tax rates and calibrate their pensions and social security accordingly.

The immediate levels may not be palatable to the Greeks, especially in the short run, but the alternative, keeping the Euro and inefficient price discovery only leads to failure of Greek markets for inputs and outputs to clear. And this is a long term problem with recurring symptoms.

 

Last Updated on Monday, 15 June 2015 06:35
 
Off Topic: Cancer A Sign Of Resilience Of The Species? PDF Print E-mail
Written by Burnham Banks   
Tuesday, 26 May 2015 09:27

Increased incidence of cancer can be indicative of the improved resilience of the human species. The environment constantly evolves in uncertain ways. To adapt to the constantly evolving environment, a species needs to also evolve. Increased mutation is equivalent to increased evolution. Unfortunately, with increased mutation comes increased negative mutation, leading to cancers. The propensity to mutate is collectively positive for the species but individually negative for a particular member of the species. Positive mutations may go unnoticed or unreported whereas negative mutations naturally draw attention as treatments are sought.

Is it possible that some cancers are in fact an early evolutionary phenomenon which left untreated could lead to a discontinuous evolution of the species?

 
Private Banking Industry In Asia 2015. Identity Crisis. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 26 May 2015 08:27

With regulation like Basel III, Dodd-Frank and other local regulations it is no wonder that banks are turning to asset management and private banking to generate fee income. The wealth generation in Asia has caught the attention of the private banking industry and many banks are investing heavily in building and growing their Asian businesses. The Asian private banking scene is an interesting one. The trust between clients and banks has been tenuous and it has been difficult to scale businesses profitably.


Principal Agent Model: Brokers, not fiduciaries.


The single most important question for a private bank is one of identity. An organization behaves the way it does because of the what it is; it cannot act against its nature. Arguably, most so-called private banks in Asia are in fact brokerages. Fee paying AUM is in low single digit percentages of total AUM. Their relationship with their clients is defined by earning commissions or transaction fees, receiving retrocessions from product providers, and providing leverage. Private bank investment research is provided for free and in return clients are encouraged to transact and thus pay commissions. Where managed products such as funds are concerned, in addition to charging the client commissions, private banks are paid trailer fees or retrocessions by product providers. For example. the distributing bank typically takes half of the management fees from the mutual fund manager for distributing their products to their clients. Transaction fees encourage activity and can lead to advisors churning their clients assets. Trailer fees lead private banks to represent the interests of the fund managers above those of their clients.

 

In discretionary and advisory portfolio management services, clients pay private banks to manage or advise on their assets. They pay an annual management or advisory fee regardless of the activity of the account. Private banks then buy the cheapest available versions of each particular investment instrument, or if trailer fees are collected, rebate these to the clients. Commissions and activity are transparent to clients. Private banks operating under this model are aligned with the client because the client is their paymaster and as a result the banks are contractually bound to represent the client above all other parties.


In Asia, discretionary and advisory assets are in the acute minority. Asian clients are reluctant to pay fees for discretionary management or advice preferring to retain control over their investments. Trust has been difficult to build in the aftermath of 2008 when products and funds sold by private banks either incurred substantial losses or restricted liquidity. Also, the dearth of international and cross asset / cross market expertise among private bank advisory staff does not instill confidence. Asian HNWs are also likely to be first or second generation wealth and actively managing their operating businesses. The returns on equity on their operating businesses far exceed what they can reasonably expect to earn in a private wealth portfolio. Clients do not yet understand that the route to a multiple of return on capital can only be purchased with a significant probability of catastrophic loss of principal. Operating businesses take time, effort and risk to build. When the time taken to generate the return multiple is taken into consideration, internal rates of return might not be that attractive. Additionally, when the risks are factored in, the risk reward may not be that attractive either. Private banking clients are the ex post successful sample, the ex post unsuccessful sample falling away and not being counted. The return and risk targets of a wealth preservation portfolio are far more conservative and the diligence and complexity of investment strategies are directed at risk mitigation rather than unfettered returns generation. Remarkably, few clients see the contradiction in leveraging up such portfolios with full recourse credit lines provided by the same private banks. The private banks clearly do not. The return on assets from the bank’s fees perspective make this a reasonably attractive business, especially if there is recourse to the client as well as to the assets.

 


Private Banks to do list:

  • Decide on their identity, if they are brokers or fiduciaries.
  • Private banks who want to be brokers are not purveyors of advice or investment management; they are purveyors of market access and transaction capability. They need scale and volume and they should recognize margin compression as a reality and an eventuality. The resources they require are very different. Brokers can survive on far fewer human resources than fiduciaries. Technology resources for brokers are also different than for fiduciaries and can and should be used to replace human resources. Brokers are more capital intensive, have lower overheads, slimmer margins, more volatility of cash flows and need scale.
  • Private banks who want to be fiduciaries seek stability and predictability of fee income and better margins. Overheads, however, will be higher as technology solutions cannot be deployed to replace costly human resources. Fiduciaries are not purveyors of transaction capabilities but of advice and investment management. Fiduciaries need to invest in experienced and expert advisors and relationship managers. Fiduciaries are less capital intensive, have higher overheads, better margins, less volatility of cash flows and do not require scale.
  • If any universal banks attempt to do both it is best that both businesses are run separately with Chinese Walls. There are no synergies to be had here, only potential for conflict and revenue cannibalization.

Clients to do list:

  • Diversify between brokers and fiduciaries. Decide on the proportion of assets they wish to allocate to active self-directed management, that is to their broker, and what proportion they wish to allocate to a discretionary manager.
  • Select a broker with the lowest all in cost, the best market access and good reporting.
  • Select a fiduciary with the best investment management talent, operational integrity, risk reporting and client service.
  • Resist the temptation to replicate the fiduciary portfolio at the brokerage. On the one hand this cheapens the fiduciary service but at the same time it concentrates the risk and dilutes the diversification benefit.

Last Updated on Monday, 15 June 2015 06:36
 
FX Rate Fixing. Banks Fined. A Clarification. PDF Print E-mail
Written by Burnham Banks   
Friday, 22 May 2015 01:11

The rights and obligations of principal and agent need to be properly defined, particularly in complex business like banking and finance. Five banks have recently been fined $5.5 billion over a rate manipulation scheme that has seen them not act in their clients’ best interest.

A bank should be clear about whether it trades as principal or agent when it transacts with a client. If as principal, the rules of disclosure may be relaxed. If as agent the rules of disclosure are clear: the client must be made aware of the detailed economics of the trade including the commissions, costs and expenses. The concept of markup pricing is incompatible with an agency trade. In fact, not only the quantum but the beneficial recipients of commissions, costs and expenses should be transparent, so that there is no ambiguity as to the interests of the agents and their delegates or associates. For principal trades, the client needs only know the all in cost of the transaction. Margins and markups, and their beneficial recipients are irrelevant.

This transforms the issue from one of transparency of pricing to one of the distinction and separation of principal or agent relationships. Client’s may want to choose whether the bank they trade with is trading as principal or agent. If there is no liquidity, it may be preferable to do a principal trade since the bank makes market. If there is ample liquidity, an agency trade may be preferable as pricing is transparent. What is required is a Chinese Wall between the principal desk and the agency desk. If a client chooses to call the agency desk, they receive full transparency but have to live with the liquidity available. If they choose the principal desk, they are aware that the bank is trading as principal and does not in any way guarantee best execution but the bank must guarantee execution.

 

Incidentally, the complaint against the banks was not that they did not act in the best interest of clients, but that they colluded to create a false market, or lack thereof, and distort prices. In a fair market, even if all transactions were principal ones, clients would have obtained price discovery by shopping around.

 

The current convention is one where banks trade as principal and therefore, rightly should have no obligation to provide transparency of pricing or best execution. When trading as principal the bank acts in its own best interests, not that of its so-called clients. The clients of the bank, when entering a principal trade become counterparties for the purposes and duration of the trade, and counterparties are owed a different set of obligations than clients or customers. The possible source of confusion is that clients are unaware or unaware of the implications of being in a principal trade. They may be under the impression that the bank acts in any way in their interests, a clearly mistaken assumption. The fault of the banks, if any, is to perpetuate the myth, actively or passively, that they in fact act in clients’ best interests. Where there is a fiduciary responsibility to do so, the law compels them to act in the best interests of their clients but where there is no such relationship, clients should beware.

 

Regulators can clear the situation by distinguishing between principal and agent transactions and setting out the standards of behavior in each relationship.

 

It would certainly be interesting to see, in a free market, which business, principal or agency, finds more custom and which is more vigorously supplied. Thin and thinning agency margins balance regulatory capital requirements needs to support principal businesses and only an unfettered market providing both alternatives will complete the market for these services. It is likely that with clarity and the clear distinction between business lines, new entrants and innovation will lead to more efficient markets less prone to abuse.

 

 

 

 

 

 

 

 

 

 

Last Updated on Friday, 22 May 2015 01:25
 
China's QE Lite. PSL, MLF, SLF a.k.a LTRO, MRO PDF Print E-mail
Written by Burnham Banks   
Friday, 15 May 2015 00:33

China is initiating QE lite mimicking the ECB's LTRO programs. The objectives are clearly to lower borrowing costs for local governments, and to establish a liquid municipal bond market as part of a reorganization of the funding mechanism for local governments which until now had used opaque, off balance sheet, so-called Local Government Funding Vehicles (LGFVs). The opacity of LGFVs lead to uncertain priority of claim and difficulty in measuring systemic risks. The side effects of QE Lite will include expanding liquidity and bank lending through the eligibility of municipal bonds as collateral in PBOC repo operations.

The PBOC has effectively halted the creation of new LGFVs, is encouraging local governments and their creditors, mostly commercial banks, to exchange LGFV debt for municipal bonds. It is also encouraging private commercial banks to invest in municipal bonds which are eligible for repo and thus provide a nexus between the PBOC and local governments.

Initial efforts have been clumsy due to the inexperience of the parties, the banks, the local governments and the PBOC. For the strategy to work, the banks have to be de facto guaranteed a return on capital exceeding borrowing costs for buying the muni bonds.

1. The bonds have to offer sufficient yield over the repo rate and other competing investments consuming the same amount of capital. This would include treasuries.

2. The capital consumption, or the risk weight assigned to these municipal bonds has to be sufficiently low so that, returns notwithstanding, they consume little or no capital.

3. The collateral standards have to be sufficiently accommodative.

The above conditions have to be in place before any muni issuance takes place. The PBOC may need to bootstrap the process by communicating and educating the banks.

Next week, on May 18, the Jiangsu government will issue 52 billion RMB of bonds, 30.8 billion of which are refinancings. The bond issue was initially planned for Apr 23 but was postponed for lack of interest. We wish the Jiangsu government and the PBOC a healthy bid to cover.

 

 

 

 

Last Updated on Friday, 22 May 2015 01:24
 
A Simple China Growth Model. Implications For Hard or Soft Landing PDF Print E-mail
Written by Burnham Banks   
Tuesday, 12 May 2015 06:15

The Chinese economy generated about 10.4 trillion USD of nominal output in 2014, representing incremental nominal output of 680 billion USD, equivalent to 7.0% growth. If the Chinese economy continues to generate this same incremental nominal output of 679 billion USD this year and next, 2015 growth will be 6.54% and 2016 growth will be 6.14%. This naïve calculation provides one potential lower bound estimate for a safe landing for the Chinese economy, that is growth rates that would not trigger significant unemployment, deflation and social unrest. On this trajectory, China will have slowed to mature market rates of growth by 2030.

Incidentally, the Economist forecasts growth of 6.90% in 2015 and 6.80% in 2016.

 

Last Updated on Friday, 22 May 2015 01:23
 
China. PBOC Cuts Rates. Economy Slows. Constructive For Equity Markets and Risk Assets. PDF Print E-mail
Written by Burnham Banks   
Monday, 11 May 2015 01:32

The Chinese economy is clearly slowing down and the PBOC is reacting by providing stimulus to maintain a sustainable rate of growth. It needs to do this in a balanced way without undoing some of the credit market reforms that have been enacted in the last year. On Sunday, the PBOC announced a 0.25% cut to its benchmark 1 year lending rate (to 5.1%) and its benchmark 1year deposit rate (to 2.25%) while raising the deposit rate ceiling from 130% to 150%.

The PBOC is seeking to reduce borrowing costs and boost output while keeping asset bubbles from inflating, particularly in its real estate market, stock market and shadow banking system. The PBOC has a host of monetary policy tools at its disposal including the Standing Lend Facility, Medium-term Lending Facility and Pledged Supplementary Lending, analogous to the ECB’s MRO and LTRO open market operations. The PBOC said recently that there was no need for QE at this point and would rely on its open market operations.

The economy is slowing down but conditions are in place for stabilization and recovery.

That said, the PBOC will likely continue to operate expansionary policy while the economy rebalances towards more consumption and less exports and investment.

Conditions are supportive of equity and risk assets, however, the current volatility may persist a bit longer as the PBOC seeks to avoid a hyperbolic equity market bubble.

Credit market reforms have been enacted that will see greater market discipline. Expect increased defaults among smaller and non-systemic issuers, even among SOEs.

Last Updated on Monday, 11 May 2015 05:14
 
Euro Convergence Trade. Buy Spain, Italy and Portugal, Sell France and Germany PDF Print E-mail
Written by Burnham Banks   
Friday, 08 May 2015 05:00

Why would German bund yields fall to zero? Why would they not? ECB QE is a rescue operation. In a rescue operation, you don't buy the healthiest, you buy the weakest. Greece is not part of the rescue operation by the way, since it is probably to weak to save and on a battlefield you save the ones who have a realistic chance of survival. Why waste the morphine...

So with a bit of explicit risk sharing, some (12+8)%, and complete implicit risk sharing through TARGET 2, I would expect convergence of yields between peripheral Europe and core Europe. The trade to be done, and the trigger point was the SNB's decision to scrap the Euro cap, was to go long Italy, Spain and Portugal and short Germany and France. You could do it at the 10year or at the 30 years, if you were sufficiently inebriated, even 50 years in the case of Spain, but the buying protection on France and Germany would have cushioned the blow, and on the German leg, actually made some money, in the current sell off.

Anyhow it is time to double up on the convergence trade, writing protection on Italy, Spain and Portugal and buying protection on Germany and France. To do one leg without the other is not a good idea. The trade is not about the weight of QE money buying, its about the risk sharing which should tighten the spreads between the wides and the tights.

 

Last Updated on Friday, 08 May 2015 05:02
 
USD. Strength or Weakness PDF Print E-mail
Written by Burnham Banks   
Wednesday, 06 May 2015 03:29

Where will the USD go, up or down? We dealt with the possibility that the Fed would delay the rate hike and concluded that any resultant USD weakness would be temporary. As long as rate hikes were on the horizon, any USD weakness would be temporary. If a rate hike was ruled out indefinitely, then perhaps USD weakness would be more durable.

Assuming that the US economy continues on a low, stable, trend growth path, the USD would only see potential longer lasting weakness after the rate hike cycle was over. To rephrase, USD weakness is more likely to only follow after rate hikes, not before.

Last Updated on Wednesday, 06 May 2015 03:35
 
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