An investor is faced with two sets of information. The first regards the commercial performance of companies thus earnings and cash flow, returns on equity etc, and the second is price information, which tells them what other investors are making of this information.

What would the world look like, what would financial markets look like, if investors were denied the second set of information? That is, they would know all they could know about the commercial and operational performance of companies but when it came to stock prices, bond prices, credit spreads, FX, interest rates and commodity prices, the investor has no memory and only sees current prices. Under these conditions, what would financial markets look like?

The reason for contemplating these investment conditions is that historical price information tends to encourage herd mentality which can lead to bubbles. Deprived of historical price information, would investors still display herd mentality and create an environment of extreme valuation?

The deprivation of historical price data addresses only part of the problem. Without historical time series data, the investor is disabled from the emotional mechanisms which encourage chasing an asset. They do not see the price of an asset rising while they feel they have under-invested in it, they do not see other investors profiting from a situation which they are missing out on, and they are less inclined to form opinions about the short term future valuations of the asset based purely on price action (since earnings and cash flow are relatively stationary processes.) They are less likely to delay purchases, seeking technical corrections.

However, the investors’ own profit and loss history cannot be obscured and so the investor will still have a price related metric which could enable market timing and momentum driven behaviour. This somewhat dilutes the objective of encouraging an investor to inform their decisions based purely on current prices. Despite this dilution, the investor is protected from the influence of other investors’ behaviour transmitted through historical prices. The investor cannot be protected from the influence of their own historical decisions transmitted through their P/L.

There is an opportunity for Europe to lead as a template for a better balance between individual and collective interests.

Tax union.

• Creation of an EU tax authority which will set the Unified Tax Code.
• Member countries will have representation in the EU tax authority which will set a Tax Benchmark.
• Member countries which have tax rates below the benchmark will be required to collect a proportion of the gap and pay this to the EU tax authority. The proportion is set at 10% in the first year and rises by 10% each year with 100% of the gap collected and paid to the EU tax authority in year 10.
• Member countries which have tax rates above the benchmark will pay 10% of the gap, which they have already collected, to the EU tax authority. The proportion is set at 10% in the first year and rises by 10% each year with 100% of the gap collected and paid to the EU tax authority in year 10.
• The Unified Tax Code will apply to personal and corporate taxes, as well as to inheritance, capital gains, asset (property or land) and other taxes.
• The Unified Tax Code will apply to VAT.

Tax devolution.

• The tax union applies only to federal taxes. Local taxes will be devolved to local tax authorities.
• The EU tax authority will determine how taxes in countries which do not distinguish between local and federal taxes is allocated.
• The convergence rules apply only to federal taxes.

General principles on Tax.

• Corporation taxes should be encouraged to converge as soon as possible to avoid tax arbitrage.
• Personal income taxes should be made more progressive with the introduction of new tax bands to cater to ultra-high incomes.
• Since tax rates will be made converge, double taxation treaties within the union and the concept of global taxation are academic. However, since the tax code is regional and not global, ex-union tax liability will have to be legislated for.

Sovereign wealth fund.

The European Union would establish a sovereign wealth fund. Unification of assets cannot be immediate so the concept of sub-funds or cells should be implemented initially.

The establishment of a sovereign wealth fund is part of a bigger effort to better define the balance sheet, the assets and liabilities of a country. It also allows countries to tranche their liabilities so that they can optimize their funding and provide investors with different investment opportunities in different claims.

All state assets should be contributed to the sovereign wealth fund so that they appear with full transparency on the fund’s balance sheet.

Each member has a sub fund, and each sub fund has its own assets and liabilities. Each sub fund will have its own credit rating and will generally face its own funding conditions.

The Union’s sub fund will house the common assets of the Union.

There is legal separation between sub funds so that the assets and liabilities of the sub funds are not commingled.

Budget union.

The state should only provide those goods and services which the market is unable or unwilling to do so. The federal budget should be parsimonious.

Budget union is not an explicit objective. Member states still collect their own local and federal taxes. Only gap payments are collected by the EU tax authority which funds the sovereign wealth fund. However, since the Unified Tax Code encourages tax convergence, any guidance towards a balanced budget or at least tendencies or limits towards budget balance will encourage budget convergence.

Budget limits.

Budget guidance will be given, perhaps, re stating the Maastricht conditions. Budget discipline will be imposed through the creation of the sovereign wealth fund since a profligate member will find its unsecured funding costs rising. If it turns to secured lending, it is no longer able to ignore claims on its assets since its sovereign wealth fund, the repository of its assets, will be subject to EU insolvency law, such law to be refined as necessary to be relevant to a sovereign wealth fund. A delinquent borrower may find its national monuments, utilities and other assets foreclosed upon.

Social security.

Social security should be harmonized. One element shall be a compulsory defined contribution pension scheme which will be funded by contributions from income as well as an employer contribution. Another element will be a social insurance scheme funded by tax.

The pension assets will be under substantial control by the workers so that no one need fund their sovereign or indeed any other member country if they do not feel so inclined. Assets will be held in custody and not on the balance sheet of the scheme. This is to prevent any de facto expropriations.

The social insurance scheme will be funded by taxation and is a general commingled pool.

To avoid benefits arbitrage, pay in rates and pay out rates will be harmonized.

Labour and individual mobility.

Labour mobility is a good thing but has to be managed. Immigrants need to be able to find jobs and fund themselves. They need to be accretive to the welfare of the host country both financially and socially. Immigration should be encouraged to fill jobs where there is a shortage of labour.

To discourage benefits arbitrage, benefits should be harmonized between member countries. Immigrants should draw on the home benefits system for before they can draw on the benefits system of the host country. In year 1, an immigrant shall be entitled to a quarter of the host country’s benefits and three quarters of their home country’s benefits, the host country entitlement rising and the home country entitlement falling by a quarter each year so that full transition takes 4 years.

Certain questions should be addressed regarding immigration:

• Are there sufficient suitable jobs? What is the impact on incumbents’ employment prospects? What is the impact on prospective employers?
• Is the immigrant accretive to the economy and society?
• Are there sufficient resources?
• Is there enough space?
• Are the cultures compatible and will the immigrant integrate into existing society
• Is the immigrant a refugee and what special conditions apply?

Settling in the EU:

Strict entry requirements apply. The above issues should be addressed in assessing eligibility.

Movement within the EU:

EU member country citizens should be accorded freedom to move and settle anywhere within the EU, however, movement should no longer be unmonitored. All movements across member countries’ borders whether by citizens or tourists should be monitored and recorded. Citizens or tourists should not normally be refused passage across borders.

How does one put an economy in order? An economy is like a business, but it is a lot more complex, with more stakeholders. Still, a business in distress is a good starting point to try to find a way out.  

Let’s look at a generic economy with

• Large quantity of public debt
• Slow economic growth
• A global recession and thus a sluggish external sector
• Persistent unemployment
• Shrinking private debt
• Stagnant housing market
• Independent central bank
• A non partisan government (for simplicity)
• Strong intellectual property capabilities.
• The country’s currency is the de facto global reserve currency.

What are the problems we seek to solve?

• Lower unemployment
• Raise economic growth
• Pay down public debt

Let us clarify the problem somewhat.

• Government deficits are rising as the government attempts fiscal reflation, for example through tax cuts and the limited provision of such public goods as healthcare.
• The central bank has so far been able to monetize government debt so as to keep interest rates low. The private sector has sterilized most of the monetary expansion. That said, the size of the monetary base presents a precarious position for the central bank in terms of price stability. The internal and external purchasing power of the currency may be questioned.

An initial solution:

• The government should raise as much long term debt as it can and quickly. It needs to remove all refinancing risk for the next 5 to 7 years. Once it has fixed its borrowing costs for a sufficiently long period into the future, it will no longer face the discipline of the bond market. It does not face this discipline today, but it may in future. It needs to lock in financing while it pursues unconventional fiscal policy (as opposed to unconventional monetary policy, which was required to bootstrap the unconventionally fiscal policy in the first place.)
• Operate an open door policy for business and capital. This may be unpopular and expensive at first. Expensive: It involves cutting marginal income tax rates and corporate tax. This may create a larger deficit in the short term but the tax elasticity of domicile will reverse the deficit given more time. This strategy is proven but it takes resolve as the initial finances deteriorate. Unpopular: Tax reform has to be designed to attract foreign capital and talent. This is a beggar-thy-neighbor policy which will be unpopular with trading partners and other countries as well as with incumbent residents who may see a deterioration of wealth and income equality. The current situation sees major economies competitively pushing capital and human resources away, counter to the more rational strategy of attracting capital and human resources.

A longer term solution:

• A government should only provide goods and services which the free market is unable or unwilling to provide. This defines the scope and scale of government, not political ideology. Shrink the government to fit. Ideally, taxes will be kept low. This is a mathematically sound approach but it does leave open the question about the use of taxation as a redistributive policy. We have noted before that the free market tends to increase the level of inequality in the system. This is outside the scope of this discussion.
• Address the major areas of moral hazard in the economy. Central banks and regulators should be responsible for the long term stability and sustainability of the financial system, to promote efficient allocation of resources, to promote full employment and most of all, to ensure a level playing field for all participants. Long term stability sometimes requires short term volatility to condition participants to the risks of participation. Efficient resource allocation requires minimum price distortion which will also require central banks to reexamine their role in the determination of interest rates, arguably the most important price of all.
• Economic reform in labour markets, particular industries, professions, banking and finance, public goods, etc etc are all well and good, but lets not be too ambitious. It is far from clear that we will even get to the initial solution let alone the longer term solution.
• A reexamination of the capitalist system of economics. Since the death of communism, capitalism has spiraled out of control without a nemesis or counterbalance. This economic soul searching can be pre-emptive or it can wait until a sufficient proportion of the global population is sufficiently disenfranchised by the particular distributive nature and inequality of wealth, income and opportunity of the current capitalist system.

Looking at how we have progressed thus far, some countries still have the means to refinance themselves sufficiently far into the future to employ the above strategy. Others do not. For these, the future is grim. Where countries have been given time and the benefit of the doubt by the capital markets, the time to act is decaying quickly.

My wife just showed me her mutual fund statements and reports which she received from the manager. After 15 years, this much vaunted fund manager had generated a nominal return of… zero.

After inflation, living in Singapore, her investment wouldn’t be able to buy a bicycle let alone pay the downpayment on a retirement home in Southern Malaysia.

I also noticed that there had been a forced redemption. The manager had shut down one of their funds. Well, thanks. So after a decade of managing her money, the manager finally decided that they were not very good at it after all, and decided to hand the money back to her. “Here, you manage it,” is not really acceptable after you’ve taken a decade of fees off the investor.

Why did my wife invest in the fund? Well, she didn’t. In my earlier days, and in my folly, I decided to give her a birthday present which was not something she could carry, wear, eat or ride around in. So I bought her units in a mutual fund. Romantically, this is equivalent to shooting oneself in the temple. Twice.

I do invest in funds. I think its the smart thing to do, if you do it in a smart way. I don’t just invest in brand names. When it comes to fund managers, brand names are often asset gatherers who are better at getting your money than they are at managing it. I avoid brand names unless I can meet and interview the specific managers managing the relevant funds. Meeting and interviewing the managers is a necessary condition for me to invest with any fund. I need to assess for myself if the track record they have achieved is the product of skill or luck. I will only pay management (and or performance fees) for skill.

I invest in funds for a number of reasons.

– I can’t get the diversification I need for the amount I’d like to invest. Funds pool investors’ money into a bigger pot which can be deployed in assets which the hapless retail investor may not have the scale to access.

– I don’t have the time to dedicate to a particular strategy. I only have 24 hrs a day. I cannot engage in arbing interest rates, hedging converts, investing in mergers, trading credit correlation and structuring reg cap relief solutions all by myself.

– I may not have sufficient skill. This will most often be the case. Understanding an investment strategy and being able to execute it with the requisite skill are two different matters. If one doesn’t understand a strategy, the best advice is to not invest. It is irrational to invest in any scheme or strategy that one doesn’t understand. On the other hand, just because you understand a strategy doesn’t mean you can do it. It just means you know how its done. That’s all.

– I don’t have the scale for certain strategies. Not every day trader in his basement can obtain the necessary terms to trade the instruments that a strategy may require.

What I never do is invest in funds for silly reasons such as:

– A good track record. A good track record is never enough. One needs to understand how the track record was achieved, and if it can be repeated. One also has to know if the track record is real. Bernie Madoff had an excellent but fake track record. Yet so many clever investors invested with him.

– A clever trade. A clever trade does not a fund make. There are specialized closed ended private equity funds that take advantage of very specific opportunities but open ended mutual funds need to be based on more than a single opportunity. And I’m fine with those, in fact I think they are very interesting vehicles that are often launched to capture phenomenal opportunities. It worries me when managers launch funds to take advantage of the recovery post 2008. What happens when the trade is done? The manager is typically unwilling to return capital and will likely try their luck in another trade, one that you didn’t sign up for, one that the manager may not be experienced at. I want strategies that can last at least 7-8 yrs, because that’s how long, at least, I expect to leave my money in their hands.

– The market is running and I want exposure. If you want market returns, use an ETF, or buy the underlying instruments yourself. Funds are not cheap. You shouldn’t be using them as trading vehicles but as long term investments. If you want exposure to a particular segment of the market and no ETFs are available, using funds is a legitimate way of buying exposure. Luxury goods companies for example are not represented by an ETF and can be accessed through a fund.

– A brand name. A brand name is not a bad thing but it shouldn’t be the only thing, and the brand should add no additional comfort. Each fund must be assessed on its merits and this means due diligence. I have never given my trust freely, and I certainly don’t give it to brand names per se. Trust has to be earned, and it takes time. Brands are often good from a due diligence perspective, however, since they provide the basis for the question: how did they build a successful brand? Usually, a high quality product or service is the answer. Due diligence seeks to confirm and verify the answer. There are no assumptions in due diligence, or at least there are very few. I have very strong views about due diligence and how it is to be conducted. You have to identify the manager, meet the manager, his team, his ops, his service providers, speak to them about what they do. Cutting and pasting an AIMA DDQ into the file is a gross dereliction of duty, and something I’ve seen done even by institutional investors. It is for these types of investors that funds like Madoff were designed.

– I don’t know the strategy well and I want to outsource it to a professional. This is an excellent way to lose money. If you don’t know the strategy well, how do you know whom to outsource it to? If one doesn’t know a strategy well, the first and best course of action is to learn all about it. The second best and quite frankly lazy course of inaction is to stay away.

Investing is not easy. Whether one invests in funds or directly in securities, one is responsible for one’s own decisions. Using consultants is one way of delegating the research and due diligence but it means one has to research and perform due diligence on the consultant or intermediary.

The problems in Europe lie in plain sight. It is likely that the ECB will eventually print money to monetize European sovereign debt, albeit at the eleventh hour, on the eve of some pan European bank threatening not to open for business one winter’s morning. The debt problems in the US are also pretty evident. Every US Treasury is now a PIK.  India’s rupee has recently been sold down as public finances deteriorate. For real trouble one has to look at China.

The mild recovery in past couple of months in the US has come through exports of capital goods to the resource rich countries to its North and South who have in turn been feeding the building boom in China. This is at risk of coming to a quick end.

So far, with over 9% GDP growth and a slowdown in inflation, China seems to be heading for a soft landing. With official statistics hard to come by and methods of data collection and cleaning unclear, it is difficult to rely on hard numbers. Instead we turn to anecdotal evidence of a credit crunch in no small part engineered by the government itself.

The confluence of fiscal expansion through infrastructure investment, credit creation through off balance sheet vehicles akin to the SIV, as well as debt monetization in the West most notably the Fed, has created inflation in China. Headline numbers of just under 6% hide food price inflation numbers of nearly 12%, a price paid most by the poor and less by the rich. Asset price inflation further increases the rich poor divide as the cost of shelter has surged.

Inflation is a politically charged issue and so while the government fine tunes policy by reducing reserve requirements for selected commercial banks, a general easing is not viable.

As the government has restricted credit creation it has not only starved companies of access to mainstream credit, it has also created an informal and thus unpoliced shadow banking system of significant size. The SIV like LGFVs and trust companies which have been deployed in financing local government infrastructure projects number over 10,000 and are estimated to be over 2 trillion USD in size. Worryingly the senior liabilities are duration mismatched through short term retail products. Current estimates of bank exposure to the LGFVs exclude backstop facilities. Indeed information is sparse as to the existence and identity of a backstop lender. Ultimately of course it will be the central government.

Exports from China have slowed. In 2008 there was a sharp singular lurch in exports as trade finance was suddenly withdrawn as the international banking system went into temporary cardiac arrest. Exports subsequently resumed but by then a weakening USD and a higher savings rate in Western economies have capped China’s export growth.

A similar risk exists today. The slowdown in Europe and the tepid growth in the US, coupled with an increased savings rate must dampen demand for Chinese exports. However, this is a continuous and orderly process.

The European sovereign crisis is now impacting European banks’ ability to provide trade finance, an area where they typically dominate. A shortage of USD in the European banking system is leading European banks especially the French banks to cut down the size of their USD assets as funding in USD becomes more expensive. US banks are reported to be stepping in to this market but they remain similarly capital constrained. A credit crunch in trade finance is likely to take a heavy toll on an export driven economy like China and will be a drag on its foreign exchange reserves.

Most of all China needs to print good numbers in growth, inflation, employment and trade. Why? Because the financial strength of any country is highly dependent on the confidence that its creditors have in it. China’s debt to GDP ratio is hard to determine and various sources cite numbers from 17% to 160%. Opacity is the enemy of confidence.

The coming Chinese Lunar New Year will be especially important. Anecdotal evidence already points at unpaid wages and zombie companies. The residential rental markets have begun to show signs of weakness as foreign company reps have been repatriated amidst weak business growth. The Lunar New Year is when workers from the central regions return home from the industrial cities for their annual family reunion. The layoffs, if any, will occur then. Businesses will not want to bear repatriation charges, will not want irate ex employees picketing shop fronts and factories, and will count on laid-off employees not incurring travel expenses to the industrial cities to demonstrate or express their grievances.

In 2012 the National People’s Congress elects the next leader of the country so it can ill afford economic instability. While economic growth is important what is more important is inflation. And inflation in the rural areas is driven by food and agricultural products where inflation is running not at 5% but closer to 12%. Absent a credit fueled infrastructure binge, China may face low growth and high inflation (there is a word for that.) The politics of China are likely to push the government to be more vigilant on inflation than on growth.