Time stamping…

2013:

We began 2013 with a continuation of a long US and Europe equity stance, convinced that innovation and brands would trump cost savings. We were of the view also that main street would survive the follies of Capital Hill and Brussels et al. We were long, albeit a bit late, the Japan trade as a momentum trade. What we initially expected to be a medium term trade evolved as we saw domestic sentiment turn decidedly positive. We were of the view that China was headed for a very bumpy landing and that the Shadow Banking system posed a significant risk. The only major about term we did intra year was to call a buy on China in late July on the back of China instructing a system wide audit of the Shadow Banking system which in our view removed a considerable tail risk which was holding back an acutely cheap equity market.

In credit, we were long high yield in US and Europe, as part of a risk on trade, comfortable that economic growth, while recovering would not be sufficiently strong to warrant rising rates. We were negative investment grade and hard duration in USD. We were long of senior, secured, floating rate bank debt as a means to obtain credit exposure without duration risk. With the announcement of QE taper, our high yield positions suffered but our significant overweight in floating rate debt dampened volatility significantly. The delay of the taper provided us an exit from US high yield. In EUR high yield we remain resolutely overweight as Europe, while recovering, does not appear to be self sustaining.

We were long US housing specifically through non Agency RMBS.

In emerging markets, we were largely underweight (through the CDS), but were long of Russia, Venezuela and Mexico while being short of Indonesia, Philippines, Brazil, Turkey, South Africa and Ukraine. We got Venezuela quite wrong with a 600 basis point widening, but got Russia and Mexico right. The shorts all performed.

We were long USD and GBP and short JPY. We had no high conviction positions in other currencies.

2014:

Among our broad themes is bank regulation. We expect that the trend in increased regulation will not be slowed or reversed for the foreseeable future. The fragmentation of legislation will make it difficult to defeat whereas a single act such as Glass-Steagall was relatively easily repealed. Solvency 2, Basel 3, the Volcker Rule, the legion that is Dodd Frank, will entrench increased financial sector regulation. This will present opportunities for investors who are comfortable with illiquidity, to earn the illiquidity premium, and who are able to manage complexity.

Private credit strategies: Banks are being put in the difficult position of being expected to make more loans and take less risk. They are being asked to be more conservative with their capital. It appears that the fractional reserve banking system is being limited by a focus on depositor insurance which creates opportunities for private capital willing and able to circumvent the banks to match the duration of assets through direct funding and to pick up a liquidity premium. Mezzanine lending to corporates or to real estate and infrastructure will continue to see attractive returns. Fortunately, or unfortunately, depending on your point of view, capital will remain scarce as search costs are high. Private credit strategies are institutional strategies which private clients and retail will have limited access to for reasons of investor sophistication and liquidity preference.

Capital structure arbitrage: Efforts to reduce principal trading strategies at banks has already led to an exodus of talent into the Shadow Banking system, that is, to hedge funds and private equity and credit. Basel 3, the Volcker Rule, Dodd Frank are making proprietary trading extremely expensive and capital intensive for banks to maintain. As a result, banks are generally winding down or spinning out these activities. Mutual funds may invest across asset classes but they do so in segmented fashion with separate silos for equities, bonds and loans. Very few mutual funds invest across the capital stack within a single management team or a single fund. Thus, while markets may be efficient within asset classes, inefficiencies can persist across asset classes. Proprietary trading within banks used to police relative value and arbitrage across the capital stack but with the retrenchment of risk capital, arbitrage and relative value opportunities can now persist. Hedge funds which invest across the entire capital structure of companies are very interesting in this environment.

Emergency capital structures of banks: The financial crisis of 2008 led to the infusion of morphine or emergency capital structures across large swathes of the banking industry. With time the banks have been stabilized and economies are recovering. Basel 3 also treats certain parts of the capital stack differently and will result in some cheap equity becoming reclassified as expensive debt. Opportunities exist in providing bridge finance to balance sheet restructurings. The recapitalization of European banks post the Asset Quality Review and pre ECB regulation is an example of an opportunity to buy expensive capital (for the issuer) in expectation of the capital being retired. Other opportunities lie where emergency funding securities are on public balance sheets which politically may not be able to maintain these positions.

Back to traditional strategies:

The US economy continues to perform well. US growth equities are the natural trade expression. With QE tapering, which we expect, and consider a positive for equities, corporate high yield, agency MBS, REITs and high dividend equities are likely to see more volatility and or suffer, relative to outright equity exposure. We think that short rates will be maintained at zero for the next 3 years so the taper should steepen the curve rather than signal a rise in interest rates. This
should favor bank stocks. Floating rate bank debt is a natural source of credit exposure without duration, although there may be some volatility from curve steepening. The problem with floating rate debt is that if rates remain low while the curve steepens, coupons will not reset upwards while discount rates increase. This may limit the efficacy of loans as a duration hedge.

The European economy is recovering and is probably several paces behind the US. Corporate risk assets should continue to perform well. Given the inflation environment and the tepidity of the recovery, duration is less of a risk than in the US. Corporate high yield bonds provide equity exposure with a more senior claim.

We are more sanguine on China risk going into 2014. That said, the equity gains are likely to be off-index in the under represented consumer sectors away from SOEs, exporters and financials. We see the Party’s efforts at rebalancing as positive and effective.

The Japan equity trade continues. We initiated this with quite a lot of skepticism, designating it a short to medium term trade, however, upgrading it to a long term holding as we saw domestic sentiment take hold. We maintain this view going into 2014. We now regard the sentiment factor a more important one than all of Abe’s three arrows.

In emerging markets we are writing protection via CDS on Mexico, India and Brazil and we are buying protection on Indonesia, Philippines and Korea. We no longer have a position on Ukraine. Generally we are no longer short emerging markets and are taking a neutral stance. We still don’t like emerging market fundamentals but think that fundamentals are now largely in the price. Elsewhere we are short Canada 10 year bond futures and buying protection on France and writing protection on Spain and Italy.

Risks:

The most interesting strategies and trades come from our identification of risks.

One overriding risks that hangs over the global economy is the shrinkage of credit and the implications for trend growth. Less credit translates into slower growth. Human beings suffer from long memory effects and get used to and attached to comforts. There is significant risk that in a slower growth environment, people are less willing to share and cooperate. This has implications for world trade, despite recent progress in the Bali Package of the 9^th WTO conference. The risk of martial conflict is also increased. The visible risks are in the East and South China Seas, but generally, the propensity for conflict has risen globally, if human behavior is a guide. A broader conflict could arise between China and the US, with Japan as a catalyst. The theater may not be spatial but financial. China and Japan own 23% and 20% respectively of outstanding US government debt and strategic games can be played around financial objectives.

The EUR continues to prevent market clearing in European labor markets. While the ECB has addressed bank liquidity and soon will address solvency, the real risks lie in the real economy and the impact on society. Europe is stable for now and the foreseeable future, which may not be that far out. The age imbalance in the labour market is troubling and could be storing up problems for the future.

Income and wealth inequality is approaching acute levels. While inequality between nations has receded steadily, inequality within nations has increased almost everywhere from socialist to communist to capitalist economies. The triumph of the capitalist model has swept aside all competing systems leaving capitalism unchallenged and unfortunately, unchecked. Purity can only be maintained by continuing trial. Without communism, capitalism has been allowed to evolve in some rather un-capitalist ways. There are limits to inequality beyond which social issues arise.

An absence of a strong ideological compass is another risk that is apparent in the compromises that individuals and organizations are happy to make. This is especially apparent in the behavior of governments. Expediency is the new ideal which drives agent behavior. This can lead to the storing up of imbalances, inefficiencies and other problems for the future. Short term strategies in public policy are driven by electoral cycles. Short term corporate strategies are driven by myopic pandering to shareholders and analyst behavior as well as executive compensation.

The coagulation of the investment industry. Smaller investment funds are struggling to grow while larger asset managers are attracting more capital. More and more capital is being allocated by a smaller and smaller community of investment managers. This correlates the demand and supply for securities. The Gini Coefficient for each asset market has been rising post 2008. This is increasing the systemic risk in the global financial markets. The application of more universal rules, the adoption of more universal standards, the aggregation of more universal methodologies, and the concentration in more universal systems, increases the systemic risk in financial markets. It is hard to quantify this phenomenon.

The most dissatisfying thing about
this entire assessment is that it is so aligned with the industry consensus. In previous years, the analysis has been different and independent. Today, independent analysis has led to an almost total alignment with the investment industry’s consensus. This is dissatisfying and dangerous.

US monetary and fiscal policy 2014 – 2017.

I believe it is inevitable that QE tapering will happen. This is driven by the need to control the growth, and one day shrink, the Fed’s balance sheet which is currently at 4 trillion USD and growing. The dangers of maintaining a balance sheet of this size are high. Any pick up in the velocity of money could cause nominal output to surge and capacity may not be able to expand as quickly. That said a reverse repo facility may mitigate much of this risk by being able to remove excess liquidity from the system very quickly. The other risk is that an unconventional policy tool has now been used quite some time with limited impact on the real economy and the Fed needs somehow to reset at least one of its policy tools in case another crisis should follow. Since QE had limited impact on the real economy, it has had significant impact on asset prices, the impact on the real economy of its gradual withdrawal should be orderly. Based on these considerations, I would say the risk of QE tapering is moderate and acceptable and the Fed will do it fairly soon.

The market has erroneously linked short term interest rates to QE tapering. QE is an attempt to monetize debt and to control the mid and back end of the curve, not the front where the Fed already has good control. A number of things suggest that the Fed will maintain its low interest rate policy for another 3 years at least (that is into 2017.)

Now there has been some talk of optimal control theory which is of limited use. Control theory is a methodology and tells us little about the actual path of interest rates or the intentions of policy makers. What the rhetoric and the introduction of control theory do is to widen the spectrum of potential determinants of monetary policy beyond inflation and growth. The definition of the Loss Function can include everything from traditional measures such as inflation and growth, but can also include multiple objectives such as unemployment, distribution of wealth, and even softer targets.

Forward guidance is another new policy tool which has been added to Large Scale Asset Purchases. Again there is little content in forward guidance. With interest rates at their lower bound, and the Fed’s balance sheet at acutely inflated levels, it seems that new and innovative ways of controlling the mid to back end of the term structure need to be found, and that forward guidance is a ‘cheap’ way of achieving this as the costs and risks are low. There are non-financial costs and risks, however, as it requires that the Fed is fairly accurate with its forecasts, and that the Fed’s credibility can be maintained. Choice and judgment are crucial in a complex and leveraged system as optimal control solutions are not unique, they yield a continuum of solutions, and the probability is high for boom and bust trajectories. The widespread adoption of forward guidance among the world’s central banks is somewhat troubling. On the one hand, if realized state variables deviate sufficiently from forecasts, central banks may lose credibility and the efficacy of forward guidance may be impaired, and on the other, such loss of credibility may lead to a more structural decline in central banks as influencers in the economy which is possibly a positive outcome.

For unclear and unspecified reasons, forward guidance and optimal control seem to imply to the market low interest rates for the next 3 years. I agree with this conclusion but present a simpler, cynical and causal explanation for my expectation. The clues to this expectation come not from the US Federal Reserve but from the US Treasury. The introduction of Floating Rate Note (FRN) issuance by the US Treasury supports the view of low interest rates for longer. As a borrower, the US Treasury has to provide investors or lenders with terms which are favorable to them in order to attract their capital. Investors are duration risk averse and seek low duration instruments. The US Treasury would like to finance itself over a longer term without steepening the term structure, and with the US Fed moderating its asset purchases, such funding terms may not be achievable. Funding itself with FRNs is useful in that it provides the US Treasury with longer term financing while providing investors with a low duration investment. The typical coupon for an FRN resets every quarter to some fixed level over the 3 month USD LIBOR or some other similar benchmark. For the US Treasury to maintain a manageable debt service profile, the US Federal reserve has to maintain short interest rates at close to zero. This is a cheaper funding strategy than longer maturity fixed coupon issuance that has to be monetized by the Fed via LSAPs.

What are some of the implications?

Short term interest rates will be kept low for some 3 years or so. The rest of the term structure will be determined less by LSAP but by market forces. Longer maturity volatility will rise, and yield levels are very likely to rise as well.

Conditions conducive to carry trades will arise. This will favor banks and deposit taking institutions. Hedge funds may also capitalize on this.

Implications for highly leveraged companies are complicated. Capital intensive industries will struggle with ongoing funding. In the current period, bond buybacks are accretive, however, over the longer run, this encourages consolidation over growth. Share buybacks will be more expensive as well, so expect a slowdown in volumes.

Increased yields and yield volatility will have real economy impact. Increased yields will discourage issuance and at least make it more expensive to finance with longer dated debt. Businesses may choose to issue more floating rate debt. On the demand side, increased yield volatility will cause investors to demand higher rates of compensation.

It is difficult to guess where the yield curve will settle without central bank large scale asset purchases. One of the more damaging consequences of QE has been to impair the allocative and productive signaling properties of the yield curve.

Why is QE ineffective in reviving current demand and employment even as it drives up equity and high yield bond markets?

The massively expansionary monetary policies have yielded surprisingly low inflation while inflating asset prices across the globe. Bond yields have compressed and equity markets have surged in the past 5 years. Why is monetary policy ineffective at restoring normal levels of demand and employment? The answer is, because our specification of the set of prices over which monetary policy has domain is incomplete. Money can be spent on more things than just goods and services; it can be spent on claims on future goods and services. This is called saving, and saving is not consumption. A confluence of low interest rates, efforts to create inflation, expectations of high future inflation and efforts to flatten the term structure of interest rates have resulted in inflating the value of assets and not goods and services.

Under elevated inflation expectations, the rational response is to consume or to secure future consumption at today’s price levels, to hedge against inflation with an appropriate hedge. Short term cash is not useful in this respect as its value will be eroded if prices start to rise. Neither is it practical to raise current consumption without bound or consideration to future purchasing power. Services are not durable goods. Notice the recovery in automobiles and other consumer durables? Durables are current and future consumption. Equities and real estate are considered inflation hedges and investors have rushed to buy them. The diversion of capital from current consumption to future consumption in the form of equity or real estate ownership is a rational response in this context. The suppression of the term structure of interest rates also means a lower discount rate for future claims to goods and services, further supporting the equity asset class.

What could derail the equity market therefore includes lower inflation expectations or a steeper term structure.

We asked ourselves in mid March if equities and bonds were one correlated bet. If the above explanation for the strength of equities is valid, what might cause the equity market to lose its support? If the economy was truly strong, then the advent of QE tapering would recommend switching from high yield to equities. If not, and equities and bonds were a single bet then QE tapering could prove damaging for equities.

Under the same hypothesis, what would the government policy look like? Asset purchases across the term structure have not helped income and employment, so if the Fed comes to realize that the above behavioral thesis holds, then how is it to encourage consumption? A non interventionist approach would be to roll back QE and step away, but we see that this might adversely impact the equity market. The interventionist approach might be to tax and spend while maintaining a neutral budget (that is still in deficit but not more so). Taxing capital gains at higher and more progressive marginal rates would achieve this. The problem with more intervention is that it risks creating more distortions and perverse agent behavior.

Despite strong economic growth, Chinese equities have been derating over the past few years. There are technical reasons for the underperformance, mostly due to regulation and the nature of the investor base, which are mostly domestic retail investors.  Still, this does not explain the cheap valuations in offshore listings of Chinese companies.

The current structure of the Chinese economy is unbalanced with an over reliance on investment and exports. These features are not bad in and of themselves, however, when globalization is being slowed down or rolled back, when capital is scarce and when trade policy becomes more contentious, such over reliance becomes a weakness.

China is embarking on a rational if unpopular and short-term painful reorganization of its economy. Some of this reform is being forced upon it but it is in line with the long-term objectives of Chinese. Fortunately, China is in many respects still a centrally planned economy, the sovereign balance sheet is healthy, the workforce is diligent and productive, households are thrifty, and the urbanization cycle still has far to run. Standing against China is rampant corruption, domination of State Owned Enterprise in industry, and complexity of regulation and administration. These issues are currently being addressed by the government. Still, there is much left to do.

1. Urban and rural land reforms.

2. Environmental protection. Take a walk down any street in Beijing and see for yourself. Or not see, as the case may be.

3. Red tape and uncertainty of administration and regulation are a drag on growth as well as provide fertile ground for corruption. Administration needs to be simplified and trimmed down.

4. Reform of the Hukou system. It can be argued that the hukou or huji system limits labour mobility and thus efficiency in the labour market, among other things. It is also a highly discriminatory policy. Reform is not so easy as social and community issues need to be simultaneously addressed.

5. As part of a longer term plan, China will need to address its demographics. Policies such as the 1 child limit may need to be re-examined.

6. As China matures it will inevitably face heavier burdens on its welfare systems. Issues surrounding unemployment benefits, healthcare and pensions will need to be addressed.

7. Fiscal and taxation reforms will have to undertaken. Current systems are not only inefficient, they are not well-defined leading to much uncertainty, always a breeding ground for rent extraction and creative reporting/accounting.

8. A move towards full liberalization of markets and the abolition or moderation of price controls. This is particularly important in resource and energy markets.

9. Liberalization of the financial system, (interest and exchange rate reforms). Current price controls disrupt the signaling value of prices and oppress savers to the benefit of borrowers.

Not all of the above are issues specific to China. Indeed China has the luxury of being a few steps behind and learning from the experience of other countries. What is clear is that, not all of the above will be addressed, and even when they are, opposition will come from interest groups, however, change is at hand. If the crisis of 2008 was useful in one respect it was to shake the world out of its stupor. The West was over-consuming and over-borrowing while the emerging markets were happy to provide vendor financing to them in return for strong economic growth. It also challenged established wisdoms, though some fallacies survived unscathed. The danger is that only half the lesson is learnt.

China’s efforts to diversify its sources of growth are laudable. There will, however, be winners and losers, as in any reorganization and this makes Chinese asset markets a fertile ground for alpha generation through stock selection. An index or passive exposure strategy to investing in China will be less useful, perhaps even counterproductive. The index is replete with banks, big exporters and resources. Financial and resource sector reform will likely remove the crutch of state support for these sectors, causing them to underperform and drag the index with them. Exporters will face increased competition. Over time, the success of domestic and consumer stocks will gain them entry to the index. It pays to cast the search for tomorrow’s market leaders today among the small and mid caps and companies less covered by sell side research.

The world is witnessing renewed economic strength. Generally, fundamentals are strong(er), especially in the developed markets. Policy, however, remains nervous and uncertain and drives financial market volatility. Equities in the performing markets seem fully priced. Credit continues to perform in the face of potentially higher interest rates. What can we make of all this? Let’s do this back to front…

Implications:

Slower global growth means less cooperative counterparties. Expect more mercantilism, currency wars, and control of cross border movement of intellectual, financial and human capital. Reward national self sufficiency.

US short term interest rates likely to be pinned at close to zero for multiple years. The longer end will be driven by market expectations. Its reasonable to expect the USD curve to be steeper than EUR and GBP term structures on both growth and inflation expectations.

EM inflation is a problem; sovereign finances may add fuel to the fire. Expect EM term structures to underperform.

In the US, high yield and credit may continue to perform despite the QE taper talk. Growth is self sustaining but weaker than the market expects. Hold with high yield now. If QE taper becomes more probable, a switch to equities may be useful.

In Europe, high yield and credit are likely to continue to perform. Equities look cheap in aggregate but when controlled for quality, equities are fully priced. EUR denominated high yield, even of non Eurozone issuers, is attractive as credit is priced off the EUR curve which is likely to outperform.

Growth:

The global economy will face slower long-term potential growth compared with before 2008. Cyclically, the developed markets of the US, Europe and Japan are experiencing a recovery. Emerging markets are slowing down, albeit from higher rates of growth.

It appears that, overall, the fundamental economy is healthy and on its way to self sustaining growth. Over the longer term, emerging market growth must reasonably be expected to moderate as those economies mature.

Post 2008, a global rebalancing is underway, which is natural after every crisis. Whereas the late 1990’s saw emerging market crises which led them to repair their balance sheets, the most recent crisis was rooted in excessive debt in the developed markets. This has been met by efforts to manage the existing stock of debt, to provide relief to poorly underwritten credit, and to scale back indebtedness. Some of these efforts will be mutually confounding.

For the developed markets the rebalancing will involve a revival of manufacturing, a reorganization and reduction in private debt, a resurgence of exports as a driver of growth, and stricter regulation of the financial system. Emerging markets will have to rebalance their economies away from exports, this will be done for them by the developed markets anyway, towards a more consumption led engine of growth. This will tend to weaken emerging market private and public balance sheets.

Emerging markets, which weathered the 2008 crisis relatively well, now face a more difficult reality. The immediate impact of the credit crisis on emerging markets was a quick reversal in their balance of trade, due to the sudden dearth of trade finance, then due to the competitive devaluation of developed market currencies, re-shoring of manufacturing, and competitive intellectual property strategies. Emerging markets have had to operate equally loose monetary policy to support their export dependent economies. They have felt able to do so due to their generally strong foreign reserves and as falling interest rates have helped to offset weak developed market currencies. At the same time, emerging markets are being rebalanced toward more consumption led growth, almost by default, as developed markets become more export competitive.

Earnings:

In the US, the economic recovery there has probably achieved escape velocity. The innovation and efficiency of US companies is driving a sustainable, secular trend in earnings. The distribution of growth is, however, uneven. Capital remains expensive and debt, while cheap, is not widely available. Small and medium businesses rely on bank credit, which remains impaired. Companies with access to debt capital markets can fund cheaply and profit from the increased demand for yield among investors. For these, a simple balance sheet restructuring in favor of debt financing is accretive to earnings per share.

In a positive but low growth environment, compounded by political uncertainty, (over the debt ceiling for example), financial engineering dominates business expansion, and employment. The dearth of bank capital also limits growth capital for small and medium businesses who tend to be more important for employment growth.

The European experience is similar although Europe is a step or two behind the US on the path to recovery. That said, Europe continues to suffer from over-capacity, as evidenced by its lack of inflation, and could profit handsomely from any uptick in growth as operational leverage remains high. Europe, however, suffers from a more acute form of funding shortage. Its banks are well behind the rest of the world in recapitalizing and SME lending is moribund. Recent signals from the ECB indicate that the problem is being addressed. The Asset Quality Review initiated just now is a good example.

As emerging markets rebalance towards more consumption and less investment and saving, the fortunes of companies will rotate accordingly. Current index heavyweights like banks, resources and exporters will likely see increased risk or weaker earnings.

Prices

Emerging markets are suffering from inflation. Inflation measures are imperfect and anecdotal evidence indicates inflation is running faster than official numbers suggest. Additionally, inflation is higher in non-administrative goods markets. This implies higher potential inflation should these goods or services markets be deregulated. What are the sources of this inflation given that emerging markets are in fact facing slowing growth? One is the inflow of capital as a result of QE in developed markets. This argument is weakened by the fact that inflation in the economies printing the money is muted. Asset prices such as real estate are rising but goods and services inflation is decidedly muted in developed markets. As the world becomes less globalized, and economies less open, the sources of inflation are increasingly domestic. Policy tools such as the exchange rate become ineffective. Interest rates on the other hand are a blunt instrument and ineffective under stagflation. Generally, trade enables price discovery and market clearing and a less globalized world encourages inflation.

Inflation in the developed markets is more complicated. Whereas central banks like the Fed have been purchasing assets and growing the money base, inflation has been surprisingly low. And yet, the risk of inflation is high. If the money multiplier or the velocity of money were to accelerate, it would multiply through a massive money base to inflate nominal output. If capacity is tight, the risk for a spike in inflation is significant. The US therefore is poised between low inflation and a spike in inflation. This is one reason that the Fed needs to reduce the
size of its balance sheet as soon as practicable. In Europe, the UK excepting, deflation is the greater risk. German influence is likely to keep the ECB tighter than it otherwise would be, even as the ECB maintains its easing stance.

Financing:

Developed market regulators are sending conflicting signals to banks, encouraging to lend more and take less risk. The Basel III capital rules have certainly reduced the amount of credit available per dollar of bank capital. With investors still hurting from the losses of the last crisis, private funding may have rebounded but have yet to fully recover to pre crisis levels. Debt capital markets are a bright spot, however, as low rates and demand from retail investors and mutual funds have driven bond issuance. Structured credit issuance and thus demand for collateral has recovered slightly overall but remains weak outside the US. With less bank capital and still sub capacity shadow banking sources, credit conditions remain constrained. Larger, developed market issuers, not necessarily better credits, will face easier credit conditions through access to bond markets.

For credit to fully recover and grow, the shadow banking industry needs to be further developed. Regulation has so far focused on banks. Some efforts have been made to bring shadow banking under the purview of regulation but the complexity of the system has so far confounded regulators’ efforts.

Policy:

The US treasury will need to continually finance itself despite cash flow insolvency. The US Fed lost its independence the day it stepped in to rescue the markets and the economy and will continue to fund Treasury. It is likely that the Fed will keep rates floored for multiple more years. Attempts by Treasury to extend its funding with low duration issues like FRNs are evidence that rates will be kept low.

QE will be moderated. The question is one of timing. The Fed needs to control its balance sheet soon or risk a spike in inflation. It has tools such as reverse repo to reduce liquidity but these are temporary measures. It is simply not prudent to maintain a balance sheet of this size. The most likely scenario remains that QE moderation will be conducted, but that sufficient noise will surround the incidence to desensitize the market. The goal remains to reduce the size of the balance sheet without steepening the term structure excessively.

Europe is significantly behind the US in terms of policy. The European recovery is still in its early stages and significant tail risks remain, notably in France, whose economy is weaker than its CDS spread suggests. The EUR continues to impede market clearing in the labor market creating chronic unemployment across the region. The ECB will likely continue its LTRO to maintain liquidity in the system while the banking system undergoes its recapitalization exercise.

Slowing growth and rising inflation plague parts of the emerging markets. Countries with sound balance sheets may spend their way out, within limits. Current account deficit an or budget deficit countries will be very constrained in what they can do. Brazil and India are the main examples, and there are more from Asia to Lat Am to Central Europe of countries where currencies are vulnerable, reserves are thin and efforts to support currencies could choke off growth.

China’s efforts at rebalancing its economy are commendable and also a sign of strength. Recent initiatives to reign in credit and to audit the shadow banking industry point to responsible management and imply strength of the financial system. Much will rest on the shoulders of the central government, though, as local governments have been impoverished and the banking system lives on very optimistic appraisals of their balance sheets.

Risks:

If it is written here, it is not a serious risk. The most serious risks are the ones that only become clear once the damage is done. But anyway…

Almost all asset pricing is dependent on some kind of discount rate. Central bank policy dictates interest rates, the most natural discount rate in any asset pricing model. One mistake and all asset prices will be mispriced. We’d better hope that central banks are able to wean the market off interventionist policy in an orderly fashion.

A corollary to the above is that nobody knows the correct price of any asset as long as quantitative easing and other unconventional monetary policies are in force.

Inequality. We have witnessed inequality fall across the globe as poorer nations got richer more quickly than richer nations. Within countries, however, the reverse was true; inequality worsened within each given country. Sufficient in-country inequality can be destabilizing socially, politically and economically.

A small pick up in inflation too soon can be difficult to manage when a central bank’s balance sheet is over inflated.

Long maturity, low interest debt is very long in duration, and very convex.

I reiterate what was said at the start of this article. Slower global growth means less cooperative counterparties. Expect more mercantilism, currency wars, and control of cross border movement of intellectual, financial and human capital. It is not a stretch to extrapolate such competitiveness to armed conflict. All it takes is a little bit of paranoia.