Investing has become more fraught with danger as policy attempts to do what policy has never done before. New ways of thinking about asset allocation need to be developed. We begin with prospects for a few economies and how they should be expressed under these new regimes.

Prospects for the US economy:

GDP is comprised of consumption, investment, government expenditures, and trade. The US economy has been in big trouble and continues to be in big trouble.

Consumption levels pre 2008 were sustained not out of cash flows from investment or employment but from credit. Supporting this credit was a rising housing market providing good collateral. With the collapse in the housing market this collateral is no longer available. With a sluggish labour market, cash flow lending is likely to remain muted. Also, recent experience is likely to increase savings rates further dampening consumption. Bottom line, consumption is likely to be very sluggish.

Investment pre 2008 was supported by a number of things not least construction encouraged by rising housing prices. With unsold inventory, land bank and inventory from foreclosures, housing construction is likely to remain depressed. Private infrastructure investment is likely to remain depressed as well as expectations for growth remain depressed. Inventory accumulation is a volatile series which is highly cyclical and subject to complex autocorrelations.

The government is quite simply broke. It is not tenable to continue to run deficit budgets with the existing level of borrowing. This puts a damper on infrastructure build and investment in the technology set of the economy. Financing the government has become a serious problem, solved only under the guise of quantitative easing.

This leaves exports. Yet not every country can be a net exporter at a given point in time. There is a risk that globalization is reversed for a time as economies become more protectionist and insular. This is unlikely though as the march of globalization has created some hard to reverse relationships and interdependencies. What is likely, however, is the repatriation of productive capacity (read manufacturing) to the US. The macro outlook does not provide, however, clear implications at the micro level. As the US economy evolves into an export driven one, quite which industries will emerge at the forefront is unclear but bears close monitoring.

A likely consequence of the repatriation of productive capacity will be a higher NAIRU compared with previous decades. In past decades, the NAIRU was kept artificially low as the US exported productive capacity abroad thus taking advantage of economies of scale and cheap foreign labour to keep inflation low facilitating the ‘goldilocks’ condition of having high growth and low inflation and interest rates. Expect higher inflation at each level of GDP growth going forward.

In the shorter term, in the next 12 months, however, expect interest rates and yields to be depressed across the curve. With GDP growth running some 3 – 4% below potential, the Fed is likely to maintain zero to negative real rates at the short end, and encourage the same at longer maturities. There remains the motivation to create sufficient inflation to debase the debt and to manage the interest burden for the US treasury as well as to try to buoy the still moribund housing market.

Europe:

Much has been written about Greece, with prospects ranging from dire to disastrous. They are all true. Sovereign debt is a strange animal. The creditor has an ill defined claim, and yet the sovereign stands above its corporate credits. Yet for all the problems that Greece faces, these are symptoms of a greater structural fault, that of the Euro and the differential pressures it exerts on different parts of the union. Greece should have been allowed to default on its own in Drachmas. But it hasn’t and its debt will now have to be aggregated into the same pool as all the other dodgy assets, transferred into default protected vehicles and eroded via inflation and cheap funding via unconventional means… A policy of transfer, hold and erode is the likely outcome. The question is transfer where and to whom? A more rational way, but one which involves too much up front pain is a restructuring. Governments and peoples prefer to defer pain.

Europe is a region still haunted by memories of war, for which economic and monetary union are seen as a glue to bind the various countries whether it makes economic sense or not. It has, however, a long history of crises and colonization and it is likely to weather the current malaise through evolution. Already European businesses are some of the most global in the world. The tiny country of Switzerland is home to some of the world’s largest companies who clearly cannot be sustained by Switzerland’s domestic economy. There are good companies in Europe which will see their stock prices decline in times of stress. The Greek situation is unlikely to be resolved quickly and is likely to plague the region for some time. There is even risk of contagion to Ireland, Portugal and Spain. These would represent buying opportunities of business whose links to Europe are largely legacy, but who derive most of their economic value from healthier parts of the global economy.

China:

The evolution of China into a more balanced economy with less export reliance and more domestic consumption has been slow. As Western economies fell into recession and are recovering only slowly, China’s economic growth has been driven more by investment than consumption. Construction and infrastructure still dominate marginal economic growth. The consumption has been localized in higher income household’s demand for luxuries both domestic and foreign. Inflation pressures in agricultural and food products erode purchasing power and encourage saving while discouraging discretionary spending. Headline inflation including shelter is rising fast despite hawkish policy. A wage price spiral may already be underway, ironically triggered by central government’s policy of wage increases to encourage domestic consumption. On the other hand the government seeks to manage overheating by maintaining high reserve ratios for the banks and raising interest rates. Perhaps it is hoped that this will encourage consumption out of cash flows without the creation of excessive credit, while discouraging excessive credit supported capacity overbuilding.

As the West repatriates productive capacity and rebuilds its manufacturing sectors China’s industry must also evolve. It must evolve to supply goods and services to satisfy domestic demand instead of export markets.

China’s infrastructure and investment binge has been criticized as unsustainable and likely to create overcapacity and lead to a deflationary recession. China’s infrastructure and development plans span decades instead of years and often appear to Western observers as irrational. It is difficult to opine on the future implications of the current build out. In any case policy has turned against unfettered infrastructure investment. What complicates the analysis of the Chinese economy is that as a centrally planned economy the number and complexity of levers available to the central planner are myriad.

The long term view is a bit clearer. China is in the ascendancy and the central planner has displayed considerable astuteness of policy despite an often elastic chain of command. The future is China’s to lose and the wildcard is the Party and the pact that it has with the people. In order to maintain growth and control inflation, at some stage, China will need to outsource to cheaper producers as well. While Africa has been merely a source of resources to China, there is scope for it becoming the factory of the next few decades producing on behalf of Chinese businesses. Otherwise, it is merely a matter of time before China bumps against its long term potential GDP growth limitations and chronic inflation sets in.

Conclusions:

The macro view is no clearer or less clear than it has ever been. That said, even with a high conviction macro outlook, the trade expression for monetizing that view has changed. This is a result of a more globalized economy, more complex relationships resulting from the said globalization, and more globalized capital markets. Whereas in the past a view on a country’s or region’s economy translated into an opinion on that region’s or country’s equities or equity indices, the current structure of the economy and markets requires a more targeted trade expression. It requires an opinion on individual stocks, not so much based on the idiosyncratic fundamentals of each stock but based on an understanding of the macro environment’s impact on each business.

The future belongs to economies like China, India, Africa. Seek targeted exposure to growth potential within each of these countries or regions but seek these wherever they can be found whether in companies located locally or in the developed economies.

Asset allocation remains the most important investment decision, however, its expression needs a more sophisticated and targeted approach.

That equities will continue to be impacted by local events while being driven in the longer term by their financial fundamentals provides the astute investor with an interesting strategy of buying developed market companies deriving a significant part of their revenues or profits from emerging markets when negative events and news depress their stock prices.

A peek at the future seen through a cracked and hazy crystal ball…

The US economy is in recession. The US economy had been supported in the past year by large scale debt monetization and concomitant Fed balance sheet expansion. The absence of monetary expansion has exposed the fragility of the recovery. That the economy is in recession does not imply falling stock markets but it does apply downward pressure. Expansionary monetary policy can and does increase the nominal output in any market including goods and asset markets. In capacity constrained markets, prices are likely to rise.

QE3 may already be underway. As the Fed ends its program of buying treasuries, volatility has returned to markets and the economy. Commercial banks have been buying US treasuries and are likely to step up purchases for a host of reasons among which are the continuing fall in house prices which formed the largest collateral base for US bank lending, Basel 3 rules for risk weighted capital which continue to rate US treasuries as zero default risk and therefore carry a zero risk weight, the ability to borrow at the short end at near zero rates and lend to the US government at 3%.
Interest rates across the yield curve likely to be capped at current levels. And may head lower at the long end. The US economy is in no condition to face higher interest rates. The mortgage market requires lower long rates. The short end is pinned at zero lest the Fed trigger another banking crisis. The USD yield curve is likely to continue flattening for the foreseeable future.

Asian Real Estate is likely to remain supported. In the near term, local factors will weigh on real estate in HK, China and Singapore, likely precipitating a correction. However, in the longer term, with G3 interest rates close to zero and the likelihood of further central bank balance sheet expansion, the prospects for liquidity driven real estate bubbles remain good. Watch out for the volatility though.

Commodities are likely to continue to rise. Emerging market growth may weaken in response to a US recession but domestic economies are strong. Emerging market manufacturing is an inefficient user of resources and for a given level of growth can be expected to consume more resources. Commodity markets were less contangoed and more backwardated pre the sharp correction in May which is indicative of fundamental demand versus tight supply. Buy on weakness.

Equities cannot be called as a group. The Short Term. The short term outlook is uncertain but certain trends are tradable. Consumer stocks have done well and are due for a correction in a sector rotation. US and European exporters with Asian and Lat Am customers have done well and are also likely to be rotated out of in a derisking. Luxuries will likely stay supported relative to staples and lower price point cyclicals. Buy food and beverage whenever margins get compressed like now, hold them through till margins normalize as they always do. The same goes for insurance companies. The Japan quake has been a significant cost to insurance companies, however, premia are bound to rise and will be accretive until the next catastrophe. Do watch the exposure to Greek debt, however.

Equities cannot be called as a group. The Long Term. The long term outlook requires stock picking to express both fundamental as well as macro opportunities. With the state of Western economies as they are, the most likely outcome is that they attempt to export their way out of their recessions. As an economy gears itself for exports, currencies are usually depressed, investment tends to rise as the economy retools itself, but it is not always clear what sectors emerge as export engines. Europe will for a long time be the supplier of luxury goods to the rest of the world. Barriers to entry are high and this is unlikely to change. Germany’s preeminence in high tech engineering can be eroded by emerging market competition. The US will continue to export capital goods. Buying Caterpillar on weakness may not be as lucrative as China’s development evolves away from infrastructure driven growth. The US does have some luxury and lifestyle brands to export to the emerging markets. Over the longer term, barriers to entry are important. The billion dollar question is: what can the US make that the rest of the world wants to buy?

Equities cannot be called as a group. Finance. Emerging market growth is expected to remain buoyant. There may be headwinds coming from the developed markets but emerging markets have clearly decoupled at the fundamental economy level. The emerging market banking systems, however, are unlikely to have sufficient capital under Basel 3 to finance their own economic growth. There is an opportunity for non-bank financials, leasing companies, direct lenders, mezzanine hedge funds, to step in to fill the financing gap. Emerging markets growth can benefit from the growth of a Shadow Banking system.

Greece is cash flow insolvent. And the asset side of a sovereign balance sheet is not well defined. Greece’s fiscal problems did not stem from an asset bubble or a real estate boom. Greece has run structural deficits which would have culminated in a crisis even if the financial crisis did not happen. There are no easy solutions for Greece. There is a risk that the people of Greece may decide against facing austerity and choose outright default much as Iceland did. The EU is desperately trying to bail out not Greece but their own banks with Greek sovereign exposure. Greece is not important enough to the EU otherwise to bail out. With little or no exposure in French and German banks, Greece would have been ejected from the union by now. The debt overhang will foreshadow the European banking system for some time to come. Trade it if you dare but be ready to bail.

Gold is not worth anything, but everything else is worth even less. Gold has no economic value in that it cannot be used for anything. For that reason there are no valuation methodologies for gold except that it is worth more in the minds of investors than other things. For this reason alone, if the hypothesis about further debt monetization is correct, the price of gold is unbounded above.

Liquidity is worth more than gold. In times of uncertainty there is no better asset than optionality and there is no better option than liquidity. It should be clear that the problems of 2008 were never addressed properly and that most of the problems have at best been transformed from one form to another. The level of debt in the global economy remains a chronic problem which has yet to find a solution. Attempts at inflating it away have only just begun and will take time to take hold. In the meantime, expect volatile markets, not so much measured in traditional measures of volatility but in the form of strong time local trends. These trends are tradable but one needs dry powder, in other words, cash. If not cash then a combination of liquidity and resolve. Liquidity to go to cash, and resolve to buy low and sell high. There is no better time to buy assets than when there is a big problem in the economy or in the markets. Macro and trading hedge funds can take advantage of such variability in markets and sentiment.

Inefficient market pricing is worth more than gold. As the world goes through post crisis oscillations and policymakers attempt to dampen the cycles, mispricings in markets occur. Empirically, the more the intervention, the greater the mispricing opportunities. In addition to mispricings, one can expect large swings in markets. Having a liquid portfolio allows one to take advantage of these big swings, provided, and this is a crucial caveat, provided one has the resolve to buy into distress and sell into recovery. This involves acting counter to human nature. For others, a safer route is arbitrage and arbitrage requires illiquidity, or forced patience. Arbitrage and relative value hedge funds require lock ups but are able to us the stability of capital to take advantage of arbitrage opportunities.

Just as the transition from QE to QE2, the purchase of MBS to the purchase of US treasuries was a seamless exercise, so too the transition to QE3, the funding of banks to purchase US treasuries will be seamless and this time if done right, done without fanfare.

The US economy cannot survive higher interest rates, in particular the housing market, now slipping back into recession with a -3.6% shrinkage in the Case Shiller Index, cannot survive higher interest rates. The benchmark 10 year US treasury yield needs to be capped and controlled. The 10 year yield has declined steadily from 3.6% to just a touch over 3% in a little over a month, a remarkable feat given that the Fed’s 600 billion USD purchase program is expected to end sometime this month.

The various recovery acts of the US to deal with the credit crisis of 2008 have required the government to either purchase, underwrite or finance an enormous quantity of mortgage debt. This requires that the government itself finds means and ways to finance itself. With the USD’s role as a reserve currency waning, with the creditworthiness of the US in question (whether or not in jest), new ways were and are required to finance government debt. QE2 was not so much an exercise in reflationary monetary policy as an attempt at monetizing government debt. There is still more debt to be monetized. Calling the new effort QE3 or calling attention to it might suggest that previous efforts were a failure, which is an unacceptable perception. Lending money to private commercial banks to in turn lend it on to the US government is as good a plan as any. For the banks, it is a profitable (the yield curve is still relatively steep) and capital efficient (US treasuries have a risk weighting of zero) trade.

Front run the pirates. Curve flatteners 2 and 10 years. Lever them up.

However, if the above analysis is valid, the supply of US treasuries will soak up significant liquidity and would likely draw liquidity from other asset markets. So the recent rally in US treasuries may not be a result of derisking from equities, high yield and commodities. It might be a mighty displacement trade.

Investors have short memories. While the reasons for the 2008 financial crisis have not gone away or been adequately addressed, markets have recovered nicely.

Some history:

• 2007, US house prices and Mortgage Backed Securities fall.

• 2008, a global credit crisis, Bear Stearns, Merrill Lynch, AIG, Lehman disappear.

• TARP, TALF, PPIP, HAMP, QE.

• So that more banks would not fail.

• 2009, equity and credit markets bottom 2Q, Libor market stabilizes, equity bull market begins.

• 2010, European sovereign debt spreads widen on PIGS default probability.

• 2010, Fed begins monetizing government debt under QE2, risk assets resume second leg of bull run.

• 2011 Gold reaches over 1550 USD per oz in an indictment of fiat currencies.

It has been a period of high volatility, of a credit crisis followed by a massive concerted effort at reflation and recovery. How could a problem of such scale have been dealt with in so short a time frame with such (relatively) little pain?

A few questions:

• Where is all the debt that precipitated the 2008 financial crisis?

• What is the status of that debt?

These are inconvenient questions but worth asking. Debt cannot be destroyed it has to be paid down, restructured or defaulted on.

The issues in 2011:

• Inflation

• Middle East North Africa political instability

• Japan Quake and Tsunami

• European sovereign debt crisis

Developed ma
rkets equities have shrugged of all of these events. Emerging markets equities began to correct on the inflation issue well before 2011, around November 2010. Otherwise investors have simply discounted these events and pushed equities further ahead.

More questions:

• Where are the housing markets in Europe and US?

• How will debt be paid down? Sovereign debt? Mortgage and consumer debt?

• Will any of the PIGS default?

• What are the prospects for economic growth globally?

• What are the prospects for asset markets?

Some answers:

• Housing markets have been slow to recover in the US and Europe (in the bubble markets).

• This is a big drag on their economies – No more HELOC.

• And on central bank balance sheets being the largest holders of mortgage debt.

• In total a massive destruction of wealth from which there has yet to be a recovery.

• Central banks have attempted to inflate the debt away with limited success. Inflation filtering into core CPI has curtailed efforts to further debase currency and debt.

• No more ability to monetize government debt.

• Or private debt.

• More creative means may be found.

• Non USD based investors in USD debt have already faced de facto default. PIGS are either cash flow or balance sheet insolvent.

• Major central banks may be facing insolvency as well.

• And may need to print
money to remain solvent.

• Which is highly inflationary.

• And may not stave off default

A few observations:

• Assets such as assets and high yield bonds deemed too expensive too hold in 2008 are deemed cheap today.

• LBO activity has recovered with leverage levels now approaching 2005-2009 levels.

• The leveraged loan market has revived with increasing examples of covenant lite issues being done.

• Approaching the end of QE US treasuries rally. What does this say about investor risk aversion?

• The VIX has gone below 2007 levels to 2003 -2004 levels.

• The MOVE has gone to late 2007, 2004 levels.

• US corporate credits yield less than they did pre 2007.

• The S&P500 rose through the Japan Quake and the MENA revolutions.

A few conclusions:

• The debt overhang from 2007/2008 has not been paid down, defaulted, reorganized or otherwise addressed.

• Central bank and government policy has been the marginal driver of economies and markets. These policies have led to highly stressed sovereign balance sheets which mean that these policies cannot continue.

• In the long run the outperformance of creditor nations versus debtor nations will take hold.

• The issues of the great financial crisis have not been solved or adequately addressed. They have been transferred out of sight.

• Risk aversion is too low. The market price of risk is too low.

• Human nature drives humans to buy high and sell low. It pays to disconnect this natural tendency and prepare to buy low and sell high. Thi
s takes discipline and patience. The risk that markets wake up to the unresolved nature of the 2008 crisis and sell risk assets down sharply is high.

Strong commodity markets create winners and losers. For example, cotton prices remain 100% higher than a year ago even after a 30% correction. Companies like Carters which make baby clothes and ladies underwear and sell mostly through Walmart will struggle to pass on costs. Abercrombie and Fitch and Ralph Lauren will find it easier to pass on costs. Moreover, materials are a smaller proportion of costs at higher price points.

High precious metals prices also create winners and losers. Swatch and Richemont will see costs rise. The retailers in China such as LukFook, Chow Sang Sang and Emperor are gatekeepers to Chinese demand and will command stronger bargaining power.

High food prices also create opportunities. Retail prices of food are sticky upwards. When agri prices are weak, food retailers like supermarkets find it hard to improve margins. Price hikes are politically unpopular and the oligopolistic markets they operate in punish the outliers. When agricultural commodity prices rise, food retailers stock prices get punished. However, this is one of their few opportunities to increase pricing. When agri prices soften, margins are improved.

I remain very skeptical about US and European banks. Stress tests that are self marked do not inspire confidence. For all the efforts of the central banks to liquefy the banks, for all the efforts of the banks themselves to recapitalize themselves, bank lending has recovered only slowly. Why? With a fragile housing market, Western banks have seen their mortgage businesses languish. With Basel 3 capital requirements banks are motivated to get behind the Fed and put on yield curve carry trades lending long and borrowing short. This leaves them vulnerable to a flattening out of the curve. I think there are more interesting opportunities in banks and credit institutions in Asia. Shriram Transport Finance for example is an excellent business with low delinquencies, strong margins, a wide network and high barriers to entry.

Elsewhere in emerging markets, telephone companies are encroaching into banking products with SMS payments and funds transfers. Vodacom, 65% part owned by Vodafone, is a mobile telco active in Sub-Saharan Africa. The upside gap risk is that the cellphone becomes a de facto ‘debit card’ or ‘cash card’.

On the macro front, a market neutral stance is preferred until we figure out what the central banks want to do. The US government still requires a bulk buyer of its debt. It remains to be seen if and how the Fed will be able to engineer a program of buying without calling it QE3, a move that would shake confidence in the sovereign’s credit quality. The European’s by having an independent central bank, or at least a variously conflicted one, will struggle to monetize its debt. The Bank of England is already an off-taker of Gilts, yet there, the English are biting the bullet and going through austerity. The emerging market central banks are girded for the inflation battle. It seems that no central bank is currently in printing mode and this is likely to create volatility first in the fixed income markets then in credit, equity and commodity markets.

FX markets I know nothing about except to say that nothing goes in a straight line and whenever there is an extreme of consensus, the market is likely to confound.