I’m back
I’m back from a pretty intense investment project and will (hopefully) have more time to put my thoughts down to magnetic media…
Civilians At The Gate. Population Growth in Singapore
The potential growth rate of an economy depends on a number of factors. It depends on land, manpower, capital and knowhow. Growth in land can be achieved by more efficient use of the available stock. Singapore has a very defined constraint on land. Growth in capital is achieved by investment. Growth in manpower can be achieved internally or through immigration. Internal growth is something that is accelerated or decelerated very slowly, as we learnt in the 1970’s then in the 1980’s. Immigration is a quicker way of speeding up or slowing down growth in manpower. Growth in knowhow comes from investing in education, can be imported, or comes through investing in R&D.
Let’s look at growth in manpower through immigration. Let’s assume that we have optimised growth in all other areas. Growth through immigration is tricky. Singapore has limited land. To house 8 million, yes, 8 million, not 6.5 million people, will be difficult. But not impossible. Moving these people around, getting them from home to work, from work to play, this will require a feat of infrastructure development.
Less obviously, immigration imports cultural and social issues that are unpredictable. Importing people from abroad, however much intellectual or financial capital they bring, means opening up Singapore, potentially to an electorate, and if not an electorate then a population of stakeholders, unused to our unique style of democracy and social organization.
Inflation. Deflation. Two things happening all at once and what a central bank might think of it all.
Two step economy:
Its quite clear anecdotally at least that the bifurcation of the world economy into rich and poor has accelerated in recent years. Wealth creation has accelerated among the rich while the rest of the population has failed to catch up. This has occurred both between countries as well as within countries. Globalisation has played an interesting role. Whereas before, labor prices were a function of local productivity, they are today a function of global productivity. As a result we see wage deflation in manufacturing where capacity has been exported to countries like China and India, while wages accelerate in services which are less portable.
Evidence of a two speed economy can be found across the globe. Aggregate inflation numbers show a fairly benign picture, and it is indeed a benign picture. However, while aggregate numbers cannot represent the extremes of consumers, they fail badly where the distribution tends towards being bimodal. Inflation numbers for the developed world range between 1% – 3% at the aggregate level. Over the last 30 years HNW inflation has risen an average of 5.5% while CPI has risen 2.3%. In the last 10 years HNW inflation has risen by 6.3% while average CPI has risen 2.6%.
Inflation risk:
The key inflation risk is not in rising commodity prices. Fuels and utilities and motor fuel account for only 5.4% and 4.1% of CPI respectively. The key inflation risk arises from the unequal distribution of intellectual capital. The long term growth potential of an economy is heavily influenced by its intellectual capital or technology for a given stock of land, labour and capital. Where inflation comes from commodity prices, human ingenuity is deployed to solve the problem. Where inflation comes from wages, human ingenuity is deployed to exacerbate the problem. And the problem lies in the relatively short supply of high value labour, particularly where the value is derived from intellectual capacity. High income and high wealth individuals are incentivised to protect their industries through high barriers to entry. It is also in their interests for their offspring to inherit their positions on the economic ladder. The high cost of education is a primary barrier in perpetuating the unequal distribution of intellectual capital. I will not discuss welfare economic further except to say that there is good argument for central planning from a general welfare perspective. The unequal distribution of wealth leads, through the education system, to unequal distribution of intellectual capital and on to unequal distribution of income which manifests in inflation data.
Central bank policy:
One suspects that interest rate policy goes beyond fighting inflation. Rates were raised aggressively in the late eighties to tackle inflation. As the economy sank into recession the Fed quickly reacted to create liquidity. In 1994 where there was little sign of inflation rates were put back up. In 2001 when recession struck again rates were aggressively cut. In 2004 rates were put back up again in a fairly benign inflationary environment. It seems that interest rate policy is driven as much by crisis as by inflation. A cynical assessment would be that rates are put back up in times of calm so as to reset the reflationary tool.
Today, as it was 12 years ago, interest rate policy is once again in the spotlight. One could argue that a ‘good’ level for rates would be in the region 6.5%. In the absence of turbulence it affords ample room for rate cuts. One could also argue that this is an acceptable hurdle rate for investment. One of the consequences of too low an interest rate is that it encourages over investment.
From an inflation point of view it looks as if rates are perfectly poised. If there is inflation it is coming from services and housing with some volatility from commodities. Since there are two inflation rates for two segments, rich and poor, each has to be looked at separately. Unfortunately there is but one interest rate that has to be set to a compromise solution.
In the US, a full 42% of CPI is due to housing of which rent is 5.8% and owners’ equivalent rent is 23%. Across the globe today we see rising housing costs, particularly in the metropolitan areas. Residential real estate prices are bifurcated along the very lines of rich and poor. Within countries and within cities, price differentials are evident and in many cases are growing. Much of this element of inflation therefore impacts the higher income segment. As prices are being driven up by income and not the other way around, this may be an acceptable situation to a central bank. At lower incomes, house price inflation is less robust and in step with wage growth so there is not an immediate problem.
We can try to generalize this. Rich sector inflation is higher. However, as incomes are higher and wealth creation derives from investments as much as wages, the marginal propensity to consume out of incremental wealth is lower. A central planner may find this acceptable. At lower levels of wealth, inflation is not just lower, its low. Looking at the aggregate economy, there doesn’t appear to be any need to raise interest rates.
Trader’s Mentality. Let’s Play a Game
You play Solitaire. The card game. Its not important what game is being played. This is just an example and Solitaire is convenient. It has an element of skill and luck. The luck bit is how the pack has been shuffled and the initial set of cards dealt.
Let’s say that you have a strategy that seems to work pretty well and the strategy involves playing from right to left, dealing with the longest piles of cards first.
You start playing. You win 7 times in a row. You lose once. You win 5 times in a row. You lose once. You win 10 times in a row. You are doing well. Then you start to lose. 4 losses in a row. You get annoyed. The cards are not in your favour. A fifth loss. You have had a good record of winning. Why are you now losing? There is some disbelief. Its just bad luck. You’ll get over it. But nobody has such bad luck, you are angry. Maybe the strategy isn’t working. You try something new. You no longer work the longest piles first but any pile that has an immediate solution. You lose again. You try again. A win! So the strategy was at fault. You continue the myopic strategy. A loss. A win. Two losses. Its pretty patchy now. You are frustrated. You should stop playing. No, wait. One more. One more win and you’ll stop. A win! You need to convince yourself that it was more than luck. You deal another hand. A win. One more you tell yourself. A loss. The disappointment is unbearable. One more. You refuse to stop when you are behind. You’ll stop when you’re ahead. You need to play until you are ahead. Then you’ll stop.
Strange thing psychology. You had a good strategy. You were winning 80% of the time. You hit a bad patch. Bad patches happen to everyone at some point. You changed your strategy to a sub-optimal one. You began to win 50% of the time. It was pure luck now. You should have stopped playing and packed up for the day. Had a rest. Thought things through and come back the next day. Instead you persisted and your track record became pure luck.
Here is how it works in a trader’s head:
– Damn I’m good.
– Its just a couple of losses.
– I cannot believe anyone can be so unlucky.
– Let’s try this other method.
– I cannot believe that nothing I do works.
– I refuse to stop until I win.
Asset Liability Management of a Hedge Fund
Yesterday we looked at how hedge funds resembled banks. In fact they look pretty much like the result of the dismemberment of banks. Now lets look in a bit closer, at the capital structure of a hedge fund. To a corporate treasurer, a hedge fund would look like a very strange animal. The hedge fund manager looks at NAV (net asset value) of his portfolio on the one hand, and investors providing capital on the other. If you don’t believe me, ask any hedge fund manager about his assets and liabilities. We rule out credit managers since this would be familiar to them, or should be familiar to them. Even the odd credit hedge fund manager does a double take from time to time. If we ask what the assets and liabilities of a hedge fund are, it should look something like this.
Assets
Current Assets – Assets that can be liquidated quickly
Cash – that’s easy
Marketable Securities – the liquid long positions
Accounts receivable – proceeds of sale of assets, premia from written options and CDS
Interest receivable – from fixed income
Non Current Assets – Assets that can’t be liquidated quickly
Illiquid investments – private equity, small caps, large positions,
Cash from shorting held with Prime Broker
Liabilities
Current Liabilities – Short term liabilities
Securities borrowed for shorting – and which may need to be covered or recalled
Short term loans – for leverage
Long Term Liabilities – self explanatory
Equity
Share Capital
The typical hedge fund is open ended, i.e. has a variable equity structure. This means that balance sheet leverage can be affected by changes in equity, as much as by the mark to market of the fund’s assets and liabilities. The fund manager has some degree of control over the assets and liabilities, hopefully. It is their job to grow the equity in a stable way. But instability can come from the equity base as well, often when the manager is not performing well. Investors can redeem out of a fund causing the equity to shrink and requiring the fund manager to reduce the size of the balance sheet. This is not always easy to do. Even if balance sheet leverage is allowed to change to handle changes in equity, providers of credit to the fund will be watching the stability of capital as well and are likely to similarly restrict funding precisely when a fund needs it. The Share Capital of a hedge fund therefore needs to be appropriately structured taking into account the strategy that the fund manager pursues and the nature of the fund’s assets and liabilities. This is the argument for lock ups and long notice periods.
Today there are funds which offer high liquidity and there are those with restricted liquidity. Mostly the liquidity terms are driven by what the fund manager can achieve. Terms that are too restrictive can hamper the growth of the fund. Terms that are too relaxed result in an unstable capital base. More often the terms are driven by the reputation of a manager. The better the reputation, the greater the demand, the better the terms in favour of the manager. Unknown quantities have to live with providing good liquidity whether their strategy warrants it or not. It is clear, however, that sometimes, restrictive liquidity terms are there for the protection of the investor as much as the business interests of the hedge fund manager.