It is always a difficult time to invest. When markets are turbulent and falling, investors will tell you it’s a difficult time to invest. When markets have been rising on low volatility for as long as the current market has, investors will tell you it’s a difficult time to invest.

Why is it such a difficult time to invest when volatility is low and markets continue to rise gently? Surely these are ideal conditions for investing? Central banks have underwritten the markets for 8 years now, and even as they lessen their accommodative efforts, they do so to enable further accommodation down the road should the economy weaken. The fact that they consider conditions sufficiently robust to lift their foot of the accelerator is surely reassuring news. They are far from slamming on the brakes. The financial system which had become acutely stressed in 2007 has been repaired and is ready to resume normal service. Growth has recovered almost universally, and even international trade has rebounded and with it global manufacturing. Economic conditions look healthy. Even the chronically lethargic Eurozone has caught up and is currently outrunning the US.

Investors are worried about valuations and they are right to be concerned. Equity valuations are as high, higher in some cases, than they were in 2007 just before the crisis. The S&P500 for example trades on 21X earnings whereas it traded at around 18X pre crisis. Eurozone equities are also trading above pre crisis valuations as is India. However, equities are not universally more expensive. Nasdaq is actually cheaper today than it was 10 years ago. Chinese equities, whether listed in Shanghai or Hong Kong are also cheaper today than 10 years ago. The dominance of US companies and markets skews valuations so that taken in aggregate, equity markets are expensive.

When equity valuations are seen in the context of alternatives or opportunity costs, the picture is more nuanced. The equity earnings yield premium over 10 year US treasuries finds that equities were extremely cheap in 2011 and have become more expensive since then, but remain probably in the region of fair value to slightly cheap, certainly cheaper than they were in the years 2003-2007.

Comparing equity valuations relative to investment grade credit also finds that equities are not overvalued. In fact they may be an indication that corporate investment grade is overvalued. The same is seen when compared with corporate high yield.

Are equities expensive? 

Are equities more expensive or corporate investment grade bonds?  (High is cheap, low is expensive)

Which is more expensive, equities or corporate high yield? 

Which brings us to the complaint that bond markets yield little value. Economic conditions are healthy and corporate balance sheets have reasonable leverage. Barring some areas where leverage has surged, notably China, leverage is closely monitored and as a result companies are less likely to lever up irresponsibly. China, by the way is a bit of a special case as the leverage has increased most where the lenders are state owned and the borrowers are state owned; one might call it off-balance-sheet QE. And even here, the PBOC is trying to ‘normalize’ its policy. In the US, the Fed is clearly of the view that corporate America is able to operate under normal conditions as opposed to the ‘intensive care’ of the past 8 to 9 years.

Investors’ concerns lie not so much with fundamentals but with pricing. HY spreads are at their tightest since the crisis and IG spreads are not far off their lows (achieved in 2014). When it comes to floating rate paper, the spreads are even tighter. Fears of rate hikes by the Fed have driven investor demand for leverage loans resulting in desperate buying.

US credit spreads are tight. But leverage is receding. 

Now there are ways to eke out a higher return, sometimes even at lower risk, and one can invest in hedge funds which take advantage of mis-pricings through arbitrage or relative value but alternative investments have alternative risks.

In fixed income, one can venture into the ABS market. Non-agency RMBS has done well and the nascent agency credit risk transfer market is another attractive area. Structured credit is another area where value can still be found. Subordinated bonds and preference shares are another potential area to hunt for returns. But with each basis point of additional yield comes additional types of risk. It is not that one should embrace the risks or dismiss them but that nothing is for free and the investor must satisfy their own understanding of the risks.

In the area of hedge funds, years of central bank policy has raised correlations and dampened volatility, a one-two knock out to traders seeking to buy cheap assets and short expensive ones. Even cross capital structure arbitrage yields acutely low unlevered returns forcing hedge funds to either leverage up (assuming their prime brokers or investors will let them), or print a lower return. Central bank policy has also confounded traditional transmission mechanisms between policy, the economy, and asset markets delivering global macro funds a particularly difficult environment.

As for systemic risk and investor complacency, we recall an old chart showing both VIX and SKEW. VIX is a widely accepted indicator of investor confidence or complacency. Of late, VIX has fallen to historically low levels and seemed impervious to events of economic and political significance. SKEW, however, shows that post 2008, investors have in fact been sceptical if not cautious. VIX has been depressed by volume call writing and SKEW has been lifted by volume put buying. The divergence between SKEW and VIX are hardly a sign of complacency. Rather it is indicative of the vigilance and worry of at least a segment of investors that has pervaded markets since the crisis as investors brace for the next bust.

Complacency or vigilance? Optimistic investors will not over-supply calls or over-demand puts. 

The only thing once can be pretty certain of in investing is that your wealth will not be the same as when you started. With some diligence and intelligence it should grow at a reasonable pace not far from the rate of growth of the economy or corporate profits. In the short run, volatility will dominate trend and in the long run the reverse is true. It is important for an investor to define their own style of investment and to maintain a consistent strategy lest one is repeatedly whipsawed by the market. Traffic in lower quality assets and one has to be nimble. Invest in higher quality assets and one has to be patient. It is extremely difficult to monetize both noise and signal. To make things a little easier.

*All chart data sourced from Bloomberg

The Singapore property market has been receding slowly since 2013. It has bottomed and will rise. There are a number of factors behind this.

The Singapore economy is stabilizing and will accelerate from this year onwards. No economy slides for multiple years without recovery. The Singapore economy is an uncommonly trade oriented economy with imports and exports together accounting for over 400% of GDP. International trade weakened from 2011 to 2016 as the world engaged in a Trade Cold War. In every trend there is a respite and international trade has rebounded. The impact on Singapore has been and will be positive. The oil sector is another significant component of the Singapore economy. Oil prices were 110 in late 2013 and have tracked lower till 2016. Since then they have stabilized providing some relief to the oil sector in Singapore. These two factors alone are sufficient to support the economy in the short term.

Interest rates (SIBOR) which rose sharply from across 2015 have now stalled. SIBOR is influenced by USD LIBOR and the SGD exchange rate, the latter being subject to central bank policy. The weakness of USD and the lack of inflation in the US has dampened the rate of ascent of interest rates. There is still a risk, however, that rates will climb. SIBOR was 0.4% in 2013/2014 and rose sharply to 1.25% in 2015. It then fell back to 0.88% in mid-2016. Since then it has risen slightly again, so this factor is not without its risks. More on this later.

Inventory build will start to weaken from 2018. Real estate is a very stationary and auto correlated industry. Low frequency of building and transaction data make planning and production slow to calibrate to demand and as a result the industry is prone to periods of over and under supply. The housing boom from 2005 – 2013 was prompted by undersupply but since then developers’ have over produced in expectation of extrapolated demand. As prices fell, developers cut back on production and the inventory build is now being eroded.

The expectation that Singapore real estate will appreciate is therefore built on sound, fundamental pillars. Demand and supply imbalances are being eroded. The cost of financing is low. The economy is in a recovery phase. Given the stationarity of real estate prices, one would argue that we are at the beginning of a 3 to 5 year upswing.

There are, however, risks to the investment thesis.

Property curbs remain in place. The limitations on household indebtedness and debt service are prudent measures which improve the stability of the banks and the housing market. Any relaxation of these measures might provide a short term boost to the property market but would contribute to future instability. Government policy may seek to moderate any increases in housing prices on social as well as economic fronts. If the situation in Hong Kong is a guide it demonstrates what can happen if house prices are allowed to rise without bound. Inequality of wealth and income in Hong Kong is acute and at risk of precipitating social discontent.

Housing as a source of wealth generation and accumulation may crowd out effort and enterprise. If people regard the provision of labour or engagement in enterprise as relatively inefficient generators of wealth compared with real estate investment, it may crowd out labour productivity and diversification of investment. The government may wish to discourage an over allocation of resources and focus to a single segment of the economy.

Interest rates are low. This may be counterintuitive but one should buy property when rates are high, and sell when they are low. This is perfectly intuitive when one replaces property with any ultra-long duration asset. An additional complication is that when interest rates are as low as they are, 1.4% for a floating rate SGD mortgage, 1.25% if you are a good customer, then debt service is very negatively convex. Consider that if interest rates were 5% and rose to 6%, the interest element of monthly payments would rise by a 20% whereas if rates rose from 1.25% to 2.00%, the interest element would rise by 60%. On a risk adjusted basis, the financing risk of such a long duration asset can be considerable. Even for those able to finance their purchase entirely in cash up front, the risk remains since if neighbours are weak holders, their transactions and indeed the valuations of potential buyers will impact the general valuations across the market.

The Singapore economy is a volatile one. Whereas quarter on quarter growth of the US economy tends to range from 1% – 3%, the Singapore economy’s quarter on quarter growth ranges between 0% – 10%. The volatility of the Singapore economy comes from a number of sources. Lack of domestic demand and a dependence on international trade means that the implied leverage of the economy is high. Also, international trade is less within the control of economic policy than a more domestically based economy. The government’s control variable is the SGD exchange rate and not interest rates, making interest rates a state variable which is not under the control of policy. At some point the real estate debt service of the nation may become a complication to economic policy.

Another source of leverage is the substantial size of the financial sector in the Singapore economy, some 13% of GDP. For comparison, financial services are less than 8.5% of the US economy, and less than 7.5% of the UK economy. The high leverage of the financial services industry pulls up the leverage of the Singapore economy making it sensitive to credit conditions and interest rates. This adds to the volatility of the economy as a whole.

Regional competition is another risk to Singapore. Singapore’s rise has been rapid as it moved from third world to first, but having made this transition it faces first world problems including inequality, accelerating aspirations relative to potential, and a natural slowdown as the economy reaches potential and achieves terminal velocity. The property market gains of the 1970s to 2000s were compensation for frontier to emerging market risk, plus an economy catching up to developed market status. Singapore is now a developed market facing the dearth of ideas and demographic and developmental speed limits of any developed market. All around it the region is catching up and offering new opportunities for development and growth.

Finally, a risk that is generic to real estate and not to Singapore alone: real estate is not liquid. To compensate for this, returns should be high. Illiquid investments are best undertaken in countries with a long history of stability, where institutions have persisted across multiple and diverse generations of government, where rule of law is immutable and durable and has persisted across multiple and diverse generations of government. Otherwise, liquidity, transferability, portability are qualities which could become valuable, qualities which cannot be found in real estate.

Mutual funds have a bad name, and yet, they remain a useful investment tool. Here are some of the advantages of investing through mutual funds.

1. They provide instant diversification. By pooling the assets of numerous investors, mutual funds allow an individual to invest an amount of capital which would be impossible to diversify if they did it themselves, alone. A mutual fund pooling the collective assets of a group of investors is able to achieve sufficient size so that it can invest in a diversified portfolio.
2. They provide access to markets which may be difficult to get access to. Buying US equities or European equities is one thing but trying to buy high yield bonds, leveraged loans, CLOs, mortgage-backed-securities, or other less accessible assets can be difficult to do. Mutual funds provide access and exposure in a single instrument making them ideal for asset allocators.
3. Mutual funds are professionally managed. This doesn’t guarantee a benchmark beating performance but at least it means that your investments aren’t being frivolously invested without some form of management experience and expertise.

And here are some disadvantages:

1. They are often expensive, especially for smaller or less sophisticated investors who may not have access to institutional share classes (bearing lower fees)
2. They tend to underperform their benchmarks. This is closely related to the fee issue. Since all funds charge fees, and the average fund achieves the benchmark performance, the average fund must generate the benchmark performance, less fees, thus underperforming. ETFs are cheaper, but do check the exact fees and expenses. Not all ETFs are cheap
3. Liquidity may be mismatched. A fund may invest in illiquid investments yet advertise daily liquidity, or redemption terms which it cannot deliver. Such funds face difficulties when too many investors want their money back at the same time, which is usually when the market is falling quickly. Liquidity may be mismatched in other ways, such as when the underlying investments are very liquid. Even the most liquid funds typically redeem at the close of business on a daily basis whereas their underlying investments trade in real time intraday.

Mutual funds are neither good nor bad. Investors have to know how to use them effectively and to have realistic expectations.

1. Do use them to access markets that are difficult to access such as bonds, loans, ABS, structured credit, emerging markets, foreign markets.
2. Do use them for instant diversification.
3. Do make sure that you know what the investment objective of the fund is. Only then can you use them effectively in your portfolio to attain your objectives.
4. Don’t expect them to beat their benchmarks consistently. They may outperform for a time but more than 2 to 3 years is a gift. For the most part, expect them to underperform to the extent of the fees, but invest anyway because access, execution and organization has a cost.
5. Do your homework. It’s your money and you want to know what you are getting into to avoid disappointment and making poor decisions when prices rise, or fall.
6. When investing in absolute return funds or hegde funds, the choice of portfolio manager is very important. It is the portfolio manager who is responsible for profits and losses, not so much the market.
7. When investing in long only, benchmark driven funds, the choice of strategy or market is very important. It is the market which is responsible for profits and losses, not so much the portfolio manager.

The ideal conditions for a country with a large national debt is high inflation. Inflation is a threat to purchasing power and can drive interest rates and debt service higher. Ideally therefore, what a highly indebted nation requires is high asset price inflation and low consumer price inflation. These are the prevailing conditions in the US where the national debt is over 100% of GDP, interest rates are low, inflation is weak but equity and corporate bond prices are inflated. The conditions seem almost ideal.

Low interest rates can drive inflation lower. Neo Fisherism predicts such a relationship based on the long term inertia of the real interest rate and thus a positive relation between inflation and the nominal interest rate, but a more concrete example, and one that can be extended to include labour markets, is that low interest rates encourage over-investment and encourages over-capacity which is ultimately disinflationary. Raising interest rates could slow investment and reduce excess capacity resulting in greater pricing power or rising inflation. In a low interest rate world, labour is relatively expensive compared with the financing cost of fixed capital. Raising interest rates would render fixed capital relatively more expensive compared with labour, discouraging capital expenditure in favour of employing more labour. It also raises the price of labour in sympathy with the relative increase in cost of capital.

The banking system is the plumbing of the economy. The past 7 years have seen this plumbing system undergo extensive repair works. While repair and upgrading works are ongoing, capacity has to be turned down and alternative infrastructure employed. Regulators like the Fed have to ensure that such alternative infrastructure is created or supported. The bond market is the back up infrastructure and has done an excellent job. Successive rounds of QE have kept base rates low and total debt costs manageable.

For the banks, the upgrading works are almost over. It may be time to review or upgrade the bond market, hence the talk of normalizing the Fed balance sheet. For the banks, it will soon be business as usual.