Traditional investing is all about asset allocation based on macro economic outlook and then drilling down to security selection. That’s a bit too fuzzy for my liking. Investing capital should be a more disciplined activity since it puts that capital at risk. The risk should always be well compensated by the prospect of returns. Thus, unless there is a very good reason to invest, capital should not be invested. There is a real cost to not being invested, but this is a relatively more certain cost, being the difference between short term cash rates and inflation. The short term cash rate will depend on the investor’s level of access and short term risk appetite. Deposit rates, LIBOR, or overnight repo rates are good proxies. This cost of not being invested can also be thought of as an option premium paid to not have exposure. It is the option to invest in the current period.

An investment would require a clear and present rationale, an event or a catalyst to justify it. Valuation itself is not sufficient. It is an important factor. Most successful value investors don’t just buy value; they buy value with a catalyst in mind. Sometimes, these investors not only have a catalyst in mind but they are active catalysts themselves. Distressed debt investors are a classic example, where the debt of a distressed business is bought with a view to reorganizing the business and the liabilities of the company in order to unlock value. Merger arbitrage is another example where the takeover code, anti trust regulation and other regulatory legislation drive investments to their fruition or deal-break.

The disciplines of event driven and distressed investing should be applied to traditional investments as well. Tighter definitions of investment rationale should be demanded by investors when they are asked to place capital in harms way.

The Volcker Rule, Basel 3. Dodd-Franck and all the rules and regulations will not help banking stability until banks are allowed to fail. As long as banks are not allowed to fail, managers will continue to be engage in willful or ignorant risky behavior.

Too much regulation also sacrifices efficiency.

The way to ensure a balance between stability and efficiency is to regulate in a different way.

• No bailouts. Period. No lenders of last resort.
• Regulate standards of disclosure in financial reporting to ensure transparency and clarity.
• Encourage linear and not convex alignment of managers’ rewards and losses to the institution’s fortunes.

If a bank is too opaque, or too complex in its conduct of business and in its financial reporting, or if managers have too convex a call on its profits, investors and savers will direct funding away from them starving them of equity and debt capital, and deposits.

It is a remarkable state of the industry that savers and investors can no longer rely on bank management to act in good faith. The need for more regulation is simply a restatement of this hypothesis. If one believes that this new level of regulation is necessary, they must also accept the hypothesis.

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.