Lest we forget, the job of the Fed is not to support equity and bond markets but to promote price stability and stable economic growth, the former a stated goal, the latter an implied one. Yet market participants continually watch the Fed as if it was the primary driver of asset markets, at least in the short term. For the last 20 years, the Fed has, for better or worse, acted to rescue the economy, and concomitantly, financial markets, from crises. The previous Fed chairman Alan Greenspan stated that averting a financial crisis was not feasible and that the best that could be done was curing a crisis situation after it had been precipitated. In the days when the only policy tool wielded by the Fed was the short term interest rate, it was clear that this policy had its limitations. Each rate cutting cycle was less effective than the last and in fact sowed the seeds of the next crisis. Thus interest rates trended lower and featured a cycle of rate cuts to address crises or recessions followed by rate hikes, not merely to cut of inflation but to reset the policy tool in case it was needed in future. That rates trended down meant that the policy was ineffective in that rates could not be reset fully before the each subsequent crisis.

Since the crisis of 2008, new policy measures have been adopted by the Fed to supplement short term interest rates, mainly in response to the scale of the crisis. Whatever the scale of the crisis or the policy employed to meet it, certain things remain. The Fed’s raison d’être remains price and growth stability. The unprecedented scale of balance sheet expansion of the Fed has led to a precarious position where the US economy is perched between high inflation and deflation. The current equilibrium of low inflation is an unstable one because on the one hand the economy remains weak and energy costs are falling leading to a deflationary environment and on the other the velocity of money multiplies through the money supply to obtain nominal output leading to high inflation risk. Any sign of self sustaining growth, even at low levels, must reasonably encourage the Fed to reduce the size of its balance sheet to avoid the tail risk of high inflation, and to be clear it is a tail risk and not a smooth risk. The size of the Fed’s balance sheet and short term interest rates are loosely related, but sufficiently loosely, that it is reasonable given the low growth, even if self sustaining, that short rates will be held low even if the balance sheet is shrunk. It would be irresponsible of the Fed not to reduce the size of its balance sheet. Moreover, the extreme open market operations we call Quantitative Easing have a perverse impact on lending. Since 2008 much lending has taken on collateralized form with the collateral consisting mostly of low risk, high quality assets like treasuries and agency mortgage backed securities. By specifically targeting these assets in its asset purchase programs, the Fed is starving the financial system of collateral necessary to facilitate secured lending. Mortgage production has kept pace, however, a sustained recovery is improving government debt service burdens and resulting in a slowdown of US treasury debt issuance. The Fed’s need to taper its QE is driven partly by the need to avoid buying an ever increasing portion of new issuance thus crowding out private and foreign participation.

A reduction of asset purchases and an eventual reduction of the balance sheet of the Fed is a desirable outcome for the economy. It resets a policy tool which was considered acutely unconventional when it was implemented to address the crisis, and which one hopes need never be used again. It also removes the tail risk of high inflation through a purely technical transmission system, and it puts back eligible collateral into the financial system. The conditions for a moderation of asset purchases is that the feeble growth in the economy today is at least self sustaining, that is that it will not be derailed by the withdrawal of QE. One aspect that has not been dealt with here is the management and expectations of QE withdrawal which bears some thought as well. The communications and management of expectations is as important as the actual withdrawal itself.

I guess if you wanted to skip the theory and causality, what I’m saying is that if the Fed shrinks its balance sheet, or even slows its growth, it’s a sign that the US economy is in good shape.

I have a dream. A dream of a different wealth management model. A model where the interests of the staff, the firm and the clients are aligned. Where the reward relies on the minimum of subjectivity. Where the people are at the top if their field. Where the infrastructure is adequate and efficient and supports the client and the business. And where there is mutual and universal professional and personal respect.

I dream of a private wealth management model where the client comes first, and where the concept is not mere rhetoric but a commercial reality. This is the first principle. The Client Comes First. This will be achieved through the co-investment of both the firm and its people into the same products it expects its clients to invest in.

The firm and its people shall be aligned to the interests of the client. To do this, a portion of the firm’s capital will be invested in the products offered to its clients. The impact of Basel 3 will be an unavoidable cost of business and no longer a convenient excuse to not invest in what is offered to clients. The firm’s capital will be invested based on the Model Portfolio.

Staff bonuses shall be formulaic and contractual and designed to reflect the particular job function. For example, some roles will be based on commissions while others will have bonus caps with bonuses reduced for underperformance or high error rates and exceptions.

There shall be intellectual integrity in investing. Conflicting views are permitted. A house view will be published which will form the basis of the Model Portfolio. The firm’s capital shall be invested in the model Portfolio.

Staff bonuses shall be subject to a holdback (based on seniority and relevance). The remainder will be paid out in cash. The holdback will be locked up for 3-4 years and may be invested in the various products offered by the firm or in cash. The aggregate allocations of the staff will be published so that clients can observe the revealed preference allocations of the staff as a group. This shall be called the Principal Portfolio. Staff redemption execution will be sufficiently delayed so clients have an opportunity to act first ahead of staff. Staff will invest on the same or at least no worse terms as clients and at similar fees, liquidity and transparency terms.

A very useful way of approaching investing is to first assess the underlying prospects for a particular company and then to find the best value and risk reward in its capital structure to buy. Often, however, we tend to assess macro conditions, then market implications and asset allocate between equities or bonds before we look at companies. This approach often fails to discriminate between the diverse geographical sources or revenues and costs. Unfortunately, the force of habit is so entrenched that mainstream investment strategies will find it hard to adjust to the more targeted approach, and so we march on with the old tools. One has to be cognizant of the existing methodology since it will drive current capital allocations and fund flows which move the market.

It has now become consensus that the US economy is in a sustained recovery, so much so that the Fed is considering slowing down the pace of unconventional policy. I think this is correct. The market expects Europe to also recover but has failed to provide any causal explanation. I see the Eurozone in continued and regular weakness due to its common currency. The emerging markets are now feeling the strain of mercantilist developed markets withholding demand, credit, free transfers of technology and other charitable acts on account of their own weakness. With an innovation deficit, China, India, Brazil et al will face a hard time growing, while facing inflationary speed limits. I hope the Japanese economy makes it sufficiently far as to ignite a self sustaining recovery but the prognosis for the longer term is poor.

I like US equities. A recovering economy, low interest rates, strong balance sheets, high operating leverage, a shrinking float on account of share buybacks bode well for US companies. They also remain the most innovative, the most important owners and generators of intellectual property and innovation. And between debt and equity, there is no question that the value lies in the equity of US companies relative to their bonds.

I like European companies. The weak European economy will delay any risk of monetary tightening by the ECB, labour costs will remain suppressed for a long time as employment switches out of the mainstream to contract hire, and material costs remain muted. European companies deriving revenues from emerging markets have a goldilocks operating environment of low costs and high growth. The underperformance of European markets has also resulted in attractive valuations. Whereas in the US over exuberant credit markets have made bonds expensive, European high yield is an attractive prospect paying higher yields and providing stronger covenants. In Europe therefore, the better approach is to assess a company then its capital structure for the optimal trade expression. For allocators who are unable to do so, buy a balanced exposure to Europe; buy equities and buy high yield.

I like Japanese equities. Tactically, the prime minister and the BoJ will need to ramp the market higher towards the elections. There, depending on the result, one should make a binary choice to double up or cut. My bet is that the elections will be positive, even if the majority is insufficient to gain unilateral control, and that the three prongs of policy will buy sufficient time for animal spirits to take hold in Japan. In the longer term, I believe that the demographic will be unable to fund the fiscal deficit and default or unconventional reorganization is inevitable. That, however, is too far down the road for our purposes and I would buy Japanese equities.

I like equity long short in Asia. Asia will see lots of winners and losers. Asia ex Japan is not as resilient as investors believe. Lack of innovation and a weakening Chinese economy will hamper the region. Much depends on China. Asia ex Japan remains a supply of resources to China or an entrepôt or a satellite to China’s hub. The lack of world class brands or technologies is a serious gap in Asia ex Japan. Pockets of innovation in Korea and Taiwan may emerge but so far the norm has been repackaging or contract manufacturing. Stock picking will be crucial in Asia. Particularly in China, where the economy is clearly evolving towards a more balanced one between consumption and investment, the differential fortunes between industries and companies will emerge. I don’t recommend a macro blanket approach to Asia. Certainly on a macro blanket basis, I am very cautious about China’s prospects. The US is re-shoring manufacturing capacity and withholding the transfer or sharing of intellectual property and until China is able to invent, produce and market its own innovations, I think it will struggle. The same argument holds to any country which cannot innovate.

I have a definite view of inflation. Indeed it is a case of Fire and Ice. Massive balance sheet expansion in the developed markets in a world of open capital accounts has led to inflation flowing to where capacity is constrained by productivity and growth is relatively strong, in other words, the emerging markets. I therefore expect the US, UK and German term structures to outperform (steepen slower or less) than emerging market term structures. In the US, UK and Europe, rates are likely to rise, but this rise will likely come from strengthening economies. In the emerging markets rising rates are likely to be the result of rising inflation. As a result, in developed markets, bond yields will likely see negatively correlated duration and credit spreads whereas in emerging markets they will see positively correlated credit spreads. This leads me to prefer developed market high yield over emerging market high yield.

I like European senior loans. I liked US senior loans. Generally, the floating rate features of loans make them attractive if one believes that interest rates have bottomed. With 3M USD LIBOR at 27 basis points there isn’t much room to fall. While I do not expect short rates to rise in the next 12 months, floating rates provide important diversification. The structural seniority of the claims, the maintenance covenants, all make senior bank debt a good asset to be in when in times of stress. The US loan market, however, has become pretty tight with the revival of the CLO market
and the return of some covenant light issues. In Europe, however, the CLO market is only just coming back to life and one could argue that the timing is ripe to invest in bank loans in anticipation of demand from a structural buyer.

I like the USD. As the US becomes more export led it will import more USD creating a shortage of USD which will likely support the USD. Otherwise, the continuing phoney currency wars make FX forecasting a very difficult game indeed.

Buy European equities. There will be no roll back of easy monetary conditions in Europe in the short to medium term. Domestic economies remain hampered by the common currency and unemployment. Labour is getting cheaper. Inputs are getting cheaper. Companies have deleveraged balance sheets and are in a position to releverage cheaply and as required. Many European companies are exposed to high growth emerging markets. Despite a palpable slowdown in emerging markets and rising inflation in many of them, European companies represent an arbitrage since they face deflation domestically and thus low interest rates across the term structure where they finance in EUR, while they reap the benefits of increasingly more consumption driven emerging market economies. Valuations are also attractive. In a world where the crowded consensus trades have hurt investors it pays to be ahead of the curve.

The Fed will roll back QE gradually and will telegraph its intentions well in advance. This is clear. And it has begun. The Fed will continue to keep QE tapering in the news maintaining a ‘will they won’t they’ stance until the market begins to get tired of the message and accept QE tapering as a reality. Only then will the Fed roll back its asset purchases. By then, the market won’t care. It will be focused on fundamentals such as earnings growth, cost of capital, balance sheet quality etc. Correlations will have slowly leached out of the system.