Today, equities, bonds, FX and most asset classes are driven by one thing. Central bank policy.

Equities are cheap when compared to treasuries. Investment grade yields are low in absolute terms but not so much when compared to their historical spread over treasuries. The same goes for high yield, not cheap but cheaper than treasuries.

The world has placed a whole bunch of bets on various assets, hoping for diversification, yet their bets can be reduced to a single highly dependent (a stronger condition than correlated) bet. They are betting that central banks will be successful at keeping interest rates low.

Poliicy rates, discount rates, repo rates, can be unilaterally declared low. Market rates like swaps and LIBOR cannot, but so far have played ball. It would take a liquidity disruption like 2008 to cause significant divergence, as much in speed and magnitude. Perhaps when the time comes, central banks would like to hire the LIBOR fiddlers to help them bring convergence.

Long rates have traditionally been market driven based on inflation expectations, pension demand for liability management, hedging of other long term products and to a lesser extent collateralization of derivative contracts. That is until the distribution mechanism was disrupted and the Fed intervened under the guise of quantitative easing. The same act can serve different objectives. Various forms of QE have involved manipulation of long rates in the open market. 

The equity markets, recently so serene and buoyant, are sensitive to rates. This was demonstrated at the end of each of QE1 and QE2. It is no coincidence that QE3 has no expiry date. The equity markets appear unable to stand on their own without the aid of QE.

As the VIX falls to an all time low below 12, and the MOVE follows after, one cannot help feel uneasy. Risk measures like VIX which are representations of the second moments of stock returns are bounded above and below (by zero) and are therefore mean reverting. The nature of the options market (an insurance market) means that vols tend to spike and decay, and repeat that pattern over and over. It seems that a spike may be due if not overdue.

The observations above are not technical but neither are they fundamental. I’ll talk about fundamentals later, but for now observe that:

Europe is in recession. China’s recovery is slightly wobbly. Emerging markets are also looking increasingly uncertain. The US, however, has solidified its recovery, albeit towards a long term potential rate of 2%, half of what we assumed it was pre crisis. Corporate profits have soared and margins have been maintained, at the expense of labour and employment. Corporate investment is moribund. An exuberant bond market has allowed CFOs to eke out efficiencies simply in capital structure optimization, borrowing in the senior unsecured claim to lock in cheap financing, pay dividends and buy back stock. This has helped buoy equity markets.

But how long and far can equities and corporate bonds go in this environment of lacklustre growth that discourages investment in future productive capacity and technology?

We can’t keep buying luxury stocks forever. The non agency MBS trade is a distressed debt strategy that will run its course and MBS are callable and thus can’t trade far above par. Leveraged loans in the US have fully recovered.

We have a strategy for today, but what about tomorrow?

In long only, macro, traditional strategies, we will eventually run out of rope. I expect equity long short to recover somewhat as a strategy, but this period of post crisis insanity has created great dislocations across corporate capital structures, for example in inconsistent recovery rates intra issuer, across their junior to senior securities. The same can be said about tranche securities. In M&A, consolidations have begun and risk arbitrage will be a very exciting strategy. At the fringes, banks will continue to try to be too clever about Basel 3, Dodd Frank and other Glass Steagall offspring. Where there is explicit regulation there is opportunity for circumvention. Credit strategies involving bank balance sheet optimization such as ‘asset reclassification’ and regulatory capital relief are lucrative but may later attract public scrutiny, just like the Magnetar Trade of 2008. A word of caution about FX strategies. In a phoney war, the tensions underlying the market which are not captured in realized or implied vols and correlation make FX especially tricky, and risky. I expect FX to trade away from lognormal thus confounding options pricing models.

Then there is distressed investing. A bit of patience goes a long way.

When the pie shrinks, people are less likely to share. It was clear back in early 2011 that with successive rounds or quantitative easing and debt monetization rotating through the world’s central banks, that eventually a trade war would develop. With the consumer demoralized, businesses cautious and governments broke, exports would be the last desperate hope for many countries seeking to grow their way out of voluntary and involuntary austerity. And so country after country, both net creditor and net debtor began to print money in an effort to either monetize a debt pile grown too big or to improve their terms of trade or both. Equal success in the former and equal failure in the latter has brought the phoney war to the surface. Japan’s once and new prime minister was firs to break the deadlock, sending the JPY into a downward spiral that today worries her trading partners but which tomorrow may worry the Japanese themselves as unforeseen consequences and diminishing returns to policy set in.

The phoney currency war has seen the build up of war chests in the form of bloated monetary bases and banking system balance sheets this far finely balanced country against country.  What happens when someone blinks? FX risk is no longer captured in option implied volatilities;’those measures are for normal and free markets. The risk of sudden and sharp, discontinuous moves in FX rates is heightened. This poses economic, political and hyperinflation risk.

While QE is by itself inflationary, it isn’t directly hyper inflationary, nor are the sources and ultimate manifestations of inflation or hyperinflation immediately clear. In a globalized world with open capital accounts, QE in weaker developed countries creates inflation in economically more robust emerging markets. Hyperinflation, however, is always a consequence of a crisis of confidence. Continuous FX markets are unlikely to cause hyperinflation. A discontinuity in FX markets could be a sufficient trigger for such a crisis of confidence.

In a trade war, the terms of trade are but one front. The cheapness of one’s goods and services are but one dimension. The other one is the quality and desirability of one’s goods and services. The ability to provide such desirable goods and service depends on the ability to innovate. Innovation and intellectual property will be the next front. Here, countries like the US, Japan and Europe have the advantage. China has seen some of the fastest growth rates in international patents sought, yet it’s share of the global total is only 9%. The US has seen growth slow over the crisis years is seeing a rebound and still accounts for over 26% of the total. Japan is second with a share of 21% and rapid growth. While Chinese companies are among the most prolific, their ability to commercialize their inventions has been less effective. Similarly, while Japan is number 2 by number and growth of number of patents filed, their ability to commercialize their intellectual property has been less impressive. What makes the US stand out is its ability not only to invent but to market and build a brand. Apple Inc was outside the top 50 companies ranked by number of patents filed yet their innovations are front and centre in consumer electronics.

As emerging market manufacturing costs and transport costs rise, developed world companies are repatriating manufacturing. This has been especially so for US companies. This theme favors the owners and generators of intellectual property over their erstwhile outsourced producers, the so-called OEM manufacturers.

Brands are another important element in trade wars. They serve as a signal of quality and desirability. Brands are valuable and take time and investment to establish. The value of brands can be seen in the premium pricing that their goods command and in the efforts to emulate or counterfeit their products. Whereas counterfeiting can often hurt sales, the power of some brands is sufficient that counterfeiting has low substitution effects. In other words the buyer of the counterfeit good could not afford the original article and would purchase the original when they can afford it. The counterfeit is therefore not a substitute for the original.

Western countries’ companies are overwhelmingly the owners of intellectual property and brands which places them well in the current brewing trade wars. While consensus economic forecasts are favorable for emerging markets like China, Asia, Latin America and the frontier markets, the nature of the growth and the trade expressions for capturing this growth through investing are not obvious or simple. China’s growth expectations are based on the growing importance of consumption and the middle class. This creates a value chain that includes both domestic as well as international companies. The relative distribution of commercial benefit, of revenues and margins will vary along this chain. A simplistic macroeconomic trade expression may miss the point. A careful analysis of who is buying what, where lies the bargaining power and thus margins, and tracking of cash flows from the ultimate buyer to the ultimate manufacturer and their suppliers and counterparties is necessary to identify who within this chain or web of supply, manufacturing and distribution profits most, and should be invested in.

In November 2011 I counseled caution on the Chinese economy, expecting a serious slowdown in growth. At the same time, I was concerned about the poorly policed financial system, a concern which has not gone away, despite the recovery in other parts of the Chinese economy. While the Chinese economy has recovered, it remains at risk from a fragile financial system and excessive credit creation.

A cursory survey of the physical infrastructure growth in China, simply by visiting cities and traversing rail and road, leads one to suspect that the scale of pace of such growth and investment cannot possibly be sustained from current income but must be financed out of credit. This is almost trivially true. A cursory survey does not, however, give us an idea of the extent of credit creation. One data point is total social financing which topped 15 trillion RMB in 2012.

The volume and pace of credit creation is not the only area of concern. Of equal importance is the structure of credit in the economy. Bank’s share of total lending has been steadily falling, as credit creation has been transferred to the bond market and the shadow banking system. This is not a bad thing, in fact, properly done, it is a good thing. However, we already see the weakness of the LGFV’s which are often poorly structured, are supported by local governments with weak cash flows, and backstopped by banks using dodgy accounting. Trust companies are another conduit whereby dodgy assets are financed by the issue of liabilities to retail investors in search of yield and who try to escape the financial repression of artificially low deposit rates. The last mile in the credit distribution system are wealth management products offered by banks and asset management companies. Retail investors are unwilling to lock up capital and wealth management products are thus structured with appropriately short maturities quite inappropriate to the duration of the assets they finance. The documentation of wealth management products and the disclosures are often sufficiently light that misselling and misrepresentation risks are high. Basically, a large proportion of assets in China are financed through structures that resemble SIVs complete with asset liability mismatches and poor asset quality, weak credit underwriting and dodgy selling practices.  

Adding to the complexity of the picture is the proliferation of credit guarantees, basically, credit default swaps with very loose margin and collateral management practices. The Chinese credit guarantee is ubiquitous for SME’s as banks tend to prefer to lend to larger firms or SOEs. Independent businesses seeking credit are forced to rely on credit guarantees.

China’s credit system is weak not for any reason other than that it has grown too quickly, and hasn’t learnt the lessons that the developed world learnt in 2008 when SIVs and CDOs blew up, CDS markets dried up and counterparty risk rose on the back of paranoia. This is a pity. The developed world behaved irresponsibly leading up to 2008 when financial innovation led prudence, but there were few examples to warn them. China, however, has copied the excesses and bad practices despite having Western history as a guide.

A Chinese Debt Obligation:

Source BoAML.

Until a week ago it was possible to buy a car in Singapore with a 10% down payment and a 10 year loan. Cars are acutely expensive a shortage of land (Singapore is a tiny island at the foot of Malaysia) has necessitated the rationing of cars through a quota system. The rationing requires car buyers to first buy a 10 year right to operate a car called a certificate of entitlement or COE. COEs are auctioned monthly with supply based on the number of cars being de-registered that month plus an acceptable growth rate. This idiosyncratic system has led to wild swings in COE prices, mostly to the upside, resulting in Singapore having the most expensive cars in the world. As an example, an Audi A6 in Singapore would cost the same as a Ferrari 458 Italia in London.

Not many people would be able to afford cars in Singapore were it not for the easy credit provided by banks. Which brings us to a rather simple question: why would anyone extend a loan, secured against a depreciating asset which almost guarantees that loan-to-values would rise from 90% at purchase to 105% overnight and to 120% in a year? Banks have to assume that car and COE prices would rise continually to defend their lending practices.

A week ago, the government stepped in to legislate that car buyers would have to put up 50% of the cost in cash and that loans should not exceed 5 years. At last someone was thinking rationally. One can only wonder who invented the 10 year car loan with 10% downpayment, for surely it is simply irresponsible lending behavior. It is an example of why regulators are necessary and why perhaps it is time to reconsider the limited liability concept, for who in his right mind would lend his own money this carelessly?

Singapore’s property market has surged since 2008 when it had previously halved from the highs of 2007. Low interest rates, easy credit and an influx of foreigners and foreign capital have propelled housing prices in the past 4 years. Money printing in desperate developed markets have also overflowed into capital attractors like Singapore fueling general inflation as well as asset prices. The state defined contribution scheme, the Central Provident Fund, is the largest creditor to the Singapore government and is the largest buyer of its bonds. This systematic deployment of the compulsory contributions of Singaporean workers is also a de facto form of quantitative easing which has probably fueled inflation to some extent. Singaporeans concerned about the credit worthiness of the CPF are also encouraged to buy property, depleting their CPF funds to reduce their credit exposure to the CPF. This adds to real estate demand on the tiny island state.

How stable is the property market and the economy? Most mortgages are floating rate mortgages or adjustable rate features, otherwise known in the US as ARMs. This makes the market especially vulnerable to rising interest rates.

Moreover, an over-dependence on foreigners in the economy creates a leveraged effect since a slowdown in the economy may well trigger an exit of work permit holders and to a lesser extent, permanent residents. By managing Singapore on purely commercial terms, the government has not fostered loyalty and stickiness among citizens. A case in point was the exodus of internationally mobile talent in the early 2000s when Singapore struggled with a weak economy. At that time senior members or government lamented the quitters and lauded the stayers. It can happen again.

It makes sense to have contingency plans in case of a property bust whether triggered by higher rates or weaker growth and resultant emigration.

A property bust is likely to also see debt service problems. A systematic program for the refinancing of positive equity properties is necessary. A nation wide scheme for standardized loan modification will avoid delays and uncertainty which would only create collateral damage and drawing out the price discovery and recovery process.

Where property owners face negative equity, there should be a scheme of forbearance under which home owners may sell their properties to a state sponsored special purpose vehicle, at market rates, while lenders will take a partial hit. The homeowner would crystallize a loss but face no further recourse. The state would put up the financing to purchase inventory and lease the same back to occupiers at controlled rates of rent. Homeowners would be given a free option to buy back their properties at the same price they sold into the scheme. Such options may be tradable subject to constraints, and certainly may be bequeathed to offspring.

These are merely initial ideas for a scheme which would address uncertainty and hopefully help avoid a disorderly market should the unthinkable happen.