Its one of those periods again when markets are falling and people are feeling down. And when they feel down, they sell assets and markets fall, and they feel even more down.

The US economy’s tepid recovery is real. In Aug 2011, the US economy began showing signs of life, and that spark caught on, albeit at a slow rate. Its main driver was emerging market demand for capital goods, driven by final demand for resources in China. The recovery is therefore highly sensitive to the Chinese economy.

Today, that demand is waning and at serious risk of faltering further, because China is slowing faster than anyone has guessed. Fortunately, on the back of some momentum in the US manufacturing numbers, and inventories being unusually low on account of acutely pessimistic managers, consumption has picked up in the US. This despite weak labour and wages numbers, has put the savings rate back on the decline. Its not healthy.

The picture in Germany is slightly brighter. Germany too has been dependent on exports of capital goods and intellectual property to the developing world and it has profited handsomely from the voracious demand from countries like China who are desperately building to fill the void left by cratering exports. With the recent downturn in China, even Germany is vulnerable.

There are cycles within cycles. Long term growth will always be positive due to the ingenuity and efforts of the species. That’s very long term growth. In the meantime, a shorter cycle exists driven by the lags and expectations of people in the economy.

Long term growth will slowdown. The world has accumulated too much debt which it must now repay. GDP counts debt fuelled growth, and now must count the cost of paying down that debt. Its just accounting. Thus, at each level of inflation, the potential growth rate will fall.

Be that as it may, in the long term, one must invest in growth and US companies are an excellent source of it since they are the owners of brands, strong reputations and intellectual property. As countries retrench, it pays to own these attributes. Europe too is attractive if not for an inefficient and dangerous currency regime. A global retrenchment, for example the US becoming a net exporter, will create a shortage of international USD pushing up the USD and USD interest rates across the term structure. Central bank policy of debasing currency and engineering as much unmeasured inflation will also support long term interest rates. Short duration fixed income is the efficient trade expression. In the long run. The problem with a long term investment strategy is that it requires more tolerance of volatility and patience than most investors can bear. Absolute return hedge funds are a better investment but search costs and fees are high. And most investors don’t understand hedge fund strategies anyway and prefer to stay away.

How about the shorter cycle? Europe, the US and China have managed to bolster growth in the past 2 years by creating more debt. It is a temporary fix and will now go away. No country in the world is in a position to create more credit, not without their borrowing cost rising out of hand anyway. Those who can, don’t need to. In any case the world has seen too much credit creation already. To boost output through the creation of more debt is a bit like putting out a fire with gasoline. With China’s shadow banking system (LGFVs) and banks at the limits of leverage and accounting creativity, output should slow quite significantly. This will have knock on effects to the resource producing nations and then on the major capital goods exporters like the US and Germany. The logical conclusion, based on the weakness in the Chinese economy in the past 6 months, is that the US economy must now slow down, likely into another recession.

Today the risk of Greece defaulting and or falling out of the Euro monetary union loom large. The impact of such an event is not well understood and markets have fallen as risk aversion has taken grip. There are countries and companies which are not viable. Today the public’s gaze is directed at Greece. Tomorrow it will be something else. In all crises there are opportunities. In Europe, performing assets misunderstood in the panic can be bought at distressed valuations. Distressed assets, however, remain expensive with few sellers.

In the meantime, as always, the market mistakes damage for risk. The risk in Europe is mostly over. The Greek drama is damage. Risk prefers a mask of calm and collected doom.

Worry about scenarios that are unlikely to happen and that others do not envisage, like the Germans throwing in the towel on the Euro and leaving. Now that would be a risk.

In the May 5^th edition of the Economist magazine, there appears an article on China’s banks. It points to the high profitability of the banks and the low level of NPLs.

It points to a couple of sources of worry, bad local-government debt and souring property loans. Much of the debt is structured in SIV like vehicles called LGFVs. While the Economist is probably right in its economic assessment a greater threat lies in store. You only need a healthy sense of curiosity.

The Chinese should be thankful for the European shenanigans for distracting attention from some very interesting goings ons in the Chinese banking industry. If the government were forced to bring all bad loans on to the sovereign balance sheet, debt to GDP would be more than the 40% or so currently reported. That number would be in the range of 90% to 160% of GDP. Based on the creative accounting currently in use in China, at which end of that range would your guess be?

How did NPLs get from mid teens and mid twenties to low single digits in a few years? Simple. You sell the NPLs at face value to someone, like an asset management company for example. Can’t afford it? No problem. Extend a loan to said asset management company. If you look closely at the balance sheets of all the big banks you will find a bunch of bonds issued during the banking reform years by asset management companies which proceeds were used precisely to buy NPLs from the banks which now hold these bonds. How can auditor possibly countenance this practice? Why are domestic financials prepared according to PRC GAAP and audited by firms whose names are the concatenation of a Big Four and some Chinese company? Most of these bonds are delinquent but not classified as non performing but are instead euphemistically referred to as receivables. The European crisis will seem small once the truth behind the Chinese economic miracle is uncovered.

A few months ago the ECB’s long term loans to the banking system appeared to have staved off risk of default or breakup for at least as long a term as the facility. The fears of default and breakup have returned with a vengeance.

My assessment was that the LTRO was sufficient to postpone the problem for at least a year if not two, subject to a few assumptions, but that they did nothing to address the fundamental issues causing the cash flow and balance sheet insolvency of peripheral Europe. The LTROs 1 trillion EUR will at least cover the Eurozone’s 2012 maturing sovereign debt if one assumes no further government largesse is required for unforeseen circumstances. This covers it for a year, assuming that the European banks cover 100% of all new issues. If they cover half, the money will last longer, perhaps 2 years. No government largesse means everyone sticks to their imaginary budgets, and more importantly, no government or bank has been misrepresenting their financial position. These are strong assumptions.

It seems that government finances are hard to define and quantify rigorously. Some people call this accounting fraud. As the only practical prosecution (there can be many plaintiffs), is a connected party, its unlikely that any legal recourse can be sought. In times of stress, one cannot rule out accounting fraud. Even if we assume that government financials have not been embellished, there is the question of whether the proposed budgets are realistic. Austerity takes care of one side of the profit and loss. With taxation at its limits, in terms of already high marginal tax rates, it is difficult to envisage higher rates. Indeed both austerity and taxation beg the question of the elasticity of output, and thus tax revenue, to taxes and fiscal austerity.

The qualitative and quantitative variability of banks’ balance sheets, even apparently strong US banks, is also cause for concern.

When banks had large scale proprietary operations, (some would say a negligent or fraudulent misuse of funds), the riskiness of banks was indeterminate. Bank CEOs would struggle to understand the nature of their balance sheets due to their complexity. The static risk of the balance sheet presented sufficient complexity but the dynamic risk resulting from the non-linearity of the exposures and additionally, the prop traders’ trading behavior made a thorough understanding of the risk not difficult but impossible.

With the winding down of prop desks one element of balance sheet complexity has been reduced. However, this is not all. The agency business has its own complexities. Typically the agency business exists to serve clients and thus the risks undertaken on behalf of clients are either transient, or hedged away. Here the financial engineers have outdone (and perhaps undone) themselves and introduced a level of complexity that confounds the concept of risk pass through in an agency business.

As profitability falls due to increased regulation and capital adequacy requirements, the reduction of prop trading and the creep of financial oppression, agency businesses need to work harder to increase returns on assets just to maintain returns on equity. The result is more aggressive financial engineering, more complex deal structuring, mostly to camouflage more aggressive fees.

As more complex structures or payoffs are sold to clients, the resultant complex risks have to be laid off in the market. There are several ways to do this. One is to find a matching less sophisticated counterparty in a clear breach of good faith. Guess who is the least sophisticated counterparty? The theoretically robust way of laying off the risk in the market is to hedge each basic element of each product individually using its theoretical replication strategy. There is almost always one, but it may not be feasible or practical. Many replication strategies have asymptotic properties that involve zeroes and infinities and may in fact exacerbate risk by requiring inordinate notional exposures. The third way is to aggregate the risk exposures of the entire client book, and to hedge the aggregate exposures rather than the individual ones. This usually works if the risk models and systems are good and there are no unexpected deviations from model. The more complex the book, the greater the risk that either the model is inadequate for handling the individual non-linearities, or a significantly large deviation from the neighbourhood of calibration confounds the model.

Banks have in the past appeared to be in more control than they actually were. The current stressed environment and post 2008 crisis conditions may present characteristics which their models have not taken into account.

And even if they were in control, in the current stressed environment, human behaviour has taught us time and again that good faith is a rare commodity.

The bottom line is that nobody, possibly not even the management of the banks, knows what the current and near term expected positions of the banks really is. 

It this lack of information, about banks and about sovereign balance sheets, that the financial destiny of the Eurozone faces. Lack of information or lack of clarity leads to fear which can lead to capital flight. Despite most European banks passing so-called stress tests, and raising more capital, deposits have been consistently flowing out of Eurozone banks.

This hints at another purpose of the LTROs, since most of the money raised by the banks still sit with the ECB earning a negative carry of 75 basis points per annum. They need the liquidity.

For all the financial wizardry that has been deployed in search of a solution, the Eurozone is poised at the point of a limited collapse. Greece is at the door and may be forced to exit the union. If Greece is ejected, the market will surely push Portugal and Ireland to the door.

For these smaller economies, the principal members of the Euro, France and Germany, may tolerate exit. Italy and Spain are problems of a different scale and would certainly pose an existential question to the Euro. This is contagion risk.

It is interesting to consider that in the absence of a Euro, local currencies, Drachma, Escudo, Pound, would be plunging, and it is almost sure that some pundit would propose pegging these to the Deutsche Mark.

Yet we currently have currency union and discuss selective exits. Perhaps it is Germany who should consider exiting the Euro. For the Euro members, the Euro itself is analogous to the gold standard which while it provides an anchor to the value of each backed currency, takes away important policy tools. Policy tools which the ECB has attempted to recover through creative and alternative means but which have interesting and exciting side effects.

The unfolding saga of the Euro makes dramatic reading and gives everyone a lot to talk about over ouzo and beer, but a storm is brewing in a teacup, a very large red teacup half way across the world where accounting principles are all but generally accepted, the shadow banking system has grown alarmingly and the banking system has an air of fiction about it. China.

Since 2008, raising capital for a hedge fund or private equity fund has become very difficult. In the case of some would be institutional or family office investors, it has always been difficult.

Especially in the backwaters of capital. The marketer is an eternal optimist. He actually believes that the investor is interested in what he has to say, that the investor understands what he has to say, that the investor understands English, basic finance, and intends to make money through investing. These are strong assumptions individually but taken together, compound the capital raising problem.

Marketers should always begin with the first principle, which is to first do no harm. The marketer has to therefore believe in his own product. He has to understand his product inside out, and most importantly, from all the possible angles and perspectives of his target investor audience. Thus armed with conviction and understanding, the marketer has to take his product to the investor.

This is easier done than one might expect. Many investors will take a meeting quite easily. Beware these investors. They are often time wasters. The investors who have no time to waste have little time for your product. The more difficult it is to get a meeting, the more serious the prospect once you get in front of them. Alas, just because an investor is difficult to pin down doesn’t mean that they are a good prospect. Good prospects are hard to pin down.

The first meeting is important. It is here that many a deal is closed. There is a class of emotional or recreational investors who will invest on first impressions. If one is lucky, the impression of the marketer will be sufficient to close a deal in the absence of the investment professionals. Madoff was a case in point. He never met any of his end investors yet managed to, through his hapless intermediaries, raise billions in capital.

Do you send material ahead of the meeting? Of course you do. The interested and diligent investor will read this material in preparation for the meeting. If you are lucky. The bored and mischievous investor will read it in even more detail so as to make the marketer’s experience at the first meeting one he will not forget for a long time. We can discuss the quality and how to put together an investment presentation in another post.

Always be formal and professional at the first meeting. The marketer may know your boss. Very often, buy side professionals will not do the courtesy of dressing up to meet the marketer. This is a mistake. Back to the marketer. Always be formal and professional at the first meeting. Investors, like all children, are very impressed by packaging. A suit and tie are required. In my experience as a buy side investor, I have always trusted the bedraggled informally dressed and the hapless and held my guard firmly up when faced with a ‘suit’. Never mind. Play it safe, wear the suit. In Asia, business cards are delivered with both hands. This is a tradition to demonstrate that one’s hands were fully tied up and not fumbling for the dagger in the back pocket. Your counterparty will also deliver their card with both hands, if you are lucky. The more intransigent investor will not offer you a card at all. Ask for one. You may never get the chance to spam this person’s email inbox ever again so make sure you get his card.

Sit down.

Never assume that the investor before you knows what you are talking about. At the same time, asking if they know what a CDO means will insult them. You need to surreptitiously explain what you are going on about while convincing the investor that you had absolutely no clue that they have absolutely no clue what everyone is talking about. Explain the investment opportunity, the investment strategy, the history of the firm and its people, and why you think this is the best investment since free lands have been expropriated from poorly armed indigenous peoples.

Some investors will attempt to demonstrate how much smarter they are than you. Let them. If you don’t you will not close the trade. Don’t just sit there and take it, engage them. This shows respect. Don’t argue. This shows disrespect. And don’t patronize. That’s just rude. After some polite sparring, make sure you lose the argument. If you actually agree with the said investor, you need a reality check when you get back to your hotel. Take notes.

Some investors will disagree with everything you say. And I mean everything. Agreeing with them will not make them stop or help the situation. You can quickly gauge if the investor simply doesn’t make these types of investments or doesn’t like you hairstyle. Don’t leave too early, use up at least 40 minutes, then take your leave politely. Before you go, use the time to find out all you can about the investor, their likes and dislikes, what they’ve invested in before. You might be able to send a less hirsute colleague next time around.

If an investor is interested, you’ll know. The questions they ask will telegraph their intentions. An interested investor does not a trade make. There are other considerations and hurdles to clear.

Have you ever wondered why that investor who was so terribly interested in your investment product and who knew the strategy and the market inside out, and who knew all the players in the industry and who asked you to send due diligence material and who said they would follow up suddenly falls silent? Sometimes these are smart junior people whose voice on the investment team or committee is simply not sufficiently loud, and they know it. Sometimes they are smart senior people who answer to an investment committee or have a process and simply do not have the discretion or authority to make an investment.

In some markets, the people who have the authority to make investment decisions are simply too busy, or too intelligent, to make those decisions. It is common to find that a professional investment team has been hired to assess investments which they then bring to a committee of ‘wise old men’ with the ultimate authority to pull the trigger. These wise men have built their careers outside of the investment industry, either in business or politics and often both, at the same time. You get the type. They don’t trust their investment team, being old and wise. Unfortunately, they don’t even trust themselves, being at least wise enough to know that their experience and expertise lie elsewhere. The result is that these wise men only invest in brand names. Their highly intelligent investment teams will have been conditioned to the likes and dislikes of their masters. They will only seriously propose brand names to their masters. Every so often, a niche, intelligent, under-researched, glaring opportunity will pass through the desks of some hapless investment analyst. They may choose to escalate this to their investment committees. This is rare.

Marketers faced with a prevaricating, delaying, unresponsive investor should not be discouraged. Its not you, its them. It likely that the investor you face is a professional gatekeeper with limited discretionary powers, with a committee to answer to, a committee comprising very wise old men, who don’t fully trust their abilities or judgment, and who think that because they’re themselves not experts in investment, they should invest with a reputable big brand name. That’s why its so important to build a brand. Marketers faced with these types of investors should not be discouraged. They should move on. Either to a more suitable investor, or to a fund manager with a brand name. And so real talent never really makes it to the masses, institutional or otherwise. And well it should be. It just serves everybody right.

Take a small island with an open economy highly dependent on trade and intellectual property, grow the economy to the hilt, run out of ideas, grow the population to grow the economy, to the hilt, or the shoreline, and what do you find? High inflation at each level of economic output.

The open economy invites imported inflation and so a natural control variable might be the exchange rate, but what of domestic inflation caused by capacity constraints?

An ever rising disparity of income and wealth is being fuelled by differing labour capacity or supply constraints in different industries. This exacerbates the inflation problem since shelter, transportation and food account for a greater share of consumption to the lower income group and it is precisely the scarcity of land, transport infrastructure related to the scarcity of land, and food which are the main sources of inflation.

The solution to this is not wage policies or subsidies across the board or by income level. This will very likely trigger a wage price spiral since it fails to address the underlying causes of inflation and localized labour market shortages.

If the economy is operating at close to full employment and inflation is accelerating beyond economic growth, structural limitations have been met and constraints are binding. To address inflation, the economy needs to be cooled. To the extent that the inflation is imported, exchange rates can be used as a control. If the inflation is due to domestic capacity utilization limits, interest rates are the appropriate control.

Differential demand supply imbalances in the economy lead to differential pricing (or mispricing) of wages. To address wage price spiral inflation dynamics, industries facing labour shortages need to either be cooled or the specific relevant labour developed or imported. The latter approach has been operated with great economic success but has faced social and political headwinds. The former approach has to be implemented or at least explored. Industries with monopoly or oligopoly employers tend to underpay. Such industries may require wage policy or labour unionization. Industries with numerous employers paying market wages can be left alone.

Wage price inflation spirals are due to two separate yet related dynamics conspiring to drive prices higher. A credible solution needs to address both prices and wages, separately yet in a related fashion. After all, a wage is nothing more than the price of labour.

One of the most difficult issues facing Singapore is the shortage of land. This is trivially true for a tiny island. It is thus the most likely source of inflation when the economy overheats. Call it the Rent Price Spiral. Prices rise resulting in higher profits resulting in competition for space resulting in rising land prices and rental leading to higher prices. Maintaining GDP growth through the unbounded growth of the labour force is not viable in the long term, and in Singapore, is fast approaching its limits. Maintaining Per Capital GDP growth, per capital income and per capital consumption is a more logical objective.

This is easier said than done, which is why to date, it hasn’t even been said.