You can’t have your cake and eat it. The economy is a complex system and like most systems it has a number of variables or parameters. Some of these you can control. Others are the consequence of what you control. It isn’t always possible to choose all the controls and consequences. Choosing a bunch of controls automatically render other variables as consequences. Some variables are mutually exclusive controls. Attempting to arbitrarily define sets of controls and states, either by design or accident often leads to unintended consequences.

Hedge funds have been some of the most successful money makers since hedge fund records have been available. Since 2008, even the best managers with long track records have stumbled. Things just don’t work the same way as they used to anymore.

The approach to solving the problems that continue to ripple from the 2008 financial crisis is an example of trying to have your cake and eat it. The Euro is a specific example. You cannot have a single currency and expect to have convergence in factor prices. Not unless you have a convergence in factor productivity, economic policy and political and social ideology. You might be able to get convergence in interest rates or other factor prices but you will need multi currencies since exchange rates will automatically become system determined variables. (An interest rate peg, how interesting. I wonder how many crazy ideas we can conjure up.)

So far no one has been able to profit from the Euro crisis. Why? In a recession when credit default rates rise, distressed debt funds are able to step in to assume risks that other investors cannot or will not. The rule of law, chapter 7 or chapter 11 in the US for example, guides the process and assigns the rights and obligations of the different claims. There is no equivalent law or regulation governing countries who default. Neither is the balance sheet of a country sufficiently defined that one can value a country let alone one of its claims. Investing in distressed sovereign debt is thus risky and highly uncertain business.

The investment landscape has become doubly difficult. Pre 2008, fundamentals were fairly straightforward, and once they were estimated, investor behavior was fairly straightforward as well. Markets have always been moved by investor psychology and how it interprets fundamentals. But now fundamentals have become dependent on more than just commercial realities and cold rationality. As the economic pie has shrunk so strategic concerns have increase in importance. The world has become more protectionist and mercantilist as peoples and their leaders seek to avoid loss and disadvantage. Hedge fund managers who have found their fundamental approach to investing confounded point to increased macro risks. This can arise from strategic policy impacting macro variables in unexpected ways which in turn impact industry conditions. As the world adjusts to this new reality, so too has the psychology of investors changed. The same information finds different interpretations. The problem for traders is that the prevailing interpretations are just not what they used to be. Investors are reacting differently to how they used to react to the same pieces of information.

The minor question is, how do we invest and profit from this new reality? We have seen relative value strategies in infinite duration assets fail miserably while arbitrage strategies within capital structures in finite duration assets have obtained encouraging results. Arbitrage it seems is the only safe play, and as we all know, arbitrage is rare, difficult to identify, difficult to implement, and often requires pre-defined gestation periods.

The bigger question is, as policy attempts the impossible, what are the consequences? Can a debt bubble induced depression be solved by the creation of more debt? Can fundamentally insolvent organizations continue to fund themselves ad infinitum? What is the final solution to the problem of excess debt?

Even more fundamentally, is today’s capitalism capitalism? Will the rolling legacy of moral hazard ever be addressed?

PS

Government Policy Put.

Governments the world over, in an effort to avert recession and disaster have written government policy puts (QEs, LTROs, Optwists) in such vast notional size that their negative gamma must be killing them.

Equities continue to rise or at the very least are resilient in the face of good and bad news., Sovereign bond yields head for zero. Meanwhile economic data seem to indicate a synchronized global slowdown. What gives?

1. Economic growth has fully recovered. The current tepid growth is a function of the necessary debt repayment and deleveraging which the world is undergoing. It is a mistake to anticipate a stronger recovery.

1. If you accept the above, then because the market doesn’t read current growth as having fully recovered, it is misinterpreting the impact of the short term business cycle. Current growth is inclusive of a peak in the short term business cycle. Hence, earnings expectations are too high and equities will be vulnerable over the next couple of reporting periods.

 I am wary of equities and other risk assets.

The world’s major central banks need to buy the debt issued by their governments. This is not just to boost the economy by increasing money supply. It is mostly because no one else will buy their junk bonds.

Most countries are able to do this, except the Eurozone. In the Eurozone, there are a number of countries who need to have their junk bonds bought by their central bank and there are also a few countries who don’t. These countries, understandably, don’t want the central bank to go about buying any junk bonds, even, or especially those issued by their fellow members. The ECB is not allowed to buy government bonds. So in December last year, the ECB came up with a clever plan. It lent money to private commercial banks in such a way that they had no choice but to buy the junk bonds issued by their respective national treasuries. This was the LTRO. The countries that are not so broke and don’t issue junk were not too happy about this. In the meantime, the countries that are broke have, under austerity measures, seen their economies get a bit worse, which is no good for tax revenues, and no good for debt service, and therefore no good for their creditors. So they need to refinance themselves and roll over their junk bonds. Once again, no one will buy this PIKable junk. So they look to their central bank to buy them. But the ECB cannot.

So here is the cunning plan. The ESM is established with a banking licence so it can borrow from the ECB. The ESM is basically the proposed successor to the EFSF and the EFSM. Don’t ask me what those are, I’m not sure I know. The ESM will basically be a hedge fund domiciled in Luxembourg, (one wonders if they will make it a UCITS and offer it to retail investors,) whose equity capital will be funded by the Eurozone member states, including (and one wonders quite how this works) the broke member states, and which will additionally be levered by the ECB. Technically, the ESM is a hedge fund and the ECB its prime broker.

It will be interesting to see if the Germans will invest in this hedge fund. They are being asked to seed it and be the largest investor with 27% of the equity capital. Not only that, Germany is a significant owner (19%) of the prime broker as well.

It is hard enough to get the Germans to invest in a for profit hedge fund but one has the feeling the ESM will be a not-for-profit hedge fund, the only one if its kind.

And what of the prime broker agreements? What leverage is being offered? At what cost? What are the margin requirements? Its going to be a long night.

Interest rates will stay low for a long time. The implications for higher interest rates are sufficiently dire that policy has no choice but to ensure low rates across the major currency curves for the foreseeable future. OK, longer than that.

Stocks look undervalued on a yield gap basis. The implication of yield gap analysis must be either that stocks are cheap or that government bonds are much too expensive. From our thoughts on interest rates above, we must conclude that stocks are cheap.

Stocks look undervalued relative to corporate bonds. A corporate bond yield to equity yield gap analysis leads one to the conclusion that either stocks are cheap or bonds are very expensive. The rationale for corporate credit has been that since governments have basically bailed out the private sector, it pays to invest in the private sector instead of in government securities. Since risk aversion is still high, investors seek a senior claim on corporate earnings and assets. Hence corporate bonds and in particular high yield.

The interest rate policy and the parlous state of sovereign balance sheets has led to a perplexing phenomenon. Credit could be a bubble relative to stocks and treasuries. Corporate yields are too low and equity valuations are even lower, but only if interest rates continue to remain low for a long time.

What could change all this? The major developed world central banks will likely keep interest rates low until they cannot. They will be able to continue unless inflation confounds the strategy, and the only threat to inflation (for various reasons I shall defer to another article) is the exchange rate. Japan has had low rates for this long in great part because inflation has been so low, and in greater part because the high savings rate internally funds the public sector. A weak JPY would require a costly defence which would see higher rates and bankrupt (further) the country. Without a high savings rate or foreign reserves, the currency would have weakened and rates would rise, all other things being equal.

All major economic regions therefore need to be able to keep rates low to avert a major repricing of equities and bonds. To do so, exchange rates cannot trend too far from where they currently are. Stationary volatility, even if elevated, is not a problem.

Exchange rates are therefore as important as LIBOR to the central banks. How much more transparent are FX markets than rates?

The problem with the wholesale and long term suppression of interest rates is that it can be inflationary, costly, distort funding markets, and plays fast and loose with relative prices in the economy. It also encourages excessive leverage, which was one of the fundamental problems leading up to the financial crisis in the first place.

The coherence of policy must be questioned. We began with excessive debt which we transferred to more stable hands and which we now hope to pay down over time. As we pay it down we want interest burdens to remain low, so we suppress interest rates. For all the public and private pensions and any institution with long term liabilities which it needs to fund, or indeed any investor wishing to preserve future purchasing power, this creates a yield drought which drives them into riskier investments for a given level of return. In 2001, the Greenspan induced yield drought drove the financial industry to create the instruments tailored to the yield junkies, triple A high yield. In less than a decade these instruments have failed. In the current yield drought, human ingenuity will without a trace of doubt find a way and a product to feed the yield junkie.

In each yield drought, the correct response and indeed the initial intention was to delever the system. The final result, once the symptoms of the initial condition were addressed, has been either a resumption or acceleration of credit creation. Because this time its different.

In these treacherous times the degree of macro risk in markets is substantial and it is tempting to try to capture these opportunities. The confident macro trader will certainly argue for the opportunity while the fundamental investor may be confounded by factors beyond their considerations. One of the more controlled ways of investing in the current environment is event driven strategies.

The current environment is characterized by weak or erratic economic growth, poor sovereign balance sheets, disparity of financial strength and commercial prospects across businesses, policy risk, political risk, and liquidity risk, to name but a few. The macro or fundamental investor is well advised to assume the specific risks they seek and to avoid or hedge the risks they do not. The event driven manager is already predisposed to this approach in the best of times and is well positioned for these erratic markets.

The current climate is certainly fertile for event driven trading. Businesses of varying financial strength make for interesting and active mergers and acquisitions. The strong have the wherewithal and currency for acquisitions, while the weak are motivated sellers or targets.

Private equity LBO activity is conspicuously quiet, yet strategic transactions continue to take place. Post 2008 PE funds continue to struggle at raising capital in the traditional buyout space and many GPs have turned to high yield, direct lending, distressed debt, and structured credit secondaries. The result for M&A is better quality and less highly levered transactions.

The differing fortunes of countries and regions encourage cross border deals with their concomitant complexity, not least from the political angle.

The difficult operating environment is also prompting balance sheet reorganizations (to stave off defaults or hostile takeovers) and defaults. The current environment encourages asset divestitures and capital raisings. In the case of default and or reorganizations, distress investment opportunities present themselves, for example in buying fulcrum securities or providing debtor in possession financing.

Event driven investing is a perennial strategy which excels in hard times and coasts comfortably in good times. The key is selecting a manager with the requisite skills. Unlike macro and fundamental investing, event driven managers require not only investment and trading skills but legal, regulatory, and strategic skills as well.

The garden variety event driven manager assesses the terminal prospects for an event. The textbook risk arbitrage trade is highly levered and has negatively skewed returns meaning that success is rewarded slightly and failure is punished acutely. However, by assessing the probability of deal break, or deal completion, and diversifying over a number of deals, a positive expected return can be achieved.

For the most part, merger arbitrage is expressed in the equity of the companies in play. There is no reason why the same event cannot be capitalized upon in the debt of the relevant companies. Some mergers feature unlisted companies which almost always have debt securities. Differential treatment of claims under change of control can cause different claims to price differently creating arbitrage or trading opportunities. Few managers have cross capital structure expertise to take advantage of these situations. Managers able to trade in the c
redits benefit from participating in less crowded trades.