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Central Bank Liquidity: Waterboarding PDF Print E-mail
Written by Burnham Banks   
Monday, 14 March 2016 23:38

Negative interest rates.

 

Hmmm. I've seen this kind of liquidity provision before...

 

Now I remember!

 

 

 

 

 

 

 

Last Updated on Monday, 14 March 2016 23:42
 
An update on the ECBs latest QE. PDF Print E-mail
Written by Burnham Banks   
Friday, 11 March 2016 07:56

The ECB’s moves were largely expected except for the inclusion of corporate debt on the shopping list. This should at least put a floor under the Euro IG market. The details, however, have not been released so we don’t know what the total or country allocations might be.

The ECB’s best policy has always been its LTRO. Its first incarnation, a 3 year unconstrained program, turned the ECB effectively into a pawnshop. It achieved a number of things:

  1. Banks bought government debt when the ECB could not. The ECB had co-opted the banks into its QE. Call it, proxy QE.

  2. National banks bought their respective national debt thus unwinding current account deficits very rapidly.

  3. Coupled with a rate cut, the ECB provided banks with a profitable business, good for 3 years, consuming no capital. The profits would recapitalize the banks to some degree.

  4. Governments’ borrowing costs fell.

The subsequent TLTROs were less effective. Why?

  1. Private enterprise is unwilling to borrow. That’s it. The TLTROs were extendable only if the banks were seen to be pivoting their loan books to SMEs and private obligors. These LTROs were not meant for government bond purchases.

  2. As one hand of the ECB provided liquidity to fund private loan growth, the other hand increased capital requirements. This placed banks in an untenable position.

What about the latest TLTROs?

The details are still patch but basically, the repo rates are zero with a discount available for compliant banks, banks with a willingness to engage in more active private lending. At a fully discounted rate of -0.4%, the ECB is basically paying the banks to lend. In effect, it is co-opting the banks to grow their loan books. Will it work? Basel III and TLAC rules still hold which will continue to constrain the banks. Assets tendered in repo are not a true sale. And for all these technicalities, demand for credit is simply weak.

Last Updated on Friday, 11 March 2016 08:02
 
How To Think About The Chinese Economy. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 08 March 2016 00:29

  • The world is engaged in a trade war which hits manufacturing and industry more than services and consumption. The composition of the Chinese economy makes it vulnerable. The Chinese are a proud people and will claim that the rebalancing is an intentional project rather than a phenomenon forced upon them.
  • China’s markets are still closed albeit becoming more open. A financial crisis in China will have less contagion effects than a financial crisis in a more open economy.
  • China’s contagion risk lies in the real economy through trade. But world trade is already stagnating and the world becoming more insular. Also, the weakness in the Chinese economy is over 5 years old and not new. Its effects have already been felt.
  • China’s nominal output is some 10 trillion USD per annum. To expect even a balanced economy to grow at 6% is very optimistic. For an economy plagued with overcapacity in heavy industry and state owned enterprises to grow at 6.5%-7.0% will require more stimulus.
  • The central bank has been stimulating the economy with Open Market Operations (repo operations), interest rate cuts and reserve ratio cuts. This will accelerate. Even so, monetary policy will be insufficient given the examples of the Bank of Japan and the European Central Bank. The Chinese government recognizes this and will engage fiscal policy, budgeting for a 3% deficit, officially, but in fact more, to boost demand. Other countries may learn from the Chinese experience, positive or negative, as their policy unfolds.
  • China’s debt stands at over 2.5X GDP. Government debt is circa 40% of GDP and is not a problem. The bulk of China’s debt is corporate debt and raised in local currency. Being mostly in local currency, China’s debt is less sensitive to exchange rate fluctuations. However, most of the debt was raised by unproductive SOEs and heavy industry and will face increasing defaults. The government has the financial ability to bail out or to absorb debt write-downs on behalf of the banking system and domestic investors without depleting its foreign reserves.
  • The government has been encouraging refinancing of USD debt in local currency, with extended maturities, and lowered debt costs by changing collateral rules and capital requirements for specific assets such as municipal bonds and LGFV debt. The total debt may rise before it falls.
  • China’s non-manufacturing economy is healthy. Despite declining, non-manufacturing PMI’s hold above 50, whereas manufacturing PMI’s have now been below 50 for close to a year. There are good sectors, industries and companies in China. Unfortunately, investing in China is a very risky endeavour. 90% of capital accounts are owned by retail investors leading to a highly sentiment and technically driven market often subordinating fundamental factors such as earnings and cash flow.
  • The macroeconomic conditions in China imply a weakening RMB. The weakness in RMB has not been entirely due to capital flight. The government’s efforts to get corporate China to refinance USD debt in RMB must result in capital outflows and a reduction in foreign reserves, which we have seen. The solution to private capital flight is a sharply weaker RMB which the PBOC is unwilling to allow.

Last Updated on Tuesday, 08 March 2016 00:33
 
Investing in tumultous times. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 17 February 2016 06:54

2016 began with very weak equity and credit markets. Markets reacted strangely and counterintuitively to data and central bank policy. So, how does one invest in times like this? Ideally, one invests in precisely the same way one invests in calm markets. When the herd is panicking, calm is the scarce resource and therefore valuable. A few principles are worth remembering.

Find the exit before the entry. This is true whether one is investing or indeed doing anything. It is a most general concept. It is fine if the exit is expected to be a tricky one. Recognizing it as such prepares one for the eventuality and advises the enthusiasm of the entry. Sometimes, the exit requires that the market comes to its senses, and sometimes the exit is structurally established. Relying on the rationality of other investors is a risky endeavor, judging by one’s own rationality or lack of it. Relying on a structural or contractual exit is better, but the returns are usually commensurately smaller.

There is no return without risk. If there appears to be such an opportunity, then one has failed to identify the source of risk. Risks are not limited to market risk. General conditions can change altering the fortunes of companies and countries. Laws and regulations can change or be open to interpretation. Contracts are not always honored or enforceable.

Compounding is powerful. It is difficult to compound a volatile investment. An investor should realize that losses are inevitable. The nature of compounding is such that you want your profits to compound, that is to grow exponentially, and your losses to be linear. The only way to do that is to limit your losses. The downside to this strategy is that you will leave a lot of profits on the table, which is still preferable to sustaining losses which take too much time to recoup.

Managing losses comes with experience. Investors who have never lost money are either economical with the truth, or have yet to make a loss and are therefore inexperienced in dealing with it and at risk of sustaining a bigger loss than one practiced in the art of losing. Lose often, not big. But not too often for that is when embarrassment takes over.

Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”, said the great Warren Buffet. This needs some qualification. The market isn’t always greedy or fearful, most of the time its just mildly manic depressive. In these in-between states, it pays to be with the herd. How can you tell when there is fear? It’s when you yourself are fearful and selling. You will feel awful and feel like selling everything. Until you get there, it’s not fear. You must be acutely opposed to buying when you buy.

Managing one’s own emotions is at least as important as the cold rational decisions one is supposed to make. Completely removing emotions from investment decisions is almost impossible to do unless one delegates the decisions to a trading algorithm. The patchy performance of such algorithms implies that there are elements of our emotions which are useful in investment decisions, or that algorithms are inherently incomplete. A few rules might be necessary to mitigate emotional biases, such as having stop losses, independent risk managers, diversification rules and time outs.

Don’t overdo it. When a great investment idea comes along, do it, but don’t overdo it. Wall Street is great at coming up with great ideas but overdoing them, that’s why they almost always end in tears. CDOs, CLOs, SIVs, CDS, portfolio insurance, risk parity. At the more practical level, this applies to sizing your investments. You will never have enough of a winning position so make sure you don’t for if you do, you might have too much of a losing position. Best to always go away slightly hungry.

Leverage is not a bad thing, it makes good things better and bad things worse. Most importantly, far more important than the multiplier effect, leverage transfers control over an investment strategy away from the sponsor or equity to the senior lender. Structure leverage and use it with care.

We are not smarter than everyone else. It is natural to believe in our own intellectual superiority, but in fact we are the average. To avoid turning investing into a game of pure chance we need a sensible process and discipline. Genius is rare and cannot be confirmed.

Last Updated on Wednesday, 17 February 2016 06:55
 
The Global Trade Depression And Its Consequences on Inflation and Central Bank Policy PDF Print E-mail
Written by Burnham Banks   
Wednesday, 27 January 2016 07:56

Global trade has stagnated since 2011.

Why has trade stagnated?

In the wake of the global financial crisis of 2008/9 countries realized that their consumers were weakened, their businesses were discouraged, and their governments had used much financial reserves to bailout their banking systems. The only feasible driver of output was trade. All countries therefore adopted attempted to increase net exports.

A state of Cold Trade War has persisted since then. Initial battles were fought in foreign exchange where each country in turn attempted competitive devaluation. Subsequent gambits included reshoring of manufacturing and protection of intellectual property to protect domestic businesses. It is impossible that all trading nations are net exporters. Currencies are quoted one in terms of the other. There is no successful resolution to trade wards, cold or hot.

What are the consequences of a Trade Depression?

In a trade war, exporters suffer, as currency volatility, protectionism and mercantilism weigh on business conditions.

Manufacturing is more export exposed than services. Manufacturing suffers relative to non-manufacturing. This has been supported by empirical data.

A general favoring of non-manufacturing over manufacturing explains the weakness in the Chinese economy as the larger part of its economy slows and the smaller services part of the economy takes over. It means, however, that the rebalancing is not a voluntary action by the Chinese but a reality imposed by circumstances.

A reduction in trade negatively impacts productive efficiency and lowers global productivity growth. Post 2008/9, productivity has been volatile and weak and this is set to continue.

Slower productivity growth implies lower efficiency and a smaller output gap. So far it has been assumed that central banks have much latitude to operate expansionary policy, however, a tighter output gap could challenge this assumption and introduce more uncertainty around interest rate assumptions across term structures via inflation expectations.

The uncertainty created around central bank policy and around the trajectory of rates and the shape of term structures will have significant impact on asset valuations.


IMF World Trade, Exports:

 


Last Updated on Wednesday, 27 January 2016 08:00
 
Investment Strategy 2016 Q1. Cautious on Stability. Going Where The Trouble Is. PDF Print E-mail
Written by Burnham Banks   
Monday, 11 January 2016 23:44

Disclaimer: All information and data on this blog site is for informational purposes only. I make no representations as to accuracy, completeness, suitability, or validity, of any information. I will not be liable for any errors, omissions, or any losses, injuries, or damages arising from its display or use. All information is provided AS IS with no warranties, and confers no rights.

Because the information on this blog are based on my personal opinion and experience, it should not be considered professional financial investment advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. My thoughts and opinions will also change from time to time as I learn and accumulate more knowledge and as general conditions evolve.

 

 

Following from our Investment Outlook for 2016 we formulate an investment strategy. A number of high level principles or themes will animate this strategy.

The strategic allocation is actually quite risk averse. The reason for this is that the global economy remains fragile and the performance enhancing drugs or policies prescribed by the world’s central banks are losing marginal effect, even if they have worked to a limited degree. The central banks of the world have no leeway or capacity to deal with a recession or other crisis, if such should happen in the next 12 months. Even the Fed has only just begun raising interest rates.

Equity markets have fared quite well in the last 5 years, the S&P 500 index for example, returning over 10% per annum. Global equities (MSCI World) has returned an annualized 5.3% in the same period. US high yield has returned 4.2% and the Barclays Aggregate 2.6% in the same period which on a risk adjusted basis, this is quite respectable. Corporate performance, however, has not kept up and companies have spent the money they raised paying dividends, buying back stock or each other instead of investing in productive assets. Valuations have therefore risen and are highly sensitive to interest rates.

The US Federal Reserve has just raised interest rates and signaled 4 further rate hikes in 2016 and the market is pricing in just 2 rate hikes. The fixed income market is not robust against a hawkish surprise by the Fed and the USD term structure is too important in the valuation of all assets from corporate credit to equities to real estate.

Global trade peaked in 2011 and has been trending sideways. When trade lags output growth productive and allocative efficiency suffer and the risk of inflation rises. That inflation hasn’t risen in the last 5 years is evidence of deficient demand. This is corroborated by the weak impact of successive rounds of quantitative easing on real output growth even as it inflates asset prices.

Geopolitical risks have been rising. The energy independence of the US has played an important part in the increased turbulence in the Middle East. The Arab Spring has been unsuccessful and ISIS is seeking the establishment of an Islamic State across Syria and Iraq. The rise of China economically has also led to increased ambitions abroad if not at least to secure its own interests. Europe’s unity has been tested in the bond markets and latterly by the election of anti-austerity and Euroskeptic parties in Greece, Portugal and Spain. Right wing nationalist parties have gained traction in core Europe as well. In the UK, an in out referendum on Britain’s membership in the European Union is scheduled to take place before the end of 2017. While geopolitical risks are always with us, the last 5 years have experienced an escalation.

Since markets were not driven by fundamentals in the post 2008 era of QE and the central bank, can we assume that fundamentals will return to drive markets in a post QE era? Are we even close to a post QE era?

With this much uncertainty in the markets it is likely that markets will be fickle and sentiment driven, at least in the next 12 months. A guerrilla trading approach may be necessary if one is to manage volatility. Long term investing is laudable but long term investing can and must also include short term risk management and trading. If we challenge established wisdom we will come to conclusion any part of an optimal investment strategy must be itself optimal, we find theoretical support for lower latency strategies. We are not talking about high frequency trading but of adjusting the optimal portfolio to suit the evolution of market prices and information.

Strategy:

Maintain an underweight in US equities. Valuations are expensive, growth is tepid, and the Fed is not expanding its balance sheet. US equities cannot rely on higher earnings multiples with the Fed in neutral and so have to rely on earnings growth, the prospects of which are not looking very attractive.

Restore overweight in European equities. We were underweight risk assets on the whole coming into 2016 simply because the macro environment just looked risky. We are restoring our position in European equities to overweight. European growth is still in recovery mode, earnings are recovering in sympathy, the ECB is still buying assets and thankfully didn’t overdo it in December when it disappointed the market with less than expected monetary stimulus. There is potential for the ECB to do more and this could propel European equities. That said, we are taking our time to restore the allocation to overweight and events may derail this deployment.

Underweight Japan. Japan appears to be pushing the limits of policy. The latest macro data is not encouraging and yet the BoJ has stopped short of increasing QE although it has tweaked the current program slightly. Japan has relied on a weak JPY to invigorate the stock market and it looks like the JPY has reached a trough.

We began the year with an underweight in China. Since then the market has fallen 15%. It may yet overshoot and lose more, but it is time to revisit the underweight call, since it has worked. China’s regulators have mismanaged the market policies and exacerbated if not precipitated the equity market sell off. The underlying economy, while slowing, is not in crisis. We think the time is right to begin seeking value in Chinese companies.

US duration is very tricky and although model weights are circa 10% for investment grade, we are err on the side of caution. The market disagrees with the Fed on the path of interest rates and is therefore vulnerable. Arguing for duration is the fact that inflation is weak and 30 year USTs are likely to outperform. The mid section of the curve is particularly vulnerable to rate hikes.

US high yield is facing a divergence between sentiment and value. We intend to raise US high yield exposure from circa 4% to circa 10% with a preference for leveraged loans. The bond market has too much energy exposure and exposure to the vulnerable belly of the USD curve.

For our European credit exposure, the ECB’s position on QE is helpful and we are happy to own peripheral duration as well as corporate credit. That Europe has yet to get over the deleveraging phase is helpful to credit and we are balanced between owning high yield and sovereign duration. A sub strategy within European credit is bank capital where the implementation of TLAC has extended a trade which began in the 2011 LTRO and the 2014 asset quality review.

We like the USD on the strength of the US economy, short term cyclical slowdowns notwithstanding. With the ECB maintaining QE and indeed having not done enough, threatening to do more, we see the EUR remaining weak. The JPY is different. While fundamentally the Japanese economy continues to languish, it appears that the BoJ and the government have reached the limits of accommodation and as a result the JPY may have found a temporary base. It may not weaken as quickly as fundamentals would suggest. CNH, however, wants to weaken, and the current weakness masks PBOC efforts to support the currency.

Cash. In turbulent times we like cash, not so much as a dampener of volatility but because there may be assets to buy. We maintain high cash levels, model weight 10%, actual weight probably 20%, in anticipation of buying opportunities in the first quarter. But we are in no hurry. We have a shopping list and we are cashed up but the cheap sale continues and the markdowns continue. Its not a bad thing to be patient.

Last Updated on Wednesday, 20 January 2016 09:22
 
Investing In Chinese Stocks Is Like Investing In A Hedge Fund with Gates and Notice Periods. Stock Sale Bans, Trading Halts and Other Means of Deterring Investment. PDF Print E-mail
Written by Burnham Banks   
Thursday, 07 January 2016 08:12

China is having a spot of bother controlling the volatility in its stock markets. For one, the circuit breakers are not functioning as intended. Trading is temporarily halted if the market moves by more than 5% and halter for the day if it moves by more than 7%. The quickest way to empty a room is to threaten to lock the doors. Also, large investors, that is investors with more than 5% holdings in a company will only be able to sell 1% over 3 months, and then only with 15 days notice to the regulator. This means that these investors are subject to hedge fund liquidity. In the jargon, its quarterly liquidity, account level gate, 15 days notice. But in a hedge fund this applies equally to all investors, whereas in these markets, such notice gives smaller investors a chance to run for the hills. Good work CSRC. Nothing cures falling prices better than low prices. Closing the gates only makes people run for them. And banning selling only de facto bans buying.

Last Updated on Thursday, 07 January 2016 08:15
 
Ten Seconds Into The Future 2016. Investment Strategy In A Clouded Outlook. PDF Print E-mail
Written by Burnham Banks   
Monday, 04 January 2016 05:58

In financial markets perception drives reality.

China:

China has been on a campaign of international engagement and integration. This opportunity has emerged as America has become more self-sufficient and insular and China has not wasted it. The desire to engage and adopt international protocols and norms is driven by self-interest. China knows that it can best influence and author these protocols and norms if it engages early, actively and constructively rather than antagonistically.

The Chinese people, however, suffer from a persecution complex precipitated by years of humiliation. As the Chinese government engages internationally it needs to maintain a show of strength for domestic consumption. This has taken the form of belligerence in the South China Sea and in its relations with Japan.

If, however, this thesis is correct, then the risks of escalation in the region are or can be contained. Some care still needs to be taken on all sides to avoid accidents and trembling hands.

China's foreign policy has domestic implications. It needs to shape domestic rules and regulations to be aligned with international standards including adopting rule of law over rule of Party and increased market discipline in equity, credit, money and currency markets.

The decision to reform is, however, a unilateral and central decision and not an evolutionary product of a democratic or capitalist process. This contradiction introduces additional unpredictability to the implementation and progress of reform. The potential for turbulence, miscommunication and mistakes is high. Take for example the change in exchange rate determination in early August 2015 which was miscommunicated and set of considerable market volatility, or the way the equity market crash was handled in the middle of the year. China is still centrally planned if not centrally controlled and reform can be temporarily rolled back if need be to manage turbulence and uncertainty. Stability is still the priority on the road to reform.

At the same time, as America relies less on Chinese production, so China must rely less on exports. A large scale rebalancing of the economy away from heavy industry and investment, and away from SOEs towards consumption, services and private enterprise. Stage two of the rebalancing will be China's response to the self-sufficiency of her erstwhile major trading partners. Expect investment in intellectual property and technology, in soft infrastructure and institutions. It is not enough that China turns to consumption but China must have the means to supply that demand as well without being overly dependent on foreign technology. Especially since the currency might not be as strong as expected in future.

An endeavour of such scale, and the cost of coincident reforms are naturally a drag on economic growth. The government has stated that it will target moderate growth despite this drag, probably at levels it deems sufficient to generate employment and growth so as to maintain social stability. Maintaining growth at or just below current levels will be challenging as the reforms are implemented and as the economy is rebalanced.

The Chinese government has a list of sometimes contradictory items to do.

  • Instill rule of law and institutions.

  • Reform economy towards market discipline.

  • Maintain growth.

  • Reduce debt or debt service for local governments and over-levered sectors.

  • Encourage credit availability for private enterprise, especially small and medium enterprise.

  • Encourage consumption including consumer credit.

  • Maintain stability in economy and markets as much as possible.

This will likely force the government into another list of actions.

  • Maintain loose monetary policy. Cut interest rates and reserve requirements.

  • Engage fiscal policy to boost demand.

  • Intervene in equity and credit markets to ensure no repeat inflation of a bubble in asset prices.

  • Intervene in equity and credit markets to prevent any collapses or crashes.

  • Intervene in foreign exchange market to slow the natural weakness of the currency against the dollar.

  • Bailout systemically important companies if they fail.

The contradictory forces in China will make it difficult to read the markets and assess business prospects. When does market discipline apply and when is it too much? Answering this question will be very important in determining the fortunes of Chinese assets and businesses.

US:

The Fed has signaled its intention to raise rates slowly, specifically 4 quarterly rate hikes of 0.25% for a year end Fed Funds Rate of 1.375%. Market expectations are for 2 to 3 rate hikes for a year end Fed Funds Rate of 0.87%.

The Fed focuses on the domestic economy when making policy but will consider external factors such as international growth, trade and financial markets. These factors are diminishing in influence as the US becomes more self-reliant. However, the Fed does have to consider the reactions and actions of other central banks insofar as they impact policy second order variables such as exchange rates and interest rate differentials.

The Fed may have to consider that trend growth has been reduced due to the stagnation of global trade and the frictions in credit transmission from new banking and financial market regulations. If true this implies a smaller output gap and would support the Fed's more hawkish stance compared with market expectations.

The Fed normalizes policy at a time when markets have already tightened credit conditions ahead of expectations. This could exacerbate the current slowdown. The risk of recession remains low, however.

One possible strategy for raising rates without creating undue turbulence is to allow the market to digest and tighten ahead of each planned rate hike. Each rate hike itself should not move market rates but would instead lag the market. This is a practical solution for the Fed and has important trading implications.

The dollar has been strong for over a year and this strength has exerted some braking power on the economy. In terms of risk, however, the long dollar trade is getting crowded and long in the tooth. Dollar strength against JPY may abate as the BoJ maintains but does not accelerate QE. The same analysis could apply to the euro and the ECB. Sterling might be weak against the dollar on Brexit risk but this is highly political and difficult to assess.

Where the dollar is more likely to see continued strength is in emerging markets. Emerging markets have slowed and do not look likely to recover quickly. Emerging market assets may be cheap but suffer from a fundamental weakness in business model. Supplying China with more basic resources when the economy is turning towards consumption and services is no longer viable and such economies struggle at reinvention.

Another potential source of dollar strength is volatility. The overwhelming consensus is that 2016 will be a volatile year for financial markets. Uncertainty, volatility and crises favour dollars and US treasuries. Unless the crisis or volatility are domestically generated in the US it is difficult to envisage a better hedge than dollars and treasuries. Sometimes, even US originated crises can buoy dollars and treasuries. In fact the more severe the crisis, the more robust is the hedge.

In the past 7 years corporate profits have grown at a decent pace but of late earnings growth has lagged expectations and equity markets have risen on multiple expansion. Part of this is fueled by the demand for yield driving bond issuance which is used to finance special dividends, share buybacks and M&A. Top line growth has been more sluggish and companies have been eking out efficiencies and cost savings instead of innovating and investing. This is not very encouraging for future growth.

The US has always been a source of innovation and technology. Innovation will be required to drive corporate profits if equity markets are to rise further. While the US remains the centre for innovation and research regulation and ethics can slow the pace of innovation in certain sectors such as healthcare and artificial intelligence. AI is probably where the most significant innovation will occur. Some of this innovation will be driven away by overly complex and burdensome regulation. US companies may seek regulatory arbitrage by relocating their R&D to countries with less restrictive regulations.

Generally, US companies have a lower propensity to invest and a preference to return capital to shareholders. In the long run this is detrimental to the growth potential of the economy further compressing the output gap.

Investment opportunities in the US will emerge more from idiosyncratic mispricing than from growth. Certain pockets of credit markets such as the high yield market are already priced for close to recessionary conditions. High yield markets have sold off sharply on concerns about the energy market, some 16% of the high yield bond market, as well as concerns over liquidity or lack thereof as regulations deter primary dealers from holding inventory. A related market is the loan market where energy is less represented (4.5%), but where liquidity is thinner. Structured credit wrappers of high yield offer even more attractive returns but are complex and can be daunting for the uninitiated. Here, fortune favors the brave.

Whereas the long duration trade was driven by falling long term bond yields, the curve may more accurately be characterised by a bear flattening than an outright lower long bond rally. Arguing for a lower yield are the current absence of inflation, weak energy prices, a strong dollar, and tighter credit conditions. Arguing for higher yields are the risk of a smaller output gap, the risk that energy prices stabilise and base effects fade, the depletion of foreign reserves in the emerging markets and China, an important source of demand for treasuries. The factors are evenly balanced.

Europe:

The European economy was already recovering at the start of 2015 when the ECB decided to embark on QE. A weak Euro and falling interest rates had already done part of the job for the ECB. Three years of open market operations to infuse liquidity while stopping short of outright asset purchases had some positive impact. QE therefore was in part symbolic and likely timed to coincide with the results from the earlier LTROs.

The Greek economy is but 2% of Eurozone output and unlike a bank, especially an investment bank, it is not a hub for financial risks. Yet when Syriza won control of the country and threatened to renege on the existing debt reduction and austerity plans agreed with creditors, it sent ripples through the Eurozone markets out of proportion to its real economic influence. Greece was challenging a status quo and a European financial orthodoxy that shoehorned financial reality into a dogma built upon deep European history and psyche. Greece was eventually forced to accept the status quo which meant no debt relief, and renewed austerity, in return for continued financial analgesic ad infinitum. The situation remains unresolved as Greece cannot reduce its debt quickly enough, if at all, it's economy is recovering too slowly, if at all, and it's economy is not evolving to the new realities of trade war and insularity even as the EU strives for greater union.

Similar political schisms have emerged in Spain, Portugal and generally across the union. Meanwhile Britain contemplates exiting the broader union in an in-out referendum which must occur by the end of 2017.

Europe's problems are hidden behind a strong stock and bond market, the latter especially supported very much by QE. Real growth, however, is weak, struggling along at 1.6% even as PMIs indicate a stable recovery. Spain's unemployment has fallen from over 25% but remains above 20%. National budgets continue to struggle below -3% of GDP. A nascent domestic profits recovery may be threatened by substantial corporate exposure to struggling emerging markets.

The Eurozone's current trajectory is not much more than a continuation of Germany exploiting a weaker currency, and the periphery bouncing back from acute financial conditions. France is beginning to falter, being neither the engine of growth that is Germany, nor having been through a period of distress from which to recover.

The ECB has been the author of much of the recovery from 2011 as it engaged in OMOs on an unprecedented scale. It would have engaged QE earlier had it not been for objections from the Germans. QE1 had pushed rates across the curve lower and had it not been for Greece's adventures in defiance might have led to even lower rates. As investors fretted about the first US rate hike in almost a decade the ECB engaged QE2 or QE1.5 since it disappointed in magnitude. What will the ECB do next? The EUR may not be sufficiently weak for their purpose so it is likely they will watch the Fed to see if the rate trajectory will cause the USD to regain the strength of the last 18 months. If it does the ECB might be able to hold and if not QE may need to be expanded.

Current consumer and business sentiment appear healthy but if these lose steam, QE2 may need to happen. The ECB is of course hopeful that no further stimulus will be necessary, not only because it would be job done but because it can expect strenuous German resistance.

Despite the importance of the ECB it does not and cannot solve the national balance sheet problems. It cannot monetise debt like other central banks. It cannot stimulate demand and it is demand deficiency that currently plagues Europe. The ECB can supply all the credit it can but without demand it is analogous to attempting to clap with one hand. National debt is constraining fiscal policy, the other hand needed clap. Were the ECB free to monetise debt, investors might allow Europe to spend its way out of weakness but that is a privilege reserved for countries which can print their own money. Thus union imposes discipline upon the central bank which imposes an inconvenient discipline on governments. Without union one could borrow, spend and monetise like the Japanese have done. How successful has that strategy been?

Of late there has been talk that fiscal policy might be engaged as the pace of growth stagnates. Some of these expenditures might be passed under extra-budgetary concessions such as military spending to address new threats to security, as well as spending to house, cloth, feed and integrate the exodus of refugees from the Middle East.

The euro has insufficient history to form empirical extrapolations but its structure suggests an accumulation of imbalances that require periodic potentially discontinuous adjustment.

The road to the euro witnessed yield convergence between member states. 2008 and 2011 saw yields diverge reflecting default risk and a test of the strength of union. Given the resolve expressed to maintain the currency union yields should converge again. However, the Greek adventure, and the hairline fractures unveiled during the Portuguese and Spanish elections indicate further volatility along the path to convergence. But converge they will unless the euro breaks. For clarity, national bond yields will converge unless there is an existential threat to the euro. National politics can create local yield divergence but these cannot be durable.

Unfortunately, one cannot rule out an eventual break up, even if a partial one, of the euro. Such an eventuality could have a long incubation but would affect asset pricing well in advance.

Europe's equity markets have been among the best performers in 2015 buoyed by lower interest rates across all maturities and a weak euro. For the equity market to continue on course would require more of the same. With the Fed having turned the corner on interest rates it is no longer trivial that euro rates will continue to fall. The US treasury spread over bunds cannot expand continually while growth rates converge. As for the euro, a move to parity with the dollar would not have the same impact as all the weakness in prior years. Corporate Europe's exposure to struggling emerging markets is another concern as they have not been substantially priced in by the markets which have derated emerging market equities while rerating European ones. Corporate Europe earns over a third of revenues from emerging markets.

Corporate credit is but another trade expression for corporate Europe's commercial fortunes. The difference is exposure to duration and to the current fad of balance sheet deleveraging which improves credit quality. Even this has its limits of earnings start to plateau or if rates should rise for whatever reason.

Japan:

Japan is intriguing. It's economy is in the process of rebirth. It was too far gone to call this a recovery. The factors behind this rebirth are a political capitulation resulting in a strong mandate necessary for the radical action which followed; fiscal stimulus, monetary stimulus and difficult reform. The consequences have been a resurgent stock market, falling interest rates and a weak currency. Meanwhile, no one who doesn't have to will hold JPY or JGB's except for quick trades front running the BoJ.

If the Abe government's gamble works, the economy will hold on to its recovery, inflation will rise, and the JPY might recover. Currently JGBs find but one fundamental buyer, the BoJ, monetizing the nation's unsustainable debt load. Foreign investors will only fund the Japanese government if they believe that the fiscal position can improve. Until then JPY will remain weak except in short covering or tactical trading. Foreign demand for JGBs in the meantime will not be to finance Japan but to warehouse bonds for sale to the backstop buyer.

Reform has been slow but the establishment will only budge in the face of success and there has been some. At the same time, QQE is highly price distorting but is necessary to monetise debt as well as to reinforce some of the government's reforms.

Towards the end of 2015, the BoJ confounded expectations that it would increase its QE efforts as weak data emerged. So far the central bank has been content with a more optimistic interpretation of data. On current form, it would take a serious deterioration in the economy to spur further action beyond the minor tweaks the BoJ periodically makes. Under these conditions JPY is unlikely to weaken further. On the other hand the conditions for JPY strength are distant.

The equity market has been driven by expectations and hope as well as targeted QE. Until these optimistic expectations are fulfilled valuations have crept higher. Japan trades at a higher multiple than China’s domestic shares, remarkable given the relative growth rates of the two economies and their companies’ earnings prospects. Further multiple expansion is difficult to justify. For the equity market to advance, returns on equity, top line and earnings growth need to improve. In addition the economy needs to show more resilience. Eking out more returns from existing resources and restructuring has its limits, limits which may have already been reached.

Tail Risks:

It is a positive that 2016 has begun with not much optimism and much caution. Even strong consensus and crowded trades have become clouded in the last days of 2015. These include, long USD short EUR, JPY and emerging market currencies. The long USD trade was the one the market was most certain about. That it has become less crowded may actually prolong it, but it is not a tail risk any longer, not unless the market returns overwhelmingly to it.

Deflation is another consensus trade and one that is a bit stronger and thus more of a concern. Global deflation has been exacerbated if not driven by weak energy prices. Bond markets and monetary policy are given encouragement and latitude by falling energy prices. Lower interest rates and bond yields support higher equity valuations and compress real estate cap rates. Energy and inflation could be a serious threat with implications across all the major asset classes, the correlation 1 factor, in a correction. It is difficult to see core inflation picking up when growth is as tepid as it is, however, headline inflation could easily rise if oil prices rise.

The demand and supply of oil is imbalanced with an oversupply of about 3 million barrels per day, rising from near balance in February of 2015. Oil demand peaked in June 2015 and is not expected to increase significantly. Greater energy efficiency in the global economy and slow growth will keep growth moderate going forward. The improvements in energy efficiency should not be underestimated. Cars and trucks are significantly more fuel efficient compared with 5 years ago. On the supply side, the same human ingenuity has produced new methods of extraction and lowered costs of production. If OPEC seeks to sweat the high cost producers, they could find thresholds lower than they expect. Fundamentally, therefore, investors are probably right in expecting weaker oil prices, some say 25 USD a barrel, to a moderate recovery if any. Lower oil prices are a sound bet, but the stakes are such that we cannot get it wrong. Going long energy could be a cheap insurance policy against a low probability event.

European equities have been among the most favored of markets, yet risks remain, among them, the risk that the British in-out referendum might result in Brexit. It is unclear yet what the implications will be for the UK, let alone the European Union, if Britain leaves the EU. Equity markets, however, loathe uncertainty, and a bad outcome is often better than a clouded one. It is not useful to attempt to assign a probability to Brexit since the decision will be more a political than commercial one.

 
Falling Interest Rates PDF Print E-mail
Written by Burnham Banks   
Monday, 28 December 2015 01:25

Why have interest rates been falling steadily for such a long time? Let’s think about interest rates in terms of the demand and supply of bonds, and not as the cost of credit or some abstract cost of money.

Demand for bonds:

  • Savings and Investment. Households may deploy their savings in bonds. Households save out of income. The more income, the more savings. The larger the population, the more income there is to be saved out of.

  • Social security, pensions and insurance companies demand bonds to match their liabilities.

  • Monetary policy. Central banks are significant buyers of bonds, especially in recent years. Much will depend on how the US Fed decides, whether it will restore its balance sheet or maintain it at current levels.

  • Greater inequality increases the demand for bonds relative to supply as it increases the savings rate.

Supply of bonds:

  • Profligate governments. Running chronic and significant budget deficits soon have a government supplying the market with bonds. There is a current focus on unsustainably high debt levels but this has not yet led to determined action to reduce debt.

  • Fiscal policy especially of the Keynesian variety can lead to a healthy deficit in need of financing.

  • Social security and healthcare costs money. Lower labour productivity increases social security costs. Ageing populations increase healthcare costs.

  • Investment requires funding and heavy investment, for example in infrastructure can result in an increased supply of bonds.

 
Ten Seconds Into The Future. 2016 Will Be Guerrilla Trading PDF Print E-mail
Written by Burnham Banks   
Monday, 21 December 2015 00:53

Last week the FOMC finally raised interest rates, the first time in 9 years. Risk markets rallied in relief before falling back on concerns in commodities and credit markets.

Equities

Year to date MSCI World is -3.45%. The S&P is -2.6%, FTSE is -7.8%, MXAPJ  is -13.6% and MSCI Emerging Markets is -15.3%. In China, H shares are -19.6% and Shanghai Comp is +10.6%. In positive territory, the Eurostoxx is +3.63% with CAC and DAX both up over 8%. The Nikkei is +8.8% and Topix +9.2%. A cursory glance observes that the weakest economies have the strongest stock markets.

Fixed Income

The Barclays Agg is -0.5%. On   the positive side, Euro sovereigns are +2.25%, China corporates are up, local IG and HY +2.95% and +6.83%. USD IG and HY are +3.45% and +10.55%. US Non Agency RMBS is +9.55%. On the negative side, US and EUR IG are -0.59% and -0.27%. US HY and loans are -6.17% and -0.94%.

FX

JPY traded within 116 – 125 in the year before settling at 121.33, or -1.30% YTD, largely flat despite weak data, as the BoJ holds firm.

EUR is -10.2% YTD, depressed by QE and the ECB’s inflationary efforts.

JP Morgan’s Emerging Market FX Index is -15.2% YTD.

Gold traded in a +-10% range YTD most recently trading at -10% YTD at 1065.

Commodities

Crude oil is -35% as supply continues to outstrip demand.

Nat Gas is -36%.

Industrial metals are broadly -30+% YTD.

Looking forward:

There is not much to look forward to really. One bright spot is the Eurozone where QE is young and PMIs are still buoyant. Still there is much uncertainty as flash PMIs have weakened, Spain will have a new government but it is not clear of what composition, Greece is still running a significant budget deficit and has signaled reluctance at further IMF support and the UK considers exiting the European Union. Fortunately the ECB’s last expansion of QE was sufficiently half-hearted to warrant a further augmentation.

The US was slowing already ahead of the rate hike. The Fed says 4 hikes in 2016 the market 3, so investors are already more optimistic about markets and less optimistic about the economy than the Fed. Without an expansionary Fed, equity markets will have to rely on earnings growth, which has been weak and hitting peak in recent quarters. At least the Americans are repacking their parachute back into the bag.

China continues to slow at a steady rate and has dragged its entire Emerging Market supply chain with it. The rebalance towards consumption and services looks to be on track, at the expense of the old economy industrial machine. The PBOC will continue to send liquidity where it is needed in copious quantities but will be careful that it does not drive asset bubbles. The H share market, already cheap keeps getting cheaper as fundamentals catch up to valuations.

Emerging markets have been in a 5 year bear market and valuations are approaching attractive levels. The problems they face are, however, not high valuations or rising interest rates or strong or weak currencies. Supplying China and the US or standing between them is no longer a viable business model when the two giants turn from one another.

Commodities’ current cycle is already very mature. However, it takes a catalyst to reverse the 5 year bear market. Such a catalyst could be a supply side shock, new legislation, previously unidentified demand.

A few spots of value may be exploitable.

Energy is evidently distressed and will soon present opportunities for restructuring. It’s probably too early and buying performing debt is probably ill advised but swaths of the industry will be headed into Chapter 11.

US high yield was overvalued but the tide has turned and not so much on credit quality than on concerns over liquidity. The HY bond market and the leveraged loan market already presents good value. However, the very nature of the mis-pricing, that is concerns over illiquidity, portend a volatile market. Risk management will be important.

Last Updated on Monday, 21 December 2015 00:56
 
Hedge Fund Business Development. An Opportunity For Prime Brokers. PDF Print E-mail
Written by Burnham Banks   
Monday, 07 December 2015 06:17

Hedge funds and their prime brokers should get more creative with their business development.

One area is illiquid side pockets which can be used to house either illiquid assets or long gestation strategies. These strategies should ideally not be in the main liquid structure of the hedge fund but carved out as a side pocket. The side pocket would be capitalized separately by investors who opt in, and or be separately offered to investors at arm’s length (that is to investors not investing in the main liquid fund.) The financing of such a side pocket would best be served by term financing or term securities lending. These liabilities might be offered to credit investors on a senior secured basis. Prime brokers could help in placing these liabilities for a fee.

Another area of development could be asset backed commercial paper issued by hedge funds. These would be shorter maturity secured paper backed by hedge fund assets. The maturities would need to be matched against the redemption frequencies and lock ups of the fund. Again, prime brokerage can facilitate the issue of these securities.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Last Updated on Monday, 07 December 2015 06:19
 
FOMC 16 Dec 2015 PDF Print E-mail
Written by Burnham Banks   
Monday, 30 November 2015 06:52

The Fed has form. When it wants to take away the punchbowl, it usually telegraphs its intentions well in advance so partygoers have time to go buy their own moonshine. So it was with QE taper, signaled in 2013, executed in 2014. By the time the Fed stopped net purchases of bonds the market had digested the eventuality and 10 year US treasury yields ended 2014 lower than at the beginning. The idea behind this is simple; the Fed wants to give the economy time to prepare for tighter policy, and constantly communicates with the market, managing expectations until when the move comes, the reaction is one of indifference. As we have seen in September, sometimes, the expectation becomes so entrenched that failure to act as signaled results in disappointment.

Forward guidance was meant more narrowly to mean central banks promising to keep interest rates lower for a longer period than signaled by traditional reaction function, an augmentation to policy once the traditional and the traditionally extraordinary have been exhausted, a last resort. Today, could it be interpreted as a more detailed statement about the intended objectives of the Fed, not just at the front end of the curve but across the curve as well? The Fed wants to hike rates, but it doesn’t want 10 year or 30 year yields to rise excessive or at all. Hence the numerous signals that the path of rate hikes will be slow, that inflation risk is de minimis, that treasury bonds will be in short supply, and so on.

Surely today, the Fed has once again engineered conditions to its tastes. The market expects a rate hike of 25 basis points, and little impact if any at the long end of the term structure. Quite in line with what the Fed intends.

 
A More Insular US. China Fills The Vacuum. China's strategy to neutralize America's containment policy. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 11 November 2015 06:39

For decades the US has relied on emerging markets, especially China, for cheap production, and OPEC and the Middle East for a steady supply of oil. In order to safeguard its interests the US has engaged the world's energy producers and exporters and manufacturing countries politically and strategically. Where America's economic and commercial interests are not served the US has been happy to pursue a policy of unilateralism which to some had come across as arrogant. America's newfound independence in manufacturing led, by onshoring and greater automation, and in energy, led by shale and fracking, have driven foreign policy to be more insular. This has created a political and strategic vacuum which China has been happy and clever to exploit.

The US has always been pragmatic about its international relations. The fight against Communism may have been its last ideological battle. Most of its other strategic campaigns have revolved around protecting commercial interests, trade routes or energy supply. Meanwhile, the US, for reasons valid or not, have been less sociable and have either failed to sign or ratify a long list of international treaties such as Protocols I and II of the Geneva Convention, the International Criminal Court, even the Mine Ban Treaty, and indeed the UNCLOS.

While the US has been busy refocusing on domestic consumption, manufacturing and energy independence China has been building bridges and winning friends. It led the establishment of the Asian Infrastructure Investment Bank to which Europe and most of Asia have signed up. Only the US and Japan have not joined the effort. Taiwan and North Korea were turned down. China has become Africa’s leading trading partner and a growing and important source of investment capital. China’s demand for resources may slow but its growing hunger for agricultural goods and farmland will likely grow. In October of 2013, the government announced the One Road One Belt initiative to improve connectivity in Eurasia.

In recent months, the Chinese President Xi Jinping has been given a very warm welcome at Buckingham Palace, as deals worth some 30 million GBP were cut. Angela Merkel’s recent visit to Beijing yielded some 17 billion USD in aircraft orders for Airbus.

In a further move towards global norms of market economics, China has further liberalized its current account, announcing a new methodology for the currency fixing to include market pricing, demand and supply. Her ambitions for the RMB to be included in the IMF Special Drawing Rights will likely be successful further drawing China into the international fold.

Last week, Xi Jinping met with the outgoing Prime Minister of Taiwan, Ma Ying-jeou, marking the event with a carefully choreographed handshake. The last time China hardballed Taiwan, the people voted in the pro-independence DPP. China is not about to make the same mistake and has toned down the rhetoric in the hope that the KMT, who are in any case expected to lose, will prevail in the coming elections.

 

In the area of financial infrastructure, the China's Cross-border International Payment System or CIPS is an important alternative payments system to challenge SWIFT. This is a significant step given the universal utility of SWIFT. When the US threatens any country with economic sanctions, denial of SWIFT is one of the most persuasive elements. CIPS is currently only used for RMB settlement and clearing, but its protocols are compatible with SWIFT and will with time erode SWIFT's monopoly.

In all of this the US is perhaps feeling slightly left out. Hence perhaps the USS Lassen’s FONOPs (freedom of navigation operations) 12 nautical miles off the Spratly’s on October 28. The US Navy’s cruise tours through the international waters of the South China Sea are legal, but it is perhaps awkward to cite the UNCLOS when criticizing Chinese ambitions in the area since the Americans have not themselves ratified this treaty.

With the Americans playing the short game and being rather more mercenarily pragmatic, China has played a more nuanced and skillful hand. China is building or joining clubs and cliques as America has pulled out of regions where they have felt their business interests do not lie.

The positive to take away from all this is that China’s strategy of engagement appears peaceful and constructive. It asks that it is allowed to do unto its own people as it sees fit but will otherwise play internationally by international rules. Fair enough since this is the same argument that gives the US pause in ratifying Protocols I and II of the Geneva convention. If this interpretation is correct it means a lower risk of martial conflict, which can only be positive. The fear has always been an insecure, insular China, turning inwards and away from the rest of the world. The same risk is less likely to apply to the US.

 

 

 

Why would China do this? It is an efficient defence against the America's China containment policy.

Last Updated on Wednesday, 11 November 2015 23:21
 
Don't You Dare Touch That Punchbowl. PDF Print E-mail
Written by Burnham Banks   
Friday, 09 October 2015 07:36

Raising interest rates is difficult when everyone is watching you. Its much easier to take the punchbowl away when people are not watching. Walking in on the party when it is in full swing and expropriating the punch bowl is likely to trigger all kinds of protest. And the withdrawal can be painful when you don’t know what kind of additives have gone into the mix when you weren’t watching.

The Fed had telegraphed its intentions to raise rates much too early and as a result got itself into a bind. The thinking then, 2 years ago, was that a rate hike would be less disruptive if telegraphed to the market early enough. Come September 2015, and conditions had changed so that a rate hike was not entirely feasible. Reasons put forward included the slowing Chinese economy, stock market volatility, falling emerging market currencies, and the risk of deflation. What was not explicitly put forward was the risk of a slowing US economy. Rising LIBOR, widening credit spreads, some 50 basis points in IG this year, some 200 basis points in HY, and a strong USD, have achieved some de facto tightening of financial conditions. Mortgage rates remain stable and have not reacted, but on average, across the economy, for consumers, retailers and producers, the impact is easily more than a 25 basis points Fed rate hike. With the starting point of such low interest rates, the percentage impact on debt service is significant and will likely slow the economy.

Another problem which can be illustrated by the punchbowl analogy is that you have a hundred guests, three drunks and everyone else is teetotal and on a diet and all you have to offer is punch and steak. Low interest rates and serial QE have not revived the economy much. The marginal returns to policy have been less than a roaring success. Asset prices are up but output and wage growth have been weak. The credit creation has not spurred growth because demand is simply deficient. Unfortunately, the antidote is fiscal stimulus, which is difficult to justify politically and ideologically. There are also risks to financing further spending after the first round went into expensive bailouts of expensive private investors.

Last Updated on Monday, 30 November 2015 06:54
 
China Revisited. Investment Prospects In The Middle Kingdom. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 30 September 2015 03:40

To understand the Chinese economy it is necessary to understand the collective Chinese psyche. it is one of great insecurity, feeling hard done by from all quarters, still harbouring an inferiority complex, and thinking that the world sees it as weak, backward and belligerent. As a result, it comes across precisely as insecure and belligerent. Even as China engages more openly in the international arena, China’s neuroses require it to behave more aggressively than it has to, for a local domestic audience, to address and belie perceived weaknesses. Most of China’s external behavior becomes more explainable in this context.

At home, China’s people have grown comfortable and confident in their economic success. Economic policy, however, is no surer, no more confident, certainly no more confident than the US Fed for example. China’s reform efforts to instill rule of law, market discipline and strength of institutions, have introduced more uncertainty into policy. It is this uncertainty that complicates much of China’s policymaking in recent times. In a centrally planned economy, policy was decree and there was a clear separation between target and measure, between state variable and control variable. As markets become more open and price driven, the effects Goodhart’s Law assert themselves. Policy cannot be made without considering the reaction of the economic agents and without risk of triggering unintended consequences. Legacy cultural tendencies to report success and suppress failure lead to noisy macroeconomic data exacerbating the problem of effective policymaking.

 

China’s ministry of finance, central bank and market and banking regulators are intelligent but are also inexperienced in operating under such conditions where policy is no longer simple or linear. Policy under open markets with all the feedback loops introduced by expectations mean a lot more than policy but include skillful communications and management of expectations. Recent policy missteps by the regulators have not so much been a failure of policy than a failure to manage expectations and communication.

 

In China, the state has interfered extensively and directly in allocating resources through administrative and price controls, guarantees, credit guidelines, pervasive ownership of financial institutions and regulatory policies, and it has done this with the SOE as principal accomplice. Recognizing the inefficiency of SOEs, China is in the midst of reforming the sector. Foreign investment will be introduced into state-owned firms via restructurings and joint ventures, as well as overseas mergers and acquisitions, the State Council said in new guidelines on SOE reforms. While welcome, the statement was deemed insufficient and vague. Notwithstanding the size and influence of SOEs, some believe that the driver of growth in China has been private businesses. According to the Economist: “Average growth in output for industrial private firms since 2008 has been 18%, twice as much as for industrial SOEs.” Private enterprise is heavily disadvantaged in particular in terms of access to credit. SOE’s still consume more credit and at lower cost than private enterprise and therefore represent unfair competition to the private sector.

 

China has a history of enterprise and innovation. The current centrally planned economy is in many ways the last ripples from the anomaly that was Communism which gripped China in 1949. China’s rehabilitation began with Deng XiaoPing who a reformer and rolled back some of the less sensible Maoist policies and principles. After him, Jiang ZeMin was the pragmatist, slowing reform where it threatened to rupture the economy or society but maintaining the general principle of Socialism with Chinese characteristics, Jiang’s own slogan was “socialist market economy”. Jiang’s leadership saw the demise of many SOEs as market reform exposed their un-competitiveness. It also coincided with a increase in corruption and cronyism and in the emergence of an oligarchy with penetrating interests in government and business. The next 10 years under Hu JinTao saw a maturing of the Chinese economy with all the associated social frictions that come from a growing middle class. In many ways, the Hu leadership set the stage for the current leadership under Xi as it sought to address some of the inequality and excesses of wealth and influence in China. Notably Hu’s government began to address corruption and lack of transparency in government and sought to narrow the gap between rich and poor as well as development between coastal areas and the interior. It was also a period where China began to more actively integrate itself into the global community beyond a purely commercial context and to assume more of the social and political norms of developed nations. Navigating this evolving political landscape was a vibrant private sector full of innovation and enterprise, saddled with the burden or task of working around market distorting policy, but profiting from the surge in investment in infrastructure both physical and institutional.

 

The image of China as a backward, reverse-engineering, IP stealing, technological laggard is persistent but mistaken. In 2014, the top and third most prolific patent filers were Huawei and ZTE, both Chinese companies. China’s annual R&D spend as a percentage of GDP, at 2%, has now exceeded Europe’s and is catching up with the US’s 2.8%. The numbers belie another trend, which is that private sector innovation is driving growth. Total factor productivity is growing 3X faster at private firms than at SOEs, according to the World Bank. A report by the McKinsey Global Institute finds that Chinese firms are particularly adept at innovation in a number of industries, in consumer facing industries such as e-commerce, in efficiency driven ones, such as manufacturing but lag in science and technology. Over regulation in developed countries may also provide China’s pragmatic model with an advantage. The same heavy hand of the state that meddles may also turn a blind eye to less ecologically or ethically ambiguous pursuits where more conservative western regulators would have acted.

 

China under Xi JinPing is facing the continuing issues of a growing middle class and a slowing economy, slowing naturally under the weight of its own size, the consequence of prior growth. Slowing growth is to be expected; economist sometimes forget that constant growth is exponential growth and unsustainable. The burden of central planning sitting alongside private enterprise is that price signals are attenuated leading to misallocation of capital and in China’s case, over investment and over capacity. Other areas such as consumer credit and mortgage credit are undersupplied. Recognizing these imbalances, the Chinese government has engaged macro prudential policies to redirect the flow of credit and lower the cost of credit for particular segments. Specifically, they intend to prevent excess credit in speculative markets, local government white elephants and SOEs while improving the access to credit for SMEs, private enterprise, consumer loans and mortgages.

 

At a more fundamental level, the Communist Party is trying to reform itself. This may appear mainly cosmetic but there are good reasons why the reform may be in earnest. A growing middle class, a better educated people, the proliferation of social media, have created an environment of de facto transparency which the government cannot reverse. To stave off an existential threat, the Communist Party has to embrace greater transparency, the rule of law, reliance on institutions, and other international norms as its new pillars. If you cannot hide, you should not try, is the principle. Transparency also places a greater responsibility back upon the people to play their part and to respond appropriately to policy. The new ideal is, however, in its own way, difficult to manage, especially for a government unused to intransigence and criticism. The rapid development of China, the size of her economy and the massive forces at play can be intimidating to the government and can and has led to policy miscalculations and hesitations. The handling of the sharp downturn in the domestic A share markets are an example.

 

From 2010, the PBOC the central bank has kept monetary conditions fairly tight with interest rates rising from 5.31% to 6.56% and the RRR rising from 15.50% to 21.50% as inflation accelerated from 2009 through 2011. Despite cheap valuations and decent earnings growth Chinese equities performed dismally, locked in a bear trend from late 2009 to mid-2014. It was only when the PBOC embarked on expansionary policy as US QE was tapered off and inflation receded that Chinese equity markets were ignited. From mid 2014 to mid 2015, the Shanghai Composite Index rose 148% in a liquidity accelerated ascent that defied reasonable valuations. Latecomers to the equity rally used leverage and margin accounts to boost returns and drove valuations further out of line with fundamentals.

 

Note that the motivation for the PBOC’s expansion was falling inflation and slowing growth, both incompatible with accelerating earnings growth. The market was driven by liquidity and sentiment alone. This is not to say that the astute investor recognizing the dynamics of the market could not participate profitably but it did mean that at the end the exit cost would be high. Ultimately the rally was ended by the confluence of an accelerated IPO pipeline, weakening company fundamentals, and the regulators themselves removing the punchbowl by regulating the growth of margin trading accounts.

 

Having burst the equity bubble the PBOC, alarmed by the pace and extent of the correction acted to slow the descent and limit the downside with a series of clumsy regulations including short sale bans, selling bans, market support funds and moral suasion. For all of September, the Shanghai Composite Index traded in a narrow band between 3000 and 3300. A 148% bull market had ended in a -44% bear market and although the market remains some 50% higher than when the stock frenzy began, sentiment has been damaged and the China market has become both the centre of attention for global investors and the alleged culprit for every market disappointment from the US to emerging markets.

 

In June 2015 the Shanghai Composite traded at a PE of 21X, still shy of the 27X seen in 2008; it currently trades at 13X, closer to levels seen in 2011. While growth is slowing, earnings growth rates remain high at over 20%. H shares in HK currently trade at a PE of 7 albeit with lower earnings growth potential, well below the recent peak of 11X in June 2015. These are aggregates of course and hide a rich detail. But even so, Chinese stocks which were acutely over-valued in the summer are now cheap.

 

 

Last Updated on Wednesday, 30 September 2015 03:44
 
Central Banks And What They Can Do For Us. PDF Print E-mail
Written by Burnham Banks   
Monday, 14 March 2016 08:40

Policy:

In December, the ECB extended QE from September 2016 to March 2017. Markets did not think it was sufficient, spreads between peripheral bonds and bunds widened, the EUR strengthened and equity markets sold off.

In late January the BoJ cut rates into negative territory and was rewarded with a stronger JPY and weaker equity markets, and the equivalent of a coronary in its money markets. Fortunately, not all was lost and JGBs rallied.

Last week the ECB was given a second chance to demonstrate determination and did so by cutting rates, increasing QE by 33%, including non-financial corporate IG to the shopping basket, and another dose of TLROs. Markets were skeptical at first but seem to be warming to the measures. This is the 3rd trading day after the announcement and markets are buoyant so only time will tell.

Tomorrow, the BoJ will announce its policy decisions. It is hard to see what it can do to boost markets. Evidently it can do nothing for the economy.

On Wednesday the Fed announces its decisions and publishes an update on the dot plot. The American economy is robust despite being in a shallow, temporary and controlled slowdown. On domestic data alone, a data dependent Fed would raise rates. The Fed is, however, unwilling to unnerve investors since their behavior impacts market interest rates and credit spreads and is therefore a Fed control variable. The Fed has not signaled strongly that it will act and therefore will likely delay the rate hike into the summer. Hopefully, the USD will be sufficiently weak, equities sufficiently buoyant and spreads sufficiently tight for the Fed to play catch up.

At some stage all these central banks are going to have to start thinking about what they can do for the real economy.

Last Updated on Monday, 14 March 2016 23:11
 
What will the ECB do March 10, 2016 PDF Print E-mail
Written by Burnham Banks   
Tuesday, 08 March 2016 07:49

The Eurozone economy has weakened in 2016 slipping into deflation with both manufacturing and services PMIs turning south in January and February. After disappointing the market in December 2015 with a mere 6 month extension of the existing QE the ECB will be expected to do more to spur demand and head off deflation.

The market will expect the following:

  1. 20 basis point rate cut to take the deposit rate to -0.5%.

  2. Additional 10 billion EUR monthly budget for bond purchases.

  3. Program extension from Mar 2017 to Sep 2017

  4. Additional TLTRO

What might not be effective:

  1. A rate cut is not likely to be effective. The problem is not willingness to lend but willingness to borrow. Banks will not be able to pass on the lower rates while incurring costs on their reserves on deposit. They might well raise interest rates to make up for the additional costs.

  2. The bond purchases are allocated according to the capital key which means 25.6% of the budget goes to German bunds, 20.1% to OATs, 17.5% to Italian bonds and 12.6% to Spanish bonds. Deflation is worst in Italy, Spain and France. Germany has zero price growth. The money is not going to where it is needed most.

  3. TLRO take up has been disappointing.

  4. Most of what the ECB can do, the market expects the ECB to do. There is no latitude for shock and awe left.

What might the ECB do to surprise the market?

  1. Moving away from the capital key and allocating the budget to the countries which need stimulus most and trying to bring rate convergence between countries’ bond yields could be more effective and would be taken positively by the market.

  2. Currently the ECB buys 8% of the budgeted bond purchases, while the National Central Banks buy a further 12% under a risk sharing program. The other 80% is not commingled and each NCB bears the default risk of their own government’s bonds. The ECB could make all purchases risk-shared. This would pull peripheral and core spreads together bringing down interest rates in Italy, Spain and Portugal.

  3. Removing limits on buying debt yielding less than the deposit rate. If the ECB cuts rates by 20 basis points, this point would be academic.

What might get in the way?

  1. On Feb 25, 2016, Jens Weidmann, President of the Bundesbank, argued that his Eurozone counterparts are putting too much emphasis on recent weak data. The Bundesbank’s own prognosis for the Eurozone economy was less gloomy. This could be a signal that the Bundesbank, the largest capital contributor to the ECB, is unwilling to do more.

  2. Draghi himself might decide that doing more of the same is not rational given that the initial program has not been effective. As long as the ECB was strenuously fighting deflation, governments would be less inclined to pursue fundamental reform.

Speculation.

  1. If the ECB simply meets market expectations, it is likely the market will be disappointed.

  2. The ECB has little room to surprise the market since the market is expecting a lot.

  3. Draghi may, if he so chooses, openly speculate about going off the capital key, or commingling the NCB’s risk, to present the Bundesbank a fait accompli at the Apr 21 meeting.

Trades:

  1. The EUR is fundamentally weak,  recent strength being related to the risk of a disappointing ECB announcement. The EUR remains a good short, however, the degree of uncertainty surrounding the Mar 10 ECB meeting recommends moderating this exposure.

  2. Under TARGET2, countries are essentially risk-shared and as such peripheral bonds should trade tighter to German and French government bonds. Convergence trades are still rational. Again the uncertainty around the possible outcomes leads us to defer this trade until we have more visibility.

 
Central Banks And The Limits Of QE. Fiscal Policy In The Wings. Leaning Left. PDF Print E-mail
Written by Burnham Banks   
Friday, 19 February 2016 06:01

Beware negative interest rates. The intention of central banks imposing negative rates upon an economy is to stimulate growth. But if 10 years of falling rates have done little to stimulate demand, 7 of those at close to zero interest rates, why would negative rates encourage more demand? Taken in the extreme, negative interest rates will encourage owners of money to change the relationship with their depository institutions from one of debtor to custodian. The result would be a withdrawal of money from the money market into a custodian network. There will of course be custody expenses but these are limited and such expenses are, at least for now, beyond the influence of central banks. Negative interest rates could therefore trigger a contraction of the money supply which would maintain the zero bound in market rates of interest while liquidity would overflow out of the money markets. The provision of liquidity to the system will have become waterboarding.

The FOMC meets March 16, the ECB March 10, the BoJ March 15. Confidence in central banks is waning resulting in more volatility surrounding signals they send whether hawkish or dovish. It certainly appears that central banks have reached the limits of policy and that efforts to boost growth will have to be even more innovative, if in fact growth needs boosting. Given the dogmatic pursuit of growth apparently beyond the natural metabolic rate of the global economy, it would not be surprising if fiscal policy were engaged.

In some ways, fiscal policy will be more effective than monetary policy. For all the magnitude of QE, it only supplies credit to the economy, it does not directly increase demand. QE policies assume that there is always demand for credit, but this is clearly not the case. If governments insist on pushing the economy towards a higher target growth rate, in the absence of private demand, it may have to spend. It cannot finance this spending out of taxes as that would sterilize the fiscal expansion. Instead, government would need to run a deficit and monetize it. When economists speak about ‘helicopter cash’, this is what they mean.

There is another way, which is to tax and spend, but to do it in a tax neutral and redistributive way. Imagine a wealth tax of 100% for all wealth over 100m USD. Put aside the practicalities and politics of such a tax for a moment and see what can be done with this. By one estimate (by Boston Consulting Group), this wealth totals 10 trillion USD, basically equal to the current nominal annual output of China. The marginal propensity to consume of these ultra-high net worth people is presumably quite low. Imagine if this, expropriation, to put it candidly, were ‘spent’ by distributing it to the bottom tenth of the global population, a group of households who could not save their income because they might be living below the poverty line, the boost to global output would be substantial. This is an absurd limiting case of course, but it illustrates the cost of inequality.

Economic orthodoxy will not easily relax the need for fiscal rectitude and austerity. Monetary policy has clearly hit a wall. Fiscal policy will eventually need to be engaged, and again, I qualify that this is if we target growth at a level beyond the natural metabolic rate of the real economy. Then countries will begin to tax and spend. Around the world, the people have already signaled their political choices, and it leans that way. Perhaps the masses know something the economists don’t.

 
Understanding China and How To Invest There. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 03 February 2016 02:45

China’s growth is evidently slowing and investors are concerned. China is the second largest economy in the world, and it is a manufacturing hub importing commodities and intermediate goods and exporting finished goods. More recently, China has extended its connectivity beyond trade in material goods but has sought participation in and sometimes led the establishment of significant clubs in the international arena. The establishment of the Asian Infrastructure Investment Bank, and the inclusion of the RMB in the IMF Special Drawing Rights are examples of how China seeks to engage and be part of the world. However, it is feared that its current and future position makes it a nexus for economic and financial contagion. To understand the potential for this it is useful to understand why China is slowing and if that rate of deceleration is a cause of concern or not.

Since 2008, the world has been in a Cold War in trade. As countries exhausted domestic consumption, their financial markets stopped funding business investment and their governments exhausted reserves in rescuing their banking and financial systems, trade became the only viable source of growth. A currency war was fought under the cover of financial system desperation’ it continues in fits and starts today. Weak economic data has become a relief as it justifies more monetary analgesic and currency debasement. New battlefronts have opened in the form of re-shoring in the case of Western economies previously happy to outsource manufacturing to foreign shores. The evidence lies in the stagnation of global trade since 2012. For an economy designed to export like China, a trade war is damaging. Exports as a share of GDP have fallen from 36% in 2006 to 22.6% at the end of 2014.

A related theme is the balance between manufacturing and services in the economy. Globally, services are growing whereas manufacturing is in decline. This is another consequence of the Cold War in trade. Manufacturing is more export sensitive than services so as global trade slows more than global growth, manufacturing must slow relative to services. This is a phenomenon measured from Asia to Europe to the US. As manufacturing capacity is re-shored, countries like China must experience a surge in excess capacity, even if GDP does not actually shrink. In the case of China, because manufacturing was the larger contributor to output, its relative weakness translates into weakness in aggregate growth.

It is illuminating of the culture that the shift from investment and exports to consumption and services is portrayed as an intentional strategy when fact it is a phenomenon which China cannot avoid.

Then there is the matter of simple mathematics. Economies are expected to grow exponentially even though this is not realistic. Economists expect constant growth rates or use this as the basis of their calculations even when they don’t expect constant growth rates. When growth rates are high, the path of nominal GDP levels, not growth, is exponential. When growth rates are lower, constant growth rates approximate linear growth in the level of nominal GDP. Technically, the higher powers of the polynomial can be ignored when the growth rate is small, and the linear component is sufficient to capture the growth. When China’s GDP was 3.5 trillion USD, it was easy to grow at 10% per annum. China’s GDP is some 11 trillion USD in nominal terms. If China adds 700 billion USD of nominal output every year, that is it grows linearly, growth this year, 2016, would be 6.4% and growth in 2017 would be 6.0%.

While China’s slowdown is understandable, it cannot and will not simply passively accept its fate. China recognizes that as the world evolves it too needs to keep up with it. It has to address a number of issues.

As China opens up as it evolves it has to adopt international standards and norms consistent with a free and enlightened society. The complexity of managing an economy without arbitrary control over the populace is risky both economically as well as socially. To diversify its risk, the Chinese Communist Party recognizes that rule of party poses to itself an existential risk, a risk which can be mitigated by embracing rule of law. This is already well underway as evidenced by the focus on the constitution and the anti-corruption campaign.

China is engaging the world by joining and creating economic and political coalitions such as the AIIB. It continues to engage in trade as buyer even if its export competitiveness has been eroded. China’s adventures in the South China Sea are most probably a device to appease the nationalists at home who tend to have a bit of a persecution complex and see China’s engagement in the context of weakness.

China is spending more on R&D than ever before and has overtaken the US, Japan and Germany in terms of patents filed. Not all of this frantic patent filing will be productive but China is reacting to the charge that it has a poor record of generating intellectual property and is more adept at stealing it or buying it.

Change has direct monetary as well as opportunity cost. Rebalancing an investment and industrial heavy economy to consumption and services is costs in growth. China has stated that it wishes to maintain growth near current levels, impossible without central bank largesse. The PBOC has been busy providing liquidity to the economy to compensate for the slowdown associated with restructuring costs. We have seen the debt accumulation post 2008 as China first reacted to the new reality in international trade. This will continue. The PBOC, however, knows it can only deal with one problem at a time and it has chosen to allow debt to pile up, as it must, but tackle the more immediate issue of debt service. Enter targeted open market operations and debt restructurings, particularly of local government debt, to reduce the debt burden on the more indebted corners of the economy, the local governments and SOEs. At the same time it is directing credit towards SMEs and households. Unlike developed world central banks who pull 2, maybe 3 levers, interest rates, size of balance sheet and maturity schedule of balance sheet assets, the PBOC has many more levers and behaves like a creditor committee working to maintain the going concern of its massive economy.

China is full of opportunity but it has never rewarded the macro investor who buys equity index exposure, not for long anyway. Investing in China requires an understanding of businesses, their prospects, the behavior of management and of the government who continues to direct capital where it is needed and siphon it away from where it isn’t. China is a stock pickers market but fundamentals are but one small part of the analysis. Policy, frustratingly opaque and seemingly arbitrary, play an important part also, in determining price discovery in this fascinating market.

 
Well That's A Good Start. Regime Change In A Central Bank Driven Market. Why Markets Are So Volatile. PDF Print E-mail
Written by Burnham Banks   
Friday, 22 January 2016 00:22

The Euro Stoxx is down 12% year to date as I write this, Nikkei down 15.85% and China down 16-20% depending on the exchange and S&P500 down 9%. A barrel of oil (-20% YTD) is now cheaper than a barrel of fried chicken at a fast food restaurant.

I read in the newspapers that the collapsing oil price, WTI now trading below 29, is one of the factors for the rout in global equity markets, and I find this a bit strange. I understand that weak oil prices are not so good if you are in the middle or the periphery of the oil industry but for consumers, this is not such a bad thing. One argument goes that weak oil demand is an indication of a weak global economy yet we are increasingly seeing data favoring services over manufacturing almost across the globe, which could weaken that particular argument.

I also read that the slowing economy in China is responsible for the weakness in global equity markets. Yet China and the US have simultaneously turned away from one another, the US reshoring manufacturing and China turning to domestic consumption. I understand that this bodes ill for economies and industries supplying old economy China, heavy industry and somnambulistic state owned enterprises. But China world trade stagnated in 2011 and has not recovered. The world is less global from a trade perspective than it used to be. China’s ability to export deflation is contained.

Emerging markets have been cited as a source of risk. Capital flows on the back of QE(N) supported unsustainable business models and propped up currencies and assets which are now retreating as capital flows reverse. Some emerging markets have again funded themselves in USD, but where credit creation has been greatest, China, debt has been raised mostly in local currency, and the Chinese government still has sufficient capacity to support its markets and economy, if it is smart about it. Even the biggest cache of ammunition is quickly depleted by a loss of confidence.

If there is a real problem that threatens to plunge us into the next crisis, it’s unlikely to be one of these. The oil price has been declining for 18 months and China has been slowing since 2012. Emerging markets do not suffer from a balance sheet problem but a business model and cash flow problem, not insignificant, but known and therefore unlikely to be a blindsiding impact. For that we have to look elsewhere.

But since the markets are looking a bit seasick, perhaps we should try to find some positives to sooth ourselves.

One, regulators have not been complacent. The banking sector is safer now than it was before. Banks have been forced to raise more capital, to deleverage and to be more prudent in lending practices. Not all regulators have been as successful and not all banks as cooperative, but by and large the system has been fortified.

Two, central banks have not been complacent, but they may have been one dimensional. Efforts to boost output through QE have been widespread and determined. The US has ended its QE activities but they have not reversed them. Plans to reverse them have, in fact, been placed on the back burner. Whether this is a good thing is another matter. The ECB has been slower to act and then less robust, but circumstances will likely pressure them to do more. The BoJ is already at the limits of credulity in its efforts and is attempting more subtle adjustments instead of outright increasing the expansion. The PBOC has the most complex problem and the most complex policies, but is supplying liquidity wherever and whenever it is required.

In the absence of cataclysmic risks it would seem rational to seek investments which offered good value. Chinese equities listed in Hong Kong are pretty cheap, so is Korea, Taiwan, Vietnam, the US auto, transportation and tech sectors, Brazil, Argentina, Russia, Turkey and just about any MENA stock market. Some of those markets are cheap for overwhelmingly compelling reasons, recession, stagflation, sovereign insolvency, broken business models, but not all of them are and value can be found. The same variation of valuations can be found in credit markets, with the same variation of credit and legal jurisdiction quality and economic strength. Generally, credit is cheap compared with benchmark sovereign and swap curves.

So, should we all go out and buy emerging, frontier and submerging market equities, leveraged loans, junk bonds, and structured credit junior tranches? It depends on your time frame. Too short, and you have volatility, too long and an unpalatable truth might emerge.

Since 2008 we have been playing a game of chicken with the central banks. The system broke, the central banks and governments stepped in to prop things up and reassure us that everything was alright, and we in turn knew that this was not the case but that the governments would have to keep the pretense up until everything was in fact alright. We always knew that one day, either everything was alright and our initially artificially elevated asset values were justified, or that things were not alright and the game was estimating when the wheels would come off the government QE machine and asset values would head lower in pretty short order.

When central banks are the determinants of asset prices, volatility is not a reflection of the risk in an asset but the risk of execution of central bank policy. A significant part of the volatility is likely due to the recent uncertainty in central bank policy. The Fed increased uncertainty when it failed to raise interest rates in September as it said it would resulting in speculation that the economy was in worse shape than suspected. At the same time, the BoJ failed to increase its asset purchases, as weak Japanese data suggested it would have to do, disappointing the market and leading to the unwinding of large consensus shorts in JPY. The ECB failed to increase its QE efforts enough, announcing a halfhearted extension to the asset purchase program from September 2016 to March 2017. The PBOC’s and CSRC’s multiple miscommunications and missteps led to a severe loss of confidence in the Chinese equity markets. So used have the markets become that they cannot make up their own minds about economic and commercial prospects they need central banks to show them the way. And when central banks themselves falter, investors understandably panic. This is unhealthy, but some change is coming, at least from the US.

The US Federal Reserve has a useful modus operandi. When it wants to do something, it telegraphs it well in advance, gets the market to price it in and then moves to align policy to the new market reality which it created, thus avoiding nasty surprises. This was not always the case, especially under Greenspan whose deliberate obfuscation may have hid bona fide confusion. From Bernanke onwards we are being fed information to manage us, to co-opt us into the deployment of policy. The Fed will now wean us off scrutinizing its actions as determinants of market behavior by itself becoming more data dependent in policy. With time, it is hoped, the market will try to gain an edge over the Fed by looking at the data.

We are in a period of adjustment, whether central banks still command markets or not, away from watching and front running central banks. It has been an easy 7 years, although many investors made it hard for themselves, relying on fundamentals instead of central banks in those early years after the crisis. Investors are as always slow to adjust. But the central banks are either losing their way, in part because there is no longer a clear and present danger, which is good, in part because policy has reached its limits, or recognizing that it is unhealthy to forever lead the market with a helping hand. Their messages are less clear and they seem less certain, even in Europe and Japan. The adjustment from policy focus to fundamental focus is a turbulent one with elevated volatility through the process.

The question then is, what will the fundamentals tell us? What valuations will we accept, under the assumption that central banks no longer drive asset prices. History is a guide but adjustments will need to be made to account for a loss of efficacy and certainty of central bank policy, a weaker credit transmission mechanism due to greater bank regulation, slower trend growth, slower global trade as countries seek greater self-sufficiency, the evolution of economies under innovation – the dominance of services over manufacturing, et al. Estimates for uncertainty around growth estimates will also need to be updated to take into account greater financial stability within the banking sector, the gradual withdrawal of central bank influence, income inequality and the risks of social unrest, increased geopolitical risk as countries become more insular, et al.

In the long run, growth will likely be lower, the loss of specialization by trade is an important factor as is credit creation which has run well ahead of itself and needs to be allowed or encouraged to mean revert, and asset markets will need to reflect this, likely with lower long run equilibrium valuations both in equities and credit. From the early 1980s we rerated in volatile fashion with booms and busts until we peaked in 2000. From there, valuations have fallen, again in volatile fashion. This long cycle derating is likely to continue, and again in volatile fashion.

In the medium term, an investor working with long term valuation assumptions will need patience and loss tolerance. The market will continue to adapt to the slowly changing reality of policy’s role in asset pricing, and in so doing will regularly overshoot in both directions providing good entry points and exit points to the lucky or smart investor. I’m happy to be either, I’m not fussy.

Last Updated on Friday, 22 January 2016 07:45
 
Insanity Investing. Ramblings From The Barstool. PDF Print E-mail
Written by Burnham Banks   
Friday, 08 January 2016 03:38

Market pundits did say that 2016 would be a difficult year for investing. However, they did say the same thing in 2015, 2014, 2013, not to mention 2010, 2011 and 2012. One can only conclude that it is always a difficult year for investing. 2009 was easy. You either couldn’t or wouldn’t exit in which case you made some money in the recovery but lost all your clients, or you could exit, did, missed the recovery, and lost all your clients. All the investors who experienced 1997, 1998, 2001, and said they were waiting for a crisis to invest, all fled, and missed the boat. These same investors are awaiting a market crash sometime in the near future when they say they will pile in, but will probably flee again when push comes to shove.

The two most important things in investing are courage and luck. Fundamentals and analysis are excellent at shoring up courage and providing very general direction. Too much a focus on fundamentals and your profit and loss will be volatile. Focus on profit and loss, and you will lose faith in your analysis. Markets are moved by the average marginal buyer or seller, and therefore by the average interpretation of the facts. The average person is by definition smarter than 50% of the population and dumber than 50% of the population, and has therefore a 50% chance of being right. Markets are therefore a coin toss. A series of coin tosses is a drunken walk (random walk is a technical term and I cannot afford precision here). To successfully trade a drunken walk, one needs courage or one will never act, and luck, or one will never win. The only other thing is discipline and risk management to ensure that one is able to replicate one’s good or bad luck day in day out. As long as you can stay in the game, you are successful. Don’t be overambitious or delusional.

In markets, perception drives reality. It’s has a parallel in quantum mechanics.

Once in a while, an obvious trade comes along. If it is obvious to many, it will become crowded and volatile and risky. Before it becomes obvious to too many, you will not be able to convince your boss, the risk manager, the client, the prime broker, the investment committee, or indeed your wife. Often you will need market counterparties to trade with without alerting them to the opportunity. Hired guns or investment banks, can help to run interference. The instruments available to capture the trade will often not be available, or you won’t be set up operationally to trade it, your risk systems cannot capture it or measure it, your back office will have no idea to settle it. If you are Supreme Commander, you might be able to surmount these obstacles, by which time, half of the opportunity has been realized by price discovery and the trade is becoming crowded.

Markets are prone to changing direction when the majority agree. If a market is going up and all agree that it will continue, it is likely to reverse. If the consensus is that the market will fall, it is likely to fall. If, there is disagreement and uncertainty, markets may be volatile but are likely to hold the current trend. When there is a strong consensus, either there is no longer incremental capital to maintain the trend, or there is sufficient incremental capital to reverse it.

Last Updated on Friday, 22 January 2016 00:29
 
Liquid Alternative Investments. The Next Big Liquidity Mismatch? PDF Print E-mail
Written by Burnham Banks   
Tuesday, 05 January 2016 01:42

Post 2008 there has been a significant preference for liquidity. UCITS alternatives and 40 act funds were a reaction to this and assets under management have grown. Central bank liquidity has suppressed base yields, and investors have tightened spreads across multiple asset classes, notably credit. Alternative strategies or hedge fund strategies have been deployed, with mixed success, to meet demand for returns. Liquidity preference has led to some less liquid strategies being packaged in liquid fund structures. 

The largest segments of liquid alternatives are credit and real estate linked funds. Not all of these strategies are liquid despite the liquidity provided by their investor pooling vehicles (funds). Liquidity has not been a problem as central banks mounted a concerted effort to inject liquidity and suppress yields. The divergence of the Fed towards a neutral to tightening stance changes the calculus. Financial market regulation also reduces dealer participation in market making further reducing liquidity in certain markets.

The importance of matching the liquidity of the underlying assets to the liquidity provided to investors in collective investment schemes may re-emerge with painful consequences.

 

2015 witnessed the closure and liquidation of Third Avenue's Focused Credit Fund, a distressed debt fund investing in the less liquid end of the credit market which was inappropriately structured as a liquid fund. Other similar distressed debt funds have closed since, the most recent being Lutetium Capital.

 

Alternative UCITS

 

 

 

 

 

 

 

 

 

 
Oil At Risk Of Rising. Saudi Commercial Strategy. PDF Print E-mail
Written by Burnham Banks   
Monday, 04 January 2016 02:53

The Saudi's have been pumping oil out of the ground come hell or high water, behaving as an insolvent merchant might. The market suspected that this was part of a ploy to drive more expensive producers like the US shale producers out of business. US rig counts are down but the Saudi's continue to pump furiously and the oil price has not recovered.

The Saudi's may have found a way to higher oil prices without sacrificing revenues. Start a fight with Iran.

 
FOMC. Current Expectations For Fed Funds Rate Evolution 2016. PDF Print E-mail
Written by Burnham Banks   
Monday, 21 December 2015 07:19

FOMC: Current expectations Dec 21, 2015.

The Fed raised rates last week Dec 16 by 0.25%. Currently, the market expects 4 rate hikes in 2016.


There are 4 FOMC meetings in 2016 in which a press conference follows and it is at these that interest rates are expected to be raised. Interest rates are not expected to be announced at FOMC meetings in which press conferences do not follow.


Thus, it is expected (96%) that at the Jan 27 FOMC, the Fed will not adjust rates. There is a 4% probability of a cut and 0% probability of a rise.

At the March 16 FOMC, there is a 53.7% chance the Fed folds, a 44.2% chance the Fed raises by 0.25% and a 2.2% chance of a cut.

At the April 27 FOMC, there is a 48.5% chance that Fed Funds will be 0.25-0.50, and a 45.1% chance that it is between 0.50-0.75.

At the June 15 FOMC, there is a 30.8% chance of Fed Funds being between 0.25-0.50, a 46.4% chance that it is between 0.50 and 0.75 and a 19.9% chance that it is between 0.75 and 1.00.

The next significant change in probabilities is Sep 21 where the probabilities are 17.6% for 25-50, 37.9% for 50-75, 30.9% for 75-100 and 11.2% for 100-125.

For the Dec 14 FOMC the probabilities become 7.0% (25-50), 22.2% (50-75). 31.2% (75-100), 24.3% (100-125).


 

The Dot Plot suggests a terminal Fed Funds Rate of 1.375% after 4 rate hikes.


No doubt these probabilities will evolve with economic data and signals from the Fed not to mention market volatility. However, it is interesting that if you calculate the expected Fed Funds Rate for year end 2016 you get 0.97%, not 1.375% as the Dot Plot suggests. They cannot both be right.

 

 

 

 

 

 

 

 

Last Updated on Tuesday, 22 December 2015 01:04
 
Asset Booms and Property Bubbles Are Bad For Economies Even If They Never Burst. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 09 December 2015 07:22

Success sews the seeds of its own demise. Adversity improves the breed. Human beings are dynamic and adaptive, which means they adapt to hardship by growing stronger, becoming more resilient and more resourceful, and they react to comfort by growing lazy, complacent and vulnerable.

A society which has won success and comfort through toil, enterprise and resourcefulness is strong. Even as success matures remnants of strength remain. Subsequent generations also observe the path to wealth and security lie in effort and enterprise.

Extended periods of success can lead subsequent generations to lose the memory of the path to success leading to lazier generations with a culture of entitlement.

When a significant proportion of a population finds success not solely by effort and enterprise, there is a significant risk that subsequent generations do not associate success with enterprise and effort but seek more comfortable factors to attribute the success.

Asset inflation is a particularly risky form of wealth creation, as opposed to accumulation of skills or capital. This is particularly acute in the case of housing booms because home ownership is likely more prevalent than other forms of asset ownership. Real estate booms result in a wide ranging and highly inclusive growth in nominal wealth. Absent multiple real estate asset ownership it is arguable if utility is improved since replacement value rises with asset value. The increase in wealth is disassociated with effort and enterprise, and this is signaled to subsequent generations. Populations which have insufficient history to observe asset busts as well as booms will have biased assessments of risk, generally underpricing the risk in the relevant asset class.

The ubiquity of the wealth effect results in a widespread accumulation of wealth which is disconnected from effort and enterprise. The impact on labour is that it discourages effort, encourages a sense of entitlement, and a sense of financial security, which together increase the propensity to shirk, since the penalties to unemployment are low.

Successful economies signal a strong causality between effort and enterprise, and success. They are sufficiently unequal in wealth to incite effort yet not so unequal that the probability of an individual moving upwards between wealth percentiles is unrealistically small. Everyone should be seen to have a fighting chance to get ahead. They have a sufficient proportion of households with sufficient accumulated equity to maintain aggregate stability in the economy and they have a sufficient proportion of households with insufficient accumulated equity to incentivize effort and enterprise. The rules of commerce and finance are sufficiently fair, and corruption is sufficiently low, to incentivize participation.

 
Private Banking Industry In Asia. An Increasingly Difficult Business. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 01 December 2015 06:45

It is important to correctly define what is meant by private banking, especially in the context of Asia.

Many private banks in Asia struggle despite asset growth because of margin and cost pressures. One reason for margin compression is the failure to distinguish between private banking, brokerage and lending businesses. A typical private bank may have 5% - 10% of AUM under discretionary management, and a further 15% - 40% in annuity fee paying AUM. The rest are deposits which are mined for transaction income.

A significant proportion of annuity income takes the form of retrocessions from managed product providers. This model too is under threat from regulation which is encouraging the industry towards greater fee transparency. Regulators are also encouraging a proper alignment of interests and guiding banks towards charging clients directly rather than charging them indirectly through the receipt of trailer fees paid by fund managers but ultimately funded out of the net asset value of investors’ capital.

Mining deposits for transaction fees is not true private banking. That is a brokerage business. Asian clients are highly fee sensitive and tend to compress brokerage fees very quickly. A bank can mitigate this by offering unique product but this is difficult as regulation encourages product providers to seek multiple distributors leading to competitive pressures on transaction fees. In the retail segment, products are bought on-line or through low cost bank branch generalist sales staff. Private banks relationship managers are too expensive to be so deployed.

Many private banks react to this margin compression by trying to grow AUM at a rate to compensate for the margin compression. In the limit this takes the form of consolidation, a dynamic already well underway in Asia. In the long run there are limits to this business strategy.

As transaction fees compress private banks have turned become leverage providers. This is a very different business as the bank now has capital at risk. Systems, processes and people have to be deployed to properly manage the risk. Essentially this is a prime brokerage business for private investors. Witness the margin compression in the prime brokerage business servicing hedge funds where sub scale clients (hedge funds) are turned away. The analog has not happened and private banks continue to compete for AUM driving down underwriting standards. Clients can shop around to find the cheapest and most leveraged offerings. It is questionable if the loans are being properly priced in terms of capital consumption. In Asia it is still possible to obtain leverage at cost of funds + 0.60% for good clients.

For clients, leverage may not be optimal, it may, but the advice around crafting a leveraged portfolio seldom revolves around risk. Clients are encouraged by relationship managers to maximize leverage. Client and relationship manager are often negotiating on the same side against risk managers. And private bank credit and risk managers are not quite as sophisticated as their counterparts at prop desks, the investment bank or prime brokerage. Very often their credit modelling is rudimentary, that is if they are not calling around to their peers on the street to align lending values. Relationship managers under pressure to perform can be persuasive and influence senior management to relax lending standards for good customers. And senior management often accommodate for the sake of quarterly revenues.

 

Leverage is not a bad per se. It magnifies upside as well as downside and when interest rates are as low as they are now, leverage can be a very attractive tool. However, private bank investor loans are rarely term loans and have strict loan to value covenants which may trigger margin calls. When leverage is not matched to either the duration of the asset or the gestation of the investment strategy, the investor crucially loses control of the strategy.

To summarize, Asian private banks define their remit as, discretionary and advisory management, which is traditional private banking, and then more innovative activities such as brokerage and leverage. That brokerage and leverage income represents the majority of income by a wide margin is not ideal. Brokerage is highly cyclical and volatile while leverage involves capital at risk.

Rightsizing a private bank like most businesses begins with self-awareness and defining the nature and core strengths of the private bank. It involves defining clearly what businesses it is in, and what businesses it will not engage in. Failure to do this will lead to over-resourcing and wastage.

The future of brokerage can be seen in the history of equity sales. Low single digit basis points commissions. The future of leverage provision can be seen in prime brokerage where only clients of a critical size are entertained as their scale and profitability pay for sophisticated risk management and engagement. In 2008, Lehman was the only major prime broker to fail but the credit worthiness of almost all of its peers were sorely tested. They survived, but only after many of their hedge fund clients were decimated.

 

The future of Asian private banking is clouded. One hopes it matures and clients engage private banks as trusted advisors and fiduciaries. Unfortunately the private banks mostly live by a quarterly revenue target which necessitates pressuring clients to transact and to leverage up. Cost pressures also discourage private banks from hiring high quality investment and risk managers and competent advisors. Faced with the painfully evident quality of advisor facing them, the client reacts rationally and eschews passing discretion to the bank. And so the cycle of mutual mistrust perpetuates.

 

 


Last Updated on Tuesday, 01 December 2015 06:57
 
Ten Seconds Into The Future: Musings From the Barstool. 2015 11 PDF Print E-mail
Written by Burnham Banks   
Thursday, 26 November 2015 04:57

A number of themes frame the global economic and financial outlook.

The world has been operating monetary and fiscal policy towards sustaining growth at a higher level than the unobserved long term trend rate. It may be doing this for a number of reasons. For one, it can’t observe the long term trend rate and could therefore simply be mis-targeting. A multi-decade period of credit driven growth may have biased estimates for trend growth to the upside. The dynamics leading to slower trend growth are slow moving and may have been overlooked. Demographics is an important factor in productivity and thus trend growth. Secondly, policy makers might recognize this mis-targeting but for other reasons, such as the servicing and paying down of an over accumulation of debt, ignore it and attempt to target growth above the long term trend rate. Whatever the reasons, this chronic mis-targeting of trend growth leads to markets mis-reading cyclical wavelengths, amplitudes and phases, and in a dynamic system such as economic and financial systems, a more pronounced cycle.

Demographics are a slow moving phenomenon. In the developed world we already have deteriorating demographics which possibly contribute to deflationary pressures on the one hand, and labour market mismatches on the other, which are inflationary. The implications for the net funding of social welfare and healthcare are also profound. In the emerging markets, once favourable demographics have now been eroded. China, for example, a heavyweight in the emerging markets, faces challenging demographic trends exacerbated by an unwise one child policy; this has now, too late, been relaxed. India appears to be the only large emerging market with favorable demographics, but even India will pass into an ageing demographic as its economy matures. Economists recommend immigration as a solution to ageing populations but such redistributions of human capital have limits in aggregate and costs to donor countries.

The shock from the 2008 financial crisis was larger than thought and ripple effects persist today. One of those effects is the initiation of a global trade war. Within this context the US has sought less reliance on external production capacity and energy supply. This new insularity has profound effects on global economics and politics. One of the primary reactions has been China seeking less reliance on US and other foreign consumer demand. This rebalancing away from exports and investment towards consumption has exposed a significant overshoot in capacity as well as resulted in slower aggregate growth as the large industrial and manufacturing sectors are de-emphasized and the economy turns towards services, retail and consumers. A consequence of the new dynamic between the US and China is that countries in the supply chain have had their business models invalidated. Many of these countries are in emerging markets.

The trade war has taken a toll on global growth. It is responsible for some of the loss in the long term potential growth rate. It is also responsible for the sharp slowdown in emerging markets which rely more heavily on trade for growth. The trade war model has some important implications for inflation expectations. Currently, markets are pricing for weak inflation to deflation. If, trend growth is lower than expected then output gaps are narrower than expected and inflation could be closer around the corner than the market predicts. If so, central bank policy could turn quite quickly when the first signs of inflation appear.

Since the financial crisis of 2008, banks have come under intense scrutiny and regulation. Once run entirely for profit, the public good supplied by banks as part of the credit and payments infrastructure was highlighted when some were deemed too big to fail. Banks are now regulated as essential utilities while remaining staffed by pathological capitalists. Governments and regulators on the other hand, have struggled to develop a coherent strategy for regulating banks, simultaneously requiring them to make more loans and take less risk. As the principal constituents of fractional reserve banking, banks thus heavily regulated have become less efficient in their function, albeit safer. The burden for funding economic growth must therefore fall upon the Shadow Banking system. Bond markets have grown in developed and emerging markets to serve the function of connecting savings to investment. One important aspect of facilitation, market making, has become impaired. New capital rules and principal agency separation legislation has led to much reduced market making activity by primary dealer banks and thus reduced liquidity, a development decried by the investing community. Inefficiencies in bank regulation have interfered with the credit transmission mechanism and blunted the effect of QE on the real economy. Rules relevant to structured finance have similarly throttled a once important credit transmission channel.

  • Banks deleveraging. Capital securities are derisking.

  • Bank disintermediation returns to rise. Direct lending, private debt, peer to peer lending, trade finance.

The past 7 years have been defined by extraordinary central bank intervention and influence in financial markets. Financial engineers are excellent at two things, innovation and over-extending. Low interest rates and QE have driven markets and to a lesser extent economic growth in this period. One, there exists diminishing marginal returns to QE in terms of impact on financial markets, and on real output. Two, the US Fed is about to move from easy to neutral and is headed for its first rate hike since the financial crisis. The ECB was late to implement QE and the impact on prices remains to be seen, thus far Europe has experienced a cyclical upturn in growth but inflation has lagged. The BoJ has maintained QE even as data has suggested they might have to expand further. China’s debt overhang and large scale restructuring of its economy has a cost and the PBOC will need to maintain easy financial conditions. Thus far they have not been buying assets but they have been serially cutting rates and reserve requirements and been very active in open market liquidity operations which have been more targeted and highly expansionary. In all this, the Fed’s divergence from the pack is interesting and will have profound impact on markets.

Central bank policy will have as much influence at the inflexion point as it did in expansion. The Fed’s rate policy is therefore important. For one, other central banks will await the Fed before making their own moves. In the face of a rate hike, the ECB for example, might be encouraged to ease more aggressively as global liquidity shrinks and financial conditions tighten. The ECB meets Dec 3, two weeks before the FOMC on Dec 16. Draghi has been vocal and signaling further accommodation. There may be a full blown expansion of QE or there may be adjustments to the current program. One area which merits adjustment is the allocation between countries. Currently, the national central banks and the ECB purchase bonds pro rata to their capital key, that is the respective national capital contributions to the ECB. This results in more capital dedicated to the purchase of German and French bonds and less to the fragile periphery for which QE is more essential. The ECB could change the composition of the bond buying to increase the proportion of Italian, Spanish and Portuguese bonds relative to the capital key.

  • EUR duration to outperform USD duration.

  • Peripheral EUR to outperform Bunds.

The BoJ has been unusually confident despite recent weaker inflation and growth data and may be waiting on the Fed to act. It too may accelerate or increase QE post a Fed rate hike. There are some who argue that core inflation has begun to recover in Europe and Japan and their central banks may stand on a Fed rate hike. However, a widening rate differential could encourage capital outflows and tighten financial conditions outside the US. It is difficult to be confident about the likely behavior of the BoJ and thus the JPY term structure.

  • USD strength, EUR, JPY weakness.

While the Fed may raise rates, and the rate hike trajectory is signaled to be gentle, the Fed clearly wants the yield curve to not steepen significantly. The Fed has talked about reducing the size of its balance sheet, and has mentioned a time frame of 1 year after rate liftoff. Recent talk, however, has opened the possibility that this could be delayed for much longer. If current financial conditions coupled with a single rate hike slow the economy sufficiently, inflation expectations may even fall and suppress yields at the long end.

  • USD 2-30 flattener or outright long 30 Y UST.

Investors have been concerned about the impact of higher rates and a stronger USD on emerging markets for some time now. The concerns are well known, capital outflows, higher costs of debt, and to some extent, a currency mismatch between assets and liabilities. The last point was a feature of emerging market sovereign balance sheets in the mid to late 1990s and was unwound when the Fed raised rates in 1994. The Asian Crisis of 1997/8 was one of the symptoms. Today, however, on the advice of the IMF and others, sovereign balance sheets feature a better currency match between assets and liabilities. Emerging market corporates, however, have increased USD borrowing significantly in the past few years although the last 12 months has seen market volatility and self-regulation unwind some of this currency mismatch. Chinese developers, for example, are calling USD bonds and refinancing in RMB. Emerging markets are likely to be better prepared for a strong USD and rising rates than before. Moreover, the Fed has signaled that the trajectory of rates is likely to be gentle, and the strong USD is already an 18 month old phenomenon.

  • EM short trade fading. Consensus it likely too bearish EM equities.

The most sentiment driven markets are equities and the bulk of the returns in the last 5 years have come from a rerating, Corporate earnings have been less robust in quantity and quality as companies have boosted earnings from cost cutting, financial engineering in the form of recaps or debt funded share buybacks. 2016 earnings estimates have been scaled back in the last quarter with Europe leading the discounting with 6%, Asia ex Japan and China with some 4% and the US and Japan with 1.5%. With a neutral Fed and equity valuations at or above long term trend multiples, the scope for further gains is diminished. Look at 2015 returns, the best performing markets have been Europe, China and Japan, the more problematic economies where central banks have been in no hurry to tighten. Stronger economies such as the US and UK have performed poorly as stronger economic data have led to expectations that the Fed and the BoE would tighten. Liquidity still rules equity markets.

  • Consensus is currently too optimistic about potential returns from European equities.

  • European equities yet to fully price EM weakness, thus vulnerable.

  • Consensus is currently cautious US equities and is likely to be proved right.

While liquidity rules equity markets, that influence will likely diminish in the US. In Europe, liquidity may limit the disappointment in equities and in China, expect the market to trade in a tight band for some time until the newly reopened IPO market has been cleared.

Credit markets have only recently found retail participation through mutual funds. While this newfound liquidity channel will add more sentiment driven volatility to the market, credit remains more fundamentally rooted than equity markets. This new found volatility has been a source of frustration as well as opportunity. Normally, credit is priced in an orderly fashion until institutional myopia accumulates a large imbalance and a liquidity crisis is triggered. Retail participation has made credit more volatile at higher frequencies but with smaller gap risk. The market has been concerned about gap risk from another source of reduced liquidity: primary dealer inventory. This is a side effect of bank regulation which discourages principal trading. This logic is flawed. Market makers make market not to provide liquidity, they do so because they believe they have asymmetric information. The current market for credit has institutional investors as the major participant followed by mutual funds and structured finance. Which is preferable, to have large, stable holders who own a significant portion of issues this reducing free float and liquidity, or to have many short term traders seeking to make high frequency profits? In either case, liquidity will be fickle. Credit can be approached from a trading perspective but to do so is to give up the advantages the asset class provides to investors.

Current credit spreads are sufficiently wide to represent value, given general conditions. Slow, positive growth is ideal for credit. In the US, credit from investment grade to high yield has underperformed recently as investors have fretted about a Fed rate hike and fears about fickle liquidity. In US credit, only the non-agency MBS market has generated steady and robust returns. While the robust housing market continues to support non-agency MBS, the opportunity is shrinking due to price discovery and a lack of new production as mortgages lean towards conforming loans which can be securitized by agencies. Agency risk transfer securities are a recent innovation and have not achieved critical market size. Corporate credit, however good value the spreads imply, have a market average duration which renders them sensitive to a rate hike, even if it is just one. Leveraged loans present a very low duration exposure to high yield corporate credit with structural seniority and security. Pricing has been stressed, however, as liquidity fears are more acute in loan markets. Spreads are wider for loans despite their seniority to unsecured bonds.

  • If the thesis is that short rates will go up once in the short term and only gradually thereafter, and that the economy will face tighter financial conditions and lower inflation expectations, and thus term structure should flatten, the efficient trade is to be long leveraged loans and long 30Y USTs.

In Europe, the interest rate cycle remains benign and the ECB is likely to maintain if not accelerate QE. At the same time regulators continue to encourage the banks to deleverage. Euro leveraged loan issuers will be encouraged to deleverage by transmission. European corporates in general remain in deleveraging mode. A significant proportion of new issue is coming from non-European issuers. The efficient trade expression is to be long duration and credit.

  • Long Euro high yield corporate bonds.

Relying on central bank largesse has been rewarding but when it is coupled with central bank regulation, the trade can be less risky as well. While European banks have been cleaning up their balance sheets since 2012, much remains to be done. The initial action of banks was to seek regulatory capital relief through creative balance sheet operations and accounting. Regulators were reluctant accomplices due to the seriousness of the problem. With greater stability and a cyclical recovery, regulators have become less pliant and are less likely to approve such transactions. The Oct 2014 AQR and subsequent capital raising has made European banks stronger. Also, recapitalized banks have now more latitude in disposing of NPLs as price discovery is less damaging. The consequence of this is the need for further capital raising. Add to this regulators’ tendency to overshoot and new TLAC guidelines and banks will be forced into more deleveraging.

  • Continue to buy European bank capital securities.

Risks to the view:

While the Fed vs ECB policy divergence supports a strong USD, the position is perhaps the most crowded in the market today. USD strength was driven by both the Fed and the ECB. Soon, the trade will lose one leg of support, that is the Fed. Once a rate hike is done, the next is likely far off. The USD trade will have to stand on one leg, the accommodative policy of the other central banks, notably the ECB.

  • Volatile USD.

Emerging markets. This is complicated reasoning. EM has done poorly because exports have stagnated. The strong USD was guilty by association and received wisdom is that a strong USD is bad for EM. One should question this. While true 20 years ago, sovereign liabilities are now better currency balanced. EM corporates have accumulated substantial USD debt and many will feel a balance sheet impact. However, many EM corporates earn USD and a strong USD has positive impact on cash flow and revenues. The market is currently very bearish on EM equities and bonds and neutral US and optimistic Europe. The EM exposure to European corporate revenues has not been priced. It is likely that 2016 will see EM assets trough and begin a forward looking recovery while Europe begins to price in EM near term or coincident weakness.

  • Strong USD may support contrarian long EM

  • Weak USD may endanger or delay EM recovery.

As we are reducing our expectations for European equity performance risks to the outlook are if European markets receive an unexpected boost. One possibility is fiscal policy. QE can improve the supply and cost of credit but it cannot improved the demand for credit. European growth has recovered somewhat but it remains tepid. More could be done if governments run fiscal deficits. Policies to deal with the refugee crisis and or defense could be approved as extra-budget items thus skirting austerity policies. While this is a possibility the constraints remain that Europe’s current government budgets remain in poor shape with the exception of Germany. France, Italy, Spain, run primary deficits below -3% of GDP, in breach of Maastricht conditions making even extra-budget expenditures difficult to justify.

  • Do not be too underweight and certainly do not be net short European equities.

Deflation is very much the consensus view. Headline inflation has clearly been depressed by falling commodity prices, particularly energy and base metals. Some of the impact of commodities leaks indirectly into core inflation. There has not otherwise been a good explanation for the weak core inflation except that final demand, consumer and business sentiment remains weak. If, however, trend growth, which is not measurable, is indeed slower, then the output gap could be narrower and inflation could rise unexpectedly.

  • TIPS may provide a tail hedge to inflation.

  • Floating rate debt instruments can provide an inflation hedge.

  • Gold’s usefulness as an inflation hedge is questionable but at for those pathologically inclined to gold there may be some rational justification for holding some of it.

Disclaimer: All information and data on this blog site is for informational purposes only. I make no representations as to accuracy, completeness, suitability, or validity, of any information. I will not be liable for any errors, omissions, or any losses, injuries, or damages arising from its display or use. All information is provided AS IS with no warranties, and confers no rights.

Because the information on this blog are based on my personal opinion and experience, it should not be considered professional financial investment advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. My thoughts and opinions will also change from time to time as I learn and accumulate more knowledge and as general conditions evolve.

 
Weird Movements in RMB and Capital Account Liberalization in China. PDF Print E-mail
Written by Burnham Banks   
Monday, 02 November 2015 09:14

On Oct 30, the PBOC announced that it would study a trial scheme for QDII2 at the Shanghai Free Trade Zone, in a step towards capital account convertibility. The reaction of CNY and CNH was puzzling. CNY strengthened from 6.357 to 6.3175 with CNH in tow.

One would have expected CNY to weaken if the capital account was more open on account of increased capital flight. I can only theorize that the move to open the capital account is another measure towards satisfying SDR inclusion criteria and that the PBOC then moved to support CNY to signal to domestic investors that although the door was open, they should not be too keen to use it.

The Nov 2 CNY fixing has more or less confirmed this view. Despite the sharpest rise in the daily fixing, the CNY has weakened back to 6.337 this afternoon.

These moves are disconcerting as they illustrate that while China moves towards a market driven economy and financial system, the government is still intervening and will likely keep intervening in markets in unpredictable ways.

This is not to single out China as an unpredictable market manipulator among the world's governments. Western democracies have had more practice interfering with market mechanisms than China who is relatively new at this game. China used to rule by decree. It is freeing up important bits of its markets and economy to market forces and will have to learn new skills to influence pricing under euphemistically free markets.

 

Last Updated on Monday, 02 November 2015 09:29
 
Ten Seconds Into The Future. Investment Outlook for the US Under 2 Rate Scenarios. Economic Slowdown in US. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 06 October 2015 08:45

The Real Economy:

2000-2005:

Low borrowing costs lead consumers to spend whether it was on houses, cars or stuff. The savings rate fell from 6% to 2% and households incurred increasing levels of debt particularly in mortgages, fueling a housing boom. House prices grew at between 10-15% per annum. Retail sales accelerated from an annual growth rate of 1.5-2% to 9% per annum in 2005. Auto sales ranged between 16-18 million cars annualized, from 14-16m in the late 1990s. Supply of credit surged as the securitization markets churned out bonds which required the creation of more collateral in the form of consumer loans and mortgages. The consumer binged on consumption financed by securitizations on which investors binged keeping borrowing costs low.

2005-2009:

Interest rates began to rise increasing debt service burdens and squeezing disposable income. Retail sales began to slip from 9% per annum growth to zero growth in early 2008 before the financial crisis led to a yearlong contraction in retail sales with rates of as much as -11.3%. In reaction, consumers retrench and savings rates surge to 8%. Unemployment surged from 4.4% to 10%. Assets from stocks to bonds to real estate selloff sharply as investors panic. Financial conditions are tight and funding markets are shut. Central banks the world over cooperate to maintain the global payments system despite a near failure of the credit system. There is a sharp retrenchment in GDP growth from 2.3% p.a. in 2007 to -4% in 2009.

2009 – present:

Despite fast and powerful recoveries in equity and credit markets, the real economy was slow to recover, taking till 2010 to recover to 3.1% and then averaging a meagre 2% till 2015. The current reading is 2.7% for Q2 2015. Employment and wages have been slow to recover, so too manufacturing.

In the aftermath of the financial crisis, banks have been tightly regulated, sometimes stifling so. Banks were blamed for the scale of the financial crisis as well as for being greedy in a time of plenty and abandoning main street in a time of need. The shadow banking industry, a close accomplice has similarly had its wings clipped. Only the corporate bond market has been conspicuously open and raising capital from investors. Unfortunately, most of the new credit has been to refinance old debt or to finance dividends, share buybacks and M&A. Weak corporate investment is a sign of weak business outlook.

Consumers on the other hand have been less willing to borrow or to consume. The memories of 2008 are fresh in the minds of the people. The sluggishness of the labour market to recover even as financial markets recovered their peaks have also dampened sentiment. The recent oil dividend, from a sharply falling oil price, was saved rather than spent.

Outlook:

There are reasons to expect a cyclical slowdown in economic growth. US trend growth is estimated to be circa 2%. This number is not observable but if true, it means that realized growth has run above trend for two years now. Core PPI has been rising for 2 years as well and may be peaking. While the ISM manufacturing PMI peaked in late 2014, the non-manufacturing ISM has been robust, peaking at 60.3 in August before retreating to 56.9. August may have been a cyclical peak.

The Fed has halted QE. While the USD curve has yet to steepen, and may more likely flatten, liquidity conditions are no longer as accommodative. Credit spreads have widened and effective borrowing costs have risen. Baa yields are at 5.33%, which are mid 2013 levels. The gains from reshoring have taken hold and are in fact fading as the rest of the world adjusts to a less trade conducive environment. Exports are falling faster than imports.

The risk of a US recession is still remote but a mid-cycle slowdown much like the mid 1990s is certainly possible and in the context of a rising rate environment, probable. The victims of a rate hike will, if 1994 was a guide, lie elsewhere. This begs the question of whether or when there will be a rate hike.

Financial Markets

2000-2005:

The Fed’s efforts to support sagging markets was accelerated by the need to maintain liquidity and open markets in the aftermath of 9/11 and saw the Fed Funds Target Rate fall from 6.5% to 1%. The thirst for yield accelerated innovation in financial products, in particular, fixed income and credit products including mortgage securities. The popularity of such securitizations led to excess demand translating into excess supply of end user credit. Low rates and weak credit standards led to securities which were not robust against economic downturns.

2005-2009:

As inflation breached 4% the Fed began to raise interest rates. The pace of rate hikes was aggressive, more so than the rate hikes of 1994 which had precipitated an emerging market crisis. Debt service costs rise, leveraged asset prices fall, real estate being topical, equities and bonds begin to fall. Collective investment vehicles like CLOs, CDOs and hedge funds begin selling assets as structured credit covenants are triggered and investors make redemptions. Bank proprietary desks and prime brokerage departments sell assets in unison. The S&P500 index falls my more than half and the iBoxx HY index falls by a third. Less liquid and more opaque markets like ABS and CDS markets seize up. Counterparties begin to fail. Bear Stearns requires a bailout by JP Morgan and by October, Lehman Brothers is no more and AIG is under government control. The Fed and Treasury draw up large scale bail out plans to buy assets and to finance the purchase of assets.

2009 – present:

Since the crisis the Fed has been the central driver of financial markets, engaging in multiple rounds of quantitative easing through the direct purchase or funding of the purchase, of US treasuries and agency mortgage backed securities among other securities. Interest rates are cut quickly to 0.25% in 2008 and there they have remained. Financial markets have reacted positively to these measures, with S&P500 rising 17.5% p.a. from the lows in 2009 to date (Oct 2015), high yield 12.5% p.a. By comparison the Case Shiller Composite 20 has risen a mere 4.3% p.a. in the same period. Nevertheless, asset prices evidently have received the policies well. The impact on the real economy has been less remarkable.

The Fed and Treasury have been simultaneously doing the following:

  • Buy distressed assets from private balance sheets, mostly private commercial and investment banks. Recapitalize the banks to allow them to continue to hold troubled assets.

  • Issue treasuries in a very targeted way to finance these purchases.

  • Suppress and control the entire yield curve through rate policy and buying treasuries.

  • Engage in austerity (the budget deficit fell from -10% to -2.4% in the period), while mitigating its painful effects with epic liquidity provision and low interest rates.

The results have been encouraging compared to the conditions in China, Japan or Europe. However, government debt has surged. Corporate debt issuance has also surged as businesses take advantage of low interest rates. Corporate balance sheet leverage has increased and credit quality fallen as a result.

The main investors in corporate debt have been institutions with mutual funds and structured credit vehicles also significant. Retail participation has certainly increased relative to the pre-crisis era when investors were mostly institutional, hedge funds or structured credit vehicles. In the past, instability came from leveraged prop desks, hedge funds, prime brokers and levered and rules based structured credit vehicles. Currently, potential instability can come from panicky retail investors but leveraged holders of corporate debt are few and far between. Structures are now designed with a lot less implied leverage, banks have already been sellers or hold significantly more capital against existing positions, and institutions tend to be unlevered and long term holders.

The main investors in treasuries, to the extent of 13 trillion USD, are foreign investors including their central banks (47%), the Fed (19%), state and local government (6.4%), private pensions (4.0%), banks (3.2%), insurance companies (2.1%), and mutual funds (8%). There is another pot of some 5 trillion USD of government debt which is held by government agencies, the main agencies being Social Security (55%), government retirement fund (18%), military pension fund (9%), Medicare (5%) and the federal operating account (9%). The potential weak holders who might impact the treasury market include foreign central banks who may have to spend dollars to defend their currencies or lack current account surpluses to invest, or simply seek to diversify reserves away from dollars. A stronger USD may trigger a defense of local currencies leading to a sell off of treasuries or it may encourage more investment in USD assets, the response is difficult to forecast. Banks may be weak holders if their balance sheets are shrunk, say by an outflow of deposits, but what could cause an outflow of deposits? A competing avenue for savings would have to present itself, perhaps in the form of higher returns in money market funds, or a healthy and trending stock or bond market. Mutual funds could face redemptions, but again, what could trigger redemptions? The types of funds holding treasuries are conservative, low risk funds designed to balance against riskier investments. Some mutual funds hold treasuries as collateral for total return swaps referencing risky underlying assets. If these funds perform poorly, they may face redemptions which could trigger a selloff in treasuries. These funds almost exclusively hold short dated treasuries of maturities less than a year. The fact is that of the US government holds about 50% of the total national debt, between intergovernmental holdings and debt held by the public.

Outlook:

While the world’s central banks continue to be accommodative, the US Fed has signaled its intentions to raise rates, by some accounts, notably the Fed Chair herself, in 2015. Time is running out and the economy is beginning to show signs of weakness which may make a rate hike impractical.

The market has tightened financial conditions to the extent of a de facto rate hike of 25 – 50 bps. A strong USD is contributing to tightening as are credit spreads; IG spreads have widened over 50 basis points in the last 6 months. 3 month LIBOR is up from 25 basis points in 2014 to 33 basis points in September.

If the Fed raises rates it will most probably flatten the curve as the long end responds to the counterbalance of weaker inflation. The pace of rate hikes will likely be glacial, unlike the monthly hikes of 2004-2006.

The Fed has signaled that it would seek to normalize its balance sheet a year after the first rate hike. This may also be impractical. Debt levels are high. Total debt to GDP stands at close to 300% including government, financial, corporate and household debt. Since 2008, household and financial debt has moderated but government debt has nearly doubled. To maintain manageable debt service levels, the US treasury would not appreciate the term structure any much higher than it is today, particularly at longer maturities. Aggressive rate hikes would lift the yield curve from short to intermediate maturities. If the Fed was to sell assets, or simply not reinvest runoffs, the risk of a steeper yield curve is significant.

If there is no rate hike till say March 2016, it is likely that market rates would fall back with LIBOR tracking back towards 25 bps. A softer economy would see a flatter curve as well so a rally in the long end should be expected.

The path of spreads is another matter. Slower growth will weaken credit quality and deter investors resulting in wider spreads. However, a benign interest rate environment will mitigate the deterioration in credit quality to a certain extent.

If the Fed hikes rates, the curve is likely to flatten with short rates rising faster than the long end. The 2-5 year sector will be particularly vulnerable whereas the 30 year will likely outperform. As for spreads, higher funding costs would exacerbate the credit quality deterioration leading to wider spreads. To a significant extent this has already happened in anticipation and if anything has overshot fair value.

As for equity markets, a slowing economy will impact corporate earnings which are already stagnating. If the Fed hikes rates it is unlikely to make a single move and will in any case put a temporary end to potential reratings and could in fact lead to a mean reversion in multiples. The risk is to the downside. If the Fed doesn’t move, then de-rating risk is lower but then reliance on earnings growth will not drive equities far either. If 1994 was a guide where the US economy slowed from 4.4% to 2.4%, avoiding a recession, the S&P500 traded in a tight range from 450 – 480.

For more volatility and potential returns, investors will have to look elsewhere.

Last Updated on Tuesday, 06 October 2015 23:40
 
Beware markets exhibiting low volatility and complacency PDF Print E-mail
Written by Burnham Banks   
Tuesday, 01 September 2015 23:20

Beware markets exhibiting low volatility and complacency. As markets rise steadily, investors with profits can protect their profits by buying put options. They tend to do this at key technical levels on broad market indices. Option counterparties do two things. They either act as middlemen, selling puts to investors seeking protection and buying puts from investors who seek to earn a premium and gain some positive delta exposure to the market. The net delta or exposure that they cannot match up, they need to hedge by trading in the underlying instruments that the options refer to.


Consider when the investor community is net long protection, or net long puts on the market. A long put position is one of positive gamma, or convexity. Option counterparties are therefore net short gamma or convexity. Their hedging strategy involves selling the underlying market when it falls and buying the underlying market when it rises. To further illustrate this, note that if the market is net long puts, the option hedgers must be net short puts. A short put is a long stock and a short call. A short call is hedged by buying at higher levels and selling at lower levels. The expected trading loss is the option premium.

 

Thus, if a market has been rising steadily and investors have been sufficiently careful to lock in some of their profits with put protection, it creates net gamma at important levels in the market. The gamma at these levels simply implies that the market cannot settle at these levels, they either rise above it or they fall below it but they cannot linger for long at those levels. It looks like 2050 was such a level on the S&P, as was 2000. And there are other important levels. As the market rose, investors would have bought protection at 1850. As we get to those levels, the gamma will cause the market to either rebound sharply, or fall sharply, but is unlikely to loiter at that level.

Last Updated on Tuesday, 01 September 2015 23:29
 
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