Ten Seconds Into The Future: Greece. China. Singapore. Other Stuff. PDF Print E-mail
Written by Burnham Banks   
Friday, 14 August 2015 08:41

When markets rise, the media quickly approach bulls to interview and feature. When markets fall, they seek bears.

In June, July this year all eyes were on Greece. Every bit of news about Greece was analyzed and scrutinized and markets reacted to these developments as if Greece was larger than the 2% it is of Eurozone output. Soon, the media and markets tired of Greece and despite lack of a credible and durable agreement, Greece was deemed problem solved and off the front page. There remains no credible solution to the Greek’s solvency or liquidity, only a temporary reprieve, if that. The apparent solution features more austerity than the Greek economy can withstand, than the electorate had elected Syriza to negotiate for, and Syriza in its entirety stood for. It threatens to fracture Syriza and result in new elections. The IMF has also recognized that the current plan is commercially not viable. Beware, once media and markets have tired of China, and struggle to find or manufacture a fresh crisis, Greece may be back on the table, despite its de minimis impact on Europe and the world.

Earlier this week the PBOC changed the way the Yuan exchange rate was determined by admitting prior closing prices (which introduce serial correlation to add stationarity to the price generation process), demand and supply and the price movements of other major currencies (which introduce market forces), into the way market makers submit their contributions to the fixing. One of the corollaries, probably a bullet point three and not bullet point one, was that the current fixing would be 2% lower, which is inside the bid offer at your local Bureau de Change. Markets and media tire of details and content but instead focus on the easy bullet point: PBOC devalues RMB 2%, in flashing red LED. News is amplified in transmission and soon RMB is falling a full 5% by day 2.

With a slowing economy in China, RMB faces natural weakness. The prior stability masked central bank operations to shore up the currency, not weaken it as some US politicians believe.

- In an open economy, weak growth weakens currency improving terms of trade in a somewhat self-correcting mechanism. China’s trade numbers have been weak.

-China is intelligent enough to realize that the structure of the world economy today renders competitive devaluation less effective on exports.

-China was probably responding to the IMF’s requirement for a more market determined exchange rate for including RMB in the SDR, something that will be considered in October.

-Now some speculation; either China is aware or believes that the Fed will raise interest rates in September and seeks to insulate the economy from potential acute USD strength dragging up RMB, or China did not factor this into their decision to loosen the reigns on the currency and the resultant relative strength of USD transfers probability of a rate hike from September to December.

-And finally something that we are sure we still do not know: what are the precise mechanics for the determination of the RMB reference exchange rate. We don’t know how many market makers there are and we don’t know what constitutes an outlier (which is excluded from the calculation) and how the previous day’s spot rate, demand and supply, and other major crosses feature in the calculation.

Trouble in paradise:

Singapore will never make international headlines but then you never know. What if the Fed raises rates in September, oil rebounds to 60, equity markets rise steadily and bonds recover? There might be little else for the media and markets to fret over but a little island state turning 50 and about ripe for a mid-life crisis. The long ruling party, the PAP began to lose ground in the 2011 elections and face a new election sometime soon. The passing of the country’s first prime minister, the celebrations at the nation’s 50th birthday coincide to provide the PAP with the strongest circumstances to contest an election. Every silver lining, however, has a slowing economy, or a weakening currency, or rising interest rates, a discontented people unhappy with the high cost of living, significant wealth inequality, overcrowding and the influx of foreign labour at all strata of society. A strong USD is putting gentle but inexorable pressure on interest rates to rise which increases the debt service costs of a nation obsessed with property ownership and funded by adjustable rate mortgages with favorable teaser rates, a significant portion of which threaten to reset. This increased debt service is eroding disposable income and consumption and slowing an economy already burdened with trading with China, whose economy is itself slowing significantly, and Malaysia, an energy and resource driven economy currently in the process of self-mutilation. Some of Singapore’s ruling party’s veterans are calling it a day as they find the pressure of managing the country beyond the generous monetary rewards of government; and why not? Like a successful private equity partner on Fund VIII, the prospect of cashing out is not all that bad. Singapore’s fortunes were built in adversity as it was evicted from Malaysia. Absent adversity and desperation, what will temper the next generation of leaders who have to find a way through the next half century? Is adversity a condition precedent for the next leg of prosperity? The world is a smaller place, and yet a less friendly place, not just for small island states but for everyone. What does a country where trade is more than twice its GDP do as countries become more insular and less cooperative?

Then there are some troublesome questions which many daren’t seek the answers to.

Greece exposes a structural inefficiency in the euro mechanism. Is it sufficient that Greece is resolved or should the Eurozone examine underlying causes and seek to stave off future potential crises? A currency union without fiscal union and indeed structural and institutional union extending to labor and commercial laws among other things is fragile.

Global debt levels are another concern. How we regard debt at an ideological level and how we deal with its repayment and servicing are questions we have decided to seek but partial answers to. Central banks of indebted countries could be seen as having lost their independence in how they police or intervene in markets. Most are creditors to their sovereigns begging the question of what does a consolidated sovereign balance sheet look like? What are a country’s assets and liabilities? At a more prosaic but no less concerning level, how does a central bank roll back quantitative easing. The US Fed is the most advanced along the line and will serve as an example to the world’s other major central banks. One hopes the Fed knows what it is doing. And that its example is replicable by countries without the luxury of the world’s most trusted IOU, the USD.

Inequality. In world where it is patently clear resources are amply sufficient for the planet, why must one person starve while another basks in luxury. Widespread poverty defers such question as much as robust growth. Slow growth and a growing middle class cast rich and poor in vivid relief. Social media and technology bring rich and poor into close virtual proximity, surely an incendiary environment. Delve deeper and questions about the value of capitalism and socialism and how we organize our economy and society arise.

But markets and media do not concern themselves with problems as intractable as these. They seek more tangible problems, problems which have an immediate or short term price impact.

Here is one. The US is sanguine about a strong USD, but only because it has never been much of an exporter, on a net basis at least. It has now achieved some semblance of energy independence. It is the most stable and robust large economy. It is even considering raising interest rates in the near future. This creates a natural, gentle upward pressure on the currency. But a rising USD changes the calculus for emerging market bonds. Bond yields which appear to be generous in places like Brazil or Indonesia are tempered by the need and cost of hedging the currency exposure. Sometimes, as in Brazil and Indonesia, the cost of hedging makes the investment less attractive than buying a lower yielding US treasury note or bond. A strong USD and an improving trade balance can happen if a structural phenomenon such as reshoring gains ground and manufacturing is repatriated to automation heavy factories. This combination not only raises local currency borrowing costs but USD borrowing costs internationally. The Fed doesn’t just tighten policy for the US, it tightens policy for the world.

Singapore General Election 2015 / 2016. SG50. What Singaporeans Want From Their Government. PDF Print E-mail
Written by Burnham Banks   
Monday, 03 August 2015 09:14

As Singapore turns 50 it and its government, the People’s Action Party, face a mid-life crisis. Support for the government fell to a historical low at the 2011 General Elections where a number of contentious issues emerged.

What does the government have to address for the people of Singapore?

High cost of living: Singapore remains a very expensive place to live in, according to the Economist Intelligence Unit and other surveys. More importantly, this is the view of the Singapore people. The government will have to address the high cost of living.

Population. Singapore is overcrowded and congested. Singaporeans are of the view that their country is overpopulated and that there is acute competition for resources. Transport is a particular example. The MRT system is overburdened and operated above capacity leading to breakdowns and service disruptions. The roads are congested despite a car ownership quota system augmented with a road pricing system.

Xenophobia. Singaporeans have developed an acute sense of xenophobia. This is related to the overcrowding problem. Foreigners are seen as taking up resources and taking up jobs.

Inequality. Singaporeans are envious of the wealth and luxury around them but which they struggle to attain. Inequality of wealth and income has grown if not in substance than in perception in Singaporean’s eyes. That much of the wealth is of foreign origin adds to the xenophobia.

Rule of law. Singaporeans have been trained to be law abiding and generally are. They perceive foreigners as being less law abiding. Foreigners have not grown up under Singapore’s well-ordered society and may treat laws as guidelines as opposed to rules. Littering is prevalent in HDB estates whereas private property is relatively clean. This amplifies the feeling of inequality in the country.

Government being out of touch with Singaporeans. Comments by government officials and civil servants have sometimes displayed a lack of empathy and fostered a sense that the government is elitist and out of touch with common Singaporeans.

What other challenges does Singapore face?

Labour shortages. Businesses face a shortage of labour and escalating labour costs. Singaporeans are unwilling and sometimes unable to do certain types of jobs. Businesses have to fill these jobs with foreigners. Unfortunately, Singaporeans often complain that these jobs are being taken up by foreigners. Another complaint is that foreigners have a better deal than locals, they have the freedom to send their children to international schools, decide if their male children register for national service or not, generally get paid more than locals, live in better conditions than locals, and have the luxury of leaving the country with their CPF funds if they choose to leave and never return.

Singaporeans are human and it is human to seek to be unique and exclusive. This is not a case of vanity but a practical evolution. It is rational to want immigration to bring in more people of lower wealth to do the jobs one needs doing without competing for one’s job. It is also rational to want immigration to bring in more employers. What the Singaporean doesn’t want is competition, a perfectly rational desire, that is people who are of similar ability and wealth who neither do anything for them nor employ them. Of course the more subtle effects are often not immediately felt even if they may be understood, and that is immigration brings increased demand and employment which is good generally for the population as a whole. In the brief history of the species, trickle-down economics has an even shorter history and is certainly not well understood outside of economic circles. Trickle-down economics has been widely sold in most modern capitalists economies although the success of the model is questionable.

Retirement planning 1. According to a study by a local bank published in 2014, the savings of the average household in Singapore, including their CPF savings, will be insufficient to fund retirement. This problem is not unique to Singapore. Many western economies have even more acute retirement funding problems compounded by complex systems and policies. CPF is unique and efficient in its defined contribution nature. Households do need to save beyond CPF for their retirement needs that much is clear. Another complaint among Singaporeans is that they do not feel their CPF monies are secure. Better investor education can go a long way to allaying their concerns. Investors need to understand matters like credit risk, investing in equities and bonds, how the CPF funds the interest rates it pays out on deposits, whether the CPF is a custodian of their money or a debtor, what the CPF does with their money, where does the CPF invest and why, is there concentration risk, how diversified is the CPF portfolio etc etc.

Retirement planning 2. The CPF is a defined contribution scheme. What happens to those who have contributed little or nothing? What form of social security do they have? The defined contribution CPF is the envy of many developed nations facing unfunded or underfunded pensions. That said, a defined contribution scheme is insufficient and has to be augmented by a social security scheme providing defined benefits. In a mature and compassionate society, social security is needed. Defined contribution schemes only serve those who have contributed and contributed sufficiently. A National Insurance should be established which would be part funded from existing reserves and part funded by either a more progressive tax system or a distinct national insurance tax. Such tax would ideally be designed to apply at higher thresholds. The actual marginal rates should initially be low and adjusted to increase with income earned. The National Insurance could ensure a basic level of medical insurance, pay unemployment benefits or fund workfare, and fund a pension. The total tax burden will rise but it is a necessary evil. It is a fantasy to expect more benefits and social security without someone shouldering the burden. That burden should be shared by the more fortunate among Singaporeans. A national insurance scheme augmenting CPF will mean that the retirement age of CPF need not be extended since it is always fully funded. The risk of frivolous spending after retirement is mitigated by the introduction of national insurance. CPF contribution rates can be adjusted down to manage cash flow and also because CPF will not be the sole asset at retirement.


The funding of more discretionary spending and investment:


Singapore has been a pioneer in the establishment and management of sovereign wealth funds. It should extend this pioneering spirit to better define sovereign assets and sovereign debt. The opportunity exists to create a priority of claim among sovereign liabilities, from the unsecured to the secured. State assets should be transferred to the sovereign wealth funds. The GIC and Temasek should be merged. The Singapore government can borrow through the issue of Singapore government bonds, a sovereign security, or it can issue unsecured and secured bonds as well as covered bonds and asset backed securities from the sovereign wealth fund. All projects and expenditures must be specifically funded by defined revenues or liabilities on the sovereign's or the sovereign wealth fund's balance sheet. This promotes transparency and an innovative mode of funding.


With time, outright expenditures as opposed to investments will also be able to be funded through the sovereign wealth fund against specific funding routes.

To reiterate: The Singapore People’s To Do List For Their Government:

High cost of living: Bring down our cost of living. In particular please address food, shelter and transport.

Inequality: We the citizens of Singapore are grateful for the roof over our heads. The next challenge is to have better dwellings. That means, not so many, not so close together, lots of greenery, less congested roads, trains and buses, make our HDB flats of a higher (not lower) quality and closer in look, feel and quality to private property. For 50 years we supported you and you gave us home ownership. But 80% of us are in HDB and we all still strive for private property. Either only 20% can live this dream or you can make the 80% of HDB close enough to private property that the difference doesn’t matter so much.

Population: Singapore is too crowded. We do not want any more people than we absolutely have to have. We know it’s a balance between bringing in more workers and employers and its difficult to strike that balance.

Immigration: This is a difficult one. We want more of the type of people who add to our society and less of those who don’t. Adding to society is more than spending or keeping money here, it means engaging with the community, providing meaningful employment and investment in productive assets. We the people do still have unreasonable requests, such as not wanting to do certain jobs yet not wanting foreigners coming here to do these jobs. You will need to educate people on the harsh reality. Pandering will only postpone the problem until one day you get total misunderstanding.

Transport: We want MRT trains and buses that work and are efficient and cheap. We probably don’t know how much it costs to build, buy and run public transport but we just want it cheap and efficient. Congestion is a big problem on our roads which COEs and ERP hasn’t solved, at least not sufficiently. Cars are where we need a more progressive tax. Politically you can get away with that provided interest groups don’t get their way. Each household only needs one car. We need more cabs, buses and trains and we need the cabs to be more evenly distributed by location and time.

Rule of law: We really feel that respect for the law has dropped. Don’t worry about antagonizing people by tightening up law enforcement. The people want to see Singapore as a safe, green and clean Garden City as it once was. Even if it means tougher enforcement of laws.

There are probably a lot of other things that are also important but which Singaporeans aren’t complaining about. Yet. Don’t forget those.

Racial harmony is sometime taken for granted in Singapore. The government has been and remains paranoid about maintaining racial and religious harmony and creating a Singaporean identity strong enough to subordinate racial and religious distinctions. This paranoia is well placed. A quick survey around the globe finds racial and religious antagonism confounding rationality. The Singapore identity must be maintained and strengthened to combat any risk of fracture. Race and religion are but two factors which can divide a people. Rich and poor may be a new distinction which arises not just in Singapore but across the globe.

Singapore’s economic and business model. The world is becoming a more contentious place. Countries are becoming less willing to trade and cooperate. The reason is that global growth is slowing, mainly due to the accumulation of debt over the last few decades which in 2008 was shuffled from private to public balance sheets, mostly in the developed world, and which remains a drag on growth. An example is Ireland which went bust bailing out its commercial banks. In such a contentious world we see China seeking to be less reliant on US consumers, and the US trying to be less reliant on Chinese factories. We see a US less reliant on OPEC and oil retract from the Middle East with serious geopolitical consequences. As the tectonic plates shift, where does Singapore find itself? How does Singapore see the economic and political development of ASEAN and South East Asia and Asia and China and India, and how will she position herself not only to prosper but to persist, to exist.

And finally a word about politics…

I myself have been critical and laudatory of the PAP. And I will give them this: it is a difficult job and very often a thankless one. 40% of the electorate do not thank them, nor do some of the 60%, some of whom vote out of pure utilitarianism. Call it 50% in all, conservatively.

Yes, the pay is high, but Singaporean’s tax drag is well below any of the developed economies who struggle to pay their bills and their politicians. And yet a politician is a public servant and the office is an office of honour and duty, not just another job. It is good that they should sacrifice some monetary reward and not draw the same pay as the high flying itinerant manager for hire. I’m not smart enough to tell anyone how much an MP should be paid.

The job is tough. It was tough in 1965 and its tough now. In 1965 it was the local topography that was shifting; today it is global tectonics. You really want the job of running the country and navigating through these waters?

And finally, could we have more debate about the issues in this election please? And less personal issues whether laudatory or critical. Thanks chaps.


Oh. Sorry, I forgot. Just one more thing. There is the little question of transparency over a whole host of issues. I am sure everything is fine but just to satisfy your citizens could you please just publish all the relevant data to the standard one would expect of a first world country. Its not such a big deal except when the queries are met with silence.



Last Updated on Tuesday, 08 September 2015 08:19
The US Economy. Growth Strong but Not Fast. Trade Expressions. PDF Print E-mail
Written by Burnham Banks   
Friday, 31 July 2015 03:34

The US economy remains the most important and vibrant in the world. China is fast catching up but for market depth and liquidity, for corporate governance and clear and well defined regulations, the US is the prime market for fixed income and equities.


Trade Expression:


1. Long term buy US equities.

2. Long term overweight USD.

3. Underweight exporters.

4. Medium term buy US non agency RMBS.

5. Medium term buy US high yield via loans and bonds.

6. Medium term buy US 30 year long bond.

7. Medium term short US 2 year bond.

8. Medium term cautious US investment grade.

9. Short term cautious US equities.




1. Long term growth is stable. US continues to enjoy a technological advantage over the rest of the world, especially developing markets.

2. Long term growth rate has been chronically over-estimated. This creates mis-estimation of cyclical highs and lows.

3. US is intentionally becoming less reliant on outsourcing of manufacturing as well as importing oil. The result is a more self-reliant economy. 4. Outsourcing manufacturing implies importing finished product.

5. The US trade balance is likely to move towards balance over the long term.

6. The housing recovery remains on track although it is a mature recovery. Affordability and house hold balance sheet recovery will support the stability of this recovery.

7. Healthier tax receipts and reduction of military footprint is reducing the budget deficit.



1. The Fed wants to raise interest rates for a host of reasons.

2. The delay is because it cannot raise interest rates, not because it doesn’t want to.

3. The rate hike trajectory will be very gentle.

4. The Fed is not independent, it considers the debt service costs of the US treasury in its calculations.



1. The Fed balance sheet is acutely inflated. At some stage the balance sheet will need to be shrunk.

2. Equity market valuations are being supported by low interest rates, access to credit, share buy backs and ample liquidity.

3. Earnings growth is not accelerating. Bloomberg estimates historical PE at 18.4, current PE at 17.8 and next year PE at 16. This implies earnings growth of 3.6% in 2015 and 11% in 2016.

4. Domestic politics. The US election will take place Nov 2016. At this early stage in the process many unexpected things can happen.

5. Geopolitics 1. A strong USD can destabilize the dollar bloc economies. It can disrupt non-dollar bloc economies as well as currency hedging costs enter the calculus for sovereign funding. The net currency hedged yield for owning a long dated BRL or IDR bond may be less attractive than owning a US treasury for example.

6. Geopolitics 2: A more self-reliant US has implications for its strategic and economic allies. Witness what self-reliance in energy has done for the political stability has done for the Middle East as American strategic assets are gradually tapered from the region.



Rationale for trade expressions:


1. Long term buy US equities.

- I like US equities for all the reasons under Economy. The economy is robust but growing moderately.

- I are cautious for reasons Risk 1, Risk 2 and Risk 3.

- Absolute valuations are not cheap. Valuations relative to treasuries are cheap. Therefore valuations are very dependent on rates. The ultra-long duration nature of equities may lead to underperformance in a rising rate environment.


2. Long term overweight USD.

- Economy 3 and Economy 4 above point to slowing imports and thus a lower supply of USD. This supports not only the USD level but will likely raise the actual cost of funding in USD internationally.

- The safe haven status of USD makes it attractive as other regions are relatively weaker or more risky than the US.


3. Underweight exporters.

- For the simple reasons that we expect a strong USD and greater trade protectionism in the world.


4. Medium term buy US non agency RMBS.

- Economy 5. Housing data has on balance been strong. We advocate the more direct and targeted exposure to US housing which is via the non-agency RMBS market than the more volatile house builders where company management introduces idiosyncratic risk.


5. Medium term buy US high yield via loans and bonds.

- A slow but positive and durable growth environment is ideal for high yield corporate debt.

- There are two trade expressions here: loans which carry little duration and will be very useful in the early stages of the rate hike cycle and bonds which carry more duration.

6. Medium term buy US 30 year long bond.

- Economy 6, Policy 3 and Policy 4 support investing in the long end of the US curve.

- Economy 6, the US budget. The congressional budget office estimates that the total and primary budget deficits will improve from now but trough in 2018.

- Policy 3 and 4. The US federal reserve and indeed most central banks have in recent times shown themselves to be not independent of their government’s funding needs. They have either monetized debt by buying treasury bonds or they have suppressed debt service costs by keeping rates lower longer than they needed to. That the US treasury began issuing 2 year FRNs in Jan 2014 only creates a direct alignment between low short term interest rates and the debt service of the US treasury.

- The consensus view on the US 30 year bond is that it will fall (yield will rise). However, given the safe haven nature of the bond (investors buy it in crises) and the fact that the US treasury market has priced in the rate hike cycle, we advocate having a small position in a balanced portfolio as a form of portfolio catastrophe insurance.


7. Medium term short US 2 year bond.

- Rate hikes will most impact the front end of the curve.

- Yield difference between 2 year and 30 year US treasuries. The curve is likely to flatten as the current economic cycle matures towards the next recession.

- If one expects the 30 year to outperform we must by inference expect the 2 year to underperform.


8. Medium term cautious US investment grade.

- I am cautious about the 2 to 7 year sector of the USD term structure. Investment grade corporates issue mainly in this sector of duration which we seek to avoid. The credit spread is insufficient in our view to surmount the duration in a rising rate environment.

- Investment grade issuers are likely acquirers in the current M&A environment so there is significant event risk.


9. Short term cautious US equities.

- Absolute valuations are unattractive. Relative valuations, however, are better. This, however, makes US equities sensitive to the coming rate hike.

- I think that the market may be underestimating the immediate and short term effect of a rate hike which may introduce volatility in the market.



Last Updated on Friday, 31 July 2015 03:46
China. Opportunities and Lost Opportunities. Prospects for China Equity Markets. PDF Print E-mail
Written by Burnham Banks   
Friday, 31 July 2015 02:35

I have been optimistic about the development of China as it matures into a middle aged, consumption led, economy governed by rule of law and subject to market forces.

What I like most about China was what I see as a genuine desire for reform, to govern by rule of law, to allow markets to be policed by demand and supply, to modernize corporate enterprise law. Evidence of this can be found in the form of the elevation of the constitution in last November’s Fourth Plenum and again earlier this year when officials would be required to swear allegiance to the constitution and not just the Party. I continue to see the anti-corruption efforts carried out with determination. The efforts to include the RMB in the SDR will also open up the country’s capital account more and allow the currency to find a market clearing level.

Even with the economy slowing from 7.5% to 7.0% this year, perhaps weaker than that, the Chinese economy would create more incremental nominal output than the US economy growing at 3%. At that rate, corporate profits would come under pressure. Among the HK H shares, PE multiples were 8 times in 2014 and expected to be stagnant at 8X in 2015 improving to 7.3X in 2016 implying a tepid 9.6% earnings growth. In the Shanghai A shares, PE multiples were 18.8 times in 2014 and expected to be 15.3X in 2015 and 13.5X in 2016 implying earnings growth of 22% in 2015 and slowing to 13% in 2016. These are aggregates of course and hide a wide range of numbers.

The main driver of equity markets was going to be liquidity and the PBOC put. Fundamentals while unexciting were sufficiently robust to hold the market in line while central bank efforts to drive the real economy would also drive down interest rates and cost of debt boosting valuations. My view therefore relied on the general economy being on the weak side, growing at between 6.5% to 7.0%, to do two things, one, generate sufficient nominal output growth to sustain the employment and investment, and two, be sufficiently weak to keep the PBOC in expansionary mode.

The PBOC is currently operating a number of market friendly policies. One, it is in rate cutting mode. It has cut the deposit and lending benchmark rates three times this year and the banks’ required reserve ratio (RRR) twice from 20% to 18.5%. With interest rates at 4.85% and an acutely high RRR, the PBOC has a lot more room to cut rates. Two, cutting rates is a blunt instrument as market rates may not react. The PBOC is actively operating open market operations, basically repo operations, to bring down market rates of interest to lower debt service across the board. Pledged Supplementary Lending, Medium Term Lending Facility, et al, are all expansionary open market operations designed to improve liquidity and lower borrowing costs. Third, the PBOC is encouraging a wide ranging rebalancing of where credit is deployed in China. Currently, corporates and local governments are over leveraged whereas small and medium enterprises are starved of credit and consumer credit while growing is yet small. The government’s local government debt swap, essentially refinancing local governments’ high debt service off balance sheet liabilities to lower cost, more transparent, on balance sheet municipal bonds is not only lowering the debt burden for local governments but is improving credit quality for creditors the large extent of whom are the country’s commercial banks. The municipal paper also serves as capital efficient eligible collateral for the PBOC’s repo operations.

The above led me to the opinion that China equities were a good investment. The question is, why did the market fall so much and what is the current prognosis?

Why did the market fall so much? When the tech bubble burst in 2000, Nasdaq fell 75% over the space of 3 years. The S&P, however, was not immune and lost 45% in the same time frame. There is a tech bubble in China. The ChiNext market has fallen some 42% since June; in the same time the Shanghai Composite has fallen 32%. ChiNext PE ratios were at 130 while the Shanghai Composite traded at 26X. Retail investors and margin investors which include corporate investors led to a bubble in some sectors which are now bursting. Margin calls are causing leveraged positions to be unwound.

What do I think of what the Chinese government is doing to support the market? In the face of collapsing markets, governments around the world and throughout history have always sought to intervene. The Americans did in during the Great Depression, they and every major economy did it again in 2008. Ireland bankrupted itself saving its banks. The question is, will it work? The answer, today in China as before in America and Europe and Japan, is no. The market must find its level. All bailouts do is delay the process of finding that level. Even the current state of the American and European markets is one where the overhang from 2008 has not been fully worked out. In the short term, market intervention can arrest a falling market. China of all countries has the financial firepower to support markets. One feature of note is that there has been no contagion. Credit markets remain stable and open, the currency is also stable. The weakness in the equity market has been isolated to just the equity market. Longer term wealth effects may take hold but these are likely to be less of an impact.

Do I think that the Chinese market intervention represents a setback to the reform efforts? Given that the intervention in markets is no more intrusive than the actions of the Fed or the BoE or the ECB in 2008, I think not. I think the Chinese government will continue with market and political reform. The reform will just have to be adjusted around any bailouts of the equity or bond markets. Just like anywhere else. China’s reform efforts are not based on altruism or a change of philosophy. The Communist Party sees the reform, the change to rule of law as opposed to rule by Party, as a strategy to avert an existential threat to the Party in the face of a maturing populace. It will not stop now.

What is the current prognosis? Have I changed how I think of the Chinese equity markets?

Yes. I think that fundamentals are poorer than I thought and that part of the reason is the sharp fall in equity markets. Retail investors’ margin trading participation was manageable, circa 8.8%, in relation to the total market capitalization. What I have no transparency into is the magnitude of leverage exposure in corporates. A common means for smaller companies to raise debt is to provide their equity as collateral. This type of activity was prevalent in the 1980s and 1990s in South East Asia. Now if the proceeds of these loans are used to invest in operating assets then while the capital structure of the business may be weakened, the operational model is not. If, however, companies invest proceeds in the stock market then clearly there is a serious issue with business models. Companies in South East Asia prior and up to the Asian crisis in 1997 were engaged in these investment practices. While not all companies did this, it introduced a feedback loop which greatly increased volatility in earnings, balance sheets and equity market pricing.

I do not see much more downside. I think that the Chinese government will not countenance lower prices as it would destabilize the real economy. Also, if my suspicions about where some companies have been deploying their capital, in financial assets rather than in operational assets, then the government will have to address the issue of corporate balance sheets and put a floor under equity markets.

I do not see too much upside. When the PBOC expanded policy in 2014 it was its intention to boost the real economy and lower borrowing costs specifically for local governments and small and medium sized enterprises. It was not its intention to inflate the equity market. In fact the PBOC recognized that the rising equity market was at some level when valuations outran fundamentals an undesirable side effect of its expansionary policy. Unfortunately, its attempts at deflating the equity market, and there were several attempts, were not sufficiently determined and a bubble inflated. The government will not allow another bubble to inflate and will therefore likely introduce cooling measures if equities should rise sharply or substantially from current levels. The behavior of the currency makes a good example of how the market can be subdued by sufficiently determined policy. The A share market is still only semi-open and thus can be supported or indeed suppressed by policy.


Last Updated on Thursday, 06 August 2015 02:01
Greece. Temporary Separation Tabled. Sovereign Capital Structures and Bankruptcy. PDF Print E-mail
Written by Burnham Banks   
Monday, 13 July 2015 01:25

On June 26, had Greece agreed to these terms a deal would have been done. Instead Tsipras calls a referendum and seeks a No vote from his people. Before the vote, Tsipras goes back to the Eurogroup to accept the terms. Merkel says that they have to wait for the referendum since Tsipras would, in the spirit of democracy, have to respect the Greek people's decision. The people give Tsipras his No vote. He comes back to the table effectively accepting the creditor terms (in the June 26 proposal) confounding the No vote he had obtained at home.

This behaviour gives a clue to what it must have been to negotiate with Tsipras and Varoufakis in the preceding 6 months. Varoufakis probably resigned when he discovered Tsipras was going to accept the creditor terms after the No vote.

The behaviour also explains why Germany may be sceptical about the representations of the Greek government. If the Greeks agree to the bailout terms, there is no guarantee that they will comply with the very terms they have agreed. A logical strategy is to ask Greece to leave the Euro, provide Greece with some level of support, but require Greece earn its way back into the currency union.

On a slightly separate note, I think the Greek experience has shown that the world needs a better sovereign bankruptcy process and a better definition and design of sovereign capital structure. I would like to see the emergence of a sovereign covered bond market with claim on sovereign assets as well as a sovereign ABS market where default would result in the assignment of portions of tax receipts to creditors or tranched ABS where cash flows are prioritized over tranches in a waterfall structure and additional cash flows are used to capitalize sinking funds under the negative control of creditors.

Greece Referendum. Analysis and Investment Opportunities. PDF Print E-mail
Written by Burnham Banks   
Friday, 03 July 2015 07:07


Greece will conduct a referendum on July 5 regarding a creditor plan of reorganization. The referendum is framed as a Yes/No vote to either accept or reject the creditors’ proposals.

1. The vote as it is framed is strictly about accepting or rejecting the creditor proposal. However, the consequences of either a Yes or a No go beyond the creditor proposal, they go to whether Greece intends to be a part of Europe, or not.

2. There are a number of scenarios:

a) Yes. Tsipras government resigns. A new government will have to be formed which is happy to comply with the referendums implications. Financial and liquidity support will resume and details of a bailout will be finalized and implemented.

b) Yes. Tsipras government does not resign. Syriza has campaigned for anti-austerity and recommend the people vote No so a Yes vote would destabilize the government. It is unclear how the creditors will proceed in negotiations with Syriza. Syriza would have to honour the implications of the Yes vote and negotiate accordingly. The ECB may not be as quick to lift the suspension of ELA and negotiations would have to continue to finalize details. These negotiations could be problematic if represented by Syriza.


c) No. Tsipras government will have a strengthened mandate. The ECB would certainly ringfence the Greek financial system and maintain suspension of the ELA. Greece may be explicitly removed from TARGET2 which would isolate its financial system. There are many possibilities under a No vote since it would imply chaos and a likely exit of Greece from the currency union and perhaps from the European Union as well.


3. Short term effects: Equity markets will likely react well to a) above. The uncertainty of b) above means that any upside is likely to be fragile. Volatility could persist until a clear deal could be reached. In c) above the immediate impact will likely be a sharp sell-off as investors seek to de-risk and avoid any potential Black Swan events. “We know how bad it is and it ain’t so bad, but we don’t know what else we could have missed…” would be the likely thinking. European markets are still on average about 10% in the money year to date and investors will want to protect that.

4. European equities will correlate closely with BTP and BONOS spreads versus Bunds in each of the above scenarios. For 30 year BTPs, spreads could tighten below 100 under a) or languish in a 100 – 150 range under b). Under scenario c) the immediate impact could be big. Spreads were over 400 in 2011 but with the ECB’s OMT, QE and LTRO operations a widening to 200 would be extraordinary and would be a trigger to buy the spread. A similar analysis applies to 30 year Spanish spreads.

5. Longer term positioning.

a) Scenario a) provides Greece a lifeline. Depending on the final nature of the bailout the outcome could be long term negative for Europe, if for example, the creditor plan was unrealistic, draconian and would cause Greece to require another bailout in a few years’ time. A realistic deal would see some form of debt write-down with conditions to rehabilitate the Greek economy. Such a scenario would be long term positive.

b) Scenario b) could not realistically play out over the long term since the raison d’étre of Syriza was anti-austerity.


c) Scenario c) presents the most interesting long term investment opportunities.

I) The Greeks might soften their demands but the probability of this after a No vote is small. The probability that the Eurozone would soften their demands following a no vote is similarly remote given the contagion risk of moral hazard to Spain, Italy, Portugal.


II) Greece is already de facto in default and a No vote would formalize this. Negotiations would begin, or in this case, resume, with creditors. In this case, creditors would be quite powerless to negotiate for anything except to eject Greece from the union and suspend all aid. Keeping Greece in the greater union but not the Euro would provide a template for subsequent member exits and is therefore unlikely to be supported by Germany or France.


III) Greece would have to mint its own currency, which would probably depreciate some 40%-50% instantaneously. Some form of capital controls will be needed to ensure the success of the new currency.


IV) At this point but not before, Greek assets and legacy debt might present value.

Last Updated on Friday, 03 July 2015 07:17
China Equities. Fundamentals Positive. Valuations High In Places. IPO Activity Sapping the Market. PDF Print E-mail
Written by Burnham Banks   
Friday, 26 June 2015 04:22
  • Long term positive China on reform and liquidity.
  • Medium term volatility from valuations and IPO issuance.


  1. There are reasons to be optimistic about the Chinese economy in the long run due to structural reform. Current growth rates will slow but China is reorganizing itself to a more durable model.

    1. Political reform, notably the leaning away from rule of Party to rule of Law. The renewed importance of the Chinese constitution.

    2. Economic reform. Refinancing the local governments, lowering debt service costs. Rebalancing leverage away from over leveraged local governments and corporates towards households and central government.

    3. Financial market reform. The introduction of market discipline such as fewer bailouts and thus more use of the bankruptcy code.

  1. The PBOC is in the midst of expansionary policy.

    1. QE lite via LTROs with muni bonds as HQLA collateral.

    2. Cutting interest rates

    3. Cutting RRR.

    4. General deregulation of the banking and savings industry.

    5. This will favor the banks.

  1. The stock market has been very volatile.

    1. Valuations in parts of the market have overshot fundamentals.

    2. The market has simply run up too high.

    3. IPOs are sapping fund flows.

  1. Not all parts of the market are overvalued.

    1. HSCEI is trading on 9.4X 2015 est earnings.

    2. SHCOMP is trading on 17.5X

    3. Shenzen is trading on 36.9X

    4. ChiNext is trading on 97.2X

Today we take a look at IPO activity.

  1. Market capitalization is rising faster than SHCOMP due to the increased volume of IPOs.

  2. June MTD China announced IPOs total over 75 billion USD (as at 26 June). This compares with an average of 27 billion per month for the last 12 months.

  3. We estimate the 12 month cumulative IPO volume as a percentage of market capitalization in the second chart below*. IPO volume is definitely diverting capital away from the market.

Chart 1: Normalized Market Cap, SHCOMP and IPO issuance. 




Chart 2: IPOs as a percentage of Market Cap. 12 month moving sum.




Last Updated on Friday, 26 June 2015 04:38
EUR: Perspective on daily volatility and market rationality PDF Print E-mail
Written by Burnham Banks   
Wednesday, 24 June 2015 23:17

The behavior of the EUR may have been confusing. If we look at the daily volatility since the Greek situation began its crescendo we have seen the EUR weaken on good news (of a deal) and strengthen when there was bad news (of no deal.)

This is not so irrational. Notwithstanding any plan for retaining Greece within the Euro, Greece’s business model is not working. Current plans for reorganization from both creditors and debtor do not present Greece as a going concern. Therefore, retaining Greece in the Euro must be negative for the EUR and lead to weakness, while a Greek exit would remove a source of uncertainty, inefficiency and cost from the Eurozone which is positive for the EUR.

How rational are markets? We often expect markets to react to bad news badly, regardless of the underlying logic. Could this be a case where the market is being remarkably rational?

Last Updated on Wednesday, 24 June 2015 23:23
Responsible Financial Behavior Punished. Rich Bounce Back as Poor Stagnate. PDF Print E-mail
Written by Burnham Banks   
Monday, 22 June 2015 07:15

If you were careful, responsible and diligent and didn't overextend yourself buying that big apartment in the prime central area and the second apartment to rent out, but maintained a reasonable debt to income and debt to equity ratio, you did OK but you certainly didn't do as well as the guy who bought bigger than he could afford, was less than candid on his loan application for his buy-to-let in prime central, levered himself to his eyeballs and got bailed out when central banks the world over cut rates and did whatever they possibly could to ensure that a free market selection process for weeding out imprudent risk takers was confounded and conservative and responsible investors were disadvantaged.

The interventions and bailouts were entirely unfair. The bailouts were sold to us by the governments that the investment banks had the world over a barrel and that Wall Street had Main Street as hostages and human shields.

And now we are told (in a Bloomberg article Jun 18, 2015) that As the Rich Bounce Back, the Middle Class Stays Stagnant.

When income and wealth inequality are moderate, there is less motivation to challenge the status quo. However, at some level of inequality, when the bottom half of the population by wealth ask themselves what the probability is that they and their children might progress to the top half through diligence and effort, and the answer is pretty low, then change may come.




India Equities Look Interesting. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 17 June 2015 07:32

India is an interesting market. Modi's election success boosted equity markets but lately delays in reform have stalled the market which is some 10% of its 2015 highs.



  • Near term the economy is slowing but long term potential remains strong.

  • India has strong demographics with the working age population rising as a percentage of total and is expected to peak only some 20 years from now.

  • The urban population in India is rising at an accelerating rate and per capital income is rising.

  • Current GDP growth is 7.5% YOY. Inflation is 5%. With a 2 trillion USD nominal GDP economy, India has plenty of room to grow.

  • India has for a long time had strong growth potential but was held back by excessive bureaucracy, corruption and inefficiency. A reformist government may unlock this potential.


  • The Modi government has a strong mandate with 282 out of 543 seats in parliament making it the first simple majority government since the Congress government in 1984.

  • Modi’s mandate is growth and development. He has been a good Chief Minister of Gujarat with 4 consecutive terms and has shown talent as a strong CEO.

  • The government is addressing a number of areas for reform:

    • Ease of doing business, moving to on line licensing and rationalizing other administrative functions.

    • Improving the investment climate, for example increasing FDI limits in selected industries like insurance, defense and railways, circumventing potential for corruption through more transparent processes, and more government co-investment in infrastructure.

    • Fiscal policy, to continue fiscal consolidation and removal of price distorting subsidies, for example in energy and transport, and to make government expenditure more efficient.

    • Taxation, simplifying the tax code, consolidating state and federal taxes into a single GST, expected to be circa 20% - 22%, also lowering corporate taxes from 30% to 25% over the next 4 years.

    • Banking and financial services, take for example the roll out of formal banking services to the general population (target circa 110 million new accounts), and the further augmenting of the bankruptcy law (last week creditors were granted rights to wrest control of management of defaulting companies.)

Corporate sector and Markets:

  • RBI has made 3 rate cuts this year, most recently 2 weeks ago to take the repo rate from 7.50% to 7.25%.

  • The Indian market is dominated by private sector business with SOE’s conspicuously absent. Companies are entrepreneurial and therefore capital and asset efficient.

  • Long run ROEs are 17% compared with 11% for the rest of the world and 12% in emerging markets.

  • Current ROEs are circa 15% and EBIT margins are around 10% which are cyclical lows.

  • Market PE is 16.3X which is at the long term average. The market is relatively cheap considering that corporate profitability is at cyclical lows.


  • Things always take longer than planned or expected in India. This is one of the consequences of India’s democracy and bureaucracy. For example, the GST bill is facing opposition in Parliament and will only be reintroduced in July. It is expected to be passed during the monsoon season.

  • While bureaucracy is being rolled back and even civil servants are optimistic about the progress legacy issues remain. Take for example the retroactive nature of the Minimum Alternate Tax which has caused much confusion and is still in resolution.

  • Inflation may yet rise. The monsoon can affect near term inflation through food prices. India is energy dependent and affected by the oil price. We expect the oil price to remain capped and that long term the oil price will not appreciate significantly.

  • Infrastructure remains poor despite the stated aims to increase infrastructure investment.

  • INR exposure is difficult or costly to hedge. Interest rate differentials imply FX hedging costs between USD and INR to be circa 7%.

Last Updated on Wednesday, 17 June 2015 08:00
Greece Needs To Focus On The Longer Term. PDF Print E-mail
Written by Burnham Banks   
Thursday, 11 June 2015 06:23

If the Greek's were hoping for a bailout, their approach to obtaining one is novel. One would have expected a more conciliatory approach. Their current approach suggests that they are unwilling or unable, probably the latter, to comply with the creditors plan. It seems therefore that the choice before the Greeks is austerity in Euros or austerity in Drachmas.

The choice for the creditors is receiving fewer Euros or more Drachmas.

You can't lend a debtor into solvency. Greece needs to find a long term solution and to do that it needs to decide what it wants to be, not simply what it wants to do. I think that it may be in Greece's interest to exit the Euro and face the austerity that it will face in any case, in Drachmas, where it will at least have freedom over its monetary policy, although it will be constrained in the international capital markets. As it is, it has no control over monetary policy and it is constrained in the debt markets.

Varoufakis' game theory experience must advise him that Greece needs to leave the Euro before it is ejected, just as the best strategy for the Eurozone is to eject Greece before it leaves lest other members see exit as painless. The fact is that the pain is not because it is the Eurozone that Greece is leaving but that it is Greece that is leaving the Eurozone. The Eurozone will want to preserve the former myth and the Greeks will probably want to avoid the latter inference. So everyone is served in some way.

The only legitimate complaint the Greeks might have is that the Eurozone suppressed their cost of debt, an analgesic that allowed the country's deficiencies to persist and accumulate without symptoms for so long. Only the return of country risk in the wake of 2008 awoke the various countries to their conditions as sovereign spreads diverged to reflect individual members' default risk.

Last Updated on Wednesday, 17 June 2015 07:34
Central Bankers Are As Lost As We Are. And They Can Do What? PDF Print E-mail
Written by Burnham Banks   
Tuesday, 09 June 2015 06:09

I guess central bankers are human too and don't have a crystal ball. So they don't know with certainty how the economy will evolve and they have to make decisions which impact the economy in a way that is imprecise. They also have to consider how their actions will impact the economy, in this imprecise way, and how the economy will react, unpredictably, to their actions, as they decide what to do. It is amazing they even bother trying. Its like trying to control a yo yo at the end of a yo yo at the end of a yo yo.

I'd have just decreed that money supply shall be some function of output, and left it at that, being silent about rates, money supply, inflation, output and all of it. If we went back to defining the use of money, and been dogmatic about supplying enough of it to serve those very functions, store of value and transaction enablement, and nothing more, perhaps we'd spend less time trying to second guess central banks in our business and financial investment decisions, believing that central bankers knew what they were doing.

They are just as lost as the rest of us, but far more powerful in affecting the economy in all kinds of unpredictable ways. The wise central banker would quit.


Last Updated on Monday, 15 June 2015 06:36
China. Markets and Economy. An Updated Overview. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 02 June 2015 08:27


  • China is moving from Party rule to rule of law: The constitution and anti-corruption

  • China is deregulating markets and increasing greater market discipline: Testing enterprise bankruptcy law and allowing defaults. Credit is becoming more an alpha market.

  • The credit markets are being stabilized through macro prudential policy: New formation of LGFVs banned. Muni bond market open. Systemic risk is reduced.

  • The PBOC is firmly in easing mode. MLF and PSL = LTRO = QE lite. Risk assets to rally for some time to come.

  • The PBOC will try to sterilize the side effects of its easing: Curbing excesses in equity markets. Buy the dips.

  • China intends to internationalize the RMB via the SDR: QDII2. PBOC is counting on outflows being balanced by foreign accumulation of RMB reserves.

  • China wants to deleverage local governments and corporates and leverage up consumers. Municipal bond markets supported by commercial banks, consumer sector supported by consumer credit.

  • Just a reminder, this is NOT a democracy.

Over a 12 month period the Shanghai composite index has risen by 2.5X and the Shenzen composite index by 2.7X. Equity valuations which were among the world’s cheapest are now among the world’s most expensive. China’s stock markets are reflecting an interesting period of reorganization in the underlying economy.

Political reorganization:

At November 2014’s Fourth Plenum, the Chinese government signaled the importance of rule of law drawing attention to the constitution and establishing a series of circuit courts independent of local government influence. This, together with the anti-corruption campaign that has been deeper and wider than expected can be taken as a sign of a very significant shift in policy. The drivers of this policy are likely pragmatic rather than ideological, yet even so, the reforms that we are witnessing are likely to be durable and positive in the long run. We are under no illusions that China’s party wishes to cede control to democratic rule. However, the government has seen what Western democracies are good at, and bad at, and are currently choosing positive elements of Western democracy for its own use. Conceptually, the central government remains a central planner which has chosen to outsource certain parts of the political and financial system to the market where they believe the market provides a better solution than central planning.

A growing middle class, an increasingly fluid flow of information through social media and the evolutionary demands of this growing middle class present to the government significant new challenges in governing the country. The scale of the problem has led the government to conclude that central government is not feasible and that management needs to be decentralized and localized. The government also recognizes that decentralization requires two elements, the first is that policy needs to be driven by rule of law, and that corruption needs to be minimized. The pursuit of these two objectives are evident.

Economic Restructuring and Policy:

In a global trade war a valuable asset is a large and engaged consumer base. Also, as the marginal returns to exports are eroded, it pays to focus efforts on areas of the economy that are less mature hence the desire to de-focus exports and fixed asset investment and encourage consumption and accumulation of intellectual capital (R&D). In 2005, China was 45% of global new patent filings, in 2010 it was 72%. China recognizes it lags in innovation and is investing in R&D to compensate.

The past 5 years have also seen a surge in credit in particular in local governments and corporate businesses. Local governments were previously prohibited from issuing bonds and instead financed their investments through local government funding vehicles, in effect SIVs. LGFVs are now prohibited; only refinancing of existing assets are allowed. Eligibility of LGFV liabilities as general collateral has also been shut down. Instead, local government has been directed towards the issue of municipal bonds, made available through new legislation. To accelerate this great refinancing, currently estimated at 1.7 trillion RMB, a fluid number likely to be increased serially over the coming years, the PBOC has established repo facilities analogous to the ECB’s LTRO, designating municipal bonds as HQLA for collateral purposes, and discounting risk weights to minimize bank capital consumption. On the corporate front, the government is removing implicit guarantees and seeking to slow the accumulation of corporate debt while Imposing greater market discipline into the market. China has an enterprise bankruptcy law enacted in 2007 which is largely untested. Expect it to be tested this year. There have been 4 defaults to date. The first was effectively bailed out, the second and third are entering litigation. The fourth happened last week.

Where is China expanding credit, if it seems to be trying to reign in government and corporate borrowing? Consumer credit needs to be unfettered if China is to successfully engage its consumer base. The life cycle of income generation makes consumer credit an important necessary condition as house prices grow and as consumer tastes develop and mature. SME lending is another area where credit can be extended. While the Chinese banking system serves SMEs relatively well compared with other countries on access, cost of financing is another matter. The PBOC clearly seeks to lower cost of debt for SME as the economy slows. Banks also have a disproportionate propensity to lend to SOEs which bear implicit state guarantees rather than risky private loans. Deposit caps artificially suppress interest expense boosting margins on low yielding loans. The PBOC has recently signaled it may remove deposit caps altogether exposing commercial banks to higher costs of debt and force them to move down the credit quality curve thus spurring SME lending.


The PBOC’s efforts at expansionary policy to address slowing growth, to reduce borrowing costs, to encourage SME lending and consumer credit, have side effects on inflation and asset markets. The PBOC will seek to mitigate some of the asset inflationary impact of its reflationary policies. The CSRC in January limited the pace of creation of margin accounts and most recently in May, brokerages have been tightening margin requirements evidently at the behest of the regulator.

These periodic interventions to cool possible asset bubbles will create volatility in asset markets but are unlikely to prevent a bubble from inflating. Capital finds a way. The credit restructuring efforts of the PBOC will likely lead to credit expansion and asset price inflation. It will likely lead to inflation in the services sector as well but this is a different story. Current valuations are already stretched but the potential expansion of system wide credit will likely carry to stock market further. Eventually, over valuation leads inexorably to correction but under current conditions this is some time away.


China will seek the inclusion of the RMB in the SDR. The RMB is the 7th largest reserve currency and 7th most used trade currency in the world. SDR inclusion notwithstanding, the RMB will become an international currency. China will soon launch QDII2, a scheme which will open up its capital account even further by allowing qualified investors with over 1 million RMB in financial assets to invest internationally. The calculus expects the opening of the capital account to help the RMB into the SDR and that the resulting foreign demand for RMB reserves will compensate from the domestic capital outflows for investments. This capital will seek a home by the way.

Reality Check:

I am pretty sanguine about the prospects for China. China is embarking on QE or QE lite on an ever increasing scale. This will fuel the asset inflation. The asset inflation will be punctuated by efforts to deflate any asset bubble, although it will likely be futile. The end game is a bust, but one that is far away.

The risk is political. The government appears enlightened and is pressing reform in many directions. One thing, however, has not changed and will likely not change. China is not a democracy and if it ever does, will not become one in a continuous or smooth fashion. While markets are being liberalized, personal freedoms are being limited. This may have little bearing for foreign investors who have but a commercial interest in China, however, there is a way in which the failure to reform the political system may be asynchronous with the economic reform. There is that old communist fallback of redirecting internal tensions into external tensions.

Last Updated on Tuesday, 02 June 2015 08:55
Autonomous Automobiles and Shared Mobility. The Possibilities Are Endless. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 26 May 2015 09:22

With the coming of autonomous automobiles and with Uber’s current exploratory steps into shared mobility, the future of the automobile is becoming interesting. From a central planner’s perspective one would like encourage better productivity of capital. As it is, people who drive to work end up parking their cars for hours a day. This is inefficient use of capital.

Roads are a scarce resource and need to be rationed. Road pricing is an efficient way to ration road usage. This tax should be levied specifically on the beneficiaries of using the respective road, not bus or taxi drivers, unless the meter is running. A form of this is already in force in Singapore.

Car ownership can similarly be rationed through taxation. The stock of cars on the road should be calculated based on the expected use of cars by a given population for a given set of road infrastructure. Redundant features beyond reasonable thresholds such as excessive vehicle size, engine displacement, engine power output, noise output, and the cost of the vehicle, should also be factored into the tax. Public transport vehicles should be granted preferential treatment. A form of this is also currently in force in Singapore.

Cleaner and more energy efficient cars should be encouraged again through taxation. This is done in many countries.

Cars should be encouraged to be put in use as much as possible. With autonomous cars, car owners can rent out their cars when they are not using them. Dedicated limousine services like Uber, taxi companies and private car owners would compete in a market for private car transport. Different markets and services will evolve which will defy efforts to predict them. Examples include using an autonomous car as a courier, as a surveillance drone, as a decoy or as a third party pick-up service.

Last Updated on Tuesday, 26 May 2015 09:24
Ten Seconds Into The Future. Investment Outlook 2H 2015 PDF Print E-mail
Written by Burnham Banks   
Monday, 25 May 2015 08:09

Outlook 2H 2015


Behind every forecast is a melee of competing ideas and arguments. Behind the veil of confidence is a dialectical process of self-questioning and reinforcement, and often, self-doubt. Behind every investment strategist is a risk manager acting as goalkeeper, and a trader dodging and weaving around short term volatility, avoiding the thousand cuts that often derails a sound strategy.



Table 1.1







· Stable growth

· Slower equilibrium growth rate

· Inflation likely has troughed.

· Secular intellectual capital advantage.

· Domestic demand base and credit channels to enable it.

· Less reliant on outsourcing to cheap EM producers.

· Low savings rates and flexible labor market.

· Growing energy independence.

· Slowdown of globalization affects productivity.

· Inflation has probably bottomed. Energy prices have stabilized, labor markets are tight and the housing market appears to be reaccelerating.


· Unstable growth

· Slower equilibrium growth rate

· Inflation likely has troughed.

· Intellectual capital advantage.

· Failure of EUR to clear markets leads to inter-member cyclicality.

· Inflation is likely to pick up as the weak EUR inflates input prices.

· EUR single currency is a structural self-inflicted inefficiency.

· Subordination of economic rationality to political reality.

· Preoccupation with fiscal probity.

· Greece is insolvent and needs to be bailed out or default.


· Steady slowing of growth rate

· No hard landing.

· Inflation likely has troughed.

· Political reform towards rule of law.

· Economic reform towards greater market discipline.

· Macro prudential management of credit markets.

· PBOC easing to accelerate.

· Economic slowdown is clear and present.

· Intellectual capital deficit – albeit being addressed.

· Social development lagging economic development – leads to social dislocation.

· De-globalization hurts export dependent countries.


· Unstable growth

· Loss of export sector as a driver of growth.

· Inflation likely to undershoot.

· Weak JPY improves terms of trade.

· Demographic drag.

· Debt levels too high. Even with monetization policies.



· Non Asia EM faces stagflation

· Demographic dividend.

· Second mover advantage in development.

· Major beneficiary of globalization will be impacted as globalization slows.

· Inflation risk.




Long Term:

The long term equilibrium trends for the various major economies remain intact. The US economy is growing steadily albeit at a lower rate than in in the preceding 30 years. Its drivers are a structural advantage that include such factors as strong institutions, deep markets, financial innovation, technology and intellectual capital. That the equilibrium trend growth rate is slower than before and slower than the market expects will lead to policy errors and allocative errors as cyclical growth is mis-estimated by econometric models.

Europe has much of the strengths of the US; however, it has a single currency, cultural differences, and partial and incomplete unification in important parts of legislation and regulation. These fractures will cause market failures from time to time. For example, the single currency causes market failures to manifest where local prices are inflexible, such as in labour markets where wages are sticky. Unemployment is some 23% to 25% in Spain and Greece, yet labour markets are tight in Germany.

China has been touted as the most important economy because of its size of economy and pace of growth. Despite having a smaller nominal output, China’s pace of growth will generate more incremental nominal output than the US, this while slowing to a still respectable 7%. The importance of China goes beyond its economic impact. China is in the process of an important political, social and economic restructuring. China is seeking a mechanically and logistically tractable way to govern the country which leads the Party logically to adopt rule of law over central control. It seeks to rebalance its economy by encouraging consumption over investment and exports, partly out of the reality that countries will become increasingly mercantilist, self-sufficient and insular. China also recognizes that rule of law implicitly requires that markets are subject to market discipline and not central planning.

India’s restructuring is less radical but will have no less significant impact on its economy. India seeks to unclog the plumbing of commerce, to simplify and rationalize its legislation and regulation so that a conceptually open economy can become a practically open economy.

Japan is also a reform story with new management promising change. So far the efforts on the monetary and fiscal side have been significant but structural reform has been slower to follow. One would argue that the pace was reasonable given the historical caution of the Japanese.

As countries all over restructure their economies for the new reality, globalization continues to slow and retreat. The financial crisis of 2008 is now 7 years behind us but the realization that trade was one of the few avenues left to drive growth has led countries to engage in a global cold trade war. The weapons deployed have included debasement of currency and FX manipulation to re-shoring and the development and protection of intellectual capital. This era of contentiousness will persist for some time to come. A side effect will be reduced global productive and allocative efficiency lowering the non-inflationary speed limit. The short term evidence does not support this view but inflation is a real risk.


Medium Term:

The US economy experienced a period of economic softness in the first quarter, attributed in part to the weather and to a port shutdown on the West Coast, and in part due to the natural metabolism of the economy. This period of softness is likely over. The labour market appears tight and while wages have lagged, they are likely to be dragged along. Manufacturing and services PMIs remain robust.

The European economy has been aided by a remarkable improvement in terms of trade through a much weakened Euro and disinflation. The natural metabolism of the European economy has turned in favor, however, and just when the ECB has initiated its QE program. The immediate effects are understandably optimistic but the structural inefficiencies of the single currency and a host of political challenges on the horizon may temper data and sentiment in future.

China’s stimulus efforts are evident and look set to continue. Market reforms in particular in the credit markets are positive in the long term but in the short term can lift credit default rates. The PBOC will ensure that system liquidity and solvency are unquestionable during the restructuring process. A side effect will be the risk of inflating bubbles in asset markets. To address this, the PBOC operates targeted macro prudential policies to direct the flow and cost of capital. Notwithstanding the efforts of the PBOC the basic tradeoffs between control and state variables mean that policy will continue to have unintended consequences which may present opportunities.



Table 1.2







· Fed expected to lift off Sep 2015.

· Less aggressive rate trajectory. However, expect a series of rate hikes.

· Possibility of July lift off cannot be ruled out.

· Inflation turns out to be stronger than expected.

· Oil prices stabilize to rise.

· Labor markets tight, lead to rising wages and costs.

· Reduced trade deficits provide less USD to be recycled into treasuries.

· US treasury debt service costs

· Weaker than expected long term growth trajectory leads to policy error.

· Erring on the side of loosening – 1930’s experience of being too tight.

· Global economic weakness.

· Strong USD hurts terms of trade.


· ECB QE just underway.

· Rate hikes are not expected soon. This could change if inflation expectations recover.

· Tight fiscal policy and loose monetary policy will cap inflation and output.

· Inflation is stabilizing and could pick up.

· ECB may consider tapering QE ahead of Sep 2016, although this is highly unlikely at this point.

· Fiscal policy will be a persistent drag on output.

· ECB QE is recent and is scheduled to run to Sep 2016.

· Credit transmission is only just recovering. Bond issuance has recovered but loan and structured credit issuance still slow.


· PBOC likely to continue to loosen and may accelerate stimulus to compensate for slowing economy and reforms.

· Current liquidity operations may be extended to QE at a later stage.

· Macro prudential policies to direct credit away from overleveraged industries.

· PBOC is vigilant over equity market and real estate inflation.

· PBOC to continue to suppress cost of debt.

· Current policy includes a host of open market operations.


· BoJ may have to loosen policy further to compensate for fiscal constraints.

· Japan is in a liquidity trap.

· Fiscal policy is tight.

· Sales tax hike delayed till 2017.

· BoJ remains loose but is running out of options as output and prices sensitivity to policy is reduced.

· BoJ may have to compensate for tight fiscal policy.




Portfolios should be positioned for the long term and traded and adjusted for the medium term while being aware of the risks.


In the US stable growth will support corporate earnings and cash flows. With the Federal Reserve no longer expanding its balance sheet, the correlation between duration and equities, distorted to the positive for the duration of QE will revert to the historically negative. While we remain exposed to US equity risk we prefer to express this in US high yield corporate credit. We obtain these risks in two ways, in traditional high yield bonds, which we are underweight and in senior, secured, floating rate bank debt which bears little duration. At the same time we obtain domestic US economic growth exposure via the housing market through credit sensitive non-agency residential mortgage backed securities.



We are in the early stages of implementation of the ECB’s QE program. We do not see significant probability for an early taper despite the current cyclical uptick in activity. While QE is in force, correlations between equity and duration will likely be positive. We are therefore long hard duration in the peripheral countries while being underweight duration in the core of Germany and France. A related trade expression is available in the sovereign CDS where we would be long protection France and Germany and writing protection on the periphery.

We find an efficient trade expression in banks’ capital securities such as contingent convertible bonds and perpetuals where improving balance sheets and capital positions encourage spread compression. While it seems reasonable that high yield corporates should tighten in this environment increased volume of issuance and lighter covenant standards increase the risk in these securities. The demand and supply environment for high yield corporates may cap the returns potential for European high yield.

In European loans we find better underwriting standards, tighter covenants and wider spreads, however, the duration protection is not something we require at the moment and the liquidity of the European market is much poorer than in the US. We do not feel compelled to invest in this area yet.


In China the conditions are positive for risk assets and the most accessible and liquid trade expression is through listed equities. In the medium term, Hong Kong listed H-shares have a valuation advantage which can be exploited. A-shares on the other hand are more directly impacted by improving local liquidity conditions, but valuations are significantly higher than their HK listed counterparts. RMB bonds are another area where the prognosis is positive but here, the government’s reform efforts are likely to drive up default rates as they test insolvency law.


Less Liquid Strategies:


For investors with a tolerance of less liquid investments the prognosis is good. The common thread running through all these strategies is the increased regulation of banks and the vacuum they leave behind.

Hedge funds:

Public data about hedge fund performance is incomplete and misleading. The hedge fund industry has evolved into one where talent is global but source of capital is predominantly US based. Europe had beaten the UCITS path and Asia had almost eschewed hedge funds altogether. In the meantime, talented managers have tightened liquidity provisions to stabilize their capital base and businesses. Illiquid strategies which may either have illiquid assets or liquid assets but long gestation strategies have done well. Examples are complex agency RMBS arbitrage involving arbitraging the relative valuations between mortgage derivatives and the underlying pools. Event driven managers have profited from the surge in M&A activity. Some hedge funds have coupled risk arbitrage with activism to operate highly successful strategies. Generally, with greater regulation and higher capital requirements for principal activities, banks have reduced their principal activities in exchange for agency businesses. The lack of cross market, cross capital structure trading by banks removes an important source of capital policing the no-arbitrage pricing of markets and securities resulting in greater price dislocation that hedge funds can take advantage of. The strategies we favor include cross capital structure arbitrage, merger arbitrage and agency MBS arbitrage. We are less confident that quant driven strategies like statistical arbitrage or trend following price data driven strategies will be able to generate consistent, repeatable performance.

Private Equity and Private Debt:

Private equity and debt strategies are the natural beneficiaries of the dearth of bank capital. However, the weight of capital flowing into private equity in the past 3 years has led to a surfeit of capital seeking deals. Certainly PE secondaries are trading at high valuations and there is a shortage of quality secondaries on the market. The shortage of deals is also leading to deals circulating between funds at increasing valuations.

The private debt market is more interesting in particular mezzanine lending to mid market companies. Restricted access to debt capital markets and a shortage of bank capital coupled with disadvantageous Basel III risk weighted capital treatment make lending to SMEs attractive. One area of low volatility returns is trade finance. Properly structured, trade finance provides very stable returns with low default rates and high recoveries. Private trade finance funds profit from the dearth of credit from bank consolidation and shrinking credit limits.


What are we not positive about? Is there anything we are not buying?


The face of capitalism was unmasked in the aftermath of 2008. Moral hazard reigns supreme. Central banks will not allow any systemically important entities to fail, and will generally err on the side of easy conditions. Fundamental health of the economy notwithstanding, central banks will be supportive of risk assets and indeed any assets with a positive wealth effect. Be that as it may, we are cognizant of the risks in the world economy today.

Broad picture:

The most important risk investors should consider is how central banks will reduce their large scale asset purchases and eventually return their balance sheets to a more manageable size, the implications will be for the real economy and for markets.


Central bank balance sheets cannot be maintained or indeed expanded for too long. A pick-up in the velocity of money can quickly multiply through the money base to result in high inflation. With interest rates at such low levels, central banks may struggle to contain an unexpected increase in inflation. At some point central banks will need to shrink their balance sheets. Not even the US Fed has entered that stage and no one is quite certain what the repercussions will be. The Fed will understandably want to be gradual, probably allowing the assets to pay down and avoid selling assets in open market transactions. When the European economy achieves a durable state of recovery, the Fed will hopefully provide a template for exit.

A by-product of low interest rates is that they impair the functioning of the savings and pensions system. There is a limit to how long interest rates can be artificially suppressed. Liabilities are inflated as much as assets by low discount rates and unfunded liabilities with time become a sizeable current problem.

Tangential to the health of the savings and pensions industry are the fortunes of banks. The future for banks is unexciting. A number of banks operated in potentially disingenuous fashion both during the 2008 crisis and after leading regulators to questions the conduct of these banks. The role of banks in transmitting and amplifying the credit crisis in 2008 added to regulators concerns about the systemic risk posed by the commercial banks. Regulation has understandably swung in the direction of excessively prescriptive policies. Banks have henceforth been regulated like essential utilities, a position they are unused to. Banks may still provide short term thematic trading opportunities, especially in respect of their continuing, albeit diminishing role as the infrastructure of finance, however, for the long term investor, better alternatives exist in the value chain between savings and investments.

Medium term:

In the US, the stability and eventual recovery of inflation recommends an underweight in duration. Curve trades may be available to trade supply and demand driven flattening but outright duration longs should be avoided.

In Europe the temptation to front run the ECB’s QE program is strong. Tactically, the ECB provides a backstop for the investor to maintain a long duration profile, especially in the peripheral member states. Greece can be excluded as the ECB backstop excludes non-investment grade sovereigns. The safer trade expression is to fund the longs with shorts in core Europe. That said, the QE backstop is compelling. We will adopt a long bias to peripheral duration with a keen eye on potential risk off selloffs as happened in the second quarter.

While we have a general preference for equities the return per unit risk of equities and the relative valuation of equities encourages us to find alternatives or proxies to equity risk which suppress volatility or realign the valuations. Where no viable alternatives are available, we will not shy from investing in equities but we will size positions based on the risk of the underlying instrument. Examples are non-investment grade corporate bonds and leveraged loans where we buy credit sensitivity as a correlated asset to equities.

Commodities are ever a volatile asset class where despite having an opinion, we do not have an edge. Oil had been exceedingly weak in 2014, surprising all including the most experienced and dedicated energy traders. Since then, the price has stabilized. Oil has significant impact on inflation expectations and can impact the direction of term structures. While we do not explicitly trade energy and energy related corporates, we monitor the market carefully. Notwithstanding the current rebound and stability in oil markets, the fundamental balance is not supportive of the oil price and we are not convinced of a durable recovery. The actions of the Saudis are illuminating. The Saudis, behaving purely as merchants, clearly regard the future value of oil in the ground inferior to the cash value of what they can sell, all the way down to circa 45 USD. This is a significant overhang.

We have in the past invested in agency mortgages where we sought additional yield over our intended long duration positioning. For one, we are no longer seeking to be long USD duration and for another, agency spreads over treasuries have tightened considerable so that the compensation for prepayment risk is no longer adequate. Tactical opportunities may arise depending on issuance and demand and supply but we are otherwise underweight agency mortgages.

Table 1.3




Fixed Income



· Earnings growth slowing.

· Valuations high.

· Long term positive.

· Short term limited upside.

· Downside risk from higher rates.

· Prefer cyclicals to defensives.

· Long duration trade is over.

· High yield to benefit from slow, positive, growth environment. However, duration will detract.

· Leverage loans provide credit exposure with floating rates and little duration.

· High conviction call on non-agency RMBS as housing recovery matures into a sustainable long term trend.

· M&A activity elevated. Allocate to event driven M&A hedge funds.

· Agency MBS relative value opportunities. Rate volatility generates dispersion and dislocation which can be harvested.

· Trends are turning and have not been established. CTA’s may suffer.


· Equity and bond correlation will be positive under QE.

· Equities cheap relative to bonds and credit.

· Convergence trade in Eurozone sovereign debt, long Spain, Italy, Portugal, short France, Germany.

· Long financials capital securities.

· European equity long short opportunities.

· M&A activity elevated. Allocate to event driven M&A hedge funds.


· Equities supported by PBOC liquidity policies.

· H shares cheap to A shares.

· High yield preferred to IG

· In real estate, prefer size and IG to HY.



· Domestic pension funds are increasing allocations to Japanese equities.

· Economic reform encouraging firms to focus on shareholder value.

· JGB market liquidity reduced to BoJ activity.

· Activist hedge funds may find more opportunities.






Table 2.0




Fixed Income



· Significant demand is coming from buybacks. Buybacks tend to be a poor indicator of timing.

· Valuations are neither cheap nor expensive. There is no advantage in equities.

· Inflation could surprise on the upside.

· Growth could slow to the extent that the Fed is unable to raise rates.

· The US Fed is first in line to taper QE and to eventually reduce its balance sheet. How will it do this and how will markets react?

· As the US becomes more insular what will become of its allies?

· How will the US react to a challenge to its hegemony by China?


· Equities are being supported by the bond market as QE remains in force. Correlation to bonds is positive and optimistic bond markets currently support the equity market. This could change when the QE program matures.

· The debate over the solvency and liquidity of Greece continues on with only tactical solutions, not long term structural solutions.

· Political risk. Syriza’s win in Greece has demonstrated the consequences of populist parties and policies. Spain’s recent local government elections are a portent of the potential risk at the Spanish parliamentary elections in December.

· The UK will have an In Out Referendum on Europe by 2017.


· Valuations are very high and downside risks are substantial.

· Event risk. The Shanghai Stock Connect had a few false starts. Fortunately it is now functioning well. The Shenzhen Stock Connect is expected later this year and could introduce more volatility.

· PBOC policy is academically sound but implementation is inexperienced. Mistakes can happen.

· The promotion of rule of law will likely increase default rates, albeit limited to systemically unimportant issuers.

· Political risk is the most significant risk. Tensions in the South China Sea are unlikely to abate absent a comprehensive solution which no one appears ready to engage in.

· The inclusion of the RMB in the SDR and the ascension of the AIIB are examples of matters which challenge the US hegemony and can become contentious.


· Equity markets are quite stretched. Much depends on BoJ stimulus efforts and a weaker currency.

· The BoJ appears to be in a corner. On the one hand it expects a slow economy and on the other it expects a rebound in inflation. If both occur it could pose a new set of challenges for the BoJ.

· Japan is a test case of extreme debt monetization and debasement of currency in the hope that growth will recover before bond markets fail. A high savings rate and a captive source of funding can delay the day of reckoning for a long time, but not forever.




In Closing:


The investment landscape is risky. The world has not yet healed from its credit binge and bust, and debt levels remain high, growth is slower than before and countries have become more protectionist thus reducing economic efficiency. And yet, central bank policy is either deliberately or unintentionally inflating or backstopping asset prices. The question is, in this environment, can the rational investor ignore markets and refuse to play the central banks’ games?

One, we are mindful of valuations as we invest. Finding cheap assets or cheap trade expressions provides us with a cushion for when markets correct. Currently asset markets are buoyed by monetary policy. Buying cheap non agency RMBS to capture growth is an example of a targeted trade to capture domestic US growth. Buying leveraged loans is a way to obtain exposure to strong corporate cash flows without exposure to duration.

Two, because central banks have such strong influence in the economy and markets today we watch them closely to understand their objectives and limitations, and the propensity for policy errors. We focus not only on what central banks are doing and thinking but we study the mechanical processes by which they effect policy to gain a head start on policy and to find opportunities from operational aspects of policy. For example, when the Swiss National Bank announced an end to the currency cap, it signaled to us the near certainty of the ECB announcement to undertake QE and allowed us to buy bonds before the announcement. Another example is where we focused not on the directional aspect of the ECB’s QE but on the risk sharing by the member states’ central banks to construct a Eurozone core-peripheral convergence trade.

Third, fundamentals and asset prices are joined by an elastic couple which can result in perverse phenomena. Weak economies can spur loose monetary conditions that drive asset prices. Strong fundamentals on the other hand can signal tighter monetary conditions that might choke off an asset rally. Being too early in to a trade can be costly, just as overstaying a theme which has run its course. We keep a close eye on that elastic couple, psychology, which drives markets, even as we maintain conviction in our fundamental views.

The problems that face the global economy are many, but human ingenuity is great. We are acutely aware of the problems and we relentlessly trade the efforts of regulators and market participants to address these problems until a point when market prices are no longer as acutely distorted by regulators and policy and markets can return to pricing assets according to their intrinsic value.












Last Updated on Monday, 25 May 2015 08:29
Defining Sovereign Balance Sheets Through A Sovereign Wealth Fund. Tax Backed Securitiies. PDF Print E-mail
Written by Burnham Banks   
Thursday, 06 August 2015 07:27

Sovereign balance sheets are not well defined in particular because it is hard to define and quantify the assets of a country. The difficulty in quantifying a country's assets can impact a country's ability to raise debt especially in times of financial stress.

One simple way of solving the definition problem is to create a Sovereign Wealth Fund. The SWF is capitalized by injecting state assets such as land, hard assets like resource rights and the capitalized tax base. The definition and quantification of the capitalized tax base is difficult but can be partially solved by a securitization.

With an SWF with a defined asset base it is possible to raise debt. In fact it becomes possible to issue a range of liabilities, secured or unsecured, convertible (to an underlying asset), fixed or floating rate, mezzanine or senior. The cost of debt would depend on the quality of the assets and how the SWF was managed. One important factor would be the dividend policy of the SWF. The dividends would be paid to the Treasury of the country.

With such definition, it is likely that the SWF would become the primary funding vehicle of the sovereign.

The Treasury could of course continue to issue debt but the poor definition of solvency, the reliance on confidence as opposed to asset value, would probably deter investors relative to the debt issued by the SWF.

To better define the capitalized tax base we securitize tax revenues. All tax revenues would be collected by an SPV, a tax collection vehicle (TCV). The TCV is basically a conduit which collect taxes and issues liabilities called Tax Backed Securities (TBS). The TBS would be tranched and rated and the stability of the tax revenues would be reported for full transparency towards efficiency pricing of the tranches. TCV's can be allocated free of payment to the SWF to capitalize it, or sold in an open auction.

All this structuring is for nothing, of course, if bankruptcy laws were weak or did not apply to the securitizations or the SWF's liabilities. By structuring the sovereign's assets and liabilities in a standard private corporate structure, albeit one where the equity was owned by the sovereign, bankruptcy laws could be applied in a clear and transparent way to define priority of claim. This would go a long way to bringing fiscally delinquent sovereigns back into the capital markets.


Last Updated on Wednesday, 09 September 2015 09:37
Singapore government's potential plan to grow the population, encourage more immigration and more foreign labour 2015 PDF Print E-mail
Written by Burnham Banks   
Monday, 03 August 2015 00:30

Singapore's government has attempted to solve a labour shortage and economic growth problem by importing foreign labour and encouraging immigration. In the last election in 2011 the topic of immigration became a serious issue. Singaporean's faced with overcrowding and competition for jobs diverted votes away from the PAP. In response, the PAP acquiesced and slowed the pace of immigration and import of foreign labour.

Yet constantly we hear of plans for an ever increasing population in Singapore. The PAP's economic plan apparently cannot see a way forward without immigration and foreign labour. As a result I expect they will engineer a means of getting Singaporeans to accept more immigration.


Here is how I think they will do it. They will build more housing in preparation for a greater population. This they have already done creating an oversupply of housing. This is uncharacteristically poor planning on the part of the government unless it is an intentional strategy to create oversupply. The government will also cool the housing market. This they have done. They may choose to lift some of the curbs on property investment or speculation but I suspect they will be more vigilant than expected in order to maintain soft property prices.


When vacancy rates rise and house prices drop they will present a solution to the people, namely importing foreigners to shore up the real estate market.


Who Will Own The Robots? We Have More Than We Need, Its Just Unequally Distributed. Post Scarcity? PDF Print E-mail
Written by Burnham Banks   
Friday, 31 July 2015 03:23

Who owns all the stuff?

In a knowledge economy labor’s share of income keeps diminishing while capital’s share keeps increasing as businesses are able to accumulate intellectual property whereas individuals have limitations. In the limit who owns the businesses?

The march of technology will see many jobs made redundant by automation. If robots replace humans then in the limit who owns the robots?

Unlike other factors of production knowledge is not consumable. Producing more of a product does not exhaust knowledge. Knowledge defies scarcity. When knowledge becomes responsible for an increasing proportion of value in the production of goods and services, who should own knowledge?

When factors of production are not unbalanced the question of who owns what factors of production do not arise. When factors of production are highly unbalanced some factors will see returns diminished relative to others. Owners of that factor are at a disadvantage and owners of other factors are at an advantage. Is there a concept of discrimination between factors of production and is there a concept of fairness?

One or all?

Deflation and interest rates.

Human ingenuity should over the long term reduce our reliance on labour and resources. The relative marginal product of both should fall as should the marginal income to both. Does this imply factor price deflation and wage deflation? Does it also imply general price deflation?

A firm has productive assets and cash which it funds with equity and debt. Productive assets include labour and technology, both have a cost as well as a return. A firm cannot own labour but rents it from individuals. A firm can either rent or own technology. The cost of owning an asset is the cost of financing it, which is the cost of equity and debt. The cost of renting an asset is its price or in the case of labor, wages. The price or wage a firm is willing to pay is the marginal revenue product of labor. If the productivity of labour is low, wages will be depressed. If final good prices are depressed, so too will wages be depressed. The corporate balance sheet likes product inflation, falling interest rates and falling wages. Falling wages and rising product inflation implies lower share of labour in output. This incentive would not be so if labour could be owned instead of rented for then its labor cost would be its cost of capital. Businesses also favor inflation the more highly levered they are as it erodes the real value of the debt.

A household derives income from income yielding assets, labour and interest on cash. Its assets consist of investment assets, the capitalized value of its labour and cash. Its liabilities include mortgages, car loans, student loans and short term debt such as overdrafts and credit card debt. Households like rising asset prices and falling interest rates. To the extent that inflation correlates with asset prices, wages and employment households like inflation. Highly levered households also prefer inflation. Younger households prefer inflation as they have a longer period of employment ahead of them and more debt and less savings; they also prefer lower interest rates and a steeper yield curve. Older households prefer deflation as they have less debt and a shorter period of employment before them’ they prefer higher interest rates and a flatter yield curve.


House prices are driven by demand and supply. For a fixed supply house prices rise where employment prospects are strong and mortgages are available and cheap. House prices are also correlated with long duration bond prices as they are themselves ultra-long duration assets priced on the basis of capitalized rental income.

In space constrained cities and countries house prices tend to rise faster than wages and affordability. Employment prospects rise only to drive greater population density which drives up house prices. The value of housing accrues not just to the occupier or owner but to the society as a whole which benefits from the clustering of skilled labour and network effects. Individuals who own multiple houses see rising wealth. Households who own a single house face no real wealth effect from rising or falling house prices as replacement costs rise and fall in step. Ownership of more than one house exposes the owner to the wealth effects of the variation in house prices. Since houses in cities and houses are a scarce resource which benefits not just the owner or occupier but society as a whole what are the economic implications when individuals or entities own multiple houses?

Inequality and ownership. Scarcity and abundance.

Businesses or corporate entities have earned an increasing share of output and income at the expense of labor. There are several factors why this might be so. One of those factors is that the economy continues to evolve towards a greater reliance on knowledge and technology. A human being can only acquire and retain a limited amount of knowledge and skill whereas a corporate entity can accumulate the ownership of intellectual property and either capitalize on it or charge a rent for its use. If the return on intellectual capital is fixed but its marginal contribution to output rises relative to all other outputs, especially labour, then labour’s share of profits will fall. Automation is a practical example of where capital and technology replace labour. In the limit labour may become largely redundant.

If labour is unnecessary in production yet the economy is able to produce all the goods and services demanded by people, how would goods and services be allocated to people? This is the post scarcity environment envisaged in some utopias. One practical question is, what things abundant without bound and be produced at no cost and what things cannot? Given sufficiently advanced technology all material things are abundant practically without bound. What might be subject to scarcity? People? People could theoretically be produced without bound. Space? With sufficiently powerful terra forming there is an abundance of planets which could be colonized. This may sound absurd but we are discussing possibilities and thus sufficiently advanced technology would surmount the most apparently intractable problems. Even space is abundant. How about location? Location is an abstract concept and could remain scarce no matter what technologies we develop.

Location is given relevance by certain qualities. Where these qualities are material they can be replicated without bound and location becomes replicable. What non material qualities could define location uniquely that it could not be replicated without bound? Proximity to and relationships with individuals in a given location would be hard to replicate. This begs the question if individuality was replicable and takes us far from our initial musings.

Time. Technology might be able to extend human lifespans without limit, however, time cannot be created. Time expended on one activity cannot be expended on some other activity. Time is therefore not abundant. Time, however, is relative and it is relative to the lifespan of the observer. A sufficiently long lifespan can lower the opportunity cost of time monotonically. In an arbitrary time frame, say in a fixed number of minutes, scarcity remains relevant. Time spent doing one thing cannot simultaneously be spent doing something else. Time remains scarce although there may be some theoretically possible practically improbable technologies which might compress time or the perception of time.


In an infinitely abundant world what is the concept of want and need? What gives the individual satisfaction? Maslow’s hierarchy presents as an ordinal stack of tranches beginning with physiological need followed by material security followed by social belonging, esteem and finally self-actualization. Maslow’s hierarchy envisages increasing sophistication, self-awareness and morality. It does not envisage what happens or can happen beyond self-actuation, or alongside it. Post scarcity may actually confound some of the expectations of this hierarchy.

Hardship and competition improve the breed. Without want there is nothing to animate natural selection and so there is nothing to distinguish negative from positive mutation. Without a mechanism to sort away negative mutation will it imply more diversity? If technology can preserve the weak, it might well imply more diversity.

Will society maintain or shed its brutality? Is the human soul predisposed to competition? How will it react when there is nothing to compete over? Will it create an abstract or an irrelevant competition? If so predisposed, is this predisposition a survival mechanism?

Back to more practical concerns:

We suspect that there are currently more resources in the world than the world needs, that poverty is not a problem of scarcity but of distribution, that inequality is unnecessary and an unnecessarily high price of progress. We don’t know why but we suspect this is the state of the world. If so, the current problems faced by humanity are an indictment of our system of economics. We have settled on capitalism and the price mechanism as mathematically and rationally, the best available allocation system. A better distribution exists but no better distribution mechanism exists and the best mechanism has resulted in the current distribution. To accept it is to be defeatist.

Certainly for the rich there is no incentive to change the current state. One doesn’t have to be very rich to fall to inertia. The conspiracy theorist might hypothesize that it is not mere inertia but an active policy of maintaining the status quo through the influence of politics and academia. Certainly even the not so well off might baulk at instigating or supporting change when they consider their fortune and the prospect of having to share what they have with those who have not. Change will only come if a sufficient proportion of the population are impoverished or come to feel that their chances of advancement are sufficiently low. When global growth is sufficient that all constituents have an increasing standard of living the risk of change is low. If, however, global growth slows, then a critical mass of malcontents may arise to drive change.

The world economy has witnessed robust growth up until 2008. Some of this growth has been borrowed from the future by being credit financed. This is an intertemporal transfer of growth. It requires that future growth is sufficient to more than compensate for that transfer. Since the crisis of 2008 growth has rebounded but slowly. A large quantity of debt has been transferred from private balance sheets to public mutualized balance sheets. They have not been defaulted upon or written down. To do so would be to accelerate the reversal of that intertemporal transfer. To hoard it away from the spotlight is to prolong the reversal of that intertemporal transfer. Repayment is immutable but can be redistributed over time.

Can current and future growth compensate for the growing inequality that capitalism naturally perpetuates?

Last Updated on Friday, 31 July 2015 03:26
Greek Bailout Solution. Unlikely To Work. And a Proposed Solution. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 14 July 2015 09:20

14 July:


It’s not over. The deal agreed by the Eurogroup with Greece will need the creditor parliaments and the Greek parliament to vote and approve before the governors of ESM can approve it. The Greeks will likely approve it although Tsipras 149 votes will likely not all be yes, it is expected some 30 will vote against, the 106 pro Euro opposition will be sufficient to carry the motion. As for the creditors, only Finland looks risky. Under normal circumstances an ESM bailout requires unanimity but the ECB can and in the event of dissent will likely decide that the action is a threat to the stability of the union and force the vote into a special motion requiring an 85% majority. The potential dissenters will unlikely get beyond 3% of the vote. And so the Greek bailout will likely be ratified.

The ESM’s response to the proposal is not unequivocal and there are potential uncertainties in the language which suggest that there could be further negotiations.

While in the short term the deal will likely be approved by the Greek parliament the fact that the deal Tsipras has achieved is worse than the June 26 creditor proposal and indeed worse than any deal in the negotiations thus far poses a risk to his leadership. The deal involves no debt write down, no end to austerity, a restart to asset sales and this time under the strict supervision of the Troika and the continued monitoring of progress by the creditors, something that was deemed humiliating and demeaning. Syriza is itself a coalition and the integrity of this coalition must certainly come under pressure given the quality of the bailout deal. One can reasonably expect a shakeup in the Greek parliament and possibly new elections.

Even assuming that all parties were agreeable it is difficult to see how Greece would comply with the budget targets. It is one thing to agree to something but another to have a plan to achieve it. So far both creditor and debtor have focused on targets without devising the means to achieving them. Few countries have achieved what the Greeks are aiming for, not even their largest creditor Germany.

The probability that Greece gets into a financially distressed situation at some stage in the not too distant future, under this plan, is quite high.



15 July:


Having had time to sleep on this I'm beginning to have doubts that the Greek parliament will pass it. Tsipras began with an anti-austerity platform and coalition party. He's now ended up with a tighter austerity program than he bargained for at the start of negotiations. Parts of Syriza will vote against the creditor plan. He is counting on the opposition to support this pretty draconian plan. Now the opposition may have been for austerity when they thought it might work but the capital controls have taken the Greek economy off the cliff, not near it, off it. ELA is frozen, thankfully not retracted, and with TARGET2 off limits the Greek economy is essentially is containment. I am simply not sure anymore if the opposition New Democracy will support what is an unworkable creditor plan.


The plan itself is incomplete, which under these dire conditions is actually a source of hope. As it stands, without a write down, the plan is unworkable and seems to have been put together either by amateurs or creditors seeking Chapter 7 instead of Chapter 11. Trying to raise cash by selling assets is a great idea on paper but is impractical. Once the seller is identified as a motivated seller, the bids will tumble to fire sale levels that no credible creditor would agree to if they believed they had claim to such assets and their proceeds of sale. If the sale program was sufficiently determined, the proceeds will fall well short of the 50 billion EUR envisaged. If the sale was attempted at reasonable prices, the fact that the assets for sale are earmarked for sale would mean that the deals will not get done and it is likely that there will be recriminations over the speed of the asset sales and the motivation of the debtors or the creditors.


A credible plan would see the following principles:


1. As close as possible to a commercially viable deal that an arms length investor would fund.

2. A long term solution as long as the longest maturing debt that will be issued as part of the restructuring.


My plan would include:


1. Debt restructuring:

* Issue of senior secured bonds with first claim to a proportion of tax revenues and a sinking fund under control of creditors.

* Issue of senior unsecured bonds with zero coupons for first 10 years and coupons stepping up thereafter.

* Issue of mezzanine GDP linked bonds.

* Legacy bonds to be written down by X% with immediate effect and the recovery value financed by the new bonds above. X could be substantial, circa 30%-50%.

2. Pension reform.

*  No new defined benefit pensions to be issued. All defined contribution schemes to be frozen (not cancelled) at this point (that is, any indexation to stop.)

*  Introduction of defined contribution pensions. Employers pay 15%, employees pay 15%. Assets held in an independent safe custody vehicle beyond the reach of government or state.

* Phased withdrawals of state pensions. Private annuity options.

* Medical insurance part funded from this pool.

3. Social security.

* Unemployment benefits and other social welfare benefits separately funded by payroll taxes.

* Medical insurance part funded from this pool.

4. Taxation.

* VAT proposed in current creditor plan.

* Corporate taxes to be cut when possible. Ideally 1% cut each year in primary surplus till 20%.

* Tax holiday for specific industries - tech, biotech, industries likely to bring investment.

* Social security tax for employers cut from 28% to 10% to compensate for 15% contribution to employee pension fund.

* Social security tax for employers replaced by compulsory pension contribution. This is a simple reclassification.

* Personal allowance of 5,000 EUR.

* 2% cut to all marginal income tax rates.

5. Investment.

* Infrastructure investment funded by private participation in infrastructure bonds and equity.

6. Anti-corruption.

* Anti-corruption campaign. This to address tax collection and tax liability as well as general rule of law.


7. Financial system recapitalization.

*  The banking system will have to be recapitalized. That much is clear. The recapitalization will have to come from first from the government and then from private sources. The banks will issue equity underwritten by the government and simultaneously issue tier 1 capital and mezzanine debt.

The government's biggest expenses are on pensions, medical insurance and social security. By moving from defined benefit to defined contribution, the burden of pensions is shifted to the people, as it should. Medical insurance is split between being funded by the pension pool (individual responsibility) and the social security pool (collective responsibility). These measures will lessen the collective burden and improve the state finances allowing for a reduction in marginal tax rates.


If the creditors are unhappy with the debt write-down and the issue of further debt and the latitude for Greece to run smaller surpluses or indeed small deficits in an interim adjustment period, then they should just eject Greece from the euro.




Last Updated on Wednesday, 15 July 2015 00:33
Greece Votes No In Referendum on Creditor Plan PDF Print E-mail
Written by Burnham Banks   
Monday, 06 July 2015 04:25

On July 2 I wrote that I expected Greece to vote Yes in the referendum. I expected the Greeks to vote in favour of anything that would restart the ATMs and get cash flowing through the banking system once again. As it turns, the Greeks voted no. Why did I and many professional investors expect a Yes vote? Because we have substantial savings. I made a forecast apparently empathizing with the average Greek but without a good understanding of the average Greek and an understanding of their circumstances.

5 years of austerity had not yielded more jobs. The probability of getting a job was low. There was little in the bank to protect or release anyway. And the Eurozone finance ministers had been making a concerted case basically threatening the Greeks into voting Yes.

This last factor could cynically be interpreted as an intentional strategy to jettison the Greeks from the currency union if one were inclined to conspiracy theories. Perhaps the Eurozone was trying to correct an earlier error, that of bending the rules to admit the Greeks in the first place. Perhaps they had just tired of negotiating with a deadbeat who was seeking aid on its own terms. Perhaps the Eurozone had tired of subsidizing Greece (the details are beyond this discussion but yes, there were net transfers to Greece), and unable to eject Greece under the current rhetoric of unity at all costs, needed to force Tsipras to the edge, and then force the Greeks to voluntarily eject themselves. If this is true, then job done. You should see an aid package (the Eurozone will not abandon an erstwhile member) involving debt forgiveness, which is what Greece had sought in the first place, but which the Eurozone could not give and then retain Greece in the union. As important as keeping its members firmly in the union is ensuring that members pay their dues and respect the bye laws.

With a No vote Tsipras can negotiate more aggressively but whether the creditors will be accommodating is another matter. If the conspiracy theory is correct then he has given Merkel her wish and maybe the negotiations will be less confrontational. This is unlikely. The tensions if anything may intensify. A lot depends on Tsipras approach. He may cock a snook at the creditors and refuse to pay, Greece is after all already in default. There is not a lot that the Eurozone can do, short of gunboat diplomacy, something that is unfashionable these days and especially with the Eurozone. A martial solution is something the West has long lost its stomach for, and a German led coalition would never make it past the broadsheets and blogs.

The creditors may recognize that even in the face of an acquiescent Greece that never went to the polls, or a Yes vote, they were never going to get the full face value of their debt back, and that they have now got the Greeks off their backs, some reasonable write down of the debt is acceptable. A more sinister scenario exists. It may have been necessary to induce the Greeks to eject themselves from the union to encourage responsible behaviour among existing Eurozone members but it may now also be necessary to deter further exits by demonstrating the high price of leaving the union.

As I have said before, Greece has always had a choice between austerity in Drachmas or austerity in Euros.

Last Updated on Monday, 06 July 2015 05:04
Greece. Yes No. What Then? Tsipras and Merkel At Last Agree. PDF Print E-mail
Written by Burnham Banks   
Thursday, 02 July 2015 23:48

I was undecided before but the rhetoric from Berlin has now convinced me that for once, Merkel and Tsipras agree. They both want the Greek people to vote No in the July 5 referendum on creditors’ terms.

Greece has been on explicit financial aid since the first bailout in 2010. In 2015, since Syriza won the general elections, all Greece has been trying to do is renegotiate the terms of its aid. It is not a bailout or a refinancing or debt reorganization, its aid. For the Eurozone, its members already struggling fiscally, with the exception of Germany, aid to an unproductive member was never sustainable. That the Greeks did not have a commercially acceptable business plan exacerbated the situation. Reprieve (for the EZ) came in the form of Syriza. Under ND, austerity had failed but its effects would only manifest will past the elections. Had Greece failed under a compliant New Democracy the effectiveness of the Eurozone’s austerity programs would have come into question. Rather fortuitously, ND lost to a strident Syriza intent on tearing up the status quo became a convenient pawn in a gambit designed to see Greece out of the Euro, by its own hand, and facing painful consequences – as a warning to Portugal, Spain and Italy, that exit has a price too high.

Unfortunately, for the Eurozone and Syriza, the vote will likely be Yes. Quite what happens after such a vote is another matter but, polls notwithstanding, the human tendency is to go with the devil you know. A Yes is more probable because, Greeks do want to stay in the Euro, they receive aid from the Eurozone, their borrowing costs are or were held down by the Euro, but most of all, they cannot envisage life without the Euro, or life with a Drachma. More immediately, the banks are closed and pension disbursements are drying up. Greece and her banks are short of cash. In the short term only Emergency Liquidity Assistance can restore the flow of cash and the ECB will certainly not raise the ceiling on ELA if there is a No vote. By imposing capital controls and a bank holiday, Tsipras may be encouraging his people to vote Yes just to free up the flow of money.

A Yes vote will mean a loss of mandate for Tsipras and his Syriza since he has recommended to his people to vote No. Tsipras may have to resign, triggering fresh elections. If so, a new government will need to be formed during which time it is not clear what the position of the Eurozone will be, they will have no one to negotiate with. The position of the ECB will be similarly unclear. Should they provide relief and lift the ceiling on the ELA? If they did, cash would start flowing again while Greek default risk would still be ring-fenced within the Greek financial system. So it is likely they would. Tsipras may not resign. A cynic might expect him to hold on to his position and resume negotiations with the creditors. He has already shown sufficient flexibility in between the time he called for the referendum and when the referendum would be held by attempting to negotiate terms with a softer stance. In any case, a Tsipras government or another government would have to respect the result of the referendum in negotiations with the creditors, basically accepting the terms of the initial creditor plan. The latitude for any government to be obstructive is significantly limited by a Yes vote. Very likely a deal will be struck and bailout disbursements would follow. Given the draconian terms of the creditor plan, Greece would limp along until the next crisis.

A No vote would keep Syriza in place but could well put Greece out of place. While it appears that anything is possible, if we are to believe the myriad official voices from Brussels to Berlin to Athens, Greece would probably be forced out of the Euro. Theoretically it could default and remain within the union, since membership does not explicitly preclude default, but the going concern status of Greece would be in question and there might be sanctions regarding Greece’s access to the European TARGET2 payments system. Another possibility might be Greece being removed from the currency union but not the European union in a similar way that the United Kingdom is part of the EU but has its own currency. In any case, Greece has for all intents and purposes already defaulted on the IMF loan due June 30. The IMF would simply formalize this by changing its status from being in arrears to being in default.

Under a No vote and default, could Greece remain in the Euro? Theoretically it could. Greek debt in Euro would default and face writedowns in the usual fashion that defaulted dollar debt faces writedowns. A plan of reorganization could still be formulated with Greece within the Euro that would restructure its debt. Creditors would still impose conditions, and Greece would negotiate for leniency, in fact the negotiations might look very much like what we have experienced in the past 5 months. The negotiations thus far have not only been ineffective, they have been irrelevant. Now it may be that the Eurozone then decides to remove Greece from the currency union. It may keep Greece in the broader union, or it may also eject it altogether. That is a separate analysis which would involve longer term strategic considerations as well as historical, cultural and emotional factors. The logistics of default are another matter. Upon default, Greece would have to be prevented from creating further liabilities, which it can do within TARGET2. Shutting Greece out of TARGET2 or limiting its access to it would be the equivalent of Europe unilaterally and exogenously imposing capital controls on Greece, which surely would encourage Greece to leave the Euro.

What other alternatives does Greece have? Tsipras has evidently approached Russia. Russia, however, is not entirely in shape for such extravagance. While the Russian economy has stabilized somewhat rates remain elevated and the currency may yet begin to weaken again and the budget has already begun to deteriorate again. Putin might be happy to spend some money on entertainment and Greece would be a source of worry in NATO’s backyard but so far Tsipras’ overtures don’t seem to have borne fruit. Unless they are waiting for a more opportune time to come out.

The polls have been all over the place beginning with favor for a Yes, to a more even balance to favoring a No. Polls tell you what people wish they could do, not what they will do. And even when the votes are counted, a new uncertainty will have begun.

Bondification. The Quest For Yield And The Turning Point. PDF Print E-mail
Written by Burnham Banks   
Thursday, 25 June 2015 05:49

When we buy an equity or a bond we buy a claim on a business but with differing payoffs, rights and obligations. The rational investor would first decide if the business in question was something they wanted to own before deciding on whether to own it through the equity or the debt. If indeed the business was attractive then the analysis would progress to which claim to buy, an analysis which would take into account the prospects for the business, the riskiness of the business and the available claims. The assessment would be made on a risk adjusted basis and not on the absolute attractiveness of the claim. I say this because if it was decided that the most senior claim was the right one, leverage could be used to scale the investment to the right size. If for example equity was the right claim but the investor was targeting a low risk, then a deleveraged position could be taken (that is pairing the position with cash).

We apply this methodology with the prices before us. Its really the best we can do. The methodology may well drive us to hold lots of cash for example if equity was the more attractive claim, yet our desired volatility was lower than the unlevered cash equity. In this case we would hold a deleveraged position, meaning a portfolio of positive cash and positive equity.

Current valuations are quite balanced. Looking at aggregates, equities are cheap compared with government bonds but they are fairly priced on a historical basis when compared with corporate bonds. The spread of investment grade corporates to treasuries is moderately attractive and at this point at least, a comparison of high yield to investment grade yields is equivocal.

The investment problem is that government bond yields are too depressed. Valuations made against government bonds are a risky practice since yields are likely to rise and could render reasonably priced assets expensive quite quickly.

It was low interest rates in 2003/2004 of 1% in the US, now a princely level, which saw the reach for yield in that decade which was sated by ratings arbitrage, necessary because institutional investors were constrained by ratings requirements. The ratings arbitrage resulted in clever constructs like CLOs and CDOs. Demand for yield drove demand for CLO origination which in turn drove demand for ABS and in particular RMBS origination to the point that the banks were more willing to lend than the homeowner was to borrow. This was the tipping point.

As we reach for yield today we should be aware of the balance of enthusiasm between lenders and borrowers. When lenders are more motivated to lend than borrowers are to borrow it is usually a sign of a credit bubble.

When Will The Fed Shrink Its Balance Sheet? In The Long Run The Fed's Balance Sheet Will Probably Grow. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 23 June 2015 09:26

Analgesics are addictive. Since interest rates were deployed to manage the economic cycle we have seen the Fed Funds Target Rate decline, making lower lows and lower highs (1980, 1984, 1989, 1995, 2000, 2007) as the Fed has been repeatedly enlisted in the bailout of asset markets and the economy.

Now that a new policy tool has been invented it will doubtless be counted upon to support further crises and excesses. This is the nature of moral hazard. We cannot un-discover QE.

With Fed Funds at 0.25% there is no room for cutting it any further. We will be fortunate when the Fed finds itself in a position to reset its policy tool higher but should another crisis or recession occur, with Fed funds at these low levels, the Fed's balance sheet can and will be deployed. While the balance sheet may shrink in the next 7 to 8 years, one can reasonably expect it to expand over a longer time frame.

Last Updated on Thursday, 25 June 2015 05:51
Investing In Mutual Funds. Rationale, Costs and Benefits. . Mutual Fund Distribution and Other Issues. Asian Fund Distribution PDF Print E-mail
Written by Burnham Banks   
Thursday, 18 June 2015 07:32

Some Issues In Mutual Fund Investing.


1. One of the problems in mutual fund investing is how they are sold to investors.


a. High front end commissions. Mutual funds typically charge a commission to invest in them. This commission is paid to the distributor of the mutual fund, such as a bank or an independent financial adviser. Just like any other product marketing has a cost. Mutual funds can charge up to 5%, sometimes more, in commissions. Distributors receive these fees ostensibly for providing advice. Perhaps, but if so, why are the fees charged by the funds and rebated to the distributors and not paid directly by clients to their bank. By accepting payment from the fund manager instead of the investor, distributors work for the fund manager, not the investor. How about sophisticated investors who do not require advice but are faced with subscription commissions wherever they turn? In a low yield environment even a 1% commission can eat up 3 months’ worth of gross returns.


b. High management fees. Mutual funds charge different clients different fees. Institutional clients pay half of what retail clients pay, sometimes even less. The primary reason for the difference is that retail funds' fees have to be shared with distributors such as banks and IFAs in what are called trailer fees. A fund charging 1.5% per annum will pay its distributor 0.75% per annum on the assets raised. Fortunately there are some banks who eschew this practice and either invest their clients’ money in institutional share classes, which incur much lower fees, or rebate any trailer fees they get on to their clients. In certain markets like the UK, it has become illegal to pay trailer fees to distributors. In Asia trailer fees are the norm.


c. Opaque fee structures and conflicts of interest of distributors. The payment of trailer fees to distributors creates a conflict of interest. Distributors have a strong incentive to sell funds with high trailer fees or commissions. Whereas fund distributors claim to represent the interests of their investors they are in fact being paid by the fund managers. Low volatility funds often also have low expected returns and fund managers scale their management fees accordingly. Since trailer fees are usually a cut of management fees distributors prefer to sell investors high risk, high returning funds which charge high fees to low volatility funds. Investors are allowed to believe that their banks are working for them when in fact they are working for the fund managers as their distributors.


2. Underperformance of benchmarks is addressed below under “When ETFs are more effective.”


3. Mutual funds are aggregation vehicles when it comes to market systemic risk. As more capital comes to be controlled by fewer independent decision makers, systemic risks are raised. CLOs and CDOs dominated the demand for loans and bonds in the years prior to the 2008 crisis.


a. The size of a fund should be seen in the context of its market. A fund which represents too large a proportion of total trading or total holdings in a particular market is risky from a liquidity aspect.


b. The aggregate size of mutual funds as a percentage of total market size is another risk factor since mutual fund managers and their investors are likely to behave similarly.



There are a number of reasons for investors to invest in investment funds.


1. They are a practical and convenient tool and component to deploy a diversified global portfolio. Regional, country, sector and asset class funds allow the investor to construct a portfolio to their own requirements.

2. Investment funds offer a diversified portfolio within a defined investment objective. Funds diversify the idiosyncratic risk while retaining the thematic risk so a single security or issuer cannot derail a sound thematic investment strategy.

3. Outsource investment strategy to experts in their particular fields. Funds allow investors to delegate investment strategy to professionals of a particular focus and specialization.

4. Related to point 2 above is divisibility. Some securities can only be traded in large values. If an investor’s portfolio is too small it may be impossible to invest in such securities or to invest in such securities with sufficient diversification.

5. Access. Certain instruments and markets are not easily accessed by retail investors. Catastrophe bonds, asset backed securities, structured credit, freight futures, commodity derivatives, etc are examples of instruments which are traded by institutional investors and not retail investors but which can be accessed through funds.



When Exchange Traded Funds Are More Effective.


1. One of the criticisms of mutual funds is costs. Mutual fund managers charge annual management fees, and some even charge performance fees. In order for a manager to return the same as their benchmark on a net basis, they must outperform their benchmarks by the quantum of their fees on a gross basis. Empirical evidence suggests that on average, mutual fund managers are unable to compensate for the fee drag. An exchange traded fund or ETF may be the solution to the fee problem. Due to scale and the mechanical nature of the portfolio construction ETFs charge very low fees. In some cases, the index replication strategies are sufficiently clever that they even recoup the little transaction, administration and custody expenses incurred by the fund.


2. Highly efficient markets are difficult to outperform. The US equity market is a good example where very few active managers outperform the index. In such markets, an ETF is more efficient.


3. Highly liquid and efficient markets are easier to replicate in an ETF. In illiquid markets.


4. ETFs can be traded at any time during the trading day. Mutual funds are typically traded at the NAV at the close of the day. Some mutual funds have poorer redemption liquidity which may be weekly or monthly.


5. The cost in trading ETFs is normal trading commissions which have seen significant compression over the years. Mutual funds can and often do involve paying a hefty up front commission to the distributor of the funds. Commissions can be as high as 5% or higher in certain markets.



When Mutual Funds Are More Effective.


1. There are some markets which are simply not tracked by indices or ETFs. An example is the non-agency MBS market. While there are a number of large and well known MBS (mortgage backed security) ETFs these invest entirely in agency mortgages. The non-agency MBS market is simply not represented by any ETF.


2. There are some funds which have a theme or strategy that is not represented by any index or ETF. Hedge Fund Research, an index compilation company has compiled investable indices called HFRX so that even hedge fund strategies are replicable and can be accessed through an ETF but there remain some areas which ETFs have not reached. ETF providers are, however, trying to complete their shelf and are constantly evolving new strategies.


3. On average, by definition, mutual funds make a gross return equal to their benchmarks, which after fees and expenses, is below the benchmark. There are, however, mutual funds whose managers consistently outperform their benchmarks. The incidence of these managers is in part determined by the efficiency of the market. More efficient markets like US equities, are more difficult to outperform. Less liquid and less efficient markets enable active management and outperformance. They also enable underperformance.



Bottom Line:


1. As with all things investors should know the product at least as well, if not better than, their advisors.


2. Regulators should address the conflicts of interest in how mutual funds are offered to end investors. Regulation in the UK for example has been enacted to address the trailer fee issue.


3. Investors should be aware not just of the fees, costs and expenses in fund investing but of who are the beneficiaries of these fees, costs and expenses so that a judgment can be made as to the quality of advice they obtain from the various parties.


4. There are circumstances under which actively managed mutual funds can be used and circumstances under which ETFs should be used. One is not always and everywhere superior to the other.






Last Updated on Thursday, 18 June 2015 23:55
FOMC Meeting This Week. What To Expect. The Fed Wants To Raise Rates. PDF Print E-mail
Written by Burnham Banks   
Monday, 15 June 2015 06:15

Since the last FOMC meeting in April, economic data have improved. Most recently US payrolls and average hourly earnings have picked up and retail sales have rebounded. Only inflationary pressures have been conspicuously missing. Yet inflation is but one consideration for the Fed. As rescuer of last resort to the economy and the financial system the Fed is now about 7 years into a recovery with all its emergency bail out policies fully deployed. It needs to reset some of these tools in case of another financial or economic crisis. Granted, it also has to do this without precipitating a financial or economic crisis.

The bottom line is that the Fed wants to raise rates. It may not be able to. It has already signalled that it wants to raise rates and it that the path of rate hikes will be gradual. We can see why, the incremental interest expense to each 25 basis point hike (assuming it flows through the rest of the term structure uniformly) will be of the order of tens of billions of USD per annum, not large but not insignificant either.

The Fed has prepared the market for a rate hike for some time and the focus and attention on the next rate hike suggests that the market is prepared for it. What the market may not be prepared for is further delays which could signal a weaker economy than previously thought.


Last Updated on Monday, 15 June 2015 08:02
RMB Internationalization and Inclusion in SDR. Implications For US Treasuries. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 09 June 2015 06:26

There is some concern that with the internationalization of the RMB and its eventual inclusion in the SDR, that China's demand for USD and US treasuries will fall. There may be other reasons why China's demand for USD and US treasuries may fall but the SDR inclusion and RMB internationalization is not a primary concern. China's decision to hold USD and US treasuries is not determined by the RMBs reserve status. As far as China is concerned, the RMB has reserve status since this is China's own sovereign currency.

A tighter trade surplus may result in lower demand for treasuries.

Greece Needs To Exit The Euro For Its Own Good. PDF Print E-mail
Written by Burnham Banks   
Monday, 08 June 2015 05:21

For there to be reform one has to quantify the problem. Under any form of bail out or support, the size of the problem is hidden. That Greece is in the Euro is already an impediment to price discovery and the quantification of the problem. The Greek economy needs to discover its marginal product for all factors and inputs. Inclusion in the Euro means that locally sticky prices perpetuate misallocation and mispricing. Since some prices will always be locally sticky, it is necessary to have an external adjustment. A Drachma is the additional degree of freedom the Greek economy requires. Under a freely floating Drachma, and there will certainly be volatility, the Greeks will be able to determine efficient factor prices, tax rates and calibrate their pensions and social security accordingly.

The immediate levels may not be palatable to the Greeks, especially in the short run, but the alternative, keeping the Euro and inefficient price discovery only leads to failure of Greek markets for inputs and outputs to clear. And this is a long term problem with recurring symptoms.


Last Updated on Monday, 15 June 2015 06:35
Off Topic: Cancer A Sign Of Resilience Of The Species? PDF Print E-mail
Written by Burnham Banks   
Tuesday, 26 May 2015 09:27

Increased incidence of cancer can be indicative of the improved resilience of the human species. The environment constantly evolves in uncertain ways. To adapt to the constantly evolving environment, a species needs to also evolve. Increased mutation is equivalent to increased evolution. Unfortunately, with increased mutation comes increased negative mutation, leading to cancers. The propensity to mutate is collectively positive for the species but individually negative for a particular member of the species. Positive mutations may go unnoticed or unreported whereas negative mutations naturally draw attention as treatments are sought.

Is it possible that some cancers are in fact an early evolutionary phenomenon which left untreated could lead to a discontinuous evolution of the species?

Private Banking Industry In Asia 2015. Identity Crisis. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 26 May 2015 08:27

With regulation like Basel III, Dodd-Frank and other local regulations it is no wonder that banks are turning to asset management and private banking to generate fee income. The wealth generation in Asia has caught the attention of the private banking industry and many banks are investing heavily in building and growing their Asian businesses. The Asian private banking scene is an interesting one. The trust between clients and banks has been tenuous and it has been difficult to scale businesses profitably.

Principal Agent Model: Brokers, not fiduciaries.

The single most important question for a private bank is one of identity. An organization behaves the way it does because of the what it is; it cannot act against its nature. Arguably, most so-called private banks in Asia are in fact brokerages. Fee paying AUM is in low single digit percentages of total AUM. Their relationship with their clients is defined by earning commissions or transaction fees, receiving retrocessions from product providers, and providing leverage. Private bank investment research is provided for free and in return clients are encouraged to transact and thus pay commissions. Where managed products such as funds are concerned, in addition to charging the client commissions, private banks are paid trailer fees or retrocessions by product providers. For example. the distributing bank typically takes half of the management fees from the mutual fund manager for distributing their products to their clients. Transaction fees encourage activity and can lead to advisors churning their clients assets. Trailer fees lead private banks to represent the interests of the fund managers above those of their clients.


In discretionary and advisory portfolio management services, clients pay private banks to manage or advise on their assets. They pay an annual management or advisory fee regardless of the activity of the account. Private banks then buy the cheapest available versions of each particular investment instrument, or if trailer fees are collected, rebate these to the clients. Commissions and activity are transparent to clients. Private banks operating under this model are aligned with the client because the client is their paymaster and as a result the banks are contractually bound to represent the client above all other parties.

In Asia, discretionary and advisory assets are in the acute minority. Asian clients are reluctant to pay fees for discretionary management or advice preferring to retain control over their investments. Trust has been difficult to build in the aftermath of 2008 when products and funds sold by private banks either incurred substantial losses or restricted liquidity. Also, the dearth of international and cross asset / cross market expertise among private bank advisory staff does not instill confidence. Asian HNWs are also likely to be first or second generation wealth and actively managing their operating businesses. The returns on equity on their operating businesses far exceed what they can reasonably expect to earn in a private wealth portfolio. Clients do not yet understand that the route to a multiple of return on capital can only be purchased with a significant probability of catastrophic loss of principal. Operating businesses take time, effort and risk to build. When the time taken to generate the return multiple is taken into consideration, internal rates of return might not be that attractive. Additionally, when the risks are factored in, the risk reward may not be that attractive either. Private banking clients are the ex post successful sample, the ex post unsuccessful sample falling away and not being counted. The return and risk targets of a wealth preservation portfolio are far more conservative and the diligence and complexity of investment strategies are directed at risk mitigation rather than unfettered returns generation. Remarkably, few clients see the contradiction in leveraging up such portfolios with full recourse credit lines provided by the same private banks. The private banks clearly do not. The return on assets from the bank’s fees perspective make this a reasonably attractive business, especially if there is recourse to the client as well as to the assets.


Private Banks to do list:

  • Decide on their identity, if they are brokers or fiduciaries.
  • Private banks who want to be brokers are not purveyors of advice or investment management; they are purveyors of market access and transaction capability. They need scale and volume and they should recognize margin compression as a reality and an eventuality. The resources they require are very different. Brokers can survive on far fewer human resources than fiduciaries. Technology resources for brokers are also different than for fiduciaries and can and should be used to replace human resources. Brokers are more capital intensive, have lower overheads, slimmer margins, more volatility of cash flows and need scale.
  • Private banks who want to be fiduciaries seek stability and predictability of fee income and better margins. Overheads, however, will be higher as technology solutions cannot be deployed to replace costly human resources. Fiduciaries are not purveyors of transaction capabilities but of advice and investment management. Fiduciaries need to invest in experienced and expert advisors and relationship managers. Fiduciaries are less capital intensive, have higher overheads, better margins, less volatility of cash flows and do not require scale.
  • If any universal banks attempt to do both it is best that both businesses are run separately with Chinese Walls. There are no synergies to be had here, only potential for conflict and revenue cannibalization.

Clients to do list:

  • Diversify between brokers and fiduciaries. Decide on the proportion of assets they wish to allocate to active self-directed management, that is to their broker, and what proportion they wish to allocate to a discretionary manager.
  • Select a broker with the lowest all in cost, the best market access and good reporting.
  • Select a fiduciary with the best investment management talent, operational integrity, risk reporting and client service.
  • Resist the temptation to replicate the fiduciary portfolio at the brokerage. On the one hand this cheapens the fiduciary service but at the same time it concentrates the risk and dilutes the diversification benefit.

Last Updated on Monday, 15 June 2015 06:36
FX Rate Fixing. Banks Fined. A Clarification. PDF Print E-mail
Written by Burnham Banks   
Friday, 22 May 2015 01:11

The rights and obligations of principal and agent need to be properly defined, particularly in complex business like banking and finance. Five banks have recently been fined $5.5 billion over a rate manipulation scheme that has seen them not act in their clients’ best interest.

A bank should be clear about whether it trades as principal or agent when it transacts with a client. If as principal, the rules of disclosure may be relaxed. If as agent the rules of disclosure are clear: the client must be made aware of the detailed economics of the trade including the commissions, costs and expenses. The concept of markup pricing is incompatible with an agency trade. In fact, not only the quantum but the beneficial recipients of commissions, costs and expenses should be transparent, so that there is no ambiguity as to the interests of the agents and their delegates or associates. For principal trades, the client needs only know the all in cost of the transaction. Margins and markups, and their beneficial recipients are irrelevant.

This transforms the issue from one of transparency of pricing to one of the distinction and separation of principal or agent relationships. Client’s may want to choose whether the bank they trade with is trading as principal or agent. If there is no liquidity, it may be preferable to do a principal trade since the bank makes market. If there is ample liquidity, an agency trade may be preferable as pricing is transparent. What is required is a Chinese Wall between the principal desk and the agency desk. If a client chooses to call the agency desk, they receive full transparency but have to live with the liquidity available. If they choose the principal desk, they are aware that the bank is trading as principal and does not in any way guarantee best execution but the bank must guarantee execution.


Incidentally, the complaint against the banks was not that they did not act in the best interest of clients, but that they colluded to create a false market, or lack thereof, and distort prices. In a fair market, even if all transactions were principal ones, clients would have obtained price discovery by shopping around.


The current convention is one where banks trade as principal and therefore, rightly should have no obligation to provide transparency of pricing or best execution. When trading as principal the bank acts in its own best interests, not that of its so-called clients. The clients of the bank, when entering a principal trade become counterparties for the purposes and duration of the trade, and counterparties are owed a different set of obligations than clients or customers. The possible source of confusion is that clients are unaware or unaware of the implications of being in a principal trade. They may be under the impression that the bank acts in any way in their interests, a clearly mistaken assumption. The fault of the banks, if any, is to perpetuate the myth, actively or passively, that they in fact act in clients’ best interests. Where there is a fiduciary responsibility to do so, the law compels them to act in the best interests of their clients but where there is no such relationship, clients should beware.


Regulators can clear the situation by distinguishing between principal and agent transactions and setting out the standards of behavior in each relationship.


It would certainly be interesting to see, in a free market, which business, principal or agency, finds more custom and which is more vigorously supplied. Thin and thinning agency margins balance regulatory capital requirements needs to support principal businesses and only an unfettered market providing both alternatives will complete the market for these services. It is likely that with clarity and the clear distinction between business lines, new entrants and innovation will lead to more efficient markets less prone to abuse.











Last Updated on Friday, 22 May 2015 01:25
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