Let us consider a model for philanthropic, development finance. An interesting model for development philanthropy is one which provides equity capital to target low income groups to finance and encourage enterprise .

Principals from a target group are invited to submit business plans for approval. Approvals will be based not purely on charitable criteria but on commercial and developmental criteria as well. The aim of these projects is to allow poor communities to develop self sustaining, commercially viable enterprise to provide growth and employment. Hence, funding costs will be aligned with commercial rates; aligned but not identical as barriers to entry may need to be mitigated in the initial stages. Commercial viability is an important criteria as such businesses need to be able to survive and grow once the sponsor capital has been repaid and the sponsor has withdrawn from the operation of the business. The businesses will focus on providing employment to the communities in which these businesses are established. Employees will be awarded equity as part of their compensation to promote an owner operator culture.

Sponsors will actively help principals in the management of the business providing training in best practices in operations and financial management while also providing corporate governance at board level and mediating between employees, minorities and management.

Capital is provided initially as equity. As profits are generated, a proportion is used to pay down sponsor equity and the remainder is used to create new equity capital, this new equity accruing to the local community owner operators. Once all sponsor equity is repaid and a target multiple or IRR is achieved, the sponsor exits the business almost entirely, relinquishing operating control entirely to the principals while maintaining board representation only insofar as to maintain standards of corporate governance. 

In summary:

1. Funded business plans are expected to be viable going concerns at the minimum.

2. Capital is provided on a semi commercial basis. Cost of capital will be benchmarked appropriately so as to avoid funding non commercially viable businesses.

3. Principals earn in their equity. All staff also earn in their equity.

4. The philanthropic sponsor eventually exits but maintains a corporate governance role by way of board membership.

5. Sponsors impart international best practice in operations and finance as much as start up capital.

6. A terminal date is set for the withdrawal of sponsor equity, and thus a target date for commercial viability is built in to each project. The initial funding needs should never become perpetual.

7. The deal resembles equity that converts to debt. Capital is provided in the form of equity. After a period of stabilization, the equity is converted to debt. Excess returns are capitalized and shares are awarded to all staff at all levels.

As the world recovers slowly from the Great Recession of 2008, employment has lagged, particularly youth and new graduate employment. Why is this? Employing new graduates and the young is a longer term investment involving money, time and resources towards future productivity. Employing older, experienced workers is an investment in current productivity. Any future productivity must be subject to discounting by variability depending on general business conditions. In times of uncertainty, it is rational to invest in fixed capital, for which there is ownership over a potentially transferable, marketable asset, and experienced workers. Only when there is less uncertainty, or sufficient comfort from current success will businesses invest in future productivity, which incidentally may be mobile with the benefits accruing to the employee, not the firm. Business investment is likely to be a leading indicator, therefore, for a recovery in youth and new graduate employment. Evidence supporting this conjecture can be found in the recovery in part time employment, while full time employment has lagged. The thesis that education derives more value as a signaling device is also supported here. Employers prefer a hard signal, that is, actual and relevant work experience over an indirect and soft signal carried by a college degree. This does not suggest that a college degree is unimportant; workers without a college degree with similar years of (in)experience fare even worse.

Nothing happens without enterprise. Nothing happens without labor. There is at least the perception, that in the past few decades, and certainly accelerating into the past few years, enterprise has had the upper hand. 3 decades of falling interest rates have certainly helped enterprise through cheap funding while returns to savers have steadily diminished but funding costs are a side show. A paradigm shift is behind the steady rise of inequality. Under a purely capitalist, market economy, the strong thrive and the weak do not. Social security and welfare are socioeconomic band aids cobbled together to address the survival of the weak, or the unlucky. It takes an exceptionally enlightened capitalist elite not to over-exploit labor. Post the Great Depression, with the rise of labor unions and the rise of Communism, the capitalist elite were circumspect in dealing with labor. The fall of Communism has, among other things, removed the need for any pretense by removing Capitalism’s nemesis and alternative. It has also contaminated the capitalist model but that is another story. On purely mathematical grounds and importantly ignoring important limitations and behavioral phenomena, a pure free market economy is efficient. However, it implies that the strong will thrive and the weak may not survive. The world has by and large adopted the free market, with modifications for political imperatives, and added an element of basic social welfare to address the social tail risks. That social welfare is tail risk management is fair enough, however, the neglect and mismanagement of social welfare, such as healthcare and pensions is illustrative of their importance in the grander scheme of things. Income and wealth inequality have increased steadily all over the world to a point at which cracks are beginning to appear. Gini coefficients have risen in Communist, Socialist and Capitalist economies. Labor’s share of GDP has also steadily fallen across most countries in the world. It is interesting to note that while wealth and income inequality has worsened within countries, they have improved between countries. The likelihood of tensions between countries is therefore likely to have diminished while the tensions between different strata within the same country is likely to have increased.

Recent political protests which have arisen independently across the world have been attributed to various grouses such as the rising costs of living, environmental issues, corruption, austerity measures and poor employment prospects. Very often an event is precipitated by one issue and evolves towards other issues. It is possible that the people are protesting inequality in general but struggle at defining their true complaint. Perhaps the issue is sufficiently broad and Ill defined and as a result the manifestations are sufficiently diverse as protesters struggle to focus. Be that as it may, there is a serious underlying problem that will eventually seek a solution. Is enterprise the only road to wealth? Is labor sufficiently compensated for its efforts?

The market will be awaiting Bernanke’s pronouncements this Wednesday in his monetary policy report to Congress. Ben will likely have prepared two speeches, one hawkish and the other dovish. Almost a month ago Bernanke telegraphed the Fed’s intention to eventually taper off QE. Since then the Fed has prevaricated and indicated that monetary policy would be accommodative. Bernanke himself talked a dovish position as recently as a week ago. Today, Bernanke is likely to be hawkish in his report to Congress. 

Employment, manufacturing, capacity utilization, personal income are all up. The stock and bond markets were initially roiled by his June 19 comments about QE tapering but have since taken this eventuality in their stride. The market is therefore well placed to tolerate another hawkish signal from the Fed.

The risks are that we are in the middle of earnings season and earnings could disappoint. The market is unlikely to fare well under the cosh of both weaker earnings and tighter monetary policy. Also, inflation is perking up, ever so slightly, but it is perking up.

On balance, however, conditions are sufficiently benign that Bernanke can deliver a hawkish signal at this turn. It will be a sequence of hawkish and dovish signals yet before the Fed actually moderated asset purchases. If the market becomes sufficiently desensitized, the. QE tapering may go ahead as planned in September.

The risk that faces the Fed today is that it will not be able to taper of its asset purchase program. All indicators point to a sustainable, albeit weak recovery. It is only reasonable that if this were true, the Fed would at some stage be well advised to reduce its balance sheet, if nothing else so that it would have the means to address the next crisis whenever that might be. By maintaining its current policy the Fed would have few other policy tools to deal with another recession or financial crisis. QE tapering is therefore a good thing and the markets appear to have come to that conclusion. Attention needs to turn now to economic fundamentals. A slowdown from here would not allow the Fed latitude to moderate its asset purchases. A climbdown by the Fed on QE tapering might come to be construed as a sign of weakness.

It is useful to consider the possibilities. A climb down from QE tapering would be negative for US risky assets if coupled with a slowdown in earnings growth, an re-emergence of financial crisis in Europe or a stronger deceleration in China. If markets are driven by both a slowdown and a postponement of QE, one would expect fixed income to rally or at least outperform. Duration would outperform and credit would underperform. Thus Treasuries would outperform investment grade, which would in turn outperform high yield. Floating rate senior loans would underperform. There would likely be a knock on effect to international and emerging markets equities and possibly their corporate bonds. The USD will generally be weakened, unless Europe or China were also sources of weakness in which case the USD might actually strengthen.

If QE tapering proceeds as planned in September, the impact on US risk assets is likely to be muted. The Fed has prepared the market for this eventuality and its execution will have been priced in. Equities will likely continue to rise, and will outperform high yield, which in turn will outperform investment grade. Floating rate non agency MBS will outperform agency MBS. Credit will generally improve even as duration underperforms. The relative exposure to credit and duration in each debt instrument will drive their performance. What if the Fed tapers but earnings slow down? This is an unlikely combination but an interesting one. It would indicate an improving labour market and economy but not generally an improvement for corporate America. How could this combination arise? The US might exhibit this phenomenon if the world is adjusting towards a less globalized, more trade protectionist, more insular state. There are reasons why this might occur which we will not discuss here. However, this might result in an internal rebalancing of the US economy towards a less export driven, more domestically driven, self sufficient economy. The predominance of global companies in the stock market, coupled with weak emerging market and European economies might result in slowing earnings growth while domestic US output continues to improve. If this held true then the asset allocation will need to be more specific. In a sense this scenario might be the most difficult to navigate since both credit and duration would underperform together.