What does Putin want? It’s not clear. It’s likely he wants more than Ukraine. Those who believed that he would stop with South Ossetia and Abkhazia were wrong.

What drives Putin? Avenging the humiliation of the USSR is a clear motivation. Having held arbitrary power within the KGB, he longs to exercise it again. He does so within Russian territory but he longs to exercise it at least to the extent of the old Soviet boundaries.

How does Putin operate? He sows discord among his enemies. He knows when to hold and when to fold but he’s always at the table. He doesn’t need allies, only that his enemies are not completely aligned. He relies on his enemies not being committed to action, a glimmer of fear, a seam of pacifism.

He lives by obfuscation, behaves erratically, arbitrarily and disingenuously. In a word, he is capricious.

Those who engage him are bewildered by his irrationality, a gambit he employs well. They misread him. The illogic is designed to confuse and to conceal a deeper logic which is only revealed when it is too late. Putin needs to be dealt with firmly. Europe’s prevarication plays into his hands. Their measured and considered approach is based more in hope than experience and they will pay for it. This man does not mean to stop at Ukraine. Nor are his ambitions circumscribed by geography. He is a danger to Europe and to world order. Deal with him meekly and the world will pay.

There is no such thing as an omnipotent central planner, even if the central planner has complete and perfect information and has unlimited resources and ultimate technology. Even an almost omnipotent central planner would not be able to satisfy everybody’s wants and needs. Sci Fi has explored such Utopian scenarios before but while they have examined the technological and social aspects of such societies, the economic aspects can confound. For one, if you give everyone all that they need, they will go crazy comparing their endowments with one another. Envy will animate avarice and before long contention and conflict will ensue. This is the human way. One mitigating strategy might be to endow each agent equally. However, different agents have different utility functions and the equal endowments will be valued differently. Envy will animate avarice and before long contention and conflict will ensue. Assuming that the central planner had access to all private information as well, it might allocate so as to equalize utility. However, utility is variable over time. Before long the equality of utility is broken and everything again descends into hostility.

Perhaps a central planner might sell the concept that each agent has the opportunity to exceed the utility of their competitors if they were good and worked hard. This is selling hope and hope is the most powerful thing ever. What precisely is that hope? It is the hope that an agent who considers themselves as inadequately endowed can achieve an equal or higher utility than their peers. That is, that they have a chance of being above average. Clearly not more than 50% of the population can be above average. It is therefore the hope that one can be above average, or equivalently, that one is not one of the 50% who will be below average.

Coincidentally, the efforts to achieve above average utility drive the population towards progress and growth. Efforts to remain above average are as strong as efforts to become above average. If all are equally successful and achieve the same incremental success, then the status quo ordinality is maintained and the efforts are ultimately futile. If the below average are more driven, under conditions of equal opportunity, they may gain an advantage over the better endowed and thus equalize the distribution of wealth. The newly below average will then strive to excel and the perpetual cycle continues.

If for whatever reason the above average excel relative to the below average then the distribution of wealth becomes more unequal. The probability of being able to move from below average to above average shrinks. In other words, hope is eroded. How might the better endowed excel relative to the less well endowed? There are all kinds of possibilities. The wherewithal to lobby government, ownership of capital, investment in knowledge and intellectual capital, networks, nepotism, the ability to cope with volatility and the unexpected are some examples. Inequality cannot increase without a point at which hope is lost, that is the probability of the below average catching up to the average or above average becomes improbably low. At this point the status quo is likely to be challenged.

What if the central planner has real time perfect information and can redistribute wealth in real time? Such a redistribution while it may bring agents into a position of equal utility on a pre-redistribution basis, will likely lead to agents valuing each redistribution payment or debit differentially. The perceived arbitrary nature of the redistribution will impair the perception of hope and is thus self defeating. Is it possible to take into account the differential valuation of the incremental transfers? Yes, but this creates a feedback loop which renders the solution hard to obtain and highly unstable. This difficulty and instability of the solution necessitates frequent adjustments to the basis of the redistribution which will render it indistinguishable from arbitrary redistribution, which again impairs the perception of fairness and hope, and is self defeating.

Absolute acceleration in aggregate wealth increases hope and stability. Absolute deceleration or negative growth in wealth decreases hope and stability. Extreme equality slows growth. Moderate to high inequality promotes growth. Acute inequality violates the social contract and leads to disruption.

The near term direction of rates and bonds are not dependent on whether or not the Fed actually hikes rates in Q3 2015 or Q1 2016. They are dependent on when the market thinks the Fed will hikes rates in Q3 2015 or Q1 2016. It is clear from the ruminations of central bankers that they themselves don’t know when they will hike rates; so much is dependent on data. Each piece of data exerts a pull on the Fed, some towards raising rates and some towards delaying the day.

1. The US economy is stronger than the Fed or the market thinks. Especially relative to the new lower long term potential mean.
2. The labour market is healthier than consensus.
3. Economic nationalism will favor economies with a deep consumer base, intellectual property generation and manufacturing capability. NAIRU will, however, be lower.
4. Inflation may surprise on the upside. Inflation could arrive sooner than expected as slack in the economy is underestimated.
5. The US treasury’s funding requirements may be lower than expected on the back of stronger tax revenues.
6. The substitution of funding type from fixed coupon to floating creates a relative shortage of fixed coupon.
7. War may change the funding requirements for Treasury. Currently, however, military spending is expected to continue to decline.

Point 1 above allows one to trade around cyclical assets as the market misjudges the cycle by misjudging growth relative to long term mean. Cyclical slowdowns are pauses which can be misinterpreted as fails creating buy opportunities. Cyclical lows are misjudged as fails when in fact they are inflexion points. Trading should be buying and selling earlier than the consensus cycle.

Point 2, 3 and 4 may introduce volatility to the treasury market and duration assets. Point 5 and 6 could imply a relative oversupply of corporate duration relative to sovereigns translating into spread widening.

Points 5 and 6 in isolation of 2, 3 and 4 suggest buying the dips of longer dated treasuries. Unless 7 takes hold.

Central banks have been printing money aggressively since 2008. The US Fed is now slowing its money printing with a view to a static stance in the near future. What are the consequences for markets and the economy?

When money is printed it has to go somewhere. So far it has gone into asset markets to a far greater extent than it has to the real economy. The transmission mechanism from large scale asset purchases and suppressed interest rates has directed liquidity to stabilizing the mortgage market, and keeping interest rates low across the USD term structure. This has stabilized the housing market and restored household balance sheets to stronger equity positions, strengthened bank balance sheets through their mortgage loan portfolios, and driven yield seeking investors to supporting the corporate bond market which in turn finances share buybacks buoying the equity markets. The impact of QE on financial markets and capital values has been significant yet the impact on the real economy, on employment and wages and on cash flows has been less ebullient.

After 3 rounds and 5 years of QE we are only beginning to see some impact on employment, investment and output. Yet the Fed began, in 2013, to slow its Large Scale Asset Purchases and is expected to end it altogether by October 2014. It is unclear when the Fed will actually either raise rates or shrink its balance sheet; it is currently expected to continue to reinvest coupon and maturing bond principal. The implications of an expanding Fed balance sheet are now known but what about the effects of a static or shrinking balance sheet?

The transmission of QE has thus far directed liquidity to asset markets, notably the agency mortgage backed securities market and the US treasury market. Liquidity, however, has struggled to spur bank lending to financing growth as banks lend out of capital and not just liquidity, and the SMEs which rely on bank lending have faced tight credit underwriting standards. The treatment of riskier, smaller loans under bank regulatory capital rules also hampers such lending. Larger businesses, usually with listed equities, have access to the corporate bond market and have taken advantage of lower rates to raise debt capital. Companies with listed equities have aggressively raised debt to buy back shares thus increasing earnings per share growth without the challenge of having to actually grow their businesses organically. Smaller companies without listed equities do not have this luxury.

That business investment has been slow is concerning. Corporates have raised significant levels of debt in the bond markets, yet hold substantial cash on balance sheet, or engage in share buybacks and M&A. Surveys of business sentiment notwithstanding, the actions of business leaders is not encouraging.

Equity valuations in the developed markets are no longer cheap. Even in Europe, the market has been selective and quality is expensive. Asia is the only region showing any significant value. Yet for equities to push higher, assuming fundamentals are in place, liquidity needs to flow into the asset class. The US Fed is close to neutral, the BoJ, ECB and BoE are all expansionary and the PBoC is probably at an inflection point ready to run loose again. As long as the world’s central banks are in aggregate accommodative, markets will find some support. Under neutral liquidity, such as in the US, for equity and other risky assets to rise, liquidity must be diverted from the real economy. The equity market is therefore highly vulnerable to inflation since such would signal a substation to current consumption. Low inflation has been a sign that liquidity was being directed to investment. The other example is Europe, where inflation has been significantly below expectations and targets. Absent direct asset purchases, a pick up in inflation is in fact a bear signal.

The current structure of the economy is possibly a consequence of income and wealth inequality and that policy has favored the rich. Whereas expansionary monetary policy is normally inflationary, where the benefits of such policy accrue to the rich, the tendency to save or invest the new wealth is high and the marginal propensity to consume is low. Perhaps this is one price of inequality: that monetary policy is blunted and diverted towards more investment and less consumption. Policy makers may wish to consider how the distribution of wealth impacts policy efficacy. Policy that is blind to the distribution of wealth and income can create positive feedback loops which lead to unstable paths or accumulating imbalances.

6 years after the crisis, monetary and fiscal policies have not improved the economy significantly, especially when taken in the context of the financial resources and measures deployed. Global growth has slowed, unemployment remains high and where it has recovered has done so at the expense of the participation rate, income inequality has worsened at the individual and commercial level and geopolitical turbulence has risen, in part from America’s energy boom but in no small part due to growth withdrawal symptoms. What is concerning is that central banks and governments appear to have exhausted their crisis management resources and tools. Interest rates are acutely low, negative in the Eurozone, central bank balance sheets are grossly inflated, and sovereign balance sheets while improving, remain fragile. That inflation is low is a relief for high inflation would inflict serious losses for holders of duration heavy assets such as government bonds which fill the balance sheets of many commercial banks, but low inflation is also failing to erode the value of the stock of debt.

How long can central banks and governments go on supporting asset markets in the hope that sentiment can drag along the real economy? How long can wealth and income inequality continue or worsen, aided and abetted by current economic policy? How long are central banks happy to carry on with their policy tools fully deployed while their efficacy has become blunted? What are the consequences of resetting policy tools such as asset purchases and suppressed interest rates? What if inflation picks up?

After a year of abnormally low volatility, high yield markets are correcting across the globe. Since 2008 the high yield market has experienced 3 bouts of turbulence

1. The European sovereign crisis in 2011.
2. The “Taper Tantrum” of 2013.
3. The last few weeks.

Why have high yield credit markets exhibited this volatility recently?

Purported reasons:

A number of events have coincided with the back up in spreads. I am not so sure they are good explanatory factors.

• The Ukraine troubles and sanctions against Russia are certainly increasing geopolitical risk.
• General turbulence in the MENA region has also increased but these have not been cited as factors.
• Argentina’s default has also been cited as a factor, however, Argentina has been isolated from international capital markets and contagion risk is low.
• Portugal’s banking troubles, specifically Banco Espirito Santo’s reorganization has been cited, but again there is little contagion risk and the Banco du Portugal has been quick to force a reorganization through the creation of a bad bank.

Other Possible Reasons:

• Market complacency. Implied volatilities are acutely low across
  • Treasuries
  • Equities
  • Credit
  • Commodities
  • FX
  • Swaptions

The level of implied vols do not reveal much about skews but generally the market was very complacent coming into the last couple of weeks.

• Realized or historical volatility has been abnormally low in the preceding 12 months. The volatility we have seen in the last couple of weeks is actually closer to normal volatility.
• While fundamentals remain healthy in the US and are improving in China and Europe, asset prices have run ahead of themselves in the US and Europe across equities, bonds and loans. A good asset bought at too high a price is a risky investment. A bad asset bought at a sufficiently low price is a less risky investment.
• Simple mean reversion in realized volatility.

Risks: Here are some of the more topical ones.

• Geopolitical risks will remain high but this is likely to be a long term problem going forward. It is not easily foreseeable so we have to either live with it and apply tighter risk management or increase our risk aversion. The slower pace of global growth, global recovery notwithstanding, is ushering in a new era of contentiousness between friend and foe alike. Expect less cordial negotiations in trade, commerce, and strategic matters in the foreseeable future. Risk = High.
• Economic growth. On the whole, global growth is stabilizing around a slower long term potential growth rate. There will be oscillations around this new rate but slower credit creation, more mature demographics, a relative de-globalization will slow the long term potential growth rate. While the secular trend is slower, the phase in the cycle is positive for the US, China and Europe. Emerging economies with small domestic demand bases or lower technology manufacturing will be at a disadvantage. Countries like Brazil for example will face not only a slower economy but a slower long term potential growth rate, inviting higher inflation at each level of growth. Reform in India and Japan are beginning to gain traction which will pay long term dividends. Indonesia’s prospects are good if the new President is able to consolidate, unite and execute. Risk = Low.
• Valuations are high in the developed markets across most asset classes from equities to bonds to loans to rea
  l estate. The concerted action of central banks has led to asset reflation almost across the board. The MV=PQ equation has not failed. The conspicuous absence of inflation has distracted the market from the obvious inflation of asset prices. The P in the equation is a vector whose components consist not only of goods and services but assets and forward markets. The liquidity operations of central banks has leaked into the asset markets while goods and services inflation has grown more moderately. As mentioned before, the risk of buying a good asset at an overly inflated price is high whereas the risk of buying a poor asset at a sufficiently low price, is comparatively low. The actions of central banks have led to a loss of price discovery in the free market. Risk = High.
• Liquidity I: Liquidity is a fickle friend. It is ample when not required but deficient precisely when it is required. The only markets with constantly high liquidity are the USD and US treasury markets where safe haven status can lead to higher liquidity in stress situations. In the context of credit markets, current liquidity remains good but untested. A test may soon be underway. Bond dealers’ ability to provide liquidity has been seriously diminished. Risk = High.
• Liquidity II: An underappreciated risk is the how investors gain access to an asset class. They do so in what can best be described as aggregation vehicles. The collective investment scheme is one example. So is the CDO or the CLO. These are significant investors across all credit assets from bonds to loans to asset securitizations. In all of these cases, the capital of a collection of investors is pooled into a single vehicle and placed under the management of a professional manager. The consequence of aggregation vehicles is that it concentrates decision making of large amounts of capital in the hands of small numbers of decision makers who often have the same behavioral traits, often the consequence of their contractual and compensation arrangements. That large swathes of the industry rent or purchase the same risk systems is another risk. Certain purveyors of risk system either dominate the market or are large asset managers themselves. By correlating the behavior of a smaller set of decision makers controlling large amount of capital, aggregation vehicles and common risk systems or standards add to liquidity by creating one way liquidity, ample on the way in and not so ample on the way out. Risk = High.

Mitigation:

• Decision making is very difficult in the face of market volatility, even if it is upside volatility. Downside volatility circumvents most human logic circuits. The decision to buy must be accompanied by sell discipline and a list of sell triggers. Too many investors buy without a selling plan. With defined triggers and milestones, a market move can be analysed with disinterest and the optimal decision taken.
• Diversify. The only investor who doesn’t need to diversify is the one who is always right. I have yet to meet this person. Diversify by region, by asset class, by issuer quality, by priority of claim. And watch those correlations. Institutional investors search relentlessly for low correlation strategies which they value as part of their diversified portfolios.
• Understand what you are buying. A thorough understanding of an investment one is making allows one to make informed decisions when prices move. Up or down. When do you average up, or down? When should you take profit or cut loss? Generally, for directional long only (or short only strategies), add risk when you move into profit and cut risk when you lose. For arbitrage strategies, almost always you should add risk when you move into a loss. That’s the rule of thumb. When the investment thesis is invalidated, sell, even if you are making money. When an investment thesis continues to hold but a position goes into loss, that’s the most difficult situation. Are you wrong? Is the market wrong? Lord Keyne’s said, some 80 years ago, the market can stay irrational longer than you can stay solvent…
• There are several ways to de-risk a portfolio.

o Increase the cash allocation by selling some risky assets.

o Switch from lower quality issuers to higher quality issuers.

o Switch from junior and subordinated assets to senior and secured assets.

o Switch from expensive assets to cheaper assets.

Practical matters:

• For investors who have a high allocation to high yield we counsel caution. We did not say sell. In particular we did not recommend a sell on European HY. We focused our caution on US HY where we felt that spreads were too tight and did not refl
  ect value despite healthy corporate fundamentals.
• In the US, we recommend diversifying from HY to IG thus moving up the credit quality scale.
• In Europe, we recommend remaining in HY but to be more specific, buying subordinated capital of financials, that is, bank capital securities.
• In Asia, equities are undervalued. So, while equities are the junior security, we recommend diversifying credit exposure into equity exposure.

Bottom line:

European high yield remains attractive. While some sovereign risk remains, and will remain as long as the European persist with the EUR, the ECB’s promise to do ‘whatever it takes’ is a back stop for the European credit markets. That inflation is low also underpins duration in European credit. The region is improving in terms of credit quality. While the US is in re-leveraging mode Europe remains in recapitalization and deleveraging mode which is constructive for credit. Pricing is certainly not as cheap as it was a year ago and bonds trading well above par are vulnerable to mark to market price volatility. Credit quality, however, is improving and underwriting standards are being maintained. European bank capital has been a big theme. While the asset class has done well, the volume of issuance, driven by increased regulation, has maintained spreads at attractive levels. Security selection is key as the theme is fairly mature. Fortunately, the variety of complex structures,  amd differential triggers and capital treatment, provides ample alpha opportunities.

In the US, high yield pricing is more stretched, not only against the sovereign curve but against investment grade credits. While investment grade is also trading tight, spreads are still reasonable against both high yield and treasuries. That said, high yield spreads remain some 50% wide of 2007 tights. IG spreads, however, are double their 2007 tights. Corporate balance sheets remain cashed up, however, balance sheets are being relevered once more and underwriting standards are faltering. The majority of leveraged loans issued this year are covenant lite. We remain optimistic about US RMBS, in particular in the Option Arm and Alt-A’s while eschewing the riskier sub-prime loans.

Asian high yield spreads are quite attractive, some 200+ basis points cheap to their developed market counterparts. The pendulum seems to be swinging towards Asia as China recovers and India and Japan pursue reform. A more accommodative PBOC can easily precipitate a risk on environment in the region. LatAm, on the other hand seems to be swooning with Brazil, once the darling of the BRIC facing stagflation and Argentina default. While EM may look attractive in parts, equities remain cheap to credit and are the preferred trade expression.

A word about convertible bonds. Issuance has been well bid and valuations are rich and getting richer even as issuers tend to be riskier. Demand has been driven by credit and yield investors (as opposed to arbs) who see converts as a yield enhancement alternative. The market appears to be demand driven with little consideration for monetizing the embedded vega or indeed value and could be vulnerable if fund flows reverse.