Without considering fundamentals, lets look at some pictures…

The global economy is in relatively rude health. The US continues to grow and employment is becoming broader based. The UK is one of the faster growing economies in the developed world. China is recovering nicely as the PBOC eases. The ECB is underwritten the Eurozone economy and is cleaning up the banks. LatAm and some other emerging markets are flirting with stagflation but China, India, Indonesia, are healthy. The MENA is in turmoil and but this is in part a consequence of their waning energy importance. On balance, the world economy looks alright. But there is a right price for everything. Sadly we just don’t know what it is until after the fact. So here are a few pictures for you to make up your own minds.

Are equities expensive? The yield gap between US equities and UST 10 year yields is still reasonable if you use 12 month trailing earnings. However, the Shiller PE is at 26X against a long term average of 17X. Which one is appropriate is a matter of inclination.

What is the relative valuation between US equities and US corporate bonds? Here is the spread between US equity yields and the yield on Baa rated corporate debt. Looks like a toss up.

What does the relative valuation between US HY and IG look like? Looks like HY is trading tight to IG and could widen.

What is the spread between Baa and UST 10 years? IG does not appear as tight as one might have expected.

How steep is the US term structure? The  2 – 10 spread looks pretty healthy. In fact, there appears to be room to flatten.

The 2 – 30 spread certainly looks like it has room to flatten.

What are inflation expectations? Here are the 5 year breakevens (spread between TIPS and USTs). Inflation does not appear to be a concern. However…

The Fed balance sheet is a bit big. And inflation can rise if the velocity of money picks up and multiplies through the balance sheet.

What can we infer from all this?

• Equities are not expensive if you use 12 month trailing earnings but are expensive based on the Shiller PE which adjusts for profitability.

• Investment grade credit is not as stretched compared with treasuries.

• High yield is over valued relative to investment grade.

• The yield curve is still quite steep. This bodes well for the economy and for equities. There is room to flatten which is actually good for carry trades and duration.

• All can be well if inflation doesn’t suddenly pick up.

Things that make you go hmmm…

Post 2008, the S&P and the Fed balance sheet seem to be going in the same direction. And now what is the Fed up to?

Equity, bond, FX, swaption and commodity volatility have one thing in common. They have contracted steadily from 2008/9 levels to 2006 levels, almost in lockstep. To some, this is a sign of complacency, to others, calm.

The US economy remains the focal point of the global economy as it is one of the few areas of sustained growth, and its interest rate policy and treasury markets will influence credit conditions globally. In Q1, this growth faltered, ostensibly due to bad weather. Currently, the economy suffers from weak consumption, capex, and exports while at simultaneously facing a manufacturing renaissance and an improving labour market. I expect growth to pick up from Q2 well into the future, driven by a revitalized consumer and a recovery in investment as US capital stock has an average age of 23 years and is overdue for a wave of replacement. As stronger data emerges, it is likely to drive rates higher across the curve. Fed policy is likely to suppress the short end for a much longer time to come. Demand and supply considerations are likely to flatten the curve, so any short term steepening is catalyst driven, likely to be short lived, and should be seen as a buying opportunity, especially at longer maturities. US equities are currently expensive, having run ahead of themselves and risen through multiple expansion in the previous two years. Corporate profitability is also at cycle highs and further gains will require a further transfer of share of output from labour to businesses, a phenomenon the Fed has identified as unhealthy for the labour market and welfare. The relentless dominance of intellectual property in the so-called knowledge-economy may perpetuate this phenomenon. Individuals have limited capacity to accumulate intellectual property compared with institutions. Unfortunately, unchecked the decreasing share of profits due to labour will also lead to further disparity of wealth and income distribution. While corporate prospects are healthy, albeit patchy, corporate bonds remain reasonably priced especially in the investment grade sector. A surfeit of capital seeking high yield has reduced spreads relative to treasuries and high grade to the extent that they are relatively expensive. The outlook for the US remains optimistic, however, conviction around this call is quite low.

In Europe, the picture is decidedly disinflationary with the exception of the UK and possibly Germany. Rates are likely to remain subdued for some time. In the Eurozone, the economy remains generally weak with pockets of fragile growth. France remains a significant risk as business conditions and sentiment remain weak. Peripheral Europe is picking up, particularly in Spain. Italy remains a problem area. What plagues Europe, generally, is that banks have not reorganized their balance sheets or raised sufficient capital and are therefore not lending, especially to SMEs which are the key to European growth and employment. The ECB has taken steps, notably with two TLTROs in the calendar, to boost bank lending to businesses. These measures are unlikely to work on their own, and more needs to be done, in particular, to improve bank balance sheets to enable lending. Policy is therefore expected to be accommodative for some time to come. New measures are unlikely in the second half as the measures announced in June are implemented and the ECB will want to see how effective they are. One area of particular interest is the vague statement by the ECB regarding its preparations for outright purchase of asset backed securities. Not only is this QE but it could signal the emergence of a liquid market for new securities, possibly with ECB credit support. This is of course speculation but would represent a step change in ECB policy and technology. Region wide, inflation is hardly a problem and fears of deflation are pervasive, with the exception perhaps of Germany. July witnessed the appointment of a new EU Commission President which presages the usual political horse-trading by member countries for key EU appointments to represent their special and particular interests, such as fiscal flexibility in the case of peripheral Eurozone. This occurs amid cynicism and disinterest amongst the people of Europe for the EU.

The UK is a slightly different picture. Growth is robust, albeit unbalanced, with big business taking the major share of the recovery. Concerns over an overheating housing market cast a pall over rates but this is unlikely to translate into immediate and significant policy action. While rates might be hiked, it won’t be by a lot and will probably be later than the market expects. Apart from luxury prime housing in the capital, fueled by foreign money backed by acutely low levels of leverage, the UK housing market is only in its early stages of recovery, and the government will not sacrifice the recovery on account of an anomalous segment of the housing market. Higher rates will choke of the recovery in SMEs which already trail big business which mostly access the bond markets for funding. Inflation has begun to rise, although it remains below the 2% level at which policy action becomes a real prospect.

Japan’s recovery feels more and more real by the day. Abe’s Third Arrow appears to be material. The concern in Japan is to do with its funding model and its export sector. Globally, exports are facing a wave of mercantilism. Japan’s debt service and refinancing prospects are precarious. Japan is cash flow insolvent. Its trade balance has gone sharply negative for most of 2013 and reserves may come under pressure. The cost of shorting the 10 year JGB is low with the yield at some 60 basis points. Liquidity in the JGB market has also become fickle of late, remarkable for a large sovereign debt market. The question for Japan is if it can grow sufficiently quickly to maintain confidence. Between reality and confidence, always bet on confidence. So far, Japan has the confidence of the market and so the risk on trade continues.

China is an interesting market. It has one of the cheapest equity markets in the world and economic growth, while slowing, remains high by any standards. The risks of excessive credit are well documented and while they should not be ignored, the ability of the central government to bail out the credit system should also be taken into account. Don’t avoid the market for this reason alone, just make sure the fire escape is unlocked. Recent data points to a cyclical recovery, to a certain extent driven by macro prudential accommodation. With a closed capital account, monetary policy plays a big part in prices of assets, goods and services, particular in asset
markets where international access is limited. It is likely that as the US Fed begins to slow the inflation of its balance sheet, the PBOC will eventually be under pressure to be more accommodative and this will likely trigger a risk on phase for Chinese domestic risk assets. This may not be too far away. While US rates are unlikely to rise, at least not significantly, for a couple of years, large scale asset purchases are being scaled back. We have seen some signs of monetary easing in China, which might trigger a sustained risk-on phase. Certainly, the sustained underperformance of China assets has led to them being under-owned and risks are to the upside.

A comment about LatAm and Brazil in particular. The World Cup is over, and the hangover has begun. Brazil’s economy has slowed significantly with no respite in sight. Industrial production has been soft and business sentiment is gloomy. As the economy has slowed, inflation has picked up again to over 6.50%. Brazil sovereign spreads have begun to widen after 6 months of tightening. If Brazil is indicative of the region, the picture is not optimistic. Argentina’s sovereign credit issues have added volatility to regional CDS spreads. LatAm is illustrative of export dependent emerging economies as de facto protectionism takes hold. Growth has to be internally generated through more domestic consumption. Without the crutch of exports to lean on, allocative efficiency cannot afford to be confounded by inflexible or policy distortion of relative prices.

Mercantilism is likely to proliferate as the world seeks a new model of growth. The past three decades were marked by accelerating globalization, offshoring, specialization and trade. The credit crisis of 2008 exposed the fragility of over-reliance on trading partners, and countries are seeking to find a better balance between domestic and export drivers. This new balance favors countries with a domestic demand base and disadvantages countries reliant on exports. The nature of domestic consumption is important. That domestic consumer base needs to demand goods and services produced domestically.

Inflation is an important indicator. The current global wave of money printing has not driven inflation, but it has driven asset prices. As long as central banks continue to print, asset prices will be supported. It is when central banks adopt a neutral or worse, a tightening position, that the trade off between goods and assets manifests. Europe will likely see further asset price inflation as the ECB continues to be accommodative and inflation remains subdued. The US is at an inflection where the Fed will slow its LSAP to only recycle run offs. There, assets will compete with goods and inflation will be a concern. In China, inflation is in a manageable range, but this hides considerable effort involving macro prudential policies.

Policymakers, central banks and regulators are always addressing the crises of the prior generation. The focus on inflation fighting led government to lose sight of more dangerous imbalances brewing in credit markets in the years leading up to 2008. Governments today are preoccupied with regulating the banking system and credit markets. It is safe to say the next crisis will not be precipitated by the banks. One risk is the re-emergence of inflation. Central banks have been in easing mode and will become conditioned to it. They may be late to turn off the taps when the barrel is full. This is a less probable risk given that inflation was a recent problem, the one prior to the credit crisis. Another risk is political risk. This can arise from a number of sources. The fracking boom has made the US more energy independent which has led it to retract from the Middle East leaving it more time and resources to concentrate more on engaging China. This has destabilized the MENA region. This theme is unlikely to reverse soon and things are likely to deteriorate further as the US becomes less engaged in the region. The reversal of globalization is also likely to make the globe a more contentious place as countries become less interdependent. Another serious issue that an entire generation has tried to defer to the next will eventually rear its ugly head and that is of retirement funding. In most developed markets, available data shows impending funding shortfalls for entire generations as they come to retire. Households are generally unprepared and have not considered their financial plans for when they cease to be in gainful employment. For many, their savings will be insufficient, and this does not even take into account risk of illness which may either curtail the period of employment, or increase the cost of care in retirement. No doubt the financial services industry will be first to offer solutions, at a price.

It is difficult for an individual to hold, accumulate or acquire intellectual property directly. Storage capacity is one issue. At best an individual can hold or acquire the last mile of the intellectual property chain. The most practical way for an individual to own intellectual property is through ownership of a company or business. (Higher education and vocational training are examples of acquiring non exclusive access to existing technology and need separate treatment.)

The storage of intellectual property is one of the possible reasons that labour’s share of income has been declining almost monotonically. Perhaps the picture might look more balanced if we include under labour’s share, a portion of corporate’s share representing labour’s ‘IP holding company.’

One of the implications of this interpretation is that the distribution of intellectual property is somewhat dependent on individuals’ investments into companies or businesses. It follows that income distribution is also dependent on the extent of equity investments.

Incremental innovation and IP accumulation can therefore imply a steadily declining share of profits for labour. How far can labour’s share decline, and what could happen? In the extreme, what happens when labour’s share tends to zero? Are wages expected to tend to zero? What then is a fair distribution of intellectual property and how would it be allocated? A concrete example would be: if robots did all the work in the world, how much would humans get paid, and who would own the robots? If we assumed an arbitrary endowment of ownership at a snapshot in time, how would this evolve? It is reasonable to assume that ownership of such assets would compound much faster and lead to a greater inequality of wealth. Owners of equity are owners of intellectual property and will obtain a disproportionate and growing share of output and income. In the hypothetical limit, income is entirely derived from ownership of assets and labour obtains zero income and employment. Clearly, before this could happen, social and welfare issues would arise.

The disruption to the current trend of rising productivity, rising corporate profitability, the decline of labour’s share of income and production, appears only to be interruptible by non-economic, extra-commercial factors.

There is more to MV=PQ than meets the eye.

Central banks can expand M but this does not mean they can expand MV. V can always fall to compensate for the increase in M, as has happened for most of the period 2008 – 2014. The maintenance or expansion of V is dependent on a number of things. Necessary conditions include a functioning fractional reserve banking system with sufficient capital and appropriate reserve ratios to transmit the increases in V. Sufficient conditions include a health demand for credit which is dependent on business sentiment.

Assuming that it is possible to increase MV, the impact on PQ and its constituents remain complicated. While PQ is a scalar, P and Q are in fact vectors. Q is a list of all the possible stuff you can spend money on, and P is the corresponding vector of prices. A couple of things to note about Q are that it includes goods, services, and assets, indeed, anything you can allocate money to, and that while the scalar PQ must rise if MV does, its not clear a) which good, service or asset market is experiencing rising nominal output or b) for a given good, service or asset market experiencing rising nominal output whether price, real output or both are rising. In other words, even if MV and therefore PQ is rising, some markets may experience falling nominal output while others may experience rising nominal output and in markets with rising nominal output it could all be due to inflation or real growth or both, but you couldn’t control which. 

All things being equal, if nominal output in a particular market is not falling, and real output is falling or decelerating, then price must increase or accelerate. An example where this might be happening is the stock market, where companies are buying back stock. All things being equal, this will put upward pressure on stock prices. M&A is also another mechanism which may reduce the float.

The bond market is a bit more interesting. Prices are rising while output (issuance) is rising. That means that the bond (and loan) markets are responsible for diverting a large amount of liquidity away from other markets such as those for goods and services.

Asset inflation could divert liquidity away from current consumption resulting in lower inflation. Conversely, a recovery in inflation could signal a diversion of liquidity away from asset markets. There is a scenario under which inflation expectations driven by QE cause investors to divert capital away from savings in fixed income assets such as bank deposits and government bonds towards risky assets such as equities and high yield bonds in an attempt to hedge future inflation. Conventional wisdom seems to imply inflation encourages current consumption but the recovery in capital goods ahead of consumer goods seems to support some extend of substitution away from current consumption to future consumption albeit in assets that provide a positive linkage to inflation. If risky corporate assets are seen as claims on future production, there is an argument that they are inflation hedges. QE therefore causes inflation of these future claims at the expense of current inflation.

Fundamentals should not be ignored. However, fundamentals can be framed within the above concept as providing the relative attractiveness of each good or asset market in the allocation problem. The global allocation is still driven by the almost mechanical and physical allocation of liquidity.

At a more mundane level:

Monetary expansion can lead to asset price inflation.

For a given level of monetary expansion, assets and or goods and services can experience inflation. Excessive inflation in assets can explain lack of inflation in goods and services markets.

A withdrawal from expansionary monetary policy could cause deflation or slower inflation in assets or goods and services.

Under neutral monetary policy, goods and services inflation implies declining asset prices.

One of the most interesting and rewarding investment opportunities currently available trades on the reform of the banking sector. We live in a world where, unfortunately, pragmatism has for too long trumped ideology. This lack of a guiding philosophy had led banks to myopia and to overreach themselves resulting in over-levered balance sheets and inappropriate operating practices, culminating in the financial crisis of 6 years ago. Regulators are still trying to reform the banking system and this has produced a host of investment opportunities. 

What is the raison d’être of a bank; why does it exist and what is its place in the economy? A bank exists to borrow money from those who have more than they can currently spend or invest and to lend it to those who have less than they can currently spend or invest. A bank is therefore no more than an intermediary. From this function, pragmatism and the profit motive led banks to turning their credit expertise to bond arranging and underwriting and ultimately to trading and hedging. From bonds, this same capability was extended to equities, commodities, foreign exchange and pretty much anything for which a market could be created. The liquidity provided by banks trading serves a useful purpose in price discovery and risk transfer. However, as is often the case, when competency trails behind the state of the art, or complacency or hubris develops, banks can and have overreached themselves leading to credit crises. Glass-Steagall in 1933 and more recently Dodd Frank are legislation enacted to manage this tendency for efficiency to dominate stability and governance, especially when clever minds are at work.

One of the primary sources of instability is not just the commingling of principal and agency activities in a bank but rather the liquidity mismatch between its assets and liabilities. This mismatch arises because banks borrow short term from depositors and each other, and lend longer term to businesses and homeowners. Normalized interest rate term structures mean that banks earn a higher interest rate lending long and pay a lower cost of funds borrowing short. This is efficient but inherently unstable. So far, no rules, limits or regulatory device have been able to mitigate the force of fear during a bank run. One way by which the financial industry has sought to address this liquidity mismatch, is the so-called Shadow Banking system. This is a parallel funding system where it is hoped that the liquidity or maturity between assets and liabilities can be matched. More cynically, they are a means of circumventing regulatory capital requirements. Generally, Shadow Banks are thought of as any non-bank institution conducting a banking business. Structured Investment Vehicles, Collateralized Debt Obligations, Collateralized Loan Obligations, Private Debt or Private Equity funds, indeed even mutual funds, can be considered part of the Shadow Banking system.

In the run up to 2008, banks who witnessed demand outstrip capital saw Shadow Banking as an outlet, but as with trading and hedging before, competency and circumspection trailed the state of the art and avarice, and before long the Shadow Bank’s collapsed, and collapsed onto the banks themselves. Regulators were quick, though late, to step in to regulate the financial system and in such a way as to limit banks to focus on their core reason for being, that is to borrow and to lend safely. This regulation, unlike the singular Banking Act of 1933 is a raft of international sanctions. As such they will be more difficult to dismantle than Glass-Steagall which was repealed by Graham-Leach-Bliley in 1999. Basel 3, Solvency 2, Dodd Frank and the Volcker Rule are some of the fragmented rules that banks will have to navigate in future.

Herein lies the investment opportunity. New leverage and capital rules will discourage banks from certain types of lending, from many types of trading, and encourage banks to restructure their balance sheets through asset sales, new methods of funding and accounting acrobatics.

Where banks are retreating from lending, returns can be earned for replacing them. Examples of this are private debt funds that lend directly to small and medium sized enterprises, to fund infrastructure or to real estate development and do so flexibly to the benefit of both borrower and lender. Many of these funds work with banks, to reduce the leverage of the bank’s funding, enabling them to lend efficiently while complying with the new regulations. Investors in such funds can reap a liquidity premium in addition to the credit spread.  Returns to secured lending can be as high as the mid teens.

Where banks are no longer trading, the public traded capital structures of companies have become improperly priced leading to arbitrage opportunities. Capital structures used to be policed by bank trading desks as they trade across equities, preferred shares, bonds and loans. Mutual funds tend to segregate trading of such securities so that the pricing of one segment relative to another is not arbitraged away. Only a small group of hedge funds did this. They are now growing as banks shutter their trading desks and traders have to find a new home. Capital structure and credit arbitrage hedge funds generate very attractive risk adjusted returns.

Banks own capital structures are inefficient. The financial crisis led to bank bailouts and rescues that necessitated emergency capital structures. As the crisis has waned and new regulation is implemented these capital structures are no longer efficient. Some capital securities will be reclassified as debt. Some apparently dangerous securities such as CoCos (contingent convertibles) are being deleveraged making them safer than the market thinks. Some of the most lucrative trades will be in the trading of bank securities across their capital structures. Some mutual funds and hedge funds are active in these securities.

Asset sales are another means of deleveraging bank balance sheets to comply with new capital rules. These assets need a new home and, at the right price, even apparently poor assets can make good investments. Distressed asset funds are on the prowl for such assets.

Lending to banks in creative ways can also be lucrative. Some private debt funds do this. By providing capital relief on assets that remain on the borrowing bank’s balance sheet, these lenders release capital allowing the bank to continue to lend. For this service they exact a high yield on their capital. Some very specialized funds invest in this area. There is even one such fund based in Singapore.

The strategies arising from bank regulation are diverse and offer rewards to risks other than market risks and therefore are a useful diversifier in any investment portfolio. The issue with these strategies is that they are often either illiquid and thus require term capital or they are complex and require special analysis. The shame is that these opportunities will likely not be made available to retail investor but will remain the preserve of institutional investors.