If we stop thinking about QE as an expansionary policy but rather as a treasury refinancing operation and debt monetization, the behavior of the Fed becomes clearer. For one, the Fed surely understands that without reducing the banking system’s reserve requirements, the money multiplier and the velocity of money cannot accelerate and thus asset purchases have very little impact on real or nominal output. Indeed by increasing capital requirements, the Fed is effectively neutralizing any expansionary effects of QE. A side effect of refinancing the treasury is an expanded balance sheet which risks runaway inflation should the velocity of money pick up. Any sign of improved fiscal position must encourage a corresponding reduction in asset purchases.

The impact on pricing of the term structure due to the Fed going forward should be regarded as at best neutral.

Current economic wisdom is that geographical labour mobility is an almost unqualified positive and an inalienable right. This should not go unquestioned.

Labour mobility is responsible for improved employment, lower costs, greater efficiency and is associated with an overall increase in welfare. Other considerations should include factors such as overcrowding in cities, hollowing out of secondary cities, towns and villages, infrastructure requirements, distribution and allocation of resources, and the equitable distribution of wealth.

One metric of welfare should be population density. There is an optimal density in the welfare function below which the incumbent population regards an increase in population a good thing and beyond which it regards it as a bad thing. A local population deserves certain rights to control the population density in their area. The problem lies in determining the appropriate level and nature of the controls.

Different groups within a local population have different objectives regarding population. Business owners and employers seek the import of skilled or cheap labour. Owners of land seek demand for labour storage. Governments may see immigration as a means for maintaining demographic characteristics and as a source of tax revenue. Employees may regard immigration as competition for jobs and resources, as demand for goods, services and housing drive inflation. The representation of various groups in government will drive immigration policy.

Sprawl has infrastructure costs related transport and communications. Some of these costs are public and some private, but the public cost is significant. Countries are collections of local populations. National policy can affect the cost of doing business in a country creating divergences between countries. Most countries are evidently operating productivity accretive immigration policies, subject to the tolerance of the majority of the incumbent population who prefer less immigration. This is indicative of the representation of the various groups in most governments. Priority is unlikely to be given to policies where the costs are not associated with commercial gain in the most direct, immediate and evident ways. That the factor of population density in the welfare function is often subordinated to more commercial interests or is omitted altogether, it is not surprising that current policies encourage concentration of population, in particular productive labour in urban centres, while less productive groups are left in suburban towns and villages. If valid, this will be evidenced by larger cities getting larger and more dense while smaller cities shrink and get less dense in a ‘winner’ take all dynamic.

The concentration if population in cities leads to potentially major disparities in real estate prices as well as rapidly inflating prices. As overcrowding sets in, proximity to resources and infrastructure also command significant premia. Foliage, water, aesthetically pleasing surroundings and locally lower population density are goods that can command significant premia. River side and park side housing show evidence of this.

As a scarce resource, real estate can become a source of rising cost for both residents and businesses in a city. Costs should rise as long as people continue to move in to cities, pushing up prices until they reach the limits of affordability. Availability and cost of credit can increase demand by spreading the cost of ownership over time and easing affordability at least in the short term. Excessive credit can create real estate bubbles if credit underwriting is too lax and or loses sight of rationality. Principal agent issues in mortgage markets where mortgage loans are sold or securitized and sold by originating banks can exacerbate the problem. Artificially low interest rates also add to the problem, enabling unsustainable real estate prices. Such interest rate policies may or may not be integral to housing policy.

This analysis is incomplete and some of the hypotheses untested. It is built on expectations and understanding of human behaviour, an approach that has worked elsewhere, such as in economics and financial markets. The above should therefore be regarded as interesting speculation rather than an academic study or survey.

It is almost elementary to professional investors that when investment decisions are made, the appropriate sizing of the investment is based on the quantity of risk that is taken and not the quantity of capital. This has a parallel in the Sharpe Ratio measurement of investment performance. Returns are only useful in the context of the risk associated in obtaining them. Similarly, returns are obtained at a price, which is risk. To obtain returns, one should allocate risk and not capital.

Here is a practical example. Say an investor would like to invest 100 USD and allocate equally to equities and bonds. If they were to allocate capital, they would invest 50 USD in equities and 50 USD in bonds. The volatility of equities, however, is roughly twice that of bonds. As a result, the investor is inadvertently taking more risk in equities than in bonds. If the investor intended to have an equal exposure to the returns and the risks of equities and bonds, they should in fact allocate twice as much capital to bonds as to equities, so that the contribution of risk to the portfolio from equities and bonds is equal. That means a 66 USD allocation to bonds and a 33 USD allocation to equities. We have made a simplifying assumption that bonds and equities are independent and thus uncorrelated.

Mean variance optimization in portfolio construction is the full blown implementation of this concept. It allocates capital (not risk) in such a way as to minimize the risk for a given target return, or conversely, it allocates capital in such a way as to maximize the expected return for a given level of risk. The generalization in mean variance optimization means that the interdependence of assets in the portfolio is accounted for in the allocation decision, but the principle is the same. If all the assets in the portfolio were mutually independent and the expected returns of each asset were equal, then a mean variance optimization would result in the efficient portfolio comprising assets sized inversely proportionately to their volatility, which is a proxy for risk.

Despite the widespread acceptance of mean variance optimization in portfolio construction, it is surprising that many professional investors continue to allocate capital instead of risk in their asset allocation.

Inequality has decreased globally, yet this aggregate phenomenon hides a more disturbing picture. As countries have become less unequal, the distribution of wealth and income within countries has become more unequal. If the material and commercial motivation for conflict between nations has receded between nations, it has certainly risen within each country.

A disinterested flavor of capitalism both requires and promotes inequality. Absent some form of social safety net, the juggernaut of capitalism crushes the weak and exalts the strong. Diversity feeds the system, and natural selection drives aggregate efficiency and productivity.

There are two reasons why social safety nets have been enacted in many developed capitalist countries. One is human charity and an innate sense that all life is precious and the neglect of the weak is too cynical a position. The other is that a sustainable system, however capitalist, requires a sustainable underclass. A parallel argument supports the saving of the environment as well as the diversity of animal and plant species. You never know when you might need them. The need for an underclass is clear and present.

To take the less cynical view, progress requires that effort and results are rewarded and sloth and failure are not rewarded. A certain level of inequality encourages effort. It is hoped that such effort promotes the common good as the profits of the successful are spent and reinvested leading to the distribution of wealth. This distribution is not always equal. It tends to concentrate business and industry rather than diversify. And marginal propensities to consume fall with higher income and wealth resulting in a wealth trap. It is possible that overly unequal economies over save. One could envisage such a definition of over saving. Another measure of over saving is to define the optimal level of savings as that amount that will allow a person to smooth their consumption over their life, with allowances for uncertainty, to a target terminal wealth of zero. Inheritance becomes topical. Is it fair to target zero inheritance? Would acutely high inheritance taxes be useful or practical?

The accumulation of wealth for wealth’s sake is an important motivation that should not be totally discouraged. Thus, a target terminal wealth of zero may be undesirable. However, inheritance taxes can still transfer some wealth without impairing ambition too much. Practicality is another matter as high inheritance taxes only encourage tax avoidance strategies such as pre mortem transfers.

It seems that while a certain level of inequality encourages progress, inequality is neither an unmitigated good nor an irredeemable bad. As long as inequality is not synonymous with unfairness, then it is a good thing. Fairness would require that each new entrant into the economy does so on equal terms. But what does equal terms mean and how far does it go? Does it require equal initial endowments of wealth and capital? Is equal access to education sufficient? Is the limiting or prohibition of extra curricular education too far to go?

The cynical view would maintain and encourage inequality subject to the constraint that such inequality does not threaten the status quo. A minimal level of social security and welfare would be provided to appease the middle to lower classes to prevent a revolt. In the meantime policy would focus on maintaining the wealth accumulation of the influential and wealthy. Bailouts of asset markets, ostensibly to avoid damage to Main Street at cost to employment and household income and consumption, support the cynical view. The increased inequality post crisis is further evidence.

Unconstrained free market capitalism tends towards extreme inequality of wealth. The accumulation of physical and intellectual capital makes wealthier households more productive than others in a perpetual cycle. Eventually inequality becomes acute and needs to be addressed. Current solutions are overly complex and politicized and treated as a necessary evil. They only slow the rising inequality without establishing basic principles and facing the primary issues. Is inequality to be embraced or tolerated? Is inequality a bad to be actively reversed? On what basis is inequality measured and what are the metrics? What are the side effects of whatever route and policy is chosen and what is acceptable?

The divergence between the US treasury market and US equities can be accounted for.

1. US treasury yields are held down because.
   1. Floating rate note issuance is expected to be circa 180 billion USD. This will substitute away some of the fixed coupon issuance. This means less supply of fixed coupons.
   2. Tax receipts are up which will also slow the issuance of treasuries.
   3. Major trading partners such as China and Japan are seeing a reduction of trade surpluses or an increase in trade deficits implying slowing supply of USD offshore and thus weaker demand for treasuries.

1. US equity markets:
   1. Economic growth remains robust. There was a speed bump due to the harsh winter but this has passed.
   2. Trend growth is not 3% but 2%. Given this, any ‘fail’ of the 3% mark is not a risk of reception but a cyclical slowdown within a global rising trend. Since 2010 GDP YOY has oscillated around 2%, which I regard as the new trend growth rate. Why is trend growth lower today than before? This is not an easy question and there are no definitive answers. One possibility is that credit creation has become impaired. Despite efforts to inflate the monetary base, bank regulation and scarcity of bank capital are constraining credit creation. The 3% average growth rate from 1980 – 2006 was probably boosted by a full 1% due to the early 80’s boom in junk bond issuance, the securitization of debt in the late 1980’s and the surge in securitized and tranched mortgage bonds in the last 15 years. Absent this credit innovation, trend growth would have been 2% as it is now.
   3. Given the above view of a secular recovery, US equities are in a secular bull market. That said, we could be at a cyclical peak given that price levels have run ahead of earnings.
   4. The continuation of the current cyclical bull requires a recovery in corporate investment which has not yet happened. The growth of the past 5 years has been driven by consumption and housing. Corporate profitability is now at a cyclical high and household savings rates have fallen from mid 5’s to low 4’s. While US equities remain fundamentally sound, a continuation of earnings growth now stands on a single pillar, corporate investment. I believe this will happen given the average age of the capital stock…

1. Conclusion:
   1. I expect the US treasury market to be more resilient than consensus for reasons of demand and supply.
   2. I expect the US equity market to be in the early stages of a secular bull market.
   3. However, I do feel that the US equity market is currently vulnerable as fundamentals have yet to catch up to valuations.