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.
Economics:
Table 1.1
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Economics
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Expectation
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Positives
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Negatives
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US
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· Stable growth
· Slower equilibrium growth rate
· Inflation likely has troughed.
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· Secu
· 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.
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· 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.
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Europe
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· Unstable growth
· Slower equilibrium growth rate
· Inflation likely has troughed.
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· 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.
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· 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.
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China
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· Steady slowing of growth rate
· No hard landing.
· Inflation likely has troughed.
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· Political reform towards rule of law.
· Economic reform towards greater market discipline.
· Macro prudential management of credit markets.
· PBOC easing to accelerate.
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· 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.
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Japan
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· Unstable growth
· Loss of export sector as a driver of growth.
· Inflation likely to undershoot.
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· Weak JPY improves terms of trade.
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· Demographic drag.
· Debt levels too high. Even with monetization policies.
·
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EM
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· Non Asia EM faces stagflation
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· Demographic dividend.
· Second mover advantage in development.
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· Major beneficiary of globalization will be impacted as globalization slows.
· Inflation risk.
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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.
Policy:
Table 1.2
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Policy
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Expectation
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Tight
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Loose
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US
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· 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.
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· 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.
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· 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.
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Europe
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· 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.
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· 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.
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· 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.
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China
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· 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.
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· Macro prudential policies to direct credit away from overleveraged industries.
· PBOC is vigilant over equity market and real estate inflation.
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· PBOC to continue to suppress cost of debt.
· Current policy includes a host of open market operations.
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Japan
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· BoJ may have to loosen policy further to compensate for fiscal constraints.
· Japan is in a liquidity trap.
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· Fiscal policy is tight.
· Sales tax hike delayed till 2017.
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· 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.
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Strategy:
Portfolios should be positioned for the long term and traded and adjusted for the medium term while being aware of the risks.
US:
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.
Europe:
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.
China:
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.
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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 arbi
trage, 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
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Strategy
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Equities
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Fixed Income
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Other
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US
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· Earnings growth slowing.
· Valuations high.
· Long term positive.
· Short term limited upside.
· Downside risk from higher rates.
· Prefer cyclicals to defensives.
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· 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.
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· 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.
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Europe
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· Equity and bond correlation will be positive under QE.
· Equities cheap relative to bonds and credit.
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· Convergence trade in Eurozone sovereign debt, long Spain, Italy, Portugal, short France, Germany.
· Long financials capital securities.
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· European equity long short opportunities.
· M&A activity elevated. Allocate to event driven M&A hedge funds.
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China
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· Equities supported by PBOC liquidity policies.
· H shares cheap to A shares.
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· High yield preferred to IG
· In real estate, prefer size and IG to HY.
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·
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Japan
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· Domestic pension funds are increasing allocations to Japanese equities.
· Economic reform encouraging firms to focus on shareholder value.
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· JGB market liquidity reduced to BoJ activity.
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· Activist hedge funds may find more opportunities.
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Risks:
Table 2.0
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Risks
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Equities
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Fixed Income
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Other
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US
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· 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.
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· 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?
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· 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?
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Europe
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· 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.
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· The debate over the solvency and liquidity of Greece continues on with only tactical solutions, not long term structural solutions.
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· 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.
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China
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· 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.
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· 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.
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· 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.
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Japan
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· Equity markets are quite stretched. Much depends on BoJ stimulus efforts and a weaker currency.
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· 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.
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· 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.
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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. Curre
ntly 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.