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A number of themes frame the global economic and financial outlook.
The world has been operating monetary and fiscal policy towards sustaining growth at a higher level than the unobserved long term trend rate. It may be doing this for a number of reasons. For one, it can't observe the long term trend rate and could therefore simply be mis-targeting. A multi-decade period of credit driven growth may have biased estimates for trend growth to the upside. The dynamics leading to slower trend growth are slow moving and may have been overlooked. Demographics is an important factor in productivity and thus trend growth. Secondly, policy makers might recognize this mis-targeting but for other reasons, such as the servicing and paying down of an over accumulation of debt, ignore it and attempt to target growth above the long term trend rate. Whatever the reasons, this chronic mis-targeting of trend growth leads to markets mis-reading cyclical wavelengths, amplitudes and phases, and in a dynamic system such as economic and financial systems, a more pronounced cycle.
Demographics are a slow moving phenomenon. In the developed world we already have deteriorating demographics which possibly contribute to deflationary pressures on the one hand, and labour market mismatches on the other, which are inflationary. The implications for the net funding of social welfare and healthcare are also profound. In the emerging markets, once favourable demographics have now been eroded. China, for example, a heavyweight in the emerging markets, faces challenging demographic trends exacerbated by an unwise one child policy; this has now, too late, been relaxed. India appears to be the only large emerging market with favorable demographics, but even India will pass into an ageing demographic as its economy matures. Economists recommend immigration as a solution to ageing populations but such redistributions of human capital have limits in aggregate and costs to donor countries.
The shock from the 2008 financial crisis was larger than thought and ripple effects persist today. One of those effects is the initiation of a global trade war. Within this context the US has sought less reliance on external production capacity and energy supply. This new insularity has profound effects on global economics and politics. One of the primary reactions has been China seeking less reliance on US and other foreign consumer demand. This rebalancing away from exports and investment towards consumption has exposed a significant overshoot in capacity as well as resulted in slower aggregate growth as the large industrial and manufacturing sectors are de-emphasized and the economy turns towards services, retail and consumers. A consequence of the new dynamic between the US and China is that countries in the supply chain have had their business models invalidated. Many of these countries are in emerging markets.
The trade war has taken a toll on global growth. It is responsible for some of the loss in the long term potential growth rate. It is also responsible for the sharp slowdown in emerging markets which rely more heavily on trade for growth. The trade war model has some important implications for inflation expectations. Currently, markets are pricing for weak inflation to deflation. If, trend growth is lower than expected then output gaps are narrower than expected and inflation could be closer around the corner than the market predicts. If so, central bank policy could turn quite quickly when the first signs of inflation appear.
Since the financial crisis of 2008, banks have come under intense scrutiny and regulation. Once run entirely for profit, the public good supplied by banks as part of the credit and payments infrastructure was highlighted when some were deemed too big to fail. Banks are now regulated as essential utilities while remaining staffed by pathological capitalists. Governments and regulators on the other hand, have struggled to develop a coherent strategy for regulating banks, simultaneously requiring them to make more loans and take less risk. As the principal constituents of fractional reserve banking, banks thus heavily regulated have become less efficient in their function, albeit safer. The burden for funding economic growth must therefore fall upon the Shadow Banking system. Bond markets have grown in developed and emerging markets to serve the function of connecting savings to investment. One important aspect of facilitation, market making, has become impaired. New capital rules and principal agency separation legislation has led to much reduced market making activity by primary dealer banks and thus reduced liquidity, a development decried by the investing community. Inefficiencies in bank regulation have interfered with the credit transmission mechanism and blunted the effect of QE on the real economy. Rules relevant to structured finance have similarly throttled a once important credit transmission channel.
Banks deleveraging. Capital securities are derisking.
Bank disintermediation returns to rise. Direct lending, private debt, peer to peer lending, trade finance.
The past 7 years have been defined by extraordinary central bank intervention and influence in financial markets. Financial engineers are excellent at two things, innovation and over-extending. Low interest rates and QE have driven markets and to a lesser extent economic growth in this period. One, there exists diminishing marginal returns to QE in terms of impact on financial markets, and on real output. Two, the US Fed is about to move from easy to neutral and is headed for its first rate hike since the financial crisis. The ECB was late to implement QE and the impact on prices remains to be seen, thus far Europe has experienced a cyclical upturn in growth but inflation has lagged. The BoJ has maintained QE even as data has suggested they might have to expand further. China's debt overhang and large scale restructuring of its economy has a cost and the PBOC will need to maintain easy financial conditions. Thus far they have not been buying assets but they have been serially cutting rates and reserve requirements and been very active in open market liquidity operations which have been more targeted and highly expansionary. In all this, the Fed's divergence from the pack is interesting and will have profound impact on markets.
Central bank policy will have as much influence at the inflexion point as it did in expansion. The Fed's rate policy is therefore important. For one, other central banks will await the Fed before making their own moves. In the face of a rate hike, the ECB for example, might be encouraged to ease more aggressively as global liquidity shrinks and financial conditions tighten. The ECB meets Dec 3, two weeks before the FOMC on Dec 16. Draghi has been vocal and signaling further accommodation. There may be a full blown expansion of QE or there may be adjustments to the current program. One area which merits adjustment is the allocation between countries. Currently, the national central banks and the ECB purchase bonds pro rata to their capital key, that is the respective national capital contributions to the ECB. This results in more capital dedicated to the purchase of German and French bonds and less to the fragile periphery for which QE is more essential. The ECB could change the composition of the bond buying to increase the proportion of Italian, Spanish and Portuguese bonds relative to the capital key.
EUR duration to outperform USD duration.
Peripheral EUR to outperform Bunds.
The BoJ has been unusually confident despite recent weaker inflation and growth data and may be waiting on the Fed to act. It too may accelerate or increase QE post a Fed rate hike. There are some who argue that core inflation has begun to recover in Europe and Japan and their central banks may stand on a Fed rate hike. However, a widening rate differential could encourage capital outflows and tighten financial conditions outside the US. It is difficult to be confident about the likely behavior of the BoJ and thus the JPY term structure.
USD strength, EUR, JPY weakness.
While the Fed may raise rates, and the rate hike trajectory is signaled to be gentle, the Fed clearly wants the yield curve to not steepen significantly. The Fed has talked about reducing the size of its balance sheet, and has mentioned a time frame of 1 year after rate liftoff. Recent talk, however, has opened the possibility that this could be delayed for much longer. If current financial conditions coupled with a single rate hike slow the economy sufficiently, inflation expectations may even fall and suppress yields at the long end.
USD 2-30 flattener or outright long 30 Y UST.
Investors have been concerned about the impact of higher rates and a stronger USD on emerging markets for some time now. The concerns are well known, capital outflows, higher costs of debt, and to some extent, a currency mismatch between assets and liabilities. The last point was a feature of emerging market sovereign balance sheets in the mid to late 1990s and was unwound when the Fed raised rates in 1994. The Asian Crisis of 1997/8 was one of the symptoms. Today, however, on the advice of the IMF and others, sovereign balance sheets feature a better currency match between assets and liabilities. Emerging market corporates, however, have increased USD borrowing significantly in the past few years although the last 12 months has seen market volatility and self-regulation unwind some of this currency mismatch. Chinese developers, for example, are calling USD bonds and refinancing in RMB. Emerging markets are likely to be better prepared for a strong USD and rising rates than before. Moreover, the Fed has signaled that the trajectory of rates is likely to be gentle, and the strong USD is already an 18 month old phenomenon.
EM short trade fading. Consensus it likely too bearish EM equities.
The most sentiment driven markets are equities and the bulk of the returns in the last 5 years have come from a rerating, Corporate earnings have been less robust in quantity and quality as companies have boosted earnings from cost cutting, financial engineering in the form of recaps or debt funded share buybacks. 2016 earnings estimates have been scaled back in the last quarter with Europe leading the discounting with 6%, Asia ex Japan and China with some 4% and the US and Japan with 1.5%. With a neutral Fed and equity valuations at or above long term trend multiples, the scope for further gains is diminished. Look at 2015 returns, the best performing markets have been Europe, China and Japan, the more problematic economies where central banks have been in no hurry to tighten. Stronger economies such as the US and UK have performed poorly as stronger economic data have led to expectations that the Fed and the BoE would tighten. Liquidity still rules equity markets.
Consensus is currently too optimistic about potential returns from European equities.
European equities yet to fully price EM weakness, thus vulnerable.
Consensus is currently cautious US equities and is likely to be proved right.
While liquidity rules equity markets, that influence will likely diminish in the US. In Europe, liquidity may limit the disappointment in equities and in China, expect the market to trade in a tight band for some time until the newly reopened IPO market has been cleared.
Credit markets have only recently found retail participation through mutual funds. While this newfound liquidity channel will add more sentiment driven volatility to the market, credit remains more fundamentally rooted than equity markets. This new found volatility has been a source of frustration as well as opportunity. Normally, credit is priced in an orderly fashion until institutional myopia accumulates a large imbalance and a liquidity crisis is triggered. Retail participation has made credit more volatile at higher frequencies but with smaller gap risk. The market has been concerned about gap risk from another source of reduced liquidity: primary dealer inventory. This is a side effect of bank regulation which discourages principal trading. This logic is flawed. Market makers make market not to provide liquidity, they do so because they believe they have asymmetric information. The current market for credit has institutional investors as the major participant followed by mutual funds and structured finance. Which is preferable, to have large, stable holders who own a significant portion of issues this reducing free float and liquidity, or to have many short term traders seeking to make high frequency profits? In either case, liquidity will be fickle. Credit can be approached from a trading perspective but to do so is to give up the advantages the asset class provides to investors.
Current credit spreads are sufficiently wide to represent value, given general conditions. Slow, positive growth is ideal for credit. In the US, credit from investment grade to high yield has underperformed recently as investors have fretted about a Fed rate hike and fears about fickle liquidity. In US credit, only the non-agency MBS market has generated steady and robust returns. While the robust housing market continues to support non-agency MBS, the opportunity is shrinking due to price discovery and a lack of new production as mortgages lean towards conforming loans which can be securitized by agencies. Agency risk transfer securities are a recent innovation and have not achieved critical market size. Corporate credit, however good value the spreads imply, have a market average duration which renders them sensitive to a rate hike, even if it is just one. Leveraged loans present a very low duration exposure to high yield corporate credit with structural seniority and security. Pricing has been stressed, however, as liquidity fears are more acute in loan markets. Spreads are wider for loans despite their seniority to unsecured bonds.
If the thesis is that short rates will go up once in the short term and only gradually thereafter, and that the economy will face tighter financial conditions and lower inflation expectations, and thus term structure should flatten, the efficient trade is to be long leveraged loans and long 30Y USTs.
In Europe, the interest rate cycle remains benign and the ECB is likely to maintain if not accelerate QE. At the same time regulators continue to encourage the banks to deleverage. Euro leveraged loan issuers will be encouraged to deleverage by transmission. European corporates in general remain in deleveraging mode. A significant proportion of new issue is coming from non-European issuers. The efficient trade expression is to be long duration and credit.
Long Euro high yield corporate bonds.
Relying on central bank largesse has been rewarding but when it is coupled with central bank regulation, the trade can be less risky as well. While European banks have been cleaning up their balance sheets since 2012, much remains to be done. The initial action of banks was to seek regulatory capital relief through creative balance sheet operations and accounting. Regulators were reluctant accomplices due to the seriousness of the problem. With greater stability and a cyclical recovery, regulators have become less pliant and are less likely to approve such transactions. The Oct 2014 AQR and subsequent capital raising has made European banks stronger. Also, recapitalized banks have now more latitude in disposing of NPLs as price discovery is less damaging. The consequence of this is the need for further capital raising. Add to this regulators' tendency to overshoot and new TLAC guidelines and banks will be forced into more deleveraging.
Continue to buy European bank capital securities.
Risks to the view:
While the Fed vs ECB policy divergence supports a strong USD, the position is perhaps the most crowded in the market today. USD strength was driven by both the Fed and the ECB. Soon, the trade will lose one leg of support, that is the Fed. Once a rate hike is done, the next is likely far off. The USD trade will have to stand on one leg, the accommodative policy of the other central banks, notably the ECB.
Volatile USD.
Emerging markets. This is complicated reasoning. EM has done poorly because exports have stagnated. The strong USD was guilty by association and received wisdom is that a strong USD is bad for EM. One should question this. While true 20 years ago, sovereign liabilities are now better currency balanced. EM corporates have accumulated substantial USD debt and many will feel a balance sheet impact. However, many EM corporates earn USD and a strong USD has positive impact on cash flow and revenues. The market is currently very bearish on EM equities and bonds and neutral US and optimistic Europe. The EM exposure to European corporate revenues has not been priced. It is likely that 2016 will see EM assets trough and begin a forward looking recovery while Europe begins to price in EM near term or coincident weakness.
Strong USD may support contrarian long EM
Weak USD may endanger or delay EM recovery.
As we are reducing our expectations for European equity performance risks to the outlook are if European markets receive an unexpected boost. One possibility is fiscal policy. QE can improve the supply and cost of credit but it cannot improved the demand for credit. European growth has recovered somewhat but it remains tepid. More could be done if governments run fiscal deficits. Policies to deal with the refugee crisis and or defense could be approved as extra-budget items thus skirting austerity policies. While this is a possibility the constraints remain that Europe's current government budgets remain in poor shape with the exception of Germany. France, Italy, Spain, run primary deficits below -3% of GDP, in breach of Maastricht conditions making even extra-budget expenditures difficult to justify.
Do not be too underweight and certainly do not be net short European equities.
Deflation is very much the consensus view. Headline inflation has clearly been depressed by falling commodity prices, particularly energy and base metals. Some of the impact of commodities leaks indirectly into core inflation. There has not otherwise been a good explanation for the weak core inflation except that final demand, consumer and business sentiment remains weak. If, however, trend growth, which is not measurable, is indeed slower, then the output gap could be narrower and inflation could rise unexpectedly.
TIPS may provide a tail hedge to inflation.
Floating rate debt instruments can provide an inflation hedge.
Gold's usefulness as an inflation hedge is questionable but at for those pathologically inclined to gold there may be some rational justification for holding some of it.
Disclaimer: All information and data on this blog site is for informational purposes only. I make no representations as to accuracy, completeness, suitability, or validity, of any information. I will not be liable for any errors, omissions, or any losses, injuries, or damages arising from its display or use. All information is provided AS IS with no warranties, and confers no rights.
Because the information on this blog are based on my personal opinion and experience, it should not be considered professional financial investment advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. My thoughts and opinions will also change from time to time as I learn and accumulate more knowledge and as general conditions evolve.
On Oct 30, the PBOC announced that it would study a trial scheme for QDII2 at the Shanghai Free Trade Zone, in a step towards capital account convertibility. The reaction of CNY and CNH was puzzling. CNY strengthened from 6.357 to 6.3175 with CNH in tow.
One would have expected CNY to weaken if the capital account was more open on account of increased capital flight. I can only theorize that the move to open the capital account is another measure towards satisfying SDR inclusion criteria and that the PBOC then moved to support CNY to signal to domestic investors that although the door was open, they should not be too keen to use it.
The Nov 2 CNY fixing has more or less confirmed this view. Despite the sharpest rise in the daily fixing, the CNY has weakened back to 6.337 this afternoon.
These moves are disconcerting as they illustrate that while China moves towards a market driven economy and financial system, the government is still intervening and will likely keep intervening in markets in unpredictable ways.
This is not to single out China as an unpredictable market manipulator among the world's governments. Western democracies have had more practice interfering with market mechanisms than China who is relatively new at this game. China used to rule by decree. It is freeing up important bits of its markets and economy to market forces and will have to learn new skills to influence pricing under euphemistically free markets.
To understand the Chinese economy it is necessary to understand the collective Chinese psyche. it is one of great insecurity, feeling hard done by from all quarters, still harbouring an inferiority complex, and thinking that the world sees it as weak, backward and belligerent. As a result, it comes across precisely as insecure and belligerent. Even as China engages more openly in the international arena, China's neuroses require it to behave more aggressively than it has to, for a local domestic audience, to address and belie perceived weaknesses. Most of China's external behavior becomes more explainable in this context.
At home, China's people have grown comfortable and confident in their economic success. Economic policy, however, is no surer, no more confident, certainly no more confident than the US Fed for example. China's reform efforts to instill rule of law, market discipline and strength of institutions, have introduced more uncertainty into policy. It is this uncertainty that complicates much of China's policymaking in recent times. In a centrally planned economy, policy was decree and there was a clear separation between target and measure, between state variable and control variable. As markets become more open and price driven, the effects Goodhart's Law assert themselves. Policy cannot be made without considering the reaction of the economic agents and without risk of triggering unintended consequences. Legacy cultural tendencies to report success and suppress failure lead to noisy macroeconomic data exacerbating the problem of effective policymaking.
China's ministry of finance, central bank and market and banking regulators are intelligent but are also inexperienced in operating under such conditions where policy is no longer simple or linear. Policy under open markets with all the feedback loops introduced by expectations mean a lot more than policy but include skillful communications and management of expectations. Recent policy missteps by the regulators have not so much been a failure of policy than a failure to manage expectations and communication.
In China, the state has interfered extensively and directly in allocating resources through administrative and price controls, guarantees, credit guidelines, pervasive ownership of financial institutions and regulatory policies, and it has done this with the SOE as principal accomplice. Recognizing the inefficiency of SOEs, China is in the midst of reforming the sector. Foreign investment will be introduced into state-owned firms via restructurings and joint ventures, as well as overseas mergers and acquisitions, the State Council said in new guidelines on SOE reforms. While welcome, the statement was deemed insufficient and vague. Notwithstanding the size and influence of SOEs, some believe that the driver of growth in China has been private businesses. According to the Economist: "Average growth in output for industrial private firms since 2008 has been 18%, twice as much as for industrial SOEs." Private enterprise is heavily disadvantaged in particular in terms of access to credit. SOE's still consume more credit and at lower cost than private enterprise and therefore represent unfair competition to the private sector.
China has a history of enterprise and innovation. The current centrally planned economy is in many ways the last ripples from the anomaly that was Communism which gripped China in 1949. China's rehabilitation began with Deng XiaoPing who a reformer and rolled back some of the less sensible Maoist policies and principles. After him, Jiang ZeMin was the pragmatist, slowing reform where it threatened to rupture the economy or society but maintaining the general principle of Socialism with Chinese characteristics, Jiang's own slogan was "socialist market economy". Jiang's leadership saw the demise of many SOEs as market reform exposed their un-competitiveness. It also coincided with a increase in corruption and cronyism and in the emergence of an oligarchy with penetrating interests in government and business. The next 10 years under Hu JinTao saw a maturing of the Chinese economy with all the associated social frictions that come from a growing middle class. In many ways, the Hu leadership set the stage for the current leadership under Xi as it sought to address some of the inequality and excesses of wealth and influence in China. Notably Hu's government began to address corruption and lack of transparency in government and sought to narrow the gap between rich and poor as well as development between coastal areas and the interior. It was also a period where China began to more actively integrate itself into the global community beyond a purely commercial context and to assume more of the social and political norms of developed nations. Navigating this evolving political landscape was a vibrant private sector full of innovation and enterprise, saddled with the burden or task of working around market distorting policy, but profiting from the surge in investment in infrastructure both physical and institutional.
The image of China as a backward, reverse-engineering, IP stealing, technological laggard is persistent but mistaken. In 2014, the top and third most prolific patent filers were Huawei and ZTE, both Chinese companies. China's annual R&D spend as a percentage of GDP, at 2%, has now exceeded Europe's and is catching up with the US's 2.8%. The numbers belie another trend, which is that private sector innovation is driving growth. Total factor productivity is growing 3X faster at private firms than at SOEs, according to the World Bank. A report by the McKinsey Global Institute finds that Chinese firms are particularly adept at innovation in a number of industries, in consumer facing industries such as e-commerce, in efficiency driven ones, such as manufacturing but lag in science and technology. Over regulation in developed countries may also provide China's pragmatic model with an advantage. The same heavy hand of the state that meddles may also turn a blind eye to less ecologically or ethically ambiguous pursuits where more conservative western regulators would have acted.
China under Xi JinPing is facing the continuing issues of a growing middle class and a slowing economy, slowing naturally under the weight of its own size, the consequence of prior growth. Slowing growth is to be expected; economist sometimes forget that constant growth is exponential growth and unsustainable. The burden of central planning sitting alongside private enterprise is that price signals are attenuated leading to misallocation of capital and in China's case, over investment and over capacity. Other areas such as consumer credit and mortgage credit are undersupplied. Recognizing these imbalances, the Chinese government has engaged macro prudential policies to redirect the flow of credit and lower the cost of credit for particular segments. Specifically, they intend to prevent excess credit in speculative markets, local government white elephants and SOEs while improving the access to credit for SMEs, private enterprise, consumer loans and mortgages.
At a more fundamental level, the Communist Party is trying to reform itself. This may appear mainly cosmetic but there are good reasons why the reform may be in earnest. A growing middle class, a better educated people, the proliferation of social media, have created an environment of de facto transparency which the government cannot reverse. To stave off an existential threat, the Communist Party has to embrace greater transparency, the rule of law, reliance on institutions, and other international norms as its new pillars. If you cannot hide, you should not try, is the principle. Transparency also places a greater responsibility back upon the people to play their part and to respond appropriately to policy. The new ideal is, however, in its own way, difficult to manage, especially for a government unused to intransigence and criticism. The rapid development of China, the size of her economy and the massive forces at play can be intimidating to the government and can and has led to policy miscalculations and hesitations. The handling of the sharp downturn in the domestic A share markets are an example.
From 2010, the PBOC the central bank has kept monetary conditions fairly tight with interest rates rising from 5.31% to 6.56% and the RRR rising from 15.50% to 21.50% as inflation accelerated from 2009 through 2011. Despite cheap valuations and decent earnings growth Chinese equities performed dismally, locked in a bear trend from late 2009 to mid-2014. It was only when the PBOC embarked on expansionary policy as US QE was tapered off and inflation receded that Chinese equity markets were ignited. From mid 2014 to mid 2015, the Shanghai Composite Index rose 148% in a liquidity accelerated ascent that defied reasonable valuations. Latecomers to the equity rally used leverage and margin accounts to boost returns and drove valuations further out of line with fundamentals.
Note that the motivation for the PBOC's expansion was falling inflation and slowing growth, both incompatible with accelerating earnings growth. The market was driven by liquidity and sentiment alone. This is not to say that the astute investor recognizing the dynamics of the market could not participate profitably but it did mean that at the end the exit cost would be high. Ultimately the rally was ended by the confluence of an accelerated IPO pipeline, weakening company fundamentals, and the regulators themselves removing the punchbowl by regulating the growth of margin trading accounts.
Having burst the equity bubble the PBOC, alarmed by the pace and extent of the correction acted to slow the descent and limit the downside with a series of clumsy regulations including short sale bans, selling bans, market support funds and moral suasion. For all of September, the Shanghai Composite Index traded in a narrow band between 3000 and 3300. A 148% bull market had ended in a -44% bear market and although the market remains some 50% higher than when the stock frenzy began, sentiment has been damaged and the China market has become both the centre of attention for global investors and the alleged culprit for every market disappointment from the US to emerging markets.
In June 2015 the Shanghai Composite traded at a PE of 21X, still shy of the 27X seen in 2008; it currently trades at 13X, closer to levels seen in 2011. While growth is slowing, earnings growth rates remain high at over 20%. H shares in HK currently trade at a PE of 7 albeit with lower earnings growth potential, well below the recent peak of 11X in June 2015. These are aggregates of course and hide a rich detail. But even so, Chinese stocks which were acutely over-valued in the summer are now cheap.
What will the Fed do?
The Fed might raise rates in September because:
It wants to reset a policy tool.
It honestly thinks that inflation is a future risk and that the labour market is sufficiently healthy.
It has signaled to the market that it wants to raise rates and if it doesn't the current market volatility will get worse.
If it postpones a rate hike to December things might look worse and if it doesn't raise rates this year, the market reaction might be even more severe.
The Fed might postpone a rate hike because:
There is no sign of inflation anywhere.
Even the labour market strength is hardly excessive.
USD strength may be exacerbated and this is already hurting profits.
Markets have already tightened credit and liquidity conditions on behalf of the Fed.
Recent equity market weakness around the globe may cause a negative wealth effect.
If the Fed stays in September, it might have to move in December because:
If it doesn't it will be a signal of a weak economy which would spook markets further and could end up tightening liquidity conditions.
It would have a pretty hard time managing expectations. If it didn't hike this year it would have to prepare the markets well before December and guide the market toward an early 2016 move.
If the Fed moves in September it will be raising rates into a slowing global economy, if not a slowing US economy. The US economy is likely still stable but is not overheating and an early rate hike will slow it down. The impact on the short end of the treasury curve will be quite direct, as one would expect, but the impact on the long end might be to suppress it. The curve is more likely to flatten. The impact on the USD would be negative. A rate decision in September would take away the expectations supporting the USD since the next rate hike would probably skip a couple of meetings and be no more than 25 basis points. USD weakness would put pressure on European and Japanese equities via the EUR and JPY as funding currencies.
If the Fed doesn't move in September it will be under pressure to move in December. Delaying into 2016 may be taken as a sign of weakness which could increase volatility and likely depress equity and credit markets. The impact of a delay to December will be positive for USD as it keeps the prospect of a rate hike on the table. The impact on European and Japanese equity markets is likely to be positive through the EUR and JPY as funding currencies.
Looking at general conditions the Fed may have to delay liftoff indefinitely and only raise rates when data suggests it is suitable to do so. This will likely introduce short term volatility into treasuries and credit markets and weaken the dollar in the short term but keep it on a firm footing over the long term. The dollar will probably only weaken after a rate hike and not before.
The fact that the Fed Funds effective rate is 15 bps and not 25 bps is reason enough not to raise rates. Central banks should refrain from moving rates about as they see fit. For one, their understanding of the economy is no better than anyone else's. How can one make interest rate policy amid this much ignorance? For another, they tinker with the most important price of all, the price of money, which anchors all other relative prices.
Market interest rates, are telling us something already. Let them be our guide. The market is being distorted by Fed OMO and rate prognostications. The market doesn't need to watch a Fed that is watching the economy. If the market focuses on the economy, the Fed can be absolved from that responsibility and go where all central banks should go absent crisis. The scrapheap.
On a more topical and practical note, the Fed has backed itself into a corner. If it raises rates, it does so into a US economy that isn't exactly firing on all 8 cylinders. You don't raise rates when inflation is this conspicuously absent, when you clutch at straws to find strength in labour markets. It is clear that the Fed wants to raise rates, is looking for an excuse to raise rates, because it telegraphed its intentions too soon, based on data that is now stale. If the Fed doesn't raise rates, given current sentiment, the market will take it as a sign of weakness and asset values will tumble further. Since the Fed has been revealed to be supporting asset markets, it won't do that. If it does raise rates, it will allay the market's fears but it will slow the real economy. It will have to go very slowly indeed into the next rate hike. And it will have to provide more liquidity support to the market. It couldn't possibly do a QE4, so a backdoor QE like the ECB's LTRO may be one idea. But if it did do that, then the effective rate would not rise substantially to the target rate and the Fed risks losing the little credibility it has left.
So we have this situation where the Fed is damned if it does and damned if it doesn't. In other words, the Fed is simply damned.
The west dealt with its financial crisis by basically swapping treasuries for non performing loans. It allowed a wholesale transfer of problem debt to the public (taxpayers) balance sheet, funded by the issue of government debt which only the Fed (and some hostage buyers like commercial banks subject to enhanced capitalization requirements) were willing to buy.
China, unfortunately is less experienced in the management of bailouts. They have left problem loans on private balance sheets and tried instead to reclassify these loans as anything but non performing.
Private balance sheets are open to scrutiny or at the least, question. China has instead tried to fund the private balance sheets to allow them to hold these NPLs instead of simply buying them out at par.
The western solution is more effective because it removes the NPLs from prying eyes of private investors and puts them on the Federal balance sheet. Taxpayers can yell all they want but they have no sway over the government like investors might on a corporate entity.
Sovereign balance sheets are not well defined in particular because it is hard to define and quantify the assets of a country. The difficulty in quantifying a country's assets can impact a country's ability to raise debt especially in times of financial stress.
One simple way of solving the definition problem is to create a Sovereign Wealth Fund. The SWF is capitalized by injecting state assets such as land, hard assets like resource rights and the capitalized tax base. The definition and quantification of the capitalized tax base is difficult but can be partially solved by a securitization.
With an SWF with a defined asset base it is possible to raise debt. In fact it becomes possible to issue a range of liabilities, secured or unsecured, convertible (to an underlying asset), fixed or floating rate, mezzanine or senior. The cost of debt would depend on the quality of the assets and how the SWF was managed. One important factor would be the dividend policy of the SWF. The dividends would be paid to the Treasury of the country.
With such definition, it is likely that the SWF would become the primary funding vehicle of the sovereign.
The Treasury could of course continue to issue debt but the poor definition of solvency, the reliance on confidence as opposed to asset value, would probably deter investors relative to the debt issued by the SWF.
To better define the capitalized tax base we securitize tax revenues. All tax revenues would be collected by an SPV, a tax collection vehicle (TCV). The TCV is basically a conduit which collect taxes and issues liabilities called Tax Backed Securities (TBS). The TBS would be tranched and rated and the stability of the tax revenues would be reported for full transparency towards efficiency pricing of the tranches. TCV's can be allocated free of payment to the SWF to capitalize it, or sold in an open auction.
All this structuring is for nothing, of course, if bankruptcy laws were weak or did not apply to the securitizations or the SWF's liabilities. By structuring the sovereign's assets and liabilities in a standard private corporate structure, albeit one where the equity was owned by the sovereign, bankruptcy laws could be applied in a clear and transparent way to define priority of claim. This would go a long way to bringing fiscally delinquent sovereigns back into the capital markets.
Singapore's government has attempted to solve a labour shortage and economic growth problem by importing foreign labour and encouraging immigration. In the last election in 2011 the topic of immigration became a serious issue. Singaporean's faced with overcrowding and competition for jobs diverted votes away from the PAP. In response, the PAP acquiesced and slowed the pace of immigration and import of foreign labour.
Yet constantly we hear of plans for an ever increasing population in Singapore. The PAP's economic plan apparently cannot see a way forward without immigration and foreign labour. As a result I expect they will engineer a means of getting Singaporeans to accept more immigration.
Here is how I think they will do it. They will build more housing in preparation for a greater population. This they have already done creating an oversupply of housing. This is uncharacteristically poor planning on the part of the government unless it is an intentional strategy to create oversupply. The government will also cool the housing market. This they have done. They may choose to lift some of the curbs on property investment or speculation but I suspect they will be more vigilant than expected in order to maintain soft property prices.
When vacancy rates rise and house prices drop they will present a solution to the people, namely importing foreigners to shore up the real estate market.
Who owns all the stuff?
In a knowledge economy labor's share of income keeps diminishing while capital's share keeps increasing as businesses are able to accumulate intellectual property whereas individuals have limitations. In the limit who owns the businesses?
The march of technology will see many jobs made redundant by automation. If robots replace humans then in the limit who owns the robots?
Unlike other factors of production knowledge is not consumable. Producing more of a product does not exhaust knowledge. Knowledge defies scarcity. When knowledge becomes responsible for an increasing proportion of value in the production of goods and services, who should own knowledge?
When factors of production are not unbalanced the question of who owns what factors of production do not arise. When factors of production are highly unbalanced some factors will see returns diminished relative to others. Owners of that factor are at a disadvantage and owners of other factors are at an advantage. Is there a concept of discrimination between factors of production and is there a concept of fairness?
One or all?
Deflation and interest rates.
Human ingenuity should over the long term reduce our reliance on labour and resources. The relative marginal product of both should fall as should the marginal income to both. Does this imply factor price deflation and wage deflation? Does it also imply general price deflation?
A firm has productive assets and cash which it funds with equity and debt. Productive assets include labour and technology, both have a cost as well as a return. A firm cannot own labour but rents it from individuals. A firm can either rent or own technology. The cost of owning an asset is the cost of financing it, which is the cost of equity and debt. The cost of renting an asset is its price or in the case of labor, wages. The price or wage a firm is willing to pay is the marginal revenue product of labor. If the productivity of labour is low, wages will be depressed. If final good prices are depressed, so too will wages be depressed. The corporate balance sheet likes product inflation, falling interest rates and falling wages. Falling wages and rising product inflation implies lower share of labour in output. This incentive would not be so if labour could be owned instead of rented for then its labor cost would be its cost of capital. Businesses also favor inflation the more highly levered they are as it erodes the real value of the debt.
A household derives income from income yielding assets, labour and interest on cash. Its assets consist of investment assets, the capitalized value of its labour and cash. Its liabilities include mortgages, car loans, student loans and short term debt such as overdrafts and credit card debt. Households like rising asset prices and falling interest rates. To the extent that inflation correlates with asset prices, wages and employment households like inflation. Highly levered households also prefer inflation. Younger households prefer inflation as they have a longer period of employment ahead of them and more debt and less savings; they also prefer lower interest rates and a steeper yield curve. Older households prefer deflation as they have less debt and a shorter period of employment before them' they prefer higher interest rates and a flatter yield curve.
House prices are driven by demand and supply. For a fixed supply house prices rise where employment prospects are strong and mortgages are available and cheap. House prices are also correlated with long duration bond prices as they are themselves ultra-long duration assets priced on the basis of capitalized rental income.
In space constrained cities and countries house prices tend to rise faster than wages and affordability. Employment prospects rise only to drive greater population density which drives up house prices. The value of housing accrues not just to the occupier or owner but to the society as a whole which benefits from the clustering of skilled labour and network effects. Individuals who own multiple houses see rising wealth. Households who own a single house face no real wealth effect from rising or falling house prices as replacement costs rise and fall in step. Ownership of more than one house exposes the owner to the wealth effects of the variation in house prices. Since houses in cities and houses are a scarce resource which benefits not just the owner or occupier but society as a whole what are the economic implications when individuals or entities own multiple houses?
Inequality and ownership. Scarcity and abundance.
Businesses or corporate entities have earned an increasing share of output and income at the expense of labor. There are several factors why this might be so. One of those factors is that the economy continues to evolve towards a greater reliance on knowledge and technology. A human being can only acquire and retain a limited amount of knowledge and skill whereas a corporate entity can accumulate the ownership of intellectual property and either capitalize on it or charge a rent for its use. If the return on intellectual capital is fixed but its marginal contribution to output rises relative to all other outputs, especially labour, then labour's share of profits will fall. Automation is a practical example of where capital and technology replace labour. In the limit labour may become largely redundant.
If labour is unnecessary in production yet the economy is able to produce all the goods and services demanded by people, how would goods and services be allocated to people? This is the post scarcity environment envisaged in some utopias. One practical question is, what things abundant without bound and be produced at no cost and what things cannot? Given sufficiently advanced technology all material things are abundant practically without bound. What might be subject to scarcity? People? People could theoretically be produced without bound. Space? With sufficiently powerful terra forming there is an abundance of planets which could be colonized. This may sound absurd but we are discussing possibilities and thus sufficiently advanced technology would surmount the most apparently intractable problems. Even space is abundant. How about location? Location is an abstract concept and could remain scarce no matter what technologies we develop.
Location is given relevance by certain qualities. Where these qualities are material they can be replicated without bound and location becomes replicable. What non material qualities could define location uniquely that it could not be replicated without bound? Proximity to and relationships with individuals in a given location would be hard to replicate. This begs the question if individuality was replicable and takes us far from our initial musings.
Time. Technology might be able to extend human lifespans without limit, however, time cannot be created. Time expended on one activity cannot be expended on some other activity. Time is therefore not abundant. Time, however, is relative and it is relative to the lifespan of the observer. A sufficiently long lifespan can lower the opportunity cost of time monotonically. In an arbitrary time frame, say in a fixed number of minutes, scarcity remains relevant. Time spent doing one thing cannot simultaneously be spent doing something else. Time remains scarce although there may be some theoretically possible practically improbable technologies which might compress time or the perception of time.
In an infinitely abundant world what is the concept of want and need? What gives the individual satisfaction? Maslow's hierarchy presents as an ordinal stack of tranches beginning with physiological need followed by material security followed by social belonging, esteem and finally self-actualization. Maslow's hierarchy envisages increasing sophistication, self-awareness and morality. It does not envisage what happens or can happen beyond self-actuation, or alongside it. Post scarcity may actually confound some of the expectations of this hierarchy.
Hardship and competition improve the breed. Without want there is nothing to animate natural selection and so there is nothing to distinguish negative from positive mutation. Without a mechanism to sort away negative mutation will it imply more diversity? If technology can preserve the weak, it might well imply more diversity.
Will society maintain or shed its brutality? Is the human soul predisposed to competition? How will it react when there is nothing to compete over? Will it create an abstract or an irrelevant competition? If so predisposed, is this predisposition a survival mechanism?
Back to more practical concerns:
We suspect that there are currently more resources in the world than the world needs, that poverty is not a problem of scarcity but of distribution, that inequality is unnecessary and an unnecessarily high price of progress. We don't know why but we suspect this is the state of the world. If so, the current problems faced by humanity are an indictment of our system of economics. We have settled on capitalism and the price mechanism as mathematically and rationally, the best available allocation system. A better distribution exists but no better distribution mechanism exists and the best mechanism has resulted in the current distribution. To accept it is to be defeatist.
Certainly for the rich there is no incentive to change the current state. One doesn't have to be very rich to fall to inertia. The conspiracy theorist might hypothesize that it is not mere inertia but an active policy of maintaining the status quo through the influence of politics and academia. Certainly even the not so well off might baulk at instigating or supporting change when they consider their fortune and the prospect of having to share what they have with those who have not. Change will only come if a sufficient proportion of the population are impoverished or come to feel that their chances of advancement are sufficiently low. When global growth is sufficient that all constituents have an increasing standard of living the risk of change is low. If, however, global growth slows, then a critical mass of malcontents may arise to drive change.
The world economy has witnessed robust growth up until 2008. Some of this growth has been borrowed from the future by being credit financed. This is an intertemporal transfer of growth. It requires that future growth is sufficient to more than compensate for that transfer. Since the crisis of 2008 growth has rebounded but slowly. A large quantity of debt has been transferred from private balance sheets to public mutualized balance sheets. They have not been defaulted upon or written down. To do so would be to accelerate the reversal of that intertemporal transfer. To hoard it away from the spotlight is to prolong the reversal of that intertemporal transfer. Repayment is immutable but can be redistributed over time.
Can current and future growth compensate for the growing inequality that capitalism naturally perpetuates?
14 July:
It's not over. The deal agreed by the Eurogroup with Greece will need the creditor parliaments and the Greek parliament to vote and approve before the governors of ESM can approve it. The Greeks will likely approve it although Tsipras 149 votes will likely not all be yes, it is expected some 30 will vote against, the 106 pro Euro opposition will be sufficient to carry the motion. As for the creditors, only Finland looks risky. Under normal circumstances an ESM bailout requires unanimity but the ECB can and in the event of dissent will likely decide that the action is a threat to the stability of the union and force the vote into a special motion requiring an 85% majority. The potential dissenters will unlikely get beyond 3% of the vote. And so the Greek bailout will likely be ratified.
The ESM's response to the proposal is not unequivocal and there are potential uncertainties in the language which suggest that there could be further negotiations.
While in the short term the deal will likely be approved by the Greek parliament the fact that the deal Tsipras has achieved is worse than the June 26 creditor proposal and indeed worse than any deal in the negotiations thus far poses a risk to his leadership. The deal involves no debt write down, no end to austerity, a restart to asset sales and this time under the strict supervision of the Troika and the continued monitoring of progress by the creditors, something that was deemed humiliating and demeaning. Syriza is itself a coalition and the integrity of this coalition must certainly come under pressure given the quality of the bailout deal. One can reasonably expect a shakeup in the Greek parliament and possibly new elections.
Even assuming that all parties were agreeable it is difficult to see how Greece would comply with the budget targets. It is one thing to agree to something but another to have a plan to achieve it. So far both creditor and debtor have focused on targets without devising the means to achieving them. Few countries have achieved what the Greeks are aiming for, not even their largest creditor Germany.
The probability that Greece gets into a financially distressed situation at some stage in the not too distant future, under this plan, is quite high.
15 July:
Having had time to sleep on this I'm beginning to have doubts that the Greek parliament will pass it. Tsipras began with an anti-austerity platform and coalition party. He's now ended up with a tighter austerity program than he bargained for at the start of negotiations. Parts of Syriza will vote against the creditor plan. He is counting on the opposition to support this pretty draconian plan. Now the opposition may have been for austerity when they thought it might work but the capital controls have taken the Greek economy off the cliff, not near it, off it. ELA is frozen, thankfully not retracted, and with TARGET2 off limits the Greek economy is essentially is containment. I am simply not sure anymore if the opposition New Democracy will support what is an unworkable creditor plan.
The plan itself is incomplete, which under these dire conditions is actually a source of hope. As it stands, without a write down, the plan is unworkable and seems to have been put together either by amateurs or creditors seeking Chapter 7 instead of Chapter 11. Trying to raise cash by selling assets is a great idea on paper but is impractical. Once the seller is identified as a motivated seller, the bids will tumble to fire sale levels that no credible creditor would agree to if they believed they had claim to such assets and their proceeds of sale. If the sale program was sufficiently determined, the proceeds will fall well short of the 50 billion EUR envisaged. If the sale was attempted at reasonable prices, the fact that the assets for sale are earmarked for sale would mean that the deals will not get done and it is likely that there will be recriminations over the speed of the asset sales and the motivation of the debtors or the creditors.
A credible plan would see the following principles:
1. As close as possible to a commercially viable deal that an arms length investor would fund.
2. A long term solution as long as the longest maturing debt that will be issued as part of the restructuring.
My plan would include:
1. Debt restructuring:
* Issue of senior secured bonds with first claim to a proportion of tax revenues and a sinking fund under control of creditors.
* Issue of senior unsecured bonds with zero coupons for first 10 years and coupons stepping up thereafter.
* Issue of mezzanine GDP linked bonds.
* Legacy bonds to be written down by X% with immediate effect and the recovery value financed by the new bonds above. X could be substantial, circa 30%-50%.
2. Pension reform.
* No new defined benefit pensions to be issued. All defined contribution schemes to be frozen (not cancelled) at this point (that is, any indexation to stop.)
* Introduction of defined contribution pensions. Employers pay 15%, employees pay 15%. Assets held in an independent safe custody vehicle beyond the reach of government or state.
* Phased withdrawals of state pensions. Private annuity options.
* Medical insurance part funded from this pool.
3. Social security.
* Unemployment benefits and other social welfare benefits separately funded by payroll taxes.
4. Taxation.
* VAT proposed in current creditor plan.
* Corporate taxes to be cut when possible. Ideally 1% cut each year in primary surplus till 20%.
* Tax holiday for specific industries - tech, biotech, industries likely to bring investment.
* Social security tax for employers cut from 28% to 10% to compensate for 15% contribution to employee pension fund.
* Social security tax for employers replaced by compulsory pension contribution. This is a simple reclassification.
* Personal allowance of 5,000 EUR.
* 2% cut to all marginal income tax rates.
5. Investment.
* Infrastructure investment funded by private participation in infrastructure bonds and equity.
6. Anti-corruption.
* Anti-corruption campaign. This to address tax collection and tax liability as well as general rule of law.
7. Financial system recapitalization.
* The banking system will have to be recapitalized. That much is clear. The recapitalization will have to come from first from the government and then from private sources. The banks will issue equity underwritten by the government and simultaneously issue tier 1 capital and mezzanine debt.
The government's biggest expenses are on pensions, medical insurance and social security. By moving from defined benefit to defined contribution, the burden of pensions is shifted to the people, as it should. Medical insurance is split between being funded by the pension pool (individual responsibility) and the social security pool (collective responsibility). These measures will lessen the collective burden and improve the state finances allowing for a reduction in marginal tax rates.
If the creditors are unhappy with the debt write-down and the issue of further debt and the latitude for Greece to run smaller surpluses or indeed small deficits in an interim adjustment period, then they should just eject Greece from the euro.
On July 2 I wrote that I expected Greece to vote Yes in the referendum. I expected the Greeks to vote in favour of anything that would restart the ATMs and get cash flowing through the banking system once again. As it turns, the Greeks voted no. Why did I and many professional investors expect a Yes vote? Because we have substantial savings. I made a forecast apparently empathizing with the average Greek but without a good understanding of the average Greek and an understanding of their circumstances.
5 years of austerity had not yielded more jobs. The probability of getting a job was low. There was little in the bank to protect or release anyway. And the Eurozone finance ministers had been making a concerted case basically threatening the Greeks into voting Yes.
This last factor could cynically be interpreted as an intentional strategy to jettison the Greeks from the currency union if one were inclined to conspiracy theories. Perhaps the Eurozone was trying to correct an earlier error, that of bending the rules to admit the Greeks in the first place. Perhaps they had just tired of negotiating with a deadbeat who was seeking aid on its own terms. Perhaps the Eurozone had tired of subsidizing Greece (the details are beyond this discussion but yes, there were net transfers to Greece), and unable to eject Greece under the current rhetoric of unity at all costs, needed to force Tsipras to the edge, and then force the Greeks to voluntarily eject themselves. If this is true, then job done. You should see an aid package (the Eurozone will not abandon an erstwhile member) involving debt forgiveness, which is what Greece had sought in the first place, but which the Eurozone could not give and then retain Greece in the union. As important as keeping its members firmly in the union is ensuring that members pay their dues and respect the bye laws.
With a No vote Tsipras can negotiate more aggressively but whether the creditors will be accommodating is another matter. If the conspiracy theory is correct then he has given Merkel her wish and maybe the negotiations will be less confrontational. This is unlikely. The tensions if anything may intensify. A lot depends on Tsipras approach. He may cock a snook at the creditors and refuse to pay, Greece is after all already in default. There is not a lot that the Eurozone can do, short of gunboat diplomacy, something that is unfashionable these days and especially with the Eurozone. A martial solution is something the West has long lost its stomach for, and a German led coalition would never make it past the broadsheets and blogs.
The creditors may recognize that even in the face of an acquiescent Greece that never went to the polls, or a Yes vote, they were never going to get the full face value of their debt back, and that they have now got the Greeks off their backs, some reasonable write down of the debt is acceptable. A more sinister scenario exists. It may have been necessary to induce the Greeks to eject themselves from the union to encourage responsible behaviour among existing Eurozone members but it may now also be necessary to deter further exits by demonstrating the high price of leaving the union.
As I have said before, Greece has always had a choice between austerity in Drachmas or austerity in Euros.
I was undecided before but the rhetoric from Berlin has now convinced me that for once, Merkel and Tsipras agree. They both want the Greek people to vote No in the July 5 referendum on creditors' terms.
Greece has been on explicit financial aid since the first bailout in 2010. In 2015, since Syriza won the general elections, all Greece has been trying to do is renegotiate the terms of its aid. It is not a bailout or a refinancing or debt reorganization, its aid. For the Eurozone, its members already struggling fiscally, with the exception of Germany, aid to an unproductive member was never sustainable. That the Greeks did not have a commercially acceptable business plan exacerbated the situation. Reprieve (for the EZ) came in the form of Syriza. Under ND, austerity had failed but its effects would only manifest will past the elections. Had Greece failed under a compliant New Democracy the effectiveness of the Eurozone's austerity programs would have come into question. Rather fortuitously, ND lost to a strident Syriza intent on tearing up the status quo became a convenient pawn in a gambit designed to see Greece out of the Euro, by its own hand, and facing painful consequences – as a warning to Portugal, Spain and Italy, that exit has a price too high.
Unfortunately, for the Eurozone and Syriza, the vote will likely be Yes. Quite what happens after such a vote is another matter but, polls notwithstanding, the human tendency is to go with the devil you know. A Yes is more probable because, Greeks do want to stay in the Euro, they receive aid from the Eurozone, their borrowing costs are or were held down by the Euro, but most of all, they cannot envisage life without the Euro, or life with a Drachma. More immediately, the banks are closed and pension disbursements are drying up. Greece and her banks are short of cash. In the short term only Emergency Liquidity Assistance can restore the flow of cash and the ECB will certainly not raise the ceiling on ELA if there is a No vote. By imposing capital controls and a bank holiday, Tsipras may be encouraging his people to vote Yes just to free up the flow of money.
A Yes vote will mean a loss of mandate for Tsipras and his Syriza since he has recommended to his people to vote No. Tsipras may have to resign, triggering fresh elections. If so, a new government will need to be formed during which time it is not clear what the position of the Eurozone will be, they will have no one to negotiate with. The position of the ECB will be similarly unclear. Should they provide relief and lift the ceiling on the ELA? If they did, cash would start flowing again while Greek default risk would still be ring-fenced within the Greek financial system. So it is likely they would. Tsipras may not resign. A cynic might expect him to hold on to his position and resume negotiations with the creditors. He has already shown sufficient flexibility in between the time he called for the referendum and when the referendum would be held by attempting to negotiate terms with a softer stance. In any case, a Tsipras government or another government would have to respect the result of the referendum in negotiations with the creditors, basically accepting the terms of the initial creditor plan. The latitude for any government to be obstructive is significantly limited by a Yes vote. Very likely a deal will be struck and bailout disbursements would follow. Given the draconian terms of the creditor plan, Greece would limp along until the next crisis.
A No vote would keep Syriza in place but could well put Greece out of place. While it appears that anything is possible, if we are to believe the myriad official voices from Brussels to Berlin to Athens, Greece would probably be forced out of the Euro. Theoretically it could default and remain within the union, since membership does not explicitly preclude default, but the going concern status of Greece would be in question and there might be sanctions regarding Greece's access to the European TARGET2 payments system. Another possibility might be Greece being removed from the currency union but not the European union in a similar way that the United Kingdom is part of the EU but has its own currency. In any case, Greece has for all intents and purposes already defaulted on the IMF loan due June 30. The IMF would simply formalize this by changing its status from being in arrears to being in default.
Under a No vote and default, could Greece remain in the Euro? Theoretically it could. Greek debt in Euro would default and face writedowns in the usual fashion that defaulted dollar debt faces writedowns. A plan of reorganization could still be formulated with Greece within the Euro that would restructure its debt. Creditors would still impose conditions, and Greece would negotiate for leniency, in fact the negotiations might look very much like what we have experienced in the past 5 months. The negotiations thus far have not only been ineffective, they have been irrelevant. Now it may be that the Eurozone then decides to remove Greece from the currency union. It may keep Greece in the broader union, or it may also eject it altogether. That is a separate analysis which would involve longer term strategic considerations as well as historical, cultural and emotional factors. The logistics of default are another matter. Upon default, Greece would have to be prevented from creating further liabilities, which it can do within TARGET2. Shutting Greece out of TARGET2 or limiting its access to it would be the equivalent of Europe unilaterally and exogenously imposing capital controls on Greece, which surely would encourage Greece to leave the Euro.
What other alternatives does Greece have? Tsipras has evidently approached Russia. Russia, however, is not entirely in shape for such extravagance. While the Russian economy has stabilized somewhat rates remain elevated and the currency may yet begin to weaken again and the budget has already begun to deteriorate again. Putin might be happy to spend some money on entertainment and Greece would be a source of worry in NATO's backyard but so far Tsipras' overtures don't seem to have borne fruit. Unless they are waiting for a more opportune time to come out.
The polls have been all over the place beginning with favor for a Yes, to a more even balance to favoring a No. Polls tell you what people wish they could do, not what they will do. And even when the votes are counted, a new uncertainty will have begun.
When we buy an equity or a bond we buy a claim on a business but with differing payoffs, rights and obligations. The rational investor would first decide if the business in question was something they wanted to own before deciding on whether to own it through the equity or the debt. If indeed the business was attractive then the analysis would progress to which claim to buy, an analysis which would take into account the prospects for the business, the riskiness of the business and the available claims. The assessment would be made on a risk adjusted basis and not on the absolute attractiveness of the claim. I say this because if it was decided that the most senior claim was the right one, leverage could be used to scale the investment to the right size. If for example equity was the right claim but the investor was targeting a low risk, then a deleveraged position could be taken (that is pairing the position with cash).
We apply this methodology with the prices before us. Its really the best we can do. The methodology may well drive us to hold lots of cash for example if equity was the more attractive claim, yet our desired volatility was lower than the unlevered cash equity. In this case we would hold a deleveraged position, meaning a portfolio of positive cash and positive equity.
Current valuations are quite balanced. Looking at aggregates, equities are cheap compared with government bonds but they are fairly priced on a historical basis when compared with corporate bonds. The spread of investment grade corporates to treasuries is moderately attractive and at this point at least, a comparison of high yield to investment grade yields is equivocal.
The investment problem is that government bond yields are too depressed. Valuations made against government bonds are a risky practice since yields are likely to rise and could render reasonably priced assets expensive quite quickly.
It was low interest rates in 2003/2004 of 1% in the US, now a princely level, which saw the reach for yield in that decade which was sated by ratings arbitrage, necessary because institutional investors were constrained by ratings requirements. The ratings arbitrage resulted in clever constructs like CLOs and CDOs. Demand for yield drove demand for CLO origination which in turn drove demand for ABS and in particular RMBS origination to the point that the banks were more willing to lend than the homeowner was to borrow. This was the tipping point.
As we reach for yield today we should be aware of the balance of enthusiasm between lenders and borrowers. When lenders are more motivated to lend than borrowers are to borrow it is usually a sign of a credit bubble.
Analgesics are addictive. Since interest rates were deployed to manage the economic cycle we have seen the Fed Funds Target Rate decline, making lower lows and lower highs (1980, 1984, 1989, 1995, 2000, 2007) as the Fed has been repeatedly enlisted in the bailout of asset markets and the economy.
Now that a new policy tool has been invented it will doubtless be counted upon to support further crises and excesses. This is the nature of moral hazard. We cannot un-discover QE.
With Fed Funds at 0.25% there is no room for cutting it any further. We will be fortunate when the Fed finds itself in a position to reset its policy tool higher but should another crisis or recession occur, with Fed funds at these low levels, the Fed's balance sheet can and will be deployed. While the balance sheet may shrink in the next 7 to 8 years, one can reasonably expect it to expand over a longer time frame.
Some Issues In Mutual Fund Investing.
1. One of the problems in mutual fund investing is how they are sold to investors.
a. High front end commissions. Mutual funds typically charge a commission to invest in them. This commission is paid to the distributor of the mutual fund, such as a bank or an independent financial adviser. Just like any other product marketing has a cost. Mutual funds can charge up to 5%, sometimes more, in commissions. Distributors receive these fees ostensibly for providing advice. Perhaps, but if so, why are the fees charged by the funds and rebated to the distributors and not paid directly by clients to their bank. By accepting payment from the fund manager instead of the investor, distributors work for the fund manager, not the investor. How about sophisticated investors who do not require advice but are faced with subscription commissions wherever they turn? In a low yield environment even a 1% commission can eat up 3 months' worth of gross returns.
b. High management fees. Mutual funds charge different clients different fees. Institutional clients pay half of what retail clients pay, sometimes even less. The primary reason for the difference is that retail funds' fees have to be shared with distributors such as banks and IFAs in what are called trailer fees. A fund charging 1.5% per annum will pay its distributor 0.75% per annum on the assets raised. Fortunately there are some banks who eschew this practice and either invest their clients' money in institutional share classes, which incur much lower fees, or rebate any trailer fees they get on to their clients. In certain markets like the UK, it has become illegal to pay trailer fees to distributors. In Asia trailer fees are the norm.
c. Opaque fee structures and conflicts of interest of distributors. The payment of trailer fees to distributors creates a conflict of interest. Distributors have a strong incentive to sell funds with high trailer fees or commissions. Whereas fund distributors claim to represent the interests of their investors they are in fact being paid by the fund managers. Low volatility funds often also have low expected returns and fund managers scale their management fees accordingly. Since trailer fees are usually a cut of management fees distributors prefer to sell investors high risk, high returning funds which charge high fees to low volatility funds. Investors are allowed to believe that their banks are working for them when in fact they are working for the fund managers as their distributors.
2. Underperformance of benchmarks is addressed below under "When ETFs are more effective."
3. Mutual funds are aggregation vehicles when it comes to market systemic risk. As more capital comes to be controlled by fewer independent decision makers, systemic risks are raised. CLOs and CDOs dominated the demand for loans and bonds in the years prior to the 2008 crisis.
a. The size of a fund should be seen in the context of its market. A fund which represents too large a proportion of total trading or total holdings in a particular market is risky from a liquidity aspect.
b. The aggregate size of mutual funds as a percentage of total market size is another risk factor since mutual fund managers and their investors are likely to behave similarly.
There are a number of reasons for investors to invest in investment funds.
1. They are a practical and convenient tool and component to deploy a diversified global portfolio. Regional, country, sector and asset class funds allow the investor to construct a portfolio to their own requirements.
2. Investment funds offer a diversified portfolio within a defined investment objective. Funds diversify the idiosyncratic risk while retaining the thematic risk so a single security or issuer cannot derail a sound thematic investment strategy.
3. Outsource investment strategy to experts in their particular fields. Funds allow investors to delegate investment strategy to professionals of a particular focus and specialization.
4. Related to point 2 above is divisibility. Some securities can only be traded in large values. If an investor's portfolio is too small it may be impossible to invest in such securities or to invest in such securities with sufficient diversification.
5. Access. Certain instruments and markets are not easily accessed by retail investors. Catastrophe bonds, asset backed securities, structured credit, freight futures, commodity derivatives, etc are examples of instruments which are traded by institutional investors and not retail investors but which can be accessed through funds.
When Exchange Traded Funds Are More Effective.
1. One of the criticisms of mutual funds is costs. Mutual fund managers charge annual management fees, and some even charge performance fees. In order for a manager to return the same as their benchmark on a net basis, they must outperform their benchmarks by the quantum of their fees on a gross basis. Empirical evidence suggests that on average, mutual fund managers are unable to compensate for the fee drag. An exchange traded fund or ETF may be the solution to the fee problem. Due to scale and the mechanical nature of the portfolio construction ETFs charge very low fees. In some cases, the index replication strategies are sufficiently clever that they even recoup the little transaction, administration and custody expenses incurred by the fund.
2. Highly efficient markets are difficult to outperform. The US equity market is a good example where very few active managers outperform the index. In such markets, an ETF is more efficient.
3. Highly liquid and efficient markets are easier to replicate in an ETF. In illiquid markets.
4. ETFs can be traded at any time during the trading day. Mutual funds are typically traded at the NAV at the close of the day. Some mutual funds have poorer redemption liquidity which may be weekly or monthly.
5. The cost in trading ETFs is normal trading commissions which have seen significant compression over the years. Mutual funds can and often do involve paying a hefty up front commission to the distributor of the funds. Commissions can be as high as 5% or higher in certain markets.
When Mutual Funds Are More Effective.
1. There are some markets which are simply not tracked by indices or ETFs. An example is the non-agency MBS market. While there are a number of large and well known MBS (mortgage backed security) ETFs these invest entirely in agency mortgages. The non-agency MBS market is simply not represented by any ETF.
2. There are some funds which have a theme or strategy that is not represented by any index or ETF. Hedge Fund Research, an index compilation company has compiled investable indices called HFRX so that even hedge fund strategies are replicable and can be accessed through an ETF but there remain some areas which ETFs have not reached. ETF providers are, however, trying to complete their shelf and are constantly evolving new strategies.
3. On average, by definition, mutual funds make a gross return equal to their benchmarks, which after fees and expenses, is below the benchmark. There are, however, mutual funds whose managers consistently outperform their benchmarks. The incidence of these managers is in part determined by the efficiency of the market. More efficient markets like US equities, are more difficult to outperform. Less liquid and less efficient markets enable active management and outperformance. They also enable underperformance.
Bottom Line:
1. As with all things investors should know the product at least as well, if not better than, their advisors.
2. Regulators should address the conflicts of interest in how mutual funds are offered to end investors. Regulation in the UK for example has been enacted to address the trailer fee issue.
3. Investors should be aware not just of the fees, costs and expenses in fund investing but of who are the beneficiaries of these fees, costs and expenses so that a judgment can be made as to the quality of advice they obtain from the various parties.
4. There are circumstances under which actively managed mutual funds can be used and circumstances under which ETFs should be used. One is not always and everywhere superior to the other.
For decades the US has relied on emerging markets, especially China, for cheap production, and OPEC and the Middle East for a steady supply of oil. In order to safeguard its interests the US has engaged the world's energy producers and exporters and manufacturing countries politically and strategically. Where America's economic and commercial interests are not served the US has been happy to pursue a policy of unilateralism which to some had come across as arrogant. America's newfound independence in manufacturing led, by onshoring and greater automation, and in energy, led by shale and fracking, have driven foreign policy to be more insular. This has created a political and strategic vacuum which China has been happy and clever to exploit.
The US has always been pragmatic about its international relations. The fight against Communism may have been its last ideological battle. Most of its other strategic campaigns have revolved around protecting commercial interests, trade routes or energy supply. Meanwhile, the US, for reasons valid or not, have been less sociable and have either failed to sign or ratify a long list of international treaties such as Protocols I and II of the Geneva Convention, the International Criminal Court, even the Mine Ban Treaty, and indeed the UNCLOS.
While the US has been busy refocusing on domestic consumption, manufacturing and energy independence China has been building bridges and winning friends. It led the establishment of the Asian Infrastructure Investment Bank to which Europe and most of Asia have signed up. Only the US and Japan have not joined the effort. Taiwan and North Korea were turned down. China has become Africa's leading trading partner and a growing and important source of investment capital. China's demand for resources may slow but its growing hunger for agricultural goods and farmland will likely grow. In October of 2013, the government announced the One Road One Belt initiative to improve connectivity in Eurasia.
In recent months, the Chinese President Xi Jinping has been given a very warm welcome at Buckingham Palace, as deals worth some 30 million GBP were cut. Angela Merkel's recent visit to Beijing yielded some 17 billion USD in aircraft orders for Airbus.
In a further move towards global norms of market economics, China has further liberalized its current account, announcing a new methodology for the currency fixing to include market pricing, demand and supply. Her ambitions for the RMB to be included in the IMF Special Drawing Rights will likely be successful further drawing China into the international fold.
Last week, Xi Jinping met with the outgoing Prime Minister of Taiwan, Ma Ying-jeou, marking the event with a carefully choreographed handshake. The last time China hardballed Taiwan, the people voted in the pro-independence DPP. China is not about to make the same mistake and has toned down the rhetoric in the hope that the KMT, who are in any case expected to lose, will prevail in the coming elections.
In the area of financial infrastructure, the China's Cross-border International Payment System or CIPS is an important alternative payments system to challenge SWIFT. This is a significant step given the universal utility of SWIFT. When the US threatens any country with economic sanctions, denial of SWIFT is one of the most persuasive elements. CIPS is currently only used for RMB settlement and clearing, but its protocols are compatible with SWIFT and will with time erode SWIFT's monopoly.
In all of this the US is perhaps feeling slightly left out. Hence perhaps the USS Lassen's FONOPs (freedom of navigation operations) 12 nautical miles off the Spratly's on October 28. The US Navy's cruise tours through the international waters of the South China Sea are legal, but it is perhaps awkward to cite the UNCLOS when criticizing Chinese ambitions in the area since the Americans have not themselves ratified this treaty.
With the Americans playing the short game and being rather more mercenarily pragmatic, China has played a more nuanced and skillful hand. China is building or joining clubs and cliques as America has pulled out of regions where they have felt their business interests do not lie.
The positive to take away from all this is that China's strategy of engagement appears peaceful and constructive. It asks that it is allowed to do unto its own people as it sees fit but will otherwise play internationally by international rules. Fair enough since this is the same argument that gives the US pause in ratifying Protocols I and II of the Geneva convention. If this interpretation is correct it means a lower risk of martial conflict, which can only be positive. The fear has always been an insecure, insular China, turning inwards and away from the rest of the world. The same risk is less likely to apply to the US.
Why would China do this? It is an efficient defence against the America's China containment policy.
The Real Economy:
Low borrowing costs lead consumers to spend whether it was on houses, cars or stuff. The savings rate fell from 6% to 2% and households incurred increasing levels of debt particularly in mortgages, fueling a housing boom. House prices grew at between 10-15% per annum. Retail sales accelerated from an annual growth rate of 1.5-2% to 9% per annum in 2005. Auto sales ranged between 16-18 million cars annualized, from 14-16m in the late 1990s. Supply of credit surged as the securitization markets churned out bonds which required the creation of more collateral in the form of consumer loans and mortgages. The consumer binged on consumption financed by securitizations on which investors binged keeping borrowing costs low.
Interest rates began to rise increasing debt service burdens and squeezing disposable income. Retail sales began to slip from 9% per annum growth to zero growth in early 2008 before the financial crisis led to a yearlong contraction in retail sales with rates of as much as -11.3%. In reaction, consumers retrench and savings rates surge to 8%. Unemployment surged from 4.4% to 10%. Assets from stocks to bonds to real estate selloff sharply as investors panic. Financial conditions are tight and funding markets are shut. Central banks the world over cooperate to maintain the global payments system despite a near failure of the credit system. There is a sharp retrenchment in GDP growth from 2.3% p.a. in 2007 to -4% in 2009.
2009 – present:
Despite fast and powerful recoveries in equity and credit markets, the real economy was slow to recover, taking till 2010 to recover to 3.1% and then averaging a meagre 2% till 2015. The current reading is 2.7% for Q2 2015. Employment and wages have been slow to recover, so too manufacturing.
In the aftermath of the financial crisis, banks have been tightly regulated, sometimes stifling so. Banks were blamed for the scale of the financial crisis as well as for being greedy in a time of plenty and abandoning main street in a time of need. The shadow banking industry, a close accomplice has similarly had its wings clipped. Only the corporate bond market has been conspicuously open and raising capital from investors. Unfortunately, most of the new credit has been to refinance old debt or to finance dividends, share buybacks and M&A. Weak corporate investment is a sign of weak business outlook.
Consumers on the other hand have been less willing to borrow or to consume. The memories of 2008 are fresh in the minds of the people. The sluggishness of the labour market to recover even as financial markets recovered their peaks have also dampened sentiment. The recent oil dividend, from a sharply falling oil price, was saved rather than spent.
There are reasons to expect a cyclical slowdown in economic growth. US trend growth is estimated to be circa 2%. This number is not observable but if true, it means that realized growth has run above trend for two years now. Core PPI has been rising for 2 years as well and may be peaking. While the ISM manufacturing PMI peaked in late 2014, the non-manufacturing ISM has been robust, peaking at 60.3 in August before retreating to 56.9. August may have been a cyclical peak.
The Fed has halted QE. While the USD curve has yet to steepen, and may more likely flatten, liquidity conditions are no longer as accommodative. Credit spreads have widened and effective borrowing costs have risen. Baa yields are at 5.33%, which are mid 2013 levels. The gains from reshoring have taken hold and are in fact fading as the rest of the world adjusts to a less trade conducive environment. Exports are falling faster than imports.
The risk of a US recession is still remote but a mid-cycle slowdown much like the mid 1990s is certainly possible and in the context of a rising rate environment, probable. The victims of a rate hike will, if 1994 was a guide, lie elsewhere. This begs the question of whether or when there will be a rate hike.
Financial Markets
The Fed's efforts to support sagging markets was accelerated by the need to maintain liquidity and open markets in the aftermath of 9/11 and saw the Fed Funds Target Rate fall from 6.5% to 1%. The thirst for yield accelerated innovation in financial products, in particular, fixed income and credit products including mortgage securities. The popularity of such securitizations led to excess demand translating into excess supply of end user credit. Low rates and weak credit standards led to securities which were not robust against economic downturns.
As inflation breached 4% the Fed began to raise interest rates. The pace of rate hikes was aggressive, more so than the rate hikes of 1994 which had precipitated an emerging market crisis. Debt service costs rise, leveraged asset prices fall, real estate being topical, equities and bonds begin to fall. Collective investment vehicles like CLOs, CDOs and hedge funds begin selling assets as structured credit covenants are triggered and investors make redemptions. Bank proprietary desks and prime brokerage departments sell assets in unison. The S&P500 index falls my more than half and the iBoxx HY index falls by a third. Less liquid and more opaque markets like ABS and CDS markets seize up. Counterparties begin to fail. Bear Stearns requires a bailout by JP Morgan and by October, Lehman Brothers is no more and AIG is under government control. The Fed and Treasury draw up large scale bail out plans to buy assets and to finance the purchase of assets.
2009 – present:
Since the crisis the Fed has been the central driver of financial markets, engaging in multiple rounds of quantitative easing through the direct purchase or funding of the purchase, of US treasuries and agency mortgage backed securities among other securities. Interest rates are cut quickly to 0.25% in 2008 and there they have remained. Financial markets have reacted positively to these measures, with S&P500 rising 17.5% p.a. from the lows in 2009 to date (Oct 2015), high yield 12.5% p.a. By comparison the Case Shiller Composite 20 has risen a mere 4.3% p.a. in the same period. Nevertheless, asset prices evidently have received the policies well. The impact on the real economy has been less remarkable.
The Fed and Treasury have been simultaneously doing the following:
Buy distressed assets from private balance sheets, mostly private commercial and investment banks. Recapitalize the banks to allow them to continue to hold troubled assets.
Issue treasuries in a very targeted way to finance these purchases.
Suppress and control the entire yield curve through rate policy and buying treasuries.
Engage in austerity (the budget deficit fell from -10% to -2.4% in the period), while mitigating its painful effects with epic liquidity provision and low interest rates.
The results have been encouraging compared to the conditions in China, Japan or Europe. However, government debt has surged. Corporate debt issuance has also surged as businesses take advantage of low interest rates. Corporate balance sheet leverage has increased and credit quality fallen as a result.
The main investors in corporate debt have been institutions with mutual funds and structured credit vehicles also significant. Retail participation has certainly increased relative to the pre-crisis era when investors were mostly institutional, hedge funds or structured credit vehicles. In the past, instability came from leveraged prop desks, hedge funds, prime brokers and levered and rules based structured credit vehicles. Currently, potential instability can come from panicky retail investors but leveraged holders of corporate debt are few and far between. Structures are now designed with a lot less implied leverage, banks have already been sellers or hold significantly more capital against existing positions, and institutions tend to be unlevered and long term holders.
The main investors in treasuries, to the extent of 13 trillion USD, are foreign investors including their central banks (47%), the Fed (19%), state and local government (6.4%), private pensions (4.0%), banks (3.2%), insurance companies (2.1%), and mutual funds (8%). There is another pot of some 5 trillion USD of government debt which is held by government agencies, the main agencies being Social Security (55%), government retirement fund (18%), military pension fund (9%), Medicare (5%) and the federal operating account (9%). The potential weak holders who might impact the treasury market include foreign central banks who may have to spend dollars to defend their currencies or lack current account surpluses to invest, or simply seek to diversify reserves away from dollars. A stronger USD may trigger a defense of local currencies leading to a sell off of treasuries or it may encourage more investment in USD assets, the response is difficult to forecast. Banks may be weak holders if their balance sheets are shrunk, say by an outflow of deposits, but what could cause an outflow of deposits? A competing avenue for savings would have to present itself, perhaps in the form of higher returns in money market funds, or a healthy and trending stock or bond market. Mutual funds could face redemptions, but again, what could trigger redemptions? The types of funds holding treasuries are conservative, low risk funds designed to balance against riskier investments. Some mutual funds hold treasuries as collateral for total return swaps referencing risky underlying assets. If these funds perform poorly, they may face redemptions which could trigger a selloff in treasuries. These funds almost exclusively hold short dated treasuries of maturities less than a year. The fact is that of the US government holds about 50% of the total national debt, between intergovernmental holdings and debt held by the public.
While the world's central banks continue to be accommodative, the US Fed has signaled its intentions to raise rates, by some accounts, notably the Fed Chair herself, in 2015. Time is running out and the economy is beginning to show signs of weakness which may make a rate hike impractical.
The market has tightened financial conditions to the extent of a de facto rate hike of 25 – 50 bps. A strong USD is contributing to tightening as are credit spreads; IG spreads have widened over 50 basis points in the last 6 months. 3 month LIBOR is up from 25 basis points in 2014 to 33 basis points in September.
If the Fed raises rates it will most probably flatten the curve as the long end responds to the counterbalance of weaker inflation. The pace of rate hikes will likely be glacial, unlike the monthly hikes of 2004-2006.
The Fed has signaled that it would seek to normalize its balance sheet a year after the first rate hike. This may also be impractical. Debt levels are high. Total debt to GDP stands at close to 300% including government, financial, corporate and household debt. Since 2008, household and financial debt has moderated but government debt has nearly doubled. To maintain manageable debt service levels, the US treasury would not appreciate the term structure any much higher than it is today, particularly at longer maturities. Aggressive rate hikes would lift the yield curve from short to intermediate maturities. If the Fed was to sell assets, or simply not reinvest runoffs, the risk of a steeper yield curve is significant.
If there is no rate hike till say March 2016, it is likely that market rates would fall back with LIBOR tracking back towards 25 bps. A softer economy would see a flatter curve as well so a rally in the long end should be expected.
The path of spreads is another matter. Slower growth will weaken credit quality and deter investors resulting in wider spreads. However, a benign interest rate environment will mitigate the deterioration in credit quality to a certain extent.
If the Fed hikes rates, the curve is likely to flatten with short rates rising faster than the long end. The 2-5 year sector will be particularly vulnerable whereas the 30 year will likely outperform. As for spreads, higher funding costs would exacerbate the credit quality deterioration leading to wider spreads. To a significant extent this has already happened in anticipation and if anything has overshot fair value.
As for equity markets, a slowing economy will impact corporate earnings which are already stagnating. If the Fed hikes rates it is unlikely to make a single move and will in any case put a temporary end to potential reratings and could in fact lead to a mean reversion in multiples. The risk is to the downside. If the Fed doesn't move, then de-rating risk is lower but then reliance on earnings growth will not drive equities far either. If 1994 was a guide where the US economy slowed from 4.4% to 2.4%, avoiding a recession, the S&P500 traded in a tight range from 450 – 480.
For more volatility and potential returns, investors will have to look elsewhere.
Beware markets exhibiting low volatility and complacency. As markets rise steadily, investors with profits can protect their profits by buying put options. They tend to do this at key technical levels on broad market indices. Option counterparties do two things. They either act as middlemen, selling puts to investors seeking protection and buying puts from investors who seek to earn a premium and gain some positive delta exposure to the market. The net delta or exposure that they cannot match up, they need to hedge by trading in the underlying instruments that the options refer to.
Consider when the investor community is net long protection, or net long puts on the market. A long put position is one of positive gamma, or convexity. Option counterparties are therefore net short gamma or convexity. Their hedging strategy involves selling the underlying market when it falls and buying the underlying market when it rises. To further illustrate this, note that if the market is net long puts, the option hedgers must be net short puts. A short put is a long stock and a short call. A short call is hedged by buying at higher levels and selling at lower levels. The expected trading loss is the option premium.
Thus, if a market has been rising steadily and investors have been sufficiently careful to lock in some of their profits with put protection, it creates net gamma at important levels in the market. The gamma at these levels simply implies that the market cannot settle at these levels, they either rise above it or they fall below it but they cannot linger for long at those levels. It looks like 2050 was such a level on the S&P, as was 2000. And there are other important levels. As the market rose, investors would have bought protection at 1850. As we get to those levels, the gamma will cause the market to either rebound sharply, or fall sharply, but is unlikely to loiter at that level.
If you sold in May and went away you'd have been back in July, re-established positions and got your throat slit in August. The S&P and broad equity market benchmarks have lost some 10% in a week, most of it in a couple of days, Europe has done slight worse, down some 12%, and China, apparent epicenter of the troubles is down a fifth, yes, 20% in the last week. Emerging markets have lost some 28% since April in a steady decline. In this time, US, European and Japanese equity markets ground steadily higher, until last week. And then they played catch up. Is this then an emerging market phenomenon unfolding before us? The Lat Am equity markets have been falling steadily since last August (2014). They have lost 50% since then, and 30% since April 2015. Emerging markets as a group are not the catalyst. Was it just China? China equities peaked in mid-June then fell precipitously while western markets chugged along unfazed. It could have been China's signal that it would no longer support its equity markets but would allow western style market forces for price discovery that broke the camel's back.
What about credit markets which investors have been fretting over for the past year or two, worrying about market liquidity and the risk of higher interest rates? The US high yield market is down 5.4% since its April high, its European counterparts are down 2.3%. The leveraged loan market is down 1.3% from its April high. Emerging market bonds are generally off their April highs by some 4.3%. Treasuries have rallied, even the US variety where a potential interest rate hike looms.
On August 11, the PBOC introduced market forces into the determination of its CNY reference rate, which resulted in a 2% devaluation. Emerging market currencies which were already weak from weak commodity markets fell further while the relative strength of the USD to EM currencies reduced the probability of a September rate hike thus bolstering JPY and EUR. But the lags in currency movements to the PBOC's announcement was measured in days, not minutes or seconds as is usual for FX markets.
Commodity prices have been weak since early 2011 with an acceleration to the downside in oil beginning in mid-2014. Commodity prices seem to have correlated well with emerging market equities and currencies.
No smoking gun. Sometimes markets move because of a confluence of events and technical price patterns. Could economic fundamentals be driving markets? The US economy is stable and growing at a very steady if slightly tepid rate. Europe is in a cyclical recovery even if it is a structurally flawed region; Europe is simply not an optimal currency region. Greece is out of the limelight, despite having found no lasting solution; it may once again serve as a focus sometime down the road. China's economic weakness is a known fact, perhaps the degree of the slowdown has been underestimated. The PBOC's relaxing of the currency reference rate mechanism could be seen as a competitive devaluation strategy signaling greater problems in China. But China has the economic and financial resources to manage any kind of liquidity crisis. In any case, given the semi closed structure of China's markets, there should not be and has not been contagion at the financial market level. There will likely be economic consequences of slowing Chinese growth. The Chinese stock market phenomenon is remarkable in the lack of contagion to its credit markets, both USD and RMB. The Chinese high yield market has seen a 3% retracement in the last couple of weeks which is well within the volatility tolerances of this market. At the fundamental level, corporate China has been borrowing against equity to invest in equity markets, a clearly unhealthy practice.
So we cannot explain what happened apart from blaming technicals and jumpy investors. So far so normal. It will not deter us from making predictions about the how the various economies and markets will evolve.
Let us look for excuses to sell the markets.
Central bank policy has created a number of problems. The US Fed is apparently at the point of raising interest rates, and some time down the line, reducing the size of its balance sheet. The Bank of England is similarly advanced in the cycle. The ECB is only in month 6 of an 18 month QE program. The Bank of Japan is in the middle of an interminable QQE program. The PBOC has been in expansionary mode since mid-2014 although it hasn't yet started to directly buy assets, it is a pretty sizeable repo counterparty.
The Fed is in a difficult position having very early on telegraphed its intentions to raise interest rates. It counted on a long runway to manage expectations and soften the blow of raising interest rates from 0.25%. A long runway has its advantages but is also vulnerable to changing conditions. The US economy is stable but there is no sign of above target inflation and one could argue quite easily is far from being in need of higher interest rates. If the Fed raised interest rates now it would certainly slow an economy only showing tepid growth. In the meantime, expectations of higher interest rates and a resurgent manufacturing sector have boosted the USD and tightened financial conditions. The recent equity market volatility is also tightening financial conditions for the Fed, making a rate hike less justifiable. Having so early on signaled its intentions to raise rates, however, the Fed now risks investors interpreting prevarication as a sign of a weakness, which could lead to wider credit spreads, weaker equity markets and thus tighter financial conditions. Over and above the question of interest rates there is the Fed's expanded balance sheet which needs to be shrunk at some point, hopefully in an orderly manner. The question of how to shrink a balance sheet gently is a question which will be asked of all the world's central banks at some stage or other.
The rally since 2011 has been driven re-rating, not so much by earnings growth. Re-rating has been driven by falling interest rates, falling cost of debt to fund buybacks. US equities are unlikely to face falling earnings but they may face a gradual de-rating. Even if earnings grow at 2X GDP growth, the range is 5-7%. A de-rating from 16.5 to 14.5 would still lead to a lower market level. European equities are cheaper than US equities but they show the same trading pattern, that is, much of the returns have come from a re-rating. That said, earnings growth in Europe is expected to be quite robust at c.18%. Also, the ECB is not quite as late in the cycle as the US Fed. The risk of de-rating is not as great.
So much is dependent on central bank policy. The widespread use of QE has led to a disconnect between fundamentals and asset prices to the extent that it is difficult to estimate asset prices in the absence of QE. The recent volatility in the US equity market is an interesting case in point. While other economies have their problems, the US economy is sufficiently robust, at least according to the Fed in the past months, for lift higher interest rates. And yet, the stock market was in free fall for three whole days, losing some 10% of value. As discussed, there are no credible single catalysts for this volatility. Perhaps it is the difficulty in valuing US assets under QE and the fact that interest rates may be raised at a time when the Fed is no longer expanding its balance sheet, and may in fact shrink its balance sheet a year from the first rate hike, that is responsible for this volatility.
Discretion is the better part of valor. I began the year still bullish on China domestic equity markets. The thesis was founded on a number of factors.
Low inflation and slowing but still positive growth had led the PBOC to significantly expansionary policy. This policy was widespread including
Cutting the RRR.
Cutting interest rates.
Various open market operations to increase liquidity and cut real borrowing costs across the board including short and medium term lending facilities, pledged supplementary lending and a local government debt swap which manufactured qualifying collateral for cheap repo.
Valuations on Shanghai Composite and H Shares were not demanding, at 15X and 8X respectively coming into the year.
But we outstayed our welcome, missing a number of things.
The level of retail margin trading was apparent and we saw that. What was less apparent was the level of corporate share financing whereby corporates used their equity as collateral for loans.
Corporate borrowing to invest in the stock market instead of operating assets. This created a feedback loop whereby falling prices triggered LTV covenants and thus margin calls on corporate investors.
And we revised our outlook for a number of reasons.
Corporate investments in the stock market implied A) company management not seeing investment opportunities in their core competencies, B) corporate balance sheets were more volatile than represented and therefore of poorer quality.
Given the signals from corporates' investment patterns, we have a less optimistic view of Chinese corporate earnings prospects. Indeed the economy appears to be slowing faster than we expected. Despite the fact that our investment thesis relied on a slowing economy, it relied on a moderate decline. The current decline appears to be more serious.
We expect that the Chinese equity markets will trade in a range.
We expect the Chinese government will not tolerate much weaker equity markets as this will threaten the solvency of corporate China. Hence there is an implicit support, a sort of PBOC put. We think the strike may be around 3500-3700 if we use the Shanghai Comp as a guide.
We expect the Chinese government will not tolerate strong equity markets either. The 18 month bull market in Chinese equities was not driven by earnings growth but by a massive liquidity operation of the PBOC resulting in multiple rerating. This encourage leveraged, speculative activity which destabilized the market. China values stability and will likely to allow the market to rise too quickly. We think there is a sort of PBOC call, with a strike somewhere between 4300-4500.
What about structural reform?
We think that the structural reform in China will continue. We do not see the anti-corruption campaign and the emphasis on rule of law and the constitution as cosmetic but rather as a genuine effort to create a socially and politically durable regime. We think that to not do so is to present an existential threat to the Party in the face of a growing middle class and greater information mobility.
Economic reform goes hand in hand with political reform. As the government is moving towards rule of law, it is pushing its economy to rule of market. The intervention in the equity markets during the recent volatility is no more interventionist than the Fed, or the ECB during the credit crisis of 2008. The recent turbulence surrounding the new RMB rate determination is also, when examined closely, a move towards more market price discovery, but was unfortunately miscommunicated, and misunderstood, as a competitive devaluation.
What are the long term prospects?
China continues to grow in size and importance. Even at 6% GDP growth, China will add more nominal output than the US economy growing at 3%.
China's to do list includes the following
Rule of Law.
Rule of Market.
Rebalance the economy.
Hold society together.
Holding society together is the most important agenda item as it gives the Party legitimacy and thus a raison d'etre. Rule of Law is simply a means to this end. Corruption needs to be addressed in order to present a fair and even playing field in a country where inequality has been rising even as the country has become richer. Rule of Law is also important in presenting the government as an impartial and disinterested arbiter. Most importantly, laws and principles are far more durable than persons or parties. By embracing the constitution instead of subordinating it as in the past, the Party gains legitimacy and longevity.
Rule of market is necessary to integrate China into the global economy even more. When China was simply a factory, integration is not important. The relationship between China and the rest of the world was sufficiently simple that it could be controlled through closed channels. If China rebalances its economy successfully, it will no longer be just a factory to the world but will be a source of capital as much as a destination, a source of intellectual property creation as much as a consumer of it, an importer as much as an exporter. Only an open economy guided by market forces, even if with some soft direction, can facilitate China's future intended relationship with the rest of the world.
In the long term, investing in China will be more like investing in the US. Today we buy US business and companies, not USA. In future, we will also be able to buy Chinese businesses and companies and not just China beta.
When markets rise, the media quickly approach bulls to interview and feature. When markets fall, they seek bears.
In June, July this year all eyes were on Greece. Every bit of news about Greece was analyzed and scrutinized and markets reacted to these developments as if Greece was larger than the 2% it is of Eurozone output. Soon, the media and markets tired of Greece and despite lack of a credible and durable agreement, Greece was deemed problem solved and off the front page. There remains no credible solution to the Greek's solvency or liquidity, only a temporary reprieve, if that. The apparent solution features more austerity than the Greek economy can withstand, than the electorate had elected Syriza to negotiate for, and Syriza in its entirety stood for. It threatens to fracture Syriza and result in new elections. The IMF has also recognized that the current plan is commercially not viable. Beware, once media and markets have tired of China, and struggle to find or manufacture a fresh crisis, Greece may be back on the table, despite its de minimis impact on Europe and the world.
Earlier this week the PBOC changed the way the Yuan exchange rate was determined by admitting prior closing prices (which introduce serial correlation to add stationarity to the price generation process), demand and supply and the price movements of other major currencies (which introduce market forces), into the way market makers submit their contributions to the fixing. One of the corollaries, probably a bullet point three and not bullet point one, was that the current fixing would be 2% lower, which is inside the bid offer at your local Bureau de Change. Markets and media tire of details and content but instead focus on the easy bullet point: PBOC devalues RMB 2%, in flashing red LED. News is amplified in transmission and soon RMB is falling a full 5% by day 2.
With a slowing economy in China, RMB faces natural weakness. The prior stability masked central bank operations to shore up the currency, not weaken it as some US politicians believe.
- In an open economy, weak growth weakens currency improving terms of trade in a somewhat self-correcting mechanism. China's trade numbers have been weak.
-China is intelligent enough to realize that the structure of the world economy today renders competitive devaluation less effective on exports.
-China was probably responding to the IMF's requirement for a more market determined exchange rate for including RMB in the SDR, something that will be considered in October.
-Now some speculation; either China is aware or believes that the Fed will raise interest rates in September and seeks to insulate the economy from potential acute USD strength dragging up RMB, or China did not factor this into their decision to loosen the reigns on the currency and the resultant relative strength of USD transfers probability of a rate hike from September to December.
-And finally something that we are sure we still do not know: what are the precise mechanics for the determination of the RMB reference exchange rate. We don't know how many market makers there are and we don't know what constitutes an outlier (which is excluded from the calculation) and how the previous day's spot rate, demand and supply, and other major crosses feature in the calculation.
Trouble in paradise:
Singapore will never make international headlines but then you never know. What if the Fed raises rates in September, oil rebounds to 60, equity markets rise steadily and bonds recover? There might be little else for the media and markets to fret over but a little island state turning 50 and about ripe for a mid-life crisis. The long ruling party, the PAP began to lose ground in the 2011 elections and face a new election sometime soon. The passing of the country's first prime minister, the celebrations at the nation's 50th birthday coincide to provide the PAP with the strongest circumstances to contest an election. Every silver lining, however, has a slowing economy, or a weakening currency, or rising interest rates, a discontented people unhappy with the high cost of living, significant wealth inequality, overcrowding and the influx of foreign labour at all strata of society. A strong USD is putting gentle but inexorable pressure on interest rates to rise which increases the debt service costs of a nation obsessed with property ownership and funded by adjustable rate mortgages with favorable teaser rates, a significant portion of which threaten to reset. This increased debt service is eroding disposable income and consumption and slowing an economy already burdened with trading with China, whose economy is itself slowing significantly, and Malaysia, an energy and resource driven economy currently in the process of self-mutilation. Some of Singapore's ruling party's veterans are calling it a day as they find the pressure of managing the country beyond the generous monetary rewards of government; and why not? Like a successful private equity partner on Fund VIII, the prospect of cashing out is not all that bad. Singapore's fortunes were built in adversity as it was evicted from Malaysia. Absent adversity and desperation, what will temper the next generation of leaders who have to find a way through the next half century? Is adversity a condition precedent for the next leg of prosperity? The world is a smaller place, and yet a less friendly place, not just for small island states but for everyone. What does a country where trade is more than twice its GDP do as countries become more insular and less cooperative?
Then there are some troublesome questions which many daren't seek the answers to.
Greece exposes a structural inefficiency in the euro mechanism. Is it sufficient that Greece is resolved or should the Eurozone examine underlying causes and seek to stave off future potential crises? A currency union without fiscal union and indeed structural and institutional union extending to labor and commercial laws among other things is fragile.
Global debt levels are another concern. How we regard debt at an ideological level and how we deal with its repayment and servicing are questions we have decided to seek but partial answers to. Central banks of indebted countries could be seen as having lost their independence in how they police or intervene in markets. Most are creditors to their sovereigns begging the question of what does a consolidated sovereign balance sheet look like? What are a country's assets and liabilities? At a more prosaic but no less concerning level, how does a central bank roll back quantitative easing. The US Fed is the most advanced along the line and will serve as an example to the world's other major central banks. One hopes the Fed knows what it is doing. And that its example is replicable by countries without the luxury of the world's most trusted IOU, the USD.
Inequality. In world where it is patently clear resources are amply sufficient for the planet, why must one person starve while another basks in luxury. Widespread poverty defers such question as much as robust growth. Slow growth and a growing middle class cast rich and poor in vivid relief. Social media and technology bring rich and poor into close virtual proximity, surely an incendiary environment. Delve deeper and questions about the value of capitalism and socialism and how we organize our economy and society arise.
But markets and media do not concern themselves with problems as intractable as these. They seek more tangible problems, problems which have an immediate or short term price impact.
Here is one. The US is sanguine about a strong USD, but only because it has never been much of an exporter, on a net basis at least. It has now achieved some semblance of energy independence. It is the most stable and robust large economy. It is even considering raising interest rates in the near future. This creates a natural, gentle upward pressure on the currency. But a rising USD changes the calculus for emerging market bonds. Bond yields which appear to be generous in places like Brazil or Indonesia are tempered by the need and cost of hedging the currency exposure. Sometimes, as in Brazil and Indonesia, the cost of hedging makes the investment less attractive than buying a lower yielding US treasury note or bond. A strong USD and an improving trade balance can happen if a structural phenomenon such as reshoring gains ground and manufacturing is repatriated to automation heavy factories. This combination not only raises local currency borrowing costs but USD borrowing costs internationally. The Fed doesn't just tighten policy for the US, it tightens policy for the world.
As Singapore turns 50 it and its government, the People's Action Party, face a mid-life crisis. Support for the government fell to a historical low at the 2011 General Elections where a number of contentious issues emerged.
What does the government have to address for the people of Singapore?
High cost of living: Singapore remains a very expensive place to live in, according to the Economist Intelligence Unit and other surveys. More importantly, this is the view of the Singapore people. The government will have to address the high cost of living.
Population. Singapore is overcrowded and congested. Singaporeans are of the view that their country is overpopulated and that there is acute competition for resources. Transport is a particular example. The MRT system is overburdened and operated above capacity leading to breakdowns and service disruptions. The roads are congested despite a car ownership quota system augmented with a road pricing system.
Xenophobia. Singaporeans have developed an acute sense of xenophobia. This is related to the overcrowding problem. Foreigners are seen as taking up resources and taking up jobs.
Inequality. Singaporeans are envious of the wealth and luxury around them but which they struggle to attain. Inequality of wealth and income has grown if not in substance than in perception in Singaporean's eyes. That much of the wealth is of foreign origin adds to the xenophobia.
Rule of law. Singaporeans have been trained to be law abiding and generally are. They perceive foreigners as being less law abiding. Foreigners have not grown up under Singapore's well-ordered society and may treat laws as guidelines as opposed to rules. Littering is prevalent in HDB estates whereas private property is relatively clean. This amplifies the feeling of inequality in the country.
Government being out of touch with Singaporeans. Comments by government officials and civil servants have sometimes displayed a lack of empathy and fostered a sense that the government is elitist and out of touch with common Singaporeans.
What other challenges does Singapore face?
Labour shortages. Businesses face a shortage of labour and escalating labour costs. Singaporeans are unwilling and sometimes unable to do certain types of jobs. Businesses have to fill these jobs with foreigners. Unfortunately, Singaporeans often complain that these jobs are being taken up by foreigners. Another complaint is that foreigners have a better deal than locals, they have the freedom to send their children to international schools, decide if their male children register for national service or not, generally get paid more than locals, live in better conditions than locals, and have the luxury of leaving the country with their CPF funds if they choose to leave and never return.
Singaporeans are human and it is human to seek to be unique and exclusive. This is not a case of vanity but a practical evolution. It is rational to want immigration to bring in more people of lower wealth to do the jobs one needs doing without competing for one's job. It is also rational to want immigration to bring in more employers. What the Singaporean doesn't want is competition, a perfectly rational desire, that is people who are of similar ability and wealth who neither do anything for them nor employ them. Of course the more subtle effects are often not immediately felt even if they may be understood, and that is immigration brings increased demand and employment which is good generally for the population as a whole. In the brief history of the species, trickle-down economics has an even shorter history and is certainly not well understood outside of economic circles. Trickle-down economics has been widely sold in most modern capitalists economies although the success of the model is questionable.
Retirement planning 1. According to a study by a local bank published in 2014, the savings of the average household in Singapore, including their CPF savings, will be insufficient to fund retirement. This problem is not unique to Singapore. Many western economies have even more acute retirement funding problems compounded by complex systems and policies. CPF is unique and efficient in its defined contribution nature. Households do need to save beyond CPF for their retirement needs that much is clear. Another complaint among Singaporeans is that they do not feel their CPF monies are secure. Better investor education can go a long way to allaying their concerns. Investors need to understand matters like credit risk, investing in equities and bonds, how the CPF funds the interest rates it pays out on deposits, whether the CPF is a custodian of their money or a debtor, what the CPF does with their money, where does the CPF invest and why, is there concentration risk, how diversified is the CPF portfolio etc etc.
Retirement planning 2. The CPF is a defined contribution scheme. What happens to those who have contributed little or nothing? What form of social security do they have? The defined contribution CPF is the envy of many developed nations facing unfunded or underfunded pensions. That said, a defined contribution scheme is insufficient and has to be augmented by a social security scheme providing defined benefits. In a mature and compassionate society, social security is needed. Defined contribution schemes only serve those who have contributed and contributed sufficiently. A National Insurance should be established which would be part funded from existing reserves and part funded by either a more progressive tax system or a distinct national insurance tax. Such tax would ideally be designed to apply at higher thresholds. The actual marginal rates should initially be low and adjusted to increase with income earned. The National Insurance could ensure a basic level of medical insurance, pay unemployment benefits or fund workfare, and fund a pension. The total tax burden will rise but it is a necessary evil. It is a fantasy to expect more benefits and social security without someone shouldering the burden. That burden should be shared by the more fortunate among Singaporeans. A national insurance scheme augmenting CPF will mean that the retirement age of CPF need not be extended since it is always fully funded. The risk of frivolous spending after retirement is mitigated by the introduction of national insurance. CPF contribution rates can be adjusted down to manage cash flow and also because CPF will not be the sole asset at retirement.
The funding of more discretionary spending and investment:
Singapore has been a pioneer in the establishment and management of sovereign wealth funds. It should extend this pioneering spirit to better define sovereign assets and sovereign debt. The opportunity exists to create a priority of claim among sovereign liabilities, from the unsecured to the secured. State assets should be transferred to the sovereign wealth funds. The GIC and Temasek should be merged. The Singapore government can borrow through the issue of Singapore government bonds, a sovereign security, or it can issue unsecured and secured bonds as well as covered bonds and asset backed securities from the sovereign wealth fund. All projects and expenditures must be specifically funded by defined revenues or liabilities on the sovereign's or the sovereign wealth fund's balance sheet. This promotes transparency and an innovative mode of funding.
With time, outright expenditures as opposed to investments will also be able to be funded through the sovereign wealth fund against specific funding routes.
To reiterate: The Singapore People's To Do List For Their Government:
High cost of living: Bring down our cost of living. In particular please address food, shelter and transport.
Inequality: We the citizens of Singapore are grateful for the roof over our heads. The next challenge is to have better dwellings. That means, not so many, not so close together, lots of greenery, less congested roads, trains and buses, make our HDB flats of a higher (not lower) quality and closer in look, feel and quality to private property. For 50 years we supported you and you gave us home ownership. But 80% of us are in HDB and we all still strive for private property. Either only 20% can live this dream or you can make the 80% of HDB close enough to private property that the difference doesn't matter so much.
Population: Singapore is too crowded. We do not want any more people than we absolutely have to have. We know it's a balance between bringing in more workers and employers and its difficult to strike that balance.
Immigration: This is a difficult one. We want more of the type of people who add to our society and less of those who don't. Adding to society is more than spending or keeping money here, it means engaging with the community, providing meaningful employment and investment in productive assets. We the people do still have unreasonable requests, such as not wanting to do certain jobs yet not wanting foreigners coming here to do these jobs. You will need to educate people on the harsh reality. Pandering will only postpone the problem until one day you get total misunderstanding.
Transport: We want MRT trains and buses that work and are efficient and cheap. We probably don't know how much it costs to build, buy and run public transport but we just want it cheap and efficient. Congestion is a big problem on our roads which COEs and ERP hasn't solved, at least not sufficiently. Cars are where we need a more progressive tax. Politically you can get away with that provided interest groups don't get their way. Each household only needs one car. We need more cabs, buses and trains and we need the cabs to be more evenly distributed by location and time.
Rule of law: We really feel that respect for the law has dropped. Don't worry about antagonizing people by tightening up law enforcement. The people want to see Singapore as a safe, green and clean Garden City as it once was. Even if it means tougher enforcement of laws.
There are probably a lot of other things that are also important but which Singaporeans aren't complaining about. Yet. Don't forget those.
Racial harmony is sometime taken for granted in Singapore. The government has been and remains paranoid about maintaining racial and religious harmony and creating a Singaporean identity strong enough to subordinate racial and religious distinctions. This paranoia is well placed. A quick survey around the globe finds racial and religious antagonism confounding rationality. The Singapore identity must be maintained and strengthened to combat any risk of fracture. Race and religion are but two factors which can divide a people. Rich and poor may be a new distinction which arises not just in Singapore but across the globe.
Singapore's economic and business model. The world is becoming a more contentious place. Countries are becoming less willing to trade and cooperate. The reason is that global growth is slowing, mainly due to the accumulation of debt over the last few decades which in 2008 was shuffled from private to public balance sheets, mostly in the developed world, and which remains a drag on growth. An example is Ireland which went bust bailing out its commercial banks. In such a contentious world we see China seeking to be less reliant on US consumers, and the US trying to be less reliant on Chinese factories. We see a US less reliant on OPEC and oil retract from the Middle East with serious geopolitical consequences. As the tectonic plates shift, where does Singapore find itself? How does Singapore see the economic and political development of ASEAN and South East Asia and Asia and China and India, and how will she position herself not only to prosper but to persist, to exist.
And finally a word about politics…
I myself have been critical and laudatory of the PAP. And I will give them this: it is a difficult job and very often a thankless one. 40% of the electorate do not thank them, nor do some of the 60%, some of whom vote out of pure utilitarianism. Call it 50% in all, conservatively.
Yes, the pay is high, but Singaporean's tax drag is well below any of the developed economies who struggle to pay their bills and their politicians. And yet a politician is a public servant and the office is an office of honour and duty, not just another job. It is good that they should sacrifice some monetary reward and not draw the same pay as the high flying itinerant manager for hire. I'm not smart enough to tell anyone how much an MP should be paid.
The job is tough. It was tough in 1965 and its tough now. In 1965 it was the local topography that was shifting; today it is global tectonics. You really want the job of running the country and navigating through these waters?
And finally, could we have more debate about the issues in this election please? And less personal issues whether laudatory or critical. Thanks chaps.
Oh. Sorry, I forgot. Just one more thing. There is the little question of transparency over a whole host of issues. I am sure everything is fine but just to satisfy your citizens could you please just publish all the relevant data to the standard one would expect of a first world country. Its not such a big deal except when the queries are met with silence.
The US economy remains the most important and vibrant in the world. China is fast catching up but for market depth and liquidity, for corporate governance and clear and well defined regulations, the US is the prime market for fixed income and equities.
Trade Expression:
1. Long term buy US equities.
2. Long term overweight USD.
3. Underweight exporters.
4. Medium term buy US non agency RMBS.
5. Medium term buy US high yield via loans and bonds.
6. Medium term buy US 30 year long bond.
7. Medium term short US 2 year bond.
8. Medium term cautious US investment grade.
9. Short term cautious US equities.
1. Long term growth is stable. US continues to enjoy a technological advantage over the rest of the world, especially developing markets.
2. Long term growth rate has been chronically over-estimated. This creates mis-estimation of cyclical highs and lows.
3. US is intentionally becoming less reliant on outsourcing of manufacturing as well as importing oil. The result is a more self-reliant economy. 4. Outsourcing manufacturing implies importing finished product.
5. The US trade balance is likely to move towards balance over the long term.
6. The housing recovery remains on track although it is a mature recovery. Affordability and house hold balance sheet recovery will support the stability of this recovery.
7. Healthier tax receipts and reduction of military footprint is reducing the budget deficit.
1. The Fed wants to raise interest rates for a host of reasons.
2. The delay is because it cannot raise interest rates, not because it doesn't want to.
3. The rate hike trajectory will be very gentle.
4. The Fed is not independent, it considers the debt service costs of the US treasury in its calculations.
1. The Fed balance sheet is acutely inflated. At some stage the balance sheet will need to be shrunk.
2. Equity market valuations are being supported by low interest rates, access to credit, share buy backs and ample liquidity.
3. Earnings growth is not accelerating. Bloomberg estimates historical PE at 18.4, current PE at 17.8 and next year PE at 16. This implies earnings growth of 3.6% in 2015 and 11% in 2016.
4. Domestic politics. The US election will take place Nov 2016. At this early stage in the process many unexpected things can happen.
5. Geopolitics 1. A strong USD can destabilize the dollar bloc economies. It can disrupt non-dollar bloc economies as well as currency hedging costs enter the calculus for sovereign funding. The net currency hedged yield for owning a long dated BRL or IDR bond may be less attractive than owning a US treasury for example.
6. Geopolitics 2: A more self-reliant US has implications for its strategic and economic allies. Witness what self-reliance in energy has done for the political stability has done for the Middle East as American strategic assets are gradually tapered from the region.
Rationale for trade expressions:
- I like US equities for all the reasons under Economy. The economy is robust but growing moderately.
- I are cautious for reasons Risk 1, Risk 2 and Risk 3.
- Absolute valuations are not cheap. Valuations relative to treasuries are cheap. Therefore valuations are very dependent on rates. The ultra-long duration nature of equities may lead to underperformance in a rising rate environment.
- Economy 3 and Economy 4 above point to slowing imports and thus a lower supply of USD. This supports not only the USD level but will likely raise the actual cost of funding in USD internationally.
- The safe haven status of USD makes it attractive as other regions are relatively weaker or more risky than the US.
- For the simple reasons that we expect a strong USD and greater trade protectionism in the world.
- Economy 5. Housing data has on balance been strong. We advocate the more direct and targeted exposure to US housing which is via the non-agency RMBS market than the more volatile house builders where company management introduces idiosyncratic risk.
- A slow but positive and durable growth environment is ideal for high yield corporate debt.
- There are two trade expressions here: loans which carry little duration and will be very useful in the early stages of the rate hike cycle and bonds which carry more duration.
- Economy 6, Policy 3 and Policy 4 support investing in the long end of the US curve.
- Economy 6, the US budget. The congressional budget office estimates that the total and primary budget deficits will improve from now but trough in 2018.
- Policy 3 and 4. The US federal reserve and indeed most central banks have in recent times shown themselves to be not independent of their government's funding needs. They have either monetized debt by buying treasury bonds or they have suppressed debt service costs by keeping rates lower longer than they needed to. That the US treasury began issuing 2 year FRNs in Jan 2014 only creates a direct alignment between low short term interest rates and the debt service of the US treasury.
- The consensus view on the US 30 year bond is that it will fall (yield will rise). However, given the safe haven nature of the bond (investors buy it in crises) and the fact that the US treasury market has priced in the rate hike cycle, we advocate having a small position in a balanced portfolio as a form of portfolio catastrophe insurance.
- Rate hikes will most impact the front end of the curve.
- Yield difference between 2 year and 30 year US treasuries. The curve is likely to flatten as the current economic cycle matures towards the next recession.
- If one expects the 30 year to outperform we must by inference expect the 2 year to underperform.
- I am cautious about the 2 to 7 year sector of the USD term structure. Investment grade corporates issue mainly in this sector of duration which we seek to avoid. The credit spread is insufficient in our view to surmount the duration in a rising rate environment.
- Investment grade issuers are likely acquirers in the current M&A environment so there is significant event risk.
- Absolute valuations are unattractive. Relative valuations, however, are better. This, however, makes US equities sensitive to the coming rate hike.
- I think that the market may be underestimating the immediate and short term effect of a rate hike which may introduce volatility in the market.
I have been optimistic about the development of China as it matures into a middle aged, consumption led, economy governed by rule of law and subject to market forces.
What I like most about China was what I see as a genuine desire for reform, to govern by rule of law, to allow markets to be policed by demand and supply, to modernize corporate enterprise law. Evidence of this can be found in the form of the elevation of the constitution in last November's Fourth Plenum and again earlier this year when officials would be required to swear allegiance to the constitution and not just the Party. I continue to see the anti-corruption efforts carried out with determination. The efforts to include the RMB in the SDR will also open up the country's capital account more and allow the currency to find a market clearing level.
Even with the economy slowing from 7.5% to 7.0% this year, perhaps weaker than that, the Chinese economy would create more incremental nominal output than the US economy growing at 3%. At that rate, corporate profits would come under pressure. Among the HK H shares, PE multiples were 8 times in 2014 and expected to be stagnant at 8X in 2015 improving to 7.3X in 2016 implying a tepid 9.6% earnings growth. In the Shanghai A shares, PE multiples were 18.8 times in 2014 and expected to be 15.3X in 2015 and 13.5X in 2016 implying earnings growth of 22% in 2015 and slowing to 13% in 2016. These are aggregates of course and hide a wide range of numbers.
The main driver of equity markets was going to be liquidity and the PBOC put. Fundamentals while unexciting were sufficiently robust to hold the market in line while central bank efforts to drive the real economy would also drive down interest rates and cost of debt boosting valuations. My view therefore relied on the general economy being on the weak side, growing at between 6.5% to 7.0%, to do two things, one, generate sufficient nominal output growth to sustain the employment and investment, and two, be sufficiently weak to keep the PBOC in expansionary mode.
The PBOC is currently operating a number of market friendly policies. One, it is in rate cutting mode. It has cut the deposit and lending benchmark rates three times this year and the banks' required reserve ratio (RRR) twice from 20% to 18.5%. With interest rates at 4.85% and an acutely high RRR, the PBOC has a lot more room to cut rates. Two, cutting rates is a blunt instrument as market rates may not react. The PBOC is actively operating open market operations, basically repo operations, to bring down market rates of interest to lower debt service across the board. Pledged Supplementary Lending, Medium Term Lending Facility, et al, are all expansionary open market operations designed to improve liquidity and lower borrowing costs. Third, the PBOC is encouraging a wide ranging rebalancing of where credit is deployed in China. Currently, corporates and local governments are over leveraged whereas small and medium enterprises are starved of credit and consumer credit while growing is yet small. The government's local government debt swap, essentially refinancing local governments' high debt service off balance sheet liabilities to lower cost, more transparent, on balance sheet municipal bonds is not only lowering the debt burden for local governments but is improving credit quality for creditors the large extent of whom are the country's commercial banks. The municipal paper also serves as capital efficient eligible collateral for the PBOC's repo operations.
The above led me to the opinion that China equities were a good investment. The question is, why did the market fall so much and what is the current prognosis?
Why did the market fall so much? When the tech bubble burst in 2000, Nasdaq fell 75% over the space of 3 years. The S&P, however, was not immune and lost 45% in the same time frame. There is a tech bubble in China. The ChiNext market has fallen some 42% since June; in the same time the Shanghai Composite has fallen 32%. ChiNext PE ratios were at 130 while the Shanghai Composite traded at 26X. Retail investors and margin investors which include corporate investors led to a bubble in some sectors which are now bursting. Margin calls are causing leveraged positions to be unwound.
What do I think of what the Chinese government is doing to support the market? In the face of collapsing markets, governments around the world and throughout history have always sought to intervene. The Americans did in during the Great Depression, they and every major economy did it again in 2008. Ireland bankrupted itself saving its banks. The question is, will it work? The answer, today in China as before in America and Europe and Japan, is no. The market must find its level. All bailouts do is delay the process of finding that level. Even the current state of the American and European markets is one where the overhang from 2008 has not been fully worked out. In the short term, market intervention can arrest a falling market. China of all countries has the financial firepower to support markets. One feature of note is that there has been no contagion. Credit markets remain stable and open, the currency is also stable. The weakness in the equity market has been isolated to just the equity market. Longer term wealth effects may take hold but these are likely to be less of an impact.
Do I think that the Chinese market intervention represents a setback to the reform efforts? Given that the intervention in markets is no more intrusive than the actions of the Fed or the BoE or the ECB in 2008, I think not. I think the Chinese government will continue with market and political reform. The reform will just have to be adjusted around any bailouts of the equity or bond markets. Just like anywhere else. China's reform efforts are not based on altruism or a change of philosophy. The Communist Party sees the reform, the change to rule of law as opposed to rule by Party, as a strategy to avert an existential threat to the Party in the face of a maturing populace. It will not stop now.
What is the current prognosis? Have I changed how I think of the Chinese equity markets?
Yes. I think that fundamentals are poorer than I thought and that part of the reason is the sharp fall in equity markets. Retail investors' margin trading participation was manageable, circa 8.8%, in relation to the total market capitalization. What I have no transparency into is the magnitude of leverage exposure in corporates. A common means for smaller companies to raise debt is to provide their equity as collateral. This type of activity was prevalent in the 1980s and 1990s in South East Asia. Now if the proceeds of these loans are used to invest in operating assets then while the capital structure of the business may be weakened, the operational model is not. If, however, companies invest proceeds in the stock market then clearly there is a serious issue with business models. Companies in South East Asia prior and up to the Asian crisis in 1997 were engaged in these investment practices. While not all companies did this, it introduced a feedback loop which greatly increased volatility in earnings, balance sheets and equity market pricing.
I do not see much more downside. I think that the Chinese government will not countenance lower prices as it would destabilize the real economy. Also, if my suspicions about where some companies have been deploying their capital, in financial assets rather than in operational assets, then the government will have to address the issue of corporate balance sheets and put a floor under equity markets.
I do not see too much upside. When the PBOC expanded policy in 2014 it was its intention to boost the real economy and lower borrowing costs specifically for local governments and small and medium sized enterprises. It was not its intention to inflate the equity market. In fact the PBOC recognized that the rising equity market was at some level when valuations outran fundamentals an undesirable side effect of its expansionary policy. Unfortunately, its attempts at deflating the equity market, and there were several attempts, were not sufficiently determined and a bubble inflated. The government will not allow another bubble to inflate and will therefore likely introduce cooling measures if equities should rise sharply or substantially from current levels. The behavior of the currency makes a good example of how the market can be subdued by sufficiently determined policy. The A share market is still only semi-open and thus can be supported or indeed suppressed by policy.
On June 26, had Greece agreed to these terms a deal would have been done. Instead Tsipras calls a referendum and seeks a No vote from his people. Before the vote, Tsipras goes back to the Eurogroup to accept the terms. Merkel says that they have to wait for the referendum since Tsipras would, in the spirit of democracy, have to respect the Greek people's decision. The people give Tsipras his No vote. He comes back to the table effectively accepting the creditor terms (in the June 26 proposal) confounding the No vote he had obtained at home.
This behaviour gives a clue to what it must have been to negotiate with Tsipras and Varoufakis in the preceding 6 months. Varoufakis probably resigned when he discovered Tsipras was going to accept the creditor terms after the No vote.
The behaviour also explains why Germany may be sceptical about the representations of the Greek government. If the Greeks agree to the bailout terms, there is no guarantee that they will comply with the very terms they have agreed. A logical strategy is to ask Greece to leave the Euro, provide Greece with some level of support, but require Greece earn its way back into the currency union.
On a slightly separate note, I think the Greek experience has shown that the world needs a better sovereign bankruptcy process and a better definition and design of sovereign capital structure. I would like to see the emergence of a sovereign covered bond market with claim on sovereign assets as well as a sovereign ABS market where default would result in the assignment of portions of tax receipts to creditors or tranched ABS where cash flows are prioritized over tranches in a waterfall structure and additional cash flows are used to capitalize sinking funds under the negative control of creditors.
Greece will conduct a referendum on July 5 regarding a creditor plan of reorganization. The referendum is framed as a Yes/No vote to either accept or reject the creditors' proposals.
1. The vote as it is framed is strictly about accepting or rejecting the creditor proposal. However, the consequences of either a Yes or a No go beyond the creditor proposal, they go to whether Greece intends to be a part of Europe, or not.
2. There are a number of scenarios:
a) Yes. Tsipras government resigns. A new government will have to be formed which is happy to comply with the referendums implications. Financial and liquidity support will resume and details of a bailout will be finalized and implemented.
b) Yes. Tsipras government does not resign. Syriza has campaigned for anti-austerity and recommend the people vote No so a Yes vote would destabilize the government. It is unclear how the creditors will proceed in negotiations with Syriza. Syriza would have to honour the implications of the Yes vote and negotiate accordingly. The ECB may not be as quick to lift the suspension of ELA and negotiations would have to continue to finalize details. These negotiations could be problematic if represented by Syriza.
c) No. Tsipras government will have a strengthened mandate. The ECB would certainly ringfence the Greek financial system and maintain suspension of the ELA. Greece may be explicitly removed from TARGET2 which would isolate its financial system. There are many possibilities under a No vote since it would imply chaos and a likely exit of Greece from the currency union and perhaps from the European Union as well.
3. Short term effects: Equity markets will likely react well to a) above. The uncertainty of b) above means that any upside is likely to be fragile. Volatility could persist until a clear deal could be reached. In c) above the immediate impact will likely be a sharp sell-off as investors seek to de-risk and avoid any potential Black Swan events. "We know how bad it is and it ain't so bad, but we don't know what else we could have missed…" would be the likely thinking. European markets are still on average about 10% in the money year to date and investors will want to protect that.
4. European equities will correlate closely with BTP and BONOS spreads versus Bunds in each of the above scenarios. For 30 year BTPs, spreads could tighten below 100 under a) or languish in a 100 – 150 range under b). Under scenario c) the immediate impact could be big. Spreads were over 400 in 2011 but with the ECB's OMT, QE and LTRO operations a widening to 200 would be extraordinary and would be a trigger to buy the spread. A similar analysis applies to 30 year Spanish spreads.
5. Longer term positioning.
a) Scenario a) provides Greece a lifeline. Depending on the final nature of the bailout the outcome could be long term negative for Europe, if for example, the creditor plan was unrealistic, draconian and would cause Greece to require another bailout in a few years' time. A realistic deal would see some form of debt write-down with conditions to rehabilitate the Greek economy. Such a scenario would be long term positive.
b) Scenario b) could not realistically play out over the long term since the raison d'étre of Syriza was anti-austerity.
c) Scenario c) presents the most interesting long term investment opportunities.
I) The Greeks might soften their demands but the probability of this after a No vote is small. The probability that the Eurozone would soften their demands following a no vote is similarly remote given the contagion risk of moral hazard to Spain, Italy, Portugal.
II) Greece is already de facto in default and a No vote would formalize this. Negotiations would begin, or in this case, resume, with creditors. In this case, creditors would be quite powerless to negotiate for anything except to eject Greece from the union and suspend all aid. Keeping Greece in the greater union but not the Euro would provide a template for subsequent member exits and is therefore unlikely to be supported by Germany or France.
III) Greece would have to mint its own currency, which would probably depreciate some 40%-50% instantaneously. Some form of capital controls will be needed to ensure the success of the new currency.
IV) At this point but not before, Greek assets and legacy debt might present value.
There are reasons to be optimistic about the Chinese economy in the long run due to structural reform. Current growth rates will slow but China is reorganizing itself to a more durable model.
Political reform, notably the leaning away from rule of Party to rule of Law. The renewed importance of the Chinese constitution.
Economic reform. Refinancing the local governments, lowering debt service costs. Rebalancing leverage away from over leveraged local governments and corporates towards households and central government.
Financial market reform. The introduction of market discipline such as fewer bailouts and thus more use of the bankruptcy code.
The PBOC is in the midst of expansionary policy.
QE lite via LTROs with muni bonds as HQLA collateral.
Cutting interest rates
Cutting RRR.
General deregulation of the banking and savings industry.
This will favor the banks.
The stock market has been very volatile.
Valuations in parts of the market have overshot fundamentals.
The market has simply run up too high.
IPOs are sapping fund flows.
Not all parts of the market are overvalued.
HSCEI is trading on 9.4X 2015 est earnings.
SHCOMP is trading on 17.5X
Shenzen is trading on 36.9X
ChiNext is trading on 97.2X
Today we take a look at IPO activity.
Market capitalization is rising faster than SHCOMP due to the increased volume of IPOs.
June MTD China announced IPOs total over 75 billion USD (as at 26 June). This compares with an average of 27 billion per month for the last 12 months.
We estimate the 12 month cumulative IPO volume as a percentage of market capitalization in the second chart below*. IPO volume is definitely diverting capital away from the market.
Chart 1: Normalized Market Cap, SHCOMP and IPO issuance.
Chart 2: IPOs as a percentage of Market Cap. 12 month moving sum.
The behavior of the EUR may have been confusing. If we look at the daily volatility since the Greek situation began its crescendo we have seen the EUR weaken on good news (of a deal) and strengthen when there was bad news (of no deal.)
This is not so irrational. Notwithstanding any plan for retaining Greece within the Euro, Greece's business model is not working. Current plans for reorganization from both creditors and debtor do not present Greece as a going concern. Therefore, retaining Greece in the Euro must be negative for the EUR and lead to weakness, while a Greek exit would remove a source of uncertainty, inefficiency and cost from the Eurozone which is positive for the EUR.
How rational are markets? We often expect markets to react to bad news badly, regardless of the underlying logic. Could this be a case where the market is being remarkably rational?
If you were careful, responsible and diligent and didn't overextend yourself buying that big apartment in the prime central area and the second apartment to rent out, but maintained a reasonable debt to income and debt to equity ratio, you did OK but you certainly didn't do as well as the guy who bought bigger than he could afford, was less than candid on his loan application for his buy-to-let in prime central, levered himself to his eyeballs and got bailed out when central banks the world over cut rates and did whatever they possibly could to ensure that a free market selection process for weeding out imprudent risk takers was confounded and conservative and responsible investors were disadvantaged.
The interventions and bailouts were entirely unfair. The bailouts were sold to us by the governments that the investment banks had the world over a barrel and that Wall Street had Main Street as hostages and human shields.
And now we are told (in a Bloomberg article Jun 18, 2015) that As the Rich Bounce Back, the Middle Class Stays Stagnant.
When income and wealth inequality are moderate, there is less motivation to challenge the status quo. However, at some level of inequality, when the bottom half of the population by wealth ask themselves what the probability is that they and their children might progress to the top half through diligence and effort, and the answer is pretty low, then change may come.
India is an interesting market. Modi's election success boosted equity markets but lately delays in reform have stalled the market which is some 10% of its 2015 highs.
Near term the economy is slowing but long term potential remains strong.
India has strong demographics with the working age population rising as a percentage of total and is expected to peak only some 20 years from now.
The urban population in India is rising at an accelerating rate and per capital income is rising.
Current GDP growth is 7.5% YOY. Inflation is 5%. With a 2 trillion USD nominal GDP economy, India has plenty of room to grow.
India has for a long time had strong growth potential but was held back by excessive bureaucracy, corruption and inefficiency. A reformist government may unlock this potential.
The Modi government has a strong mandate with 282 out of 543 seats in parliament making it the first simple majority government since the Congress government in 1984.
Modi's mandate is growth and development. He has been a good Chief Minister of Gujarat with 4 consecutive terms and has shown talent as a strong CEO.
The government is addressing a number of areas for reform:
Ease of doing business, moving to on line licensing and rationalizing other administrative functions.
Improving the investment climate, for example increasing FDI limits in selected industries like insurance, defense and railways, circumventing potential for corruption through more transparent processes, and more government co-investment in infrastructure.
Fiscal policy, to continue fiscal consolidation and removal of price distorting subsidies, for example in energy and transport, and to make government expenditure more efficient.
Taxation, simplifying the tax code, consolidating state and federal taxes into a single GST, expected to be circa 20% - 22%, also lowering corporate taxes from 30% to 25% over the next 4 years.
Banking and financial services, take for example the roll out of formal banking services to the general population (target circa 110 million new accounts), and the further augmenting of the bankruptcy law (last week creditors were granted rights to wrest control of management of defaulting companies.)
Corporate sector and Markets:
RBI has made 3 rate cuts this year, most recently 2 weeks ago to take the repo rate from 7.50% to 7.25%.
The Indian market is dominated by private sector business with SOE's conspicuously absent. Companies are entrepreneurial and therefore capital and asset efficient.
Long run ROEs are 17% compared with 11% for the rest of the world and 12% in emerging markets.
Current ROEs are circa 15% and EBIT margins are around 10% which are cyclical lows.
Market PE is 16.3X which is at the long term average. The market is relatively cheap considering that corporate profitability is at cyclical lows.
Things always take longer than planned or expected in India. This is one of the consequences of India's democracy and bureaucracy. For example, the GST bill is facing opposition in Parliament and will only be reintroduced in July. It is expected to be passed during the monsoon season.
While bureaucracy is being rolled back and even civil servants are optimistic about the progress legacy issues remain. Take for example the retroactive nature of the Minimum Alternate Tax which has caused much confusion and is still in resolution.
Inflation may yet rise. The monsoon can affect near term inflation through food prices. India is energy dependent and affected by the oil price. We expect the oil price to remain capped and that long term the oil price will not appreciate significantly.
Infrastructure remains poor despite the stated aims to increase infrastructure investment.
INR exposure is difficult or costly to hedge. Interest rate differentials imply FX hedging costs between USD and INR to be circa 7%.
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