Madoff is not representative of the hedge fund industry

The Madoff Fraud is bound to have investors running from hedge funds. However, one should realize that Madoff was not structured as a typical hedge fund. The Madoff structure was unique, and allowed ample latitude for fraud.

Investors in Madoff:
-Did not buy shares in an offshore entity advised or managed by Madoff.
-Did invest in an offshore entity which in turn placed funds in a brokerage account.
-Had the said brokerage account held at Madoff Securities.
-Therefore had their assets custodied, managed, executed and reported by Madoff Securities.
-Lost an independent source of information and were thus vulnerable to fraud among other things.

The typical hedge fund is structured as follows:
-investors buy shares in an offshore entity.
-the entity would appoint an independent custodian to hold its assets.
-the entity would appoint an independent administrator to manage it on a day to day basis, such management to include the calculation and determination of the gross and net asset values.
-an investment manager would manage the assets of the entity.
-the investment manager would execute trades through independent third party brokers.
-the investment manager would not be able to operate the bank accounts of the company or limited partnership without the involvement of the third party, independent administrator.
-the company or limited partnership would engage reputable and independent third party auditors.

It is sad that a long standing and prominent member of the hedge fund community has succumbed to fraud. The reputational impact to the industry is significant, however, with time it is hoped that investor faith will be restored.

It is likely that the Madoff Fraud will precipitate certain changes in the industry. Whether these changes are useful or not is not the issue.

-Investors will lean towards having managed accounts.
-This will allow them to use service providers and counterparties of their choice, or at least influence the choice of service providers and counterparties.
-A managed account will provide investors better transparency as well confidence.
-This will allow them to live test the portfolio from time to time, albeit at a cost.
-Bespoke mandates eliminate style drift and allows better segregation of risk factors.
-Places control back in the hands of the investor.

Strategies for 2009

Strategies for 2009


Distressed Asian Convertible Bonds
Long only and unlevered
Closed end fund format
Asia has performing assets at distressed prices
Distressed investors, not distressed issuers
List of quasi sovereign issuers – which can later be hedged with sovereign CDS when counterparty risk is settled
Currently poor liquidity – market likely to return albeit smaller than before
Full exposure to credit default risk

Distressed Convertible Bonds
Long only and unlevered
Closed end fund format
Distressed investors purging convertible portfolios has created distressed pricing
Currently poor liquidity – market likely to return albeit smaller than before
Full exposure to credit default risk

Bond Basis
Long cash bond long credit protection through CDS
Closed end fund format
Wholesale deleveraging from cash bond investors has created arbitrage opportunity
Open to CDS counterparty default risk

Distressed Debt
Long biased
Closed end fund format
Recession has accelerated default rates
Technical selling pressure has created distressed pricing across performing and non performing assets

Capital Structure Arbitrage
Long Short
Closed end fund format
Technical selling has created arbitrage opportunities intra issuer
Long senior short sub – positive jump to default at low to non negative cost / no negative jump to default at positive carry

Capital Structure Arbitrage Distressed
Closed end fund format
Long short
Recession has accelerated default rates
Long fulcrum security – converts to equity
Short most senior non recoverable to hedge non-default spread duration

Trade finance
Open ended fund
Senior secured, over collateralized, liquid collateral, commodities or commoditized goods only
Acute shortage of capital has improved margins
Secondary market opportunities
Particularly attractive in emerging markets

Receivables finance
Open ended fund
Acute shortage of capital has improved margins
Shorter duration assets
Structured with limited recourse
Obligor / credit risk arbitrage

Deep value equity
Long biased / Long only
Open ended with lock up
Wholesale de-risking has created attractive valuations even under recessionary assumptions
Strategy variant: buy out (which would require either a closed end or long lock up fund)
Strategy variant: activist (financial restructuring)

Merger Arbitrage
Open ended with lock up
Value is available and there is a good proportion of corporates with cash
ROE and valuation differentials encourage cross border deals
Developed world acquirers, developing nation targets
Cross border skills required


Most of the above strategies would not survive a run on the fund situation and hence require a closed end structure. They are also vulnerable to mark to market divergence and thus should not be leveraged with a prime broker on standard terms. Many of these strategies could be leveraged if one could term finance the trade bundles and lock in financing rates.



Strategies I would be less inclined to recommend:


Convertible arbitrage – gamma or carry
Needs borrow that may be hard to get
Needs leverage that is hard to get
CBs are trading through their bond floors – no gamma

Risk Arbitrage - traditional in country
LBO deals are dead
There is no finance to leverage the large private equity buy out deals

Equity/Credit market neutral
Valuations not supportive of shorting
Broken business models in industries at risk of bailout
No liquidity in other shorts

Longer duration direct lending
Cyclical strategy – cash flow predictability is poor
Although spreads are highly attractive
Attractive only if it is the intention to acquire the collateral
Default rates likely to rise

Volatility – Long Biased
Long vega game is unlikely to continue to pay
Long gamma is opportunistic

Madoff

Last week Bernard Madoff decided to throw in the towel on his own Ponzi scheme and confess to one of the largest cases of alleged fraud in the hedge fund industry, known to date. The list of direct investors includes astute and reputable investors. The details of the scheme are as yet unknown but the opportunity for fraud and the vulnerability of the structure of the fund is immediately apparent and indeed has been apparent to investors since inception. In fact, the fund documents are transparent as to all the structural weaknesses of the fund.

How does one invest in a fund managed by Madoff? Unless one has a sufficiently large checkbook, the only way to invest is through a feeder fund. Madoff’s business model is based on scale and to this end, rather than have in house distribution and marketing, Madoff uses intermediaries to raise capital in what is sometimes known as white labeled or private labeled products. An intermediary sets up a fund and raises capital for that fund. This fund then invests substantially all of its assets in a ‘fund’ or more accurately in the case of Madoff, a managed account managed by Madoff. Typically in a white labeled agreement, a feeder fund invests in a master fund. That is, an investor puts money in the feeder fund. The feeder fund then invests that money in the master fund. Corporate governance requires that each fund will have its own investment advisor, independent administrator, prime brokers, custodian banks, auditors. In the case of Madoff, the feeder funds did have their own investment advisor, independent administrator, prime brokers, custodian banks, auditors. The master accounts with Madoff Securities, unfortunately, did not.

In the typical structure of a Madoff run fund, the white labeled fund into which the end investor puts their money would have a reputable independent administrator, custodian, auditor (usually one of the big 4). The investment advisor would be the sponsor (and marketer) of the fund. The fund, however, would establish an account at Bernard L Madoff Investment Securities Inc, a registered broker dealer it should be noted, who would trade the account. The prime broker and custodian of the fund would also be Bernard L Madoff Investment Securities Inc. And here the independence is lost. Without independent oversight, the opportunity for fraud became abundant. One should note that the structure itself was not the fraud, it was the weakness in control that the structure introduced that provided the opportunity for fraud.

The marketing materials of many of these white labeled funds would often refer to the transparency that they were getting from Madoff Securities, and there is no reason to doubt this claim, however, one should question the value of receiving said transparency from a custodian which was a connected party to the fund manager.

In a sense, the white label sponsors were conspirators after the fact since it would have been very difficult to perpetrate a fraud without their involvement. An investor investing directly with Madoff, had there been such a fund offering would have seen the weakness of not having an independent custodian, let alone prime broker, let alone administrator. The auditors would have had to face individual investors for each and every round of due diligence. Too often, an end investor gaining access through the white labeled fund would have seen only the service providers of the white labeled fund and been satisfied with the quality of these service providers without delving further and asking the same questions of the managed account at Madoff.

At the heart of the problem is NOT a failure of due diligence, since the weaknesses of the structure were fully disclosed in fund due diligence materials and offering memoranda. There was no effort to misrepresent the structure or to cover it up. Investors therefore invested with full information or at least access to sufficient information to make an informed judgment. Why would reputable sponsors attach their reputations and fortunes to a deficient structure, and why did end investors knowing invest?

Some investment strategies for 2009

Closed end funds:
Fund structure mitigates investor risk
Suitable for arbitrage strategies
Suitable for relative value strategies
Suitable for distressed and private equity strategies
Lends itself to efficient and risk controlled deployment of leverage
Technically complex strategies which rely on multiple trade legs

Distressed investing:
Current cycle is attractive for distressed investing
Distressed assets and distressed pricing in developed markets
Distressed pricing and performing assets in emerging markets

Recovery strategies:
Distressed strategies are a subset
Deep value equity
Deep value credit

Direct lending:
Dearth of credit, easy or otherwise
Banks are retrenching from the market
Spreads and margins are priced for distress despite strong and performing obligors
Bespoke deal structures to mitigate specific risks
Trade finance

Stale strategies:
Short or market neutral credit
Short or market neutral equity
Long volatility - vega
Systematic global macro

Fresh strategies:
Long equity
Long credit (including CBs and private CBs)
Capital structure arbitrage
Distressed investing: control over asset
Factoring, receivables finance, trade finance
Fixed income arbitrage
Risk arbitrage – cross border strategic

Convertible Bonds

An opportunity exists today for a long only buy and hold strategy. The strategy is vulnerable to further mark to market losses but a strategy of investing in CBs from a credit point of view, as opposed to an equity arbitrage point of view yields interesting opportunities. Things could get cheaper next year, and indeed the way economic fundamentals are deteriorating this seems likely, but current pricing is already very attractive for the investor who can buy and hold.

Note that the classic convertible arbitrage construction doesn’t really work and one has to take on both the open equity and credit risk. Neither can one lever the portfolio, not that one needs to. Stock borrow, restrictions on shorting, terms of borrow make delta hedging a potentially futile exercise. Some converts are trading distressed to the extent that while a non zero delta has re emerged, convexity is no longer positive. Credit hedging the CB runs into all sorts of prime broker counterparty risk, and the correlation between CBs and straight bonds let alone CDS is broken at the moment. This makes life simpler, actually, since if one has the resources in credit analysis, there is no need to hire a hedge fund manager.

A Currency Call

Commodity prices are overly depressed. See post 27 Nov 2008, A Quick Macro Overview.

Buy AUD, sell USD. 

Central Planning

Why is it a bad thing for a central planner to allocate resources in an economy? The Soviet experience is one example. Underlying it is the lack of alignment of interest between principal and agent. If one does not reap the benefits of one's investment decisions, those decisions are bound to be less than optimal. A central planner will never offer a better solution than rational independent agents making private decisions. 

In my previous posts, I have argued that the setting of interest rates by central banks is already a dangerous compromise to the principle of a free market. So, given that we have made that compromise, and the moral hazard that resulted has taken us in no small part to where we are today, a financial crisis feeding and fed by economic recession, lets ask a couple of silly questions. 

Why is it a bad thing for a central planner to lend directly to private consumers and private enterprise? From our initial premise, it is equivalent to allocation of resources, in this case financial capital. It presupposes that the central planner has sufficient information and motivation to act in the best interest of the collective (always a dangerous concept), and isn't too clumsy as to make too many mistakes.

Today, however, credit spreads have widened to acutely high levels, despite central banks liquefying the banking system. Banks which previously lent in greed, now withhold credit in fear. We know that a central planner is sub optimal compared with rational agents and their private decisions, but what about timees when agents are irrational? (again calls for a very tenuous definition of rational and irrational.) 

When government chose to bail out the financial system in the Fall of 2008, it had already abandoned the idea of free market solutions. It must have concluded that a climate of irrationality, or, where individual rationality conflicted with collective rationality, existed. Its efforts included a massive liquefication of the banking industry, an effort that has so far proved futile as banks have saved the liquidity and placed the capital back with the central banks. The intention to get the banking industry to lend once again has been foiled. 

If the premise remains that a climate of irrationality, or ,where individual rationality conflicted with collective rationality, exists, central planners should be happy to extend their abandonment of market solutions. 

Lend directly to private individuals and enterprise. 

That is the conceptual argument. The devil is in the details. More on this later. 

A quick macro overview

Economic data is pointing towards a global recession deepening in 2009. The scale of the slowdown in economic activity, the damage done to the banking system, the losses accumulated in residential real estate and the impairment of household balance sheets call for extraordinary policy measures. A more or less global though not entirely concerted policy for dealing with the ailing banking system is already underway. It is not working as well as expected or intended. Similarly, monetary policy has become more accommodative globally in an effort to revive rapidly slowing economies. Monetary policy on its own is insufficient as it addresses the ability and not the intention to spend or invest. In a slowing economy, it is individually rational to increase saving at the expense of consumption, and to cut back on investment in capacity, even though it is collectively irrational to do so. Enter government. Governments will have to spend and invest on behalf of households and companies to stabilize economic growth. This approach addresses demand directly but is not without its risks. Developed markets now operating below full potential output, are less at risk of direct crowding out. Inflationary risks are another matter and may raise funding rates to cause de facto crowding out.

There are several ways to fund fiscal reflationary efforts. Taxation is one. Developed world taxation is already high and the scope for increases is limited. It is risky to argue that increased economic activity may result in increased tax receipts. More immediately, cutting taxes may be a necessary element in fiscal deficit spending. Raising taxes on the rich has limited use as the rich are a marginal taxpayer given globalization and the prevalence of tax arbitrage. Another way of financing fiscal deficit spending is of course borrowing through the issuance of public debt. This can create the so called crowding out of private investment. A third way, is seignorage, which is of course inflationary and historically untenable. This may not be the case today and a range of options may be a more appropriate approach. There is another way, which is enterprise and investment, a technique established in the form of sovereign wealth funds. It is unlikely that deficits will be funded by taxation in the middle of a recession. If so, it might take the form of highly targeted taxation, or cosmetic taxation, such as an increase in marginal taxes on the rich. If anything, marginal tax rates on consumption and lower income earners is likely to be reduced on the rationale that the marginal propensity to consume out of income decreases with increasing income and wealth. This would have a negative impact on tax receipts. Financing deficit spending through the printing of money is directly inflationary but has the advantage of immediately supporting asset prices as well. The cost is in a weaker currency both internally and externally. The inflation cost can be high and depending on the prevailing inflationary conditions might not be viable. The most natural route is financing deficit spending through borrowing, preferably from future generations. This is the most likely approach most nations will take. The impact in the US for example is higher interest rates. Once again, the crowding out effect is unlikely to bite as the US economy is clearly below potential.

A word about inflation ex policy. We have seen the path of the oil price rising from 20 USD per barrel in 2001 to 147 USD per barrel in the summer of 2008 before falling below 50 USD again. Similar patterns are seen in coal, metals, ags, softs, energy. Markets overshoot on both the upside and downside. The equilibrium price ex speculators, that it paid for by people who would like to burn the oil is probably in the 70 – 80 USD range. At these prices, inflation does not decline as much as policy makers would hope. Alternative sources of energy are not commercial once development costs are included. US CPI inflation would probably settle at around 4% while PPI inflation might be slightly higher from 4 – 6%. These levels are not overly concerning but they are not low by any means. (As an aside, if inflation does increase, the need for pensions and endowments to meet their obligations will likely bring them back into the market for risky assets). All this assumes of course that in the course of fiscal reflation, banking bailouts and other extraordinary measures, governments do not debase their currencies.

If currencies are debased, such as in banking bailouts or where fiscal deficits are funded by printing money, for example, inflation pressures will be exacerbated. The likely candidates where this scenario is likely can be found by an examination of public finances. This is a different analysis from looking at sovereign balance sheets. Developed countries with budget deficits will likely be in this group. They will likely face weakening currencies and inflationary pressures. This could lead to a vicious cycle of rising commodity prices and rising inflation. Currently this is a contrarian view. A little inflation, however, is a good thing. Deflationary recessions maintain and inflate the real value of debt.

Monetary policy across the globe is currently extremely loose, and, given the expected depth of the slowdown, interest rates are likely to be driven further down to zero. This is likely to result in steep yield curves as public debt issuance is increased and inflation expectations are revived. Generally, the market expects little to no inflation and there are even expectations for deflation risk. It is likely that there will be volatility at the long end of the curve. The likely evolution is an early 1980’s yield curve as the expectations oscillate between inflation and recession.

Apart from developed countries where economic dogma eschews the direct allocation of credit by a central planner, developing countries do have the option to lend directly where their banking system may be paralysed. In particular, in Communist countries operating market economies, the banking system can be directed to lend. Without the burden of economic dogma, certain countries have full freedom to deploy a host of economic tools to revive their economies. They can spend on behalf of consumers, they can put cash in the hands of consumers, they can invest in place of companies, they can print money to finance fiscal deficits, they can borrow to create a normalized yield curve and provide the banking system with a carry trade, they can tax selectively and tactically to synthesize inflation, if it was called for, they can invest in infrastructure, in improving the capital stock, in improving the knowledge base, in human capital. These measures may terrify the free marketer, but ever since the slew of blanket bail outs and ad hoc rescues in the West, criticism is unlikely to arise from those quarters.

A global recession seems unavoidable given the scale of leverage and excess as the global economy drifted into 2007. However, there exist the tools to soften the blow. Most of these tools run counter to the prescriptions of free market economics. The challenge will be the restoration of order and a proper market mechanism once conditions normalize. One of the failings of the system that was at least in part, and possibly in large part responsible for the excesses of the past few years has been the moral hazard created by the US Fed in particular in underwriting the economy and asset markets. More generally, one can extend the critique to the existence of an institution that unilaterally determines the price of money, the central bank, undermining the concept of an efficient money market. Unfortunately, the rescues that are mounted today move us further from a free market and therefore entrench the regulators where in fact the regulators should have their powers diminished. This is likely to create new and greater imbalances and thus sustained uncertainty and volatility in the future. In certain cultures, however, there is the concept that uncertainty is the mother of opportunity.

Trading and Investing

You cannot do it solely for the money. If you do, one day it will hurt you so badly you can't go on.

You have to deal the cards as a meditation. It can't be done for profit, it can't be done for respect. It's done to find the answers, to discover the sacred laws of chance.

Relief Rally

In 1997, when the Asian Crisis broke, equities tumbled in a flurry of panic selling. Markets were down between 60 - 70% in the first downdraft. When Asian governments rushed to bailout their banks and corporates the market found its footing and rallied between 50 - 100% as disbelief was converted to relief.

All the financial engineering and arm twisting could not address the broader more deep rooted causes of the crisis and with time markets began to price in fundamentals. Asian market made new lows, between 20 - 50% lower than the 1997 lows.

2008 is a bit different. The scale is different. The world economy is in a synchronized slow down. But the psychology that drives markets is pretty much the same. Complacency, fiddling while Wall Street burns, somewhere there is a whiff of smoke, it turns to panic, the panic spreads, soon the fire is the least of concerns as a stampede for the exit begins, the fire is put out, order returns, people cheer, and then somebody looks at the ruins. Eventually, however, the rebuilding begins.

As an aside, in 1997, as Asian governments nationalized parts of their economies, forced consolidation upon the banks, spent the public coffers on bailout plans, the IMF, the developed world and every academic worth his publications condemned these non market solutions that would doom the region to failure after failure.

Hedge Fund Redemptions Dec 2008

Hedge funds will face massive redemption requests for 31 December 2008 as investors seek to reduce risk across the board. This is an unprecedented position for the industry. Hedge funds often face liquidity mismatches in that there are positions with longer duration than the redemption intervals offered by these funds to their investors. They can therefore only meet a portion of redemptions should everry investor redeem fully from the fund. In case redemptions exceed a certain proportion of total assets under management, hedge funds have mechanisms which limit redemptions (called Gates), or have the right to suspend redemptions. Another failsafe is the right to meet redemptions in kind, that is delivering securities held in the portfolio, to redeeming investors.

Fund of hedge funds are in a similar if not worse liquidity mismatched position as hedge funds.

As investors redeem from funds of funds, they in turn are forced to redeem out of the hedge funds they invest in.

Hedge funds provide liquidity on a monthly, quarterly or annual basis. Some have lock ups ranging from 1 year to 5, but few have more than 3. 10 years ago, most hedge funds provided monthly liquidity. Today, most funds have at best quarterly liquidity and the number with lock ups has also increased.

The industry is today caught in a Prisoner's Dilemma. Performance of the hedge fund notwithstanding, the expectation of redemptions incentivizes investors to redeem. Stable holders aim to redeem ahead of weak holders so that individually rational decisions lead to collectively irrational outcomes. Extrapolation leads to the conclusion of mass redemptions leading to closure.

For the hedge fund manager who has performed poorly, there is no escape, and closure is inevitable. Their security strategy, is to do nothing, face the flood of redemptions requests and either gate the fund or suspend redemptions.

For the hedge fund manager who continues to perform well, there are various options. Their best strategy is to communicate with their investors and to manage the investor base.

For too long, hedge fund managers have neglected the management of their investor base. For a company structured with variable capital, this is a necessary and crucial part of risk management since capital can be withdrawn. Leverage is a function of capital and can increase precipitously if capital is withdrawn.

For the hedge fund manager, a prudent strategy would be to communicate with their investors so that the majority of their capital can be secured. This should be done before assets begin any substantial decline, before any substantial redemptions are submitted. The investors, in effect shareholders, should be presented with a strategic plan for either supporting the fund as a going concern, or an orderly liquidation. In any case, a suspension of redemptions would be a likely feature of the plan, as well as time line for which to either lift the suspension or liquidate the fund. A number of hedge funds have done this, albeit when their assets have declined severely, and redemption orders have flooded in. A pre-emptive coordination with investors preserves the reputation and franchise of the hedge fund manager.

September 2008 and Beyond

Short Term:

· The consensus expectation is for recession and a hard landing particularly in US and Europe with a protracted trough before recovery. There is some disagreement over the outlook for emerging markets but sentiment is beginning to deteriorate. The short term, however, is a poor guide for the medium to long term.

· All markets are trading on liquidity and not on fundamentals. Opportunities abound for the unlevered investor.

· Market attention was focused on the proposed Troubled Asset Relief Program, a 700 billion USD bailout of the US banking system. The substance and material impact of the Program is limited and the majority of its utility was in shoring up confidence in the financial system. Debating the Program and delaying it has blunted its signaling value.

· The hedge fund industry is facing large scale redemptions starting first from investors exiting funds of funds, and funds of funds redeeming from their hedge funds to meet their redemption needs. Most funds have calendar quarter redemption dates and the September redemptions have been known for some time. Aggregating the outflows from the annual redemption funds with those that are quarterly and monthly, implies that December will be a highly risky month for hedge funds and the markets in which they invest, as gross exposures are reduced in large scale. It is expected that a significant number of hedge funds may not survive.

· A large number of hedge funds will be suspending redemptions. A Prisoner’s Dilemma situation now exists where strong holders need to redeem ahead of weak holders. Hedge funds will not have the liquidity to meet the expected volume of redemptions.


Medium Term:

· Falling stock prices and house prices will have knock on effects on consumer confidence and thus consumption plans.

· Increased credit spreads have raised the cost of debt and will impact corporate profitability going forward. Availability of credit from cash strapped banks will also be reduced. Demand for credit will be impacted by expectations of consumer confidence and exports which will be dampened by slowing economic growth elsewhere.

· Economic data from around the world are indicative of a severe economic slowdown. Inflation is unlikely to be a problem at least in the developed world.

· The influence of liquidity will remain for a time. However, as the velocity of capital outflow slows, asset prices will come to be driven more by fundamentals than by momentum.

· Regulatory changes almost always follow large dislocations in financial markets and recessions. One can expect the financial sector to be regulated as a public good. There is much uncertainty here as regulators do not have the best access to information, can make errors in policy, are often driven by politics before economic efficiency, and plan over different time horizons.

· The CDS markets, and more generally the OTC markets, are likely to be regulated and moved on exchange.

· Investors will take some time to regain their risk appetite. As they do, they are likely to realize the risks in liquidity mismatches inherent in various investment vehicles from hedge funds, to structured products, to banks. Many hedge fund strategies which are sound and logical, fail because of liquidity mismatches. The closed ended fixed term fund, the investor vehicle of choice in private equity, is well suited to many hedge fund strategies. One could argue that with greater certainty of outcome than private equity, and with greater certainty of maturity in arbitrage, such investor vehicles are even more appropriate for hedge fund strategies. Examples of such structures arose in 2005 in the structured credit markets, triggered by the credit ratings downgrades in the US auto sector.

· Investors are likely to be wary of highly leveraged investments and will scrutinize more closely the magnitude and structure of levered investments. Many credit hedge fund strategies are levered implicit providers of capital to the economy. Leveraged provision of credit is a strategy that has most visibly failed not only in hedge funds, but banks as well. Here lies a two fold opportunity. For the Asset Based Lender, a beleaguered banking industry provides them the opportunity to take market share and to grow in scale. For businesses, Asset Based Lenders are an efficient source of credit, providing more responsive client service, bespoke financing solutions and thus more flexible pricing. For the investor, Asset Based Lending Funds provide the opportunity to participate in the new banks, lending institutions without the excessive leverage, complex and opaque proprietary trading books, sprawling organizations and overall operational and financial complexity.

· The face of hedge fund investing will change. Before Aug 2007, hedge fund analysis focused on the skill, talent and integrity of the manager, the operational infrastructure and mostly investment issues. While the astute investor scrutinized the investor base, the importance of this consideration in the greater scheme of things was not as high as it will be going forward. Henceforth, the stability of the equity base and of funding will be a major consideration. For established funds with a long list of legacy investors, this analysis is complicated, more so than for a small or medium sized fund with an anchor seeder that has stable capital and can offer marketing support to strategically build the asset base. Risk management will include policies, limits and guidelines for funding as well as for the investor base. Transparency to the structure, if not the identities, of the investor base will be important.

September Round Up

The credit crisis that first broke in August 2007 deteriorated very quickly in September 2008. The month was dominated by bank failures and bailouts, a dysfunctional LIBOR market, free falling equity markets, failing credit markets and a general crisis of liquidity. Equities, bonds and commodities all sold off simultaneously as investors sought to reduce risk in any way shape or form. Below is a quick time line of the key events in September as the US financial system lurched precariously to the edge, where at the time of this writing, it remains.

- September 7: Federal takeover of Fannie Mae and Freddie Mac.


- September 14: Bank of America takeover of Merrill Lynch over fears of a liquidity crisis.


- September 15: Lehman Brothers files for Chapter 11 bankruptcy protection.


- September 17: Federal Reserve rescue finance of 85 billion USD extended to support AIG.


- September 19: Treasury Secretary Paulson announced the proposed "Troubled Asset Relief Program."


- September 19: The US SEC leads a number of regulators around the world in establishing a ban on short selling.


- September 25: Washington Mutual is placed under receivership of the FDIC and its assets sold to JP Morgan.


- September 28: Fortis NV partially nationalized.


- September 29: Congress votes down the "Troubled Asset Relief Program."

· Money market stress increased to unprecedented levels with the TED spread widening from 1.09% at the end of August to 3.42% at the end of September. 3 month US T bills traded briefly with negative yield.

· Currency markets gyrated significantly, with the EUR starting September at 1.463, weakening to 1.399, rebounding to 1.4866 and closing the month at 1.409. Similar trading patterns were seen in GBP and CHF. JPY traded from 109 to 104 then to 106.

· Equity markets were broadly weaker, the US markets losing between -6 to -10% depending on your benchmark. Small caps were more resilient as the sell off was driven by capital flows. European markets saw greater damage with European indices losing between -6 to -20%. Asia experienced even heavier losses, with Japan losing -14%, HK -19%, and various markets losing of the order of mid teens. Similar losses were recorded in Lat Am.

· In fixed income, the Lehman Aggregate lost -2% in the month. Credit spreads widened sharply in the final weeks of September, US AAA’s widening 1.6% on average, AA’s 1.9%, A’s 2.4%, Baa’s 3.2% and High Yield an alarming 9.5%.

· Commodities also fell as pricing started to reflect recession expectations. Crude futures fell -16%, driving the whole energy complex down by similar amounts. Base metals, softs and ags were all sharply weaker. Only gold was higher at +4.8% over August purely reflecting the degree of risk aversion in the markets.

Paulson’s address at the Shanghai Futures Exchange March 2007:

China's third challenge is a banking system which, while making progress, is still transitioning to a modem, efficient, market-driven system with proper controls, management, and professional staff. Some risk-averse credit officers may still believe it is safer to lend to state-owned enterprises backed by what they see as implicit government guarantees, rather than to dynamic small, medium-sized, and private businesses.

The continued large role of non-market factors that influence both state-owned enterprises and private enterprises - including financial services companies - stifles the dynamism of economic decision-making and the strength of regulatory integrity. Increasing the pace of privatization of state-owned enterprises would be beneficial.

the reality of the situation is that an open, competitive, and liberalized financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention.

Short Selling and Market Efficiency

A few interesting findings about short selling:


1. There is evidence in short selling activity consistent with information leakage and front-running. (Do Short Sellers Front-Run Insider Sales? Khan and Lu, June 2008.)

2. Short selling restrictions tend to be effective against negative skewness at market level but not at individual stock levels. (Efficiency and the Bear: Short Sales anad Markets around the World, September 2004, Bris, Goetzmann and Zhu.)

3. Where short sales are possible, aggregate stock returns are less volatile and there is greater liquidity. When countries start to permit short-selling, aggregate stock price increases, implying a cost of capital. There is no evidence that short-sale restrictions affect either the level of skewness of returns or the probability of a market crash. (A Study of Market-Wide Short-Selling Restrictions Jan 2005, Caroenrook and Daouk.)

4. While short-sellers take larger positions in stocks with recent price declines than in stocks with recent price increases, when the analysis is conditional on accounting-based measures of fundamental value, the positions of short-sellers in stocks with price declines are concentrated in stocks that are overvalued relative to fundamentals. (Does short-selling amplify price declines or align stocks with their fundamental values? May 2008, Curtis and Fargher.)

5. Stocks with limited lending supply and high borrowing fees respond more slowly to market shocks. Second, short-sale constraints have a small impact on the distribution of weekly stock returns. Limited lending supply is associated with higher skewness, but not with fewer extreme negative returns. Third, stocks with limited lending supply and higher borrowing fees are associated with lower R2s on average. (Price Efficiency and Short Selling, January 2008. Saffi and Sigurdsson.)

Point 1 above is interesting. It implies that someone somewhere has asymmetric (superior) information and at least some of these are short sellers.
Points 3, 4, 5 all point to greater market efficiency where short selling is permitted.
Point 2 implies that short selling has some negative impact on market returns but not on efficient pricing at the stock level. Measures that slow the momentum of short selling may correct some of the negative skewness without taking away too much from the market efficiency. An uptick rule would likely widen bid offer spreads as well as encourage smaller but more frequent trades.

Economic Consequences of the Paulson Plan

In the US:

The consumer is quite broke. Unemployment is rising. Firms have no access to credit. And now the government is quite broke too. The cost of cleaning up the banking system will fall on the government first. A budget deficit would imply austerity and a severe limitation to government fiscal spend as well as possibly higher taxes down the road.

The Fed will have to cut rates or face deep recession. Normally this is highly inflationary but given that the BRICs are slowing down as well, inflation is likely not to be a problem.

The USD will come under pressure improving terms of trade and providing some relief to the economy in the form of export growth. This will be limited by the synchronized slow down in Europe and Asia.

The recovery will take multiple years depending on the approach taken. If the scale of the bailout is big enough and the time frame is short and decisive enough, this could take a further 2 years or so to work through.

Equity markets should begin to price this in earlier but no further than 1 year in advance. Credit markets may react more quickly.

This is the good case scenario.

Market Manipulation, Nationalized.

The Fed and Treasury are putting their heads together to find a solution. They need to figure out first what the problem is beyond the symptoms we see. It is, however, a first step. Managing expectations at a time like this is as important as material policy.

It looks like they propose a system wide solution since their ad hoc measures are not working and the fairness of their process or lack of it has been called into question. It doesn’t mean that ad hoc solutions won’t be found for Goldman Sachs and Morgan Stanley. It certainly buys them time for a more orderly solution.

On the subject of bailouts, the US cried foul when Malaysia established currency controls, when HK spent 15 billion USD (1997 prices, in a much smaller market than it is today), to fend of the speculators, when Malaysia’s Khazanah bailed out the banks by buying their assets.

Academic purity reacts to all this by pointing out that:

Singapore did nothing during the 1997 crisis but emerged from recession ahead of Malaysia.

Bailouts sew the seeds of the next crisis.

The Greenspan put which was responsible in great part for the current crisis is now replaced by the Paulson put.

The intentions of the current plan look highly domestically focused and internationally myopic.

The intentions of the current plan look highly market focused and economically myopic.

The reality is that:

-Singapore was a sound economy and Malaysia wasn’t. Malaysia emerged stronger than Thailand which took the IMF’s prescribed hard medicine.

-Bailouts sew the seeds of the next crisis if lessons aren’t learnt. Bailouts are necessary so that there is enough residual industry to face the next crisis.

-The Paulson put has higher theta and omicron compared to the Greenspan put.

-It is likely that any bailout plan will be negative for the USD which would be positive for terms of trade

-It is likely that any bailout plan will be inflationary.


On the subject of banning shortselling, it will have the effect of:

-Impairing market efficiency by limiting the feasible set, this is mostly an academic objection.

-Forcing investors to sell long positions to scale risk instead of hedging whenever they want to reduce market exposure. This will have practical consequences.

-Making it hard for option holders and writers to hedge positions. The uncertainty that the restrictions introduce to derivative markets is significant.

-Lowering liquidity in the markets at a time when market liquidity is an important factor in the crisis.


Some conjecture:

The creation of some agency to purchase distressed assets from financial institutions has to be paid for. It will have to be paid for by the government. The government will have to raise cash. They will have to issue debt. Who will buy this debt? They could just auction new debt and see what the free market thinks of US sovereign risk. Given that the faith of the US government in the free market is not all that strong these days, its likely that they will need a backstop. Foreign investors may not be willing to take USD risk. US investors whether healthier corporates or individuals through asset management companies may not be willing to take that risk either. The financial institutions in receipt of aid may be asked to be that backstop resulting in a de facto swap of US Treasuries for risky assets. System wide, this would only defer the liabilities, not crystallize them. It would, however, reflate the financial institutions, providing them income bearing risk free assets in exchange for toxic waste, without relying on external price discovery.

Credit and the economy

The scale of the credit crisis is huge and current wisdom, and it is pretty convincing, is that there will be no way out for at least a couple of years more. On the other hand, US economic growth remains robust even as unemployment rises in certain sectors and retail sales falter. 

We already see that economic growth is not going to be driven by the consumer, by investment or by the government, primarily because all 3 groups have stressed cash flows and balance sheets. The one leg upon which any faster than expected recovery or softer than expected landing rests, is trade. 

How does the current credit crisis fit into this scenario? Spreads are generally wide. That makes it hard for consumers to borrow for consumption and hard for firms to borrow for investment. Libor has been very volatile indicative of the damaged integrity of the banking system. Fannie Mae and Freddie Mac are likely insolvent, and in any case are levered to extreme levels. With a combined market cap of less than 6 billion USD, 36 billion in prefs and 19 billion in sub debt, while backing over 5 trillion USD of mortgage debt, the insolvency of the GSE's is not improbable. That said, the fact that the banking industry is a large holder of prefs and that the banks themselves are large issuers of prefs, mean that any bailout will likely have to be a wholesale bailout across the prefs as well as common equity. The costs to the taxpayer, already 25 billion and rising. On top of the primary action, the CDS market, side bets if you like, total over 6 trillion USD. Aside from the scale of the financial impact, roughly half of 6 trillion since there are two parties to each swap, so 3 trillion, X whatever default rates X the residual value, there is the issue of locating the risk since CDS are over the counter, non exchange traded instruments. This could potentially create a domino effect as CDS triggers result in counterparty defaults. 

All this pretty much impacts the domestic economy, but what about trade? Trade decisions are based on relative demand and supply and comparative advantage. Trade finance while Libor based are relatively short term, fully secured against cargo and unlikely to see the extent of spread widening in corporate debt markets. While the BRICs are slowing as well, the nature of their demand is likely to evolve so that infrastructure investment begins to take centrestage. Even Socialist and Communists can be Keynesian. The high tech and capital goods and industrial supplies economies of the US and Germany are likely to profit from this, as long as the terms of trade are favorable. The Japanese solution throughout the 1990s was in part to depress prices, debase the JPY and export its way out of trouble. In the meantime, the Fed may hope that while they keep interest rates low, long term US government bond yields will rise creating a steeper yield curve and the opportunity for banks to reflate via another (risky) carry trade.

Time is what the US economy needs. For the weaker USD to take hold, for the trade balance to adjust, for tax receipts to stabilize government coffers, for export and (later) tax cuts to sow the seeds of growth in another evolution of the US economy. 

Will they be given that time?

Europe

The Eurozone recorded its first quarter of negative growth since 2003. Annual growth had peaked in 2006 at 3.3% and is currently 1.5% and slowing. The distribution of growth was not uniform with Spain and Italy clearly slipping towards recession. France and Germany continued to report stable albeit slowing growth. The UK also was slipping towards recession.

Domestic consumption saw a similar picture. Spain saw particular weakness, as did Italy, France and the UK. Germany registered robust growth. In retail sales, Spain has fallen off a cliff. Italy and France were also very weak. UK retail sales appeared to be holding steady while in Germany, retail sales accelerated.

In Exports, Germany, the UK and Italy registered steady growth. France saw some weakening. German trade balance has been in surplus and steady since 2000. In France the trade balance has been volatile, in Italy it has been steadily deteriorating while the UK has recorded a persistent deficit.

Economic confidence peaked in Summer 2007 and has since slumped across Europe. Business Confidence has been very weak in the UK and in Spain has nose dived. In Germany and France it declines but remains positive.

Consumer confidence tracked business confidence, collapsing in all except Germany where it is just beginning to turn down.

Employment numbers had been positive for the last 7 years averaging 7.2% unemployment in the EU and 5.2% in the UK. The current economic slowdown has not impacted employment yet but signs that it is beginning to are showing, particularly in Spain.

The one bright spot in Europe is Germany where a significant external sector fuelled by demand for capital goods from emerging economies continues to support the economy, this despite a strong EUR and disadvantageous terms of trade.

Already the German Ifo business climate and expectations lead indicators have fallen sharply in the last month. Construction holds steady but has never really been a source of strength, manufacturing, wholesale and retail indicators were all substantially weaker. Industrial production has fallen sharply from 5% to 1%.

The currency will be an important factor as the recessionary economies of the US and Europe vie for the emerging market dollar.

Twenty seconds into the future...

Investment Outlook 2008


Economic growth:


Despite expectations of recession, US economic growth remains fairly robust. Retail sales and personal consumption growth has slowed but remains in positive territory. Consumption is no longer viably financed by credit, and has to be financed by wealth creation or income. Asset values are falling. Personal income growth has slowed but remains in positive territory. The savings rate, however, has fallen to dangerous low levels. Growth in consumer credit is likely to slow as banks tighten lending standards. The connection between house prices and consumption is contentious. With credit availability being reduced for at least 2 quarters now, the impact would have been felt in retail sales. That it hasn’t may be due to the tax relief in the first quarter of this year. Unemployment has been rising for a year and is expected to rise further. Consumption is fragile.

Conference board business confidence and expectations indicators have been depressed. Given that consumer confidence is similarly depressed, the outlook for consumption is poor, consumer credit is likely to contract and asset values are declining, business confidence is likely to fall further. However, they are near historical lows marked in the late 1970’s, early 1990’s and 2000 recessions and are likely to bottom out when GDP growth confirms recessionary conditions. Until then it is unlikely that firms will undertake to increase investment. Investment is also driven by ROI hurdles defined by prevailing and expected interest rates as well as risk premia. With credit markets in decline, credit spreads widening and bank lending in decline, investment will need to be funded by cash flow and ultimately profits. Corporate profitability is likely to be squeezed from the inability to pass on imported inflation to consumers. Corporate revenues will face headwinds from weaker consumption growth. The overall outlook for investment is poor.

The external sector may provide some relief to output. A weak USD is supportive of trade and could reverse the balance of trade deficit. The trade balance with Japan is unlikely to adjust given economic growth in Japan. Europe is an important trade partner as well by size, however, weak economic growth in Europe will limit the potential improvement of the trade balance with that region. The likely areas for improvement will be with China, Pacific Rim, LatAm and OPEC. The US export sectors are concentrated in capital goods and industrial supplies. Consumer, autos, technology are unlikely to contribute much in any reversal. The infrastructure investment of Asia and OPEC is likely to play to the strengths of the capital goods and industrial supplies heavy exports of the US. The outlook for trade is favorable.

Overall, it appears that the US is headed for a protracted slowdown with weakness in consumption and investment. The government is not in a position to operate an expansionary fiscal policy in the face of rising inflation and a significant budget deficit. The external sector will likely provide some relief.

If inflation recedes as we expect it will this may allow the Fed to lower interest rates or at least keep them on hold.

In Europe, the picture is similar. Economic growth is expected to slow. Unemployment may take a longer time to adjust, upwards. Retail sales have fallen sharply across the Euro zone.

GDP growth in China remains robust although it has now slowed over the last 3 quarters (since 4Q 2007). Unemployment remains low. Average earnings remain robust. Inflation has been rising. Retail sales have been remarkably strong. At the same time, consumer sentiment is falling quite quickly. Economy was euphoric in the summer of 2007. Government policy has been hawkish on inflation in the past year. The recent slowdown in growth, albeit from elevated levels, has given policymakers pause. Rhetoric has been indicative of more accommodative policy going forward. Demand for exports, particularly from the US, will come from investment and to a lesser extent from consumption. In the meantime, China continues to diversify its trade from the US and Asia towards Europe and Africa.

India has been experiencing robust and stable economic growth. Inflation has been accelerating, however, and the RBOI has been actively raising rates to reign in inflation. Industrial production peaked in early 2007 and has slowed down substantially.




Inflation

Inflation has been trending up in most countries and is substantially higher than a year ago. On the demand side are the high growth emerging economies such as China, India, Lat Am. On the supply side, bottlenecks in the infrastructure in emerging economies are responsible for increased volatility.

In the US, PPI is rising at 14.5% per annum, a rate not seen since 1979, 1974 and 1951. Import prices are rising at 20.5% against export prices which are rising at 8.5%. CPI has been rising as well, albeit less rapidly, rising 5% year on year to June 2008. Core inflation is rising at a less robust 2.4%. The main source of inflation is from food and energy and from imported inflation. Energy prices are volatile and will likely recede quickly if economic growth slows globally. Food price inflation is driven by two forces, one is the competition for inputs from energy and the other is a emerging market populations such as China and India substituting to less calorie efficient diets (grains to meat). The latter will be a more persistent source of inflation. Inflation from poor infrastructure, the result of underinvestment in past years will also be more protracted. Given the composition of CPI in the US, while energy and food price inflation is a problem, we do not see it as a debilitating one.

Capacity utilization peaked in 2005 around the low 80’s and currently has broken below 80. There exists domestic capacity to relieve some of the inflationary pressures from a weak USD and rising external inflation. This may provide some economic justification for the otherwise misguided protectionist tendencies arising in the US. The economic impact of any protectionist policies may therefore not have as dire an impact as might be expected otherwise.

Note that with the US economy slowing, US bank bailouts are highly inflationary and the implementation of any bailout needs to be specific and temporary.

Unit labor costs, personal income and employment costs have not seen significant strength in the past 8 years. Wage inflation has not been in evidence although this is clearly an area of concern going forward. Wages have lagged profits and may have to adjust. If so, this may drive inflation.

The analysis of the US can be loosely extrapolated to the developed world.

Where inflation will be a serious problem will be in poorer countries where food and energy are a significant proportion of CPI. In the past 12 months the largest increases in inflation have been in
The rise in inflation has indeed been broadly negatively correlated with per capital GDP. LatAm, Eastern Europe and MENA have seen substantial inflationary pressures. Even agri economies have not been spared as open economies import inflation.

2007 has seen robust growth in infrastructure spend particularly in emerging markets. Inflation pressures will limit the extent to which these economies will be able to operate fiscally reflationary policies. This will put to test the theory that emerging markets domestic demand is rising as a driver of economic growth.



Policy

US: As the US is the world’s largest financial economy, the Fed is hostage to it. If as we expect, inflation turns out not to be as persistent a problem, the Fed will not have to aggressively raise interest rates. It is likely that it will delay any decision in the hope of receiving more encouraging news on the inflation front. One thing to note is that bank rescues are inflationary in nature and may require some balancing by the Fed. On balance we expect the Fed to hold steady. That does not mean that the current Fed Funds rate is signaling the appropriate market clearing interest rate. US interest rates are probably too low for normal conditions and are probably more appropriate to addressing flagging domestic demand. In any case the source of inflation is not domestic and it is unlikely that higher interest rates will dampen price pressures.

UK: The UK is broadly in the same position in the US in terms of interest rate policy. Inflationary pressures from economic bottlenecks are probably higher than in the US thus calling for a more hawkish stance. The BoE is similarly caught between slowing economic growth which is at risk of deteriorating further, and risks that inflation accelerates. Unlike the US, a good proportion of inflation is domestically generated and can therefore be addressed with higher rates. On In addition the BoE has explicit inflation targets. We therefore expect the BoE to raise rates rather than keep them on hold.

Europe: Euro area inflation has been rising substantially. Unlike the Fed and the BoE, the ECB has actually acted to raise interest rates by 25 basis points to 4.25% on 3 July 2008. Inflation has been particularly strong in Spain, Greece and Ireland. The ECB has been quite clear as to its intentions on the inflation fighting front and we can expect rates to rise further if inflation continues to rise. We expect, however, that inflation numbers will moderate and the need for further rate increases will abate.

China: Inflation is running at 7.1% YOY June 2008. Surprisingly the pattern of inflation across urban and rural areas is fairly balanced. As expected the price pressures were concentrated in construction costs, food and energy. Consumer non durables and services saw little if any inflation. It appears that China is a classic case of cyclicality in growth and prices with the expected lags. The PBOC is actively addressing inflation while trying to maintain stable growth. China is in the middle of a major infrastructure build out which in itself is highly inflationary. The PBOC will have to act to counteract the impact of this government expenditure. In a lower per capita GDP economy, marginal propensities to consume tend to be larger as consumer staples account for a larger proportion of expenditure. The PBOC has so far acted to restrict bank credit to minimize any multiplier effects from the financial system. It is not clear if the PBOC will try to impact multiplier effects on the consumption side. Increasing specific consumption taxes will go some way to mitigate these impacts.

India: The RBI is already hawkish as inflation is rising quite quickly. Currency volatility has been a concern recently as the INR weakened significantly this year. India is desperately in need of improved infrastructure but a substantial budget deficit is straining the government’s ability to fund it. At the same time, any infrastructure spend would be highly inflationary. There is overinvestment in the real estate sector and risk of a severe reversal.




Equity

US:
Corporate earnings have come in weak, as expected. Exporters are showing some signs of strength on a weak USD. Valuations are still elevated by historical standards. In the oil shock stagflation of the early 1970’s valuations fell from the 20’s to single digits. The current average PE of the S&P500 is still in the high teens. Under an inflationary scenario, this is likely to test the single digits. With earnings downgrades in progress, the outlook for US equities is quite unfavorable.


Europe:
Corporate earnings in Europe will similarly come under pressure. A strong EUR will further disadvantage Euro Zone companies. Valuations, however, have priced in inflationary conditions as well as weaker earnings. The Estoxx trades at an average PE of 10X, as does the FTSE. Expectations are for zero growth over 2009. The Swiss market, however, trades out of line in the high 20’s. Currently the European markets represent relatively good value.

Greater China, Asia:
The slowdown in the US and Europe will inevitably impact the earnings of China companies. Domestic inflation fighting policy will also dampen economic growth. The market is still expecting earnings growth of mid teens to mid twenties for China companies in the current year and similar growth rates in the following year. Valuations are in the mid to high twenties in China and low teens in Hong Kong. Greater China companies were acutely overvalued at their heights in mid 2007 but have retraced by between 40 – 50 % since then.

Japan:
The Nikkei 225 and Topix PEs are circa 16X. Growth is slowing and the economy is at risk of slipping back into recession. The difference this time is that inflation is actually rising, albeit from a low base.

India:
The market PE is circa 14 with zero growth expected in the current year and mid teen growth expected in the following year.



Corp Debt

Foreigners will be switching out of US treasuries. Some substitution into corporate debt. Valuations crucial and market always overshoots.
If someone is switching out of lending to the US government, unlikely they will want to lend to a US corporate. Ditto UK. Will only switch country. Or asset class.


Sovereign Debt

Japan, China together hold about 1 trillion in US sovereign debt. UK holds 250 billion USD, Oil producers hold 140 billion USD.

For China and Japan, buying US treasuries is the equivalent of a leasing business serving US consumers in aggregate. The BoJ has slowed its purchases of US treasuries and its holding of US treasuries has also decreased. China, however, continues to be a buyer and its holdings are still increasing. Part of this will be due to efforts to control the natural strength of the CNY. As inflation and credit market problems and bailouts debase the USD, foreign central banks and will not be as willing to accept US treasuries to fund US consumption. The US as a nation will likely find the cost of debt rising. Yields on US treasuries should rise. Taken together with our view on the Fed’s inflation and growth stance, the yield curve is likely to continue to steepen.

Foreign investors will not likely want to lend to US consumer. The may like to own US assets but at lower valuations.



Commodities

Industrial Metals – likely to be weaker, range bound in a new range, unlikely to retreat to 2003 levels, steel and infrastructure related resources likely to be supported.

Gold – inflation hedge and risk barometer is likely to weaken as risk becomes fully priced and inflation begins to ease off.

Softs and Ags – energy impacted crops likely to ease off, however, generally strong from changing dietary habits from developing countries.

Energy – highly cyclical and likely to fall from highly overbought territory, do not see a return to 2003 levels but expect significant short term weakness.



FX

FX is highly unpredictable. Notwithstanding, we expect FX to be driven as follows.
USD generally weak, big C/A deficit, inflation, need to be more export competitive,
GBP weak, big C/A deficit, inflation, need to be more export competitive,
EUR, generally weak, need to be more export competitive,
JPY strong, C/A surplus, may weaken as Japan slips into recession,
RMB strong, rising domestic demand, middle class, consumption, acquisition currency,
Asian FX strong in general,
INR weak, C/A deficit, Inflation
Latam FX strong, credit ratings upgrades, agri commodities,
CHF, SGD strong, flight to safety, will weaken as global risk pricing comes off,
MENA FX strong,
AUD, CAD, MYR strong, commodities impact, AU is running a very high C/A deficit and inflation is high, will likely come off as commodities rally peters out.

Inflation Comment

The US and Europe cannot fight inflation by raising interest rates because their domestic economies are not pushing against full employment. The source of inflation is from the emerging markets. The US and Europe need China and India to raise interest rates and fight inflation. If they get what they need, that means interest rates in emerging economies rising faster than USD and EUR rates. In terms of term structure, USD and EUR yield curves will only flatten if BRL, CNY and INR curves flatten first.

The more likely scenario is that China and India are facing serious inflation. China will act to slow inflation, India is slightly caught between a rapidly cooling economy and together, aggregate demand will slow. The implications for the rest of the world will be an easing off in energy prices, then food prices, albeit to a lesser extent, and thus lower risk of inflation. The US and Europe will find themselves less motivated to combat inflation.

The price of stable prices will be slowing emerging economies and thus demand for US and European exports. Taking the US as an example, consumption is likely to be weak from poorer consumer sentiment, rising unemployment and weaker income, investment is likely to be weak from scarcity of credit, poorer business expectations, weaker corporate profits, the government is broke, any spending might be inflationary. Trade is almost the last hope for any earlier or stronger than expected recovery. That requires export demand from countries other than those in similar financial health or lack thereof: the developing world. If that part of the world is slowing down, it doesn't leave much hope for a quick recovery.

What could change that is investment in infrastructure in parts of the developing world where inflationary pressures can be addressed by ad hoc and specific measures, i.e. where market prices do not apply wholesale to the economy and there is sufficient central planning, and where balance sheets corporate or sovereign still have the firepower.

Strategies for 2008

Lets see how wrong I can be in a year's time:

US:

Distressed will do poorly relative to expectations. Too much money chasing too few defaults.

Risk arb to do well. Dispersion of valuations and financial strength, cross border opportunities for emerging market acquirers. Currency effects, cheapening USD makes US companies interesting targets.

Equity long short. Hard to generalize but dispersion likely to increase, so positive for the strategy.

Direct lending. Good place to be. Bank credit contraction is very positive for the strategy. PIPEs will struggle in the exit thoughl.



Europe:

Distressed to do well. Fewer players, less capital, more economic leverage even if less financial leverage.

Risk arb to do well. Mid caps heating up. Cross border heating up.

Equity long short. Dangerous place to be given how export dependent Europe has become. German economy very levered to China and Asia. Infrastructure growth in Asia to support demand for capital goods and intellectual property in countries like Germany.

Risk arb, interesting currency angle across the pond.


Generally:

Convertible arbitrage. CBs are cheap by any measure. Asian CBs, India, Japan, India, cheap. European CBs are less interesting.

Vol arb should profit as volatility remains high. Implieds have cheapened while real vol remains high.

Cap structure arbitrage. A very interesting strategy for the times. Ample opportunities to get it horribly wrong. Temptation is very high to double up and pray for convergence. Stability of capital will reward this strategy. Arbitrage profits exist and remain quite rich but mark to market risk is high.

Strategies to do poorly:

US distressed debt. As above, too much money, legacy of cov lites. Strategy likely to do well but not in 2008. In 2009 should be a roaring strategy.

Commodities. Too many directional traders taking a long view on energy and ags, chasing returns, riding momentum. Demand picture is strong but not robust.

Direct lenders. The ones who give up yield for equity upside are going to find their kickers more volatile than valuable. IPO markets moribund. No exits.

Not many strategies will do poorly. As the world works its way out of recession most strategies will find tailwinds.

Oil and Gold

Forecasting is a losing game. Forecasting commodity prices is a particularly risk losing game. So here goes.

The price of oil in gold has traded in a range 0.04 – 0.06 from 1989 to 1999. In 1999 it rises to a new range. 0.08 – 0.12 breaking to 0.15 in 2005. Currently the ratio trades at 0.12, near the top of its range.

A research study by Purvin and Gertz, an energy consultant has the oil price at 60 – 70 USD per barrel if you exclude non economic demand, that is speculative demand and accumulation of strategic reserves.

A plausible explanation for elevated oil prices is that the Middle East peace process (a misnomer clearly) was derailed in 1999 and the new Intifada began in 2000. Accumulation of strategic reserves provides a base line of support for oil prices.

The Intifada isn’t ending any time soon. If anything the region has become less stable and there has been an escalation in posturing in recent weeks and months. On the other side, India and China are operating disinflationary policy, the US and Europe are in recession. Economic demand for oil is likely to fall.

Short oil spot. Long out of the money call on oil to hedge. Long gold futures spot, hedge with short call on gold. Alternatively long put spread on oil, long call spread on gold. More expensive but less exciting. All strikes and notionals to reflect the view that oil quanto gold will fall from 0.12 to 0.08.

Outlook 2008

In my view, the crisis precipitated by sub prime mortgages and the structured products into which they were packaged is merely symptomatic of a broader, simpler theme: over-leveraged consumers, themselves, symptomatic of an even simpler theme: conflicted central banks operating confused policy.

The existence of central banks is an admission of the inefficiency of money markets. By unilaterally setting short term interest rates, a central bank removes the information that a market rate of interest would provide to the market. When central banks use interest rates to ‘manage’ the economy, they also create moral hazard. Each period of rate cutting has been in response a crisis, each crisis born of a prior period of excess precipitated by an earlier rescue. The reflationary efforts of the US Fed in the current equity market downturn is a risky strategy. The USD is weak and the US faces commodity price inflation. Cutting rates to bail out home owners and financial institutions creates further inflationary pressures through a depressed exchange rate and increased liquidity.

Securitization technology provided the opportunity for adverse selection. If loans can be arranged and the risks transferred, then the motivation for lenders is subverted in that credit underwriting standards become subordinated to volume and scale. The structured credit invention, in itself neither good nor bad, provided the vehicles for leverage to be applied by providing funding to the securitized assets.

Therefore, I do not believe that CDOs are to blame, or that banks are to blame or that regulators are to blame. Sadly, it is investors who are to blame. Principal agent theory points to the misalignment of interests in loan origination arising from debt securitization and should have counselled scrutiny of the underlying debt much more carefully. ABS and CDOs introduce great complexity and opacity making it difficult to understand the risks in such securities. The solution is not to eschew the technology completely but to embrace it with more scrutiny. Securitization and structured credit are useful technologies if properly implemented and understood.

If the underlying problem is one of over-leverage, the solution must be a bout of de-leveraging. The process unfortunately implies decreased consumption and investment leading to slower economic growth if not recession. For the under-levered balance sheet, however, there is the opportunity for profitable expansion. For more levered balance sheets, there will not be the opportunity to double down. What is clear is that there will be significant distress in debt markets of the developed economies. Already, large amounts of capital are lining up in preparation for this opportunity in the US which may actually slow the price discover process and lower returns. In Europe, the opportunity for distressed investing may be higher due to the higher economic leverage created by unions and inflexible employment policies. Covenant light loans and weaker credit standards also pose their own particular problems leading to a more protracted downturn and companies entering restructuring or bankruptcy in much weaker shape.

In the short to medium term, M&A deal flow will slow as domestic deal flow dries up. Leveraged deals, in particular those involving private equity buyouts will be at risk. Current pipeline is already showing increased risk of deal breaks. The likelihood is that those with committed financing will renegotiate but endeavour to close and those with weaker agreements will simply break. The motivation for acquirers to renege on current deals is high but war chests remain full and activity should rebound. GPs suggest that the environment will not normalize till as far as 2009. Of late, banks have been reneging on contractual obligations to fund agreed deals. This is disturbing in cases where the litigation risks of failure to perform exceed the mark to market losses that would occur if they simply do the deals. It signals that banks may be as unable as they are unwilling to lend. There is, however, a silver lining albeit a bit of a wildcard. A protracted commodity boom has enriched the developing world under whose feet are found metals, oil, fertile soil. Their sovereign wealth funds find themselves bursting with capital with which to invest. The opacity of their objective functions, corporate governance standards and accountability maintain a level of uncertainty over their value as rational commercial investors. As with all investors, not all are of the same quality.

The commodity boom has also benefited emerging market companies who find their debt and equity valuations inflated by the influx of capital in search of returns. At the same time, the robust growth of the economies of BRICs and their less well known cousins from Latin America to Sub Saharan Africa, have similarly attracted investors leading to the same inflation of valuations. These companies not only have strong balance sheets but have high equity valuations representing attractive acquisition currency. Cross border M&A is expected to increase. The path will not be smooth as a shrinking pie precipitates nationalistic, protectionist and mercantilist policy responses. I can only hope that commercial rationality triumphs.

I believe that there has been a significant decoupling between developed and developing economies. The deleveraging of the developed economies of US and Europe will have significant impact on the emerging markets. The impact will be most felt in public markets which are most susceptible to correlation. Private markets will be impacted as well, although the exact winners and losers may be unexpected. In any case, private transactions are sheltered from the full extent of the over valuation and the subsequent downside volatility in emerging economies’ public markets.

Globally, banks will be deleveraging. Two elements are required for banks to resume normal expansionary credit: the willingness and ability to lend. The ability to lend is currently highly impaired. A recapitalization of the banking system is a prerequisite and it is something that is beginning to happen. The willingness to lend is less clear. With weak covenants in loans originated in the last two years, companies in stress or distress may not trigger covenants for some time and may have ample opportunity to deteriorate. Banks are unlikely to be willing to extend new credit until current loan obligations are restructured. The subsequent dearth of credit will provide interesting opportunities in direct lending and alternative finance. A potential arbitrage exists in emerging markets where economic growth is robust, corporate earnings growth is healthy, balance sheets are strong but local banks are undercapitalized and international banks are delevering. Structuring a bank funded as a hedge fund may provide an efficient means of gaining exposure to this theme.

The path of economic growth and the role of central planners

One of the simplest dynamic systems is the harmonic oscillator. Big word for a yo yo or a weight on the end of a rubber band or spring. The motion (dynamics) of such a system is described by a second order differential equation.

m d^2x/dt^2 + b dx/dt + wx = F(t)


m is mass. b is drag, w is the elasticity of your rubber band or spring. F(t) is what you do with the other end of the spring, or your finger in the case of a yo yo.

Lets assume for the moment that F(t) = 0, a constant. What this equation describes is the bouncy bouncy motion of the weight at the end of a spring. If the drag term is big enough, there isn’t much bouncy bouncy, think of the suspension of a car but with dampers, or shocks as the Americans call them. By arranging the right ratios of m, b and k, you get either a smooth ride a la Lexus, or bouncy bouncy like a Land Rover Defender. Forget about the F(t) for now.

Economic growth is cyclical and can be modelled as an oscillation like we described above. If all the long term policies are right, rule of law, demographics, industry diversification, etc etc, then there is less chance of bouncy bouncy. Like a Lexus. If an economy has concentrations of risk, imbalances, poor corporate governance, then bouncy bouncy. In fact if you solve the equation for the path of the economy, the general solution is such that the set of solutions for which there is no bounciness, is very small, almost infinitesimal compared to the set of solutions for which there is a lot of bounciness.

Lets get back to F(t). This term is like economic policy, both fiscal and monetary. Its how the government or central planner can ‘guide’ the economy and try to smooth out the bounciness of growth. The central planner basically tries to obtain the solution to the Left Hand Side of the equation, figure out how bouncy things will be and then use F(t) to try to smooth things out. The risk here is that if you time things wrong, then F(t) can make things even more bouncy. This is bad. Also, things are path dependent. Once you start your F(t), managing the system down the road is dependent on what you did before.

If the central planner has perfect information, i.e. knows everything there is to know about the economy, then it can obtain a solution to the Left Hand Side and design an F(t) to damp the oscillations. Alas, life is not like that and the central planner either doesn’t have perfect information, or makes mistakes, is plain dumb, or has been trading their PA a bit too actively. Using the wrong F(t) can lead to big bouncy bouncy. Which is bad.



Technically, the solution to the second order differential equation is

x(t) = A exp(pt)+ B exp(qt)


If p or q are real numbers, you have an exponential blow up (bad, and not going to happen) or decay (good). If p and q are complex, and they are the roots of a second order polynomial and are very very likely to end up being complex, you have an oscillation. The chance of all the stars lining up so that F(t) is countercyclical is almost surely zero. Only with F(t) = 0 or any other constant, is the probability of resonance (creating a diverging envelope) zero. Any other time there is the risk of creating bigger and bigger oscillations.

I'm back

I'm back from a pretty intense investment project and will (hopefully) have more time to put my thoughts down to magnetic media...