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...

Civilians At The Gate. Population Growth in Singapore

The potential growth rate of an economy depends on a number of factors. It depends on land, manpower, capital and knowhow. Growth in land can be achieved by more efficient use of the available stock. Singapore has a very defined constraint on land. Growth in capital is achieved by investment. Growth in manpower can be achieved internally or through immigration. Internal growth is something that is accelerated or decelerated very slowly, as we learnt in the 1970's then in the 1980's. Immigration is a quicker way of speeding up or slowing down growth in manpower. Growth in knowhow comes from investing in education, can be imported, or comes through investing in R&D.

Let's look at growth in manpower through immigration. Let's assume that we have optimised growth in all other areas. Growth through immigration is tricky. Singapore has limited land. To house 8 million, yes, 8 million, not 6.5 million people, will be difficult. But not impossible. Moving these people around, getting them from home to work, from work to play, this will require a feat of infrastructure development.

Less obviously, immigration imports cultural and social issues that are unpredictable. Importing people from abroad, however much intellectual or financial capital they bring, means opening up Singapore, potentially to an electorate, and if not an electorate then a population of stakeholders, unused to our unique style of democracy and social organization.

Inflation. Deflation. Two things happening all at once and what a central bank might think of it all.

Two step economy:

Its quite clear anecdotally at least that the bifurcation of the world economy into rich and poor has accelerated in recent years. Wealth creation has accelerated among the rich while the rest of the population has failed to catch up. This has occurred both between countries as well as within countries. Globalisation has played an interesting role. Whereas before, labor prices were a function of local productivity, they are today a function of global productivity. As a result we see wage deflation in manufacturing where capacity has been exported to countries like China and India, while wages accelerate in services which are less portable.

Evidence of a two speed economy can be found across the globe. Aggregate inflation numbers show a fairly benign picture, and it is indeed a benign picture. However, while aggregate numbers cannot represent the extremes of consumers, they fail badly where the distribution tends towards being bimodal. Inflation numbers for the developed world range between 1% - 3% at the aggregate level. Over the last 30 years HNW inflation has risen an average of 5.5% while CPI has risen 2.3%. In the last 10 years HNW inflation has risen by 6.3% while average CPI has risen 2.6%.


Inflation risk:

The key inflation risk is not in rising commodity prices. Fuels and utilities and motor fuel account for only 5.4% and 4.1% of CPI respectively. The key inflation risk arises from the unequal distribution of intellectual capital. The long term growth potential of an economy is heavily influenced by its intellectual capital or technology for a given stock of land, labour and capital. Where inflation comes from commodity prices, human ingenuity is deployed to solve the problem. Where inflation comes from wages, human ingenuity is deployed to exacerbate the problem. And the problem lies in the relatively short supply of high value labour, particularly where the value is derived from intellectual capacity. High income and high wealth individuals are incentivised to protect their industries through high barriers to entry. It is also in their interests for their offspring to inherit their positions on the economic ladder. The high cost of education is a primary barrier in perpetuating the unequal distribution of intellectual capital. I will not discuss welfare economic further except to say that there is good argument for central planning from a general welfare perspective. The unequal distribution of wealth leads, through the education system, to unequal distribution of intellectual capital and on to unequal distribution of income which manifests in inflation data.


Central bank policy:

One suspects that interest rate policy goes beyond fighting inflation. Rates were raised aggressively in the late eighties to tackle inflation. As the economy sank into recession the Fed quickly reacted to create liquidity. In 1994 where there was little sign of inflation rates were put back up. In 2001 when recession struck again rates were aggressively cut. In 2004 rates were put back up again in a fairly benign inflationary environment. It seems that interest rate policy is driven as much by crisis as by inflation. A cynical assessment would be that rates are put back up in times of calm so as to reset the reflationary tool.

Today, as it was 12 years ago, interest rate policy is once again in the spotlight. One could argue that a ‘good’ level for rates would be in the region 6.5%. In the absence of turbulence it affords ample room for rate cuts. One could also argue that this is an acceptable hurdle rate for investment. One of the consequences of too low an interest rate is that it encourages over investment.

From an inflation point of view it looks as if rates are perfectly poised. If there is inflation it is coming from services and housing with some volatility from commodities. Since there are two inflation rates for two segments, rich and poor, each has to be looked at separately. Unfortunately there is but one interest rate that has to be set to a compromise solution.

In the US, a full 42% of CPI is due to housing of which rent is 5.8% and owners’ equivalent rent is 23%. Across the globe today we see rising housing costs, particularly in the metropolitan areas. Residential real estate prices are bifurcated along the very lines of rich and poor. Within countries and within cities, price differentials are evident and in many cases are growing. Much of this element of inflation therefore impacts the higher income segment. As prices are being driven up by income and not the other way around, this may be an acceptable situation to a central bank. At lower incomes, house price inflation is less robust and in step with wage growth so there is not an immediate problem.

We can try to generalize this. Rich sector inflation is higher. However, as incomes are higher and wealth creation derives from investments as much as wages, the marginal propensity to consume out of incremental wealth is lower. A central planner may find this acceptable. At lower levels of wealth, inflation is not just lower, its low. Looking at the aggregate economy, there doesn’t appear to be any need to raise interest rates.

Trader's Mentality. Let's Play a Game

You play Solitaire. The card game. Its not important what game is being played. This is just an example and Solitaire is convenient. It has an element of skill and luck. The luck bit is how the pack has been shuffled and the initial set of cards dealt.

Let's say that you have a strategy that seems to work pretty well and the strategy involves playing from right to left, dealing with the longest piles of cards first.

You start playing. You win 7 times in a row. You lose once. You win 5 times in a row. You lose once. You win 10 times in a row. You are doing well. Then you start to lose. 4 losses in a row. You get annoyed. The cards are not in your favour. A fifth loss. You have had a good record of winning. Why are you now losing? There is some disbelief. Its just bad luck. You'll get over it. But nobody has such bad luck, you are angry. Maybe the strategy isn't working. You try something new. You no longer work the longest piles first but any pile that has an immediate solution. You lose again. You try again. A win! So the strategy was at fault. You continue the myopic strategy. A loss. A win. Two losses. Its pretty patchy now. You are frustrated. You should stop playing. No, wait. One more. One more win and you'll stop. A win! You need to convince yourself that it was more than luck. You deal another hand. A win. One more you tell yourself. A loss. The disappointment is unbearable. One more. You refuse to stop when you are behind. You'll stop when you're ahead. You need to play until you are ahead. Then you'll stop.

Strange thing psychology. You had a good strategy. You were winning 80% of the time. You hit a bad patch. Bad patches happen to everyone at some point. You changed your strategy to a sub-optimal one. You began to win 50% of the time. It was pure luck now. You should have stopped playing and packed up for the day. Had a rest. Thought things through and come back the next day. Instead you persisted and your track record became pure luck.

Here is how it works in a trader's head:

- Damn I'm good.
- Its just a couple of losses.
- I cannot believe anyone can be so unlucky.
- Let's try this other method.
- I cannot believe that nothing I do works.
- I refuse to stop until I win.

Asset Liability Management of a Hedge Fund

Yesterday we looked at how hedge funds resembled banks. In fact they look pretty much like the result of the dismemberment of banks. Now lets look in a bit closer, at the capital structure of a hedge fund. To a corporate treasurer, a hedge fund would look like a very strange animal. The hedge fund manager looks at NAV (net asset value) of his portfolio on the one hand, and investors providing capital on the other. If you don’t believe me, ask any hedge fund manager about his assets and liabilities. We rule out credit managers since this would be familiar to them, or should be familiar to them. Even the odd credit hedge fund manager does a double take from time to time. If we ask what the assets and liabilities of a hedge fund are, it should look something like this.

Assets

Current Assets – Assets that can be liquidated quickly

Cash – that’s easy
Marketable Securities – the liquid long positions
Accounts receivable – proceeds of sale of assets, premia from written options and CDS
Interest receivable – from fixed income

Non Current Assets – Assets that can’t be liquidated quickly

Illiquid investments – private equity, small caps, large positions,
Cash from shorting held with Prime Broker


Liabilities

Current Liabilities – Short term liabilities

Securities borrowed for shorting – and which may need to be covered or recalled
Short term loans – for leverage

Long Term Liabilities – self explanatory

Equity

Share Capital


The typical hedge fund is open ended, i.e. has a variable equity structure. This means that balance sheet leverage can be affected by changes in equity, as much as by the mark to market of the fund’s assets and liabilities. The fund manager has some degree of control over the assets and liabilities, hopefully. It is their job to grow the equity in a stable way. But instability can come from the equity base as well, often when the manager is not performing well. Investors can redeem out of a fund causing the equity to shrink and requiring the fund manager to reduce the size of the balance sheet. This is not always easy to do. Even if balance sheet leverage is allowed to change to handle changes in equity, providers of credit to the fund will be watching the stability of capital as well and are likely to similarly restrict funding precisely when a fund needs it. The Share Capital of a hedge fund therefore needs to be appropriately structured taking into account the strategy that the fund manager pursues and the nature of the fund’s assets and liabilities. This is the argument for lock ups and long notice periods.

Today there are funds which offer high liquidity and there are those with restricted liquidity. Mostly the liquidity terms are driven by what the fund manager can achieve. Terms that are too restrictive can hamper the growth of the fund. Terms that are too relaxed result in an unstable capital base. More often the terms are driven by the reputation of a manager. The better the reputation, the greater the demand, the better the terms in favour of the manager. Unknown quantities have to live with providing good liquidity whether their strategy warrants it or not. It is clear, however, that sometimes, restrictive liquidity terms are there for the protection of the investor as much as the business interests of the hedge fund manager.

Systemic Risk in the Hedge Fund Industry: Risks arising from the liability side of hedge fund balance sheets:

Are hedge funds banks? Some people seem to think so. In particular a research report, excerpts of which are available at http://ftalphaville.ft.com/blog/2007/02/07/2365/the-great-unwind-is-coming-warn-dresdner-pair/ , draw comparisons between Citadel and Deutsche Bank’s investment banking division. The similarities are remarkable. For a long time there has been a preference for hedge funds set up by proprietary traders as opposed to asset managers. Historically asset managers tend to be seen as long only index benchmark huggers and prop traders as swashbuckling long short risk takers. Its pretty clear that one could take a bank, cut it up into little bits and end up with a collection of hedge funds. Fixed income traders trade relative value and global macro. Structured derivatives desks need to lay off their option risks in everything from fixed income to credit, equities, FX and commodities. Equity sales desks provide flow information. Equity prop desks beef up trading profits to augment fee and interest income. On the commercial lending side, asset liability management requires credit traders. In wholesale credit, asset backed and structured credit desks are active. In distressed debt, the commercial lending activities also cross over. In investment banking, mergers and acquisitions provide event driven opportunities. In trade finance and factoring we have the basis for the asset based lending hedge fund.

Many articles on hedge fund risk consider the risks that hedge funds pose to investors. Tail risk, liquidity risk, concentration risk, excessive leverage, short optionality, are oft cited criticisms of hedge funds. But there is also risk on the liability side of hedge funds’ balance sheets. We’ve made a stab at associating hedge funds with banks. Now lets look at how banks are funded. The deposit taking bank is funded by a large number of depositors each providing small amounts of capital to the bank. The fact that there are many diverse individuals, each with their own liquidity requirements, providing capital, means that a bank can quantitatively model the aggregate liquidity requirements of the collective and thus optimize its asset base to the collective and not the individuals that make it up. It allows banks to borrow short term, through current accounts and short term deposits, and lend long term through mortgages, term loans, and other forms of longer term assets.

If you ran a bank, how comfortable would you be if you had 100 depositors, each providing you with 10 million dollars in deposits? That’s 1 billion dollars of capital. Additionally, how comfortable would you be if 70 of these depositors came from the same industry and 80 of them from the same country? This is typically what many hedge funds face. Most of the capital they receive come from a small number of investors. Most of these investors are funds of funds. The representation of investors from New York, London and Geneva is disproportionately high. Most of these investors talk to each other, exchange notes and are very likely to behave as a coalition.

This is not to deny that there are systemic risks arising from the asset side of hedge funds’ balance sheets. The risks on the liability side are as great. At the heart of this strange evolution of the typical hedge fund funding base is the evolution of the industry. By their opacity and coyness, hedge funds have traditionally found that investors find them instead of the other way around. The only investors in the business of expending considerable search costs are professional investors. Funds of funds are the largest such aggregators.

Aggregators do more than reduce the granularity of assets. They create correlation. To the extent that hedge funds are influenced by the preferences of their largest clients, large aggregators decrease independence in trading behaviour and hence the returns. If regulators worry about a hedge fund blow up potentially precipitating a system wide problem they should perhaps look at the stability of the system arising from the source of capital.

More later on the asset liability management of the hedge fund.

Hedge Fund Strategies: The Outlook for 2007

We are no better off letting the weatherman predict the economy and the economist predict the weather... having said that, let us press on.

Stock selection:

Stock selection strategies and strategies that profit from an increase in specific risk will find more opportunities this year. The withdrawal of liquidity by central banks of US, UK, the Eurozone and the Japan over the past three years is beginning to take effect. Liquidity will diminish as a driver of financial market returns relative to fundamentals, increasing the share of idiosyncratic risk as a proportion of total risk in asset prices. This favours equity long short, event driven, credit long short strategies which are based on fundamental security selection.


Macro:

Global macro has always profited from trending markets. Trending equity markets, surging ones in some areas did not help macro in 2006. The changing face of macro is responsible. Discretionary and directional macro is out of fashion and in some cases out of businesses. Whereas in the mid 1990s discretionary macro was able to profit despite considerable uncertainty over policy by punting equity markets, today’s macro is more fixed income driven, more systematic, less discretionary. Fixed income markets have behaved erratically and counter intuitively. Whether they settle into a pattern this year is crucial to macro. As always, macro is difficult to call. Macro managers who can and do actively participate across all asset classes will find ample opportunity. Macro managers trading in fixed income land will likely continue to generate sub par results.


Event Driven:

Over the years the event driven space has grown in variety and richness. Once dominated by merger arbitrage and distressed investing there is now a growing supply of multi strategy event driven funds. Activists are a resurgent breed within the space. Merger deal flow will continue until corporate balance sheets are once again stretched. For the moment they are still relatively fat. When equity swap deals begin to proliferate will mark the time for caution. Until then, bet long on this strategy. At the distressed end, value is slowly being squeezed out of the market as default rates struggle to keep up with demand from ever sprouting hedge funds. In the convertible space, distressed investing has all but dried up from the dearth of low delta issues. The hostile activist which was in the limelight in 2005 and 2006 has lost some of its shine. High profile retractions show chinks in the armour. In emerging markets, a friendly activist still finds ample opportunities as corporates look to them for assistance.

Convertible Arbitrage:

Convertible arbitrage managers have returned to profit despite volatility remaining low. While implied vols have fallen back from the elevated levels of last summer realized volatility has risen. This has created opportunities particularly outside the US. In the US, the VIX continues to track realized volatility closely. Convertible arbitrage is more than being short implied and long realized vols. With the protracted shakeout of 2004, convertibles are showing good value. Rising deltas on the back of strong equity markets have improved the returns of synthetic puts. The trading of convertibles from a credit or equity directional view has also gained ground during gamma’s troubled years. Increasingly capital structure arbitrage, directional views on a particular stock, are expressed in the convertible market. These strategies are more exposed to event and execution risk than global trends in implied or realized volatilities.
As credit spreads have compressed across ratings, convertible bond issuance has slowed. This has implications on the competitive environment in the convertible arbitrage space. As corporate balance sheets re-lever and equity valuations become stretched, convertible bonds become a more attractive source of funding for corporate treasurers.


Credit:

In the tranched credit markets, correlations have been rising. This has provided the long equity versus senior trade some tailwind. The liquidity scenario painted above, of rising inflation and more hawkish central banks threaten this scenario as it encourages dispersion.

Credit spreads continue to decline, particular in HY where spreads are near historical lows. IG spreads remain barely wide to 10 year lows. Private equity investors continue to be active creating LBO risk and higher volatility in spreads. This is expected to continue into 2007 providing the event driven credit strategy healthy deal flow. For fundamental long shorts, LBO activity is a risk they have to manage carefully as private equity investors become less demanding and hence more unpredictable.


Asia:

Asia represents considerable threats and opportunities. Just as 2005 witnessed hedge fund assets growing in Japan on the back of high returns generated by levered long bets on the direction of the Japanese equity market, so too Asian hedge funds have printed remarkable results, also on the back of levered long bets on Hong Kong, China and India. In early 2006, the Japanese equity market wobbled and Japanese hedge funds recorded large losses. A similar risk plagues Asia ex-Japan.
Just as Japanese managers who have weathered the storm are now emerging with more reasonable and stable returns, well risk managed hedge funds in Asia will find the region a rich and rewarding space. Activists will find particularly interesting situations if they are happy to be constructive critics. Credit funds are finding improved market depth and range. Stock borrow improves daily in Asian markets while derivative technology opens up shorting opportunities in India and China.
The attraction of Asia is clear: India and China as the new engines of world growth. The complex relationships within Asia mean that obvious trends often result in counter intuitive outcomes. For the astute investor, the less efficient markets of Asia present rich pickings.

Commodities:

A four year bull market in commodities, following nearly 20 years of dead money, has led to strong interest in the asset class. This despite a very volatile and negative 2006. Interest has rotated first from precious metals in 2002 as a store of value, USD short, to industrial commodities such as base metals and energy on the China growth story, to softs and ags almost by default. A secular growth story supporting a long only exposure based investment strategy no longer works. Investors seek more intelligent trade expression which they hope to find in hedge funds. Whether they will find it is another matter. Commodities are factors of production with very peculiar supply dynamics. Too many financial traders participate in a market which should be driven by marginal cost. The result is ample alpha for the skilled trader and a high attrition rate among managers.

Hedge Funds: Excellent Scapegoats, an example of what could have happened

Hedge funds are secretive, or private businesses who shun the limelight. Their success and sometimes spectacular implosions make them excellent news material and often a target for sensationalists. They are also excellent scapegoats. Here is an example of how this can be done:

Assume now that you are the ruler of a small emerging market economy. In South East Asia, say. The year is 1997 and things are getting a bit rough in the financial markets in the region. Your currency is trading at 3.20 to the USD. You see weakness in the currency of your neighbours to the north and further south. You read and hear daily about the turmoil that traders and hedge funds are causing with their speculative attacks on South East Asian currencies. Your currency, thankfully, has been spared. You decide to take preemptive action to head of any speculative attack.

You call your central bank governer to take action. In a matter of days your currency is at 3.50. The newspapers report of speculative attacks on your currency. You are annoyed. You call your central bank governer again demanding more action. One week later the currency is at 3.80. Interest rates are put up to deal with the run on the currency. The stock market begins to react, badly. More news about a general speculative strike against the financial markets of your country.

Night meetings over the local equivalent of pizza with the finance minister, the central bank governer, powerful local bankers and businessmen. The currency slips towards 4.20 to the USD. The equity market is falling. Some of your local corporates have been borrowing in USD and DM. Not a good move after all. Nobody can identify the source of speculative selling.

At last it dawns on someone in your crisis committee. Your currency is quoted in number of local units per USD. Someone subtly hints it to you. Realization. At 3.50 there was little interest in your currency or stock market. Your directive to the central bank for preemptive action led them somehow to take the currency to 3.80. You are furious. Embarrassed. You need a scapegoat. Hedge funds! Who is the biggest. Soros! Perfect. The personal profile is perfect. George Soros did it.

Maybe he did but not at 3.50. From 3.80 to 4.20 perhaps.

You need to stem the flow. Stop the bleeding. Stop everything. How about a currency board? A peg? Perfect. 3.50? It would never hold. 4.00? Doesn't help. 3.80.

A word about global financial markets based on the preceding world view

Reflecting the strength of global economic growth has been rising equity markets where the MSCI World index has risen 13.60% in the last 12 months. The main disappointment has been Japan where the broad market had risen but 5.84%, a number masking devastation among small and micro caps. Where investors were cautious and somewhat negative there has been a measured advance, the S&P500 rising 10.79%. European markets where there had also been some caution rose 13.77% on average. The healthier UK market managed to lag rising only 7.62%.

The highlight of the year was Asia ex Japan. Philippine and Indonesian markets gained over 40% but Asian quality markets such as Singapore and Hong Kong also managed returns of over 28%. Despite some extreme volatility in May, India rose nearly 45%. It was China that stole the show, however, as China listings in Hong Kong gained 54% and Shanghai and Shenzen listings rose by over 120%. Here an artificial construct – listing A shares at discount to H and then awaiting convergence- has been responsible for the outperformance. The market price of risk has diminished, itself a warning sign. In addition the price of insurance, implied volatility has also sunk back to levels not since for 12 years, despite a short spike in May 2006.

The prognosis for equities is favourable. While equities have risen against caution, it is the caution that makes the rise measured and sustained. Valuations are slightly stretched in the US but in Europe remain within historical limits. In Asia ex Japan, even Hang Seng valuations are undemanding. In China, however, valuations have run ahead of themselves and risk is no longer well priced. The extent of over valuation is by multiples of multiples and is indicative of an asset bubble. Lessons can be taken from Japan at the end of 2005 when a healthy market began to run ahead of itself. Japanese equities started the year in high expectations yet managed to underperform most of the major developed markets as well as Asian and other Emerging Markets as well. 2007 could well spell the same for China.

In US fixed income, as in the UK, anti-inflationary measures have lifted the short end of the curve. The long end has lagged as demand from liability matching investors has competed for yield. That said, inflationary pressures and expectations are likely to build. The US Fed has returned real rates into their 1990s neutral band and is unlikely to move any more in either direction, thus a steepening curve is to be expected. In the UK, however, real rates remain relatively low, near 2002, 2003 levels and further rate action may be expected and the curve is unlikely to steepen.

Inflation is expected to rise from 1.9% current to 2.1% for 2007 in the Euro area and from 0.3% to 0.4% in Japan so curve steepening is also likely in EUR and JPY. ECB policy remains hawkish but is unlikely to go too much further as real rates have returned unto mid 1990s range. In Japan, the BoJ is unlikely to raise rates soon given past history.

Credit spreads actually tightened through 2006 and continue to compress. Demand for yield, healthier corporate balance sheets and robust earnings growth underpins the credit markets. The level of caution resulting from the immense growth in the CDS market has also worked to focus attention on risk and prolong the credit bull market.

On almost every front, the outlook is benign. In the absence of some major disruption on the geopolitical front, current trends are likely to continue. Any changes in direction are likely to be smooth. It is a feature of major trend reversals that they are unforeseen and that the reasons for their happening are not well understood until well after the fact. What risks are at the forefront of investors attention rarely precipitate substantial disruptions. Let’s list some of them.

• Imbalances in US current account versus the rest of the world but particularly with China and Opec.

• The state of the US housing market and the impact on consumption.

• The size of the credit derivatives market.

• The impact of hedge funds on financial markets.

• The weight of capital flowing into private equity.

• The rich poor divide which cuts between but increasingly across countries.

• The eerie calm that greets geopolitical events of late

A word about the global economy.

There is considerable uncertainty regarding the state of the US economy. For the better part of 2006 the US economy was thought to be under inflation risk. The Fed Funds rate has, however, been left unchanged in 4 of the last FOMC meetings, this since a sharp correction in energy prices has taken pressure of CPI which peaked at 4.3% in June 2006 and is currently running a comfortable 2.5%. Indeed sentiment has shifted in favour of easing. This is predicated on current growth staying below the unobserved long term equilibrium growth rate. There is a risk that this rate of growth has as real investment has sought higher returns in developing economies and that even a lower current growth rate my be at risk of inflation. This remains to be seen.

Both new and existing home sales have seen a sharp slowdown but appear for the moment to have consolidated. Given the importance of the consumer in the US economy and the reliance on the consumer on extracting home equity to finance consumption this is an area of concern.

On the labor market front, data continues to be volatile. Late 2006 data indicated a robust labor market but the dynamics of restructuring an economy away from manufacturing towards services expects some volatility. The January initial jobless claims number was higher than expected.

Retail sales have actually softened through 2006 indicating weaker consumer demand. US economic growth is firmly supported by the corporate sector, as evidenced by the increasing proportion of profits as percentage of GDP. The marginal product and hence the price of labour, it would appear continues to slow.

Indicative of the state of health of the US economy is the USD which has been weak against EUR and GBP throughout 2006. Seasonal year end effects should be discounted which would discount weakness against JPY and other Asian currencies.

All the signals point toward a soft landing in the US economy. What remains are large scale imbalances which need time to work out. Global inflation is under control, growth rates are healthy and there is a healthy trend of active diversification taken by all quarters from China and India directing their engagement towards Europe and Africa and away from the US and Europe reciprocating. This results not in a marginalization of the US economy, which would be unrealistic given its size and importance, but a diversification of systemic risk on a global scale. The re-emergence of Japan as a global economic force reinforces this diversification. Eurozone GDP grows at 2.7%, unemployment continues to fall for a second year running, and inflation is running at 1.9%, within ECB tolerances. The Japanese economy is running at 1.6% growth, revised down but healthy nonetheless for an economy just recovered from a long depression. Asia ex Japan, remains highly leveraged to the US economy but is also actively diversifying exposure by increasing inter-Asian trade. Commodity driven economies within Asia ex Japan will find increasing exposure to the Chinese economies while service economies will find increasing dependence on India.

The price of this stability and growth is active management of inflation and inflation expectations, which has led to an almost concerted effort of central banks from China, to the EU and England and the US, to restrain liquidity. Only the Bank of Japan keeps policy fairly benign.



More later about the impact on Markets.

Correlation and risk

We would like to know what risk we are running in our portfolio which consists of a clutch of hedge funds. To do this we measure the individual volatilities of each hedge fund. We also need to know how these funds relate to one another.

Question: Do we measure the correlation of returns of each fund with another? Or should we find out what each fund has in its portfolio and measure the relationships between portfolio components?

The Importance of Track Record in Hedge Fund Investing

Let’s do a little experiment. Lets take 1000 fair coins. Let’s give them names and flip them to see which ones come up heads and which ones come up tails. Now let’s take another 1000 fair coins and do the same, given them unique names and flip them recording which ones come up heads and which ones tails. While we are flipping this second batch, flip also the first batch and record their results. Now add another 1000 coins naming them, flipping them and recording their results. Do this for the previous batches as well. Continue doing this until you have 8 batches of 1000 coins.

Using simple rules of probability, of all the coins that have been flipped 8 times, that is from the first batch of course, how many would one expect to have come up heads precisely 8 times? Being fair coins, the number would be 0.5 raised to the 8th power X 1000, or roughly 4 coins. Of all the coins that have been flipped precisely 7 times, that is from the second batch, one would expect the number of coins to have only ever come up heads in every toss to be 0.5 raised to the 7th power X 1000, or roughly 15.


8 heads out of 8 tosses: 4 coins in 1000
7 heads out of 7 tosses: 8 coins in 1000
6 heads out of 6 tosses: 15 coins in 1000
5 heads out of 5 tosses: 30 coins in 1000

Thus, out of 8000 coins there are 57 coins who have never come up tails. Now supposing we loosely defined heads as the ability to generate good returns in a given year and tails the complement, and if we gave the coins strange names like ABC Capital, DEF Capital, GHI Partners, JKL Asset Management and so on…

Here in our database of 8000 coins there are 57 who have never had an unsuccessful year. Because we stopped our count at 5, you could compare this to searching a hedge fund database for funds with at least years of track record and have been successful in every year of their operating history.

The thing about the coins though is that the probability that one chosen from that 57, would have no more than an even chance of coming up heads next flip.

The above example is just an illustration. The definition of successful in a given year has not been clearly made. What is a successful year for a hedge fund? It depends on the level of risk they take. It depends on conditions in the markets. Depending on how demanding you are, success could be a very tough condition and the probability of being successful could be significantly less than 50%.

Let's do some calibration. Let us say that 5% of all managers have a good 3 year track record. We are thus defining success. This implies that success occurs with 37% probability. Using this probability we go through our calculation again and find that there are

0 managers with 8 years of unblemished track record.
1 with 7 years
2 with 6 years
7 with 5 years
18 with 4 years

Thus 28 with at least 4 years of unblemished track record. That's still quite a lot. And on the information we have, any one of these 28, thus chosen would have a 37% chance of being successful in the next year.