Review of recent thoughts: Risk/reward ratio less interesting

Please find below an extract sent to clients summarising thoughts discussed with clients. We summarise thoughts in different sub headings.

You may have noted we have been particularly quiet over the last few months. The words best used to describe this inactivity is fear. Over the last three years we have moved to being aggressive buyers of bonds to cautious buyers of equity. Recently, the current preference has been the steady accumulation of cash (20 - 25% in a portfolios makes us comfortable).

1 Can an economy get out of a crisis born from leverage by issuing more debt?

Many of you have probably just sighed. Here he goes again...talking about over leveraged economies. Doesn't he get it that governments are printing money so that there will be no debt crisis?!

Perhaps this is correct. However, I fear the following: if a country prints money to meet obligations, they risk creating a loss of confidence in that currency. As a result, the cost of attracting foreign capital into that economy will have to increase for debt outstanding. This may exacerbate fears in the value of the currency of that economy, which may increase the cost of capital for that currency, and so forth, creating a positive feedback loop that can cause rapid changes in the value of risk assets and the currency of that economy. Such events are not linear. As Hemingway answered the question, "How did you go bankrupt?: Two ways. Gradually, and then suddenly".

Let us use an example. In Japan, recent discussion has suggested Japan's parliament may target a more aggressive hard inflation target of 2-3%. For the past 10+ years investors in Japan have agreed to receive less than 1.5% in nominal yield. Considering that during this period the country experienced deflation of 1 -3% per year, this provides the buyer with a real yield of between 2.5% - 4.5%. If the Bank of Japan (BoJ) was to target inflation of just 1 - 2%, what rate would investors demand to have a positive real yield?

HERE IS THE PROBLEM, most lucid in the case of Japan. If the BOJ chooses an inflation target, the Japanese central government's cost of capital could increase by more than 200 bps (2%). This would increase their interest expense by more than 20 trillion YEN. Note that approximately every 100bps change in the weighted average cost of capital is roughly equal to 25% of the central governments tax revenue (Source: Haymans). Do you think 1.5% rates are sustainable? I don't. Neither do many market participants...However, while the music keeps playing, lets play the same game...

What we don't know is when the game changes. However, it is important to note the game can change. More points on average (in terms of portfolio return) are given for being aware (and reacting to this) then pretending to time the event precisely. Other developed countries have not quite reached this level of debt outstanding, but are playing the same game, and are developing a similar dependence on extremely low interest rates. My conclusion: debt matters.

Please also note that Japan has the much documented problem of an aging population. As previous Japanese government bond investors start dipping into their capital as they retire, rather than buying more bonds, the country will become more dependent on foreign funding. As most foreign countries are currently experiencing inflation rather than deflation, they will demand a higher nominal yield than those requested from local Japanese investors. Here in lies the problem which can create the above mentioned problem....

Such consequences are huge, and many believe the probabilities of them occurring are small. In the past such events have led to collaboration amongst developed economies to create a peace of mind amongst the investment community. However, many of the developed economies are now significantly leveraged.

In any case, we are looking to develop products that can offer a return should such "tail risk" events occur. However, it will only be pursued if the "quasi insurance" is cheap enough. The reason we do this is should the above mentioned event occur, most risk assets are likely to suffer. We are looking for a little flower that can pop out should such extreme events occur. We will update you as such products are developed.

Conclusion: In general, we are not buyers of long term bonds.


2 Europe

We still feel the problems in Europe are being labelled a liquidity crisis rather than a solvency crisis. This denial of the problem makes it difficult to find a solution. We remain concerned.

Conclusion: We are not keen on increasing exposure to the EUR.


3 USD and Oil

Many have expressed fear of the USD weakening relative to the EUR recently. Simultaneously the oil price has been spiking upwards. In my opinion, it is no surprise the USD weakens as oil spikes. The US is the largest user of oil in the world and oil imports make up almost half the trade deficit. As oil goes up, the trade deficit effectively increases and more foreigners hold USD. These foreigners may sell USD as they have too many or may want to diversify, hence reduce the value of the USD relative to other currencies. Remember, oil is traded in USD. If risk aversion was to grip the world, I would continue to want to hold some USD.

Conclusion: We do not feel a dramatic dash to sell USD. If you have no USD, it may be interesting to start holding a position


4 Surely choosing inflation over default is better?

Much is said on the media (the entertainment business) about how inflation is preferred over default, it creates less "damage" to an economy. However, if inflation will be created by increasing liquidity generated via increasing the debt load of the economy (be it via the government, corporates or the household), then at one point once a certain debt load is reached relative to assets and income received, the possibility of default is increased by increasing the flow of credit (i.e. the potential of greater inflation expectations).

Hence, at one point increasing credit does not dilute the problem, but exacerbates it. In the case of Japan provided above, I believe that point has already been past. Money printing is another option. But what is money printing. It is the process of buying back financial securities and placing cash in that bank account in return. However, if that liquidity is used to purchase other financial securities then they will rise in price. If the currency does not fall, you are likely to see less interest by foreign buyers as a consequence. This is not wise for a country that may have trade and budget deficits and requires foreign money to pay their bills. As a result the currency is likely to drop of the cost of borrowing will be forced to increase by market pressure.

Free markets are like water. If one route is blocked, another will be found to reach the destination. Water follows the line of gravity, capital follows the line of the risk/return ratio. These variables can be seriously skewed over short periods of time: I feel both are currently mis priced. Too little return for too much risk. Today, cash can be a good investment and should be a part of the portfolio. Since no one can be sure what will happen (uncertainty always exists) we need to adapt the asset allocation accordingly. A 20 - 25% cash allocation in the current environment seems sensible to me.

Conclusion: Markets are pricing economic recovery too positively. We are not keen on purchasing growth stocks or cyclical companies at current prices. Opportunities do still exist in high quality companies. These are low debt, high return on capital companies that work in slow moving market sectors with few competitors and where the company in question has a dominant position.

As an aside, we have been asked by many clients what could cause an equity market re rating. As we have seen over the last few weeks, the world is uncertain and it could come from anywhere. However, if I was to summarise my answer in one sentence, I would say the following: "A re rerating of risk assets is likely to come from the bond markets rather than the equity markets."

High oil prices could lead to lower margins for capital intensive companies in the next quarterly earning. This may reduce steam in the current equity market rally. However, the re re rating of the S&P 500 going to 1100 or less (current pricing is 1310) is more likely to come from the bond markets - the same source of funding that has effectively allowing the equity market rally to occur.