The First Degree View

Asset markets - stocks, bonds, property - are performing well.  The popular press points their finger at the easy money policies of the Central Banks as the source of asset market strength.  Does this argument have merit?

'Quantitative Easing' (QE) is the trendy expression for expanding the Monetary Base (currency and bank reserves) in the financial system.  This does not, of itself, expand the money supply. Monetary expansion takes place only if the banks use their reserves to increase lending.  The 'Velocity of Money' measures how willing and effective banks are at lending out the fruits from QE.  The following diagram shows that velocity has fallen significantly since 2007.

The decline in velocity is staggering and questions whether QE in the US has been expansionary at all. How can asset price increases be blamed on QE when banks do not seem to have been passing on the FED's actions in the form of loans?   

If QE is not the culprit for the run in asset prices, then what is?  Investor preference for risk would seem to be the best candidate. I have made this argument many times, but it would seem that investors have ratcheted down the compensation for risk that they are prepared to receive in the marketplace. This is plainly evident in the European bond markets where yields on everything from Greek bonds through to German Bunds have almost halved in recent months, and no-one can argue that the Debt Crisis is over nor can they argue that policies are in place to reduce debt - on the contrary, the discussion in Europe is all about raising debt levels!

If not QE, what is driving asset prices? Falling risk aversion is driving asset prices

European regulators are implementing plans for a trading tax to penalise 'short term speculation' and 'reduce volatility'.  While it is unclear that a trading tax can achieve either of these objectives,  one certainty is that a trading tax will lead to less turnover, lower profits and job losses in the financial sector.  But is a trading tax really necessary in the current environment where broker/dealers are already feeling the pain of low volumes?

One inadvertent side-effect of low interest rates is that it chokes off trading.  Broker commissions can run from 5bp to 25bp on a bond transaction depending on the size of the deal.  When base rates are 4 or 5%, the commission as a proportion of 1 year return is almost negligible, so few investors will baulk at executing their intended trade.  When base rates are 0%, however, the trade motivation must be compelling before an investor proceeds with the trade - simply put, the trade starts out in negative territory at the annual horizon.

This became a major hurdle during our flagship First Degree Long Horizon Absolute Return Fund's recent rebalancing exercise.  We ranked trades on a pre- and post- commission expected return basis, with two of our six candidate trades being knocked out simply because trading commission mopped up too much of the juice.

Brokers and dealers know this and it remains a mystery why they are still reluctant to cut their commission - when confronted with the option of executing at a lower fee or shelving the deal they choose the latter.

Politicians with a vendetta against the finance industry need not worry about a trading tax - their Central Bankers are effectively squeezing profits and shutting down the industry for them.

Iggy Pop and David Bowie could hardly have predicted how many Central Bankers would want to emulate the Bank of Japan's approach to FX intervention when they wrote the famous song 'Turning Japanese'.  It seems, however, that every nation experiencing upward currency pressure wants to turn Japanese.

The BoJ, acting for the Ministry of Finance, began accumulating significant FX reserves to stem their currency's appreciation way back in the early 1990's.  The rest of Asia followed suit in the wake of the Asian-currency crisis in the late 90's as strong capital and trade inflows were soaked up by the monetary authorities and held as Foreign Reserves.  South Korea, Taiwan, India, Thailand, Malaysia, Singapore and, of course, China, have all taken this route.

The BIG news today, however, is that the Reserve Bank of New Zealand has broken its 30 year 'hands-off' approach to currency intervention and is now actively accumulating reserves in preference to letting the NZ dollar appreciate.  The RBNZ has turned Japanese. The previous no-intervention policy was born out of reversed fortunes when the RBNZ attempted to support the NZD when it was under attack - this was a futile exercise simply because the size of the country and its reserves were miniscule compared with the might of the financial markets.  Its a little different today since the RBNZ has the means to print unlimited quantities of NZD's to buy foreign reserves - this means they can match any speculator who wants to go against them.

The disappointing aspect of todays news is that it marks the end of the only truly free-floating currency in the global financial system.  It also opens the RBNZ up to future pressure should the NZD's fortunes turn negative, and a potential replay of the crisis in the early 1980's.

Revolution is a central thesis of Marxist-Leninist economic theory.  The argument is the following: Capitalists exploit the Proletariat by paying just enough in wages to allow the labour pool to subsist. Profits are pocketed by the Capitalists.  The Proletariat doesn't like this very much and spontaneously rise up and - bang - Revolution! The key ingredients for a Marxist-Leninist revolution are Capitalists and Proletariat...

...No such luck for Mao Zedong.  His aspirations for a traditional Marxist-Leninist revolt lacked the key ingredients.  China was, and still is, a predominantly agrarian society which meant that there were very few prols, and even fewer capitalists, to incite a revolution - just a bunch of farmers. Like any power hungry politician, Mao needed an ideology to justify his actions and rally the troops, so he and his comrades reinterpreted the Marxist-Leninist conflict to be between the farmer and urban progress.  The farmer, being under attack from the drift toward the cities, would eventually be enslaved by capitalists as an urban proletariat worker.  Therefore, the best thing to do if you were a farmer was to march with Mao, revolt and nip the evils of urbanisation in the bud.

Mao's success in grabbing power backed him into a difficult  position since he now needed to stop the urban drift or risk losing farmer support and therefore control.  The 'Cultural Revolution'  solved this problem nicely.  The Cultural Revolution was a kind of nationwide 'Greenacres' experiment (remember that horrible US Sitcom starring Eddie Albert and ZsaZsa Gabor?),  where citydwellers, the intelligentsia and other counter-revolutionaries were forcibly relocated to the farming community to turn back the clock.  

Fast-forward to the present day and we find that the incoming Chinese leadership is populated by men who were victims of the Cultural Revolution in their youth.  And guess what their central platform is?  Rapid urbanisation!  Mr Li KeQiang, in particular, was appointed First Vice Premier which commands the Finance and Treasury portfolio, and he wrote his doctoral thesis at the elite Beijing National University on the need for accelerated urban centred growth to continue China's development.   China's leaders turned their back on Mao many years ago but the new leaders are confronting Maoist ideology head on.  

There had been some speculation that China's new leadership might throttle down the growth engine in favour of 'quality-of-life' reforms for the population.  The message from the leadership appointments yesterday is that its full-steam-ahead...its time to buy China!

"Greece fails in attempt to buy-back their bonds" will be the headline in a few weeks following the poorly conceived tender off that will be presented to bondholders.  How so?

Many moons ago I enthusiastically agreed with the proposal to reduce Greek debt through outright purchases of bonds on the secondary market. I had expected that the bond purchases would be covert in the sense that the authorities would simply sit in the market and absorb as much or as little of the discount securities as they were offered.  Liquidity motivated sellers would have valuable market depth and for every Euro spent, Greece's outstandings would be reduced by three Euro.  The program could have been operated indefinitely therefore placing a floor under the market and ultimately coaxing unwilling lenders back into the Greek bond market.

The latest bailout package announced by the EU/ECB/IMF troika has, as its centrepiece, a buyback program. On the surface this sounded like a major advance but - as with all things Europe - the proposal wreaks of idiocy.  Rather than an open ended on-market operation, the  plan envisages a single below market tender offer with the threat of compulsion for those who refuse the offer.  Here's what Bozo the Clown, the buy-back's financial adviser, had to say about the plan he conceived,

"The plan has three key planks designed to ensure 100% participation

1.  We will offer bondholders a price lower than current market levels. This will ensure that the hedge funds who have been purchasing Greek bonds do not make a profit

2. In the unlikely event that there are holdouts, we will invoke Article 9 of the EU constitution which allows us to repudiate the contractual terms that we,ourselves, put in place 8 months ago in the original PSI restructuring because they are not in the public interest. This allows Greece to ignore the protection of English Law and redesign the Collective Action Clauses to compel acceptance with 0% (or more) participation in the  offer.  The fact that we invoked Article 9 to force through the PSI in the public interest all those months ago, doesn't contradict the fact that the PSI turned out to not be in the public interest.  We are the government and we know what the public interest is and that it changes all the time.

3.  Official institutions are exempt from the buy-back except for the rich Asian and Middle Eastern ones.

I have assured Ms Lagarde that she needn't worry about not achieving full acceptance of the offer.  She is waiting before she agrees to disperse additional funding.

Signed Mr Clown, Bozo T."

Good luck Bozo!  Shine your bright red nose and floppy shoes...we will see you in court 

I went to sleep on Tuesday night content that the markets were in good shape - only to wake up to the news that a 2% fall in the S&P was being blamed on Philly Fed President Charles Plosser's '...attack on QE3.'  The financial press left it at that - but Chuck is no fool, and in fact a far brighter scholar than Ben Bernanke, so let me enlighten my blog followers on what he actually said and what he actually meant.

Chuck was my thesis Chairman and he doesn't take issue with light matters nor does he seek publicity.  His comments should be savoured.

His first point is that the US recovery is actually quite mature and by his estimates likely to accelerate.  Noting that property markets have adversely affected individual's wealth, it is not surprising that people are spending less in order to rebuild their portfolios through saving.  This is standard New-classical thinking - negative wealth shocks need to be rebuilt with future saving - and therefore the recovery cannot rely on consumption to spur growth.  This is a big shock to the Keynesian's but the logic is compelling.

His next point follows immediately...if the recovery is happening, why QE3 and why risk the Fed's reputation if, all of a sudden, they need to reverse policy?  Stupidly, Bernanke and his supporters have chosen to 'commit' the Fed to a calendar policy timetable - that is, the Fed has said that there will be no rate hike's until 2015.  Plosser's simple point is that the unemployment rate could easily fall to, say, 6% in 2013 and this would place huge stress on the Fed to renege on their own timetable.  Why not, said Plosser, make Fed policy conditional on economic outcome rather than a calendar date?  For example, if unemployment falls to 6% then the Fed will raise rates to 2%....

...Plosser deserves a Nobel prize for eloquence and simplicity.  But creating a monetary policy rule that relates Fed action to economic outcome naturally takes the fun and bravado away from the Extreme Central Bankers that now hold court around the world.  

Plosser's final warning is that policy confusion ultimately leads to market volatility....here we go again!

The 'Hillbilly cycle' was a well documented price cycle between the price of corn and the price of pigs.  Hillbillies in the US were characterised as the swing producers of either corn or pigs. Basically, high corn prices this year would lead the Hillbilly to switch from producing pigs to corn.  As the supply of corn rose, and the supply of pigs fell, corn prices would fall the following year while the price of pigs would rise.  On seeing this price change, the Hillbillies would switch from corn to pigs and hence the cycle would repeat itself.

Silly Hillbillies, you think...surely that would not happen in the modern markets which are forward looking, informationally efficient and dominated by smart people from Goldman Sachs and JPMorgan?  Well thin again...

....last night's 7.6% fall in the Corn price welcomes home the Hillbilly!  Yes, folks, participants in the Corn market were apparently surprised that last year's massive run up in the Corn price has actually triggered a large, positive supply response.  The USDA reported 5billion bushels of Corn stocks in the US which was over 5 times greater than the market had expected.  Needless to say, Corn prices fell by the most on record to $6.45 per bushel.  My guess is the  price will normalise at something close to $4 per bushel, which is consistent with pre-drought prices.

That means the Corn market has a long way to fall from  here so get short and you can thank the Hillbillies at Goldman Sachs and JPMorgan for the profits...

In the fairytale, his egg misplaced before birth, the 'ugly duckling' is born into a flock of ducks. Being ugly, the poor little duck is beaten and ostracised, only to reveal himself as a graceful swan after a troubled youth, admired by all.  So it will be with Governor Kuroda san at the Bank of Japan.  His egg, however, has yet to hatch...

Kuroda san needs to get the inflation rate in Japan up to 2% or suffer horrible shame and loss of face.  For the microeconomic reasons I have articulated previously (he can give the people money but he can't make them spend!) he is doomed.  Valiantly, he has promised to double, or maybe quadruple, or maybe just buy without limit, as many assets as the BoJ can print the money to buy.  But this won't force Ms Watanabe to do anything other than deposit her Yen in the Postal Savings Bank.

Kuroda-san's 'ugly duckling moment' will come in 2 years time when the inflation rate has not budged and he is disgraced...so wherein cometh the Swan?

Kuroda-san has entered a trade that makes every hedge-fund manager salivate - the ability to buy almost limitless amounts of something with limitless amounts of nothing.  The trade goes like this,

Kuroda san: Hi, I'm Kuroda from the BoJ and I want to buy all of Fifth Avenue, Bond St and can you throw in half of China?

The world: Sure, how do you want to pay for that?

K: Do you take Yen?

TW:  Sure...nice doing business

Yes folks, the Nihon ugly duckling may well fail to debase his currency, but he sure is going to make many generations of Japanese super wealthy in the meantime.  Behold Kuroda the Swan 

Why would 50% of US Republican voters favor a tax rate hike now to pay for Obama's spending? The answer is that they are going to have to pay for it at sometime in the future, so now is as good a time as any.

This logic is not only simple and compelling, it also explains why the doomsday forecasts for the 'fiscal cliff' are rubbish and, moreover, that triggering the tax hikes and spending cuts associated with the expiry of the Bush Jobs for America legislation may actually BE GOOD for the US economy.

I have written about the Ricardian Equivalence doctrine previously.  This argues that economic agents are forward looking in their expectations for taxes and government budget deficit financing such that what matters is the present value of future taxes that need to be raised to finance a budget deficit today.  This means that government spending is NOT stimulatory since people need to save to pay for the necessary tax in the future.  Government spending is exactly offset by savings for future taxes.  

Viewed in this light, triggering the fiscal cliff should have little effect on US growth as it will simply collect taxes a bit earlier than expected while at the same time cutting spending.  People will adjust their asset portfolios to reflect the timing of taxes while keeping their consumption plans largely intact.  So while Ricardian Equivalence doctrine suggests that the effect of triggering the tax hike/spending cuts will be largely neutral, what good can come out of it?

It is well known that government deficit spending is not stimulatory, and that long-term deficit spending multipliers are actually NEGATIVE i.e..higher deficits reduce economic growth in the long term.  If you don't believe me, just look at Europe.  Triggering the tax hikes/spending cuts may permanently block the Obama deficit spending juggernaut.  If so, then the Fiscal Cliff may well turn out to be the Stairway to Heaven!

When I ordered 20,000 shares in State Street's High Yield ETF (ticker JNK) in 2009, my broker was concerned that the order was too large to complete in a day without moving the market.  JNK was a relatively new vehicle with a market cap of $700m that didn't trade that often.  Four years on, JNK is a $12billion fund with daily turnover of $300m and is the preferred hedging vehicle for High Yield investors seeking liquidity.  What has happened to the High Yield market?

High Yield used to be open only to a few privileged institutional investors.  This was mainly because the bonds traded in relatively large parcels ($500K-$1m per issue) so that constructing a diversified portfolio of 100+ names required $200m to start.  Unlike in the equity markets where trade lots are much smaller, retail investors were largely excluded from High Yield.  ETF's like JNK broke down this barrier and now Mr and Mrs Mainstream investor can access the HY market.

This has changed the HY market forever and is the primary reason that the HY market continues to offer solid expected returns despite the significant decline in yields.  The reason?  HY bonds dominate equities in return per unit risk.  After a decade of extremely volatile stockmarkets with lacklustre overall returns, retail investors are expressing their preference for HY bonds over equities, and allocating their capital accordingly.  While some commentators caution that the supply of HY bonds is too low given the inflows, I take the opposite view: corporate treasurers will switch from equity to the HY bond market to raise capital if demand is there and there is a clear cost advantage to doing so.

In my opinion, the HY market is undergoing a significant structural realignment that will see the proportion of debt financing on corporate balance sheets rise and the long run risk premium for HY investments decline.  This contrasts with most commentators who argue that the HY market is at best fairly priced, or more commonly that it is cyclically over-bought.  At the same time, it is reasonable to expect that the size of equity markets will fall.  The Streets' equity stars had better start brushing up on their fixed income skills!

The high profile US Hedge Fund group Pershing LLP has recently launched an 'attack' (of sorts) on the HK dollar.  Pershing has amassed significant call option positions on the HKDUSD, reasoning that the inflationary spillover from Bernanke's ultra-loose monetary policy will not be tolerated by the monetary authorities.  Pershing expects the Hong Kong Monetary Authority to either (i) revalue or (ii) abandon the peg altogether.  Fat chance!

Adding to supposed pressure on the HKMA is the fact that they have been forced to add to their foreign reserves twice this month as the peg touched the upper bound of the permitted range.  This means that the HKMA injected cash into the system in return for additional USD reserves, which ultimately gets 'sterilised' by the issuance of domestic tbills and bonds.

Will the HKMA buckle this time?  We don't think so for a number of reasons...

First, the HK government has been very open with their contentment at outsourcing monetary policy to the US Federal Reserve.  Running a fully funded fixed exchange rate means that the HKMA has essentially dollarised their economy.  Hong Kong is a very small, very open economy and they are neither interested in operating an independent monetary policy nor are they set up operationally to do so. 

Second, HK is no stranger to accumulating and managing significant quantities of Foreign Reserves.  Their investments have performed very strongly over many years, and arguably has reduced the tax burden on its citizens.  If accumulating significantly more reserves is the cost of the current Pershing attack then the HKMA's attitude is simply '...so be it'.  The country will benefit from the investment return that Pershing (and others) are implicitly foregoing.  [Who would have imagined a transfer of wealth from a group of hedge funds to a sovereign state's coffers?  This takes the whole concept of voluntary taxation to another level!]

Put simply, the HKMA is quite content to defend the peg and it is under no pressure at all.  The attackers should take their loss and move on. 

Survival is a strong instinct. Animals, viruses and even humans go to great lengths to avoid death and extinction. In many cases, the organism's will to survive can cause others to suffer.  Charles Darwin theorised that survival of the fittest generates the strongest societies. Darwin, however, overlooked one institution whose will to survive leads to second-best outcomes - that institution is Government.

A particularly atrocious example of the will to survive to the detriment of the common good is the EU's handling of the Debt Crisis.  The core problem is that the 27 or so Governments in Europe spend too much.  Debt is the result of spending exceeding revenue.  The logical fix to the crisis is to stop spending.  But this would shrink the size of Government, threatening the very survival of the Eurocrat species.  So the approach to the crisis has not been to fix the core problem; instead it has focused on finding large enough pools of money to sequester. 

The first act of survival was the 'Greek Solution' which confiscated private bondholders assets by retrospectively inserting collective action clauses and subordinating private claims in the government bond market. That created a few problems for the Eurocrat, such as uniformly higher borrowing costs for the government debt that they continue to amass.  Another problem was the destruction of bank balance sheets that had held Greek Debt for reserve purposes - particularly the banks in Cyprus.  Which brings us to....

....the "Cyprus Crisis".  This is an entirely Eurocrat-inflicted wound on their own constituents based on survival at all costs.  The drama is still unfolding as I type, but the prognosis is not good.  Weak banking institutions should not be supported but the Cypriot banks are victims rather than villains.  The Eurocrats nevertheless have raided the banks' wealthy deposit base to pay for the Eurocrats' mess.

The only beneficiaries of these actions are the Governments themselves.  Collectively, the EU has agreed that there is '...a need for stimulus...' to help the '....economies to grow out of their Debt...'.  What drivvle.  This just entrenches the Eurocrats further in the system.

What is the long-term result of this fight for survival?  Capital flight.  This began a decade ago and will gradually accelerate.  Capital will land in nations who are net-creditors, namely banks in Asia and the Middle East.  

In the meantime, the Eurocrats will continue to trash their own backyard.  What are they going to do next?

18 months ago Mr Jes Staley was being groomed to be Jamie Dimon's successor at JPMorgan.  Three month's ago Mr Staley somehow fell by the wayside as other, younger, suitors gained favour as Dimon's successor.  This is not unusual in the power politics of large banking organisations and Mr Staley's departure from JPMorgan, announced this week, was to be expected.

The unusual aspect of Jes's resignation is that he elected to join a small hedge fund instead of seeking the helm of another financial supermarket competing with JPMorgan.  Moreover, Jes is buying a stake in the operation, Blue Mountain, with his own money rather than being welcomed gratis. 

What does Jes bring to Blue Mountain?  Jes is not a superstar investor, nor is he a rainmaker salesman.  His career at JPMorgan was largely in organisational planning and the machinations of internal decision making.  These are hardly valuable skills to a small hedge fund operation.  One valuable skill that Jes does have however, and I know this first hand, is VISION.

The 'vision thing' in this instance is expressed by his action.  For Jes, the days of the big bank financial supermarket are numbered. The promised synergies that were to follow from the Merger activity over the last 20 years have not materialised.  Instead, clients have been let down by their trusted banking brands (i.e. ripped off), senior management have lost control of sprawling organisations, scandals have been unearthed and punished (market rigging, illegal dealings), compensation is under attack and zealous regulation is targeting the biggest names in finance.  

At the same time, however, the financial sector as a whole is still vibrant owing to the fact that people are still getting rich and somebody is needed to manage their money.  For instance, the share of the Financial Sector in GDP in the US in 2012 is 5% (versus 5.6% in 2007 at the peak of the boom) while countries like Singapore have seen the Finance Sector grow from 11.2% to 12.1% over the same period.  

The Finance sector is going through a transition.  Big institutions are losing ground to small, privately held entities staffed by the talent that walks out the door of the big banks every night and, one-by-one, decide not to come back the following day.  Jes Staley is one of these people. As these small entities grow, their culture will change from brash upstarts to dignified partnerships, just like the JPMorgan of old, before the umpteen mergers, and of which Jes Staley was originally a product.  This is the value Jes brings to Blue Mountain.

Jes is going back to his roots.  This is the vision of the future.

One of the recent success stories for new financial instruments is the CBOE's VIX futures market.  The VIX is a measure of expected S&P500 stock index volatility - sometimes known as the 'fear index'.  Because the VIX is calculated using a complex formula and scores of Put and Call options, the VIX itself can neither be bought nor sold.  CBOE's VIX futures market partially solved this problem by offering futures linked to the VIX. Investors are able to take positions in the VIX without having to construct the physical portfolio of options.  The market's appetite for a volatility hedging instrument is so great that the VIX futures now trades over 100,000 contracts per day, and the CBOE is about to offer the contract on a 24hr basis...

The VIX futures market is only a partial solution to the lack of an investible underlying VIX portfolio. SInce the VIX does not exist, physical delivery is not possible and therefore the market is cash settled.  For VIX futures to have credibility, they must be closely tied to the VIX itself.  Theoretically, forcing the VIX future to expire at the same price as the VIX should achieve this goal but there is potential for unscrupulous traders to manipulate closing VIX prices for personal gain in the VIX futures settlement process.

The CBOE knows that this is a weakness, and so they have instituted a procedure to protect market participants using a 'Special Opening Quotation' system to calculate settlement prices.  The problem is that the SOQ doesn't work - in fact, the process invites manipulation of settlement prices by (i) separating the SOQ price from the actual VIX and (ii) providing unscrupulous traders with pinpoint accuracy as to the timing of their bogus bids or asks that drive the SOQ calculation.

For example, the October 2012 VIX settlement price was announced last Wednesday to be 15.96. However, simultaneously, the actual VIX was quoted at 15.35 having never been above 15.60 during the opening of the S&P500 options market and the SOQ process.  How could the settlement price be 15.96 when the VIX itself never reached anything like this level? This settlement price affected 60,000 open futures positions as well as 3.15million option contracts.  The economic implication of the overstatement of settlement price amounts to at least $27.6m in favour of the longs versus the shorts futures holders, and more if we factor in the call option holders.  

The potential gains from manipulating the SOQ settlement price are clearly large, and this threatens the viability of the VIX futures market.  The CBOE needs to act quickly to redesign their settlement price determination process.  An effective way to think about a new framework is to create one where the costs of manipulation become large relative to the benefits.

One way to increase the cost of manipulating prices is to create uncertainty in the timing of the futures expiry.  It is one thing to enter a bogus bid or ask price for a once-off SOQ calculation, quite another to be forced to defend that bogus price for minutes, hours or even a full trading day. Eating the cost of bidding $1 higher for 1000 option contracts is palatable if a trader can materially influence the settlement price, but holding that $1 overbid for an hour is potentially ruinous.

This is the solution that First Degree has put forward to the CBOE following Wednesday's skulduggery.  There may well be other solutions.  One thing is certain, however.  If settlement manipulation continues then the VIX futures market will shrink and die. 

The Singapore Government announced its SEVENTH round of taxes and regulations in 3 years, designed to stop the upward accretion of property prices in the City State.  The government believes that a property bubble has formed that needs to be deflated.  Are they correct and what can be done?

First, I think the price bubble diagnosis is wrong.  Strictly speaking, price bubble's occur when prices rise today simply because prices rose yesterday and the same thing will happen tomorrow.  There is no other reason.  Price bubbles accelerate exponentially and reach explosive proportions in short time.  Singapore's property prices exhibit contrary behaviour to this description - prices have been rising for more than 5 years, they have accelerated, decelerated and even fallen at some point during this period.  Moreover, there are fundamental reasons why Singaporeans have accumulated assets that need investing during the last 5 years - growth in incomes has been strong, housing affordability is at historically cheap levels, rents have risen and people are getting richer.  Price behaviour and the fundamentals both suggest that there is no price bubble...

So what is happening?  Basically, individual's balance sheets are very strong and there are few investment options available domestically and internationally. Domestically, Singapore is a very small country so that investments in industries are few.  Bank deposits offer little more than zero interest while education costs are high restricting the flows into human capital development.  Property offers a much higher yield and its limited supply supports the view that it will hold its value against high inflation.  As far as domestic investments are concerned, property promises yield plus maintenance of purchasing power.  

With a limited supply of domestic assets, the logical alternative for investors is to invest internationally.  But here's the rub - the SGD is undervalued so that future capital appreciation implies losses on offshore investments.  On this basis, domestic property dominates international everything and this is why the property market is well bid.

It follows that, rather than tax property transactions, if the Govt wants to reduce rational portfolio demand pressure on the property market then it should appreciate the currency.  Partial equilibrium solutions carry unintended consequences (this is a topic for the next blog entry), and while there will be losers from a stronger SGD, the many Singaporean portfolio investors will benefit from the expanded investment universe it will open up and we wont have to concentrate our wealth in domestic property.

"The reason we hire big managers is because, if something goes wrong, they will fix it internally. Its too hard for our Investment Committee to fire a manager, so we rely on our managers to respond themselves" - CRA's pension plan sponsor, 1993.  This comment still resonates with me nearly 20 years after the conversation.  Back then, there was a clear connection between brand and quality in the Asset Management industry.  Can the same be said today?

Probably not.  Over the years there have been mergers, breakups, bankruptcies, scandals and illegalities affecting nearly all the major financial brands in the market.  Citi, Barclays, Goldman Sachs, Lehman, JPMorgan, UBS, RBS, HSBC, Standard Chartered, Merrill Lynch etc etc roll off the tongue while the rest share the same criticism - just about every major financial institution has had their brand tarnished in some way or another.  Financial brands are no longer an assurance of quality.

Those of us in the markets are wary of 'recommendations' from major houses.  We are skeptical that fees dominate their motive rather than sound advice.  Who can an investor trust?

Quality of advice, quality of process, quality of performance and quality of service are in a vacuum because the major brands have squandered their moral high ground.  The Quality Vacuum, however, creates an opportunity for others to occupy and win the confidence of investors.  Who is best placed to fill the void?

Alternatives and Boutiques, that's who.  This Asset Manager group has hitherto operated outside of the mainstream, since the big brands grip was unassailable.  The core-satellite structure is an example where the bulk of assets are managed by a core branded manager while small allocations to 'satellite-managers' might include the odd boutique. Alternative and boutiques needed to distinguish themselves as significantly different from the mainstream to gain attention, therefore pidgeon-holing themselves at the outer-edge of the industry.  But the Quality Vacuum that the major brands have brought upon themselves changes this message - Alternatives and boutique can now argue that they can offer the SAME services as the major brands, and do it BETTER!

Quality, quality, quality...one only needs to look at the legions of highly qualified and experienced investment professionals who have voluntarily left the major brands to start their own operations to know that quality is transferable and leaking away from the majors.  A small shop with 3 or 4 professionals can offer the same or better advice to a $100m Family Office that one of the majors can - the only difference is that the $100m family office would be considered too small to bother with by a major!

If the Alternative and Boutique sector embraces the quality issue then the opportunity is to collectively own the mainstream asset management space.  The following opportunities exist,

1. Despite the scandals and lost respect, people are still getting richer and they still need their money managed.  Something like 4% of GDP is spent on financial services in the US, so this represents the size of the cake on offer

2. Fund of funds can re-orient their focus from delivering outstanding performance to delivering quality performance (a subtle but significant difference - top quality does not mean highest return)

3. Alternative asset management funds are surprisingly competitive fee-wise if investors go direct to the manager.  There is a role for an aggregator who measures quality and offers a conduit for investors to access managers.  

4. Product is perhaps the biggest opportunity.  Rather than offering niche structures that are expensive to construct and operate, new products can be simpler and even traditional in structure.  The reason being that high quality investment expertise is the characteristic attracting investors as opposed to complexity or obscurity.

The losers from all this will be the three or four layers of management back at the HQ's of the major brands that are responsible for the current state of disrepair...

Here is an extract from last Tuesdays BoJ board meeting:

Shirakawa (Governor): Minosan (everyone please listen).  Prime Minister Abe-san has set us a 2% inflation target.  How are we going to achieve this target?

Board members: (Collective silence)

And that was that ... lets face it, what can the BoJ do to raise the inflation rate after having flooded the economy with Yen for the last decade or two?  The Keynesian/Monetarist response that is necessary to drive money into price increases doesn't work.  This transmission mechanism is naively the following: (i) BoJ buys assets in exchange for Yen and (ii) the sellers of assets buy consumption goods bidding up prices.  The first step works well, but the second step does not - instead of buying consumption goods, the sellers have been ploughing their new Yen back into asset markets, primarily deposits.

This is the micro-economic reality in Monetary Theory.  A little known problem in Monetary Theory is just how difficult it is to get economic agents to hold cash.  Theoretical models force agents to hold cash either by putting money into each agent's utility function (very weak justification for this) or through a 'cash-in-advance' constraint which forces people to hold cash balances now to pay for consumption tomorrow.  The need for cash-in-advance is arguably justifiable in economies with less developed financial systems, however difficult to assume in Japan...near money assets which substitute for cash renders monetary policy ineffective.

So what can the BoJ do to create price pressures now that we understand that printing Yen wont work?  Investors react favourably to anything which raises the marginal productivity of capital ie higher profits.  Deregulation and a lower currency have this effect.  Adopting an openness to investment from both domestic and foreign sources will stimulate real activity, which may reflect in the future as higher prices.

Our intrepid CEO, Tony Morgan, noticed an article on CNBC (http://www.cnbc.com/id/48721090) that reported on the post-GFC inquiry into the activities of the $700Billion Norwegian Sovereign Wealth Fund, Norges Bank.  Many had expected that the inquiry was going to berate Norges Bank for not cutting risk during the Global Financial Crisis.  On the contrary, to the astonishment of many, the inquiry criticised Norges Bank for not allocating toward risk assets as their prices were falling.

The argument the committee accepted was that the risk premia offered by risky assets rose considerably during the GFC. Consequently, investors such as Norges Bank were offered cheap assets with high expected returns and they should have taken advantage of this opportunity.  While some may argue this is obvious, the findings represent a watershed shift in official thinking.

Traditionally, expected asset returns have been viewed as static values that do not change through time.  Asset consultants and practitioners operating on this assumption then proceed to recommend a static strategic benchmark allocation that must be followed irrespective of market conditions. This traditional approach is challenged once expected  returns are accepted as time-varying.  In fact, this opens the door to active asset allocators such as Global Macro investors.

Our investment process at First Degree is predicated on time-variation in expected risk premia and it is heartening to read that this concept is catching on with major institutional investors.  The trick is to identify temporary changes in valuations that signal asset allocation shifts.  Our guess is that this will be a growth industry within asset management over the coming years.

My previous post argued that the Singapore property market is not in a price bubble.  This is because the shape and longevity of the price move itself (it doesn't look like an accelerating exponential speculative market), as well as the demographic in Singapore.  However, while ruling out a price bubble, one cannot argue against cyclic variation in the property market.

Cyclic price movements in all asset markets are a fact of life.  Governments and investors may not like the bull-bear cycle but it serves a purpose.  In the case of residential property, for instance, higher prices signal an undersupply of housing which in turn stimulates new construction.  Asset prices are the most efficient way for allocating resources.

The Singapore government's cooling measures are a classic example of the futility of fighting markets forces.  Were the property market in a bubble, then the first or second round of measures would have deflated the speculation.  The need for a SEVENTH round, which now reaches into the heartland of the average Singaporean, should be evidence enough to a pro-markets government that something more fundamental, other than speculation, is driving this.  Worse still, the more the government tries to contain the rise in residential property markets, the more it distorts asset markets elsewhere.

Industrial property, for instance, has jumped in price as investors switched from residential property to avoid the Government's taxes.  The implications are far reaching, since higher industrial property prices lead to higher rents and higher costs of production.  The Government has now reacted by imposing a tax on industrial property prices, but this is the policy equivalent of '...putting your finger in the dyke...' since the pressure on asset prices will spill-over elsewhere.  What's next?  The Singapore stock market of course, and maybe the market for used cars...

The real issue is that Singaporeans are getting richer and they need an investment universe that offers a reasonable rate of return, both onshore and offshore.  As argued in my last post, a stronger currency will open up a world of opportunity for investors, relieving the pressure on domestic asset markets.

The next financial crisis, according to recent media reports, will be a 'currency war'.  I am not quite sure what this is however I think it is when one country lowers its exchange rate and this leads another to do the same.  A series of competitive depreciations follows and this constitutes a war.

Currencies are strange animals, particularly in the current environment where there is no standard of value - that is, there is nothing to judge the value of the US Dollar, or the Yen or Euro or Renmimbi or anything by.  The best we can say is $US1 equals 93 Yen, but that says nothing about purchasing power.

In this situation, the so called 'war' simply acts to keep relative currency values constant.  For instance, if Japan lowers the Yen by 10% against the USD and the US retaliates by lowering the USD by 10%, we are simply back to where we started.  Where's the crisis in that?

Despite the media speculation, any currency crisis will not be sparked by planned warfare, rather it will be driven by uncontrollable currency volatility.  How can the Bank of Japan stop the Yen from falling is the real problem now that sentiment is firmly against them?