Money for nothing... Buffett style

BBC 2's Evan Davis met the world's greatest investor and summed up Buffett's simple strategy like so...

1. Invest... don't speculate. It's the cash flows from the asset that generate your return, not the movement in the price.
2. You don't have to diversify. "If somebody owns 50 stocks, can they really like the one they rank as number 50 as well as the one they rank as number 1? Can they know it as well? I don't think so."
3. Be a business owner. Don't just buy shares.
   
4. Allocate capital efficiently. Take the profits of one business and invest them in another.
5. Don't get into debt. "If you're smart you don't need it, and if you're dumb you've got no business using it."

The mark of an intelligent person is one who can make the complicated sound simple. Buffett and his investment style embody this in spades.

The deflation vs. inflation debate continues...

On Thursday I went to a presentation by Charles Dumas of Lombard Street Research and Ian Harnett of Absolute Strategy Research. Here are the key messages…

Charles Dumas in the deflation corner 

US fails all 4 of the Friedman's 4 steps to inflation (his evidence is in brackets):

1. Rapid growth of broad money (money supply collapsed)
2. Asset price boom (markets 25% off peaks)
3. Overheating of economy (US in recession)
4. Inflation (CPI falling)

US M3 growth c. 4% but underlying this, the picture is different. Bank lending to private sector -6% so M3 growth coming from QE and govt stimulus 

US unemployment rising (currently 9% which is highest since 1982), therefore wage growth negative. Dumas expects unemployment to continue rising & then stabilise as GDP next year will be way below normal recovery rates. Given the NAIRU (non accelerating inflation rate of unemployment) is 5-6% in the US, don't expect any wage growth (and by extension inflation) any time soon. Indeed, hourly wage growth of only 0.5% + rising unemployment ≠ rising CPI  

US trend growth is c. 3%. Going forward, trend growth will be lower at 2.2% due to the collapse of key industries such as financials. In this recession, GDP has fallen -5.6% so output gap is c. -7.8%. If the US economy grew by +4% to +5% p.a. for 3 years the output gap would be closed. He therefore believes CPI will stop falling in 3 years time, although this is optimistic given lower expected growth rates. Dumas notes that the coefficient between the US output gap and CPI is c. 25% (i.e. if gap is -4%, CPI = -1%). 

Finally, CNY/ USD peg has reduced Chinese export prices, which has increased China's market share. So, China wins if USD is weak, as does the US since their exports are also cheaper. However, this is negative for Japanese and European exports. 

Conclusion slide shown below…

 

Ian Harnett in the inflation corner 

Inflation will be caused by 2 factors:

1. Low inventories will result in frictional inflation due to supply shortages
2. Liquidity creation is causing asset price inflation 

This is more of a corporate rather than a consumer recession (e.g. US consumption contribution to GDP is still positive while investment & inventories are negative contributors). This is causing a supply shock. Supply chains have been built on the Great Moderation and are therefore unable to cope with economic volatility and associated sudden pick ups in demand. To demonstrate this he looks at US ISM prices paid and ISM inventories minus shipments (orders), which move in tandem (see chart). Both are positive as prices paid are rising due to sudden inventory rebuild.

The corporate response to the credit crunch has been to slash costs & capex in order to preserve free cash flow. However, this can't continue and Harnett expects employment to pick up in the near future (see chart of claims [lagged 6 months] & unemployment). This, will also increase monetary velocity.

 
Asset prices are rising across the board (he highlights the 14% annualised growth in UK house prices over the last 3 months as well as the rise in the oil price). This combined with the fact that the Bank of England appear to be targeting nominal GDP growth of +5% (MPC member Charles Bean Feb 09 speech re targeting "growth in overall economy of circa 5%"). A focus on price levels of assets such as house prices will keep policy looser for longer. The BoE will therefore tolerate much higher CPI in order for prices to get back to pre crash levels.

Inflation will appear in asset prices before consumer prices, which will be the catalyst for rising yields (e.g. US 2 year currently below level of US core CPI, a relationship that will not hold for much longer).

So there you go. Please excuse my crude attempt to distil such complex arguments and make your own mind up.

The bull is rolling over

SPX falling out of bullish channel, closing below 1,060 suggests weakness to come. SELL!!

Beware of gravity!

The equity market is in a gravity defying 'sweet spot' of low interest rates, QE, returning M&A, cash rich, yield hungry investors, and earnings and economic fundamentals are working off ultra low bases. Of these elements, the most likely tap to be closed off first is QE, then interest rates, which will probably be the catalyst for gravity to take over.

Why have bond and equity markets been rallying in tandem?

The answer is simple. Equities have rallied BECAUSE bond yields have fallen, reducing the cost of capital and forcing investors to take more risk to maintain their yield. This amounts to a universal carry trade driving everything including corporate bonds, equities and currencies.

Moreover, the fall in long bond yields is being driven by the short end, on which they are anchored. So, as the 2 year yield is squeezed lower by FSA liquidity requirements and lower for longer base rates, longer dated yield shave also benefited from the carry offered by the steepest yield curve in over 20 years. This interplay is demonstrated by the 2's 10's spread, which has remained stable, as the 2 year has hit a record low...

Anatomy of a liquidity trap

Liquidity trap: A situation in which prevailing interest rates are low and savings rates are high. As a result, monetary policy is ineffective.

The effectiveness of QE is being compromised by unwillingness on behalf of UK banks to lend. As a result, for every £1 spent on QE, less than £1 is being lent out, which means banks are hoarding the money in order to bolster their balance sheets. This is clearly demonstrated in the charts below, which are based on weekly data from the Bank of England. The first chart shows how a large part of the BoE's ballooning balance sheet has come from reserve balances. The second chart suggests that the cumulative Gilt purchases by the Bank of England have been responsible for the increase in commercial bank reserve balances held at the Bank.


Having initially been about increasing “the amount of money that’s held by the wider economy”, the purpose of QE has been refined by the Bank of England to restoring M4 (ex Intermediate OFCs) growth to 5% per annum. Therefore, the Bank of England acknowledged in the August Inflation Report that QE is not meeting their 5% target:

One potentially useful diagnostic of the impact of the Bank’s asset purchases is the extent to which they boost the stock of broad money. Broad money growth remained weak in Q2. That reflected continued underlying weakness in nominal demand: nominal GDP fell by 3% in Q1, and is likely to have fallen further in Q2. Absent asset purchases, it is likely that money growth would have been even weaker.

Indeed, despite QE, M4 is moving further away from their target...

Given the ineffectiveness of circa £150 billion of Gilt purchases to date, speculation is mounting that the Bank will resort to increasing the QE programme to £200 billion and charging negative interest rates on reserve balances at the BoE in order to boost the money supply and force banks to lend. This, coupled Mervyn King's prognosis of a "slow and protracted recovery", explains why yesterday the two year Gilt yield reached an all time low of 0.74%, Cable sold off two big figures and interest rate futures are pricing in low interest rates will continue for the foreseeable future…

Let's party like it's 2009!

The recovery party is in full swing, fuelled by an enormous punch bowl of monetary and fiscal stimulus. Having initially threatened to call time by discussing exit strategies, the G20 has agreed to leave the stimulus in place. In doing so, the world's finance ministers have unilaterally committed to underwrite the economic recovery.

Thus, cheap money has increased the price of everything from oil to stocks. Furthermore, in the short term the rally has become a self perpetuating virtuous circle, pushing sentiment indicators higher which in turn sustain further gains. However, easy money and sentiment can only take markets so far. In the end, unless they are supported by above consensus earnings, GDP and clear signs of demand, markets will falter.

Indeed, beneath the benign exterior of lower for longer interest rates lurks a liquidity trap and an economy delicately poised on a knife edge (more on both of these to come).

It is usually sensible to leave a party while it is still in full swing.

China, the engine of global growth or a bubble in the making?

The case for
Chinese GDP in the second quarter was a whopping +14.6% p.a., contributing 1.6% to global GDP, which without China would have been flat.

The surge in the copper price and the fall in the US Dollar are testament to the fact that China has become an undisputed key force in many markets. If China is the engine of global GDP then its demand for materials and assets will drive global asset prices higher.

The case against
Chinese economic data and its method of calculation is questionable (e.g. goods count as having been sold when shipped to retailers, not when purchased by consumers). Furthermore, the latest set of first-half GDP numbers from provincial authorities are far higher than Beijing’s national figure, raising questions on the accuracy of statistics.

The current liquidity boom is reminiscent of the US from 2000 to 2007, with cheap money fuelling asset price bubbles. Loan growth is unsustainable and instead of being deployed strategically, must have been used speculatively judging by the rally in the real estate prices and the Shanghai Composite index (+80% year to date!). The Shanghai Composite index trades on 24 times forward earnings, which is 41% premium to the S&P 500, which trades on 17 times expected earnings.

Other evidence of a bubble can be found in recent Chinese IPOs. China State Construction Engineering Corp smashed IPO records, raising 50.2 billion yuan (or 43x recorded earnings) and was up 56% in its first day's trading! When a market is that 'hot' it is either fuelled by retail demand or a sign of far too much easy money chasing too few good investments opportunities. Both signal overvaluation and impending correction. As every tech bubble veteran knows, the hotter they are, the harder they fall.

Finally, as if all of the above was not bad enough, Chinese asset prices appear to be under the control of the country's government who themselves admit that fresh asset bubbles are forming. On Wednesday 29th July the Chinese equity market fell 7% on news that the government would restrict the amount of bank lending. Realising the impact of their announcement, the following day the government announced it would 'unswervingly continue to apply appropriate loose monetary policy' and stocks recovered the previous day's losses. For this reason alone, Chinese equities deserve a higher risk premium since they are vulnerable to government intervention. Although, so are most Western markets.

Conclusion
In the long term China will undoubtedly become an engine of future global growth. However, in the short term, investors in Chinese assets have got ahead of themselves and allowed prices to go too far, whilst ignoring the risks associated with a torrent of liquidity. If left unchecked, such aggressive stimulus risks bursting what is now a bubble, as Nouriel Roubini notes in a recent post on his blog:

Aggressive government led stimulus (direct government investment and encouraging banks to lend) contributed to a reacceleration of growth in Q2 2009, one of the first countries to have a growth acceleration in H1 2009. While upside risk is certainly present for China's GDP growth outlook, serious downside risks from China's fiscal and monetary expansion remain. In particular the risks that stimulus is contributing to asset bubbles in property and equity markets, worsening the risk of non-performing loans and adding to overcapacity could, especially in the absence of a rebound of external demand contribute to weaker than trend growth in 2010-11.

Asian Development Bank predicts Asia ex Japan GDP to recover to pre recession level of 6% in 2010...

... however, it is too early to declare V for victory. Governments have substituted public investment for private investment and exports that have evaporated. With Western demand unlikely to pick up the slack, 6% GDP must come from domestic demand, which is unlikely. The ADB report shows that Asian demand, including China, accounts for 22% of demand for Asian exports. Moreover, H1 Chinese imports fell -25%. So, until Asian economies can create sustainable domestic demand, their recovery will remain fragile.

The long & winding road to recovery

Labelling the recovery with letters of the alphabet such as 'W' or 'V' is such a cliché. Song titles are far more effective. For example, the Vapors' Turning Japanese describes Japan-style deflation and Yazz's The Only Way Is Up describes a bullish 'V' shaped recovery. So, which song best describes the outlook for the world economy and markets… The Beatles' The Long & Winding Road?

Faced with considerable headwinds of reduced credit supply, corporate and consumer deleveraging, and falling house prices, GDP will remain below its long term average. The road to recovery is therefore going to be both long and winding. Indeed, the IMF noted last week that:

The global economy is beginning to pull out of a recession unprecedented in the post–World War II era, but stabilization is uneven and the recovery is expected to be sluggish. Economic growth during 2009-10 is now projected to be about ½ percentage points higher than forecast by the IMF in April, reaching 2.5 percent in 2010… the global recession is not over, and the recovery is still expected to be slow as financial institutions remain weak and credit intermediation impaired, support from public policies will gradually diminish, and households in countries that suffered asset price busts will rebuild savings.

So, although GDP growth is receiving a short term boost from fiscal and monetary stimulus and an inventory rebuilding cycle, the durability and strength of the recovery will ultimately depend on consumer spending. Since the US consumer accounts for c. 70% of GDP, US growth is likely to remain subdued until consumers save less and spend more. Furthermore, this is a global recession, which means that exports are unlikely to provide sufficient impetus to either GDP or consumption.

Equities
So, what does a prolonged period of below trend GDP mean for equity markets? Lower GDP growth implies lower earnings growth (see charts below). Therefore, P/E ratios will remain lower for longer since equity prices cannot move substantially higher unless supported by earnings growth.

Moreover, suffering from a debt hangover, management at over-leveraged companies are being distracted from growing earnings. Instead, they have to focus increasingly on reducing debt and balance sheet restructuring. Thus, companies who went into the credit crunch with robust balance sheets are likely to steal a march on their over-indebted peers. Anecdotal evidence of this includes Greene King's equity raising to buy pubs from distressed seller, Punch Taverns. In the housebuilder sector, Berkley Group learnt it's lesson from the last housing crash and went into this crash debt free, whereas Taylor Wimpey was in bad shape and returns on equity suffered…

However, even if equity prices remain stagnant for the next year, investors can still earn 5-7% p.a. in dividends, which is substantially higher than 12 month LIBOR at 1.5%. So, provided one invests in companies with sound balance sheets and dividend cover of over 2 times, the equity market is likely to be an attractive source of return.

Interest Rates
There is a limit to how high long bond yields can go while base rates are anchored at or near zero. With unemployment in the developed world converging on double figures and GDP remaining below trend, base rates will remain lower for longer. Thus, if longer yields rise too far, the carry becomes too attractive for them to rise further and institutions that can take advantage of low-cost funding from central banks will start buying, pushing yields lower.

However, this is a risky game and the stakes are high due to the many risks facing the government bond markets (QE overhang, record issuance and inflation to name but a few). Thus, in the UK at least, the yield curve has never been steeper, implying that investors are demanding a substantial risk premium over shorter yields to hold Gilts.

Inflation
As discussed previously in Inflationistas have been smoking too much 'green shoots'! inflation is being kept at bay by a wide output gap. If GDP remains below its historical average then it will take longer than average to close the output gap, postponing inflation in the process.

In conclusion, the recovery has started in earnest, but it's going to be a long and winding road to recovery. However, provided one is positioned accordingly and with realistic return assumptions, there is no reason why the road shouldn't be a profitable one.

BlackRock's Bob Doll on the outlook for equities

The following is an article written by Bob Doll and published in the FT on 3rd June 2009...

A different kind of rally

It would be an understatement to say that global equity markets have been volatile in 2009.

After sinking sharply in January and February as economic data continued to worsen and as investors grew uncertain about policymakers' next steps in combating the credit crisis, global equities went on the rise in the next couple of months and now seem to have entered a period of uncertainty.

Is the recent rally for real, or merely a blip in a longer bear market? Does it represent the start of a new bull market? Will we see less volatility from here, or should we expect the roller coaster to continue?

Since the bear market began in earnest last September (with the collapse of Lehman Brothers marking an important inflection point), several global equity rallies have failed to take hold. In our opinion, however, the rally that started in March is different. That rally (which, from trough to peak, has resulted in global price advances of more than 30 per cent) is based on a combination of technically oversold conditions, aggressive global policy actions and a general sense that the global economic recession is moving past its period of greatest weakness.

The question now is whether the rally marks the end of the bear market, or if it merely represents a temporary bounce from oversold conditions. It would be premature to suggest that a new bull market has emerged or that we have seen the end of the see-saw patterns that have been in place since last autumn.

Nevertheless, we do believe there are several important differences between current conditions and the failed rally attempts that previously occurred. From a technical perspective, this rally has been marked by strong momentum and expanding volume on the upside, and diminishing momentum and volume on the downside. Additionally, lower quality and more cyclical areas of the market have been outperforming, as have emerging markets when compared with developed markets, trends that occur when more sustained recoveries begin.

The extent to which equities are able to continue to advance will depend largely on the degree to which the global economy is able to recover. On balance, our view is that the global economy is still in the midst of a severe and dangerous recession, but, importantly, the massive policy initiatives around the world have begun to bear some fruit. The dramatic interest rate cuts, spending increases, tax cuts, capital injections, bank rescues and plethora of new government programmes have all helped to combat ongoing credit-related deflation risks.

We believe the fourth quarter of 2008 and the first quarter of 2009 will mark the low points for economic growth. We expect a small gain in world economic growth by the third quarter of this year. We also expect to see modestly positive levels of growth in the United States at some point in the second half.

While investors have grown more optimistic in recent months in the face of some "less bad" economic news, it is important to remember that less bad is not the same as actual good news. As such, we believe the rally that started in early March may be running out of steam and that a resumption of the rally will require more solid evidence of an economic recovery.

At present, we believe equities are entering a correction phase, although we believe this correction will be marked more by sideways action and less by a sharp decline. We think it is extremely unlikely that prices will retreat back to their early-March levels, but we could see some modest near-term declines and believe that continued volatility is likely. Typically, such corrections result in a give-back of between one-third to one-half of recent gains (which, in the United States, would result in a short-term drop to between 800 and 850 for the S&P 500 Index).

Over the longer term, however, we expect improving economic conditions will help equities to rise, and we believe that stocks will outperform bonds and cash over the next 12 months.

The writer is vice chairman and global chief investment officer of equities at BlackRock

Little Wing Macro: May 2009 review

The portfolio performed well in May, adding 4.5% net of costs, bringing year to date performance to 9.3%.

The majority of gains came from equity and FX, which added 2.2% and 2.6% respectively to the bottom line. Call options on Chinese and UK equities were once again the biggest contributors to performance, up 29% and 13.8% respectively. In FX, the portfolio was well positioned for dollar weakness with short USD and long gold holdings. However, the addition of Norwegian Government Bonds seemed premature as GBPNOK went through the 10.00 mark, falling 5% and costing the portfolio 0.5% on the month.

Rates also cost performance -0.4% as 10 year Gilt yields spiked 25 basis points during the month. On the plus side, short Treasury and index linked exposure offset losses with gains of 6.8% and 1.5% respectively.

A fall in portfolio volatility to sub 30% (currently 24%) allowed more cash to be deployed and cash now accounts for over 30% of assets, its lowest weight to date.

Inflationistas have been smoking too much 'green shoots'!

After the recent deflation scare, inflation expectations have normalised (see chart below of UK 10 year breakeven inflation). Nonetheless, the 'inflation-deflation' debate continues. Indeed, inflationistas such as Marc "Dr Doom" Faber would have us believe that the US is headed towards Zimbabwe-style hyperinflation!


However, while the risk of inflation has certainly increased, fuelled by monetary stimulus and rising commodity prices, to believe that inflation is about to take off requires a large leap of faith. Inflation does not just happen, it requires a transmission mechanism - usually an increase in credit supply. Increased credit supply facilitates increased demand which drives prices higher. However, given we are in a 'credit crunch', it is unlikely that the financial system will provide the transmission mechanism necessary for inflation. Moreover, until house prices trough, there is unlikely to be a recovery in the securitisation market, and therefore credit growth.


Even when the credit taps are turned back on, there is enough spare capacity to absorb increased demand and wage inflation is being kept in check by rising unemployment. Thus, with the output gap in the US at its widest since 1982, it is unlikely that inflation will make a comeback anytime soon.


Finally, if the market is pricing in inflation prematurely, then the additional 250 basis points of risk premium investors can receive by moving out of 2 year Gilts into 10 year Gilts looks extremely attractive. Indeed, the Gilt curve hasn't been this steep since 1992!

Cautious optimism

Three months into a near 40% rally in equities it is time to take stock and assess the economic outlook. Talk of a new bull market is still premature and further upside will depend on a sustained improvement in economic fundamentals and company earnings, or at least their ability to surprise on the upside.

The improvement in economic fundamentals suggests Q1 2009 marked the point of greatest weakness. Indeed, had activity continued to fall off a cliff before long we'd be back in the Stone Age!

However, despite talk of green shoots, most economic data is still negative:

Moreover, after such a sharp and synchronised cut in output, to what extent is the improvement down to restocking as opposed to a sustained demand growth? Whilst forward looking indicators such as OECD leading indicators have ticked up, measures of actual demand such as consumer spending are still in decline. Indeed, consumer demand is unlikely to improve until unemployment and the savings rate stop rising and the supply of credit increases.

Indeed, in an interview with CNN this week, US Treasury Secretary Timothy Geithner suggested consumer demand and credit supply will remain weak for some time.

"You're going to see less credit flowing, as people go back to the point when they're living within their means. That's a healthy process for the economy... But it means that you're going to see a slower recovery than what you normally see."

So, as the G8 finance ministers noted in their communiqué this week:

"There are signs of stabilization, including a recovery of stock markets, a decline in interest rate spreads, improved business and consumer confidence, but the situation remains uncertain and significant risks remain to economic and financial stability."

Bear market rally (March - May 2009) R.I.P.

It takes nerves of steel to remain in cash, on the sidelines of a 30%+ equity market rally. With every 1% that the market moves higher, the greater the temptation to join the party for fear of missing out or being proved wrong. So it is strange that the recent rally coincides with a growing consensus that large amounts of cash await a correction before being invested. Thus, in the absence of improved economic data or company earnings, the market cannot move substantially higher while this cash pile remains uninvested.

An improvement in inter-bank lending alone, as measured by the falling TED spread, is not cause for a sustained bull market. Nor is the thawing of the primary credit market. What started as a financial crisis quickly spread to the real economy with devastating effect. Therefore, the problem is wider than the banks and is not solved, but rather one important part of the puzzle (the financial system) appears to be falling into place. However, there remains a lot to be done before we can say the financial system is fixed.

Since, this recession is unlike any other in living memory, it will take even more time to fix the real economy. What makes this recession different is the almost total collapse of the financial system coupled with a synchronised global slowdown in trade and growth. This combination will make this recession more severe in terms of both length and depth than any other in recent history. Whilst the worst of GDP and financial Armageddon may be behind us, unemployment and consumer deleveraging are likely to continue to deteriorate beyond 'normal' levels, extending the duration of this slowdown in the process.

On the plus side, the extent and speed of the response matches the severity of the problem. Trillions of dollars of toxic alphabet soup (CDOs, SIVs, CDS etc.) have been replaced with equal amounts of state-funded acronymed stimulus such as TARP, TALF, APF, QE... Excessive private sector debt has been replaced with public sector debt, something of which ratings agencies are well aware. Indeed, Moody's and S&P have put the UK on negative watch and this recession will undoubtedly claim more sovereign AAA ratings.

However, while the stimulus undoubtedly made the difference between depression and recession, we have effectively borrowed from the future to pay for the present. The huge increase in money supply and public debt: GDP ratio adds its own set of risks and will lower growth in the future. In an environment of higher perceived risk, investors demand higher risk premiums.

So, expect higher bond yields and lower p/e ratios, which will increase the cost of capital and constrict economic growth. Don't be fooled by the current euphoric bear market rally.

The trend is still your friend

The chart above shows the S&P 500 from May 1960 to May 2009 using a log scale. This raises the following obervations:

1. Notwithstanding the bear market from 2000 to 2009, a clear upward trend is still in place
2. The S&P 500 is currently -2 standard deviations from the trend, which, if still in place, suggests a buy signal as the bear market is now complete, having moved from +2 to -2 standard deviations versus their long term trend
3. It is unsurprising that US equity returns have experienced a 'lost decade' given how out of line US equities were in the late 1990's (+2 standard deviations vs. long term trend)

Perspectives on commodities

Some recent eclectic thoughts from John Reade, of UBS Investment Bank:

• China will buy those commodities that it considers strategic (i.e. required to meet centralised growth plan) as well as those that it does not produce a lot of. Therefore, expect these commodities to trade at a premium (e.g. copper is required for infrastructure growth & China is a net importer).


• A suggested FX basket for playing commodities: NOK (oil), CLP (copper), AUD (iron ore) & BRL (oil, iron ore & aggregates).


• ZAR is not as much of a commodity play as other currencies since it is unable to increase its commodity exports.


• OECD industrial production (IP) is a good leading indicator for commodity demand. Expect IP to trough mid 2009.


• Excluding oil, China is consuming 20-30% of annual commodity production and its GDP is c. 10% of global GDP. China is therefore 'punching above its weight' in term of commodity consumption.


• Disagrees with peak oil theory since we are not yet at the point where there are no know exploitable oil fields.


• The marginal cost of production for oil is $70 bbl, driven by other commodity prices essential to extraction (e.g. steel, concrete...). When the prices of those commodities rise, so does the breakeven oil price.


• Having initially been a gold bear, he expects gold to average $1,000 in 2009 due to the sheer level of inflows into the commodity. Having initially benefited from risk aversion (see performance of gold versus TED spread or 2 year swap spreads), future performance likely to come from the inflation trade. However, he doesn't recommend buying gold yet, until scrap sales & risk appetite wane and jewelry demand increases. Ultimately, gold is a scarce asset and so only a small increase in demand is required for a large increase in price.

Little Wing Macro: April 2009 review

The portfolio rose +0.5% net of costs in April, which was disappointing given the 10%+ rally in equity markets.

Of the three risk 'buckets' - rates, FX & equity - equity was the only positive contributor. The portfolio's Chinese & UK equity call options rose 39% and 36% respectively. However, the decision taken at the beginning of the month to pre-empt "sell in May" with FTSE 100 June puts, reduced the equity contribution to the bottom line to c. +6%.

In rates, TBT (short 20+ year US Treasury ETF) turned around previous negative performance, adding 13% as Treasury yields went into reverse on renewed risk seeking. However, the portfolio's Gilt holdings offset this as Gilt yields rose above 3.5% on supply & debt:GDP concerns. With the 10 year Gilt yield at c. 3.7% and an additional £50 billion in the Bank of England's APF, the risk reward ratio appears skewed in favour of maintaining long Gilt positions. For further insight on the reassessment of the Gilt market, see Reassessing Gilts: don't panic Mr Mainwaring! and When in trouble, double!.

The portfolio's FX investments, namely long USDJPY and gold investments suffered at the hands of 'animal spirits' as save haven assets bore the brunt of the return of 'animal spirits'. However, the portfolio's USD hedge compensated as the Dollar fell 3% against Sterling, breaching 1.47 in the process.

Overall, it was a difficult month for the views expressed in the portfolio, although by no means a disaster since the portfolio was up on the month. Indeed, May is shaping up to be another good month with the portfolio up c. 4.5% month to date. Volatility declined over the month to 35%, and continues to do so, enabling the portfolio's risk budget to be increased. Short GBPNOK and extending Gilt duration look like possible candidates for implementation...

Wake up & smell the coffee! China goes short duration

When the largest investor in any asset aggressively reduces their exposure, it's time to reassess that investment.

With holdings of $744.2 billion, China is the largest foreign holder of US Treasuries. This amounts to 24% of foreign holdings.

However, in a recent research note, Standard Chartered note that:

"Although bulk buying of Treasuries has ended, China is not reducing its stock of US securities. It is reducing its holdings of agencies and maintaining growth in its holdings of Treasuries, but is switching from long-term to short-term securities (tenors of less than one year)... holdings of short-term Treasuries surged to USD 182bn in February 2009 from USD 19.87bn in September 2008."

In portfolio management terms, this equates to an aggressive short duration position - standard practice if you expect yields to rise. Perhaps the scale of this positioning (25% of their holdings in sub 1 year paper) is a measure of how much they expect yields to rise. Indeed, Chinese officials have recently been vocal about their concerns regarding Treasuries and the US Dollar.

Could this mark the reversal in the 20 year bull market for Treasuries? Dr. Marc Faber certainly thinks so...

"The asset market that has the highest probability of having a made a secular high (such as Japan in 1989, or the NASDAQ in March 2000) is the U.S. long-term government bond market. Despite a still-weakening economy and massive quantitative easing, long-term bond yields appear to be on the verge of breaking out on the upside."

When in trouble, double!

Since the initial announcement and subsequent implementation of QE, Gilt yields have steadily risen (see above chart). Mervyn King has therefore lost money on his £52 billion of Gilt purchases. So, like any punter would do when faced with a loss, big Merv has doubled up.

At today's rate announcement, the Bank of England revealed that it will increase its existing QE facility by an additional £50 billion:

"The Committee also agreed to continue with its programme of purchases of government and corporate debt financed by the issuance of central bank reserves and to increase its size by £50 billion to a total of £125 billion. The Committee expected that it would take another three months to complete that programme, and it will keep the scale of the programme under review."

The 10 year Gilt yield fell 10 basis points. Could this be an inflection point in the 75+ basis point rise in Gilt yields?

Chaos theory: a pig flaps its wings in Mexico...

Swine flu is a sideshow, blown out of proportion by the media. Having rallied over 25%, equity markets were vulnerable and looking for an excuse to go lower even before the outbreak.

To date, and tragically, swine flu has accounted for 149 deaths in Mexico, a country of 111 million people. This represents 0.0001% of the population.

So, if swine flu is no more of a serious and lasting issue to world health than SARS or bird flu were, there are bargains to be had in those sectors particularly hit by pandemic hysteria.

Airlines, in particular, come to mind, as do other travel sectors such as hotels. However, these sectors were already struggling in the face of the global slowdown, and companies with stressed balance sheets may be at risk.

Reassessing Gilts: don't panic Mr Mainwaring!

In light of the 30-35 basis point back-up in the 10 year Gilt yield, pushing it above 3.5%, it is time to reassess the investment case for Gilts.

A tumultuous week for Gilts started with Alastair Darling's pre-budget speech, in which he announced the Government will borrow £220 billion this fiscal year, increasing the public debt:GDP ratio from 45% to 76.2% by 2013. This was followed by a Moody's report, How safe are safe havens?, which sent yields higher and Sterling lower, on concerns over the UK's credit rating. Finally, Q1 UK GDP came in worse than expected at -4.1% year-on-year, the worst since 1979.

So, which, if any, of these facts warrant higher Gilts yields?

Increased Gilt issuance

Economic s 1.01 says that, increased supply of a good results in a lower price unless there is a similar rise in demand. However, as the chart below demonstrates, there is little or no relationship between Gilt issuance and Gilt returns. Indeed, the 2008/ 09 financial year saw record gross Gilt issuance of £146.4 billion and the third highest Gilt 12 month total return of 6.8%.

Further proof that bond issuance and returns are not related comes from Japan, where a sustained increase in public debt has been accompanied with a fall in JGB yields.

Moreover, the supply-demand dynamic has shifted in favour of Gilts due the Bank of England's QE programme. The full £100 billion authorised by HMT for Gilt purchases represents 18% of the overall £543.9 billion Gilt market and 45% of the gross issuance this financial year.

These percentages are not small. Indeed, at the end of Q1 2009, the Bank of England had 'only' spent £12.9 billion on Gilts, out of a possible £75 billion. Mervyn King has plenty of firepower left at his disposal with which to mop up new issuance and force yields lower. Thus, to some extent, what the Chancellor giveth, the Bank of England taketh away.

Moody's report
Next, the Moody's report. For all the hysteria it generated, the essence of the report was not as bearish as the market reaction. The conclusion is summarised below:

"Moody's believes that Aaa governments' unconventional policies are defensive responses that are – at best – ratings-neutral if they succeed in kick-starting economic activity. However, if they lead to massive increases in public net debt and a permanent deterioration of debt affordability without tangible growth effects, Moody's cautions that they will be ratings-negative. In extremis, since confidence is not a linear process, these policies could potentially increase 'tail risk', and therefore also the (currently small) risk of sharp rating migration."

Indeed, a spokesman for Moody's confirmed, "the [UK] rating has not changed, and it's not under review for a downgrade. The outlook is stable."

UK GDP

GDP and Gilt returns have a negative correlation, meaning that as GDP falls Gilt returns increase. The chart below demonstrates this by comparing year on year GDP against the 12 month total returns of Gilts.

So, why then was worse than expected GDP cited as a negative for Gilts? The answer could lie in the relative position of the UK versus other developed nations. IMF forecasts for developed nations' GDP are as follows:

The economic outlook for the UK may not be good, but it is no worse than in others countries, indeed, with the exception of the US, it is the best of a bad bunch.

Conclusion

Therefore, it appears that, on balance, nothing has changed the medium term term outlook for Gilts. Yes, inflation is a risk for the longer term, but as the above evidence suggests, none of the developments last week appear to warrant higher Gilt yields.

So, in the immortal words of Corporal Jones, "don't panic Mr Mainwaring!".

George Soros interview with Bloomberg

The following are excerpts taken from a transcript of Bloomberg interview with George Soros on 6th April 2009...

The effect of the Western financial crisis on 'periphery' countries
After the bankruptcy of Lehman, the countries - the United States and the European countries - felt obliged to effectively guarantee their banking systems. And saying no other financially significant company will be allowed to go into bankruptcy. But countries at the periphery were not in a position to provide similarly convincing guarantees. And there was a flight of capital from the periphery to the centre. And that is what precipitated the crisis in Eastern Europe; and of course, in Brazil as well. So that was the unintended side effect of this artificial life support. And now that some support is extended by empowering the IMF, and also coordinating better the banking regulations.

China
China is now also simulating domestic growth. They have a pretty big stimulus package. And it is not enough. They are going to use more because not being a democracy, they know - the leadership knows - that their very survival, the avoidance of social unrest, requires them to generate growth. So they will - that’s for them the top priority. And they are in a position to do it. And so China is going to be coming out of their recession before the end of the year. And they will also try to maintain exports by providing credit to other countries. After all, they provided a lot of credit to us. Now they just made a swap agreement with Argentina. And they will similarly do the same with other countries in Africa, Latin America. And so they will actually restart their export industry, too.

Brazil
I think Brazil is another country that’s relatively well-situated. It was doing very well until the Lehman bankruptcy and the sudden collapse. And then you had a crash in Brazil. It did a certain amount of damage. But I think Brazil will also be a country that’s coming - will come out of the recession relatively soon. They have a big deal with China, I think invested something in the neighbourhood of $10 billion to develop the new oilfields there. China will be an avid buyer of Brazil’s soybeans and so on. And eventually will again buy their iron ore. So I think Brazil, actually - together with China, will be among the recovering countries. I don’t know about rapidly recovering, but I think the outlook for Brazil is better than for most other countries.

Oil
It’s very much a question of when does the economy recovery. Because when the world economy recovers, the price of oil will recover. And since the world economy suddenly collapsed, the price of oil collapsed. It hit a low below $40 from $140. And now it’s slowly climbing up. But the longer-term future deliveries never fell that far. And in fact now oil is about $50. And it will probably recover perhaps to $70 or so because the marginal cost of developing new oilfields is around $70. Maybe that will fall if prices fall. So it may be lower. But $50 to $70, somewhere in there.

You see, this is a clear example where you have that conflict between the short term and the long term. Because in the long term, there is no question that first of all, the cost of discovering oil is getting bigger and bigger. And the really large oilfields are getting exhausted. There hasn’t been that much new very large discoveries, except, let’s say, in Brazil in very, very deep and very far out waters. And as the Arctic ice melts, then under the Arctic Ocean, we will find oil. But that’s going to be quite expensive. So long term, price of oil has to rise. And we do have this very serious problem of global warming, which really requires us to develop alternative forms of energy, which are also initially, more expensive than the existing sources. The big difference between the new - the alternative sources that with time, their costs may decline. So right now, let’s say solar energy, is more expensive than natural gas. However, as you develop the technology, those prices may rise. So we have no alternative but to develop those. But the collapse in prices short term has really pulled the rug out from under all these alternative sources of energy. And that is directly counter to what we need in the long term. So here’s another example where the short term is directly contradictory to our long-term interests.

Banks & financial system
The banks are functioning. But they are weighed down by a lot of bad assets, which are still declining in value. So the banking system as a whole is seriously under water. The amount is difficult to estimate. But I think it’s in the region of maybe $1.5 trillion.

I am afraid that we are basically setting ourselves up on a route which will lead to preserving the banking system, preventing it from collapsing, but not recapitalizing them, but allowing them to earn their way out of the hole. And that is going to weigh on our economy for a considerable length of time and set - instead of providing new energy in terms of new loans, it will actually sap our energies by the banks charging heavy fees and restricting credit in order to improve their own earnings, in order to first of all survive so they don’t have to put themselves into hands of the government; and if possible, to buy themselves out by repaying the loans that they have got.

HSBC just raised $18.5 billion and I also subscribed.

On when to cut losses
If it isn’t working, I re-examine it. And it depends on the re-examination. It may be that I find nothing wrong and I can explain why its not working the way it’s supposed to. And I might actually increase my position. Or, I discover something that I left out of account,
and then I cut my loss. So - and I don’t cut my losses automatically. And sometimes, actually, I greatly increase my positions because the - I find the situation more attractive.

INTERVIEWER: So you still do your analysis and just - even if it’s going against you for a while, if the argument that got you there still working, you stick with it?

SOROS: Yes, yes.

Has the rally got legs?
I think it’s a bear market rally because we have not yet turned the economy around. What people don’t seem to understand, that something quite profound has happened. It doesn’t happen very often that the financial system actually collapses. So this is not a financial crisis like all the other financial crises that we have experienced in our lifetime.

The US Dollar's role as reserve currency
To some extent it has already been replaced because it’s not the sole reserve currency anymore. The euro is an important alternative. But there aren’t other alternatives. And the special drawing rights, which I think is a very good thing to use for other reasons, is not an alternative currency. Those are merely bookkeeping entries at the IMF. They can’t be used to buy goods. You know, to use them that way, you have to convert them into useable currency.

US fiscal deficit
You are not going to have a widening U.S. deficit, because there isn’t any more the desire to finance those deficits. And we are not in a – the households are not in a position to use the appreciating house values to savings. And so the savings rate of U.S. households will increase substantially. So the deficit is already falling, and it will continue to fall. So we will actually get back into closer to balance than we were. That’s not a very optimistic view because it’s very painful because it means that we are - economy will not grow that much.

The only way is not up, it's sideways

Equity markets have probably stopped falling, but that doesn't mean they are now on an upward trajectory. They were pricing in Armageddon, which hasn't materialised, so the rally brings markets back in line with fundamentals, which are weak. However, it is fair to say that we have seen the lows of this bear market, since a further severe decline in fundamentals would be required to push prices to new lows.

From an economics standpoint, the fall in output has caught up with the fall in demand, which should prevent further deterioration in industrial production. Indeed, whilst retrospective indicators show no sign of improvement, current sentiment & demand indicators such as US & UK Manufacturing PMIs show signs of improvement, as the chart below demonstrates.

Indeed, Fed Chairman, Ben Bernanke, commented this week that:

"Recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, home building and consumer spending, including sales of new motor vehicles... A levelling out of economic activity is the first step toward recovery... [However,] we will not have a sustainable recovery without a stabilisation of our financial system and credit markets"

However, this is not cause for celebration as it is unlikely there will be a substantial bull market or significant economic recovery, merely a period of low growth punctuated with large fluctuations in asset prices, both up and down, for the foreseeable future. Indeed, this was the case in Japan, where, despite having peaked in December 1989 and falling 75% to March 2009, the TOPIX had a number of very large bear market rallies over the period (see chart below).


In fact, Barclays Capital noted this week that:

"US data have surprised to the upside to some extent over the past month or so. But sooner or later, the recovery in risky asset prices is unlikely to be sustained if some of the more important economies do not show convincing signs of recovery."

So, failing a sustained improvement above expectations, the current 25%+ rally in world equities may yet turn out to be another in a series of bear market rallies to come.


Therefore, expect interest rates to be kept low for the foreseeable future and inflation to remain subdued whilst growth remains stagnant. Moreover, given the amount of monetary stimulus that will eventually have to be removed, there is a high margin for policy error, increasing inflationary risks on a longer term perspective.

Calling half time in the UK house price crash

According to Nationwide, UK house prices have fallen 19% from their October 2007 peak and are now equivalent to 4.1x average earnings. Given that wages are unlikely to rise due to falling inflation and rising unemployment, house prices will have to fall a further 20% in order to reach a multiple of 3.3x earnings, in line with their long term average.

However, it could be argued that UK house prices can sustain a higher multiple due to lower interest rates (UK base rates averaged 11.7% in the 1980's, 7.8% in the 1990's and 4.6% since 2000 according to the Bank of England) and increased availability of mortgage finance, notwithstanding the current credit crunch. Therefore, assuming a higher P/E ratio of 3.5x, UK house prices would have to fall a further -15% in order to reach equilibrium, which means we're only half way through the crash!

Little Wing Macro: March review

March was a successful first month as the portfolio was up 4.6% net of 2% p.a. costs. However, intra-month gains were running at over +15% and these were lost towards the end of the month, although they have thus far been recuperated in April.

Large gains were made on Chinese & UK equity index call options, up 65% and 10% respectively, as they captured the rally in equity markets. Profits were taken in FTSE puts before the rally started however, following a 10-20% rally in equities from March lows, FTSE puts have been added back into the portfolio as insurance against a reversal in risk appetite. Given their continued gains in April and the subsequent extent of the profits (+50-150%) made in long equity investments, the decision was taken in April to lock in part of these gains and keep the proceeds in cash.

Having got off to a good start following the announcement and implementation of QE, the portfolio's Gilt positions sold off towards the end of the month as save haven assets in general lost their appeal. Nonetheless, the BoE's commitment to buy Gilts is greater than any other market force and will therefore push yields inexorably lower. Gilts also remain an effective hedge against deflation or another round of economic deterioration.

Gold contributed negatively to performance, with the physical price falling -3% over the month and the portfolio's call option position falling -37%. However, implied volatility remains high and the rationale for holding gold remains intact since longer term inflation risks have not gone away.

In FX, the short USD versus GBP June forward added 9%, whilst the short JPY versus USD warrants lost -5.4% as USDJPY retreated below 100 on profit taking. Longer term, the risk to the US dollar is to the downside and it may make sense to take profits on short USD versus GBP in order to express this view verus a wider currency basket, such as the DXY index. During the month, the Norweigan Krone (NOK) knocked the USD of its perch to become the safe haven currency du jour, backed by strong public finances and oil revenues that are poised to benefit from a turn in the oil price.

The portfolio's cash allocation remained fairly constant at c. 50% and portfolio volatility declined from c. 60% to sub 50% by the month end.

Interesting FT story on Germany's perspective on the possible economic aftermath

Germany warns on 'crisis after crisis'
By Bertrand Benoit in Berlin, 12 Apr 2009 10:57pm

The world could face high inflation and a "crisis after the crisis" when the global economy recovers, Peer Steinbrück, German finance minister, has warned.

The comments, in a weekend interview, are the latest sign of concern from Germany at the extra-loose monetary policies conducted by central banks around the world and the ever-larger fiscal stimuli being unveiled by governments.

"I am concerned that the countermeasures we are seeing around the world, financed by enormous amounts of debts, could be paving the road to the next crisis," Mr Steinbrück told Bild, a tabloid daily.

"So much money is being pumped into the market that capital markets could easily become overwhelmed, resulting in a global period of inflation in the recovery.

Mr Steinbrück's warning comes after Angela Merkel, chancellor, told the Financial Times last month that pumping too much money into reviving global growth would create an unstable recovery.

German officials fear the liquidity being injected into financial markets could prove difficult to reabsorb, creating long-term inflationary pressure and, possibly, new asset price bubbles. "We do not have a short-term inflation problem," Mr Steinbrück said. "But in the medium term we must start thinking about how to pull the billions we are pumping into our economies out of the system again. This will be a special challenge for the central banks, including for the European Central Bank."

Because of its strong reliance on exports, the German economy has been one of the worst affected in Europe by the global economic downturn. It is set to shrink by 4.5-7 per cent this year and statistics published last week showed Germany had its lowest inflation in 11 years.

Peter Bofinger, one of the five top academics who advise the government on economic policy and, like Mr Steinbrück, a member of the Social Democratic party, said that Berlin's concerns about inflation were unwarranted. "Germany faces no risk of inflation for the foreseeable future. On the contrary, I see a clear danger of deflation," he told the Handelsblatt.com website.

Rising unemployment in the coming months would put wages under pressure, said Prof Bofinger, creating a potential downward spiral in wages and prices. Asked about how to fight the crisis, Mr Steinbrück conceded that there were "no intelligent alternatives" to higher public investments programmes. Unlike in the US, he said, there were no signs yet the German economy had turned the corner. "We are not through yet. Nobody can say if the worst is behind us."

China, what credit crunch?

Chinese data released over the weekend showed that banks had continued to lend for new investment projects with record new loans of $277bn in March. China's latest trade numbers revealed signs of stabilisation for both exports and imports over the past year to March. The news, together with the record surge in bank lending and money supply last month, fuelled hopes of an early economic recovery in the country and boosted Chinese equities. The Shanghai Composite gained 2.8 per cent to reach its highest level in eight months as turnover ballooned to Rmb187.3bn, the highest for nearly a year.

Why QE will push Gilt yields lower

The fat lady hasn't sung yet and the Old Lady of Threadneedle Street can go on buying Gilts indefinitely until it has the desired effect...

http://www.bondvigilantes.co.uk/blog/2009/04/02/1238686980000.html

Fortune favours the patient

The rally in risk assets over the last couple of weeks amounts to nothing more than a short squeeze. Fundamentals have not changed, indeed some measures such as the recent Non Farm Payrolls and today's -13% YoY UK industrial production number continue to worsen.

However, it is important to distinguish between absolute and relative risk/reward ratios and between trading and investing. Trading, a more 'sexy' name for market timing, is either for the fortunate or the brave, whilst investing, based on sound analysis of long term risk/reward prospects, is for the patient.

The longer the world's economic problems go on unresolved, the longer the recovery will be delayed, causing the price of risk assets to grind ever lower. So, should the investor sit tight in cash and invest only at the inflection point? Of course not. Not only is it impossible to consistently time the market, but also the opportunity cost of holding cash or government bonds is low given their current yields. Thus, make steady investment into risk assets, locking in attractive risk premiums by buying from impatient market timers, disillusioned that the world has not infact recovered overnight.

Fortune favours those with the patience and tenacity required for a long term investment horizon, just ask Warren Buffett!

UK CPI: one swallow doesn't make a summer

UK CPI (February YoY) came in ahead of expectations at +3.2% versus consensus of +2.6%. The 10 year Gilt yield rose to 3.37%, up 24 basis points. Mervyn King commented this morning on the higher than expected inflation number in an open letter to the Chancellor:

"Since last summer, world commodity prices have fallen sharply and that has helped drive a fall in overall CPI inflation from 5.2% in September to 3.2% in February. But the effect on UK consumer prices of decreases in world prices has been dampened by the depreciation of sterling. Since my December letter, the sterling effective exchange rate has depreciated by about 5%, bringing the total depreciation to 28% since the summer of 2007. February's inflation out turn is somewhat higher than expected. That could reflect pass-through of the exchange rate depreciation to consumer prices since much of the strength in the out turn appears to be concentrated in components where a large share of goods is imported."

Later, when questioned by the Treasury Committee about the implications about the implications for the Bank's QE programme, Mervyn King commented:

"We might need to do less on QE than £75 billion if it works... the target is to complete something in the order of £75 billion in QE over the next three months"

However, one swallow doesn't make a summer and it is still premature to say whether monetary policy is working or if it is stoking inflation. Indeed, Mervyn King noted in a statement to the Treasury Committee this morning that inflation is likely to fall in the medium term:

"Inflation in the UK is currently still above target. CPI data released this morning show that inflation was 3.2% in February, triggering another open letter from me to the Chancellor. At its next meeting, the Committee will want to consider further the implications of this inflation out turn. But the sharp slowdown in spending is likely to generate a significant margin of spare capacity in the economy, which, in turn, will bear down on inflation in the medium term. So the key question for the MPC is how to ensure nominal demand returns to a level that is consistent with meeting the inflation target."

Back to basics: 7 investment principles for successful investing

The application of all of the following seven principles should result in successful long term investment. However, achieving success requires diligence, patience and discipline to adhere to one approach. It cannot be achieved overnight with a series of short term 'punts' which, at best, can work in your favour 50% of the time and, at worst, could cumulatively destroy capital rather than growing it.

1. Accept that you can never be 100% sure what will happen or what will be the best performing asset class, so diversify.
2. Even if you are 100% certain, it is impossible to time the market consistently, so be patient and deploy capital gradually.
3. Construct and manage a portfolio, not a series of independent asset classes. Be aware of the risk exposures contained within each asset class and maximise portfolio diversification by avoiding the unintended duplication of risk exposures that arises from allocating according to asset class.
4. Diversification done one the basis of capital allocation alone can be misleading. Given that diversification is about reducing risk, it makes sense to allocate according to, or at lease be aware of, the portfolio's risk allocation.
5. Despite their infrequent occurrences, high impact low probability events can have a severe effect on portfolio returns, often eliminating years of previous positive performance. So, hedge against tail risk.
6. Demand a large risk premium on every investment since the level at which an investment is entered into is a key determinant of the subsequent return.
7. The past is never a guide to the future.

The week that was

• Fed announces $300 billion of QE in 2-10 year Treasuries, US curve flattens, long yields fall 50bps, pushing 10 year sub 3%
• USD safe have status evaporates on QE (DXY -4.5% on week), investors look to NOK as new haven (+7% vs. USD on week), backed by oil revenues and robust finances.
• UN preparing recommendation to member countries to diversify away from USD reserves & to adopt a currency basket. Likely impact unclear as UN doesn't have the financial muscle of the IMF or G7.
• USD weakness pushes gold (+3%) & oil (+10%) higher as well as broad commodity indices - it's H1 2008 all over again.
• Equity rally peters out (MXWO +6% on the week)
• IMF forecasts global economic activity to contract by 0.5% to 1% in 2009 on an annual average basis—the first such fall in 60 years before growing 1.5-2.5% in 2010. The US is expected to contract by 2.6%, the Euro area by 3.2% and Japan by 5.8% with advanced economies as a whole contracting by as much as 3.5% and emerging and developing economies likely to grow only 1.5-2.5%. The contraction in the U.S. is expected to push the output gap to levels not seen since the early 1980s.
• UK jobless claims worst since 1971 but BoE chief economist, Spencer Dale, thinks "a substantial amount of the total contraction we’re going to see has come through”, saying the economy would begin growing again by the end of the year and expand at normal rates throughout 2010
• UBS CDS tightens 75bps on improved Tier 1 ratio driven by buyback of Tier 2 debt

Anything you can do...

Anything you can do,
I can do better.
I can do anything
Better than you.

No, you can't.
Yes, I can. No, you can't.
Yes, I can. No, you can't.
Yes, I can,
Yes, I can!

Following the Bank of England's recent announcement that it intends to purchase £75 billion of Gilts, the Fed announced today it will purchase up to $300 billion of long dated Treasuries over the next six months. Beat that Mervyn!

Despite being a drop in the ocean (c. 2.7%) relative to the $11 trillion of outstanding public debt, $300 billion was enough to push yields down significantly. Longer dated Treasuries surged on the news, with 10 year yields falling 47 basis points to 2.54% and 30 year yields fell 37 basis points to 3.46%. The 10/2's spread flattened 37 basis points 1.62%.

However, the move stoked fears of inflation and currency debasement, pushing gold 6% higher. Bloomberg reported that:

The dollar fell the most against the euro since September 2000 as the Federal Reserve said it will purchase $300 billion of longer-term Treasuries, spurring speculation the central bank is debasing the currency. The dollar depreciated as much as 3.3 percent to $1.3493 per euro before trading at $1.3468 at 3:20 p.m. in New York. The dollar lost 2.5 percent to 96.17 yen from 98.60. The yen dropped 1.1 percent to 129.44 per euro from 128.35. The Dollar Index, which the ICE uses to track the greenback’s performance against the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona, dropped 2.7 percent to 84.595. The gauge fell 5.6 percent since reaching 89.624 on March 4, the highest level since April 2006.

Quantitative easing is now de rigueur amongst the world's major central banks. The Bank of England is buying government bonds and corporate debt, the Bank of Japan is snapping up government notes and making subordinated loans to banks, and the Swiss National Bank is intervening to weaken the franc. Naturally, anything the rest of the world can do, America can do it bigger and better...

Bear or bull market rally, you decide

The debate on whether this is a bear market rally or the foundations of a bull market goes on but I thought it would be interesting to consider some of the facts given that, relative to the change in fundamentals, the market recovery appears somewhat excessive.

Last week's economic numbers were in general appalling and the rate of change continued to decline. The chart below shows year-on-year industrial production numbers for Jan & Feb. I have focussed on industrial production numbers because all of the major countries released figures in the last 7 days so they are a good basis for comparison.

This compares to equity market performance over the last 6 trading days shown below...

QE gets under way

UBS Investment Bank reports:

"The Bank of England embarks on its quantitative easinig effort today with a £2 billion gilt purchase. This will the first of a bi-weekly event that will continue for the next 3 months until the Bank has acquired around £75 billion of gilts and corporate bonds."

Purchases will be made via a reverse auction, in which sellers determine the price that the BoE pays. The Bank will hold only one auction this week, but there will be two per week from next week on Mondays and Wednesdays. The central bank will take non-competitive offers until 12:00 p.m. on auction days, announcing the amount it will allot to such offers at 1:00 p.m.. It will then also publish the size open to competitive offers, and will take bids for that operation between 2:15 p.m. and 2:45 p.m. British time. It will announce the results of that operation soon thereafter.

In today's auction the BoE has specified it wants to buy £2 billion of Gilts maturing from 2014 to 2018. M&G's bond team note, via their blog, Bond Vigilantes:

"The Bank is not buying back sub 5 year paper as part of this programme, as that is where overseas Central Banks (big financers of the UK budget deficit) own gilts, and it could lead to a big reduction in the gilt market's investor base and a possible knock on impact on the £ if overeas investors sold their gilts back to the authorities. Nor is the Bank buying gilts over 25 years in maturity, which would exacerbate the illiquidity in ultra long dated gilts, and possibly cause further problems for pension funds."

Auction results
The reverse auction was 5.25 times subscribed as the BoE receioved offers of £10.5 billion and bought £2 billion. Bull flattening is under way, with the UK 10-2 spread having tightened by 50 bps since the BoE first announced QE on Thursday.

A portfolio for all seasons

"[Thomas] More is a man of an angel's wit and singular learning. I know not his fellow. For where is the man of that gentleness, lowliness and affability? And, as time requireth, a man of marvelous mirth and pastimes, and sometime of as sad gravity. A man for all seasons."

Robert Whittington, 1520

Attempting to construct a portfolio at the moment is at best difficult due to the uncertainty surrounding the state of the global economy. On the one hand, a protracted period of synchronised recession and deflation suggest that taking risk will not be rewarded and that investors should park their cash in safe haven assets until the economic storm has passed. On the other hand, a lot of bad news is already in the price and the size of the stimulus matches the severity of the problem, suggesting that opportunities abound and potential returns are more than commensurate with the risks.

On whichever side of the fence you sit, there is a common factor that make the risks of being wrong very painful: volatility. Investor behaviour has become bipolar, split between fear and greed. So, the bears who invest in fear assets, such as US Treasuries and gold, do so at high prices which can quickly reverse when the risk barometer turns back to greed.

The challenge is therefore to create a portfolio for all seasons. Such a portfolio should be split between fear investments that profit from a bearish outcome, and greed investments that profit from a bullish outcome.

Fear investments

Long dated conventional Gilts are the instrument of choice to play the risk of deflation and depression. Indeed, the BoE believes so too, since they are prepared to buy £100m of them in order to stave off deflation and stimulate the economy. As discussed previously in QE in the UK, this implies a bullish flattening of the Gilt curve. Therefore, given the BoE's plans to acquire 24% of eligible medium and long Gilts in the first £75 billion tranche of QE, extending duration across the 7 to 25 year maturities is likely to best capture any fall in yields.

As for equities, if Nouriel Roubini is to be believed then:

"If a near depression were to take hold globally a 40% to 50% further fall in U.S. and global equities from current levels could not be ruled out... Earnings per share (EPS)of S&P 500 firms will be in the $50 to 60 range, but they could fall to $40. The price earnings (P/E) ratio may fall in the 10 to 12 range in a U-shaped recession. If earnings are closer to 50 or the P/E ratio falls to 10 then the S&P could fall to 600 (12 x 50 or 10 x 60) or even to 500 (10 x 50)."

Buying out of the money puts on the S&P 500 or FTSE 100 is therefore a cheap method of insuring against possible Armageddon.

For investors looking for a save haven, the US dollar remains the favoured currency. However, this notion of safety is an illusion, based on the relative attractiveness of the Dollar (see The relative illusion of USD safety). Fundamentally, the Dollar is no better off than its counterparts, however its strength lies in investor appetite for US Treasuries and forced buyers of the currency who are unable to refinance their debt. However, once the financial system shows signs of stabilising, the Dollar is likely to collapse under the weight of huge deficits, inflation and overvaluation, possibly challenging the long established Dollar hegemony. Thus, in the longer term, gold is likely to be a better store of value and in the short to medium term the Dollar is likely to continue to appreciate versus another previous safe haven currency, the Japanese Yen.

Greed investments

What if the talk of depression is overdone and if risk aversion turns to risk seeking? Fear investments will be a 'busted flush'. Admittedly, this seems unlikely, although if there is one thing that the last 18 months have taught us, it is to expect the unexpected.

Equities are the most effective and liquid way to increase risk. The freeze in credit markets is unlikely to thaw overnight, leaving corporate bonds illiquid outside of the primary market. Notwithstanding a further 10-20% cut in earnings, many markets are trading on single digit P/E ratios (e.g. FTSE 100 trading on 9.2x forward earnings & €Stoxx 50 trading on 7.9x forward earnings, which would increase to 9.8x if earnings were cut a further 20%). Moreover, many other metrics of value suggest that equities are oversold.

However, with high volatility the risk of investing too early or all out depression means that being wrong can result in significant losses. Options are therefore an effective way of playing any potential rally in stock prices, since they allow the investor to participate in the upside with leverage and the downside is limited to the loss of one's premium.

Given that risk aversion is now a consensus trade, any bad news would have to get even worse in order to affect the price of safe haven assets. If the situation improves or, at least does not deteriorate further, a mass exodus from safe haven assets is possible. This has clear implications for the US dollar and US Treasuries, the biggest recipients of safe haven flows, both of which could see a sharp unwind if risk appetite returns. Indeed, at his annual press conference, China’s Premier Wen noted:

"We have lent a huge amount of money to the U.S., so of course we are concerned about the safety of our assets. Frankly speaking, I do have some worries."

The risk reward trade-off for shorting the Dollar and US Treasuries have therefore improved and any collapse in the Dollar will more than likely support the gold price.

A combination of short Dollar, short US Treasuries and long gold also happens to be an effective hedge against a wildcard, inflation. The further interest rates fall in the shorter term, the greater the risk of inflation in the medium to longer term. Thus, at some point, assuming the stimulus has the desired effect of reflating the economy, inflation will rise again. Moreover, given that the stimulus has been funded by record amounts of government borrowing, yields are likely to respond in kind to both rising inflation and issuance as investors demand a higher risk premium. Indeed, it is possible that governments and central banks may want to induce a period of above target inflation in order to reduce the public and private debt burden. For now, the market is concerned about possible deflation and breakeven inflation rates have fallen to levels that make insuring against inflation attractive.

Conclusion

A portfolio for all seasons is therefore characterised by fearful greed, where asymmetrical payoffs are expressed in the main via out of the money options whose downside is limited to the loss of premium and upside is unlimited. Given the high levels of asset price volatility and leverage built into options, risk management is essential. Setting a risk budget, using a VaR limit, ensures that portfolio risk is kept within acceptable levels.

Finally, the ideas expressed in this note have been expressed in an illustrative £1 million portfolio, which began 1st March. Performance will be monitored on a monthly basis, net of a total expense ratio of 2%. Capital and risk allocation are divided between four 'buckets': interest rates, FX, equity & cash (see current capital allocation below). The portfolio is already performing well, up 11.8% with most of the P&L coming from 5-15 year Gilts, FTSE 100 puts and FTSE/ Xinhua 25 calls.