Sunday, June 23, 2013

Yen and how it may impact global asset classes

Originally written on 16th May 2013

BoJ’s ambitious plan to simulate domestic economy by sloshing the system with monetary easing (printing yen and exchange these yen to buy bonds and mortgages of all maturities) in order to stimulate domestic demand and inflation (2% inflation in 2 years by expanding the monetary base by 2 times) will have repercussion far beyond Japan

For one, printing money to artificially sequester real interest rates will at some point make investors in JGBs reluctant to either buy more JGBs or continue holding existing ones in the portfolio-consider the plight of an investor who has sacrificed consumption in the past to buy these bonds now find its claims at par with those who have brought the bonds by simply printing the money!-That scenario, if it comes to pass, will spell doomsday for Japan as the country currently has the highest Debt to GDP ratio (>200%) in the world (to put it in context, struggling Italy and Spain have debt to GDP ratio near about 100% but unfortunately cannot print their way out of the problem) and public debt is mainly financed through domestic savings.

After the bursting of the real estate and stock market bubble in early 1990s’ Japanese retail investors have mainly preferred to invest savings in bank deposits which in turn are channelized to buying JGBs. Loosing investor confidence may result in steep rise in yields –no matter how much more the government keeps printing money. On the other hand, retail investors were comfortable buying JGBs near zero return given that inflation was negative in Japan for a very long time and stagnant economy subdued outlook for other asset classes (such as domestic real estate and equities), that may now change with inflation outlook becoming positive and Nikkei at 5 year high giving investor more options than putting money in boring JGBs

The aggressive stimulus may have unexpected impact on Japan something with which the world has no prior experience in recent history, If I were to make a wild guess, I suspect the impact will be mainly on driving up steeply Yen yield curve (the trick is plain to see for JGB investors) and the associated problem Japan may face to funds its unbridled public debt –a scenario which will see yen depreciating much more

What would this mean for global asset classes
1.   First and foremost, selling one currency to buy another one eroding its value at a slower pace is not a solution, the ultimate hedge will remain hard assets such as real estate, commodities and metals
2.   Secondly, even though global economic growth may be sluggish, equities are placed relatively better than bonds fundamentally, as they are natural hedge against hyperinflation, as well as, share any upside that monetary stimulus is purportedly suppose to achieve. In that case, equity valuation multiple may remain higher than can been the case in recent past even without encouraging topline or bottomline growth
3.  Gold price correction in the recent past is puzzling when juxtaposed with the debasing of currency in Japan / US and maybe soon in EU due to competitive pressures. Gold has always and will remain a hedge against monetary debasing and threat of future inflation
4.    As lower yen conquers market share at Germany’s expense, EUs incentive to debase euro further which will meet the interest of both northern and southern members will rise, the question is if all three major currency blocs (EU, Japan and US) desire a lower exchange rate for itself,  the depreciation will be relative to which currency?
5.   An event / catalyst which can trigger market to reject buying QE prone currencies and nominal bonds denominated in those currencies will be a milestone event for world monetary policy. And possibility of countries once again reverting to fixed exchange rates or exchange rates tied to gold reserves cannot be ruled out in next decade or so. Although this may sound far-fetched now, such arrangements and reversion from free floating to fixed exchange rates and vice versa have happened multiple times over the past 200 years. With each episode of reversion from floating to fixed exchange rates being subsequent to sharp episodes of inflation usually after rising wartime public debt
6.   That view also explains why holding gold as long as printing presses at major central banks keep humming (and a few years after that to confirm status on ensuing inflation) is a good idea even though there may be opportunity costs involved here.

7.   Also for the first time in a generation, equities might actually be a safer assets than the risk-free asset called government bonds we grew up learning about 

Near term prospects for Bahrain goverment debt yields

Originally written on 20th May 2013

Bahrain faces a steep challenge relative to its other oil rich neighbors in the GCC over the medium terms in putting its fiscal health on a more sustainable path. In a nutshell concerns over Bahrain’s fiscal health have their provenance in two sources
1.  Generous state subsidies (including those on fuel, electricity, water, selected food items)
2. High dependence on Bahrain’s limited hydrocarbon production to support fiscal spending and generous subsidies

The political unrest which began in early 2011 and continues to this day-albeit having stabilized progressively-have put further pressure on state coffers to increase spending in order to both simulate a stagnant private sector, as well as, create employment on urgent basis. Secondly, subsidies tend to be sticky with steps to control / cutting back remaining highly unpopular with the constituencies, reform in that direction though urgently needed will be extremely challenging politically given the already stressed relationship between the government and a large majority of its countrymen.

Bahrain’s current break-even oil price at $115 is already above the market price and perhaps the highest among all oil exporters in the world.(breakeven price is the price of oil, keeping export volumes constant, would be required to fully fund budgeted state expenditure without resorting to borrowing or liquidation of past reserves). To me that would imply that the country will continue to run fiscal deficits persistently since my subjective judgment is for that expenditure on other hand will be extremely difficult to cut back and near term oil prices have probabilistically more downside risk rather than upside.

Given the small size of the economy and flagging private sector growth, a incrementally rising debt to GDP ratio will not be quite appeasing for both existing investors as well as prospective investors in Govt. of Bahrain paper. I consider the prospect for credit premium on Bahraini debt and CDS to increase over the next 2-3 year horizon from current levels than to decrease. Once the exigency to control ballooning government debt becomes a consensus opinion, a downward revision in Bahraini dinar-USD exchange rate (devaluation of the BHD) cannot be ruled out either.

On the positive side, Bahrain remain geo-politically important to contain Iran’s influence in the Arabian peninsula and has historically shared very strong relationship with regions big boy Saudi Arabia. A GCC bailout or soft financial assistance (as the current $10bn 10 assistance) is also a quite likely scenario in case of sudden distress. That would make investing in short term Bahrain government debt (after the yields have spiked in tune with new information) a attractive proposition in future if the country goes through a financial panic in coming years.

Key economic statistics of Bahrain

1.  GDP  2012 – 2.7% p.a.  (Historically, from 2000 until 2012, Bahrain GDP Annual Growth Rate averaged 4.61 Percent)

2.  Current account to GDP – 15.4%

3.  Government Debt to GDP – 31.6% (Historically, from 2000-2012, Bahrain Government Debt To GDP averaged 19.84 Percent)

4.  Yield on Bahrain (2020) government USD bond – 4.12% p.a. (USD 10yr T-Bond 1.95%)

5.  5 years CDS spread –c.2.05% p.a.


When in Investing, why worst is best

Originally written on 19th June 2013

Interesting chart on yearly and 10 year cumulative return delivered by different Asset Classes…..the exhibit underscores one often touted characteristic of the markets…That it is nearly impossible to predict the best performing or for that matter the worst performing asset from one year to next (Remember, safer and less volatile assets are usually at the bottom in return ranking, but that does not mean that you can predict their outperformance or underperformance relative to riskier asset classes from year to year). A equally weighted allocation across all asset classes as represented by the ‘Asset Allocation bloc (in Grey) is one best method to both remain reasonably well diversified and making sure your portfolio does not end up at the bottom (but will also preclude its possibility of ending at the top). A second observation, is that asset classes (particularly risk asset classes) that performs worst on relative basis in given year(s) usually has a higher probability of outperformance in subsequent period(s). Hence a strategy of buying losers and selling winners may result in long term outperformance.

Below i present a mechanical asset allocation strategy that:
1.   Invest in the subsequent year in the best performing asset of the previous year (eg. invest 100% in MSCI EME in 2004 after the asset class being best performing in 2003)
2.   Invest in the subsequent year in the worst performing asset of the previous year (eg. invest 100% in Cash in 2004 after Cash being the worst performing asset class in 2003)
3.   Invest in three best performing assets of any given year in subsequent year on an equally weighted basis (eg invests in MSCI EME, Russell 2000 and MSCI EAFE in 2004 on equally weighted basis)
4.   Invest in three worst performing assets of any given year in subsequent year on equally weighted basis (eg invests in Cash, Barclays Aggregate bond index and Market Neutral in 2004 on equally weighted basis)

The results of this exercise tabulated below are rather interesting, The contrarian strategy of holding worst performing assets in subsequent period is more than twice as profitable than the strategy of holding the best performing assets. Secondly, on risk adjusted basis, the sharpe ratio of the contrarian strategy is better than that of the momentum strategy. Thirdly, the portfolio model (three best and three worst) approach is more superior than holding 100% of single asset in both absolute return and risk adjusted return terms.

Cumulative Return
Std Deviation of Return
Maximum Drawdown
Sharpe Ratio
Best performing asset previous year





Worst performing asset previous year





Three best performing assets classes in previous year (Eq wt)





Three worst performing assets classes in previous year (Eq wt)






I have highlighted the year 2007, 2008 and 2009 to draw special attention to another interesting observation. As one would notice, the previous year best performing asset and equally weighted portfolio usually have a return in double digit whilst the worst performing asset and portfolio of worst performing assets has a low single digit return in most periods. So why does the worst performer come out best over the 10 year period?

The answer lies in 1) the sharp volatility of best performing but more riskier assets such as MSCI EME index (-compare Maximum Drawdown statistics). The best performing assets after three years of double digit return were cut into less than half in the financial crisis of 2008/09 while the worst performing asset of 2007 were trading at a depressed valuations going into 2008 and logically were relatively less impacted. Also the worst performing asset of 2008 were grossly undervalued  going into 2009 due to duress in the market at that time (having being cut in half or less in just one year time) and hence recovered sharply in the subsequent year.

So what lesson does the above study holds for an average investor?
1)   Not losing money is more important than making money due to the power of compounding (see the compounded performance of best and worst performing assets between 2004-2009). Every dollar invested in best performing asset and rebalanced annually was worth only 21 cents in 2009 despite three years of double digit growth. On the other hand, every dollar invested in the worst performing asset in 2004 was worth 41 cents in 2009 twice as much as its counterpart

2)  Dislocation in asset prices due to duress in the market can be good time to accumulative worst hit assets as prices are riddled for reason other than the long term earning capacity of the asset and investor outlook on valuations of such assets is at the nadir. Such dislocation provide opportunity to earn excess return in subsequent periods while valuation recover back to its historic average. This strategy is also safer as reflected in maximum drawdown and sharpe ratios.

Why rising rates is not necessarily a bad news as framed by market action past week

23rd June 2013

Asset prices and volatilities across the world surged in the past week (ending Friday, 21st June) after FED comments that it would consider ‘gradually’ tapering its massive $85bn a month bond buying program by the end of the current year (most likely in Dec) or beginning of the next year. Bonds and stocks plummeted globally and dollar appreciated against all major currencies.

The common reason provided for the correction in asset prices is mainly
As the FED intervention at the long end of the yield curve recedes, bond yields (long term interest rates) should rise sharply
Rising rates are bad for the economy as it would impede borrowing (mainly recovery in housing through higher mortgages rates) and consumption
Lesser liquidity would translate into reduced demand for other risk assets

Additionally, the above reasoning and sudden change in sentiment spurred capital outflow from EMs bonds and equities resulting into sharp depreciation in asset values and currencies of many EMs.

We find the above reasoning and its subsequent implications as they have unfolded over the past week to be surprising rather close to surreal. Our reasoning is as below
The QE was a emergency measure and was expected to be withdrawn at some point, its colloquial to an individual on a life support who has subsequently recuperated enough to get off the life support, this would be regarded as an incrementally good news. However, the market action past week was as if, the news was incrementally negative

Secondly, The argument with interest rate going up and the economy being stifled at the same time is one that is internally inconsistent. The Fed intends to roll-up the printing press only when it is satisfied that the economy is on path of sustainable recovery and has categorically stated that as a precondition to determine the timing and extent of the tapering. If the incoming data on the health of the economy were to be weak, long term rates will remain muted irrespective of the monetary exercise continuing or not.

For one, US economy has plenty of spare capacity as reflected in its current and targeted unemployment rate. Secondly, stronger dollar would pull down any tendencies in imported inflation, both developments keeping domestic inflation in control. Fundamentally, long term rates have been guided by two major forces 1) expected inflation and 2) growth prospects, with many economist now penciling the trend GDP growth rate at 1.5% and current inflation expectations at 1.5% long term rates (currently at 2.5%) have limited room past 3.5-4.0% in the medium term (c.2015). Thirdly, improvement in fiscal and current account deficit (stronger dollar; shale gas; and fiscal sequestration) should reduce run rate of Treasury issuances this and next year. It is also pertinent to note that T-Bond demand from overseas Central Banks is irrespective of the yield and will likely remain strong.

We also tend not to agree with the argument that rising rates will suffocate the benign recovery in housing through higher mortgage rates. It needs to be noted, that the recovery in US housing is broadly location and sector specific. Housing market in US has structurally changed between now and 2008 in terms of both financing access and demand. And is coming out after way-warding at the bottom for three straight years! As long as the expected return on the asset is above its costs, high interest rates in itself are not sufficient to stifle demand.

Lastly, the fear that lesser liquidity will be bad for risk assets is logical deduction but may not be factual in the current situation. Globally, prices of commodities, precious metals, equities (mainly EMs) are down YTD and many parts of the world are seeing correction in real estate prices. The general mood among market participants is more of gloom and towards safety than optimism and adventure. Asset bubbles are more likely to arise in the later state than former. The only asset class that we believe should logically be pricked by rising in interest rates is credit spreads trades such as Corporate and Junk bonds, USD denominated non-US Sovereign debt and TIPS where credit spreads were it lowest and may expand in coming days as the attractiveness to take advantage of higher yields available with T-Bonds adjusted for expected inflation surpasses the risky credit bet in credit spread products.

Friday, January 4, 2013

3, Jan 2013 -The fate of fiscal cliff and my expectation

3, Jan 2013  -The fate of fiscal cliff and my expectation

Equity and bonds markets not only in US but world over have been fixated over the impending fate of fiscal cliff. Given that the US public debt has reached a particular ceiling (i think its USD 16tr) the ruling govt has to determine between two equally distasteful options, either increasing the debt ceiling further or reducing the rate at which debt is accumulated, which would consequentially require reduce spending, increase taxes or both. Increasing the ceiling will provide room to increase debt and hence allow the government to follow expansionary fiscal spending mainly unemployment doles and medical bills for the uninsured. Reducing spending will have immediate repercussion in terms of riddling an already soft economy and govt balance sheet delevaraging at the same time that the private sector is deleveraging after bust in equity and house prices (primary measure of household wealth) and a high level of structural unemployment (reduces current income). Doing so would risk higher dissatisfaction among the constituency and contracting growth will put more pressure on loosing monetary policy further. With current short term rates close to zero and long term rates below expected long term inflation, every incremental dose of program to loose monetary policy further will be lesser and lesser effective.

I believe the most important goal for the govt at this moment is reducing unemployment and the monetary policy has explicitly made it clear that monetary base will keep expanding until unemployment reduces from current 7.8% to 6.5%. Any attempt to cut back on spending will not only put the future growth at risk but will also undo a large portion of what the monetary policy has been trying to incessantly achieve over the past  four years. Another important point, is that given the low real interest rate and subdued inflation expectations, its is advantageous to increase public spending now. Also any multiplier effect of higher or same public spending now relative to reduced spending will allow the economy to better cope up with higher fiscal austerity in future than reducing the spending now and pushing the economy back into a recession, reducing its earning and paying capacity in the future which will also endanger the sustainability of a tighter govt wallet in the future ineffect offsetting the primary objective of the fiscal discipline in the first place.

On the other hand, increasing the debt ceiling further will cause holders of govt debt more jittery which should be lead into selloff of govt debt, specifically, longer term debt and hence increase in yields. Additionally, the costs of selling new debt may be higher than what has previously been the case, resulting into higher and steeper yield curve in future.

But how practical is the above scenario.

for the sake of simplicity, lets classify the holders of govt debt into domestic and foreign investors. For foreign investors to disdain US govt debt would require taking a big loss on the existing value of its reserve currency, depreciating dollar (as investors dump US denominated assets and repatriate capital) would put upward pressure on their own currency and downward pressure on exports (but if all currencies appreciate in general against the dollar, the disadvantage in terms of export competitiveness may not be much). But countries particularly those that are more export oriented may be incentivised to manage their currency vis a vis dollar limiting the amount of depreciation possible with respect of atleast some currencies and the need to keep shoring up USD reserves. In a alternative scenario, lets say the many export oriented countries of today become consumption oriented and hence may benefit from higher domestic currency than in the alternative scenario. Rising domestic consumption will require progressive development of social, financial and economic infrastructure similar to that of what US and other developed world has achieved which in many countries is away by many decades if not more . Rising consumption in rest of the world plus a weaker USD will be a boost for manufacturing in US, also weaker USD will induce inflation and hence reduce govt debt burden through implicit default (since principal is to be returned in nominal not inflation adjusted dollars). Also, lack of confidence in dollar assets will require some sort of new mechanism for global monetary arrangement (where the influence or atleast the desire for influence of the large developing nations like China, India, etc. will be stronger, but almost all developing nations lack the depth and breadth of financial markets as well as respect for property laws that US has and are years way from  doing so. also none of them look like being in a consensual leadership position as of now). To conclude, the outcome or atleast the immediate outcome of increasing the debt ceiling in terms of foreign investor action is uncertain at best, though a gradually depreciating USD is favorable for both US consumers, businesses, govt and foreign holders (to the extent that they limit overtime the building of USD bubble through their own actions and ultimately own peril). The fundamentals or the disequilibrum that has caused USD strength and lower borrowing costs for US govt inspite of a deteriorating credit profile has not changed drastically now so as to warrant a selloff in the bond market by foreign participants atleast in the short term. Rising debt ceiling will raise voices about the unsustainability and prudence of doing so, but its impact in terms of market disruptions will be limited. to summarize, raising the debt ceiling has benefits that cannot be ignored

  1. supporting the economy when its needed the most
  2. future recession due to cut in govt spending will undo efforts of the monetary policy and may leave little option but to resume fiscal spending in future again
  3. low real interest rates make it an opportune time to borrow
  4. There are incentives for the foreign holders of US debt to continue the status quo atleast for time being even when real returns may be low in future from rising yields and depreciating dollar or both given the lack of feasible and consensual alternative to the dollar presently

From the perspective of domestic investors

The relevance of domestic investors appetite to hold domestic government debt is a bit of a puzzle (for the want of better word). Let say, domestic investor are wary to hold govt bond given the fiscal imprudence. in that case, bond yields on govt debt would increase (keeping foreign investor mute for time being) but that scenario would lead to higher incremental yields on all semi and non government bonds. So the question faced by domestic bond investors would be one of asset reallocation from domestic credit products to international credit products. Major developed country bonds markets outside US include Europe and Japan and maybe Australia and Canada to lesser extent.. Europe and Japan are no better than US in terms of their own fiscal prudence. Most other bonds markets even in big economies are not much liquid to accommodate trades worth billions of dollars daily. Also many countries outside US and Europe who have debt denominated in their own currencies may not be able to stand the high level of volatility that foreign capital flows may entail. Another alternative to domestic investors would be to increase allocation to equities and other asset classes at the expense of domestic debt holding, that would have implications on the portfolios price and cashflow characteristics and would engender other more complicated asset allocation challenges for large institutional investors. The above alternatives can be implemented at the periphery of the core portfolio with the extent of reallocation decision based on constrains over liquidity, volatility and price risk tolerance for given domestic investor. Also if higher yields were to destroy asset value it would simultaneously reduce present value of future obligations for domestic pension funds who are the largest domestic holders of government debt. Finally, there is nothing stopping the government from hand wringing domestic savers from financing the government through coerce policies and regulations. 

To sum it up, the near terms benefits of rising the debt ceiling are apparent and objective however the expected unfavorable outcomes of doing so in terms of investor confidence (both foreign and domestic) are a bit convoluted given the current situation. 

The risk of cutting down on spending are too great for the government and the economy to sustain. Also a contractionary fiscal policy will run opposite to the goals and objectives of a expansionary monetary policy which may do little to simulate business investments and consumer spending (given the concerns about future taxes and lower subsidies). this phenomena is currently playing out in Europe most notably in Spain. 

In case the US government decides to increase the debt ceiling versus implement fiscal austerity, the main challenge will be communicating this intention to the market as the initial response of market commentators will be on the unsustainability of the growing debt pile which could lead to further credit rating assessment and rise in yields. Hence, one possibility could be talking about spending cuts while not implementing one (remember it will be the implementation that will risk de growth in GDP) and doing some spending 'under the table' ie to say, disguised spending. 

All in all, my predictions is that the US govt will prefer rising the debt ceiling than cutting down on spending to the magnitude required to keep deficit under control (which is other way of saying rising the debt ceiling) but it may find innovative ways to communicate or not communicate this to the market. that would nevertheless result in rise in government bonds yields this year, but only modestly and I see no major dislocation in the US bond market in terms of foreign and domestic investor action even if the above scenario were to play out. 

Overtime however demand for non US bonds and equities across the world should increase its share at the expense of the US bond market but that is a steady progression and also hinges of the fate of economies and regions outside the US. 

Jan 2013