The Gold price conundrum and coming bout of inflation. Oh really?

Thursday, Sep 25, 2014 (2:10 pm) San Diego

For atleast past two and half years, equities world over in general and US in specific have been influenced to a large extent by the Central Bank action and speculations regarding the course of the non-conventional monetary policy and its ultimate outcome. Pundits on both side of the aisle have had their own opinion in support or against FED actions. Though both (for and against) arguments are equally logical and potent, it is hard to take sides. Remember how Gold first outperformed (until end 2012) and then underperformed, in absolute terms, based on which side of arguments the general consensus approved of at a point in time.

When money printing seemed like a habit with no end (between 2011-2012), inflation mongers took refuge in Gold to preserve purchasing power. Gold bug argued that Central Banks if, intent on debasing paper money, will eventually succeed in doing so. In which case, money will loose its purchasing power vis-a-vis Gold. The evidence presented to corroborate the argument being, historical periods of high inflation triggered by loose monetary policy and Gold coming out as a winner in term of preserving real purchasing power during such episodes of inflation. When fear ruled supreme, Gold continued to do well and the hypothesis being vindicated.

When former FED chairman Ben Bernanke hinted sometime in Sep of 2013 of rolling up the game over a reasonable period , Gold started loosing momentum. In fact by end 2013, the mighty Goldman Sachs termed short Gold position as a 'Slam dunk'. The argument being extinguishment  of actions to debase currency, takes the punch bowl away from inflation mongers and hence invalidates the hypothesis in favor of investing in Gold. A secondary and smaller argument, being rising value of USD post the QE era also subverting price growth in USD denominated assets such as Gold.

Gold lost some of its sheen in 2013 having provided negative returns for the first time in any calendar year since 2002. So where did the inflation mongers go wrong? Did they not expect FED to stop some day? Did they not expect inflation in the short term remaining subdued due to the moribund employment and economy, plus the deflationary impact of govt and private sector deleveraging?

Answer to all of the above question requires no special intellectual faculties. Simple common sense and simple logical inferences would suffice. Lets start with the first of the two: It was reasonable to expect the FED to stop somewhere and at sometime. Even if no view is taken on how long they go before they stop. To make this point of thinking intuitive, let us for a moment assume, that the FED does not stop ad-infinitum. That would be the case only when the argument for QE remained valid (that being a hypothetical scenario where the economy would never return to a state of full employment). Resultantly, if the economy never gains the traction as desired by public policy, it would be hard to find a argument for inflation running amok in such as scenario. So we can infer here that if FED were never to stop than inflation or Gold would never hit the roof.

Now, it is possible that the inflation mongers did anticipate FED to stop at some future date but also anticipated the interim term to be so long and the magnitude of debasing so high that inflation in future would indeed be a high probability event. However, in that case, they implicitly are maintaining the position that: 1) Both, inflation will be persistently quite high for given period of time and Central Bankers will not be able to control high inflationary expectation by any policy tool.

If their view on any of the determining factor such as: 1) level of inflation 2) The period of sustained high and uncontrolled inflation 3) Policy tool ineffectiveness, is inconsistent with the original argument (that FED will some day stop and we will still have high and uncontrolled inflation in future) than the whole hypothesis is again under the scanner of critical cross examination . Lets go a step forward and assume that the view on the above determining factors is consistent with the hypothesis. In such situation, the analytical framework beneath the hood becomes quite complex. As complex assumptions have to be made about time horizon (persistence), level of inflation (magnitude), what constitutes high inflation compared to normal inflation in some future environment, Government fiscal and monetary policy response and Global trade and currency dynamics.

Although this all may sound little verbose, in my opinion, anyone who think that inflation is coming but also opines that QE will stop some day, is in effect consciously or unconsciously having a position on the above further assumptions. That level of prediction is far more complex than the starting notion of monetary debasing leading to future higher inflation and loss in purchasing power of paper money. The more factors involved, the more interrelationships to think about and the more stochastic the range of ultimate outcome becomes (increases error rate).

Coming to the second question of expecting short term inflation to remain low due to moribund economy and deleveraging, but however, expecting high long run inflation; brings us to an important juncture in our analysis. That being whether sharply appreciating Gold prices between 2009-2012 could withstand the continuous negative reinforcement in the short run of low realized inflation? What would happen to mass psychology in that event, would they stick to the original hypothesis even when proved wrong (even if only in short run)? Where goes the consensus, so goes the price. And this is what has been observed in case of Gold prices and investor interest in Gold between 2012 and 2013 end.  Even though the hypothesis of long run inflation without short run inflation were to remain true, it is not a necessary condition for Gold prices to keep creeping up. As one group of investors would reverse the trade mainly because they cannot have the patience of waiting for the long run. For most investors on the periphery, if there is no inflation today than there is not reason to remain invested in Gold.

In my opinion, this is exactly where lessons from history diverge from investor mentality and asset return today. Investors get into the bandwagon giving historical evidence of why the thesis should work, but forget that historical time horizon of couple of years in making is different than the daily, monthly or at best yearly time horizon that consensus price determining opinion has.  Another way to put it is even if a particular view in context of historical study is logical and might well come to pass, investors also need to have time horizon in line with that view. A shorter time horizon can lead to being wrong in the interim. And being wrong can put immense peer pressure on changing the course (self doubt).

This also brings me to yet another insight. Given the dynamics and complexities involved, in determining long term future and all together different set of dynamics and challenges (both practical and psychological) involved in sticking to an investment strategy consistent with those long run expectation. I believe taking investment position based on such line of thinking can be self defeating. I however caution that does not mean a bias towards short-termism or prejudice against long term investment outlook. What I mean is that it can be very difficult to make accurate long term assumptions (no matter how cogent the argument may sound).. More so when implicitly you are unconsciously making further assumptions and unknowingly increasing the error rate. At the same time committing large part of the portfolio that is benchmarked incorrectly (by you or the outside world) to such a position.

To return to our Gold conundrum, I think Gold price will increase when there is an actual evidence of high and persistent inflation and failing policy tools to control it (irrespective of the starting price of Gold). That is to say, that currently high realized inflation will lead to current positive return on Gold prices without much ado about prognosis few years back. Or if the consensus opinion again shift in favor of coming bout of inflation, even if only for a while.

It is hard to say what determines consistent success in the field: Whether it is ability to correctly draw long term trends and forecast (from the above I think it ain't); Whether it is ability to patiently stick to your conviction without getting distracted with short term outcome (it could, but it also poses the threat of self confirmation bias) or Whether it is about understanding and correctly anticipating consensus fears and concerns?

(all feedback welcome)

China and the value trap

The above chart shows how value added (or alternatively excess returns) is distributed across the Global electronics industries. Although, it reinforces what we already know about it for long, the chart allows for more deeper analysis. After looking at the below chart, it strikes to me that most of the world's most successful businesses have followed this operating model for atleast past two decades and some for even longer, examples include Coca Cola; VISA, Qualcomm, Apple, Cisco, Nike, even Colgate and P&G, 

Strikingly, firms in the hi-tech business that were active across the value chain (including manufacturing) are experiencing or have experienced problems in the past, examples: Hp, IBM, Intel, almost all Japanese electronic firms. One reason being, their investors primarily value them as hi tech companies rather than low tech manufacturing hubs which is sometimes untrue when low value add is more of the revenue mix than high value add. 

A modern company contradicting this trend and still steeply overvalued is Amazon which is diversifying from high value added activities (its potent online platform) into lower value added and more capital intensive ones (company owned warehousing and now logistics). It will be interesting to see whether Amazon proves to be an exception to the rule or will its market price react to this trend over time (now that is a short idea!). 

(Aside: This also reminds me of our original investment thesis in Aramex (high on brand, low on capital intensity), and why Aramex is truly under-appreciated.)

Infact, in Emerging countries there are many instances of listed entities moving from high to low value added. Usually, the devil lies with the initial success, as cash builds up, management in companies with poor corporate governance and shareholder monitoring, are motivated to reinvest the surplus and grow the size of the firm than to distribute the same to shareholders. Expanding downhill is more easier and certain than uphill which makes the decision look prudent for time being and safer for incumbent management. 

It also tells me something interesting about China and how probable it is for that country to make into the upper echelons of the income pyramid. China over the past three and half decades has grown mainly by becoming the workshop of the world -the activity which has least value addition across the chain. That success was made possible with fortuitous combination of 1) large initial supply of cheap factors of production Land, Labour and Capital. Being a authoritarian state, the government owned the land, made capital cheap by repressing market clearing interest rate (which also explains the real estate bubble in China). In an urgency to get unemployment and poverty down for hundreds of million of unskilled people after "The Party" came to power, what better than create low skill, low pay jobs by creating subsidies manufacturing base. Externally, this process coincided with the trend of rising Globalization and economic integration in 80s. 90s and 2000s. 

However, China has not been able to move upscale to more value added activities and it is likely that when the wind is out of the sails on the initial trigger factors (labour, land and capital), China will increasingly face the same risk that other middle income countries face -of stagnant incomes. Infact China's case it will be even difficult because liberty and freedom are prerequisites for providing the environment to innovate. Now, that tell us that whether "The Party" will have to go or Chinese aspirations will have to settle for less. 

The GCC economic growth in many ways is similar to that of China, given almost all GCC countries are authoritarian states of varying degrees. A large percentage of non-oil, non-consumer services GDP comes from low value add manufacturing in industries such as petrochemicals, aluminium, fertilizers, steel, etc. These sectors are globally competitive as long as they have access to cheap feedstock. Though the GCC is lauded for its economic stability and growth rates in excess of 5% and the bureaucracy extolling the growing role non-oil sector. The concerning point is that the non-oil sector is viable to a large extent only due to the indirect subsidies and surplus from the oil sector. That dependence on oil and how fast non-oil GDP can crumble when oil is removed from the equation, justify why long dated GCC assets (high duration bonds, equities and real estate) should correctly trade at a discount to other countries with similar growth but without the oil induced distortion. 

This line of thought also explains why Mr. Alabaar's (Chariman of Emaar) proclamation of Dubai real estate trading at a discount to London or Singapore should be taken only with a grain of salt. A large grain indeed!

The state of Indian Democracy

India heads for the biggest and greatest democracy show in Apr-May 2014 as the country of 1.2bn and registered voters of more than 800M goes to elect its new government in the center.

The election this year is very unusual and interesting from the past precedents. This years election is focused more on individual personalities that would potentially lead this country of old civilization and young population out of the longest period of moribund since early 1990s. At the center of this high pitch drama is Narendra Modi, the decade old recalcitrant Chief Minister of the western Indian state of Gujarat largely credited with engineering one of the fastest state level GDP growth.

Narendra Modi has also other feathers in his hat than just Economic development ( a preception that is selling like hot cakes in India as the country rellies from one of the slowest growth in more than a decade, rising inflation, unemployment, and never ending goverment goof ups driving scarce capital). Mr Modi is largely perceived as having covertly been a accomplice of the 2002 pogrom of the Muslims (13% of the population) under his watchful eyes in his state in 2002. A accusation that he has neither accepted and never rejected. A Supreme Court enquiry let him off the leash largely due to lack of substantial 'evidence' though the US Govt revoked his US visa and banned him from travelling to the US due to his alleged role in the genocide.

The whole campaign of the right leaning, nationalist Bhartirya Janata Party whoes PM candidate is Mr. Modi is foused on this superlative economic performance of Gujarat attributable to solely and squarely to the leadership, vision and dicision making skill of Mr. Modi. We will not go into cross examining the authenticity, and statistical analysis of that perception  here. Though sufficient to add in this context, that Gujarat has historically been a state with GDP growth higher than that of the aggregate India and Modi's autocratic and dictatorial style has earned Gujarat capital investments from national and international businesses at the expense of sidelining (sometime by force and other coercive methods) other interest-such as displacement of poor, land acquisiiton, environment, etc. A heavy handed approach indeed has its benefits, particularly in terms of raw economic growth as reflected in the 'China Model'. However India's political and economic setup is very different from that of China (Indian is the worlds largest democracy and China is the worlds largest communist). Albeit the only similarity between the two is entrenched political corruption, rent seeking and the nexus between the businessmen and politicians.

What is very puzzling and equally disappointing is that millions of Indias support Modi (including millions who knew nothing much about him and his achievements before his candidature for the top post) with the same fevour as they support their national Cricket team (India has almost no sport to talk about except Cricket). What they fail to realize is that they are choosing a leader to head a democratic country as vast and diverse as India, someone whoes values, past track record and very achievements are precisely an antithesis of democracy. All that sacrifice, based only on perception and expectation of being able to bring India on track of enviable economic growth. That is indeed a great sacrifice, as it reflects the mentality of average, mostly educated, Indian of today. He is ready to overlook (almost forgotten) the governments role in the pogrom that killed over 1000 of his fellow contrymen only a decade back, plus countless other miseries such as rapes, displacement, illegal appropriation of assets, and discrimination at work place, education institutes, and public offices of the minorities. He is ready to overlook the fact that: long term development, that is more meaningful and equitable, than just raw GDP data; it is necessary for the goverment to tackle issues that pose challenge to the 'capital investment' based model in its policy making, and respect the rights and concerns of other stakeholders than just the capitalist. Sidelining those concern and stakeholder, though can create jobs and growth in the short -run, it will eventually extract its price: by mainly rising social and ecnomic inequality, threat to internal national security and harmony and a unbalanced, unsustainable growth path that will engender anothet set of political issues to deal with down the line, as China has realized in the past 3-4 years.

Another trait of this elections campaign mania has been the ease with which the Indian voter (educated and otherwise) can be obfuscated with glizty marketing and branding ploys. Though there are millions of Indians to harp about Modi's economic miracle in Gujarat and his leadership (most of them confusing leaderhsip with autocracy) very few and I repeat indeed very few actually can articulate what those 'achievements' indeed are and still fewer have any idea of how they have been achieved. Not much doubting the depth of critical mindset of Indian voters, the BJP campaign machinery has gone the 'end of the world' in marketing Modi strength as the sole purpose of it being the rightful candidate to form the government at the center without devoting much time and energy in communicating What and How the Economic Growth implicty proffered to the voters in exchange of their votes will be achieved. Nor Mr. Modi has made any attempts to articulate what his vision for the country is, what issues does he intends to tacke and how? to re-ingite the India Shining story.

Although, I have to concede here that the last of the problems mentioned in the prior paragraph is across the Indian political landscape where candidates promises are more friction than facts. Very few, even those running for the highest posts, make any attempts to go into detail of their game plan for the country and how they intend to achieve it. Candidate never debate with one another on the same stage on issues vital for the country and how they intend to tackle it (maybe they too have no clue on that!). Mass rallies are similar in analogy to religious sermons where its sacreligious to ask questions and you have to use your emotions more than your head to believe that your candidate tells you. As much as 50% of the time is spend in only jibbing at and belittling the opponent on issues that are sensational rather than of national importance.

The Modi led BJP govt seems to be likely at the center after the May elections and that is what the polls suggest. It will be interesting to see what and how much Mr. Modi delivers when the rubber meets the road. I will endevour to update this article after the May election results outcome.

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 

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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.

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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.

	2003	2004	2005	2006	2007	2008	2009	2010	2011	2012	Cumulative Return	Std Deviation of Return	Maximum Drawdown	Sharpe Ratio
Best performing asset previous year		1.26	1.12	1.33	0.84	0.47	1.06	1.19	1.08	1.20	20.8%	26.2%	-53%	0.79
Worst performing asset previous year		1.01	1.03	1.04	1.16	0.62	1.79	1.00	1.05	1.19	74.8%	30.5%	-38%	2.45
Three best performing assets classes in previous year (Eq wt)		1.22	1.20	1.21	1.12	0.56	1.03	1.18	0.95	1.08	39.6%	20.8%	-44%	1.90
Three worst performing assets classes in previous year (Eq wt)		1.04	1.04	1.09	1.09	0.79	1.47	1.02	1.04	1.12	76.6%	17.4%	-21%	4.39

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.
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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, 21^st 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.

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