Tuesday 28 March 2017

Is EM FX cheap?

It seems the asset allocation community, perhaps on a least worst basis, has pumped EM local bonds and equities this year. Set against an expensive US Dollar and cheap Euro are EM FX rates cheap?
Just looking at the REERs of some of the bigger countries it seems:
  • Commodity exporters are generally at undemanding levels and maybe benefiting from a recovery in commodity prices over the next few years
  • However some de-valuers such as Nigeria and Turkey have maybe offset much of the devaluation through inflation
  • Many of the others are not 'cheap', in part as the FX falls they have had have been eroded by inflation and also the Yen/ Aussie/ Euro falls of recent years. China is also seemingly on a controlled devaluation path for the foreseeable future
  • Some of the East European countries pegged to the Euro look expensive as well as Saudi. If the Euro rallies it will pressure the East European countries even more.
  • At a cross current to this you have negative political dynamics in several countries (notably Turkey and some of the sub-Saharan African countries)
Against this, this Friday we have US PCE numbers which may refocus attention on how much the Fed's hands are tied, particularly given we have just had a US fixed income short positioning clear out.

Baby Boomers are structural sellers of equities and corporations the only real buyers in this cycle

Baby Boomers as structural sellers of equities while corporations in this cycle have been the main buyers. But corporations are only going to buy when things are going well. Factset's last quarterly (next one due soon) had corporations buying back 2/3rds of their earnings last year. Hard to see why Goldman expect buyback rates to grow a lot this year, apart from needing to get to a positive net equity demand number. If corporations 'only' buyback $500bn, then net equity demand is zero according to their other numbers. 



Robotics to improve manual labour productivity

Printed concrete, printed welding, modern pre-fabrication and robotic brick laying have the potential to speed up/ reduce the cost of the building process a lot.

If you want minimum wages to go up 50% you need to do something to up productivity.



Monday 20 March 2017

Commercial real estate under Trumponomics


This cycle has seen a wave of institutional money going into a few areas, commercial real estate being one big beneficiary as institutions tried to capture yield versus liabilities.
Trumponomics aims to deliver a few key rebalancings:
  • Wages as a percent of GDP higher, in particular minimum wages higher
  • Imports lower, domestic production and exports higher, driven by BAT tax
This has to deliver higher medium term inflation and nominal GDP outside of temporary recessions. The Fed, Eurodollar futures and bond yields are starting to reflect this expectation of higher nominal GDP. Most people I speak to see US corporate defaults rising.

Under globalisation and neo-liberalism combined with several economic sectoral deficits, the corporate sector profits as a percent of GDP has only really been higher towards the end of the 1920s credit boom, while wages have never been lower:

The FIRE sectors (finance, real estate and insurance, none of which directly contribute to output) as a percentage of GDP have increased to over 20%:


And while debt to GDP has been growing at around $3 of debt for each $1 of GDP, the finance sector growth has stalled with ZIRP. As rates rise the finance sector in the short term could even increase as a percentage of GDP before it busts.

More generally as corporates get squeezed by rising wages, BAT-increased import costs and higher financing costs, they have to cut costs elsewhere. One way is to increase productivity (positive) and other is cut optional costs; which brings us to real estate.

Offices will see less demand due to remote working which is better enabled by improved internet access. There is a general hollowing out of the mid-market of many industries to a bar-belled low price or high value industry structure. Some areas related to consumer spending and domestic production and exports will benefit, but most areas of commercial real estate will suffer from falling rents and falling occupancy.

The worst area (as discussed here by Charles Hugh-Smith http://charleshughsmith.blogspot.co.uk/2017/03/the-next-domino-to-fall-commercial-real.html) is likely to be big box and shopping mall retail, some of which is seeing more or less zero recovery value as marginal assets become uneconomic to operate, similar to the rust belt industries in the 80s and 90s. These retail sectors apart from wages/ BAT taxes, are also being hit by the structural shift to online.

According to CBRE the typical cap rates for investable retail assets are 3-5% (http://www.us.jll.com/united-states/en-us/research/capital-markets/commercial-real-estate-investment-trends/retail)

What could be the trigger for committed selling from institutions, starting with marginal retail assets?
Duration losses from government and IG bonds as the market prices in 4-5% nominal Trump GDP growth triggering the need to raise liquidity might be one.

Quant quotes

Over 11 years of meeting hedge funds there were quite a few memorable meetings and characters. From the events of 2008 to meeting people like Lars Steffensen and attending the Bear Stearns ABS cap intro and education event in April 2008.

But one of the best interactions I had was over several meetings with the CEO of a well known quant fund who schooled me that 'words are important' after I asked a few vague but reaching questions. So I decided the next time I would write down what he said verbatim. So here are a few of his quotes from one cap intro conference:

On trend:
'Medium term trend... we dont see it as having a problem' (i.e. returns
havent eroded over time)

On their carry strategies:
'(we) see all these carry models as uncorrelated, but independently have
low Sharpe ratios, put them together and the portfolio Sharpe is higher'

On their equity mn strategy:
'cash equity market is not very liquid'

'the strategy has 3% stand alone vol, but only adds 10bps to the total

On Aug-07 quant flash crash:
'it was just a small cap liquidity crisis'

On risk management:
'stuff happens (referring to 1987) ...but you can forecast volatility
pretty well most of the time'

'forecasting correlation is not that hard' (see last point)

'the volatility that you choose (to run a strategy at) is pretty much
arbitrary' (see previous points)

'all of this (his risk management comments) has been on the basis that the
markets are Gaussian... markets are nearly normal(ly distributed)'

'if the correlation isnt what you think it was then you realise more risk'

'we dislike the bad more than we like the good'

This cycle's secondary opportunity coming up

Institutions flooded LBO funds pre-08 with money and then post-08 you had a big PE secondary opportunity. This time round money has flooded real estate PE funds and mid-market direct lending...

Puerto Rico and other 'special opportunities'

I remember being shown some 'special opportunity' funds about 2 years ago by US distressed groups to desperate to buy Puerto Rico bonds given how little other distressed opportunities there were at that time. Without going into the details the country has something like $70bn of debt, $28bn of tax revenue and a shrinking economy. Looked like a sub-50c recovery to me on average with some bonds having specific assets or taxes pledged and less secured bonds potentially faring worse. But eitherway the final outcome seemed very unpredictable. 

At the time the general bonds were around 80c, and Obama was calling for some sort of debt restructuring while the funds were suggesting PR would get a bailout and the funds would buy at 80 and get par plus coupons. Doesnt seem like the trade is going to plan... 

 As US rates rise and the USD funding shortage gets tighter, more EM sovereign defaults to come, with many expecting Vene to be next. 

The post-default environment could present interesting opportunities though...


The myth of the cash prime residential buyer

There is an assumption that people buying for £1-5m are cash buyers. Surely some are and over £5m presumably the majority are. However I thought I would share this. 

A couple of years ago while Osborne and Carney were busy pumping up the housing market to try and offset austerity with a 'wealth effect', we had an internal education event for private bank colleagues. In the reception after I chatted to someone on the Asian offshore desk (ie South Asian nationals banked offshore in London). I asked her if her desk's clients bought many of our products (HF, RE, PE), she said 'no'. So I asked what business they were doing, she said 'its only residential property'. Turns out the clients were buying apartments to let in prime London with maximum LTV. I then suspected that they were borrowing the 'deposit' over in Asia and bring it here to leverage up the capital gain trade to the max. To print enough business to be a client I think they would have to do several of these deals to meet the minimum criteria. 

Since then Sterling has slumped, the BoE is likely to start following the Fed soon and now the price of the properties in question seems to be falling, with many having been bought at the equivalent of a 1-2% gross rental yield.

Fed confirms intention to stay behind the wage-inflation curve

Wages growing 3-3.5% by year end? Or will they accelerate as U6 struggles to go under 9% and Trump implements various policies? The benefit of a strong USD, flat/ negative prices paid and falling commod prices are also in reverse or flat now.

Fed is about 0.5% behind the curve by their own standards, given Libor is higher than Fed funds. However projecting forwards 12 months if U6 drops to say 9%, the Fed funds were at 3% last time... 

Last time however the Fed was not pursuing an overt policy of financial repression and debt was not growing 3x faster than nominal GDP. But this time next year, who knows who will be Fed chair or what the central policy goal will be - although I'm sure Steve Bannon has a few thoughts on the matter.


The Fed's rate forecasts are based on the following assumptions:
  • Full employment this year
  • PCE stabilising at 2%
  • GDP growth stabilising at 1.8%

So they are assuming that jobs will be created and economic growth delivered but there will be no knock on impact on inflation or wages? Seems unlikely. PCE is 1.7% and on a generally rising trend. 

If PCE goes to 2.5% and the Fed is still below 1.5%, ie this year, and that rise in PCE is underpinned by wages, then the Fed will be in a bind. They wont want to hike rates as it risks a recession, but they will be in breach of their inflation mandate. 

In my view the next Fed chair will be politically appointed and will be expected to let wages run, which again underpins a wage-inflation cycle. In otherwords, despite the Fed gradually hiking rates, real rates become even more negative now. In fact Yellen even argued the case that -2% real was now 'neutral' in last weeks press conference. 

Sunday 5 March 2017

The FIRE economy under Trumponomics

Will a US rate hiking cycle be the final nail in the coffin for large areas of finance?

  • Banks with one way CSAs against swap books
  • Asset managers relying on client inertia or a 'lack of other options' business model
  • Consultants advising pension funds on how to meet liabilities growing with inflation vs an asset portfolio losing money on duration
  • Hedge funds and other alternatives offering conditional alpha, or leveraged long in private assets

Finance as a % of GDP is at an all time high and the tide is about to start going out. While there will be big losers, there will also be massive winners and new businesses built on the changing environment.

As shown in the chart above, the so called FIRE sectors have grown from under 15% of US GDP in the 1970s to around 20% now. The sector has flat-lined since the early 2000's as perhaps debt growth has been offset by lower interest rates.

Its clearly a sector that can shrink as a % of GDP as Trump wage inflation pushes up wages as a percent of GDP and defaults rise, set against still continuing negative real Fed rates and nominal GDP rising faster than debt creation at some point.

In the short term though as debt is growing about 3x faster than GDP, perhaps some rate hikes will even increase the FIRE sector's share of GDP before the structural reversal sets in.