Hedged.Biz http://www.hedged.biz A look at investments, economics, finance and the irrational economic human being Fri, 17 Jan 2020 02:53:28 +0000 en-US hourly 1 https://wordpress.org/?v=4.9.13 ESG Investing Is Hard To Do. http://www.hedged.biz/esg-investing-is-hard-to-do/ Thu, 16 Jan 2020 06:50:12 +0000 http://www.hedged.biz/?p=3117 I had discussed ESG in this previous article entitled: ESG: Externalities Unpriced, in an attempt to move analysis of ESG towards a more formalized framework, arguing that ESG leads to better investment results due to a more comprehensive understanding of the factors surround a business so that these factors can be integrated into both a risk mitigation strategy as well as a business origination strategy from the point of view of the business management, as well as providing a better description of the said business for a better appraisal of the strengths and weaknesses of the business from the point of view of the shareholder.

Even with these ideals in mind, ESG is more complicated than I’d thought. And here we are not discussing greenwashing but assuming good faith efforts in the pursuit of more sustainable business practices.

Purpose. The purpose of business is profit. It is practically intractable to maximize two measures at the same time unless we establish a strong dependence between the two. For a business to maximize profits and social or environmental impact is simply too difficult to do. A business should profit maximise. The reason ESG is important to a profit maximiser is that it increases the information available to the business to facilitate that profit maximization. The objective horizon is important. Short term gains can be made through behaviour which in the long term may be irresponsible. It is therefore important that management is incentivised to maximize business value over sufficiently long time frames. Attempts to maximize or focus on measures other than or in addition to profit, present management with confusing mandates which risk management failure. This is an unnecessary risk and should be avoided. Business are expected to make money, and to avoid irresponsible practices while they go about it.

Identifying and prioritizing ESG factors. As ESG is a relatively new concept, the availability and quality of data is an issue. Business managers need to identify all factors which can impact financial performance and to determine the importance and priority of such factors to the business. The importance of a factor can vary over time and can correlate with other factors. The importance of social diversity of a firm can vary as the client base of the firm evolves over time to include more cultures or instead focuses more exclusively on some cultures to the exclusion of others. Investors need to understand the scope and priority of the ESG measures management is focusing on both to understand the business better, and to benchmark the performance of management.

The ESG label implies a systematic focus which sometimes obscures the bigger picture. ESG appraisals often focus on internal processes and appraises the firm in isolation rather than its role as a part of an ecosystem. A firm’s impact on society and environment begins before it acquires raw materials and after it sells its product. The sustainability and financial fate of a firm is impacted by its sourcing decisions and its legacy. The cost of recycling, decommissioning and otherwise disposing of lithium based batteries can potentially be put back to manufacturers someday, directly, or indirectly if buyers are charged decommissioning costs. Firms are best appraised within their ecosystem, and not just within their competitors and their immediate supply chain. Impact investing, which is distinct from ESG investing, has tools for measuring the impact of a business within its ecosystem, tools which it may be useful for ESG investors to borrow.

ESG heightens the trade-off between subjectivity and objectivity. In any form of decision making, such as in the field of investments, there is always a trade-off between a subjective versus an objective approach. The ESG investing industry is thus bifurcated. One camp prefers a systematic and transparent approach which is rooted in exclusions or inclusions based on objective ESG metrics. The other approach integrates ESG factors into traditional discretionary securities analysis.

The systematic approach is decisive, auditable and transparent. However, it is susceptible to type I errors, rejecting acceptable firms. The integrated approach is less susceptible to type I errors, is not more susceptible to type II errors, that is, accepting an unacceptable firm, but is less transparent, less systematic and is less decisive leading to more indeterminate classifications, that is, neither accepting nor rejecting. Some investors take the view that their capital should animate social, environmental and corporate governance improvement and so favour the integrated approach. This necessitates the use of some impact metrics to validate the thesis. For investors, some combination of the systematic and the discretionary approaches is useful. There will be type I and II errors but there are sufficient investment opportunities that some level of waste is acceptable. On the other hand, a systematic approach makes the investment problem more tractable while the discretionary approach makes it more purposeful.

Measuring impact is hard to do. If one is borrowing impact metric measurement to augment their ESG program, it is important to be able to measure impact. This is doubly important since our interest is ultimately not the impact itself, but its information content as regards the financial outcome. How do we know that the impact metric we are interested in has real impact on financial outcome, whether as a driver or a risk mitigant? This requires good econometrics. It also brings to the fore the problem of gestation. The investment community is focused on measurement, which is understandable, but often is unaware of the gestation periods between decisions and results. In public markets, the availability of daily prices encourages very short-term expectations. Private markets dearth of pricing data encourages longer term expectations. In the area of non-financial impact, the lag between action and result can be considerable. In climate change for example, the consequences of current behaviour can manifest over decades. The desire for better and higher frequency data can encourage short termism. Also, the complex relationships in non-financial metrics require careful model specification, a problem compounded by the financial industry having a patchy track record in theoretical rigour.

Common sense is not so common. There is sometimes a lack of common sense in investment management. The narrow focus on profit can lead to tunnel vision. Complexity replaces simplicity. Conventions which may be irrational persist due to investor inertia. Many ESG factors and considerations are a matter of common sense and not some specialized analytical lens. Many impact goals would evidently reward an investor seeking to address them since they address a need. If there are persistent gaps and adverse outcomes, they are often due to market failures. Solving these market failures is a more efficient endeavour than addressing the gaps and adverse outcomes. In fact, such gaps and micro failures can be outright profit opportunities to private capital willing to provide a solution. This raises the question faced by many a for profit organization. Fix the problem once and for all, or provide analgesics for ever, bringing us back to the question of purpose. 


2020 Investment Strategy. Generally Cautious. http://www.hedged.biz/2020-investment-strategy-general-caution/ Mon, 13 Jan 2020 23:41:11 +0000 http://www.hedged.biz/?p=3102 Reduce equity exposure.

Equity markets have outpaced fundamentals recently. In any reversion to mean, equities will perform in line with fundamentals which suggests a much more moderate performance in 2020. On that basis alone, investors should reduce equity exposure. By how much? In a balanced portfolio with 35% in equities and 65% in fixed income, one might reduce exposure to 25% in stages. The economy is experiencing a short term rebound which could impact monetary policy expectations and lead to a weaker market. Further out along the horizon weaker growth could lead to re-emergence of rate cut expectations which could propel markets to higher valuations.

Maintain a close allocation to the MSCI World.

Markets are very flow driven which helps the simplest allocation outperform more sophisticated ones. Over the long term one would expect China and India to outperform. Moderate over-weights in those countries at the expense of US make sense, but one should not deviate too much. Sector deviations can be volatile this year.

There is opportunity to outperform in fixed income.

Reduce EUR and JPY duration. The ECB and BoJ are exhausted. Japan and Europe will turn to fiscal policy for their economic support and this will mean higher yields across EUR and JPY yield curves.

USD duration is complicated. Maintain a neutral to underweight duration exposure. The Fed has room to cut and could do so if pressured by the President or if economic data weaken. Fiscal policy remains loose and both political parties are not focusing on fiscal prudence. This will likely steepen the USD curve.

Maintain neutral IG corporate credit exposure. There is still some return to be squeezed from corporate credit. In investment grade, the long duration (circa 6 to 8 years) may call for hedging.

In high yield rotate from bonds to loans. The general duration + credit spread trade has done well but is long in tooth. Leveraged loans are a better trade expression. Very low duration by reason of floating rate coupons, senior, secured, and higher in the priority of claim, loans are preferable to bonds.

There is some opportunity in CLOs.

CLOs repackage loans into a variety of liabilities from equity to mezzanine to senior. In the current environment, the liquidity and balance of credit risk in the BBB segment is attractive. The time for equity investment is not yet upon us but if the economy slows and corporate balance sheets get stressed, be ready to buy CLO equity or junior mezz.

Overweight residential mortgages in the US.

The relative credit quality of household balance sheets relative to corporates’ or the states’ makes agency residential mortgage backed securities an attractive investment. Even here, pricing is tight but relative to everything else, there is still safer yield to be harvested.

Bank subordinated capital.

Last year was a very strong year for so-called CoCos. However, the market is still relatively cheap compared to non-financial corporate credit. 


Generally Cautious:

Hold a bit more cash in 2020 than in 2019. Resist the temptation to extend risk just to get that extra bit of yield.

Political risk is higher given the US Presidential elections. Trump can be even more erratic as he seeks re-election. Sanders and Warren, while long term positive for the US economy will be a drag on growth and markets in the short term. In Japan, Prime Minister Abe is in his final term. The China US struggle continues. A trade deal is likely to be cosmetic and represent short lived détente.

Valuations are high, not only in equities but in credit. Liquid IG and HY corporate bonds are unattractive. Yes, one could expect markets to tighten 50 yo 60 basis points over the year, but the risks are asymmetrical with a higher chance of widening. The yield compression from capital inflows from ETFs and tourists is significant and thus also is the unwind risk. Once attractive areas where the more sophisticated investor squeezed returns, i.e. CoCos, CLOs, ABS, are now expensive. They are not as expensive as corporate debt but their additional complexity and somewhat lower liquidity demands a higher hurdle.

The economy is slowing. The next 6 to 9 months may see some improvement but this is likely to be temporary. There are new innovations driving the next leg of growth. The trade war has reduced the productive efficiency of the economy. The acute inequality in the world has reduced the allocative efficiency of the economy.

Central banks are at capacity. If there is any serious slowdown, the ECB and BoJ are already at their limits. They have cut rates to below zero and are still buying bonds. The US Fed may have stopped cutting rates but they are also still buying bonds. The PBOC is operating a comprehensive policy of easing. Central banks did not reset their policy tools soon enough after the last crisis and their capacity to support the economy is seriously diminished.

Too early for distressed investing. But do the homework now. There are areas of stress and distress even in a period of growth. The large cap defaults are likely to be deferred at the expense of recoveries. Caution is warranted. When the corporate defaults come, the scale may be substantial and could take markets by surprise.

Bank Regulation. Banking regulatory capital requirements continue to support bank disintermediation and or bank regulatory capital arbitrage. Private lending continues to be a good opportunity despite a good deal of spread compression. Focusing on credit quality, covenant strength and collateral quality is key. Trade finance and real estate finance are areas of interest. So too are mid market senior first lien loans. 

Look for shorts. It is still too early for a turn in the economic or market cycle but scanning, filtering and looking for short ideas takes time and effort. Sometimes, they are easier to spot by their rarity.

Duration is not a haven. Fiscal policy is likely to push yields higher. Inflation may creep higher as the labour market gets tighter. Central banks being at the limits of efficacy also speak against duration. EUR and JPY duration are unattractive. USD duration is in an uncertain place. The Fed may cut further or extend the duration of their SOMA holdings but the balance of fiscal and monetary policy puts USD duration in a fine balance. 

The repo market is showing signs of strain. When QE was initiated the term structure flattened. When QE was tapered, the expectation was that the curve would steepen back up. It flattened further instead. When the Fed balance sheet was actually shrunk, the term structure actually inverted. In September 2019, overnight repo briefly rose to 10%, well beyond the Fed fund’s target range. This is an anomaly. The Fed has had to intervene in the repo market with large scale liquidity provision, and resume buying bonds at rate of 60 billion dollars a month, now increasing its balance sheet. They assure us this is not QE. It looks more like a QE trap. 

Prefer safety over gain. Generally, prefer value over growth, dividends over capital gains, senior over junior, secured over unsecured, and quality over yield.



Gold. Political Risk Hedge. The Schadenfreude Trade. http://www.hedged.biz/gold-political-risk-hedge-the-schadenfreude-trade/ Thu, 09 Jan 2020 23:42:48 +0000 http://www.hedged.biz/?p=3098 The case for gold has never been stronger with the rise in geopolitical risk since 2016. Since 2000, the price of gold has risen sharply, at an annualized rate of nearly 14%, only to peak in 2012 before losing 40% in 3 years for an annualized rate of -7.4%. Since then it has risen erratically to the current height of over 1550, a gain of nearly 50% in 3 years or an annualized gain of over 9%.

The main uses of gold are jewellery and electronics. The rest of gold’s utility is as a store of value. Gold’s economic value is therefore mostly derived by its being an alternative to other financial instruments. It’s value derives from the value of everything else. When other currencies are debased, the value of gold rises. When other assets are debased, the value of gold rises. When central banks cut rates to zero, when bonds yield less and less, when there is a surfeit of money, the scarcity and constancy of gold enhance its value.

Gold is also a hedge against political and social uncertainty. As inequality rises and with it, social unrest, indignation and anger, the value of gold rises.

The value of gold to an investor depends on increasing turbulence in the socio-political landscape and having sufficient numbers of other investors who hold less gold than they desire (or no gold.)

The risks to gold are:

Political risks subside. This is unlikely to happen in the near term given the US elections, but politics is more unpredictable than the economy or financial markets. If anything, conditions are conducive to a rise in political risk.

Central banks stop debasing currencies. This is unlikely to happen, although the debasement is unlikely to accelerate since central banks are at the limits of monetary policy.

Deflation sets in. This could happen even in a growth scenario if technology advances sufficient or if central banks cut rates further. The latter dynamics are controversial but appear to be empirically supported. The Fisher Effect and inertia of real interest rates obtains this result.

So, to own gold or not?

When my analysts recommend gold as a hedge to the ills of the world, I see that gold bugs essentially need a world in trouble and all others to be unprepared, and I tell them, “find a better way.”


When yield curves are sufficiently flat, a duration matched steepener is a positive carry trade with capital gains potential and is a hedge for risk assets if the fall in risk assets is substantial. In other words, it is not a good hedge for small or gradual declines.

When markets are flow driven and capital causes convergence in asset prices, often the convergence overlooks quality. Long high quality short low quality credit pairs can be low cost, sometimes zero cost hedges for long credit portfolios.

Shorting funding currencies is another cheap hedge. When markets turn risk off, funding of risk positions is unwound putting pressure on low yielding (sometimes zero or negative yielding) currencies used to fund those positions.

10 Seconds Into 2020. Geopolitics and US Elections. http://www.hedged.biz/10-seconds-into-2020-geopolitics-and-us-elections/ Wed, 08 Jan 2020 02:35:52 +0000 http://www.hedged.biz/?p=3089 Welcome to a long rambling piece about the economic and market outlook. There is a lot to think about but in the end, if all you are interested in is the direction of the financial markets, go to the end of the article on US Elections and Trump.

Geopolitics. A key driver of economics and markets.

In the China versus US conflict we have a good old-fashioned rivalry between a rising power and a declining one. The conflict is already joined on the trade front. It is unlikely that two powers who are already at high levels of wealth would risk a shooting war, however, proxy wars are possible. One is likely already being fought in Hong Kong. More will likely emerge in unexpected and exotic locales, such as cyberspace.

China is rising. Proof of this can be found in US policy towards China, surely a defensive response to what it regards as a threat to its hegemony. Economic growth will slow as it does in all mature economies. Constant positive growth implies exponential growth which is unreasonable. The nature of China’s growth is changing as well. Once the 52nd state of the USA, tasked with being the cheap factory of America, China is shifting from exports to a balanced, self-supporting economy with a more diversified export base. The Belt and Road Initiative is very interesting and parallels the US Marshall Plan in some respects. It will extend China’s influence globally and further threaten the US hegemony. It is reasonable to expect an American response, but the scale of financial resources China is holding out to the rest of the world is probably more than can be ignored, even by America’s allies.

That the US is turning its back on the rest of the world does not help its own cause, as China further integrates into the international community. As America builds walls, China builds bridges. America’s trade war is not only with China but with its neighbours and with its traditional allies, the Europeans. Not only is America turning away from business with Europe, it is turning away from NATO. This is a puzzling strategy given that NATO was the martial plan accompanying the Marshall Plan to address a belligerent Moscow. The direction America takes will depend somewhat on the outcome of the 2020 US Presidential Election.

Europe is a weak point in the global economy, especially under conditions of trade war. Brexit will soon be underway robbing the EU of its business lobby. At the same time, German leadership of the EU may not be as certain as Germany herself faces political uncertainty in the post-Merkel era. Meanwhile Macron’s differences with the French people remain unresolved and Italy continues to be plagued by populist politics.

In all this, trust Russia to strategically align itself with the China bloc. Already Russia has aligned with India and China on military exercises as well as building parallel redundancies in financial infrastructure to reduce reliance on American standards. It is almost normal to expect more electoral interference by Russia in the coming US elections.

And speaking of India, the Prime Minister continues to operate a risky form of Hindu nationalism. Meanwhile the economy flounders as poor execution hamstrings an otherwise useful raft of reforms. Most recently, its insolvency law was confounded by an inexplicable ruling by the National Company Law Tribunal, the body to implement these very laws.

And finally, Japan, host of the Olympics this year. Who will replace Abe? The Prime Minister is in his third and final term as head of the LDP, although he may be able to get an extension for a fourth term.


Trade War.

As previously noted, the trade war is most visibly one between the US and the rest of the world, with special attention paid to China. If successful, the US will have reduced trade account imbalances, caused a great unwinding of globally supply chains, catalysed a spike in capital expenditure as capacity is relocated globally, and led to more robust but less efficient production. The result is likely to be higher prices at each given level of growth. This limits already limited central bank policy. Simply, it means either higher prices or lower growth and less capacity for policy to deal with it.


Fiscal and monetary policy. Central banks at their limits.

10 years of loose monetary policy has inflated assets while failing to raise growth or inflation. Orthodoxy is slowly pivoting towards fiscal policy.

In 2019 we saw the US Fed do a U turn and reverse its rate hikes, not only cutting rates 3 times but basically restarting QE and calling it something else. Most other major central banks were already in easing mode. The ECB had previously contemplated reversing QE but realized that the economy was too weak for that and in the end had to formally restart QE and cut rates further into negative territory. The PBOC had been easing all year, albeit in less noticeable fashion.

Why the need for so much monetary easing? The global economy had begun to slow, in part in line with its natural cycle and in part to do with a trade war. Either way, regulators were unwilling to let nature take its course and thus had to cut rates, buy bonds and provide liquidity somehow.

The ECB has recognized that it is at the end of its monetary rope. The negative rates are waterboarding the financial system. Banks, insurers and pensions are suffering. Outgoing ECB president Mario Draghi called for fiscal help even as he announced QE and a rate cut. Incoming ECB president Christine also called for fiscal help further signalling that more monetary easing would be of limited utility.

Among central banks, the ECB and BoJ are probably at zero marginal effectiveness. The US Fed has room to cut and may need to do so just to maintain the economic status quo. The PBOC has its own toolkit and is far from exhausted.

This fiscal policy. Europe has the most reason and room to do it but has political frictions to overcome. In the end, the relative weakness of the German economy will likely lead to some give from the Germans. The other members of the EU are less likely to press for budgetary discipline.

In the US, the Republicans are most likely to maintain fiscal discipline except that they are led by Trump, a natural profligate. The Democrats are unlikely to be any more disciplined given their current agenda.

Fiscal policy seems almost like an idea whose time has come again.

The textbook dangers of unlimited monetary and fiscal support are excessive and rising national debt and the eventual loss of confidence in policy and currency leading to runaway inflation or a currency crisis. This has not happened in Japan where nearly 3 decades of constant support have failed to either provide results or induce a crisis. Whether such policies can be operated elsewhere with such benign and ineffective results remains to be seen. Japan might be a special case.

A more fundamental question is, what is the right level of growth that policy should aim for? Is it that level that maintains low unemployment? And what if inflation resurfaces?

Since the 1980s most policy responses to recessions have been monetary which exerts downward pressure on interest rates. The engagement of fiscal policy exerts upward pressure on interest rates and will have unfamiliar implications for markets and the economy. Additionally, fiscal policy is not only an economic decision but involves many political ones and can raise lines of division.


Inequality. Beyond fairness.

In a knowledge economy the ability for capital or institutions to accumulate generations of intellectual capital versus a human being’s ability to store one lifetime of IP encourages a chronic decline in labour’s share of output. Owners of capital benefit from passive accumulation of intellectual property and hence wealth whereas labour must constantly actively acquire intellectual capital to maintain relevance. This increases inequality, potentially without bound.

In many countries, electoral success correlates with the ability to raise campaign finance such that political outcomes are influenced by wealth. Political lobbying is also a costly activity further biasing outcomes towards the interests of the wealthy.

Inequality in moderation encourages progress. However, excessive inequality lowers the informational efficiency of an economy and lowers growth. It is also a risk to social order. The awareness of inequality has risen in recent years. When inequality begins to feel like injustice, social stability is threatened. Dissatisfaction can manifest in many ways which may be appear only tangential to the real issue.

Greater inequality also means more financial investment which means richer assets. That inequality slows growth by skewing the marginal propensity to consume of a population means that demand for financial assets rises as growth slows leading to higher valuations.


Global Outlook

A temporary respite. A difficult future.

Growth had slowed but is currently flattening out. Expect 6 months to a year of recovery in the global economy but that this is only a temporary respite as the world reorganizes itself to a new trading environment. It is likely to be a capex driven recovery as new capacity is built and old decommissioned in the reorganization of supply chains. Beyond this, there is unlikely to be any game-changing technological advance to drive growth to a protracted and new cycle. Growth likely peaks within a year.

With the supply chain reorganization following the trade war, inflation is likely to resurface. Fiscal policy, if engaged by then, will keep economies at close to full employment and could fuel more price pressures.

US equity markets have done well in the past year and are expensive. For them to rise further would require rising earnings, a cessation of trade war, more rate cuts or rising share buybacks. If the US economy slows, the Fed could resume rate cuts. It is already operating QE in all but name. Rising earnings or a cessation of trade war are low probability events. For buybacks to re-accelerate would require low interest rates.

There is a heightened risk of underperformance from US equities relative to the rest of the developed markets.

Credit markets should correlate well with equity markets. Duration is another story. There is significant risk around duration as geopolitics impacts the treasury market. The Presidential Election coupled with threat of a Trump impeachment, will add volatility. One should be cautious around duration exposure, which will be less predictable than credit spread exposure. Household credit (RMBS) is preferred to corporate credits. Floating coupon is preferred to fixed. A year’s outlook is too short to prefer IG or HY with the preferences probably switching through the year.

European equities also did well despite a weak economy, so even Europe is no longer cheap. European rates have been cut to rock bottom and it is hard to see any more rate cuts, or acceleration of QE. If fiscal policy is engaged, the EUR curve will likely steepen. European equities, however, are supported by cheap funding which is advantageous if they do significant business outside Europe. For banks, a steeper term structure will be a relief. Apart from banks, European equities are at risk of underperforming developed Asia.

European credit will correlate with equities. The IG term structure has done well and there is no need to extend spread or rate duration. The duration outlook is less rosy as fiscal policy looms in the background. CoCos have been an area of focus and while the outlook remains good, extension risk will have to considered.

China’s growth while slowing remains high. Also, there is some visibility to future growth as investments in Belt and Road Initiative pay off. This is, however, not a 2020 trade but one for the longer term. The PBOC is likely to remain accommodative and provide significant credit and liquidity via the formal banking system. In the shorter term, this dovish monetary policy is likely to drive equities.

The credit market will be more challenging. It is clear that China is balancing between stability, which it craves, and a more robust credit system. Robustness requires a working NPL resolution process, which by definition involves some level of instability as companies file for bankruptcy or default. The market may take some time to absorb this new reality. It is best to avoid any reliance on moral hazard, and to remain with quality credits until bankruptcy becomes part of the normal course of business.


US Elections and Trump:

Many factors can move the market but at any one time, only one does. The challenge is identifying that one factor. In 2019, that one factor was central bank policy. It doesn’t mean its easy to figure out the market, since its just a transformation of the problem from figuring out the market to figuring out central bank policy. Sometimes, central banks themselves can seem a little lost.

In 2020, financial markets will likely be driven by geopolitics. 2020 has not a busy election calendar except for the US Presidential Elections. The European calendar is fairly quiet, though ructions can arise off-calendar. French PM Macron’s ratings seem to have stabilized after falling sharply during his spat with the gilet jaunes. Even with impending Brexit, the UK now seems stable as the recent election allowed PM Johnson to consolidate his control. The risk may come from Germany, the pillar of stability which is now rocked by the rising support for AfD and the challenge Merkel successor Kramp-Karrenbaur faces in holding her coalition together. Spain seems to be seeking to form a government on a continual basis.

The most important event in the calendar will be the US Presidential Elections. The incumbent Trump heads into battle under the shadow of impeachment. His strategy for staying out of trouble and in the White House will determine influence the path of international and domestic politics, which will in turn impact markets in 2020. Given also, his psychological profile, President Trump will make this election all about him.


Trump versus the Fed.

Having won previous rounds, there is a good chance Trump will continue to harass the Fed in 2020. The economy is slowing and data could support a resumption of rate cuts. That said, given treasury issuance and a possible international buyers’ strike, the Fed may face a steepening term structure even if it keeps short rates low. Trump may pressure the Fed to restart QE. The Fed is in fact already back on QE, just not calling it that. On balance, short rates are capped and could be cut. In the longer term, inflation will likely support the term structure but in the short term, the curve might go nowhere.


Trump versus China.

This is a fundamental struggle and one that will not go away. Here, Trump finds bipartisan support, although his methods may confound the more strategic plans of business leaders and more strategic minded policy makers. Before you wage war, get your assets out of there. Expect a disengagement of commercial interests and supply chains. The result will be slower growth, higher inflation and in the interim, a rise in capex.

Taiwan holds elections this Jan 2020. The result will hold opportunities and risks for both China and the US. For the US, Taiwan is an opportunity to stir trouble in China’s backyard. The strategic goals are not clear, but it would be too good an opportunity to inconvenience and embarrass China if a pro independence party won the election, or if a pro-China party wins, to stir up protest and revolt. If this happens, it could be the start of a threat to the semiconductor industry and their clients.

The ongoing Hong Kong troubles are an excellent area for stoking trouble for China. If the US has not already done it, it would make sense for them to fund, instigate or otherwise encourage more anti-China sentiment and action in Hong Kong. This could lead to another year of underperformance for Hong Kong stocks.

There is a risk that Trump’s engagement with China becomes more reckless and takes on a military dimension. This could arise in the South China Sea. Such a conflict has the potential to ignite acute risk aversion globally.

However, given China’s rising strength and influence, Trump may be more careful to pick a fight he can back out of, or win easily.


Trump versus Europe.

The Trump view of Europe is a transactional and tactical one. President Trump has cited contributions to NATO and bilateral trade deficits with the EU as areas of concern, seeking to extract greater commitment from Europe on defence spending as well as efforts to close the trade gap. It appears that Trump has abandoned a 70-year-old thesis that a strong and united Europe is good for America. Complicated relationships between Russia, the Middle East, Europe and the US are likely to create more tensions.

In an election year, Europe is a good target. It is still a friend and it is relatively weak. For Trump it is important to engage in a fight he can win easily and or back out of, which could be difficult with China.


Trump versus the Middle East.

In a region where the line between friend and foe is sometimes blurred, the aggressive approach of President Trump is likely to stir up all sorts of uncertainties. Generations of strategic thinkers have grappled with the issue in the Middle East with limited durable success. The Trump approach is likely to alienate some friendly forces while the risk of making friends of foes seems remote. Depending on the European response to Trump’s Middle East policy, the risk of further tensions between Europe and the US are heightened.

Buy oil, gold and TIPs. Keep duration short but non negative.


Trump versus Democrats.

At this time the Democrat front runners are Biden, Sanders, Buttigieg and Klobuchar. So far, their campaigns have been too much about Trump. Can the moderates compete against the erratic charisma of Trump? Will the progressives alienate the people? A Warren Presidency would be good for America, but only if she could do two terms and the benefits would only accrue to her successors. Warren would be immediately painful for America, like bitter, necessary medicine. A Warren or Sanders Presidency would be negative for risk assets but an opportunity for healthy reform.

Bet long the moderates, and short progressives.


Trump versus Russia. Its complicated…

Information, Efficiency and Scale http://www.hedged.biz/information-efficiency-and-scale/ Mon, 30 Dec 2019 10:35:12 +0000 http://www.hedged.biz/?p=3080

Central planning is superior to free markets if the central planner has perfect information, and acts in good faith. Free markets are better when information is imperfect. When information is localized by a factor or location, decentralized groups can process information more effectively. These groups, can be regarded as centrally planned cells within a neighborhood in which information is close to perfect. They are then able to optimize locally and then interact with the rest of the system on the basis of the price mechanism. 

In reality we do not have a free market system. What we have are mostly centrally planned firms which interact with the economy on a market based system.

The rise of mega sized corporations is a manifestation of better information. For a given quantity and quality of information, there is an optimal firm size. Any firm which grows beyond this size is at risk of failure.

Entire economies may attain a certain level of information quantity and quality that makes central planning superior to decentralised market based organisation.


China and the US. Is the Belt and Road Initiative China’s Marshall Plan? http://www.hedged.biz/china-and-the-us-is-the-belt-and-road-initiative-chinas-marshall-plan/ Mon, 23 Dec 2019 07:00:45 +0000 http://www.hedged.biz/?p=3074 What does China want?

What did Germany want in the 1930s? A little respect, a little less bullying, and a bit more space. Germans felt aggrieved at the terms of Versailles, that reparations had gone too far and that they had been unfairly treated. What did Russia want in the 1950s? Security. Russia was driven by fear, that it was being contained, constrained, outmanoeuvred and threatened by a new Germany supported by the USA.

In the aftermath of WWII, America decided that the only way to avoid being drawn into another costly conflict, in money and lives, was a prosperous and united Europe. Europe was in dire straits with regionwide depression and deprivation which animated the communist threat. Before the fall of Berlin, the trust between Russia and the allies had already broken down. America believed that the only way to prevent another war, this time with erstwhile ally Russia, was to strengthen Europe and to do it economically and financially through the European Recovery Program, a.k.a. the Marshall Plan, a 12 billion dollar aid program to rebuild Western Europe, and militarily, through NATO.

The Marshall Plan was neither charity nor ambition but a logical if unusual alignment of self-interest and compassion. America was motivated by fear of another costly war, and the impact of a weak Europe on the US economy. It also recognized the dire conditions in Europe after the war. The Marshall Plan was established to rebuild Europe and unite it under democratic, capitalist principles. The Russians, however, saw this as American expansionism and actively resisted it wherever possible. American hopes that an economic solution would be enough were misplaced and, in the end, a military solution was established to support the Marshall Plan. The view that European economic union and NATO are part of American expansionism, or Russian containment, has survived the dissolution of the USSR and persist even today.

Since the fall of communism, America has not required a coherent and strategic foreign policy. Absent a competing ideology, capitalism has been allowed to evolve in suboptimal ways. America, facing a decline in global influence has turned towards isolationism and insularity. Today’s America has turned away from global trade, threatening and imposing sanctions on friend and foe alike. Its trade war with China has escalated and is unlikely to find a significant or durable resolution. Progress is likely to be more cosmetic than material.

What America wants is to be left alone to prosper. It feels aggrieved that the world has prospered at its cost. It provides security yet pays more in military investment than its allies. It invests more in technology, yet others steal its technology. Its trade balances are evidence of massive freeloading by the likes of China and other partners. It feels unfairly treated and wants reparation. An industrial policy of cost containment through outsourcing has led to significant intellectual property transfer to China to aid the development of manufacturing capacity in China to suit US consumption needs. A weak USD and an increasing current account deficit are evidence of this policy and its efficacy.

The global financial crisis of 2008 led to lower economic growth and a beggar-thy-neighbour growth policy. Since then the world has been in a trade war, albeit a cold one, fought both in currency, in re-shoring and only latterly in open warfare characterized by tariffs and embargoes. Once an expedient, outsourcing and the concomitant IP transfer it necessitated were no longer convenient. The extent of American reliance on China was exposed leading to popular backlash. The narratives supporting this policy redirection included IP theft, unfair trade practices, and more incredibly, national security. What America wants is to be less reliant on China, and to contain China, to compete with China for influence, prestige and power and to maintain its hegemony in the face of China’s rising economic and political power.

Generally, what America wants is power, prestige and privilege. What it doesn’t want is to pay the price associated with that hegemony. It definitely doesn’t want China to supplant it as leader in the world and it is dismayed by China’s willingness and ability to buy prestige, power and privilege.

Now China. What any country wants is a high and rising standard of living for its citizens, markets for its goods, resources for its economy, and security for its borders and interests. It also wants to be treated fairly and with respect and dignity in the international community. Often, in the pursuit of its interests, countries are happy to subordinate the interests of others to its own, leading to war and conquest. There are costs associated with every action.

With a large population, albeit an ageing one, China has sufficient domestic demand to sustain its economy. It needs to ensure that growth can provide gainful employment to the labour force and that labour costs do not rise out of control. The macro prudential policy levers that the central bank and government have decided to activate are adequate for this type of control, given the increase in quantity and quality of data that China is now collecting. On the manufacturing front, China needs to ensure that it has access to resources at reasonable rates. To this end it is investing heavily abroad to secure such access. The Belt and Road Initiative (BRI) involving financial institutions such as the Asian Infrastructure Investment Bank and the Silk Road Fund is a broad program of investment in infrastructure and development stretching from Europe to East Asia.

Just as the Marshall Plan was interpreted as partially a martial plan, so the BRI has come to be viewed by some, not least America, as being China’s weapon of mass influence, a device for extending China’s economic power and ambition abroad.

Note that the Marshall Plan would not have stood on its own. The reaction of the Russians almost guaranteed that a military plan was necessary, hence NATO. The BRI is a laudable plan which will bring investment, growth and development to its members. Given current geopolitical sentiment, the question is, can the BRI stand alone as an economic program without a concomitant martial plan? This will depend on America’s response, generally, to China’s rise. Already the BRI has come under criticism for its environment, social and governance (ESG) credentials. Critics warn that the BRI is an instrument of Chinese oppression, and that the large-scale infrastructural investments will have adverse impact on the environment and society along its path. Yet China has shown leadership in many respects. It has made significant improvements in the environment. Air quality around the country has improved in the last five years to the extent that Beijing will drop out of the top 200 most polluted cities by the end of 2019. China and the City of London Corporation’s Green Finance Initiative have worked together to create the Green Investment Principles (GIP) for the Belt and Road.

Resistance to China’s rise will likely result in mutual escalation. Whereas the Chinese are unlikely to have territorial ambitions outside of the South China Sea, they may be forced into more robust military expansion if they feel their interests are generally threatened. It is unlikely the Chinese feel threatened by her Central Asian neighbours to the west. These Central Asian states are unlikely to find much strategic support from America; proximity to Russia complicates any American plan of support. A greater risk is China’s treatment of Muslim minorities in Xinjiang which could trigger sympathy from her Muslim dominated neighbours. America’s efforts could at best extend to agitating anti-Chinese sentiment by throwing a spotlight on Beijing’s treatment of its own Muslim population. This will likely be of limited effect given America’s own relationship with Islam. Russia and China have a marriage of convenience which is unlikely to be upset by current geopolitical conditions. If anything, America’s rivalrous engagement is likely to strengthen Sino-Russian ties. This leaves the South China Sea where China is staking a robust claim. Taiwan, Japan, Vietnam and Korea are potential locations for a US proxy war, but Hong Kong and Macau make better targets because they are part of Chinese territory. The cold war between the US and China is likely to waged in more than geographical dimensions. Weapons in cyberspace have infinite range, depth and scale. Rivalry for dominance in global financial infrastructure will have more impact in an increasingly electronic world. In payment systems, the all-important underlying plumbing of the financial system, China, Russia and India are cooperating on an alternative to SWIFT, linking Russia’s SPFS with China’s CIPS. The Asian Infrastructure Investment Bank (AIIB) is a Chinese sponsored development bank rivalling World Bank and the IMF and has to date attracted 75 members including India, Russia, Germany, Korea and France. The USA is not a member.

The rise of China presents challenges and opportunities. America, as the incumbent hegemon, can resist China by trying to contain it, or it can engage it constructively. President Trump has so far adopted a strategy of confrontation. In a zero-sum game, this may be a suitable strategy. However, the odds of a poor outcome are high. A world split between a China bloc and an America bloc may even flourish, but the missed opportunity of cooperation will be a pity. The risk of confrontation leading to victory for one and defeat for the other is high, with serious costs to both sides. Equally risky is if the cost of hostility is high enough that the global aggregate standard of living is impaired, a loss to all. Far better for America, in her current state of strength, prosperity and wisdom, to engage constructively with China, a country equally strong, prosperous and wise, for mutual understanding and benefit. Wise, empathic and strategic leaders are necessary for engagement.


Efficient Oppressors http://www.hedged.biz/efficient-oppressors/ Fri, 06 Dec 2019 01:17:04 +0000 http://www.hedged.biz/?p=3069 Human history is replete with class oppression. In an unequal society the natural tendency is for those of superior wealth or power to maintain supremacy. This often requires some form of oppression.

Persuasion is greater than force. Efficient oppression involves convincing the oppressed that they are not oppressed or that their wealth and welfare are improving. Less efficient oppression is more overt and involves the use of force or law or artificial legitimacy, but is all ultimately backed by force.

The efficient oppressor addresses the welfare of the oppressed, aiming and working to continually improve welfare and standards of living, at least in absolute terms. The aim of oppression is to maintain relative supremacy and therefore it is necessary to ensure that the rates of growth experienced by the oppressed pale in comparison to the rates of growth of the oppressors. However, it is important to at least maintain a positive growth rate for the oppressed. 

When average growth rates are insufficiently high and rates of growth for the oppressed fall to negative levels, the risk of revolt rises. Moderately or temporary re-distributive policies can maintain the status quo which is preferable to regime change.

In the face of slow growth and high inequality, reluctance to adopt some re-distributive relief policies can lead to revolt and regression to oppression by force. This is inefficient.

The last decade is characterized precisely by slow growth and high inequality, conditions conducive to spontaneous revolt. Incidences of passive aggressive revolt and outright revolt have been rising. The ostensible catalysts appear unrelated, petrol taxes in France, extradition laws in Hong Kong, separatists in Catalunya, isolationism in the US and the rise of populists in Europe. The common thread is disenchantment with the status quo and the desire for any kind of change.

The enemy without has often been a convenient distraction for the enemy within. Could it be that the absence of an enemy without, a nemesis, has created a vacuum inducing an enemy within? Could the demise of communism have allowed capitalism to outgrow itself and transform the efficient oppressor into an inefficient one? Might capitalism balanced with communism have had to maintain some limits or moderation and avoided the extreme conditions that have emerged? Given current conditions, what can be done to prevent escalation?

Fools are to Society as Carbon Control Rods are to Nuclear Reactors. http://www.hedged.biz/fools-are-to-society-as-carbon-control-rods-are-to-nuclear-reactors/ Sun, 10 Nov 2019 07:28:37 +0000 http://www.hedged.biz/?p=3064 Something to slow down the informational transmission of a society to increase informational efficiency. Since each node has an optimal rate of processing information, a network that transmits information too quickly is not efficient. Fools serve a useful purpose and should be valued.

US Drug Approval Process – Extracted from various sources. For Personal Reference Only. http://www.hedged.biz/us-drug-approval-process-extracted-from-various-sources-for-personal-reference-only/ Mon, 04 Nov 2019 23:21:55 +0000 http://www.hedged.biz/?p=3060 The entire process of moving a drug from design to clinical trials takes 10 to 12 years on average.

Preclinical studies

Deciding whether a drug is ready for clinical trials (the so-called move from bench to bedside) involves extensive preclinical studies that yield preliminary efficacy, toxicity, pharmacokinetic and safety information. Wide doses of the drug are tested using in vitro (test tube or cell culture) and in vivo (animal) experiments, and it is also possible to perform in silico profiling using computer models of the drug–target interactions. As in clinical trials, there are certain types of trials that have to be done, such as toxicology studies in most cases, and other trials that are specific to the particular study compound or question.

Phase 0 clinical trial

Phase 0 involves exploratory, first-in-human (FIH) trials that are run according to FDA guidelines. Also called human microdose studies, they have single sub-therapeutic doses given to 10 to 15 subjects and yield pharmacokinetic data or help with imaging specific targets without introducing pharmacological effects. Pharmaceutical companies perform Phase 0 studies to decide which of their drug candidates has the best pharmacokinetic parameters in humans.

Phase I

Phase I trials are the first tests of a drug with a small number of healthy human subjects. Patients are generally only used if the mechanism of action of a drug indicates that it will not be tolerated in healthy people. They are primarily designed to assess the safety and tolerability of a drug, but the pharmacokinetics and, if possible, the pharmacodynamics are also measured. The typical Phase I trial has a single ascending dose (SAD) design, meaning that subjects are dosed in small groups called cohorts. Each member of a cohort might receive a single dose of the study drug or a placebo. A very low dose is used for the first cohort. The dose is then escalated in the next cohort if safety and tolerability allow. Dose escalation is stopped when maximum tolerability and/or maximum exposure is reached. SAD studies are usually followed by multiple ascending dose (MAD) studies, which have a very similar design, with cohorts and escalating doses. The only difference is that the subjects receive multiple doses of the study drug or placebo. While safety and tolerability are still important endpoints, the multiple dose setting often allows first investigations of the pharmacodynamic effects in addition to the pharmacokinetics. Depending on the risk potential and the safety and tolerability revealed by the SAD study, many MAD studies may already involve patients rather than healthy individuals. That said, it is important to enrol a relatively healthy patient population with as few complications and concomitant diseases as possible.

Phase II

Phase II trials are performed on larger groups of patients and are designed to assess the efficacy of the drug and to continue the Phase I safety assessments. Most importantly, Phase II clinical studies help to establish therapeutic doses for the large-scale Phase III studies.
Phase II studies are sometimes divided into Phases IIA and IIB. Phase IIA is designed to assess dosing requirements whereas Phase IIB focuses on drug efficacy. The exact design of Phase II studies depends heavily on the compound’s mechanism of action. A proof-of-concept study should be included in Phase II if it has not already been done during the MAD-study in Phase I. In addition, a treatment study with several different doses of the compound in comparison with a placebo and/or an active comparator over a treatment duration of 12 to 16 weeks is usually an essential part of the Phase II program.

Phase III

Phase III trials are randomized controlled multicentre trials and provide most of the long-term safety data. Phase III trials investigate the efficacy and safety of a new drug over 6 to 12 months or longer in a large patient population (several hundred patients or more) under conditions that reflect daily clinical life much more closely than the Phase I or II trials and allow evaluation of the overall benefit-risk relationship of the drug. These trials are usually conducted on an outpatient basis with no in-house days and include an active comparator, at least in the case of metabolic diseases, because exposing patients to several months of placebo treatment would not generally be ethical. Because of their size and comparatively long duration, Phase III trials are the most expensive, time-consuming and difficult trials to design and run, especially in therapies for chronic medical conditions. Therefore, drugs that do not show promising results in Phase II are often not pursued in phase III. In fact, only 25-30 % of drugs in Phase II proceed to Phase III. Phase IIIA studies are used for the approval of the drug from the appropriate regulatory agencies (known as Pivotal study). The results of these studies are included in the submission package to regulatory authorities. Between submission and approval, Phase IIIB studies are often performed to obtain additional safety data or to support publication, marketing claims (label extension) or to prepare launch for the drug.
Drug-drug intervention (DDI) studies may be part of another large Phase 2 or Phase 3 study. However, the DDI program depends on DDI potential of the drug and should be discussed with appropriate authorities.

Phase IV

Phase IV trials are also known as post-marketing surveillance trials involving safety surveillance (pharmacovigilance) and ongoing technical support after approval. However, not all Phase IV studies are post-marketing surveillance studies. There are multiple observational designs and evaluation schemes that can be used in Phase IV studies to assess the effectiveness, cost-effectiveness, and safety of an intervention in real-world settings. Phase IV studies may be required by regulatory authorities (e.g. change in labelling, risk management/minimization action plan) or may be undertaken by the sponsoring company for competitive purposes or other reasons. This could entail the drug being tested in a certain new population (e.g. pregnant women). The safety surveillance is designed to detect any rare or long-term adverse effects over a much larger patient population and longer time period.

Thoughts after 2 weeks Off The Grid. November 2019. http://www.hedged.biz/thoughts-after-2-weeks-off-the-grid-november-2019/ Sun, 03 Nov 2019 23:31:40 +0000 http://www.hedged.biz/?p=3056 Equity markets have made new highs while bond markets have stalled. Economic data are mixed following months of signs of slowing. India’s economy has slowed drastically, China’s slowdown seems to have moderated, Europe still looks weak albeit the data seems to have stopped deteriorating and the US economy seems to have firmed from prior weakness. The overall picture still looks weak and the central banks have had to maintain or increase accommodation. While I was out, the Fed cut interest rates another 25 basis points and the probability that rates will not be cut further this year has risen from 60% to 80%.

Why are equities rising? The Fed continues to provide liquidity, cutting rates, and increasing repo operations as well as bond purchases, in a move it has declined to call QE, yet is practically identical to QE in form if not in detail. Share buybacks continue apace as cheap credit allows firms to raise debt to fund buybacks, increasing corporate leverage further. Bad for bond holders but good for shareholders. Lower interest rates also support higher valuations.

Why are bonds stagnating? The bond market is broader than the equity market. There are many corporate issuers without listed equity, there are mortgages, and other ABS. The weak economy is manifesting in this broad measure, while the equity market representation is shrinking.

The loan market has been an area of focus. Weaker covenants and documentation, collateral leakage, and falling short term interest rates have impacted this market. The fundamental reality is that if loans are in trouble, equities are in much worse trouble, since they are first loss. The practical reality is that technicals, that is demand from investors and ETFs, central bank liquidity, share buybacks, et al, support equity markets while falling interest rates make loans less attractive. Interest rates are an important driver of loan performance these past weeks as a comparison with HY bonds reveals. Spreads have not widened much for HY bonds, yet loan spreads have widened (suffered) more.

Where to from here? The Fed has signaled that it will be data dependent from here and has removed any language signaling a leaning towards raising or cutting rates. The momentum from the recent rate cut is still driving asset prices and the bond market but the transition from easy to neutral at the Fed is likely to take hold in the coming weeks.

Equity markets should continue to richen into the year end as central banks continue to support markets for risk assets. They will do so until they cannot and it could be some time before they run out of ammo. When they do, they will have raised valuations to even loftier levels and the correction will be steep. Until then, for the intrepid trader, momentum will carry the market.

Duration is hard to call. The Fed needed to get the inversion out of the front to 5 year end of the curve and it has nearly achieved that. Recessionary pressures from the yield curve are gone. But the curve is sufficiently flat that there is no room for flattening without inversion and recession, and there is little impetus for steepening while the Fed has resumed bond buying.\

As for EUR duration, Draghi’s swansong rate cut and QE resumption probably marked the end of the EUR duration trade for some time. Both Draghi’s and Lagarde’s concerted call for more fiscal support are a signal that either the ECB will not accelerate accommodation, or it cannot. And if fiscal support really comes, it would certainly push rates higher.