The impossible targets...

It is no wonder that the euro-zone peripheral countries are having such a difficult time getting their acts together, they are basically shooting themselves on the foot.
They don't have access to monetary policy tools that could help them inflate their way out of the debt conundrum, they don't have a federated political system that would automatically inject much needed cash into their economies, they don't have an independent central bank to rely on as "lender of last resort" that would put a cap on borrowing costs. To make matters worse, they cannot even resort to the tools that they do have at their disposal such as fiscal stimulus plans. These are severely constrained due mainly to outside imposed hard core austerity measures. They are in fact so severe that they risk triggering uprisings, threatening to plunge the whole continent into a deep recession with significant long term consequences.
To provide you an idea of what I am talking about, I recently came across some of the austerity measures that will be imposed on Greek citizens. I found them worrying to say the least.
According to the plan:

• Wages would be cut on average by 15%
• Pensions would be cut on average by 20%
• VAT would be increased by 4%
• A "solidarity" tax of between 2 and 5% would be levied
• The income tax threshold would drop from 12,000 EUR to 5,000 EUR
• Property tax would jump from 3 EUR to 5 EUR per square meter

There were additional measures which I don't recall but, even without them, this would be more than sufficient to trigger widespread rioting were it to be enforced.

In the end, when push comes to shove, it is likely that European authorities will take extraordinary measures to avert a total meltdown. What they are not really paying attention to, however, is that the more they wait, the more costly it will be.

Lender of last resort...

There is a reason why the Euro-zone seems unable to get itself out of the quagmire. It is dealing with the growing problem in a passive-reactive manner. There is a discernable pattern here:

1. the crisis shows signs of brewing
2. the core members of the zone get together to discuss the problem
3. at the meeting they announce that they have reached an agreement to boost the limit of the "bailout" fund
4. the markets react favorably for a day or two until the cycle is repeated again.

With a moving target in a deteriorating environment, it is difficult to see how readjusting the size of the bailout could ever work. Most of what is going on is psychological to begin with. The markets are very much aware that the tools the euro-zone members have at their disposal are insufficient to tackle the problem.

Psychology works in funny ways, we tend to overshoot all the time. In a stable environment, greed takes the upper hand whilst fear tends to reign when markets are in turmoil. In both cases there are exaggerations and the degree of the exaggeration depends very much on the circumstances of the time. It seems clear to me at least that the current approach has failed but what is more worrying is that the window of opportunity for the zone to extricate itself out of the quagmire is rapidly narrowing. Soon the only option on the table to avoid a meltdown will be to take out the heavy weapons.

The ECB, unlike many other central banks, does not have a mandate as lender of last resort and it may unwilling to use this option to avoid encouraging the risk of "moral hazard" down the line but it may end up being the only effective way to quash the psychological effect. The reason why this would work is because the human mind is much less effective in dealing with the concept of infinity: If you announce that you are taking a stance in the markets and you have close to unlimited resources to defend your stance, it will be far more credible than if you announce the ceiling of your resources from the very beginning. The Swiss National Bank's intervention in defense of the Swiss franc is a perfect example of this!

From idiosyncratic to systemic...

It is crucial to distinguish idiosyncratic risk from systemic risk. The former is related to risk that originates from or is inherent to a specific entity such as a firm, whilst the latter is risk that is exogenous to the firm. The reason why making a clear distinction between the two risks is so important is because their expected antidotes are so different. Idiosyncratic risk is normally handled by the management team of the firm and only involves outside intervention in situations of "too big to fail" where repercussions in terms of systemic risk become all too real. Systemic risk, on the other hand, is usually beyond the scope of management, it is more within the domain of policymakers.
Applying the distinction to the current Euro-zone crisis, we began with a form of risk when the peripheral members started to ring the alarm bells in the first half of 2010 that was borderline idiosyncratic but still relatively contained. This explains why the initial response to this "mini" crisis was relatively muted: the creation of a fund that would aim at bailing out heavily indebted nations that were having difficulty with their payments. The risk started to take on a more systemic form when the number of troubled countries began to increase and as it began to involve countries that had economies that were far bigger than the first wave. The EU response to this was mainly to increase the size of the "bailout" fund but not much else when what they really should have been doing was to approach the problem from a completely different angle. But herein lies the problem: the Euro-zone in its current incarnation was never designed to handle such challenges.

It seems to me that the original architects of the Euro-zone project are now paying a heavy price for having suppressed the major risks or negative points that were outlined in the independent study on the creation of a Euro-zone that had been commissioned by the core governments of the project. As we can see from the CDS graph of Italy, it is just another example of too little, too late.

The commodities - stagflation link...

There is growing consensus that the broad based commodity price rise is here to stay at least for a while. This is mainly because of growing demand coming from emerging markets. The rise in prices is having a material wealth distribution impact on the economies of emerging and developed countries. Commodity rich emerging market economies are benefitting tremendously from the price hikes which is also fueling their appetite, whilst for those of most if not all developed markets, the impact is similar to a tax effect as the commodity price increase is almost entirely passed on to the consumer.
Another less obvious effect of this long term rise in prices is the potential it has of triggering a much dreaded stragflationary environment. This is mainly because developed market economies have already entered a period of weak growth/recession at a time where "headline" inflation remains clearly above the target of central banks. In theory, the longer inflationary pressures persist, the greater the risk that they have an impact on the future expectations of inflation, which in some instances, can eventually lead to an inflationary spiral. Once a spiral sets in, it becomes very difficult to control. Although we may be far away from such a scenario, the effect of a long term rise in commodity prices should not be underestimated.

In double-dip territory?

There is ongoing debate as to whether the economies of both the U.S. and Europe have re-entered a recession, but the real question should be whether it ever got out of one! We unfortunately will not know for sure for at least a couple of years to come because of the tremendous adjustments lag between the initial data collecting and the final official figure. There are, however, strong clues that the recession that began soon after the sub-prime crisis erupted in 2007 is still around. The only reason why markets were rallying in 2009 and 2010 were because of the massive concerted government efforts to keep their respective economies afloat. A bull in a bear market if you will but, as the ammunition is being rapidly depleted, the effects of this are reverberated across the financial spectrum. Volatility is rising sharply, commodity prices are dropping and treasury yields, the ultimate safe haven investment (despite the downgrade), is at record lows. So from a technical standpoint, there is growing evidence to suggest that what we are experiencing is not a double-dip or "W" type of recession but more like a very extended "U" type. The rally in 2009 and 10 were just smokescreens and the markets are just discovering that now.

What the sectors are telling us...

A cursory look at stock market sector performances can provide a good sense of the current market sentiment. The graph above measures the year to date performances of the major sectors of the world economy and is not distorted by currency fluctuations.

As a first observation, it is interesting to note the wide performance divergences between the various sectors. There is, for example, more than a 20% difference between the best (health care) and worst (financials) performing sectors. This tends to occur in periods of uncertainty.

The next interesting observation would be the divergence between cyclical and defensive sectors. The better performers (health care, consumer staples) tend to be the defensive sectors which would indicated very bearish sentiment in the markets.

It should come as no surprise that financials are suffering the most considering the uncertainty facing European banks exposed to the sovereign debt of troubled euro zone peripheral countries. What is more curious, however, is the relatively strong positioning of sectors like information technology or energy. For the tech sector, it reflects the boom in technology stocks. Some pundits are drawing parallels with the nineties, arguing that the market may actually be in a bubble.

For energy, however, it is a bit more baffling, markets are clearly pricing a high probability for recession (the negative ranking of materials and industrials clearly show this) but oil prices do not seem to reflect this! Pressure from proponents of peak oil and the continued strength of emerging market economies may go some way to explain this, but who knows? Sentiment can sometimes be finicky.

Rebalancing vs. Buy & Hold

In these tumultuous times, one wonders what sort of investment strategy to adopt. The modern portfolio theory rule of thumb would be to "stick to one's guns" by remaining thoroughly diversified and keeping a disciplined approach to rebalancing the portfolio when asset class weights deviate "too far away" from a defined optimal value.

Rebalancing can actually be tricky in times of high volatility not only because it may require quick action to counter large sways in the market but also because of the additional transaction costs that frequent "adjustment" trading could entail.

There is, however, an optimal level of rebalancing that can be implemented, depending on market volatility conditions. Studies show, for example, that rebalancing (adjusted for transaction costs) outperforms buy and hold strategies in periods of high volatility where markets experience sharp reversals. The opposite occurs in bull or bear market conditions, where the markets follow a clear trend. In this environment, buy and hold strategies tend to outperform rebalancing.

An optimal portfolio allocation strategy would therefore be one that is a function of the volatility levels of the markets. When volatility levels spike, as they have over the last couple of weeks, it would trigger a rebalancing signal for the portfolio. This could be in the form of a tightening of the rebalancing band limits of the respective asset classes. In contrast, when volatility levels are subdued, those same band limits should widen, reducing the probability of rebalancing but not eliminating them altogether, which would be risky, especially in transition periods from low volatility to high volatility.

A double dip?

According to the latest remarks from the Fed, the stimulative policy that began soon after the sub-prime crisis began in 2007 is likely to remain for some time to come. If we read between the lines, this would basically mean that the Fed is becoming increasingly pessimistic on the growth prospects of the economy and rightly so, considering the growing deficits that the U.S. and Europe are facing. In fact, as we have been saying since the end of 2008, this crisis is likely to remain with us for at least another couple of years. There is no quick way out of it, unless a very aggressive form of "financial repression" combined with hard core austerity is forcibly implemented, but if the U.K. riots are any sign of how ugly things can get, there doesnt seem to be much that can be done in the short run.
Market sentiment in this environment has become risk averse to such a degree that even treasuries, that recently lost their triple-A rating, have actually been rallying. This would be the second time in four years that "pundits" have gotten the direction of interest rates seriously wrong.
In summary we should be embracing ourselves for a global "double dip" as the U.S. increasingly embarks into what looks like an austerity program in disguise!

A revised Big Mac Index...

One fascinating index that has gained in popularity through the years is the Big Mac Index that is published by the Economist newspaper. It is interesting because it provides a very different approach to measuring the over or under valuation of exchange rates, based on the Purchasing Power Parity (PPP) theory which states that in the long run, the exchange rates between countries should adjust themselves to bring about parity in prices.
As the "Big Mac" is a commodity that is readily available in most parts of the world and because its price is very easy to obtain prices, it is very suitable for making cross comparisons.
One large drawback with the measure, however, has been that it does not adjust for differences in productivity which means that for emerging markets with cheaper labor, it will tend to introduce an underweighting bias to the figures. This bias is confirmed by a simple regression of the price of a Big Mac to GDP per capita. There is a clear positive correlation between the two.
In order to account for this, the Economist recalculated its figures by adjusting for differences in productivity. The end results are very different from the original calculations. China, for example, which was thought to have a currency that was undervalued to the dollar, according to the original figures, now finds itself slightly overvalued with the new calculations! It is also interesting to note the substantial overvaluation of the Brazilian Real and the continued overvaluation of both the Swiss Franc and the Euro.
In these times of growing uncertainty and rumors that official CPI figures may be rigged, the Big Mac index provides a more reliable measure of the PPP adjusted currency exchanges.

Playing with fire...

...describes well the dangerous games of partisan politics in the U.S.

Postponing a deal on the debt ceiling which is scheduled to expire in the beginning of August to the last minute is akin to playing with fire not because they will not strike a deal before the set deadline (they most likely will) but because the markets are right now at arms length of entering panic mode as tensions continue to build up. Our June newsletter outlines the so called "clear and present dangers" that are on the sidelines, waiting for that as yet unidentified catalyst that could trigger another dreaded crisis on the markets.

It should be noted that the U.S. debt debacle is taking place on the backdrop of a clearly worsening debt crisis in Europe, which is now showing signs of spreading to the bigger peripheral country economies of Italy and Spain. The reason why investors have become so jittery is because both Spain and Italy happen to be just too big to rescue.

Although stock market volatility rates remain subdued there is a clear "flight to quality" momentum that is building up as gold, the Swiss Franc and government bonds of countries perceived to be less affected by the debt debacle break records.

So what is one to do when the threat levels are just one notch before panic mode? Well, for one you should stick to the old adage of ensuring a sufficient degree of diversification. But you also run the risk of losing more through diversification if things suddenly improve. That is because the probability that things are going to get worse currently have a greater weight in the market pricing of assets than the probability that things will improve, so if things do improve and you are diversified into investments that are meant to protect the portfolio in bad times, those are the ones that will suffer the most. It is always easier to construct a portfolio in stable rather than unstable market conditions because the risk premium component of the value of an asset will be a smaller percentage of the total. So there is a timing element to diversification but that should matter less over the longer term.

On the horns of a dilemma...

At each cry of help, the powers that be are injecting a potent but short lived dose of life sustaining matter into the system, but this is unfortunately just another case of too little too late. The political setup of this European "experiment" is their "Achilles heel" that impedes them from doing what is needed to avoid a train wreck. With the record erosion of the Euro against the Swiss franc and European stock markets now firmly in negative territory there is little that can be done to stop contagion from spreading. Default is still in the cards but the more time passes the less likely that it can be conducted in an orderly manner.
Mind you, the U.S. is in its own mess too, still recovering from a colossal debt burden and no way out of it, other than to print more money to buy more time. Still, the fact that the U.S. enjoys both economic and political integration puts it at a major advantage to Europe, and right about now, the markets seem to agree with this.

Distrust with a slump...

The steady rise in the value of gold to a large extent reflects the eroding trust in the monetary authorities of the world, most notably those of the U.S. and Europe. Commodity prices have been following the same pattern until very recently. The price of oil, for example, has been surging on the back of speculation related to a potential constraint on the supply side, reflecting the ongoing conflicts in the Middle East. This speculation has also appeared on the demand side, reflecting the anticipation of more demand from emerging markets and, at a more distant future, greater demand from developed markets as their respective economies recover.

More recently, the price of oil has seen a sharp drop in value reflecting the economic turmoil that is brewing across Europe and the U.S. In the speculators mind, two things have changed on the demand side of the equation. Emerging markets, battling a surge in inflation are applying the monetary brakes more aggressively whilst the economic conundrum in Europe and the U.S. that seems to be showing signs of worsening is likely to postpone any sustainable recovery to a more distant future.

In summary, what these two indicators are telling us at this point in time is that the distrust in monetary authorities continues but that the global recovery is in peril.

Gold, the pseudo commodity...

Asset managers and investors typically classify gold as a commodity. After all it shares characteristics of commodities such as the fact that it is tangible, can be traded and is used in the production of goods.

Gold also has certain characteristics that is highly specific to it that really put it in a class of its own. The price of gold, for example, is not impacted by changes in demand and supply, unlike commodities. This is because annual demand and supply are only a fraction of the outstanding gold in circulation. This characteristic makes it curiously similar to paper money or stocks, with the big difference that gold does not produce any revenue or cash flow streams and therefore does not have an intrinsic value. The price of commodities, on the other hand, are very much impacted by current and expected demand and supply dynamics. Almost all of the supply of a commodity will be consumed in one form or another, only a small portion is stored indefinitely. In the case of food, this is pretty obvious whilst in the case of hard metals, it is converted to become part of something else in a production chain somewhere around the globe.

So what is it that influences the value of gold? There are several factors that have an impact on the price of gold. Amongst the most important is sentiment, more specifically how much confidence an investor has on monetary authorities. If confidence is being eroded, the price of gold is likely to go up as it serves as a refuge investment in the event of uncertainty in the financial system. This is also the reason why the price of gold rises when there is "money inflation", which is exactly what is happening in the U.S. today.

Gold is not only a surrogate for money, it is a powerful diversifier that softens the blow when monetary authorities get it so very wrong. This makes it a rather unique investment which is why any sound portfolio should contain some.

Paving the way for QE3?

Things are not looking good on the housing front in the U.S. The latest figures show that prices slumped yet again in March, dragging the closely watched Case-Shiller index to its lowest point since the start of the downturn (see graph above).
Sure, there is still some distance to go before the housing bubble is completely burst, but any further drop in prices will be a drag on the economy as it widens the already dire "negative" equity situation for a large number of households.
Quantitative easing is a critical tool in maintaining a floor on housing prices because of its influence on the 10 year maturity yield. A large number of market participants including mortgages, pension funds and the good old dividend discount model (DDM) use it as a benchmark to set their rates. In other words, the latest housing price figures are likely to put additional pressure on the Fed to do something post QE2 which will end very soon.

Embracing for a restructuring?

Somewhere along the line, Greece and probably Ireland and Portugal are going to have to restructure their debt. It is almost inevitable because all other options that would effectively help avoid restructuring don't seem to work. Those "options" would be:

• A sharp rise in taxes, which will probably only lead to a further paralysis of the economy, especially given the chronic level of tax evasion in a number of the peripheral countries involved.
• A devaluation of the currency which unfortunately is no longer an option for the countries of the Euro-zone given that they no longer have this tool at their disposal.
• An internal form of devaluation which is effectively a sharp and sustained cut in wages across the board. As with a hike in taxes, such a move would be so deeply unpopular that it would provoke more riots that would plunge the respective economies into further turmoil.
• A sharp cut in fiscal expenditures or the infamous austerity measures. This is yet another "dead in the water" option as it is unlikely to resolve the debt problem on its own and would also contribute to weakening the other options such as tax income further.

Given the above, it becomes clearer that the only viable option would be some form of restructuring. But then again, there are different shades of restructuring to choose from and the outcome can be materially different depending on which one is selected. At one end of the spectrum is the more painful approach of applying a "haircut" which is effectively paying back a fraction of the original value of the debt. This would force the various banks to take losses by writing off a large amount of debt in their books. At the other end is a softer technique known as "reprofiling" which is effectively to extend the maturity of the bonds and by doing so, buy precious time for the troubled governments. This option, which seems to be the one favored by the core European countries, begs the question as to how exactly buying additional time would resolve the problem. Considering that the various alternative options are likely to be ineffective, the only effect of buying time will be to postpone the inevitable to a future date.

This brief analysis clearly suggests that restructuring is the only viable option at the table. The question to be asked is what form of restructuring will be applied and when will it take place.

How to tackle spiraling debt...

There are a couple of ways that a government can tackle a mounting debt problem.
If the debt itself is reasonable, and the economic conditions are stable, the method with the least repercussions is through growth. If the economy is expanding rapidly enough, the debt of the country should be very manageable. Austerity measures or cutting spending is another solution although, once again, it assumes that the debt is reasonable to start with.
But what happens when the debt is out of proportion relative to the gross domestic product of a country? The quick and dirty way of getting out of it is to simply default. The main problem with this solution is that the consequences are bound to be extremely damaging. Think Lehman's and multiply the effect a thousand times! A softer version of this is to restructure the debt by means of applying a haircut or just simply extending the maturity. That is, for example, what the markets are anticipating for Greece.
Another method is for a country to try to inflate itself out of the debt spiral. The idea is that by stimulating the economy, prices will begin to rise high enough to depreciate the value of the outstanding debt. The real value of that debt has actually changed since the lender is getting paid less in real terms than what was lent in the first place. The major drawback with this approach is that the impact of inflation goes beyond debt and is therefore bound to be politically unpopular.
A related method is the devaluation of the currency, a tool that is unfortunately unavailable to the peripheral nations in Europe who need it most. By devaluing the currency, foreign lenders get paid less in real terms, so technically it becomes cheaper for the borrow to service the debt. This is a very attractive proposition for the U.S. where the large bulk of debt is in the hands of foreign owners. It would explain why the Fed is in no hurry to tighten rates like the rest of the world is doing. Depreciation has its drawbacks too. It could trigger inflation by boosting demand for exports and spiking the price of imports.
Although the examples show that there are several ways a country can tackle its debt problems, it doesn't mean that they have access to all these methods. Eurozone countries are a case in point: By joining the Euro they gave up the very monetary tools that would have provided them with greater flexibility. Without these tools, they can't inflate themselves out of the debt and nor can they depreciate the currency. This leaves them with two possible solutions: hard core austerity (which doesn't seem to be working) and restructuring. It looks increasingly likely that some form of restructuring will eventually have to take place.

A surge in the price of Gold...

Just as the dollar has been steadily losing value, the price of gold has surged passed $1500 to the ounce. This is once again a reflection of the dire conditions that monetary authorities around the globe find themselves in.

The U.S. is facing challenges from various fronts, starting out with a growing interest rate decoupling with the rest of the world. As central banks across the globe begin tightening rates, the federal reserve is sticking to its stimulative plans. The situation is further exacerbated by the fact that the second $600 billion quantitive easing program will end by next June and there are no plans to introduce an additional round which means that we can expect a sharper slope between the short end and the rest of the yield curve.

Last but not least, there are growing signs that China's appetite for dollars may be dwindling. This can be seen with the steady appreciation of the Yuan against the dollar, which means that Chinese authorities may be shifting its policy on exchange rates. Other countries in the region are likely to follow suit.

The U.S. monetary authorities are not the only one's experiencing trouble. The Euro is also under pressure despite the ECB's 25 basis point rise in its target rate. Serious trouble seems to be brewing in the peripheral countries, most notably Greece, where there is growing anticipation that some sort of restructuring is in the works. Most pundits would agree that this is the only viable option considering the country is stuck in a perpetual cycle of weak growth. Restructuring could include "reprofiling" its debt which is basically extending its maturity whilst keeping the rest of the conditions intact. It could also include a haircut which would hurt the banks that hold Greek paper.

Finally, we have Japan that is reeling from the disaster that ravaged a large chunk of the country. Reconstruction will take place, but this will occur over the longer term and its impact on growth wont be felt for a while to come. The disaster will also give Japanese industries an excuse to relocate their remaining factories to mainland China. Add to this a weak government and it becomes difficult to see how the country is going to pull itself out of the mess.

No wonder then that gold is surging.

A bottomless pit?

The dollar has been on a long term downward spiral ever since reaching a peak in 2001. The most recent plunge has been caused by a growing disconnect between the U.S. and the rest of the world. This disconnect is a result of the following factors:

• A surge in commodity prices and signs of overheating of the economy in emerging markets is prompting a growing chorus of central banks to tighten rates. The ECB was the latest to raise rates last week in response to a commodities fueled steady rise in headline inflation.


• The second round of quantitative easing still has a couple of months to go and there is talk of a possible third round if things dont improve.


• A U.S. government shutdown may have been narrowly averted but the upcoming confrontation on raising the debt ceiling would have far greater consequences in the event that an agreement is not reached by around May 16 in which case the government would no longer be able to honor its debt obligations.

In summary, the dollar is weakening because other currencies, especially those of "commodity rich" countries provide an attractive hedge against inflation and because the unique "dual mandate" status of the Fed effectively forces it, in the context of the current environment, to be less proactive on the inflation front. Although the Fed will eventually have to tighten rates, there will be a lag in timing relative to the 18 other countries (mainly emerging) that have already embarked on hikes.

correlations from different angles

Correlation measures are meant to provide an idea of the relationship between two variables. It answers the question as to how one variable relates to another. Do they tend to move in the same direction? Do they move in the opposite direction or are they actually unrelated to one another? Correlation figures can also be misleading because they tend to change over time. A negative correlation between say two variables could suddenly turn highly positive or vice versa. So correlations can be useful in devising a portfolio but one needs to be aware of this major caveat.

There are also other, more subtle factors that should be considered when studying correlations. Take "Cat Bonds" as an example, which are insurance linked bonds that basically pay out in the event of a specific natural disaster such as the earthquake/tsunami that recently ravaged Japan. Looking at the correlation between this particular sub asset class and the stock and general bond markets, even over long periods, one gets the impression that they are not related (see graph). In fact, their very nature should ensure that for most events there should be no positive correlation, but like for any investment, this rule can break down when "extraordinary" events occur. The Japanese quake was extraordinary in the sense that it was not only the largest experienced in Japan but also amongst the top five largest in the world for more than one hundred years. This should therefore be considered as an "outlier" event, something of extremely rare occurrence but which can provoke the sort of correlations that one is trying to avoid in the first place.

Here is an outline of the sequence of events that would help explain the sudden sharp rise in correlations between Cat bonds and the equity markets: The Japanese earthquake/tsunami devastated a large part of the north of the country, causing an estimated $25 billion in damages to be covered by insurers. This is on the back of a series of other natural disasters (albeit at a smaller scale) since the beginning of the year, which have depleting the reserves that insurance companies had set aside for such events. On the stock market front, the Japanese disaster comes on the back a number of other events that have the potential of derailing the global economic recovery. These include the ongoing European sovereign debt crisis that seem to be worsening, turmoil in the Middle East that show no signs of ebbing and commodity prices that continue to rise. In the context of such a backdrop it is no surprise that markets would respond with a correction following the damage caused to the third largest economy in the world. Still, these are extraordinary events, never before observed in such a configuration and are unlikely to repeat themselves. Nevertheless, it is important to note that no matter how rare an event may be, it still has the potential of occuring and by not accounting for it is understimating the risks involved.

The "new normal" reinforced

As the dust settles on Japan, a clearer picture of the impact on the global economy is starting to emerge. The third largest economy and roughly 9% share of the world capitalization, the troubles in Japan, when combined to the ongoing debt crisis in Europe and growing tensions in the Middle East is likely to shave at least a percentage point from global economic expansion this year. Oil has once again broken the $100 barrier, reflecting not only the potential supply issues emanating from the Middle East but also Japan's woes as it contemplates switching to oil as a substitute to the shortfall created by the loss of nuclear power. As a rule of thumb, a 10% rise in oil typically shaves around 0.2% of growth.
But Japan's troubles stretch further than just oil. Japan is a major supplier of components for both the electronics and car industries. In the near term the shortfall in production will translate into a rise in component prices. For firms that don't have substitutes for the components, this will translate into reduced production.
Finally, the impact of uncertainty on businesses should not be underestimated. Typically when faced with uncertainty on the economic front, businesses tend to postpone projects and investments which will invariably have an impact on growth.

Black swan observations...

There are two particular observations of "black swan" events that tend to repeat themselves over and over again.
The first has to do with the fact that they occur more frequently than we think they do. Our cognitive brain has a way of erasing or minimizing unpleasant experiences, so we almost tend to forget that they ever occurred, unless something of that "unpleasant" experience persists. That probably explains why we tend to repeat the same mistakes or when the tide runs down, so to speak, a lot of people are caught swimming naked.
The second has to do with clustering or the fact that a negative event almost instantly tends to attract other negative events like a magnet, which means that the original event is subject to a snowball effect. Take the last two months as an example. It began with an uprising in Tunisia, rapidly spread to Egypt, and now Libya and other countries in the region. As if that was not enough, commodity prices have been surging (adding more fuel to the fire) and now we have the totally unanticipated quake/tsunami disaster in Japan and a growing risk of leaks from nuclear reactors in the region. Impressive and worrying series of events that have the potential of dragging the rest of the world into another slump.
So if there are certain "predictable" patterns built into black swans, can we do something about them? This is the topic of much debate, and there seems to be growing consensus that strategies can be built around them. I guess the first place to start would be to accept these observations as a given and to "strategize" accordingly.

Risks on various fronts...

From inflation fears triggered by a surge in commodity prices to growing tensions in the middle east to more downgrades in peripheral Euro zone sovereign debt, it is challenging to figure out where or in what form one can find shelter from the damaging effect of a sudden "fat tail" event. This challenge stems from the fact that the last couple of years have shown us that what used to be considered "safe" may no longer be. If you cannot differentiate between high risk and low risk, you are in trouble.
The Euro zone debt debacle is a case in point with the onetime almost "risk free" sovereign debt of a number of member states suddenly finding themselves in "junk bond status" territory. Another example would be the infamous money market funds that at one time was considered as safe as cash but in fact carried an disproportionate amount of risk as managers, under pressure to enhance returns, stuffed the funds with significantly higher risk instruments.
What about commodities such as gold which has experienced a nice run since the beginning of February? Sure, when visibility is low and the threat of systemic risk rears its ugly head, gold seems to be a safe bet. It is in a way the collective expression of distrust towards monetary authorities across the globe. At the same time, gold, just like other commodities, exhibit a tremendous amount of volatility as it is very much guided by sentiment which tends to be fickle when tensions run high.
At the end of the day, the only effective method in facing these challenges is to diversify. Not just any sort of diversification mind you, but one that involves a well thought out approach where the underlying risks are clearly identified.

A slight exaggeration in the making?

Earlier this week the U.S. government published its forecast for the budget deficit in coming years. In summary, the deficit is expected to narrow as a result of planned cuts on expenses but also, and this is where there seems to be a bit of an exaggeration, a substantial increase in receipts which, believe it or not, is hoped will come from expectations of a recovery combined with a planned increase in taxes and other forms of income. The goal is that the deficit drops from the current 10% of GDP to 3% by 2017.

So how realistic are these projections? I have a hunch that a large amount of the reduction actually bets on a strong recovery and that is where the problem lies. In the context of the current environment, it is difficult to see how the recovery can take on a sustainable path. Short term, maybe so, given the extension in tax breaks and the impact of the second round in quantitative easing, but longer term, probably not. In other words if the deficit, instead, remains stagnant or, worst case scenario, continues to widen, we can expect further pressure not only with regards to borrowing costs but also on the greenback. A weaker currency should undoubtedly help boost the economy by boosting exports to emerging countries, but if you factor in the brewing inflation troubles facing those same countries, the outlook suddenly looks bleak when compared to the "goldilocks" scenario of the government.

Reconciling Asset Allocation and Market Exposure...

According to a paper published by Gary Brinson in the 80's, the asset allocation decision was thought to be the single most significant contributor to performance, explaining roughly 80% of overall performance in a portfolio. His work was quickly noticed and widely adopted by the industry, remaining unchallenged for almost 3 decades. In early 2010, Ibbotson et al. published a research paper in the Financial Analyst Journal (FAJ) in which they disproved Brinson's original assertion. According to them, Brinson had mistaken asset allocation for market exposure. In other words, it was market exposure rather than asset allocation that contributed most (60%) to performance although, combined with asset allocation, the contribution hovered again around 80%.

The conclusion from this study would be that most of the effort in portfolio construction and investment policy should be put into determining market exposure and asset allocation rather than asset allocation by itself.

Controlling market exposure would require a form of market timing but, as any honest investment professional will tell you, trying to time the markets over the long run is a futile and sometimes very costly exercise, mainly because of the inherent randomness of markets.

On the other hand, studies have shown that if it were possible to mitigate the degree of drawdowns over the long run, doing so would substantially improve the end performance result.

Since controlling market exposure may require large changes in asset classes, isn't combining asset allocation and market timing a contradiction in terms? Dont you actually substantially change your asset allocation if you fully apply market timing? The answer is yes, but you have to think of the asset allocation element as a sort of structural backbone or foundation of the portfolio. The asset allocation decision is a pure function of the risk profile of the investor. It is the default portfolio exposure when the market conditions are "normal" or when asset classes behave as expected. Market exposure is more of a tactical overlay, its main purpose, at least in this context, is to mitigate the impact of drawdowns. In other words there is no contradiction to speak about when the roles of asset allocation and market exposure are clearly defined.

Coming back to timing markets, it is a futile exercise if human judgement is involved in the decision process. There are certainly ways around this, and if done properly, it can lead to a much better control of performance.

Negative Tail risks in 2011 and beyond...

The world will probably not come to an end in 2011 or even in our lifetime for that matter but there is something else that is likely to rock the rest of our lives: "black swan" or "fat tail" events.
They have always existed but, unfortunately, human memory suffers from a bout of short termism, we tend to forget longer term experiences, especially if they are unpleasant. I guess it is an inherited trait of our ancestors which explains why the human spirit tends to be on average optimistic. Because of our short term memory bias, however, we dont realize that "fat tail" events in fact occur more frequently than we think they do. Also I would add that a "black swan" event can also be a pleasant one such as when a major market rally occurs but we like to concentrate on the negative end because that is what needs to be controlled.
For this year, we see several risks that have negative "black swan" potential. The table above summarizes the more important ones.

Can the Eurozone survive?

The more time goes by, the worse it looks. The Eurozone frailty is getting more difficult to manage by the day and to understand why, we need to dwelve into the mechanism behind the Euro. Both Europe and the U.S. are in deep trouble but the source of their troubles and, in turn, the approach to resolve those troubles are very different.

The Euro project, from the very beginning, was meant to unify Europe on the economic front only. By creating a single currency, it was believed, trade would flourish and mobility would increase. A single currency makes it far easier and less costly for industries to plan ahead with production.

What everyone seems to forget is that there is also an implied cost to this, which may not seem evident when things are going well. A single currency without a political overlay can be problematic in certain situations like the one that is currently unfolding in the European continent. By joining a single currency, a country is effectively giving up independence on the monetary front. Without political unification, however, fiscal policy stays local. This is in stark contrast to the U.S. with its federal government in which both monetary and fiscal policy is managed at the federal level. What this means is that a state is unlikely to find itself in a situation like many of the peripheral European countries are facing today, having trouble raising capital to pay for maturing debt. This is because such issues are dealt with at the federal level.

So what actually happens when you lose monetary independence but keep fiscal independence and you are facing the type of challenges that we are seeing today? Well, you get hit by a so called double whammy. Let me explain: The booming years inflated prices and now that the crisis has hit and the asset price bubble burst, costs such as wages need to come back down. For a country with an independent monetary system the solution is rather straight forward. Instead of cutting wages, you just depreciate your currency and the problem is pretty much resolved as it is the equivalent of cutting wages. In a country that does not have monetary independence the only real solution is to cut wages, and if history is any guide, this can be a slow and painful process. Prices tend to be sticky on the downside, producers will wait for wages to come down before cutting prices (to preserve margins) and workers will wait for deflation to hit before agreeing to have their wages cut. This is exactly the problem facing a highly unionized Europe, which, through austerity will have to apply the painful cost cutting process as it is the only possible solution at their hands short of regaining monetary independence or defaulting on their obligations which are unlikely to happen any time soon.

Stagflation in Europe?

The euro zone's annual rate of inflation hit a 2 year high in December, driven by fuel, food, alcohol and tobacco prices at a time when the ECB is dealing with a major sovreign debt crisis.
Consumer prices rose 0.6% from November, pushing the year-to-year rate up to 2.2% from 1.9% the previous month, the highest annual rate since October 2008 when it stood at 3.2%.

A surge in cost price inflation that is likely to be passed on to consumers, just as European governments are embarking on an austerity program limits the ECB's flexibility on the monetary front somewhat. But at the same time it should not be forgotten that price stability (i.e. low inflation) is the primary objective of the ECB, in contrast to the Fed that targets both price stability and unemployment.

Applying the brakes at a time when stimulation is most needed could bring Europe closer to the brink of stagflation. Considering the sovreign debt related uncertainty surrounding Portugal and especially Spain, the austerity measures and a whole lot of other problems, a rate hike might just prove too much to handle.

Risk vs. structure based asset allocations

2008 reminded us that diversification can fail spectacularly when risky assets are clumped together. This is because when panic sets in, there is a sort of hoarding activity in the markets as investors jump ship from risky to less risky assets. By doing so, the correlation between risky assets spike, leading to simultaneous losses from investments of different asset classes. This is why, for example, at the peak of the crisis, high yield and emerging bonds and commodities followed the exact same path as equities at the very moment when the benefits of diversification were most needed. What use to be diversified suddenly becomes concentrated.

How can we avoid or at the least minimize such serious pitfalls? One method would be to implement a risk based asset allocation, grouping together investments according to their risk characteristics.

The traditional approach to asset allocation has been to classify assets according to their structure. Genotype/phenotype are good biological analogies to help illustrate the differences. Genotype describe hereditary characteristics (structure based classification) whilst phenotype are the observed properties (risk based classification). As an example, grouping together fixed income investments comprised of bonds with characteristic cash flow streams that include coupons and a final payment at maturity would belong to a traditional structural classification. The problem with the traditional classification is that the investment landscape has changed substantially over the last decade. The risk spectrum of investments with a similar underlying structure has broadened substantially. Today, for example, bonds can include low risk, short duration treasuries as well as high yield/emerging debt that share risk characteristics that are comparable to that of equities.

There are effectively two ways to tackle this problem:

• Managing the risk internally, within the asset class by implementing strict guidelines
• Defining risk at the asset class level

The first method would involve limiting the choice of underlying investments for more effective risk control. One such approach would be to implement a core/satellite approach in which the "larger" core would comprise of less risky investments in contrast to the satellites.

The second method is best explained as a target based approach in which the asset classes are defined as targeting specific objectives. We could very well imagine, for example, a portfolio comprised of four "asset classes" with the following defined objectives:

1. Longer term high returns (equity like risk/reward characteristics)
2. Hard assets (namely for inflation protection)
3. Liabilities matching (high quality low duration fixed income)
4. Pure excess return (de-correlated to the rest of the markets)

This method has the advantage of providing greater transparency and better risk control, at the same time allowing for a greater degree of specificity in matching investor objectives and constraints. A person close to retirement, for example, would typically allocate a large portion of their wealth to liability matching instruments in contrast to someone at the prime of their career, in which case the attributions would probably be more balanced between the four classes.

The two proposed methods aim for the same objectives, the big difference is in the approach.