Month: September 2015

Very interesting post on risk parity

Longshorttrader with interesting thoughts on risk parity:

  • Why is Ray Dalio making more media appearances than even Warren Buffett? Arguably, Cliff Asness too, though his/AQR’s appearances seem a bit more measured. Both seem highly defensive of risk parity. Why? If you’re in a position of strength, why be defensive? Does not pass the “sniff test”.

  • Why does Bridgewater “backtest” returns without factoring in the impact that their and other RP funds’ presence would’ve had on markets in those past periods?

  • Why is it that some obscure outfit called Renaissance Technologies seems to obsess over modeling expected profit potential of a strategy as a function of its size?

  • If Bridgewater and other RP funds’ AUM went to zero, would the world care? Would the world be any worse off?

  • Assume I am wrong. Examine the claims of the RP proponents.

  • Compare/verify/test the proponents’ claims with evidence.

  • How much AUM is dedicated to RP strategies? How much EXPOSURE do these funds have (i.e., how much leverage)?

  • The Leon Cooperman / Omega Advisor quotes regarding Risk Parity are a distraction…the reality and truth are perversely ironic. Time will reveal all.

  • Why should the immediate and more distant future resemble the past, when the immediate past and present wildly differ from most of history?

  • The best “risk-adjusted” way of implementing “Anti Risk Parity” will likely be quite…boring. Though immensely profitable.

I share his concerns. Although I used to admire Ray Dalio when I started investing more than ten years ago for the breath of his analysis and curiosity, I am much more sceptical of him now. I mean how serious can you take a guy who calls this,


a “beautiful deleveraging“…

And of course and as regular readers know, I fully disagree with him on China…

So what has happened to the combative, truth-seeking manager of ten years ago?

I think that Ray Dalio has to be very balanced in his public comments – a direct consequence of Bridgewater’s huge size. No doubt, he has many clients (sovereign wealth funds, pension funds, foundations etc.) who are very wary with whom they associate. As a consequence, he is obliged to balance a hundred considerations at once in every public appearance. His position is understandable from a profit-maximizing viewpoint, just be aware that the obligation precludes intellectual honesty (and don’t take his statements at face value)…




The Euro and the Austrian view (Part III: Formulating the Problem)

This is the continuation of my series on Greece’s and the Euro (click for part I and part II)

There is little doubt that Greece and the rest of the PIIGS have been experiencing a credit induced boom-bust cycle. According to the mainstream view, the main culprit is the Euro which before the crisis imposed a “one-size fits all interest rate” that induced the southern countries to take out too many loans, whereas now it’s a “one-size fits all monetary policy” that acts as “a straightjacket” on the struggling economies in southern Europe, as it doesn’t allow them to conduct their own monetary policy. If you believe in this narrative, you will also believe that “a Grexit” is the only viable solution for Greece.

(The other narrative, mostly told by Eurocrats, is that the reason for the Greek crisis is the result of a “lack of political union” and that it is not the Euro per se that is faulty, but the lack of political centralization. Since this opinion mostly stems from bureaucrats’ wet dreams, rather than any theory known to me, I will not explicitly discuss it here for the sake of brevity)

Problem is: the story is (way) to simplistic and its implications somewhat confusing.

For, how can it be that the Euro led to uniform interest rates before, whereas since the start of the crisis rates have differed between the core countries and the rest? Apparently, it is possible to have the Euro AND different interest rates at the same time. And doesn’t a market that differentiates according to credit risks improve capital allocation anyway? Isn’t that how it should be? After all, that’s what one learns in Econ101 and that’s also what happens in the Eurobond market every day. Finally, why is interest rate heterogeneity across the Euro zone bad now, whereas it is precisely the homogenous interest rates before 2009 that are considered a major cause for the current trouble?

Is this bunch of inconsistencies really the best economic science has to offer? Is it any wonder that everybody is confused by the advice of these “experts”?

Now, the typical Keynesian/Monetary economist would probably defend his position citing Keynes, “…when the circumstances change, I change my mind…” an attitude which will bring him a lot of sympathy – especially among market participants – since flexibility of mind is, no doubt, a laudable goal. However, I do not see how the attractiveness of a flexible mind translates automatically into flexibility in monetary arrangements as a desired outcome. For, as we are currently witnessing, entering and exiting a currency union is no trivial matter and the costs are enormous. It is certainly not feasible to change your monetary system whenever a supposed “external shock” hits the economy and you need some kind of “painless” adjustment mechanism – it doesn’t work.

The confusing statements of mainstream theory arise from a tendency to focus on the present, disregarding intertemporal dynamics. Since the dysfunctional state of the Greek economy has roots in the past, it CANNOT be properly analysed by models that do not account for path-dependency and changes in time, or that leave out the financial sector entirely, as most macro-models do. This leads to conflicting and often nonsensical prescriptions of mainstream economists who fail to come up with something that could work.

The path dependency of an economy arises from a complex capital structure as we typically find in large-scale societies based on the division of labour. In other words, past (investment) decisions do matter and it’s the balance sheet, i.e. decisions made in the past that ail the Greek (and many other) economy. That there is something wrong with the allocation of capital in Greece and the rest of the PIIGS is obvious even to the casual tourist: empty highways and golf courses in the south of Spain, a huge and overpaid bureaucracy in Greece etc. I am sure everybody can come up with some example.

But what, we have to ask, does the EURO have to do with it?

Well, it turns out the answer to this question is a little tricky. For, as I have argued before, the fact that there is a common currency is not problematic per se – see the gold standard, or the various dollarized/euroized economies in the world. Rather, it’s the specific design of the Euro zone and how it has been implemented that are faulty. Now, we all know that the current monetary system characterized by the absence of an automatic and continuous rebalancing mechanism for capital flows, differs radically from the 19th century world gold standard. However, that’s not what I want to focus on here as it is a problem shared by every other economy in the world, not just the Euro zone. Don’t get me wrong, this is a huge problem, but it is not Euro-specific.

Therefore, I want to reframe the question somewhat:

Why has the Euro had a disproportionately negative effect in the PIIGS (and not in “the core”)?

Europe pre-Euro

Before the introduction of the Euro (and its predecessor the ECU), every European country had its own currency “printed” by the local central bank. Since the breakdown of Bretton Woods in the 70ies most currencies had been freely floating. Many countries in Europe still adhere to this model: Scandinavia, the UK and most of CEE. The results of these freely floating currencies were mixed. Whereas southern Europe experienced high inflation as a result of generally more statist inclinations, currencies of “the core” performed better (or worse if you are Keynesian :-)) notably Germany, Austria and the Netherlands, the latter two pegging their respective currencies to the DM-Mark, arguably the most stable fiat money in the world, in the late 70ies.

By the way, while in Southern Europe statist policies led to regular depreciation and high interest rates, the formerly outright communist countries of Eastern Europe experienced bouts of severe inflation and hyperinflation. For instance, two of the worst hyperinflation in recorded history happened in the 80ies (Yugoslavia) and 90ies (Romania) in this geographic area (here).

In an inflationary environment, the best way for individuals to preserve wealth was to store it in the relatively most stable alternative available: the DM-mark. And that’s exactly what most people did. Indeed, the communist government of block-free Yugoslavia even permitted citizens to open FX deposits in foreign currency providing the elite (together with neoliberal IMF loans) with precious foreign exchange letting them to kick the can down the road somewhat longer.

Regardless whether we are talking about communist Europe or the Euro periphery, the respective banking systems were similar, i.e. characterized by high interest rates and low complexity. At high rates the demand for loans was naturally limited to short maturities and lending was done mostly to connected (read: government related) parties. Private debt levels and experience with financial products was low. Since savings occurred mostly in the form of real estate (hence the very high home ownership across southern Europe and CEE) and FX deposits, but rarely in local currency (exception: Italy) it was critical for bank management to keep a sufficient reserve in FX as a cushion against bank runs. In short, the situation for Greece, Spain, etc. was akin to what we find nowadays across Emerging Market banking systems adjusted for local specifics.

To make a long story short: what actually happened in Greece was that an EM-type banking system (Greece) joined a reserve currency block (the Euro) more or less overnight. This is a highly unusual thing to happen and to my knowledge has not happened anywhere else in this form in history – it is indeed a specific Euro problem…

In the next part I will show how this event caused most of Greece’s current problems by first analysing this phenomenon deductively and then have a look at a truly natural experiment – a rare case in economics. Stay tuned…

Is it time to buy Emerging Markets?

The recent sell-off in many Emerging Market currencies and bonds has led to a sizeable outflow from EM funds. As this article in the FT points out, the bad performance has lasted since 2011 and the JP Morgen EM currency basket which tracks the 10 most important EM currencies has reached new historic lows.

Is this a new secular low and therefore time to pile into EM assets?

Not so fast. While it is true that I have taken the opportunity to accumulate RUB assets in the recent sell-off (here) and I start to see value in places like Brazil, it is also true that many Emerging markets have yet to crash (notably: Turkey, Nigeria, China…). These things usually end with a bang and there has been no bang yet, merely weakness

In other words, I believe this to be a relative value market environment, not a secular bottom which is why I prefer to trade around positions while keeping a sizeable portion of cash.

There are two reasons for my scepticism:

  1. The unresolved external debt problem of many EMs (estimated at USD 9-10 trillion)
  2. The technical market positioning

While there has been much focus on the former and there is no need to dwell on this topic (see my short post from last year) now, the article has opened my eyes as regards the latter.

Just look at this chart,


The red line depicts the development of the spot rates comprising the JP Morgan EM currency index. It is at an all-time low and suggests an undervaluation of historic proportions. As usual, you have more and more “experts” coming out and explaining how this is a “historic” buying opportunity. I have no doubts that many a private banking client is shown a version of this chart by his financial advisor as I write this piece.

The second line (rose/orange) shows the performance of a carry strategy applied to said basket taking the interest rate differentials into account. I observe that despite recent disappointing performance, most carry traders are either sitting on long-term gains or on small losses such that making them up must still feel feasible for most.

Carry trading has historically been a highly volatile strategy. But having a healthy risk appetite is merely a necessary not sufficient condition in investing. In order to be long-term successful, one has to be able to avoid the “permanent loss” disasters such as devaluations and sovereign defaults that characterize many of these markets. It is not to be expected that buying and holding a basket of high yielding currencies will positively compound capital in the long-term, as it has since the start of the millennium. This is consistent with Interest rate parity theory which suggests that on average, no returns from holding high yielding currencies can be expected.

Now we know that as a result of its “success” until 2011, carry trades have gone mainstream with many retail investors and institution piling into financial products promising to escape low DM interest rates in recent years. Experience tells us that these newcomers neither have the stomach for high volatility, nor the ability to successfully differentiate between markets. Most of them are starting to experience the high volatility nature of carry trading. You will know the market has bottomed when permanent losses are realized…