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Traders know that being long means when the market goes up or sideways they win. This forms the basis for carry trades. That’s winning two times out of three. The edge comes from the asset’s income exceeding the cost of financing. Short sellers have a harder time. The cost of borrowing can be hugely expensive. Timing is not a luxury they have. Timing is also in our minds when we think about central bank tightening. When will it happen and how rapid will it be? In the meantime zero and negative rates make sitting on the side lines similar to running short. But nearly eight years have elapsed so the compounded effect is painful. There is no simple answer but it's probably better to stop trying to guess the next policy move and accept that being invested is the only answer.  Albeit that at this point in the cycle your bias may prefer keeping leverage down and hope that time is on your side.

Just before the big vote few people expected the UK to opt out of the EU. If you believe that markets are, by and large efficient, the small risk of Brexit was priced in albeit with a low probability. However because of a yes/no decision the unexpected vote makes larger waves. Something traders call gamma risk. It’s a problem because it’s almost impossible to hedge. It also means that normal models (deltas, VaR etc) don’t fully describe your downside (or upside) potential. Political risk is something for which they aren’t designed. In a world of low growth, as capital and labour fights for a bigger slice of pie this risk is magnified. It’s therefore appropriate to ask how you capture it. The standard approach is scenario or stress testing. The problem is that often the picture painted isn’t one of political disruption. It’s more a “what-if” based on moderate volatility. A more instructive approach would be to consider why turmoil occurs and what it can do. Good places to start would be 19th November 1967, 18th October 1987, 16th September 1992 for longer periods consider 1987-1993. This will look ugly. But it helps you understand two things. What courses of action can you take? And Is your business balanced? If like me you think politics are back it’s a worthwhile exercise.

If you have tried any of the following you could be in for a nasty surprise. Things are not as smooth as advertised. Opening an account Moving money Altering an asset manager Changing details The list goes on…… With the aid of technology they should all be simple and seamless but you end up doing a lot of unpaid work for the provider and things can still go wrong. Once manual intervention is needed mistakes multiply. Big banks are particularly guilty. It’s where technology meets human intervention when things invariably go awry. When dealing with retail customers banks, in the rush to apply IT, seem to have forgotten that when things don’t work the fall back is email, phone and paper. Resolution requires some old fashioned skills. Unfortunately finding people who understand the issues rather than reading from a script isn’t easy. Furthermore getting action within an appropriate timescale is nigh on impossible. The worst part is that this wouldn’t have occurred three decades ago. These are problems of capital allocation. Why spend money on sorting things out if you can’t demonstrate a return? It’s simple. A business that loses customers by neglect needs to reconsider where it will be in the future.

What do the following two examples have in common? Example 1: If a 25-year-old saves £1,000 for retirement in 40 years’ time how much will they have? That depends on the rate of return. Using a 5% rate (realistic in current conditions) the amount is £7,040. A fund manager who charges 1% reduces this to £4,801. Factor dealing costs of an additional 1% and you have £3,262. In other words, you lose (7,040-3,262)/7,040 = 53.6% of your investment. Example 2: A customer pays 0.99% for a 2 year £70,000 mortgage with a fee of £1,499. Amortise the fee and the rate is (1,499/2)/70,000 = 1.07% higher or 2.06% The common theme? It’s how Joe Public gets side tracked or should I say "ripped-off". Whether this is a regulatory issue is a moot point. Suffice to say that retail facing financial services are under a fiduciary duty but also have a conflict of interest (profit). Therefore, unlike other industries they should be duty bound explain in simple terms how much they are taking out of the customer in terms that the customer can understand. It’s interesting to see that the teaser rate and fee model has been dropped by some banks. This is a step in the right direction. But a lot more could be done. In particular the funds industry needs to be open to showing dealing costs in the expense ratio. No one wants to see over half of their pension disappear in fees and commissions.

US bank stocks are indicating that the new administration may scale back the regulatory onslaught that followed 2008. Could this make Bank capital requirements less restrictive? It could. Other countries would need to follow suit or be at a competitive disadvantage. Whether you think this is good news depends on your views. On balance some rules have been helpful but regulation has become an industry that doesn’t add to productivity. If the regime is relaxed it could have important economic implications. Whilst quantitative easing has lowered interest rates the anticipated economic upturn has been very muted. After all before the crisis a 5% cut in rates would have led to a red hot economy. But if banks once again are free to expand their balance sheets it could turbo charge the current policy stance. Whether this happens depends on credit demand and banks’ risk appetite. If it does it's sure to be inflationary. The economies that would be most affected stand to be where banks do the most intermediation. That’s Europe…..Interesting times.

In this low rate environment pension liabilities have ballooned and companies have opted to close final salary schemes. Many private sector workers are therefore reliant on money purchase schemes. This means they save a proportion of their salary in a tax-free account ready for the day they retire. Handing this responsibility to individuals is in many respects good provided two things are present: First, have sufficient understanding to enables them to weigh-up what to do before they do it. Second, the institutions that they deal with don’t fleece them. Sadly, in the UK this isn’t the case. Many people do not seem to understand money - not even in the Micawber sense of cash in and cash out. The reason for this is it is not taught at an early age. And if you don’t understand the basics how are you supposed to deal with the firms that handle your investment. Do you end up losing your arms and legs? Could we improve this situation? You bet. Policy should: Bring money into the classroom and; Target public information (just like health).The market will also find an answer. For financial firms that offer value there are benefits. Witness how “passive” is now gaining in the US. Is this a market where the average consumer is better informed? Probably. It will happen here too.

Last week I was discussing liquidity and market risk with two different banks. On reflection, it’s apparent that the way we set risk appetite is inconsistent. For liquidity risk one of the key measures is the liquidity coverage ratio. The survival period is measured on a stressed basis. This is relatively severe and is backed up with chapter and verse from the regulator on how it’s done and what happens if you don’t do it properly. This risk has had the full treatment.  Consequently, banks hold much more liquidity than a decade ago. But there are still breaking points. Has market risk had the full nine yards too? No. We know that on a series of bad days you can lose a fortune so we add stress testing to gaps, deltas and vars. But does it go to the same extent as liquidity in battening down the hatches? I think not. It’s as if, encouraged by QE, market risk is the dog that didn’t bite. Inconsistencies like this can cost us dear. Have we overcooked “liquidity” and underdone “market”? If we have we are buying insurance for something we don’t need whilst taking on a risk for which we aren’t properly prepared.

Reinvestment of interest is the cornerstone of successful long term investment. Einstein recognised compounding as the eighth wonder of the world (“…he who understands it, earns it…he who doesn’t… pays it.”) The law of 72 shows that a return of 4.1% takes 18 years to double your money and a return of 1.60% takes 45 years. Incidentally these are the yields on Diageo and Long Gilts. (You pays you money and takes your choice). It’s a fact that long term assets that pay little or no return damage terminal value (retirement plans). “Modest” fees and commissions do the same. Pay fees and commissions of 1.5% on a portfolio yielding 4.1% and it takes 27 years to double your money. That’s 9 years more. Fund managers tell us not to worry. The key to performance is concentration. That’s what you’ve got to do. But something’s missing. What’s the appetite of the investor for risk? If it’s pension savings I bet it’s quite low – better a quiet old age not one shelf stacking. And herein is the problem. Why bet the house when you don’t need to? Some managers have a fantastic performance but what's the future? In the US investors asked this question and found no answer. Their safest bet - passive. If you don’t fancy stocking shelves but really must have a flutter don’t put all your money on one horse or for that matter one rider- It’s the bookies that win. Good luck on Saturday’s National!

According the FT on 27/4/17 local councils are borrowing from the Treasury at about 2.5% to fund real estate yielding around 8%. The net interest income being used to fund spending. The balance sheet of some councils now being dominated by this carry trade. On 2/5/17 The Times reported an investigation into the motor industry. Have PCP contracts been mis-sold? Credit cards have also come into the spotlight. Is new business being written at rates that will fail to cover future defaults? These things appear to be unconnected. But in truth they result from depressed interest rates. At this point in the economic cycle and without policy intervention rates would be 2%-4% higher. The resultant higher borrowing costs would deter additional marginal financing. Whilst rates are so low the normal questions about loan affordability are suspended. The longer this continues the bigger the eventual problem. Once rates head North defaults will rise. Mitigating action can be taken. Affordability tests and increased capital requirements slow down marginal lending. But “fine tuning” like this has never been that successful. Surely a better solution would be slightly higher rates now.

To be an equity investor (active or passive) you must be an optimist. You believe that the future will be better and with this income and growth will accrue.  The route may be bumpy but you know that if you are invested for two decades it’s almost impossible to lose money. This applies even before major sell offs like 1987. Why? Because economies grow and those in them get richer. If you have any doubts just compare today with the past.  We have more of just about everything. Earlier generations would be aghast at the way we now spend. On top of this the things we buy are better. (Think cars, T.V.s, computers etc, how we factor this into GDP is another story). But the trend is not continuous. Sometimes our financial well-being treads water, occasionally it goes backwards. But to be sure progress is inexorably Northwards. Would you rather be living today or fifty years ago? During this election campaign, several things have struck me which may go on to influence this trend. Much of the rhetoric wants us to believe that we are worse off today than were in the past. It also offers little hope of improvement in the future (a point I will come back to). The discussion of the country’s financial situation has been largely ignored. This at a time when, as an open economy, sound economics is essential to our future prosperity. There is disregard for business and “supply side” issues. Wealth creation seems a “dirty” concept. What’s to be missing? I call it Leadership. Surely any party that hopes to win must offer a vision of the future. A place where we are all doing better. It must convince voters that they can participate through hard work, effort and entrepreneurism. Robbing Peter to pay Paul is not the answer. What of the future? As an equity investor, I am optimistic. But I recognise that poor policy selection (of the type I am currently hearing) has the potential to harm. In other words, we will be better off but not by as much as we should be.

How much should I invest in stocks? How much should we hold in liquidity? These similar questions arise from different sources. One personal the other corporate. The key ingredient is attitude to risk. For an individual who can’t tolerate losses stocks aren’t the thing. For those who want some diversity in their investment the question is one of how much can you lose on a series of bad days? As a rule of thumb 50% is probably a reasonable place to start. How would you feel? As for liquidity that’s something that banks “model”. And under scenarios 8%-15% of liabilities may suffice. But there is a difference between personal and corporate risk. At a personal level, it’s unlikely you are leveraged. If 20% of your wealth is in stocks you won’t be wiped out (but you may be leaving money on the table by being cautious). However in a really ugly scenario banks take more risk than both their capital and liquidity allows. In truth to cover such eventuality would be prohibitively expensive. That’s why they don’t do it. The saving grace (for banks) must therefore be action. When things get rough, unlike the personal investor, banks can’t afford to sit back and wait. If they call it wrong and things go from bad to worse they are done. That’s why scenarios are so important. It’s not about predicting what will happen (things don’t happen as planned, ask any economist) it’s about deciding when and how to act to ensure you say in business. The key point. Stress testing doesn’t tell you how much you can lose. It allows you to develop action that deals with adverse consequences thereby staving off failure. Ironically in the real world behaviour plays a big role. Personal investors respond to big market falls by selling at the bottom and banks often sit on thumping losses hoping it will all come right in the end. Is this because collective board responsibility reduces the perception of individual risk whereas the average investor is scared witless?

During the summer regulators have been busy. Latest musings highlight the risks that threaten. A perennial theme seems to be the housing market. Others include Brexit, QE tapering, market liquidity, personal sector debt, PCP and so on. Is it that by highlighting everything you can’t be blamed when things happen? To be sure, cast wide enough, include war and famine, then almost any misfortune is covered. But it’s as much use as the proverbial stopped clock. What we know is that there are good times, bad times and occasionally very bad times. The useful question is one about survival. What happens when things unfold? Diversification is key. It takes you away from the extreme towards the average. Simple estimates of drawdown risk (equity 70%, property 60%, bonds 40%, bills 5%) can also help paint a picture. However, it is by no means clear how the system will behave under extremes. It is conceivable that in the last ten years the amount and nature of regulation that has occurred has given false comfort. An extraordinary amount of “groupthink” has gone into regulatory design. Banks therefore run their businesses along similar rules. Hardly a diversified system. Instead of trying to point out all risks that may befall us regulators should be asking whether they themselves are unwittingly increasing the chance of systemic failure. It seems to me that events will happen and the system will get tested. That’s obvious. A mixture of banks doing different things is potentially safer. Excessive size needs to be rebalanced. Unfortunately, that’s not what’s happening. Similarity and concentration rule.