“We live in a very strange period,” Friedman said. “Between 1991 and 2008, we all thought that geopolitics had been abolished, that the only thing that mattered was the market — and that the truth will set you free and make you rich. That was a complete aberration.”

During the 20^th century, Friedman noted that the U.S. spent 17% of its time fighting full-scale wars, not counting such things as the Cold War or the Cuban missile crisis. In the new century, however, the U.S. has spent just under 10% of its time fighting other wars.

What does that mean for investors? “The financial markets seemed to take this two ways,” he told delegates. “First, there’s the error of thinking that these things don’t happen all the time. War has been the fabric of human existence: the other side of economics. Second is that it’s not unpredictable. There’s a belief in financial markets that if it’s not quantifiable, it not predictable.” If geopolitics is not quantifiable, it is understandable, if you have a theory on the constraints of what’s going to happen.

Misunderstanding North Korea

Take North Korea for example. “If we were to watch market commentators, we’re on the edge of destruction,” he said. In reality, Friedman says North Korea has limited options. To guarantee regime survival, it has to appear fearsome, and it does so by “exploding weapons underground.” But it does not have a missile capable of delivering a nuclear warhead. The second issue is that Korea is facing a massive food crisis that will, given time, cause the country to collapse. So the North Koreans act as if they are crazy, said Friedman: “ if you’ve played poker you know that you want to be the one no one can predict.” In that way, they’ve managed to get the U.S., Japan, Russia and South Korea to the negotiating table.

For investors, however, misunderstanding the Korean situation, Friedman argues, is akin to making an investment based on a press release. You understand fully that in the financial markets, a press release is just a press release,” he says. “Yet, when a politician makes a crazed announcement, you take it seriously.” Investors’ reactions to those announcements moves markets, even though the actual threat is not all that dire.

North Korea is not an outlier event, Friedman notes – in fact, it happens all the time. “There’s constantly something like this going on … financial markets are part of a system. They are a subsystem that includes political, military, financial and economic considerations.” But markets often fail to notice that and when they do, “it results in a massive, and  in my view, humorous, overreaction.”

Europe perhaps illustrates this best.”[T]he Europeans announce that we have solved the problem of Europe. We had a meeting and we all shook hands and the deputy assistant minister of something assures it. The markets see that and say it’s over. Things don’t happen that easily.”

In fact, the European Union was built on two considerations: binding France and Germany together to ensure peace after two catastrophic wars, and ensuring prosperity. For almost 20 years, the Maastricht Treaty made Europe tremendously prosperous. Until the 2008 mortgage defaults in the U.S..

The U.S., having been through financial crises before – New York City’s financial crisis in the 1970s, the third-world debt crisis of the early 1980s, the Savings and Loans crisis of the late 1990s and the subprime crisis of 2008 – acted like an 800-pound gorilla, Friedman says, wincing after being whacked by a 2 X 4, but moved on. Europe, by contrast, was “smashed.” In this, Friedman concludes that size matters, although it is little acknowledged. “The Federal government bails out [the banks] the banks take the money and then condemns the Federal government for irresponsible behaviour. I love it. It’s an American opera.”

But not so in Europe. That’s because the European project, peace and prosperity aside, was based on a fundamental irrationality: Germany. It’s economy depends on exports, mostly to Europe. But there’s also the geopolitical background. Germans fear a return to the 1920s: “recession, which leads to unemployment and social instability.”

The trouble with Germany

In the process, however, what Germany has done is export unemployment to the rest of Europe, maintaining a low 5.6% rate of joblessness itself against a European average of 11%. Germany has an industrial base that is far higher than its consumption base, Friedman says.

That sets up a clash between France and Germany, over stimulus measures. France wants less unemployment. Germany fears inflation. And smaller nations, such as Cyprus, are sacrificed.

But in this is the seed of the Maastricht Agreement’s undoing, and in two ways. First, although the headline news was about Russian deposits in Cyprus, the majority were from Cypriot corporations. With banks deposits above $100,000 taxed or frozen,, the tourism industry suffers, since the hotels can’t pay their employees full salary and the employees may default on their mortgages, many owned by Italian banks. But Germany can’t bail out Italy.

So a second consequence is the rise of social movements, as in the 1920s, garbed in nationalism. “When you move into a room talking about Europe, you are no longer a European anymore. You are the French talking to the Germans, you are the Greeks talking to the Italians. The nation-state is very much back,” says Friedman.

And could become stronger, as states rebel against European Central Bank directives that essentially decimate the middle classes.

China in decline

So among the three pillars of the post-Cold War global architecture, one is bloodied but surviving and a second is on the ropes. The third pillar of the post-Cold War era, China, is facing a Japan-like decline. Like Japan, it was a low-wage, high-growth economy. “Japan had been the low-wage, high growth economy in the 1980s, but as it matured the costs of labour rose and the profit margins on exports declined. The government came in to make loans to subsidize the banks to make loans to companies that really weren’t making much money.”

So the banks had lots of non-performing loans, but needed to keep lending to keep the economy alive. Why? “Unemployment around the word is now more important than sovereign debt, rates of  return on capital or anything else because unemployment can bring regimes crashing down,” says Friedman.

But there’s another parallel between Japan and China. Many thought it “stupid” for Japanese firms to buy New York City’s Rockefeller Center in the late 1980s. But some Japanese outsiders wanted out of the  Japanese economy in order to protect their wealth. Now the Chinese are doing the same. “They’re looking for apartments, condos, houses, companies and dirt – whatever you have – just so long as it’s not where it was,” Friedman explained.

That’s one reason why  U.S. stock markets have perked up. Europeans are moving money out of Europe, at least in part thanks to the Cyprus precedent – a country “too small to worry about,” according to Friedman. The Chinese are moving money out of China and into to the next growth hot spots, countries in Latin America, Africa and Southeast Asia where low-wage, low-technology garment work seems to offer a path that could emulate China’s own growth.

In the meantime, Friedman looked to the future and asked the audience, “What happens next? The United States, big, dumb and ugly, comes through again, not because it should, but because ‘what the hell here we go again.’” As it nears energy independence, factories are moving back. And it’s regarded as a safe haven for investments,” he said.

As for explosive, Chinese-style growth? Well, there could be a budding textile factory in Uganda.

Consider that the U.S. spent 17% of the 20^th century engaged in full-scale multi-divisional war, not counting the Cold War and the Cuban Missile Crisis. So far in the in 20^th Century, the U.S. been engaged in war 100% of the time. Geopolitics is closely tied to economics, Friedman noted.

Friedman discussed his view on the key geopolitical challenges in the world today – one of which is not North Korea. Rather, Friedman believes the situation in that country has been overblown through headlines that lead us to believe the country has gone completely mad and that we’re on the brink of nuclear war. This is not in the cards said Friedman who pointed out that regime preservation is the top priority for that country’s government. Nuclear war would not serve that purpose, especially considering the country does not have any viable nuclear weapons.

Friedman instead turned most of his focus towards Europe where he believes the biggest risks lie. The failure of the “European Project” has says is the most important event of our time. The attempt to bind Europe together through prosperity post-World War II is in the midst of failure, as Germany tries to maintain its export-led economy in a region where unemployment in countries like Spain tops 26%. As other European countries grapple with high unemployment and social unrest, Germany has managed to maintain prosperity and higher employment.

But as Europe languishes in depression, countries like Germany, Luxembourg and Austria are slipping into recession. Right now, Friedman said, we are experiencing economic dislocation in Europe not seen since the 1920s. This is a breeding ground for extreme nationalism.

China’s decline

Friedman also offered comments on China’s prospects for the future, painting a gloomy picture of a country in decline. “China has reached the end of its cycle,” he said calling it “Japan on steroids.” While Japan’s decline in the 1990s was prompted by its own economic troubles, China faces a much worse situation, with a vast number of Chinese earning less than $2 a day, the idea of trying to stimulate the economy through improved consumer spending is virtually impossible, especially when many people in the country don’t even have electricity.

Where will the next leaders be? The focus says Friedman will shift back to the U.S., which is moving towards energy independence. Right now, the country is a last haven for foreign capital from less stable regions like China and Europe. He also identified a series of countries he believes are the next successors to China when it comes to growth. Turkey, Mexico, Uganda and the Philippines were among those that topped the list.

Som Seif, president and CEO of Purpose Investments Inc., attributes part of this growth to greater awareness and education. The 2008 financial crisis reinforced the importance of liquidity, which has drawn attention to the ETF structure, he said, speaking at Canadian Investment Review’s ETF Summit in Toronto last week.

Another reason for the massive growth has been the trend toward a passive and active investing blend. “We have to get past this idea that this is an active versus passive debate,” said Seif. “It is an active and passive market; not everything is passive and not everything is active. Segmenting where active matters and segmenting where passive matters is where we can save fees.”

While pension plans use ETFs mainly for cash management and transition, Yves Rebetez, managing director and editor of ETF Insight, said that doesn’t meet all of the needs of plans out there. ETFs are not necessarily a transition vehicle (i.e., a place where a plan can “park” the money while transitioning between managers), he said, there are a great many solutions that are underutilized (think portfolio completion or hedging).

Seif agreed, adding that ETFs can be used for short- medium- and long-term investment objectives. For example, the Canada Pension Plan has bought emerging market ETFs to get exposure in the space.

Similarly, the CAAT Pension Plan (which has been using ETFs since 2009) has had an investment in an emerging market ETF since 2010. “We were thinking of that as a temporary solution, but it’s been with us now for a couple of years,” said Asif Haque, director, investments, with CAAT.

Anthony Martinello, manager of Independent Electricity System Operator (IESO) Pension Plan, which hasn’t entered the ETF space yet, said that IESO is close to using ETFs as a transition vehicle.

But whether used as a transition vehicle or not, ETFs are a convenient and quick way to get the exposure the United Church of Canada Pension Plan wanted in emerging markets, said Dan Foster, the plan’s investment manager.

Haque concurred. “[ETFs are] easy and efficient to get in and out of. And we don’t rule out [using] ETFs in the future in different parts of the fixed income space.”

Rebetez said that ETFs can help plans with the democratization of access. “You can access areas that you formerly didn’t have the ability to access as readily and as easily, and on a cost basis that is generally attractive.”

Using an ETF was an easy and convenient way for the United Church of Canada plan to get exposure, but Foster said he had trouble with the mechanics.

“The toughest part was buying the things,” he said frankly. “We are a small plan, just over $1 billion. I thought this was going to be like buying at a discount brokerage online—you just hit a button. For plans or investors that aren’t doing their own trading, how do we physically get our hands on these things?”

Rebetez was sympathetic. “It’s surprising in this day and age when someone wants to execute a trade and it’s not as easy [to do],” he said. “The channels and access maybe aren’t as open and accessible from an end user point.”

Then there’s the cost. Foster said he would like to see a flat fee, not so much per share for commission rate.

Regulations

From a regulatory standpoint, Canada is a great place for ETFs. “We have proper regulations around the use of swaps and derivatives; and our securities lending rules are tightly regulated,” said Seif. “There’s very little room for manipulation.”

However, outside Canada, it’s a different story. The U.S. has different rules around securities lending (e.g., it allows for third-party lending and lending up to 100% of a portfolio). “Who is guaranteeing that loss?” asked Seif.

In Europe, it’s more of the same. There are relaxed restrictions around what is collateral and securities lending practices, he said.

The industry will continue to see the value of ETFs and their increased use in portfolios, explained Seif. But, he stressed, ETF providers need to address the perception of higher fees (relative to other strategies, pooled funds, futures), as well as increase product understanding by ensuring that investment managers are fully educated about how ETFs can be used. That way, they can be more than just a “parking spot.”

But another argument, advanced by Richard Duncan, chief economist at Blackhorse Asset Management, who is based in Bangkok and a keynote speaker at April’s 18^th annual  Global Investment Conference suggests that events in the 1960s laid the foundations for recurring bubbles and busts.

The starting point is the breakdown of the Bretton Woods system of fixed exchange rates in 1968. Bretton Woods, while not a gold standard in the usual sense, had succeeded in curbing curbing trade imbalances between countries. When  the U.S. renounced convertibility of the dollar into gold in 1971,  “the dollar standard” came to govern the global balance of trade.

One result has been a persistent U.S. trade deficit with the rest of the world. With trade deficits come bubbles, in both the debtor country and the creditor country. Globalization has only served to encourage this, Duncan argues,  “because of the extreme wage-rate differentials between  the United States and the developing world, which inevitably lead to larger and larger trade imbalances and these trade imbalances have destabilized the global economy, firstly because the countries with the trade surpluses tend to blow into bubbles — Japan in the 1980s and the Asia-crisis countries in the 1990s.” Now it’s China as it recycles export earnings into whatever U.S. investments are available – and for the period from 1996 to 2006, there was a shortage of U.S. government debt to buy. So the money went into bubbles: in the U.S. because the money had to be invested; at home because the People’s Bank of China had to print yuan to buy exporters U.S. earnings.

But there’s no going back to a self-regulating gold standard, Duncan also argues. That genie has escaped from the bottle and no amount of austerity will shove it back in. Says Duncan: “We could do what the Tea Party wants in America and immediately balance the government budget and  ban the Fed. That would immediately result in us collapsing into a new Great Depression.” The world economy is far too dependent on credit-led expansion.

The second alternative isn’t much better. Indeed, it’s also a deflationary trap. “We could  do what Japan has done for the past 23 years, continue to have very large budget deficits every year and stimulate the economy and keep it from collapsing into a depression that way, but just to spend all the money wastefully as Japan has done, building bridges to nowhere and paving the Japanese countryside with cement. That’s effectively what we’re doing now. We have very large budget deficits but we’ve largely been wasting most of this money on too much consumption and war. So we can do that for another 10 years, maybe and then eventually go bankrupt like Greece. That’s the most likely scenario.” Just treading water with expanded credit creation won’t do the trick.

Duncan’s preferred solution “is to learn from Japan’s mistakes and to understand that we’re going to have to spend this money to keep the economy from collapsing. But rather than spending it wastefully, the government should invest this money very aggressively on a very large scale in transformative 21^st century industries and technologies. If they do, they could generate such a massive investment return that the returns would pay for the investments many times over. It would allow a complete restructuring of the U.S. economy that would the United States an absolutely unassailable lead in 21^st century industries.”

It’s a unique moment, he argues, use cheap credit to something productive.

His other books on warfare and intelligence have included America’s Secret War, The Future of War and The Intelligence Edge. In addition, he has briefed the Australian Command and Staff College, Eglin Air Force Research Laboratory, U.S. Marine Corps Command and Staff College and many other military and government organizations. Major television and radio networks such as CNN, Fox News, and NPR frequently invite Dr. Friedman to appear as an international intelligence expert. He and STRATFOR have also been featured in cover stories in Barron’s and in the UK’s New Statesman. Dr. Friedman has been featured in Time Magazine, The New York Times Magazine and The Wall Street Journal. He is frequently quoted in The New York Times, Fortune, Newsweek, USA Today, the International Herald Tribune and many other publications.

A key to success in the private debt market is active relationship-based investment management. Private debt market managers maintain direct contact with borrowers from the inception of the investment until it is fully repaid and they actively perform all the functions that are usually managed by intermediaries in the public bond market. This requires investment management skills that are more fundamental than those generally employed in public market bond investing. This significantly reduces risk due to greater control over the structuring, management and administration of the investments.

Investing in the private debt market is primarily a manufacturing process. By comparison, public market bond investing is mainly process of selecting investment exposures from an inventory of pre-packaged debt securities.

The manufacturing process involves several steps, including pro-active direct origination of investment opportunities, fundamental credit analysis (often on businesses that do not have any publicly available information), negotiation of the structure, terms and conditions of the investment (often custom designing the loan to deal with the unique situation of the borrower), and, with the assistance of legal counsel, documenting the transaction to ensure the terms and conditions of the investment are fully and accurately captured.

Post-closing the investment manager pro-actively monitors the ongoing creditworthiness of the borrower and directly administers the investment. The direct relationship, timely receipt of information on the borrower’s activities and short lines of communication reduce credit risk by ensuring early intervention in the event of credit deterioration.

Although it is infrequent in the investment grade private debt market, adjustments to the terms of an investment may be required from time to time. This can be due to a positive event (e.g. a growth enhancing capital spending program) or as a result of a negative event (e.g. a cash flow strain that limits the ability to make debt service payments). In either case, the private placement debt manager has the in-house analytical, negotiation and documentation skills and resources to deal with the changes and thus minimize risk.

The alpha from the private debt market comes from a combination of two identifiable and measureable sources: a higher interest rate and lower loan losses than public market bonds, plus active relationship based investment management. The higher interest rate comes from an illiquidity premium and/or a uniqueness premium. This illiquidity premium recognizes that private debt is a buy and hold investment that is intended to be held to maturity and that there is no active secondary market for private debt.

However, there is structural liquidity as there is a contractual maturity date for the debt, many of the investments have amortization schedules that partially or fully repay the debt during the term of the loan and interest and principal payments are often monthly. As a result, the ongoing cash flow from a private debt portfolio is higher and smoother than that of a public market bond portfolio.

The uniqueness premium obtains a higher interest rate from borrowers who have unusual or complex borrowing requirements. Because this type of borrower has difficulty obtaining financing, they are more focused on the availability of the funds than the cost of funds. While additional time, effort and skill is required to assess the creditworthiness of these borrowers, the payoff for investors is often a higher interest rate for less credit risk than for easier to understand borrowers.

Loan losses are much lower in the private debt market than in the public bond market. The stronger covenants in private placement debt combined with the ongoing direct relationship with the borrowers results in early intervention in the event of credit deterioration. At the same time, in-house skills and resources and a commitment to minimize losses results in higher recovery rates. In the public market, bond investors usually do not have the skills and resources to deal with defaulted loans and are required by investment policy to sell defaulted or downgrade bond exposures resulting in low recovery rates. Consequently, investors in the private debt market not only benefit from a material yield pick-up over public market bonds but, with the passage of time, the yield pick-up widens due to lower loan losses.

In conclusion, the investment grade private placement debt market is a safe, sustainable and easy to understand source of meaningful yield pick-up over the public bond market. It increases the rate of return on fixed income portfolios, provides stable and predictable cash flow and is a highly valuable asset class for implementing an LDI strategy.

Donald W. Bangay is Chief investment officer, Integrated Private Debt Corp.

A Canadian IPP project can either be financed through a bank loan, a rated bond issue or through a privately placed loan (private placement or private debt). The most appropriate source generally depends on the size of the required financing. Transactions requiring less than $150 million in long-term financing are generally done in the private debt market, which is currently dominated by life insurance companies. While these transactions are rarely rated by a rating agency, they are considered investment grade (BBB or higher) as the federal government regulator (Office of the Superintendent for Financial Institutions) requires life insurance companies to take a BBB capital charge against private IPP debt transactions.

Given the similarities between the liabilities of a life insurance company and that of a defined benefit pension plan, pension plans should consider lending into non-merchant IPP projects because the investment grade private debt market offers significant opportunities to extend duration and enhance yield without significantly increasing fixed income portfolio risk. Private IPP debt transactions offer investors:

• Predictable, long-term cash flows;

• A good match for plan liabilities, with durations ranging from nine to 15 years;

• An alternative source of investment grade transactions (i.e. portfolio diversification);

• Premium yield over comparable social infrastructure bonds and loans;

• A wide variety of covenants providing early warning signals and enhanced credit protection.

Private debt transactions are generally buy-and-hold investments and the lack of external rating considerably reduces the pool of investors. As such, investors are able to extract premium returns for a given level of risk. Private IPP debt transactions also offer premium returns over the private social infrastructure debt market because the pool of buyers has expanded beyond the life insurance companies, which caused bond market spreads to tighten and drove down the “private debt” premium.

The underwriting considerations and the terms and conditions included in IPP transactions are generally similar to what most investors would find in social infrastructure loans. For example:

• The borrower is a non-recourse special purpose vehicle (“SPV”);
• The financing term must match the term of the underlying contracts (20 – 40 years);
• There should be first charge on all of the project assets, including assignment of material project documents;
• Leverage and debt service coverage ratios should reflect the resource availability under various stress tests;
• Distribution restrictions are required;
• Reserve accounts are also key (debt service, major maintenance, etc.);
• Cost overrun support can be provided by one or more of the following: letter of credit, budgeted contingencies, profit retention and/or corporate guarantees;
• Lenders require third-party consultants (independent engineer, legal counsel, cost consultant, insurance consultant) to review the project prior to closing.

Because these transactions have long lead times and are generally heavily negotiated, it is difficult for most pension funds to access this market, save and except for those pension funds with in-house expertise. The recent launch of dedicated infrastructure debt funds will help pension plans to access this market, where long-term, predictable cash flows are available at a premium over social infrastructure bonds and loans.

Louis Bélanger, CFA, FRM is Managing director, Stonebridge Infrastructure Debt Fund