We follow Piketty at our peril!
by Richard Cluver
Tax authorities the world over have been getting excited about the work of French economist Thomas Piketty who based much of his thinking upon what has transpired to be an incorrect assumption about the South African economic model.
Recognising that South Africa is blighted by a massive wealth disparity between Rich and Poor that makes us the global leader in the Gini Coefficient stakes, Piketty incorrectly assumed that the wealth of rich South Africans had grown out of proportion to the rest of the economy and accordingly argued that when capitalist economies are left to their own devices, the rich will enjoy the unfair advantage of seeing their wealth grow faster than the growth of salaries of ordinary workers.
Piketty accordingly argued that governments should tax the wealthy on a progressive basis in order to arrest this situation. Furthermore this view found fertile ground in our Davis Tax Committee which consequently argued for massive increases in estate duty among other wealth taxes. Thanks to the Financial Mail, however, the work of Stellenbosch University PHD student Anna Orthofer disproving Piketty’s thesis in the South African context, has been brought to public attention and, more importantly, Orthofer’s supervisor and Stellenbosch economics department head Prof Stan du Plessis has found a receptive ear in Judge Dennis Davis whose work is expected to inform the future course of South African taxation.
What does all of this mean for ordinary investors like you and I? Well it is a globally accepted truism that investors who, through thrift and good financial management manage to accumulate investment nest eggs over the course of their lifetimes not only spare the State the responsibility for caring for them in their twilight years, but much more importantly contribute to the creation of a vital source of development capital that in turn speeds economic growth. It is for this reason that progressive governments worldwide have generally put in place systems to encourage such capital creation.
However, in South Africa in recent years there has developed a disturbing trend among our leaders to regard capitalism as an evil and capitalists as the enemy of the workers. Thus the entrepreneur who puts himself at great financial risk in order to create business opportunities and who universally represents the greatest single creator of employment is seen by many socialist thinkers as an undesirable exploiter of human capital.
With such thinking in government, it is hardly surprising that business confidence has plunged in recent years and now sits at an all-time low, paralleling the steady erosion of jobs. Officially there are 5.5-million people unemployed in this country, but this measure only counts people who have actively been searching for employment in the past month. It ignores those who have given up the unequal struggle and merely subsist on the state welfare grant. The actual figures are that of a working age population of 35.8-million, only 15.5 million actually have jobs out of a total population estimate to number 54-million. Thus, by practical deduction we can see that 38.5 million or 71.3 percent of South Africans are without work of which approximately half are adults who draw the dole; some 17-million who depend for their livelihood on the taxes paid by just 7-million taxpayers, of which 5.5-million pay 97 percent of all taxes. Add to this some 2.1-million state employees who effectively produce nothing in the sense of taxable products though representing approximately 40 percent of the tax base, and our economy begins to take on the complexion of a giant Ponzi scheme.
Not surprisingly then, in the face of these challenges, in the third quarter of this year, business confidence as measured by the Stellenbosch University Bureau for Economic research has fallen to a low of 38, which is the lowest figure since the last quarter of 2011 and should be compared with an average rate of 45.13 between 1975 and 2015
Fortunately however, we in South Africa have many world authorities who are keen to see us succeed as a democracy and so a series of “wise man” groups have visited us in recent years to study our unemployment problems and suggest solutions, all of which have been incorporated into the ANC’s economic development plan which has been widely hailed as an intelligent solution.
In essence it calls for major infrastructure spending which will jump-start the economy by creating jobs in the construction industry and creating new infrastructure on the back of which secondary industry is expected to boom. Secondly, it aims to increase the rewards and reduce the risks of entrepreneurial activity so that people with the necessary skills will be activated to take the chance of starting small businesses.
Why is this so important? Well to take the UK as an example, small firms currently account for 99.3 percent of ALL private sector businesses. Britain estimates that there are 5.2-million small businesses operating within its borders and they collectively employ 25.2-million people. The result; according to The Economist, Britain continues to add jobs—103,000 in the third quarter, smashing expectations—and unemployment is now 5.7%, down from 7.2% a year ago. Both the employment rate (73.2%) and job vacancies (718,000) are at a record high.
So what is stopping the ANC from getting on with its economic development plans? It’s anyone’s guess, but the popular view is that a leadership more interested in gouging percentages for themselves has been reduced to effective impotence as a consequence of internal bickering. Thus the only solution our leaders can see to growing public resentment is to keep on expanding the public service and signing ever greater numbers onto the dole. But lack of money is frustrating this objective and so the perceived solution is to tax the wealthy on an ever-rising scale. That is why the Government has so gleefully attached itself to Thomas Piketty. But the consequence would be the direct opposite of what is needed to get the economy on the move.
*According to the World Bank, the Gini index measures the extent to which the distribution of income (or, in some cases, consumption expenditure) among individuals or households within an economy deviates from a perfectly equal distribution. A Lorenz curve plots the cumulative percentages of total income received against the cumulative number of recipients, starting with the poorest individual or household. The Gini index measures the area between the Lorenz curve and a hypothetical line of absolute equality, expressed as a percentage of the maximum area under the line. Thus a Gini index of 0 represents perfect equality, while an index of 100 implies perfect inequality
Understanding the power of compound interest
by Richard Cluver
Increasingly these days I find myself talking to people who have never grasped the reality of what Albert Einstein described as the most powerful force in the universe.
Just in case you are one of them, the father of atomic fission argued at the end of his life that the greatest power in the universe was “compound interest. I always relate the story whenever I encounter folk who express concern about their financial future because I believe that it is one of life’s easiest problems to deal with. It requires only that you regularly invest a small proportion of your income in a growth investment, ideally in a vehicle offering the highest consistent rate of growth which, in my experience is blue chip shares
To illustrate the point, I then cite the story of the man who reputedly invented the game of chess in order to entertain the emperor of China. Supposedly, the emperor was so impressed that he asked the man how he could reward him. As the legend goes, the inventor of the game at first demurred, stating that his reward was seeing the delight of his emperor. But the emperor insisted and so the man said that he would be satisfied with a grain of rice on the first square of the chess board, doubling as he moved to each successive square.
Given that there are 64 squares on a chess board, you can try it for yourself’. As you can see it is impossible to get very far with this exponentiation and satisfying his promise reputedly bankrupted China.
Now, doubling your money annually is a very demanding challenge. However, Johannesburg Stock Exchange Blue Chip shares have over the past 20 years consistently increased in value at compound 25.2 percent and have delivered an average dividend of four percent making, with dividends reinvested, a total return of 29.2% as illustrated by my graph:
So let us replace rice grains with Blue Chips and grow the capital at that rate:
Noting that young graduates are starting work these days on around R200 000 a year, we assumed that in their first year at work they were to invest half that sum into JSE Blue chips and never saved a cent after that. As you can see, R100 000 grew to R1.3 million in ten years, to R16.8-million in 20 years and to R218-million in 30 years. But what if our graduate committed to saving R100 000 EVERY year for the rest of his working career. Well, after 10 years he would have achieved R4.4 million, after 20 years R61-million and after 30 years R795-million.
Meanwhile, a portfolio which I run for readers of my Prospects investment newsletter, is rising at 30.2 percent . We began with R1-million but only reinvest the dividend income so it is interesting to note that it is now worth R2.7-million after four and a half years and, if we were to add R100 000 a year to it, would be worth R69-million after 20 years and R972-million after 30 years.
Just thought you might like to know!
Why I don’t use stop loss positions
by Richard Cluver
Mr GJ wrote to me asking how I worked out my stop loss positions ahead of a share purchase and I imagine he was somewhat surprised to learn that I do not use them.
Having run numerous simulations, I am satisfied that no matter how smart a trader you are, you cannot make more money trading than you can from a long term Blue Chip share investment strategy. Given the average error rate and the fact that trader’s profits are taxed by the Receiver of Revenue at their marginal tax rates, trading is in fact a mugs game.
Just in case you do not understand stop losses, the concept loss is a theoretical price at which a trader would sell if he bought securities with a view to making a profit from a price recovery if, in fact the trade went against him. Thus, to provide a practical example, if he were buying a share that today stood at 100 cents, the average trader would make a note to himself to sell if the share price fell below 90 cents. In other words, a stop loss scheme assumes that if the trade goes wrong the most our trader will lose would be 10 cents. The usual stop loss calculation requires that you chart the share price and determine “resistance lines” by linking previous price turning points.
Now here is the important thing, the moment you apply a stop loss, you are declaring yourself to be a trader in the eyes of the Receiver of Revenue because you are in effect admitting that the purpose of your purchase was to make a profit. By selling on the dictate of a stop loss you are admitting that the trade failed to deliver a profit and so you are extricating yourself before the situation worsens. Note, this thinking applies even though, by acting on a stop loss you are likely to have made a loss on the transaction. And once the Receiver labels you as a share market trader, he assumes that EVERY share deal you do in future is a trade. Practically too, people who have been so labelled, find it almost impossible to persuade the Receiver to change his mind about ALL their future share transactions.
Now, for a moment let us consider the situation of the share market investor as opposed to the share market trader. The Receiver of Revenue defines an investment as action taken to provide yourself with an income stream. If the Receiver asks you why you bought a certain share and you respond that you expected it to grow in value over the years, he will argue that your purpose was trading even if you then held the share for 25 years (though he might have a hard time making that stand up in a court if you had indeed held it for that long). Ideally, however, an “Investor” invests money to achieve a constant dividend stream
Now let us consider the case of the share market investor. When he makes a purchase, the Receiver assumes he has done his homework very carefully and determined that the share he is buying represents a reputable company with a long history of delivering dividends that rise constantly at a rate that is usually better than the rate of inflation. Thus, when you buy as an “investor” you are by definition claiming that you believe you have paid a fair price for the share.
Now, no matter how carefully you have done your homework and no matter how you have studied the share price cycle, something might subsequently emerge which can lead you to believe that this investment is no longer as secure as you thought it to be. Thus you decide to sell in order to protect your capital. This will be regarded by the Receiver as a capital transaction and, if you have sold at a profit he will ask you to pay capital gains tax at a rate of 33.3 percent of the net gain which, you will quickly see, is more attractive than having to pay a 40 percent trading tax.
So how does the “Investor” deal with the vagaries of daily market sentiment changes? Well, recognising that the best time to buy is after a share price has fallen significantly as a result of a market bear trend, the problem is to determine when the trend is over. Here technical analysis helps and most investors today have a basic understanding of the techniques involved in making such a determination. For example, the artificial intelligence system built into my ShareFinder computer system has proved to be the most accurate market direction determinant available to investors delivering, over the past 12 months, an accuracy rate of 94.2 percent. Notwithstanding this accuracy rate, the implication is that one trade in every 20 will go wrong.
Happily, there is a very simple strategy for dealing with this error rate. This dictates that you divide your lump sum into two or three parts and make your first purchase. If the price subsequently falls you wait until you perceive that the decline has ended and then buy a second parcel and in turn a third parcel, thus averaging your way into the market. There is a minor drawback in adopting this strategy. First of all brokers charge on a sliding scale and so the most cost-efficient way to buy is in tranches of R100 000 or more and so by splitting your capital you might end up paying a bit more in brokerage, but you will enjoy the peace of mind of getting a low price average.
That, however, is why I do not bother with stop losses.
Thoughts from across the Atlantic
by John Mauldin
Retirement is every worker’s dream, even if your dream would have you keep doing the work you love. You still want the financial freedom that lets you work for love instead of money.
This is a relatively new dream. The notion of spending the last years of your life in relative relaxation came about only in the last century or two. Before then, the overwhelming number of people had little choice but to work as long as they physically could. Then they died, usually in short order. That’s still how it is in many places in the world.
Retirement is a new phenomenon because it is expensive. Our various labour-saving machines make it possible at least to aspire to having a long, happy retirement. Plenty of us still won’t reach the goal. The data on those who have actually saved enough to maintain their lifestyle without having to work is truly depressing reading. Living on Social Security and possibly income from a reverse mortgage is limited living at best.
Retirement is not nearly as attractive if all we can look forward to is years of sickness and penury. We are going to talk about the slow-motion train wreck now taking shape in pension funds that is going to put pressure on many people who think they have retirement covered. Please feel free to forward this to those who might be expecting their pension funds to cover them for the next 30 or 40 years. Cutting to the chase, US pension funds are seriously underfunded and may need an extra $10 trillion in 20 years. This is a somewhat controversial letter, but I like to think I’m being realistic. Or at least I’m trying.
Midwestern Train Wreck
Four months ago we discussed the on-going public pension train wreck in Illinois (see Live and Let Die). I was not optimistic that the situation would improve, and indeed it has not. The governor and legislature are still deadlocked over the state’s spending priorities. Illinois still has no budget for the fiscal year that began on July 1. Fitch Ratings downgraded the state’s credit rating last week. It’s a mess.
Because of the deadlock, Illinois is facing a serious cash flow crisis. Feeling like you’ve hit the jackpot through the Illinois lottery? Think again. State officials announced Wednesday that winners who are due to receive more than $600 won’t get their money until the state’s ongoing budget impasse is resolved. Players who win up to $600 can still collect their winnings at local retailers. More than $288 million is waiting to be paid out. For now the winners just have an IOU and no interest on their money (Fox).
As messy as the Illinois situation is, none of us should gloat. Many of our own states and cities are not in much better shape. In fact, the political gridlock actually forced Illinois into accomplishing something other states should try. Illinois has not issued any new bond debt since May 2014. Can many other states say that?
Unfortunately, that may be the best we can say about Illinois. The state delayed a $560 million payment to its pension funds for November and may have to delay or reduce another contribution due in December. Illinois and many other states and local governments are in this mess because their politicians made impossible-to-keep promises to public workers. The factors that made them so impossible apply to everyone else, too. More people are retiring. Investment returns aren’t meeting expectations. Healthcare costs are rising. Other government spending is out of control.
Nonetheless, the pension problem is the thorniest one. State and local governments spent years waving generous retirement benefits in front of workers. The workers quite naturally accepted the offers. I doubt many stopped to wonder if their state or city could keep its end of the deal. Of course, it could. It’s the government.Although state governments have many powers, creating money from thin air is, alas, not one of them. You have to be in Washington to do that. Now that the bills are coming due, the state’s’ inability to keep their word is becoming obvious.
Now, I’m sure that many talented people spent years doing good work for Illinois. That’s not the issue here. The fault lies with politicians who generously promised money they didn’t have and presumed it would magically appear later.On the other hand, retired public workers need to realize they can’t squeeze blood from a turnip. Yes, the courts are saying Illinois must keep its pension promises. But the courts can’t create money where none exists. At best, they can force the state to change its priorities. If pension benefits are sacrosanct, the money won’t be available for other public services. Taxes will have to go up or other essential services will not be performed. This is certainly not good for the citizens of Illinois. As things get worse, people will begin to move.
What happens then? Citizens will grow tired of substandard services and high taxes. They can avoid both by moving out of the state. The exodus may be starting. Crain’s Chicago Business reports:
High-end house hunters in Burr Ridge have 100 reasons to be happy. But for sellers, that’s a depressing number. The southwest suburb has 100 homes on the market for at least $1 million, more than seven times the number of homes in that price range – 14 – that have sold in Burr Ridge in the past six months. The town has the biggest glut by far of $1 million-plus homes in the Chicago suburbs, according to a Crain’s analysis.
“It’s been disquietingly slow, brutally slow, getting these sold,” said Linda Feinstein, the broker-owner of ReMax Signature Homes in neighbouring Hinsdale. “It feels like the brakes have been on for months.”
We don’t know why these people want to sell their homes, of course, but they may be the smart ones. They’re getting ahead of the crowd – or trying to. Think Detroit. I have visited there a few times over the last year, and the suburbs are really quite pleasant (except in the dead of winter, when I’d definitely rather be in Texas). But those who moved out of the city of Detroit and into the suburbs many decades ago had a choice, because Michigan’s finances weren’t massively out of whack.
I’ve been to Hinsdale. It’s a charming community and quite upscale. It is an easy train commute to downtown Chicago. Look at it this way: with what you know about Illinois public finances, would you really want to move into the state and buy an expensive home right now? I sure wouldn’t. That sharply reduces the number of potential homebuyers. The result will be lower home prices. I’m not predicting Illinois will end up like Detroit… but I don’t rule it out, either.Further, more and more cities and counties around the country are going to be looking like Chicago. Wherever you buy a home, you really should investigate the financial soundness of the state and the city or town.
Pension Math Review
Political folly is not the only problem. Illinois and everyone else saving for retirement – including you and me – make some giant assumptions. Between ZIRP and assorted other economic distortions, it is harder than ever to count on a reasonable real return over a long period. Small changes make a big difference. Pension managers used to think they could average 8% after inflation over two decades or more. At that rate, a million dollars invested today turns into $4.7 million in 20 years. If $4.7 million is exactly the amount you need to fund that year’s obligations, you’re in good shape.
What happens if you average only 7% over that 20-year period? You’ll have $3.9 million. That is only 83% of the amount you counted on. At 6% returns you will be only 68% funded. At 5%, you have only 57% of what you need. At 4%, you will be only 47% of the way there.
This math works the same way no matter how many zeroes you put behind the numbers. Each percentage point of return makes a huge difference. Missing your target just slightly can have big consequences. Keep in mind these need to be real, after-inflation returns. Inflation is not a problem right now. How much will you bet that it will stay under control for the next two decades? You might be right – and then again you might be wrong, so you really need to aim even higher. Retirement incomes are not something that should be gambled with.
Pension managers know this, of course. The National Association of State Retirement Administrators has some good data on its member’s activities. Their Public Fund Surveyhas data on public retirement systems covering 12.6 million active workers and 8.2 million retirees and beneficiaries. At the end of FY 2013 (the latest data they show), members had $2.86 trillion in assets. That is about 85% of all state and local government retirement assets. This data is comprehensive, though a little outdated. The average public retirement system funding level in FY 2013 was 71.8%. That number has been trending steadily downward since the survey began. In 2001, it was a healthy 100.8%.
This is not a good trend. What is the problem? Here is how NASRA explains it.
Figure B [shown above] presents the aggregate actuarial funding level since 1990, measured by Standard & Poor’s from 1990 to 2000 and the Survey since 2001. This figure illustrates the substantial effect investment returns have on a pension plan’s funding level: investment market performance was relatively strong during the 1990s, followed by two periods, from 2000–2002 and 2008–09, of sharp market declines. Other factors that affect a plan’s funding level include contributions made relative to those that are required, changes in benefit levels, changes in actuarial assumptions, and rates of employee salary growth.
The average state and local retirement system can pay only roughly 72% of its obligations as of now. That means state and local governments need to come up with an additional $1 trillion or more. Some states, of course, are 100% funded. Some have barely half the needed funding. That is a lot of money for financially strapped states to come up with. I can’t think of any reason to believe the situation will get better. I can imagine quite a few scenarios in which it will get worse.
Looking at the assumptions, the median plan in the Public Fund Survey assumed 7.9% annual investment returns and 3.0% inflation. The average asset allocation was 50.7% equities, 23.2% fixed income, 7.2% real estate, and 15.1% alternatives, with the rest in cash and “other.”
I’ve played with those numbers using what I think are reasonable return expectations. I can’t find any combination that would bring the real return after inflation up to the 5% area that the plans need. That means the 71.8% funding ratio is too optimistic. It is somewhere below that level. How far below? We’ll know in 20 years. (We will look at some scholarly projections of future portfolio potentials in a moment.)
If you are a state or city worker in one of these severely underfunded systems, or a recently retired one, now is an excellent time to develop your Plan B. Your chance of getting the full amount you were promised is somewhere between slim and none. The money simply isn’t there.
Private Plans No Better
If you are a corporate worker and think your plan is better than those managed by politically driven bureaucracies, you may want to rethink your position. First, you should (probably) thank your lucky stars if you have some kind of defined benefit plan. Such plans are an endangered species outside of government and union-run plans. Most workers now are lucky to get a 401K that shifts responsibility off the company’s shoulders and onto theirs.
On the off chance that you do have a defined benefit pension, on average that pension plan is likely to be in the same boat as the governmental plans discussed above. Actuarial firm Milliman, Inc., tracks these plans and has a handy “Milliman 100 Pension Funding Index.” It tracks the 100 largest corporate defined benefit plans.
As of September 2015, Milliman data shows these 100 plans had a funded percentage of 81.7%. They are collectively $312 billion below where they ought to be. This is actually better than where they began 2015. The chart below shows this figure monthly since 2010.
The dotted lines are Milliman’s optimistic, baseline, and pessimistic forecasts. The baseline scenario’s expected rate of return is 7.3%. I would call that excessive, for the same reasons we will discuss in a moment. I think their optimistic 11.3% return is very unlikely to pan out, and the pessimistic 3.3% is not pessimistic enough.
In short, the suggestion I made for public workers applies to private workers, too. If you don’t have Plan B, start working on one now.
Central Banks Print Money – Pension Funds Assume Money
Pension fund boards are typically populated by political appointees and representatives from the various pension groups. In an effort to make sure they are making realistic projections (and after they have been on the board for a few months, when they understand how serious the task is), they hire outside consultants. The pension-consulting gig is lucrative and very competitive. It is also quite political.
It is political because the assumptions you make about your future returns directly affect state and city budgets. Typically, states require themselves to “dollar-cost average” their funding over time so that pension funds stay fully funded. If you reduce the future returns you expect to make on your investments, you increase the amount of present-day funding needed from the various government entities.
The average pension fund is 71.8% funded. But that’s assuming high returns. What are returns actually likely to be? Let’s look at a few estimates by professionals. First, the folks at GMO annually make a seven-year real return forecast. This is the one from the end of last year:
Note that US stocks are projected to produce negative returns. US pension funds are heavily weighted to US markets. Even adding in developing-market equities would still leave you with negative returns. I highly doubt that any pension-fund consultant would suggest that their clients aggressively overweight emerging-market equities. Now, look at the returns for bonds. This forecast would suggest that, over the next seven years, returns will be negative for the balanced portfolios that most pension funds have. If GMO is correct, pension funds will require significant state and local funding to make up the difference, .
The Macro Research Board (MRB) recently developed a total portfolio forecast for dollar, euro, and pound sterling portfolios. They made detailed forecasts for equities, bonds, currencies, and commodities, taking into consideration inflation and global growth. These are guys I take very seriously, as their forecasting methods are rigorous. Let’s go straight to their 10-year forecast.
The average US pension fund, according to the data above, can expect returns somewhere between MRB’s balanced and aggressive portfolio projections. That suggests positive real returns of around 3.6% for US pension funds – a far cry from the almost 6% that most funds are projecting and nearly two full points lower than many pension funds are currently anticipating. MRB’s projections mean that today such funds actually have only 68% of what they need to be fully funded in 20 years.
Do you think MRB’s forecasts are pessimistic? Actually, the assumptions they make and their projections are more generous than the ones I would make and also exceed the more conservative GMO assumptions. I could go tick off a whole host of reasons why I think growth is going to be slow (though not fall off the cliff), but there isn’t enough room today. Suffice it to say that I still believe in my Muddle Through economic scenario.
But since funds are already funded at only about 72% of what it would take to pay promised benefits to retirees, the math means that funds have less than 50% of the money they need currently in their accounts. Since funds have $2.86 trillion (give or take), then no matter how you slice it, pension funds are underfunded today by about $2 trillion, if you assume MRB’s projections are correct. Since pension funds are forecasting that they will grow their funds almost fivefold, that means a future shortfall in the neighbourhood of $10 trillion, which during the intervening time is going to have to be made up from tax revenues.
Of course, I made a lot of assumptions in the preceding paragraph. What if states decide to aggressively start making up the shortfall? That would certainly reduce the ending deficit. There are other factors that could positively affect returns as well. This is certainly a back-of-the-napkin estimate; but if I am wrong, it is only in the final destination and not in the direction of the problem. Pension funding is going to be a huge burden on government budgets everywhere, in a time when they are already strained.
On top of that, add in the cost to the government of Social Security and other entitlements. Further compounding the problem, as I demonstrated over the past two weeks, is the very real potential that the average person retiring today will live 10 years longer than actuaries currently predict. Various estimates say entitlements in the US will run to the tune of $80 trillion over time. And the situation is just as bad in Europe. In fact, many countries in Europe are in worse shape than the US.
You’re On Your Own
There are no easy answers for individuals here. I think more and more potential retirees will find it necessary to continue working. Further, you should plan on living a great deal longer than you probably assume in your current financial plan. And unless your financial manager is a wizard, you should seriously think about what kind of returns she can produce for you and what level of withdrawals you can actually afford. The 5% annual withdrawal that many financial planners use in their models is simply not realistic in today’s low-yield world.
Making sure you have enough money for your retirement, whatever that looks like, is very serious business. It is okay to hope that governments figure it all out and can send you your pension and meet their other obligations. But hope is not a strategy, just as denial is not a river in Egypt. We (and I do include myself here) need to be very realistic about the assumptions we are making for returns and what our future retirement portfolio values will be.
I Can Feel Your Presents
By John Wyn-Evans*
At an event last week I was formally wished a “Merry Christmas”. Now I know that I wasn’t going to see this chap again until next year, and I have also heard that West End stores are already playing festive songs, but even so it all felt a bit premature – it was still British Summer Time for goodness’ sake!
And yet, even as Noddy Holder is only beginning to clear his throat, some early presents have been delivered (or at least promised) to investors.
We have being going through a period where investors have not been sure whether bad economic news is actually bad news or good news – bad news because the implications for corporate profits are negative; good news because it means that monetary policy will be loosened further (although quite by what means is debatable). Last week two central banks got the wrapping paper out early. First we had Mario Draghi, the president of the European Central Bank. At Thursday’s press conference he reiterated the threat to growth from external factors such as weak emerging markets and commodities and said that monetary accommodation would be re-examined at the December meeting. The market took this as a broad hint that Quantitative Easing will be extended and/or expanded, and possibly that interest rates will be cut further. Cue a near 3% rally in European equities on the day, with the German 10-year bond yield heading below 0.5% for the first time since May.
Next up was the People’s Bank of China. On Friday morning it announced the sixth cut in interest rates in the last year to 4.35%, with official deposit rates falling to 1.5%. It also reduced the level of reserves that banks have to hold against their loans. Again markets reacted positively. There are also high hopes that the Bank of Japan will loosen policy further when it meets at the end of this week. There are two forces at work here. First of all stimulus to the Chinese economy raises the prospects for global expansion owing to the fact that China is currently responsible for about a third of the world’s growth. That’s good for company profits. Second, lower interest rates and bond yields continue to force investors to take greater risks in search of returns and income. This has been at least in part the central banks’ agenda since 2009, although it remains questionable just how much the inflation of asset prices has boosted economic activity. However, the problem with opening presents early is that Christmas Day itself can be something of an anti-climax. Could that be the case for markets?
It is worth reminding ourselves that today’s share (or bond) price is the net present value of many years of future cash flows, dividends and coupons. That value is derived from the (hopefully) risk-free rate of return of high quality government bonds, or the discount rate. All other things being equal, which they rarely are, a lower discount rate leads to a higher valuation for riskier assets. However it doesn’t necessarily mean that the company (and certainly not the bond) will generate higher cash flows over the lifetime of the investment, so a higher valuation often implies a lower long-term return. I have described this before as converting tomorrow’s income into today’s capital gain – great if you have the capital gains in the bag, but not so good for the future.
One feels that there is only so far that risk assets can be buoyed by liquidity and lower rates, although it is pretty much impossible to calculate the point at which investors lose their nerve, so everyone stays on board before something triggers an unseemly rush for the exit as we saw in August. This makes for continued volatility at current market levels, although we continue to believe that the underlying trend remains upward.
The reporting season is in full flow this week. Of interest will be the Oil sector, where BP, RD Shell, Total (Thurs) and BG Group (Fri) all report. All the majors have cut back on investment and trimmed their sails to suit the low oil price environment, and it will be instructive to see how they are coping, and especially how sustainable dividends are. Shell yields a prospective 7%, for example. Banks are also to the fore, with Lloyds (Weds), Barclays (Thurs) and Royal Bank of Scotland (Fri) due to provide updates. Rehabilitation definitely continues and if these beasts can turn themselves back into dividend paying utilities they could potentially be attractive investments again. On the economic front, I wouldn’t normally highlight German Retail Sales (Friday), but Europe needs a confident Germany and there has been some evidence of slower activity after the summer’s market wobble and the VW affair. The big (non-) announcement of the week will be the US Federal Reserve’s interest rate decision on Wednesday evening. Almost zero chance of a rise, but the accompanying statement will be all important.
(Just in case you were wondering what the title was about… Obi Wan Kenobi says to Luke Skywalker on Christmas Eve: “Luke, I know what you are getting for Christmas”. Luke: “Obi Wan, is this because of your great gift of intuition?” Obi: “No, Luke. I have felt your presents.” I’ll be sticking to the day job…)
*John Wyn-Evans is Head of Investment Strategy at Investec Wealth & Investment UK.
Notes from the Asylum
By Jared Dillian
Now on to today’s topic. You probably heard that Dreamy McDreamerson is the new Canadian prime minister, opening a can of Canadian whoop-ass on Harper. Here is the crux of it.
Harper, in some ways, had an accidental 10-year reign. Canada is about 60% left-wing and 40% right-wing, but has two left-wing parties (the Liberals, who are center-left, and the NDP, who are allegedly far left) that have been splitting their votes in every election. Canada is slipping into recession, and Harper, sort of a Canadian Sean Hannity, has worn out his welcome over time with his hawkishness/paranoia.
Going into the election, people were talking about the idea of “strategic voting.” There was a dominant theme of Anybody But Harper, so it was just a matter of whether the votes would go to the Liberals’ Trudeau or the NDP’s Mulcair. Trudeau, who had been languishing throughout the campaign, had a late surge, and everyone piled on, driving him to not only victory, but a parliamentary majority.
Now what?
Trudeau, I think, is a little further left than people give him credit for, with a clear authoritarian streak. Aside from legalizing marijuana (which has everyone all revved up), Trudeau’s other concrete proposal is to intentionally run a deficit by raising taxes (on the rich) and spending even more money on infrastructure.
Classic Keynesian stuff, countercyclical fiscal policy. Theoretically, Canada is in recession, but it has been pretty mild so far, and if Trudeau wants to build a few dozen bridges between Vancouver Island and mainland B.C., I can’t imagine what’s going to happen when Canada slides into a deep depression.
Actually, I can. Canada’s budget—which is basically balanced—will, in a few years, reach a deficit of 10% of GDP.
That’s not good for the Canadian dollar, which has been in a two-plus-year bear market. And I am aggressively shorting it.
Trudeau has a reputation of being somewhat of an empty suit, a know-nothing—and these are the sorts of things that his own supporters acknowledge. Canadian investors have told me privately that they believe this outcome to be even worse than if Mulcair had been elected, which is really saying something.
The CAD has been basically unch (trader talk for “unchanged”) over the last two days, leading the FX reporters at the news bureaus to report that international capital flows don’t seem to be fazed by the Trudeau election. Maybe not in the short term, but certainly in the long term.
Model D for Done
I’m a huge Elon Musk and Tesla fan, but there is trouble afoot.
The Model X was unveiled, and it is proving to be a disappointment.
· The base price is $80,000-$90,000, but to get the car you want, most people are going to have to pay $130,000.
· It’s essentially a minivan.
· Nobody is going to pay $130,000 for a minivan.
· It’s a cool minivan, but it’s still a minivan, just with fancy doors.
· On top of it all, they delivered it two years late.
If you’re TSLA, with a $30 billion market cap, with zero earnings as far as the eye can see, and a very fragile valuation case, you can’t do these sorts of things. This is a strategic screw-up. But with maybe a different word instead of “screw.”
Then, a week later, Consumer Reports comes out and says that Tesla cars are not especially reliable.
Down goes Frazier.
The bull case on TSLA is not that the cars are electric. Nobody cares that the cars are electric. People like Tesla because the cars are awesome and the engineering is spectacular.
But if the cars really aren’t awesome, as Consumer Reports alleges, that kind of kicks out the one remaining bullish leg of the chair.
Whenever I talk about being bearish on TSLA, people usually tell me that Tesla is worth something to someone and will get bought eventually. By whom? At what price? Can you think of a scenario in which Elon would sell? Things would have to be pretty dire.
So there is a lot more downside, potentially.
The chart looks like death, and there is a confluence of bad news. This stock was a short-murderer for years. Not anymore.
The Pace of Medical Innovation
My wife and I were watching TV last night and the Opdivo commercial came on—the lung cancer immunotherapy drug by Bristol-Myers Squibb (I am the unhappy holder of the stock, which hasn’t done much in the last 6 months).
Yes, Opdivo is the first FDA-approved immunotherapy drug. It is essentially a cure for cancer, although they can’t really say that on TV. They say that it lengthens your life… yeah, by curing cancer!
All kinds of biotech companies are working on immunotherapy treatments. There are about 300 different kinds of cancer, and each one needs an individual cure.
In my lifetime (assuming no whammies, which we will discuss in a second), getting cancer will be little more than an inconvenience. Incredible.
As you know, health care and especially biotech have taken a massive hit over the last three months. In the case of biotech, it was about a 30% drawdown.
And if you were paying attention, you know that was because there is an increased focus on drug pricing. Hillary Clinton proposed outright drug price controls on the campaign trail, and the entire health care sector took the Metamucil.
Prices are signals. The reason we are getting all these great drugs is because… prices are high! People are incentivized to find cures for stuff. Some people have this idea that cures for cancer should be developed by these Jonas Salk-type lab rats toiling in anonymity, out of pure altruism, but that isn’t how it happens.
My moral compass says that anyone who develops a cure for something that cures a bazillion people should get to be a bazillionaire.
Lots of people knock on Obamacare, but mercifully, it leaves intact (mostly) the price signals that allow the drug market to function. We go to single-payer—no more fancy drugs. The pace of medical innovation drops to zero.
I’m still bullish on health care, but you can’t put the drug price genie back in the bottle. This will be a topic of conversation throughout the campaign. Expect tape bombs galore.
The Wall
By Jawad Mian
Pink Floyd’s The Wall is a musical milestone unlike any other. The album’s highly acclaimed release in 1979 was followed by an imaginative tour in 1980-81 and a visually intriguing movie in 1982 of the same name.
The songs trace the tortured life of Pink, a fictional protagonist modelled on band members Syd Barrett and Roger Waters. The storyline begins with his fatherless childhood, domineering mother, and abusive school teachers. Events lead him to become a rock star, only to feel jaded by the superficiality of stardom.
To live free from life’s emotional pain, Pink begins to build a mental wall between himself and the world. Every personal wound is another brick in his wall of exile. As his wall nears completion, spurred by the revelation of his wife’s infidelity, he convinces himself that his self-imposed isolation is a desirable thing.
At first, the gathering of bricks seemed fairly innocent. Now, all that’s left is a giant wall that encloses him from all sides. Pink, unable to arrest his frenzied mind, spirals into insanity.
Tell me,
Is there anybody out there?
Never thought that I would end up all alone,
Everyday I’m feeling further away from home,
I can’t catch my breath,
But I’m holding on.
In the wake of emotional destruction, the gravity of his life’s choices sets in.
Source: Pink Floyd
This has been a tremendous bull market in stocks. Yet, people still remember what happened during the early 2000s and 2008. Having lived through that period, most of us fear a repeat and will do everything possible to avoid it. In this “avoidance process,” we built a wall of mental detachment to cope with bear market-inflicted wounds.
While the wall helped temper our emotions to the market’s gyrations, it further severed our understanding of the rapidly changing investment environment. In the last six years, the common investor (let’s also call him “Pink”) has missed a lot of opportunities as a result.
With the self-deluding rationale that this time is different, the metaphor of “the wall” makes its first appearance after the spectacular tech crash in 2000. The wall is a defence mechanism that renders Pink comfortably numb to his own mistakes. With bitter satisfaction, he continues his hopeful journey.
It was just before dawn,
One miserable morning in black September ‘08.
Dick Fuld was told to sit tight,
When he asked that his bank be bailed out.
The Fed gave thanks, as the other banks,
Held back the enemy tanks for a while.
And Lehman Brothers was held for the price,
Of a few thousand ordinary lives.
It was dark all around,
There was frost in the ground,
When the tigers broke free,
And no one survived.
The 2008 meltdown etches an indelible mark on Pink. He resigns from the cruel investment world, watching with scepticism and disdain as the market is rescued by the central bankers’ dirty tricks. You can hear him yell out from a lonely bend, “Hey! Central Banker! Leave the markets alone!”
All in all, it just leads to another brick in the wall.
The US housing bust, European sovereign debt crisis, Japan’s deflation demon, China’s hard landing, the commodity crash, and currency wars are all bricks in his ever-growing wall. Every financial wound leads him to drift farther from reality. The more he blocks out the world and retreats into his own ideological biases, the worse off he becomes.
Years of oppression lead to full revolt against manipulated markets. He rebukes central bankers, who he blames for molding freethinking investors into mindless followers. He is eventually typecast in the role of the fear mongerer.
His wall looms so high that it blocks sight of the macro landscape. He can only see the ominous writing on the wall, because the bricks are constant reminders of the kind of pain that markets can inflict.
Pink is left desolate, still waiting for retribution, and completely cut off from the investment world. He feels abandoned by the stock market (too little, too late)…
People keep thinking that we are stuck in a secular bear market and that another lurch down into the abyss is just around the corner. This “availability heuristic” helps explain the abnormally large “wall of worry” that still persists.
The lesson here: we can’t run our portfolio as if a repeat of 2008 is all but certain. Those who did missed this wonderful bull market.
And investors who remain fixated on the ghosts of the deflationary past can’t embrace the possibility of a major secular change.
Tear down the wall!
Tear down the wall!
Tear down the wall!
Investment Observations
It has been my experience that a standard obstacle to maintaining an objective investment stance occurs when we inflexibly adopt a preconceived idea of where the market is headed. This happens all the time. People are slow to change an established view. Everywhere we see signs of confirmation bias – investors overweighting evidence that confirms their prior notions and underweighting evidence that contradicts it.
With Stray Reflections, my trick is simple. I try not to take my eye off the bigger picture and take advantage of the fact that others have. With eyes wide shut, most investors simply don’t expect to see what they are not looking for. I want so much to open your eyes. As per Helen Keller, the only thing worse than being blind is having sight but no vision.
In this Outside The Box, I present my investment outlook and key asset allocation recommendations. I sense a wave of scepticism about the global macro landscape, leading people to underestimate the gains and overestimate the risks.
Riding Out The Deflation Scare
The recent market volatility has been disconcerting, but it does not impact the big picture or my pro-growth investment stance on a 6- to 12-month horizon. It is important to stay focused on the macro themes that are likely to prove durable.
There are compelling signs that we are nearing the end of a valuation-driven correction rather than morphing into a prolonged bear market. While the technical damage has been severe, most markets have maintained uptrends and are still holding above key support levels. I am encouraged by the market’s basing action since the August 24th volatility spike, and suspect the correction lows are already in place.
The late-September decline had all the hallmarks of a successful retest, which is defined by positive divergences (new lows in some benchmarks not confirmed by others) and less selling pressure (lower volume and volatility during the retest). Even if we were to see more downside near-term, I feel confident that the worst of the correction is behind us. The NYSE short interest is at the 2nd highest level ever, which implies that any further selling will be contained.
Source: Barchart.com
Much ink has been spilled over the merits and impact of a Fed rate hike on global markets and the world economy. To my great chagrin, the warnings by some luminaries have bordered on fear mongering, with a chorus among them even calling for QE4.
I find myself in vehement disagreement with this policy prescription. I firmly believe economic conditions in the US, as well as globally, necessitate a December rate hike. The world doesn’t need further stimulus. It needs leadership.
We have reached the point in the investment cycle where the Fed must inspire investor confidence by normalizing policy. Growth conditions are becoming increasingly self-reinforcing, and do not require ultra-accommodative monetary policy.
The household debt-to-income ratio is back to its 2002 level; business confidence has healed; credit is growing at a healthy pace; auto sales are at 10-year highs; construction spending is rising at the fastest pace since 2006; and unemployment claims recently hit a 42-year low.
A Fed rate hike should reinforce the signal that the US economy is in a durable expansion and that macro risks are diminishing rather than intensifying. If Yellen keeps delaying the rate hiking cycle, the equity correction will worsen. Fed dovishness is no longer a reason to be bullish on stocks.
Historically, US stocks have corrected about 10% around the start of the last three Fed-tightening cycles (1994, 1999, and 2004). In our current experience, the correction looks front-loaded, with the S&P 500 down 13% ahead of the Fed’s lift-off.
I am convinced the much-anticipated Fed rate hiking cycle will prove to be bullish for global stocks. The most-discussed risks are often not the ones that end up being influential.
Once the US leads the global policy rate cycle, the discussion and pressure to dial back central bank aggression will emerge in even more countries. That said, major central banks would lag behind the growth curve and maintain a reflationary bias, which is ultimately beneficial for stocks, to the detriment of government bonds in general. The global stock-to-bond ratio should rise as a result.
A Whole New World
There is no shortage of things to worry about, but global growth conditions are currently improving rather than deteriorating. While the manufacturing sector has been uninspiring, it is worth noting that global services PMIs are still expanding. The services industry is far more important to the health of the world economy as it represents around 75% of GDP in the US, Europe, and Japan. Even in China it has now become the major driver of growth and accounts for a record half of GDP. The global economic recovery may pale by historical standards, but it is now on a much better footing than in previous years.
Source: J. P. Morgan
Europe’s economic turnaround is still in its early phase. The combination of a weaker euro, increased bank lending to the private sector, less fiscal austerity, and lower oil prices should yield a positive growth surprise over the coming year. The improvement in the credit cycle will also feed through to core inflation and unemployment, with a lag. Although the euro area unemployment rate is at 11%, hiring growth has been strong and employment posted the largest rise in four years during the second quarter.
German unemployment is around post-reunification lows, and real wages are growing at the fastest pace in more than 20 years. This is an essential part of euro area rebalancing that should support growth in neighbouring countries by way of a competitive boost. The Spanish labour market has enjoyed its best year since 2007.
A spate of recent economic data has once again raised the spectre of Japan falling through the deflationary trapdoor. Missed in the reporting is that core inflation (which excludes both food and energy) is still accelerating, reaching 0.8% in August. The broadest measure of inflation, the GDP deflator, has been positive for the past five quarters. This has not happened for 20 years. I believe deflation is in the process of ending in Japan.
For Abenomics to deliver on its promise in the long run, there must also be a sustainable transfer of wealth from the corporate sector to the household sector. There are some indications this may happen. The 3.4% jobless rate is the lowest since 1996, while the job offers to applicants ratio is at its highest since 1992. Although recent wage gains have slowed, such labour market tightness suggests this will only be temporary.
The consensus view that Chinese growth has cratered, which set off the surprise currency “devaluation,” is wide of the mark. Although China’s manufacturing PMI has steadily worsened, hard data from industry does not point to a deeper crisis. In fact, Chinese economic activity should strengthen in response to past easing and growth-friendly initiatives. The property market is already rebounding and fiscal stimulus is picking up. Despite the prevailing market narrative – with Chinese hard landing fears at an all- time high – consumer confidence in China continues to rise.
China’s slowdown is nothing new and should be taken as a sign of success, not angst. China’s per capita income (at around $12,000) has reached a level similar to Japan’s in the 1970s and Korea’s in the 1990s, after which both countries saw their growth rates gradually but steadily come down. As China gets richer and the economy rebalances toward services and consumption, its growth will also keep slowing. That said, even at a much slower growth rate, China’s contribution to global growth (at around 1%) will remain the same as during its heady days in the early 2000s because it’s own economy is so much bigger.
The Fed is also not a real threat to emerging markets (EM). EM risk assets have typically faced a major setback when the Fed is actually cutting rates, not hiking. Rather than Fed policy, it is shifting domestic fundamentals that largely explain the fluctuations in EM stocks, bonds, and currencies in the medium and long term.
As there is little indication that policymakers are prepared to introduce the pro-market reforms necessary to reverse the secular decline in productivity and potential GDP growth, EM economies will continue to suffer and defaults will inevitably rise. That said, I don’t expect financial stress in the emerging world to snowball and threaten the global economy and financial system as it did in the past.
EM currencies have been in a downtrend for over four years, investors have shunned EM stocks since 2013, and global banks that have made loans face far tougher regulations and are generally better capitalized. A Fed rate hike will not lead to a disorderly carry trade unwind, an EM debt crisis, and another global recession. Although EM external debt is back to mid-1990 levels, it has declined as a share of GDP, and EMs are less exposed to currency mismatch risks than they were in the 1990s.
Previous Fed rate-hike cycles (1994, 1999, and 2004) have also coincided with an improvement in global trade flows. As the trade cycle regains strength, EM risk assets should recover.
Why