Author Archive for Niels Jensen

A Century of Policy Mistakes

By Niels Jensen, Absolute Return Partners

There are four types of countries: the developed, the underdeveloped, Japan and Argentina.”

– Simon Kuznets, Nobel Laureate

When Archduke Franz Ferdinand and his wife Sophie were assassinated in June 1914 whilst visiting the city of Sarajevo, little did the people of Argentina realise what would follow. Not only did it mean four years of death and devastation in Europe but, for the good people of the Pampas and beyond, it would also mark the beginning of a very long slide from riches to rags.

It is not my intention to pick on Argentina; however it represents a unique opportunity to analyse and understand the long-term consequences of policy mistakes. In the case of Argentina, the fact that the ruling classes were kleptocrats didn’t exactly make the situation any better.

Don’t cry for me Argentina

Now, before you accuse me of having converted to the philosophy of Karl Marx, consider the following: A century ago Argentina ranked as one of the wealthiest countries in world, behind the United States, the United Kingdom and Australia but ahead of countries such as France, Germany and Italy. Its per capita income was 92% of the G16 average; it is 43% today. Life in Argentina was good. It enjoyed the benefits of one of the highest growth rates in the world and attracted immigrants left, right and centre. Boom times galore.

Argentina’s wealth was based on agriculture, but also on its strong ties with the UK, the pre-World War I global powerhouse. Equally importantly, it understood the importance of free trade and took advantage of the relatively open markets which prevailed in the years leading to the Great War. Most importantly, though, it benefitted from, but also relied upon, enormous inflows of capital from the rest of the world. All of this is well documented in a recent piece in The Economist which you can find here.

However, World War I changed all of that. The British Empire began to lose its gloss during the period that followed. The depression of the early 1930s effectively put an end to the free trade system which Argentina relied so much on and, critically, foreign investments dried up. These factors alone do not fully explain Argentina’s demise, though. The misery was amplified by a series of policy mistakes. At the most basic level, it failed to educate its children. For a country of such wealth, it is an embarrassing fact that it had a much lower literacy rate than its peers. The land owners provided primary education but little or nothing beyond that. They had no real interest in doing so, and the government did nothing to change it.

In the post war years, as the rest of the world reduced its reliance on commodities and became more and more industrialised, Argentina got stuck in the old system. Having failed miserably to use its wealth to develop other industries, its over-reliance on commodities eventually caught up with them. Furthermore, post-World War II, as the rest of the world began to open its borders again, under the leadership of Peron, Argentina chose to go the other way and became more and more closed. A succession of military coups beginning in 1930 didn’t really help its course either.

More recently, decisions seemingly designed to please the uninformed, but having the effect of peeing off the rest of the world (such as the decision to boot Repsol out of the country), haven’t exactly done their standing in the international community any good either. All in all a fairly capacious catalogue of policy mistakes. No wonder foreign investors are not lining up to invest in the country today.

Enough about Argentina. After all, I will be going there for the very first time a few short weeks from now, and I don’t want to be turned away at the border!  Sitting here in the relatively cosy surroundings of Southern England (if it weren’t for the flooding), it is tempting to conclude that we are smart enough to avoid the sorts of problems that have dragged Argentina down over the past century. At the same time, that is probably the most uneducated, and certainly the most dangerous, conclusion to reach. Time and again we have seen our political leaders demonstrate that they have spines no stronger than that of boiled spaghetti. Business partner and good friend John Mauldin often jokes that politicians are like teenagers. They opt for the easy solutions until there is no other way out. Only when their backs are firmly nailed against the wall, will they make the difficult choices. Sadly he is spot on.

The challenges facing Europe

Here in Europe we face at least two massive challenges over the next decade or two, and how they are handled will probably determine the welfare path in our part of the world for many, many years to come. At the moment our political leaders largely ignore both of them.

At the most basic level, economic growth is driven by population growth and improvements in productivity – i.e. how many people are there in the workforce and how much can they produce? Simple as that. Whilst productivity can, and does, vary modestly, the size of the workforce can be predicted many years out with only limited uncertainty. It is therefore possible to establish relatively precise long-term growth expectations based on demographic models. That is precisely what our friends at Research Affiliates have done (chart 1).

The picture is worrying to say the least. Most countries will be facing significant headwinds from demographic forces in the decades to come. Now, as many people ask me when I bring up this issue, why is economic growth so important? Couldn’t we all live happily in a low – even zero – growth environment? After all, isn’t Switzerland a prime example that you don’t need much economic growth to stay rich? (Switzerland has enjoyed one of the lowest growth rates in the world over the past couple of decades, yet it is one of the most prosperous.)

I have several problems with that argument, the first one being how expectations are managed by the political leadership. Precisely because the political establishment is a profession dominated by moral pygmies and mental midgets (Bertrand Russell’s words, not mine), policy makers won’t have the nerve to tell the truth, meaning that the current climate of debt financed consumption – whether in the private or public sector – could quite conceivably continue until it collapses under its own weight. As pointed out in a somewhat more diplomatic tone by the authors of the Research Affiliates paper:

“If we expect our policy elite to deliver implausible growth, in an environment in which a demographic tailwind has become a demographic headwind, they will deliver temporary outsized “growth” with debt-financed consumption (deficit spending). If we resist the necessary policy changes that can moderate these headwinds, we risk magnifying their impact.”

Chart 1:  Forecasts of Economic Growth Based on Demographic Forces



Source: Research Affiliates, Mind the (Expectations) Gap, June 2013.

The second issue I have with the Switzerland argument has to do with the absolute level of debt which continues to rise despite all the talk about austerity. In simple terms, the higher the overall level of debt, the more economic growth one needs to service that debt. The debt trajectory in some of the largest countries in the world is nothing short of frightening, yet we continue to pile on more debt (chart 2). The projections provided by the Bank for International Settlements are quite obviously meant as a stark warning to politicians around the world. Do nothing and this is what will happen. You should be aware that the projected rise is a function of changing demographics; more specifically the result of the entitlement programmes that are currently in place. An end to the crisis environment we have been in since 2008 will not change the path, only the steepness of the curve.

Chart 2:  Long-Term Sovereign Debt Projections



Source: Bank for International Settlements

It is pretty obvious that something will have to give. Otherwise we will end up in a situation where only a modest rise in interest rates could destroy entire countries. So, when Switzerland has been able to maintain its high living standards despite it sub-par growth path, it is at least partly down to the fact that the country, unlike most, is not heavily indebted.

The third reason Switzerland is a poor proxy for the rest Europe is the massive difference in youth unemployment. Whereas in Switzerland it is hovering around 8%, youth unemployment in the Eurozone is now 25%. Even though I have some issues with how the EU calculates youth unemployment (they back out students from the overall youth population which has the effect of dramatically reducing the denominator) there is no denying that Europe is facing an unemployment crisis of gigantic proportions.

We are at great risk of losing an entire generation of people to permanent unemployment which is nothing short of tragic. Rapid economic growth (in the range of 3-5% per annum) over an extended period of time would probably be required to bring most of these people back into the workforce but, for the reasons outlined earlier, it simply isn’t going to happen; however, that should never be used as an excuse to do nothing.

There are solutions

The single most potent pro-growth policy tool is deregulation. Deregulation of labour markets first and foremost but also of products markets, in particular across borders. Policy makers in North Carolina removed long-term unemployment benefits last summer. Since then the rate of unemployment has plummeted from over 11% to less than 7% (chart 3). Obviously the downward path has benefitted from an overall decline in U.S. unemployment and probably also from many people dropping out of the workforce altogether as a consequence of the loss of benefits, but the effect has been significant nevertheless.

Chart 3:  Unemployment in North Carolina less National Average




Infrastructure spending is another powerful tool and one which I have written about in the past. If we accept that we cannot eliminate public deficits from one day to the next without creating a deep recession, we should at least aim to spend the money on infrastructure projects where the return on invested capital is measured in future economic growth and not in number of votes at the next parliamentary elections.

At the moment, policy makers seem to have forgotten that there is more than one knob to turn on the control panel. To quote the brilliant Woody Brock who is kind enough to share his insights with us and our clients:

“Monetary policy on its own will not and cannot achieve these long-overdue goals. Repeat:  Fed Watchers go jump in the lake!”


This month’s Absolute Return Letter is a short one by my standards. I have delivered the key message. No reason to go on for much longer. Unless serious action is taken, Europe in particular (but the U.S. is not far behind) is at risk of falling into a very deep hole from which it may be extraordinarily difficult to dig itself out of. Once in, it will prove ever so hard to get out again. That is one of the key lessons learned from Argentina, even if the nature of Europe’s problems is different from those of Argentina.

Let me round this month’s letter off with a couple of investment implications:

There appears to be a widespread belief amongst investors that wealth creation (here measured as GDP growth per capita) and equity returns are highly correlated. In other words, invest in those countries with the highest GDP per capita growth, and you will achieve the most attractive returns. After all, it would be a perfectly logical conclusion to arrive at. In reality, nothing could be further from the truth. Over the long term the two have actually been negatively correlated (chart 4). It could therefore prove to be a costly mistake to exclude Europe from a global equity portfolio just because you have (valid) reasons to believe that growth – and thus wealth – will stagnate in the years to come.

Chart 4:  Real Equity Returns & Per Capital GDP, 1900-2013



Source: Credit Suisse, Global Investment Returns Yearbook 2014

Secondly, when it comes to managing a debt crisis of sorts, currency issuers have a significant advantage over currency users. The latter have to go outside their own country to fund their deficit, hence the risk of default if they can’t access international markets (usually the result of mis-management). Currency issuers, on the other hand, can issue unlimited amounts of IOUs in their own currency and may, as a result, avoid overt default in perpetuity. This distinction is highly significant, given the elevated levels of debt at present.

As sovereign debt continues to grow in many countries, should interest rates begin to rise, servicing the debt would take a bigger and bigger toll on public budgets. It is therefore reasonable to expect governments to collude with central banks to try and keep interest rates under control in the years to come. Now, investors are not stupid. They will look to get paid for the added risk they take, either explicitly or implicitly. If interest rates are perceived to be grossly manipulated, market mechanisms will ensure that investors will instead turn their attention to exchange rates to seek the necessary adjustments. Consequently, we expect currency markets to take the brunt of the adjustments that will have to happen over the next several years as it becomes increasingly clear who is in the ‘deep hole’ and who is not.

Challenging the Consensus

By Niels Jensen, Absolute Return Partners

The Absolute Return Letter 0214


Squeaky Bum Time

By Niels Jensen, Absolute Return Partners

Smart people learn from their mistakes. But the real sharp ones learn from the mistakes of others.”

Brandon Mull, Fablehaven

The 2002-03 season in the English Premier League, which ended with Sir Alex Ferguson winning a seventh Premier League title, developed into a hectic battle between Manchester United and Arsenal. At the height of the race for the title, with only a few weeks left of the season, Sir Alex uttered the now famous words: “It’s getting tickly now – squeaky bum time, I call it.”

Squeaky bum time describes very well my emotional state at the moment. Equity markets continue to set new highs, seemingly prepared to disregard economic fundamentals. I have never felt entirely comfortable when I struggle to rationalise investor behaviour and I am not alone. All over the world market pundits are busy declaring this rally the latest in a long string of market bubbles which have been doing the rounds over the past few years.

Meanwhile business partner and good friend Nick Rees has now left the Canary Islands on board a rowing boat set for Antigua in the Caribbean where they expect to arrive in late January (you can follow Nick’s progress here). If you click on the race tracker map, Nick is in the boat called Team Neas Energy (very kindly sponsored by our friends in Aalborg, Denmark). Ellen (Nick’s wife) posted this report (see here) over the weekend:

“At 5pm last night (Friday) Nick and Ed were on deck, Nick rowing, Ed eating dinner. They were having a good chat apparently! A freak wave described by Nick as ‘enormous’ reared up behind the boat.  The wave knocked them out of the boat and it capsized to the side, but righted very quickly and the boys (who were wired onto their safety lines) were able to get back on board safely.  Nick got back on the oars to try to continue rowing, and Ed went into the cabin – however another wave threatened to roll them again and Nick joined Ed inside. They were then rocketed forward at a terrifying 14.5knots by the waves.”

Squeaky bum time indeed!

How to spot a bubble

Back to the infamous bubbles. Not the sort of bubbles most of us enjoy at New Year but man made bubbles. Bubbles that are the product of irresponsible behaviour and greed. Bubbles that can destroy wealth in no time at all. There is a long history of deflated bubbles beginning with Tulipmania in the Netherlands in the 1630s[1]. When a bubble bursts, the typical monetary policy response is to flood the markets with liquidity. The 2008 occasion was no exception. Central banks all over the world provided, and five years later continue to provide, ample supplies of cheap money.

The results are there for everyone to see. Asset prices have rallied strongly as I pointed out in the November Absolute Return Letter. Yet rising asset prices, even rapidly rising asset prices, are not necessarily akin to a bubble. One must distinguish between what is sustainable and what is not. The Financial Times Lexicon defines an asset bubble this way:

“When the prices of securities or other assets rise so sharply and at such a sustained rate that they exceed valuations justified by fundamentals, making a sudden collapse likely – at which point the bubble bursts.”

Asset bubbles are not always easily identifiable. Alan Greenspan has been widely ridiculed for asking the following question:

“How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?”

The man has a point, though. We can all spot the bubbles when using the rear-view mirror, but that is a luxury only available to academics and couch potatoes. Investors do not have the luxury of a rear-view mirror[2]. We need to make real time calls all the time and that is not always straightforward. A 1963 Ferrari 250 GTO changed hands back in October for no less than $52 million. Only four weeks ago a Francis Bacon painting fetched $142 million at an auction in New York. I feel very tempted to declare both of those transactions a product of

irrational exuberance. Who in their right mind would pay those prices for unproductive assets? Yet I feel tempted to quote the age old Danish saying: “What do farmers know about pickled cucumbers?” I hope you get my point.

When I look at Bitcoin, the chart screams ‘bubble’ to me but how do I value it? I am not smart enough to figure that out. In such a situation the wise move is no move. Another example: Central London property prices. Reasonably intelligent people declared London property to be in a bubble more than a decade ago. Meanwhile prices continue to rise. Is it a bubble? I don’t know, but I do know that as long as misguided politicians in France, Spain, Italy and Greece continue to make bad policy decisions that make their own citizens pack up and leave, London will continue to prosper (and price normal people out of the property market, but that is another story altogether). As long as there doesn’t seem to be any shortage of stupidity amongst the political elite in Europe, I will not bet against further price increases on central London property.

The DNA of the 2012-13 bull

Now to the big question: Is there a bubble in global equity markets? That is what the rest of this letter is all about. Let’s begin by putting the current rally into a historical context. Chart 1 shows all uninterrupted S&P 500 bull runs since 1927 that have lasted 50 weeks or longer. Altogether there have been 25 of them and, contrary to what many seem to think, the 2012-13 rally is not an outlier. It has neither been exceptionally long, nor has it delivered outsized returns (yet), at least when compared to the other major bull runs.

This hasn’t prevented many commentators from raising the red flag. Allow me to share a few examples with you (forgive me for the number of charts to come, but they often say more than thousands of words). One of the most popular charts on financial blogs in recent weeks compares the ongoing rally to the great bull market of the late 1920s which, as we all know, ended very badly (chart 2).

Chart 1:  S&P 500 bull runs since 1927



Source: Ineichen Research & Management. 

I am amazed to see how much value many investors assign to charts like these. What does chart 2 really tell you? As far as I can tell not much. For every chart that suggests a relationship, I can find two that contradict it. To me technical analysis is long on voodoo and short on substance (I may have lost a couple of thousand readers right there, but so be it).

Chart 2:  The 2012-13 bull market vs. 1928-30




Another popular chart doing the rounds in recent weeks is the so-called Death Cross shown below (chart 3) which has been presented as ‘proof’ that global equity markets are on collision course with economic fundamentals.

Chart 3:  Global equities vs. economic fundamentals (simplistic study)




A more thorough analysis would reveal that the relationship between equity markets and economic fundamentals broke down a couple of years ago (chart 4). In fact, and as we shall see later, there is absolutely nothing unusual, let alone alarming, about such a disconnect. It is all about where we happen to be in the economic cycle.

Chart 4:  Global equities vs. economic fundamentals (detailed study)



Source: Minack Advisors 

Another very popular chart, showing an apparent link between the expansion of the Fed’s balance sheet (i.e. QE) and the rise in U.S. equity prices, has been marketed recently as Perhaps the only chart that matters (chart 5).

Unless one digs a little bit deeper, it is easy to get carried away when looking at charts like these, but digging deeper is precisely what the good people at Minack Advisors have done and their findings are quite interesting. If QE was solely responsible for the re-rating of equities that has taken place, one would expect a strong correlation between P/E ratios and the size of central banks’ balance sheets throughout the post-crisis period (i.e. from early 2009); however, P/E ratios actually contracted during the first two years of QE (chart 6). In other words, QE alone does not explain the recent bull-run.

Chart 5:  QE vs. equities




Now, before you jump to conclusions, do not for one second think I am about to do a Hugh Hendry (Hugh, CIO of Eclectica Asset Management and a long-standing bear, threw the towel in the ring a few weeks ago and turned bullish for the first time in years). I cannot possibly do what Hugh Hendry did because I was already bullish. Having said that, many more will do what Hugh Hendry has just done. The recent rally is still not widely embraced. Many investors continue to be deeply suspicious about the underlying economic reality and for good reasons, I might add. See for example this article in the FT.

Chart 6:  QE vs. equity market valuation



Source: Minack Advisors 

The beauty of financial alchemy

Talking about having good reasons to be suspicious, take a look at chart 7, courtesy of Bill Gross and PIMCO. Even a casual look at the chart suggests that the chickens may still come home to roost. U.S. corporates are desperately trying to deliver earnings growth when measured on a per share basis even if the underlying earnings trend is flat to negative. The primary tool to achieve such magic is obviously stock buy-backs. A whopping $1 trillion (+/-) is spent every year on buyback programmes in the U.S. just to keep the show on the road.

Chart 7:  The art of financial alchemy



Source: PIMCO, Bianco Research

There are potentially two dynamics at work here. The first one is straightforward – the economic cycle. Perhaps chart 7 is telling us that the U.S. economy – and more broadly the global economy – is not quite as robust as U.S. corporates want us to believe. The second one is more complex and has to do with how national income is divided between labour and capital.

For many years it was a relatively stable relationship. 65% of national income went to labour with the balance going to the owners of the capital[1]. As recently as 10-12 years ago that was still the case. Then things started to change and labour’s share has been under pressure ever since. Today labour receives just short of 60% of national income.

The reason I bring this up in the context of chart 7 is that there are signs that labour’s share of total income may have begun to mean revert with labour again taking a larger share of national income which, if sustained, will put corporate profits under pressure in the years to come. It is still early days, but it’s worth a separate discussion which I will revert to in one of the next Absolute Return Letters.

Bubble or no bubble?

In the meantime, let’s try and get back to the central question in this month’s letter – bubble or no bubble? In order to answer that question we need to look at some valuation charts. Chart 8 doesn’t provide much comfort for the bulls. Four different valuation metrics lead to more or less the same conclusion – U.S. markets are significantly overvalued although not yet at levels seen at the peak of the secular bull market in 2000.

Chart 9 which measures the aggregate valuation of all developed markets paints a quite different picture. There is nothing to suggest that valuations are in any way excessive. Even when adjusting for the lofty days of the late 1990s (the green line in chart 9), global equity markets appear only to be very modestly overvalued.

Chart 8:  Different valuation metrics applied to the U.S. market



Source: Advisor Perspectives (see here).

Our suspicions are confirmed when we compare U.S. equity valuations to those of other markets (chart 10). It is obvious from this chart that the strong bull-run in U.S. markets has opened up a significant valuation gap, in particular vis-à-vis emerging markets. One should also remember that European corporate earnings are depressed at present, sending valuations higher so, on a cyclically adjusted basis, European equities look much more attractively priced than their U.S. peers.

Chart 9:  Valuation of equities in developed markets (two year forward P/E)



Source: Minack Advisors

The real opportunity set seems to lie in emerging markets, though. Once global economic growth re-accelerates, EM equities are likely to come back into favour, and much of the valuation gap could and should disappear as a result.

In a bubble-like environment investors rarely distinguish between good and bad. We saw it in the late 1990s when low quality dot com companies were bid up to ridiculous valuations and we saw it again in the housing bubble in the mid naughties when investors forgot about the golden rule of property investments – location, location, location. When I look at investor behaviour today, I see the opposite. Most, if not all, investors, are highly selective and approach markets with a great deal of scepticism.

Chart 10:  A growing valuation gap



Source: Minack Advisors 

Our friends at Sanford Bernstein ran an interesting chart for me which partly supports my argument. Investors have not yet fully embraced this rally. They have invested in a ‘cowardly’ fashion, focusing on defensive, low beta stocks rather than more aggressive, often cyclical, high beta stocks (chart 11). If history provides any guidance, there will be a shift to more cyclical, higher beta names, before this rally is well and truly over.

Chart 11:  Price-to-Book Valuation – High vs. low beta stocks



Source: Sanford Bernstein. MSCI Developed Markets, Jan. 1980 – Nov. 2013.   

Chart 12 provides further insight into what it is investors have actually been chasing in the recent rally. As one can see, stocks with the highest dividend yields have become quite expensive, even if valuations have come back down somewhat more recently. It is almost unheard of for the highest yielding stocks to trade at a premium to the large cap universe, but they do now and have done for a little while.

Now, any company wanting to return capital to investors can choose to do so through dividends or alternatively through share buy-backs. The black line in chart 12 (shareholder yield) combines share repurchases and dividends. As one can see, investors have not taken buy-backs to their hearts in the same way they have rewarded the highest yielding companies. The answer, I believe, lies in the relentless appetite for yield which is a direct function of the changing demographic landscape with millions of baby boomers worried about how to fund their retirement.

Chart 12:  Valuation discount – top quintile yield vs. U.S. large cap



Source: O’Shaughnessy Asset Management. Valuations based on trailing 12 month P/E ratios.   

The typical equity cycle

It is time to re-visit one of the issues I discussed in the early parts of this letter – should we worry that the link between equity markets and economic fundamentals seems to have broken down? Peter Oppenheimer, European Equity Strategist, produced an interesting chart in a recent research report, which casts some light on this question. Looking at economic cycles since 1973, he divides the equity cycle into four phases – despair, hope, growth and optimism (chart 13).

Chart 13:  Phases of the ‘typical’ equity cycle



Source: Goldman Sachs Global Investment Research. Europe ex. UK. Based on economic cycles back to 1973.

Peter argues, and I am inclined to agree, that we are coming to the end of the hope phase which is the part of the equity cycle where returns are the highest. In the next phase – the growth phase – returns are likely to be much more modest and largely a function of the companies’ ability to convert the accelerating economic momentum into rising corporate earnings. You will also note from chart 13 that, in the growth phase, P/E multiples actually contract somewhat, yet earnings growth more than compensates for that, leaving investors with a positive, albeit relatively modest, return. It is only in the final phase of the equity cycle (optimism) that investors tend to get carried away and build in unrealistic expectations which they subsequently pay dearly for in the despair phase.

Goldman’s research is based solely on European data. One might argue that the U.S. is well in to the growth phase and thus closer to the exit point than most other markets. I wouldn’t disagree with such an observation.


Being closer to the exit point does not, however, imply bubble behaviour. Yes, there are signs of excesses creeping back in to the markets. The FT ran a piece on asset-backed securities recently which should worry everyone (see here) and, yes, covenant light loans are yet again on the rise (see here); however, I do not see much in terms of the classic signs of bubble behaviour – excess leverage, taxi drivers giving you his stock pick de jour, etc. etc. It is, after all, the most unenthusiastic rally I have ever experienced.

One of the key reasons for the apparent lack of enthusiasm is the widely held view that interest rates will begin to rise before long. Some disagreement exists as to when and by how much, but one has to look really hard to find dissenters who are prepared to take the view that interest rates could indeed fall further. I should add ‘before they rise’ because ultimately they will rise. I think we all know that. However, one important lesson learned from Japan is that it is the ‘when’ that we may get so horribly wrong. With current inflation trends in mind, it is not beyond comprehension that we could see 10-year bond yields hit 2% before we touch 4%. One lesson I learned many moons ago is never to underestimate the markets’ insatiable appetite for inflicting maximum damage.

On the other hand, should interest rates begin to normalise, going to say 4-5% on the 10-year bond, I wouldn’t be overly concerned about that either, as long as it happens in an orderly fashion. Chart 14 shows the correlation between interest rates moves and equity returns. As one can see, in the past, upwards moves in interest rates have only hurt the stock market when rates have been north of 5%.

Chart 14:  The bond vs. equity sweet spot



Source: JP Morgan

Nor am I troubled about all the tapering talk. Financial markets took a bit of a knock back in May and June following Bernanke’s comments on 22 May which markets were completely unprepared for. Now, almost seven months later, the necessary expectation adjustments are largely behind us, and tapering will most likely turn out to be a non-event.

Having said that, we are not out of the woods yet, economically speaking. We will have to face many challenges over the next several years yet, on the margin, things are getting better and, as long as that is the case, the stock market is likely to respond in kind, even if the easy money has been made at this point.

For all those reasons I remain a cautious bull.

Euthanasia of the economy?

By Niels Jensen, Absolute Return Partners

”Crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”

Rudi Dornbusch, Economist

In his masterpiece The General Theory of Employment, Interest and Money John Maynard Keynes referred to what he called the ‘euthanasia of the rentier’. Keynes argued that interest rates should be lowered to the point where it secures full employment (through an increase in investments). At the same time he recognised that such a policy would probably destroy the livelihoods of those who lived off their investment income, hence the expression. Published in 1936, little did he know that his book referred to the implications of a policy which, three quarters of a century later, would be on everybody’s lips. Welcome to QE.

Before I go any further, please allow me to inject a brief personal comment. This month’s Absolute Return Letter is the last before my partner, Nick Rees, departs for the Canary Islands for the final preparations before he sets off to row, unaided, from La Gomera on 2 December on his conquest of the Atlantic. I don’t think any of us can quite comprehend what a mammoth task it is to row 3,000 miles across the Atlantic. Nick and his rowing partner Ed will be in the boat for 50-60 days before arriving in Antigua in late January, and they probably won’t speak to each other for 50-60 months thereafter! It is all done in support of Breakthrough Breast Cancer, one of the leading cancer research charities globally, and you can read more about the project here. Many of you have already supported Nick, and for that he is eternally grateful but, if you have somehow missed it, it is not too late to make a contribution. So many people continue to be diagnosed with breast cancer every year, 1 in 8 women over the course of their lifetime. Nick’s wife, Ellen, was one of them. Please click here if you would like to support this great cause.

Now back to QE – the topic of this month’s Absolute Return Letter. Over the past couple of years it has gradually become the consensus view that QE has failed because it hasn’t created the economic growth that everyone was hoping for. I find that view overly simplistic and naïve in equal measures. QE – or broadly similar monetary policy initiatives – has saved the world from a nasty and potentially very damaging financial meltdown not once, but twice – following the Lehman bankruptcy in the autumn of 2008 and during the depths of the Eurozone crisis in the second half of 2011. It is not clear at all (because it is impossible to quantify) how much worse off we would have been without QE, but worse off – in terms of GDP growth – we almost certainly would have been. Estimates range from 5% to 15% below actual numbers, but nobody really knows.

QE’s effect on asset prices

The second indisputable effect QE has had is on asset prices. The central banks’ unprecedented buying of bonds have had a material, and overwhelmingly positive, effect on asset prices – to the point where more and more people worry that we are in the process of forming a new bubble. Chart 1 below, borrowed with gratitude from the Financial Times, illustrates very well how effective QE has been in terms of moving asset prices higher but, at the same time, it demonstrates the dilutive effect over time. QE2 did not deliver returns of the same magnitude as QE1 and QE3 has been even less effective, at least when measured in this way.

I do not wish to enter into a longer discussion about whether this is bubble territory or not, as that is the subject of next month’s Absolute Return Letter, but let me make one thing clear. The current equity bull market is not a rally based on irrational behaviour. To the contrary, investors are behaving perfectly rationally. As policy makers continue to signal an intent to keep rates low for a very long time, investors merely respond to such intent. That, on the other hand, is not akin to saying that buying equities at current valuations is a virtually risk free proposition, but more about that next month.

Chart 1:  The effect of QE on various asset classes



Source: The license to print money is running out, FT Money, 19-20 October 2013 

Misguided inflation concerns

When QE was introduced in late 2008 there was plenty of concern that it would lead to higher inflation. Some even suggested it could lead to hyperinflation and the gold bugs suddenly found themselves with plenty of wind in their sails. As QE became QE2, the inflation protagonists gathered further momentum and the price of gold took another leap. Suddenly you were no longer considered an extremist by suggesting that the Fed would turn the USA into the United States of Zimbabwe.

And what happened? The reality is that almost exactly five years after the introduction of QE, the so-called ‘money printing’ has had little or no effect on consumer price inflation. If anything, it looks as if QE has paved the road to Tokyo rather than Harare (chart 2).

Chart 2:  Consumer price inflation in selected countries


Source: ECB, FRED, ONS 

How could nearly everyone get it so horribly wrong? Could it be that we haven’t seen the inflation ghost yet? Are we in the lull before the storm? Is it possible that QE is in fact long term deflationary? The reality is that we have seen plenty of inflation already from QE – just not in the places nearly everyone expected it to show up. Asset price inflation is also inflation, and we have had asset price inflation galore. Many emerging economies have struggled with consumer price inflation in recent times. It looks as if we have been very good at exporting it.

I rarely brag about my predictions when, occasionally, I turn out to be on-the-money, partly because my mum taught me always to be humble, and partly because it usually comes back and bites you in the tail if you get too big-headed. Having said that, I never believed the scare mongering, and I still don’t. I am absolutely convinced that QE will generate little or no consumer price inflation in the western world, although I do recognise that some countries (for example the U.K.) have higher structural inflation rates than others. This is not the lull before the storm.

Is it Japan all over again? I believe the jury is still out on that one. Good friend and business partner John Mauldin made me aware of a very interesting study presented by the Bank of England back in 2011 which appears to suggest that at least the U.K. central bank expects QE to deflate asset prices, consumer prices and economic growth in the long run (chart 3). That is not akin to saying that we have already fallen into the same deflation trap as Japan; however, given the disinflationary trend we are currently in, we are perhaps only one or two policy mistakes away from deflation – in particular in the Eurozone. Extending QE could be one such mistake.

Chart 3:  The qualitative economic impact of QE 


Source: Quarterly Bulletin, Bank of England, 2011 Q3

Does QE destroy economic growth?

Let’s take a closer look at a very important question raised by chart 3. Does QE actually destroy economic growth in the long run? In order to understand the dynamics at work, let’s start with a quick snapshot of how much the world has actually de-levered since the lofty levels of 2007 when the first signs of crisis began to materialise (chart 4).

For the sake of clarity I should mention that, in the following, I focus on QE. In reality, most countries have combined QE with various austerity measures which makes it difficult to distinguish the effect of one policy measure from another. Having said that, the U.S. hasn’t engaged in austerity to any meaningful degree which gives us good insight into the (side) effects of QE.

Chart 4:  Gross debt as % of GDP (excl. financial sectors)


Source: Back to Black, Citi Research, October 2013.

The first, and very important observation, when looking at chart 4 is that total debt is higher almost everywhere since the outbreak of the crisis. It is indeed a case of robbing Peter to pay Paul as Matt King of Citi Research so succinctly puts it. Where household debt has been reduced (for example in the U.S. and the U.K.) government debt has replaced it.

Italy’s government debt has jumped from 121% to 132% of GDP over the past two years alone. Spain’s debt-to-GDP has gone from 70% to 94% and Portugal from 108% to 124% over the same period. An interesting brand of austerity I might add! Expanding the government deficits at such speed would have been devastatingly expensive in the current environment without QE. And to those of you who want to jump at me and say that the ECB does not engage itself in QE (yes, I am aware that its charter strictly prohibits such activity), I say look at the ECB’s balance sheet. It may not be QE in the legal sense of the word, but the end result is no different.

So, in effect, QE has permitted a number of crisis countries to fund their escalating deficits at rates which would have been impossible to obtain in a free market, but that’s the least of my concerns. QE has also permitted banks in those same crisis countries to re-capitalise themselves without the use of tax payers’ money. At one level that is good news, because using tax payers’ money would only have made government deficits worse. However, there is a bothersome side effect of such an approach.

Think about it the following way. When deploying its capital, a commercial bank effectively has the choice between lending it to its customers or engaging in proprietary trading activities. With central banks underwriting the cost of capital in the banking industry by promising to keep policy rates at record low levels for some extended period, the choice is a relatively simple one. On a risk-adjusted basis, margins on lending simply cannot compete with the profits that can be made on proprietary activities. This in effect deprives the real economy of working and investment capital and thus has a detrimental effect on economic growth longer term. This, and other possible side effects of QE, was pointed out in a brilliant paper published by the Federal Reserve Bank of Dallas last year, which you can find here.

For the economy to grow, not only is it necessary for banks to be willing to lend, but borrowers must also be willing to borrow. Many consumers were over-leveraged going into the crisis and are taking advantage of the lower interest rates to de-lever faster than they could otherwise hope to do, but that is not the only reason why consumers may refrain from borrowing at present. There are signs that QE may in fact be having a direct, and negative, effect on the appetite for borrowing.

Here is how it works. Seeking to impact inflation expectations forms an integral part of monetary policy, and policy makers have been very effective at anchoring those expectations around 2% in recent years. Needless to say, if inflation expectations had moved significantly as a result of QE, I would have had to write a very different letter this month.

Behind all of this is some economic gobbledygook called the ‘rational expectations hypothesis’ which suggests that economic agents (read: consumers and businesses) make rational decisions based on their expectations. So, when the Fed – and other central banks with it – keep ramming home the same message over and over again (and I paraphrase): “Folks, we will keep interest rates low for some considerable time to come”, consumers and businesses only behave rationally when they postpone consumption and investment decisions. They have seen with their own eyes that central bankers have been able to talk interest rates down, so why borrow today if one can borrow more cheaply tomorrow?

QE’s effect on income

Charles Gave of GaveKal Research produced a very interesting paper earlier this year, linking the low income growth to QE – another nail in the coffin for economic growth. Charles found that during periods of negative real interest rates (which is a direct follow-on effect from QE), income growth in the U.S. has been low or negative (chart 5). I am sure we will hear more from GaveKal on this topic in the future. It is the first time I have seen anyone present this hypothesis which, if true, has dramatic implications for monetary policy going forward. It is well known, for example, that President Obama has been keen to find ways to get income growth back on a more positive trajectory again.

Chart 5:  The link from QE to income growth


Source: The emergence of a U.S. underclass, GaveKal Research, July 2013

QE was meant to stimulate economic growth and I believe it worked well as a short term crisis management tool in 2008 and 2011. However, for policy makers to expect a longer lasting, and positive, effect on economic growth, they would have had to assume that the wealth effect (from rising asset prices) would kick in and stimulate economic growth through increased consumption. When making this calculation, they may have underestimated the power of demographics, though.

As I demonstrated in last month’s letter, middle-aged and old people, who control the majority of wealth (chart 6) do not create economic growth. Young people do, but QE may have deprived the younger – and income dependent – generations of growth capital for the reasons already discussed, whilst making the wealthy even wealthier. One could say that QE has increased inequalities in income and wealth.

Time to clean up the banks

When talking about the financial sector and how they have been able to take advantage of QE to re-capitalise their damaged balance sheets, it ought to be said that QE has effectively allowed banks to ignore their underlying problems. QE has become a life support machine for the financial sector at virtually no cost to them but at a significant cost to the rest of society. That cannot go on ad infinitum. At some point in the not so distant future it will be financial reckoning day for the sector which bodes particularly badly for the European banks, most of which are way behind their U.K. and U.S. peers in terms of cleaning up their balance sheets.

Chart 6:  Distribution of UK household financial assets by age group 



Source: The distributional effects of asset purchases, Bank of England, July 2012.

Note: Numbers exclude pension assets.

The IMF provided some very granular information on the state of European banks in their most recent Financial Stability Report. More than 50% of Spanish companies with loans in Spanish banks have an interest coverage ratio of less than one. In other words, the EBITDA of over half of all Spanish corporates does not even cover their interest expense (you would expect a healthy corporate borrower to have an interest coverage ratio of 3-5 times depending on the nature of the business). What’s worse, the situation in Italy and Portugal is only marginally better. All of these problems have been largely ignored since the ECB stepped in with their brand of QE about two years ago and saved the European banking sector from a complete meltdown, but few, if any, of the underlying issues have yet been addressed.

Other unintended consequences

Meanwhile, QE has left a trail of potential problems in the rest of the world. Ultra easy monetary policy in the West has resulted in a virtual credit explosion in many EM economies, many of which pursue a policy which is either directly or indirectly linked to U.S. monetary policy (chart 7). This is a key reason why I predicted in the September Absolute Return Letter (see here) that we may have to face a re-run of the EM crisis of 1997-98 before this crisis is well and truly over.

In China, the transformation currently taking place may have some unexpected consequences for inflation in our part of the world. From a peak of 10.1% of GDP in 2007, its current account surplus now stands at 2.5% of GDP and the surplus continues to trend down. In September, Chinese exports to the rest of the world dropped by 0.3% when compared to the same month last year, whereas imports grew by 7.4%.

Consequently, China is no longer building massive amounts of foreign exchange reserves, and it is quite likely that the Chinese balance of payments will turn negative in the foreseeable future. We had a foretaste of that in 2012 when they posted the first quarterly deficit since 1998. All of this is important in the context of inflation v. deflation because the renminbi may actually begin to weaken as capital outflows gather momentum – a nightmare scenario for us in the West as we would then begin to import deflation from China at a most inopportune time.

Chart 7:  Change in private sector debt (gross, non-financial, % of GDP) 



Source: Global Economic Outlook and Risks, Citi Research, September 2013

I could go on and on about how QE has created, and will continue to create, unintended consequences. I haven’t really touched on how QE has distorted market mechanisms in the financial markets and the implications of that. For example, as a direct result of QE, dealer inventories have been dramatically reduced since 2008 during a period where assets under management in the mutual fund and ETF industry have exploded (chart 8). When the herd wants out of credit, who is going to provide the liquidity to facilitate that?

Chart 8:  U.S. credit mutual fund assets v. dealer inventories



Source: Back to Black, Citi Research, October 2013.

I have failed to mention how QE has undermined the retirement plans for millions of people across Europe and the United States as their pension savings no longer provide a sufficient income to live on. I have not entered into any discussion about how QE could quite possibly undermine the credibility of central banks longer term and how that may impact the effectiveness of monetary policy and possibly even present a threat to global financial stability.

Could the U.S. lose its reserve currency status?

All of these are important issues that deserve a mention; however, I am running out of time and space. Allow me to leave you with one thought, though. Since the end of World War I, the U.S. dollar has retained its position as the reserve currency of choice. Such a position carries with it many advantages. Approximately 60% of the world’s foreign exchange reserves are held in U.S. dollars today. In an era where the U.S. government spends considerably more than it earns, the status as the world’s preferred reserve currency comes in quite handy. Having that status is equivalent to writing cheques that nobody cashes in. What a wonderful position to be in.

The Americans seem to take their status for granted. Perhaps they need a reminder that reserve currency regimes come and go (chart 9). Given its status as a large debtor nation with insufficient domestic savings to finance its deficits internally, it could prove very painful, should the rest of the world decide that it is time for a change. The longer QE goes on for, the more likely that is to happen.

Chart 9:  Reserve currency regimes since the middle ages



Source: JP Morgan via Zero Hedge

My good friend Simon Hunt reminded me the other day that, only a couple of weeks ago, an article in China’s official news agency called for a new reserve currency to be created to replace the U.S. dollar. According to Simon, the renminbi’s share of world trade has grown from zero in 2009 to around 17% in the first half of this year. Given its exponential rise, it could easily account for 40% or perhaps even 50% of world trade by 2017.


It is time to call it quits. QE proved to be a very effective crisis management tool, but we have probably reached a point where the use can no longer be justified on economic grounds. Just as John Maynard Keynes talked about the euthanasia of the rentier back in 1936, we are now facing the euthanasia of the economy, unless we change course. The obvious problem facing policy makers, though, is that if financial markets are the patient, QE is the drug that keeps the underlying symptoms under control. We have already seen once how dependent the patient has become of this drug (think 22 May when Bernanke mentioned the mere possibility of tapering), and the market reaction clearly scared central bankers on both sides of the Atlantic.

The western world was very critical (and rightly so) of Japan in the 1990s for not dealing decisively with its sick banking industry. Twenty years later, Japan is still paying the price for its dithering. The problem is that we are now making precisely the same mistake. QE has proven effective of suppressing the underlying symptoms, but that doesn’t mean we should stay on that medicine forever. In order to reinvigorate economic growth, and avoid falling into the Japanese deflation trap, we need a healthy banking industry. That will only happen if it is thoroughly cleaned up once and for all.

PS. To all those out there who think that the world is returning to normal, that everything will be safe and sound as long as we give it a bit more time (a strategy also known as kicking the can down the road), I suggest you read this piece in the FT.

Heads or Tails?

“Once one starts to think about it, it is hard to think about anything else.”

Robert Lucas, Economist and Nobel Laureate, on economic development in emerging economies.

Demographics captivate me. There are around 7.1 billion of us occupying planet earth today, going to 10 billion by 2050. I often think about how good old mother earth will cope with the additional 3 billion people we are projected to produce between now and 2050. More people translate into increased pressure on already scarce resources, but that is only part of the story and a story well covered by now.

From an investment point of view, it is more interesting that over 150 million people from around the world join the middle classes each year. The Brookings Institution reckons that about 2 billion people can be classified as middle class today. By 2030, Asia alone will be the home of 3 billion middle class people, and the global middle classes will be approaching 5 billion, 90% of whom will come from countries we today consider EM economies. In other words, less than 20 years from now, Asia will have 10 times more middle class citizens than North America and 5 times more than Europe. When we entered the new millennium not many years ago, 1 in 6 middle class people came from the United States. By 2030, only 1 in 25 will be American (see here). Meanwhile, in Latin America, the middle classes have grown by 50% over the past decade and now account for 30% of the population (see details here).

You can define ‘middle class’ in more than one way, but let’s not get hung up on details. The important consideration here is the sheer magnitude of this demographic shift and the effect it will have on pretty much everything. Rising living standards imply more money available for iPhones and package tour holidays, but it also entails increased consumption of fat and sugar and thus growing obesity problems. Over 300 million people worldwide are now classified as clinically obese, a function of the changing eating habits and exacerbated by increasingly sedentary lifestyles. In China alone, well over 100 million people are now considered obese, and half of them are children.

Growth of the middle classes is not the only thing to consider, though. Just as EM economies will produce armies of middle class people, our part of the world will become noticeably older. Worldwide, the population of over 65s is growing at 3.3% per annum compared with 1.1% growth overall. And vanity seems to prosper amongst those who are turning grey. The global market for anti-ageing products is worth an estimated $262 billion this year and is expected to reach $340-350 billion by 2018.

For all these reasons I find demographics intriguing. Yet there is one more reason why I can’t take my eyes off the subject. When speaking to people in our industry about it, I usually come up against what I call ‘polite interest’ which I usually interpret as utter disinterest. It is not that everyone can’t see that this seismic shift is going to have significant impact longer term. Yet the majority seems to think that it won’t really have any meaningful impact for the foreseeable future. From an investment point of view that is ideal, because it means that the changes to come are not yet fully priced in.

Many blamed the Arab Spring on the totalitarian regimes in the region, and that undoubtedly played a role. At the same time, though, it was a very powerful manifestation of demographic pressures. When confronted with the combination of unemployment and sharply rising food prices, people took to the streets. It had, and will continue to have, a tangible impact on the MENA region as well as on the rest of us. Demographics are not only for the long term!

In short, we have two very powerful dynamics at work. We have the tailwinds created by the growing middle classes in EM economies, and we have the headwinds from the greying of the boomers in the old world. Which ones will prevail? Heads or tails? That is what this month’s Absolute Return Letter is about.

The greying baby boomers

Let’s begin with the easier one – how ageing affects the economy and financial markets. Chart 1 provides a simple illustration of the age-wise distribution of the U.S. population. The baby boomers are easily identifiable as the hump in the middle of the chart. In 2000, the biggest cohort was the 35-40 year olds. Today, almost 14 years later, the biggest cohort is the 50-55 year olds.

Chart 1:  U.S. population by age and sex, 2010 v. 2000



Source: U.S. Census Bureau

We all know intuitively that our spending and savings patterns change as we get older. The daily school run is replaced by the occasional visit to the local GP. The trekking trip in the Himalayas becomes a cruise on the Nile. The Skoda becomes an Audi (and then a Skoda again), but is any of this actually significant enough that one can measure it on economic growth and returns on stocks and bonds?

In 2012, Robert Arnott and Denis Chaves published what I believe to be the largest study ever conducted on the effect on economic growth, stock and bond market returns from changes in age distribution (you can find the study here).

Charts 2a-c are taken from Arnott’s & Chaves’ paper and deserve close inspection as the results are highly significant; however, I need to explain how to read the charts. Arnott and Chaves used 60 years of data across more than 100 countries. The objective was to assess whether changes in the age-wise composition of the population has a significant effect on equity and bond returns and/or on economic growth. Returns were measured as excess returns over cash in order to adjust for the fact that the risk-free rate of return is vastly different across markets and time.

Let’s take a closer look at chart 2a. The chart peaks at around 1% for the 50-54 age cadre, meaning that a 1% higher concentration of 50-54 olds would lead to an increase in annual excess equity returns of approximately 1%. Likewise a 1% higher concentration of the 70+ age cadre would lead to a decrease in annual excess equity returns of about 2%.

Chart 2a:  Equity returns vs. demographic shares



Chart 2b:  Bond returns vs. demographic shares



Chart 2c:  GDP growth vs. demographic shares



Source: Demographic Changes, Financial Markets, and the Economy, Robert Arnott and Denis Chaves, Financial Analysts Journal, Volume 68 No. 1, 2012.

Arnott and Chaves sum up their findings better than I could hope to do:

“Children are not immediately helpful to GDP. They do not contribute to it, nor do they help stock and bond market returns in any meaningful way; their parents are likely disinvesting to pay their support. Young adults are the driving force in GDP growth; they are the sources of innovation and entrepreneurial spirit. But they are not yet investing; they are overspending against their future human capital. Middle-aged adults are the engine for capital market returns; they are in their prime for income, savings, and investments. And senior citizens contribute to neither GDP growth nor stock and bond market returns; they disinvest to buy goods and services that they no longer produce.”

Given the large number of boomers knocking on the 70+ door, these findings should not be ignored. In another study from 2012, McKinsey Global Institute found that U.S. households reduce their exposure to equities in a meaningful way as they grow older, supporting Arnott’s and Chaves’ conclusion that large cohorts of 70+ year olds is bad news for equity returns (chart 3). We know that U.S. baby boomers own 60% of the nation’s wealth and account for 40% of its consumer spending, so their effect on the economy and financial markets shouldn’t come as a surprise.

Chart 3:  U.S. households’ asset allocation by age cohort



Source: The impact of demographic shifts on financial markets, McKinsey Global Institute June 2012

Note:   The numbers exclude retirement assets.

In a very interesting paper from 2011 (which you can find here), the Federal Reserve Bank of San Francisco found a powerful relationship between the age distribution of the U.S. population and equity market valuation, measured as the price-to-earnings ratio. Using what they call the M/O ratio – which measures the middle-aged cohort (those 40-49 years old) to the old-age cohort (those 60-69 years old) – they predict falling equity valuations out to the mid-2020s where the U.S. P/E ratio should bottom out at 8-9 times earnings. Valuations are then projected to rise again gradually (chart 4). The FRBSF study found that the M/O ratio explains about 60% of the change in equity valuations over the past 60 years which suggest quite a potent relationship.

Chart 4:  Projected equity valuations from demographic trends 


Source: Federal Reserve Bank of San Francisco, Economic Letter 2011-26

I will rest my ‘old age’ case here. I believe there is both ample and powerful evidence that the greying of the baby boomer (which, in my case, is actually thinning as much as greying) could quite possibly create significant headwinds for ‘old world’ financial markets in the years to come. Having said that, the fact that a study is statistically significant (which both of the above are) does not necessarily imply that it can be trusted to accurately predict the future. More about this in the conclusion later. Perhaps I should also note that my observations are not particularly pointed at the U.S. situation. I have used U.S. centric papers to support my arguments but only because the topic is much better researched in the U.S. than it is elsewhere. In many ways, the problem is much bigger in Europe and Japan.

The effectiveness of monetary policy is at risk

Before I go to the other side of the story, allow me to briefly mention a recently published IMF paper called Shock from Graying: Is the Demographic Shift Weakening Monetary Policy Effectiveness, which you can find here. The paper concludes that there is a strong link between the old-age dependency ratio[1] and the effect of monetary policy on inflation and unemployment. I quote:

“The results reveal that a graying society, as measured by the old-age dependency ratio, exerts a negative (in absolute terms) statistically significant long-run impact on the effectiveness of monetary policy. All else being equal, an increase in the old-age dependency ratio of one point lowers (in absolute terms) the cumulative impact of a monetary policy shock on inflation and unemployment by 0.10 percentage points and 0.35 percentage points, respectively. The corresponding maximum impact of monetary policy is lowered by 0.01 percentage points and 0.02 percentage points. These estimates thus imply, when taken at face value, quite a strong negative long-run effect of the ageing of the population on the effectiveness of monetary policy. This is particularly significant when linked to, for instance, the projected 10 point rise in the old-age dependency ratio in Germany over the next decade.”

The implication of this is that monetary policy may have to change as the greying of society intensifies. Perhaps the solution is simply bigger moves in policy rates. 50 bps may become the new 25 bps. Maybe new and altogether different policy tools will have to be introduced. Nobody really knows because the IMF’s findings are very recent and probably not fully digested yet. For most EM economies this won’t be an issue because wealth is not skewed towards the older generations which quite conveniently brings me to the next part of my story – the outlook for EM economies which, in most cases, are characterised by an age profile very different from that of the more advanced economies.

Headwinds for some will be tailwinds for others

The oldest country in the world today, at least when measured in demographic terms, is Japan with an old-age dependency ratio just over 40 (you can check the old-age dependency ratio of your country here). At the other end of the range you find mostly Middle Eastern and African countries with ratios well below 10. Generally speaking, when the working age population grows faster than the broad population, demographics become a tailwind as far as economic growth is concerned. Hence, what is likely to become a significant headwind for advanced economies in terms of economic growth, will almost certainly become a tailwind for most EM economies.

However, that doesn’t necessarily mean that EM equity and bond returns will prove attractive. Let’s re-visit charts 2a and 2b which suggest that a ‘surplus’ of younger cohorts is a negative for equity and bond returns respectively. Now, I would not for one moment suggest that returns on EM equities and bonds are likely to disappoint for this reason alone, but it does highlight a potential challenge that those markets are facing. In order to deliver what the growing middle classes of those countries will expect, enormous investments shall be required and that is likely to drive up interest rates which may in turn hold equities back somewhat.

Rob Arnott and Denis Chaves concluded their groundbreaking study by projecting how the changing demographics may affect economic growth, equity and bond returns in every corner of the world (chart 5). I have only included the equity chart here, but you can find them all if you follow the link provided previously. Several observations stand out. First and foremost, with only a limited number of exemptions, equity returns are likely to be relatively modest over the next several years – in particular when viewing projected returns on a market-cap weighted basis.

Secondly, it is not simply a question of ‘old’ versus ‘new’ world. Some EM economies, in particular in Africa, do not come out as well as one might have expected, and some advanced economies do surprisingly well. Thirdly, within Europe, countries around the Mediterranean, often portrayed as the old people’s home of Europe, do relatively well compared to many countries further north. The Nordic countries fare particularly poorly.

Chart 5:         Projected stock market returns, 2011-2020 (annualised)



Source: Demographic Changes, Financial Markets, and the Economy, Robert Arnott and Denis Chaves, Financial Analysts Journal, Volume 68 No. 1, 2012.

Note:   Forecasts using changes in demographic shares.

Concluding remarks

Most of the observations and conclusions in this letter are based on regression analyses of historical data. In a rapidly changing and increasingly global economy, can one realistically expect behavioural patterns of yesteryear to be repeated? That is a question to which there is no obvious answer. Only time can tell.

This implies that one needs to interpret the output with care. One example: With few exceptions, the largest companies in the world today are truly global and much less dependent on their home market than they were previously. The fact that Switzerland, and with it most of Europe, will age rapidly over the next 15 years will mean much less to Nestle now than would have been the case 20 or 30 years ago. One therefore needs to look not only at each and every country in terms of where it is in demographic food chain, but also at the constituents making up the local stock market.

One also needs to put the U.S. predicament into perspective. As noted earlier, most of the observations made above are based on U.S. data for one simple reason; the U.S. is simply better researched than the rest of the world. This is not good news as far as Europe and Japan are concerned, both of which are burdened with an age profile much longer in the tooth than that of the United States. Germany, the largest economy in Europe, will have an old-age dependency ratio in excess of 50 by 2030. The same ratio in the U.S. will be a more manageable 37. (Let’s not even talk about Japan’s situation. They will be out of business by then unless drastic measures are taken.)

One should also spare a thought for the echo boomers. Have another look at chart 1. We discussed the hump in the middle of the chart and attributed it to the baby boomers. Further down the same chart you will find another hump. That’s the children of the baby boomers – also known as the echo boomers. Those countries with large populations of echo boomers, of which the United States is a prominent example, are likely to find that the echo boomers could quite possibly offset a not insignificant part of the negative effect from the baby boomers growing old and tired. As F. Scott Fitzgerald wrote in The Great Gatsby: “There are only the pursued, the pursuing, the busy and the tired.”

One final note: It is a poorly kept secret that economic growth in EM economies in recent years has been driven primarily by exports. The recent slowdown across most EM economies (which I discussed in last month’s Absolute Return Letter) is a reflection of the simple fact that exports to Europe in particular have deteriorated. As their middle classes gain increased traction, domestic consumption will become gradually more important to these countries, but it may also become important to us.

In a region full of old people, Europe must figure out what these people will want to buy, because that is the only way we can maintain economic growth and thus pay for a decent sunset for our elderly. Ironically, if we get this right, years of running external deficits could be replaced by an extended period of unusually favourable conditions for our export industries as we meet the needs of the ever rising number of affluent consumers across emerging markets.


A Case of Broken BRICs?

By Niels Jensen, Absolute Return Partners

Whilst many chose to spend August on the beach, a full-blown crisis developed across emerging markets, and the BRICS in particular. The ‘B’ got into trouble with its currency under severe pressure. So did the ‘I’ and the ‘S’, whilst the ‘R’ and the ‘C’ both experienced loads of bad news on the economic front. Not exactly what you have come to expect from the BRICS.

The first seven trading days of September have offered all of these markets some much needed breathing space with EM currencies, bond and equity markets all doing considerably better. It is thus tempting to conclude that this was just another one of those summer hiccups that have become the norm in recent years. I do not buy that argument for one second, though. There are some very sound fundamental reasons why the crisis erupted now, which we will get into a little bit later.

Perhaps most surprisingly, though, the EM crisis didn’t (and still doesn’t) get a huge amount of media coverage. I suspect that, when you come up against a human disaster like the one which is currently unfolding in Syria, a currency crisis tends to be somewhat overlooked. The use of chemical weapons is a much better news story than collapsing foreign exchange rates and, as we all know, the world’s media are so utterly one-dimensional that they can only deal with one crisis at a time.

Read the full note here:

The Absolute Return Letter 0913


The Wisdom of Crowds

By Niels Jensen, Absolute Return Partners

“Those who have knowledge don’t predict. Those who predict don’t have knowledge.”

Lao Tzu, Chinese philosopher, 6th century BC

Several years ago, off-duty airline pilot Robert Thompson walked into a convenience store somewhere in the United States; however, having just entered the store, he turned around and left again without buying anything because, as he would later testify, something about the place spooked him. Was it the customer wearing a heavy jacket despite the hot weather? Maybe the shop assistant’s intense focus on the customer in the jacket? Or was it the single car in the parking lot with the engine running? Whatever drove him to walk out of there, Thompson’s decision was the right one. Shortly after he left the store, a police officer walked straight in to an armed robbery and was shot and killed. Thompson did not realise it at the time, but his reaction came instantly and instinctively, way before he became cognisant of the potential danger.

Now, go back some 80 years to March 1933 when unemployment in the United States was reaching an all-time high. Thousands of banks had failed in previous months. Bread lines stretched around entire blocks in many cities across the country. Against this depressing backdrop, Roosevelt was about to deliver his first address to the American people. The newly elected President began his speech not by discussing economic conditions but with a powerful observation that still resonates today:

“So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself – nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance”.

Fear impacts our behavioural patterns, whether consciously or subconsciously. If someone threatens us with a knife, the instinctive reaction will be to take flight. If the stock market falls 20% in a single day, we will tend to react in very much the same way, even if the threat is not physical.

Fear, like greed, makes people, and that would include investors, behave irrationally. You may argue that physical threats cannot be compared to financial threats and, in some respects, they cannot, but research into the human brain suggests that it is the same part of the brain that kicks into action in both instances.

The Efficient Markets Hypothesis

I trained as an economist in the late 1970s and early 1980s and was indoctrinated to believe in Modern Portfolio Theory (MPT), the Capital Asset Pricing Model and, over and above all else, the Efficient Markets Hypothesis (EMH). I wasn’t alone. Millions of students all over the world have been taught the same since the 1960s and they still are.

MPT is based on a number of assumptions, some of which are more restrictive than others. For example, it is assumed that the relationship between risk and returns is linear and that it is static, not only over time but also under varying market conditions. It is also assumed that investors behave rationally at all times. Last, but not least, returns are assumed to be stationary (normally distributed) and markets are assumed to be efficient. In this type of world, alpha doesn’t exist.

Obviously, if you want to pick a fight, each of those assumptions can be challenged, but that’s not the point. The real question is whether the sum of those assumptions is so far off the mark that it renders the entire theory absolutely useless. Effectively the question is whether EMH, and with it MPT, should be ditched altogether.

Behavioural economists take a different view

The battle lines between believers and non-believers have been drawn for years. Supporters of EMH say that while behavioural biases most certainly exist in the real world, they are of limited relevance because markets will tend to arbitrage those inefficiencies out very quickly. Opponents of EMH argue that those biases are systemic and have an ongoing, significant effect on markets, because investors suffer from over-confidence and other biases. One group of opponents – behavioural economists – are known for taking a particularly dim view of EMH.

James Montier, one of the best known proponents of behavioural finance, wrote a now famous paper back in 2005 calledSeven Sins of Fund Management – A Behavioural Critique. In his paper he asked an interesting question: Given the overwhelming evidence that investors are simply awful at predicting the future, why does forecasting play such a pivotal role in the investment process? He provided a plausible explanation himself:

“In part the obsession with forecasts probably stems from the ingrained love of efficient markets. It might seem odd to talk of efficient markets and active managers in the same sentence, but the behaviour of many market participants is actually consistent with market efficiency [EMH]. That is, many investors believe they need to know more than everyone else to outperform. This is consistent with EMH because the only way to beat an efficient market is to know something that isn’t in the price (i.e. non public information). One way of knowing more is to be able to forecast the future better than everyone else.”

Not resting on his laurels, James went on to provide an explanation as to why we get it so horribly wrong most of the time. He believes it is due to a phenomenon psychologists call ‘anchoring’ and did a simple study to demonstrate how it affects decisions by asking his fund manager clients to write down the last four digits of their telephone number. He then asked them whether the number of doctors in their capital city is higher or lower than the last four digits of their telephone number, before finally asking them for their best guess as to the actual number of doctors in their capital city. Those with the last four digits of their phone number greater than 7,000 reported an average of 6,762 doctors, whilst those with telephone numbers below 2000 arrived at an average 2,270 doctors.

The conclusion is straightforward. When faced with the unknown, people (in this case, fund managers) will use whatever information they can get hold of. Hence we shouldn’t really be surprised that fund managers extrapolate current earnings trends when forecasting future earnings, despite the evidence that it is a futile exercise. In his paper James Montier provided powerful evidence of such anchoring amongst equity analysts (chart 1).

(A very good friend of mine, who happens to be a meteorologist, always tells me that the most accurate weather forecast for tomorrow is today’s weather, so perhaps I should treat anchoring with a little bit more respect, but that’s a story for another day.)

Chart 1: U.S. corporate earnings – actual vs. forecasts (deviation from trend)



Source: James Montier, Seven Sins of Fund Management, DrKW, 2005

Another example of behavioural biases is provided by MIT Professor Dr. Andrew Lo in his 2011 paper which you can find here. Dr. Lo makes the following point:

Suppose you’re offered two investment opportunities, A and B: A yields a sure profit of $240,000, and B is a lottery ticket yielding $1 million with a 25% probability and $0 with 75% probability. If you had to choose between A and B, which would you prefer? While investment B has an expected value of $250,000 which is higher than A’s payoff, you may not care about this fact because you’ll receive either $1 million or zero, not the expected value. It seems like there’s no right or wrong choice here; it’s simply a matter of personal preference. Faced with this choice, most subjects prefer A, the sure profit, to B, despite the fact that B offers a significant probability of winning considerably more. This is an example of risk aversion.

Now suppose you’re faced with another two choices, C and D: C yields a sure loss of $750,000, and D is a lottery ticket yielding $0 with 25% probability and a loss of $1 million with 75% probability. Which would you prefer? This situation is not as absurd as it might seem at first glance; many financial decisions involve choosing between the lesser of two evils. In this case, most subjects choose D, despite the fact that D is more risky than C.

When faced with two choices that both involve losses, individuals seem to behave in exactly the opposite way – they’re risk seeking in this case, not risk averse as in the case of A versus B. The fact that individuals tend to be risk averse in the face of gains and risk seeking in the face of losses – which Kahneman and Tversky (1979) called “aversion to sure loss” – can lead to some very poor financial decisions.

To see why, observe that the combination of the most popular choices, A and D, is equivalent to a single lottery ticket yielding $240,000 with 25% probability and -$760,000 with 75% probability, whereas the combination of the least popular choices, B and C, is equivalent to a single lottery ticket yielding $250,000 with 25% probability and -$750000 with 75% probability. The B and C combination has the same probabilities of gains and losses, but the gain is $10,000 higher and the loss is $10,000 lower. In other words, B and C is identical to A and D plus a sure profit of $10,000. In light of this analysis, would you still prefer A and D?”

For having “integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty”, Kahneman was awarded the Nobel Prize in Economics in 2002, the first time ever that a psychologist walked away with this prestigous award, and a sign that the establishment had finally begun to take behavioural finance seriously.

The Great Modulation

Now, you may begin to think that I am firmly siding with the proponents of behavioural finance and thus the opponents of EMH, but it is not that simple. What creates the doubt in my mind is that, for almost 70 years, EMH actually worked rather well. Between the mid-1930s and the early 2000s you could, by and large, ignore the occasional shortcomings of EMH and apply MPT in your portfolio construction.

Chart 2: U.S. actual earnings vs. forecasts (deviation from trend)



Source: “Adaptive Markets and the New World Order”, Dr. Andrew Lo, December 2011.

Following the Great Depression, the world entered an unprecedented period of economic growth and prosperity which resulted in a long and virtually uninterrupted rise in stock prices (chart 2). Dr. Lo calls this period the Great Modulation which is characterised not only by strong equity returns but also by comparatively low volatility (chart 3). Apart from a brief period around the October 1987 crash, equity volatility didn’t break the mid-twenties level for more than six decades which is quite an achievement.

During this period, the U.S. stock market, and with it most other stock markets around the world, produced a nearly linear, log-cumulative growth curve. Indexing your portfolio over the entire period (which is what true believers in EMH want(ed) you to do) would have yielded a return that would almost certainly have outperformed 99.9% of all active managers. It would be hard to shoot down MPT and EMH on the back of the performance of financial markets over this period.

Chart 3: Annualised volatility of U.S. equity returns ( 125-day rolling window)



Source: “Adaptive Markets and the New World Order”, Dr. Andrew Lo, December 2011.

One of the consequences of this extraordinary period was the invention of the 60/40 model. All you had to do – and many did it, and continue to do it – was to invest 60% in equities, 40% in bonds and sit back and let time do the job for you. Irresistibly simple. Then it all changed.

The new paradigm

Two major equity bear markets in the last 13 years have traumatised investors. The belief in MPT in general and EMH in particular has been shaken and finance theory will have to be re-written, or so it looks. So what is it specifically that has changed? Human behaviour certainly hasn’t. Greed and fear have been factors to be reckoned with since day nought. Dr. Lo, who has pioneered the research into how EMH can be adapted to incorporate behavioural factors, offers the following explanation (and I paraphrase):

The growing importance of the financial services industry, together with geopolitical changes (the U.S. is no longer the only dominant economic force in the global economy), and rapid advances in technology, have destabilised the equilibrium. The obvious implication, or so Dr. Lo argues, is that investors must change some of the tools in their tool box.

Interestingly, he doesn’t suggest that EMH should be mothballed altogether. To the contrary, he believes that EMH can work for extended periods of time provided investors behave rationally. I had the pleasure of meeting him in Cambridge (Massachusetts) a few weeks ago, and he delivered a convincing case that investor behaviour is actually rational most of the time when looked upon in aggregate. He calls it the Wisdom of Crowds and illustrated what he means with a simple example:

Imagine somebody puts a large jar full of jelly beans in front of you and you are meant to guess how many jelly beans the jar contains. You have no idea, but you are up for it, so you come up with a number. Sadly, unless you happen to be lucky, the chances are that your guess is miles off the true number. Now imagine that the same question is put to a large number of people and that the mean is calculated as the simple average of all the estimates. Interestingly, research suggests that the mean estimate is likely to be within a few percentage points of the true number. The Wisdom of Crowds.

The FT ran a story at the height of the credit boom back in April 2006 on the rapid growth of the CDO market in Europe. When asked by the FT to comment on this remarkable growth, Cian O’Carroll, European head of structured products at Fortis Investments, replied:

“You buy an AA-rated corporate bond you get paid Libor plus 20 basis points; you buy an AA-rated CDO and you get Libor plus 110 basis points.”

On the back of this statement, and despite all the evidence of froth in financial markets in 2005-07, it seems like the crowd was still quite wise. As Dr. Lo states in his 2011 paper:

“It may not have been the disciples of the Efficient Markets Hypothesis that were misled during these frothy times, but more likely those who were convinced they had discovered a free lunch.”

Occasionally, the Wisdom of Crowds turns into the Madness of Mobs and all rational behaviour goes out the window. History provides many examples of that – from the tulip mania in the Netherlands in the 17th century to the more recent bubbles we have experienced in dot com stocks and housing markets around the world. The once golden boy of central banking, Alan Greenspan, labelled it irrational exuberance in a speech in 1996 when commenting on what already then looked like lofty P/E levels on U.S. equities. As we now know, the bull market not only continued for a further 3 ½ years; it actually grew stronger. Once the mob gets going, it takes a great deal to stop it.

EMH is entirely unsuited to deal with froth. Charlie Munger (of Berkshire Hathaway fame) once said, and I paraphrase, what made economists love the EMH is that the maths behind it is so neat whereas the alternative truth is a little messy.

The Adaptive Markets Hypothesis

So what is the alternative to EMH? Dr. Lo has labelled it the Adaptive Markets Hypothesis (AMH), a name he coined back in 2004. AMH is an attempt to reconcile EMH with behavioural finance. AMH begins with the recognition that human behaviour is a complex combination of decision making systems. The focus is not on any single behaviour, but rather on how human behaviour responds to changing market conditions. Humans (investors) are neither perfectly rational nor entirely irrational. It all depends on circumstances.

In Dr. Lo’s own words, AMH is characterised by:

  • Individuals who act in their own self-interest;
  • Individuals who make mistakes;
  • Individuals who can learn and adapt;
  • Strong competition which drives adaptation and innovation;
  • A natural selection process which shapes market ecology; and
  • An evolutionary process which determines market dynamics.

The implications of AMH

AMH and EMH only agree on the first point. Investors usually act in their own self-interest. The rest is a departure from classic EMH thinking. The consequences of this are many and quite profound.

For example, according to AMH, the relationship between risk and return is not linear and it is certainly not stable over time. This implies that the equity risk premium should fluctuate meaningfully as a function of time and cycle. I note with interest that people who entered the investment management industry in the 1980s and 1990s ‘grew up’ in a world where the relationship between risk and return was extraordinarily stable; EMH by and large worked. I suspect that many of those individuals continue to subscribe to EMH and see the more recent changes in the investment environment as an aberration. My suspicion that this is indeed the case only gets stronger when I see how many continue to cling to the 60/40 model.

Another implication of AMH is that the relative attractiveness of investment strategies will ebb and flow over time as some strategies (asset classes) are likely to perform better in certain types of environments than in others. Income generating strategies have performed very well recently, partly because of demographic factors which have driven pension funds and individuals away from equities and into asset classes offering a higher yield. EMH assumes that such ‘arbitrage’ opportunities are competed away immediately.

Furthermore, AMH, unlike EMH, distinguishes between characteristics such as ‘growth’ and ‘value’, permitting investors to take advantage of sentiment factors. A classic example is the late 1990s when value investors dramatically underperformed growth investors. AMH would have picked up such a trend. EMH did not.

Importantly, AMH also provides a distinction between risk and potential. In EMH, returns are normally distributed and there is no distinction between downside risk (bad volatility) and upside potential (good volatility).

Concluding Remarks

AMH is a new paradigm, still very much in its infancy, but there are things investors can take away from this.

Most importantly, if the best you can hope for in a world of rational investors is to perform in line with the markets (classic EMH thinking), then a vital consequence of AMH is that you can actually outperform the markets over time through a dynamic allocation strategy which varies the capital it allocates to equities in response to changing levels of risk.

Secondly, unless you truly believe that the current environment is an aberration, and the ‘good old days’ will soon return, the 60/40 model should be buried once and for all. It is entirely inadequate to deal with the realities of the current environment. Many universities and business schools around the world are yet to figure this out, so students all over the world continue to graduate in the belief that EMH has it all worked out, but the reality is starkly different.

Finally, EMH is a hypothesis. MPT is what practitioners in the investment management industry use to implement the theories behind EMH. AMH is a hypothesis as much as EMH is and tools allowing investors to adopt this new paradigm must be further developed. The process has already begun, though. If you are interested in learning more about how it works, please contact us.

In the Long-Run We Are All in Trouble

By Niels Jensen, Absolute Return Partners

“The long run is a misleading guide to current affairs. In the long run we are all dead.” – John Maynard Keynes

I often find myself caught between what is appropriate for the short-term vis-à-vis the long-term. Should I allow myself to become captivated by the long-term challenges that we are facing or should I do what the majority of investors seem perfectly happy to do – ignore the long term and focus on the present? Moral deliberations, career risk considerations, greed – you name it – all seem to be factors.

I vividly recall the misfortunes of Tony Dye. Tony was one of Britain’s best known fund managers in the 1990s. As equity markets became more and more expensive towards the end of the decade, he became increasingly adamant that markets were overvalued and began to reduce his equity exposure. In 1999 his firm was 66th out of 67 in the UK equity league tables and in February 2000 he was sacked for poor performance. Within a few weeks of his dismissal, the FTSE peaked and one of the largest bear markets of all times began, all of which taught me a very important lesson – poor timing can ruin even the best investment decisions. All this came back to me after I published a chart in last month’s Absolute Return Letter produced by Albert Edwards and his colleagues at Société Générale (chart 1).

Chart 1: Total Government Liabilities


Source: Societe Generale Cross Asset Research.

Many of you came back to me, asking if this something we have to worry about. More on that later but I would like to start elsewhere. I want to address the question that seems to preoccupy investors more than anything at the moment. Will monetary policy lead to runaway inflation or will it not? There is so much scare mongering going on that it is time to take a deep breath and look at the facts.

Why inflation will remain subdued

There are at least a couple of reasons why investors in most countries shouldn’t worry unduly about inflation in the short to medium term (what will happen in the long term I honestly don’t know). As so aptly demonstrated in a recent IMF paper, the interaction between inflation and the economic cycle is very different today when compared to the 1975-1994 period. Whereas inflation back then was pro-cyclical, it is largely non-cyclical today with inflation well anchored around 2% regardless of the underlying economic conditions (chart 2). The obvious implication of this is that inflation should behave relatively well even as (if) economic fundamentals improve.

Chart 2: Inflation vs. cyclical unemployment



The other reason has to do with how monetary policy is interpreted – or rather misinterpreted. I have written extensively about this in the past so please refer to some of the older letters for detail. Suffice to say that many investors do not appear to grasp the difference between the monetary base and the money supply and that is indeed a mistake.

Using August 2008 – the approximate time of the Lehman bankruptcy which kick-started the new, more expansive era of central bank policy – as the base (i.e. index = 100), the U.S. monetary base has grown to 347, but the money supply (M2) has only grown to 135. The UK monetary base now stands at 433 with its money supply stuck at 110. In the eurozone, the monetary base is at 157 while the money supply stands at 107. Finally, in Japan, the monetary base is at 150 (and about to go much higher) but the money supply is only at 113 (see here).

At the end of the day, it is the money supply, not the monetary base, which sets the tone for inflation. Another way to illustrate this is by having a glance at QE’s effect on bank lending (chart 3). There has been no growth in bank lending at all despite all the so-called money printing. Investors are quite right in keeping their eye on the ball but, through my lenses, it looks as if they are focusing on the wrong ball.

Chart 3: QE’s effect on bank lending


Source: Nomura Research Institute

The ostrich rules in European banking

As an interlude – because that is not what this month’s letter is principally about – in the short to medium term, I worry primarily about the total state of denial in the European banking sector. Many of our banks are effectively bankrupt but the ostrich principle applies – with the apparent blessing of the authorities. Bury your head in the sand and hope for the problem to go away before anyone notices.

Over the past several months there has been a rather heated debate across Europe as to how far Germany is prepared to go, and should go, to keep the eurozone afloat. I would suggest very far. Here is the reason: Only a few days ago it was revealed that Deutsche Bank’s gross notional deriatives exposure now stands at a whopping €55.6 trillion (not a misprint) – more than 20 times the size of German GDP (chart 4).

Chart 4: German GDP vs. Deutsche Bank’s gross derivatives exposure


Source: Zero Hedge

Many will argue that Deutsche’s net exposure – which is only a tiny fraction of its gross exposure – is what matters, and that is theoretically correct. However, as Zero Hedge points out, the netting out works fine only to the extent the chain is not broken. The moment there is discontinuity in the collateral chain, all bets are off (see here). As many of Deutsche Bank’s counterparties are other European banks, it – and the rest of Germany – simply cannot afford for the European banking industry to come clean.

Despite all of this, I believe the short to medium term outlook is relatively constructive. The scare mongers and the gold bugs – who are more often than not one and the same – want you to believe that the world is coming to an end, which it is not. The U.S. Treasury Department is even planning on making the first down payment on federal debt since 2007. Who saw that one coming?

Here in Europe, the anti-austerity movement has suddenly got some long overdue wind in its sails, following the revelation that Reinhart and Rogoff made some pretty basic mistakes when preaching to the world that “>national debt in excess of 90% of GDP spells economic mediocrity. Apart from those elementary mistakes, which may or may not be material, Reinhart and Rogoff never distinguished between currency issuers (e.g. the U.S., U.K. and Japan) who can never be forced to default on debt issued in their own currency, and currency users (e.g. the eurozone members), a fact which always made me suspicious of their conclusions, but that is a story for another day.

The long term outlook for equities is bleak

What worries me more is the long-term outlook for equities which I think is mediocre at best, and I base that on two observations. Firstly, it is becoming increasingly obvious to me that we should expect interest rates to stay low for an extended period of time, both on an absolute and a relative basis. I actually expect real rates (measured as inflation-adjusted 10-year bond yields) to remain flat to negative in most G10 countries for several more years to come. Now, what can we deduct from that? Negative real rates are highly unusual and imply that capital is not priced correctly. It is an important indicator of financial repression.

What’s more, real rates are a proxy for trend growth. Negative real rates in a growing number of countries around the world suggest falling trend growth or, at the very least, a drop in expected trend growth. In the past, real rates have also been correlated with equity returns and negative real rates have usually led to low equity returns (chart 5).

Chart 5: The link between real interest rates and equity returns


Source: Barclays Equity Gilt Study 2013

Secondly, I worry a great deal about demographics and the effect they will have on financial markets. The link between demographics and equity valuation is well documented. Barclays researched it in the 2010 edition of the Equity Gilt Study (see here) and the FT picked up on it more recently (see here). The logic is fairly straightforward. In our younger years we save mostly for our children’s education and equities play a lesser role in our portfolios. As the children get older, and we begin to focus on our own retirement, our savings patterns change with equities now dominating our portfolios. Hence the demographic mix is likely to impact equity valuations, and that is precisely what has happened (chart 6).

Now, due to the ageing of society, the big equity buyers (the 40-49 year old) are being outnumbered by the big bond buyers (the 60-69 year old), pushing bond valuations up and equity valuations down. Importantly, that trend is likely to continue for at least another 6-8 years. This observation brings another question about – how much of the recent strength in the bond markets should actually be attributed to various QE programmes and how much is due to demographic factors? Nobody really knows the answer to this question, but I suspect that the significance of central bank policy is overestimated.

Chart 6: The link between savings and equity valuation


Source: “The population conundrum”, Financial Times.

Now back to chart 1. Equity markets have treated us well in the last couple of years but you don’t have to be über-bearish to see that we have to negotiate some pretty strong headwinds in the years to come. Jagadeesh Gokhale produced a noteworthy paper back in 2009 named Measuring the Unfunded Obligations of European Countries (which you can find here). The findings in that study feed straight into chart 1.

The growing age-related liabilities imply that we either need to reform our welfare programmes or the tax rate will have to increase to an average 60% across the EU to meet future obligations. Put slightly differently, the average EU country would need to put aside an amount equivalent to almost 10% of the annual GDP to fully fund future liabilities. Is that going to happen? I suspect not.

Across the Atlantic, the situation is as bad, if not worse. The U.S. payroll tax would have to double from current levels to fully fund future liabilities and each year that the U.S. government takes no action to reduce the projected shortfall, the funding gap grows by more than $1.5 trillion after adjusting for inflation.

The real zombie of Europe

Based on these calculations it is difficult to remain optimistic about the long term. Undoubtedly a solution will be found. It may be that we all have to work until we reach the tender age of 80. Or it may be that state sponsored benefits will be phased out completely and we will all have to rely exclusively on private pension arrangements. I don’t know precisely what the preferred path will be, but I do know that it will be a very bumpy road indeed. Europe has a history of dealing with social change in a very immature way, and the road to the new equilibrium is likely to be littered with social unrest.

France is a prime example of Europe’s self-inflicted hardship. Here are some revealing stats borrowed with gratitude from Gurusblog:

In 1999 France represented 7% of world exports. Today the number is 3%, and the figure continues to fall.

In 2005 France ran a trade surplus amounting to +0.5% of GDP. Today the surplus has turned into a deficit equivalent to 2.7% of GDP.

The total value of French car and machinery equipment sales to China is one-seventh the value of German sales of those same products to China.

In France 42% of wage costs of a company are social charges or taxes. In Germany it is 34% and in the UK 26%.

Since 2005, the total cost of producing a car in France has risen 17%, while in Germany the cost has increased 10%, in Spain 5.8%, and in Ireland 2%.

In France a worker earns on average €35.30 per hour, while in Italy the average is €25.80 and €22.00 in the UK and Spain.

The profits of French companies have fallen to 6.5% of GDP, a level that puts them at 60% of the European average. Lower margins mean less money to invest in new plants or technology leading to a 50% drop in the R&D of French companies over the last four years.

In my book, France is an accident waiting to happen. Unlike countries like Portugal or Spain where there is at least some political appetite for addressing the shortcomings, in France such appetite is virtually non-existing. It is therefore not unreasonable to suggest that the real test for Europe will come when the financial markets finally come around to the inevitable conclusion that France is the real zombie of Europe.

Concluding remarks

Now, you may well deduct from all of this that I am as bearish as I have ever been, but nothing could be further from the truth. The issues I have discussed in this month’s letter are clouds on the horizon which are likely to take years to play out and, in the meantime, investors will continue to be preoccupied with far more mundane issues. All I know is that financial markets cannot stay disconnected from economic fundamentals forever so, ultimately, the Tony Dyes of the world will be proven right. Unless they lost their jobs beforehand, that is.