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.

Looking For Bubbles

By Niels Jensen, Absolute Return Partners

Recent weeks haven’t offered much fodder for the optimists of this world. Eurozone leaders continue to rely on their central bankers to do the dirty work and the dithering is beginning to have an effect on consumer and business confidence across the world. What was meant to be a relatively shallow European recession this year now threatens to become something far more serious (chart 1).

Chart 1:  A Deteriorating Economic Outlook

Source: Citigroup

Recent PMI data confirms the negative trend in economic activity (a PMI reading below 50 is consistent with negative GDP growth). In our view, a European recession is already baked in the cake. Meanwhile, in  the U.S., a (mild) recession is starting to look like more than just a perma bear’s fantasy (chart 2).

Chart 2: Recent PMI Data Points towards a Global Slowdown

Source: Morgan Stanley Research

In Asia, China appears particularly vulnerable at this point. As I have pointed out repeatedly, the official macroeconomic data coming out of China is misleading even at the best of times. I feel tempted to quote Geraldine Sundstrom, the well-known emerging markets fund manager at Brevan Howard who is fond of saying: “Don’t listen to what the Chinese authorities say. Look instead at what they do.” I decided to do just that and found that they have recently slammed a 20% vacancy tax on undeveloped land (see here). That is a genuinely drastic measure and supports my long held thesis that the Chinese slowdown is more pronounced than the China bulls are prepared to admit.

A cyclical slowdown is not the only challenge the Chinese are facing. The urbanisation of the country is slowing from an estimated 3-4% over the past decade to 1-2% over the next decade. The labour pool is peaking as we speak and demographics will become an increasingly negative factor in the years to come, all of which suggest that annual GDP growth in China is likely to slow to 5% or even less in the not so distant future. The one mitigating factor, not only for China but for all oil consuming nations, is the recent drop in oil prices. Whilst its impact should not be exaggerated, falling oil prices are akin to a tax cut. A $20 fall in the price of crude translates into a 1% transfer of wealth from oil producing nations to oil consuming nations. As the consumption rate is higher in oil consuming countries, the net effect of a $20 drop in the price of crude oil is an increase in global GDP of about 0.5% (see here).

Interestingly, I find that many American investors are oblivious to much of this. They have for the most part pulled out of Europe and are thus focused mainly on domestic developments. As U.S. corporate profit margins continue to impress (chart 3), there seems to be a belief across the pond that U.S. corporates are well protected against events in Europe. I have a sneaking feeling that is about to change. Let’s see. U.S. corporates will begin to report second quarter earnings in the next few days. It will make for some interesting reading.

Chart 3: All-Time High U.S. Corporate Profit Margins

Source: There is more information to be found on (see section F7).

You may wonder where I am going with all of this. None of the above is rocket science but it is highly relevant in the context of the discussion I opened in the May Absolute Return Letter – where will the next asset bubble surface? As I have stated repeatedly in recent months, current monetary policy is conducive to the creation of echo bubbles. It is only a question of where and when.

I documented in the May letter that policy rates throughout Asia are dangerously low (see here), but does that translate into imminent danger? Allow me to recap what I wrote two months ago:

“A Perfect Financial Storm will occur when (1) investors have bets based upon very similar forecasts, (2) their bet is a ‘big’ one, for example, a bet on the price of their principal asset (their house), and (3) both investors and their banks are maximally leveraged.”

Asia arguably meets the first two conditions but not the third one yet. Paraphrasing the work of Duncan Wooldridge at UBS, the credit cycle begins with several years of growth in debt-to-income ratios, usually fuelled by easy access to cheap credit. The readily available credit leads to a growing misallocation of capital, causing an increase in nonperforming assets. This is the second stage of the credit cycle and is broadly speaking where Asia finds itself today. The third stage is the critical point where loan-to-deposit ratios in banks reach an unsustainable level. As a result, liquidity and funding problems become more prevalent and non-performing loans grow dramatically.

As is evident from chart 4 below, loan-to-deposit ratios are still well below the levels experienced in 1997. Moreover, most Asian countries (ex India) are creditor nations today, providing them with a cushion they didn’t have in 1997.

Chart 4: Asia Today is Healthier than Asia in 1997

Source: UBS

In the short term at least, the key challenge for Asia is its continued reliance on exports. The domestic sector is still too small to compensate for a dip in demand from overseas. This is illustrated in chart 5, courtesy of PIMCO. On average, every 1% increase in the U.S. current account deficit leads to a corresponding 1% increase in GDP growth across emerging markets.

In the aftermath of the 1997-98 crisis countries across Asia learned that they could export their way to prosperity. All it requires is a mercantilistic approach (read: artificially low exchange rates) and something the rest of the world is prepared to buy. Asia has since gone from strength to strength with almost every Asian country having accumulated large foreign exchange reserves over the past 15 years (see here), yet only Singapore’s currency has appreciated in value against the U.S. dollar since the mid 1990s. It is a testament to the lack of political leadership, and the sheer stupidity, we have suffered from in the West in recent years. The Asians must be laughing all the way to the bank. For the record, I don’t blame the Asians. They are only doing what everybody else would be doing if offered the opportunity. I blame the imbeciles running the asylum in this part of the world.

Chart 5:  The U.S. Deficit Drives Emerging Market Growth

Source: PIMCO

Countries that run persistent current account surpluses traditionally place a large proportion of their foreign exchange reserves in U.S.treasuries. These are usually held in custody by the Federal Reserve Bank. The growth in such holdings has slowed to a trickle in recent months (chart 6), suggesting a material slowdown in Asian exports to the U.S.

If you further consider that the monetary base in many emerging economies is defined by the size of their foreign currency reserves, the inescapable conclusion is that the liquidity picture across Asia is deteriorating. On the margin, this raises the probability of a negative credit event in Asia (the third stage of the credit cycle referred to above) happening sooner rather than later. However, in all likelihood, such an outcome is probably not months but years away.

Chart 6: Foreign Holdings of USTs Held in Custody by the Fed

Source: CrossBorder Capital

A much more likely candidate for a near term blow-up is the Australian property market with its inflated prices (chart 7). The counter-argument is the vast amount of wealth which has been created in Australia in recent years as a result of the boom in the mining industry – an argument which was put forward by several readers following last month’s letter.

Chart 7: Australian Property Prices in Bubble Territory

Source: Steve Keen’s Debtwatch

Now, that argument would be perfectly valid if it wasn’t for the fact that commodity prices follow a rather predictable pattern – on average about one decade of strong price appreciation followed by two decades of falling prices – and we are coming to the end of a decade of strong commodity prices. In the long run, this has resulted in commodity prices going practically nowhere (chart 8).

Chart 8: Commodities for the long run, anyone?

Source: SG Cross Asset Research

Another, and admittedly slightly less academic, way of looking at things is to compare the current bull cycle in commodity prices with the dot com boom in the late 1990s. At the height of the dotcom boom some 12-13 years ago, high tech stocks accounted for about 25% of global market capitalisation, and the boom had created 75 dollar billionaires in the IT industry versus only 29 coming from the energy industry. A good decade later these numbers have completely reversed. It is now commodity stocks (energy and materials) that account for one-quarter of the global market value and we have 91 energy related dollar billionaires versus 36 coming from the IT world. A sign of things to come?

The alert reader should by now have figured out that I don’t buy the ‘this time is different’ argument put forward by the commodity bulls. Loyal followers of the Absolute Return Letter will know that I am a firm believer in human ingenuity (see for example here). Creativity and resourcefulness will ultimately prevail which explains why commodity prices go nowhere in the long run. The one exception I make to this rule is agricultural commodities; we have not yet figured out how to produce artificial protein on a commercial scale, although we may not be too many years away from that either (see here).

Bonds are referred to by many as being in bubble territory. I don’t buy that argument. Bond prices are controlled politically these days. I still remember the first year at university when we were told that the central bank controls the short, but not the long, end of the curve. Not anymore. What’s more, our central bankers know only too well that the global economy is extremely fragile and that an increase in rates, at both ends of the curve, could have catastrophic consequences. I do not expect a material increase in yields anytime soon and I have absolutely no intentions of betting against my own government with its virtually unlimited resources. That is a bet I would almost certainly lose.  Equity prices at current levels are looking quite attractive (chart 9). Even if there is some short term cyclical risk to earnings, and thus to valuations, it is hard not to be long term bullish. We just need some clarification on the Eurozone problems so the world can move forward again. My money is on Merkel grabbing the bull by the horns in the next six to nine months so that it doesn’t become too big a theme in the German parliamentary elections later next year.

Chart 9: Equities Are Attractively Priced for the Long Term

Source: UBS. Valuations updated through May 2012.

That leaves commodities, and crude oil in particular, as my only other serious candidate for the ‘bubble that is about to burst’ prize. There is a serious glut of oil in the world at the moment. U.S production has been ramped up dramatically in the last 12 months. Libya and Iraq have both come back faster than expected. Meanwhile, most OPEC producers continue to cheat (chart 10) and all of this is happening in an environment of slowing economic growth.

In the interim, money has continued to come into commodity based funds. According to estimates from Morgan Stanley, commodity assets under management worldwide have more than doubled in the last five years to over $400 billion and the daily trading volume in energy futures is now a whopping 25 times the daily demand for energy.

Chart 10:  OPEC Producers Are Notorious Cheats

Source: Macquarie Research

If the global economy continues to weaken and oil producers don’t adjust their production accordingly, there is a pretty good chance of crude oil prices coming back further which would be a great tonic for the global economy going into 2013.

So it is not all doom and gloom. We are staring into a cyclical downturn in the second half of this year. Behind that is a whole other set of challenges, more structural in nature, which will take years to sort out. Our American friends – except for a small but rather vocal minority – won’t accept that they have their own set of problems which are quite serious. Our Asian friends will continue to ‘cheat’ their way to prosperity until we put our foot down. And the Europeans will argue ‘til the cows come home about what is the right remedy for our disease whilst society as we know it unravels around us.

But, as Churchill used to say (and I paraphrase), they will eventually make the right decisions once they have pursued every other avenue. It is precisely for that reason that equities are cheap. We just don’t know how long it will take. If my inkling about Merkel is right, the next equity bull market is not that many months away.Cheer up and enjoy the summer. Back in September…


By Niels Jensen, Absolute Return Partners

“In the science of physics, we know that water freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed.” – Robert Wenzel, Editor of the Economic Policy Journal, speaking at the New York Fed

In the science of economics there are no such constants, yet investors often behave as if they operate in a world of logic and certainty. Because such assumptions are made, history is littered with investors who have failed miserably.

Before I go any further, allow me to take you back in history for a moment – more precisely to year 1,012. My Viking forefathers had already raped and pillaged their way through the British Isles for more than a century and King Knut was only six years away from bringing the Danish and English crowns together for the first, and last, time. Having been captured by the Danes the previous year in a raid on Canterbury, 1,012 was also the year that Ælfheah, the Archbishop of Canterbury, was brutally murdered by a Danish mob after he refused to be ransomed.

It was also in year 1,012 that little Johnny was born. He was a thrifty lad and, almost immediately, put £1 into his piggy bank. It didn’t take him long to realise that the piggy bank wouldn’t earn him any interest so he began to lend money to the farmers in his village, allowing them to harvest ever larger areas of farmland. All Johnny demanded was a modest rate of interest amounting to inflation + 3% which was not unreasonable. After all, he took risks that he should be paid for. It was a perfectly rational request.

Johnny was not only thrifty; as he grew into a young adult he taught his own children some business acumen, so, long after Johnny had perished as an old but wealthy man, his children and their children continued to earn a modest 3% over inflation, year in, year out. 40 generations later, Johnny’s great-great… grandson is now easily the wealthiest man on earth with a personal fortune of no less than £6.87 trillion. That’s the power of compounding.

Now, we all know that there is no single person on this planet worth anywhere near £7 trillion, so something is wrong with my maths. Apart from the evil called the tax man – the obvious mistake I make is not taking into account the value destruction which has decimated our wealth at regular intervals since the sun rose for the very first time – due to war, disease, bursting asset bubbles, or because some odd meteor from outer space chose to crash land in our backyard. The reasons are many but the end result the same.

The point I want to make here is that our brains are not calibrated to deal with the unexpected. Most of us believe we are good risk managers but in reality we are not. Most of us trust that risk can always be quantified and expressed through some fancy modelling whereas, often, it cannot. When I went to lunch on the 11th September, 2001, little did I know – or expect – that less than an hour later I would get a call from my assistant suggesting that it was probably best if I came back to my desk as quickly as I possibly could.

The world is not normal, yet universities continue to teach our young students the wisdom of Markowitz and Sharpe which brought us modern portfolio theory and, more specifically, the capital asset pricing model. Garbage In, Garbage Out, as they say. One of the fundamental assumptions behind modern portfolio theory is that asset returns are normally distributed random variables. I suggest you take a glance at chart 1 below. The bright (smooth) blue line depicts a perfect normal distribution. The darker (uneven) blue line represents actual equity market returns over the past couple of decades. Even the untrained eye can see that the return profile of US equities fairly closely matches that of a normal distribution with the exception of large negative returns. They have come about more frequently than one would or should expect.

Chart 1:  The Return Distribution of Equities is Non-Normal

Source: “Global Volatility Outlook 2012”, Barclays Capital.

Note: Histogram of 3-month overlapping returns of S&P500 since 1990.

You can’t model risk, yet armies of risk managers all over the world attempt to do so every day of the year. Value-at-Risk (VaR) is a prime example of such thinking. If a risk manager notifies the portfolio manager that his one day 1% VaR is $8 million, he basically tells the manager that there is a 1% probability of losing more than $8 million in one day’s trading. VaR assumes normally distributed returns. We already know that large negative returns occur more frequently than one might expect, so a use of the VaR model in isolation or relying on the absolute numbers only is likely to lead to the risk manager underestimating the frequency and magnitude of large losses. That is not the only problem, though.

We know from experience that periods of relative calm – and hence low volatility – often precede panic. VaR falls when volatility drops so, following a period of low volatility, the risk manager will often allow the portfolio manager to increase his risk taking, for example through increased use of leverage. In other words, the portfolio manager may walk straight into a financial storm with far too much risk on his books, if such storm has been preceded by a period of more benign market conditions.

Furthermore, VaR establishes the largest loss that the portfolio manager is likely to lose 99% of the time (assuming the risk manager uses 1% VaR) but it says nothing about what might happen in the remaining 1% of cases. Isn’t that at least as important and probably more so? After all, 1% still accounts for two, maybe three, trading days every year. VaR is a quasi useful tool in the right hands but a highly toxic one in the wrong hands.

The brilliant economist Hyman Minsky understood this only too well. Whilst lecturing at University of California, Berkeley, he developed the thesis that stability in itself is destabilising – an idea that led to his Financial Instability Hypothesis. Not surprisingly, Minsky’s ideas have attracted widespread attention more recently, following the worst financial crisis of three generations which came about after years of unprecedented prosperity.

Stability breeds instability for several reasons – key amongst them is our inclination to look in the rear mirror for clues about the future. Portfolio managers, risk managers and regulators all tend to do so when looking for clues as to where the system is vulnerable. U.S. residential mortgage loans offer a prime example of such behaviour (see chart 2).

Chart 2:  Charge-Off Rates for Residential Mortgage Loans and Business Loans

Source:, Federal Reserve Bank of St. Louis.

During the recession of 1990-91, charge-off rates (i.e. bad loans) on U.S. residential mortgage loans (the red line in chart 2) hardly changed. Broadly the same picture emerged during the 2001 recession. Business loans, on the other hand, demonstrated a classic cyclical pattern with a significant rise in charge-offs during both those recessions (the green line in chart 2). Based on this knowledge, going into the 2007-09 recession, consensus was that residential mortgages would do relatively well in a recession whereas business loans would experience a significant pick-up in charge-offs. As we all know now, this turned out to be the mistake of the century and one which I, to my great regret, made myself. Never fight the last war when managing risk! 

Whether we like it or not, we will continue to make mistakes. It is simply part of human nature. However, the effect mistakes have on financial markets are compounded when they are correlated. A “correlated” mistake is one in which investors share a common forecast that proves to be wrong. An “uncorrelated” mistake is one where investors’ forecasts are widely spread out symmetrically around the eventual outcome (the Truth). Our economic adviser Woody Brock makes the following observations on correlated versus uncorrelated mistakes:

 “The more correlated the forecasting mistakes of the individuals in a market are, then the greater the market correction (and hence volatility) will be in the market once the Truth is learned. When forecasts are uncorrelated and distributed symmetrically around the Truth, then once the Truth is learned, for every seller there will be a buyer and market price does not change. There is no volatility. In the case of a correlated structure, the reverse is the case: everyone becomes either a buyer or a seller in unison, resulting in sharp changes in price.”

Leaning on Kindleberger’s work, Woody Brock goes on to conclude:

“In applying this insight to help explain the case study of the Global Financial Crisis three years ago, I arrived at what I have termed the Fundamental Theorem of Risk: A Perfect Financial Storm will occur when (1) investors have bets based upon very similar forecasts, (2) their bet is a “big” one, for example, a bet on the price of their principal asset (their house), and (3) both investors and their banks are maximally leveraged. It can be demonstrated formally that these three conditions will generate a Perfect Storm of maximal volatility — and note how perfectly these three conditions were met in the US housing market collapse. The role of excess leverage is to nonlinearly amplify market distress.”

Woody Brock’s work is critical in terms of understanding why 2011 turned out so differently from 2008 and, more importantly, why the painful experience of 2008 is not likely to be repeated any time soon, at least not in Europe or the United States. In 2011, investors were (and still are) deeply divided as to the longer term consequences of the policy being pursued – witness the great deflation vs. inflation debate – so Woody’s first condition (investors having bets based upon very similar forecasts) was not met in 2011 and is still not met today unlike in 2008 where all three conditions were fulfilled in abundance.

Abuse of statistics is another source of poor risk management in our field. One such example is the widespread confusion between correlation and causation. Just because a statistician can prove a correlation between ice cream consumption in Angola and the number of single mums in Panama doesn’t mean that there is causation (i.e. one is a function of the other).

Neither are correlations stable over time as so amply demonstrated in chart 3 below. Those who based their risk management approach around 1999-2000 on the assumption that US Treasuries and US equities were positively correlated were in for a rude awakening. Today everyone takes for granted that the two are negatively correlated. For now they are but for how long?

Chart 3:  Rolling 5-Year Correlation of US LT Treasuries vs. S&P 500

Source: Richard Bernstein Advisors. Note: Total returns, Dec 1980 – Dec 2011.

My favourite case of data abuse is unquestionably Reinhart and Rogoff’s work on debt versus economic growth (see here). In their much quoted research paper they state the following:

“We have shown that public levels of debt/GDP that push the 90 percent threshold are associated with lower median and average growth; for emerging markets there are even stricter thresholds for external debt while growth thresholds for advanced economies remain an open question due to the fact only very recent data is available.”

These four rather innocuous sounding lines have since become gospel in many quarters. It is now widely accepted that 90% debt-to-GDP is the invisible line in the sand. Once crossed, you are doomed. Economic growth will tank and you will ultimately default on your obligations, or so many believe.

The reality is that Reinhart and Rogoff’s work is based on a relatively small sample of countries of such disparity in socioeconomic profiles that providing an average figure is almost meaningless. It is akin to suggesting that yesterday was a very pleasant day with an average temperature of about 20C when in fact it was -10C at night and +50C during the day – both highly unpleasant. However, and for the record, I don’t blame Reinhart and Rogoff who did caveat their findings; no, the blame lies firmly with all those who have taken those findings at face value and used them out of context.

Another example of poor risk management is the one-dimensional thinking so often exuded by investors. It manifests itself in a number of ways.  More recently it has become clear to me that investors are incapable of focusing on more than one crisis at any given point in time. 2011 became the year of the euro crisis; pretty much nothing else mattered. The inability to apply multi-dimensional thinking is also clear from how markets treat economic news. In the U.S., (un)employment data have stolen most of the headlines in recent months with less emphasis on other, and equally important, economic statistics. This could have significant implications for financial markets. Here is why.

I suspect that the U.S. economy is in the process of inheriting Europe’s long standing problem of high structural unemployment. If my fears are well founded, investors are likely to underestimate the strength of the U.S. recovery as they will mistakenly conclude that continued high unemployment is synonymous with persistent economic weakness. It may not necessarily be the case if the unemployment is structural in nature. Allow me to show you a chart supporting my suspicions (chart 4). The green line is a proxy for the output gap and used by the Fed. The red line is the Fed funds rate. Two observations immediately stand out: (1) The two correlate relatively well over time, and (2) The output gap has now all but evaporated since it peaked in late 2009. In plain English: the economy is stronger than suggested by the employment data and, more importantly, the Fed may be forced to raise rates as they are increasingly at risk of falling behind the curve. This may also explain why there is growing dissent inside the ranks of the Fed.

Chart 4:  Is the Federal Reserve Bank Behind the Curve? 

Source: UBS, Bloomberg

I could go on and on. I could mention (some) investors’ one-dimensional focus on the absolute level of P/E ratios when it makes little sense to assess P/E ratios without taking the level of interest rates into consideration. Following this logic, investors should pay more attention to the equity risk premium and less so to the absolute valuation of equities.

Or I could talk about the effect the ‘risk on – risk off’ mentality has had on the ability to diversify risk. In today’s environment asset classes fall into one of two categories – they are either risk assets or safe haven assets. Traditional diversification techniques have stopped working with significant implications for asset allocation and portfolio construction.

Perhaps I should also have allocated more time and energy to one of the classic traps of investing – investor overconfidence. Most investors have a remarkable and deeply fascinating ability to blame others for their mistakes whilst giving themselves credit for all the correct investment decisions. As my old boss used to say – Don’t confuse genius with bull market.

The list goes on and on. Instead I will finish this letter by looking into the future and give my response to the all important question: Where should investors look for the next big crisis? Many pundits are pointing to the bond market as an accident waiting to happen. Andy Xie says that the current policy “will lead to catastrophic bond market collapse”. Frank Veneroso says “bonds and bunds at these yields are a sheer madness”. Both men are widely respected and very astute observers of financial markets; however, if Woody Brock’s logic proves correct, betting on the bond market as a major accident waiting to happen may prove rather futile. My money is on Asia. Here is the logic.

We know from experience that an asset bubble that bursts is likely to create what are often referred to as echo bubbles. An echo bubble is a follow-on bubble from the initial asset bubble and is usually created when monetary and/or fiscal policy is relaxed in response to the bursting of the initial bubble. Some market observers have actually argued that the financial crisis of 2008 was in fact the bursting of an echo bubble created by the very lax monetary policy created in response to the bursting of the dot com bubble in 2001-02.

We also know the effect artificially low interest rates can have on a country. Think Spain or Ireland, both of which adopted artificially low interest rates when they first joined the eurozone; however, rates were low at the time to accommodate a rather weak German economy. The low rates did wonders for Ireland and Spain in the early years of the eurozone membership but it is now painfully clear that enormous excesses were created as a result.

Now switch your attention to Asia. Many Asian currencies are pegged to the U.S. dollar, either directly or indirectly. As a result, the central banks of those countries are forced to keep the policy rate at a level which may be entirely inappropriate for the rapidly growing Asian economies. Obviously, removing the dollar peg would address this dilemma, but that is a pie in the sky so long as the mercantilist approach that most Asian countries subscribe to prevails.

The Bank for International Settlements published a paper recently where it pointed out just how lax monetary policy is throughout Asia. With the exception of Japan, every single country in the BIS study appears to be behind the curve (see chart 5). This raises all kinds of issues for Asia longer term – increased use of leverage, inflationary pressures, asset price bubbles, etc. Does it sound familiar?

Chart 5:  Policy Rates and Those Implied by the Taylor Rule

Source: BIS Working Paper No 378

To me it looks and sounds like a potential re-run of Europe. When it looks like a fish and smells like a fish, it usually is a fish. The parallels are certainly there for everyone to see, although Asia’s crisis may take years to unfold. Investors in Spain and Ireland had six or seven years of exceptional returns before the tide turned and those who exited prematurely left an awful lot of money on the table. At this stage we are merely monitoring events, but the yellow flag has been raised.

Perhaps the best the Asian monetary authorities can hope for is that the Fed takes a very hard look at chart 4 above and concludes that perhaps the U.S. does need higher interest rates after all. Such swift action might still save Asia from a repeat of the European malaise.




By Niels Jensen, Absolute Return Partners

Remember the scene in A few Good Men where Colonel Jessup (Jack Nicholson) and Lieutenant Kaffee (Tom Cruise) trade insults? Following some pretty intense questioning, Kaffee yells at Jessup: “I want the truth”. With the deadly glare that only Jack Nicholson can muster, Jessop retorts: “You can’t handle the truth”.

I was reminded of this rather famous moment in film history when a long time reader of the Absolute Return Letter asked me recently: Why don’t you tell the truth about the UK economy? Why don’t you tell it as it is – that the situation in the UK is worse than it is in the eurozone? I decided to take up the challenge from the reader. I am not sure that I actually agree that the UK is in a worse position than most eurozone countries; it is worse in some respects but better in others. More about this in a moment.

The UK government’s strategy appears to be based on the age old philosophy that the best line of defence is attack. In recent months, Prime Minister Cameron has been unusually vocal about the shortcomings of the other major European powers at a time when everything is not plain sailing back home. On the major issues facing the UK domestic economy, Cameron and his government have been deceivingly quiet – perhaps because we can’t handle the truth?

Back to the outlook for the UK. There is no denying that it is grim; however, and despite all the weaknesses of the UK economic model, it has two key advantages over most of its European neighbours.

Firstly, it is a currency issuer rather than a currency user, meaning that it has full control of its monetary and currency policies and can apply precisely the policy required at any point in time rather than being held hostage to the needs and requirements of the other members of the European currency union. As a currency user, it cannot overtly default unless it chooses to do so, although there are ways it can default covertly as we shall see later.

Chart 1:   The UK Labour Market is Highly Flexible

Source: Bank Credit Analyst, John Mauldin

Secondly, the UK has gone much further than most other countries in terms of restructuring its labour markets (chart 1), granting it key advantages over its European competitors many of whom are still saddled with labour market practices that do not stand a chance in today’s environment where the market place for both labour and goods has turned truly global.

Having said that, the UK is in trouble. On several fronts. To begin with, the UK has not yet got its debt crisis under control. Despite talking the talk, debt has escalated further since the crisis erupted in 2008, making the UK one of the most indebted countries in the world (chart 2). When combining debt from the three main sectors – households, corporates and the public sector – of the major economic powers only Japan is now more indebted than the UK and it is only by a fraction.

Chart 2:   Total Debt in 10 Largest OECD Countries

In truth, it is not the public sector that is highly indebted. In fact, most of Britain’s debt problems originate from households and banks (chart 3) both of which have done little so far to address the problem. Unlike in the United States where households have been deleveraging – to a large degree through personal bankruptcies – UK households have not reduced debt levels at all, mainly because banks have been relatively lenient, granting forbearance to troubled borrowers where perhaps foreclosure would have been a more sensible strategy. The Bank of England estimates that as much as 14% of all UK home loans are either delinquent or in some sort of forbearance process. Nobody really talks about this because nobody wants property prices to fall out of bed. Can we handle the truth?

One reason for the high level of leverage in the UK banking system is a poorly understood business practice known as rehypothecation. Hypothecation is another word for lending against some underlying collateral and is an every day event in the banking world. Rehypothecation is a somewhat more complex lending practice and presents a much bigger risk to financial stability. It typically occurs in the world of prime brokerage which is the department within banks that services hedge funds and other customers who wish to use leverage in their portfolios and/or short stocks.

Chart 3:   The Composition of Debt in Selected Countries


Rehypothecation occurs when collateral posted by a client of the prime broker is re-used as collateral by the prime broker itself for leveraging its own book. It is perfectly legal; however, in the United States it is regulated activity under Rule 15c3-3 and is capped at 140% of the client’s debit balance. An example best illustrates how it works.

Assume a customer of the prime broker has pledged $100 million in securities against a debit balance of $50 million, resulting in net equity of $50 million. The prime broker can now rehypothecate up to 140% of the client’s debit balance or $70 million. In other words, the prime broker can borrow $70 million against collateral that has already been used by the customer to secure the original loan and it doesn’t stop there. Successive rounds of rehypothecation are permitted; however, if you think this is a bad practice, it is about to get a great deal worse.

In the UK, unlike the US, there is no cap on rehypothecation. No prize for guessing the game the global investment banks have been up to. By moving the majority of their prime brokerage activities from New York to London, it has been possible for investment banks to dramatically scale up of what is an enormously profitable business activity during good times but what has the potential to create havoc when markets go haywire.

Other than the multiple layers of leverage, which is bad enough in itself, a key problem associated with this business practice is the lack of segregation of client assets which many prime broker clients only came to realise when Lehman Brothers went bust. Clients of Lehman Brothers International Europe Ltd (also known as LBIE – the UK subsidiary of the US parent) found that their assets were not segregated when it was too late. So did clients of MF Global.

Following the demise of Lehman, prime brokerage clients began to read the fine print of the collateral agreements and many hedge funds now refuse to grant their prime brokers unlimited access to their assets. Chart 4 shows the decline in rehypothecation which has occurred following the Lehman crisis, but it remains a widespread practice which has the potential to cause massive problems at a time when you need stability more than anything.

Chart 4:                Collateral Received at U.S. Banks Approved for Rehypothecation

Let me repeat: There is nothing illegal about this business practice. However, more than three years after the messy bankruptcy of LBIE, hundreds of people remain involved in sorting out the chaos left behind by its prime brokerage unit. It is astonishing that no regulator or government has shown any interest in changing the rules, following what happened to clients of LBIE. Maybe they can’t handle the truth.

Now to something altogether different. Here in the UK we have not been short of assurances from our government[1] that QE is good for us and for the economy. Companies will benefit from lower borrowing costs and savers will benefit from rising asset prices, or so they say. This is, however, an over-simplified account of what truly happens. Only the largest companies can access capital markets with small and mid-sized enterprises having to rely instead on bank finance the cost of which has not come down. In many instances, the opposite is the case.

But that is not the biggest problem. In the UK, most pension schemes are defined benefit (DB) plans (as opposed to defined contribution plans). In a DB scheme, liabilities are calculated by discounting all future payments back to present value, using the long bond yield as the discount factor. When bond yields drop, unless the pension fund has hedged this risk, the present value of future liabilities will rise.

The bad news is that the corporate sector in the UK has not been fully hedging this risk. By one estimate, UK corporates are £90 billion worse off as a result of the latest round of QE which has driven UK bond yields down to new lows. With unfunded pension liabilities in the UK already at around £300 billion before this latest bout of QE (approximately 30% of total pension liabilities), such a further shortfall is an unmitigated disaster (see here for details).

For individuals, the outlook is equally dire. Savers have seen their interest income plunge and the millions of baby boomers who will retire over the next 15 years will see the income from their annuity schemes being decimated as a result of lower interest rates.

If the government really wanted to support economic growth as it says it does, it wouldn’t penalise the corporate sector to this extent. It would be buying gilts with short and medium term duration instead. It would possibly also be buying corporate bonds – in particular those issued by our troubled banks. And if the government really wanted to help the pensioners, it would issue longevity linked gilts instead of the 100-year

gilts (Ros Altmann’s idea – not mine) which has been the talk of town recently as such bonds would help the pricing of annuities.

But the government will do nothing of the above. It will in all likelihood continue to pursue a policy of negative real bond yields at the long end of the curve, whatever the cost to the private sector. For the government such a strategy is a win-win. It can finance its debt extraordinarily cheaply and the negative real yields will allow it to accelerate the pay-back of its debt. For the rest of us, it is default by stealth.

Sadly, this is only a small part of the problem. Britain’s pension model dates back to 1948. Some changes have been made to the model but the state pension age remains the same[1] despite the fact that life expectancies for both men and women have improved by some 10 years over the interim period. If you build a DB model on the assumption that, on average, your members will live 8-10 years beyond the day of retirement, and they instead live for another 20 years, you will by definition end up with a major problem.

In an attempt to address the future funding problem created by the improvement in life expectancies, the then labour government passed the Pensions Act 2007 which stipulates that the state pension age will be increased to 66 between 2024 and 2026, to 67 between 2034 and 2036 and to 68 between 2044 and 2046. As we say where I come from – this is akin to wetting your pants to stay warm!

The problem in a nutshell is that there is absolute no appetite in government for addressing this problem. What goes on is effectively a government endorsed Ponzi scheme where today’s retirees steal from future generations. If I were 30 years old today, I would demandthat the government change the pension system rather than go on the barricades to prevent change.

Whereas the newish British government has shown little or no appetite for dealing decisively with the pensions crisis, it has said and done all the right things in order to protect its coveted AAA rating. I am just not convinced that it really matters. First of all, government debt is not the main issue in the UK; it is private sector debt which remains the problem. Given the combination of low interest rates and long average maturities of the debt outstanding, the UK government can quite comfortably support current debt levels.

Secondly, would it matter if the UK lost its AAA rating? I don’t think so. The downgrade on US debt had no impact on the cost of borrowing over there. Financial markets still consider the US the benchmark of the world and the fact that US debt is now rated one notch lower means that AA+ is the new AAA. Financial markets are already tuned into the fact that most of those countries still rated AAA – including the UK – are almost certainly going to lose that rating in the next few years which means that bond prices already reflect that reality.

However, the British obsession with keeping its AAA rating risks derailing the domestic economy further. GDP growth has been slightly negative for the past two quarters so, technically, we are back in recession, and things are not likely to improve as long as the current policy is pursued.

As I have pointed out in previous letters, we currently find ourselves stuck in a balance sheet recession (see for example the March 2010 Absolute Return Letter here). Monetary policy becomes quite ineffective when that happens and fiscal policy should be expansionary to compensate for the loss of monetary efficiency. The policy currently being pursued in Britain is exactly the opposite – expansionary

monetary policy and tight fiscal policy. Would someone please tell our government that they are walking down the road of self destruction!

Britain’s dilapidated infrastructure needs urgent attention. We are desperately short of runway capacity at London’s airports to support economic growth in and around the capital; yet the political establishment is happy to spend 15 years discussing the pros and cons of another runway at Heathrow. We live in one of the wettest countries in the world, yet we don’t have enough water to meet demand in the south of the country. Our government encourages people to use public transport; yet it is the most expensive – and one of the most useless – public transport systems in the world.

I could go on and on. Now is the time to spend money on infrastructure. But the money must be spent wisely so that it enhances productivity and thus sow the seeds of future economic growth. Bond investors are intelligent enough to distinguish between such expenditures and the reckless spending that the previous government became known for.

So, back to the original question: Is the outlook worse in the UK than in other European countries? It is probably fairer to say that the UK is plagued by a different set of problems than mainland Europe. Sadly, our problems here in the UK are actually manageable if only we had political leaders with spines that were not made up of boiled spaghetti. There should be a law against making a career out of politics. Most of the current generation of political leaders in the UK have gone straight from university into politics and they have no clue about most of the issues facing the people of our country and, even worse, they don’t seem to care.

All they want to do is to cling on to their seat and you don’t usually keep your seat if you implement policies which are right for the country in the long run but immensely unpopular when first implemented. Wasn’t it the great Theodore Roosevelt who uttered the famous words (and I paraphrase): You can do what is right for the country or you can do what is right for the people but you can’t do both. It has never rung truer than now.

Current UK economic policy is all but guaranteeing low growth for several more years, meaning that the Bank rate, currently at 0.5%, will probably stay low for some considerable time. So will yields on gilts unless there is an exogenous shock to the economy, resulting in a rapid escalation of inflationary pressures, which is quite unlikely to happen in a balance sheet recession.

Many investors predict rising bond yields in the years to come, mainly as a result of the massive amounts of QE in recent years. I don’t think it is that straightforward. The combination of (i) ongoing deflationary dynamics emanating from continued deleveraging in the private sector which is only going to intensify, (ii) the pension sector’s enormous appetite for anything with a half decent yield and (iii) the strong incentive to maintain negative real interest rates, is likely to keep a lid on bond yields.

UK equities are quite attractively priced which should offer some considerable downside protection even if the economy continues to weaken. However, the lack of economic growth is likely to limit the upside potential. Our view thus remains unchanged. In the short to medium term, UK equities are likely to be range bound. In the long run, there is considerable upside potential.


By Niels C. Jensen, Absolute Return Partners LLP

Question for you: Which distinctly British asset class has offered the most attractive returns over the past decade? Central London property? Not even close, even if it has done rather well. UK farmland is the answer, having more than tripled in value over a decade which will otherwise not be remembered for its outsized returns (see story here). The rise in farmland values is not only a British phenomenon. All over Northern Europe and North America farmland values have responded well to higher commodity prices. Last year alone, farmland prices in the US Midwest appreciated by 22% on average (details here).

Now, if ‘rental income’ on farm land is going up as measured by higher crop prices, it is only logical that the value of the land appreciates, similar to the dynamics in the commercial property sector. However, I have long been puzzled by the fact that you find virtually no exposure to farm land in institutional portfolios despite the supremely attractive yields on offer when compared to commercial property. Pension funds happily buy office buildings, earning a return of 4-5%, maybe 6%, yet few have ventured into farmland where yields can be as high as 10% if the farm is big enough and run professionally enough.

In this month’s Absolute Return Letter we will take a closer look at agriculture. Should you be exposed to agriculture in the first place? Is it too late to buy farm land? Are there other and better ways to be exposed to agriculture? These and other questions I will address in the following.

Let’s begin with some numbers to set the stage. There are approximately 7 billion people in the world today. FAO (the food and agriculture organisation of the United Nations) expects that number to grow to approximately 8.3 billion by 2030. The average person consumes 2,780 kcal per day but the average masks a significant gap between the developed and the developing world. Whereas people in developed countries consume 3,420 kcal per day, people in developing countries consume no more than 2,630 kcal per day. By 2030 the average calorie intake is expected to have risen to 3,050 kcal per day, driven primarily by rising living standards in developing countries.

Adding these numbers up, global daily calorie consumption is approximately 19.5 trillion kcal, growing to an estimated 25.3 trillion kcal by 2030 – an increase of about 30%. An increase of that magnitude should, on its own, be quite manageable; however, things are not quite so straightforward. Here is the problem. Whereas diets in developing countries consist primarily of grains (rice, corn, wheat, etc.), diets in the wealthier parts of the world are dominated by protein, fat and sugar.

As the poor get wealthier, they will want more protein – mainly chicken, pork and beef. Converting a grain rich diet to a more protein rich diet will increaseoverall demand for grain significantly as livestock is inefficient in terms of converting grain to energy. It takes 2-3 kilograms of grain to produce 1 kilogram of chicken, about 4 kilograms of grain to produce 1 kilogram of pork and as much as 7-8 kilograms of grain to produce 1 kilogram of beef. Hence, if the average daily calorie

consumption grows by 30% between now and 2030 as projected, demand for grain will grow by a multiple of that.

In other words, the ag story is very much a story about rising living standards. The world produces increased spending power at an unprecedented scale. During its own industrial revolution in the late 18th and early 19th century, it took the United Kingdom no less than 154 years to double its per capita GDP. It has taken China a mere 12 years to accomplish the same. The OECD projects that the global middle classes will increase by 3 billion people over the next 20 years. These people will want their fair share of protein. This is likely to put unparalleled pressure on both livestock and grain prices.

Chart 1:  Chinese Urban Food Expenditures Outstrip Rural Expenditures (per capita – RMB thousands)

Source: “The China Files”, Morgan Stanley, October 2011.

Let’s focus on China for a moment. China’s transition from developing to developed country is already in full bloom and thus offers some excellent insight into the effect it has on natural resources. China industrial revolution began in earnest about 20 years ago. Since then, there has been massive migration from rural districts to urban areas. Chart 1, courtesy of Morgan Stanley, suggests that people in urban parts of China spend 2.7 times more on food items than those living in rural parts of the country. While some of the difference can undoubtedly be explained by higher prices in the cities, the bulk of the difference is down to the higher living standards that come with urbanisation.

It is not so much that the Chinese eat more when they move to the cities. It is rather the composition of their diets which changes. They simply consume more animal proteins. Between 1994 and 2009, the Chinese effectively doubled their meat consumption from about 35 kilograms per annum to approximately 70 kilograms[1]. Despite this rapid increase, as you can see from chart 2, the Chinese are nowhere near the top of the league tables in terms of animal protein consumption. The United States, New Zealand and Australia are the heaviest meat eaters in the world with an average annual per capita consumption of about 110 kilograms. For comparison, the average EU consumer downs about 80 kilograms of protein per year.

Chart 2:  Animal Protein Consumption Driven by Growth in GDP

Source: Laguna Bay Pastoral Company, Australian Farm Institute

Within a few years China will have more middle class families than the United States (chart 3). Analysts tend to focus on what that means for the car industry, for energy, steel, cement and copper prices. Few talk about agriculture but the implications are likely to be dramatic. I have written before about human ingenuity (see here) and my views remain unchanged. Many new technologies are in the pipeline, some only a few years away.

Some of these new technologies are likely to transform the use of many raw materials; however, food is a commodity where only limited technological progress has been made. Scientists have had some success with drought resistant crops which should improve yields meaningfully and genetically modified food will, whether we like it or not, gain some traction in years to come, but I have seen nothing that suggests to me that some groundbreaking new technology will revolutionise farming any time soon.

Chart 3:  Expect Rapidly Rising Living Standards in China

Source: Morgan Stanley, Commodities Outlook, November 2011

The Chinese leadership has long considered food self-sufficiency as a matter of national security and has allocated considerable resources to maintain its self-reliance. It worked for a while but the Chinese are running out of the two main resources required to remain self-sufficient – land and water. The ongoing urbanisation of China causes more and more cropland to be lost to city dwellers. Obviously rising yields can to some degree offset those losses, but China increasingly finds itself a buyer of grains in international markets.

Water is the second major constraint with China having to feed 20% of the world’s population on 6% of its fresh water. The average Chinese has only about 2,100 cubic metres of fresh water at his disposal every year – less than one-third of the global average – and a growing percentage of it is allocated to industrial companies. According to the World Bank, the water shortage is likely to get a great deal worse as there is evidence of excessive ground water depletion in many parts of China. In some areas around Beijing, ground water tables have dropped by as much as 300 metres.

For all these reasons there is only one probable outcome and that is for China to import a growing percentage of the food it will need to satisfy the changing dietary habits of its population. South Korea offers some interesting insight into what China may look like 10-15 years from now. The Chinese consume virtually the same number of calories as the South Koreans – about 3,000 kcal per day – but whereas the Chinese diet is still grain rich and low on fat and sugar (they should try and keep it that way!) – the Koreans have increasingly adopted a Western lifestyle. If the Chinese were to consume the same amount of chicken, pork and beef as the South Koreans, and they almost certainly will eventually, Chinese meat consumption would increase by 5.5 billion pounds – up 8% from today’s levels. The biggest effect would be on chicken meat. An increase to Korean consumption levels would result in a rise in global demand for chicken meat of no less than 10%.

According to estimates from Morgan Stanley, a full 70% of China’s corn produce and about 14% of its wheat already goes towards feeding the livestock industry. As the Chinese stuff themselves with ever more meat, only the world’s largest grain exporters are big enough to deliver on the scale the Chinese will need. It will be countries such as Argentina, the United States, Russia and Australia that are likely to benefit from the Chinese protein feast.

Chart 4:  Arable Land is Shrinking as World Population Continues to Grow  

Source: Laguna Bay Pastoral Company

I haven’t even touched on the rest of the world yet. China may deliver a large chunk of the 3 billion new middle class consumers the OECD projects for the next 20 years, but people all over the world will want to climb the protein ladder. This will happen at a time where the amount of land available for agricultural use is under more pressure than ever before (chart 4). Urbanisation is a global phenomenon and arable land is lost every day of the year to a growing number of people who opt to live in urban areas.

FAO estimates that global demand for meat will grow by 23% over the next decade as a result of a rising number of people with enough purchasing power to afford animal protein. With less and less land available, there will be considerable pressure on grain producers to deliver the amount required to feed the extra livestock.

The bio fuel madness Finally, a word on bio fuels. If your brain works broadly like mine, you probably wonder what went through the heads of those law makers who came up with the rather daft idea of creating a grain based bio fuel industry (chart 5). It is a sad testament to the weakness of modern day democracy where the elected simply bribe their way to longevity. Having said that, I do not for one second expect our political leadership to do a u-turn on bio fuels, however rational such a move might be. Hence, for many years to come, consumers all over the world will have to compete with American gas guzzlers for the next corn on the cob.

Chart 5:  Global Ethanol Production

Source: Global Green Agriculture

Now, let’s look at the investment implications of all of this. The answer to the first question I raised – should investors be exposed to agriculture in the first place? – is an unequivocal ‘YES’. Arable land is a finite resource and so is water. Demand on existing resources will be immense over the next few decades as living standards increase around the world. In the long run it is very hard to be pessimistic on grain prices.

So, if it is such a great story, why is that so few are exposed to agriculture? Maybe it is because of the complex nature of trading futures (managing contango versus backwardation and the cost of carry associated with it); maybe it is down to the inherently cyclical nature of agricultural commodities. Farmers are notorious for chasing returns. In practice this means that, following a season or two of, say, strong wheat prices, every farmer and his mother will want to grow wheat, which will lead to a temporary oversupply of wheat and thus weak prices.

There is also a risk that financial investors have overwhelmed what is in fact quite a small market. If financial investors outnumber fundamental investors, when we go from risk-on to risk-off (a phenomenon I have discussed extensively in previous letters), it has the potential to derail ag prices in the short to medium term. However, if you can stomach the cyclical nature of this asset class, I find it hard to envisage an environment where the returns do not comfortably outpace returns on bonds and equities when looked upon over the next 5-10 years.

If you manage pension money, can take a 10 year view and have no quarrels about the relatively illiquid nature of farmland, that’s where I would be putting my money. Importantly, farm land prices do not need to appreciate for this to be a good investment. The best farmers in Australia generate cash returns in excess of 10% at current crop prices and we hear anecdotal reports of 25-30% annual returns in some countries in Africa. That is obviously very attractive when compared to more traditional commercial property investments. We are currently assessing one such opportunity in Australia. Let us know if you wish to learn more.

If liquidity is important to you, I suggest you consider a relative value approach. Agriculture is particularly suited to relative value strategies because of the large relative price moves between different crops. We are aware of one or two excellent managers in this particular corner of the market. Again, let us know if you are interested. Alternatively, you can invest in managed futures strategies; however their exposure to agriculture varies enormously from strategy to strategy so you need to do your home work.

If you insist on managing the exposure to agriculture yourself, don’t be a hero. Stick to a portfolio of listed securities which is likely to serve you well over the next 10 years. Focus on providers of machinery and fertilizers as you don’t run the risk of betting on the wrong crop.

One final word on cyclicality. All commodities are at risk if the global economy weakens substantially. Many investors suspect that the current upswing in the US economy will prove a fluke and that the Americans will be flirting with recession later this year (I don’t). An even bigger number of investors expect the economic landscape to deteriorate further in Europe as 2012 progresses (I don’t). If they are right and I am wrong, you could see a major sell-off in all risk assets, including agricultural commodities.

I will be in Singapore during the period 28-30 March and am available for meetings, should you wish to discuss this or any of our other investment themes.


By Niels Jensen, Absolute Return Partners

Europe is going from crisis to crisis as the rest of the World is doing its best to muddle through. Meanwhile, global equity markets do not seem to care one jot. They only recognise one direction at present and that is higher. Many investors are perplexed. Fundamentals stink, or so most investors seem to think. Some commentators even talk of a pending equity meltdown of cataclysmic proportions. What on earth is going on?

The bears have a point. Fundamentals are not exactly rosy. I have just returned to the UK from a week in Mallorca where I have had the opportunity to take the temperature of Spain through the local media and through speaking to people on the ground. The picture I was presented with was not pretty.

The latest report from Instituto Nacional de Estadistica suggests that the overall level of unemployment in Spain now stands at 22.85% (see here) and youth unemployment has risen to more than 50%. Although a flourishing black economy in Spain ensures that not all these people are without work, the relentless rise in unemployment is crippling the domestic economy.

Hardest hit are retail sales. December sales came in 5.4% below year-ago levels (chart 1), confirming the dramatic loss of purchasing power in Spain. Most other macro indicators confirm this depressing trend, suggesting that GDP should in fact be much weaker than it has turned out to be.

Chart 1:  Spanish Retail Sales Continue to Disappoint

Source: Bankinvest

The subject of Spanish GDP has intrigued me for a while (I am a sad case, I know). When I began to do research for this letter back in December, the working title was Is Spain Cooking Its Books?Inspired

primarily by Frank Veneroso’s excellent work[1], I came to the inevitable conclusion that the economic statistics coming out of Madrid simply did not add up[2].

Then, on a quiet day between Christmas and New Year when most people had their Bloombergs switched off, the new Spanish government which had come into office only a week earlier, broke the news that the 2011 fiscal deficit would probably reach 8% of GDP – a full 2% over the target agreed with the European Union only a few months earlier (see here).

Embarrassingly, the admission came only four weeks after the outgoing government had confirmed that Spain was very much on target to keep the deficit below the 6% agreed with the EU. So, yes, Spain was cooking its books and Frank Veneroso was absolutely right in raising the red flag, but I had lost a good headline for the February letter. Back to square one.

The other big issue facing the Spanish economy is the blatantly overvalued property assets on the balance sheets of the banks and savings banks (see here). From what I heard whilst in Mallorca, the Bank of Spain is becoming steadily more forceful in its handling of the crisis, demanding a far more aggressive approach as to how the banks mark repossessed properties on their books.

To give you an idea as to how bad the situation is, a 2010 profit of about €50 million in Caja de Ahorros del Mediterraneo turned into a loss of €1.7 billion by June 2011 after its property book was marked to market. And that is just one small savings bank (that has since ceased to exist).

The new government has already put out an estimate of how much they expect (read: request) Spanish banks to set aside in additional provisions against bad property loans – €50 billion or approximately 4% of GDP. If that number proves sufficient, the property crisis is probably manageable. It is certainly not of the magnitude seen in Ireland.

On the other hand, consider this: Spain’s financial system has about €338 billion of property related assets on its books, €176 of which are classified as bad loans. If Fitch is correct in its analysis that the average foreclosed loan in the Spanish banking system is 43% overvalued (see here), then Spanish banks should set aside a lot more than €50 billion in provisions. And property prices continue to fall.

Much of the weakness in Spain, and elsewhere, is blamed on austerity but the facts simply do not support this argument. Most of the countries supposedly in the midst of an austerity drive – including the UK whose government has managed to convince the rest of the world that it is doing all the right things but the facts suggest otherwise – continue to run massive fiscal deficits. Something else must be at work.

In a credit-based economy, which would include pretty much every country currently finding itself in a crisis of sorts, aggregate private sector demand is not only a function of income but also of changes in debt. Proponents of this idea include economists such as Richard Koo and Steve Keen but, despite the logic of their message, it is a concept ignored by many economists. As Steve Keen writes:

“Bizarre as it may sound, these arguments by leading economists ignore decades of empirical research into and practical knowledge on banking, which have established that their fundamental premise is false: a new debt is not a transfer from one bank customer’s account to another’s—which is effectively what Krugman models and Bernanke assumes above — but a simultaneous creation of both a deposit and a debt by the bank. A bank loan thus gives a borrower additional spending power without forcing savers to reduce their spending power to compensate.”

In a highly leveraged economy such as the UK, even modest changes in household leverage can have a profound impact on the economy as the debt reduction absorbs capital otherwise ear-marked for consumption. Chart 2 below illustrates precisely how much private debt has escalated in the UK in recent years and how much de-leveraging is still to come, assuming we need to return to debt levels last seen in the 1980s before the explosion in private debt.

Chart2:  The De-leveraging Process Has Only Just Begun

Source: Steve Keen’s Debtwatch

Given those dynamics, and given the bleak prospects of a sustained upswing any time soon in Europe, there are commentators who argue that the ECB should engage in quantitative easing similar to the policy pursued by the Federal Reserve Bank and the Bank of England. To those people I say: Wake up. Where have you been for the past six months? The ECB together with the national central banks of the eurozone have engaged in massive QE since last August (chart 3) although they have done their best to be quite discreet about it.

As pointed out by Frank Veneroso, the ECB’s balance sheet has expanded almost 50% in the last six months to €2.7 trillion and it doesn’t stop there. The balance sheets of the 17 eurozone central banks have grown even faster and now add up to €1.7 trillion, creating a consolidated balance sheet in the European central bank system of €4.4 trillion, almost twice the size of the Fed’s balance sheet. And this is beforeyou add in the €489 billion provided through the LTRO

programme announced on the 8th December. This certainly hasn’t gone unnoticed in European equity markets which have performed much better since the announcement.

Chart 3:  ECB Bond Purchases Exploded in 2H2011

Source: Bankinvest

What’s more, European banks are set to more than double their crisis loans from the ECB when the next LTRO auction opens on 29th February according to a survey in the Financial Times (see here). The conclusion is crystal clear: It is not a question of whether the ECB should or should not engage in QE. The ECB is already knee deep in a QE programme that has been firing on all cylinders since last August, and there is a lot more to come.

There is no question that the liquidity made available by the ECB has eased the liquidity squeeze in the European banking system and thus provided some much needed energy to the equity markets; however, in order to fully understand what is going on, you need to look at chart 3 in conjunction with chart 4. It is no coincidence that M3 (a broad measure of money supply) has begun to fall at the same time as the ECB has expanded its balance sheet aggressively.

Chart 4:  Eurozone M3 in Decline

Source: Note: All numbers in billion euros, seasonally adjusted

As the crisis in the European banking industry has mounted over the past couple of years, the only type of interbank lending that has continued to work well is repo lending (secured lending usually, but not necessarily, with government bonds provided as security), but repo lending is not ideal for banks in the current environment as it is mostly short term finance.

Having the ability to finance their liquidity needs longer term would give the banks much needed stability and that is precisely what the ECB programme provides and why so many banks took up the ECB offer. This has had the effect of draining the interbank market of collateral (which is now with the ECB). Since repos are included in the M3 but secured lending provided by the ECB is not, the M3 drops as banks shift from the repo market to the ECB.

You may say, so what? However, this is not only of academic relevance. Obviously the need for the ECB to step in and offer an alternative to repo funding is a signal that the credit conditions in Europe are far from ideal. If one drills one level deeper, it is possible to obtain information as to which countries have seen the biggest drop in repo funding, which should be a proxy for relative credit conditions. Not surprisingly, Italy accounts for almost 50% of the drop in repo funding with Spain accounting for almost 20% and Belgium for about 15% (see here for details).

Now, this information has been used by some commentators to suggest that Italy is being suffering a slow and painful death in the euro system. Ambrose Evans-Pritchard wrote a stinging article in the Daily Telegraph a couple of weeks ago, suggesting that “The euro is pushing Italy into depression” (see here). Using chart 5 below, he argued that:

 “There is no clearer indictment of the dysfunctional nature of monetary union. Italy is being pushed into depression. Criminal.”

Chart 5:  Italy’s Contribution to Euro Area Monetary Aggregates

Source: Banca d’Italia. Note: 12-month percentage changes

Now, remember what I said earlier. Repos count towards M3. ECB secured funding doesn’t. So, when Italian banks move away from the repo market and fund themselves through the ECB instead, the effect on M3 will be profound. Italian banks are much better off with the ECB programme but M3 looks ugly as a result. Sometimes there is more to the story than first meets the eye.

Which brings me to one of my pet hates. The emergence of the internet as a provider of (usually) independent and (occasionally) high quality research has made it more important than ever not to take everything you read at face value. I am referring to the thousands of market commentators cum economists (let’s just call them bloggers although, strictly speaking, they don’t all blog) who see it as their call in life to

comment on every bit of economic and market news, whatever the relevance to the rest of us.

Now, I shall be the first to admit that many bloggers do a very respectable job and their services are certainly needed as an antidote to the self-promoting investment banks which have always done – and always will do – everything in their power to talk the markets up. Having said that, many bloggers are as negatively biased as the investment banks are positively inclined, so the neutral needs to understand that there is bias in both camps.

The other and bigger problem is that most bloggers do not manage money. Talk is cheap when there is no accountability. Back in the late 1990s, fund manager Tony Dye became a household name in the UK for sticking to his view that equity markets were dramatically overvalued. His employers began to lose clients and finally lost patience with Tony who was sacked in February 2000 (no points for guessing when the markets topped out). Tony was a fund manager with great vision who was prepared to stand by his views, but he paid the price for getting his timing wrong.

Where am I going with this? You are about to find out. In the blogging sphere timing rarely matters. Bloggers can operate on a completely different level from market practitioners, and most of them do. Good friend and fellow investment manager Kim Asger Olsen of Origo (see here) refers to it as Economists’ Hypothetical Time (EHT) versus Real Market Time (RMT). His point – and I wholeheartedly agree – is that, whereas market practitioners (those who manage money and thus have an effect on markets) are forced to operate in RMT if they have any desire to make money for their clients, bloggers tend to work in EHT (this is a polite way of saying that they dwell for too long on what already belongs in the past in RMT).

Market practitioners no longer care about Greece. Neither do they care about Portugal for that matter. In RMT these countries no longer matter in the bigger scheme of things (to my friends in those countries: don’t take it personally, but that is the reality). So, when Portuguese bond yields blow out as they have done in the last week (chart 6), the reaction in the markets is muted to say the least. EHTers think it spells the end of the world. RMTers, on the other hand, know that Portugal doesn’t need to finance itself through the bond markets for at least another 30 months. Hence they ignore the Portuguese predicament. Instead they are now entirely focused on whether Italy and Spain can ride out the storm and, on the evidence of the recent performance of European markets, the verdict is that they can.

Chart 6:  Weekly Change in Eurozone Bond Yields

Source: Bankinvest. As at 1 February 2012. 

Much of the €489 billion that the ECB dished out in December has come back into the coffers of the ECB as overnight deposits (which may have disappointed the ECB somewhat) but, irrespective of that, the programme still did the bond markets in the eurozone’s periphery a world of good. Charts 7 a-b below show the Spanish and Italian yield curves as at 7 December (the day before the ECB announcement) and [28 January] respectively. The improvement is significant, in particular on 2-4 year maturities where the effect of the LTRO has been the greatest.

We can debate from now ‘til the cows come home whether Italy can afford to pay 6% on its 10-year debt, and that is precisely what occupies the minds of those operating in EHT, but what matters to RMTers is that Italy can finance itself cheaper now than they could 8 weeks ago. Doomsday has moved further away and equity markets have reacted accordingly. Who said QE doesn’t work?

Chart 7a:  Spanish Yield Curve

Chart 7b:  Italian Yield Curve


Now to the $64 million question: Are we in the early stages of a major new bull trend or is it simply a bear market rally? Most EHTers will tell you it is the latter. RMTers are divided. Let’s look at some of the risks before I reveal where I stand.

Few people would probably disagree that the biggest risk facing the world today is the unfolding eurozone crisis but, as I have at least

attempted to demonstrate with this piece, that crisis is now in decline, at least temporarily. I say temporarily, because there can be no doubt that the ECB has not solved the eurozone crisis yet. All it has achieved so far is that it has bought a not inconsiderable amount of time which is no small accomplishment given the near meltdown only a few months ago. On that basis, the equity rally is more than justified.

But the eurozone crisis is not my only worry. After a decent run in equity markets, individual investor euphoria is on the rise and is now in dangerous territory – at least in the US (chart 8). This is not a dead sure indicator, but when sentiment reaches these levels, it often precedes a sell-off (small or large).

Chart 8:  Investor Sentiment in Dangerous Territory

Source: American Association of Individual Investors, Pragmatic Capitalism

If individual investors are perhaps getting a bit carried away, Wall Street analysts certainly aren’t. Earnings estimates for 2012 have come down significantly over the last few months (chart 9) at a time where the US economy has surprised pretty much everybody by its strength. This doesn’t add up. Are analysts overly pessimistic (not usually in their DNA) or is this an indication that the current upswing in US economic fundamentals will prove short-lived? The last thing Europe needs now is for the US to lose momentum again. It can hardly afford it.

Chart 9:  US Earnings Estimates Under Pressure

Source: Morgan Stanley

I wish the list would stop there but it doesn’t. I am concerned about China (don’t think they tell the truth about the true extent of the current slowdown) and I agonize over the situation in Iran (the world economy is too fragile right now to withstand an oil price at $150). Most of all, I worry about pension liabilities in Europe (see here) which continue to grow without any serious attempts being made to address the problem.

In other words, there is plenty to keep me awake at night; however, to use an old cliché, equity bull markets have always had to climb walls of worry and this is no different. At least for now, valuations are sufficiently attractive (see our October 2001 letter here for a detailed discussion of current valuation levels) to keep this bull market going.

Is it the beginning of a structural bull market? I doubt it. We are still in a risk-on / risk-off environment where investors blow hot and cold. One of the fallouts of the crisis of the past 3-4 years is a shortening of investors’ time horizon (stat of the day: did you know that the average holding period for US equities is now 22 seconds?). Long term investors have become an endangered species and the effect on markets is there for everyone to see. I doubt this will change any time soon but, for now, it is risk on.

This is not the time to be fully invested but neither is it the time to be side lined. We are in a nervous market where great opportunities present themselves at regular intervals. We recommend holding 25-50% in cash or cash like instruments (depending on your risk profile) which can be deployed at short notice when those opportunities arise.

We have recently produced a brief strategy document where we outline a number of investment strategies which we believe fit into this type of environment. This document is available to clients of Absolute Return Partners. Please contact either Nick Rees or myself if you would like a copy.


By Niels Jensen, Absolute Return Partners

What have Bill Gross, John Paulson, Anthony Bolton and Bill Miller all got in common? They are all ‘rock star’ fund managers who have fallen on hard times more recently. Life in the fund management industry is not what it used to be like. Life is tough even for the supremely skilled. Markets are changing, fund managers are struggling to adapt and clients are growing restless as a result.

If I told you that the composition of an average UK equity fund changes by 90% a year, would that startle you? How would you feel if I added that the 20 funds with the highest turnover returned just 4.7% to investors in the 3 years to the end of March 2011 whereas the 20 funds with the lowest turnover returned 16.8% over the same period?[1]

From the same source: Out of 1,230 funds across 12 different strategies, only 35 fund managers produced a performance consistent enough to earn their fund a place in the top quartile in each of the last three years (upper half of chart 1). In a universe of 1,230 funds, over a three year period and completely disregarding skill, the expected number of funds consistently ranked in the top quartile is 1,230*0.253=19.22.

In other words, more than half the 35 managers were there not because of skill but because, statistically, someone was always likely to ‘over-achieve’. This leaves about 15 fund managers out of a universe of 1,230 – ca. 1% – who could with some right claim that they have consistently been in the top quartile.

Chart 1:   The TRMC Consistency Ratio (through September 2011)

Source: Thames River Multi Capital Quarterly Survey

The problem is we don’t know who they are. All we know is that none of them are managing Asian equities, North American equities or Global fixed income funds as those three strategies didn’t produce a single top quartile performer between them. And when you look at the second, and slightly less demanding, part of the study – those who have been in the top half in each of the past 3 years – the picture is broadly the same (lower half of chart 1). 177 fund managers achieved the required consistency but 154 of the 177 are likely to have done so because of luck, not skill.

I have never come across a fund manager who openly admits that his (or her) outperformance is down to luck. On the other hand, I often come across fund managers who suggest their underperformance is down to bad luck. I suppose no manager ever skilfully underperforms, but to put it down to bad luck is an insult when we all know that human error is the most common cause of underperformance.

If a fund manager’s outperformance is based on skill rather than luck, wouldn’t one expect the majority of the outperformance to come from those stocks with the highest weights in the portfolio? This seems a reasonable assumption given that one would expect any rational fund manager to allocate the most capital to his/her highest conviction ideas.

However, in a study conducted by UK consulting firm Inalytics (see here), 39 of 42 Australian funds managers who outperformed their benchmark owed their outperformance to the ‘underweights’ in the portfolios – suggesting that human error is not only the source of underperformance but perhaps also of some of the outperformance.

Bestinvest produces an annual survey called Spot the Dog (see here for the latest survey) which has gained considerable attention in the UK fund management industry, although it is not a league table you will be proud to be mentioned in. According to the 2011 survey published back in August, over £23 billion is currently managed in so-called dog funds[2], an increase of no less than 74% since the previous report.

You don’t become a dog just because you have a bad quarter or two. The members of that exclusive club have a history of serial underperformance, yet they will generate in the region of £350 million of fees to their firms this year despite the obvious value destruction.

And the story gets worse – much worse in fact. According to an unpublished report conducted by IBM, our industry destroys $1,300 billion of value annually – a staggering 2% of global GDP (see here for details). This includes about $300 billion in fees on actively managed long-only funds which fail to outperform their benchmarks, $250 billion spent on wealth management fees for services which do not meet their benchmarks and $50 billion in fees on hedge funds which underperform. Do I need to say any more?

Why are fund managers finding it harder than ever to outperform and what are the long term implications of those miserable performance statistics? Let’s deal with the ‘why’ first. There is no question that managing money – in particular equity mandates – has been a delicate affair over the past decade.

Through the 1980s and 1990s global equity markets benefitted from a strong undercurrent of bullishness. As a result, fund managers went into the bear market of 2000-01 on a wave of optimism (who doesn’t recall the repeated calls in the late 1990s of a new investment paradigm?) epitomised by the record high P/E levels in 1998-1999 just before it all went pear shaped in 2000.

Since then investors have been punished for their optimism. As you can see from chart 2, those who bought UK equities in 1998, 1999 and 2000 and held on to them for 10 years have suffered the indignity of negative inflation-adjusted returns.

Chart 2:         The Link between Long-Term Returns and Starting Point P/E Ratios

Source:                    Blackrock, Oriel Securities.

Based on FTSE All Share Index as at 7 September, 2011. 2012 P/E = 8.9.

I believe much of the underperformance of recent years is a bi-product of the excessive optimism of the late 1990s. An entire generation of investors grew up believing equities would always go up in the long run. Since 2000 the investment environment has changed for the worse but the faith in equities has only gradually been undermined, causing fund managers to only slowly adapting to a more challenging environment.

Another factor making life difficult for active managers in more recent times is the rising dominance of the ‘risk on’ versus ‘risk off’ mentality. Not that it represents a new paradigm. Investors have always been either pro risk (risk on) or against risk (risk off). What is new is how those cycles appear to become more and more compressed and how investors increasingly demonstrate herd-like behaviour (i.e. most of us are either risk on or risk off at the same time).

It is not for me to speculate on why that is but the implications are there for everyone to see. As risk on switches to risk off, virtually all share classes sell off simultaneously, rendering simple portfolio techniques such as diversification largely useless. Until active fund managers embrace the new world and adjust their portfolio management techniques accordingly, they will likely continue to struggle.

Consulting firm FundQuest has analysed the performance of 32,730 US domiciled non-index mutual funds over a 30 year period (see chart 3). Managers were judged to have generated alpha if they beat their benchmark by more than 50 basis points.

Chart 3:         Correlations Up, Alpha Down % of Fund Managers Generating Alpha

Source: FundQuest, Funds Europe Magazine

Several conclusions stare the reader in the face:

  1. Giving money to active bond managers is (statistically) a losing proposition in any environment. When well over 50% underperform their benchmarks even at the best of times, it is hard to see the justification for using active managers in this asset class.
  2. Managers in charge of equity and commodity funds can only justify their existence in more benign market environments. When the going gets tough (risk off), less than half the managers deliver alpha.
  3. Alternative managers have nothing to be proud of. With only about half the managers generating alpha regardless of environment, you might wonder whether you should resort to the art of throwing darts.
  4. Multi asset class managers struggle badly (only 15% outperform) when correlations rise – not really surprising considering high correlations undermine the very idea of the multi asset class strategy (i.e. diversification across asset classes) but worth bearing in mind if the ‘risk on/risk off’ environment which has so dominated the investment landscape in recent years continues for a prolonged period of time.

So far my focus has been on actively managed long-only funds but that doesn’t imply that hedge funds are covering themselves in glory – far from it. Hedge funds have enjoyed tremendous growth in recent years, spurred on by what looks to the untrained eye as vastly superior returns when compared to long-only funds. In a research paper published back in January (see here) this perception was challenged.

Using data from 1980 to 2008, the authors calculated the compound annual return for the average hedge fund to be 13.8%, easily outperforming more traditional asset classes over the period in question. This number makes hedge fund managers look like superstars when compared to traditional fund managers and is used by the hedge fund industry as one of the key reasons why everyone should invest in hedge funds.

Now to the naked reality. The best performance in the hedge fund industry came in the early years when assets under management were much smaller. The authors adjusted for this by calculating dollar-weighted returns instead; i.e. more recent returns when assets under management have been much bigger carry a higher weight than more distant returns when assets under management were negligible. The dollar-weighted number is thus a much better proxy for actual profits earned by investors in hedge funds. For the whole period 1980-2008 that number is 6.1% as opposed to the 13.8% headline number. Hardly blowing your socks off!

Now, if the hedge fund universe is difficult to navigate, can funds of hedge funds add any value? Regrettably the answer seems to be a resounding ‘NO’. In the paper referred to above the buy-and-hold return on funds of hedge funds for the entire 1980-2008 period was 11.0% per annum whereas the dollar-weighted return was a much more modest 4.1% per annum.

In another study on the performance of funds of hedge funds (see here), the authors conclude that, during the period 1994-2009, only 21% of all funds of hedge funds generated pre-fee alpha and, once the extra layer of fees were taken into consideration, only 5-6% of all funds of hedge funds outperformed the hedge fund benchmark.

These results are obviously disappointing and explain why funds of hedge funds are struggling to keep up with the growth of the hedge fund industry. In 2007 funds of hedge funds accounted for about 43% of underlying hedge fund assets. Three years later, their share had dropped to 33%, suggesting that more and more hedge fund investors go directly rather than through funds of funds (see here for details).

As a footnote, and in the spirit of full disclosure, Absolute Return Partners’ main line of business used to be funds of hedge funds and it is no secret that our funds of hedge funds have struggled and continue to suffer the consequences of decisions made back in 2005-07 when we all thought we could walk on water.

So, if the performance of the average long-only manager stinks, the typical hedge fund does not fare much better and the run of the mill fund of funds add little or no value, what should investors do? Well, to begin with we should clean up the way investment products are sold and that is precisely what the UK regulator intends to do.

If the Financial Services Authority has it its way, from January 2013, the so-called Retail Distribution Review (RDR) will outlaw kick-backs from UK fund managers to IFAs. RDR will make life miserable for the dog funds – those that serially underperform but continue to survive because they pay handsome fees to introducers who are prepared to disregard the dismal performance. Instead, IFAs will have to charge their clients an advisory fee.

This is a step in the right direction for an industry which has undermined its own credibility for years by ‘bribing’ IFAs to sell poorly performing funds; however, the technocrats in Brussels (as if they didn’t have bigger and better things to worry about at the moment) are not entirely happy with the British initiative and have tried to throw a spanner in the works. We can only wait and see what the next twelve months bring.

In the meantime, ETFs and other index trackers are seen by many as the solution to poor performance, but ETFs are not without their share of problems. Hargreaves Lansdown, a leading UK financial services provider, states on its website that it offers access to more than 2,000 funds at no initial charge. On the other hand, as far as I have been able to establish, it doesn’t state anywhere that it won’t include a fund unless it receives a significant kick-back from the fund manager.

With ETFs becoming more and more popular amongst investors, Hargreaves Lansdown has seen the writing on the wall and has responded with an extra charge for holding ETFs and other index trackers on behalf of its clients, potentially undermining the ability of small investors to track indices (see here).

More worryingly, the problems do not end there (and I am no longer referring to Hargreaves Lansdown). Many index trackers are sold without full disclosure – such as commodity index trackers which are subject to the cost of carry and index trackers which are exposed to significant counterparty risk because the underlying collateral is a total return swap (the consequence of which many investors do not understand) – and it is only a question of time before our industry faces its first major mis-selling scandal related to index trackers.

Finally, in my humble opinion, index trackers are more of a bull market than a bear market instrument. I have argued repeatedly over the past seven years that we are in a structural bear market (defined as a market of declining P/E values). The long-term inflation-adjusted return in a structural bear market is near zero and that is precisely the return UK and US equities have delivered since 2000. I can see the point of tracking an index in a raging bull market where it may be difficult to keep up with markets; however, in markets like these I believe other types of strategies are required.

So what can you do? A few ideas spring to mind:

  • Stick with people, not firms. In our industry the key assets walk out of the door every evening and, if they do not return the next morning, neither should you.
  • Identify an investment strategy you are comfortable with. Whether you believe in value, growth or something entirely different is less important. All active managers have their ups and downs, and it is when the going gets tough that it becomes critical that you are entirely onboard with the fund manager’s investment approach.
  • Prohibit high frequency trading (HFT). HFT uses powerful computers and sophisticated software to take advantage of microscopic inefficiencies in markets around the world. HFT models will often sell a security within a few milliseconds of having bought it. Does that add any economic value to financial markets? I don’t think so. Does it create unwarranted volatility occasionally? I very much believe so. Although I am not in favour of the much discussed financial transaction tax proposed by the Germans and the French, ironically, a modest transaction tax (if it were global) would wipe out all HFT based strategies, and the world would be a better place as a result.
  • Don’t invest in hedge funds for performance reasons. Do it because it is one of the few areas where you can truly diversify your investment risks. For example, the average managed futures fund was up well over 20% in 2008% when most asset classes collapsed.
  • Consider multi-strategy funds as an alternative to funds of hedge funds. The downside is that you concentrate your manager risk but you often achieve better strategy diversification and more attractive returns. Multi-strategy funds outperformed funds of hedge funds by approximately 3% last year and they are on target to do so again this year (see here).
  • Do not disregard sound advice. Those of us who have worked in the industry for decades know where many of the pitfalls are and can help investors stay clear of most of them. Just make sure your interests are aligned with those of your adviser.
  • Or you can simply do as the 1.5 million people in the UK who, according to a survey conducted earlier this year by Schroders, hold all their equity investments in a single company. Not my preferred approach, but who am I to challenge the wisdom of 1.5 million people?

Niels C. Jensen

5 December 2011

© 2002-2011 Absolute Return Partners LLP. All rights reserved.

[1]      Study conducted by Thames River Multiple Capital (3 years through March 2011) and based on the IMA’s All Companies Sector.

[2]      Bestinvest defines a dog fund as a fund that (a) has underperformed in each of the last 3 years, and (b) underperformed their benchmark by at least 10% over the last 3 years.


By Niels Jensen, Absolute Return Partners

“A country is bust when the markets decide.” Albert Edwards, Societe Generale Cross Asset Research

The ink on the Greek rescue agreement had barely dried before a triumphant, nappy-changing French President with an ego to match the heels of his shoes went on French television to portray himself as the saviour of Europe. “We find ourselves at the start of a new world”, he jubilantly proclaimed.

Meanwhile, here in the UK, an unconvinced British press did not hesitate to denounce the Brussels agreement as hopelessly inadequate, and the euro sceptics in Parliament, of which there are many, had a field day. The point so sadly missed by many in this country, though, is that we are all in this boat together. As a Danish proverb says, you shouldn’t saw off the branch you are sitting on!

Perhaps more surprising, and considering the euro project has been saved (for now), the German reaction wasn’t exactly exultant. Here is what some leading German newspapers had to say:

Frankfurter Allgemeine Zeitung: “Whoever believes that the crisis has now passed its zenith is terribly mistaken. It is unlikely that the ‘firewall’ against market volatility that European leaders had hoped for has now been put in place.”

Die Tageszeitung: “Above all, €1 trillion simply won’t cut it, because not even €2 trillion would be enough. The crisis now has a life of its own and has eaten its way into the heart of the euro zone.”

Die Welt: “But what does the euro crisis now mean for Europe? It will change the union down to its very foundation. Relations among the member states are likely to become more difficult and battles over resources more intense.”

Kenneth Rogoff, Harvard professor and co-author of This Time Is Different, also chipped in, suggesting that the package agreed in the early hours of Thursday, 27 October, will only buy the political leadership in Europe a few months (see here).

Even George Soros was damning in his assessment. Soros is a European with a capital E which is why his words carry so much weight. This is what he had to say about the rescue package:

“Given the magnitude of the crisis it is again too little too late. It will bring relief partly because the markets were so obsessed by the lack of leadership. The mere fact that something was achieved was a major relief and it will be good for any time from one day to three months.”

Not exactly the sort of words one would have liked to hear from Mr. Soros. So what is wrong with the Brussels agreement? For starters, it is

desperately short on detail, signalling that Europe’s leaders have struggled to reach a consensus with the finer details yet to be worked out. But that is by no means the only problem.

No agreement has supposedly been reached yet with the holders of Greek sovereign debt. What happens if investors refuse to play ball? At least some of them are non-EU banks and hence outside the scope of EU regulators who apparently are putting considerable pressure on EU banks to participate in a ‘voluntary’ deal. Last time we were in this position they were struggling to reach 75% participation, and then the proposed haircut was only 21%. Why is it they now believe they can reach 90% participation if the haircut is 50%?

And it gets worse. According to George Soros, the deal involves only the private sector. What has been touted as a 50% haircut is therefore effectively only a 20% haircut. If you do the maths on Greece, with an ongoing budget deficit in the region of 7-8% of GDP and real GDP growth of -5% for this year and probably also next, a haircut of such modest proportions will do little to reduce Greek sovereign debt over the next few years (read: there will be further haircuts).

If you are still inclined to give Greece the benefit of the doubt, I suggest you study the works of Egan-Jones, a credit rating company located in Haverford, Pennsylvania. Contrary to most other rating companies, Egan-Jones does not receive any compensation from bond issuers (a huge conflict of interest in the world of credit rating agencies) and, unlike most of its competitors who haven’t exactly covered themselves in glory in recent years, Egan-Jones has a formidable track record (see it here).

Sean Egan, co-head of Egan-Jones, predicts the eventual haircut on Greece to be close to 90%. He has done his homework and believes that Greece can support no more than €40 billion of debt through tax revenues. That amounts to only 10-15% of outstanding Greek sovereign debt. Sean put his case forward brilliantly in an interview in Barron’s earlier this year. You can find it here.

What’s more, Sean Egan expects the crisis to be replayed in Ireland, Portugal, Spain, Belgium and Italy. The argument is the same. What can reasonably be expected in tax revenues? What does it cost to service the debt? The conclusion is depressingly similar. None of these countries are likely to be able to fully repay their debt. Italy was forced to pay 6.06% only ten days ago on a 10-year auction – a price which they can hardly afford. Now, less than two weeks later, the same 10-year bond is trading above 6.6% after Berlusconi, always the man for an eye-catching remark, made a complete fool of himself over the weekend by saying that investors shouldn’t worry – Italy’s restaurants are still full (as I write these lines, there is a rumour coming out of Italy that he is about to resign and Italian equities are jumping in undiluted joy).

Italy is not Greece though. It has many things going for it that Greece hasn’t but Italy is now paying the price for past sins. You may wonder, why now? The world and her mother have known of Italy’s fiscal problems for a generation or more. What has changed? In truth, not a lot but there is no hard and fast rule as to when a country is bust (chart 1). Japan should really be bankrupt at current levels of debt but clearly isn’t. Spain with its low levels of sovereign debt shouldn’t really be in trouble but clearly is. As Albert Edwards dryly remarked in a recent research paper: “A country is bust when the markets decide”

Chart 1:  Debt to Revenues at Selected Sovereign Defaults

Source: Societe General Cross Asset Research

Through 20+ years of fiscal mis-management, Italy has worked up a debt-to-GDP ratio of about 120%. Admittedly, Japan’s debt-to-GDP is even higher but with the noticeable difference that it is paying 1% on its 10-year bonds. Italy’s government bond market is Europe’s largest with about €1,600 billion outstanding (chart 2). If Italy goes down, the European dream is over. For precisely that reason, Italy remains the line in the sand for Europe.

Chart 2:  Bonds Outstanding by Asset Class and Country

Source: Morgan Stanley Credit Strategy, November 2011

Over the next two years, Italy must refinance €400 billion worth of bonds (chart 3). The bond market is telling you it is going to be a challenge. The ECB has until very recently seemed capable of controlling Italian bond yields through market interventions; however, over the last week or so, Italian yields have continued to rise despite ongoing ECB purchases. According to Italian bond market insiders, there have been days recently where the only buyer has been the ECB. This is unprecedented in a market of that size.

Chart 3:  Italian Sovereign Refinancing Needs

Source: Pioneer Investments, July 2011.

And the story gets worse; in fact much worse – not only for Italy but for pretty much every major country in the OECD. The truth is, our governments are not telling the full story. Future liabilities (mostly pension-related) are to a large extent kept off balance sheet, resulting in true obligations many magnitudes higher than the widely publicised official debt ratios (chart 4). If you have the stomach for the full and unmitigated truth about future liabilities, look at this link.

Chart 4:  Total On- and Off Balance Sheet Government Liabilities
Source: Societe Generale Cross Asset Research, 27 October 2011.

At the Fed summer symposium in Jackson Hole earlier this year the Bank for International Settlements (BIS) presented a paper which spelled out the challenges facing policy makers in the years to come[1]. The authors concluded:

“A clear implication of these results is that the debt problems facing advanced economies are even worse than we thought. Given the benefits that governments have promised to their populations, ageing will sharply raise public debt to much higher levels in the next few decades. At the same time, ageing may reduce future growth and may also raise interest rates, further undermining debt sustainability. So, as public debt rises and populations age, growth will fall. As growth falls, debt rises even more, reinforcing the downward impact on an already low growth rate. The only possible conclusion is that advanced countries with high debt must act quickly and decisively to address their looming fiscal problems. The longer they wait, the bigger the negative impact will be on growth, and the harder it will be to adjust.”

More and more analysts conclude that the ECB will ultimately be forced to monetise debt in the eurozone to give it a fair chance of survival. The problem with this line of thinking is that Merkel only secured the support of the Bundestag for the Greek rescue package on the strict condition that the ECB will never be permitted to pursue such a policy and herein lies the challenge for the ECB. Does it adhere to German demands which will almost certainly engineer at least a decade of abysmal economic growth in Europe? Or does it risk the wrath of Germany with everything that entails, including a possible German exit from the eurozone? I am not entirely sure which outcome will prevail, but I do know that the answer to this question will ultimately define the European political and economical landscape for at least a generation.

Given Germany’s history you can understand why they are slightly paranoid about monetisation of debt; however, inflation should be the least of our concerns in the current environment. De-leveraging is by definition deflationary, not inflationary, which provides monetary policy makers with a unique policy opportunity. For that reason I fully expect the ECB eventually to join the Fed and the BoE in pursuing a more expansionary monetary policy.

The Germans will pretend to be both angry and disappointed but do not be mistaken. A weak-ish euro is a massive advantage for Germany’s large export industry and the Germans would be mad to leave the euro in exchange for a new currency which would instantly appreciate in value.

All of the above leaves investors in a bit of a pickle. With a wave of retirements fast approaching from a generation of boomers now in their 50s and 60s, investors need income but, where income is (deemed) safe, yields are low, and where yields are attractive, investors do not want to go. That is at least the case in the market for sovereign risk.

An alternative to sovereign risk is corporate risk. Corporate bond prices – particularly in the high yield space – took a knock back in July-August as investors reduced the risk profile in their portfolios and they have not yet fully recovered. As a consequence, high yield spreads, measured as a percentage of total yields, are near 25-year highs (chart 6) but, unlike sovereign balance sheets which are in a sorry state in many countries, corporate balance sheets are overall in good condition.

Chart 5:  U.S. High Yield Spreads as % of Total Yield

Source: Kingdon Capital Management, JP Morgan.

Note: Shaded areas indicate U.S. recession.

Meanwhile, default rates are close to 25-year lows (chart 7), reflecting a combination of solid balance sheet improvements over recent years and an economy that is muddling through if not firing on all cylinders. Equally importantly, high yield issuers took advantage of a benign funding environment in 2009-10 to refinance existing loans and bond issues. This effectively means that the refinancing needs for corporate bonds issuers for the next several years are only a fraction of that of sovereign issuers. (Unfortunately, I do not have a similar chart for Europe but would expect the picture to be broadly similar.)

Chart 6:  U.S. High Yield Default Rates near Lows

Source: Kingdon Capital Management, JP Morgan.

Note: Shaded areas indicate U.S. recession.

Returning to the European opportunity set for a moment, high yield spreads are currently more attractive here than they are on the other side of the water (chart 8). This is partly due to the eurozone crisis and partly because of inferior liquidity in European markets when compared to US high yield markets. However, European corporate balance sheets are by and large of comparable quality to US corporate balance sheets, providing an attractive opportunity for investors.

Chart 7:  Leverage Adjusted Spreads More Attractive in Europe

Source: Morgan Stanley

Take another look at chart 2. European non-financial companies have issued just over €1 trillion of investment grade debt and about €134 billion of high yield debt, representing a market about 15% the size of the €7.5 trillion EU sovereign bond market. If more and more investors buy my thesis – that many corporate bonds offer better value than government bonds – there is the potential for a massive valuation shift between the two.

Having said that, I wouldn’t touch the market for corporate bonds issued by financial firms – a €1.2 trillion market according to chart 2. The good times are over for Europe’s banks. The future will be characterised by higher capital requirements, less risk taking and thus lower return on equity. At the same time, as the sovereign crisis worsens (yes, it is going to get worse before it gets better), policy makers will not be able to ring fence the banks in perpetuity. Bond holders will suffer the consequences.

On the other hand, the appetite for income will continue to grow – from private investors keen to secure some steady income during retirement but also from pension funds faced with a tsunami of retirements amongst their members over the next 10-15 years. This dynamic is already in play and has driven bond yields in (so-called) safe havens down to levels considered unimaginable only a few years ago.

It is a fallacy that there is a shortage of capital in the world today; there is actually plenty of dosh around. What the world lacks is not money but risk appetite and that could take a long time to change – a very long time. Confronted with this reality, investors will increasingly look for alternatives to the meagre returns of 1-3% they are offered on those government bonds deemed to be relatively safe. As long as corporate treasurers continue to manage their balance sheets as well as they have done in recent years, they could fill a void for which there is enormous appetite.

Precisely for that reason I fully expect more and more investment grade corporate bonds to trade at yields equal to or below that of comparable sovereign bonds and I certainly wouldn’t be astounded to see significant yield compression in high yield over the next few years. Just one note of caution: expect the road to be bumpy!

Niels C. Jensen

8 November 2011

© 2002-2011 Absolute Return Partners LLP. All rights reserved.