Monday, March 31, 2014

Apologies for the lack of posts lately. I've been busy with assignments and will continue to be fairly quiet for the next week or so, I think.

Monday, March 24, 2014

Cash - Sometimes King, Sometimes Pretender To The Throne

This is an addendum to my post trying to understand why value investors hate the Fed. In the previous post, I tried to understand why value investors seemed particularly disposed among the investing community to finding fault with the Fed's actions since 2009. I'm not sure any of the answers I received convinced me individually, but as a whole, they offered some interesting parts of the puzzle.

Jason Zweig (whose excellent edited version of The Intelligent Investor was one of the first things I read on value investing many years ago, right after Lowenstein's Buffett biography) said value investors objected to the Fed's actions "because low rates goad naive investors into ignoring fundamentals". That didn't quite answer my real question, which was why value investors were more disposed than other investors to feel that way about the Fed and fundamentals (you can be a growth investor who still cares about fundamentals, I hope!).

But I thought he raised the exact issue where many value investors and I seem to disagree:

1) Low nominal rates on safe assets do not signify low rates for all actors in the economy; in fact, they usually indicate a flight to safety. Low rates on Treasuries rarely "goad" naive investors into heading back into equities until long after the smart money has sounded the all-clear.(Quick digression: I actually agree that extended periods of low nominal rates on safe assets can cause "reaching for yield" behaviour which has pernicious outcomes. But the solution, in my view, is therefore to be more aggressive from a policy standpoint early on. It's the combination of low rates for an extended period of time and a growing complacency among investors that eventually leads to financial trouble. I look forward to reading the recent Brookings Institution piece on whether QE has made financial institutions riskier.)

2) Money and credit aren't the same thing, so it's a mistake when people equate low rates with easy money. Low rates on credit instruments show the price of credit for those instruments. The price of money is of course the inverse of the price level. So when asset and goods prices fall, the price of money is higher.

I think it's perfectly correct to think of cash as an asset class, and weigh its prospective risk/return against other assets (standard mean-variance stuff - for a more interesting view, see global macro investor Jim Leitner's chapter in The Invisible Hands, though unfortunately I can't find a web link). Actually, value investors are particularly good at thinking about cash as an asset class (see Baupost - willing to be in cash as 40-50% of assets; see also Fed-skeptic James Montier on the value of cash). So I find it doubly surprising that they don't appreciate the Fed's actions to maintain price levels on track, and thereby maintain the price of money. 

Perhaps another answer is the (over?) emphasis value investors place on P/E ratios. Miles Kimball noted that low risk-free rates tend to make P/E ratios look high. The anchoring bias of supposedly "fair P/E ratios" can be detrimental. But again, I'm surprised that the value investors I've listed (who are incredibly sophisticated investors) are swayed by this. One of my initial guesses noted the overlap between value investing and conservative political beliefs, despite the Democratic leanings of its most famous exponent, Warren Buffett. I have to say I still find this a persuasive guess for the bias, so I hope that the likes of David Beckworth, Ramesh Ponnuru & Jim Pethokoukis will continue fighting the good fight.

I suppose that once you've decided that low rates are bad, and P/E ratios are high, it's only natural that you find further expansion of P/E multiples dangerous. Matt Yglesias responded that value investors were in favour of policies that depress P/E ratios, which sounds a bit snarky, but it's obviously true that people like to have high prospective returns on their assets. So, if you're a value investor who goes to cash more than other investors, you enjoy it when your cash has a high price compared to assets. 

If I were summarizing how this feeds into a sound investing philosophy:
- An over-reliance on P/E ratios can lead you astray; it may be more helpful to think of investing as harvesting premia when the market's offer is too high.
- Good investors should be willing and able to think of cash as another asset class. Cash isn't always king, but it's nice to have it just before its coronation.

Tuesday, March 18, 2014

Financial Services and Niebuhr's Serenity Prayer

An essay I wrote was featured in Financial News. Enjoy.

Draghi is guiding interest rates, Yellen is tapering the quantity of reserves (Guest Post by Vaidas Urba)

Readers of this blog will notice that while I write about monetary policy quite often, I usually approach this from an investor's point of view, given its importance for all asset prices in the economy. That said, I rarely delve into the technical specifics of monetary policy, which are often beyond my level of understanding. One frequent commenter in the blogosphere with no such technical limitations is Vaidas Urba, who will be familiar to many of you from his comments on The Money Illusion and Twitter, where you can follow him @VaidasUrba. Vaidas has written a (relatively non-wonkish!) guest post on the nature of monetary policy. I criticised the ECB's belief in forward guidance in a recent post, and Vaidas takes up the issue in this post. So with that, here's Vaidas:

Draghi is guiding interest rates, Yellen is tapering the quantity of reserves

What is monetary policy? Is it concerned with setting interest rates, or is concerned with setting the quantity of reserves? This question makes no sense. We might as well be asking "Is it colder in Celsius or in Fahrenheit?”. Monetary policy is all about central bank reaction functions. We may describe a central bank reaction function in interest rate coordinate space, but we could express the same reaction function in terms of quantity of reserves - both ways are equivalent mathematically.

At the zero lower bound, interest rate coordinate space has a disadvantage - the current interest rate does not help us in distinguishing between different central bank reaction functions, and we absolutely need forward guidance for this purpose. On the other hand, if we use the quantity of reserves, we get a simple albeit simplistic form of forward guidance already built in. The Fed has used this property of quantity of reserves to a great effect. With QE Infinity, every passing month had brought us stronger and stronger forward guidance. This powerful effect has disappeared when Bernanke hinted at tapering last year, and after a period of market turbulence the Fed started the process of divorcing the credibility of reaction function from QE.

Interestingly, the ECB is trying to get away with not using QE to bolster the forward guidance. Instead of a blunt message delivered by the rising line in the quantity of reserves chart, we are getting subtle signals about the ECB reaction function every month. "Firmly reiterate the forward guidance“ has replaced "confirmed its forward guidance". A bit later "a presence of slack" has joined in. Now we are getting "euro exchange rate increasingly relevant in our assessment of price stability" and "real rates are set to fall over the projection horizon". Unfortunately, marginal market players are still looking at that old-fashioned quantity of reserves chart.

For the sake of science, I hope the ECB will succeed in avoiding QE, as in this case we would get a clean test of Woodfordian theory. For the sake of the European economy, I hope the ECB will start QE soon. Let's use the QE language everybody understands, or the ECB reaction function might get lost in translation

Sunday, March 16, 2014

Everybody Knows That

The ability to be contrarian effectively is one of the most important traits an investor or analyst needs. You'll notice how I phrased that: being contrarian effectively means going against the grain of consensus opinion, but understanding that you may be either wrong or early, and managing that risk accordingly. In my first job, I'd sometimes criticize prevailing views I disagreed with, and my boss would retort, "Soros used to say consensus is only wrong at inflection points." That was both a reminder of the "wisdom of crowds" and that when the crowd failed, it could "stay irrational longer than [we] could stay solvent", just to fill this sentence with lots of lovely cliches.

One of the reasons I blog is to keep myself intellectually honest. It's a tough task, not because I'm unusually dishonest, but because as Richard Feynman said, "The first principle is that you must not fool yourself, and you are the easiest person to fool." So, writing thoughts down in a public forum is a good way to keep track of what I thought at a particular point in time. It's also a great way to elicit comments from others, and as you probably know, I worry constantly that I've tricked myself into thinking that I'm open-minded when I'm not (probably better to be biased and realistic about it).

So, with that preamble, welcome to the first edition of "Everybody Knows That", a list of commonly held opinions. The title of this post is a long-running family joke. Often, one person in the family will say something they think is unusual or little-known, and one of my sisters invariably responds, "Yeah, everybody knows that." But what does Everybody Know about the global economy and financial markets? I'll loosely define these as things that 2/3 or more of educated market participants, commentators or observers believe. I neither endorse nor deny these assertions (well, I do, but that's not the point of writing them down). The point is simply to get a feel for "consensus", and either shoot against that consensus in my writing or investing, or simply to observe when consensus has shifted. For example, I'd guess that as late as Dec 2012, Everybody Knew That emerging markets were the best place to be. Today, that of course looks very different. Equally, there are very smart people arguing against some of these views (e.g. on labour slack, see Evan Soltas). Again, not the point - I'm just trying to identify Things Everybody Knows. So here we go:

1) The Fed has been keeping interest rates low, but global interest rates are headed up.
2) As a result of (1), you'll lose money on bonds.
3) Emerging markets are slowing down, especially China.
4) China is rebalancing its economy from one that is driven by investment and exports to one driven by domestic consumption.
5) The Chinese shadow banking system presents a serious threat to the stability of the Chinese (and world) economy.
6) The slowdown of emerging markets, particularly China, will hurt the demand for commodities. Investing in commodities will be difficult, as will investing in commodity-driven economies, even developed ones like Australia and Canada.
7) Debt ratios are too high for advanced economies and its households.
8) Europe will probably go through a long period of slow growth (more than 3-5 years) as it goes through a deleveraging process. 
9) Most of the advanced economies will grow slowly too, as they also deleverage, but faster than Europe.
10) There's a lot of slack in the US economy.

 Feel free to add more in the comments section!

Friday, March 14, 2014

Forward Guidance, Backward Progress: Taking Aim at Draghi

A few days ago, I tweeted: "When forward guidance with a reputation for credibility tackles an economy with a reputation for low NGDP growth, it's the reputation of the economy that remains intact." This was a poor and much less funny paraphrasing of Buffett's quip that "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." 

Mario Draghi's latest speech gives me another chance to point out what are some of the weaknesses of forward guidance. First of all, let me give Draghi credit for acknowledging "too low inflation" is currently more relevant than inflation being too high. Second, the acknowledgement of the dearth of capital for SMEs is positive because thankfully, he isn't saying "but rates are low in the Eurozone!". I also think the review of the banking sector is both necessary and welcome (if fraught with political issues).

Nevertheless, I simply couldn't resist disagreeing when he came to the section on monetary policy. Draghi said:
- The Governing Council is committed to keeping interest rates at present or lower levels for an extended period of times, which will help the deleveraging process through balance sheet channels.
- Forward guidance creates a de facto loosening of policy stance, leading to falling real interest rates. Falling real interest rates will support the demand for credit by encouraging higher business investment.
- A declining real interest rate spread between the Euro area and the rest of the world will, all else equal, put downward pressure on the exchange rate. Given the current levels of inflation, the level of the exchange rate is "becoming increasingly relevant in our assessment of price stability."
- Risks of deflation appear quite limited, but the longer inflation remains low, the higher the probability of such risks emerging. That's why the ECB has been preparing additional non-standard monetary policy measures to guard against such an event and why it stands ready to take further decisive action when needed. Any material risk of inflation expectations becoming unanchored will be countered with additional policy measures.

Some of this sounds reasonable enough. But let me make a few points:

1) Forward guidance is a weak tool:
- No serious person should think that investors' views are dominated by real interest rates (I mean those pursuing investment in the economic, not financial, sense). Talk to any businessperson and ask if they are thinking of expanding their operations. I can guarantee that their decision will be based on two things - growth and profitability. Businesses in the Eurozone aren't investing because their expectations of future economic growth are low. Committing to low future rates is much less powerful than committing to higher rates of future NGDP growth. I used to think that this "textbook" view of the interest rate channel was just the the way monetary policy was taught to simplify it for beginners. But it appears that policy makers genuinely believe that view, and I just think it's wrong. 
- Interest rates are currently low for safe assets in the Eurozone. This is not translating to healthy credit to SMEs. Unless the banking sector clean-up happens faster than anticipated (and more challenging, in an environment of low economic growth), why should the promise of low rates encourage investors  that they will enjoy healthy credit in the future?
- Credibility is a nebulous notion. I think the ECB has credibility to (a) not let inflation rise above 2% and (b) not let the economy fall into complete and utter chaos. I do not think they have credibility to (c) improve economic growth. I think the Fed was similarly credible in ways (a) and (b) but only gained (c) when they announced the unemployment target. But that's obviously up for argument.

2) If inflation expectations become unanchored, the ECB will have already failed. I suspect that if inflation expectations become unanchored, it won't happen in a vacuum. It will probably happen with a decline in asset prices, the Euro and possibly outright panic. This volatility is almost certain to deter investors, and harm the real economy. After all, you'd naturally demand a higher real interest rate for a riskier investment. So this could well end up offsetting any decline in real interest rates. Why not act in a resolute fashion now and just head the whole thing off?

I know, I know. Even if Draghi agreed with the above, the politics is too hard. But the only way the political balance will ever tilt that way is if the drumbeat of public opinion allows the audacious to outvote the timid. So I persist. As I said above, the review of the banking sector is both necessary and welcome. But what the Eurozone needs first and foremost is NGDP growth. Without it, promises to keep future interest rates low are a mere sideshow. As far as I'm concerned, relying on forward guidance is backward progress.

Thursday, March 13, 2014

Why Do Value Investors Hate the Fed?

Seth Klarman is undoubtedly one of world's top money managers. Klarman is one of the most successful exponents of the philosophy known as value investing, fathered by Benjamin Graham and popularized by Warren Buffett. His fund, The Baupost Group, has grown into a $30b beast, despite generally eschewing leverage, and has racked up mid-teen returns over its lifetime, which is a truly impressive feat. Klarman's book, Margin of Safety, sells for an absurdly high price on Amazon, because it's out of print, and his insights are understandably sought after (you can, however, find free copies on the Internet - that's arbitrage for you!).

But even the rich and brilliant should be challenged. In late 2010, Klarman and a host of other investors, economists and commentators penned an open letter to Ben Bernanke, asking him to reconsider and refrain from further monetary easing. In his latest investor letter, Klarman is full of disdain for the Fed. Here are some choice excerpts:

- "Someday, rising stock and bond markets will no longer be government policy. Someday, QE will end and money won't be free. Someday, corporate failure will be permitted."
- "As experienced traders who watch the markets and the Fed with considerable skepticism (and occasional amusement), we can assure you that Fed's itinerary is bound to be exceptional, each stop more exciting than before. Weather can suddenly turn foul, the navigation faulty, and the deckhands hard to understand. In short, the Fed captain and crew are proficient in theory but lack real world experience. This is an adventure into unexplored terrain, to parts unknown; the Fed has no map, because no one has ever been here before. Most such journeys end badly."
- Comparing the US economy to The Truman Show, where the lead character lives in a totally fabricated, made-for-TV environment: "Every Truman under Bernanke's dome knows the environment is phony. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no-one wants it to end, and no-one want to exit the dome until they're sure everyone else won't stay on forever."

All investors are entitled to their own views of where the economy is headed. As I discussed in a previous post, that call can sometimes make or break an investment. It's worth pointing out that Klarman is no bull - he is, after all, returning $4b in capital to his investors due to concerns about market valuations. But he's not alone among value investors in chiding the Fed. Fellow successful value disciple David Einhorn garnered a lot of attention for comparing Fed policy to a steady diet of jelly donuts. Value junkie and financial writer Jim Grant continually bashes Fed policy, and even gets quoted by Klarman in the letter: "the Fed can change how things look, it cannot change what things are."

Please don't misunderstand me here - I'm neither wildly bullish on the prospects for equities in the near-term, nor a devout supporter of all Fed policy. I don't even mean to disparage the value philosophy. Applied correctly, it is a powerful foil to human tendencies to over-optimism and faddishness. (However, I'm critical of dogmatic value investing, which Aswath Damodaran demolishes quite effectively here and here.) And ironically, the decision to return investor capital could look very bright in retrospect for exactly the wrong reason, i.e. a concerted tightening by the Fed and the PBoC while the ECB dithers. But part of the challenge of investing, or analyzing its success, is trying to be right for the right reasons. It would be equally disappointing if value investors resorted to what I've called "the Zhou Enlai theory of monetary policy." It's often reported that Zhou, when asked in 1972 what he thought of the French Revolution, responded that it was too early to tell. Ignoring the fact that this story is almost certainly apocryphal, it's disingenuous to say "we don't know yet what the results of Fed policy have been" unless you set up an explicit counterfactual, or provide a prediction of what you think will happen and in what timeframe. At some point, no doubt, the economy will turn down and financial crisis will ensue... but sorry, you don't get any prizes for stating the obvious.

My question is, why do value investors hate the Fed? One answer that I'll reject out of hand is that Klarman and his friends are rich hedge fund types who are indifferent to the suffering of the unemployed and luckless. Klarman, for example, is renowned for his philanthropy,as is Elliott Associates' Paul Singer. I believe Klarman, Singer, Chanos et al when they say they are genuinely concerned that Fed policy will harm the economy. Perhaps the question I mean to ask is "why are value investors more predisposed to look unfavourably upon Fed action?" Here are some possible answers:

1) The correlation is not between value investors and Fed-haters, but between conservatives and Fed-haters. Despite the best efforts of David Beckworth, Ramesh Ponnuru & Jim Pethokoukis (among others) , conservatives still seem more likely to view Fed policy as pernicious. It just so happens that many value investors are conservatives (although we should then ask why...) - Jonathan Haidt and Miles Kimball would probably suggest that value investors/conservatives have strong leanings towards karmic retribution.
2) It's a subconscious response to stocks becoming fairly valued. Buffett once said he was like "an oversexed guy in a harem" when stocks became cheap in the 1970s. I assume that means that when equities are fairly valued, he feels like, well, every guy of average libido. Perhaps this is a variation of Benjamin Cole's criticism that Richard Fisher gets upset when a strong economy raises rare book prices.
3) Value investors are broadly mean reversionists, and are trained to look for cycles & bubbles (unlike growth investors, who are more interested in secular stories). The Fed is an obvious contributor to the business cycle, and is therefore particularly odious to value investors. The existence of investor favourites like Tesla and Netflix is merely anecdotal, but reinforces value guys' belief that the cycle is turning.

Frankly, none of these seem like particularly strong theories to me. I'd appreciate comments with other theories - please, no comments saying "if you're so smart, why aren't you rich?". But let me end by saying that whether they like it or not, successful value investors owe the Fed. Those who have made their names buying at "cheap valuations" have profited from the fact that the Fed didn't pull a 1929 or a Japan. I can only assume Japanese value investing was a fool's errand for 20 years. And some of those who made their names shorting overvalued securities from 2006-2009 (whether it was the homebuilders, the bond insurers or banks) profited from the Fed's failure to stabilize nominal GDP. Not all of them, mind you - lots of these securities were over-valued given the industry conditions. But bearish bets were made to look much better by the economy's unimpeded march downwards. Sadly, the investors just don't seem to know it.

Sunday, March 9, 2014

We Need To Talk About Malcolm

Warning: What I'm about to write about the Glazers will make some people very angry. If you have something constructive to say, please feel free to do so in the comments section. I'll delete abusive posts because frankly they're a waste of everyone else's time. The source of most of my info is the prospectus the company had to file with the SEC when the Glazers sold shares in an initial public offering (IPO). But I hope that you'll read closely particularly if you dislike the Glazers, and do your best to be objective about my conclusions.

The recent string of poor results at Manchester United (MUFC) has fans and commentators searching for the causes, and for possible solutions. Like many, I've been quite critical of the manager, David Moyes, arguing that he hasn't shown much managerial acumen in his first season. Another (not mutually exclusive) cause for the poor performances is an aging pool of players that the club failed to bolster meaningfully in the summer transfer season. Unsurprisingly, attention has also been called to the majority owners of the club, the Glazer family. It would be a massive understatement to say that the Glazers have never been popular with fans since buying the club in 2005 for roughly GBP 800m. The common narrative is that they loaded the club with debt to fund their purchase, which put it in a precarious financial situation and hampered the club's ability to sign big-name players as they paid off high-interest loans. The Glazers have also taken money out of the club, which could have been used for marquee signings. Finally, they have to take ultimate blame for David Moyes because they hired him, and they did so primarily because he had a reputation for overachieving with a limited budget. Again, this would allow them to save money, which could be funnelled back to them. 

Perhaps the most articulate expositor of this viewpoint is Scott the Red, who wrote a superb piece on David Moyes's shortcomings, but concluded that "whilst the protests against Moyes will likely come first, it is the Glazers who are responsible, and they are the real enemy here." It seems many people disagreed with Scott's conclusion, so let me try to express those objections here. Football fans are understandably passionate, and reasonable people can disagree, so I don't expect to change too many people's minds today, but if I can contribute something to the debate, I'll consider it a worthwhile endeavour.

First, let me say that much of the hatred for the Glazers in the early days had a xenophobic and anti-Semitic element to it. As a United fan not from Manchester, I found that distasteful. You don't hear people criticise them for being "Yanks" too much any more, but let's be honest that some of the ire is tinged with xenophobia so that we can assess them somewhat objectively as owners. Some people will say "you're not from Manchester, so you don't get it". Should clubs be completely locally owned? Frankly, I don't think so. Recognizing that the core of club is local is absolutely crucial, but I think fans have benefited from having some of the world's best players arrive in England funded by non-English sources of capital.

Now on to the issue of debt. It is completely undeniable that the Glazers took on a stupendous amount of debt to purchase the club. But let's think about why they did that. They did it because they wanted to own the club, but didn't have the cash to pay for it in full, the same reason you take out a loan to buy a home. Sometimes fans say "the club was debt-free before them." Let me point out very briefly that the optimal amount of debt for a business is rarely zero. I was amazed at the amount of debt the Glazers were taking on because it seemed risky for them financially. I've written here and here about why football clubs aren't great investments, so the risk to the Glazers was quite high, because of and reflected by the levels of interest they were paying. Mind you, there were lots of transactions outside of football where people funded purchases with massive amounts of debt (and many of these have turned out horribly for the equity owners and lenders). But let's not forget that the Glazers own the club's equity. So it's not fully right to say they loaded "the club" with debt. They basically put other people ahead of them in line to receive money the club was earning (not out of altruism, of course, but in order for them to make money, they'd have to NOT drive the club into the ground). And yes, they've taken cash out of the club. Isn't that kind of the point of a financial transaction? You pay for it upfront and you get paid back by some stream of income throughout its life or by selling it a higher price. For the same reasons as I'll argue about the debt, I struggle to believe that these dividends to themselves have hindered the club in the transfer market. 

Furthermore, it's very difficult to say that this high level of debt prevented the club from making big-name acquisitions. Post-Glazer, the club spent large sums of money on Carrick (18.6m), Hargreaves (17m), Anderson (27m), Nani (25.5m), Tevez (fee unknown), Berbatov (30.8m), Valencia (16m), Jones (16.5m), Young (17m), de Gea (18.9m), van Persie (24m), Fellaini (27.5m) and Mata (37.1m). Realistically, would we have bought better players if the debt load had been lower? I can't for the life of me see why. And perhaps this is the right time to talk about Fergie. The man was a managerial genius, and provided me with some of the most enjoyable football moments of my life. But he, not the Glazers, was the last word on these transfers. The man clearly prided himself on his Scottish frugality, often complaining about a lack of "value" in the transfer market. And maybe it's for the best that he wasn't signing marquee players all the time. Some of these transfers turned out to be pretty crap actually. Arguably, United have done very well with less touted names (Solskjaer, Ronaldo, Vidic, Evra) but have a far more mixed record on the big-name signings (add Veron to the above). So, again, it's hard to make the claim that United, sans Glazer, would have spent more money on players, and that doing so would have translated to greater footballing success. If you're going to point fingers, Fergie was the real man in charge.

The same is true with the hiring of Moyes. Fergie has been very clear that Moyes was his choice. Should the owners have overruled the architect of the club's greatest era? I don't think they hired Moyes solely because he had a reputation for operating on a shoestring budget. I believe the expectation was that if he could get Everton to a consistent 6th or 7th, he would be able to do much better at United given the resources at his disposal. That is not the same as saying he was hired because he wouldn't spend a lot of money. The ludicrous amount of money paid for Fellaini seems to debunk the notion that the Glazers expected Moyes to keep transfer fees down.

You may wonder why I'm bothering to write this. I'm not particularly pro-Glazer. Some of the stuff that goes in the club seems a little weird to me, like making personal loans to the family, or creating a second shareholder class with significantly worse rights. Those are just other reasons to give one pause about owning shares in the company. But I just think it detracts from the real causes of the club's woes to paint them as the ominous bogeyman in the background. Fans are very right to debate whether Moyes is the right man to lead a club of United's standing. Linking it back to the owners at this point just seems a bit of a stretch, and an unwelcome distraction from the nub of the issue.

Friday, March 7, 2014

The Conundrum of Investing in the Eurozone

I was asked yesterday whether I thought macro or micro factors were more important for investing. I probably didn't do a very good job answering the question, but I think there's a great danger in trying to create a dichotomy between the two. Legendary fund manager Peter Lynch famously boasted, "I've always said if you spend 13 minutes a year on economics, you've wasted 10 minutes." I agree you can get too caught up thinking about the big picture, and fail to recognize when investor expectations are too negative. But I also think you're doing yourself (and your investors) a grave disservice if you aren't thinking about how individual companies will perform in various macro scenarios. And specifically with monetary policy, it's easy for equity investors to ignore until it goes wrong, as it did in 2008. (I think David Beckworth has made this point in a blog post, but I can't find the exact post to cite him.) If you think low economic growth is likely to persist, or that full-blown crisis may reignite, that had better darn well be in your cash flow projections or your discount rate.

It won't come as surprise to many of you that I am fairly negative on the prospects of the Eurozone. It's a far from optimal currency area, with divergent economic levels and models, greatly hindered by a central bank that appears to approach its (dangerous) single price mandate with asymmetry. Eurozone NGDP is far from its pre-crisis trend, leading to severe unemployment and dangerously low inflation.

Still, I'm concerned that I'm being too unimaginative about how a recovery could take place (this blog is called The Insecurity Analyst, after all). We're all susceptible to confirmation bias, and it's almost harder to escape today, since many of us create our own information bubbles by selecting people to follow on blogs and Twitter. So let's consider a bullish case for the Eurozone as an investment.

1) Savvy investors are returning to the area. George Soros said his fund is investing in European banks, while he and Paulson are also investing in Spanish property. Of course, we're missing what price they're investing at. Obviously, you can make money if you think an investment will only return 50 cents on the dollar, but is trading at 20 cents. Expectations matter! (And as another aside, I recognize that being negative on the prospects on the Eurozone can be expressed several ways - most likely, shorting the currency, peripheral debt or equities. Even if the Eurozone does badly, these aren't all equally sensible trades. You'd have done well shorting Japanese equities but gotten murdered shorting the yen - see below.) 

2) NGDP isn't returning to pre-crisis trend, but improvements in other indicators signal a recovery and passive easing of monetary policy. Since the dark days of 2012, the CAC 40 is up 50%, the DAX and MIB about 60% and the IBEX 35 almost 70%. Those are pretty stunning returns. Meanwhile, the yields and spreads on peripheral debt have fallen dramatically. I sat in on a presentation by Nomura's peripheral debt desk, and their strategist laid out some fairly comprehensive statistics on how Portugal can continue to muddle through (not reducing their overall debt load, mind you, but not collapsing into crisis again either).

3) Some investors continue to underestimate the political will to keep the Eurozone together. Policy makers will react slowly to crises, but when their backs are against the walls, they'll do the right thing.

I don't want to be too pig-headed about this. As I conceded earlier, valuations matter. Soros, among others, says he thinks economic conditions are calming down but that Europe could face a long period of stagnation like Japan. But I'm still skeptical for two reasons. First, look at the chart of the Nikkei 225. You would have struggled to make money in Japanese equities, unless you were a hell of a trader. You could have sounded the all-clear at many points between 1990 and 2009, and then proceeded to be totally wrong. Tight monetary policy is not good for equities. Second, Japan is famous for its social cohesion, which allowed society to continue functioning despite dire economic performance. Similarly, Sweden can survive with its overly tight monetary policy today. Do you think the Eurozone will survive another 10, or even 5 years of similar economic performance? I just find that hard to believe, and have to think that, once again, we'll see the "political news slipping into the financial section."

But I'd like to be convinced otherwise. So go for it!

Sunday, March 2, 2014

Will The Real Mr. Roosevelt Please Stand Up? (Obliquity & Monetary Policy)

Earlier this week I posted on Brazil's hyperinflation (here, here and my personal favourite, here). Although those posts were partially for pure intellectual interest, I've been wondering what practical relevance that history has for today's world. No doubt there are countries like Venezuela and Argentina who still face hyperinflation. But these countries are fairly small and unusual. Indeed, it seems that persistent low inflation (bordering on deflation) is of greater concern in the advanced economies, particularly Europe. Does Brazil's hyperinflationary history hold any lessons for today's Europe?

I think it does, and I don't think this will be too controversial: Changing expectations about inflation or deflation requires a credible commitment from the monetary authorities. In Brazil, a commitment to a hard exchange rate target lacked credibility in the absence of fiscal restraint and economic reform such as privatization of state-owned entities. Furthermore, stop-and-go policies reduce the credibility of future actions since economic actors justifiably expect them to be reversed quickly. It happened in Brazil, and I worry that it's happening in Europe. In the Eurozone, low inflation and inflationary expectations are a reflection of the ad hoc nature of monetary stimulus.

I posted on deflation earlier this week, arguing that we can think of "deflation" as a loss of confidence in one's prospects and pricing power, which is much closer to its everyday sense of the word. This obviously complicates the identification of deflation from the "simple" technical measure of a price index (not so simple in reality). But the real world is much more complex than can be captured completely in a single measure. Consider this my plea for obliquity in policy-making. In John Kay's excellent book of the same name (which is a must-read for anyone like me who's a sucker for the thinking about thinking genre), he says, "Obliquity describes the process of achieving complex goals indirectly." Later, he writes, "Good decision making is pragmatic and eclectic. Oblique approaches rely on a tool kit of models and narratives rather than any simple of single account. To fit the world into a single model or narrative fails to acknowledge the universality of uncertainty and complexity."

I'm starting to think that the ECB is hamstrung (perhaps fatally) by its single mandate on price stability allied with a deference to the Bundesbank-influenced inflation-phobia. It's one thing to defend flexible inflation targeting, but inflexible inflation targeting (and failing!) is another altogether. Marcus Nunes has done a superb post arguing for nominal GDP as the best indicator of monetary policy. Perhaps it's too much to ask for a single indicator that reflects something as complex as the stance of monetary policy. I've praised market monetarism in the past for being an oblique method of judging policy, with its reference to various asset prices. (In fact, I can  foresee a situation where NGDP might conflict with other indicators, and I think pragmatic market monetarists would have to step back from a singular focus on NGDP in such a case. But we're a long way from that now.)

There is one point in Kay's obliquity that I'm not totally clear on, best illustrated by his description of Roosevelt. He first lauds Roosevelt for his approach as one of "bold, persistent experimentation." "Try something," Roosevelt said. "If it fails, admit it frankly, and try another."" But it gets a bit confusing when he talks about Roosevelt the commander-in-chief. "Both Roosevelt and Lincoln understood that to approach their goals too directly would risk failure to achieve them. Their obliquity caused frustration to many around them, and to many historians who record their careers today. As we read a modern account of Roosevelt gently edging his country towards the inevitable war, we wonder constantly: "Why doesn't he get on with it?" Roosevelt, like Lincoln before him, understood that the scope of his authority was inescapably limited by the imprecision of his objectives, the complexity of his environment, the unpredictability of the reactions of others and the open-ended nature of the problems he faced. All these factors mean that even the most powerful men in the world must proceed by choosing opportunistically from a narrow range of options."

Will the real Mr. Roosevelt please stand up? Was he a cautious, oblique tinkerer, or a bold visionary filled with the "Rooseveltian resolve" that monetary historians admire? I suppose one could argue "both", and that that was precisely his strategic brilliance, which allowed him to select the right option for the right set of circumstances. But what prescriptions are there for someone like Mario Draghi, who must act boldly despite the political and institutional realities of the ECB? I'm starting to think that credit-focused policies (of the kind suggested by Jacob Kirkegaard and Francesco Papadia are viable Plan B's to increase the monetary base. But in some matters, cautious tinkering is insufficient. The Fed's unemployment-linked guidance was decidedly second best from a market monetarist/NGDPLT standpoint, but it had the effect of providing the sort of credible commitment to monetary expansion that was needed, powerfully shifting the regime away from ad hoc QE and twisting. David Beckworth posted recently on how the Fed failed in 2008 because they failed to change the expected path of monetary policy. I can't agree enough, and that's why more may be needed from the ECB than credit programmes.

A man of Draghi's intelligence, experience and political savvy doesn't need my advice. But I can't resist giving it, so let me again cherry-pick Kay's work to buck up Draghi's courage should it be flagging. Kay cites Francis Cornford: "The Principle of the Dangerous Precedent is that you should not now do an admittedly right action for fear you, or your equally timid successors, should not have the courage to do right in some future cases, which, ex hypothesi, is essentially different, but superficially resembles the present one. Every public action which is not customary, either is wrong, or, if it is right, is a dangerous precedent. It follows that nothing should ever be done for the first time." My guess is that the Eurozone will probably be at risk of monetary instability as long as the single mandate defies obliquity. In the here and now, though, Draghi and his colleagues are quickly approaching the point when they must decide which Mr. Roosevelt they want, or need, to be. 

Cardoso's Plano Real Does The Trick

In an earlier post, I wrote about the beginning of Brazil's hyperinflation. In this post, I turn to the policy reforms that led to its cessation.

Brazil’s hyperinflation was finally defeated in 1994 through the Plano Real (Real Plan), championed by Fernando Henrique Cardoso, who was appointed Finance Minister in 1993. This was a comprehensive agenda aimed at tackling both the underlying causes and symptoms of Brazilian hyperinflation.  The first step was the introduction of a new currency called the real. The central bank would act to maintain the value of real within a range of the dollar, which would constrain its ability to finance the government through base money production.  Exchange rate stabilization was designed to win credibility by setting a visible and easily monitored anchor of stability. (Singh)

Previous hard exchange targets had failed because they were not accompanied by explicit measures to limit fiscal deficits or increase central bank independence.  (Singh) Crucially for the Plano Real, the new currency was to be supplemented with steep budget cuts. The creation of the “Social Emergency Fund” effectively forced Congress to cede control of $15b of government spending to the Finance Ministry, roughly 1/6 of the total budget. Furthermore, to break the public’s inflationary expectations, the government requested shops to listed items with two prices, i.e. in the old currency (cruzeiro real) and in the theoretical value of new currency from March 1994 to July 1994. The stability of this non-monetary reference currency, known as the Unidade Real de Valor (URV, or Real Value Unit), was meant to showcase the stability that the real would bring. Despite the plan being heavily criticized on both right and left, the stability of the currency soon won popularity with ordinary Brazilians (though not before almost being derailed in an amusing episode). “We never expected inflation to fall so far, so fast. Following monthly rates of 45 percent in March and Apr, inflation slowed to only 2 percent in July, the month the real was launched.” (Cardoso) Inflation fell sharply and persistently, from a monthly rate of 47 percent in June 1994 to just over 1 percent eight months later. Equally importantly, private capital flowed into Brazil. Even with the tightening of macroeconomic policy that accompanied the Plano Real, real GDP grew strongly, by 5.7 percent for 1995 as a whole. The rebound in economic activity produced a primary fiscal surplus that exceeded what the government had thought possible. (Boughton)

While I, in my earlier post, criticized the notion of hyperinflation as inevitable, it is undeniable that the success of Plano Real benefited from the fulfilment of several preconditions. First, the time was ripe for broad institutional reform in Brazil.  President Collor was forced out of office in August 1992 after a corruption scandal, leading to political turmoil.  “In a strange way, however, the nation derived a certain amount of confidence out of the incident. Brazil’s institutions had proven to be stronger than any one man. We had handled a severe crisis by the book and without the intervention of the military.” (Cardoso)

A second factor that supported reform was increased urban migration. (Cardoso) A larger urban middle class was able to make its voice heard and express discontent with hyperinflation. Meanwhile, Israel and neighbouring Argentina had solved their hyperinflation problems, leading to belief that Brazil too could solve its problems with the right policies.

Finally, Brazil was able to negotiate a deal with external creditors and regain some of its standing in the international arena, which eventually led to a return of capital when the Plano Real was introduced. Early moves towards these negotiations benefited from the personal credibility of Marcilio Marques Moreira, who was appointed Finance Minister in May 1991. (Boughton) He negotiated with the IMF to secure a stand-by lending arrangement in Jan ’92. The Paris Club of official creditors agreed to reschedule Brazil’s debts in Feb.  In July, Brazil reached an agreement with international bank creditors on a comprehensive reduction in debt and debt service.  Collor’s impeachment and the government’s  failure to formulate a credible fiscal policy led to Brazil falling out of compliance with the IMF programme. Unable to secure a new IMF lending programme, Brazil circumvented the IMF by successfully rescheduling debt owed to international banks and collateralizing new debt with US treasuries bought in the open market with central bank reserves (not subscribing to the Brady programme, which required an IMF-supported programme).

It is worth noting that the end of hyperinflation brought its own problems. Greater macroeconomic stability expanded Brazil’s access to external finance and lowered borrowing costs, especially in foreign currencies, which, in turn, encouraged greater debt issuance along with a shift to riskier short-term external financing. A financial and economic crisis in Brazil in 1999 led to a forced exit from the hard exchange rate targeting regime. However, this did not result in a return to triple-digit inflation.  Despite a depreciation of the real of almost 60 percent in 1999, inflation averaged under 10 percent that year and remained in single digits until late 2002. (Singh et al) This showed that Brazilian monetary policy had won credibility at long last, which eventually allowed it to move to a flexible inflation targeting regime.

Here are some charts from the IMF (report by Anoop Singh et al) showing the Brazilian experience:

P.S. Marcus Nunes has some good posts on Brazil's hyperinflation here.

Saturday, March 1, 2014

Brazilian Hyperinflation: Setting the Stage

I had to write a paper on Brazil's hyperinflation, and thought it was sufficiently interesting to post here. (It's just a draft so footnoting is spotty, but I'm happy to provide references if anyone is interested). I've broken it up into two different posts so it's more readable, with a third post on why this is important today.

Brazil’s Monetary Policy
Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” is well-understood in the monetary policy literature. It is equally true, however that the institutional arrangements and external circumstances surrounding monetary policy are equally important in generating positive or negative outcomes. The history of Brazilian monetary policy culminating in the hyperinflation of the late 1980s and early 1990s shows clearly the truth of this assertion.

The initial spark for hyperinflation was the existence of large fiscal deficits, which required central bank financing. Cardoso notes that “For a shaky democratic gov’t or military dictatorship of questionable legitimacy, doling out money was the obvious way to stay in power”, pointing to the modern era of runaway inflation that started in the 1950s under Juscelino Kubitschek. By the 1970s, in particular, Brazil was running large fiscal deficits.

Of course, large fiscal deficits aren’t necessarily inflationary if the central bank is independent. This was sadly not the case in Brazil.  The central bank had little choice about expanding money during this period given the rules and procedures under which monetary policy was conducted.  Meltzer notes similarities between the Italian experience of the 1970s and Brazil in the 1980s & 1990s. He writes, “The Italian government ran large budget deficits and issued debt finance. The Bank of Italy was responsible for purchasing all the bonds not sold in the market at a given rate of interest. The rate of interest was not allowed to clear the bond market, so the Bank of Italy issued base money to purchase the bonds.” Similarly, in Brazil, when inflation rose, the market put securities to the central bank, which issued base money to finance them. Nominal and real rates in the market were not high enough to ensure private participation.

Politicians were not the only ones benefiting from inflation. As Cardoso observes, Brazilian banks were the intermediaries for many bills, such as utility bills. They received payment for utility bills but waited three days before sending the money on to the utility companies. In a hyperinflationary environment, this practice of “floating” gave them an easy 8% profit in real terms.  An estimated 25% of Brazilian bank profits came from “floating”.

Not everyone agreed with this monetary & fiscal explanation for Brazilian hyperinflation.  Cardoso reminds us that with Brazil inflation reaching 2,500 percent in 1993, many were resigned to hyperinflation. “Attributing it to inherent structural issues within our economy, they simply threw up their hands in defeat”, he wrote. Slightly more subtle was the inertial argument of inflation, outlined by Kiguel and Liviatan. They asserted that the Brazilian and Argentine hyperinflations “were the final stage of a long process of high and increasing rates of inflation, in which a final explosion was all but unavoidable.”

There are shades of truth in the Kiguel and Liviatan argument.  Certain structural elements had served to reinforce inflationary expectations for economic actors. The practice of indexation was an attempt to outrun inflation by including a component to offset inflation.  This, however, only served to entrench inflationary expectations and formalize those expectations into economic life. As Cardoso says, “Inflation was built into virtually every contract in Brazil with a monetary value: rent, taxes, bank loans, utility rates etc… Indexation became almost as important a cause of inflation in Brazil as the original sin of budget deficits.” Due to indexation, “the economy became a captive of its own inflation-mitigation technology.” (Kiguel and Liviatan)

The entrenched nature of high inflation also stemmed from the incredible and desultory anti-inflationary policies pursued by various governments. Jose Sarney’s Cruzado Plan relied on price and wage controls with no adjustment on the fiscal side. Follow-up stabilization plans – the Bresser Plan, Summer Plan, and so forth - were essentially the same. (K&L)  In 1988, Sarney’s plan to introduce a new currency failed, and inflation soared to 1,038 percent. Brazil went through three different currencies in five years.  As each currency lost value, the government had to stop payment on its foreign debt. (Cardoso)

The government’s lack of credibility was clear when inflation probably accelerated in anticipation of a new income-based stabilization plan by the Collor de Melo administration (K&L). Indeed, the Collor plan, while superficially ambitious, did little to “frontally [attack] the structural features that gave rise to an inflationary economy, namely addressing public debt, reducing the size of the public sector and institutional reforms to control the money creation process.” (K&L) Furthermore, some of the elements designed to give the appearance of tackling those structural features merely served to weaken the real side of the economy.  For example, the government instituted a mandatory freeze of 70% of financial assets for 18 months. While depositors lost access to money during the freeze, the funds were supposed to earn indexation plus 6% per annum.  Most public financial assets were domestic government debt, so the purpose of freeze was to postpone payment on the service of domestic debt and improve the fiscal balance.  (K&L) Not only was this merely deferring the problem of government deficits, it heightened uncertainty in Brazilian financial markets. Furthermore, when this drastic reduction in liquidity started to exert recessionary pressure, the government partially reversed some of its policies.  Needless to say, the Collor Plan didn’t work. This led to Collor II in Jan 1991. Some attempts were made to deepen fiscal adjustment, but these were still accompanied by price and wage control and increased regulation of financial markets. (K&L) We thus see that, rather being inevitable, hyperinflation was “the combination of high inflation and induced nominal instability, caused by unsound stabilization strategies, [creating] the conditions for inflation to explode.”