Will the Fed generate a tipping point?

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Following the election of Thatcher, Reagan and Kohl in the late 70’s, early 80’s three main interrelated trends have created a very benign environment for investment markets for more than 30 years. These trends were globalisation, disinflation and developments in monetary policy.

Together they have created a long bull market (rising prices) in bonds, as inflation fell, so did bond yields, which are inversely correlated with prices. Globalisation allowed much faster corporate earnings growth than GDP growth as more plentiful and cheaper labour boosted margins whilst consumer markets expanded. Lower inflation, interest rates and bond yields allowed a higher multiple to be applied to those earnings by the global stock markets. This in turn has generated a multi decade rise in equities, fixed interest and other asset prices, albeit with considerable volatility along the way. Most asset prices around the world are currently expensive relative to their own history, some such as US equities are arguably excessively so, some emerging market equities less so.

A new political order is emerging (or you could argue has emerged) with different policy priorities. Thus, globalisation may be replaced with nationalism and protectionism. Monetary policy (central bankers determining the price and availability of credit) may be replaced by fiscal policy (politicians deciding how much to tax and spend). Global trade and hence corporate earnings may suffer, whilst disinflation may be replaced with inflation.

This combination may result in a reversal of the benign trends enjoyed over the last 30 odd years and result in an inflection point that will reverse the bull market in bonds, reduce the multiple applied by the stock market to corporate earnings and occasion a rotation from growth companies to value companies.

Since the election of President Trump some of this rotation has already happened. Value companies have reversed their long underperformance of growth companies. Bond yields have backed up (prices fallen) and inflation has started to pick up- although this was in train prior to and not because of the recent political changes.

But so far, equity markets have taken what for many was a surprisingly positive view of prospective policy changes- with global equity markets up substantially since November last year. The promised fiscal stimulus has been taken very positively and clearly outweighed the negative impact of the rise in inflation and bond yields.

What might reverse the rise in equity markets?

Throughout my 40-odd year career in the investment management business equity bear markets (declines in prices) have been in anticipation of, or because of, economic recessions. Economic recessions have come along because of rising interest rates as central bankers decide economic growth and employment levels are sufficiently strong to be a danger to steady inflation and they raise interest rates, just as the US Fed started to do in December 2015, did more of in 2016 and is warning it will continue to do this year.

They hope to do just enough to curb inflation but not significantly detract from growth. Sadly, it rarely turns out this way. More often than not, too little too late means bigger rate increases eventually generate a tipping point and recession ensues.

Each cycle has its own characteristics that allow commentators to argue it will be different this time.
This cycle has been characterised by a heavy carry over of debt from the 2008 financial crisis that has kept short rates much lower for much longer than anyone ever imagined. This in turn has allowed a further build-up of global debt which is estimated to be 50% higher now than in 2008.

All of this highlights the difficulty of the task facing US policy makers. Hopefully, they will be able to set interest rates at a level which allows continued economic growth without too much inflation.

The dilemma facing professional investors is where to go if traditional asset classes are all expensive and at risk from rising US rates. Their response has been to raise the weighting of ’alternative assets’, formerly the preserve of institutional and high net worth investors but now readily available to retail investors through funds on the big investment platforms.

What’s next? Helicopter money? – Gregor Logan

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Greece is facing debt repayment deadlines again and so is ‘renegotiating its debts’ with the EU (a euphemism for borrowing even more). The last time this happened in July 2012 Mario Draghi, president of the European Central Bank, said in an unscripted off the cuff remark “within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”. These few words have been credited with saving the Euro, or at least prolonging its agony, as confidence returned to financial markets and the cost of debt in Greece, Italy and Spain fell dramatically, allowing Greece to roll over its debt.

The world relies on ever more experimental monetary policy because after the Global Financial Crisis in 2008 governments of the developed world had accumulated too high levels of debt and ongoing deficits to introduce classical Keynesian reflationary fiscal policies of tax reduction and higher government spending.

Since the early 1990’s central banks have been tasked with controlling inflation as their primary policy aim. This has been interpreted as 2% is good, but above or below 2% requires monetary contraction or expansion. When zero interest rates proved insufficient to generate more than anaemic growth and hence the required 2% inflation, the central bankers introduced further monetary stimulus in the form of bond buy back’s, now termed Quantitative Easing or QE. First introduced in the US, it was followed with varying levels of speed and enthusiasm by the UK, Japan and Europe.

This has enabled the global economy to enjoy so-so economic growth of 2% or so, but has only been possible because consumers and corporates have returned to spending tomorrow’s income today and in the process run up considerably larger debts than before the crisis; debts which in many cases are only affordable because of the prevailing very low interest rates. It has also fuelled the much debated rise in asset prices and consequent divergence in wealth.

Many think all this is simply storing up a bigger crisis for the future. Nor has it addressed the major imbalances in the global economy — characterised as the developing world exporting cheap goods and low paid workers to the developed world and in the process deflating consumer prices, lowering the cost of borrowing and encouraging the propensity for Western consumers to borrow and spend.

In Japan, the central bank has done so much QE there are fears they may have run out of ammunition. In the US, Donald Trump has said the previously unthinkable by a politician and suggested the Government should pay back its national debt with discounts. You might write that off as another attention seeking maverick quote, but he is merely voicing what many are thinking.

In our press ‘helicopter money’ is widely talked about as the next step — but only one that will be taken in extremis — just like QE before it. Helicopter money is when central banks print money for the government to spend as it chooses or transfers are simply made to individuals to spend, typically within a specified time frame so the money cannot be saved. There are recent precedents. In 1999 Japan gifted shopping coupons with a six month life to families and the elderly and in 2008 US taxpayers received a one-off gratuitous rebate of $300.

I think this begs two important questions. The first was prompted by Mario Draghi in 2012 when he prefaced his remarks with ‘within our remit’: Just how far does the remit of a central banker go? Is it continuously assessed, and if so by whom and why don’t we hear or see evidence of it? I ask this question because in many ways they now appear to be acting as unelected governments, determining — not just implementing — economic policy, often seemingly and regrettably on the hoof.

The second question is why will helicopter money work after zero and now negative interest rates combined with QE have been insufficient to cure our perceived economic ills and may even, as some commentators suggest, be storing up yet more trouble for the future? Why will it not be just another short-term boost that fades with time leaving us back where we were but with even more debts created by fiat money?

Financial markets have placed huge confidence in the ability of central bankers to ‘do what it takes’. With fading global growth, government bond yields already low or negative, even in high debtor nations like Greece, and equity valuations at the upper end of their historic levels, a pretty big rabbit is going to have to come out of someone’s hat sometime soon.

What next from central bankers? – Gregor Logan

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I went to see The Big Short recently. What a great movie. I thought it was as good if not better than the book. And interesting timing with financial markets in disarray as fears over Chinese growth, falling oil prices and the Fed’s interest hike take their toll. We await the response of central bankers to the latest equity market weakness. Mario Draghi, Head of the European Central Bank, has hinted at further unconventional stimulus, but given no detail. The Fed has backpedalled fast on their proposed four hikes in 2016. With interest rates already at near zero and fiscal budgets still under strain, further unconventional measures are surely not far off.

A fascinating review of past policy failures and alternative policy options for the future are given in Adair Turner’s excellent book ‘Between Debt and the Devil’ in which, surprisingly for a former Chairman of the Financial Services Authority (FSA) and general establishment figure, he challenges conventional economic and policy wisdom on many fronts. I warmed to him in the first few pages when he describes starting work as Chairman of the FSA in September 2008. He quickly concludes we faced the biggest financial crisis in 80 years and humbly admits “seven days before I started I had no idea we were on the verge of disaster.” He also suggests almost no one else amongst all of the central banks, regulators, or finance ministries, nor in financial markets or major economics departments knew either. I encourage you to read the book to get the full benefit of his intellectual rigour.

In brief, his conclusion is that central bankers’ current desire to stimulate bank lending via low interest rates and QE is misplaced and instead of solving anything is merely adding to the problems we already have. In particular, it helps the wealthy drive up already inflated real estate prices. He goes further by suggesting we may not need private credit growth at all to fuel economic growth. As a result, and to create a much more stable environment commercial bank’s debt equity ratios should be regulated down to much lower levels than even the new post crisis frugality dictates.

In contrast, he seeks to banish the existing taboo (at least on the political right) of high government deficits and suggests rising government debt is okay as long as it is in a controlled fashion and inflation remains low.

As to how we get out of the current impasse of already low rates and high government deficits, he recommends a large dose of Fiat money in the belief that it is an erroneous notion that printing money will lead to harmful inflation. He writes: “To escape the mess created by past policy errors, we sometimes need to monetize government debt and finance fiscal deficits with central-bank money.”

In other words he argues that the mantra of private debt good, public debt bad should be turned on its head with private debt taxed as toxic and public debt forgiven by the vast creation of Fiat money.

If equity markets continue to decline and fears of a global economic recession become mainstream thinking I expect to see some of his suggested policies being more widely discussed and adopted.

Stock market vigilantes put the Fed between a rock and hard place – Gregor Logan

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I was surprised the Fed actually went ahead and raised rates in December — but not surprised by the negative reaction of global stock markets. I sympathise with the Fed’s predicament. There were already obvious signs of distress in the junk bond market, continuing weakness in emerging market economies and currencies and growing evidence of economic slowdown in western economies. However, the asset price bubbles in stock and real estate markets continued to inflate, taking markets to historically elevated valuations and giving the, perhaps, false impression that all was well in underlying economies. This view was helped by strong employment numbers in the US and improving employment trends elsewhere in western economies.

The need to ‘normalise’ rates appears to have been thought appropriate to give the central bankers some policy options should economic activity turn down again. The US economic recovery was already one of the longest post war, albeit one of the most anemic, and should it turn down due to some unforeseen shock there would have been precious little the Fed could do with ZIRP still in place and their balance sheet already inflated from past QE.

The big question is of course what happens now. To answer that question I think we have to put where we are today into context. Since the financial crisis, global government and corporate debt has risen faster than GDP to levels way above where they were in 2008. Despite this, bond yields have fallen due to the combination of ZIRP and QE. This in turn has allowed stock markets to rise far faster than corporate profits, in part because price earnings ratios are a reciprocal of interest rates — but also because there was no reasonable alternative for large institutional investors.

Inflation has been absent, with many economies experiencing disinflationary if not deflationary tendencies, despite the best efforts of central bankers. The collapse of commodity prices has exacerbated this trend. Emerging market economies have been weakening for some time despite currency depreciation, whilst the western economic recoveries are not yet clearly self-sustaining. Most leading, and some coincident, economic indicators are already suggesting a continuation of the weakening trend; for example, global shipping rates as measured by the Baltic Dry Index are down nearly 50 percent over the last year.

All of which confirms the economic and financial world was in a pretty precarious state to cope with a rate rise. Only 0.25 percent, and you might reasonably respond, but it was also a doubling of rates after many, many years of ultra-low rates and build-up of debt to pay for ever higher asset prices.

The Fed’s resolve is clearly being tested. It appears we have stock market vigilantes pushing prices down to encourage the Fed to not raise further and perhaps even reverse the rate rise. This puts moral hazard back on the agenda, and a further postponement of the evil hour when debts have to be repaid and stock prices decline to more reasonably reflect the level of underlying earnings.

A suggestion to help curb pay disparity

The public, politicians and institutional investors all seem to agree that the disparity in pay between the top few and the rest has become too great. According to the High Pay Centre, the average pay of FTSE CEO’s is now 130 times that of the average employee in the same company, up from 47 times in 1998 and less than 20 times in 1980 and the ten highest multiples of FTSE 100 CEO’s range from 250 to a wonderful 780 times for Martin Sorrell at WPP.

Since 2006 annual reports are obliged to include full disclosure of all forms of pay and typically give details of at least 5 separate types of remuneration: fees and salaries, taxable benefits, annual incentives, LTIP and pension contributions. Designed to shame companies into paying less, it appears to have had the opposite effect of allowing easy comparison to enable the NED’s to justify their own CEO’s pay on the basis he should be paid top quartile for his excellent work. I suspect in most cases it is not about the utility of the money earned, it is just a way of keeping score.

There have been other initiatives to control the worst excesses of executive pay, but little progress appears to have been made despite this much greater disclosure of the whole process. Some may even have been counterproductive. For example, the shift to greater emphasis on EPS or share price growth in calculating bonuses has arguably led to short-termism at the expense of long term strategic planning and investment.

I have a suggestion for a simple tweak to the present system of hiring and rewarding CEO’s and other board members. It should be made a requirement that at least three candidates make the shortlist. When the appointment process gets down to those final three they should be asked to say how much they are willing to do the job for, on the stated understanding that the one who is willing to do it for least is most likely to be appointed.

This Dutch auction will hopefully reverse the bidding war that typically occurs. And once in place, instead of the annual review focusing on the peer group and insisting that your appointee has to be top quartile, ask the same question of the incumbent again.

I have no doubt the current participants in the process will explain how unworkable this suggestion is. Head-hunters will hate the idea; their fees are typically a percentage of first year’s remuneration. Non-Executive directors will talk about succession planning and the importance, if not necessity, of getting the right person. I counter that it is mostly self-interest that perpetuates the current system. Also, there is now a considerable weight of research to suggest that the success or otherwise of CEO’s is mostly down to luck. If that is the case let’s pay as little as possible to find out who is going to be lucky.

Two must-read books for investors – Gregor Logan

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Mark Dampier, head of research at Hargreaves Lansdown has just published an excellent book, ‘Effective Investing‘, outlining how the reader can take control of their own finances. Whilst suggesting a discussion with a professional is always a good starting point, he rightly points out that the development of online platforms, greater tax incentives such as ISA’s and free research available online have made the process of looking after one’s own finances much easier, although not entirely effortless. Even if you invest through a professional, reading this book will equip you with a much better understanding of what is being done on your behalf and improve your ability to question both the process and outcome.

Should you be setting out on a journey of self-investing, Mark lays out in a reader-friendly, logical way: how to go from blank sheet of paper to being fully invested in carefully chosen, actively managed funds suitable to your investment objectives and risk tolerance. He suggests the choice of which funds to buy is as important, if not more important, than getting your asset allocation right. He offers help and assistance in reducing the “bewilderingly large” number of funds down to a few that you might sensibly own.

Lars Kroijer in his also excellent book ‘Investing Demystified‘ starts out with a different and contrasting theory; that the markets are actually quite efficient and seeking to be one of the few who does manage to outperform is most likely to end in tears. With this as the key premise of his investment methodology, he suggests that by deciding on a sensible asset allocation, which is in turn invested through low cost tracking funds, you are much more likely to meet your expectations. The certainty of compounding of the added return from very low fees more than makes up for the chance of outperformance from actively managed, but high fee funds. He too then takes the reader on a journey from theory to fully invested practice.

These two writers agree on many aspects of investing, the critical difference is whether it is worth paying more in the hope, not certainty, of achieving above market returns from the funds you own.

One way to assess who has been correct historically is to back test the aggregate results of the wealth managers in the City. By doing what is referred to as attribution analysis one can determine and compare how much of a portfolios return comes from asset allocation (i.e., the percentage in equities, bonds, property and cash) and the return actually achieved form these assets, commonly known as stock selection. The results are unequivocal, using the same asset allocation, the low fee, index tracking solution offers superior returns. Although in theory the professional should be able to choose funds that outperform, in practice, in aggregate, they choose funds that underperform after fees of course.

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Welcome to my website. I'm Gregor Logan, an independent management professional with over 35 years of experience in all asset classes, including equities, bonds, property, private equity, alternative assets and bonds. I previously held senior-level roles at MGM Assurance, Pavilion Asset Management and New Star Asset Management.

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