Thursday, April 9, 2009

Daily Economics 09/04/09: Riches in peril

Today's statement by Peter Sutherland on RTE radio concerning the alleged riches of Irish households is misleading in so far as it focuses on two mis-interpreted claims:
  1. Irish GDP per capita is still on of the highest in the OECD; and
  2. Irish wealth is well underpinned even despite the ongoing crisis.

I will tackle these in order.

Per Irish GDP per capita:

Ireland's GDP is expected to be €170-171.5bn(my forecast and DofF April 2009 forecast) in 2009. Our GNP is €142-144bn (as above). The GDP-GNP gap is standing at 16-16.5% and it is accounted for by the transfer pricing of multinational companies located in Ireland. In other words, the Dells and Intels of this world take inflated price of inputs they import into the country and then inflate value added in this country so they book more profits here. Precious little of the actual activity takes place here, but accounting shows it to be Irish-generated. This then goes into our figures for GDP. GNP excludes multinational transfers, so it is a cleaner measure of what we actually do produce in Ireland (inclusive of the real production by the multinationals).

Now, per CSO data for April 2008 - the latest we have - total population of Ireland is 4,422,100, which implies that 2009 GDP per capita is €38,443 and GNP is €32,111. There is an added trick. This does not take into the account the relative cost of living in Ireland, compared to the rest of the world. This is done by applying Purchasing Power Parity (PPP) adjustments. I don't have much recent data on PPP rates of exchange, but it does not change dramatically our position in the world rankings.

For example based on 2007 data - the latest for which global comparisons are available - we were still ranked the 3rd highest PPP-adjusted GDP per capita. However, taking PPP- adjustments to GNP and comparing ourselves with the rest of the world shows that Ireland ranked 14th in terms of PPP-adjusted GNP per capita in the world in 2007, which is, incidentally exactly where we were ranked in terms of our PPP-adjusted per capita consumption as well.

This shows two things:
  1. using an actual measure of our income (GNP) instead of a bogus measure (GDP) implies that we are scoring below (in order of ranking): US, Iceland, UK, Norway, Canada, Austria, Switzerland, Netherlands, France, Australia, Sweden, Belgium, Germany and Denmark in terms of our income, and
  2. that GNP per capita is reflective of our true consumption and investment positions, unlike GDP per capita.

Now to the second point concerning our wealth
In March issue of Business & Finance magazine I gave a detailed analysis of the wealth destruction that hit Ireland since 2008. Here is an excerpt.

“The bursting of the property bubble and of the equity bubble… showed that most of the ‘wealth’ that supported the massive leverage and overspending of agents in the economy was a fake bubble-driven wealth; now that these bubbles have burst it is clear that the emperor had no clothes…” said Nouriel Roubini in a recent update on the US economy. The same rings true for Ireland.

Two years ago, the Irish media was full of self-congratulatory patter about our riches. Our social welfare NGOs were using this myth as the grounds for demanding more welfare increases to offset the allegedly growing ‘relative poverty’. At the time just a handful of economists, this column included, were warning that our wealth was excessively geared toward one asset class – property. This lack of diversification, coupled with a lazy and often inept management of investment portfolios by the majority of Irish investors – from the most influential ones, like Sean Quinn, down to the 3-bed-semi families – is now coming to haunt us.

Nursing Real Losses
Majority of us are, by now, aware of the deep declines in housing (minus 30% plus relative to peak already and counting) and commercial (down 15% and still dropping like a stone) property values, and share prices collapse (off ca 70-80% depending on the index used). But few understand that our investments performance to date relative to other countries’ investors has been even more abysmal. This is true because of the opportunity cost of not actively managing our portfolios.

Per July 2007 Bank of Ireland report Wealth of the Nation (based on 2005 data) an average Irish investor held some 70% of gross assets in housing, 10% in cash, 8% in pension funds and 5% in business equity. Direct ownership of equity, investment funds shares and commercial property accounted for 2-3% allocations each. My own study, conducted in February 2007 on the basis of a sample of some 1,200-plus actual and potential high net worth individuals produced very similar results. In addition, it also showed that majority of Irish investors (over 72%) do not actively manage their own portfolios. Some 65% reported zero willingness to let professionals handle their investments. Instead of seeking proper advice (only 30% of Irish investors sought investment advice outside real estate agents’ offices) and acting upon well-researched information (only 43% of our savers actually searched around for best financial product offers), majority of Irish investors were keen on simply leveraging their assets as much as possible and dump most of it into high-risk property and shares deals.

Even less important for Irish investors was the idea of sectoral and geographical diversification. According to my data, only 10% of Irish retail investors held any exposure to non-property asset classes with allocations outside Ireland. Just 8% had more than 25% of their equities in non-property linked plcs.

2008 was a pivotal year in terms of changes in the Irish investment markets. Since then, factoring in the declines in asset values, the composition of the Irish wealth has been changing.

One important aspect of this change is that residential property share of overall wealth is poised to decline from ca70% in 2005 to ca55% in 2010. The latter figure is still roughly 38% above the OECD average, but the dynamic of change suggests some diversification out of property. Does this mean we are getting wiser with our money? Recently, a senior financial services professional suggested to me that because of the large pools of wealth we have allegedly held in the past, once the upturn occurs, cash will be available for investment in shares and financial funds. Sadly, I do not share his optimism.

Most of this diversification away from bricks-and-mortar is happening not because we somehow wised up to the need for diversification, but due to attrition in property values and lack of transparency in business equity valuations. In the longer term, most of this diversification will be going into increasing the importance of cash deposits implying excessively low yields in years ahead. Direct equity, investment and pensions funds and other asset classes that give investors exposure to the potential upside due to active management will remain the poor cousins of property and cash.

Using the changes in values for the main categories of assets held by Irish investors, I estimate that in 2008 Ireland’s total net private wealth has contracted by ca €150bn – from €712bn in 2005 (€805bn in 2006) to €559bn today. By my estimates, the current trend may see private net worth in this country shrinking to €307bn by the end of 2010 – a total loss of a staggering €405bn on 2005 figures. Adjusting for inflation, the total loss in wealth between 2007 and the end of 2010, by my estimates, will equal to roughly €470bn. Assuming marginal propensity to consume out of wealth of, say 3-3.5% (for US, this value is around 5%, so ours is a conservative estimate for Ireland), such wealth destruction will imply a fall-off in overall annual consumption of ca €4.8-5.5bn in 2008-2010, with a knock on loss to the VAT revenue of €900-1,100mln per annum.

A hefty opportunity cost
But this would be only half of the problem, were Irish investment portfolios actively managed through the downturn. During the current contraction cycle equity and property markets have posted unambiguously deep declines in all developed and middle-income economies around the world. However, several other highly liquid asset classes have shown relative gains. Prior to Autumn 2008, a number of international Exchange Traded Funds (ETFs) with commodities and fixed income exposures have recorded double digit dividends that would have seen the returns on these investments offsetting some of the short-term capital losses. Since late 2008, fixed income ETFs focusing on some corporate and public debt have continued to produce strong yields. Other classes of debt were also providing upsides. In many cases, such ETFs offer capital gains potential in the medium term similar to the fully diversified equities-based portfolios, but unlike equities, they pay strong current yields.

So what does this mean in practical terms? Over a dozen balanced managed portfolios blending ETFs, corporate and sovereign fixed income and actively managed money markets funds that I reviewed in recent months have been trading since September 2008. On average, this class of products has delivered a yield of ca 6-7% pa and a capital loss of 2-4%, when traded on a higher frequency basis. Compared to NASDAQ’s – 6% year to date slide, S&P500’s -13%, ISEQ’s -10.4%, accounting for re-invested dividends, some managed non-equity portfolios are returning a premium of 6-17% on average US, Asian, UK, EU and Irish indices.

In terms of the losses in Irish wealth, a switch of personal investment allocations into the actively managed asset classes (pensions and investment funds) and reversal of the direct equity holdings into an actively managed non-equity, yield-generating strategy could have saved some €1.2-3.4bn pa in wealth that is being lost due to asset allocations imbalance in Irish investment portfolios between 2009 and 2010. This is far from chop change. More active management of portfolios can generate enough savings on the investors’ balance sheets side to offset over 30% of the expected fall in our national income between these years. It can also, potentially, generate some €200-570mln in Exchequer revenues annually. The latter, of course, requires for such investment management to take place in this country – a proposition that is not exactly likely, given our poor tax treatment of investment markets and investors.

And the cost of poor governance
So enter our Government’s latest attempt at economic policy – the mini-Budget 2009 Part A. Why part A? Well, having predicted in this very column last year that we will face a new Budget by the end of Q1 2009, I can pretty much with certainty predict that whatever comes on April 7 will not be sufficient to plug the hole in the public deficit. Expect Part B some time before the end of the summer.

April’s mini-Budge will attempt to soak any PAYE earner with income above €60,000. The Government will do absolutely nothing to stimulate new investment and savings in this country. This, in turn, will lead to a double blow to our economy. First, in a series of straight jabs rapid flight of private investors’ capital out of the tax-choked economy will lead both to falling national wealth and further shortfalls in the Government revenue. Second, an uppercut of collapsing wealth will hammer pension funds across Ireland, as retail investors lose incentives to save at home and shift their longer term assets to jurisdictions with better management and more economically literate Government.

Should such scenario unfold, we’ll be lucky if our total national net assets pool does not fall below €200bn mark by the end of this recession.

Peter Sutherland is simply wrong to stress our relative wealth - just as the NGO were wrong to stress the importance of the relative poverty. The latest CSO stats on CPI - issued today - show that we are now worse off in real income terms than we were in August 2006.

4 comments:

Paul MacDonnell said...

Dr. G.

You are Einstein and James Bond combined. Nothing more needs to be said. This exposes the fatal flaw in Sutherland's thinking.

Paul MacD

Gerard O'Neill said...

Great post Constantin.

Another dimension to the wealth destruction you describe is the shattering of the faith of Irish investors in Irish wealth managers.

I have interviewed enough 'high net worth' (or formally HNW) investors in Ireland to know that a) they will never put most/all their eggs in the Irish basket ever again; and b) they will never just leave it to 'the experts' to manage their wealth - they'll take a far more direct interest in allocations themselves.

Though this is a cultural point rather than an economic one, it does suggest that the shift by retail investors of their diminished net worth to other jurisdictions will happen very quickly (if it isn't already).

Dr. Constantin Gurdgiev said...

Gerard, thanks for the comment.

I don't have any data on migration of clients, but so far, I have not heard of traditional advisers suffering from clients walking away.

In the US, about 80% of investors claim to be looking for new advisers and some smaller brokers I know have been gaining new business on the back of solid track record and good strategies.

In Ireland, it is still Davy, Goody's and the rest of the gang. It might be because they hold clients accounts that are so decimated that client migration is simply impossible - in other words, they cannot close positions. Or it might be something else.

More worryingly, judging by the research notes some of our smaller brokers have been putting out - e.g. 'turnaround is coming' and 'markets do come back' dated around late Summer early Fall 2008 - there has not been much of change in the way brokers formulate public advice. If anything, they are converging onto the big boys model of 'head in the sand' and 'band together'.

The disease of complacency, and I have had some first row seat view of it, is not so much a matter of analysts, but of middle/upper management in the brokerages.

But then it is also glaringly present in the business community at large.

Two examples. One, a senior manager of one of the main business organizations (Partnership-level) recently argued publicly that criticism of the Government and its policies should not be allowed for it undermines our credibility and reputation internationally. He had no idea that it is people like him - the 'sweep it under the carpet' types - who do more damage to out reputation abroad. Two, at a recent business gathering, business leaders of very high caliber applauded Brian Cowen delivering a speech about 'shared pain' policy approach. I asked a group of them what they thought of the speech. They all were enthused that the Government is about to do something significant. I said, ok, when he - Brian Cowen - screws you over with his policies in the mini-Budget, come back to me and tell me you were impressed... I wonder if they are impressed now.

But they are still not migrating to real view. They are afraid to destroy the consensus that is destroying them. Some years ago I asked a business audience, why do they all subscribe to Irish Times, given that the paper is staunchly anti-business, anti-wealth creation. There was no response. The bitch about Fintain O'Toole and then keep on paying his wages.

So I am very skeptical about the changes in Irish investors attitudes and behavior. May be they are now wiser. May be not. But they surely are not moving from the big 3 brokers.

We can track any shifts at least of significant size if we are to look at the external investment positions or external debt positions. It will take some time for data to percolate to the surface, but I'll be interested keeping an eye on this. Maybe we can develop an index?

Good Easter!

Myles Duffy said...

Constantin, I also enjoyed your perspective on this. The CIA World Fact Book lists our GDP (purchasing power parity) in 2008 as $191.9 billion and GDP (PPP) per capita estimated as $46,200.

It is interesting to reflect on the implosion of confidence in Irish wealth investors and the huge ambiguity with respect to toxic property related loans. When the 2008 annual report from Irish Nationwide emerges the headache will surely become more severe.

Enjoy Easter weekend! Myles