Sunday, December 30, 2018

29/12/18: It pains me to no end to see America being reduced to this...

I am not a psychologist or psychiatrist. I am not even a sociologist. So my comments below are based simply on my observations as a human being.

In literature - from Arendt to Kafka, from Levi to Bulgakov, from Platonov to Solzhenitsyn, from Shalamov to Gogol, from Ionesco to Kundera, from Klima to Marquez, from Kinckaid to Coetzee, from Brodsky to Walcott, and so on - a license of power awarded to one by a title or a job, by the state or the sovereign policy, by order or diktat is commonly associated with dehumanization of the awarded. In more common media and popular studies, see and the notion of a sadistic bureaucrat / soldier / officer / office holder is commonly associated with the license for violence promoted by the State.

With this in mind, in a case of our modern liberal democracies, when such violence / sadism does arise, the dehumanization of its victims and the dehumanization of the officials involved in these acts reinforce each other. Repeated on a rare occasion, such violence and dehuamization of its victims by the officials simply erodes our social trust. Repeated systemically, it risks dehumanizes our entire society, potentially creating systemic racism, xenophobia and debasement of core human values.

With a good part of the last two decades associated with a new - in nature, although not, necessarily in levels - degrees of violence the American society has inflicted onto other states (via numerous regime changes, direct wars, indirect/proxy wars, bombings, drone attacks, etc), and within its own borders on its own people (police violence, police shootings, snooping & spying on its own citizens, mass surveillance, state violence against whistleblowers and so on), the dehumanization of the American society has been growing at a frightening pace. As the result, xenophobia, anti-immigrant sentiments, white supremacism, ant-semitism, Russophobia, political polarization, and other forms of general incivility have been pushed from the extreme fringes of the American society toward its center. The values the Americans still espouse in verbal and propagandistic discourses - those of the freedom of speech, of family, of the land of opportunity, of social mobility, of competition, of private enterprise, and so on - are now coming under the pressure when tested against empirical reality.

And, as of late, we have entered yet another, even more worrying turn of this vicious spiral downward: the dehumanization of our security apparatus. This worries me. A lot. The brutality with which we are treating people, families, kids arriving at our borders with a legitimate claim to an asylum and a legitimate hope (subject to testing) for better lives is contrary to the basic foundations of the American society: its openness to others, its support for the family, its willingness to extend opportunity for betterment of self, its basic humanity.

Last night, this prompted a twitter thread from me that some of you asked me to reproduce in one place. Here it is:

I have travelled to the U.S. for 28 years now. As a Green Card holder, as a Russian and an Irish citizen, as a GC holder again. In ALL my personal interactions with Border Control, I never witnessed any non-professional, non-courteous behavior toward myself or others around. +

+ The accounts from the treatment of asylum seekers, illegal migrants, and the Dreamers are - to me - one of the core pieces evidence of how America’s institutions are changing and have changed over the years from being a melting pot of colures and ethnicities, a land of +

+ opportunity for millions of newcomers, a place where family and children are treasured to a heartless, callous, amoral regime. Here are the facts (via… @NYMag ): +

“A. Portillo, …was taken into custody by CBP in California… her 5-month-old was sick. [Portillo] was giving her baby an antibiotic but said she wasn’t allowed to keep the medication after she was detained. Her baby got sicker as they were held in “freezing” cells — iceboxes — +

+ In a different case, “the seven-year-old Guatemalan girl died of a combination of septic shock, fever, and dehydration, just hours after she was taken into CBP custody.” +
+ Yet “another young girl who fell dangerously ill while in CBP custody. The girl, whose mother told officials her daughter had a preexisting medical condition, went into cardiac arrest but eventually made a full recovery.” +

+ These are not the acts of a civilized law enforcement. These are acts of barbaric power-drunk abusers of the basic principles of humanity. That we endow them with jobs, salaries, pensions, respect & even veneration is beyond the pale for a 21st century ‘liberal democracy’. +

+ These are not even the acts of law enforcement consistent with the principles of the rule of law, for it treats legal asylum seekers - those who have a legal RIGHT to apply for asylum - as sub-human subjects. +

+ If you doubt my judgement on this, here are U.S. Congress legislators on the subject: "New Mexico representative Ben Ray Luján said the holding cells where children and adults are held are “inhumane.” +

+ Texas representative Al Green said what he saw was “unbelievable and unconscionable.” “The [ASPCA] would not allow animals to be treated the way human beings are being treated in this facility,” Green said. “To tolerate what I have seen is unthinkable.”

+ We are empowering this behavior by those representing us at the borders. Just as we are empowering the behavior of police abusers who kill innocent people with zero consequences. We are empowering them by idolizing the brutality of coercion the state licenses out to them. +

+ We are empowering them by voting for the lawmakers who can note - on the record, in the media - the inhumanity of our regime, yet do absolutely NOTHING to stop it. We are empowering them by believing that Putin, Xi, Iran, whoever else you can imagine are causing our problems. +

+ We are empowering them by mistreating migrants, including those who are undocumented, who live and work around us. Before it is too late, before we’ve lost all remnants of civility, decency, honour, compassion, we must stop. Stop ourselves, first.

I am pained by the fact that the American society has grown to tolerate such abuses of power, without demanding better from their lawmakers, their executive, their officers of the State. We are marching toward the inevitable and unenviable collapse of civility as long as we tolerate such abuses to be perpetrated in our names, in the name of the law. 

Saturday, December 29, 2018

29/12/18: Vultures, Prime Ministers and the Mud of 'Values' in Newtonian Finance

In a recent conversation with the Irish Times (, Ireland’s Taoiseach (Prime Minister), Leo Varadkar, “has defended so-called vulture funds”, primarily U.S-originating buyers of distressed performing and non-performing mortgages, “stating that they are more effective at writing down debts than banks which “extend and pretend” rather than reaching settlements with homeowners.”

Mr Varadkar alleged that:

  • “…homeowners whose mortgages were sold off to such funds would be “no worse off” than those whose loans were owned by the banks.”
  • And, “he disagreed with the use of the term “vulture fund” and criticised the practices of our own banks.”

A direct quote: “I’m always reluctant to use the term vulture funds because it is a political term. What we’re talking about here is investment banks, investment funds, finance houses, there are lots of different things and lots of different financial entities there and the term is used, vulture funds. But you’ll know from the numbers that they’re often better at write-downs of loans than our own banks. Our own banks tend to ‘extend and pretend’ rather than coming to settlements with people.”

Let’s deal with Mr. Varadkar’s claims and statements:

1) Is ‘vulture fund’ or VF a political term? 

The answer is no.

As a professor of finance, I use this term without any political context or value judgement. As do Investopedia, and the Corporate Finance Institute (CFI), along with a myriad of text books in finance and investment, as do the Wall Street, Bloomberg, Reuters, Wall Street Journal… In fact, all of the financial sector. For example, CFI defines VFs as “a subset of hedge funds that invest in distressed securities that have a high chance of default”. So, Mr. Toaiseach, the term ‘vulture fund’ is a precisely defined concept in traditional, mainstream finance. It is not a political term and it is not a term of ethical value assigned to a specific undertaking. In fact, as a finance practitioner and academic, I see both positive and negative functions of the VFs in the markets and society at large. Just as a biologist would identify positive aspects of the vulture species in natural environment.

Vulture Funds are invested in and often operated by ‘different financial entities’, including ‘investment banks’. They are a form of ‘investment funds’ when they are stand-alone undertakings. Which covers the entirety of the Taoiseach’s argument on this.

As an aside, a term ‘financial house’ used by the Taoiseach is not a definable concept in finance in relation to mortgages or other assets lending. Instead, FT defines a financial house as “A financial institution that lends to people or businesses, so that they can buy things such as cars or machinery. Finance companies are often part of commercial banks, but operate independently.” 

In other words, financial organisations and entities purchasing distressed and insolvent Irish mortgages cannot be classified as ‘financial houses’, and any other classification of them allows for the use of the term Vulture Fund.

2) Can VFs be regulated into compliance with the practices other lenders are forced to adhere to?

The answer is no. 

They simply cannot, because VFs always, by their own definition, pursue a strategy of recovery of asset value, not the recovery of debtor solvency. Regulating them as any other undertaking, e.g. banks, will remove their ability to exercise their specific strategies. It will de facto make them non-VFs.

Here is CFI on the subject: ““Vulture” is a metaphor that compares vulture funds to the behavior of vulture birds that prey on carcasses to extract whatever they can find in their defenseless victims.” Note the qualifier: defenceless victims: CFI is not a softy-lefty entity that promotes ‘victims rights’, but even corporate finance professionals recognise the functional aspects of the vulture funds. VFs cannot trade/exist on the same terms of traditional lenders, because: (1) they are not lenders (they do not pursue transformation of short term funding into long term assets, as banks do), (2) they have zero (repeat zero) social responsibility (no legislation can induce them to have any such a mandate in terms of social responsibility in funding assets as banks have, because such a mandate would invalidate the VFs investment model), and (3) unlike lenders, VFs deal with specific types of assets and specific areas of risk-pricing that cannot be covered by the lending markets precisely because of the implied conflict between the lenders’ longer-term market strategies, and the need to recover and capture asset values. In other words, you can’t make vultures be vegans. And I place zero political or social value in these arguments. It’s pure finance, Taoiseach.

“Vulture funds deal with distressed securities, which have a high level of default and are in or near bankruptcy. The funds purchase securities from struggling debtors with the aim of making substantial monetary gains by bringing recovery actions against the owners. In the past, vulture funds have had success in bringing recovery actions against sovereign governments and making profits from an already struggling economy.”

What this tells us is (a) VFs pursue legal seizures of assets from debtors as a norm (in the case of mortgage holders - this amounts to evictions of renters and forced sales of owner occupied properties); and (b) VFs are good enough at that job to force sovereign nations into repayments (which puts into question even the theory of efficacy of any consumer protections the Government can put forward to restrict their practices).

3) Are debtors better off or as well off under the vulture fund management of their debts as under other banks’ management?

The answer is: it depends. 

If a debtor genuinely cannot recover from insolvency, then forcing earlier insolvency onto them actually provides a benefit of offering an earlier restart to a ‘normal’ financial functioning of the debtor. This is the ‘clean slate’ argument for insolvency, not for VFs. In order to achieve this benefit, the insolvency must be done with a pass-through of losses write-downs to the debtor (avoiding perpetual debt jail for the defaulting debtor). The VFs simply do not do this on any appreciable scale, and are even less likely to do so in the tail end of the insolvency markets (later into insolvency cycle).

Why? Because they have no financial capacity to do so. Do a simple math: suppose a VF purchases an asset for EUR60 on EUR100 of debt face value (40% discount on par). Costs of managing the asset can be as high as 5%. Cost of capital (and/or expected market returns) for VFs is ca 15%-18% due to high risk involved. The asset is assumed to return nothing - it is severely impaired, like a mortgage that is not being re-paid. To foreclose the asset, the VF has to pay another cost of, say, 10% (legal costs, eviction-related and enforcement costs, etc including costs involved in disposing of underlying property against which the mortgage is written). And the process can take 1-2 years. Suppose we take the mid-point of this at 1.5 years. There is uncertainty about the legal costs and timings involved. Suppose it involves 10% of the total mortgages pool purchased by the fund. The cost or recovering funds for the VF, accounting for compounded interest on VF’s own funding, is now EUR22.99-25.91. Take the lower number of this range, at EUR22.99 per EUR60 asset purchased. Suppose the VF forecloses on the house and sells it. Suppose the house is an ‘average’ one, aka, consistent with the current residential property price index metrics, and the mortgage was written around 2005-2007 period. This means the house is roughly 20 percent under the valuation of the mortgage at the mortgage origination. So the VF will get EUR80 selling price on EUR100 loan. If the mortgage was 90% LTV, roughly EUR90. Take the latter, more favourable number to the VF. and allow for 1.5 years cumulative asset growth of 20% (property values inflation). VF’s cumulative returns over 1.5 years are 25.06% or 16.04% annualised. The VF has barely performed to its market returns expectations. There is zero room for the fund to commit any write downs to homeowners in this case. None in theory, none in practice.

In contrast, the banks do not face market expectation of returns in excess of 15% pa on their assets, nor do they face the cost of funding at 15-18%, which means they can afford passing discounts to the homeowners.

The situation is entirely different, when a debtor can recover from insolvency, e.g. via pass-through to the debtor of market value discounts on their debt (30-40% that VFs would get in the sale by the bank), or via restructuring of the loans, a VF will never - repeat, never - allow for such a restructuring, because it results in extending the holding period of the asset required for recovery. VFs are not in business of extending, and, yes, Taoiseach is correct on this, they are also not in business of pretending.

Now, the logic of selling non-recoverable (via normal routes of working out) assets to VFs can accelerate the speed of insolvency. But the logic of selling recoverable assets to VFs only forces insolvency onto borrowers where they do not require such for the recovery. Any restructured, but performing mortgages sold to VFs will be inevitably foreclosed (insolvency created), even though they are recoverable (insolvency is not optimal). And there is nothing the Government can do, short of forcing VFs to become non-VFs, to avoid this.

I append zero, repeat zero, social impact costs to this analysis. These are, however, material in the case of mortgages and foreclosures, especially due to the adverse impact of such actions on demand for social housing, and in light of ongoing housing crisis in Ireland.

4) Are VFs subject to “the the same regulations and the same consumer protections as the banks,” as the Taoiseach claimed?

Answer is no. 

VFs do not adhere to the same regulations and the same oversight as the banks. The proof of this is the fact that Government is currently supporting legislative attempts to bring VFs into the regulatory net, aka the Michael McGrath’s bill that FG support. If the Government is supporting a new legislation, the Government is admitting that current regime of regulation for the VFs is not sufficiently close to that of the banks. If the current regime is sufficient to cover consumer protection to the extent that the banks regulations are, then why would there be a need for a new legislation?

In a summary: the Taoiseach is simply out of his depth when it comes to dealing with the simple, well-established in mainstream finance, concept, such as the VFs. This is doubly-worrying, because the Taoiseach is leading the charge to provide a new regulatory regime, to cover the areas that he appears to have little understanding of.

Per Taoiseach: “We support that and we are going to make sure that anyone who has a mortgage, who is repaying their mortgage, making a reasonable effort to pay it, continues to have the exact same protections, the exact same consumer protections as they would if the loan was still owned by the banks.”

This is a wonderfully touchy statement of the objective. Alas, Mr. Taoiseach, you can’t have asset ownership by the VFs combined with the regulatory protection measures that invalidate VFs’ actual business model. And you can’t scold the banks for ‘extending and pretending’ on borrowers, while at the same time codifying these ‘extensions’ for all investment funds, including the VFs. The cake vanishes once you eat it. Finance is Newtonian, in the end.

Friday, December 28, 2018

28/12/18: BTCD is neither a hedge nor a safe haven for stocks

A quick - and dirty - run through the argument that Bitcoin serves as a hedge or a safe haven for stocks. This argument has been popular in cryptocurrencies analytical circles of recent, and is extensively covered in the research literature, when it comes to 2014-2017 dynamics, but not so much for 2018 or even more recent period dynamics.

First, simple definitions:

  1. A financial instrument X is a hedge for a financial instrument Y, if - on average, over time - significant declines in the value of Y are associated with lower declines (weak hedge) or increases (strong hedge) in the value of X.
  2. A financial instrument X is a safe haven for a financial instrument Y, if at the times of significant short-term drop in the value of Y, instrument X posts increases (strong safe haven) or shallower decreases (weak safe haven) in its own value.
So here are two charts for Safe Haven argument:

The first chart shows that over the last 12 months, there were 3 episodes when - over time, on average, based on daily prices, stocks acted as a strong hedge for BTCUSD. There are zero periods when BTCUSD acted as a hedge for stocks. The second chart shows that within the last month, based on 30 minutes intervals data (higher frequency data, not exactly suitable for hedge testing), BTCUSD did manage to act as a hedge for stocks in two periods. However, taken across both periods, overall, BTCUSD only acted as a weak hedge.

The key to the above is,  however, the time frame and the data frequency. A hedge is a longer-term, averages-defined relationship. Not an actively traded strategy. And this means that the first chart is more reflective of true hedging relationship than the later one. Still, even if we severely stretch the definition of a hedge, we are still left with two instances when the BTCUSD acts as a hedge for DJIA against two instances when DJIA acts as a hedge for BTCUSD.

People commonly confuse both hedging and safe haven as being defined by the negative symmetric correlation between assets X and Y, but in reality, both concepts are defined by the directional correlation: when X is falling, correlation myst be negative with Y, and when Y is falling, correlation must be negative with X. The downside episodes are what matters, not any volatility.

Now, to safe haven:

Again, it appears that stocks offer a safe haven against BTCUSD (6 occasions in the last 12 months) more often than BTCUSD offers a safe haven against stocks (2 occasions).  Worse, the cost of holding BTCUSD long as a safe haven for stocks is staggeringly high: some 60-65 percentage points over 12 months, not counting the cost of trading.

In simple terms, BTCUSD is worse than useless as either a hedge or a safe haven against the adverse movements in stocks.

27/12/18: Mr. Draghi's Santa: Ending QE, Frankfurt Style

It's Christmas time, and - Merry / Happy Christmas to all reading the blog - Mr. Draghi is intent on delivering a handful of new presents for the kids. Ho-Ho-Ho... folks:

The ECB balancesheet has just hit a new high of 42% of Eurozone GDP, up from 39.7% at the end of 3Q 2018. Although the ECB has announced its termination of new purchases of assets under the QE, starting in January 2019, the bank has continued buying assets in December, and it will continue replacing maturing debt it holds into some years to come.

Despite the decline in the Euro value, expressed in dollar terms, ECB's balancesheet is the largest of the G3 Central Banks, ahead of both the Fed and the BOJ.

Ho-Ho-Ho... folks. The party is still going on, although the guests are too drunk to walk. Meanwhile, global liquidity has been stagnant on-trend since the start of 2015.

And now the white powder of debt is no longer sufficient to prop up the punters off the dance floor:

Ho-Ho-Ho... folks.

Saturday, December 22, 2018

22/12/18: Millennials and Buffetts: It’s a VUCA Investment World

My August 2018 Economic Outlook for Manning Financial:

What unites Warren Buffett, Apple and the financially distressed generation of the Millennials? In one word: cash and preferences for safe haven assets. Consider three facts.

Financial Markets

One: at the start of August, Berkshire Hathaway Inc. gave Buffett more room to engage in stock buybacks, just as company cash holdings rose to USD111 billion at the end of 2Q 2018, marking the second highest quarterly cash reserves in history of the firm. This comes on foot of Buffett's recent statements that current stock markets valuations price Berkshire out of "virtually all deals", just as the company took its holdings of Apple stock from USD40.7 billion in 1Q 2018 filings to USD47.2 billion in 2Q filings. Historically, Berkshire and Buffett are known for their high risk, nearly contrarian, but fundamentals-anchored investments: a strategy for selecting companies that offer long term value and growth potential and going long big. Today, Buffett simply can’t find enough such companies in the markets. His call is to return earnings to shareholders instead of investing them in buying more shares.

Two: on August 2nd, Apple became the first private company in history to top USD1 trillion market valuation mark when company stock closed at above USD207.05 per share. Company's path to this achievement was based on far more than just a portfolio of great products. In fact, two key financial engineering factors in recent years have contributed to its phenomenal success: aggressive tax optimisation, and extremely active shares buybacks programme. In May 2018, the company pledged USD100 billion of its USD285 billion cash stash (accumulated primarily off-shore, in low tax jurisdictions such as Ireland, Jersey and in the Caribbean) for shares buybacks. As of end of July, it was already half way to that target. Apple is an industry leader in buybacks, accounting for close to 15 percent of all shares buybacks planned for 2018. But Apple is not alone. A study by the Roosevelt Institute released in August shows that U.S.-listed companies spent 60 percent of their net profits on stock buybacks between 2015-2017. And on foot of the USD1.5 trillion tax cuts bill passed by Congress in December 2017, buybacks are expected to top USD 800 billion this year alone, beating the previous historical record of USD 587 billion set in 2007. Whichever way you take the arguments, accumulation of tax optimisation-linked cash reserves, and aggressive use of shares buybacks have contributed significantly to the FAANGS (Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG)) dominance over the global financial markets.

The Squeezed Generation

And this brings us to the third fact: the lure of cash in today's world of retail investment. If cash is where Warren Buffetts and Apples of the financial and corporate worlds are, it is quite rational that cash is where the new generation of retail investors will be. Per July 2018 survey data, 1 in 3 American Millennials are favouring cash instruments (e.g. savings accounts and certificates of deposit) for investing their longer-term savings. In comparison, only 21 percent of Generation X investors who prefer cash instruments, and 16 percent for the Baby Boomers. American retail investors are predominantly focused on low-yielding, higher safety investment allocations. For example, recent surveys indicate that only 18 percent of all American investment portfolios earn non-negative real returns on their savings, and that these households are dominated by the Baby Boomers generation and the top 10 percent of earners. Amongst the Millennials, the percentage is even lower at 7.4 percent.

The conventional wisdom suggests that the reasons why Millennials are so keen on holding their investments in highly secure assets is the fear of market crashes inherited by their generation from witnessing the Global Financial Crisis. But the conventional wisdom is false, and this falsehood is too dangerous to ignore for all investors - small and large alike.

In reality, the Millennials scepticism about the risk-adjusted returns promised by the traditional asset classes - equities and bonds - is not misplaced, and dovetails neatly with what both the largest American corporates and the biggest global investors are doing. Namely, they are pivoting away from yield-focused investments, and toward safe havens. The reason we are not seeing this pivot reflected in depressed asset prices, yet is because there is a growing gap between strategic positioning of the Wall Street trading houses (all-in risky assets) and those investors who are, like Buffett, focusing on longer-term investment returns.

Overvalued Investment

In simple terms, the U.S. asset markets are grossly overvalued in terms of both current pricing (including short term forward projections), and longer term valuations (over 5 years duration).

The former is not difficult to illustrate. As recent markets research shows, all of the eight major market valuations ratios are signalling some extent of excessive optimism: the current S&P500 ratio to historical average, household equity allocation ratio, price/sales ratio, price/book value ratio, Tobin's Q ratio, the so-called Buffett Indicator or the total market cap of all U.S. stocks relative to the U.S. GDP, the dividend yield, the CAPE ratio and the unadjusted P/E ratio. Take Buffett's Indicator: normally, the markets are rationally bullish when the indicator is in the 70-80 percent range, and investors pivot away from equities, when the indicator hits 100 percent. Today, the indicator is close to 140 percent - a historical record.

But the longer run valuations are harder to pin down using markets-linked indices, because no one has a crystal ball as to where the markets and the listed companies might be in years to come. Which means that any analyst worth their salt should look at the macro-drivers for signals as to the future markets pressure points and upside opportunities.

Here, there are worrying signs.

In the last three decades, bankruptcy rates for older households have increased almost three-fold, according to the recent study, from the Consumer Bankruptcy Project ( This suggests that not all is well amongst the wealthiest retired generation, the Baby Boomers, who are currently holding the vastly disproportionate share of all risky assets in the economy. For example, 80 percent of Baby Boomers own property, accounting for roughly 65 percent of the overall housing markets available assets. All in, Baby Boomers have over 50.2 percent share of net household wealth. As they age, and as their healthcare costs rise, they will be divesting out of these assets at an increasing rate. This effect is expected to lead to a 3-3.5 percent reduction in the expected nominal returns to the pensions funds for the Generation X and the Millennials, per 2016 study by the U.S. Federal Reserve ( The latter is, in part, the legacy of the 2007 Global Financial Crisis, which has resulted in an unprecedented collapse in wealth held by the American middle classes. Based on the report from the Minneapolis Federal Reserve (, current household wealth for the bottom 50 percent of U.S. households is at the lowest levels since the mid-1950s, while household wealth of the middle 40 percent of the U.S. households is comparable to where it was in 2001. In other words, nine out of ten U.S. households have not seen any growth in their wealth for at least 18 years now.

Over the same period of time, wages and incomes of those currently in middle and early stages of their careers, aka the Generation X and the Millennials, have stagnated, while their career prospects for the near future remain severely depressed by the longer in-the-job tenures of the previous generations.

June 2018 paper from the Opportunity and Inclusive Growth Institute, titled “Income and Wealth Inequality in America, 1949-2016” ( documented the dramatic reallocation of purchasing power in the U.S. income across generations, from 1970 to 2015, with the share of total income earned by the bottom 50 percent dropping from 21.6 percent to 14.5 percent, while the top 10 percent share climbed from 30.7 percent to 47.6 percent. Share of wealth held in housing assets for the top 1 percent of earners currently stands at around 8.7 percent, with the remained held in financial assets and cash. For top 20 percent of income distribution, the numbers are more even at 28 percent of wealth in housing. Middle class distribution of wealth is completely reversed, with 62.5 percent held in the form of housing.

The problem is made worse by the fact that following the financial crash of 2007-2008, the U.S. Government failed to provide any meaningful support to struggling homeowners, focusing, just as European authorities did, on repairing the banks instead of households.

Markets Forward

What all of this means for the asset values going forward is that demographically, the economy is divided into the older and wealthier generation that is starting to aggressively consume their wealth, looking to sell their financial assets and leverage their housing stocks, and those who cannot afford to purchase these assets, facing lower incomes and no tradable equity. This is hardly a prescription for the bull markets in the long run.

In this environment, on a 5-10 years time horizon, holding cash and money markets instruments makes a lot more sense not because these instruments offer significant current returns, but because the expected upcoming asset price deflation will make cash and safe haven assets the new market king.

The same is apparent in the corporate decisions to use tax and regulatory changes to beef up their cash holdings and equity prices, as opposed to investing in new growth activities. Even inclusive of buybacks, and Mergers & Acquisitions in the corporate sector, aggregate investment as a share of GDP continues to slide decade after decade, as highlighted in the chart below.


What makes matters even worse is that until mid-2000s, the data for investment did not include R&D activities, normally classed as expenditure in years prior. Adjusting for M&As, buybacks and R&D allocations, aggregate investment in G7 economies has declined from 24.9 percent of GDP in the 1980s to around 16-17 percent in 2010-2018. In simple terms, neither the public nor the private sector in the largest advanced economies in the world are planning for investment-driven growth in the near future, out into 2025.

None of which should come as a surprise to those following my writings in recent years, including in these pages. Over the years, I have written extensively about the Twin Secular Stagnations Hypothesis - a proposition that the global economy has entered a structurally slower period of economic growth, driven by adverse demographics and shallower returns to technological innovation. What is new is that we are now witnessing the beginning of the demographics-driven investors' rotation out of risky assets and toward higher safety instruments. With time, this process is only likely to accelerate, leading to the structural reversal of the bull markets in risky assets and real estate.

22/12/18: Chile on course for a higher credit rating

My recent comment on improving credit conditions in the case of Chile via Euromoney:

Wednesday, December 19, 2018

19/12/18: Assets with Negative Returns: 1901-present

Highlighting the evidence presented in the earlier-linked article, here is the chart based on data from the Deutsche Bank Research team, showing historical evidence on the total percentage of all key asset classes with negative annual returns:


Source: Data from Deutsche Bank Research and author own calculations.

I have highlighted 7 occasions on which the percentage of negative returns assets exceeded 50%. Only three times since 1901 did this percentage exceed 60%, including in YTD returns for 3Q 2018.

19/12/18: From Goldilocks to Humpty-Dumpty Markets

As noted in the post above, I am covering the recent volatility and uncertainty in the financial markets for the Sunday Business Post :

Below is the un-edited version of the article:

2018 has been a tough year for investors. Based on the data compiled by the Deutsche Bank AG research team, as of November 2018, 65.7 percent of all globally-traded assets were posting annual losses in gross (non-risk adjusted) terms. This marks 2018 as the third worst year on record since 1901, after 1920 (67.6 percent) and 1994 (67.2 percent), as Chart 1 below illustrates. Adjusting Deutsche Bank’s data for the last thirty days, by mid-December 2018, 66.3 percent of all assets traded in the markets are now in the red on the annual returns basis.

CHART 1: Percentage of Assets with Negative Total Returns in Local Currency

Source: Deutsche Bank AG
Note: The estimates are based on a varying number of assets, with 30 assets included in 1901, rising to 70 assets in 2018

Of the 24 major asset classes across the Advanced Economies and Emerging Markets, only three, the U.S. Treasury Bills (+19.5% YTD through November 15), the U.S. Leveraged Loans (+7.45%), and the U.S. Dollar (+0.78%) offer positive risk-adjusted returns, based on the data from Bloomberg. S&P 500 equities are effectively unchanged on 2017. Twenty other asset classes are in the red, as shown in the second chart below, victims of either negative gross returns, high degree of volatility in prices (high risk), or both.

CHART 2: Risk-Adjusted Returns, YTD through mid-December 2018, percent

Source: Data from Bloomberg, TradingView, and author own calculations
Note: Risk-adjusted returns take into account volatility in prices. IG = Investment Grade, HY = High Yield, EM = Emerging Markets

The causes of this abysmal performance are both structural and cyclical.

Cyclical Worries

The cyclical side of the markets is easier to deal with. Here, concerns are that the U.S., European and global economies have entered the last leg of the current expansion cycle that the world economy has enjoyed since 2009 (the U.S. since 2010, and the Eurozone since 2014). Although the latest forecasts from the likes of the IMF and the World Bank indicate only a gradual slowdown in the economic activity across the world in 2019-2023, majority of the private sector analysts are expecting a U.S. recession in the first half of 2020, following a slowdown in growth in 2019. For the Euro area, many analysts are forecasting a recession as early as late-2019.

The key cyclical driver for these expectations is tightening of monetary policies that sustained the recovery post-Global Financial Crisis and the Great Recession. And the main forward-looking indicators for cyclical pressures to be watched by investors is the U.S. Treasury yield curve and the 10-year yield and the money velocity.

The yield curve is currently at a risk of inverting (a situation when the long-term interest rates fall below short-term interest rates). The 10-year yields are trading at below 3 percent marker – a sign of the financial markets losing optimism over the sustainability of the U.S. growth rates. Money velocity is falling across the Advanced Economies – a dynamic only partially accounted for by the more recent monetary policies.

CHART 3: 10-Year Treasury Constant Maturity Rate, January 2011-present, percent

Source: FRED database, Federal reserve bank of St. Louis. 

Structural Pains

While cyclical pressures can be treated as priceable risks, investors’ concerns over structural problems in the global economy are harder to assess and hedge.

The key concerns so far have been the extreme uncertainty and ambiguity surrounding the impact of the U.S. Presidential Administration policies on trade, geopolitical risks, and fiscal expansionism. Compounding factor has been a broader rise in political opportunism and the accompanying decline in the liberal post-Cold War world order.

The U.S. Federal deficit have ballooned to USD780 billion in the fiscal 2018, the highest since 2012. It is now on schedule to exceed USD1 trillion this year. Across the Atlantic, since mid-2018, a new factor has been adding to growing global uncertainty: the structural weaknesses in the Euro area financial services sector (primarily in the German, Italian and French banking sectors), and the deterioration in fiscal positions in Italy (since Summer 2018) and France (following November-December events). The European Central Bank’s pivot toward unwinding excessively accommodating monetary policies of the recent past, signaled in Summer 2018, and re-confirmed in December, is adding volatility to structural worries amongst the investors.

Other long-term worries that are playing out in the investment markets relate to the ongoing investors’ unease about the nature of economic expansion during 2010-2018 period. As evident in longer term financial markets dynamics, the current growth cycle has been dominated by one driver: loose monetary policies of quantitative easing. This driver fuelled unprecedented bubbles across a range of financial assets, from real estate to equities, from corporate debt to Government bonds, as noted earlier.

However, the same driver also weakened corporate balance sheets in Europe and the U.S. As the result, key corporate risk metrics, such as the degree of total leverage, the cyclically-adjusted price to earnings ratios, and the ratio of credit growth to value added growth in the private economy have been flashing red for a good part of two decades. Not surprisingly, U.S. velocity of money has been on a continuous downward trend from 1998, with Eurozone velocity falling since 2007. Year on year monetary base in China, Euro Area, Japan and United States grew at 2.8 percent in October 2018, second lowest reading since January 2016, according to the data from Yardeni Research.

Meanwhile, monetary, fiscal and economic policies of the first two decades of this century have failed to support to the upside both the labour and technological capital productivity growth. In other words, the much-feared spectre of the broad secular stagnation (the hypothesis that long-term changes in both demand and supply factors are leading to a structural long-term slowdown in global economic growth) remains a serious concern for investors. The key leading indicator that investors should be watching with respect to this risk is the aggregate rate of investment growth in non-financial private sector, net of M&As and shares repurchases – the rate that virtually collapsed in post-2008 period and have not recovered to its 1990s levels since.

The second half of 2018 has been the antithesis to the so-called ‘Goldolocks markets’ of 2014-2017, when all investment asset classes across the Advanced Economies were rising in valuations. At the end of 3Q 2018, U.S. stock markets valuations relative to GDP have topped the levels previously seen only in 1929 and 2000. Since the start of October, however, we have entered a harmonised ‘Humpty-Dumpty market’, characterised by spiking volatility, rising uncertainty surrounding the key drivers of markets dynamics. Adding to this high degree of coupling across various asset classes, the recent developments in global markets suggest a more structural rebalancing in investors’ attitudes to risk that is likely to persist into 2019.

19/12/18: Debt-Debt-Baby: BBB-rated & lower 'bump'

Gradual deterioration in the quality of corporate debt traded in the markets has been quite spectacular over 2018:

The above chart shows that at the end of 3Q 2018, the market share of BBB and lower-rated corporate  credit is now in excess of 50%, in excess of USD4.4 trillion, matching prior historical record set at 4Q 2017-1Q 2018. BIS' Claudio Borio was quick out on the rising risks:, saying "...the bulge of BBB corporate debt, just above junk status, hovers like a dark cloud over investors. Should this debt be downgraded if and when the economy weakened, it is bound to put substantial pressure on a market that is already quite illiquid and, in the process, to generate broader waves. ... What does this all mean for the prospects ahead? It means that the market tensions we saw during this quarter were not an isolated event. ... Faced with unprecedented initial conditions - extraordinarily low interest rates, bloated central bank balance sheets and high global indebtedness, both private and public - monetary policy normalisation was bound to be challenging especially in light of trade tensions and political uncertainty. The recent bump is likely to be just one in a series."

You can read my views on the latter aspect of the markets dynamics in the post that will follow.

19/12/18: Ten Years of True Economics

Just a quick note to say that yesterday, True Economics celebrated its tenth anniversary.  It has been a long walk without a destination.

19/12/18: Schroders' Lloyds deal signals more bank-asset manager tie-ups

My comment on consolidation in asset management industry and the Schroders' Lloyds deal via S&P Global Market Intelligence

Saturday, December 8, 2018

8/12/18: Back to the 1950s: Tracing Out 25 Years of the Credit Bubble

While the current cycle of declining interest rates has been running for at least 25 years, the most recent iteration of the period has been exceptionally benign. Since the end of the global financial crisis, Corporate and, to a greater extent Government, borrowing costs have run at the levels close to, or even below, those observed in the 1950s-1960s.

Since 2002-2003, FFR, on average, has been below the risk premium on lending to the Government & corporates. This has changed in 4Q 2017 when Treasuries risk premium fell below the FFR and stayed there since. In simple terms, it pays to use monetary policy to leverage the economy.
Not surprisingly, the role of debt in funding economic growth has increased.

And, as the last chart below shows, the relationship between policy rates (Federal Funds Rate) and Government and Corporate debt costs has been deteriorating since the start of the Millennium, especially for Corporate debt:

In simple terms, risk premium on Corporate debt has been negatively correlated with the Federal Funds Rate (so higher policy rates imply lower risk premium on Corporate bonds) and the positive relationship between Government debt risk premium and Fed's policy rate is now at its weakest level in history (so higher policy rates are having lower impact on risk premium for Government bonds). In part, these developments reflect accumulation of Government debt on the Fed's balancesheet. In part, the glut of liquidity in the banking and financial system (leading to mis-pricing of risks on a systemic basis). And, in part, the disconnection between Corporate debt markets and the policy rates induced by the debt-financed shares buybacks and M&As, plus yield-chasing investment strategies, all of which severely discount risk premia on Corporate debt.

8/12/18: Shares Buybacks Hit Diminishing Marginal Returns

The S&P 500 Buyback Index Total Return data tracks the performance of the top 100 stocks with the highest buyback ratios in the S&P 500 in terms of total return. As the chart below shows, the Buyback Index has generally and significantly outperformed S&P500 returns since 2008:

with three discernible periods of outperformance highlighted in the second chart:

In simple terms, since December 2015, the Buyback Index Total Return performance relative to S&P500 returns has stagnated, despite accelerating buybacks by the S&P500 corporates. In part, this is driven by the increased buybacks activity in the less active companies (not constituents of the Buyback Index), but in part the data suggests that the returns to buybacks are generally tapering out.

At the same time, correlation between S&P500 returns and Buyback Index returns has been weakening from around the same time:

All of the above indicates a breakdown in the traditional post-2008 pattern of returns, as buybacks role as the drivers for improved ROE performance for top S&P500 shares re-purchasers is starting to run into diminishing returns.

Thursday, December 6, 2018

6/12/18: Are Younger Americans More Comfortable With a Multipolar World?

When it comes to challenging status quo heuristics, the younger generations usually pave the way. The same applies to the heuristics relating to geopolitical environment. While the older generations of Americans appear to be firmly stuck in the comfort-seeking status quo ante of 'Cold War'-linked hegemonic perception of the world around us - the basis for which is the alleged positive exceptionalism of the U.S. confronted by the negative exceptionalism of Russia and, increasingly, China, Americans of younger cohorts are starting to comprehend the reality of multipolar world we inhabit.

At least, according to the Pew Research data:

The gap between the tail generations (the Z-ers and the Boomers) is massive, and the spread within the generations is relatively more compressed for the Z-ers.

6/12/18: When it comes to geopolitical & socio-economic anxiety, Europe's problem is European

Europe is a sitting duck for major geopolitical risk, but the U.S. is getting there too:

And volatility surrounding the uncertainty measure is also out of line for Europe, both in levels and trends:

Just as the Global Financial Crisis in Europe was not caused by the U.S. financial meltdown, even if the latter was a major catalyst to the former, so is the current period of extreme policy anxiety and instability is not being driven by the emergence of the Trump Administration. Europe's problem seems to be European.

5/12/18: Bitcoin: Sell-off is a structural break to the downside of the already negative trend

Bitcoin has suffered a significant drop off in terms of its value against the USD in November. Despite trading within USD6,400-6,500 range through mid-November, on thin volumes, BTC dropped to a low of USD3,685 by November 24, before entering the ‘dead cat bounce’ period since. The Bitcoin community, however, remains largely of the view that any downside to Bitcoin is a temporary, irrationally-motivated, phenomena (see the range of forward forecasts for the crypto here:

Dynamically, Bitcoin has been trading down, on a persistent. albeit volatile trend since January this year. Based on monthly ranges (min-max for daily open-close prices), the chart below shows conclusively that as of mid-November, BTCUSD has entered a new regime - consistent with a new low for the crypto.

This regime switch is a relatively rare event in the last 11 months of trading, singling that the BTC lows are neither secure in the medium term, nor are likely to be replaced by an upward trend. While things are likely to remain volatile for BTCUSD, this volatility is unlikely to signal any reversal of the downward pressures on the crypto currency.

Consistent with this, we can think of two possible, albeit distinctly probable, scenarios:

  1. Scenario 1 (the more likely one): BTCUSD will, in the medium term of 1-3 months, drop below USD3,000 levels, and
  2. Scenario 2 (least likely one): BTCUSD will repeat its December 2017 - January 2018 ‘hockey stick’ dynamics.

Noting the above dynamics, the lack of any catalyst for the BTC upside, and the simple fact that since mid-November, larger volumes traded supported greater moves to the downside than to the upside, current trading range of USD3,900-4,100 is unlikely to last.

Scenario 2 supports going long BTC at prices around USD3,800, but it requires a major, highly unlikely and unforeseeable at this point in time, catalyst. A replay of the 2017 scenario needs a convincing story. Back then, in September-October 2017, a combination of the enthusiastic marketing of bitcoin as a 'solve all problems the world has ever known' technology, coupled with the novelty of the asset has triggered a massive influx of retail investors into the crypto markets. These investors are now utterly destroyed, financially and morally, having bought into BTC at prices >$4,000 and transaction costs of 20-25 percent (break-even prices of >$5,000). The supply of new suckers is now thin, as the newsflow has turned decidedly against cryptos, and price dynamics compound bear market analysis. Another factor that led BTC to a lightning fast rise in December 2017 was the promise of the 'inevitable' and 'scale-supported' arrival of institutional investors into the market. This not only failed to materialise over the duration of 2018, but we are now learning that the few institutional investors that made their forays into the markets have abandoned any plans for engaging in setting up trading and investment functions for their clients. In the end, today, the vast majority of the so-called  institutional investors are simply larger scale holders of BTC and other cryptos, unrelated to the traditional financial markets investment houses.

Scenario 1 implies you should cut your losses or book your gains, by selling BTC.

5/12/18: BRIC PMIs for November: A Moderate Pick Up in Growth

BRIC PMIs are in, although I am still waiting for Global Composite PMI report to update quarterly series - so stay tuned for more later), and the first thing that is worth noting is that, based on monthly data:

  1. Brazil growth momentum has accelerated somewhat, in November (103.2) compared to October (101.0), although both readings are consistent with weak growth (zero growth in my series is set at 100). November reading is the highest in 9 months, although statistically, it is comparable to growth recorded in March, April and October this year).
  2. Russia growth momentum de-accelerated from 111.6 in October to 110 in November, although, again, statistically, the two numbers are not significantly different from each other. November was the second highest reading in nine months, and the third highest reading in 2018.
  3. China growth has improved from 101.0 in October to 103.8 in November. Despite this, last two months remain the lowest since April this year. From statistical significance point of view, October reading was distinctly below November reading, but November reading was consistent with August-September.
  4. India posted substantial rise in growth conditions, from already robust 106.0 in October to a 24-months high of 109.2. This reading is statistically above all other period readings, with exception of being tied with July 2018 level of 108.2.
Thus, overall, BRIC Composite growth indicator rose from 102.8 in October to 105.3 in November, the highest in 10 months. BRIC ex-Russia reading was at 105.4 in November, compared to 102.7 in October. November reading for ex-Russia BRIC growth indicator was also the highest since February 2013.

Couple of charts to illustrate monthly data trends:

While the chart above clearly shows that Russia supports BRIC block growth momentum to the upside, this effect is somewhat moderating due to both ex-Russia BRIC growth momentum rising and Russia growth momentum slowing slightly.

The chart below highlights BRIC estimated growth contribution to global growth momentum:

Overall, as the chart above shows, BRIC economies contribution to global growth momentum has accelerated in November, but remains bound-range within the longer-term trend of weaker BRIC growth for the last five and a half years.

As noted above, I will be posting more on BRIC growth dynamics signalled by the PMIs once we have Global Composite PMIs published by Markit. Stay tuned.