BNY Mellon's Currency Strategist on the Euro

The CFA Society of Minnesota hosted Samarjit Shankar and Simon Derrick of BNY Mellon. Shankar's presentation covered their iFlows product for traders which tracks $33 trillion in daily institutional trading volumes, which he said is about 15-27% of overall volume.  These represent real transactions and real positions submitted by their clients, which are aggregated, parsed and returned in reports before the opening bell the following day.  It's about as close to real time flows as is feasible.

Simon Derrick is the head of the Currency Strategy team at BNY Mellon.  It was an interesting presentation, very much in line with what we've been saying since the beginning of the Euro crisis, but Derrick's presentation incorporates current iFlow data analysis and forecasts. 

Non-European investors have not pulled away from the euro, which is still key to their diversification away from the dollar.  Rather they have reallocated their purchases away from the periphery--Spain, Portugal and Poland--towards the core countries.  Current instruments of safety are bunds, U.S. Treasuries, and Swiss bonds.  The Australian dollar, charts showed, is heavily leveraged to the Chinese currency. 

Derrick noted the same design flaws in the currency union that we have noted.  His overall characterization of the euro, abstracting from any allegiance to the British position, is that it has been "a disaster."  That got some heads raised from picking at their salads.

In his view, a euro built on Germany, the Benelux countries, and Norway could have been a strong, viable currency even without fiscal unification.  Notice the omission of France from his list.  The admission of Italy, nominally the third largest European economy, was the beginning of cracks in the system.  After this admission, he says, it was politically impossible not to open up the doors of the euro to all comers.

China's reserve currency stockpile has been and continues to be a major factor in the Eurozone and in the valuation of the euro: a distinction which Derrick feels is key.  In 2005, BNY data shows that China's official reserves were 75% in U.S. dollars, whereas the level fell to 57% as of the end of last summer.  The diversification between these two periods was primarily to the euro, which kept the official euro exchange rate strong.

In fact, he says, it has been changes in Chinese reserve growth that have statistically best explained runups or flattening in the euro exchange rate.  This diversification and its impact on the euro rate are quite unrelated to current developments in the Eurozone circus of meetings, and conferences and resolutions.  I thought this was a very helpful insight, as it has been difficult for me to understand why the euro rate seems to hang at relatively high levels. 

Their forecast for the back half of 2012 is not fun.  Weakening oil prices, which we've always felt were not driven by fundamentals anyway. Slowing Chinese growth, which means zero growth in Chinese official reserves.  This means that the major pillar of support for the euro exchange rate will start eroding towards the end of the year.

European populations are totally out of sync with their elected leadership who talk about austerity.  Thus, as we have long said, it is political suicide for governments to continue to support austerity imposed by outside nations in the Eurozone. Derrick saw a scenario where "weasal words" would be used to walk away from the austerity concepts.  Classic diplomacy. 

An important announcement had been made by the China Investment Corporation that it would not add any further to its purchases of European sovereign debt.  Since the CIC had already been moving away from peripheral debt, this isn't good news for the core countries.  Derrick foresees a "quantitative easing" for Europe which will ultimately serve to put the euro in further peril.  He didn't elaborate on what this meant, but he didn't seem to be talking about the hull of the ship splitting in two, but perhaps a slow descent to the ocean floor.

I asked Simon about recent comments about creating a "soft Eurozone," and a "hard Eurozone."  He dismissed these as inoperable and wishful thinking. 

A tail risk, he said, was that Greece leaves the euro and re-establishes the drachma.  One of the factors which makes this not too difficult is the fact that very little Greek debt is held by external creditors, so that there would not be protracted negotiations about revaluations.  Capital, he said, has already flown, so that is not a big issue either. 

This led to a very interesting discussion with the Mancunian Simon who graduated from University College, London, where he lives. London property values are at record levels, which is not the case in other areas like the Midlands. Why?  French investors are now looking for safety in real assets, and London property is a ferry boat ride or puddle jumper away.  He talked about the London football clubs, like Chelsea, Arsenal and QPR, as being safe, real assets which are fun to own!  I wonder if this means a French consortium bid for Spurs? 

In the tail risk case where Greece were to leave the euro is a somewhat orderly way, Derrick feared the domino effect which would result in Ireland, Spain and Portugal leaving also.  At the same time, he said, the current euro system had "devastated" those economies in terms of resource misallocation, so leaving might be the best long-term strategy.

I couldn't finish my salad, but this presentation was definitely food for thought.

How Could A Credit Card Binge Be A Good Thing?

This is from a WSJ Real Time Economics Blog:

"Talk about March Madness: consumers went on a borrowing spree, adding $21.4 billion in borrowing for the month.

The surge was the largest–in both dollar and percentage terms–since November 2001. What was unusual was an increase of $5.2 billion in revolving debt. The category–which includes credit cards–had been on a downtrend over the last three years. That lack of credit use had limited consumer spending."

I don't see how this is a good thing.  The people with strong credit ratings and FICO scores continue to use their point cards, but pay off the balances.  Card issuers have purged weaker credits from their files, as well as lowering their  limits, increasing fees and margins, and tightening up grace periods for the average consumer, meaning everyone but lawyers, venture capitalists, politicians, and hedge fund managers.  If the average consumer is using this unsecured credit to ramp up spending, which may very well be likely, it won't turn out to be a "good thing."  It could be that consumers are buying Vespas.

Value Investing and Research With No Value

Dodge and Cox Growth Fund's portfolio managers Diana Strandberg and Charles Pohl recently gave an interview to Morningstar in which they made a brief, clear case for their thinking in adding the much maligned Nokia to the portfolio.  It's the value investor's case in a nutshell, and one very much in tune with my analyst practice on both the buy and sell sides.  Strandberg and Pohl appear on the featured video for 5/8/2012 on the Morningstar subscription site.

On research with no value, we have the comment from a Wedbush Morgan analyst that Select Comfort is a "Buy" at $30 with a $39 target price.  The company, to its credit, has branded the air mattress.  Remember the one that many of us purchased at the army & navy store for $10?  A marketing person came up with a dial on an electric pump, branded it your "Sleep Number" and sold a story of restful nights counting sheep for a premium mattress investment. Sales took off and profits followed. However, when the shares hit $1 during the financial crisis, with the same business, same pricing and same marketing strategy, analysts were in their bunkers, reducing any positive ratings to "Hold."  This is exactly when savvy analysts and investors do their work and Buy.  Today, hedge fund mogul Steven Cohen has been accumulating shares at average prices of $29.  Tomorrow, we might expect "Strong Buys." 

I don't know if Dodge & Cox are right on Nokia.  I went the wrong way on it early in its evolution, but certainly their risk/reward proposition makes more sense than taking a flyer on air mattresses.

Karzai Calls The Shots in U.S. Security Deal

Instead of pulling out of Afghanistan, Karzai has successfully played the Obama administration, which is totally focused on re-election, into a preposterous security deal which perpetuates his regime and lines his pockets with U.S. taxpayer money.

In the months leading up to this desperate deal, we had to listen to President Karzai demand the end to drone flights, allowing prosecution of U.S. military personnel in Afghan courts for crimes against civilians, and prior notice of military actions against Taliban targets.  It was a well laid out plan which took the PR initiative and put the U.S. on the defensive.  Karzai understood his Presidential counterpart's re-election needs all too well.  Now, billions more in taxpayer dollars will flow to a regime of a failed state which no amount of foreign nation building can resuscitate. Meanwhile, there is no agenda for Pakistan, without which there can be no long run solution for Afghanistan anyway.

A Christian Science Monitor poll shows Americans disapprove of this deal by 66% compared to a 33% approval rating.

Here is an excerpt from a current story from Radio Free Europe/Radio Liberty:

"The Taliban and criminal gangs, old and new warlords, and tribal leaders rule vast parts of the country. The authority of the government, many of whose ministers are considered corrupt, barely extends beyond its offices in Kabul. In order to survive, the Karzai government has to ignore or accommodate all those forces working to undermine it, from the Taliban to the warlords. This has even empowered them, occasionally forcing Karzai to appoint them as governors or to acknowledge their local authority.


Based on these criteria, Afghanistan is a failed state. For years, it has been, and still is, one of the world's top 10 failed states, along with Sudan, Somalia, Iraq, Zimbabwe, and others.In an effort to secure his government's survival, Karzai invited "non terrorist Taliban" to participate in the government. He even proposed negotiations to Taliban leader Mullah Omar, saying he would guarantee Omar's safety if he would accept the authority of the government. Omar's group rejected that proposal, saying that it is Karzai himself, and not the Taliban leader, who should be concerned about his safety.

Longing for security and an improvement in their lives, Afghans have been increasingly turning their backs on a government that has failed to deliver either. A recent ABC/BBC/ARD poll indicated that support among Afghans for the Karzai government and U.S. efforts has dropped by half since 2005. The biggest danger is that, as in 1996 after four years of chaotic mujahedin rule, people will have no choice but to turn to the Taliban to impose countrywide "security" within the framework of an archaic and totally repressive system.

Reports that Karzai's brother Ahmad Wali, head of the Kandahar Provincial Council, has been involved in drug trafficking have caused widespread public disappointment. A second Karzai brother has taken over Afghanistan's only concrete factory in Pul-i Khumri and acquired by dubious means ownership rights to vast state lands. A third brother, Jalil Karzai, is said to have simply driven away after a recent car crash in Kabul involving his car and a taxi that killed five people.

Escalating violence and widespread corruption fueled a surge in opium poppy cultivation in 2006 and 2007, pushing opium output to an all-time high. Despite efforts by the Afghan government and their U.S.partners, Afghanistan is now the source of more than 90 percent of the world's illegal opium."

The writers of this story strive to be optimistic, saying that forty percent of the population believe that the country is moving in the "right direction."  The math isn't complicated: sixty percent of the population do not believe it. 

There's no doubt that we have to stay engaged with the Afghan people, but a military vanguard with no winnable mission isn't the answer.  Funding a cynical, self-serving government that is beholden to militant extremists like the Haqqani Network for survival, is not the answer either.

More on Yale, Alternative Investments and Individual Investors

As we've noted in a previous post, the Yale Endowment has taken a very aggressive position in using alternative investments in its portfolio's asset allocation. For the year ended June 30, 2011, alternative investments in total (absolute return hedge funds, private equity, and real assets comprised 81.5% of the portfolio!  Liquid investments (domestic equity, foreign equity, and fixed income) net of cash comprised 18.5% of the portfolio.

This statement appears in the annual report, "...the actual (2011) allocation produces a portfolio expected to grow at 6.3% (real) with a risk of 15.4%.  Disclosures in the report don't provide expected returns by asset class, nor do they suggest the distribution of expected portfolio returns for which 6.3% might be a measure of central tendency.  I confess to being surprised that the portfolio's expected real rate of return was not higher given the preponderance of alternative assets.

This, in turn, made me start thinking about other studies of expected return and about the gross distortions being introduced into financial markets by the Fed's enabling policy of spreading liquidity around  like Halloween candy. 

Vanguard's Capital Markets Model recently ran simulations on the expected average annualized returns for a 50/50 equity-bond portfolio.  Their results returned a nominal portfolio return centered in the range of 4.5%-6.5%, or in real terms an expected range of 3.5%-4.5% over the next decade.  These are pretty meager returns for most investors, especially when compared to historical returns over the Great Moderation. 

So, the Yale Endowment portfolio is expected to outperform the Vanguard investor's simulated, balanced portfolio by 180-280 basis points over the investment horizon.

Reading the Endowment's report for the period ended June 30, 2011 doesn't clear up some of the obvious questions.  Performance numbers are given in nominal terms. Yale's domestic equity portfolio returned 24.5% for the year, underperforming their benchmark index return, as opposed to the expected return, by 7.8%.  The foreign equity portfolio by contrast returned 18.6%, outperforming its benchmark index return 7.0%. 

The absolute return hedge fund asset class, 17.5% of the portfolio, returned 12.7% for the year.  From previous annual reports, one can read that this class is expected to return 12-13% per annum, and so this was right in line with expected returns.  Historically, absolute return funds as a class have produced a 10.2% annual return, so Yale's 2011 performance was better than the long-term historical  average performance of the asset class.  Given Yale's' assumption about correlations between absolute return and liquid equities being zero, and the variance of absolute return being about one-third that of equities, absolute return funds lowered the overall portfolio variance as well as raising its returns.  Almost a free lunch!

So, in this persistent, distorted low rate environment, ordinary investors are forced to chase yield and return. If investors are seeking to lower risk, they don't have the options that the Yale Endowment does, rather they have to fly to Treasuries and bid up their prices to the point where their risk may increase rather than decrease.  Talk about distorted market signals! 

Liquid investments, like domestic public equities, generally offer lower returns because this liquidity comes at a premium. However, in the low rate environment against a risky economic background, investors tend to pay too much for this liquidity, thereby depressing the likelihood of higher future returns.  Again, market prices are distorted from long-term, economic cash flow related valuations. 

Finally, corporations flush with cash focus on stock buybacks and dividend increases rather than on productive investments for the future, which don't offer the easy returns fostered by this low rate environment.  Berkshire Hathaway analysts have suggested that instead of more cash flow reallocation to insurance businesses within the portfolio, investments like Burlington Northern Santa Fe should be keeping their cash flows and making long-term investments to grow and maintain their economic moat in the future.  However, the promise of almost eternal low rates pushes even astute managers to take the easy road to short term gains. 

Alternative Investments and The Individual Investor

My previous post about alternative investments and the Yale experience drew considerable readership and a few questions.  In various talks, Dave Swensen has characterized alternative investments, e.g. real estate, commodities, and private equity, as offering higher returns in order to compensate investors for risk and for their illiquidity.   This makes them perfect vehicles for investors like the Yale Endowment which, as Swensen says, is built to be indefinitely lived and which should not have liquidity needs. 

In the previous post, we noted that the liquid part of the endowment offers a substantial cushion even in the unlikely event that the fund were to have liquidity needs.  So, an investor like the Yale Endowment is perfectly suited to maximize alternative investments in particularly illiquid vehicles like private equity.  To the extent that Yale has a long history with private equity fund managers, who in turn are attracted to Yale's size and appetite, Yale should be able to enjoy a higher return and lower risk profile for its alternative investments than other institutional investors.

Now, take the case of institutional investors like state pension funds.  As we noted before, they neither have the experience, competence or appetite for risk that the Yale Endowment does.  And, most importantly, state retirement funds may very well face liquidity issues in the future.  A significant body of academic research shows that the unfunded pension liability of state funds in Ohio, Illinois and Texas for example, will ultimately require large tax increases to pay for the tails in actuarial lives of current retirees as well as for future retirees.What if the taxpayers revolt?  What if these funds somewhere down the road are restructured into two-part vehicles combining a DB element with a DC element?  I'm not saying that this will happen, simply because of our politics.  However, unlikely doesn't mean improbable. Political forecasters do worse than economic forecasters, after all. As Dana Carvey's George H.W. Bush would say, "Gotta be prudent!" 

State pension funds cannot afford to reach for return in the way the Yale Endowment does.  Finally, the last group which is completely ill-suited for alternative investments is the average individual investor, who could easily be subject to unexpected events like a catastrophic, uninsured illness or unplanned for long-term care.

In what seemed to my readers to be a contradiction, Dave Swensen has advocated portfolio construction for individual investors from traditional asset classes, using low-cost index funds.  Alternative investments are a no-no for these investors, he says.  In fact, it's not a contradiction at all.

Vatican Official Speaks at St. Thomas on Religious Freedom

Yesterday, the University of St. Thomas hosted Archbishop Francis Chullikatt, who is the Papal Nuncio and Permanent Observer of the Holy See to the United Nations, speaking on the subject of religious liberty.  In my time working at the United Nations, some Papal Nuncios chose to do their work behind the scenes, like good diplomats, and they were not often outspoken.  Archbishop Chullikatt's international experience as a diplomat and pastor, recently in Iraq, demands that he be outspoken on issues which he has experienced personally.  The auditorium's full house was in rapt attention during his remarks.

In 1987, he said that there were 1.4 million Chaldean Christians living in Iraq.  In northern Mosul, across the river from Nineveh, Chaldean Christians had long been the majority in the city.  In 2010, the Syriac Catholic Cathedral was attacked by gunmen, killing 52 men, women and children.  Children, he said, were shot in open view of their mothers before they themselves were killed.  Two priests, both personally known to Archbishop Chullikatt, were also killed.

By 2003, only 800,000 Christians remained in Iraq, and today the number is about 200,000.  A large community of Iraqi Christians has established itself in Detroit.  In May 2011, St. Mina Coptic Church was burned to the ground in Egypt while the Egyptian army stood passively and watched.  Incredibly, the Grand Mufti of Saudi Arabia, the highest religious authority in the country, called for the destruction of all Christian churches on the Arabian Peninsula. Western mainstream media stories reacting against these inflammatory remarks are curiously absent from Google searches on the subject. 

The Papal Nuncio cites persecution of Christians in Nigeria, India, Pakistan and Burma.  In Burma, he notes, Christians are portayed as carriers of Western liberalism and lax cultural mores, such as women's rights.  Burmese nationalists, who clothe themselves in Buddhist trappings without the values, focus their efforts on the Christians are representing unwanted outsiders who are enemies of the true Burma.

In our own country, Archbishop Chullikatt cited the philosopher Christopher Dawson, who said that the modern state is no longer satisfied with the "passive obedience" of the governed, but it increasingly requires its ambit to stretch out over every aspect of the lives of its citizens from cradle to the grave.  Thus, our own government's constant reference to "worship" (as opposed to religion) as being a private matter.

For a much better reflection of the Nuncio's views, here is a link to his talk at the April National Prayer Breakfast.  I am really glad to have had the opportunity to hear such an impassioned and informative talk on a subject of vital worldwide importance.