A slight change in focus can produce a profoundly different understanding

Covid-19 and Market Failure

One of the difficult things about markets is sometimes you have to look through the human costs (potentially to yourself) and focus on market outcomes. The markets have finally woken up to the disruptive potential of Covid-19. I am surprised it has taken this long. It is likely that problems in Northern Italy and the failure to identify ‘patient zero’ in this outbreak has caused the market concern. Covid-19 has broken out of China and we may now have a global human crisis. We already have a market problem.

The market problem comes from supply disruption. Supply chains have become global and, with lockdown being the main weapon against viral contagion, supplies of essential materials and components are being seriously disrupted. Such disruption affects revenues. You do not get paid for things you have not delivered or have not made because you cannot get components and materials. Unfortunately you still have debt to service and people to pay. You can lay people off but you cannot avoid contractual debt. If you do not pay there could be a credit event. You could end up going out of business. But the market problem is even worse.

It is unclear which firms will go out of business. It is unclear which firms will be most affected. Markets are now beset with uncertainty; risk that they cannot quantify. The reaction in such situations in my experience (which dates back to 1975) is to avoid credit risk as much as possible. Counter-party risk suddenly looms large. Is the person with whom you are doing business going to fulfil the bargain? If in doubt don’t do it. Banks will not wish to lend. Bonds will become risky. Credit risk will be generally avoided. If this becomes systemic markets could fail.

In a market failure basically no one wants to trade. Liquidity drops and small (usually forced) trades generate disproportionate price moves. These quite unrealistic prices are then used to to mark-to-market. The resulting gains and losses from the mark-to-market trigger other economic actions which typically reinforce the price moves and trigger further mark-to-market economic responses. Chaos and catastrophe ensue. Anyone trading in 2007 and 2008 will recognise this description.

The most vulnerable group are financials. Other firms tend to owe them money. Credit events are never good for financials as a sector. Next we have the over-leveraged. They may survive one quarter of cash drought but two quarters become a challenge. The financials may extend credit but for the over-leveraged to accumulate more debt is hardly sensible when the loss of revenue from supply disruption is permanent. All assets will be revalued and in the main downwards.

The Covid-19 supply shock could not have come at a worse time for markets. There is widespread suspicion that some assets are simply too expensive and kept so by copious amount of cheap liquidity from central banks and yield hungry investors. The sign to look out for is when you read not about buying on dips but selling on rallies. I suspect this morning may have begun this process, but we shall see.

Hunger, Headlines, and Moral Philosophy

The Guardian once rang out with the headline World faces worst humanitarian crisis since 1945, says UN official. On reading the article one discovers that famine threatens some 20 million people in Yemen, Somalia, South Sudan, and north-east Nigeria. All four of the countries are in the midst of conflict. The conflict can only occur on such a disruptive level if there are heavy weapons. The source of the weapons is typically the same countries to which the UN is appealing for humanitarian aid. Morally such aid should come from arms manufacturers. This famine is a man-made humanitarian crisis. These countries are not predisposed towards famine. Yet such headlines always leave the sense that somehow famine is the natural order of things in some parts of the world and things are progressively getting worse. Actually they are getting better.

Hunger Notes provides some interesting information in this respect. The prevalence of global undernourishment has fallen from 18.6% in the early 1990s to 10.9% today. It is still to high but that is some serious progress. Odd that this has not made the headlines. Still, maybe ‘things not as bad as they were’ and ‘things getting seriously better’ does not sell newspapers or get hits and advertising revenue. There is a natural bias towards ‘bad’ news in the media and this must influence the mental health of the readers. Narratives always do. Should the media not have a moral obligation to present a balanced view of humanity?

Early this morning (too early) I was reminded of advances made in genetics. One can select the sex of a child. Very soon it will be possible switch on and switch off genes to tailor offspring to some selected design. No doubt many as yet unimagined possibilities will emerge. We do because we can. But is it not time to stop and ask if we should and what the possible consequences doing so might be? Humanity has already moved beyond the boundaries of known moral philosophy and is rapidly entering a brave new world. This is no longer science fiction. It is science fact. Artificial intelligence and genetics raise huge philosophical questions. Where are these being talked through, studied, and resolved?

In the human sciences (medicine and psychology) there are strict guidelines for use of human participants. Increasingly experimental designs are being used in sociology and economics. The human science ethical guidelines are probably being used to guide such experiments but it may be time to develop specific guidelines governing all experimental designs using humans. It would probably help to tighten up on those using animals as well. Respect for life is a continuous spectrum and if there is no respect at one end it can lessen it at the other. So why am I rambling this Saturday evening? have I had one too many? No. I don’t drink any more. But I do worry.

Moral philosophy is concerned with ethics. The advances in technology are leaving our ethics behind. Our infatuation with immortality and perfection,and our arrogance, is going to tempt us into ethical sleight of mind to justify doing what we want. This is dangerous. It is particularly dangerous to individual freedoms. Humans form personal and social identities as much by constructing who they are not as who they are. The people they are not are always lesser (by construction). Our treatment of ‘lesser’ life speaks for itself.

The Buddhist philosophy deals with ethical conundrum by valuing all life. However, one can see from Myanmar, China, and Japan that word and action often deviate. Other religions restrict inclusiveness to their own (in practice if not in word). The heterogeneous mass of the irreligious  has no consistent ethical code even in principle. Humanity is in need of more moral philosophy not more technology. But no one ever became a billionaire from ethics.

UK Fiscal Policy

The resignation of Sajid Javid and elevation of Rishi Sunak to Chancellor (Treasury Minister for non UK readers) has raised the prospect of more expansive fiscal policy (at least in the UK press). If the sole goal of Boris Johnson is to be re-elected in 5 years this is not such a bad idea. The new Tory voters stolen from Labour are partial to state spending. Traditional Tory voters are normally less keen but circumstances may make them more welcoming, especially as taxes need not go up. Propitiously, an expansive fiscal policy may be just what the economic doctor ordered for the UK at present.

Fiscal policy has two aspects. The macro aspect focuses on how much government spending exceeds revenues. The excess is normally funded by borrowing, though it need not be. The central bank could just print money and hand it to the state to pay bills. We will assume it is funded by borrowing. The micro aspect focuses on how total state spending is distributed. The two are not strictly independent but it is a useful separation and one commonly made by economists. We will continue with this separation.

UK macro fiscal policy has hitherto attempted to match current expenditure to revenue and restrict borrowing to state investment. The implication of recent press reports is that borrowing to finance current expenditure might also be allowed. The distinction between current public expenditure and state investment is often blurred so the focus here will be on how much the outstanding stock of UK net debt will be allowed to grow. This is normally measured as a % of GDP. The accepted wisdom is that to allow the net Debt to GDP ratio to rise above X will bring forth the four horseman of the apocalypse. X varies across countries and it is clear to anyone but dogmatic economists that the appropriate level of X can vary over time and geography. The evidence is that in the UK it has room to increase quite a bit without triggering any events from Revelations.

The key economic variable (according to me) is potential output. How fast can the economy be run without triggering accelerating inflation. In a closed economy one need only look at monetary policy and, of course, inflation. Monetary policy has been loose for 10 years and still inflation keeps dropping below target. This is prima facie evidence that there is potential for output to grow faster. If macro policy is expansive it will bring forth employment of resources hitherto not employed and without accelerating inflation. Note that as GDP will grow faster as well as debt X may not change and could indeed go down. The UK is, of course, an open economy and the current account is also a constraint. UK fiscal expansion will also stimulate other economies in so far as the extra spending ends up being spent on imports. This means that some of the growth in UK debt will have to be bought by overseas investors (aka Johnny Foreigner) in order to generate the necessary foreign currency to enable the extra imports. At present there is good reason to believe such purchases of UK debt will forthcoming. Indeed many will be trampled in the rush.

Real yields on UK debt are negative. They are very negative. They have been negative for some time. Real yields are around -1.5%. There are more people wanting to hold bonds than there are bonds available. In part this reflects the fact that the Bank of England keeps buying them. If the BoE observes an expansionary fiscal policy it may cut back purchases. It should cut back purchases. The real yield may rise but in the present environment that will most likely be met by a wave of grateful buyers. Both domestic and foreign bond investors are desperate for positive real yields. They will settle for less negative. Put differently, the UK government will have no trouble selling debt in the immediate future. Pension plans and insurance companies alone will take whatever they offer. Moreover, yields will not need to rise much to bring forth the necessary demand even if the BoE stops buying.

The risk to this strategy is that the government will not take corrective action when required. If Boris Johnson runs an expansionary fiscal policy long enough then inflation will start to accelerate. UK debt yields will rise and foreign demand for UK debt may tail-off putting downward pressure on sterling, which will in turn exacerbate inflation. At this point he should stop and go into reverse. The risk is he does not because it is electorally inconvenient. It is fear of political expediency that has driven the fiscal prudence movement not economic theory. Governments cannot be trusted to do what is in the best interest of the country because they always believe they are in the best interest of the country. The history of the 1960s and 1970s (and in Germany, Weimar) is often cited as a warning as to the temptation of fiscal expansion. But of course the context was quite different.

The fiscal expansions of the 1960s and 1970s were accompanied by a peculiarly unionised labour force. The peculiarity was pay relativities. The unions established their own hierarchy of pay. If one union achieved a pay rise based on productivity agreements (hence affordable) all unions wanted an adjustment based on ‘relativities’ whether productivity improved or not. The process was underwritten by the state which had a commitment to ‘full employment’ and which expanded fiscal policy in pursuit of this commitment. The Bank of England could not counter the policy because it was not independent. It was an arm of the Treasury. As many of the industries were then nationalised, the state simply paid up whether it made productivity sense or not. The result was inevitably accelerating inflation, very high nominal yields, sectoral decline, and balance of payments crises. This situation does not apply today (though perhaps it could have reared its ugly head if Corbyn was pm).

The present government would be expanding fiscal policy into a flexible labour market. The only caveat I would offer is their own immigration policy. The aim is to get net migration down which may reduce the working population. This could create pockets of excess labour demand (skill shortages) and force up wages or simply make expansion in certain sectors impossible. This could be inflationary. It is ironic that many of those that complain of immigrants taking their jobs in fact only have jobs because immigrants complete the labour supply and make the industry viable. The migration policy needs to be flexible with an expansionary fiscal policy. In the long run labour shortages may bring forth the productivity improvements that have eluded this country for so long. However, Boris Johnson is only interested in the next election date. One way around labour shortages is of course to get foreign firms to build infrastructure and bring their own (temporary) labour force. Hence getting the Chinese to build nuclear power stations and railway lines in exchange for UK debt.

The micro aspect of fiscal policy is more difficult to gauge. There will be a bias towards spending ‘up north’, and no doubt keeping tax rates stable if not reduced. Allowances may be where all the innovation takes place. Generally it cannot be too harsh a micro fiscal environment because Boris Johnson has a much broader voter base than previous Tory pm’s. The usual binary trade-offs no longer apply. The next 5 years looks like being a benign fiscally stimulated environment which suggests that, barring accidents, Boris Johnson will win another term. The constitutional changes this may bring are worrying but domestic economic policy, for once, is not so concerning.

From an investment strategy point of view it is as well to focus on those stocks that stand to benefit from a fiscally stimulated environment. Some stocks may be obvious. Others are not. At times like this services such as or QI can be very helpful enabling a screening of stocks that would be expected to benefit from the environment described above.

  • I am shareholder (less than 1%) of the holding company that owns QI

The Economics of Climate Change

Mnuchin telling Thunberg to get an economics degree made me laugh. An undergraduate degree in economics from a USA university would not render you an ‘economist’. This, of course, is the only studied degree that Mnuchin has I believe. Hypocrisy aside his comment is also disingenuous. Climate change is not an economics problem. It is a political problem. The obstacle to resolving the problem is political. It is rooted in nationalism and the lack of institutional infrastructure required to resolve a global issue.

The economics of climate change is simply a more urgent example of economic structural change usually arising through technological advance. The problem is one of transition from old economic structures to new economic structures. Capital, physical and human, committed to the old economic structure is rendered obsolete. New capital is required to develop the new economic structures. Horses to cars, handlooms to power looms, etc, all constitute examples of similar economic change. The problem is that fossil fuel, and the associated capital, is such a large proportion of the global economy.

To get some sense of this imagine what would happen if a world government banned the consumption of all fossil fuel overnight. Every mode of transport using fossil fuel would be rendered obsolete. Oil dependent economies would lose revenue. Huge amounts of debt would become unserviceable. Bankruptcies would create a financial crisis that would make 2008 look like a blip. Unemployment would soar and it would be highly localised. Pressure for economic migration would grow. A great depression would most likely ensue. In time, clean energy would replace fossil fuel and a new global economic structure emerge. But the ‘short-term’ cost in human suffering would be huge and not equally distributed. Given existing technology it would be a world with aeroplane travel. This is the scenario that Mnuchin is impressing upon Thunberg.

Greta Thunberg’s response is that if climate change is not reversed there will be even more serious human suffering and it will not be ‘short-term’. She has a point. Climate change will raise sea levels and change weather patterns. It will render some places uninhabitable whilst others may become economically viable. Human suffering will be great, regionally localised, and unequally distributed. Indeed the viability of organic life on earth is at stake. Pressure for economic migration would be unprecedented. The economic shape of Thunberg’s scenario is much the same as that of Mnuchin, just much more serious. It seems she has a better grasp of economics than he realised.

The reality is that climate change is forcing structural change on the global economy. It is going to happen. Protecting the jobs of coal miners today will not protect them forever. The best approach is to start managing the process of transition from a fossil fuel to a clean energy global economy in order to mitigate as much of the short-term damage as is possible. The evidence is that we have left it late and that mitigation will not avoid quite dramatic and unequally distributed suffering. The problem is that we have not started managing the transition because the globe is organised as nation states and has not a global institutional infrastructure. The incentive for individual states to free-ride on the back of the efforts of others is high.

In the last analysis the only functioning global institution we can rely on at the moment is the market. The ultimate anarchic structure it can impose its order on the whole world and across national boundaries. If the consumer acts to reduce the demand for fossil fuel linked products and raise demand for clean energy linked products the market will make sure the required structural transition happens and pretty damn quick. The future of the human society is in everyones hands.

Negative Real Yields

The link between economic outcomes and investment performance is both complex and simple. It is simple because the basic structure is (relatively) easy to grasp. It is complex because generating the necessary inputs to the process is virtually impossible. The complexity arises through attempts to approximate these inputs. The example of a listed corporation can be used to illustrate the issues.

The (Enterprise) value of a listed company is simply the value of Equity+ Debt-Cash. If you tried to buy the firm you would need to pay out the equity holders and the creditors but would keep any cash. If this is not obvious think of your house. It has equity and you have a mortgage. The value of the house is the sum of the two. Unfortunately this does not really help much as it merely begs the question what is the value of equity and debt?

Another way of valuing this corporation is to calculate the free cash flow. In accounting terms you start with EBIT deduct the tax, add depreciation, and deduct capital expenditure and working capital. In economic terms it is the stream of cash flow after you deduct the claims on those flows necessary to keep the business going and thus generate the flow. It is what is left to meet the claims of creditors and equity holders. The concept of a stream of cash flow is simple but calculating such a stream is not unless you can see into the future. It is however now clear how economic developments impact investment values. It is through the stream of free cash flow.

There will be a macro economic impact on the stream of free cash flow. The sensitivity of free cash flow to macro economic events can be estimated through the history of the firm. This does not tell us what these events will be in the future but it does give an indication how business lines might be affected by macro economic developments. It gives us an insight into the macro economic risk. This must be combined with the specific risk to the business line. Oil companies for example have a sensitivity to GDP growth because it impacts oil demand. They have a specific sensitivity to changing preferences in the use of fossil fuels because of climate change*. The concept of a risk adjusted stream of cash flow emerges.

The valuation process is to discount the risk adjusted stream with the risk free rate of interest. This should be the yield on a perpetual government bond but there are not too many liquid bonds outstanding. A long term government bond yield is used. For those not familiar with discounting (so not having read earlier blogs!), if the yield is positive near cash flow is worth more than further cash flow. If the yield is zero then cash flow is worth the same whenever it occurs. If yield is negative then future cash flow is worth more! The value of the firm is the sum of the discounted risk adjusted free cash flow. (if you are still confused about discounting think about bank deposits. The higher the interest rate the less you need to deposit now to get £1 in the future).

So, we have future cash flow, macro and specific firm risk to the cash flow, and the government bond yield. The key determinant of the nominal bond yield is inflation. This now begs the question, so what determines the real risk free interest rate (the nominal bond yield minus expected inflation)?This can now be read as the yield on an index linked bond (a bond with a coupon and principle that rises with the rate of inflation). Real yields are presently negative (as indeed are some nominal yields). In real terms future cash flow is worth more than current cash flow. Any firm that offers the prospect of strong future cash flow will be highly valued relative to the risk involved even if current cash flow is non-existent. This goes a long way to explaining the valuation of many ‘tech’ companies.

The impact of real yields on asset valuation has recently been illustrated by the Bank of England vis a vis property prices. The rise in house prices can be entirely explained by the fall in real yields ( ). This should come as no surprise given the above analysis. A 1% rise in real yields is estimated to imply a 20% drop in house prices once the effect works through. Another research paper from the BoE traces a secular decline in real yields from the 14th Century ( In other words the current level of real interest rates is not an aberration. It is the result of a secular trend.

The above text leads us to the relevant question; what determines the equilibrium (or natural) real rate of interest? If we can answer this question then we have some basis for estimating how asset valuations may change in the years ahead. We must also estimate risk adjusted cash flow but we have ways of making a decent stab at this quantity. The real challenge is explaining, and thus forecasting, the real interest rate. There is a possibility, especially given the BoE work, that the current level of negative real rates may persist for some time. In which case current asset valuations are not excessive and will only vary in line with risk adjusted free cash flow. In other words asset values will respond to GDP growth rates and specific industry factors.

The efforts of central banks in the last ten years have been designed to raise the inflation rate to some target. Inflation stubbornly refuses to rise to target keeping CB money aggressively easy and real interest rates negative. I would suggest CBs are out of ammunition and perhaps were doomed to fail. The missing ingredient might be an expansionary fiscal policy and this should certainly have an effect on real rates in the short term. The real concern is the secular decline in real interest rates identified by the BoE research. This trend has worked over every conceivable macro regime over 800 years. We may be facing negative real rates for some time.

*Diversification across sectors of course reduces the specific industry risk to a portfolio but the macro risks are harder to avoid. They impact all investments to some extent.

Passive Investing

There still seems to be some confusion and perhaps deliberate misinformation regarding passive investing. Indeed some have painted some quite alarming scenarios arising from this style. It is little more than an extension of the idea of owning the market portfolio plus some cash or other risk free asset and this is the basis of most financial theory.

Passive investing is normally understood as buying a fund that tracks an index. The latter is constructed by some agency and designed to reflect some market or perhaps the whole market. The tracker fund will exhibit tracking error, the magnitude depending on how it is constructed. If the index goes up your tracker value goes up and vice versa. You can control your overall portfolio risk by holding less than 100% in risky assets and some in risk free assets such as cash. You can also structure your collection of passive funds to reflect your view of the investment universe. There are a lot of decisions required in passive investment. These decisions constitute asset allocation.

Active investment is where you choose a fund that actively tries to beat a benchmark. Guess what is the benchmark! It is usually some index. The active manager deviates from the index component weights and hopes to generate a superior performance than the benchmark, net of fees. The latter point is quite important because active investing normally costs the investor significantly more in fees and operating costs. The drive towards passive investment arose because of statistical evidence that, as a group, active managers failed to consistently beat their benchmarks net of fees. Individual active managers inevitably had some success ex post but there was no way to pick such managers ex ante. In other words, past active manager performance is no guide to the future.

The active manager has an advantage in a down market because they can move into cash. The tracker fund is always fully invested. It is impressive that as a group they still underperform over long periods as one would expect them to be better at timing than investors and do better in down markets. Nevertheless some still cite this defensive feature as a reason to use active funds! Individual investors are free to move into cash but generally best advised to stick to whatever asset allocation and strategy they decide on to start with.

One oft cited criticism of passive management is that it forces investors into a narrow range of stocks. We buy the good and the bad. But most active managers would be buying these stocks as well! They just buy different proportions. It is rare for active managers measured against a benchmark to zero large capitalisation stocks. The individual investor may well be invested in a declining stocks but is, by definition, also invested in growing stocks. If the active manager can do better net of fees by selecting the latter and dropping the former all well and good. But where is the evidence?

Another source of concern is that too much is invested in index stocks. If this is the case then they quickly become very expensive relative to non- index stocks and price adjustment occurs. This does not require active management. There are small capitalisation indices and ‘all share’ indices. Diversification is the key to passive investing. The ultimate diversification is the market portfolio. This is what the collection of all investors own. Whether they own passively or through active funds does not alter this. The only difference is what % of the growth goes to the managers. If active managers are any good net of fees then the statistics would reveal it. They don’t so on average a passive approach remains advisable.

Financial Illiterate Or Just Lazy?

The level of financial illiteracy never ceases to amaze me. More serious is the willingness of the regulator to pander to this illiteracy or, in my thoughts, laziness. The FCA is bringing in new regulations for bank deposit interest rates. Deposit takers will be able to offer introductory rates for new customers for up to 12 months but must then offer a single rate across all of their easy access accounts. The motive is to rescue those savers that do not switch savings accounts and may find they are earning very little even though the same institution is offering more on exactly the same type of account under a different name. Sounds good but why on earth is such an intervention necessary?

First, you could just check what rates are available on other easy access accounts of your bank and switch. Quite often just a message on the online platform is required. Second, you could switch to another bank but this is more work. Moreover, you will be forever switching. This is the best way to get the best rates but it does involve effort. Finally you could look for an account that pays the same basic rate to all and at all times. The FCA proposal for a unified easy access savings rate within each bank in fact replaces a plan to introduce a universal basic savings rate. Perhaps it is because they realised it already exists. However this begs the question is this new regulation really necessary.

The basic savings rate is the rate on the Direct Saver account from NS&I. It always seems to be 25bp above the BoE base rate. This may not be policy but it seems to work this way. The Direct Saver is an easy account. It can be opened with £1 and hold up to £2 million. It is operated via transfers to a nominated current account. Everyone gets the same rate. At present it is 1%. This is not the best rate available in the market but it is much higher than the 59bp that MoneyFacts calculates is earned on the average easy access account and is the reason being offered for this regulatory change. It is not necessary. If everyone that cannot be bothered to switch, either intra- or inter- bank, uses a direct saver then the problem is solved. So why do the financially challenged not just use NS&I?

NS&I is 100% safe up to £2 million so there is no need for the £85k FSCS insurance limit. You can keep all your cash in one place. If you have more than £2 million in cash mazel tov. Nice problem to have. NS&I do occasionally offer other products at good rates. If you have a direct saver, and thus online access , you are well placed to catch these before they are withdrawn (and the good ones are always withdrawn pdq ). You can be reasonably sure of what you are getting on on your direct saver; probably base rate +25bp. So, if you are a lazy saver and getting 59bp just switch it all into a direct saver and be lazy there.

If you wish to be more active or just wish to see what your laziness is costing I recommend . This site is quite comprehensive and has some good explanatory articles. The best standard easy access accounts for new depositors are offering 1.35-1.36%. However the one offering 1.36% comes with a 12 month bonus, so it most likely will drop below 1% after 12 months, catching the lazy saver out. The lazy savers could just use a direct saver of course. Market dynamics would probably force all bank savings deposits to settle at just above the direct saving rate. Instead the lazy saver is relying on the FCA to validate laziness.

Of course if the whole saving community were to switch as I am suggesting there would be a reaction from NS&I. It would probably withdraw the Direct Saver from new customers and/or cut rates. It may however provoke government to review the role of this under-utilised state bank and legislate for some expansion. It has a dual purpose of encouraging saving and providing government funding. It seems to me it could usefully do more of both.

Embracing Negative Nominal Yields

The phenomenon of negative nominal yields continues to perturb the financial community. I seem to be the only only person neither perturbed nor surprised by this phenomenon. Indeed I see some significant positives arising. Negative nominal yields are not novel but the pervasiveness may well be historically unprecedented. Negative nominal yields arise when you pay someone to borrow money from you. You lend them £100 and they repay you with, say, £99.5. You are happy with this arrangement because, well, otherwise why make the loan? The question is why are you happy with this situation.

The financial crisis removed the too-big-to fail status from banks. As I never stopped repeating during the crisis, governments do not bail out banks. They bail out depositors. Bank shareholders lost a lot of money in the crisis. I know as I was one of them. Bank depositors (outside of Cyprus) lost nothing. The willingness to resolve failing banks and include depositors came in with the (eurozone) crisis and was demonstrated in Cyprus. If you have over £85k with a separately licensed UK bank you are in principle at risk of loss of anything over this amount if the bank fails. There are specific circumstances under which greater sums are protected but these are limited. Any amount over £85k is a loan to the bank, albeit a senior loan. Your cash will not be the first port of call for the resolution agency but if things are bad enough it could get a haircut.

If you have a large amount of wealth that you wish to hold in cash or near cash then a bank may not look as safe as it once did. You could buy a very big safe but even this costs money, and then you have ongoing insurance costs. Cash in a safe earns you nothing so the costs of storage and insurance constitute a negative yield. You see, negative nominal yields are nothing new. They are in part the cost of safe storage of cash, The safest (though not necessarily completely safe) storage is in a government bond. Government bonds typically (but not invariably) yield a bit less than other bonds denominated in the same currency because they are safe(r). This is the insurance cost. This has always been true so why suddenly are there so many yielding a negative amount?

The other factor bond yields try to compensate for is inflation risk. Cash is only worth what it will buy. The relevant interest rate is the real interest rate. If you earn 1% and inflation is 2% then you are receiving -1% in terms of what you can buy. If you check history you find that periods of widespread negative real interest rates are common. There is nothing new or shocking about negative real rates. Investors have often lent money and got back less than they lent in terms of what their cash would then buy. Negative nominal rates clearly has also got something to do with inflation.

Negative nominal interest rates is a logical consequence of insufficient risk free near cash assets, and very low inflation rates and inflation expectations. The remaining question is why inflation has remained stubbornly low in developed economies despite the best combined efforts of central banks to boost inflation? The answer probably lies with fiscal policy. Budget surpluses and reduced debt has become the political mantra of our times. This has reduced the supply of risk free assets just when there was a need for more, and reduced deficit spending. The latter has often been implicated in generating inflation so the corollary is that its absence might be implicated in subdued inflation. The stubbornly low inflation in the face of easy central bank money is the best indication that governments have room to borrow and spend (based on this logic).

The UK has yet to experience negative nominal interest rates though nominal yields are very low and real yields quite negative. Moreover, the expectation is that the BoE will be cutting rates in the new year. Is this a situation to be lamented or enjoyed? Negative real yield is never a positive for the saver but it is hardly a new phenomenon. In the past money illusion has obscured the problem. People have earned 6% interest rates when inflation has exceeded 6% and felt all was well. The high nominal rates dragged many into higher tax brackets making after-tax real interest rates even more negative. The money illusion left investors content with this situation. The great advantage of negative nominal yields is that it dispels the veil of money illusion and lays bare the real situation.

NS&I presently pays 1% on its instant access account. The last reading of the CPI inflation rate was circa 1.5%. If you have £85k in cash you can earn £850 pa. This is still a real loss since the value of your cash has declined by £1275 in terms of the CPI basket. However, you have no tax to pay on the interest as the first £1000 is tax free in the UK. If inflation jumps to 3.5% and interest rates jump to 3% you are potentially worse off because now your interest over £1000 is taxed at your marginal tax rate. The real interest rate is still -0.5%.

Rational investors should not worry themselves unduly about negative nominal rates. They should focus on after-tax real interest rates and recognise that keeping cash safe is not costless. In fact negative nominal rates could even be a friend of the investor if inflation is even more negative. Try the above example with inflation at -1.5% and and interest rates at -1%. Of course there are wider macro economic consequences arising from such situations and these may create other problems. The point is that the current obsession with negative bond yields in isolation is naive.

Investment 2020

The round of forecasts for the 2020 investment outlook has begun. Should the average investor care? In my view, not very much. The average investor is a price taker in the sense that the investor has no informational advantage. Trying to time the market, pick winners etc is a futile exercise and the outcome largely determined by chance. Investment strategy should be determined in relation to an objective and designed to give the best possible outcome given complete ignorance. So this blog is about how to invest in ignorance and still meet your objective.

The macro economic environment is quite simple. The key variable at the moment is inflation. Interest rates will not rise much unless inflation starts to trend higher. Central banks have been pushing on the inflation string since 2009 without much effect. No reason to assume they will do better repeating the same policies. That would be insane. Fiscal policy has room to expand. The muted level of inflation is the only evidence one needs. The corollary may be that the only way to boost inflation is through a more expansive fiscal policy. One might expand deficits until inflation starts to trend higher. One then needs to stop! Unfortunately, fiscal ‘prudence’ has become a dogmatic mantra which may be difficult to overcome. Inflation may well continue to be low and stable and hence so might interest rates.

Is inflation a good thing for the investor? Previous blogs have indicated I think not. Inflation just introduces fiscal drag, which is to say it drags you into higher income and capital gains tax brackets. After tax real returns may well go down if inflation picks up. The key variable of interest for the investor is the real (after tax) interest rate. This is universally negative but it can also be negative at higher interest rates. In the 1970s it was even more negative than now but with high inflation. It was not a great time for investors. Will real interest rates move positive? Good question to which there is no answer. However I doubt it as long as inflation remains below the proximate target of central banks ( which seems to be 2% for some arbitrary reason).

So what should the ignorant investor do? First decide why you are investing. If it is to get so rich that you can rule the world then you will need to take some risk. Of course risk is symmetric and you may end up losing everything. There is not much useful I can say about this except that the rich people I have known (and I include two billionaires in the list) got rich by acquiring an informational advantage. So not really the path for the ignorant investor. I think I shall limit my comments to those saving to generate an income from capital and those that have some capital and need to generate income from it now. Let us call the former workers and the latter retirees. So the problem is either accumulating a lump sum or generating income from a lump sum. In total return terms the two strategies need not be that different.

Are we completely ignorant? Not entirely. We know that equities follow a sub-martingale which is to say a random walk with a positive drift. Equities tend to go up over time but can wander around like a drunk much of the time. Equities also tend to be very liquid (you buy and sell easily and cheaply). I am not familiar with the stochastic process that best models property but the accepted wisdom is that property prices also tend to drift up. Property however is not liquid. Cash depends on the rate of interest as is indeed to do nominal bond returns.

If you want to accumulate wealth you need to put together a portfolio of assets that can reasonably be expected to grow over time. This means a high weight in equities and probably property. If you are building up from zero then in the early years you might even invest 100% in equity and property. The reasoning is that since you will be investing over several cycles you will be averaging over the cycles. Once you have a substantial lump sum and are likely to be taking income rather than investing more, you should also accumulate some cash and bonds. In fact you should probably pick an asset allocation that suits your risk preference. A popular strategy is to have 50/50 cash/equity. If markets go up you divest and keep your ratio at 50/50 and vice versa. However 50/50 is arbitrary it can be whatever you feel comfortable with and still provides sufficient income. The point is once you settle on an asset allocation it is best to stick to it. So what is going to happen next year is not really of interest to the ignorant investor.

What about the distribution of investment across equities? Clearly, you need to diversify as widely as possible subject to meeting your income requirement. If an asset has a positive expected return and is not too closely correlated with the other assets it is worth considering. The easiest way to achieve adequate diversification is to invest in a range of index funds across different regions. These funds will pay dividends so you may need to weight your portfolio in part to meet your income needs.

In principle you should take a total return approach and maximise your total return (dividend and capital gain) and then sell what you need in order to meet your income requirements. In practice it easier to treat dividends as ‘natural’ income and use this stream to meet income requirements. The two approaches are not necessarily neutral as the asset allocation for an income portfolio is often different to that of a growth portfolio. In accumulating capital you should definitely use a total return approach. In generating income there may be some advantages to looking at dividend yield in particular. One reason is that dividends (in the UK at least) tend to be reduced only in extremis whereas total return can be quite variable. You are paying for the privilege of a steady income cash flow but as your portfolio is a quasi annuity this may be appropriate.

The example I have often used in the blogs is an annuity versus the FTSE 100. A joint life annuity with 3% escalation and 50% spouse’s pension is 2.87%. So for £100k they will give you £2870 until you die and then half this to your spouse. On death of both the pay-outs cease. The pay-out grows by 3% per annum to allow for inflation. The FTSE 100 has a trailing dividend yield of 4.25%. A £100k pays you £4250 from the start. Dividend growth of 3% per annum is historically not much of a challenge and the value of your holding is likely to grow some as well. The principle holding remains your own and can be bequeathed under income drawdown. There is some uncertainty in the dividend stream but as you begin with almost 50% more income there is quite a buffer to absorb any early variation in dividends.

Of course you do not need to (and should not) restrict yourself to the FTSE 100. There is a very low cost passive fund that tracks the FTSE All share and has a trailing yield of circa 3.5%. Similar funds exist for Europe ex UK yielding 2.5%, Pacific ex Japan yielding 3.25%, Japan yielding 2%, and (more expensive) property trusts yielding 4.5%. You can construct a very diversified portfolio from this selection that beats the annuity and I have not even mentioned North America and emerging markets. One salutary warning is that if someone offers you a ‘safe’ investment yielding more than 4.25% you should be suspicious and very careful.

Safe assets such as NS&I in the UK yield very little and may soon yield even less. An instant access NS&I account presently pays 1%. You can get a little more fixing for longer periods but not that much. If you feel uneasy investing your whole pot at some arbitrary point in time (now) then you could scale in. In fact you might always want to hold some cash to take advantage of opportunity or just in case. If you hold 30% in NS&I cash and invest 70% in FTSE 100 now you can get a portfolio yield of approximately 3.275%. This is still initially higher than the annuity. The return on the cash component will of course rise with interest rates.

In conclusion forecasts are of little relevance to the typical investor. What is required is a strategy to meet needs subject to what is available and the risk tolerance of the investor. Once in place this requires regular review and rebalancing but not based on market forecasts. Investments offering more than stock index yields should be viewed with a jaundiced eye. Annuities offer little value (unless you and your spouse expect to live a very long time and perhaps not even then) as sensible portfolios are presently possible which dominate. An income yield in excess of 3% is easily achieved with good potential for growth even at current asset price levels. If you need income in excess of 5% this may be difficult without risking eroding capital.

Housing and the UK REIT

The UK Real Estate Investment Trust is a simple but interesting way to invest in UK property. For the company, all income and capital gains derived from rental income is free of UK tax. The investor is taxed on dividends as if they are rent from owning a property directly. However, unlike buy-to-let one can hold a REIT in an ISA and receive this income free of all income and gains taxes. REITs are listed on UK exchanges and traded like all stocks. In short, a UK REIT is a tax efficient and liquid way to earn rental income and have exposure to UK property. Moreover, UK REITs are required to pay out at least 90% of their rental income so dividend streams are regular and substantial.

The main problem with REITs is that there are not enough and in particular not enough of the right type. The bulk of the outstanding stock involves commercial property which is having its own particular problems. The small investor saving to buy a home is more interested in residential property in a particular area. Nevertheless the concept of saving for a deposit through holding residential REITs in an ISA is worth consideration. It is also worth considering residential REIT investment as a hedge against rent. Residential REIT dividends are (obviously) highly correlated with rent so if you choose to rent it is a logical way to save, and a tax efficient one if you can do it via an ISA.

The main advantage (and disadvantage) of buy-to-let and indeed owner-occupation is leverage. You can borrow a lot against a specific property. If the price goes up it means your return on equity (your deposit) is magnified by the leverage. It also works in reverse if the price goes down (and for specific properties prices can go down in all market conditions). You could end up with negative equity. Moreover, single property ownership is illiquid. It takes time and money to sell and in the case of buy-to-let involves capital gains tax calculations. Meanwhile all along you are potentially liable for tax on any rental income, empty periods, agents, and maintenance.

The REIT is a share that you can buy or sell in seconds. The company may also leverage though leverage will typically be lower than personal leverage. A professional team manages a portfolio of properties. There are charges of course but they are largely known and must be compared to the cost of DIY property ownership. The rent is received in a tax efficient way via an ISA. The main disadvantage is the annual ISA limit (£20k pa) but for many first time buyers and small investors this is quite enough. The really big challenge is to identify the right REITs to own.

Apart from direct holding of REITs it is also possible to invest in REIT ETFs. These may or may not hold actual REIT shares but will try to replicate some index of REITs. These are derivatives and so there is an additional risk of the counter-party failing. Nevertheless they offer another potential source of REIT investment. Ideally one should own REITs directly and the right type of REIT for your specific needs. Investing in a REIT that owns property in Scotland if you live in London may not work. The two rental streams will still be correlated but perhaps not enough.

Investing in REITs via an ISA is an interesting option for those now renting but wanting some way of hedging their rent and having a toe (the small one) in the housing market. Indeed, for the youth of today perhaps this the sensible option. Renting provides a degree of flexibility in where one locates oneself. Mobility may well be important. Buying a home is really only a serious need when one has a family with children. Young people are choosing to settle down later. One way of staying in touch with property without committing to a specific area or property is provided by the REIT. The accumulated assets will pay a dividend stream that is correlated with rent, free of all taxes, which can be used to pay rent. Moreover, the investment demand for such assets may generate more of such assets.

The REIT is not a panacea for the housing crisis. However, expansion of this sector into residential property could be very helpful. The need for quality residential properties at all rent levels will stimulate development of new properties. It may also help restore and reorganise the existing housing stock. It is a route for all to have a ‘piece of this action’ and in a very tax efficient way. It enables everyone to have a some stake in property without being tied to a specific property and until one wishes to be so tied.

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