Gestaltz

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The Fallacy of Ethics

Athenian Democracy distributed power to the Citizens but not all inhabitants of Athens were Citizens. Only adult males who had completed military training had the right to vote. This meant that 80-90% of the population were excluded from the political process. The nascent democracy of America permitted negro slavery by the simple trick of classifying negroes as a subspecies. Hitler’s Germany did the same with people of the Jewish faith in order to justify genocide on an industrial scale. There is little point in having a concept of human rights if the category of human can be redefined so easily. Today many countries, including the United States, have political groups that promote the idea of superior-categories of human ( in which they obviously include their members). The incumbent President of the United States appears not unsympathetic to such ideas. This is the case despite the horrors of the holocaust which are still fresh in our minds and the obvious legacy of suffering of the African-American. Planet earth, we have a problem…

The concept of subspecies and the ethics of our relationship with the life forms that we classify as such go beyond the human. Other mammals are deemed to be subspecies and this classification is used to justify our outlandish treatment of animals. We keep them as pets, breed them for food, hunt them to extinction (for fun!), and conduct ‘scientific’ experiments on them. We do this in the interests of ‘mankind’ without a second thought as to what is appropriate for the animals. If you have a pet you may see yourself as an animal lover but are you sure the animal is happy? I used to think that the concept of the ‘subspecies’ was the source of all the misery humans heap on themselves and other lifeforms.

It seemed that if we could eliminate the classification of lifeforms into categories of species then our heinous behaviour could be avoided. If we are all Life, and Life is sacred, then we must treat all as we would have ourselves treated. One creed seemed to offer this philosophy and attracted my attention many years ago. To this day I have a version of the Dhammapada on desk. It is always there. The last section is entitled the True Master and it lists amongst the characteristics:

He hurts nothing

He never kills

Seems unambiguous no? Section ten in my copy is entitled Violence. The second paragraph is:

See yourself in others

Then whom can you hurt?

What harm can you do?

There is a section in the four gospels of the New Testament that carries the same sentiment. A healthy philosophy.

Some years ago a lady called Aung San Suu Kyi gained international acclaim (and a Nobel Peace Prize) for her heroic struggle to bring democracy and human rights to Myanmar. At the same time (and indeed before) there was an ethnic/religious group living in Myanmar being systematically persecuted not only by the military but by the majority buddhist population. These were the Rohingya, a muslim group. I took an interest because the majority were Buddhists. This persecution has snowballed into ethnic cleansing and I fear may turn into genocide. The silence of Aung San Suu Kyi has been deafening. The behaviour of these Buddhists is quite perplexing.

Buddhists supposedly revere all life. Buddha would reputedly not step on an insect. Are the Rohingya not life? It seems that my hope, that if we recognised all life as life, and deemed all life as sacred, then the horrors of subspecies classification might be eliminated, is in vain. When it suits we even change our classification of what qualifies as life. For anyone that is capable of thinking, the events in Myanmar should be profoundly depressing. There is very little hope for humanity. If we do not protect the Rohingya it is our own future that we are condemning. If Buddhists can do this, then there is no hope….

My copy of the Dhammapada has finally gone into the bookshelf, next to the Bible, another self-serving text.

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Pavlov’s Traders

Pavlov’s experiment with the classical conditioning of dogs is one of the first things covered in undergraduate psychology. Dogs salivate when presented with food. This is an automatic response hardwired into dogs (and some humans). It is an unconditioned response (salivation) to an unconditioned stimulus (presentation of food). But learning is possible. Pavlov noticed that initially the dogs did not salivate when his lab assistant entered the room. The lab assistant was a neutral stimulus. He elicited no response. After a while the dogs began to associate the lab assistant with the arrival of food. Pavlov noticed that they now salivated when the lab assistant entered the room even when he did not bring food. The neutral stimulus had become a conditioned stimulus. Pavlov designed an experiment in which he had a bell ring when food was brought. After a while salivation could be elicited simply by ringing a bell. Classical conditioning arises when a neutral stimulus is associated with an unconditioned stimulus to produce a conditioned stimulus that elicits a conditioned response.

In financial markets traders respond quickly to news. Over time they come to associate specific financial instruments with particular news events. Certain instruments have come to be associated with ‘haven’ or ‘risk-off’ responses. If the news event signals risk-off then these instruments are the goto haven. Three currently very popular haven instruments are the Swiss Franc, the Japanese Yen, and Gold. At some point there was probably a logic to each being treated as a haven but traders have become conditioned to treat all three as havens even if the original logic no longer applies. So atomic war risk in the China seas has seen all three rally.

The Yen achieved haven-status because of the large non-Yen portfolio holdings of Mrs Watanabe. In times of uncertainty investors will return to home base. In the case of Mrs Watanabe this meant selling foreign currency holdings and buying back Yen. The Yen would rally and traders became conditioned to Yen rallies in times of uncertainty, just like Pavlov’s dogs. This conditioning has survived. If there is a localised atomic war around the China seas the Yen is not the most logical haven. Moreover, even Mrs Watanabe might grasp she is better off keeping her international non-Yen assets. Such is the power of conditioning.

The use of gold as a haven asset needs no explanation. However, there is a difference between buying physical gold and putting in a safe, and placing a bet on the gold price. This difference is often forgotten in the rush for safe havens. Most gold holdings are derivative. What you have is a claim on some counterpart to pony up the value of your holding in currency. You have little if any claim to physical gold and even then you have to get it and transport it. If your counterparty is eliminated in an atomic war or even goes out of business because of the war you have a claim but no gold. Once again the conditioning overwhelms cognitive processes.

The Swiss Franc is a logical haven under virtually all scenarios. Thanks to neutrality and some flexible banking practices it has become the bank vault of the world. Even Kim Jong-un probably has a numbered account in some Swiss bank. No one will invade Switzerland or bomb it because those likely to do such things have to keep their wealth somewhere. The Swiss Franc is as safe as it can get if there is a localised atomic war in the China seas.

 

When Correlations Fall

Robin Wigglesworth of the FT notes that stock correlations have collapsed. This is an important development which Wigglesworth succeeds in trivialising. He notes this gives active managers an opportunity to recover lost ground. He notes that 54% have beaten their benchmarks in the first half of 2017. This means 46% have not despite what he terms a favourable environment. Hardly a ringing endorsement of active management. The main problem is choosing your manager and this is still effectively a coin toss. The most serious sin is that he seems blissfully unaware of the significance of his observation.

Correlations often change. During periods of change they typically collapse first. In macro factor models, such as that of Quant Insight, one observes that the R-squared of various factors drops. Assets are always correlated to something but the pattern of correlations can change. During a ‘regime’ change observed correlations may drop until new correlations assert themselves under the new regime. A period of stable, albeit different, factor sensitivities will emerge. The importance of the drop in correlations is that it signals a regime change is imminent.

It is not difficult to grasp that the investment regime may be changing. Liberal democracies are giving way to autocracy. Racial divisions are reaching levels last seen in the 1930s. Nationalism is on the rise. The quality of leadership is declining. New alliances are being formed and the balance of power is shifting across the world. The shift from the US to China has its parallels in the 1930s. Technological changes blended with social concerns are also in evidence. The combination of concern over climate change and new technologies is depressing fossil fuel prices. The increasing resistance to migration flows is boosting artificial intelligence investment. Most important, the prospect of a nuclear conflict is real.

The fluctuations in stocks (a small but highly correlated move I might add) in line with the actions of North Korea is not illogical. North Korea has nuclear weapons and some facility to deliver them. Moreover, it is led by a somewhat egotistical and erratic autocrat. Unfortunately, North Korea is not the only country so led ( I can think of at least two more). The assumption has always been that North Korea is a China surrogate and that nothing would happen without China approval, and why would China allow nuclear war? There is growing evidence that this pit-bull has slipped its leash and that China is not able to control it. It may need a collective effort to corral and put down before it bites someone. This is a very dangerous process. This morning a nuclear test by North Korea caused a sizeable earthquake. There will be consequences.

The popular conception is that a nuclear conflict would be a global catastrophe. In such circumstances worrying about investment regimes is a bit pointless. The idea of a localised nuclear conflict was normally attributed to somewhat deranged US generals. It now looks like a real possibility thanks to North Korea. It will have a knock on effect on how Iran, Israel, and Pakistan are viewed. Geo-politics is changing and established factor sensitivities are breaking down. How they will reassert themselves remains to be seen. One can never be sure. But they will reassert themselves.

 

The Pension Crisis in the UK

One keeps reading about a pension crisis. One also reads about an alarming lack of trust in pensions and the pensions industry. Could these two phenomena be related one wonders! The source of the pension crisis lies, in my opinion, in wilful ignorance on the part of the general population aided and abetted by the authorities for their own political expediency. Financial illiteracy is perhaps more common than general illiteracy and potentially more lethal. Perhaps a brief blog can alleviate this illiteracy.

State Pensions and the National Insurance Fund

The state pension is a pay-as-you-go scheme. This may not be obvious given talk of a NI fund. Surplus NI contributions are invested in gilts (loaned to the state) and used when NI contributions in any year are not sufficient to cover pensions in payment. So what happens if the fund runs out? There will be a Treasury grant to make up the shortfall. In other words, it is covered by general taxation. The state could of course increase NI contribution rates. The important point here is that the state pension is underwritten by the taxpayer. You will get whatever you are promised, though promises can change for each geneeration.

Talk of crisis in part reflects the decline in the NI fund surplus. This reflects the upgrading of the terms of pensions in payments coinciding with slow wage growth (and hence slow growth in NI contributions). The logical response is to raise NI rates. It is after all a pay-as-you-go system. Politically it has not been expedient to do so overtly. The only crisis is a political one. The government of the day does not wish to upset pensioners by downgrading the inflation adjustment of pensions in payment and thus reduce the cost. Pensioners have votes and tend to use them. It has chosen to effectively raise NI contributions by raising the age of retirement for state pension purposes. You pay the same for longer. There is no crisis. It is a pay-as-you-go system and subject to the vagaries of demographics and terms of contributions and benefits.

Public Sector Pensions

Many people work for state organisations. These typically have defined benefit contribution schemes. The state promises a retirement income based on some ratio of final salary and years of service. Employees make contributions from current salary and the state also makes some contribution as the employer. There may even be a fund accumulated from these contributions (which is loaned to the state). Whether the fund is adequate is irrelevant as the taxpayer underwrites such arrangements. The state cannot renege on liabilities. As with state pensions, public sector pensions constitute a contingent liability of the taxpayer. There is no crisis except a political crisis as this contingent liability becomes a real liability. The important point is that a promise by the state will be honoured.

Defined Benefit Private Sector Pensions

These superficially resemble public sector pensions. The employer and employee make contributions into a fund which is nominally used to meet pension promises based on final salary and years of service. The fund however is the property of the corporation. There are state regulations as to what kind of fund must exist in relation to liabilities but ultimately the promises are only as good as the corporation that makes them. Unlike the state a corporation may not honour its promises.

A pension contribution is a deferral of income. A direct deferral is made via the employee contribution normally before tax. An indirect deferral is made via the employer contribution. This could have been paid to you as part of your salary. The deferred income is loaned to the pension sponsor in exchange for promises based on final salary and years of service. Promises by the state are typically honoured. Promises by corporations may not be. Part of the problem has been that people have not grasped this latter point.

The Funding Crisis

The ‘crisis’ has in some respects been artificially created. Pension liabilities stretch a long way into the future (technically, forever). In order to get some idea of the size of the fund necessary to meet these liabilities we need to discount the future liabilities to obtain the present value. I have explained this discounting process in many previous blogs. If the discount rate is positive then a future pound is worth less than a present pound because you can earn interest on a present pound. Interestingly if interest rates are negative the opposite is true. If interest rates are zero then all pounds are the same value irrespective of when earned so the present value of liabilities is the sum of all of the future liabilities. The lower are interest rates the greater the present value of the liabilities and the bigger the fund needs to be to match liabilities. It also means the bigger the contingent liability of the state and the corporate employer.

The funding crisis emerged when the state required pension plans to present value liabilities using a discount rate based on long dated gilts and then proceeded to crush long dated gilt yields through a deliberate monetary policy. At the same time rising life expectancy increased projected liabilities. There is no basis for projecting current gilt yields indefinitely into the future. The correct discount rate should be that related to the potential return on assets. If one includes, equities, credit products, commodities, and property, this is much higher and thus the so-called pension deficits much lower. The use of the discount rate insisted on by the state effectively assumes all assets are invested in gilts.

Defined Contribution Pension Plans

In order to deal with the pension ‘crisis’ employers have been shifting as quickly as possible to defined contribution plans ( you may know these as ‘money purchase’. Basically the contributions, employer and employee, go into a personal investment pot and accumulate until retirement. The pot at retirement depends upon investment performance and contributions. At retirement one buys an annuity or invests the pot and lives off the investment income.

The annuity provides certainty of income in retirement but depends upon average life expectancy and gilt yields. Rising life expectancy and very low gilt yields have reduced annuity rates. The funding crisis has been shifted to the individual. A pot that sounded fine when you started out on your career now buys much less certain income. It may be less than you hoped. The reality is that unless you had a promise from the state, certain income in retirement was never on offer. Your employer could always default. The ‘crisis’ is as much about false expectations as funding.

Solving the Pension Crisis

The first step is to explain to all that certainty of income in retirement is an illusion unless it is underwritten by the taxpayer. Making this clear is politically dangerous but necessary. The taxpayer in the corporate sector might wonder why she is underwriting a public sector employee. It would help if a correct valuation of this contingent liability is included when comparing public and private sector pay. Other things being equal public sector employees should earn less than private sector employees by an amount equal to the value of this contingent claim.

The next step is to stop talk of ‘funds’ when a system is pay-as-you-go. The nature of the system should be made clear to all and risk assessments made public. Once again politically difficult but important to do. The state pension is pay-as-you-go and NI contributions may need to rise if demographics and pay rates require. Indexation of pensions in payment may also need adjustment. Some frankness from politicians is necessary (so don’t hold your breath).

The next step is to do away with the requirement to value liabilities using a discount factor based on gilts. If gilt yields rise in the next few years the pension deficits could disappear and move into surplus and all talk of a funding crisis will look quite Malthusian. The correct discount rate is one based on the expected return on all asset classes. Pension funds do after all invest in all asset classes.

Finally, one needs to educate the individual on investment. Instead of sitting in cash or bonds or the same high charging, low performing, managed fund for a career span, the individual should be encouraged to opt for a low-cost, diversified passive fund structure. They should be encouraged to switch providers as the industry adjusts and new possibilities open up. They should be encouraged to understand and monitor what it is they are saving into. Moreover, the regulator should force the industry to encourage individuals and to educate them as well as making switching easier. If one has saved sensibly over 40 years it might be easier to generate and cope with an uncertain income in retirement. One reason pensioners make poor decisions is because it is the first time they ever really think about the problem of generating income from a pot of capital.

Finally a word on the easy caveat, ‘take financial advice’. this is about as useful a comment as ‘gamble responsibly’ or ‘when the fun stops, stop’. Financial advisers are not all of the same quality or integrity and there is no kitemark. They are expensive and offer variable service. In my experience if you can use a financial adviser successfully then you can probably do most of it yourself. The knowledge needed to choose and interact with a financial adviser successfully is huge. They need to acquire the professionalism of solicitors and accountants before ‘take financial advice’ is a useful caveat.

 

AI and Society

AI has hit the headlines again. Two Chatbot’s were found to be chatting in their own made-up language that the coders could not understand. That is a bit disturbing. There is also concern that the sequential process that leads to an AI decision is not always obvious from the decision or the programming. There is a black-box between input and output. It is hard to predict output from the input and to infer input from the output. In other words, the AI ‘thought’ process is not linear. The human thought process is not linear either and these issues show how close we have come with AI to replicating human thought processes.

To give this abstract discussion some substance consider the response of a human to some random comment. We could never predict the response unless we knew the exact context. We can never know the exact context and we would need some kind of computer chip embedded in the brain to track the precise thought process. Scientists are suggesting precisely this for AI, a thought process tracking device. Given how complex AI is becoming only another form of AI is likely to be able to track AI thought processes. Who will track the tracker?

If AI has reached the point when Terminator is no longer science fiction (except the time travel of course) then the productivity potential must be huge. There is it seems as yet no limit on the potential to replace human activity with AI. There is a substantial AI dividend to come. The social problem is how to ensure the capital investment in AI and distribute the dividend in a socially cohesive way. This is a big problem and promises some ugly possibilities.

If AI can replace human activity humans are less necessary to the economic process. Many will be unable to contribute. Our societies universally require some association between contribution and right to consume. As things stand, some humans face an existential threat from AI long before the robots go nuts and try to kill us all. If one cannot contribute and contribution is linked to consumption then one cannot exist. It is the principle of contribution linked to consumption that is the first threat of AI and one that is not being addressed.

The AI revolution is not like past technological revolutions. These destroyed some traditional often well rewarded jobs and replaced them with usually many more often less well rewarded jobs. AI has the potential to eliminate the need for most humans in economic activity except consumption. Without humans to consume what is the point of the activity? Given the huge potential productivity of an AI production system, a lot of humans (with entitlement) would be needed to keep it justified.

So AI makes us more productive by eliminating the need for humans in production but without humans the incentive for production is lost. This conundrum will be resolved but there are many ways in which in can be resolved. The resolution will fundamentally change the society in which we live. The link between contribution and entitlement will need to change. A status of ‘entitled’ will emerge with profound implications for fertility policies, immigration policies, and class structures. Some potential resolutions look very ugly.

Solving the Housing Crisis

Home ownership can be viewed as buy-to-let where you are your own tenant. There are many advantages to this arrangement, notably tax. You waive any rent so income tax does not enter the equation. Sale of the property is capital gains tax exempt. There are advantages with stamp duty. There may be a greater selection of properties to buy than to rent. You can be as good or as bad a landlord as you choose. You have security of tenure. The terms of an owner occupation mortgage are materially better than those of a buy-to-let.  There are also disadvantages. You are invested in a single property asset, in a single location. The specific risk is huge. The liquidity risk is huge. It is easier to get a buy-to-let mortgage. You are responsible for managing and maintaining the property.

In both cases you have great specific risk (unless you are a big landlord) and you are leveraged and this contributes to the high returns from single property investment. You put down 50k and buy a 500k property. The price rises 10% so you make 50k. That is 100% return on equity (the 50k deposit). This also illustrates the absurdity of the existing system of home acquisition. It assumes ever rising prices. For long periods this is a reasonable assumption, but punctuated by occasional crashes. The last  general UK crash was 1987-1994. Many have forgotten. Looking abroad one can find more recent crashes. Indeed within the UK there have been regional soft spots. If you owned a property in one of these locations then the property boom has passed you by.

The present system also favours those in larger and more valuable properties. A first time buyer will eventually need to trade up. The assumed steady house price inflation constantly transfers money wealth upwards because the absolute amount you need to spend to trade up increases with price inflation. If you pay too much initially the overpayments cumulate to a huge error over time. First time buyers think they have solved the problem by getting on the housing ladder. They have merely ameliorated the problem. Perversely, first time buyers should be hoping prices crash even after they have bought.

If I went to a bank and asked to borrow 500k to invest in a Real Estate Investment Trust they would probably show me the door. But let us assume they would listen first. I could show them my income and outgoings and that I could comfortably service the debt. The loan would be secured on the value of the trust. I could even let them choose the trust or a selection of trusts. These trusts invest in a wide range of property assets and pay out 90% of taxable income. They have high dividend yields, 4-5% not atypical. The loan interest would thus be more or less covered by the yield. Many trusts trade at large discounts to net asset value. So in effect I would be borrowing to buy a selection of assets at below what the valuers believe they are worth, generating a dividend income that will cover most if not all of the interest, on top of the fact that my income could service the debt in any event. Still I suspect they would show me the door.

One reason might be that REITs are already leveraged. But if the NAV is 30% more than the price of a share there is quite a buffer for the bank (assuming valuations are reasonable). The REIT generates income from rents but is not subject to corporation tax. In exchange it pays out 90% of net income. If the discount to NAV makes the bank nervous they can insist you invest in a REIT that trades at or above NAV. They exist as well. It logically makes no difference. Information is largely in the public domain so these discounts and premiums are probably accurate reflections of this information. If this is not the case then there are some serious anomalies in this sector that are hard to explain.

The purpose of this little diatribe is to highlight that owner occupation is a popular investment because of the tax advantages and the ease with which leverage is available. If the tax advantages are removed and leverage is equally available for diversified, liquid REITs then owner occupation looks less interesting. In this situation you could borrow to invest in a portfolio of REITs and rent somewhere suitable to live (perhaps owned by one of your REITs). If you change jobs, have a family, divorce, etc you can move to more suitable rented accommodation without the hassle and expense of selling up and buying again. The greater willingness to invest via REITs would expand the availability and range of accommodation as the demand and capital allocated expand. It is a different model of property ownership but everyone can still own property and have somewhere to live.

The solution to the housing crisis lies in creating a system of flexible accommodation units that allow people to move around without penalty. Council housing fixes people in one location and there may be no suitable work in this location. Owner occupation creates friction on movement and in some extreme regional cases may mean it is impossible. A system of flexible accommodation units providing good standard accommodation of the right type would allow friction free movement. It could be highly regulated according to standard and security of tenure. It could be coordinated with support services. It could be funded and managed by either public or private capital or both. It does not preclude owner occupation. It may however require that a system so biased in favour of owner occupation be reformed.

Happiness and the Media

The media, social and private, seem determined to undermine personal happiness. Quite why this the case is unclear. It seems negative news attracts more attention (gets more hits, sells more advertising) than positive news. The net effect is to make society, all societies, less happy. The constant stream of negativity creates an endless sense of anxiety and fear. Moreover, the response to this relentless anxiety creates behavioural responses that aggravate and validate the initial anxiety.

The problem is evident in all areas of life. My recent blogs How much should you save? and Pension saving and the lifetime allowance address the prevalence of this phenomenon in the context of making provision for old age. The press likes to state that you need to save some impossible amount to avoid penury in old age. The natural response is to get depressed and not save anything and throw yourself at the mercy of the state 40 years on. A different presentation of the same information suggests making reasonable provision for old age is quite possible and well worth doing. If presented correctly many more would make some provision and feel better for it as well as being better off in old age. However, the media has no incentive to present positive scenarios. The moral of this story is perhaps you should think for yourself and use media solely for information. This requires a little critical thinking but it is not too taxing. Let us try it.

A 30-year-old single person has to make some important decisions. Today they may or may not be in a stable relationship and are quite likely to be living at home. Living at home brings its own stresses and strains but is likely to be very specific to individual circumstances. Social convention frowns upon living at home at this age but unless the condition brings specific problems why worry about social convention? When I was young social convention expected one to be married by this age. This convention no longer applies. The first rule of happiness is live your life and not that of Joe Average. Why do you want to be average?

The future is completely unknown and the past is not much of a guide. Things change. So what strategy is best for you in this stark and frightening situation? It rather depends on who ‘you’ are. Someone living in the middle of a homogenous community with a wide social support group will view life very differently from someone living in a heterogeneous community with no reliable support group. In today’s multi-ethnic, multi-cultural, urban society, the ‘average’ conceals some serious dispersion. You do not need to think too deeply about who you are in this sense. Your emotions will reveal it. Trust your emotions and do what feels right today and not what the media tells you is right. In a world of an unknown future and an unhelpful past, the only thing you can control and optimise is how you feel today. But do not let the media tell you how you should feel.

So how does this odd dialogue translate into financial strategy? You could just live for today and let old age look after itself. It is 40 years or so away and a lot will change before you get there. The state may provide and even if you save the state may take it away from you. So why bother? It is certainly true that my retirement is nothing like I expected it to be when I was 30 years old. If I had known then what the situation would be when I retired I would have done a lot of things quite different. I was fearful of the future and sacrificed much happiness in the present trying to secure the future. It was in retrospect an unnecessary sacrifice. But then hindsight is 20/20.

The emotional message is thus think of the future but not to the extent that it makes you unhappy in the present. So try to save some money but don’t worry too much if it is not as much as the media are telling you that you need to save. In my blogs above I tried to illustrate that saving relatively manageable amounts can lead to meaningful long-term outcomes. It is the power of compound interest and averaging at work. I assumed a 2% inflation rate (the Bank of England target), 35bp charges, and nominal equity returns with dividends reinvested of 7%. All assumptions can be justified though they offer no guaranty. If you save £200 pm under such assumptions you will end up with savings of approximately £500k which will be worth roughly half in today’s money. Worth having. Of course this is illustrative not a recommendation. You can vary what you save every month and increase as your pay increases. The point is that regular saving in the right asset class over long periods can have meaningful results. It is the habit, and the asset class, that is important not the amount.

 

 

Financial Market Outlook

Financial markets have become a little disconnected in the last month or so. As a rule financial and economic variables exhibit stable relationships. These relationships can change but then they exhibit stability for sustained periods once again. This stable relationship is sometimes referred to as the macro regime. Changes in macro regime are typically preceded by periods of disconnection with prices and interest rates moving seemingly independently. My friends at Quant Insight can confirm that this breakdown of macro economic regime is now quite general. Such periods can be quite unsettling and quite dangerous.

The trigger for this breakdown in macro regime has, in my view, been the central banks. I have hinted at this in earlier blogs. The financial crisis is evidently over and the emergency policy rates and actions taken to restore financial stability are no longer required. Central banks are looking to raise rates not because of an imminent inflation risk rather despite the lack of one. Such low rates and aggressive QE are simply no longer necessary. The relatively well contained inflation environment means there is no rush to raise rates but the bias has now shifted to higher. The markets are adjusting to this and it is never a smooth process hence the disconnection. The only exception to this situation is Japan but regular readers of my blog will know Japan is a special basket case.

Although there is no imminent inflation threat the conditions for higher inflation are in place so the CB bias is sensibly forward-looking. Bank balance sheets are restored and more prudent practices are in place. The banks and regulators have fumbled their way to more confidence and this will enable bank credit to grow faster going forward. A rise in interest rates will generally benefit bank profits so this will act to increase credit capacity. The logic is that higher rates will also reduce demand but this does not necessarily follow (oddly enough) immediately. The immediate impact of higher rates may thus boost economic activity though if rates rise far enough and for long enough there will eventually be a negative impact. A gentle rise in rates is thus no immediate threat but the markets are never quite this subtle in their responses.They will either assume a rise is ill-conceived and will quickly be reversed or extrapolate way too many increases. Moreover the prevailing mood may shoot from one view to the other on a weekly basis until a new macro regime is settled on.

The disconnection is not solely down to the CB shift however. There are other issues for markets to digest. Trump is proving to be a problem for US policy with a state of paralysis setting. There are very visible geo-political changes taking place globally. Erdogan’s Turkey is not a good Nato ally and is breaking away from traditional loyalties and behaviours. Relations between the EU and Turkey are breaking down. Relations between the EU and US are breaking down. Russia seems to be influencing geo-politics despite efforts to isolate and contain via sanctions. Meanwhile China is quietly growing and asserting its presence everywhere but especially in the China seas. Middle-east states are turning on each other. North Korea is behaving like a naughty child seeking attention. Sooner or later someone is going to give way to the urge to reprimand it.

The markets themselves have reached levels that are making many nervous. Call it financial vertigo. No one quite believes the valuations but no one is yet willing to go against them. Everyone would be a little happier with a corrective test and is quietly adjusting positions to allay nervousness. The resulting price action adds to the sense of disconnection. Generally markets do not fail when there is this much nervousness but the next step is complacency. Markets always fail when they get complacent. It is hard to tell from where I sit when complacency has set in. It is evident in some quarters but seems not yet general.

If you have a sensible investment strategy the best thing to do in this situation is nothing. You might want to skew your portfolio towards stocks that benefit from rising rates (like banks) and reduce utilities exposure. You might want to reduce bonds in favour of cash. But your basic low risk/high risk asset allocation should not change. If you have chosen correctly then it is designed to ride precisely this environment. How do you choose the right allocation for you?

Let us simplify by talking in terms of cash and equity as the low risk/high risk asset classes. Ask yourself how you would feel if equities fall by 50% (can happen). If your response is to rub your hands with glee and mumble ‘opportunity’, then maybe a 40/60 cash/equity allocation works for you. If your response is heart palpitations then maybe 60/40 or even 70/30 is best. Of course you never know your true response until the 50% fall occurs but you have to try. In my experience most people are either in managed funds and have much higher equity allocations or in cash and have no equity. In other words they have never given the matter any thought. I suggest you do and soon.

Pension Saving and the Lifetime Allowance

Grim warnings about inadequate provision for old age abound. For the typical 30-year-old trying to make rent and save for a deposit on a home, such warnings will most likely have the effect of persuading them to ignore the whole pension saving issue entirely. They will do nothing. This a shame and rather unnecessary. It is all in the presentation.

Pension saving is a specific example of saving. The difference is you are targeting a pot to provide income 38-40 years hence ( I stick with my 30-year-old). Pension saving can get help from an employer through employer contributions and own contributions are relieved of tax. The amount invested on your behalf can be significantly greater than you give up in disposable income. If say you earn £25k and your employer contributes 3% (£750 pa) and you contribute 10% (£2500 pa) tax relieved at 20% (£2000 pa) then £3250 pa is invested on your behalf and you disposable income is reduced by £2000 pa or £166 pm. This is still a substantial sum for someone on £25k pa but not impossible. Moreover you could start with a £100 or less and increase later. The important thing is to start and get into the discipline.

The amount £3250 pa invested on your behalf might, on reasonable assumptions, enable a pension of £19500 pa in today’s money. This is worth having. The important thing to note is that it is not necessarily worth saving much more through a pension scheme. This is because of the lifetime allowance being set at £1m. If your pension pot exceeds this figure in 38 years then penal tax rates are imposed. To achieve £1m in 38 years may be easier than one might think. On my assumptions this would be achieved by investing £398 pm for 38 years. On more conservative assumptions it might require £617 pm for 38 years. Bearing in mind nominal salaries increase this could be achieved by starting lower and increasing saving over time. The message is there is not much point in saving more than say £500 pm through a pension scheme, including the employer contributions, as long as the LTA is £1m.

This does not mean it is not worth saving. ISAs provide a very useful savings wrapper. This is because everything within the wrapper is free of tax. If your pension contributions have you on course to achieve £1m LTA by retirement it is fruitless to invest more in a pension even if contributions yield tax relief. If you exceed £1m the excess will be taxed back. The constant complaint one hears is that people do not make enough provision for retirement and specifically through pension contributions. But the rational amount of pension contributions is logically capped at a fairly low-level. General saving still makes sense but this is subject to current needs.

My advice to young people is think about achieving a pension pot of £1m. You have a 40 year or so time horizon so you can start small. The important thing is to start and keep going. Invest in assets that have good growth prospects (not cash). Low cost passive equity funds are ideal. Keep the costs low. Keep saving and make sure you use an employer scheme, if the employer makes a contribution. Increase your contributions in line with income but remember you need only increase up to the point that makes £1m over the 40 years likely. If you have the correct investment strategy and are consistent then it is unlikely that you will need to contribute much more than £600 pm into a pension plan and part of that will be an employer contribution. And once you are a 40% tax payer (which happens quicker than you might imagine if inflation picks up), every pound you contribute only costs you 60p in deferred disposable income. Do not let sensation seeking journalists put you off saving for retirement.

Collective Choice and Social Welfare

The title of this blog is taken from Amartya Sen’s book. It was first published in 1970, the year before I became an economics undergraduate, and has recently been expanded. It addresses how societies an make social choices and how social welfare connects to the welfare of the individuals that make up society. It is a difficult area of economics and some argue it is not a legitimate part of economics. The relevance to current affairs is very evident. The HS2 rail link, the expansion of Heathrow, and, of course, Brexit are all collective choices that impact the welfare of individuals and thus of our society. Do these projects improve social welfare?

All three above decisions have been made through the democratic process. The UK has a specific example of representative democracy known as parliamentary democracy. Representatives are elected by constituency on a winner-takes-all basis. It is a pluralist system so each member of parliament has a duty to represent all constituents even if they did not vote for her/him. Campaigns are based on political parties which offer a particular political ideology and often make specific promises prior to election. The parliament elects a government based on the support in the House of Commons and the government can continue as long as it has the support of a majority on key legislation. There is a huge distance between the voter and what the government ultimately chooses. It is the government that makes the social choices that impact social and hence individual welfare.

The UK system allows for a government which may have only directly received a minority of votes. Moreover even those that voted for the party that formed the government may disapprove of specific social choices. It is possible in the UK system for substantial social choices to be made based on the preferences of a small minority of the population. The government of the day should take into account the impact on the whole population but is not obliged to do so. If it commands a simple majority in the House of Commons it can more or less do what it wishes. It can be harassed and delayed by the House of Lords but ultimately it can make the social choices it wishes to make. The population’s only legal defence is to vote for parties that promise to amend or reverse the unwelcome choices of the present government. Occasionally the public can resort to public disorder in order to assert the majority preference (Poll Tax Riots).

The Brexit outcome is a particularly interesting example of this process. The government of the day decided to take direct advice from the population on whether to leave the EU. The result was a (very) small majority of the votes cast in favour of leaving but a minority of those eligible to vote. The government of the day was happy to proceed to leave on this basis but was forced by private citizens to ask parliament through a vote. Parliament approved the government’s action even though there was a substantial majority of MPs that had openly supported remaining in the EU. This odd outcome validated the decision to leave. The government of the day decided to have another election and was allowed to do so by parliament even though the fixed parliaments act was designed to stop opportunistic general elections. The result was the two largest parties in parliament both being committed to leaving the EU even though there is strong evidence that most MPs did not, and the majority of the population no longer, support this commitment. The UK parliamentary system can throw up some social choices that are self-evidently suboptimal. Moreover, the cost of Brexit is high and reversing it is very difficult.

Social choice through voting systems does not make interpersonal comparisons. In all choice situations there are winners and losers. There is no attempt to compare winners and losers and say, for example, the winners gain more in individual welfare than the losers give up so it is a choice that increases social welfare. One of the purposes of Sen’s book is to explore the conditions under which such comparisons are possible. Economists have typically shied away from such comparisons. At best, they have applied the compensation principle. If the winners could compensate the losers and still be better off then social welfare is improved by the choice. This ignores the significance of wealth distribution in social welfare. Moreover, it reduces welfare to money values.

Interpersonal comparisons are not impossible. If a social choice will make a few rich people richer, and a great many poor people poorer, it could be argued that social welfare is being reduced even if compensation is possible. The welfare increase to the rich from getting rich is relatively small compared to the welfare loss of the poor from getting poorer. It might work if the poor are actually compensated but then the rich might not want the change. The point is, who is winning and who is losing is not unimportant in collective choice and social welfare but the electoral system alone may not take this into account. Indeed the system is inevitably biased towards those that have the most political power and know how to exercise it. They tend to be wealthy.

The purpose of this blog is to remind you that democracy is not a panacea. It can lead to outcomes that reduce social welfare. In particular all voting systems ignore interpersonal comparisons. It is possible to consider who the winners and losers are in all collective choices and this will influence the welfare judgements on such choices. It is important to look at each case carefully and not hide behind process and vague words. In particular, ” I’m alright Jack”  and ” Not in my back yard” need to be exposed and held up to scrutiny every time.

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