Avoiding Wealth Destruction over the Long Term
Carl Otto passed away on April 19, 2012. During his career, he was consistently at the forefront of introducing new and innovative investment strategies to pension funds. He was, as one client described him, an icon of the Canadian investment community.
Carl used Perspectives to synthesize many of the ideas the he espoused throughout his 50+ years in the industry, ideas that are being confirmed by new research and data. He began his final Perspectives while in the hospital and we, his colleagues, put the finishing touches on it when he was unable to continue.
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Investors have, by and large, structured their portfolios around one simple belief: in the long-run, equities will always produce higher returns than safer assets. Fixed income assets round out a portfolio to offset the volatility of equities and, together, these asset classes allow pension funds to meet their fiduciary responsibilities. The second half of the 20th century did much to reinforce this Cult of Equity as valuations skyrocketed. The Equity Risk Premium was high and investors poured their money into equity markets accordingly despite the obvious paradox that high valuations are bound to ultimately produce low returns.
This paradox has become painfully clear to pension funds. At 8.3%, the Equity Risk Premium was at its highest during the 40 years between 1940 and 1980; today it is calculated at less than half that figure.
Many pension funds counted on equities continuing to rise and are now in deficit as a result of the economic downturn in developed economies and significant dissipation in the markets. The Tokyo market, for instance, remains an astounding 75% below its apex in 1989.
Pension funds have been further hampered by low fixed income returns and are falling well short of the target needed to meet their liabilities. Funds will either need to increase contributions or reduce benefits. In the case of government plans, this would mean increasing taxation, which is never a politically attractive option.
A recent paper by Maria Belen Sbrancia[1], of the University of Maryland, looks at the period following WWII and notes the parallels to today’s economic circumstances. In both eras, public debt escalated precipitously. Investors anticipated a lengthy economic slowdown and high levels of unemployment. At the end of WWII, Allied leaders gathered at Bretton Woods to regulate the international monetary system. What followed was a period of financial repression intended to relieve large debt burdens.
The 2008 Crisis has similarly created a situation where several countries are at risk of defaulting on their debt and many more are struggling with the economic and political change needed to reduce debt to more sustainable levels. Ms. Sbrancia notes that many of the present regulatory changes share elements in common with the policies that characterize the Bretton Woods period, a period marked by negative real interest rates. She indicates that the yield on 10-year Treasuries is lower than the market’s expectation of inflation over the next decade. Negative real interest rates are similarly found in China, Europe, Canada and the United Kingdom and they pose a serious threat to the real value of bond portfolios.
Given the recent escalation of public debts, governments across the developed world have a shared interest in maintaining rates below the level of inflation.
In this century, high dividend markets have performed most solidly. Pension plans would be wise to replace some of their traditional fixed income investments with dividend growing equities and floating rate loan instruments of high credit rating in order to protect the real value of their bond portfolios.
It is notable that the debt to GDP ratio remains much healthier in emerging markets where, despite having to deal with high capital flow volatility, high growth has been sustained.
Pension funds remain overtly preoccupied with liquidity, though most have a duration of two decades. Most foundations and endowments, for their part, have infinite terms. They have positive cash flows and little operational needs for liquidity. Investors, however, continue to be married to the idea that liquidity is important in order to facilitate change and turnover. In the 2010 SBBI Yearbook, Ibbotson shows that the opportunity lost by restricting a long-term portfolio to highly liquid assets is substantial. From 1972 to 2009, Ibbotson determined that, of all stocks traded on the NYSE, AMEX and NASDAQ, the least liquid quartile returned 16% with a standard deviation of 20%, while the most liquid quartile returned 8% with a standard deviation of 29%.
It is in the investor’s interest to look for investments that will provide long-term steady returns that are well above the rate of inflation. This is far more important to the health of a portfolio than liquidity.
Over the last decade, the roles of advanced and emerging economies have clearly reversed, yet few pension funds have changed the structure of their portfolios to reflect this new reality.
History proves that government debt levels of over 90% of GDP necessarily generate long periods of slow economic growth, high unemployment and, ultimately, financial repression. As such, it is interesting to note that, by 2016, emerging markets will produce 38% of world output but hold only 14% of world debt. This is in stark contrast to projections for the US, the UK, Japan and the Euro Zone.
Value-oriented active investing based on skilled bottom-up fundamental analysis is critical to the success of any emerging market investing. Floating rate instruments that can provide stable, long-term returns have earned their place in the prudent portfolio where quality and true value will always represent the best investment decisions.
April 2012
[1] M. Belen Sbrancia, Department of Economics, University of Maryland College Park: Debt, Inflation, and the Liquidation Effect, Preliminary Draft, latest update: August 6, 2011
The “2 and 20″ Fee Structure
Not satisfied with traditional management fees of 0.2 to 1 percent, the Street has engaged in all manner of financial engineering, creating an array of “new” investment vehicles packaged under various names. These vehicles promise great returns, which allow them to charge a 2 percent management fee and a 20 percent carry fee. While this has been a terrific deal for the investment managers, the promise of these funds rarely comes to fruition for the investors.
The poor returns to investors from hedge funds are documented in Simon Lack’s recent book[1] where he states that “if all the money that has been invested in hedge funds had instead been put into US Treasury bills, the results would have been twice as good”. Lack writes with authority because he invested in hedge funds for J.P. Morgan for many years, providing the bank’s capital and endorsement (!) to new funds in exchange for a share in the lucrative fees charged to later investors [2].
A well researched academic paper of January 2011[3] documents that “dollar-weighted returns (to investors) are of the magnitude of 3 percent to 7 percent lower than corresponding buy-and-hold returns (reported by the fund industry)”. The authors find that the real alpha of hedge funds for investors has been close to zero. The paper’s conclusions suggest that hedge fund investors take higher risk and earn lower returns than previously thought, for fees that can be ten times higher than traditional fees.
With the generally poor results of hedge funds and the often disappointing results of private equity funds, the investment management industry continues to look for new ways to replace the erstwhile lucrative fee generated by these products, the latest being Impact Investment Funds[4].
While ‘top quartile’ managers earn their fees, the number of funds that can maintain this classification for more than three years running is minute. Investors need to consider the impact the fees have on fund returns, particularly as we have entered a period of low market returns.
January 2012
[1] The Hedge Fund Mirage, John Wiley and Sons, 2012
[2] Financial Times, December 29, 2011
[3] Ilia Dichev of Emery University and Gwen Yu of Harvard University, Higher Risk Lower Return: What hedge fund investors really earn, Journal of Financial Economics 100 (2011), pages 248 to 263
[4] J. P. Morgan, Insight into the Impact Investment Market, December 2011
The Future Ain’t What It Used to Be
When Yogi Berra famously declared that “the future ain’t what it used to be,” he proved himself to be oddly prescient. In a similar vein, he easily could have been describing the European debt crisis when he cautioned that “it ain’t over until it’s over.”
As PIMCO’s Bill Gross reminds us in his year-end Investment Outlook, it will be years before Europe, the U.S., Japan and other developed countries overcome the challenges of high debt and low growth, with financial market returns remaining low and volatile as a result. He concludes:
“If you can get long-term returns of 5% from either stocks or bonds, you should consider yourself or your portfolio in the upper echelon of competitors. To approach those numbers, risk assets in developing as opposed to developed economies should be emphasized”.
Bill’s return expectation suggests a real return after inflation of 2 to 3%, or less than half what most foundations, endowments and pension funds are expecting, thereby raising the question of which asset classes to avoid and which ones to emphasize.
Fixed Income
In real terms, U.S. Long-Term Government Bonds returned 2.5% p.a. over the past 84 years[1]. Consultants and some CIOs bravely base their expectation of future fixed income returns on that number. However, if you break down this long-term real return into seventeen 5-year calendar year periods[2], it becomes evident that the 2.5% was achieved because of the unprecedented drop in bond yields over the past three decades, which cannot be repeated, unless interest rates turn negative.
Before making a fixed income real return projection for the next decade(s), the brave forecaster should remember that for the 36 years ending September 1981, U.S. Long-Term Government Bonds suffered a negative real return of 2% p.a., which wiped out half of the real value of the bond portfolio.
Floating Rate Instruments[3]
This asset class is comprised of Index-Linked Bonds, like RRBs and TIPS, and Floating Rate Loans. As index-linked real yields have dropped to 0%, leaving the investor with a return equal to the rate of inflation, they are no longer priced attractively enough to be considered.
Floating Rate Loans are usually priced with a yield spread of 3 to 5% over LIBOR. Since the LIBOR rate is highly correlated with that of US T-Bills, we should look at the T-Bill real rate of return over the past 84 years which is 0.6%[4]. However, if we again break this down into 17 5-calendar year periods[5], we see that this long-term average was pulled down during the periods of World War II and the Korean War.
The real return of U.S. T-Bills for the 50 years, from 1960 to 2010, was 1.2% p.a., or twice the long-term rate used by consultants and some CIOs. In other words, floating rate LIBOR-based loans are likely to produce a real return of 4 to 6%, which is close to the most commonly used actuarial real yield assumption of 4.5%. Institutional investors should, therefore, consider shifting at least part of their fixed income bond portfolios into floating rate debt portfolios with a meaningful loan exposure to developing countries where the borrowers are less levered and of higher credit rating.
The Case for Emerging Market Debt
Most of us realize that over the last decade the roles of advanced economies (AEs) and emerging markets (EMs) have been reversed, but few of us have changed the structure of our portfolios to reflect this reversal.
In the past, foreign-currency debt constituted a large part of the external liabilities of EMs. Today, however, foreign direct investment (FDI) and portfolio equity form the largest part.
In the case of AEs, debt and bank loans constitute the major share of their external liabilities.
|
General Government Gross Debt |
||||
| 2007 | 2011 | 2016 | ||
| $ Trillion[1] | AEs | 18 | 30 | 41 |
| EMs | 4 | 5 | 7 | |
| % GDP[2] | AEs | 73 | 102 | 108 |
| EMs | 36 | 35 | 30 | |
As academic research has demonstrated in various papers, government debt levels of over 90 percent of GDP have always resulted in long periods of slow economic growth, high unemployment and, eventually, financial repression.
By 2016, EMs will produce 38% of world output, but will hold only 14% of world debt.[3]
In contrast, the four major reserve currency areas, (US$, €, ¥ and £) will account for 58 percent of global GDP and 81 percent of global debt.[4]
As Eswar Prasad pointed out to the central bankers at their recent meeting in Jackson Hole, “High and rising debt levels among advanced economies pose serious risks to global macroeconomic stability.”
Rising debt levels in advanced economies will result in crowding-out effects which, in turn, will affect productivity growth. The resulting productivity growth gap between AEs and EMs implies that EM currencies will appreciate relative to those of the AEs. Since foreign exchange reserves account for 50 percent of EMs’ total assets, and since 60 percent are in US dollars, EMs will be vulnerable to a likely further devaluation of the US dollar.
I trust these notes confirm the case for emerging market debt, both private and public. Cordiant has been focussing on private EM debt and is proud of the superior results it has achieved over the past 10 years.
As Prasad’s paper and the IMF data suggest, the exchange rates of some leading emerging market countries are likely to appreciate vis-à-vis today’s ‘reserve currencies’. Cordiant, therefore, will likely be looking for select opportunities to invest in EM currency denominated loans.
September 2011
[1] Prasad, Cornell, ‘Role Reversal’, Jackson Hole, August 2011, page 11
[2] IMF Fiscal Monitor, April 2011, page 127
[3] Prasad, page 12
[4] IMF estimate
World Economic Outlook
In the June update of its Economic Outlook, the IMF confirms the slowdown in the world’s economies, from 5.1% growth in 2010 to 4.3% in 2011. Developing Countries, with 6.6% growth, continued to outpace the 2.2% growth of Advanced Economies.
This slowdown is occurring in all regions except Sub-Sahara Africa where growth is expected to accelerate to 5.5% from 5.1% in 2010.
Global inflation picked up from 3.5% in the fourth quarter of 2010 to 4.0% in the first quarter of 2011, mainly because of commodity prices. Among developing economies, inflation pressures have become increasingly broad-based, reflecting a higher share of food and fuel in consumption as well as accelerating demand pressure.
The IMF update expresses concern about the insufficient pace of progress on banking system repair. There is a risk that markets may lose patience and become disorderly if political developments derail momentum on fiscal consolidation and financial repair and reform.
In its Financial Stability update, the IMF notes that, as leveraged loan prices recover and yields fall, investors are increasingly turning to financial engineering to achieve double-digit returns. Both new and refinanced private equity transactions suggest that related corporate balance sheets are quickly approaching pre-crisis leverage multiples. Though the aggregate amount of financial leverage provided remains less than before the crisis, high-yield corporate bond and leveraged loan investors have recently been borrowing at higher earnings multiples, not much below 2007 levels.
This search for yield and concern over the US$ caused substantial flows into emerging markets, notably corporate bond markets. Flows into mutual funds for emerging market bonds have also been strong. As a result, even record amounts of EM corporate bond issuance could not keep up with demand. EM corporate bond issuance in the first quarter of 2011 was $65 billion and is expected to set a new record for the full year as illustrated by the chart below.
While EM bond spreads have narrowed, loan spreads held up as banks, because of Basel III, retreated from infrastructure and other project lending.
The IMF update points out the risk that, if these flows into EM bond markets continue, too much capital may be moving too quickly to emerging markets and this could lead to a mispricing of credit or a sudden reversal.
The IMF’s Financial Stability update concludes:
“Deep-seated financial challenges remain, even if vulnerabilities are masked by highly accomodative monetary and liquidity conditions. The current window of opportunity to prepare the financial and economic system against potential systemic shocks, importantly by providing clarity on euro area-wide solutions to strains in the periphery, could close unexpectedly. It could be closed by market developments if a sudden pickup in risk aversion … leads market participants to narrow their tolerance for incomplete policy solutions.”
July 2011
Floating Rate Debt: A Distinct Asset Class
Not only has the corporate landscape undergone a notable and dramatic improvement since the bottom of the financial crisis, but the high expectation of corporate default that accompanied the crisis proved to be wildly overestimated. Instead of the anticipated rate of 25%, actual default rates were closer, in fact, to 11%, and today they stand at a three-year low of 1.1%. This post-crisis realignment of risk expectations occurred against a backdrop of abnormally lax monetary policy. This confluence of events has focussed investor attention en masse to products like inflation index-linked bonds which, in turn, drove indexed yields down. As a result, a market hungry for income is now ready to look more closely at alternative Floating Rate Debt products. An important asset class in their own right, leveraged loans are a viable option.
Floating Rate Debt, which is usually linked to LIBOR, provides a stable current income investment alternative to more traditional fixed income allocations. Government real return bonds, for instance, have appreciated so much that their real yield above the rate of inflation has become marginal.[1] This has spurred both individual and institutional investors to look for higher yielding buffers against inflation. In the US, Floating Rate Debt mutual funds have attained $71 billion in assets, an increase of $18 billion since the end of 2010 and well above the pre-crisis peak of $47 billion. European markets are similarly gaining momentum.[2] As inflation anxiety increases with excessive quantitative easing in the US, Mercer estimates that 80 percent of European pension schemes will increase their allocation to inflation-linked and inflation-sensitive assets, including Floating Rate Debt.
With the increased interest in Floating Rate Debt, let us examine more closely the inflation protection provided by T-Bills and LIBOR.
SBBI’s 85-year history suggests that LIBOR and T-Bills produced a real return of 0.6 percent over and above the rate of inflation. If you look at the real rates of return for T-Bills over each of the past decades, they were positive in 6 out of 10 decades.
| 1920s | 1930s | 1940s | 1950s | 1960s | 1970s | 1980s | 1990s | 2000s | 2010s |
| +4.8% | +2.6% | -5.0% | -0.3% | +1.4% | -1.1% | +3.8% | +2.0% | +0.3% | -0.1% |
Based on Federal Reserve data, Ben Inker shows that real returns on T-Bills, as a proxy for LIBOR, were +3.7 percent for the period of 1920-1940, -0.1 percent for 1941-1981 and +2.0 percent for 1982-2009.[3]
In other words, LIBOR and T-Bills provide a reliable inflation protection over the long term, despite imperfection over the short and medium term. This is confirmed by the significant, though not perfect, correlation between CPI and T-Bills. [4]
Unlike sovereign real return bonds, Floating Rate Debt instruments, like leveraged loans, generally involve a greater element of credit risk. As such, investors in Floating Rate Debt have to be very credit conscious because these loans are mostly made by banks that do not necessarily have the same underwriting and credit analysis skills as the Private Placement departments of life insurance companies and specialty firms like Cordiant. Cordiant, over its 10-year history, has only had one minor write-off (less than 0.02%) and only one percent per annum in non-performing loans, the majority of which are very likely to be successfully recovered.
With an expectation of normalization in developed world monetary policy and the subsequent real risk of accelerating inflation, Floating Rate Debt products will continue to receive increased attention. As we move through the next stage of economic recovery, market participants will no longer be rewarded for simple macro directional strategies like sovereign real return bond plays. They will instead generate alpha through credit differentiation and fundamental analysis. As such, Floating Rate Debt accessed through funds like those managed by Cordiant becomes an attractive asset class for pension funds and foundations who require absolute returns to meet their fiduciary responsibilities.
June 2011
[1] On May 10, the Canada 4.25% of 2021 yielded 0.5%; the UK 2.4% of 2024 yielded 0.6%; the US 3.625% of 2028 yielded 1.5%
[2] Financial Times, Floating Rate Loans Have Their Moment in the Sun, Steve Johnson, April 24, 2011
[3] Ben Inker, The Dangers of Risk Parity, The Journal of Investing, Spring 2011
[4] SBBI 2011 Yearbook, page 44
Frontier Markets
“Frontier Markets” is an economic term coined by IFC’s Farida Khambata in 1992. It is used to describe a subset of very small emerging markets. They have lower market capitalization and less liquidity than more developed emerging markets. The IFC’s definition of frontier markets is wider than that of the index providers. IFC’s strategic priorities include a focus on frontier markets: low income countries rated high-risk by investors, where there are very limited private capital flows. The IFC provides financing to sustainable private sector enterprises, sometimes in partnership with institutional investors like Cordiant, and then further supports these enterprises through its Technical Assistance and Advisory Services. Frontier market index providers, on the other hand, restrict their index components to countries with functional stock exchanges that are open to foreign investors, but do not meet the volume and liquidity requirements for being included in the emerging markets composite.
The S&P Frontier BMI (Broad Market Index) tracks 36 frontier markets. The 565 companies in this index have a total market capitalization of over $300 billion. S&P also has the Extended Frontier Index with 150 of the larger companies in 27 countries.
However, these and other Frontier Market Indices, like MSCI Barra, are not homogeneous since they include countries as diverse as Bangladesh and the United Arab Emirates or Vietnam and Estonia. They include stock markets as small as Uzbekistan’s, with a $700 million capitalization, and Nigeria’s with more than $25 billion.
From 2000 through 2009, Frontier Markets represented 17 of the 20 fastest growing economies in terms of average annual GDP growth. For several frontier countries, the GDP growth in 2011 is forecasted to be greater than China’s and India’s, like Qatar 16%, Ghana 13%, Mongolia 12%, Eritrea 10% and Ethiopia 9%. As documented by this year’s UN publication ‘World Economic Prospects 2011’, developed economies declined in 2009 by 3.5%, while developing countries reduced their GDP growth rate to 2.4% and, interestingly, the ‘least developed countries’ reduced their superior growth rates to only 4.0% in 2009. Looking ahead, the same UN publication estimates this and next year’s growth rates, for all countries and regions, to be lower than in 2010 with ‘least developed countries’ being the sole exception, showing accelerating growth rates through 2012.
Do these, admittedly insufficient, statistics suggest that young small economies tend to grow faster than large ones, like small cap stocks grow faster than large caps? Young organisms grow faster in percentage terms than old ones. This applies to plants, animals, humans and social organisms. As a child completes his fifth year, he grows at a rate of 20%, while a person celebrating his/her 50th birthday only grew by 2%. One should remember, though, that the mortality rate of young organisms is higher than that of mature ones. So much for the ‘small-size premium’.
Frontier markets have adequate liquidity in bull markets, but liquidity is sharply reduced or disappears in bear markets. The 2010 Ibbotson Yearbook contained, for the first time, a well researched chapter by Roger Ibbotson on liquidity. It clearly demonstrates that ‘less liquid securities have higher expected returns’. From 1972 to 2009, of all stocks traded on the NYSE, AMEX and NASDAQ, the least liquid quartile returned 16% p.a. with a standard deviation of 20, while the most liquid quartile returned 8% with a SD of 29. Perhaps this proven ‘illiquidity premium’ also applies to stock exchanges, particularly in frontier markets.
If your Frontier Market Public Equities Fund only holds sound and conservatively levered companies with a proven dividend growth history and good growth prospects, you don’t have to be concerned with liquidity, if you follow disciplined rebalancing guidelines. Assuming, for example, a frontier market policy allocation of 5% and a rebalancing band of 3.5% to 6.5%, you will find – after a 30 percent market appreciation – all the liquidity needed to scale your holding back down to 5%. On the other hand, if your frontier portfolio has dropped by 30 percent to 3.5% of your total portfolio, you will easily be able to bring it back up to 5% because there will be many panic sellers and no bidders.
Frontier markets account for 22% of the world’s population and 7% of the world’s GDP, but only 3% of the world’s market capitalization, compared to emerging markets with 63% of the world’s population, 42% of world GDP and 42% of market capitalization.
The following chart shows the 15-year annual returns of US, EAFE, Emerging and Frontier markets:
The frontier market index outperformed the EM index in six of nine years of up-markets and in five of six years of down-markets. For the 10-year return to December 2010, the SDs and correlations with the S&P 500 were as follows:
The population demographics in frontier markets are even more favourable than those in emerging markets. The valuations of these markets are lower than most developed and emerging markets, like Bulgaria with a PE of 6x, Serbia 7x and Kazakhstan 8x.
What follows are two examples of sound companies, which I have taken from Larry Speidell’s Frontier Market Select Fund portfolio:
Swissport, Tanzania, handling the airport’s cargo, with a PE of 5, a ROE of 53%, a Yield of 15% and Earnings Growth of 15%. Auditor: PWC.
Searle, Pakistan, manufacturer and marketer of pharma products and baby food, with marketing agreements with Pfizer, Forest Labs, 3M England and others. EPS have grown from $2.92 in ’06 to $11.96 in ’10, ROE 27%, PE 4x, PB 1x, Yield 7.3%.
The total portfolio of the Frontier Market Select Fund, for instance, has an average market capitalization of $628 million, a PE of 8x and an ROE of 22%.
While I am generally a strong advocate of passive investing in developed markets, through fundamental index funds, value-oriented active investing in frontier markets has proven to produce substantially better results than the respective indices. Over the three years to December 2010, the Frontier Market Select Fund had a return of 17.3% with a Standard Deviation of 14%, compared to S&P Frontier BMI ex-GCC of -54.8% with a Standard Deviation of 25%. Other fund managers have had similar experiences. The Templeton Frontier Markets Fund has returned 65.4% since launched, compared to the index of -13.6%. Over the same time period, the Morning Star Sector Average produced 64.6%, which confirms that value-oriented active investing pays off handsomely in frontier markets.
The number of frontier market managers is still small and includes Frontier Markets Fund Managers, a Mauritius-incorporated company jointly owned by Standard Bank and FMO, the Dutch Development Bank and Emerging Market Partners of Washington, DC; Schroders Frontier Markets Equity Fund was launched earlier this year; Swiss and Global Asset Management, a subsidiary of Julius Bear of Switzerland; and the above mentioned Frontier Market Asset Management of La Jolla, CA.
When selecting a frontier market equity fund, make sure that its manager is a skilful bottom-up fundamental analyst and not a top-down arbitrageur between country markets. His/her portfolio should consist of sound companies with a history of, and prospects for, growing dividends. The portfolio should consist of consumer staples, food, drink, pharma, manufacturing, telecom and financials, but should have little or no exposure to natural resources and other cyclical sectors. Your chosen portfolio manager should follow a ‘buy-and-hold’ strategy with a portfolio turnover of not more than 25 percent.
There are also a number of ETFs available, like Claymore/BNY Mellon Frontier Markets and PowerShares MENA Frontier Countries. Barclays Global Investors will soon launch a BGI Frontier Market Fund for institutional investors that will invest in 15 Frontier Markets and will be benchmarked to the MSCI Frontier Market Index.
Let me remind you that Frontier Markets remain overlooked and misunderstood by most investors. As some Emerging Markets will be moving into the Developed Market category, so will some Frontier Markets move into the Emerging Markets category. In planning your long term asset allocation, let us not forget that, by 2030, the developing world’s middle class will equal today’s combined population of Europe, Japan and North America.
When planning your asset allocation policy, do not restrict your emerging and frontier market exposure to public and private equity funds. Include floating rate debt funds with emphasis on infrastructure debt. That is an area Cordiant, in partnership with multi-lateral International Financial Institutions, has been active in for 10 years. During that period, we have made nearly 200 floating rate loans to 30 private sector industries in more than 50 developing countries and have not experienced one single write-off.
One of Cordiant’s particular areas of expertise is infrastructure projects in developing countries. These projects offer a better risk profile than the ones in developed countries because the former are supported by favourable demographics and rapidly growing tax bases. Furthermore, they are not encumbered by the need to tear down existing infrastructure in order to replace it. Infrastructure debt, when done in partnership with multi-lateral IFIs, has superior risk return characteristics compared to infrastructure equity financing.
April 2011
Double, Double Toil and Trouble Fire Burn and Cauldron Bubble
The following summarizes the IMF’s view on capital flows into developing countries.[1]
Developed country sovereigns have experienced 25 downgrades since early 2008, while emerging market sovereigns have seen 21 upgrades during 2010. The following chart[2] illustrates the diverging trends between developed and developing markets.
Custodial flow data points to an ongoing portfolio reallocation of assets toward emerging markets and away from mature economies. Since 2003, the share of portfolio flows to emerging market assets has almost quadrupled. Most of the growth can be attributed to equity inflows but, among bond inflows, Latin America exhibited the fastest growth.
There is scope for additional sizeable asset reallocation to emerging markets, which could be overwhelming in some cases. Institutional investors worldwide have not yet adopted a global approach in their equity allocation process. US investors heavily underweight non-US equities. The reallocation of a small portion of financial assets of advanced countries could have very large effects on emerging market countries. A one percentage point reallocation of global equity and debt securities held by G-4 investors would result in additional portfolio flows of $485 billion. Countries receiving a large share of these flows relative to the size of their markets could face significant challenges. IMF research suggests that the combination of large capital inflows and accommodative monetary policy raises the risk of asset-price boom-bust cycles. Investor flow data suggests emerging markets tend to suffer from herding behaviour. There is evidence of a self-reinforcing cycle between inflows and returns.
There are various macroeconomic policies that can be deployed to address the effects of capital inflows, including exchange rate appreciation, reserve accumulation, and tighter fiscal policy. Brazil has chosen to reimpose a two percent upfront tax on capital inflows in October 2009 to limit exchange rate appreciation. These capital controls had a small but discernable impact on interest rate arbitrage. However, they do not appear to have reduced aggregate capital flows into Brazil. After this IOF was imposed, the nominal appreciation against the dollar came to an end, but reserves continued to rise steadily and the Real continued to appreciate against the Euro.
While publicly listed securities in emerging markets do not appear overpriced as yet, given the favourable risk-adjusted rate of return outlook, there is clearly a base forming for a potential bubble. I have been advocating for years that portfolios should have a large exposure to emerging markets, but this exposure should not consist exclusively of publicly traded securities. They should account for five percent of the total portfolio, to be increased to ten percent whenever there is a pullback in these markets. Secondly, the portfolio should have a five percent exposure to infrastructure loans and other loans that enjoy the umbrella protection of IFIs. Thirdly, the portfolio should have a ten percent equity exposure to world class blue chip companies that derive a large and growing portion of their revenue from emerging markets, such as Unilever, Proctor & Gamble, Caterpillar, Nestlé, Johnson & Johnson and Novartis to mention–but not recommend–just a few examples.
Institutional investors will have to rethink their approach to emerging markets and restructure themselves accordingly. Emerging and frontier markets should not be a small and speculative sideshow, but should form a major portion of the portfolio, encompassing all asset classes like public debt and equity, private loans and infrastructure debt, private equity and real estate. In order to do justice to these asset classes in developing countries, the institutional investor has to re-staff and retrain the investment department and has to form close alliances with experienced and trustworthy emerging market experts. This is a daunting task which will take years to implement.
October 2010
[1] IMF Global Financial Stability Report, October 2010
[2] Ibid., p.24
Advisor versus Advisee
Haven’t we all wondered about the usefulness of expert advice? How often do advisees implement the advice they receive? Why do advisees pay substantial fees to their advisors, only to ignore such advice and do exactly what they wanted to do in the first place? The following quotes may interest or, at least, amuse you:
Advice is seldom welcome; and those who want it the most, always like it the least. - Lord Chesterfield, 1748, in a letter to his son.
Get the advice of everybody whose advice is worth having–they are very few–and then do what you think best yourself. - Stewart Parnell, 1957.
Let the client talk. Don’t try to sell him what you’ve got to sell. Get him to tell you what his problem is and that will give you time to think about it. Try and give him the answer to his problem in his own words. He’ll think, ‘How remarkably clever this man is, he’s telling me exactly what I always intended to do anyway.’ – Siegmund Warburg, 1960s.
Advisers advise and ministers decide. – Margaret Thatcher, 1989.
Good advice is often contrarian. Investment managers, whose results are, unfortunately, compared only to those of their peers rather than to their fund’s unique objective, don’t dare move too far away from the consensus because, as long as his portfolio performs in line with those of his peers, his job remains secure
At the historic peak of interest rates in the eighties, when the consensus was that the bond market was dead forever, managers moved from bonds into equities. After the recent crash, managers moved from equities into record low yielding bonds. From my perspective, the very few advisors who recommended the contrary were discontinued or ignored, while the majority of advisors who supported the prevailing view increased their client base and augmented their advisory fee revenue.
In order to overcome this costly conundrum, boards and investment committees of foundations, pension funds and family companies have to (i) become more diligent in selecting advisors and (ii) educate their board’s members.
Selecting Advisors
First and foremost, make sure that your advisors are not conflicted the way brokers and investment bankers often are.
Request copies of advisory letters written at the time of past peaks and troughs in equity, real estate, bond and commodity markets.
Be fully cognisant of an advisor’s methodologies, the length and depth of his historic data bases and his investment beliefs with regard to (i) growing income return versus total return, (ii) holding versus trading, (iii) style commitment versus style rotation and (iv) truly global versus US centred.
Educating Boards
Give each member annually a copy of Ibbotson’s SBBI year book (now Morningstar) and Dimson’s The Triumph of the Optimist (now Crédit Suisse).
Make board members understand why a percentage point of a manager’s under-performance against the benchmark in an up-market is forgivable, but under-performance in a down market is not.
Educate them to look at the equity and real estate markets not as a facility for trading perceived overvalued for undervalued paper (speculation), but as a place to select your fund’s partnership in the world’s finest and proven industrial, real estate and financial corporations (investing).
Adopt a rigorous mechanical re-balancing policy, with reasonable minimum and maximum percentage limits for each asset class, and then stick to it, regardless of whether the consensus is one of ‘irrational exuberance’ or Wall Street brokers jumping out of windows en masse.
Conclusion
If you implement a more rigorous selection process for choosing your advisor and if you are successful in educating your board and your investment committee, you will successfully navigate the Advisor versus Advisee conundrum.
Postscript
In order to understand this irrational behaviour, I consulted with Professor John Lyndon of McGill’s Department of Psychology. He informed me that this ‘Advisor vs Advisee’ behaviour is readily explained by well understood psychological phenomena like ‘Resistance to Prior Knowledge’, ‘Implementation Mindset’ and ‘Deliberation Mindset’. Space does not allow me to elaborate on his comments, but I learned that a committee discussing how to implement a previously set goal will be less effective achieving consensus and results, than one that deliberates on the appropriateness of that goal and then moves on to implementing it, perhaps in a modified version.
March 2011
Why Interest Rates Will Rise
The recent reports by McKinsey and the IMF have confirmed the strategy adopted by Cordiant in the late nineties.
The decline in interest rates over the past three decades is often attributed to the ‘savings glut’. In reality, however, the global savings rate as a percent of global GDP declined from 24 percent in 1980 to 21 percent in 2009 despite the high and rising savings rate in emerging markets. As McKinsey documents in their study1, the real reason for this decline is that global investment in infrastructure, residential real estate and other productive investments including plant and equipment have declined since 1970, as illustrated by the following chart:
The current low interest rate environment is likely to end in the coming years because developing economies are embarking on one of the biggest investment booms in history, financed partly by capital inflows. Total inflows to Emerging Asia over the past four quarters quadrupled relative to 2008 levels and the five Latin America economies also experienced a resurgence in capital inflows.1
This coming investment boom will put sustained upward pressure on real interest rates as the demand for capital will exceed the supply of savings.
There have been a number of economic periods in history that required massive investment, such as the Industrial Revolution and the post-war reconstruction of Europe and Japan. We are now at the beginning of
another investment boom, this time fuelled by rapid growth in emerging markets. The global investment rate has already increased from a recent low of 21 percent of global GDP in 2002 to 24 percent in 2008 and it will exceed 25 percent of world GDP by 2030, or $24 trillion compared with $11 trillion today. Emerging economies already invest more than twice as much in infrastructure as mature
economies, namely 5.7 percent of GDP versus 2.8 percent. The following chart illustrates the dramatic global growth of investment by sector.
This rising investment demand will put upward pressure on interest rates if not matched by increased savings. However, global savings will not increase sufficiently to meet the demand for capital. China’s saving rate will decline as the country grows richer. Demographics in the developed world suggest continued low, if not declining, saving rates.
If real long-term interest rates were to return to their 40-year average, they would rise by 150 basis points from the fall 2010 level. History, however, tells us that real interest rates could rise to well over three percent, as they did in the second Industrial Revolution from 1870 to 1913.
Investors will want to re-think their strategies as any increase in real interest rates will mean losses for bond holders. Rising real interest rates could also reduce the value of equities as the resulting higher real discount rate lowers the net present value of future cash flows.
Those projections confirm Cordiant’s commitment to private floating-rate loans and private equity in emerging markets. While most of the capital for ‘other productive assets’ will come from corporations in the form of plant and equipment spending, residential real estate–the second largest portion of the investment boom in emerging markets–will probably be financed locally encouraging a rapid build-up of the mortgage industry. For an institutional investor in the developed world, it will be difficult to participate in this residential real estate growth because the industry is fragmented, poorly regulated and not protected by IFIs like the IFC, EBRD ADB and others.
That leaves the emerging market infrastructure sector where investors can find sound IFI-protected investment opportunities, particularly in the floating-rate debt portion of such financings.
January 2011
1 McKinsey Global Institute, December 2010, Farewell to cheap capital? The implications of long-term shifts in global investment and saving, www.mckinsey.com/mgi
2 IMF, October 2010, World Economic Outlook
The Ease of Doing Business
Economic activity requires an encouraging regulatory environment and effective rules that are transparent and accessible to all. The 2011 issue of Doing Business1 confirms that the trend towards the streamlining of regulations continues, particularly in the developing world.
Between June 2009 and May 2010, governments in 117 countries implemented 216 business regulation reforms. These reforms made it easier to start and operate a business, strengthened transparency and property rights, and improved the efficiency of commercial dispute resolution and bankruptcy procedures. More than half those policy changes eased start-up, trade and the payment of taxes.
Economies in East Asia and the Pacific were among the most active in making it easier for local firms to do business. In 2006, only a third of the region’s economies implemented such reforms; in the past year, 75 percent have. Emerging market economies such as Indonesia, Malaysia and Vietnam took the lead by easing start-up, permitting and property registration for small and medium-size firms and improving credit information sharing.
In this past year, Kazakhstan implemented the largest number of regulatory improvements. It amended its company law and reduced the minimum capital requirement. It made dealing with construction permits less cumbersome and traders benefited from improvements to the automated custom information system. Kazakhstan also increased the legal requirements for disclosure in related-party transactions.
Small and medium-size businesses have great potential to create jobs. They account for 60 to 80 percent of employment in such economies as Chile, China, South Africa and Thailand. Improving their regulatory environment is a key way of supporting them.
The following table is a selected sample of the respective rankings.
Improving the ease of doing business by reducing and streamlining bureaucratic regulations has an immediate effect on a country’s economic growth and job creation. The positive impact has a more lasting effect on developing countries than traditional foreign aid and, for a company like Cordiant, serves to both encourage and support our investment activities in the region.
As we prepare to launch to the Cordiant Emerging Infrastructure Fund, this accelerated pace ofregulatory reforms in developing countries is particularly reassuring. It will reinforce the rapid growth of the middle class in these countries and will lead to an expansion of the tax base, which is an important prerequisite for prudent financing of infrastructure projects. This is in contrast to tax bases in developed countries, which will shrink over the term of infrastructure financings because of the negative demographic trends in most parts of the developed world.
These regulatory reforms in developing countries and the higher tax revenue they generate will reinforce what are already strong fiscal balances, while most OECD countries will have to deal with excessive levels of debt and unsustainable fiscal deficits for years to come.
December 2010
1 IBRD/WB, ISBN: 978-0-8213-7960-8, www.doingbusiness.org
Benchmarking an Investor’s Objective
Just because everybody is doing it does not make it right, or to quote Henrik Ibsen: “the majority never has right on its side”.
Capitalization weighted indices do not reflect the reality of institutional portfolios unless they are indexed. Actively managed portfolios do not hold three times as large a position in ABC as compared to DEF only because ABC represents 1.5 percent of the index while DEF represents only 0.5 percent.
As Felix Goltz concludes in his recent FT article and EDHEC paper , a cap-weighted stock market index is not the market portfolio of financial theory and is not supported by any academic evidence.
Equal weighted indices, such as S&P EWI, resemble more closely typical actively managed institutional portfolios. However, while the growing dividend income stream of EWIs may meet the portfolio’s objective, the volatile capital portion of the return may not. Furthermore, investment managers don’t like to be benchmarked against an equal weighted index because it tends to outperform the cap-weighted index over the medium and long term.
The benchmark against which the portfolio performance should be judged must reflect the investor’s ROR objective and not the volatile variances of the capital return. For this reason I have been advocating as the appropriate benchmark for a portfolio: growth of dividend income. Such growth must average at least eight percent per annum over a running three-year moving average. At a growth rate of eight percent, the portfolio’s income will double every nine years and the volatile capital return will follow eventually.
Investment managers are reluctant to accept a mandate under such terms and claim that an eight percent dividend growth rate is unattainable since the dividend growth rate of the indices is only five percent. In the following table, I demonstrate that sixty-seven blue chip US companies, representing twelve industry classes, had a company weighted average dividend growth rate of 9.0 percent per annum over the past fifty years ending December 31, 2009. The 12 pharmaceutical companies accounted for 18 percent of that dividend growth followed by the 14 packaged food companies with a 17 percent share.
In addition to these ‘old timers’, there are a good number of younger US companies with an equally impressive dividend history and prospects for continued growth.
If one were to include blue chip EAFE and EM corporations with superior dividend growth history and prospects, the number of companies would grow to over 100, a well diversified quality portfolio by any standards.
* Last 25 years. 50-year data not available.
July 2010
1) Flawed beliefs in the worth of cap-weighting, FT 21-06-10
and EDHEC-Risk Institute Publication on Capitalisation-Weighted Indexing, 01-10
2) 2010 SRC Green Book (www.srcstockcharts.com)
Misconception of Liquidity
Call me outdated but, as an investment advisor, I have always been puzzled by some of my clients’ concerns about liquidity. Most pension funds have a duration of two decades, while most foundations and endowments have an infinite term. They have a positive cash flow and little operational needs for liquidity. Why, then, would they turn down good returning investments because of their illiquidity?
To choose instantly liquid, and often volatile, investments over superior long-term steady returns from less liquid investments is a costly trade-off
If you have done your due diligence analysis and you have chosen an investment that will give you predictably stable increases in investment income, well above the rate of inflation, you should realise that the liquidity of such a portfolio holding is a function of its most recent negative or positive investment return.
If you bought, for instance, a private fund of sound income producing properties on a cash-on-cash yield of 8 percent and the re-appraised market value then drops to a 10 percent yield, this affords you the wonderful opportunity to double up your investment and, thereby, greatly increase your current and future cash return.
If, on the other hand, the re-appraised market value of this real estate investment appreciates in value to a 4 percent cash-on-cash yield, your investment will become as liquid as T-Bills and you can take advantage of the bubble by selling it to any ‘greater fool’.
The same applies to small cap stocks, private loans, private equity, infrastructure and public equities in emerging and frontier markets. When they are down, you want to buy more of them and thereby achieving superior returns. Vice versa, when these so-called illiquid asset classes have appreciated to values of unreasonable expectations, they become very liquid and you will not have any trouble realising your gains.
My point is that liquidity is a function of your analytical ability to identify quality and true value, be it in a corporation, a real estate fund, infrastructure or a pool of private equities or loans. And, most important of all, having identified the investments you want to be with for the long term, to add to them when they are down and their liquidity is poor and to part with them when everybody else wants to own them, will give you better returns.
I am not advocating a trading approach along these lines, but I suggest that you re-appraise your thoughts about liquidity because by overemphasising the need for liquidity, your institution is leaving a lot of money on the table.
Related to liquidity is my favoured subject, the importance of growing investment income, be it in the form of growing dividends, growing net-rental income or CPI Indexed Bonds. If the income from your investments grows steadily and well above the rate of inflation, the volatile capital return will follow over the median term.
Institutional investors appear to have been brainwashed about liquidity by conflicted agents. A broker, for example, makes his commissions and spreads by trading liquid stocks and bonds. He does not want you to buy-and-hold a successful mid-cap, family controlled company in which you want to become a long-term partner. He does not want you to buy-and-hold Index-Linked Bonds that give you a small but guaranteed inflation adjusted real return because you will never trade them and will only buy more of them if they fall to a higher real yield level.
Investors are repeatedly told that liquidity is important in order to facilitate change and turnover. However, liquidity and turnover have a high price and will ultimately be a detriment to investment returns.
Rather, become a long-term partner in the world’s best businesses, liquid or not, and benefit from the steady disbursements of their growing income. It is that simple, but only a few are prepared to go that route because it does not lend itself to conventional benchmarking, which is a questionable yardstick anyway – but that is a subject for another memo.
Postscript: After writing this memo, I received the 2010 Ibbotson SBBI Yearbook which contains, for the first time, a well researched chapter on Liquidity (pages 107-111). It clearly demonstrates “that less liquid securities have higher expected returns”.
From 1972 to 2009, of all stocks traded on the NYSE, AMEX and NASDAQ, the less liquid quartile returned 16% p.a. with an SD of 20%, while the more liquid quartile returned 8% with an SD of 29%.
Extending the analysis to the Size and Value/Growth effects the difference in returns becomes even more pronounced. The lowest liquidity quartile of Small Stocks returned 18% p.a., while the lowest liquidity quartile of Large Caps returned 12%.
Value Stocks in the lowest liquidity quartile returned 21%, while Value Stocks in the highest liquidity quartile returned 12%. Growth Stocks in the lowest liquidity quartile returned 11% and those in the highest liquidity quartile 3% p.a.
Roger Ibbotson’s chapter confirms that the opportunity loss from restricting a long-term portfolio to highly liquid assets is indeed substantial.
May 2010
China in Africa
China’s interest in Africa is rooted in its experience with Japanese investment almost forty years ago. Complementary economic interests fuelled relations between the two nations as Japan became a major force behind China’s drive for modernization. In 1973, Japan began to import oil from China. In 1978, Japan offered to use low interest Yen loans to finance the export of $10 billion of its modern plant, materials and industrial technology, while China agreed to pay for the loans by exporting the equivalent of crude oil and coal to Japan. By the end of that year, Chinese officials had signed 74 contracts with Japan to finance turn-key projects that would form the backbone of China’s modernization. All would be repaid in oil.
In her recent book[1], Deborah Brautigam presents the well-documented real story of China in Africa. I would like to highlight the following:
China learned from its Japan experience, which proved to be win-win for both countries. In the fall of 2000, the Forum on China–Africa Cooperation (FOCAC) was launched and 44 African countries sent their foreign ministers and economic ministers to Beijing. Soon, Chinese contractors were winning more than half of the construction contracts funded by other donors in the early years of that decade. At that time, a total of over 42,000 Chinese engineers and skilled workers were working in Africa. The two-way trade between the two regions surpassed the $10 billion mark. By 2005, China’s outward investment in manufacturing exceeded that for mining.
Created in 2006, the China-Africa Development Fund (CADF) helped Chinese companies to relocate their more mature factories to 50 special economic cooperation zones offshore. The CADF was not aid but rather a market-based fund that invested between $5 million and $50 million in individual projects like a glass factory in Egypt, a power plant in Ghana, and a chromium plant in Zimbabwe.
China’s overseas zones were not only about export processing; they were to be built by Chinese enterprises as profitable ventures. Half of the expenses for Chinese enterprises moving into the zones could be reimbursed. This facilitated an orderly way to transfer mature industries abroad rather than simply letting them destruct. The Ethiopia zone would concentrate on textiles and the Zambia zones on metal processing while the zone near Lusaka concentrated on electronics. The Chambishi zone in Zambia will, by 2011, have 40 Chinese companies and 10 from other countries. The operators of that zone will have its environmental management certified at the global standard ISO 14000.
The idea that the Chinese always bring over planeloads of their own workers and do not employ Africans is wrong. Construction of the famous Tan-Zam railway employed 16,000 skilled Chinese, but many tens of thousands of Africans. In the case of the multi-billion dollar infrastructure and copper mining venture in the DRC, at least 80 percent of the workers must be Congolese.
China has further deepened its ties with Africa by developing relationships at the community level. Its medical aid to Africa began in 1963 and, by 2008, there were 1000 Chinese medical workers on the continent. Following the 2006 FOCAC summit, China built 27 hospitals in Africa and 30 anti-malaria centres equipped with diagnostic and treatment facilities. Each country receiving a centre is assisted by two Chinese experts who were dispatched to train African medical workers in the use of Chinese herbal drugs. With respect to education, Beijing gives over 4000 scholarships annually to African students. These scholarships cover the costs of air fare, tuition, housing and a small stipend. In return, students incorporate Chinese history, literature and philosophy into their field of study.
Under the 2006 FOCAC pledge, China will provide short-term training in Africa to 15,000 Africans over three years including 1500 principals and teachers for the schools built by China and 1000 doctors and nurses for the hospitals they are building in 30 African countries. In Ethiopia, a large training and vocational education centre financed by Chinese Aid and jointly operated by the two countries opened in early 2009. The school will eventually enrol 3000 students. China also builds and operates vocational training centers in Uganda and Angola.
Western nations have much to learn from the way China has woven itself into the African landscape. When the West buys natural resources from African countries, part, or in some instances all, of the sales revenue ends up with the respective government. More often than not, only a small part of it trickles down through the country’s economy. China has taken a very different approach. With its Resource-Backed Infrastructure Loans, a loan granted to a country will be serviced and repaid through the sale of, for example, copper or oil valued at market prices prevailing on the day of its sale. China, however, remains in control of the cash of the total loan amount and will use it, in consultation with the local government, to build roads, schools and hospitals while supplying equipment, engineers, doctors and skilled workers. Such infrastructure-linked loans have the dual benefit of supporting Chinese exports while, at the same time, developing the host country’s vitally needed infrastructure.
As Brautigam concludes, “China is now a powerful force in Africa and the Chinese are not going away. Their embrace of the continent is strategic, planned, long-term and still unfolding. China’s own experiments have raised hundreds of millions of Chinese out of poverty, largely without foreign aid. They are applying the tools of investment, trade and technology as levers for development, not out of altruism, but because of what they learnt at home, namely that their own natural resources could be assets for modernization and prosperity”.
April 2010
[1] The Dragon’s Gift, by Deborah Brautigam of the American University’s School of International Service in Washington, DC, Oxford University Press, November 2009
Debt versus Growth
The low level of debt in developing countries augurs well for the continuing strong growth of their economies and markets. As Reinhart and Rogoff[1] demonstrate in their January 2010 paper, there is a strong relationship between the level of government debt and real GDP growth.
For both developed and developing countries, GDP growth is highest when Debt/GDP is below 30%. It tapers off slightly as this percentage rises and falls sharply when Debt/GDP reaches 60% for developing countries and 90% for developed countries.
The following three examples, taken from 24 Emerging Market Economies, illustrate this point.
The relationship between debt levels and inflation is less strong in most developed countries, with the exception of the United States. In Emerging Market Economies, this relationship is statistically significant. For the period from 1946 to 2009, the inflation rate of the Median of the 24 countries was 6.0% when Debt/GDP was below 30%. It rose to 11.7% when that percentage was 60-90% and climbed to 16.5% when debt was over 90%.
Analysing the US 216 data observations from 1790-2009, real GDP growth was 4%, when Debt/GDP was below 30%, dropped to 3½% when 30-90%, but turned 1½% negative when it was 90% and above. At this 90% threshold, the US inflation rate rose from 0.25 % to 4%.
The well documented findings of Reinhart and Rogoff are based on 3,700 observations over time periods varying from19 to 219 years. Many Emerging Market Economies, and for that matter Canada, have a Debt/GDP of 30-40%, while the United States, Japan and most European economies are, or will soon be, at the 90% threshold.
Real GDP Growth as the Level of Government Debt Varies:
Selected Emerging Market economies, 1900-2009
(annual percent change)[2]
[1] GROWTH IN A TIME OF DEBT by Carmen M. Reinhart (U of Maryland) and Kenneth S. Rogoff (Harvard), http://www.nber.org/papers/w15639 .
[2] Taken from page 15 of the Reinhart & Rogoff paper.
India Update
While the limelight is on Brazil and China, we should not overlook the impressive economic achievements and prospects of India.
India’s economy has grown over the last decade by seven percent per annum, reducing poverty from 35 to 25 percent of the population and raising GDP per capita to over US$3000, according to the December 2009 CIA World Factbook update.
As Arshad Zakaria reminded us in his presentation to the CFA Chicago seminar last July, India’s middle class is estimated to reach 120 million this year, or 12 percent of its population. This number is likely to double over the next decade.
The fundamental driver of India’s recent and future growth is strong domestic demand. For example, for the 12 months ending May 2009, growth in wireless subscribers was 11 million subscribers a month. Over the same period, auto and two-wheeler sales were up by 20 percent.
As Zakaria documents in his presentation, India’s financial system is underleveraged. The ratio of consumer debt to GDP is a mere 11 percent, compared with 59 percent for the other ‘Asian Tigers’ and a disturbing 130 percent for the United States. The patterns of consumption are shifting away from staples and toward non-food and higher margin consumer products.
Furthermore, more than 50 percent of the one billion population is under the age of 29, which, as Zakaria points out, could have the same effect on India’s growth that the Baby Boomers had in the United States.
These trends have been reflected in corporate earnings which have grown at a 20 percent rate since 2001. For the quarter ending March 2009, while the rest of the world was in recession, the top 100 companies in India had a YOY net profit growth of 24 percent.
Taken from the CIA update, the following table illustrates the future growth potential of India’s economy as young labour continues to move from agriculture to better paid, higher value adding and more productive industry and service sectors.
Agriculture is accounting for only 18 percent of India’s GDP but employs 60 percent of its total labour force.
Strong institutions, together with economic liberalization, have allowed India’s macroeconomic position to improve considerably. In 1991, India’s foreign currency reserves were essentially zero. Today, it holds reserves of approximately US$265 billion, which makes India one of the largest holders of foreign reserves. India’s currency exchange rate has been stable and the Prime Minister is a proponent of making India’s currency more free floating. Exports constitute only about 15 percent of GDP, which has helped the Indian economy weather the global financial storm.
While illiteracy rates are still high and primary education in the villages weak, two million highly qualified graduates emerge from India’s universities each year.
The lack of infrastructure is, according to Zakaria, both a problem and an opportunity. Though the current rate of infrastructure investment is only 3.5 percent of GDP, the government is targeting a rate of 8-10 percent. This will require reforms in the laws governing foreign direct investments and public/private partnerships.
From 1991 until May 2009, India was governed by coalition governments, which made the reform process arduous. In last year’s election, the United Progressive Alliance (primarily the National Congress Party) won a much larger position in Parliament, opening the way for a stable government for the next five years and one that will be able to carry out economic reforms.
Zakaria concludes, “The Indian economy has made remarkable progress since 1991 as a result of economic liberalization. If the country builds on the policies that have worked so far, the outlook is promising. But India also faces challenges in the areas of infrastructure and power, dependence on agriculture, income distribution, education, and health care. Nevertheless, future growth—and even the challenges —offers opportunities.”
February 2010
New Observations on Demographic Megatrends
No prudent and forward looking asset allocation program can be designed without understanding the massive demographic changes that will reshape our world over the coming decades.
The traditional classifications of asset classes no longer fit the economic and financial realities of today’s world and even less so tomorrow’s. Basing equity classifications on the location of a head office is an antiquated approach that fails to recognize the geographic diversity of revenues and profits. For instance, the overseas revenues and profits of Proctor & Gamble will soon surpass those from the United States. The same can be said for companies like Nestlé, Caterpillar, HSBC and Unilever who now derive a large and growing portion of their sales and profits from developing countries. The catch-all description of ‘emerging markets’ is also becoming increasingly ineffective for asset allocation because of the heterogeneity of these markets.
It is for these reasons that I would like to share with you Jack Goldstone’s article The New Population Bomb which appeared in the January-February 2010 issue of Foreign Affairs. Professor Goldstone is from the George Mason School of Public Policy in Arlington, VA. What follows is a synopsis of his most interesting paper.
The global population growth will nearly halt by 2050. By that date, the world’s population will reach 9.2 billion people, compared to 6.8 billion today. Since global economic output is expected to increase by two to three percent per year, global income will increase far more than population over the next four decades.
The relative demographic weight of developed countries will drop by nearly 25 percent, shifting economic power to the developing nations. Labour forces in developed countries will age and decline substantially, constraining economic growth in the developed word and raising the demand for immigrant workers.
In 2003, the combined populations of Europe and North America counted for 17 percent of the global population. In 2050, this figure is expected to be just 12 percent.
The West’s relative decline is even more dramatic if one also considers changes in income. At the beginning of the 19th century, Europe and North America together produced about 32 percent of the world’s GDP. By 1950, that proportion had increased to a remarkable 68 percent. By 2003, this percentage had dropped to 47 percent and is expected to drop further still to less than 30 percent by 2050.
Nearly 80 percent of the world’s GDP growth between 2003 and 2050 will occur outside Europe and North America. The World Bank predicts that, by 2030, the number of middle-class people in the developing world will be 1.2 billion, which represents a rise of 200 percent since 2005, and will be larger than the total populations of Europe, Japan and the United States combined. The main driver of global economic expansion will be the growth of newly industrialized countries such as Brazil, China, India, Indonesia, Mexico and Turkey.
The substantial ageing of their populations at unprecedented rates is one reason why developed countries will be less economically dynamic. In 2050, approximately 30 percent of Americans, Canadians, Chinese and Europeans will be over 60, as will more than 40 percent of Japanese and South Koreans. Europe is expected to lose more than 40 percent of its prime working-age population, or 120 million workers by 2050, while its 60-and-older population will increase by 47 percent. In the United States, because of higher fertility and immigration, the working-age population will grow by 15 percent over the next four decades. Nonetheless, this represents a steep decline from its growth of 62 percent between 1950 and 2010. By 2050, the United States’ 60-and-older population will double. All this will have a dramatic impact on economic growth, health care and military strength in the developed world.
Economic growth in the West, Japan and Korea will also be hampered by a decline in the number of new consumers and new households.
For all these reasons, Goldstone expects that the annual economic growth rate of 2.5 percent experienced by the West until 2005 will slow down to 1.5 percent over the next four decades. In many developed countries, productivity is likely to decline as population ages. A large portion of this reduced economic growth will have to be diverted to pay for the medical bills and pensions of the growing elderly populations.
In contrast, fast-growing countries in Africa, Latin America, the Middle East and Southeast Asia will have exceptionally youthful populations. Today, nine out of ten children under the age of 15 live in developing countries. Many developing countries have few ways of providing employment to their young and fast-growing populations. They will be increasingly attracted to the labour markets of the ageing developed countries. Current levels of immigration from developing to developed countries are paltry compared to those that the forces of supply and demand might soon create.
The world is urbanizing to an unprecedented degree. In 1950, less than 30 percent of the world’s populations were urban. By 2050, more than 70 percent will be urban. Low-income countries in Asia and Africa are urbanizing especially rapidly, as agriculture becomes less labour intensive and as employment opportunities shift to the industrial and service sectors.
In his concluding remarks, Goldstone reminds us that definitions born of the Cold War are now obsolete, namely: First World – democratic industrialized countries; Second World – Communist industrialized countries; and Third World – developing countries. A better approach would be to consider a different three-world order with a new First World consisting of the ageing industrialized nations; a Second World comprising fast-growing and economically dynamic countries like Brazil, Iran, Mexico, Thailand, Turkey, Vietnam and China until 2030 [after 2030, China’s one-child policy will have produced significant ageing]; and a Third World of fast-growing, very young and increasingly urbanized countries with poor economies and often weak governments. To cope with the instability that will arise from the new Third World’s urbanization, economic strife and lawlessness, the new First World must build effective alliances with the growing powers of the new Second World and, together, reach out to Third World nations. Second World powers will be central to international security and cooperation.
These eclectically summarized points of Goldstone’s brilliant article confirm that no long-term investor can design a prudent, forward-looking and flexible asset structure program without understanding the economic and financial implications of these firmly entrenched demographic trends. Cordiant’s focus on private debt and equity investments in developing countries is based on such continuously updated understanding.