Tuesday, 30 June 2009

Interest rate decisions: What to consider...

Cees Bruggemans, Chief Economist of FNB, discusses the various factors that a central bank (such as the Reserve bank in South Africa) should consider when making interest rate decisions. He wrote the following article after the SA Reserve Bank to keep further interest rate cuts on hold earlier this month:

Interest rate decisions are not easy moments...

There are many aspects taken into account when deciding where to pitch interest rates. Given today’s fashions in the world at large the main considerations can be simply summarized and constitute perhaps a useful checklist for future occasions to signal rate changes.

The Taylor Rule, now about two decades old, tries to capture four thoughts. In addition, we also now have to take into account asset prices and risks to the forecast.

In terms of Taylor, firstly, any market-based capitalistic system with an active well-developed banking system at its core needs real interest rates to reflect the cost of money over time relative to generally changing price trends (inflation/deflation).

To discount the future to the present should cost something, if only to signal scarcity. This premium should be high enough to prevent excesses but low enough not to intimidate unduly. Similarly, saving resources in the present for the purpose of delayed consumption in the future should be worth a premium reward.

The Fed unofficially defines this real rate required as being 2% (for its intervention rate, our repo rate, over time). If banks maintain a 3.5% spread, a real prime rate of 5.5% comes into focus, something that we can observe over long periods of time in our own financial history.

Secondly, interest rates are one of the most important prices in the economy, with the exchange rate being the other major pivotal.

In an increasingly integrated world with free capital flows, a policymaker stands little change of controlling the exchange rate. Indeed, trying to do so (betting against market forces) can prove very costly.

For policymakers to influence the economy successfully, the preferred lever is short-term interest rates. Such policy interventions may at times be necessary as and when the economy starts to show signs of imbalances and disturbances, preventing optimal performance.

The central aim of policy in support of long-term growth is to maintain financial stability. To this end a stable real short-term interest rate is seen as anchoring the economy and expectations.

But things hardly ever remain stable. Shocks occur (from the outside) and human behaviour is temperamental (from the inside).

Both these forces have a way of deflecting economic growth from a stable potential trajectory (determined by long-run institutional features such as rate of fixed investment, supply of labour, rate of technological change, including qualitative changes in the labour force, regulatory limitations and policy interventions, for good or bad).

These same forces, and other influences, decide the extent to which prices are behaving, and any broad inflationary or deflationary tendencies.

Bearing all these aspects in mind, these many forces are on the loose daily, threatening the stability of real interest rates and thus the optimal growth trajectory, from time to time inviting policymakers to act and undertake course corrections.

Thus besides incorporating a real rate premium, interest rates should at least match (reflect/incorporate) the expected inflation rate to come.

In addition, there is embodied within Taylor the analysis and proposed treatment of two major possible deviations from stability inviting policymaker activism, namely deviating output tendencies (over- or undershooting potential growth) and changing inflationary conditions (over- or undershooting an optimal price trend).

Thus, thirdly, Taylor interrogates the inflationary condition. Is the inflation condition stable, near the ideal policy norm (2% in most industrial countries today, but in our instance still pitched at 3%-6%)?

Or is the inflation trend deviating, and changing future expectations, reinforcing this change and starting to influence the economic growth trajectory as well?

If deviating, and creating a so-called ‘inflation gap’, Taylor suggests that in order to dampen accelerating inflation behaviour beyond the policy norm, nominal interest rates should be raised sufficiently to undo such expected inflation acceleration (and its expectation).

This is done by ensuring that the real interest rate is being maintained. In other words, the expected rise in inflation over and above the policy norm is matched with a rise in nominal short-term interest rates, thereby exerting countervailing pressure to the disturbing influences emitted by the accelerating inflation signal, inviting it to subside back towards the policy norm.

Fourthly, the condition of the economy may also become disturbed. Growth may be under- or overshooting its potential, best described by an ‘output gap’ observed by comparing actual resource utilization with potential resource utilisation (a combination of labour force and physical production capacity utilisation).

To the extent that the economy is underperforming its potential, interest rates may be lowered temporarily. Similarly, if the economy is outperforming potential it could overheat, inviting temporary interest rate increases to temper such excess demand on resources.

So far, we have established an ideal policy setting, in which the economy is progressing along its potential growth trajectory accompanied by appropriately limited inflation reinforcing this ideal growth condition.

Guiding this condition is an appropriate real interest rate regime. If deviations occur within the inflation and/or the growth condition, countervailing action can be taken to raise, lower or keep nominal interest rates largely unchanged.

Over the years, however, refinements to this simple Taylor guide became necessary. One concerned asset prices. The other concerned risk (that things may not work out as thought).

Asset prices also can have a way of fundamentally influencing the condition shaping the economy’s growth trajectory. Exuberantly rising asset prices can invite excessive risk taking and can lead to overheated growth conditions because rising asset prices generate wealth effects that boost consumption expenditure. Similarly declining or excessively depressed and stagnant financial asset prices may inhibit risk-taking, thereby creating a drag effect on actual economic growth through negative wealth effects.

Whereas it is extremely difficult to judge market price signals as to whether asset prices are acting excessively exuberantly or depressed, it is nonetheless accepted today that there can be feedback loops to inflation and growth over time.

Lastly, every central bank is confronted with risk, that its readings of the future turn out to be wrong (wrong assumptions), or that new developments, unforeseen or otherwise, cause a different outcome from the one presumed in the policy stance at any moment in time.

As interest rate changes take up to two years to fully work in on the economy, central banks face potentially a two year window of risky uncertainty in which their original actions may or may not be derailed.

Therefore, after taking into account current views of the likely inflation and output gaps expected over the next two years, and the likely behaviour of asset prices (especially houses, equities and bonds), there comes a final moment where the central bank should second-guess its own main assumptions and bias.

If there is a clear risk formulation of potentially being wrong in a particular direction, this may encourage insurance being taken out in pitching the interest rate decision accordingly with some bias built in (out of safety, just in case).

The Americans call this over-engineering, but such safety precautions are taken for good reason. One rarely can foresee all future mishap and surprises, and to the extent that there is disagreement about the likely course of events, such sense of risk should be incorporated in any decision to a sensible degree.

One is now ready to take the plunge daily and set interest rates.

Because certain things change only slowly, and one does not want to confuse market participants unduly with frequent policy changes, a certain time lapse is advisable between policy deliberations about any course changes to be made.

Today’s decision probably had a few simple ingredients.

The CPI inflation rate is now 8% and is forecast to decline towards 5% later next year. The inflation gap is at least 3.5% (the difference between 8% and the midrange of the 3%-6% CPI target range).

Meanwhile the economy is in serious recession, this year probably registering 1.5% decline in GDP, even though the potential growth rate is closer to 3.5%.

Depending on how one wants to calculate potential relative to actual GDP, the output gap could already be in the 4% to 5% range across the broader economy.

Asset prices remain currently depressed or are still declining. Equity prices are at least 35% below their (overheated) peak of last year, though stabilizing with an upward bias, while price/earnings multiples today seem to be more realistically priced for the long term.

House prices will likely fall 10% in nominal terms peak-to-trough, but again from probably overheated levels, with at least another five years of eroding real house prices ahead of us.

Risk today mainly focuses on the depth of the recession and output gap (it could get somewhat bigger than expected), implying also downward pressure on inflation.

But core inflation also shows evidence of rigidity. Food price inflation is slow in coming down. Services inflation is high and sticky. Wage and salary trends are typically backward-looking, seeking compensation for recent inflation surges, besides demanding any premiums for reasons of skill scarcity, political influence or simply union size and strength.

In addition, there are future commodity price surges to worry about, oil having again risen by half this year and markets generally being worried about current central bank actions and future inflation playouts (such worries creating premiums, whether warranted or not).

Summarising all this requires some appeal to the Wisdom of Solomon. The main idea, though, is that the real interest rate premium of 5.5% is sacrosanct. We are expecting a 5% CPI inflation rate next year which needs to be matched by interest rates today.

That gives us a minimum prime of 10.5% before deviations and risks are to be addressed.

Here we have at least a 3.5% positive inflation gap and a 4%-5% negative output gap. Adding up and dividing by two (as is done in the real world) gives us a small negative 0.5% policy activism requirement, lowering the intended prime to 10%.

Asset prices look low and depressed and are possibly exposed to further decline, though there seems to be an upward bias globally. Yet when these current asset values are set off against recent overheated peaks, and taking into account cyclical behaviour and likely future income streams, these asset values don’t look overly out of place. Perhaps a slight accommodation bias may be warranted, but let us not overstate our case.

That leaves risk, all of it negative on the inflation side (as mentioned) but also on the output side, with the growth and employment loss possibly turning out bigger than expected, still undershooting over the coming year.

Is all that risk worth a 1% premium, the targeted prime rate rising to 11%, matching the ruling prime interest rate and warranting no change to today’s policy stance, with perhaps a rain cheque taken to look again at the situation at the next MPC meeting in August?

Or should we build in only a 0.5% risk premium, boosting the target prime rate back to only 10.5% and warranting a 0.5% rate cut from the ruling 11% prime to 10.5% today?

As to future movements in interest rates, keep track of the real rate at 5.5%, the CPI inflation 18 months out (how will it deviate from 5%?), the current inflation rate (it will fall from the current 8%, reducing the size of the inflation gap), the output gap (it will eventually stabilize and then narrow as recovery proceeds, but how fast will this in fact happen?), asset price behaviour (stabilization and gradual recovery, but nothing that needs more policy support?) and risks to the SARB policy forecast in every dimension.

Thursday, 25 June 2009

No more Great Depression

Rex Nutting of MarketWatch reports that top U.S. monetary-policy makers at the Federal Reserve are breathing a big sigh of relief in so far economic conditions at the moment indicate that the second coming of the Great Depression has been averted.

In a statement Wednesday following its two-day closed-door meeting, the Federal Open Market Committee took a first big step toward normalizing monetary policy. For the first time in months, the FOMC statement was largely upbeat, at least about the economic outlook. The committee had no new lending or credit-easing programs to announce, and most of what it had to say about the economy was positive.
The committee noted the obvious: "The pace of economic contraction is slowing." After the worst six months for the economy in more than 50 years, the pain is easing. But officials were quick to caution that "economic activity is likely to remain weak for some time."
It's no time to start raising rates, or remove the sizable props that have been holding the economy up. Support from the Fed is still needed. Perhaps the biggest change in the statement was the removal of any warning about the threat of deflation. The FOMC acknowledged the rise in energy and commodity prices but stuck to its contention that "substantial resource slack" would keep inflation "subdued for some time."

The FOMC took a big first step toward a first rate hike by erasing earlier comments about deflation. The tentative good news on growth needs to be followed up with actual growth before the Fed will contemplate rate hikes, or reverse the credit-easing policies that have flooded the banking system with $1 trillion in idle reserves.

Wednesday, 24 June 2009

The Credit Crunch spared no one....

The financial crisis led to a major downturn in the real economy. Unemployment is on the rise and households are under severe pressure to survive the crisis. Their retirement savings and net wealth have taken a turn for the worse. That much we know by glancing at the latest economic reports. But what about the rich?
Financial Times reported on the latest World Wealth Report compiled by Merrill Lynch and Capgemini:
The ranks of the world’s super-rich have been shredded by the credit crunch, putting paid to the theory that the wealthy are better at holding on to their money. The global population of “ultra high net worth individuals” – defined as those with at least $30m to invest – shrank by nearly 25 per cent in 2008. That leaves just 78,000 left worldwide after a year of bank crises, government bail-outs and stock market routs.
High net worth individuals – worth a mere $1m, excluding their homes – fared poorly as well, seeing around $8,000bn shaved off their bank balances.
The unprecedented declines wiped out two years of robust growth, reducing both the total number of rich people and their wealth to levels last seen in 2005.
“As markets recover, high net worth individuals will have the flexibility to readjust their strategies and reinvest in new, developing opportunities along the way.” China, unsurprisingly, is expected to drive much of this expansion. The world’s fastest-growing major economy surpassed the UK for the first time in the report’s rankings of the total number of rich people by country.
There are now an estimated 364,000 dollar millionaires in China, the fourth largest population in the world. Hong Kong, by contrast, lost 61 per cent of its millionaires in 2008, with India, Russia and the UK also suffering steep declines.
The economic uncertainty also took a hefty bite out of the luxury good markets. Perhaps the report’s most telling statistic? The number of used private jets available for sale worldwide hit an all-time high last November.

A glimmer of hope...

In recent months we have been bombarded with a spate of bad or negative economic news as the fallout from the global financial crisis became real. Now today The Organisation for Economic Co-operation and Development (OECD) has revised its World Economic Outlook upwards for the first time in two years and concludes that the global economic downturn is nearing a bottom.
Financial Times reported as follows:

In its report the OECD revised its growth forecast for 2009 to a decline of 4.1 per cent, down from a contraction of 4.3 per cent. It said that in 2010, it expects very modest growth where earlier it expected none.
“OECD activity now looks to be approaching its nadir, following the deepest decline in post-war history,” the report said, adding caveats that the recovery is “likely to be both weak and fragile for some time”. Moreover, it warned that the negative economic and social consequences of the crisis would be long-lasting.

“Yet, it could have been worse. Thanks to a strong economic policy effort an even darker scenario seems to have been avoided,” the OECD concluded.
Equally, financial conditions are likely to remain constrained for some time and the actual bottom of the recession is will probably not be reached until the second half of this year. Moreover, unemployment within the OECD will not peak until next year.
However, the OECD said the risks to growth have become more balanced, thanks to massive policy intervention on the fiscal and monetary fronts and quick efforts to stabilise financial institutions.
Already, growth appears to be under way in most non-OECD countries, especially China. There are also signs that the contraction in the US may be near the bottom as well as signals that Japan may be coming to the end of its trade-induced contraction.
The report cautions governments against sudden withdrawal of fiscal stimulus, a likely response given the build-up of apparently unsustainable levels of public borrowing. “However, it is necessary to balance concerns about fiscal sustainability with the need to avoid an overly rapid phase-out of fiscal support,” the report said.

It noted that some countries including Germany
, Canada and some Nordic countries may have scope to increase fiscal stimulus because they have relatively low levels of debt. But Japan, Italy, Greece, Iceland and Ireland have no such leeway.

The drag on output from the sharp fall in housing activity across all economies should peak this year and house prices are falling in all OECD countries for which there is data, except Switzerland, the report noted. The report pointed to evidence across the OECD that the contraction phase of past house price cycles is typically five years, and that the drag on consumption from falling housing values are likely to be most marked in countries where the ability to extract cash from a rise in house prices was greatest.
Meanwhile, the fall in world trade seems to have moderated after the collapse in the fourth quarter of 2008 and first quarter of 2009. Nonetheless, OECD exports and imports have most likely been falling at double-digit rates in the second quarter, the decline being less pronounced for the non-OECD area.
For 2009, world trade, in real terms including non-OECD states, is expected to contract by 26 per cent and recover modestly in 2010 to expand by 2 per cent.

Tuesday, 23 June 2009

What we know and don't know

How will history judge the current economic turmoil? For sure, there are a lot of unknowns how the economic and political order of the world will develop from the current crisis, yet there are some aspects we do know enough about to make convincing statements and predictions. Martin Wolf, chief economics commentator for the Financial Times, recently wrote the following article wherein he summarises the major trends we have seen so far:

On the economy, we already know five important things. First, when the US catches pneumonia, everybody falls seriously ill. Second, this is the most severe economic crisis since the 1930s. Third, the crisis is global, with a particularly severe impact on countries that specialised in exports of manufactured goods or that relied on net imports of capital. Fourth, policymakers have thrown the most aggressive fiscal and monetary stimuli and financial rescues ever seen at this crisis. Finally, this effort has brought some success: confidence is returning, the global economy is “around the inflection point” - the economy is now declining at a declining rate.
We can also guess that the US will lead the recovery. The US is again the advanced world’s most Keynesian country. We can guess, too, that China, with its massive stimulus package, will be the most successful economy in the world.
Unfortunately, there are at least three big things we cannot know. How far will exceptional levels of indebtedness and falling net worth generate a sustained increase in the desired household savings of erstwhile high-spending consumers? How long can current fiscal deficits continue before markets demand higher compensation for risk? Can central banks engineer a non-inflationary exit from unconventional policies?

On finance, confidence is returning, with spreads between safe and risky assets declining to less abnormal levels and a (modest) recovery in markets. The US administration has given its banking system a certificate of reasonable health. But the balance sheets of the financial sector have exploded in recent decades and the solvency of debtors is impaired.
We can guess that finance will make a recovery in the years ahead. We can guess, too, that its glory days are behind it for decades, at least in the west. What we do not know is how far the “deleveraging” and consequent balance-sheet deflation in the economy will go. We also do not know how successfully the financial sector will see off attempts to impose a more effective regulatory regime.
What about the future of capitalism? It will survive. The commitment of both China and India to a market economy has not altered. People on the free-market side would insist the failure should be laid more at the door of regulators than of markets. There is great truth in this: banks are, after all, the most regulated of financial institutions. But this argument will fail politically. The willingness to trust the free play of market forces in finance has been damaged.
We can guess, therefore, that the age of a hegemonic model of the market economy is past. Countries will, as they have always done, adapt the market economy to their own traditions. But they will do so more confidently.
Less clear are the implications for globalisation. We know that the massive injection of government funds has partially “deglobalised” finance, at great cost to emerging countries. We know, too, that government intervention in industry has a strong nationalist tinge. We know, as well, that few political leaders are prepared to go out on a limb for free trade.
Most emerging countries will conclude that accumulating massive foreign currency reserves and limiting current account deficits is a sound strategy. This is likely to generate another round of destabilising global “imbalances”.

The state, meanwhile, is back, but it is also looking ever more bankrupt. Ratios of public sector debt to gross domestic product seem likely to double in many advanced countries: the fiscal impact of a big financial crisis can, we have been reminded, be as costly as a large war.
This, then, is a disaster that governments of slow-growing advanced economies cannot afford to see repeated in a generation. The state is back, therefore, but it will be the state as intrusive busybody, not big spender.
Last but not least, what does the crisis mean for the global political order? Here we know three important things. The first is that the belief that the west at least knew how to manage a sophisticated financial system has perished. The crisis has damaged the prestige of the US, in particular, pretty badly, although the tone of the new president has certainly helped. The second is that emerging countries and, above all, China are now central players, as was shown in the decision to have two seminal meetings of the Group of 20 leading nations at head of government level. The third is that efforts are being made to refurbish global governance, notably in the increased resources being given to the International Monetary Fund and discussion of changing country weights within it.
We can still only guess at how radical the changes in the global political order will turn out to be. The relationship between the US and China will become more central, with India waiting in the wings. The relative economic weight and power of the Asian giants seems sure to rise. Europe, meanwhile, is not having a good crisis. Its economy and financial system have proved far more vulnerable than many expected.
What then is the bottom line? My guess is that this crisis accelerated some trends and has proved others – particularly those in credit and debt – unsustainable. It has damaged the reputation of economics. It will leave a bitter legacy for the world.
To paraphrase what people said on the death of kings: “Capitalism is dead; long live capitalism.”

Thursday, 18 June 2009

How to regulate the financial markets...

George Soros is an astute investor. To discard his sound advice is done at one's own peril. Recently he wrote a piece in the Financial Times how he thinks the financial industry should be regulated.

I am not an advocate of too much regulation. Having gone too far in deregulating – which contributed to the current crisis – we must resist the temptation to go too far in the opposite direction. While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences, therefore regulations should be kept to a minimum.
Three principles should guide reform. First, since markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan, the former chairman of the Federal Reserve, and others have expressly refused that responsibility.
If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually recalibrate to correct their mistakes.
Second, to control asset bubbles it is not enough to control the money supply; we must also control the availability of credit. This cannot be done with monetary tools alone – we must also use credit controls such as margin requirements and minimum capital requirements.
Currently these tend to be fixed irrespective of the market’s mood. Part of the authorities’ job is to counteract these moods. Margin and minimum capital requirements should be adjusted to suit market conditions. Regulators should vary the loan-to-value ratio on commercial and residential mortgages for risk-weighting purposes to forestall real estate bubbles.

Third, we must reconceptualise the meaning of market risk. The efficient market hypothesis postulates that markets tend towards equilibrium and deviations occur in a random fashion; moreover, markets are supposed to function without any discontinuity in the sequence of prices. Under these conditions market risks can be equated with the risks affecting individual market participants. As long as they manage their risks properly, regulators ought to be happy.
But the efficient market hypothesis is unrealistic. Markets are subject to imbalances that individual participants may ignore if they think they can liquidate their positions. Regulators cannot ignore these imbalances. If too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, a collapse. In that case the authorities may have to come to the rescue. That means that there is systemic risk in the market in addition to the risks most market participants perceived prior to the crisis.
The securitisation of mortgages added a new dimension of systemic risk. Financial engineers claimed they were reducing risks through geographic diversification: in fact they were increasing them by creating an agency problem. The agents were more interested in maximising fee income than in protecting the interests of bondholders. That is the verity that was ignored by regulators and market participants alike.
Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogeneous, standardised and transparent.

Custom-made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. I have in mind credit default swaps. Consider the recent bankruptcy of General Motors.
Some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else’s life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed.

A new era of regulation...

Pres. Barack Obama announced on Wednesday fundamental changes to the regulatory environment in which U.S. businesses operate in the financial industry. Financial Times reported as follows:
Big US companies ranging from Wall Street banks to insurers, investment groups and General Electric on Wednesday faced fundamental changes in the business environment as President Barack Obama proposed what could be the biggest regulatory revamp since the 1930s.
The plan, which still must win congressional approval, includes not only traditional lenders, but any company with significant financial operations, such as GE.
Remuneration and profits at Wall Street and beyond could be hit by the reforms, which would see the administration attempt to tighten capital and leverage rules at global banks.
The administration sees the new rules as a rejection of Alan Greenspan light-touch approach.

“A culture of irresponsibility took root from Wall Street to Washington to Main Street,” said Mr Obama on Wednesday. Mr Obama said he did not undertake intervention into the economy lightly. “We are called upon to recognise that the free market is the most powerful generative force for our prosperity – but it is not a free licence to ignore the consequences of our actions,” he said.

Corporate experts said the extension of the Fed’s powers would change the playing field for companies with finance operations, including Ford and General Motors, and others. It also could affect the strategies of companies such as retailer Wal-Mart, which had considered entering the financial sector.
Large private equity groups and hedge funds such as Blackstone and Fortress could also come under the Fed’s purview if their size and importance to the economy continues to grow.
The proposals attempt to bring transparency to previously opaque areas of financial markets, such as over-the-counter derivatives trading, and give the government unprecedented power to seize failing institutions.
The new powers are intended as a response to the authorities’ inability to deal with the failure of large financial companies, such as AIG and Lehman Brothers, which were systemically important but remained outside the purview of the main US banking regulators.

Wednesday, 17 June 2009

Only a handful of winners in the long run

Every year the top-performing investment funds are crowned for their recent successes. What do these laurels actually mean for the ordinary investor? Should you invest or switch your investments to these star performing funds? The latest research indicates that this is not necessarily such a great idea.

Mark Hilbert wrote the following article, The Prescient are Few, appearing in The New York Times on July 13, 2008:

How many mutual fund managers can consistently pick stocks that outperform the broad stock market averages — as opposed to just being lucky now and then?
Countless studies have addressed this question, and have concluded that very few managers have the ability to beat the market over the long term. Nevertheless, researchers have been unable to agree on how small that minority really is, and on whether it makes sense for investors to try to beat the market by buying shares of actively managed mutual funds.
A new study builds on this research by applying a sensitive statistical test borrowed from outside the investment world. It comes to a rather sad conclusion: There was once a small number of fund managers with genuine market-beating abilities, as judged by having past performance so good that their records could not be attributed to luck alone. But virtually none remain today. Index funds are the only rational alternative for almost all mutual fund investors, according to the study’s findings.
The study, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas,” has been circulating for over a year in academic circles. The statistical test featured in the study is known as the “False Discovery Rate,” and is used in fields as diverse as computational biology and astronomy. In effect, the method is designed to simultaneously avoid false positives and false negatives — in other words, conclusions that something is statistically significant when it is entirely random, and the reverse.
The researchers applied the method to a database of actively managed domestic equity mutual funds from the beginning of 1975 through 2006. To ensure that their results were not biased by excluding funds that have gone out of business over the years, they included both active and defunct funds. They excluded any fund with less than five years of performance history. All told, the database contained almost 2,100 funds.

The researchers found a marked decline over the last two decades in the number of fund managers able to pass the False Discovery Rate test. If they had focused only on managers running funds in 1990 and their records through that year, for example, the researchers would have concluded that 14.4 percent of managers had genuine stock-picking ability. But when analyzing their entire fund sample, with records through 2006, this proportion was just 0.6 percent — statistically indistinguishable from zero, according to the researchers.
This does not mean that no mutual funds have beaten the market in recent years, Professor Russ Wermers said. Some have done so repeatedly over periods as short as a year or two. But, he added, “the number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives” — just lucky, in other words.
Professor Wermers says he was surprised by how rare stock-picking skill has become. He had “generally been positive about the existence of fund manager ability,” he said, but these new results have been a “real shocker.”
Why the decline? Professor Wermers says he and his co-authors suspect various causes. One is high fees and expenses. The researchers’ tests found that, on a pre-expense basis, 9.6 percent of mutual fund managers in 2006 showed genuine market-beating ability — far higher than the 0.6 percent after expenses were taken into account. This suggests that one in 10 managers may still have market-beating ability. It’s just that they can’t come out ahead after all their funds’ fees and expenses are paid.
Another possible factor is that many skilled managers have gone to the hedge fund world. Yet a third potential reason is that the market has become more efficient, so it’s harder to identify undervalued or overvalued stocks. Whatever the causes, the investment implications of the study are the same: buy and hold an index fund benchmarked to the broad stock market.
Professor Wermers says his advice has evolved significantly as a result of this study. Until now, he says, he wouldn’t have tried to discourage a sophisticated investor from trying to pick a mutual fund that would outperform the market. Now, he says, “it seems almost hopeless.”

Monday, 15 June 2009

Is optimism the same as realism?

Wolfgang Munchau, columnist for the Financial Times, wrote in a recent article that one should wake against some complacency that the financial and economic crisis will give way to a speedy recovery process, which financial markets may have started to discount in recent months.
Last week, the green shoots shrivelled. In South Korea, China and Germany, exports were declining once again. In the US, the Federal Reserve’s Beige Book said “economic conditions remained weak or deteriorated further during the period from mid-April through May”.
The March signs of revival turned out to be little more than a technical inventory correction, with no change in the underlying trend. The world economy is still contracting, though perhaps not quite as fast as at the start of the year.
Global industrial output is still on the same trajectory as it was during 1930. The only question is whether we can avoid 1931 and 1932. The answer is yes, but on conditions that seem increasingly implausible if we extrapolate current policies. We can avoid calamity if monetary and fiscal policies remain supportive throughout the duration of this crisis, if we fix the banking system and if we impose regulations to constrain a resurgent financial sector. We also have to be lucky to avoid another round of market turbulence in the near future.
In other words ... the answer may well be no. Central banks and governments therefore risk moving too swiftly out of a recession-mode strategy. When the president of the Bundesbank, Axel Weber, publicly talks at this time about how to communicate a rise in interest rates, it tells me that the danger of a premature exit, at least in Europe, is clear and present.

Nobody is solving the toxic asset and recapitalisation problems of the banks. Financial regulation does not seem to be extending much beyond populist pseudo-measures on tax havens. Plus there is still financial meltdown potential in the system. Latvia, for example, is a ticking time bomb.
So at this point, I see the chances as roughly even between a global slump and a return to quasi-stagnation. What is so galling about this scenario is that it is avoidable. The central banks took the right decisions. But the political reaction has been near-catastrophic almost everywhere.
Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world.
Even if the US were to generate some growth, as is likely after this summer, it would not benefit global exporters; China may be one of the fastest growing economies in the world, but it is only about half as large as the eurozone in dollar terms. While Chinese investments are up by more than 30 per cent from last year alone, imports are down 25 per cent. All this hype about decoupling and China pulling the world out of recession is baloney. The data tell us that China’s exports and imports are both falling, and that imports are falling faster.

As everybody expects the others to move first, nobody ends up moving. In the meantime, the problems grow worse. US house prices, which are down by a little over 30 per cent from their peak, still have some way to fall. Until the US housing market hits rock bottom, perhaps sometime in 2010, there is no chance of a recovery in the securitisation market, without which there may not be sufficient credit growth.
As the recession continues, the number of personal and corporate insolvencies will rise, which in turn will aggravate the problems of the banking sector. I am not surprised that the Bundesbank’s Mr Weber resists the publication of stress tests for the banking system. It would show that the German banking system was insolvent – and that bad and potentially bad assets were equivalent to about one-third of gross domestic product.
This is why last week’s news about the withering green shoots is so important. It tells us that the non-strategy of waiting until things get better is not working. The March signs of life reinforced complacency. Optimism will get us out of this crisis only if it is founded in reality.

Tuesday, 9 June 2009

Getting rid of TARP...

Financial Times reported today that the US Treasury has announced that it would allow 10 banks to repay government aid because they raised sufficient capital.

The Treasury will recoup $68bn, much more than it had originally expected, if the banks choose to return the full amounts that they received. The swift return of the funds is a sign that some stability has returned to a sector that was stricken last year and could restore confidence in US banks.
“These repayments are an encouraging sign of financial repair, but we still have work to do,” said Tim Geithner, US Treasury secretary, said in a statement.
The Treasury did not reveal the names of the banks that are now eligible to begin the first wave of repayment. But people familiar with the matter said that the nine banks, all of which passed last month’s government stress tests, included JPMorgan, American Express andGoldman Sachs, plus Morgan Stanley, which had a capital shortfall. Northern Trust, BB&T, State Street, US Bancorp and Capital One Financial will also make repayments, according to people familiar with the matter. Morgan Stanley said it would be repaying its $10bn with “an attractive return for taxpayers.”

Friday, 5 June 2009

U.S. job losses continue, but at a slower rate

Unemployment figures are the key how deep the current global recession will be. Even if there are early signs of economic recovery, continued job losses will change the sentiment and confidence to dark pessimism.
Financial Times reported on the latest U.S. unemployment data as follows:
The US economy shed 345,000 jobs in May, bringing the unemployment rate to a 26-year high of 9.4 per cent, but offering a clear sign that the pace of job cuts is slowing.
The latest non-farm payrolls data were much better than the drop of 525,000 that economists were expecting and was nearly half of the average monthly decline during the last six months. Although the number remains painfully high, it is a sharp improvement from April’s revised 504,000 and offers hope that the economy’s free-fall could be ending.
Much of the May improvement was driven by a rise in education and health service jobs. The manufacturing sector continued to be hit hardest, shedding 156,000 workers, while construction lost 59,000 jobs - nearly half of what was lost in April - and professional and business services lost 51,000.
Since the recession began in December 2007, 7m jobs have been lost and the unemployment rate has climbed by 4.5 percentage points, leaving 14.5m Americans without jobs. Companies have been forced to slash their payrolls to cut costs in the face of falling demand for their goods and services.

Friday’s figures still provide a reminder that the stricken labour force will likely have a longer road to recovery than other parts of the economy. Movements in the labour market tend to trail the rest of the economy by several quarters, and economists predict more job losses and rising unemployment to come.
Last month the Congressional Budget Office said that while the US economy is likely to start growing again in the second half of this year, unemployment is expected to keep rising through 2010 to peak at more than 10 per cent. Barack Obama, US president, has argued that the $787bn stimulus bill will save or create 3.5m jobs by the end of next year.

A batch of recent indicators and a healthier stock market have fostered a new sense of optimism that the US economy is beginning to emerge from the deepest downturn since the Great Depression.

Wednesday, 3 June 2009

A more efficient market index?

Fundamental indexation has hit the investment community a year or two ago with real excitement and huge expectations. But thus far the performances of funds based on this methodology (securities are weighted according to their fundamental (economical) attributes instead of their market cap) have been mixed relative to the conventional indexation strategy.
John Spence of MarketWatch wrote the following story:
With a track record spanning about three years and including a brutal bear market, a new breed of index-based funds is showing mixed results, and the debate about them continues.

The backers of this new style of investing -- often called fundamental indexing -- contend that mutual funds and exchange-traded funds based on the Standard & Poor's 500-stock index , at the core of millions of small investors' portfolios, are flawed. The problem, they say, is that the S&P 500 can become top-heavy with pricey shares by using companies' market value as a way to weight stocks.
Their innovation: funds based on indexes that weight stocks by factors such as high dividend yields and low share-price-to-earnings ratios. They say these funds are less risky and offer a better chance for long-term outperformance.

So how have the ETFs that follow this approach fared?
PowerShares FTSE RAFI US 1000 Portfolio ETF averaged a negative return of 6.7% a year since its December 2005 launch through May 28, versus a negative 7.1%-a-year return for SPDR S&P 500 ETF for the period, according to Morningstar Inc.
For the past 12 months, it returned a negative 30.4%, versus a negative 32.8% for its S&P 500 rival.
WisdomTree LargeCap Dividend Fund has had a tougher time. From its June 2006 launch through May 28, it averaged a negative 9.9%-a-year return; the S&P 500 ETF lost 8.4% a year.

Rob Arnott, founder of Research Affiliates LLC, which created the index used by the PowerShares fund, says the market often values stocks incorrectly, so the goal "is to break the link between a stock's price and its weight." He favors weighting stocks by things like book value, cash flow, sales and dividends.

Research Affiliates readjusts its index annually, shifting the ETF more heavily into sectors where fundamentals are strong but stock prices have fallen. This has the practical effect of loading the index with "whatever stocks are most loathed" and lightening up on "whatever stocks are most beloved," so that investors can benefit "when market mood turns, as it always does," Arnott said.

The most recent rebalancing, in late March, boosted the PowerShares ETF's exposure to financial stocks to about 27% or so from 13% or so, said Jason Hsu, Research Affiliates' chief investment officer. The ETF benefited from the rally in financial stocks in April and May.

Because banks historically have been big dividend payers, the WisdomTree ETF's dividend-heavy focus exposed it to financial stocks during the worst of last year's financial crisis. Even so, the ETF bested the S&P 500 ETF for calendar year 2008, down 35% versus 36.7%.
"Investors need to keep their eye on long-term performance" of at least three years, said Luciano Siracusano, chief investment strategist at WisdomTree Investments Inc. .

In general, WisdomTree's earnings-focused ETFs have fared better than its dividend-weighted ones over the past two years, Siracusano said.

The firm's international dividend ETFs also have performed better, mainly because more international companies pay dividends, so there is a bigger subset from which to choose, he says. To accommodate investors in the U.S. who don't want to bet heavily on the financial sector, the firm recently restructured two of its 34 dividend ETFs to exclude financial shares, he said.

At Vanguard Group Inc., which decades ago pioneered indexed investing for the masses based on the S&P 500, Chief Investment Officer Gus Sauter remains a skeptic of the new methodology. He said it gives a tilt to "value" investing, the hunt for shares that are undervalued.

"My view is that fundamental indexing is a triumph of marketing," he said. "It's a midcap value fund dressed up as something different."

Fundamentals-based indexing beat the S&P 500 during the bear market of 1973 and 1974, and after the dot-com bust of 2000-02, Sauter noted, but not during the tech-stock rally of the late 1990s.

Hsu and WisdomTree President Bruce Lavine say fundamental-indexing strategies aren't designed to outperform in speculative markets. They perform well in other environments, however, especially after bubbles burst, Hsu added.

As measured by money under management, the revolutionaries trail. The PowerShares ETF had about $434 million recently, and the WisdomTree LargeCap Dividend had about $350 million -- compared with more than $60 billion in the S&P 500 ETF

Monday, 1 June 2009

The beginning of a new bull market? No, leading investors don't think so

Barclays Capital found in a recent survey among leading decision-makers and investors that most are sceptical that the current rally is sustainable.

Financial Times reported the following story:

The majority of the world’s leading investors do not believe the recent strong performance of stocks and other risky assets is sustainable. The FTSE All World equities index has surged more than 60 per cent since hitting a low for the year in March.

But Barclays Capital has revealed that just 17.5 per cent of the 605 investors interviewed for its quarterly FX investor sentiment survey – including central banks, asset managers, hedge funds and international corporate customers – think risky assets have further to rise.

This is one aspect of a generally gloomy outlook for the global economy, which undermines optimism that “green shoots” of recovery are starting to emerge.
Just 4.5 per cent of respondents believe the trajectory of the global economy over the next year will be “V-shaped” – indicating weakness followed by a sharp recovery.

The majority, 69 per cent, believe the path of the global economy will be either “U-shaped” or “W-shaped”, meaning that growth will remain weak for some time before a gradual recovery begins, or that a recovery will prove temporary and renewed weakness will set in.

Six out of every 10 respondents believed that the recent rise in equities is a “bear market rally”, indicating that global investors still have a large share of their funds parked on the sidelines in cash. The survey revealed that 91 per cent of investors were running positions that were “light” or “average” in terms of their risk limit or capacity. This leaves just 9 per cent whose positions are “large” or “at limit”.

Investors are most optimistic on Asia’s prospects, with 57.5 per cent believing emerging market currencies in the region will outperform those in Latin America and eastern Europe in the next three months.