The Retirement Lottery

Thursday, March 4th, 2010

This article is a guest contribution by Neils Jensen, Absolute Return Partners LLP.

“What you as the City of London have done for financial services, we as a government intend to do for the economy as a whole.”

-  Gordon Brown speaking at Mansion House in June 2002.

I was born in 1959, right at the tail end of the baby boom. I consider myself less fortunate than my parents, both of whom were born in 1935, when Fred Perry won at Wimbledon and President Roosevelt pushed through new social security legislation in the US as part of his so-called New Deal (some things don’t die easily!).

My parents are no different from most other parents. Entirely consistent with Modigliani’s life-cycle hypothesis (which I wrote about in the October 2009 Absolute Return Letter - see the link here), my parents didn’t really start saving for their retirement until they reached their mid 40s. That effectively gave my father a good 20 years to ensure that he and my mum can enjoy their retirement without worrying too much about the balance between in- and outgoings.

Chart 1: Return on global equities since January 1970

My parents were lucky, because they started saving in earnest in the early 1980s, at the outset of what would become the biggest bull market of all times and, by the time the bull market came to an end in 2000, they were home and dry. In that 20 year period, a global equity portfolio generated an annualised real return of just over 13% in dollar terms, equivalent to a total inflation-adjusted return of about 850%!

Meanwhile, aggressive advertising feeds us with the fallacy that, as long as you invest for the long term, equities will deliver solid returns (see chart 1 for ‘evidence’ of the long term positive trend in global equity markets). Yes, provided your investment horizon is 30 or 40 years, that may indeed be the case but, as I have already pointed out, most of us have only got 20 years to do the job.

However, what the sales people don’t tell us is that it absolutely matters when you invest and what the rate of inflation is whilst being invested. Take a quick look at chart 2 where I have made the appropriate adjustments. Suddenly, the ten year return (since April 2000) does not look that attractive: -25% or thereabouts in real terms. Ten years is half a life time of investments for most people. No wonder many investors are deeply frustrated.

Read the complete letter here.

Tags: Absolute Return, Baby Boom, Baby Boomers, City Of London, Dollar Terms, Fred Perry, Global Equities, Global Equity, Gordon Brown, Last Decade, Life Cycle Hypothesis, Mansion House, Mid 40s, Modigliani, Neils, New Deal, New Social Security, President Roosevelt, Relative Comfort, Social Security Legislation
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If PIIGS Could Fly

Tuesday, February 2nd, 2010

This article is a guest posting from Niels Jensen*, Absolute Return Partners.

“A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy…”

Alexander Fraser Tytler, Scottish lawyer and writer, 1770

It was always naïve to believe that a crisis so deep and profound was going to go away with a whimper; however, an increase of more than 50% in global equity prices can be very seductive, and nine months of virtually uninterrupted gains have led many to believe that the problems of 20 08-09 are now largely behind us.

Well, not quite everybody. Friend and business partner John Mauldin remains a sceptic. I have had the pleasure of travelling across Europe with John over the past week or so and, as the week progressed, my mood swung decisively towards a state where Prozac would probably be the most appropriate remedy.

Now, John and I do not agree on absolutely everything. For example, I believe – and have believed for a while – that he is too bearish on equities. But, before we go there, allow me to share with you the essence of John’s views which can be summed up quite nicely by two charts, courtesy of BCA Research.

Chart 1: De-leveraging has a long way to go in the US

Source: BCA Research

In John’s opinion – and I do not disagree – we are still only in the second or third innings of the de-leveraging process (chart 1). Years of excessive debt accumulation cannot be reversed in 18 months, and it will take at least another 5-6 years to play out, possibly longer.

Chart 2: US Government borrowing has replaced private borrowing

Source: BCA Research

The other part of John’s argument – and again it is hard to disagree – is that it remains an open question how much de-leveraging has in fact taken place. As you can see from chart 2, US sovereign debt has…

Read the complete article here.

*Niels C. Jensen is a founding partner at London, England-based Absolute Return Partners. For more information visit, www.arpllp.com.

Tags: 6 Years, Absolute Return, Alexander Fraser Tytler, Business Partner, Democracy, Excessive Debt Accumulation, Form Of Government, Generous Gifts, Global Equity, John Mauldin, Loose Fiscal Policy, Niels Jensen, Nine Months, Partner John, Prozac, Public Treasury, Remedy, Sceptic, Scottish Lawyer, Whimper
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Mental Midgets and Moral Pygmies

Thursday, December 10th, 2009

This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.

I have arrived at the fourth and final letter in our series about macro themes likely to shape the future. The topic this month is the role of the consumer; the fact that he has over-extended himself financially in recent years and the implications of that. Please allow me to start with a disclaimer: this topic is so vast that I cannot possibly cover every aspect of it. One area which I don’t touch on, for example, is the effect lower consumer spending will have on corporate earnings. Also, I fully accept that not all countries are as leveraged as the UK and the US; the following is predominantly a discussion about the Anglo-Saxon model. Accept the letter in that spirit and you should enjoy it.

Up to the neck in debt

It is really quite simple. The problem is leverage - leverage at every level of the economy. The consumer is up to his neck in debt, but so are our banks and our governments (or, at the very least, they soon will be). In the US (chart 1a), total leverage has risen from a post World War II level of about 150% of GDP to roughly 350% of GDP today with households and the financial sector responsible for most of that growth. Meanwhile, in the UK (chart 1b), total leverage has grown from 200% of GDP to a mind-boggling 500% of GDP in little over 20 years with households and financial companies also accounting for most of that growth.

Chart 1a: Total US debt as % of GDP

Source: Deutsche Bank

So, while it is true that governments on both sides of the Atlantic are currently taking on potentially dangerous amounts of debt, it is not quite true that they are behind the excessive creation of debt over the past few decades. If anything, they should be accused of naivety, ignorance and perhaps even stupidity for allowing the current situation to develop in the first place.

Midgets and pygmies

Now, why didn’t anyone see this coming? Why did our ‘midget’ leaders permit leverage to grow out of control? Well, as a starting point, it is important to understand that, from the consumer’s point of view, increasing leverage has been a logical response to the lower macro-economic volatility experienced over the past 25-30 years. As demonstrated by Dr. Woody Brock at SED (chart 2), household income has become much more stable in recent years with volatility on personal income being cut in half when compared to the 70s and by almost 80% when compared to the 40s. As a consumer, it is perfectly rational to increase financial leverage if you experience rising income stability. What is less rational is to take it to the extreme, as both US and UK consumers have done in the past 6-7 years (note how the slope of the US debt-to-income ratio in chart 2 steepens post year 2000).

Chart 2: Development of US household debt

Source: Strategic Economic Decisions, Inc.

Click here for the full report.

* Niels Jensen has 25 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP and is its chief executive partner.

Source: Niels Jensen, Absolute Return Partners LLP, December 8, 2009.

Tags: 1a, Absolute Return, Anglo Saxon, Consumer Spending, Corporate Earnings, Current Situation, Dangerous Amounts, Deutsche Bank, Executive Partner, Financial Sector, GDP, Governments, Growth Chart, Households, Leverage, Mental Midgets, Niels Jensen, Stupidity, T Touch, World War Ii
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Absolute Return Letter, Neils Jensen (October 2009)

Tuesday, October 6th, 2009

This article is a guest contribution by Neils Jensen of Absolute Return Partners LLP.

A Country for Old Men and a Bit of Samba
October 2009, Neils Jensen, Absolute Return Letter

“Excuse me Sir, can I see your Man Card?” The stone-faced look of the security guard at Dallas Fort Worth Airport gave nothing away and, after two days of celebrating John Mauldin’s 60th, my brain was probably operating somewhat below full capacity. “I need to see your Man Card Sir”. Couldn’t he just go away, I thought to myself, not really sure how to deal with the situation. Suddenly his face cracked wide open and in the broadest possible Texas drawl he said: “With those pink socks on Sir, I need to make sure you are a man”. Welcome to Dallas!

The highlight of the weekend was a two hour roundtable discussion on Saturday afternoon where John had asked 15 of his friends and business associates to share with the group what their fears and hopes were for the next 15-20 years. I duly noted that the issues on the minds of our American friends are not at all dissimilar to what we worry about in Europe - our children’s welfare, unemployment, immigration, racism, the impact of technology and the aging of our society to mention but a few.

This month’s letter is about demographics and is the second in our series about major trends defining the future of the world we live in. Last month I wrote about the energy outlook, and I had an unusually high number of emails commenting on the letter. Many of them made the point that the world is in better shape than I seem to think, even if oil supplies are dwindling, as natural gas reserves are ample. We just need to switch source. Whilst I don’t disagree that natural gas seems the way forward, one should not underestimate the task ahead of us. About 2/3 of all oil is used for transportation purposes and it is an enormous task to reduce our oil dependency. It will take many, many years and cost gigantic sums of money.

It is the banks, Stupid!

Back to this month’s topic - in the financial press, there has been no shortage of attempts to apportion blame for the credit crisis. Disregarding the more obvious finger-pointing (it is the banks, stupid!), there seems to be a growing acknowledgement that large imbalances in the global economy are to blame for the current mess.

Put differently, a large number of countries - mainly Anglo-Saxon in origin but also the majority of our Eastern European friends - became credit junkies and spent beyond their means, year-in year-out. Conversely countries with large current account surpluses (e.g. China, Japan and Germany) were only too happy to deliver the drug to the intoxicated.

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It is therefore too simplistic to suggest that only the deficit countries are to blame. The suppliers of credit must accept that they carry no small part of the responsibility, just like the drug dealers do when supplying junkies. In the past, I have been critical of Ms. Merkel of Germany when she stated publicly that Germany should continue to do what Germany does best, and that is to export goods of high quality. The obvious point here is that if Germany pursues such a strategy, the world will be no more balanced ten years from now than it is today, and a crisis similar to the one we have just been through could happen again.

It should therefore be obvious that not only should the deficit nations become more disciplined (i.e. save more and spend less), but the large surplus nations should actually put measures in place to ensure that their citizens save less and spend more. In practice, however, that is easier said than done. Demographic forces have a much bigger say on spending and savings patterns than generally acknowledged.

Read the complete letter here.

Tags: Absolute Return, American Friends, Business Associates, China, Dallas Fort Worth, Dallas Fort Worth Airport, Energy Outlook, Enormous Task, Future Of The World, Impact Of Technology, Jensen, John Mauldin, Natural Gas Reserves, oil, Oil Dependency, Oil Supplies, Old Men, Pink Socks, Saturday Afternoon, Security Guard, Sums Of Money, Texas Drawl, Transportation Purposes
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Niels Jensen: The Hamster on the Wheel

Thursday, September 3rd, 2009

This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.

It is not universally appreciated, but the last 25-30 years have, in general, been staggeringly good to most investors. Technology induced productivity enhancements combined with favourable demographic trends, minimal government involvement, accommodating labour unions and the globalisation of international trade have all contributed to a benign inflation environment and strong economic growth, leading to arguably the biggest bull market of all times in both bonds and equities.

So much for the good news. The long lasting tail winds have finally turned around, and we now face, and will most likely continue to face, head winds for years to come. The list is long, but some of the most important factors contributing to this change include:

The demise of the Anglo-Saxon consumer driven growth model:

The Anglo-Saxon consumer is exhausted; he has over-extended himself and must reduce his debts for years to come. This may shift the powers from West to East, but only if Asia can drum up sufficient domestic demand to replace the western consumer.

The shift from small to big government:

Ever since Reagan and Thatcher stated that small is beautiful, at least as far as government is concerned, investors across the western world have benefited. Now, with most OECD countries suffering the implications of the worst crisis since the Great Depression, small is out and big is back in. This has dramatic implications for tax, productivity and hence also for corporate profits.

An ageing population:

Baby boomers (those born between 1945 and 1960) are now retiring in large numbers and will continue to do so for the next 15 years or so, with all sorts of negative implications. As the experience from Japan shows, an ageing population slows down economic growth and becomes a drain on public finances at a time where we can least afford it.

Dwindling energy supplies:

Evidence is growing that the world’s largest oil producers either cannot or will not maintain oil supplies at levels sufficient to support continued economic expansion. The facts are few and far between in the world of oil, but there is plenty of circumstantial evidence to suggest that the oil markets are getting tighter and tighter.

In a series of articles over the next few months I will tackle these issues one by one, as they are all critically important. I open this month with an essay on oil. In March 2004, when crude oil was trading just below $30, I predicted $100 prices within the next decade. Please note I made that prediction way before Goldman Sachs made the same projection, for which they got the whole world to sit up and listen. Before I get too carried away, though, it should not be forgotten that Woody Brock, our economic adviser, inspired me to make the $100 projection back in 2004. Likewise, new research from Woody has inspired me to write this month’s letter.

Click here for the full report.

* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP and is its chief executive partner.

Tags: Absolute Return, Ageing Population, Anglo Saxon, Baby Boomers, Corporate Profits, Dramatic Implications, Driven Growth, Executive Partner, Gold, Great Depression, Growth Model, Hamster Wheel, Head Winds, Labour Unions, Minimal Government, Negative Implications, Niels Jensen, Oecd Countries, oil, Productivity Enhancements, Public Finances, Tail Winds
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Make Sure You Get This One Right

Friday, July 3rd, 2009

This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.

As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won’t have to get more than a handful of key decisions correct - everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.

Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those “make or break” decisions which will effectively determine returns over the next many years. The question is a very simple one:

Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or “quantitative easing” as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?

Let’s begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that “less bad” doesn’t necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn’t suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

Click here for the full report.

* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP and is its chief executive partner.

Tags: 24 Years, Absolute Return, Banki, Central Banks, Defining Moments, Deflationary Spiral, Executive Office, Executive Partner, Fiscal Stimulus, Global Stock Markets, Goldman Sachs, Good Chance, Investment Banking, Life Time, Niels Jensen, Obscurity, Paul Volcker, Printing Money, Rest Is History, Single Day
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Hendry: Fears of inflation could trigger bigger downturn

Tuesday, June 30th, 2009

We have followed Hugh Hendry, the outspoken and bold CIO of Eclectica Asset Management, and one of the few profitable absolute return hedgies during the last 12 to 18 months, as he built his high conviction case for deflation, and invested as such, in long dated government bonds, Gilts and 30-year US treasury bonds. Last year, it was Hendry who pointed out that 10-year US treasury bonds were signalling deflation, and that in a sea of risky assets, they were the only asset that was up, and up by 15%, while stocks declined in value by 20% or more, the first half of 2008. Falling interest rates, a flattening yield curve, which came as a result of investors flight from risk in equities and commodities, paid off, with Hendry ending the year up some 40% in his flagship Eclectica hedge fund.

In the months since the beginning of March, however, his thesis has been challenged by the market’s renewed embrace of inflation risk, and stocks recovered off brutal lows, as a result of the deemed “risk” trade. By April, Hendry, who is not known for being a buy and hold investor, despite his standing beliefs, reduced his positions in long duration government bonds, treasurys and gilts in the short term, challenged by yields returning to last year’s levels as the economic “green shoots” teased.

We recently posted Hendry’s June 2009 letter to investors in which he re-iterates his view on inflation/deflation, and explains in fair detail that rough waters lie ahead for stocks and commodities as a result of the markets’ over-anticipation of the effects of the whirring central banks’ printing presses. He has avoided investing in stocks for most of the last year, making almost all of his fund’s returns from owning long duration government securities.

Hendry, an avid market historian, believes it possible that we have already experienced the very inflation and hyperinflation the market fears, during the 2002-2007 period where creditor nations (BRIC) amassed enormous forex reserves in the trillions, while gold broke out of a 27-year trend and oil skyrocketed to $147 per barrel. In yesterday’s interview, he also points out that during in the last 7 years the US dollar lost 40% of its value, an occurrence which is often overlooked or underplayed, but that he calls unprecedented. He explains this view in yesterday’s CNBC interview. As usual Hendry’s clarity on the matter is enlightening, as he has a mastery of the complexity of currency effects arising from carry trades and currency crosses.

One year ago, Hendry warned the Hungarian finance minister that the Hungarian economy, and others like it in Eastern Europe, which were financing their growth with Yen and Swiss Franc crosses and/or carry trades, would be unable to keep up with the spectre of cyclical currency fluctuations which could rapidly destroy the monetary liquidity they were awash in during the “strong Euro” era.

Click play to watch the June 29, 2009 interview:

CNBC: Fears about inflation and hyperinflation could create another economic downturn, bigger than the one the world went through, Hugh Hendry, chief investment officer at hedge fund Eclectica, told CNBC Tuesday.

The stock markets are due for a correction after having risen dramatically this year, but this is not likely to come in the summer and another rally is possible, Hendry, who said he was remaining risk-adverse this year, told “Squawk Box Europe.”

“We have a huge intellectual conviction… that this is a more profound downturn that we’re experiencing and markets will be under pressure,” Hendry said.

“People get more get more concerned about government debt… and it sows the seeds of its own destruction,” Hendry said. “We’re actually tightening the screw, we make monetary policy tighter and tighter.”

Long-term yields on government bonds have been rising, as investors fear central banks, especially in the US and the UK, will have to absorb excess liquidity from the system and raise interest rates to fend off inflation once an economic recovery takes hold.

“I think this paranoia today that inflation is happening today I think it puts in place a motion for a decline in the economy,” Hendry said. “I think they’re not printing enough money… with regards to the wealth destruction that has been happening over the past 18 months.”

“We raised interest rates and actually we killed the golden goose,” he added.

Stock Market Correction

A correction in the stock market is likely, but it will not come over the summer, and the S&P 500 index may even hit 1,000 before the downturn, according to Hendry, who admitted he is not stepping in to catch the tail of the rally.

“It’s kind of fun watching it from the sidelines, I must say I’m not participating,” he said. “My flower opens in the winter, not in the summer.”

There is a tight correlation between the oil price and the Chinese currency, the yuan, with oil prices rising as the yuan was strengthening, Hendry said. This is because Chinese speculators had borrowed in dollars as the yuan firmed, and all that liquidity was thrown into the oil market last year.

“The one non-confirmation in the world is that, since July, the Chinese currency has done nothing, it was flat vis-à-vis the dollar,” he added.

Hendry said he still prefers conventional government bonds, and admitted they were the cause his fund was 3 to 4 percent down on the year. But, he added, government bonds were down 20 percent – although he doesn’t think they will end the year like this.

China and other countries with a current account surplus are not as safe as they seem at first glance, because their economies are still hugely dependent on exports to the US, which is still “down on its luck,” he said.

“If that’s the case, the last place you want to be is the surplus countries,” Hendry said.

Source: CNBC, June 29, 2009

http://www.cnbc.com/id/15840232/?video=1167997692&play=1

Tags: Absolute Return, BRIC, Central Banks, Chief Investment Officer, Cnbc, Cnbc Interview, Commodities, Creditor Nations, Duration Government, Economic Downturn, Excess Liquidity, Finance Minister, Flattening Yield Curve, Forex Reserves, Gilts, Government Bonds, Government Debt, government securities, Hedgies, Hugh Hendry, Hyperinflation, Inflation Deflation, Inflation Fears, Inflation Risk, Intellectual Conviction, Investing In Stocks, Lows, oil, Printing Presses, Risky Assets, Rough Waters, Squawk Box, Stock Markets, Stocks And Commodities, Term Yields, Treasurys, Trillions, Us Treasury Bonds
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Asian markets won’t retest lows, says Chris Wood

Thursday, June 4th, 2009

Chris Wood, street smart Global Equity Strategist of CLSA, yesterday said in an interview on CNBC-TC18 that the US markets remained in a bear market rally while Asia and India were in a secular bull market.

He said the Indian and Asian rally was started by local money, which according to him was a big long-term positive. He added that Asia and emerging markets (EMs) would be the biggest beneficiary of the Fed’s monetary easing. He also said liquidity could lead to massive asset bubbles in Asia and EMs.

Click the image below to view the interview. The video clip is followed by a verbatim transcript.

Q: What have you made of the markets’ move in the past few weeks?

A: I was expecting what I call a counter-trend rally, driven by a counter-trend rally in the S&P this year. The key point is that the S&P in the fourth quarter last calendar year went further below its 200 DMA, and at any point since 1932, in the midst of the Great Depression. So, it was almost inevitable that we were going to have a counter trend rally at some point in 2009. Actually, I thought it would start with the arrival of the new administration in January-February, but it didn’t start so much.

My guess as to how far this rally can go is 1000-1050 on the S&P, but I am viewing this as a counter-trend rally in a secular bear market for the US. I have a different view for Asia and India. I believe Asia and India remain in a secular bull market. So I have a fundamentally different view for the Western world and Asia.

Q: How would you describe what happened in 2008 then in India and other Asian markets like China? Deep cyclical correction? Over 10-15 months in an overall secular bull market?

A: I would describe that as a deep cyclical correction in Asia and EM driven by massive collective damage from what was going on in the Western financial system. That is why with my Absolute Return Portfolio I have been recommending to investors from the middle of 2007 only to own my recommended portfolio, by hedging the Western financial risk by being short on Western financial stocks. But in my view, the sell-off in Asian stocks last year was exacerbated by dramatic liquidation by foreign money, particularly by hedge funds and so-called funds of funds.

What is positive in the rally that began in Asia in October-November last year is that we’ve seen growing local investor participation in Asian market, so the people who bought earlier in this rally since late last year weren’t foreign fund managers but local investors throughout the region. That growing local investor participation is a long-term positive.

Q: So are you saying that the secular bull market has commenced again in India and other Asian markets?

A: Yes, I think it has recommenced. Two technical pieces of evidence support that view. First, Asian markets and EMs have been leading this rally ever since they bottomed last October-November. Second, when the S&P made a new low in March, the Asian markets and EMs did not make a new low. That is technical evidence to me that Asian markets and EMs have become the asset class of choice in global equities.

In the very short term, because Asian markets and EMs have outperformed dramatically, there is some scope for the S&P to outperform. However, in the long run, in my view, the asset class of choice in which to remain fundamentally overweight is Asia and EMs.

In my view, the biggest beneficiary of the dramatic monetary easing, quantitative easing undertaken by the Western central banks led by the Fed, won’t be American/British consumers or American/British stock markets. The biggest beneficiaries will be Asia and EMs. In fact, the dramatic monetary easing could lead to massive asset bubbles in due course in Asia and EMs because the excess liquidity will flow to the best growth story and the best growth stories in the world are Asia and EMs. They have the best demographic dynamics and have the healthiest economies because, unlike the Western world, they do not have the structural leverage problems.

Q: Often, the measure of the restart of a bull market after a bear market is when the previous highs get taken out. How long is it before you think India and other Asian markets can take out their old bull market highs?

A: I don’t assume that happens quickly, because I am bearish on the Western world. If I wasn’t bearish on the Western world, then I would say very quickly, but I am. So in my view we are in a process here, we have commenced a process of incremental decoupling from Western markets. At the beginning of 2008 many investors in China and Indian equities believed in decoupling but by the end of 2008, after a dramatic collapse in Asian stock markets after the Lehman bankruptcy, investors stopped believing in decoupling and started believing in the absolute opposite.

The absolute opposite was an export-correlated train wreck with the US consumer. People became extremely negative on the most important EM story, which was not India but China. This year the Indian and Chinese economies have shown growth momentum; those very bearish concerns were misplaced. So we now have some empirical evidence that Chinese and Indian economies are able to decouple to a certain extent from the American economy, from the American consumer.

The American economy is not growing, so that is building confidence in asset classes. We have begun the process of incremental decoupling. But I think unfortunately when the S&P turns down again, when people realise that it is an L-shaped situation in the US, not an U-shaped or V-shaped recovery, you will get renewed correction. But my view is that next time the Western stock markets go down the Asian markets will prove much more resilient. But this process is incremental; it is not going to happen on a 12-month view.

Q: How bearish are you on the US markets?

A: I would expect a retest of the 660 level in due course in the US if the equities correct and it coincides with the new dollar rally because the dollar rally is on deleveraging. But if the dollar keeps declining, the lows on the S&P need not be so large because some of the downside will be taken on the dollar.

Q: Even if the S&P were to go for a retest you think none of the EMs, including India, will go for a test of their 2008 lows?

A: I don’t believe in a world where the S&P revisits the lows of March. I don’t think the Asian equity markets, India, will revisit the lows because the Indian economy has demonstrated its domestic demand-driven resilience this year. We are now getting people talking of 5.5-6% growth - a few months back the RBI had come out with statements that growth was going to be much slower than expected and it said that growth was going to be 6%.

Reality is that at the beginning of this year investors thought 6% was not attainable, but the data that have been coming out have been a positive surprise. The Indian economy is keeping its growth - not by artificial stimulus measures by the government - so basically the data have been a positive surprise this year and the government has been another positive surprise, which has been a clear mandate that should allow a more coherent policy that should allow for a renewed vigour in the infrastructure cycle now.

Q: How positive is the election?

A: I don’t want to over-dramatize it because of the Indian government’s history of disappointing on reform expectations. But I what I do think is positive is that most foreign investors were on the sidelines before the election as they knew the situation is inherently unpredictable. So because of the clarity and because you don’t have a weak coalition government, I think that was a major catalyst for foreigners to reinvest in India, and logically the sector that should benefit is the infrastructure sector. The other point is that it has removed the risk that the fiscal deficit in India could get out of control.

Q: What are you overweight on in India and China?

A: I am overweight both on India and China but in the last quarter more India, because I was more overweight China in the first quarter. But in my long only portfolio, I am 33% in India and my biggest weight is in Indian banking though I did add an infrastructure name after the election.

Q: Public sector units or private sector?

A: Both, but if I were making a new allocation it would be to a private sector bank.

Q: This trait to tanking up to defensives, you think that trend is over?

A: Tactically, Asian markets have had a big rally and people were fortunate to be in the high-beta names and they should be thinking of moving to less-high-beta names now, 70-80 on the oil price, you should reduce the beta names. But I would reduce in the commodity-driven stocks, not banks.

Q: Do you find any discomfort with regard to valuations in India?

A: PEs look scary in India, especially infra, but India is a genuine domestic demand-driven growth story. So it deserves a high PE premium. On a price to book basis India looks undemanding. The whole risk in Asian valuations is in the potential negative correlation to the Western world.

Source: CNBC-TC18, June 3, 2009 (Hat tip: Viktor Capitalist).

Tags: 15 Months, Absolute Return, Asian Markets, Beneficiary, Bubbles, Cnbc, Dma, Emerging Markets, Ems, Global Equity, Great Depression, India, Key Point, liquidity, Lows, Market Rally, New Administration, Retest, Secular Bear Market, Secular Bull Market, Strategist
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Green Shoots or Smoking Weed?

Monday, June 1st, 2009

This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.

Asset bubbles are strange animals. Ideally, you would like to punch the air out of them early before they become a real danger but, in practice, it is not quite so simple. Ben Bernanke and Alan Greenspan have actually both argued that asset bubbles cannot be detected and monetary policy should therefore not in any way be used to offset suspected bubbles.

I am not sure I agree with the two gentlemen, but that is less relevant for now. What is important to understand is what happens once the asset bubble bursts. In my experience, almost all post-bursting bubbles share two characteristics:

1) At the very least, asset prices revert to the mean, although many actually overshoot on the downside.

2) A long (and often painful) period ensues, where asset prices gradually claw back lost value. History suggests that this period is measured in years and sometimes in decades; never have asset prices recovered from a deflated bubble in just a matter of months.

The recent collapse of residential property prices - at this point still more advanced in the US than in Europe - is a classic asset bubble which is now deflating. The reason I have decided to write about it this month is because the “green shoot” campaigners are missing a hugely important point about the effect that falling US property prices are going to have - not just on the US but also on the global economy.

Recovery will prove temporary

Make no mistake. I always expected and continue to expect an economic revival later this year, which unfortunately will prove temporary. There are many good reasons to expect such a short-term recovery, as I discussed in detail in the April issue of this letter. However, it is what happens afterwards that I worry about. The economic uplift is likely to last no more than one or two quarters after which we will have to face more gloom and doom.

There are at least two reasons property prices are so important to the overall economy. The first reason has to do with leverage. There has been a lot of talk about de-leveraging in recent months, and the consensus seems to be that most of it is now behind us. Perhaps, in the narrowest possible sense, that is correct.

But leverage is not confined to hedge funds and banks. Many private households run heavily levered balance sheets as a result of their home ownership and it is this leverage that is rapidly growing at the moment. Why is that? Because leverage is a function of both the numerator and the denominator and, as American home owners are about to find out for the first time, falling property prices can have a devastating effect on your balance sheet.

Secondly, property wealth has become an important part of many people’s lives. In both the US and the UK (and in numerous other countries as well) many people have directed their savings towards property in recent years, and no small part of the profits have been recycled into the economy through equity withdrawal schemes. This has created a level of consumption which cannot be sustained if property prices do not continue to rise.

Click here for the full report.

* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP and is its chief executive partner.

Tags: Absolute Return, Alan Greenspan, Asset Prices, Ben Bernanke, Bubble Bursts, Bursting Bubbles, Campaigners, Economic Revival, Economic Uplift, Executive Partner, Global Economy, Gloom And Doom, Important Point, Many Good Reasons, Niels Jensen, Painful Period, Smoking Weed, Strange Animals, Two Gentlemen, Value History
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The $33,000,000,000,000 question

Friday, May 8th, 2009

This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.

Is the crisis really over?
Commercial paper spreads have come down dramatically. Libor rates are (hmm - almost) back to normal. Even high yield spreads are narrowing. It certainly appears as if the credit crisis is well and truly over or, at the very least, the light which most of us think we can see at the end of the tunnel is no longer that of an oncoming freight train.

No wonder equities are currently enjoying one of their best spells ever. And while equities continue to go up and up, most of us are left scratching our heads. Is this the real thing or will it go down in history as ‘just’ another bear market rally? Not so long ago, the entire financial system stared Armageddon in the face. Now, only a few months later, equity markets behave as if all the worries of yesterday have been washed away. How is that possible?

The great bank illusion
The current bull market began in earnest in the second week of March, but what really got everyone going were the surprisingly good Q1 US bank earnings which were reported during the first half of April. Most commentators interpreted the numbers as the clearest piece of evidence yet that we are now firmly on the road to recovery.

Of course US banks made good money in Q1. The environment created for them is the equivalent of the US government reducing the cost of goods to zero for its embattled car manufacturers and then going on to buy - courtesy of the US tax payer - a couple of million cars that nobody really needs. Even Detroit would make money given those conditions!

Liquidity is trapped
The problem for the rest of us is that the banks are not sharing the candy they have been handed. Much of the liquidity created by the central banks remains trapped in the financial sector. Quite simply, the multiplier is not doing its job, as many banks prefer to hoard cash rather than increase lending at this juncture.

This is both good and bad news at the same time. Good because it implies that we probably do not have to worry too much about the inflationary effect of the aggressive monetary easing currently taking place; bad because it means that the economy is not going to kick back to life as quickly as everyone would like - and expect

Meanwhile investors are growing cautiously optimistic about the GDP outlook for the second half of the year with many now forecasting modest growth – at least in the United States. Only a fool would suggest that GDP would shrink by 5-10% per quarter in perpetuity, as has been the case over the past two quarters. The economic slowdown is now decelerating and, as I pointed out last month, there are good reasons why we may see a temporary lift in economic activity later this year, but it will almost certainly prove transitory.

Click here for the full report.

* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP and is its chief executive partner.

Tags: Absolute Return, Armageddon, Bear Market, Car Manufacturers, Central Banks, Commentators, Credit Crisis, Executive Partner, Financial Sector, Freight Train, high yield, Hoard Cash, Job Banks, Libor Rates, liquidity, Market Rally, Million Cars, Multiplier, Niels Jensen, Tax Payer, Us Bank
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Europe on the Ropes

Thursday, March 5th, 2009

This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.

Many of today’s policy proposals start from the view that “greed” and “incompetence” and “poor risk assessment” are the ultimate source of what went wrong. In fact, they were not the true cause at all. Moreover, even if they had been, it is fatuous to think that we will now create a post-crash generation of bankers and traders who are not greedy, much less a new generation of quants who will be able to assess and manage risks much better than “the idiots” who have brought us to the current abyss. Greed cannot be exorcised. Nor can the inherent inability of any quants to determine the “true” probability distributions of all-important events whose true probabilities of occurrence can never be assessed in the first place.”

Woody Brock, SED Profile, December 2008

Policy mistakes “en masse”
The last few weeks have had a profound effect on my view of politicians (as if it wasn’t already dented). All this talk about capping salaries for senior bank executives is quite frankly ridiculous. It is Neanderthal politics performed by populist leaders. That Gordon Brown has fallen for it is hardly surprising but I am disappointed to see that Barack Obama couldn’t resist the temptation. The mob wants blood and our leaders are delivering in spades. The stark reality is that we are all guilty of the mess we are now in. For a while we were allowed to live out our dreams and who was there to stop us? Policy mistakes - very grave mistakes - permitted the situation to spin out of control. From the U.S. Federal Reserve Bank under the stewardship of Alan Greenspan being far too generous on interest rates to the British Chancellor of the Exchequer - who now happens to be our Prime Minister - advocating ‘Regulation Light’.

Policing must improve
If you really want to prevent a banking crisis of this magnitude from ever happening again, the focus should be on the way banks operate and not on how much they pay their staff. And, within that context, any discussion must start and end with how much leverage should be permitted. The French have actually caught onto that, but their narrow-mindedness has driven them to focus on hedge funds’ use of leverage which is only a tiny part of the problem. It is the gung ho strategy of banks which brought us down and which must be better policed. And guess what; if banks were better policed - and leverage restricted - then profits, even at the best of times, would be much smaller and there would be no need to regulate bankers’ compensation packages.

It is pathetic to watch our prime minister attacking the bonus arrangements of our banks when the UK Treasury, on his watch, spent £27 million pounds on bonuses last year as reward for delivering a public spending deficit of 4.5% of GDP at the peak of the economic cycle. Even my old mother understands that governments must deliver budget surpluses in good times, allowing them more flexibility to stimulate when the economy hits the wall. What Gordon Brown has done to UK public finances in recent years is nothing short of criminal.

So, with that in mind, let’s take a closer look at the European banking industry. The following is not pretty reading. I have rarely, if ever, felt this apprehensive about the outlook. So, if the crisis has made you depressed already, don’t read any further. What is about to come, will make your heart sink.

More leverage in Europe
Let’s begin our journey by pointing out a regulatory ‘anomaly’ which has allowed European banks to take on much more leverage than their American colleagues and which now makes them far more vulnerable. In Europe, unlike in the US, it is only risk-weighted assets which matter to the regulators, not the total leverage ratio. European banks can therefore apply a lot more leverage than their US counterparties, provided they load their balance sheets with higher rated assets, and that is precisely what they have been doing.

That is fine as long as you buy what it says on the tin. But AAA is not always AAA as we have learned over the past 18 months. Asset securitisations such as CLOs proved very popular amongst European banks, partly because they offered very attractive returns and partly because Standard & Poors and Moodys were kind enough to rate many of them AAA despite the questionable quality of the underlying assets.

Now, as long as the economy chugs along, everything is dandy and the AAA-rated assets turn out to be precisely that. But we are not in dandy territory. Many asset securitisation programmes are in horse manure to their necks, so don’t be at all surprised if European banks have to swallow further losses once the full effect of the recession is felt across Europe. The two largest sources of asset securitisation programmes are corporate loans and credit cards. Senior secured loans are still marked at or close to par on many balance sheets despite the fact they trade around 70 in the markets. The credit card cycle is only beginning to turn now with significant losses expected later this year and in 2010-11.

Not much of a cushion left
Citibank has calculated that it would only take a cumulative increase in bad debts of 3.8% in 2009-10 to take the core equity tier 1 ratio of the European banking industry down to the bare minimum of 4.5%. By comparison, bad debts rose by a cumulative 7% in Japan in 1997-98. One can only conclude that European banks are very poorly equipped to withstand a severe recession. Seeing the writing on the wall, they are left with no option but to shrink their balance sheets. Despite talking the talk, banks will use every trick at their disposal to reduce the loan book. No prize for guessing what that will do to economic activity.

The wheels are coming off
But that is not the whole story. It is not even the most worrying part of the story. For the true horror to emerge, we need to turn to Eastern Europe for a minute or two. Nowhere has the credit boom been more pronounced than in Eastern Europe. And nowhere is the pain felt more now that credit has all but dried up. One measure of the credit fuelled bonanza is the deterioration of the current account across the region. Credit Suisse has calculated that in four short years, from 2004 to 2008, Eastern Europe’s current account went from +6% to -6% of GDP. That is a frightening development and is likely to cause all sorts of problems over the next few years.

Meanwhile Western European banks, eager to milk the opportunities in the East after the iron curtain came down, have acquired many of the region’s banks (see chart 1). Now, with many Eastern European countries in free fall, ownership could prove disastrous for an already weakened banking industry in the West.

Chart 1: Western European Ownership of Eastern European Banks

Source: FT.com

The problem is widespread
To make matters worse, the problems in the East are beginning to look systemic. Credit Suisse has produced an interesting scorecard where they rank a number of countries around the world on factors usually taken into consideration when assessing the credit quality of sovereign debt (see chart 2). At the top of the tree (i.e. the worst credit score) you find Iceland - hardly surprising considering their current predicament. More importantly though, of the next 14 countries on the list, 8 are Eastern European - not what you want to hear if you are an already undercapitalised European bank with huge exposure to Eastern Europe.

Swedish banks are already reeling from their exposure to the Baltic countries. Austrian banks are in even worse shape, having been the most acquisitive of any European banks. Some Italian banks could be dragged under by their Eastern European exposure and even the conservative banking sector in Switzerland doesn’t look like it can escape the mayhem.

Worst of all, the problems in the East are just about to unfold at a point in time where the European banking industry is bleeding heavily from massive losses already incurred in other areas. With no access to private funding, banks find it virtually impossible to re-build their capital base with anything but tax payers’ money.

US banks are in less of a pickle. Unlike the subprime debacle which hit both the US and the European banks hard, US banks have little exposure to Eastern Europe. To prove my point, according to the IMF, European banks have 75% as much exposure to US toxic debt as American banks, but 90% of all cross border loans to Eastern Europe originate from Western European banks. And, to add insult to injury, European banks have been much slower than US banks in terms of recognising their losses. Write-offs now total about $750 billion in the US and only about $325 billion in Europe.

Chart 2: Country Vulnerability Scorecard

Click here for a larger image.

The great mortgage show
The problems in Eastern Europe begin and end with their large external debts. In recent years, ordinary people all over the region have converted their traditional mortgages to EUR- or CHF-denominated mortgages. Some have even switched to JPY mortgages. Who can possibly resist 3% mortgages? Didn’t anyone inform them of the risk? As currencies across the region have fallen out of bed in recent months, these mortgages have suddenly become 30-50% more expensive. No wonder the local economy is suddenly tanking.

Chart 3: Eastern Europe’s Net Foreign Liabilities as % of GDP

Credit Suisse has calculated that net foreign liabilities (as a % of GDP) have risen from 47% to 65% in recent months as a direct result of the loss of local currency values (see chart 3 - and don’t ask me why Credit Suisse has included South Africa in Eastern Europe!).

Chart 4: Eastern European versus Asian Crisis

Source: Wall Street Journal

Back in 1997-98 Asia went through a similar currency crisis. However, as you can see from chart 4, Asian current account deficits were much smaller than Eastern European deficits are now. So were debt levels. Despite that, the Asian crisis did enormous damage to the local economy. Eventually Asia came good, primarily because the devalued currencies allowed the Asian countries to export more. Eastern Europe does not share this luxury. With over 90% of the world’s GDP in recession, who are they going to export to anytime soon?

Austria is in greatest trouble
According to the latest estimates from BIS, Eastern European countries currently borrow $1,656 billion from abroad, three times more than in 2005 and mostly denominated in foreign currencies (ouch!). 90% of that can be traced to Western European banks. About $350 billion must be repaid or rolled over this year. Not an easy task in these markets. Austrian banks alone have lent about $300 billion to the region, equivalent to 68% of its GDP according to the Financial Times. A default rate of 10% on its Eastern European loans is considered enough to wipe out the entire Austrian banking system. EBRD has gone on record stating that defaults in Eastern Europe could end up as high as 20%.

An extra $250 billion to the IMF
Hungary, Latvia and Ukraine have already received emergency loans from the IMF and both Serbia and Romania are reportedly considering asking for help. Meanwhile the IMF’s coffers are draining quickly and it has asked leading industrial nations for new funding. At their summit a week ago, EU leaders coughed up an extra $250 billion but nobody said where the money is going to come from. Even if they find the money, it is likely to prove hopelessly inadequate. Our leaders must grow up. Measuring everything in billions is so yesterday. Trillions are the new billions, like it or not.

Conspiracy or…?
On the 11th February the Daily Telegraph’s Brussels correspondent Bruno Waterfield wrote an article under the header: “European banks may need £16.3 trillion bail out, EC document warns.” In the article, the reporter revealed that he has seen a secret document produced by the EU Commission which briefed the union’s finance ministers on the true extent of the banking crisis. Less than 24 hours later, the article’s header was changed to “European bank bail-out could push EU into crisis” and two paragraphs had mysteriously disappeared. Here they are:

“European Commission officials have estimated that “impaired assets” may amount to 44pc of EU bank balance sheets. The Commission estimates that so-called financial instruments in the ‘trading book’ total £12.3 trillion (13.7 trillion euros), equivalent to about 33pc of EU bank balance sheets.

In addition, so-called ‘available for sale instruments’ worth £4trillion (4.5 trillion euros), or 11pc of balance sheets, are also added by the Commission to arrive at the headline figure of £16.3 trillion.”

Do yourself a favour - read those two paragraphs again. Newspaper editors do not change content light-heartedly. Did the Telegraph editor receive a call from Downing Street? Or Brussels? Did he have second thoughts about the avalanche that he could possibly instigate? I don’t know and I probably never will. But one thing is certain. If the EU Commission’s estimate of £16.3 trillion of impaired assets is correct, then the crisis is far worse than any of us could ever imagine. Not only would we have to get used to the prospects of a systemic meltdown of our banking system, but entire nations may go down as well.

Public debt to rise and rise
Even if actual losses prove to be much, much smaller (and I sincerely hope so), the banking sector cannot, in the current environment at least, raise sufficient capital to stay afloat, so more, possibly a lot more, tax payers’ money will have to be put forward. This can only mean one thing. Public debt will rise and rise. The official estimate for the UK for next year is already approaching 10% of GDP, an estimate which will almost certainly rise further. We probably have to get used to running 10-15% deficits for a few years, a fact which seriously undermines the notion of government bonds being next to risk-free.

BCA Research has calculated the effect on public debt in a number of countries, as a result of further bank losses being underwritten by tax payers. Obviously, those countries with the largest banking industries (as a % of GDP) will be hit the hardest (see charts 5a and 5b).

Chart 5a & 5b: Eastern Europe’s Net Foreign Liabilities as % of GDP

For that very reason, and as pointed out in last month’s Absolute Return Letter, there is a real risk that investors will demand much higher risk premiums on government debt. Only a few days ago, Ireland issued 3-year bonds at almost 250 basis points over corresponding Bunds. As more and more debt is transferred to sovereign balance sheets, we will likely see the spreads between good and bad paper rise further but we will also witness increasingly desperate measures being applied by the men in power. If they could prohibit short-selling of banks on the stock exchange (which didn’t work), why wouldn’t they consider prohibiting short-selling of government bonds? Not that it would necessarily work any better, but desperate people do desperate things.

Can Germany rescue us?
Most investors remain convinced that Germany will come to the rescue - in my opinion not as simple a solution as widely perceived given the enormity of the crisis. One possible solution which has been mentioned frequently in recent weeks is for all the eurozone nations to get together and start issuing joint bonds. This would undoubtedly help the weaker nations, but the idea was shot down by the German Finance Minister only a few days ago when he said that closer economic harmony across the eurozone would be needed before Germany would be prepared to entertain such an idea.

The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis. Given this outlook, do you really want to be long euros?

* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP and is its chief executive partner.

Tags: Absolute Return, Alan Greenspan, Bank Executives, Banking Crisis, Barack Obama, British Chancellor, Chancellor Of The Exchequer, Executive Partner, Federal Reserve Bank, Gordon Brown, Grave Mistakes, Niels Jensen, Policy Proposals, Poor Risk Assessment, Probability Distributions, Profound Effect, Quants, Stark Reality, True Cause, True Probability
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Do BRICs (and Germans) Eat PIGS?

Saturday, February 7th, 2009

This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.

When the euro was introduced about ten years ago, the pessimists didn’t give it much chance of reaching its tenth anniversary. The euro, or so the argument went, was doomed from the outset because of the disparity in economic performance amongst the member countries. In this respect not much has changed. At one end of the scale you still have the highly disciplined, but also slow growing, economies of Germany and the Netherlands; at the other end you find faster growing but ill disciplined countries such as Spain and Greece. As icing on the cake, you also have countries that lack in both departments, such as Italy, making it difficult for the union to ‘gel’ – well, according to sceptics.

There is admittedly an embedded weakness in the way the European currency union is structured. In the United States, arguably the largest currency union in the world, fiscal transfers between member states allow for the federal government to adjust for variances in economic performance. There is no such mechanism within the eurozone, which explains why the member states are subject to a number of rules. These rules require strict fiscal discipline. The problem is that few countries play by the rules.

The best example of this is the huge spread in the rise of unit labour costs over the past few years. Unit labour costs measure labour (wage) costs adjusted for changes in productivity. It is probably the best measure that exists in terms of tracking the changes in competitiveness between nations. The currency union is governed by the so-called Stability and Growth Pact. There is no mention of unit labour costs in the pact which, with the benefit of hindsight, is a major mistake. Even Jean-Claude Trichet, the Head of the European Central Bank, who rarely admits mistakes, has publicly stated that if he could design the currency union all over again, he would push for a unit labour cost stability pact.

Back to the early sceptics. What they failed to realise was that Europe, together with the rest of the world, was about to enter a period of unprecedented prosperity. The good times would not only gloss over the  deeper problems, but the euro would actually go from strength to strength to a point where it now threatens to unseat the US dollar as the premier reserve currency of the world. It will be a mystery to some of you, then, why one should question the longer term viability of the euro. That is nevertheless what I intend to do.

Click here for the full letter.

* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP and is its chief executive partner.

Tags: Absolute Return, BRIC, BRICs, Competitiveness, Disparity, Economic Performance, European Currency Union, Eurozone, Executive Partner, Fiscal Discipline, Fiscal Transfers, Hindsight, Jean Claude, Member Countries, Member States, Niels Jensen, Pessimists, Stability And Growth Pact, Stability Pact, Tenth Anniversary, Unit Labour Costs, Variances
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