Category Archives: Investment

The Absurdity of ‘Abenomics’ and the PM’s ‘Three Bendy Arrows’ (Part 3: Monetary Policy and a Fictitious Can)

In my two previous posts on Abenomics (here and here), I argued that Japan is a post-growth economy. As the OECD explains in its Compendium of Productivity Indicators 2012, growth can be achieved in only three ways:

Economic growth can be increased either by raising the labour and capital inputs used in production, or by improving the overall efficiency in how these inputs are used together, i.e. higher multifactor productivity (MFP). Growth accounting involves decomposing GDP growth into these three components, providing an essential tool for policy makers to identify the underlying drivers of growth.

Therefore, if I am to be proved wrong in my declaration that Japan is post-growth, Abenomics must be able to boost labour inputs, and/or increase capital inputs and/or improve multifactor productivity (innovation and efficiency). By definition, the Abe agenda must encompass one or more of the three—there are no other means of achieving growth.

Against this background, Prime Minister Abe has given top billing to monetary stimulus within his ‘three arrow’ policy agenda. He campaigned and won a general election on a pledge to force Japan’s central bank, the Bank of Japan, to adopt a binding 2% inflation target through unlimited monetary easing and thus slay deflation. Moreover, to execute such a strategy, he backed a new BOJ governor, Haruhiko Kuroda, who took office in March. Kuroda, in turn, has executed Abe’s monetary policy agenda with gusto. (For a fascinating article on how Kuroda deftly manoeuvred the BOJ board into unanimously support the policy shift, see this Reuters’ article here).

In contrast with the speeches of his predecessor, Masaaki Shirakawa, Kuroda’s early utterances have been accompanied by a very thin chart pack dominated by the now famous ‘all the twos’ slide (click for larger image):

BOJ Quantitative Easing jpeg

These measures will give rise to an extraordinary jump in the monetary base over a two-year period from ¥138 trillion at the end of 2012 to ¥270 trillion at the end of 2014. In fiscal 2012, Japan’s GDP was estimated at approximately ¥475 trillion in nominal terms, so the monetary base is targeted to rise from around 30% of GDP to 55% of GDP.

Monetary Base Target jpeg

By contrast, the action by the Federal Reserve Board in the U.S. looks positively cautious (here), with the monetary base a modest 17% of GDP. Continue reading

Cyprus: Let’s See What Happens When We Turn the Dial

The rather eccentric New Zealand economist William Phillips made a hydraulic computer in 1949 out of, among other things, old bits of WW2 Lancaster bombers. The contraption—more formerly called the Monetary National Income Analogue Computer (MONIAC)—was built to mimic the British economy. If you ever find yourself in London’s Science Museum (or to be exact the museum’s history of computing gallery), you can see one of these machines (here):

MONIAC jpeg

Coloured water represents money and this flows around the hydraulic computer, just as money does within an economy. Moreover, by adjusting various valves, levers, taps and pumps, you can see what happens when various changes are made to tax, government spending, investment, savings and so on. At a time when electronic computers were still at an embryonic stage of development, the MONIAC was at the cutting edge for conducting “what if” experiments with the economy. A 1950s student could ask his or her teacher: “what happens to the economy if we turn this dial all the way to the left?”

But, of course, nowadays we don’t need simulations. Take Cyprus. In this country’s case, we are performing a real time, live experiment. We are taking the Cypriot economy and saying “Let’s see what happens when we turn this dial all the way to the left and cut off credit completely?” Continue reading

Delusional Investing in a Post-Growth World (And a Possible Alternative)

The internet certainly has its faults, but one can’t but admire how it has democratised information. It is now possible to get access to a multitude of private-sector reports that would only have been available to investment professionals a mere 10 years ago.

One example, with a high degree of quality, is the Credit Suisse Global Investment Returns Yearbook. You can get a pdf of the 2013 report here. Within its pages is a wealth of information on cash, bond and equity returns. Critically, the report chronicles a recent revolution in the prospects for investments. Moreover, the ‘new normal’ savers face gives off some telling signals with respect to future economic growth and, unexpectedly, provides some good news for the economics of sustainability projects.

The three authors behind the report—all from London Business School—provide a short introduction that doesn’t pull any punches in its message to the investment community:

To assume that savers can expect that the investment conditions of the 1990s will return is delusional. Many investors seem to be in denial, hoping markets will soon revert to “normal”.

The report covers cash, bonds and stocks, and all three have seen a collapse in expected returns. Let’s take a closer look at bonds, since they dominate pension-related savings in most countries. You can plainly to see that nominal yields have slumped (click for larger image):

Average Yields on Long Bond jpeg

But once we take inflation into account, things are far worse. In the chart below (taken from the full report), the authors have used inflation-protected bonds starting from the year 2000 (or equivalent where such bonds are not issued by a particular country) to see what kind of real returns investors are prepared to accept (click for larger image).

Real Yields jpeg

This kind of chart always shocks me. Continue reading

Links for Week Ending 23rd February

  • The Forward on Climate Rally organised by 350.org attracted 40,000 people on 17 February and received wide publicity. This prompted a lively discussion as to whether direct protests make a difference to potential climate change outcomes or not. I think I fall into the camp of David Roberts at Grist who believes that street activism has a strong part to play in countering climate change. An excellent piece by him arguing against the more wonkish incrementalist approach of the NYT’s Andrew Revkin is here, and a follow-up piece on where the movement should go post the Keystone XL pipeline decision is here. The U.S. climate change movement now appears to have last gained some grass roots activist momentum in the U.S. I wish the same were true in the U.K.
  • Stuart Staniford has an update on “All Liquids” volume output  and OECD consumption trends at his Early Warning blog. Output appears to have been on a bumpy plateau for about a year now.  Not surprisingly, oil prices have been creeping up again. As I always say, if the cornucopian belief in technology is to be proved right, and previously inaccessible hydrocarbons can be easily unlocked, we need to see rising oil volumes and falling prices. We are currently seeing flat volumes and flat to rising prices.
  • Given what is happening in the oil markets, I recommend peak oil observers keep abreast of the work of Michael Kumhof, a senior economic modeller at the IMF. I previously blogged on the IMF’s incorporation of geological constraints into its forecasts here. To get a direct insight into Kumhof’s work, take a look at an easily accessible 20-minute presentation he gave here. A more technical IMF paper covering these issues was published in October 2012 here.
  • Via Barry Ritholtz’s The Big Picture, this article in the English edition of Le Monde diplomatique charts the surge in financial investment into agriculture. The article is a bit messy in its arguments but the key, and I think basically correct, point is that more and more people will be shut out of food markets via price. Everyone should think hard about how they can hedge against this.
  • Another horrible and depressing paper about permafrost thaw from Climate Central. This is one of the ‘known unknowns’ that we are gradually ‘knowing’ a lot more about. And it is not good.

Forbes, Climate Change and the Investment Process

“New NASA Data Blow Gaping Hole in Global Warming Alarmism” trumpets Forbes. So are the risks advanced by the Intergovernmental Panel on Climate Change (IPCC) all wrong? For any investment professional without an advanced degree in climatology (that is nearly all of us) it is difficult to reach our own conclusions faced with these kinds of “he said, she said” debates, but I believe it is possible.

First, a degree of skepticism is required when dealing with the climate skeptics. Not least of which is to be suspicious that any one single finding will suddenly upend an entire body of work that encompasses multiple strands. Sir Paul Nurse, the current President of the UK Royal Society, brings out this point clearly in a recent BBC Horizon documentary (I encourage everyone to watch the entire programme). Nurse states:

An important aspect of science is that it makes sense as a whole…..it is no good cherry picking one part of it….

As a medical analogy, scientists continue to discover errors in medical treatments; for example, up until recently most stomach ulcers were thought to result from poor diet or stress—only recently were bacteria found to be a dominant cause. But such discoveries do not bring down the whole structure of modern medicine. The discovery of ulcer-causing bacteria did not cause us to reject the latest treatments for cancer or heart disease.

Second, what is the counter argument to the case being put? Thankfully, the web gives you access to two superb sites that aggregate the consensus response to skeptic arguments: www.skepticalscience.com and www.realclimate.org. And as it happens, Real Climate addresses the paper underlying the Forbes article here.

The point I am making is that you should use an identical discipline to that of buying a stock. Say you find an interesting candidate to add to your portfolio on the long side. Do you a) go out and read all the analyst “buy” recommendation reports on the stock since you know in advance that they will back your initial buy bias or do you b) intentionally seek out and read the “sell” reports to unearth counterarguments that you were not aware of? If you answer was a), then I can tell you that your life in the financial industry will be nasty, brutish and short.

Third, when you receive an investment pitch, are you interested in the track record of the person pitching it to you? Now the two authors of the paper behind the Forbes article, Roy Spencer and William Braswell of the University of Alabama in Huntsville, are no Lord Monkton-type intellectual lightweights. They do, however, have a rich climate skeptic past that you can see if you punch their names into the search engine of Skepticalscience.com. In particular, Spencer is famous in climate circles for claiming in the early 1990s that satellite data on global temperatures contradicted the terrestrial temperature measurements. Indeed, if Forbes had reported on Spencer’s papers at the time, the headline would have looked something like this: “New Satellite Data Blow Gaping Hole in Global Warming Alarmism”.

Nonetheless, climate change science is an edifice built on multiple foundations as Sir Paul Nurse emphasised above. And here again we had multiple strands of research pointing to one conclusion and Roy Spencer and his partner John Christy pointing to another. Thus the most likely (but by no means certain) conclusion was that Roy Spencer was wrong. To cut a long story short, further investigation of the satellite data led to the discovery that Spencer and Christy’s analysis was wrong (you can see a discussion of the topic here). Spencer and Christy, I believe, accept that their original papers had flaws. Further, the latest paper co-authored by Spencer disputes the consensus IPCC view on the speed of warming from a different angle.

In investment terms, Spencer has a track record of coming out with big ballsy contrarian calls. Like a Henry Dent shouting that the Dow will reach 40,000 kind of call. Now Dent recently came out with a Dow 3,800 call. Could he be right? Yes. But, umm, how have his other big swings at the ball panned out to date? Well…..

Notwithstanding all the above arguments, I do not dismiss Spencer out of hand, and regularly read his posts on his blog here. I think his arguments form the benign version of the tail risk (that is the other end of the tail from the catastrophic outcomes); in other words, temperature sensitivity to CO2 is so low that global warming will be a slow-motion affair, thus giving mankind plenty of time to mitigate and adapt. However, nothing he has done to date has dissuaded me from tracking the negative tail risk. In sum, risk is probability times outcome, and it is with the truly bad outcomes that the major risk resides.

Finally, investment professionals constantly make decisions with regard to fields of investment in which they have no scientific expertise. As a portfolio manager, I bought pharmaceutical stocks but have no medical-related Phd. Comfort in those decisions came from data, either the stock price action itself or the trends in underlying metrics like prescription and sales stats.

Diving into Roy Spencer’s site is a bit like diving into the fundamental analysis behind a blockbuster drug—a level of analysis that you can’t hope to fathom without a couple of advanced degrees in the relevant field. However, the decision to buy a pharma stock is generally made at a much higher level: how is the drug clearing FDA-related approval hurdles and then how is the drug selling? Likewise, the bottom line for Spencer is to check whether global temperature trends are going up or down. Indeed, you can go directly to his site here and look at the chart (surely the first thing you do before buying a stock).  Moreover, just like with same-store sales release of a retailer, every month you will get a new data point to confirm or refute the trend. It is not that difficult.

In conclusion, the kind of analysis put forward in the Forbes article wouldn’t gain a pass mark at CFA Level 1. The article should have read: “New Data Put together by Analysts Who Were Wildly Wrong in the Past that Claims to Blow a Gaping Hole in Global Warming Alarmism Not Supported by Multiple Findings of Numerous Other Analysts with a Better Track Record (but Just in Case Let’s Track the New Data as it Arrives)”. OK, maybe something snappier. But frankly the article’s analysis was lightweight and I expect better from Forbes.

Jeremy Grantham and Climate Change

I am sometimes amazed by how climate change has become almost a taboo issue in certain circles of the investment community. For example, John Mauldin, who writes Thoughts from the Frontline, probably the most-widely circulated and read financial newsletter in the world, barely touches on the issue. Is he a skeptic? My sense is ‘yes’ based on his musing on volcanoes in his 2011 New Year piece, although it is difficult to tell.

Yet regardless of his own inclination,  my suspicion is that John has decided to ignore climate change for fear of upsetting his readership base, given the political polarisation that the issues produces. Paraphrasing Oscar Wilde, climate change has become the investment topic that dares not speak its name. It is therefore refreshing to find at least one high profile investment manager who is not afraid to take a very public stand on the issue: Jeremy Grantham.

In the GMO Quarterly Letter written in July 2010, Grantham came out with one of most succinct explanations of global warming for investment professionals I have seen under the title “Everything You Need to Know about Global Warming in 5 Minutes”. It is worth spending 5 minutes of your time to read it through:

1) The amount of carbon dioxide (CO2) in the atmosphere, after at least several thousand years of being quite constant, started to rise with the advent of the Industrial Revolution. It has increased by 40% and is rising each year. This is certain and straight forward.

2) One of the properties of CO2 is that it creates a greenhouse effect and, other things being equal, causes the temperature to rise. This is just physics.

3) Several other factors, like changes in solar output, have major influences on climate over millennia, but these effects are known, are observable, and have been allowed for in current models. Critically, there have been no important changes in these other factors over the last 100 years.

4) The doubts arise when it comes to the interaction of CO2 with other variables in a complicated system, especially water vapor. It is impossible to be sure whether the temperature will rise slowly or rapidly. But, the past can be measured. The temperature has indeed steadily risen and is well within the boundaries predicted for the man-made effect. But the forecasts still range very widely, from a harmless negligible rise to a potentially disastrous +6 degrees Fahrenheit or higher within this century. The main danger of the CO2 interaction with water vapor is the high probability that it will cause a great increase in severe precipitation episodes.

5) Skeptics argue that this wide range of uncertainty lowers the need to act: “Why spend money when you’re not certain?” But since the penalties rise hyperbolically at the tail, a wider range implies a greater risk (and a greater expected value of the costs). This is logically and mathematically rigorous and yet is still argued.

6) Pascal asks the question: What is the expected value of a very small chance of an infinite loss? And, he answers, “Infinite.” In this example, what is the cost of lowering CO2 output and having the long-term effect of increasing CO2 turn out to be nominal? The cost appears to be equal to foregoing, once in your life, six months’ to one year’s global growth – 2% to 4%, or less. The benefits, even with no warming, include: energy independence from the Middle East; more jobs, since wind and solar power and increased efficiency are more labor-intensive than another coal-fired power plant; less pollution of streams and air; and an early leadership role for the U.S. in industries that will inevitably become important. Conversely, what are the costs of not acting on prevention when the results turn out to be serious: costs that may dwarf those for prevention; and probable political destabilization from droughts, famine, mass migrations, and even war. And, to Pascal’s real point, what might be the cost at the very extreme end of the distribution: definitely life changing, possibly life threatening.

7) The biggest cost of all from global warming is likely to be the accumulated loss of biodiversity. This features nowhere in economic cost-benefit analysis because, not surprisingly, it is hard to put a price on that which is priceless. 

8.) A special word on the right-leaning think tanks: As libertarians, they abhor the need for government spending or even governmental leadership, which in their opinion is best left to private enterprise. In general, this may be an excellent idea. But global warming is a classic tragedy of the commons – seeking your own individual advantage, for once, does not lead to the common good, and the problem desperately needs government leadership and regulation. Sensing this, these think tanks have allowed their drive for desirable policy to trump science. Not a good idea.

9) Also, I should make a brief note to my own group – die-hard contrarians. Dear fellow contrarians, I know the majority is usually wrong in the behavioral jungle of the stock market. And heaven knows I have seen the soft scientists who lead finance theory attempt to bully their way to a uniform acceptance of the bankrupt theory of rational expectations and market efficiency. But climate warming involves hard science. The two most prestigious bastions of hard science are the National Academy in the U.S. and the Royal Society in the U.K., to which Isaac Newton and the rest of that huge 18th century cohort of brilliant scientists belonged. The presidents of both societies wrote a note recently, emphasizing the seriousness of the climate problem and that it was man-made. (See the attachment to last quarter’s Letter.) Both societies have also made full reports on behalf of their membership stating the same. Do we believe the whole elite of science is in a conspiracy? At some point in the development of a scientific truth, contrarians risk becoming flat earthers.

10) Conspiracy theorists claim to believe that global warming is a carefully constructed hoax driven by scientists desperate for … what? Being needled by nonscientific newspaper reports, by blogs, and by right-wing politicians and think tanks? Most hard scientists hate themselves or their colleagues for being in the news. Being a climate scientist spokesman has already become a hindrance to an academic career, including tenure. I have a much simpler but plausible “conspiracy theory”: that fossil energy companies, driven by the need to protect hundreds of billions of dollars of profits, encourage obfuscation of the inconvenient scientific results.

11) Why are we arguing the issue? Challenging vested interests as powerful as the oil and coal lobbies was never going to be easy. Scientists are not naturally aggressive defenders of arguments. In short, they are conservatives by training: never, ever risk overstating your ideas. The skeptics are far, far more determined and expert propagandists to boot. They are also well-funded. That smoking caused cancer was obfuscated deliberately and effectively for 20 years at a cost of hundreds of thousands of extra deaths. We know that for certain now, yet those who caused this fatal delay have never been held accountable. The profits of the oil and coal industry make tobacco’s resources look like a rounding error. In one notable case, the obfuscators of global warming actually use one MIT professor who also defended tobacco! The obfuscators’ simple and direct motivation – making money in the near term, which anyone can relate to – combined with their resources and, as it turns out, propaganda talents, have meant that we are arguing the science long after it has been nailed down. I, for one, admire them for their P.R. skills, while wondering, as always: “Have they no grandchildren?”

12) Almost no one wants to change. The long-established status quo is very comfortable, and we are used to its deficiencies. But for this problem we must change. This is never easy.

13) Almost everyone wants to hear good news. They want to believe that dangerous global warming is a hoax. They, therefore, desperately want to believe the skeptics. This is a problem for all of us.

And Grantham has not been shy of putting his money where his mouth is—not least through funding the Grantham Institute for Climate Change at Imperial College and the Grantham Research Institute on Climate Change and the Environment at the London School of Economics.

The New York Times has just published an article entitled “Can Jeremy Grantham Profit from Ecological Mayhem” that I hope will introduce Grantham’s views to a wider audience. The title of the article is somewhat deceptive to the degree that Grantham’s charitable actions aim to prevent ecological mayhem. But what is new in the article is Grantham’s proposal that climate change should be recast as a resource issue to gain some political traction. In his own words:

“Global warming is bad news. Finite resources is investment advice.”

Personally, I believe that climate change can be sold as a financial threat from a variety of angles.  To the question “Have they no grandchildren?”, I think the answer is “Yes they do”. And the grandchildren will take a variety of hits. Some via climate-induced resource limitations bearing down on economic growth, and some through direct hits via sea level rise and extreme weather events. In the final analysis, those ignorant of global warming will see their wealth, and wealth of their families, transferred to those who are informed.