Apple Average

It’s always strange when you have a relief rally in a stock (in after hours at least) because the actual results are not as bad as expected. So it seems to be with AAPL’s Q3 results. iPhone sales were not as bad as expected (albeit the lowest unit iPhone sales in 7 quarters at just above 40 million units) and the current quarter revenue guidance was above expectations. The average revenue per phone was below $600 for the first time in 2 years due to the the latest models with promises of improvements from management in future quarters. When the dust settles on the Q3 results though it could be time to finally reassess AAPL’s future trajectory.

The graph below shows the latest results by product which illustrate just how poor a quarter this was relative to historical trends, with services being the sole bright spot.

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AAPL Revenue by product Q32016

The split by revenue by region again illustrates the challenges AAPL is having in China. It also shows the lackluster response to Apple’s current products in the US.

click to enlargeAAPL Revenue by region Q32016

On valuation, AAPL still looks reasonable on a forward PE excluding cash basis (using analysts estimates for the next 4 quarters), as per the graph below.

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AAPL Forward 12 Month PE Ratio Q32016

The bulls are hyping up the iPhone 7 cycle as a source of future growth which is now the tired but only realistic growth thesis for AAPL. In the medium term however AAPL looks range bound around $100.

Anarchy in the UK

Uncertainty reins and the economic impacts of Brexit on the UK and on Europe have yet to become clear. And a big factor in the uncertainty is the political path to Brexit. The UK political class are now trying to rally around newly agreed leadership of their respective parties (assuming Labour MPs eventually manage to get rid of their current leader) and craft policies on how to engage in the divorce negotiations.

A unique political feature of the UK is their first past the post (FPTP) electoral system. The graph below of the 2015 general election shows how the system favours the larger political parties. It also shows how parliamentary representation under FPTP can be perverse. The Scottish SNP, for example, got 4.8% of the vote but 8.6% of the members of parliament (MPs). The right wing little Englander party UKIP, whose rise in popularity was a direct cause of the decision to have a referendum on Brexit, got 12.6% of the vote but just 0.26% of the MPs. Despite its obvious failings, the British are fond of their antiquated FPTP system and voted to retain it by 68% in a 2011 referendum (albeit with a low voter turnout at 42%).

click to enlarge2015 UK General Election Results

One lasting impact of the Brexit vote is likely to be on the make-up of British politics. Much has been commented on the generational, educational and geographical disparities in the Brexit vote. A breakdown of the leave-remain vote by the political parties, as per the graph below, shows how the issue of the EU has caused schisms within the largest two parties. Such schisms are major contributors to the uncertainty on how the Brexit divorce settlement will go.

click to enlargeUK Brexit Vote Breakdown by Political Party

Currently both sides, the UK and the EU, have taken hard positions with Conservative politicians saying restrictions on the freedom of labour movement is a red line issue and the EU demanding that Article 50 is triggered and the UK agree the divorce terms before the future relationship can be discussed.

Let’s assume that all of the different arrangements touted in the media since the vote boil down to two basic options. The first involves access to EU markets through the European Economic Area (EEA) or the European Free Trade Association in exchange for some form of free movement of labour, commonly referred to as the Norway or the Switzerland options. The second option is a bilateral trade agreement with a skills based immigration policy, commonly referred to as the Canadian option (although it’s interesting to see that there is political uncertainty in Europe over how the Canadian trade deal, which has been agreed in principle, will be ratified). I have called these option 1 and option 2 respectively.

Let’s assume the negotiations on Brexit in the near future will be conducted in a sensible, rather than an emotive, manner whereby the economic impacts have been shown to be detrimental albeit not life threatening. And both sides come to realise that extreme positions are not in their interest and a workable compromise is what everybody wants. In such a scenario, I have further assumed that the vast majority (e.g. 98%) of remain voters would favour option 1 and I have judgmentally assigned political preferences for each option by political party (e.g. 90% and 75% of Conservative and Labour leave voters prefer option 2 respectively). Based upon these estimates, I calculate that there would be a 56% majority of the UK electorate in favour of option 1, as per the graph below.

click to enlargeBrexit Options Breakdown by Political Party

Now, the above thought experience makes a lot of assumptions, most of which are likely to be well off the reality. Particularly, I suspect the lack of emotive and divisive negotiations is an assumption too far.

What the heck, let’s go one step further in these fanciful thoughts. Let’s assume the new leadership in the Conservative party adopt option 2 as their official policy. Let’s also assume that the Labour party splits into old labour, a left wing anti-globalisation party, and a new centre left party whose official policy is option 1. In a theoretical general election (which may be required to approve any negotiated deal), I guesstimate the result below under the unpredictable FPTP system.

click to enlargeTheoretical post Brexit General Election Result

This analysis suggests a majority government of 52% of MPs with option 1 as their policy could be possible with a grand coalition of the new centre party (Labour break away party), the Liberal Democrats and the SNP. The Conservatives and UKIP could, in this scenario, only manage 35% between them (the old labour party at 9% of MPs wouldn’t tolerate to join such a combination no matter what their views on the EU). The net result would be a dramatic shift in UK politics with Europe as a defining issue for the future.

Yea, right!

Back to today’s mucky and uncertain reality….

 

Follow-up: I thought I was been clever with the title of this post and I only realised after posting it that the Economist used it in their title this week! Is there nothing original any more….

Naive Newcomers

The insurance sector has been hit by the Brexit fallout on worries about macro-economic impacts; albeit not to the same extend as the banks. Swiss Re has their latest Sigma world insurance report out. The impact of investment returns on the life insurance sector is obvious but it is interesting to see the contribution from investment income on the profitability of the aggregate of the eight largest markets in the non-life insurance sector, as per the graph from the report below.

click to enlargeNonLife Insurance Sector Profit Breakdown

The insurance sector faces a number of challenges as a recent FT article pointed out. The reinsurance sector also faces challenges, not least of which is a competitive pricing environment and the destabilising influx of new yield seeking capital through new innovations in the insurance linked securities (ILS) market. I have posted my views on the ILS sector many times (more recently here) and in this post I offer more similar thoughts. It is interesting to compare the ROEs in the Sigma report from the non-life insurance sector against those from the reinsurance sector (with the ROEs since 2005 coming from the Guy Carpenter composite index), as per the graph below.

click to enlargeGlobal Insurance & Reinsurance ROEs 1999 to 2016e

The graph is not exactly comparing like with like (e.g. non-life insurance versus composite reinsurance) but it gives the general idea of higher but more volatile ROEs in the reinsurance side compared to more stable but lower ROEs on the direct insurance side. The average since 1999 for insurance is 7% and 9% for reinsurance, with standard deviations of 3.6% and 4.6% respectively. It also confirms that ROEs are under pressure for both sectors and as capital markets continue to siphon off volatile excess catastrophe exposed business, the ROEs of the more proportional traditional reinsurance sector are converging on those of their direct brethren, although a differential will always exist given the differing business models.

It is important to note that these ROEs are returns on equity held by traditional insurers and reinsurers, the majority of which are highly rated by external agencies, who hold a small fraction of their total exposure (if measured as the sum of the policy limits issued) as capital. For example, the new European solvency framework, Solvency II, requires capital at a 1 in 200 level and it is generally assumed to be akin to a financial strength rating of BB or BBB, depending upon a firm’s risk profile.

As I argued previously (more recently in this post), these (re)insurers are akin to fractional reserve banks and I still struggle to understand how ILS structures, which are 100% collaterised, can offer their investors such an attractive return given their fully funded “capital” level in the ROE calculation. The industry argument is that investors have a lower cost of capital due to the uncorrelated nature of the pure insurance risk present in ILS.

My suspicion is that the lower cost of capital assigned by investors is reflective of a lack of understanding of the uncertainties surrounding the risks they are taking on and an over-reliance on modelling which does not fully consider the uncertainties. My fear is that capital is been leveraged or risks are been arbitraged through over-generous retrocession deals passing on under-priced risk to naive capital newcomers.

The accelerating growth in the so-called alternative capital in insurance is shown in the graph below from Aon Benfield, with growth in the private collaterised reinsurance being particularly strong in the last four years (now overshadowing the public CAT bond market). ILS funds, managed by professional asset manager specialists, are largely behind the growth in private collaterised deals with assets under management growing from $20 billion in 2012 to over $50 billion today. Private collaterised deals are usually lower down the reinsurance tower (e.g. attach at lower loss levels) and as such offer higher premiums (as a percentage of limits, aka rate on line or ROL) for the increased exposure to loss. On a risk adjusted basis, these don’t necessarily offer higher ROEs than higher attaching/lower risk CAT bonds.

click to enlargeAlternative Insurance ILS Capital Growth

Property catastrophe pricing has been under particular pressure in the past few years due to the lack of significant insured catastrophe losses. In a previous post, I crudely estimate CAT pricing to be 25% below its technical rate. Willis Re is the first of the brokers to have its mid-year renewal report out. In it, Willis said that ILS funds “were more aggressive on pricing during the second quarter as spreads declined for liquid reinsurance investments”. I also find it interesting that the collaterised ILW volumes have ticked up recently. Pricing and lax terms and conditions in the retrocession sector are historically a sign that discipline is breaking down. Asset managers in the ILS space must be under pressure in maintaining their high fees in a reduced CAT risk premia environment and this pressure is likely to be contributing to the potential for market indiscipline.

I therefore find the graph below very telling. I used the figures from Lane Financial (see here) for the annual total return figures from CAT bonds, which closely match those of the Swiss Re Total Return Index. For the ILS fund returns I used the figures from the Eurekahedge ILS Advisors Index which I adjusted to take out the not unconsiderable typical ILS fund management fees. The 2016 figures are annualized based upon published year to date figures (and obviously assume no major losses).

click to enlargeCAT Bond vrs ILS Fund Returns

The graph shows that ILS fund returns have broken with historical patterns and diverged away from those of CAT bonds as the prevalence in private collaterised deals has grown in recent years. In other words, ILS funds have moved to higher rate on line business, which is by definition higher risk, as they push to service the larger level of assets under management. The question is therefore do the investors really understand the significance of this change? Have they adjusted their cost of capital to reflect the increased risk? Or are some ILS funds representing the higher returns as their ability to get higher returns at the same risk level (against the trend of everybody else in the industry in a softening market)?

Innovation is to be encouraged and a necessary part of progress. Innovation dependent on the naivety of new investors however does not end well.

I can’t but help think of Michael Wade’s comment in 2009 about the commonality between the financial crisis and problems at Lloyds of London (see this post on lessons from Lloyds) when he said that “the consequence with the excess capital was that underlying risks could be underpriced as they were being passed on”. My advice to ILS investors is the next time they are getting a sales pitch with promises of returns that sound too good, look around the room, and ask yourself who is the greater fool here….

Stuff just happened…

Many, like me, are scratching their heads this weekend about the Brexit vote. Besides the usual little Englanders and other crazies who crave an idealised yesteryear, a significant proportion of sensible people registered their protest in the vote, in a result that is clearly against their and their children’s economic interest. Places in the UK with significant employers dependent upon European access, places like Sunderland, Swindon and Flintshire (with bases for Nissan, Honda and Airbus), voted to leave.  They choose to ignore the consensus advice of the experts and their political leaders, the elite if you like. That’s what makes the outcome of this vote so significant.

In an article two years ago called “The Pitchforks are Coming”, the billionaire Nick Hanauer, who made his fortune on Amazon and aQuantive, wrote the following to his fellow billionaires:

“If we don’t do something to fix the glaring inequities in this economy, the pitchforks are going to come for us. No society can sustain this kind of rising inequality. In fact, there is no example in human history where wealth accumulated like this and the pitchforks didn’t eventually come out.”

The thing is, would the populations of other major European countries also register such a protest, even where it was clearly against their interest? The graph below from Bloomberg suggests it could be a distinct possibility.

click to enlargeBrexit Contagion Bloomberg

The problem now is that the EU cannot be seen to give the UK a deal which may encourage more discord. And, of course, the UK has no idea what deal it wants. The political turmoil in the UK government means they can’t even decide when to trigger Article 50 of the Lisbon Treaty, which will likely need a vote in parliament. The economic factors upon which any deal should be decided are illustrated in the exhibit below from a 2015 Open Europe report on Brexit. These economic factors may not play as important a part in the negotiations as they should given the emotive opposition to free labour movement, aka migration, which is a key issue for all Europeans.

click to enlargeOpen Europe Sectors Impacted by Brexit

Matching these interests to the exit options available, as outlined in the exhibit below from Bloomberg, whilst satisfying the diverse opinions of the Brexiteers is the mess that we are now in. Any deal, whenever it arrives, will likely have to be voted upon again by the British public, maybe in the form of a general election.

click to enlargeAlternatives of EU for UK Bloomberg

Before that agreement can be made, we are in for an extended period of uncertainty. Radical uncertainties are a more apt term, with the emphasis on the radical.

Let’s hope that pitchforks are not part of our future.

Stuff Happens

Mervyn King is not remembered (by this blogger at least) as a particularly radical or reforming governor of the Bank of England. It is therefore surprising that he has written an acclaimed book, called “The End of Alchemy”, with perhaps some of the most thoughtful ideas on possible reforms we could make to get the global economy out of its current hiatus. One of the central themes in the book is the inability of existing Western economic orthodoxy to adequately consider the impact of radical uncertainty. He quips that “current policies based upon the model of the economics of stuff rather than the economics of stuff happens”.

King defines radical uncertainty as “uncertainty so profound that it is impossible to represent the future in terms of probabilistic outcomes”. A current example could be the Brexit vote this coming Thursday, with commentators struggling to articulate the medium term knock-on impacts of this tightly forecasted vote. This post is not about Brexit as this blogger for one is struggling to understand the reasons and the impacts of the closeness of the vote. I do think the comments from Germany’s finance minister, Frank-Walter Steinmeier, this week that a leave vote would mean “the EU will find itself in a deep crisis” are pertinent and amongst the many issues we will likely face in the medium term if the UK actually disengages from the EU. The current mood of voters in Western economies, such as the UK and the US, does underline the urgent need for radical thinking to be adopted into the way we are addressing global economic and social issues in my view.

King’s book is not only full of interesting ideas but he also has a cutting turn of phrase. Amongst my favourites are:  “economists mistrust trust”, “liquidity is an illusion”, and “any central bank that allows itself to be described as the only game in town would be well advised to get out of town”. Before I go over some of King’s ideas, I think it would be useful to recap on the conclusions from other recent books from UK authors on policy measures needed to address the current stagnation, in particular “The Shifts and the Shocks” by the highly regarded Financial Times commentator Martin Wolf and (to a lesser extent) “Between Debt and the Devil” by the former UK financial regulator Adair Turner. Wolf’s book was previously reviewed in this post and Turner’s book was referenced in this post.

Wolf articulated the causes of the financial crisis as “a savings glut and associated global imbalances, an expansionary monetary policy that ignored asset prices and credit, an unstable financial system, and naive if not captured regulation”.  Wolf argues for practical policy measures such as much higher and more resilient capital requirements in banking (he rejects the 100% reserve banking envisaged by proponents of the so-called Chicago Plan as too radical), resolution plans for global systemic financial institutions, more bail-inable debt in banking capital structures and similar alignment changes to the terms of other financial contracts, proper funding of regulatory bodies and investigators of criminal misbehaviour, tax reform with a bias towards equity and away from leverage, tax on generational transfers of land, measures to address income inequality (due to the resulting dilution of demand stimulus measures as a result of the rich’s higher propensity to save) and measures to encourage business and infrastructure investment, education and R&D.

Wolf also highlights the need for new thinking at global institutions, such as IMF and those (unelected) bodies governing the Eurozone, particularly the urgent need (although he is pessimistic on the possibility) for global co-operation and radical action to address the imbalances in the global economy. The need for deeper co-ordination, irrespective of narrow short term nationalistic interests, is nowhere more obvious than in the Eurozone with the alternative being financial disintegration. The Brexit vote is an illustration of the UK electorate’s preference for disintegration (as is the popularity of Trump in the US), presented by shady politicians as a return to the good ole days (!??!), and is perhaps a precursor to a more general disintegration preference by voters across the globe. Wolf observes that “financial integration has proved highly destabilizing” and that “the world maybe no more than one to at most two crises away from such a radical deconstruction of globalized finance”.

Turner’s book is more focused on the failure of free markets to “ensure a socially optimal quantity of private credit creation or its efficient allocation” and the need for policy makers to constrain private credit growth, particularly excessive debt backed by real estate, and the creation of less credit intensive economies. Turner argues that “the pre-crisis orthodoxy that we could set one objective (low and stable inflation) and deploy one policy tool (interest rate) produced an economic disaster”. In common with Wolf, Turner also advocates structural changes to tax and financial contracts to incentivize credit away from land and towards productive investment and policies to address income inequality. Turner also rejects 100% reserve banking as too radical in today’s world and favours much higher capital requirements and restrictions on the shadow banking sector. On the need for China and Germany to take responsibility for the impact of their policies on global imbalances, he repeats the pious lecturing of current elites (without the negativity of Wolf on the reality of such policies actually happening). Similarly he repeats the (now) consensus view on the need for the Eurozone to either federalise or dissolve.

As to real solutions, Turner states that “our challenge is to find a policy mix that gets us out of the debt overhang created by past excessive credit creation without relying on new credit growth” and favours the uses of further monetary measures such as Bernanke’s helicopter money, once-off debt write off and radical bank recapitalisation. Although he highlights the danger of opening the genie of money finance, his arguments on containing such dangers in the guise of once-off special measures are not convincing.

King highlights many of the same issues as Wolf and Turner as to how we got to where we are. The difference is in his reasoning of the causes. He points to significant deficiencies in the academic thinking behind the policies that govern Western economies. As such, his suggestions for solutions are more fundamental and require a change in consensus thinking as well as changes in policy responses. As King puts it – “I came to believe that fundamental changes are needed in the way we think about macroeconomics as well as in the way central banks manage their economics”.  According to King, theories upon which policies are based need to accommodate the reality of radical uncertainty, a model based upon the economics of stuff happens rather than the current purest (and unrealistic) models of the economics of stuff. King states that “we need an alternative to both optimising behaviour and behavioural economics”.

One of King’s most interesting and radical ideas is for a compromise between the current fractional banking model and the 100% reserve narrow bank model proposed under the so-called Chicago Plan. As King observes “to leave the production of money solely to the private sector is to create a hostage to fortune” and “for a society to base its financial system on alchemy is a poor advertisement for its rationality”. The alchemy King refers to here (and in the title of his book) is the trust required in the current “borrow short-lend long” model we employ in our fractional banking system. Such trust is inherently variable due to radical uncertainty and the changes in the level of trust as events unfold are at the heart of the reason for financial crises in King’s view.

Perhaps surprising for an ex-governor of the Bank of England, King highlights the dangers of overtly complex regulations (the UK PRA rule-book runs to 10,000 pages for banks) with the statement that “by encouraging a culture in which compliance with detailed regulations is a defence against a charge of wrong-doing, bankers and regulators have colluded in a self-defeating spiral of complexity”.  He warns that “such complexity feeds on itself and brings the system into disrepute” and that “arbitrary regulatory judgements impose what is effectively a high tax on all investments and savings”. This is a sentiment that I strongly agree with based upon recent experiences. All of the authors mentioned in this post are disparaging on the current attempts to fix banking capital requirements, particularly the discredited practise of applying capital ratios to risk weighted assets (RWA). A recent report from the Bank of International Settlements (BIS) illustrates the dark art behind bank’s RWA calculations, as per the graph below.

click to enlargeAverage Risk Weighted Assets

King’s idea is to replace the lender of last resort (LOLR) role of Central Banks in the current system to that of a pawnbroker for all seasons (PFAS). In non-stress times, Central Banks would assess haircuts against bank assets, equivalent to an insurance premium for access to liquidity, which reflect the ability of the Central Bank to hold collateral through a crisis and dispose of the assets in normal times (much as they currently do under QE). These assets would serve as pre-positioned collateral which could be submitted to the Central Bank in exchange for liquidity, net of the haircut, in times of stress who would act as a pawnbroker does. The current regulatory rules would then (over a transition period of 10-20 years) be replaced by two simply rules. The first would be a simple limit on leverage ratio (equity to total nominal assets). The second rule would be that effective liquid assets or ELA (pre-positioned collateral plus existing Central Bank reserves) would be at least equal to effective liquid liabilities or ELL (total deposits plus short term unsecured debt). The graphic below represents King’s proposal compared to the existing structure.

click to enlargeFractional Banking Pawnbroker Seasons Banking

King states that “the idea of the PFAS is a coping strategy in the face of radical uncertainty” and that it is “akin to a requirement on private institutions to take out compulsory insurance”. He highlights its simplicity as a workable solution to the current moral hazard of the LOLR which recognises that in a crisis the only real source of liquidity is the Central Bank and it structurally provides for such liquidity on a pre-determined basis. Although it is not a full narrow bank proposal, it does go some way towards one. As such, and as the graphic illustrates, it will require a significant increase in equity for private banks (similar to that espoused by Wolf and Turner, amongst others) which will have an impact upon overall levels of credit. Turner in particular argues strongly that it is the type of credit, and its social usefulness, that is important for long term sustainable economic growth rather than the overall level of credit growth. Notwithstanding these arguments, the PFAS is an elegant if indeed radical proposal from King.

Another gap in modern economic theory and thinking, according to King, is the failure to follow policies which address the problem of the prisoner’s dilemma, defined as the difficulty of achieving the best outcome when there are obstacles to co-operation. King gives the pre-crisis failure to recognise that each private bank faced a prisoner’s dilemma in running down its holdings of liquid assets, and financing itself as cheaply as possible by short-term debt, as the only means of competing with its peers on the profit expectations of the free market. The global economy currently faces a prisoner’s dilemma as the current (tired) orthodoxy of trying to stimulate demand is failing across developed economies as people are reluctant to consume due to fears about the future. In his own acerbic way, King quips that we cannot expect the US “to continue as the consumer of last resort”.

Current policy measures of providing short-term stimulus through low interest rates are diametrically opposite to those needed in the long run in King’s view. People, in effect, do not believe the con that Central Bank’s artificial reduction in risk premia is trying to sell, resulting in a paradox of policy. King believes that “further monetary stimulus is likely to achieve little more than taking us further down the dead-end road of the paradox of policy“. This means that Central Banks are currently in a prisoner’s dilemma – if any of them were to unilaterally raise interest rates, they would risk a slowing of growth and possibly another downturn in their jurisdiction. A co-ordinated move to a new equilibrium is what is needed and institutions like the IMF, who’s role is to “speak truth to power”, can hypnotise all they like about what is needed but the prisoner’s dilemma restricts real action. Unfortunately, King does not have any real solution to this issue besides those hopeful courses of action offered by others such as Wolf and Turner.

The unfortunate reality is that we seem to be on a road towards more disintegration rather than greater co-operation in the world economy. King does highlight the similarities of such a multi-polar world with the unstable position prior to the First World War, which is a cheery thought. Any future move towards disintegration across developed economies doesn’t bode well for the future, particularly when the scary issue of climate change is viewed in such a context. I hope we wouldn’t get more illustrations of the impact of radical uncertainty on our existing systems in the near future, nor indeed of our policymaker’s inability to address such uncertainty in a coherent and timely way.

I do however strongly recommend King’s book as a thought provoking read, for those who are so inclined.