Tag Archives: income inequality

Peak Uncertainty

As we face the peak weeks of the COVID19 virus in the major developed economies, one thing the current COVID19 outbreak should teach us is humility. As humans, we have become far too arrogant about our ability to shape the future. A new book by the economists John Kay and Mervyn King (a former Bank of England governor during the financial crisis) called “ Radical Uncertainty” argues that economists have forgotten the distinction between risk and uncertainty with an over-reliance on using numerical probabilities attached to possible outcomes as a substitute for admitting there are uncertainties we cannot know. How many one in a century events seem to be happening on a regular basis now? Their solution is to build more resilient systems and strategies to confront unpredictable events. Such an approach would have a profound impact on how we organise our societies and economies.

Currently, planning for events with a large impact multiplied by a small probability allows us to effectively continue as we have been after assigning the minimal amount of contingency. Imagine if sectors and industries were run based on been prepared for tail events. That would be a radical change. Very different from our just in time supply chains which minimise capital allocation and maximise return on investment. Our approach to climate change is an obvious case in point and how we have heretofore ignored the environmental externalities of our societies and economies. Given the financial costs this crisis is going to place on future generations, I would suspect that the needs of this cohort of our society will become ever more urgent in the aftermath of the COVID19 pandemic.

As many people grapple with the current uncertainties presented by this pandemic, we are currently at peak uncertainty in Europe and the US. We are only now getting a sense of how the outbreak is peaking in Europe given the lock down measures in place. How the virus reactions to the relaxation of current measures, how the outbreak will peak across the US and other continents, the economic impact of the outbreak, or the societal impact amongst many other issues are as yet unknown. We do know however that with time over the coming weeks some of these answers will become clearer. For example, as the graph below from the FT shows, we known the approximate path of the outbreak given the policies being pursued today.

A positive narrative could be that existing medications pass rushed COVID19 trials and prove they can blunt the impact of the virus thereby altering the shape of the curve. We can also speculate that once the first wave is contained, we will develop strategies on a combination of mitigation measures (e.g. reduced isolation methods, antibody and other testing to return sections of the population to work, immunity passports, etc) to slowly transition to the new normal. The logistics of such a phased return to normal will be complex and a nightmare to enforce, particularly if self-isolation measures are in force for lengthy periods and people believe any second wave can be well contained by battle hardened health systems. We can be confident that a vaccine will be developed, hopefully by early 2021, but it will take time to get the vaccine distributed and administered in bulk. Mid 2021 is likely the best we can realistically hope for.

At this stage, my rough guess at a base case scenario on the timing for European and US lockdown is 3 to 5 weeks with another 6 to 10 weeks to transition to a semi-new normal. That’s somewhere between mid-June and early August with Europe leading the way followed by the US. A more pessimistic case could be that discipline amongst the population gets more lax as the weeks drag on and a second wave gathers momentum with a second lockdown required over the summer followed by a more timid and gradual transition afterwards lasting until the end of the year. Obviously, these timings are pure guesses at this time and may, and hopefully will, prove way off base.

The economic impacts are highly uncertain but will become clearer as the weeks pass. For example, with just the first fiscal stimulus package passed in the US, the politicians are already listing their priorities for the second (and likely not to be the last either), Morgan Stanley expect the cyclically adjusted primary fiscal deficit to rise to 14% of GDP and the headline fiscal deficit at 18% of GDP in 2020, as per their graphic below. Given the unknown impact of the crisis on GDP numbers, these percentages could approach 15% to 20% with total debt of 110% to 120%. It’s depressing to note that prior to this crisis the IMF said the U.S. debt-to-GDP was already on an unsustainable path.

Although the euro zone comes into the crisis with less debt, last year it was 86% of GDP, Jefferies said in a ‘worse case’ outcome where nominal GDP falls 15% this year, the bloc’s budget gap would balloon to 17% of GDP from just 0.8% last year. They estimate in this scenario that the euro zone debt-GDP ratio could rise above 100% in 2021. As a percentage of GDP, Morgan Stanley estimated the G4+China cyclically adjusted primary deficit could rise to 8.5% of GDP in 2020, significantly higher than the 6.5% in 2009 immediately after the global financial crisis. Unemployment rates in the short term are projected to be mind boggling horrible at 20%+ in some countries. It seems to me that the austerity policies pursued after the financial crisis will not be as obvious an answer to repayment of this debt, not if we want western societies to survive. Addressing generational and structural income inequalities will have to be part of the solution. Hopefully, an acceleration of nationalism wouldn’t.

On the monetary side, the Fed’s balance sheet is now estimated to be an unprecedented $6 trillion, an increase of $1.6 trillion since the start of the Fed’s unprecedented bailout on the 13th of March. Bank of America estimates it could reach $9 trillion or 40% of GDP, as per the graphs below.

As to corporates and the stock market, dividends will undoubtably be under pressure as corporate delevering takes hold and without the crack cocaine of the bull market, share buybacks as the graph below shows, I fear there will be more pressure on valuations. The Q1 results season and forward guidance (or lack thereof), although it may have some surprises from certain firms in the communication, technology and consumer staples space, will likely only compound the negativity and uncertainty.

Using unscientific guesses on my part, I have estimated base and pessimistic operating EPS figures for the S&P500 as below. Based upon a forward PE (on a GAAP EPS) of 15 (approx. 12.75 on operating EPS basis), which is the level reached after the dot com bubble and the financial crisis, the resulting level for the S&P500 is 2,000 and 1,600 in the base and pessimistic scenarios respectively. That’s a further 20% and 35% drop from today’s levels respectively.

The coming weeks will likely be horrible in terms of human suffering and death across the developed world (one cannot even comprehend the potential suffering in the developing world if this insidious virus takes hold there). There is always hope and uncertainty will reduce over time. Major decisions will need to be made in the months and years ahead on the future of our societies. Learning from this pandemic to build more resilient societies and economies will be a task that lasts many years, possibility even generations. Major changes are coming after this health crisis subsides, hopefully they will be for the better.

Stay safe.


As is now customary ahead of Davos week, the latest World Economic Forum report on global risks was released and the usual graphic of the top 5 global risks in terms of likelihood and impact are reproduced below. Environmental risks and technology risks again dominate the likelihood list which is indicative of the current consensus. As this post highlights, the likelihood of irreversible climate change within the next 10 to 20 years is the short, medium and long-term issue of our times.

Although the report does state that “geopolitical and geo-economic tensions are rising among the world’s major powers” and that these “tensions represent the most urgent global risks at present”, I was somewhat surprised to see that geopolitical risk did not make the top 5 likelihood list this year. Despite the current market (wishful in my view) thinking of a kick the can down the road fudge outcome, Brexit in 2019 may result in a constitutional crisis in the UK or the possibility of a large portion of the population being alienated by a possible rushed outcome this Spring (e.g. hard Brexit or permanent custom union). His Orangeness and his ability to flame division, whether internally in the US after a bad Mueller report or against China to deflect from his pitiful negotiating style, are ever present possibilities for 2019 (if not hopefully remote ones). Although maybe somewhat alarmist, I can’t but help worry that his reign may end with some form of violent turmoil, he will not go quietly!

As an aside, the wonderful TV show “Brexit: The Uncivil War” from the UK’s Channel 4, which I think is on Netflix now, does raise the issue of how democracies will operate in a world where all sides can use technology to manipulate a (potentially decisive) disengaged minority to the political extremes. If the long-term success of democracy is dependent upon compromise, then we may be in trouble. Pundits say the implications of Brexit politics is a break from the traditional left/right or conservative/liberal divide, into a much more complex mixture of differing tribes. In fact, I would highly recommend this video from Dominic Cummings, the main subject of the show, who ably explains the parameters of the new political landscape (if you don’t have the time to watch it all, watch a few minutes after the 15-minute mark on how they did it).

click to enlarge

One other item that caught my attention in the WEF report, in section 6 called Open Secrets, was the assertion that when “the huge resources being devoted to quantum research lead to large-scale quantum computing, many of the tools that form the basis of current digital cryptography will be rendered obsolete”. The article further asserts that “public key algorithms, in particular, will be effortlessly crackable” and, under certain scenarios, “a collapse of cryptography would take with it much of the scaffolding of digital life”. Do I hear a new arms race approaching? The report predicts “as the prospect of quantum code-breaking looms closer, a transition to new alternatives—such as lattice-based and hashbased cryptography—will gather pace” although “some may even revert to low-tech solutions, taking sensitive information offline and relying on in-person exchanges”. Imagine having to rely on people meeting other people to get things done……..unthinkable!

Crises Chronicles

Ray Dalio is on a mission to share insights gained over 40 years at the helm of the vastly successful Brightwater Associates. After the financial crisis, Dalio published an excellent article on the workings of the economy. In 2017, he expanded on his previously published philosophy in a book called Principles (as per this summary). More recently he published a free downloadable book called A Template for Understanding Big Debt Crises, available here.

I have a copy of Principles but I must admit I have yet to finish reading it (on my to do list!). I have read the first section of the latest Big Debt Crises book and would highly recommend it. The second section of the book has detailed case studies (the US 2007-11, the US 1928-37, and Germany 1918-24) and the third section is a compendium of 48 other case studies.

Two graphs below from the Big Debt Crises book are worth reproducing, reflecting key factors behind our economy today.

click to enlarge

click to enlarge

Dalio is an astute student of history. He recently commented that “the biggest mistake that most people make is to judge what will be good by what has been good lately”.

Amen to that.

A Riskier World?

This year’s Davos gathering is likely to be dominated by Donald Trump’s presence. I look forward to seeing him barge past other political and industry leaders to get his prime photo opportunity. As US equity markets continue to make all time highs in an unrelentingly fashion, it is scary to see the melt-up market been cheered on by the vivacious talking heads.

Ahead of Davos, the latest World Economic Forum report on global risks was released today. 59% of the contributors to the annual global risks survey point to an increase in risks in 2018, with environmental and cybersecurity risks continuing their trend of growing prominence, as can be seen below.

click to enlarge

Undoubtedly, environmental risks are the biggest generational challenge we face and it is hard to argue with the statement that “we have been pushing our planet to the brink and the damage is becoming increasingly clear“. That said, what is also striking about these assessments (and its important to remember that they are not predictions) is how the economic risks (light blue squares) have, in the opinion of the contributors, receded as top risks in recent years. The report does state that although the “headline economic indicators suggest the world is finally getting back on track after the global crisis that erupted 10 years ago” there is “continuing underlying concerns”.  Amongst these concerns, the report highlights “potentially unsustainable asset prices, with the world now eight years into a bull run; elevated indebtedness, particularly in China; and continuing strains in the global financial system”.

A short article in the report entitled “Cognitive Bias and Risk Management” by Michele Wucker caught my attention. The article included the following:

Risk management starts with identifying and estimating the probability and impact of a given threat. We can then decide whether a risk falls within our tolerance limits and how to react to reduce the risk or at least our exposure to it. Time and again, however, individuals and organizations stumble during this process—for example, failing to respond to obvious but neglected high-impact “grey rhino” risks while scrambling to identify “black swan” events that, by definition, are not predictable.


One of the most pervasive cognitive blinders is the availability bias, which leads decision-makers to rely on examples and evidence that come immediately to mind. This draws people’s attention to emotionally salient events ahead of objectively more likely and impactful events.

I do wonder about cognitive blinders and grey rhinos for the year ahead.

Still Dancing

The latest market wobble this week comes under the guise of the endless Trump soap opera and the first widespread use of the impeachment word. I doubt it will be the last time we hear that word! The bookies are now offering even odds of impeachment. My guess is that Trump’s biggest stumble will come over some business conflict of interest and/or a re-emergence of proof of his caveman behaviour towards woman. The prospect of a President Pence is unlikely to deeply upset (the non-crazy) republicans or the market. The issue is likely “when not if” and the impact will depend upon whether the republicans still control Congress.

Despite the week’s wobble, the S&P500 is still up over 6% this year. May is always a good month to assess market valuation and revisit the on-going debate on whether historical metrics or forward looking metrics are valid in this low interest rate/elevated profit margin world. Examples of recent posts on this topic include this post one highlighted McKinsey’s work on the changing nature of earnings and this post looked at the impact of technology on profit profiles.

The hedge fund guru Paul Tudor Jones recently stated that a chart of the market’s value relative to US GDP, sometimes called the Buffet indicator as below, should be “terrifying” to central bankers and an indicator that investors are unrealistically valuing future growth in the economy.

click to enlarge

Other historical indicators such as the S&P500 trailing 12 month PE or the PE10 (aka Shiller CAPE) suggest the market is 60% to 75% overvalued (this old post outlines some of the on-going arguments around CAPE).

click to enlarge

So, it was fascinating to see a value investor as respected as Jeremy Grantham of GMO recently issue a piece called “This time seems very very different” stating that “the single largest input to higher margins, though, is likely to be the existence of much lower real interest rates since 1997 combined with higher leverage” and that “pre-1997 real rates averaged 200 bps higher than now and leverage was 25% lower”. Graham argues that low interest rates, relative to historical levels, are here for some time to come due to structural reasons including income inequality and aging populations resulting in more aged savers and less younger spenders. Increased monopoly, political, and brand power in modern business models have, according to Graham, reduced the normal competitive pressures and created a new stickiness in profits that has sustained higher margins.

The ever-cautious John Hussman is disgusted that such a person as Jeremy Grantham would dare join the “this time it’s different” crowd. In a rebuttal piece, Hussman discounts interest rates as the reason for elevated profits (he points out that debt of U.S. corporations as a ratio to revenues is more than double its historical median) and firmly puts the reason down to declining labour compensation as a share of output prices, as illustrated by the Hussman graph below.

click to enlarge

Hussman argues that labour costs and profit margins are in the process of being normalised as the labour market tightens. Bloomberg had an interesting article recently on wage growth and whether the Phillips Curve is still valid. Hussman states that “valuations are now so obscenely elevated that even an outcome that fluctuates modestly about some new, higher average [profit margin] would easily take the S&P 500 35-40% lower over the completion of the current market cycle”. Hussman favoured valuation metric of the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues), shown below, predicts a rocky road ahead.

click to enlarge

The bulls point to a growing economy and ongoing earnings growth, as illustrated by the S&P figures below on operating EPS projections, particularly in the technology, industrials, energy, healthcare and consumer sectors.

click to enlarge

Taking operating earnings as a valid valuation metric, the S&P figures show that EPS estimates for 2017 and 2018 (with a small haircut increasing in time to discount the consistent over optimism of analyst forward estimates) support the bull argument that current valuations will be justified by earnings growth over the coming quarters, as shown below.

click to enlarge

The IMF Global Financial Stability report from April contains some interesting stuff on risks facing the corporate sector. They highlight that financial risk taking (defined as purchases of financial assets, M&A and shareholder pay-outs) has averaged $940 billion a year over the past three years for S&P 500 firms representing more than half of free corporate cash flow, with the health care and information technology sectors being the biggest culprits. The IMF point to elevated leverage levels, as seen in the graph below, reflective of a mature credit cycle which could end badly if interest rates rise above the historical low levels of recent times.

click to enlarge

The report highlights that debt levels are uneven with particularly exposed sectors being energy, real estate and utilities, as can be seen below.

click to enlarge

The IMF looked beyond the S&P500 to a broader set of nearly 4,000 US firms to show a similar rise in leverage and capability to service debt, as illustrated below.

click to enlarge

Another graph I found interesting from the IMF report was the one below on the level of historical capital expenditure relative to total assets, as below. A possible explanation is the growth in technology driven business models which don’t require large plant & property investments. The IMF report does point out that tax cuts or offshore tax holidays will, based upon past examples, likely result in more financial risk taking actions rather than increased investment.

click to enlarge

I also found a paper referenced in the report on pensions (“Pension Fund Asset Allocation and Liability Discount Rates” by Aleksandar Andonov, Rob Bauer and Martijn Cremers) interesting as I had suspected that low interest rates have encouraged baby boomers to be over-invested in equities relative to historical fixed income allocations. The paper defines risky assets as investments in public equity, alternative assets, and high-yield bonds. The authors state that “a 10% increase in the percentage of retired members of U.S. public pension funds is associated with a 5.93% increase in their allocation to risky assets” and for all other funds “a 10% increase in the percentage of retired members is associated with a 1.67% lower allocation to risky assets”.  The graph below shows public pension higher allocation to risky assets up to 2012. It would be fascinating to see if this trend has continued to today.

click to enlarge

They further conclude that “this increased risk-taking enables more mature U.S. public funds to use higher discount rates, as a 10% increase in their percentage of retired members is associated with a 75 basis point increase in their discount rate” and that “our regulatory incentives hypothesis argues that the GASB guidelines give U.S. public funds an incentive to increase their allocation to risky assets with higher expected returns in order to justify a higher discount rate and report a lower value of liabilities”. The graph below illustrates the stark difference between the US and Europe.

click to enlarge

So, in conclusion, unless Mr Trump does something really stupid (currently around 50:50 in my opinion) like start a war, current valuations can be justified within a +/- 10% range by bulls assuming the possibility of fiscal stimulus and/or tax cuts is still on the table. However, there are cracks in the system and as interest rates start to increase over the medium term, I suspect vulnerabilities will be exposed in the current bull argument. I am happy to take some profits here and have reduced by equity exposure to around 35% of my portfolio to see how things go over the summer (sell in May and go away if you like). The ability of Trump to deliver tax cuts and/or fiscal stimulus has to be question given his erratic behaviour.

Anecdotally my impression is that aging investors are more exposed to equities than historically or than prudent risk management would dictate, even in this interest rate environment, and this is a contributing factor behind current sunny valuations. Any serious or sudden wobble in equity markets may be magnified by a stampede of such investors trying to protect their savings and the mammoth gains of the 8 year old bull market. For the moment through, to misquote Chuck Price, as long as the music is playing investors are still dancing.