Tag Archives: the Economist

Summer Blues

After the holidays, it’s time to pack the bucket and spades away and get back into the routine. It has been a volatile August.  A bear call in a post in early May is looking pertinent (as is the post on a suggested tie-up between Paddy Power and Betfair!) given the 7% drop in the S&P500 since then, although it is more likely dumb luck.

The market concern is centred on the prospects for China’s economy. Growth is widely believed to be a lot lower than the official 7% with exports down, concerns about zombie loans and the political ramifications of managing a lower growth economy. The Economist, in an article this week, highlighted the potential impact of a slow-down in China and other emerging markets on global growth, as per the graph below.

click to enlargeGlobal GDP Growth Breakdown 1980 to 2015

Amongst the usual holiday reading, I brought two books on economics for the beach. The first was the FT’s Martin Wolf’s “The shifts and the shocks” from late in 2014 and the second is the recently published “Postcapitalism” by Paul Mason. Although often a laboured read, I did manage to finish the former whilst I only got to start the latter (which is a much easier read).

Reading Wolf’s book as the China led volatility was unfolding only led to an enhanced feeling of negativity from the themes of the book, namely the lessons as yet unlearned from the crisis. Wolf competently covers much of the causes of the crisis and its aftermath – a global savings glut and associated global imbalances, an expansionary monetary policy that ignored asset prices and credit, an unstable liberalized financial system supervised by naïve regulation. The following graph from the IMF reminds of the global imbalances that proved so toxic when combined with a rampant financial sector.

click to enlargeGlobal Current Account Imbalances 1980 to 2013

Wolf questions the “belief that government borrowing is the illness for which private borrowing is the cure has survived all that has happened”. Some of the solutions that Wolf proposes include much higher capital requirements for banks than is currently being implemented under Basel III, deleveraging initiatives such as tax incentives towards equity and away from debt, corporate tax changes to encourage corporate investment, changes in debt contracts to convert to equity on macro-economic metrics, policies to address income inequality and to promote research and education.

A more radical reform of the financial system, along the lines of the Chicago Plan for 100% reserve banking whereby the ability to create money is taken away from profit seeking banks and given solely to central banks, is a step that Wolf favours but believes is unrealistic given the realpolitik of the developed world system. On the globalised financial system, Wolf believes that the “obvious truth that unless regulation and the supply of fiscal backstops is to be much more global, finance should be far less so” and suggests a greater segmentation of the world’s financial system.

There are many themes in Wolf’s book that got me thinking and I am hoping that Mason’s book will do the same, albeit from a totally different perspective. I think the market volatility has more time to play out and hopefully my summer reading, although yet to be completed, will assist in understanding what may come next.

Tails of VaR

In an opinion piece in the FT in 2008, Alan Greenspan stated that any risk model is “an abstraction from the full detail of the real world”. He talked about never being able to anticipate discontinuities in financial markets, unknown unknowns if you like. It is therefore depressing to see articles talk about the “VaR shock” that resulted in the Swissie from the decision of the Swiss National Bank (SNB) to lift the cap on its FX rate on the 15th of January (examples here from the Economist and here in the FTAlphaVille). If traders and banks are parameterising their models from periods of unrepresentative low volatility or from periods when artificial central bank caps are in place, then I worry that they are not even adequately considering known unknowns, let alone unknown unknowns. Have we learned nothing?

Of course, anybody with a brain knows (that excludes traders and bankers then!) of the weaknesses in the value-at-risk measure so beloved in modern risk management (see Nassim Taleb and Barry Schachter quotes from the mid 1990s on Quotes page). I tend to agree with David Einhorn when, in 2008, he compared the metric as being like “an airbag that works all the time, except when you have a car accident“.  A piece in the New York Times by Joe Nocera from 2009 is worth a read to remind oneself of the sad topic.

This brings me to the insurance sector. European insurance regulation is moving rapidly towards risk based capital with VaR and T-VaR at its heart. Solvency II calibrates capital at 99.5% VaR whilst the Swiss Solvency Test is at 99% T-VaR (which is approximately equal to 99.5%VaR). The specialty insurance and reinsurance sector is currently going through a frenzy of deals due to pricing and over-capitalisation pressures. The recently announced Partner/AXIS deal follows hot on the heels of XL/Catlin and RenRe/Platinum merger announcements. Indeed, it’s beginning to look like the closing hours of a swinger’s party with a grab for the bowl of keys! Despite the trend being unattractive to investors, it highlights the need to take out capacity and overhead expenses for the sector.

I have posted previously on the impact of reduced pricing on risk profiles, shifting and fattening distributions. The graphic below is the result of an exercise in trying to reflect where I think the market is going for some businesses in the market today. Taking previously published distributions (as per this post), I estimated a “base” profile (I prefer them with profits and losses left to right) of a phantom specialty re/insurer. To illustrate the impact of the current market conditions, I then fattened the tail to account for the dilution of terms and conditions (effectively reducing risk adjusted premia further without having a visible impact on profits in a low loss environment). I also added risks outside of the 99.5%VaR/99%T-VaR regulatory levels whilst increasing the profit profile to reflect an increase in risk appetite to reflect pressures to maintain target profits. This resulted in a decrease in expected profit of approx. 20% and an increase in the 99.5%VaR and 99.5%T-VaR of 45% and 50% respectively. The impact on ROEs (being expected profit divided by capital at 99.5%VaR or T-VaR) shows that a headline 15% can quickly deteriorate to a 7-8% due to loosening of T&Cs and the addition of some tail risk.

click to enlargeTails of VaR

For what it is worth, T-VaR (despite its shortfalls) is my preferred metric over VaR given its relative superior measurement of tail risk and the 99.5%T-VaR is where I would prefer to analyse firms to take account of accumulating downside risks.

The above exercise reflects where I suspect the market is headed through 2015 and into 2016 (more risky profiles, lower operating ROEs). As Solvency II will come in from 2016, introducing the deeply flawed VaR metric at this stage in the market may prove to be inappropriate timing, especially if too much reliance is placed upon VaR models by investors and regulators. The “full detail of the real world” today and in the future is where the focus of such stakeholders should be, with much less emphasis on what the models, calibrated on what came before, say.

Reluctant Bulls

There was a nice piece from Buttonword in the Economist where he concluded that despite all the indicators of the equity market being overvalued that “investors are reluctant bulls; there seems no alternative”. This seems like a rationale explanation for the relatively irrational behaviour of current markets.

He highlighted indicators like the high CAPE, figures from the Bureau for Economic Analysis (BEA) on the profit dip in Q1, high share buybacks, figures from SocGen’s Andrew Lapthorne that the ratio of corporate debt to assets is close to its 2009 peak, and a BoA Merrill Lynch poll which shows that 48% of institutional investors are overweight equities whilst a net 15% believe they are overvalued.

Despite the bearish indicators everywhere, investors seem frozen by central bank indecision on whether economies still need help by remaining accommodative or that the recovery has taken hold and monetary policy needs to start to tighten.

Andrew Lapthorne released some analysis earlier this month highlighting that a significant amount of the previous year’s earnings growth was down to M&A from Verizon and AT&T and concluded that EPS growth by M&A and from share buybacks is a classic end of cycle indicator. Lapthorne produced the graph below of historical peaks and troughs in the S&P500 and noted that the average historical 1% down days is 27 per year since 1969 an the S&P500 has only had 16 in the past 12 months and that we have gone through the 4th longest period on record without a market correction of 10% or more.

click to enlarge
SocGen peak to through

Albert Edwards, also at SocGen, points to the difference in the BEA profit statistics and those reported being down to the expiration of tax provisions for accelerated depreciation and he concludes that “the bottom line is that the U.S. profits margin cycle has begun to turn down at long last“.

Even the perma-bull David Bianco of Deutsche Bank has cautioned against overvaluation calling the market complacent and moving into mania territory using their preferred measure of sentiment, namely the PE ratio divided by the VIX. The graph below from early June illustrates.

click to enlarge
DB Price Earnings VIX Ratio

From my point of view, I think the chart of the S&P500 for the past 10 years tells its own story about where we are. As Louis Rukeyser said “trees don’t grow to the sky“. Nor do equity markets.

click to enlarge

S&P500 Past 10 Years