Category: Events
Market update: Measures to stall Coronavirus’ spread begin to impact global economic activity

Market update: Measures to stall Coronavirus’ spread begin to impact global economic activity

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This week has seen two precipitous declines in US stock markets. The volatility has been attributed to fears of the Coronavirus strain named COVID-19. This infectious disease has now spread to several countries and caused over 2700 deaths. The reports of confirmed cases have almost certainly been under-counted as numerous developing countries with weaker health systems lack the resources to identify and respond to such outbreaks. To keep things in context, the annual flu causes more deaths in the US alone.

The market drop on Monday was driven by fears about the impact of COVID-19 on global trade. On Tuesday, federal officials warned that COVID-19 would almost certainly spread in the United States. They indicated that health professionals, hospitals, communities, businesses and schools should begin making preparations. This would include “social distancing measures,” like smaller groups in classes, canceling meetings or conferences and making arrangements to work from home. Dr. Nancy Messonnier, director of the National Center for Immunization and Respiratory Diseases, said in a news briefing that “it’s not so much of a question of if this will happen anymore but rather more of a question of exactly when this will happen.”

While we can’t speculate about the disease itself, or its spread, as this is far outside our area of expertise (we would urge readers to follow guidance from public health and safety officials), what we can do is evaluate the economic impact of the CDC’s recommended containment measures. We know that measures taken in China to prevent the spread of COVID-19 have been very disruptive. Most commercial flights within China have been cancelled. Almost all international airlines have suspended flights into and out of China. Supply chains for numerous industries have been reduced to a standstill and economic activity measured by power has slowed markedly. Oil demand in China has fallen 20%. In Europe, sports events have been cancelled, the hospitality industry in affected areas has seen cancellations and schools have sent students who recently visited northern Italy home. A major bank issued a warning that Switzerland may enter a recession due to the COVID-19 outbreak.

If the measures discussed by the CDC were to be implemented in the US, there would be a significant impact on economic activity and by extension corporate earnings. Millions of Americans can telecommute to work and it is reasonable to expect they could continue to work through such a potential crisis. However, a large segment of the US manufacturing and service sectors would be hobbled. This includes most entertainment, food service, travel, manufacturing and retail. It is difficult to estimate the precise impact on earnings, but the fact that we were recently at all-time highs and at the end of a maturing business cycle suggests any drop in expected earnings would have a significant impact on markets.

We are also concerned about the current administration’s preparedness for such a crisis. In 2018, part of the pandemic response infrastructure put in place after the Ebola outbreak was dismantled, without an adequate replacement put in place. This gap may lead to less than optimal coordination between federal agencies. The current crisis also reminds us of Michael Lewis’ 2018 book, The Fifth Risk. Lewis interviewed senior staff and ex-staff across numerous government agencies after the current administration took office amid reports of a haphazard transition with qualified personnel were leaving without being replaced. One of Lewis’ observations is that the Federal government is partly in the business of risk management. It evaluates and contains risks that are too big for any other US organization to handle. Funding cuts and the loss of experienced personnel severely undermines this mission.

Our healthcare system also has idiosyncratic vulnerabilities when dealing with such public health crises. Unlike other developed countries, most Americans face out of pocket expenses for healthcare. There are reports that individuals asking to be tested for COVID-19 received large medical bills. We know that the fear of unexpected bills often prevents people in the US from seeking timely care, necessitating expensive, late-stage interventions. The lack of timely diagnosis and treatment could exacerbate the spread of COVID-19 and have widespread public health impacts. 

Even prior to the COVID-19 outbreak, we believed high equity valuations merited caution. Containment measures in China have already begun to impact the global economy, we expect the rising number of cases in Europe will have similar effects. If containment measures are required in the US, they are likely to have a significant impact on corporate earnings.

We reiterate our recommendation that investors maintain a defensive position in equities and other risk assets. We recommend caution as this situation continues to develop.

Q4 2016 letter

Q4 2016 letter

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Dear Friends,

We hope you have had a good start to the New Year and wish you the best for 2017. As always, in our first letter of the year we have attached a review our 2016 investment themes and a list of our investment themes for 2017.

The fourth quarter of 2016 revolved around politics, with a focus on the US presidential election. In Jan 2016, we wrote there was a “strong possibility one or both major party nominees will be from outside the establishment mainstream”. In retrospect, that looks like an understatement. A series of unusual news stories and the eventual surprising result of the US presidential election led to sharp drops in US equities in early November. Markets recovered quickly and ended the year close to or at their highs. In some ways this is a relief rally, driven by the realization that much of the Republican establishment will support the Trump administration and vice-versa.

The political upheavals of the past few months have not changed the underlying economic realities confronting investors. We are likely at the tail end of a bull-market that is almost 8 years old, and several risks loom on the horizon. Interest rates in the US will continue to rise as the Fed attempts to normalize historically low borrowing rates. This will modify the calculus for investors as interest bearing assets become attractive and rising rates impact the denominator in equity valuations.

The results of the US election have created enormous uncertainty about the US’s future economic policies, particularly with respect to trade. We believe that workers’ concerns about economic insecurity do require political solutions. We are not, however, convinced that protectionist barriers are the answer to job-losses in the US manufacturing sector (the last US experiment with high tariffs, 1930’s Smoot-Hawley Act, likely exacerbated the effects of the Great Depression). Nor do we believe it is in the US’s long-term interests to loosen environmental rules. The incoming administration seems bent on trying or threatening one or both of these approaches.

Roughly 50% of sales for S&P500 companies occur overseas. This underscores the global nature of the world we live in, and the degree to which US businesses rely on foreign operations. The prospect of a full-fledged trade war with major regions or countries should worry investors deeply. Though some investors may have been emboldened by the November/December recovery, we would advise caution given the significant headwinds and uncertainties facing us.

As always, we have published our investment themes for the upcoming year and reviewed our themes for 2016.

 

Regards,

Subir Grewal, CFA, CFP                                                        Louis Berger

2017 Themes: The Doldrums

2017 Themes: The Doldrums

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  1. Fed stays the course: We expect the Federal Reserve will continue to raise rates as stated. We expect the Fed-Funds rate to rise above 1.5% over the course of 2017.
  1. Equities Caution: We continue to be cautious on US equities, as we have been for the past several years. S&P 500 is priced at over 25 times last-year’s earnings. Even if we use projections that forecast a recovery in energy sector prices, P/E ratios are over 20. Rising rates erode support for outsized price-earnings ratios. We are also in the eighth year of a long bull market with a number of credit related issues in markets across the world. We continue to advocate for a cautious allocation to stocks and expect to see negative returns for US equities this year.
  1. Artificial Intelligence: Technology continues to come at us hard and fast, but the groundwork has been around for decades. We recall using voice-recognition software to dictate texts almost 20 years ago. It was slow and cumbersome. Modern voice recognition is vastly improved by faster hardware and refined software. When coupled with the ability to search for information and issue instructions to connected devices, this technology can seem very much like science fiction, evoking both fears and dreams. Yet, asking Alexa to lower your blinds is in essence no different than using “the clapper” to turn on the lights. We expect this to be the year that voice activated instructions come to various devices, including cars and household appliances. Companies with effective voice activated solutions will find themselves partnering with manufacturers of all sorts of devices, not simply computer and phone makers. The revenue and earnings implications are less clear. Licensing fees may not amount to much and a large part of the value for technology companies may derive from sales of media and in Amazon’s case, all sorts of goods. We expect performance for companies providing intelligence features in devices to outpace the consumer durables index over the next three years, we will evaluate ourselves annually on this call.
  1. Continental shifts: For much of human history Asia has been the center of the global economy. That changed in the centuries following the European industrial revolution and colonial expansion. Over the past thirty years, rapid growth in China has brought gross East/South Asian annual GDP (ex-Russia) to roughly 25 Trillion USD. This exceeds both that of North America and Europe/Central Asia, both around 20 Trillion USD. The big laggard in Asia has been India, where per capita GDP is 20% that of China. We expect India’s growth rate to exceed that of China’s for the next several years, with the relative difference in per capita GDP falling. Despite the numerous hurdles to doing business in India, we expect investors will begin to pay more attention to companies with exposure to India and an India related strategy. Over the next several years, we expect Indian markets to outperform those in China and the developed world.
  1. European upheavals: This will be a busy year of European politics, there are major elections in France and Germany. Looming over it all is last year’s British decision to exit the Europe zone. Any or all of these have the capacity to inject more policy uncertainty and create market upheavals. Though we believe European stocks to be more attractively priced than US equities, these concerns give us pause. Nevertheless, we expect European stocks to outperform US equities.
  1. Dollar strength continues: We expect the dollar to remain strong against major currencies worldwide. This impacts the returns dollar-based investors can expect to realize from foreign investments.
  1. Drones are going to be delivering much more than bombs: Many of us have been concerned about the impact of automated weapons on conflicts across the world. This technology raises numerous difficult ethical questions, alongside legal dilemmas. Less attention has been paid to the revolution soon to overtake transport and delivery services of every form. Remote operations and autonomous guiding systems are approaching the point where not just driverless cars, but pilot-less planes, captain-less ships and person-less food delivery are about to become a reality. These technologies are going to create immense disruptions for various work-forces across the aviation, shipping and transport sectors. As with so many other technologies, the armaments industry has led the way. But the long-term impacts on our economy, politics and lives will be driven by the commercial applications of these technologies. We expect companies building these technologies to outperform the freight and shipping transportation companies.
  1. Renewable Utilities: Though the incoming administration is not supportive of renewables, we think renewable utility companies or YieldCos will outperform conventional, fossil-fuel based utility stocks. Despite a high likelihood of loosening EPA standards, we think YieldCos benefit from a newer fleet of power plants and stock prices that haven’t recovered much from the energy crash of 2014/15.
  1. Retail Real-Estate: We believe the retail real estate sector will come under pressure from rising interest rates and a secular shift towards online purchases. We expect real estate companies that own large portfolios of malls and brick and mortar stores to underperform other real estate investments.
  1. Optimism about Trump presidency short-lived: We expect any investor-optimism surrounding the Trump presidency to evaporate rather quickly in 2017 as markets find he is unable to follow through on his lofty campaign promises.
2015 year-end review of themes

2015 year-end review of themes

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Overall, we did well on our call for 2015. We were right on six, half right on three others and had one wrong. In general, the year lived up to our expectations of a low return environment with the anticipated Fed rate hike being the biggest influence.

 

  1. ~ If not now, when? If not the Fed, who?: We expect the Federal Reserve to raise interest rates in 2015. We expect rates to gradually rise to a 1.0%–1.5% target, which would still be historically low. We were right on this call, but the Fed chose to wait till December to raise rates to 0.50%.Though the Fed has signaled rates will be raised to 1.25-1.50%, we are calling this one half-right.

 

  1. ~ No one rings a bell at the top of the market: […] we expect major US indexes (S&P 500, Dow Jones, Nasdaq) to finish the year in negative territory. We were mostly right here, two out of the three indices ended down. The S&P500 ended 2014 at 2,059 and 2015 at 2,044; the Dow Jones dropped from 17,823 to 17,425; but the Nasdaq rose from 4,736 to 5,007.

 

  1. + Emerging troubles: Emerging economies will continue to stumble in 2015, this includes resource dependent countries such as Russia and Brazil which have run into roadblocks as energy prices have fallen dramatically. […] We expect emerging market stocks and bonds to underperform developed markets this year. The MSCI Emerging Markets Index ended the year down 17%. The Chinese markets ended the year down over 10%, Brazil was down almost 16%, Russia down over 6%, and India down over 2%.

 

  1. + Commodities weighed down: […] We see commodities finishing the year flat to negative. The Goldman-Sachs Commodities Index ended 2015 down over 30%.

 

  1. +  The trouble with oil: We do not expect oil prices to substantially recover in 2015. […] We expect brent crude prices to remain under $60 by year’s end. Brent crude started the year around $57 and ended 2015 around $37.

 

  1. + Playing defense: For US equities, we believe defensive sectors, including healthcare and utilities will outperform others over the course of 2015. In any sort of correction, we expect enterprises providing essential goods and services to maintain profitability and revenues. Over-levered companies that have benefitted from speculative euphoria in recent years are particularly vulnerable to sell-offs in our view. We were half right on this call as healthcare outperformed the S&P 500 Index in 2015 (S&P Healthcare Index +5.8%) while utilities lagged (S&P Utilities Index -7.9%).

 

  1. + Euro Crisis, back to the future: […] Depending on outcomes, another round of brinksmanship will likely begin between Greek politicians, the markets and EU officials. Over the past few years, attitudes have hardened and we believe there is a real chance that Greece may be forced to, or choose to leave the Euro. Over the course of the year, we saw another round of concerns about Greece that led to weeks of tense negotiation. The Euro ended the year down about 10% against USD (from 1.20 to 1.07) partly s a result of continued concern about the longer-term prospects for the Euro-zone. Though economic issues have faded from view as a continuing refugee crisis absorbs headlines, we do not believe the Euro-zones strategic challenges have been dealt with.

 

  1. + Junk bonds get kicked to the curb. […] With rates rebounding (even marginally), we believe investors will find the reward that comes with high yield bonds no longer worth the risk.  We were correct on this call as high yield bonds suffered their first down year since 2008.  The Barclays High Yield Bond Index was -6.77% for 2015.

 

  1. × Growth in Renewables: […] With oil prices falling again, we’ve seen many renewable stocks follow suit, as sort of a knee jerk reaction by investors. We think this provides a tremendous buying opportunity, particularly in the YieldCo space where, like utilities, companies own a portfolio of newly constructed power projects with long term power purchasing agreements in place.  We believe we’re a bit early on this call, but for year-end list-scoring purposes we were wrong.  Renewable energy stocks had a negative return for 2015 impacted by falling prices for conventional energy. Renewables did however, outperform traditional fossil fuel energy stocks.  The Nasdaq Clean Edge Green Energy Index was -6.21% while the S&P 500 Energy Index finished -21.12%.

 

  1. + The Russian question: […] We are bearish on Russia and expect the Russian market to underperform in 2015. The Russian market ended the year down 6%.

 

2015 Investment Themes: The bells that toll

2015 Investment Themes: The bells that toll

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  1. If not now, when? If not the Fed, who?: We expect the Federal Reserve to raise interest rates in 2015. We expect rates to gradually rise to a 1.0%–1.5% target, which would still be historically low. Short term rates after the tech wreck and 9/11 were kept below 2.0% for 3 years. For one of those years, rates were at 1.0%. Since the financial crisis of 2007/2008, rates have been kept below 0.25% for over 6 years. Both the level of the rates and the duration of the rate cut is extraordinary.

 

  1. No one rings a bell at the top of the market: US stock markets ended the year at almost three times the lows reached at the bottom of the market less than six years ago. We expected sharp corrections last year that failed to materialize. We are renewing our call this year and urge equities investors to exercise caution. And while we recognize the US stock economy looks healthier than those overseas, we expect major US indexes (S&P 500, Dow Jones, Nasdaq) to finish the year in negative territory.

 

  1. Emerging troubles: Emerging economies will continue to stumble in 2015, this includes resource dependent countries such as Russia and Brazil which have run into roadblocks as energy prices have fallen dramatically. The challenges are different, but as impactful for economies with internal imbalances created by over-investment in infrastructure such as China, and those facing enormous upheaval and political instability like Turkey. In the Chinese case, we are particularly concerned about the state of local and provisional government finances. We expect emerging market stocks and bonds to underperform developed markets this year.

 

  1. Commodities weighed down: With a slow-down in emerging markets and the global economy in general, we expect commodity prices to continue to come under pressure. While prices in certain commodities may stabilize, we do not expect a bounce back to levels seen in recent years.  We see commodities finishing the year flat to negative.

 

  1. The trouble with oil: We do not expect oil prices to substantially recover in 2015. It is clear that major OPEC participants in the middle-east are keen to minimize the profitability of oil as a source of funding for rebel groups in the region. They are also responding to medium-term strategic threats from unconventional oil producers (shale, deep sea, and tar sands) by forcing prices to levels that makes investment in such projects unprofitable. Continued unrest in major oil producing regions (Middle East, Russia, Venezuela) does not seem to have impacted supply or prices. We expect brent crude prices to remain under $60 by year’s end.

 

  1. Playing defense: For US equities, we believe defensive sectors, including healthcare and utilities will outperform others over the course of 2015. In any sort of correction, we expect enterprises providing essential goods and services to maintain profitability and revenues. Over-levered companies that have benefitted from speculative euphoria in recent years are particularly vulnerable to sell-offs in our view.

 

  1. Euro Crisis, back to the future: The Euro and Greek debt crises have faded from world news headlines over the past three years. A series of loans by the EU and IMF have succeeded in bringing down interest rates on Greek debt. In the past two months, however, a confluence of factors have roiled European markets. An impending election and veiled threats to renege on prior commitments by the party leading in Greek polls (Foriza) weigh heavily. We also expect court rulings on whether the European Central Bank can follow in the Fed’s footsteps with quantitative easing . Depending on outcomes, another round of brinksmanship will likely begin between Greek politicians, the markets and EU officials. Over the past few years, attitudes have hardened and we believe there is a real chance that Greece may be forced to, or choose to leave the Euro.

 

  1. Junk bonds get kicked to the curb. If, as we expect, interest rates rise over 2015, the long winning streak of high yield bonds will likely come to an end.  Junk bonds have benefitted from the Fed’s zero interest rate policy as savers have been forced to invest in increasingly lower quality bonds in order to find yield.  With rates rebounding (even marginally), we believe investors will find the reward that comes with high yield bonds no longer worth the risk.

 

  1. Growth in Renewables: 2008 saw high flying clean energy stocks taken to the wood shed when oil prices collapsed.  The thinking then was that renewables were not viable in a world flush with cheap energy.  While that thesis made sense seven years ago, the renewable industry has grown in leaps and bounds since.  Utility scale solar and wind projects have proven to be viable sources of energy as costs have come down and demand for renewable power has increased globally.  With oil prices falling again, we’ve seen many renewable stocks follow suit, as sort of a knee jerk reaction by investors.  We think this provides a tremendous buying opportunity, particularly in the YieldCo space where, like utilities, companies own a portfolio of newly constructed power projects with long term power purchasing agreements in place.

 

  1. The Russian question: 2014 has been a disorienting year for Russia. Ukraine, a neighboring state with long historical ties to Russia saw enormous unrest leading to a revolutionary change in government and the potential breakup of the country into Eastern and Western factions. Russian forces occupied and appear to have annexed the region of Crimea. Meanwhile, declining oil prices have placed substantial pressure on Russian public finances and may begin to erode support for Mr. Putin among both the grassroots and his oligarchic supporters. It is difficult to see non-traumatic paths out of the morass. Under Putin’s leadership, Russia’s structural problems (declining population, aging industrial base, and undiversified economy) have become worse. We are bearish on Russia and expect the Russian market to underperform in 2015.
Sustainable Investing Panel Discussion

Sustainable Investing Panel Discussion

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Louis will be speaking on a sustainable investment panel with the Portfolio Director of the Acumen Fund next Monday November 24th at the Center For Social Innovation.  The panel starts at 6pm and it should be an interesting and lively discussion.  If you would like to attend, please reserve a spot by clicking on this link.

2013 Q1 Letter: Spanish Mortgages, Cypriot Banks & Earth Day

2013 Q1 Letter: Spanish Mortgages, Cypriot Banks & Earth Day

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We hope 2013 has gotten off to a good start for you.

We want to start off by wishing you a Happy Earth Day! We exhibited at the Green Festival in NYC over the weekend, and it was great to see so many friends there, and to make some new ones. We are always pleasantly surprised by the number of people who are eager to learn more about Socially Responsible Investing and how their portfolio can do good as it grows.

The first quarter of 2013 saw risk assets continue to rally. Despite continued concerns about the state of continental Europe, major US stock indices reached fresh all-time highs in March, six years after they last reached such elevated levels. The effects of inflation and dividends that have accrued to investors effectively cancel each other out, and so it is rather impressive that six years after the first warning signs of the impending credit crisis appeared, investors have regained most of the lost ground. Of course, the constitution of the indices have changed, many enterprises that were mainstays of the Dow and S&P have been expelled from them and new upstarts have taken their place. That, however, is the creative destruction of the market at work.

CyprusIn Europe, a low-grade fire continues to smolder and it seems as if the news continues to get gloomier. March brought news that overall unemployment in the Euro-zone reached 11%, a level not seen for over 50 years. Investors should not be sanguine; the economic crisis in Europe is severe and will take many years to recede. The roots of Europe’s problems lie in the excess of development, spending and borrowing that occurred in the Medittereanean states, most of it funded by loans from the North. It has been illuminating to see the difference in responses between crisis-stricken Northern European countries and those in the South, which appear to have played out like a parody of Max Weber.

The first casualties of the crisis were Iceland and Latvia. Both are small countries with financial sectors that had recently ballooned. Another was Ireland. In each instance, the general population seemed almost resigned to the effects of the bubble bursting. It was almost as if, as per the caricature, Northern Europeans were used to misfortune and hardship, taking it in stride. Draconian measures were taken in all three countries. Banks were liquidated, along with real-estate developers and many ordinary businesses caught in the indiscriminate downturn. Meanwhile, families adapted quickly to a far less comfortable lifestyle, embracing austerity with an almost welcome sense of Lutheran penance.

Meanwhile, similarly crisis-stricken countries in the South (Greece, Spain, Italy and now Cyprus) have seen wide-spread unrest as their citizenry have resisted austerity measures every step of the way. We empathize immensely with the ordinary people caught in economic events that are not of their making. In many cases, individuals with limited financial experience just happened to have made poorly timed decisions, with no understanding that there are good and bad times to extend oneself by taking on debt. For the past three years, Eurozone nations have been haggling over how to apportion the blame and cost of the cleanup.

This quarter saw two diverging answers appear. The first is from Spain and was not widely covered though it has far-reaching implications. The second is from Cyprus and was widely covered by the media due to its dramatic nature.

Spanish mortgages are very different from American mortgages in one key respect: a mortgage in Spain is both a secured debt and a personally guaranteed, recourse loan. Lenders can repossess the property securing the loan, and continue to pursue the borrower for any shortfall or costs resulting from the repossession, till the entire debt is repaid. A Spaniard who has his house repossessed and sold by the bank will continue to owe the bank any shortfall between the sale price and the amount of the mortgage. Personal bankruptcy is not an option for most, so it is almost impossible to start with a clean slate.

Many Spaniards discovered the nature of their mortgage debt after the crisis, and after home prices were halved. Thousands of ordinary Spaniards have been evicted from homes they owned due to delays in mortgage payments and subsequently find themselves owing the bank tens or hundreds of thousands of Euros since the property does not cover the entire debt. Scores of former homeowners have been driven to suicide to escape crushing debts. Meanwhile, unemployment in Spain hovers around 25%. These are truly depression-era conditions, and they have seen wide-scale protests similar to the depression.

Amidst all this turmoil, The European Court of Justice heard a case brought by an evicted home-owner, Mohammed Aziz, and decided the original terms of the mortgage agreement were unfair. Spanish courts can now overturn evictions and repossessions on the grounds of consumer protection.

Meanwhile in Cyprus, an event almost as remarkable was briefly averted. For a few days, it looked like deposit insurance was about to be over-ridden for all Cyprus bank customers. The largest Cyprus banks found themselves facing large losses on recent purchases of Greek sovereign debt. As part of a deal to provide rescue funds for them, Northern European finance ministries insisted that depositors bear some share of the burden. Late one Sunday, a plan was announced to levy a 5-7% charge against small depositors and a much larger one against those with deposits larger than 100,000 Euros. As one might expect, this led to pandemonium in the streets and in the Cyprus parliament.

In one way, this episode was a good reminder for us all that deposit guarantees are only as good as the political will that stands behind them. In the case of Cyprus, its Eurozone partners were politically unwilling to rescue the banking system of an offshore financial center widely reviled in the tabloids as a conduit for tax-evasion. Sweden’s politicians did not find it palatable to make whole Russian businessmen. We do agree that large depositors should face some losses during major bank failures. In recent years, many have forgotten that their deposits are liabilities of the banks and only as sound as the institution’s health. Indiscriminate bank rescues perpetuate moral hazard. That said, we believe it was a grave mistake even to suggest that smaller depositors would no longer enjoy full deposit coverage for their accounts. It doesn’t matter whether the levy is called a wealth tax or a deposit charge, imposing losses on small depositors weakens the banking system for everyone. What’s even more embarrassing than the sight of finance ministers making mistakes that Bagehot warned against 150 years ago is that the moment the plan saw clear light of day and they heard the uproar, all the decisions were reversed. So, the EU members have managed to look weak and incompetent while scaring small depositors and instigating a full-fledged bank run within the Eurozone.

So what does this mean for investors in the short and long-term? We believe the European crisis has yet to reach it’s denouement. We live in a interconnected world, and despite record profits for US corporations, any rapid deterioration in Europe or Asia could impact US stocks very quickly. We believe investors will be well-served to exercise caution in equities markets and consider taking profits selectively. Meanwhile, bond investors have to reconcile two competing concerns: any eventual removal of quantitative easing will hurt bond prices, especially since we are seeing record low yields and record highs for bonds. That said, a recession or crisis in Asia or Europe would lead to a flight to quality and likely support US bonds of all types.

Regards,

 

Louis Berger                                                                          Subir Grewal

Facebook, Cypherpunk and Psychohistory

Facebook, Cypherpunk and Psychohistory

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One of the more notable financial news stories of the year so far is the decision of social media heavyweight Facebook to go public (an event we alluded to in our top 10 themes for 2012). The question on everyone’s mind is whether a potential $100 billion market valuation is appropriate for a company that had roughly $1 billion in net income last year. It wouldn’t be the first tech company to trade at a three digit P/E (we’re looking at you salesforce.com), but it would be the largest. We are going to leave the valuation question aside for a moment and think in broader terms.

In our view, there are a few factors to keep in mind when considering the lofty growth expectations that surround Facebook.

Fewer, poorer, new users: At 845 million relatively regular users, Facebook already has the cream of the crop when it comes to potential consumers. The economic elite — by far the most attractive consumers — are, for the most part, already on Facebook. The next billion users will have less spending power, and will not consume as many of the digital goods Facebook wants to sell them, nor will advertisers pay as much for access to them.

With the exception of China (where Facebook is banned), the network has no other large upper-middle class markets it can tap into. Since the next billion Facebook users will have more modest means and this could be a tricky cultural and business shift. Facebook initially set itself apart by limiting usage to select colleges. Over time it has successfully expanded availability to new demographics (older users and international users) . But its user base has always been the more affluent segment of each market.

By highlighting this, we’re not trying to diminish the broader value of an open social network and its ability to connect people and create opportunities for them. We hope Facebook continues to be another powerful Internet tool available to a person of modest means to foster deeper connections, expand their horizons and develop themselves. But we do recognize that social networks by definition will mirror divisions in societies, and certain virtual spaces will be more attractive than others to specific groups.

User disengagement: There’s a chance Facebook jumps the shark and usage drops. Despite its meteoric rise in recent years, Facebook operates in the notoriously fickle world of social media, where users may tire of a particular platform and seek out the next hottest thing (let’s not forget Friendster or Myspace, once robust social networking communities before Facebook came along).  While Facebook has done a phenomenal job building its user base and cornering the social media market, there are other platforms out there waiting to swoop in should there be a misstep (Google+), or capitalize if users ultimately decide they prefer to segregate their status updates (Twitter) from their picture sharing (Instagram) and location data (Foursquare).

In addition to the possibility of competitors poaching away market share, there is also a question as to how users will interact with the platform going forward.  We already see a divergence in the frequency with which men and women use Facebook. Women use Facebook much more regularly than men do. Over time, we could see photo-sharing and instant updates lose their novelty value for certain users who then disengage from Facebook.

Advertising could be ineffective on Facebook: It’s tough for an advertiser to grab a Facebook user’s attention when they are competing with photos and updates from their nearest and dearest. Ads on Google search are powerful revenue generators primarily because the user is searching for something and the ad is related to the search. A Facebook user, on the other hand, is visiting the site because they wish to see photos or updates of their family and friends. An ad on Facebook generally disrupts the user-experience.

Of course, Facebook could use the reams of data it has on each user to suggest a gift for your wife or girlfriend based on browsing or comment history; but this could easily mis-fire and be considered intrusive. Similarly, word of mouth recommendations are very powerful drivers of product sales, and Facebook is an effective medium for friends to share these; but advertisers tamper with word of mouth at their own risk. Our sense is that Facebook has become a virtual family gathering or a dinner party, and overt advertising or sponsorship will always feel slightly out of place at such an event.

On Facebook everyone knows who you really are, even if you’re a dog. All that said, there is one aspect of Facebook that sets it apart from virtually every other website and could end up being extremely valuable. From the very beginning, Facebook has insisted on “real names” and worked to keep anonymous or fraudulent identities off the platform. The result is that Facebook can tie virtually each of its 845 million users to a real-world identity. They have also built an authentication framework on their platform which other sites can use in lieu of asking users to pick new passwords or user ids. Since Facebook has photographs of all your friends, they can be used as a challenge if unauthorized activity is detected. Your ability to recognize your friends, along with Facebook’s knowledge of who they are, combined with a large photo database, makes it very difficult for an unknown attacker to try to hijack your profile. This has meant an enormous shift in the previously anonymous world that the Internet was, and it remains a rare and valuable commodity. It is a service Facebook could charge other sites for down the road. For Facebook, it may be the next big thing. Perhaps bigger than targeted ads.

Further Reading:

The genesis for this post came as a result of a wide-ranging conversation we had recently, and which led us to think about two of our favorite books…

The first is Neal Stephenson’s Snowcrash, a 20 year old book that predicted much of the impact the Internet would have on human society. No one who has ever read that book can underestimate what anonymity can lead to and what power accrues to an entity that can definitively identify 20% of humanity.

The second book is Asimov’s Foundation series, which is what got one of us interested in Economics and reinforced the constancy of human behavior.  Some of the conversation about 3-D printing and replicators also brought to mind Asimov’s gem, The Last Question.

 

Photo credit: Flohuels

“2011 Themes: These Go To Eleven” Year End Review

“2011 Themes: These Go To Eleven” Year End Review

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Since we’ve now closed the chapter on 2011, we’d like to review our “11 Economic Themes For 2011” from last January, to see how well our ideas performed.

1.   No.   Raise ’em sort of high: We expect the Fed to raise short-term interest rates towards the end of the year, in response to slow but steady growth and a more hawkish group of voting members. We were flat out wrong on this one. The Fed kept rates steady at the lowest possible level of 0-0.25% throughout the year. A blip in US economic data mid-year and continuing concerns about Europe held back even the most hawkish voting board-members from recommending a raise.

2.   Not exactly.  Risk Off: We believe stock prices are quite a bit higher than underlying fundamentals support, at a trailing P/E of around 18.25 , prices are at the upper end of historical range. We were right to think that 2011 would be a year where market participants would lower risk, but we focused on US Equities. In fact, US Equities became a relative safe-haven as investors fled the Emerging Markets and Europe.

3.    Yes.  United States of Europe: We expect the deterioration of sovereign credits in peripheral Europe to continue as these governments struggle with difficult but necessary financial decisions. We expect continued friction between fast-growing Northern European economies and Southern Europe. We have been discussing this theme for years, but it did come into its own in 2011. If anything, the conversation about potential outcomes has moved much faster than we would have expected. A year ago, who would have thought the markets (and even some in European political circles) would be discussing Greek default, and the break-up of the European currency union. The conclusion of the extraordinary events in Europe is still unclear and this will be a theme for 2012 as well.

4.    Yes.  Moody & Poor: We expect the US municipal bond market and state finances to continue as a topic of discussion. We expect certain weaker revenue and real-estate projects linked bonds to default… large scale defaults by major issuers (state GOs, water/sewer) are very unlikely. Municipal and State finances have continued to be in the news all year. We saw a very high-profile bankruptcy in Jefferson County, Alabama. We expect the role that financial intermediaries played in that case, and others, to receive attention over the course of 2012. As we anticipated, defaults in the municipal space were limited and the muni-market did quite well in 2011. However, the longer-term challenges remain in place. State revenues improved in 2011, but the fate of state-guaranteed pension funds and health benefits is still uncertain and remains a huge future liability for most US state and local government.

5.   Yes.   Running on Empty: The Chinese stock market did not fare well in 2010, and we expect the Chinese economy will experience lower growth in 2011. It is now clear to most participants that China is at an inflection point. The Chinese equity market has been in an unbroken bear market since reaching an all-time high in 2007. We believe other asset bubbles in China are at the point of bursting as well, and that this could well lead to large-scale social and political change in China.

6.   Yes.   Consuming Confidence: We expect consumer de-leveraging to continue in the US as consumers pay down debt till it approaches historical averages. Deleveraging continued as US consumers reduced debt wherever possible. Debt service and financial obligation ratios fell over the course of the year as rates remained at all time lows. Total outstanding consumer credit rose by 2%. Consumer sentiment returned to where it was at the tail end of 2010, after spending much of the year at depressed levels.

7.   Yes.   Help Wanted?: We expect unemployment in the US to remain high, slowly falling below 9% towards the end of the year. We also expect broader measures of unemployment and underemployment (the BLS’s U6) to stay above 15%. Though headline unemployment took a large drop towards 8.5% in December, it had spent most of the year around or above 9%. And if the political discussion is an accurate measure, the country as a whole remains concerned about jobs. As we anticipated, U-6 stayed over 15%, suggesting almost one in every seven workers is under-employed in some way.

8.    Yes.   Arrested Development: Though it is notoriously capricious to forecast, we expect GDP growth in most emerging markets will continue at high single-digit rates, while slowing in the US and Europe to a sub-trend 2% rate till household and government deleveraging has run its course. Though the full-year numbers are not available as yet, growth in the first three quarters in the US was estimated at an annualized rate of 0.4%, 1.3% and 1.8%. Unless the fourth quarter growth rates were truly remarkable, we will be well under 2% for the year. The story in Europe was, if anything, worse, with full year growth rates for the 27 member EU estimated at 1.6% and growth-forecasts for 2012 at 0.6%.

9.   Yes.   Double Helix: We expect health-care technology related to genetic sequencing to increasingly take center stage in preventive and curative care as sequencers become cheaper and consumer testing becomes more prevalent. We started 2012 with the news that a number of companies expect to offer solutions to sequence a person’s entire genome for about $1,000. We believe the rapid commercialization of this technology will change health-care and many other realms of human activity.

10.  Not exactly.  Feast and Famine: We expect 2011 to be a very volatile year for commodity prices. We believe the environment is ripe for a sharp price correction in some commodities, gold and oil for example, and perhaps certain base metals as well. We were partially right here. Commodities remained volatile in 2011, with the DJ-UBS commodities indices down over 13%. However, the two commodities we highlighted, gold and oil, remained relatively strong though gold did see a selloff during the second half of the year.

11.  Yes.  Death and Taxes, It’s all Politics: In the run-up to the US presidential election in 2012, we expect the political discussion to focus on debt and tax reform. The Congressional debt ceiling crisis and the subsequent downgrade of US treasuries by S&P this past summer brought this topic to the fore. As with everyone else, we wait to see what reform proposals the tax discussion will bring to the 2012 political season.

 

The final score is 8 out of 11, which is not bad.

 

 

Q3 2011 Letter

Q3 2011 Letter

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The third quarter saw equity markets trade substantially lower from where they began—the S&P 500 index started the quarter at 1,320.64 and ended at 1,131.42, a loss of nearly 15%.  On October 4th, the S&P 500 saw an intraday low of 1,074.77, which marked a decline of more than 20% from the 2011 high of 1,370.58 reached on May 2.  This level was important both from a technical and psychological standpoint since a 20% major index decline is the metric used to determine whether or not we have entered a bear market.  Equity markets have bounced back over the past several days, but it remains to be seen whether we are entering a longer term bear market in stocks or if we are merely experiencing a “soft patch”.

So what has caused this decline in stocks?  There are several factors at play:

US Economic Data

The US economic picture, which we have long viewed as being fragile and artificially supported by government stimulus, is showing substantial cracks in its façade.  In early August, the US GDP for Q1 was revised down from an initial estimate of 1.9% to .4%, a huge 1.5% move down.  Second quarter GDP came in at 1.3%, well below analyst estimates of 1.9%.

While many market commentators at the time pointed to the Congressional budget standoff and the S&P’s lowering of the US credit rating to AA+ as the reasons for the stock selloff, it’s now apparent that the problems run much deeper.  Over the course of the quarter, as employment, housing, manufacturing and consumer sentiment data rolled in, it became clear that the selloff was a response to a US economy losing its footing rather than a gridlocked Congress (although that certainly didn’t help matters).

Federal Reserve policy

From our perspective, the stock market rally of the past two plus years can largely be attributed to the stimulus policies of the Federal Government and the monetary policies of the Federal Reserve rather than an organic economic recovery.

While government stimulus has largely dried up after Republicans regained control of Congress in the 2010 mid-terms, the Federal Reserve has continued to implement a monetary easing policy with ever more inventive sequels to the original QE.

These measures include: ZIRP (zero interest rate policy), quantitative easing (versions QE1 and QE2) and POMO (permanent open market operations).  While the economy and unemployment rate has seen little in the way of tangible benefits as a result of these strategies (although it could be argued that the Fed’s policies helped stave off a Depression), interest rates remain at rock bottom levels and the stock market has roared back to life. The question on every investor’s mind is whether this is a sustainable burst of energy, or a sugar high that will soon wear off.

If the latter is the case (which we believe) then it appears the stock market has gotten ahead of itself and its bullish trajectory does not accurately reflect the fragility of the economy.  Instead of an organic recovery driving the markets, it seems stocks are being buoyed by the Fed’s policies and can only continue moving upwards if the Fed keeps refilling the punch bowl of liquidity.  But what happens if the Fed decides to end the party and cease its easy monetary policy—will the economy be able to expand on its own?

Increasingly, it looks like this decisive moment has arrived. When the QE2 program expired at the end of June, the Fed elected not to renew it. Instead of entering into another round of buying bonds with cash, as many investors hoped/expected, the Fed went in a different direction.  On August 9th the Fed announced its expectation that it would extend the ZIRP policy through 2013 in an effort to keep interest rates low and encourage lending.  On September 22nd, they also announced Operation Twist, an action in bond markets designed to push down long term interest rates on everything from mortgages to business loans, giving consumers an additional incentive to borrow and spend money.  This approach was first used in the 1960’s (originally named after the dance craze that swept the nation).

While both of these measures are intended to help support the economy, they failed to elicit the same level of excitement in stock investors as the first two rounds of quantitative easing. We remain skeptical of these policies since, in our mind, the problem is not high interest rates, but rather the desire and ability of businesses and consumers to borrow. If businesses do not believe expanding their operations will be profitable, they will not borrow to do it. If households do not believe they will earn more in the future, they will not borrow to finance home-purchases and consumption today. And if loan and credit officers across the country do not believe the economy and employment will grow in the next few years, they will not extend credit. The problem is not the supply or price of credit (the interest rate), rather it’s the demand for it.

European Sovereign Debt Crisis

Ah, our dear old friend, the problem that just won’t go away, no matter how many summits are organized to exorcize it.  It seems we always devote some space to this topic every quarter and this letter will be no different.

The problems in Greece and in other European debt-ridden nations, reared its ugly head again this quarter.  However, the focus shifted a bit from the nations themselves to the European banks which hold much of this bad debt on their balance sheets.

The major concern many economists and market participants have is that several of these banks would not survive a Greek default.  So, if Greece were to go down, it could create a cascading, domino-like event, similar to what was narrowly averted during the 2008 credit crisis.  The prevailing view is that the countries and banks are so interconnected that one failure – a European country or a bank – could potentially bring down the entire system.  Of course, nobody knows for sure whether or not this is really the case, but elected officials do not seem interested in testing this hypothesis after witnessing firsthand the economic carnage that was unleashed when Lehman Brothers failed. The trouble, however, is that their constituents do not want to pay for the cost of rescuing Greece or even large pan-European banks.

In our view, this train-wreck will continue to play out in slow-motion for the next several months. The solution has to involve some restructuring of Greek debt, and some mechanism to conclusively stop the damage from spreading to Spain and Italy. We do not hold out high hopes for a speedy resolution though. The outlines of the solution have been known for quite some time, but the relevant political and regulatory actors do not appear to have the will or courage to take decisive action and implement it.

So where does this leave investors?

We think the status quo will continue for the near future: structural headwinds in the US economy will persist and the debt problems in Europe are still a long ways from being resolved.  Barring another massive monetary intervention by the Federal Reserve (QE3), we believe stocks will continue their slide lower. If there is a QE3 announcement too soon, we think there’s a pretty substantial chance it will be seen by the markets as a sign of desperation on the part of the Fed. We believe the chance that Congress manages to enact meaningful tax or budget reform, or additional fiscal stimulus, is negligible as we enter the presidential election cycle.

We have seen a few weeks of remarkable volatility within financial markets. Stock indexes have moved hundreds of points in both directions with some regularity. Interest rates, bonds and the FX markets have also seen very sharp moves in each direction. We believe this period of volatility will continue for the next few months as the European crisis grinds towards its inevitable conclusion and signs of stress in China make themselves apparent.

As a result, we continue to recommend a defensive portfolio for clients, with high quality, short term/intermediate bonds and cash making up the bulk of client holdings.

We think there will be an opportunity to buy high quality stocks on the cheap in the coming weeks/months and have targeted a list of companies using the following criteria:

  1. Large cap, US-based companies that have significant exposure overseas, particularly in developing markets
  2. Companies that have sustainable, attractive businesses and a history of paying dividends to investors through tough market cycles
  3. Preference for defensive/non-cyclical industries like consumer goods and utilities rather than banks or financials

We believe that, longer term, investments in these types of companies will perform well.  In the short term, they will provide cash flow through dividends, so investors will benefit by being paid to hold these stocks in the event the stock market trades in a flat or negative trajectory.

All Eyes on Jackson Hole

All Eyes on Jackson Hole

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“It’s like deja vu all over again.” — Yogi Berra

 

Let’s take a look at some economic bullet points, shall we?

* The stock market, after peaking in April, is in the midst of a summer swoon.

* The sovereign debt crisis in Europe is getting progressively worse.

* Unemployment remains stubbornly high and the housing market remains stagnant.

* Gold continues to climb as investors speculate that safe haven currencies like the USD, Euro and Yen will see continued pressure as debt levels mount.

*Quantitative easing from the Federal Reserve has recently expired and Government Stimulus money has run dry.

*Investors wait with baited breath as Fed chairman Ben Bernanke is due to give a highly anticipated speech at the annual Jackson Hole economic summit.

Sound like a good encapsulation of where the financial markets are today?   Perhaps,  but I’m actually describing where things stood last summer on the eve of the Jackson Hole summit.  While a lot has certainly changed in the past twelve months, many of the problems facing the global economy remain the same.

And so here we are, almost exactly a year later, and the markets are waiting/hoping/praying that tomorrow Ben Bernanke can pull a rabbit out of his hat in his Jackson Hole address like he did last August, when it looked as if the stock market rally was sure to falter.

So how did things play out last summer?

As we wrote in our last quarterly letter:

“When Ben Bernanke announced the QE2 plan on August 27th, 2010 the S&P 500 was trading at 1,064 (mired in a summer slump after peaking at 1,217 on April 23rd). Once the QE2 announcement was made, equity markets promptly rallied for the next 8 months, peaking at 1,370 in April 2011 on the belief that the Fed’s policies would provide the necessary support and impetus to boost economic growth.”

Many stock market bulls believe that a third round of quantitative easing will deliver similar results.  While we concede that another round of QE will likely give the stock market a short term boost, we don’t believe it will cure any of the underlying ills that the economy suffers from (high unemployment, anemic housing market, low consumer confidence etc).

But never mind all that negativity, a stock enthusiast might say, will there be a QE3?

It’s hard to predict.  The Fed’s dual mandate is to provide economic growth and boost employment.  While it can be argued that the last two rounds of quantitative easing helped the US economy avert a depression, the main beneficiaries of these market interventions, particularly the last round, seems to have been stock holders — not exactly the constituency most in need of the Fed’s support.   And to compound the problem, two byproducts of these policies have been rising commodity prices and a weakening dollar, which creates a whole host of other issues for consumers.

Given that the Fed’s fiscal policies have come under increasing criticism from all corners of the financial and political world, including from some of the Fed’s own Board of Governors, it seems to us that another QE round would be enacted only as a policy last resort.  It’s also entirely possible that the next fiscal action from the Fed would not be a QE package, per se, but rather something resembling Operation Twist, which was an approach used in the 1960’s.

But if the financial markets continue their move further south, the question becomes: what other entity could possibly intervene to provide support?  Congress has demonstrated, through the debt ceiling fiasco and the rise of Tea Party influence over the Republican party, that a stimulus bill would almost certainly be dead in the water.  And as we get closer to the 2012 elections, it becomes increasingly difficult for our elected leaders (namely Obama) to institute major economic policy decisions without being accused of playing politics, particularly in the toxic partisan environment of Washington.

So, really, that leaves the Fed as perhaps the only game in town when it comes to market intervention.  If things get worse, then there may be increased pressure on the Fed to act since they have the mandate and resources to step in — whether that means tomorrow or at a future date remains to be seen (and regardless what your views are on the Fed’s policies, at least they can reach a decision and act on it in a timely manner — unlike our distinguished members of Congress).

So, has this summer sell-off and rampant speculation of potential Fed action hanged our investments thesis?  Not really.  We remain cautious and reiterate what we said in our last quarterly letter, in July, before the stock sell-off began:

“We are a bit skeptical that equity markets can rally further without this backstop and recommend clients remain defensive until it becomes clearer that the economy can stand on its own two feet absent the crutch of Federal Reserve support.”

 

Must Read: Jeremy Grantham’s Quarterly Letter

Must Read: Jeremy Grantham’s Quarterly Letter

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Terrific piece from the always insightful Jeremy Grantham of GMO on the state of the financial markets and where things may be headed:

Grantham August

2011 Q1 Letter & upcoming webinars

2011 Q1 Letter & upcoming webinars

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We held our first “webinar” earlier this month on the timely topic of municipal bonds. We have posted the narrated presentation at www.youtube.com/wsqcapital for the benefit of those who were unable to attend. We plan to host three webinars this quarter:

To register for any of these webinars, please visit blog.wsqcapital.com. We will continue to add recordings of future presentations to our page on youtube. Feel free to pass along an invitation to anyone in your circle interested in learning more about these topics.

IRA contributions, Roth IRA conversions

Most taxpayers can make IRA contributions for the 2010 tax year up until the individual tax-filing deadline, which is April 18, 2011 this year.

Roth IRA conversion rules have changed and virtually anyone can now convert a traditional IRA into a Roth IRA. Partial conversions of an IRA account are also permitted. Please contact us if you’d like to discuss specific issues surrounding your circumstances.

Interest Rates & QE2

In prior letters, we have discussed the extraordinary measures the Federal Reserve and other central banks around the world have taken to keep interest rates at historic lows. Short-term rates in the US remain below current inflation levels, which means savers are being penalized for holding cash. This is no doubt due to the actions of the Fed which continues to purchase the bulk of newly issued US Treasuries under its Quantitative Easing program. We estimate short and medium-term rates are 1.5% to 2.0% below where they would otherwise be.

Meanwhile, the flames of inflation have begun to flicker. A combination of increased demand and easy money policies has driven up food and commodity prices. If this trend continues, maneuvering through the obstacle course of rising inflation will take a toll on the global recovery. And as is usually the case, the burden will be heaviest for the world’s poorest who spend a higher percentage of their income on necessities. We are beginning to see some policy action and rate hikes in developing markets. Unless inflation levels stabilize quickly, this will begin to impact global trade. We caution bond investors that future returns are likely to be lower than those in recent years past. We continue to recommend high-quality bonds with 3-5 year maturities.

Budgets and Bluster

The issues facing most developed-market governments are remarkably similar whether we are talking about Greece, Ireland and Spain, or the US, California and Illinois. The long-term challenge involves tackling unfavorable demographics and enacting the painful policy reforms required to tackle the cost of social programs. In the short term, the double-whammy of a real-estate/financial crisis requiring an immense expenditure of government support, followed by a great recession driving down tax revenues have created huge deficits. The exact mix differs: in Ireland the cost of a bank bail-out has supercharged the national debt, whereas in Greece the crisis is compounded by a culture of tax-evasion and protectionism. In the US, the core problem is reforming Medicare and a health-care system that takes in more revenue per person and results in lower levels of health than those in other developed countries.

The imminent congressional debates over the federal budget and the national debt ceiling will bring fiscal issues front and center in the US. As the 2012 election campaign kicks off over this summer, we expect fiscal issues will be key in every race. In Europe, meanwhile, the moment of reckoning for Greece, Ireland and Portugal fast approaches. European institutions will either have to come up with a plan for debt-restructuring or direct support to assist struggling governments in the short-term. Meaningful progress towards the longer term demographic and policy challenges will also need to be made.

 

Nature, Energy and Politics

The March 11 earthquake and tsunami took a terrible toll on the people of Japan. The economic damage is also enormous as a significant percentage of the area’s power generation and distribution capacity has been offline for weeks, impacting businesses and residences across the main island of Honshu. Rolling blackouts have affected many areas, including Tokyo. Two nuclear power generation facilities (Fukushima I and II), with a total of ten operational reactors between them, suffered severe damage. It is now clear that all the reactors at Fukushima I will need to be scrapped. A large amount of fuel from the operating reactors and spent fuel stored at the facility has been damaged and released into the environment. The situation remains critical and the full extent of the crisis is still unknown.

Nuclear power generation requires operational and design expertise far more specialized than other forms of energy production. In general, the industry has recognized this and a great deal of thought and effort has been put into improving design and procedures. We should also not forget that most other forms of energy generation carry their own risks, and often a higher carbon footprint. For instance, the production and burning of coal costs numerous miners their lives every year, and damages the respiratory systems of populations globally. Hydro-electric dams have failed due to design faults or natural disasters causing a large number of casualties. We firmly believe renewable energy must be at the core of any long-term solution to global energy needs. Nevertheless, replacing our current energy infrastructure is a multi-decade project and represents an enormous investment. One step towards that process would be to accurately account for the true health and environmental costs of all forms of energy production. As things currently stand, the conventional energy industry derives numerous economic benefits from tax-breaks, favorable industrial policy and political gridlock in assessing the true environmental cost of greenhouse gas emissions.

With all this in mind, we believe certain modern nuclear plant designs can play a role as a crucial bridge technology. In many fast-growing economies, nuclear power is the only viable alternative to coal and gas for large scale power generation. It is clear though, that the nuclear industry will face tough public scrutiny and a risk re-assessment is underway. We are particularly concerned about the operational safety of nuclear power in countries without a strong tradition of accountability, independent oversight and open public discourse (see China). Some of these concerns are acute for certain developed nations such as Japan, which has few energy resources of its own and relies on nuclear power for 24% of its electricity needs. As a result, we continue to view long-term investments in renewable energy favorably.

Upheaval in the Middle East

Mass protests in the Arab world have captured the world’s imagination since the sudden, largely peaceful overthrow of Ben-Ali in Tunisia. We certainly do not believe every group engaged in protest has benign intentions and recognize that in some countries one repressive regime may be replaced by another. That said, we are hopeful the power of public protest and increasing civic engagement by ordinary citizens will transform the moribund political and economic regimes in the region. For the time being, we expect this part of the world will continue to experience upheaval over the next decade or more. In many of these societies, oil wealth has distorted economies and politics. A demographic bulge is now bringing about rapid change. Investors should remain aware that demographic and political change may cause certain markets to be disrupted over the next decade.

We are positive on emerging markets in the long-term, but advise caution for the present since asset prices have risen very rapidly. Further rises in oil prices could accelerate inflation and lead to a slow-down in global growth, which would impact emerging markets negatively.

 

Regards,

 

Louis Berger                                                                                        Subir Grewal

 

 

Recording of our Municipal Bonds webinar

Recording of our Municipal Bonds webinar

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We held a webinar earlier this month on municipal bonds. We provided a basic overview of the municipal bond market and discussed recent events. We’ve now posted a replay on youtube, the links are below:

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