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Posts by: David Stevenson

Digital ledgers vs Dinosaurs: How the blockchain could destroy high street banks

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dino wars

FT columnist David Stevenson writes for Glint on why cryptocurrency will endure because of its digital ledger technology and how it might be about to condemn high street banks to the history books

I have an admission to make – a few months ago I decided (possibly foolishly) to buy a few tracker shares in ethereum. By way of background, a few weeks ago my office kicked off its annual stocks competition. The idea is to select a long and short combination of underlying shares or tradeable assets. My short choice was a UK small cap in the collectables space while my long choice was a racy UK oil stock. But something much more interesting struck me about many of my peers’ choices: There seemed to be an overwhelming consensus on shorting bitcoin and, as a contrarian, this uniform cynicism obviously piqued my interest.

I wasn’t alone in my contrarianism though. The most technologically aware person in the office was aggressively long ethereum. Pete – the tech supremo – gave lots of convincing explanations about why ethereum was the better digital currency. The technical language sometimes blends into the background but the long and short (!) of it was essentially that because ethereum is connected to the blockchain, and because it is NOT bitcoin, it could easily emerge as the default cryptocurrency. The biggest digital currency of all, of course, is still bitcoin with a rough market capitalisation of US$185 billion, followed by ethereum with US$84 billion and then ripple with US$35 billion. These three cryptos account for more than two-thirds of the entire cryptocurrency universe by value. A year ago, the top three made up an ever larger 94% share of that universe.

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At this point, the vast majority of people my age – being honest, the dividing line seems to be around 45 years old – roll their eyes and, in a perfectly rational manner, argue that a currency is usually boring and backed up by meaningful institutions such as central banks. By contrast, cryptocurrency’s shocking price volatility is the exact opposite of what most sensible people want out of currency. But ethereum – which I would argue is like that other notional currency: gold – isn’t really the same as a dollar or a pound in my pocket, i.e. a predominantly trade based exchange currency. It is a notional currency but in reality, it’s a store of value and expectations, nothing less, nothing more. Like gold, it can be used as a trading currency but that’s very far from being its primary purpose.

This isn’t a message many want to hear. In fact, over the last six months, we’ve seen a concerted attack on all cryptocurrencies by every rational economic actor, and a few irrational ones. Not unsurprisingly, prices have crashed but not quite back to the levels widely predicted, which was next to zero according to the legion of uber-bears. This (relative) price resilience in the face of an almighty (rational) onslaught is, I think, fascinating. It shows the huge weight of money that is still flooding into digital currencies overall. Innovations in structure and the rise of futures markets around cryptos which allow people to long and short it, are, of course, the primary factors that have geared up the levels of investment but, while that innovation has facilitated greater demand, it is itself the result of demand.

Demand command

I’d cite one recent survey as (limited) evidence. It comes from respected media relations firm Citigate Dewe Rogerson and is entitled Investor Perception: Crypto-Currencies. The survey’s authors talked to a wide range of financial professionals and found that 56% intend to buy more digital currencies over the next 12 months, compared to 31% who plan to retain or reduce their exposure. Despite the recent volatility in the market, just 8% intend to sell all their cryptocurrency holdings.

Are cryptocurrencies a poisoned chalice?

Are cryptocurrencies a trap?

Some findings from this report stand out for me. The first is that we all collectively expect a veritable tidal wave of regulation for cryptos – the report reckons that 62% of financial professionals interviewed expect a dramatic increase in the level of regulation around cryptocurrencies over the next 24 months.  This sounds convincing to me; regulators have clearly been caught off guard by digital currencies and feel that they ‘need to be seen’ controlling this wild west frontier. Whether those new regulations will achieve their desired purpose is anyone’s guess but regulations do often help ‘normalise’ alternative asset classes.

The last set of numbers within the survey point to what I think is the most obvious weak point for all cryptocurrencies – that they all provide a dreadful customer experience. I thought it was noticeable that only 22% of the Citigate survey panel thought there would be a dramatic increase in the use of digital currencies as payment or money transfer methods over the next five years.  My guess is that the other 78% of that sample have realised what any visitor from Mars would have known from day one about bitcoin: it’s a complete bugger to use.

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One useful statistic on bitcoin’s lack of ‘user friendliness’ – in 2016 only five of the Top 500 US retailers accepted bitcoin and last year this dropped to just three. It’s also worth noting that bitcoin’s operating costs are insanely high. Remember that it costs roughly 2 cents to process each cash transaction, 12 cents per credit card and 26 cents per online transaction, whereas it costs US$2.80 for a blockchain settlement. This transaction in turn takes at least 10 minutes to verify compared to major credit card outfits which settle upwards of 65,000 per second (using only around ½% of the energy required by blockchain).

So, RIP cryptos? Not quite. I have a hunch that cryptos will also be outlived by their blockchains – or, more precisely, their distributed ledger systems.

Blockchained melody

These systems might even end up destroying the current monetary system as we know it. Or that at least is the conclusion of a fascinating recent analysis by Michael Howell of Cross Border Capital, entitled Lonely Bytes – Cryptocurrencies & The Future of Money: A New Technology Solution Desperately Seeking A Problem? This London-based investment research house reckons that distributed-ledger technology (DLT) offers huge attractions to the existing central banks in helping them digitise their existing monies.

In short, blockchains and DLTs will up end the traditional banking model via emoney and put central banks back in control of ordinary transactions and credit creation. Here’s the most incendiary part of the analysis by Cross-Border – it is worth quoting at length because of its revolutionary idea.

“This single digital ledger, in economists’ jargon, describes a narrow banking model, much like Peel’s 1844 Banking Act in the UK that legally split the Bank of England Issue Department from the Banking Department in order to more clearly identify the gold backing for the note issue. With a recognised central authority policing settlement, the plodding and costly blockchain verifications can be easily swapped for instantaneous and cheaper digital settlements. These e-dollars and e-pounds simply become the digital equivalent of paper notes, but available via, say, smartphones. (Note that alongside this emoney, notes and coins may still physically exist.) The net balances of e-money will attract zero or low-interest rates from the Central Bank.”

The real victims of DLT will be high street banks. According to Cross Border “the dinosaurs out there are what we term ‘bank money’ and the traditional high street banks. They face extinction. Traditionally, these banks developed as ‘safe’ places to physically deposit cash, with safety determined, first, by the quality of the assets that ‘secured’ their deposits and second, by their unique access to Central Bank funding in extremis.”

Do high street banks risk becoming financial fossils?

Do high street banks risk becoming financial fossils?

Since central governments are already effectively underwriting high street banks’ credit creation processes, and emoney is spreading like wildfire, why bother with high street banks for the payment function, especially when they charge so much for so little? Why not use central banks, emoney and DLTs to manage the whole financial ecosystem?

The bottom line? Money market funds will compete for deposits, and, in turn, fund specialist lenders (e.g. car finance, mortgages, student loans) while dinosaur high street banks edge to extinction as wholesale money markets and specialist lenders replace them.

This is, I think, a revolutionary set of conclusions. But as Cross Border observes, this new world puts credit risk even closer to becoming central systemic risk. Can we really trust the promises made by central banks for our money held via DLTs and blockchains? How will central banks work to create credit within this new distributed system and how will this inform day to day decision-making on who they lend to?

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David Stevenson writes the Adventurous Investor column for the Financial Times, for whom he has also written several books. He has previously worked for the BBC, ITV and Channel 4 and has advised a number of firms on investment and communications, including HSBC and EY

Market volatility: Whose fault? Who wins?

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volatility

FT columnist David Stevenson, writes for Glint on the real winners from the stock market’s recent eruption of volatility, pointing to commodity based emerging economies and telling us to watch the FX canary

Calling all cave dwellers: the great moderation is over and volatility is back in business. Without wanting to sound a tiny bit smug, can anyone really have been surprised that volatility measures such as the ‘Vix’ (tracking the CBOE index based on S&P 500 equities) shot up over the last few weeks?

The last time we saw measures for the Vix move into single digits was back in late 2006 and early 2007 – and we all know what happened next. So, in simple terms, anyone who was still short (betting against) volatility and the Vix was probably playing with fire. Cue the entirely unsurprising news that a number of US volatility products have now ‘blown up’. In fact, the CBOE’s own Volatility Index soared three-fold in just three days as $3 trillion was wiped from equities amid signs the U.S. economy could be overheating. And what started in the US has also hit other developed world markets – the VFTSE (the FTSE’s volatility index) went from under 10 to peak at over 23, while the VSTOXX (the Euro Stoxx volatility index) also shot up to 35.4 from a low of 11 last month.

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What went wrong with the supposed great moderation which would see the S&P soar past 3000? The trail of breadcrumbs was always clearly on display…

One of the primary supports for equities over the last decade has been accommodative monetary policy and low interest rates. This has allowed debt levels to carry on increasing – in fact there has been $72 trillion ($72,000,000,000,000) of new debt created since 2008, taking global debt to over 327% of GDP. But that extra liquidity has also supported share prices. So, when interest rates started to increase – helped along by worries about resurgent inflation – it wasn’t any surprise that we saw market volatility.

The only surprise was why anyone thought it wouldn’t happen. A good summary of where we had got to came from risk analysts at CheckRisk who observed that: “In January equity markets globally had become extremely overbought, both on a valuation basis and also from a technical perspective, with relative strength indicators (RSI) of greater than 90 recorded. These are at the absolute upper bounds of what we have seen.”

So why now, early in 2018? What made investors panic in February? One easy way of explaining the mayhem is to focus on the nice round numbers beloved of investors. Take long-term investment returns from risky assets. A huge variety of research studies have shown that most of us expect returns of around 6 to 7% per annum over the long-term from investing in equities. It’s a similar story for dividend yields for equity valuations. Most of us have an instinctive understanding for what constitutes poor value: where price to earnings (PE) ratios shoot past 25 and then 30. And what constitutes good value: anything with a PE below 15.

Given this fetishisation of numbers, it won’t come as a great surprise to learn that bond investors also have ‘magic numbers’ which they think constitutes an important signalling mechanism. The yield on US Treasury bonds is one such example. Most assume that anything above 2.5% for ten-year “govies” constitutes an important turning point, while anything above 3% strikes most as a big flashing red light. One investment bank recently headlined an email to investors with “Is there life at a US Treasury yield of 3%?”. The implication being that any yield above 3% implies that equities might steadily collapse in value. The chart below shows that those concerns are bound to grow over the next weeks and months – yields look they are set for a challenge at 3%.

Yields at 3%

US Government Bond Yields

Nevertheless, a recent report from analysts at Cross Border Capital does give us some perspective. They published a cracking chart which showed G4 yields (UK, US, Japan and Eurozone) over the last thirty plus years. The current upturn barely amounts to more than a tiny uptick, an almost invisible blip, compared to long-term averages. If bond investors are worried about rising yields, their worries have only just started if history is anything to go by.

Overall though, the prognosis is grim for bonds I suspect. Cross Border reckons global bond markets will suffer a “tough 2018, with G4 markets losing an average 5-6%, and with losses concentrated in US Treasuries and Japanese Government Bonds…. We continue to expect ten-year bonds to test 3.5% yields this year”. If Cross Border are right expect more stock market volatility as first that 3% US Treasuries yield barrier is breached and then 3.5%. If that is the case, expect equities to be about as serene as a white water rapids instructor with a broken paddle up the proverbial creek.

Special FX

The next breadcrumb on our trail of destruction involves those lovable rogues over in the FX markets. Many years ago, I remember having coffee with a wizened old investment academic who gravely intoned: “David, always watch the FX markets. Everyone focuses on stock indices and bond yields, but the trouble usually starts with FX rates”.

His argument was simple. As the world globalises and becomes more inter-dependent, the interplay between the main currencies – the dollar, euro, Japanese yen and increasingly the Chinese remnimbi – tells you everything you need to know about capital imbalances and the direction of the global economy. Eventually, the widely followed rates, interest rates and inflation rates start to give us signals about those capital imbalances. Asset classes also react accordingly with commodities especially sensitive.

So, it’s with those wise words ringing in my head that we approach the elephant in the room: the weakening dollar. The chart below comes from the US Federal Reserve and shows the trade weighted value of the dollar. Do you notice anything about the direction of travel since the beginning of 2017? You guessed it. Since the start of 2017, the dollar has been falling again. Inflation expectations are on the rise slightly, as are inflation rates (compared to consumer prices during the 2015-16 downturn). Commodities are up, including West Texas crude oil.

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Again, it doesn’t take a genius to work out why this might be happening – read the US President’s own words. Trump last year said that while a strong dollar “sounds good”, his actual view on this issue was that “our dollar is getting too strong…it is very, very hard to compete when you have a strong dollar and other countries are devaluing their currency”.

US dollar index

US dollar index

The titanic battle is a clash between two world views: getting a weaker dollar and damn the inflation expectations or unleashing the inflation hawks in the central banks and getting sharply higher interest rates.  My money is on the former, especially given the fact that the new Fed chair seems a very long way indeed from being a Paul Volcker – i.e someone who will hike interest rates sharply to kill inflation dead.  If he did, it would crush Trump’s (and the Republicans’) re-election prospects overnight.

Assuming all the cynics are right, the chart above indicates that we could see more dollar weakening in the next few volatile months  – with a decline of another 5 to 10% on the cards. If that was the case, the asset class implications are clear. A weak dollar is bullish for oil prices: much higher oil prices could be the big surprise in 2018. And remember that every major episode of galloping inflation since 1973 has been fuelled by a surge in oil prices. Emerging market economies are also likely to benefit from a growing influx of capital as the dollar weakens. Lastly, historically at least, there is an inverse correlation between the U.S. dollar and gold.

Riders on the storm

All of which brings us nicely to the possible investment payoff: expect more volatility but also gains for emerging markets and commodities. Again, not that that conclusion should come as any surprise at all – commodities, for instance, have been booming. During the second half of 2017, commodities overall posted a scorching 18% return, making them the  best performing asset class.

Analysts at Goldman Sachs foresee what could be called a virtuous “3Rs” scenario, with emerging markets the biggest beneficiaries. “Strong demand growth against limited supply growth due to OPEC and Chinese supply curtailments created significant reflation in commodity prices last year,” say the Goldman analysts.

“Given the high level of debt held by commodity producers, not only do higher commodity prices reduce the number of bad loans and free up capacity on bank balance sheets, higher commodity prices also help strengthen emerging market (EM) currencies and weaken the dollar via the accumulation and recycling of rising excess savings. On net, this in turn lowers EM funding costs and leads to EM releveraging. More EM leverage leads to more EM growth reconvergence, reinforcing even more synchronised global growth and, ultimately, reflation pressures – creating a feedback loop”.

Goldman Sachs 3Rs feedback loop

Goldman Sachs’ ‘3Rs’ feedback loop

I find this analysis fairly convincing but for now we’ve got to deal with more immediate consequences. Will the market volatility persist, or will we see a more robust bounce back? It’s certainly worth watching so-called “Volatility Control” and “Risk Parity” funds which target a specific level of volatility. According to Bloomberg, this could unleash some $225 billion of equity market sales. Also, some $500 billion of global funds are attached to such strategies and in many cases are driven by algorithms. Such a wave of sell-offs could keep market volatility high at best and could cause a crash if volatility continues to rise.

My own sense is that we are probably experiencing another variant of 2013’s Taper Tantrum. The markets know that interest rates will rise but they’re signalling that they think rates shouldn’t rise too aggressively. Maybe they’ve underestimated the steely resolve of the central bankers to crawl back towards monetary ‘normality’. On the other hand, perhaps too much volatility will scare the central bankers back into a more cautious stance. Who knows!?

My own guess is that if the FTSE 100 finds itself under 7000 – and the S&P 500 under 2400 – I’d probably think about venturing back into the markets. Whatever target level you have, I’d observe that a consensus view is beginning to crystallise: long (bet on) emerging markets versus some developed markets, caution on the US, short bonds and long some commodity trades.

David Stevenson writes the Adventurous Investor column for the Financial Times, for whom he has also written several books. He is the editor in chief of AltFi, has previously worked for the BBC, ITV and Channel 4 and has advised a number of firms on investment and communications, including HSBC and EY.

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Record low volatility could signal high market complacency

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Wall Street

FT columnist David Stevenson, writes for Glint on the market’s record volatility lows and says if  “extra ordinary” low risk means steady returns, it can also mean price warping and complacency

Unless you were living in a cave over the last year, you might just have noticed that investors are in an exuberant mood at the moment. The big benchmark equity indices have nearly all peaked in recent weeks and most investors seem to be in fairly chipper mood. The global economy is humming along nicely, inflation is under control, and the US Fed is slowly but steadily raising rates.

The flip side of this bullishness for risky assets is that volatility has collapsed. This matters because equities, for instance, are what economists call ‘risky assets’: i.e. they give you, the investor, an extra return for taking greater risk. If there isn’t much risk – as there is, at the moment – then economists tend to get a bit worried. No investment can be a one-way bet, except of course government securities. History teaches us that such over-confidence usually results in financial cataclysm.

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It’s worth dwelling on volatility because it is so crucial, not least to anyone who invests in gold – the precious metal has traditionally been seen as a great hedge against market volatility. In sum, volatility within the global markets has utterly collapsed and many key measures of this market turbulence are now trading at multi-decade lows.

Most of us are in a state of obvious incredulity about this peculiar state of affairs. Last year volatility barely budged for instance even when President Trump started threatening North Korea with nuclear war. Surely the prospect of a radioactive Korean peninsula might cause some major jitters? The markets thought otherwise.

It’s quiet…too quiet?

The story of the ghost of volatility – as measured by indices such as the US ‘VIX’ – has been a truly remarkable one, constantly retold over the last few years. One of the most cogent observers of this narrative has been Andrew Lapthorne, a quant strategist at French investment bank SocGen. In a note to his clients earlier this week he summarised the peculiar state of affairs thus: “The MSCI World (equity index) delivered a positive total return every month of the year and for 14 months in a row, (while) realised daily MSCI World volatility over the year was less the 6%, half the usual rate, and the index experienced a maximum drawdown of only 2% – and if you run a regression trend-line through the year’s performance, the fit is the highest recorded! All of these are records not seen in the data since records began in 1969.”

Lapthorne isn’t the only perplexed observer. In the dying trading days of mid-late December, Hamish Preston of S&P Dow Jones Indices reminded his clients that US equities haven’t been this calm since the 1970s, while European equities are also at a decade low.

According to Preston, the average observed 1-month volatility in the S&P 500 in 2017 is “lower than in any other year since 1970 [my emphasis added]. Market participants have also seemed intensely relaxed about the expected impact of anticipated news-flow on S&P 500 constituents; 47 of the lowest 56 closing VIX levels since January 1990 have been observed in 2017, as well as two new all-time low closing levels. This environment helped the S&P 500 VIX Short-Term Futures Inverse Daily Index to a 175.63% year-to-date total return.”

What’s true for the US is also true for Europe according to Preston – he observes that “risk was the dog that didn’t bite this year” in Europe, as victories for the favourite candidates in Dutch, French, German and Japanese elections did not provide the unexpected results typical of 2016. “Without such surprises, and supported by ultra-low stock-to-stock correlations, the average monthly volatility in the S&P Europe 350 has been lower in 2017 than in any other year in the past decade”.

The chart below fleshes out this story in a very graphical form.

Average 30-day realised volatility

Average 30-day realised volatility

I also think it’s worth making another observation – on credit default swaps. I watch this market very carefully, not least as an indicator for worries about the health of the major investment banks. Again, we’ve seen some remarkable changes in this market over the last year. Put simply, pricing for these options has collapsed, as investors have stopped worrying.

Structured product provider Meteor collates the latest numbers every month and you can see the latest December stats here. What they tell is that rates on credit default swaps are near all-time lows. What’s also striking is that over the last 12 months credit default swap rates have declined markedly for all banks in the list, with most experiencing a 50-70% decline. One very final observation – the cost of insuring against a bond default by UBS – over the next five years – is now less than the cost for insuring UK government gilts.

Calm before the storm?

Whereas most ordinary investing folk don’t seem to care about this extra ordinary state of affairs, most dismal economists and their analyst peers smell a rat. They think we should care, as all this boosterism usually ends up going wrong at some stage. Lapthorne at SocGen for instance, observes that low risk markets tend to have a big knock on effect with “positive feedback mechanism embedded in many risk models, i.e. the less risk they see, the more risk they allow you to take”. As a result, investors end up chasing financial assets to high valuations – MSCI World equity investors are (according to the well-established I/B/E/S data) now paying a 35% premium to get the same level of EPS they got back in early 2008 with the US dividend back below 2% and at levels not seen since 2007. Soaring valuations also encourage corporates to buy back more shares and increase dividends – by taking on more debt. Barely a day goes by now without some giant US or UK corporate issuing dirt cheap, multi-billion dollar bonds at bargain basement rates to fund buybacks, dividends and bumper executive pay – but one thing they have noticeably not funded is more capital expenditure to pay for the better running of their company, arguably the spend most necessary to justify these high valuations.

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We shouldn’t, of course, be surprised by any of this. This is exactly what the central banks want to happen. Keep rates low and flood the market with liquidity to create stable conditions for an upturn. Mission accomplished! And there’s even evidence that the central bankers are now explicitly monitoring volatility indices as a form of macro-prudential regulation – thus the chief snapshot of turbulence itself becomes the policy tool, opening up all sorts of Heisenberg-esque quips about uncertainty.

Pricing a complicit volatility

The flip side of this is that investors are also focusing on volatility themselves through their portfolios. Indices such as the VIX (tracking ups and downs in the S&P 500) can easily be invested in via futures and exchange traded notes (ETNs). In fact, one could argue that this new asset class has become so popular that it’s actually warping the underlying market itself, producing all sorts of pricing distortions. One small example: with the VIX at record low levels, there has never been a better time to buy portfolio hedging for any big downside risk to your investment portfolio.

And, crucially, I don’t see this strange state of affairs changing any time soon, unless president Trump gets tempted by that “much bigger & more powerful” big red button sitting on his desk and decides to fry North Korea. Central bank interference in asset markets isn’t going away any time soon and interest rates will remain low. The barbarian populists at the gate aren’t even a threat, as most of them seem to be every bit as capitalistically inclined as their hated establishment peers – bar Jeremy Corbyn that is.

The big turn, when it comes, I think will come either from the FX markets or China or both. Experience teaches us that many major macro-economic crises emerge either out of excessive leverage or from fundamental imbalances in the global capital and trade system expressed through FX rates. Eventually the global financial markets do find a way of accurately pricing risk, and it usually ends up hitting FX rates. As always, it’s worth watching the dollar – dollar spot rates lost almost 10% during 2017 and more than 12% against the euro. That weak dollar has helped the US economy surge forward, but at what cost to the stability of the global financial system? Alternatively, we could see a sharp slow down in China, resulting in mayhem in the FX markets. But when a ‘regime change’ comes, watch volatility spike – the greatest show on earth will then begin again.

David Stevenson writes the Adventurous Investor column for the Financial Times, for whom he has also written several books. He is the editor in chief of AltFi, has previously worked for the BBC, ITV and Channel 4 and has advised a number of firms on investment and communications, including HSBC and EY.

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Why we need to trust the fintech robots to benefit from them

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Robots

Financial Times columnist David Stevenson, addresses the need for investors to break their habits and give fintech the power to change an overpriced system

As a financial columnist I’ve always had a soft spot for the paradox. Something that is seemingly contradictory to common sense, and yet is perhaps true, is always a challenge to render in words but often remains so deliciously absurd you can’t help but try.

Take the example of how increased money supply does not necessarily make us feel wealthier, or how political rhetoric on safely managing the economy makes us less certain that we are in good hands. I’ve also always been fascinated by the paradox that although stockmarkets and their investors might hate free spending governments, they love it when ample amounts of pork barrel is lavished on their individual stocks. Thus Democratic presidents in the US usually end up being historically better for US stocks than ‘free market’ Republican ones.

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For me though, the biggest paradox of all has to centre on the relationship between money and technology. I’m rather sick and tired of those cynics and academics who say we live in an era of minimal technological change. Have these people ever spent any time in the world of money, finance and investment?

Technology has been, and continues to be, utterly transformative. I’m just about old enough to remember being amazed by a bank ATM and the advent of internet banking, innovations that gave my expectations a considerable fillip: nowadays I’m mercilessly angry if I can’t run a transaction in seconds. However, the paradoxes remain, for, despite all this advance, all this genuine transformation and, yes, disruption; why is it that all this new shiny technology actually seems to be costing us more?

If you have any spare time one bank holiday track down a cracking paper called Has the U.S. Finance Industry Become Less Efficient?. It was first published back in November 2011 by Thomas Philippon. The US based academic studied whether financial intermediation in the U.S. over the past 140 years had actually made the industry more efficient — and thus cost less. The resounding answer was no. Or, as the author observes, in a slightly less polemical fashion: “Surprisingly, the model suggests that the finance industry has become less efficient: the unit cost of intermediation is higher today than it was a century ago. Improvements in information technology seem to have been cancelled out by increases in trading activities whose social value is difficult to assess.”

In damning detail the good professor highlights what’s gone wrong with finance, investment and banking (a story which is echoed in another ground-breaking work called A Demon of Our Own Design by notorious hedgie Richard Bookstaber). According to Philippon the finance industry’s share of GDP in the US “is about 2 percentage points higher than the neoclassical growth model would suggest based on historical evidence — this would represent an annual mis-allocation of about $280 billions”. Another US academic, Ken French, has looked at similar trends relating to financial intermediation for fund managers. He’s also discovered colossal mis-allocation of capital, away from productive activities towards obscene fund manager fees. The caution of the tale is obvious: better technology, more choice, and greater competition has, in large part, actually ending up costing you and I more. Not quite the techno-panacea we all imagined.

The price of change

But change is coming from the growing mob of fintech upstarts out there determined to hurl a cart load of apples at the shining bastions of financial capitalism. Countless myriad startups in the payments, funding and asset management space are busily perfecting super sleek, app-based platforms that have the potential to release those hallowed efficiencies we’ve all been promised for decades.

But a problem remains; and here the paradox reappears.

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We may all love change, more choice and lashings of technology, but the reality is that we are also creatures of habit when it comes to behavioural finance. Which is a pointy head way of saying that in fact you and I, us, we’re the problem. Technology can change everything but it requires us to play along, and, unfortunately, the evidence is that our money based habits are governed not by excitement for the new but by fear and distrust of it.

Let me take one small but pertinent example: Robo-advice.

This horrible term describes the cohort of disruptors busily at work looking to smash the traditional asset management model. Their troop of Trojan horses is simple enough to understand: Great automated technology, at the touch of a button, that manages your portfolio. Add in a splash of low cost solutions based on computerised index trackers and exchange traded funds (ETFs) and you have a great way of cutting out the rate receiving stockbroker and the largesse of financial intermediation; thereby reducing costs and boosting investor efficiency.

Many younger investors in particular are embracing this revolution – but a problem remains. I caught sight of one top secret, confidential venture capital report recently which looked in phenomenal detail at the sector and its finances. I’d have to kill every reader if I disclosed the main details of the report but two facts stood out. The first was that they estimated average customer acquisition costs were in the hundreds of dollars per client. A figure which compares poorly with the actual average revenue per client they were able to achieve, which struggled to get much above a few hundred dollars. The challenge of garnering trust is clearly made all the more difficult by the mutual lack of self-affirming returns.

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But the really damning number related to their internal estimates for average customer investments in a robo-account. They put this as somewhere between $7,500 and $10,000 — not very much at all. Put simply, the economics of this particular revolution currently don’t stack up. You charge less if you think you can scale up quickly and massively. But if scaling up costs tens of millions via advertising campaigns on the tube only for you to pick up tiny client accounts, you’ll be bust within a year or two.

The report’s authors also quizzed investors as to why they didn’t put more money into these shiny new investment accounts. The answer was blindingly obvious and anchored in the habitual behavioural motives we all understand. “I don’t trust these new brands with much of my money,” was the common thread. It’s the same horrible logic that keeps transfer rates among energy consumers in the UK at incredibly low levels — and retention rates for the Big Six at such high levels, despite the paradox of these giants charging more! So we might hate big banks and big investment organisations but it is we who don’t want to change anything substantive about our financial behaviour. We might love new technology but, as yet, we’re not benefitting from the lower costs. The paradox abounds.

David Stevenson writes the Adventurous Investor column for the Financial Times, for whom he has also written several books. He has previously worked for the BBC, ITV and Channel 4 and has advised a number of firms on investment and communications, including HSBC and EY.

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The mega-trends stalling inflation

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Global

FT columnist and AltFi editor-in-chief, David Stevenson, writes for Glint on the global trends that he believes are suppressing inflation despite QE’s flurry of paper money printing 

In my long experience, investors, especially professional investors, are a pretty dismal and miserable bunch. Too many of them trained as economists which means they can never quite bring themselves to think the best of a good situation. So, when Trump does the one thing that he’s promised in legislative terms, namely cut taxes – pretty much the only thing he’s promised by the way – investors inevitably tend to add a caveat. “Yes, it’ll be good for equities,” they say “but with growth humming along…inflation is set for a return!”

In fact, inflation is increasingly the hot topic for many inveterate financial worriers and soothsayers. It is one of the four great horsemen of the financial apocalypse, the others being civil war, deflation and government expropriation. Inflation never really went away of course after the global financial crisis but was exiled to godforsaken places such as Zimbabwe and Venezuela. Having enjoyed its time in the tropical sun, inflation is back again in the developed world, courtesy of the populists.

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Overall, I’d suggest there are three main narratives about the inflation story at the moment, all of which are explicable using my favourite set of metaphors, namely cars and the stupid things we all do with them on a regular basis.

The first, beloved of all QE critics and bond vigilantes, is that we are one step away from the great inflationary car crash. Zimbabwe and Venezuela loom large here because they represent how monetary policy will spin out of control as the evil central bankers lose power over their balance sheets.

The second narrative can be called the sensible ‘check the temperature gauge’ concern, beloved of all families stuck on a long journey: “Darling, it’s been a long journey but did you check we have enough water in the engine or we’ll overheat in this traffic jam”. By and large, this is probably the collective mainstream view of most dismal investors after a year or two of solid global economic growth.

The last scenario is the one I subscribe to. It’s named after every teenage encounter with a steep hill – the stall scenario – and describes the impossibility of generating meaningful inflation in the face of the steep hill of disinflation, generated by globalisation and technological change.

Crash safety

Personally, I think the car crash scenario is the one most easily dispatched. In essence, it rests on two arguments. The first is that we’re measuring all the wrong prices and that inflation measures such as the consumer price index (CPI) and the retail price index (RPI), doesn’t tell you what’s happening in the real world of asset prices. To which I can only reply – so what? That’s always been the case. Ever since the dawn of time people have complained that official measures don’t include what others think should be included in inflation measures. But we have these measures because they work, are clearly understood and easy to explain. I accept that asset price inflation is a problem but believe that controlling this should not be part of inflation policy but a more general regulatory and fiscal approach (tax the stuff going up in value for no reason).

The next step in the bond vigilantes argument is to say that at some point we’ll see all this fiat money wash into the real world via wage inflation. Again, a great many very clever people have been waiting for the missing wage inflation story to resolve itself – and no one has found any evidence that it is a looming economic monster of mayhem. Albert Edwards at French bank Société Générale, for instance, has been closely following US wage measures for some time and singularly failed to find overwhelming evidence of major cost-push pressures from wages (yet).

There are certainly isolated pockets of skilled wage inflation but the overall picture is actually very dismal, consisting of real wage decreases for the majority of the population. One other concern, oft repeated, is that we’ll see pressure from the commodity space as all this monetary debasement erodes confidence – with oil prices the key measure (not gold bizarrely, which has stayed fairly stable in price terms). The extreme view is that oil will break out of its narrow $40 to $60 trading range and then head north. This is a not a completely unrealistic fear, but I would suggest that the current price highs are related to some obvious OPEC gerrymandering and a slowdown in capital allocation to the US unconventional energy sector. Once OPEC’s self-discipline breaks down – which it will, as night follows day – and the US unconventionals open the capital markets tap, we’ll see prices head back down again. Thus, taking with them any commodity price fears.

The next coherent narrative around inflation comes from mainstream equity market analysts, in awe of the Trumpian threat to massively decrease taxes and worried that the US recovery will overheat and nudge inflation higher. A recent note from Blackrock’s global strategist Richard Turnill, I think, nicely sums up this mainstream view.

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He reckons that it’s probable that the U.S. economy is shifting from reflation to inflation and says he has greater confidence in inflation returning to its medium-term trend and the Federal Reserve’s target. “Better wage growth and potential fiscal stimulus should cement this transition…This year’s surprise was better-than-expected growth coinciding with cooling inflation, partly due to one-off factors. We see that changing in 2018 as the U.S. economic slack created by the deep 2007-09 recession disappears. The market pricing of higher Fed rates has shifted up, yet the chart shows it remains well below the Fed’s and our own outlook. We believe the Fed is on course to increase rates in December and match its projection of three increases next year. We see the potential for four rate rises in 2018 if growth gets a boost from fiscal stimulus.” The chart below sums up the consensus market view about interest rate projections – personally I think the market pricing is about right for interest rates, though I concede we could see a top for US interest rates at 2.25%.

Fed interest rate projections

Fed interest rate projections

Turnhill suggests that inflation expectations “were dented this year due to the surprise slowdown, tied to major one-off drops and moderation in some categories such as housing. Yet we see inflation expectations firming up as prices climb at a gradual pace.” To help measure this potential upwards inflexion, Blackrock launched something called the Inflation GPS earlier this year “to help cut through the noise on price trends. The Inflation GPS is consistent with core prices climbing back towards the Fed’s 2% target. The October Consumer Price Index supports the signal from the Inflation GPS.” In particular, the Blackrock strategists reminds us that for once “China is exporting much less deflation abroad. That has removed a key drag to global inflation – especially as China’s cuts to industrial capacity underpin commodity prices.” Nevertheless, Turnill reminds us that various “structural factors – including the role of technology – should keep price pressures in check”.

I’d suggest this is something of an understatement by Turnill. In my stalled car scenario, global consumers are staring at a monumental wall of disinflation produced by the twin forces of technological disruption and globalisation. Coincidentally, just to ram home this observation, last week saw the release of a report by private equity firm HarbourVest, revealing their global investment “megatrends” for the next 10 years for private markets. They are:

  • A technological leap-forward
  • Demographic shifts
  • The global role of China

This is all obvious stuff, frankly, but no less revolutionary – and all likely to power the enormous global engine of disinflation. The populists of the Left and the Right understand this disinflationary wall of fear better than the bond vigilantes – who sit around worrying about QE and monetary debasement.

Wisdom of crowds?

What the populists and the PE firms both realise is that ordinary families haven’t seen strong wage growth for decades – and that’s because the unions have been broken. They also realise that there’s always an army of cheaper wage labourers waiting to do their job at the drop of a PE, or outsourcer’s, hat – thus restraining wage inflation. They see government budgets under threat from capital globalisation and poor wage inflation, and instinctively understand why debt mountains are growing bigger by the day. The populists will soon be attacking the technology giants and their lackeys in the media, accusing them of shape-shifting internationalism. And of course, every good populist genuinely understands the threat from China. Or “Chiiinnaaa” as Trump used to keep saying on the election trail.

Just like Marx in the 19th century, the populists have identified many of the main problems, and then promptly suggested all the wrong solutions. But salute their observational skills nevertheless. And then consider why all these forces – technology, China, an ageing population, towering amounts of debt – will keep a lid on inflation for decades to come. And then stop worrying. And buy income producing assets and sit tight.

David Stevenson is an experienced investment commentator and author, writing for a number of leading publications including The Financial Times, where he is a columnist, the Investors Chronicle, and AltFi News

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Central Banking’s Brave New World

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money rocket

Financial Times columnist and author David Stevenson, argues that the liquidity creating role of central banks and our increasing reliance on quantitative easing may lead to a dystopian monetary future 

When I was young the only con or magic trick I could half decently perform was the three shells and a pea game – juggling was beyond my physical abilities and most card tricks required a much higher level of intelligence. That crudely executed shell game taught me the importance of deceiving observers by distracting their attention from the real action. As an investment commentator I sometimes sense echoes of this con in the actions of central banks. They love to focus our attention on that momentous decision about interest rates – will they, won’t they – but what you and I should actually be watching is off-centre, with the dynamics of their balance sheets.

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To be clear, I’m not saying those interest rates don’t matter, they do. Especially as they begin to impact on that all important 2.6% barrier which many bond investors (including Bill Gross) think is the real signal for a bear market in bonds. But if you subscribe to my vision of the ‘Low Rates, Longer’ thesis, even a short term peak interest rate of 2% or, god forbid, 2.5% (at a push, and the Fed better get a move on) is not hugely relevant. Just like the Grand Old Duke of York, central bankers will get to those lofty heights of 2.5% and then come marching straight back down again because we’ll be one step away from recession within a year or two, as the business cycle naturally ebbs and flows.

Balancing Act

The real game in town is the balance sheet, rather than interest rates, as it is more likely to trigger a recession. Put simply central banks and especially the US Federal Reserve, want us to believe that their balance sheets are too big and that QE needs to be unwound. The stated aim is for what’s called balance sheet normalisation, with the US Federal Reserve slated to cut the size of its US$4 trillion balance sheet by US$1-1½ trillion over the next five years. Good luck with that!

To understand why this vain attempt will fall at the first hurdle we need to head back into the world of economics and the concept of debt stock and capital flow that is key to determining what might happen next to central bank balance sheets. The prevailing myth is that QE has resulted in absolutely bloated central bank balance sheets and no one is doubting that some drastic slimming is required: i.e. the stock of assets and liabilities is way too big and needs to be squeezed. But observers who closely watch global liquidity and capital flows beg to differ. London based research firm Cross Border Capital is dedicated to monitoring the stock of central bank debt and the flow of capital and it reckons that we’ve all got the numbers wrong.

In a recent report they estimated that “aggregate World Central Bank QE is already turning lower, but importantly from mid – rather than high – levels, therefore, questioning the popular belief that world domestic monetary policy is still ‘excessively loose’. This is particularly true for the US Fed.”

Balance sheets only seem bloated if one sticks to the old central bank model, a narrow one which simply assumed a limited number of powers and minimal, short term focused, money market operations. In our liberalised, capital flow focused global economy, central banks have a much bigger role to play. In effect they operate less like central banks and more like an active sovereign wealth fund on steroids whose job is to manage national liquidity, control credit creation and generally reduce systemic risk. In this model the US Fed might actually just have the balance sheet it needs – but is about to reduce it to lower, more dangerous, levels.

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Which brings us to the flow of capital markets lubricated by QE. Experience teaches us that major financial crises usually occur when big, speculative, cross-border flows of capital are coinciding with persistently tight central bank money. It’s these abrupt changes in capital flows, and their interaction with central bank balance sheets which cause the big moves in real rates. So where are we with those flows? Back to Cross Border Capital again on the big moves of the last few years that are about to unwind in flow terms. “Taken in absolute size, cross-border capital flows, over the past year, represent some 17% of developed market central bank liquidity injections, 68% of emerging market central bank liquidity injections, and a huge 157% of frontier market central bank liquidity injections.”

QE = Quite Essential?

Here’s the really important bit though. Over the last three years an astonishing US$3 trillion of capital “quit China, the Eurozone, Japan and the other Emerging Markets,” according to Cross Border Capital. “In the comparable period beginning 2007, these same economies enjoyed US$1 trillion of net inflows”. Obviously, QE has a role to play in these flows not least in Europe, where 70 cents in each Euro printed by the ECB’s QE programme looks like it left continent. With the ECB now joining in the QE slowdown that outflow will probably now turn into an inflow.

Step back from all these cross-border trends and we see a worrying situation brewing. China is looking stronger than ever, while European outflows are declining sharply as the mainland economy stabilises. The US, by contrast, is determined to shrink its central bank balance sheet whilst its president engages in inspired mayhem.

In this scenario do you think that central banks are really about to stick, monk like, to a new regime of squeezed balance sheets, especially when the proverbial populist inspired dung hits the fan? Of course not.

Let’s rehearse what I think is the likely scenario for the global economy over the next 2 to 3 years. Capital flows switch markedly (out of the US, into China and Europe) while the US and the European central banks attempt to shrink their balance sheets even as they try desperately to increase interest rates.

Volatility, especially in the FX markets, increases markedly whilst the business cycle also nears its peak. A slowdown looms and global capital flows pick up again as a result. Come late 2018 the US Fed discovers that it has most room for manoeuvre – it has managed to get interest rates to 2.5% and slimmed down its balance sheet markedly.

Responding to populist pressure as the economy slows, the US Fed drags down interest rates to 0.5% again. But it’s not enough – the shock power of such a move isn’t anywhere near what it used to be.

The Feds balance sheet starts to grow again markedly and global investors push their money back into the US while dollars flood out of Europe and the emerging markets again. Other central banks (especially our own) have even less room for manoeuvre – rates are lower and balance sheets bigger – so they resort to increasingly desperate monetary experimentation including helicopter money and variants of modern monetary theory. Calm returns and everyone realises that the myth of ‘Old Central Banking’ with its narrow fiduciary responsibilities and slimmed down balance sheets is just that: A myth. Welcome to the New Global Order and a New World of Central Banking.

David Stevenson is an experienced investment commentator and author, writing for a number of leading publications including The Financial Times, where he is a columnist, the Investors Chronicle, and AltFi News

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