ROOM TO MANOEUVRE? YOUR RATES IN THEIR HANDS
& HOW TO MANAGE RISK & RETURN IN TURBULENT TIMES
MBMG Group Research Paper
MBMG Group Research Paper Paul Gambles, Bangkok, March 2012 Additional research provided by Leigh Pearson 2
MBMG GROUP RESEARCH: Room to manoeuvre? Your rates in their hands & How to manage risk & return in turbulent times FOCUS: Cash con nues to gain strategic importance as an investment asset class in the current defla onary stage of the long term economic cycle which has persisted, in indebted developed western markets, since the turn of the millennium. As one of only three asset classes expected to outperform during this 15 to 25 year phase, it has become increasingly important not only to allocate an adequate propor on of investment por olios to cash but also to ac vely manage that money in order to achieve op mal returns in a low or zero interest rate environment against a backdrop of ongoing fears of a global depression. IMPLICATIONS: During such a defla onary period, two key issues come to the fore: â€˘
Strategically managing asset alloca on with due regard to the risks and rewards of each asset class â€“ recognising the three most suitable asset classes for this long term phase (namely gold, bonds and cash), whilst exploi ng tac cal alloca on to other assets, notably risk assets such as equi es and property, so as to capture counter trend reversals
Maximising the poten al returns of each of these three strategically appropriate asset classes
These issues need to be considered from a wide range of currency perspec ves and all investment criteria, in terms of the global asset and currency opportunity set, no ng that the most favourable long term returns and investment opportuni es are likely to be found within un-indebted, higher growth economies, such as those in South East Asia. Although a short term US Dollar rally seems likely, interna onal assets will become consequently less a rac ve. Depositors need to be aware of this from a currency perspec ve and choose the op mal exit point from any interna onal currencies. OUTLOOK: A sharp retrenchment is expected in the value of risk assets throughout 2012 and 2013. Currency vola lity is also expected to increase, leading to both elevated levels of risk and greater opportuni es.
EXECUTIVE SUMMARY Zero interest policy causes problems for investors: all that’s gold, does not gliƩer The consequence of uninhibited lust for credit, which has defined economic and capital market ac vity for the last thirty years, is slowly, inch by agonising inch, reaching its inevitable conclusion as both people and na ons are star ng to learn the hard way about the need to live within their means. Yet the UK, the US and Europe con nue pumping billions more Dollars into their economies in a bid to s mulate a recovery, while many other countries have started to follow suit. Most notable and most alarming of these is China, in view of both the sheer scale of its capital base and the worrying inadequacy of Chinese regulatory oversight or transparency. Capital flows have caused unintended consequences increasing the daily cost of many consumer staples beyond the ability of many socie es to cope, constrained as they are by their increasingly unequal income and wealth dispersion characteris cs. Evidence of this has spread from Athens, through the s ll con nuing Arab Spring, via the streets of many UK ci es to the Jasmine riots in China. An intellectual debate con nues to rage about what ac ons the Fed, IMF, ECB and all central banks or supra-na onal bodies can or should take; whether Federal Reserve Chairman Ben Bernanke’s handling of the Global Financial Crisis (GFC) - based on the narrow and seemingly incorrect historical perspec ve of monetarist economic theory - can win the day. Investors could learn a great deal about the current situa on and future outlook by studying long term market cycles – especially MBMG’s Kondra eﬀ Seasons:
The policies that have been adopted are jus fied with reference to economic theory but the jus fica ons provided are spurious and, therefore, investors should not expect be er or diﬀerent outcomes to the previous instances of the global ‘Winter’ phase of the economic cycle. Accep ng that cash, gold and bonds are the three strategically appropriate assets for this phase, investors need to understand the challenges associated with each of these. For bonds and gold that challenge is not to get caught holding the me bomb when these asset values fall oﬀ a steep cliﬀ, although that may not be imminent. For cash, the test ahead is to get any kind of returns in a zero interest environment. This is a very challenging investment environment but awareness of the larger context will help investors to find the most appropriate solu ons.
PROFESSOR BERNANKE’S ACADEMIC LACK OF INTEREST Even proponents of the policies that have taken the global economy to the brink, such as Bernanke’s predecessor Alan Greenspan, admit that these policies are a huge experiment, lacking any scien fic grounding or precedent. Indebted western economies currently remain deeply mired in the depths of Kondra eﬀ ’s winter despite the unconven onal s mulatory economic policy and smorgasbord of bailout packages. The three asset classes which perform best during this winter phase are, as previously stated, gold, bonds and cash. Gold has already risen from below USD250 per oz to a peak of USD1901.35 per oz last year. It has the poten al to climb rather higher than that before the end of the winter period, but it also, in the longer term, appears inevitably condemned to fall back below USD1000 per oz, meaning that investors holding gold need to keep an eye firmly on the exit door. Bonds and cash each face the horns of a vicious dilemma.
THE DILEMMA Central bank policy has created a feedback loop where, in a kind of Pavlovian nightmare, investors are, in the short term punished for prudent, strategically appropriate asset alloca ons and rewarded for wild, excessive and specula ve behaviour. Sadly, unless you are prepared to take a leap of faith based on blind belief in the power of central banks, this will inevitably end in the failure of these government sponsored specula ve excesses. It is a diﬃcult challenge for many por olio managers, let alone individual investors, to maintain the required focus, understanding and discipline in the face of such manipula ons. The best performing por olio managers ask two key ques ons – Which asset classes oﬀer be er risk/reward than cash? How to get the best cash returns? US Bond and T-Bill rates dictate both global interest rates and investment returns, but one month T-Bills now pay annualised interest of just 0.05% and one year bonds just 0.13%, a nega ve real return once infla on is factored in. The benchmark 10-year note has been gyra ng around the 2% per annum level for some me. To get a 3% annual return you have to buy long-dated (30 years to maturity) treasuries with the added caveat of price vola lity between now and maturity, i.e. if interest rates increase by just 1% then the capital value of 10-year notes would instantly fall by the best part of 10%. For thirty year notes the price drop would be almost three mes as bad. This becomes even worse if interest rates increase more.
3 yr 0.31
5 yr 0.72
7 yr 1.27
FLAWED THEORY: BONDS AND BERNANKE’S BLIND MAN’S BLUFF Bond prices have pre y well reached their apex with interest rates on US Treasury Bills having fallen to almost zero. This is likely to endure for as long as Bernanke & Co. con nue to press ahead with flawed s mulus policies. Although nega ve real rates (interest rates minus infla on) look as though they are here for some me and longer term rates (such as 30-year government bond rates) can fall, especially if manipulated by government policies, interest rates look certain to move higher over me thus pushing down the price of bonds. While this scenario may not be imminent – MBMG’s near term expecta on is for prices to con nue to increase – it is all but inevitable, and may be drama c once it takes root, so investors need to know where the exit door is located. Given the heightened risks surrounding inves ng in gold or bonds, cash emerges as the hardiest asset class in mes of economic winter despite the pressure that investors face to chase higher-yield/higher-risk investments. This is the ul mate central bank manipula on and is generally jus fied by reference to a range of economic theories including The Taylor Rule which is a formula developed by Stanford economist John Taylor in 1993. It was designed to provide central banks with guidance on se ng interest rates in response to changing economic condi ons by systema cally reducing uncertainty and increasing the credibility of the central bank’s future ac ons through the process of fostering predictable price stability and full employment. One of the key elements of the theory is that any rise or fall in infla on should at least be matched by rela ve increases or decreases in base interest rates, thereby dampening growth with higher interest rates when growth leads to infla on, or by s mula ng economic ac vity (spending and investment) by cu ng rates in mes of low growth. As it is not possible for interest rates to drop below zero, an implied nega ve rate from Taylor’s Rule would seem to jus fy “prin ng money” – the introduc on of new money supply by central banks, now universally known as Quan ta ve Easing (QE) – as means of s mula ng growth. A problem arises, however, from the fact that in 1999, Taylor wrote a further paper in which he discussed and tested a number of variants to his original theory. It is these variants that have been cited by Bernanke when defending his fiscal and monetary policies. This strongly contrasts with Taylor’s posi on as he is now distancing himself from these departures to his original theory due to their failure to stand up to historical experience and inves ga on. Specifically, the variants of Taylor’s Rule suggest very diﬀerent responses to the financial crisis. Whereas Taylor insists that his original theory, which be er stands up to historical evidence, suggests only limited QE in the ini al stages of a financial crisis, Bernanke is ci ng an unproven or even discredited variant of the rule, which is based on forecasted rather than actual infla on and a larger gap between actual and poten al economic growth. Bernanke’s monetarist postulate supports loose monetary policy and massive levels of QE.
H. J. Huney, 2011
ALL EYES ON EUROPE Poli cians and European central bankers, driven by a desperate desire to preserve the status of the impossibly flawed single currency have followed a similar course of ac on to Ben Bernanke.
Tyler Durden, 2011,
A FICKLE TWIST OF RATE Despite pledging their allegiance, central bankers globally have discarded Taylor’s rule book, based on his study of economic precedents. In doing so, they have turned global capital markets and the global economy into a terrifying laboratory test experiment. Unless you are convinced that today’s central bankers wield hitherto undiscovered powers that can change the essen al nature of economic ac vity then it is important to realize that these policies will only serve to amplify the extent of the current defla onary cycle, boos ng the gold and fixed-interest boom, exaggera ng the subsequent bust and increasing the out performance of miserly cash rates compared to the severe losses expected from risk assets such as equi es, commodi es and property. Expert Witnesses This Time Is Diﬀerent: Eight Centuries of Financial Folly, (Kenneth Rogoﬀ and Carman Reinhart) makes a very clear and convincing argument as to why central bankers are engaged in pure folly. It concludes that the experiment will fail and that this me is no diﬀerent, in which case, the long term cycles, the four Kondra eﬀ Seasons, will con nue their relentless transi ons. This means that investors need to avoid risk assets un l the economic Winter ends and ushers in a new, more hopeful Spring, at which point they need to be ready to unload their gold and fixed-interest holdings and hold high levels of cash and cash equivalents.
INVESTORS’ DILEMMA Those who depend on the interest from their investments to fund their lifestyle may be unable to resist being forced further up the risk spectrum than is really advisable for them. In order to meet the short term need for yield, they may take on risks that permanently impairs their capital base while other investors seek what they hope will be secure capital apprecia on from gold bullion – an asset class which is des ned to collapse at some point in the future.
SAVINGS: SAFE HAVENS OR NET LOSS Not only has the zero interest rate environment increased the demand for secure, liquid deposit and investment vehicles thereby driving down yields to the point where the end result, once infla on has been taken into account, is a net loss but also, in recent months, the market has once again witnessed nega ve no onal interest rates. This is where, at the 9
moments of greatest fear, short term government bonds returned, thirty or ninety days later, less than the amount actually invested, without even taking into account the eﬀect of infla on on the real value. Some large American banks have actually quoted nega ve shortterm interest rates in an a empt to deter depositors.
FORGOTTEN RISK/REWARD The lack of secure, liquid returns has prompted some investors to explore high-yield stocks. The Vanguard High Dividend Yield Index (see below) fell by more than one-half from 11,011 in 2008 to 5,303 in 2009. This currently pays an annual yield of 3.2%, which appears totally inadequate compensa on for the risks involved. Other investors have chosen to chase the yield on corporate bonds – forge ng that in 2008-9 these assets also faced losses as bad as the 50% hit for dividend stocks.
RETURN OF CAPITAL ͵ NO GAIN, NO PAIN Many investors find it diﬃcult to accept the premise that making nothing at all is be er than the risk of losing 10% of the value of their investment every me rates are hiked. However, in an environment where investors and depositors are worried about the manifold risks of double dips, currency collapses, poli cal gridlocks and social unrest, Main Street is showing an increasing willingness to simply accept the return of their capital – even without allowing for the extent to which infla on takes its toll – as opposed to a return on their capital. (The challenges faced by depositors and investors are highlighted in Appendices One and Two)
FX ͵ RISK OR OPPORTUNITY Vola lity in foreign exchange rates, another significant challenge that today’s investors must face, increased significantly from the beginning of August 2011 to January 2012 (see the chart below). The major currencies con nue to hold an ‘ugly contest’ and take turns in claiming the prize of being the least desirable currency to invest in. 10
The idea of locking your wealth into any long term currency posi on seems too risky for the me being, especially as the current pi ful yields and deposit rates do not oﬀer suﬃcient compensa on to warrant taking such risks. The Greenback remains our current flavour of the month, looking set to embark on a vola le, but generally upward trend for the near term. Medium to long term forecasts are much more uncertain.
One should remember, especially in the short term, that currency rela onships are never straigh orward or linear. The US dollar, in par cular, may benefit as a safe haven currency during the more vola le mes. In a crisis, do not be surprised to see the Baht weaken below 35 Baht to the US Dollar, only to ul mately strengthen beyond 25 Baht to the US Dollar. Clearly this gives opportuni es for ac ve currency management to produce gains over me. MBMG Group’s chosen por olio manager, Mar n Gray of Miton, recently discussed this ma er on Squawk Box Asia: hƩp://video.cnbc.com/gallery/?video=3000073330)
Mar n has held substan al cash holdings but has put this cash to work by enhancing meagre cash rates with impressive currency a ribu on.
THE ASSETÍłBACKED SOLUTION The other alterna ve is to iden fy assets with similar investment characteris cs to cash but which produce higher returns. Asset-backed investments generally provide a reasonable level of security depending on the underlying assets in ques on although in many cases liquidity is compromised. There are some excep ons to this including our own current preference. This is the Two Seasons 21st Century Fund which consists of tangible assets such as residen al and commercial property or the assets of businesses such as plant, machinery or stock. The levels of security are determined by the price stability of the underlying asset. Residen al property is generally the preferred security. In the safest and most liquid assetbacked investments, the ability of the underlying asset to source alterna ve funding is a key factor in ensuring an acceptable level of liquidity. The actual return on the fund is not in any way dictated by the returns or income of the asset itself which is merely held as the security if the interest and/or capital payment obliga ons to the fund are impaired in any way. This is similar to the way that building socie es and credit unions issue loans using depositorsâ€™ funds and take security against these. However, the main diďŹ€erences are that the funds do not leverage their exposures, so the levels of security held by the funds are much higher than those generally required by most building socie es and credit unions. Also the underlying quality of the credit issued by the funds is a much higher calibre than most credit ins tu ons yet the resultant returns are significantly higher.
CONCLUSION There has never been such a diﬃcult period for investors and analysts to ‘join the dots’. The risk on/oﬀ phenomenon is the manifesta on in capital markets of the ba le between economic fundamentals and the ar ficial eﬀects of interven on. The massive debt levels of households, the banking sector and government debts are slowly but inevitably strangling the economic system. This is not a short-term phenomenon nor is any quick fix likely – hard, painful decisions are required but are unlikely to be forthcoming. Economists can only try to explain what is happening while investors need to play the card that they have been dealt. If they follow the conclusions of this guide, we expect investors to significantly outperform. Poli cal factors rather than fundamental factors currently drive markets but the ar ficial recovery manufactured by prolonged distor on of economic rules will ul mately have to face reality. Central bank policies so far have generally taken the exact opposite path to the one required to deal with the economic downturn. This course of ac on is leading to another, larger crisis down the road.
Central banks and interna onal organiza ons have used specious jus fica ons and distorted precedents to jus fy their ac ons. Academic research is distancing itself from this and appears increasingly uncomfortable with the adopted policies. Last year, and for the last decade, it has been vital to understand the economic context in order to achieve best risk-adjusted returns. The global economy is in a ‘winter’ phase. The “new normal” - slow economic growth, increased vola lity and disappoin ng investment returns - seen in 2011 is a taste of what is to come. Winter gives rise to counter trend relief rallies in risk assets but investors who tac cally exploit this need to be careful not to get caught “picking up Nickels in front of bulldozers”. Investors who study economic history will be able to be er an cipate the pending calamity than those who have blind belief that the unprecedented experiment currently being conducted by central bakers can, and will, change the essen al nature of economic cycles. The mess that led to the credit crunch and the GFC has never been died away or dealt with – only swept under the carpet. Europe is a disaster wai ng to happen at some point, even if the can could be kicked further down the road. If they do not get things right then China may be a greater problem than Europe. Strategic asset alloca ons should be to cash, gold and fixed interest. As the end of winter gets closer each day, investors need to be aware of the poten al need to exit these posi ons in the future but winter is likely to persist for a number of years. Cash has less poten al downside than gold or bonds but cash returns are extremely meagre. It is vital to maximize returns from cash holdings without compromising security or liquidity. The two keys to enhancing cash returns are either to exploit long term currency trends or to iden fy assets with higher returns which also oﬀer cash characteris cs. Currency trends have been, and con nue to be, most successfully implemented by Mar n Gray within por olios such as Special Situa ons, Strategic and Rhodium, all of which have moved from exploi ng Yen strength to inves ng in Asian currencies. The few asset-backed investments, such as 21st Century, that provide adequate security and liquidity provide the best cash equivalent investments. Whilst the environment is challenging for investors, it is not impossible to stay ahead of the curve and keep your future in your own hands.
APPENDIX APPENDIX 1 To highlight the challenges faced by depositors and investors, MBMG Research has compared the rates oﬀered by 33 oﬀshore deposit-taking ins tu ons and concluded that shopping around for the best deal is now more crucial than ever. More secure banks generally oﬀer lower interest rates to depositors. Larger bank deposits con nue to a ract be er rates. Longer deposit terms con nue to provide the best yields. Only six of the 33 banks surveyed oﬀer any kind of interest on call deposits (investment accounts which allow customers to make instant withdrawals), with higher risk banks oﬀering higher returns on larger deposits.
GBP 3 Month Deposits Provider Credit Rating Minimum Deposit ABN AMRO (Guernsey) Ltd (A+) 250,000 HSBC Bank (AA) 100,000 AIB International Savings Ltd (AA+) 25,000 Allied Irish Offshore (BBB) 50,000 Bank of Ireland Ltd (BB+) 5,000 Ulster Bank International (BBB+) 875,045 Lloyds TSB Offshore (A+) 25,000 Irish Nationwide (Baa3) 20,000 Clydesdale Bank International (A+) 10,000 Zurich Bank International (AA-) 10,000 Australia & New Zealand Banking Group Ltd (ANZ) (AA) 31,720 Barclays Wealth (AA-) 10,000 Barclays Wealth (new monies only) (AA-) 10,000 Alliance & Leicester Intl (AA) 5,000 Royal Bank of Scotland International (A) 5,000
Annual % interest 0.73 0.45 2.75 2.75 2.6* 1.58 1.11 2.5 0.9 1.0 0.93 0.86 1.25* 0.93406 0.84 * valid as of 31 Jan 2012
* valid as of 31 Jan 2012
Only 14 of the 33 banks oﬀer three-month deposit terms, but the highest rates oﬀered s ll don’t keep pace with infla on, even with the riskier banks.
GBP 12 Month Deposits Credit Provider Rating Bank of Ireland Ltd (BB+) AIB International Savings Ltd (AA+) Nationwide International (A+) Allied Irish Offshore (BBB) Alliance & Leicester (AA) Irish Nationwide Ltd (Baa3) Britannia International (A-) Cater Allen Private Bank (AA) Lloyds TSB Offshore (A+) Nationwide International (A+) Clydesdale Bank International (A+) Nationwide International (A+) Ulster Bank International (BBB+) Zurich Bank International (AA-) Royal Bank of Scotland International (A) Royal Bank of Scotland International (A) (new monies) ABN AMRO (Guernsey) Ltd (A+) Australia & New Zealand Banking (AA) Group Ltd (ANZ) Nationwide International (A+) Barclays Wealth (AA-) Barclays Wealth (new monies only) (AA-) HSBC Bank Plc (AA)
Min GBP Deposit 5,000 25,000 100,000 50,000 5,000 20,000 50,000 50,000 10,000 50,000 10,000 5,000 875,045 10,000 5,000
Annual % interest 3.5* 3.5 3.5 3.5 3.2 3.5 2.3 3.2 2.5 3.2 3.3 2.5 2.37 1.75 1.74
31,720 5,000 10,000 10,000 100,000
1.51 2.9 1.49 3* 1.15 * valid as of 31 Jan 2012
* valid as of 31 Jan 2012 Only 21 of the banks oﬀer 12 month deposit rates. When comparing tradi onal bank rates on oﬀer to Sterling investors, we don’t feel that there is enough reward on oﬀer to jus fy exposure to the riskier banks where capital loss is a very real possibility. Neither do we feel high rates for the inconvenience of a 12-month lock-in are jus fied in such an uncertain environment where flexibility and liquidity are vital. For tradi onal Sterling deposits, we therefore favour Na onwide Interna onal’s instant access rate of 1.8% per year on balances exceeding ₤25,000 However, this survey of bank deposit rates reinforces our conclusions about the need to be more ac ve at maximizing rewards and avoiding risk with cash and cash equivalent holdings.
APPENDIX 2 For investors with local deposits, Thai banks con nue to earn a rac ve returns for shareholders rather than depositors with high spreads between lending and deposits rates. The reduc on in local investor protec on which is currently being phased in means that the main Thai banks, whilst s ll rela vely secure, are less secure places to deposit than they were a year or so ago but rates to en ce depositors remain extremely low.
Bank Bangkok Bank Krung Thai Bank Kasikornbank Siam Commercial Bank Bank of Ayudhya TMB Bank United Overseas Bank CIMB THAI Bank Standard Chartered Bank Thanachart Bank TISCO Bank Mega Intâ€™l Commercial Kiatnakin Bank Land and Houses Bank ICBC (Thai) Thai Credit Retail Bank
MBMG GROUP RESEARCH: ROOM TO MANOEUVRE? YOUR RATES IN THEIR HANDS & HOW TO MANAGE RISK & RETURN IN TURBULENT TIMES
Important Disclaimer This commentary has been prepared using informa on based on the research capabili es of MBMG Group and represents the current opinions of MBMG Group. The opinions expressed are subject to change without no ce. Where informa on has been sourced from par es outside MBMG Group, these are generally believed to be reliable but reliability and accuracy is not guaranteed. This commentary is for informa onal purposes only and does not in any way cons tute investment advice and should not be construed as an oﬀer to sell, a solicita on to buy, or an endorsement or recommenda on of any company or security in any jurisdic on. Nothing in this document cons tutes a formal legal opinion or cons tutes investment advice. Each reader should consider whether this research is en rely or par ally suitable for their par cular circumstances and, if appropriate, seek addi onal, specific, professional advice. Neither MBMG Group nor its oﬃcers can accept any liability for the consequences of any ac on taken or not taken as a result of reading this commentary. MBMG Group is an independent researcher of informa on and does not provide investment advice or asset or financial management in Thailand. MBMG Group is aﬃliated with MBMG Asset Management Limited, a Mauri an ins tu on that is authorized and licensed to provide investment management services in Mauri us. All investments contain risk and may lose value and past performance is not a guarantee or reliable indicator of future results.