A Scary Story for Emerging Markets

By John Mauldin
 
Oct 26, 2014

The consequences of the coming bull market in the US dollar, which I’ve been predicting for a number of years, go far beyond suppression of commodity prices (which in general is a good thing for consumers – but could at some point threaten the US shale-oil boom). The all-too-predictable effects of a rising dollar on emerging markets that have been propped up by hot inflows and the dollar carry trade will spread far beyond the emerging markets themselves. This is another key aspect of the not-so-coincidental consequences that we will be exploring in our series on what I feel is a sea change in the global economic environment.

I’ve been wrapped up constantly in conferences and symposia the last four days and knew I would want to concentrate on the people and topics I would be exposed to, so I asked my able associate Worth Wray to write this week’s letter on a topic he is very passionate about: the potential train wreck in emerging markets. I’ll have a few comments at the end, but let’s jump right into Worth’s essay.
 

A Scary Story for Emerging Markets

By Worth Wray

“The experience of the [1990s] attests that international investors have considerable resources at their command in the search for high returns. While they are willing to commit capital to any national market in large volume, they are also capable of withdrawing that capital quickly.”

– Carmen & Vincent Reinhart

“Capital flows can turn on a dime, and when they do, they can bring the entire financial infrastructure [of a recipient country] crashing down.”

– Barry Eichengreen

“The spreading financial crisis and devaluation in July 1997 confirmed that even economies with high rates of growth and consistent and open economic policies could be jolted by the sudden withdrawal of foreign investment. Capital inflows could … be too much of a good thing.”

– Miles Kahler
 

In the autumn of 2009, Kyle Bass told me a scary story that I did not understand until the first “taper tantrum” in May 2013.

He said that – in additon to a likely string of sovereign defaults in Europe and an outright currency collapse in Japan – the global debt drama would end with an epic US dollar rally, a dramatic reversal in capital flows, and an absolute bloodbath for emerging markets.

Extending that outlook, my friends Mark Hart and Raoul Pal warned that China – seen then by many as the world’s rising power and the most resilient economy in the wake of the global crisis – would face an outright economic collapse, an epic currency crisis, or both.

All that seemed almost counterintuitive five years ago when the United States appeared to be the biggest basket case among the major economies and emerging markets seemed far more resilient than their “submerging” advanced-economy peers. But Kyle Bass, Mark Hart, and Raoul Pal are not your typical “macro tourists” who pile into common-knowledge trades and react with the herd. They are exceptionally talented macroeconomic thinkers with an eye for developing trends and the second- and third-order consequences of major policy shifts. On top of their wildly successful bets against the US subprime debacle and the European sovereign debt crisis, it’s now clear that they saw an even bigger macro trend that the whole world (and most of the macro community) missed until very recently: policy divergence.

Their shared macro vision looks not only likely, not only probable, but IMMINENT today as the widening gap in economic activity among the United States, Europe, and Japan is beginning to force a dangerous divergence in monetary policy.

In a CNBC interview earlier this week from his Barefoot Economic Summit (“Fed Tapers to Zero Next Week”), Kyle Bass explained that this divergence is set to accelerate in the next couple of weeks, as the Fed will likely taper its QE3 purchases to zero. Two days later, Kyle notes, the odds are high that the Bank of Japan will make a Halloween Day announcement that it is expanding its own asset purchases. Such moves only increase the pressure on Mario Draghi and the ECB to pursue “overt QE” of their own.

Such a tectonic shift, if it continues, is capable of fueling a 1990s-style US dollar rally with very scary results for emerging markets and dangerous implications for our highly levered, highly integrated global financial system.

As Raoul Pal points out in his latest issue of The Global Macro Investor,The [US] dollar has now broken out of the massive inverse head-and-shoulders low created over the last ten years, and is about to test the trendline of the world’s biggest wedge pattern.”

One “Flight to Safety” Away from an Earth-Shaking Rally?
(US Dollar Index, 1967 – 2014)

 
For readers who are unfamiliar with techical analysis, breaking out from a wedge pattern often signals a complete reversal in the trend encompassed within the wedge. As you can see in the chart above, the US Dollar Index has been stuck in a falling wedge pattern for nearly 30 years, with all of its fluctuations contained between a sharply falling upward resistance line and a much flatter lower resistance line.
 
Any break-out beyond the upward resistance shown above is an incredibly bullish sign for the US dollar and an incredibly bearish sign for carry trades around the world that have been funded in US dollars. It’s a clear sign that we may be on the verge of the next wave of the global financial crisis, where financial repression finally backfires and forces all the QE-induced easy money sloshing around the world to come rushing back into safe havens.

Let me explain…
 

The EM Borrowing Bonanza

As John Mauldin described in his recent letter “Sea Change,” the state of the global economy has radically evolved in the wake of the Great Recession.

Against the backdrop of extremely accommodative central bank policy in the United States, the United Kingdom, and Japan and the ECB’s “whatever it takes” commitment to keep short-term interest rates low across the Eurozone, global debt-to-GDP has continued its upward explosion in the years since 2008… even as slowing growth and persistent disinflation (both logical side-effects of rising debt) detract from the ability of major economies to service those debts in the future.
 

Global Debt-to-GDP Is Exploding Once Again
(% of global GDP, excluding financials)

*Data based on OECD, IMF, and national accounts data.
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.
 

As John Mauldin and Jonathan Tepper explained in their last book, Code Red, monetary policies have fueled overinvestment and capital misallocation in developed-world financial assets…
 

Developed World Financial Assets Still Growing
(Composition of financial assets, developed markets, US$ billion)

Data from the McKinsey Global Institute
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.

… but the real explosion in debt and financial assets has played out across the emerging markets, where the unwarranted flow of easy money has fueled a borrowing bonanza on top of a massive USD-funded carry trade.
 

Emerging-Market Financial Assets Have Nearly DOUBLED Since 2008
(Composition of financial assets, emerging markets, US$ billion)

Data from the McKinsey Global Institute
Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.

 
These QE-induced capital flows have kept EM sovereign borrowing costs low…
 


 
… and enabled years of elevated emerging-market sovereign debt issuance…
 


 
… even as many those markets displayed profound signs of structural weakness.

Raghuram Rajan at the Bank of India explains that this emerging-market borrowing binge is a logical consequence of “Code Red” monetary policies like ZIRP, QE, and aggressive forward guidance in the United States and other developed markets:

When monetary policy in large countries is extremely and unconventionally accommodative, capital flows into recipient countries tend to increase local leverage; this is not just due to the direct effect of cross-border banking flows but also the indirect effect, as the appreciating exchange rate and rising asset prices, especially of real estate, make it seem that borrowers have more equity than they really have.

But the problem goes beyond a logical response to easy money. With growth in global trade demand running well below the pre-2008 average, emerging markets face a dangerous dilemma: slow down along with their developed-world customers (which brings on the nasty prospect of social unrest and political regime change) or lever up in an attempt to make the tricky transition to domestically led growth (which may allow incumbent governments to stay in power).


Trouble is, as we are seeing in China today, it is exceptionally difficult, if not impossible, in the current weak trade/volatile capital flows environment, to smoothly transition from an export-led growth model to a domestic consumption-driven growth model without a major slowdown along the way. And attempting to make the transition via debt-fueled, state-directed, investment-led growth is likely to result in massive debt bubbles, unmanageable piles of nonperforming loans, and the prospect of a very hard economic landing.

Brevan Howard’s Luigi Buttiglione, along with co-authors Philip Lane, Lucrezia Reichlin, and Vincent Reinhart, explained this dynamic in the latest Geneva Report on the World Economy:

Some nations that avoided the direct effects of the financial meltdown have recently built up excesses that raise the odds of a home-grown crisis…. A number of emerging economies reacted to the global crisis and the consequent slowdown in exports by switching from export-led growth to domestically led growth, engineered by a strong expansion in domestic credit…. The result was the strong increase in the ratio of total debt (ex financials) to GDP for emerging economies, by a staggering 36% since 2008. Higher leverage, although helping to shield these economies from the chilling wind blowing from advanced economies, is an increasing concern in terms of the future risk profile given the ongoing steep slowdown of nominal growth, which reduces the “debt capacity” of emerging economies exactly when they would need to expand it.


John and I have written about this topic several times in the last year (“Central Banker Throwdown” and “Every Central Bank for Itself”), and I believe that understanding the massive flows of capital from developed to emerging markets and the potentially disastrous dynamics behind an abrupt reversal in the emerging-market bubble boom may be the key to comprehending how the final act of the global debt drama will play out.
 

Carry Trade Junkies

After years of enjoying relatively easy capital inflows and high levels of debt growth against a backdrop of deteriorating fundamentals, the “Fragile Eight” (Argentina, Brazil, Chile, India, Indonesia, Russia, South Africa, and Turkey) find themselves in the “addicted to capital” phase of the balance of payments cycle (outlined in the chart on the next page from Bridgewater Associates), with high vulnerability to a reversal in flows.

According to the latest Geneva report, these economies (shown as EM1 in the graph below) have fallen into dangerous current account deficits compared to less fragile emerging markets (EM2)…
 


Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.

 
… and continue to exhibit a dangerous net-negative international investment position, making the Fragile Eight serious candidates for capital flight.
 


Source: Buttiglione, Lane, Reichlin, & Reinhart. “Deleveraging, What Deleveraging?” 16th Geneva Report on the Global Economy, September 29, 2014.

 
Broad-based, debt-fueled overinvestment may appear to kick economic growth into overdrive for a while; but eventually, disappointing returns and consequent selling lead to investment losses, defaults, and banking panics. And in cases where foreign capital seeking strong growth in already highly valued assets drives the investment boom, the miracle often ends with capital flight and currency collapse.

Economists call that dynamic – an inflow-induced boom followed by an outflow-induced currency crisis – a “balance of payments cycle,” and it tends to occur in three distinct phases.
 


Bridgewater Associates, January 2014

 
In the first phase an economic boom attracts foreign capital, which generally flows toward productive uses and reaps attractive returns from an appreciating currency and rising asset prices. In turn, those profits fuel a self-reinforcing cycle of foreign capital inflows, rising asset prices, and a strengthening currency.

In the second phase, the allure of continuing high returns morphs into a growth story and attracts ever-stronger capital inflows – even as the boom begins to fade and the strong currency starts to drag on competitiveness. Capital piles into unproductive uses and fuels overinvestment, overconsumption, or both, so that ever more inefficient economic growth depends increasingly on foreign capital inflows.
 
Eventually, the system becomes so unstable that anything from signs of weak earnings growth to an unanticipated rate hike somewhere else in the world can trigger a shift in sentiment and precipitate capital flight.

In the third and final phase, capital flight drives a self-reinforcing cycle of falling asset prices, deteriorating fundamentals, and currency depreciation… which in turn invites more even more capital flight. If this stage of the balance of payments cycle is allowed to play out naturally, the currency can fall well below the level required for the economy to regain competitiveness, sparking runaway inflation and wrecking the economy as asset prices crash.

In order to avoid that worst-case scenario, central bankers often choose to spend their FX reserves or to substantially raise domestic interest rates to defend their currency. Although it comes at great cost to domestic growth, this kind of intervention often helps to stem the outflows… but it cannot correct the core imbalances. The same destructive cycle of capital flight, falling asset prices, falling growth, and currency depreciation can restart without warning and trigger – even years after a close call – an outright currency collapse if the central bank runs out of policy tools.

John and I believe that this worst case is the looming risk for many emerging markets today, particularly in the externally leveraged “Fragile Eight” (Argentina, Brazil, Chile, India, Indonesia, Russia, South Africa, and Turkey) and, in the event of a forceful unwind in the USD carry trade, maybe even China.
 
Not only have those countries amassed a disproportionate share of total inflows to emerging markets, but each also has its own insidious combination of structural and political obstacles to long-term growth. Each of these countries is not without options, but the longer they delay in being proactive, the greater the risk.

The question for 2014 is, what happens when the tide of easy dollars reverses and reveals a more challenging funding environment?

With John’s blessing, I hope to profile each of the fragile emerging markets individually in the coming months and in our upcoming book (working title: Sea Change); but for now I have to limit our discussion to a couple of charts from a recent letter titled “Carry Trade Junkies,” by my good friend Josh Ayers at Paradarch Advisors, along with a few specific observations on three of the most fragile economies.

According to official data reported by the Bank for International Settlements and the IMF, Turkey, South Africa, and Chile look like obvious candidates for capital flight and are three of the leading currency-crisis candidates.

Not only do these economies rank among the most externally leveraged in the world…
 
 

External Debt to FX Reserves

Sources: Paradarch Advisors, BIS, IMF

 
… but their banking systems also rank among the most externally leveraged.
 

External Bank Debt to FX Reserves

Sources: Paradarch Advisors, BIS, IMF

In addition to enduring high levels of leverage that remain uncovered by FX reserves,
Turkey, South Africa, and Chile are also liable to serious USD shock risk, based on their economic fundamentals (unlike Poland and Hungary, which are less likely candidates for immediate currency collapse given their very low levels of domestic inflation).

The lesson here is clear. The catalysts are already in position to spark an initial flight to safety if the USD moves just modestly higher.

Some economies (like Turkey, South Africa, and Chile) are more fragile than others (like Russia, Brazil, and India); but an initial wave of crises can push the USD higher and easily lead to larger accidents.
 
The experience of the 1990s shows how, against the backdrop of a relatively strong US economy and policy divergence between major central banks, extreme stress in the emerging markets can lead to elevated US dollar strength, which in turn can trigger additional crises and push the world’s reserve currency to even greater heights. For example, the Mexican “Tequila Crisis” of 1994 played a role in pushing the USD higher and, along with Bank of Japan easing, helped trigger the Asian Financial Crisis in 1997. The Asian crisis, in turn, set off a sharp jump in USD strength and an equally sharp fall in oil demand, which, along with an oversupply of oil, contributed to a crash in oil prices in 1998 and threw Russia into crisis.

As the example of Russia shows – and the inverse relationship between the US dollar and oil prices highlights – this is not just a matter of capital inflows turning into outflows, but rather inflows giving way to outflows while the value of commodity exports falls simultaneously. So, this dynamic gets more and more dangerous for increasingly fragile economies as the dollar reaches new heights and commodity markets are stressed.

US Dollar Index vs. WTI Crude Oil

Turkey, South Africa, and Chile may be the likely “first wave,” which policymakers around the world may see as inconsequential… but it’s easy to see how that first wave could grow into a tsunami.

Financial Repression Backfires

When asked about the concept of financial repression (a technical term for policies that are intended to fuel a domestic wealth effect and force savers to take on more and more risk over time to maintain a manageable level of income), former Treasury Secretary (and recent Fed Chairman runner-up) Larry Summers recently commented, “I think the instinct to financial repression is there. But it strikes me that the world is pretty global and there are a lot of places to put money, and even if one wanted to financially repress, I don’t think that [in] most of the industrialized world is going to be that easy on a large scale.” (Click here & fast-forward to the 1:03:48 point to see his comments.)

It never made the nightly news, the front page of the New York Times, or even the news page on Bloomberg, but Summers’ comment is a tremendous revelation from the man who almost succeeded Ben Bernanke as Fed Chairman earlier this year.

By trying to shore up their rich-world economies with unconventional policies like ultra-low nominal interest rates; outright balance-sheet expansion; and aggressive, open-ended forward guidance, major central banks have dramatically widened international real interest-rate differentials and forced savers to seek out higher (and far riskier) returns for more than five years running.

But that money did not just move further out on the risk spectrum from low-yielding cash equivalents to higher-yielding assets like US stocks, high-yield bonds, and MLPs. In the process of fighting naturally deflationary impulses and forcing investors to take more risk, the Federal Reserve has also forced an enormous amount of money to move out of the United States and into the emerging world. The risks have been clear to policymakers all along, but emerging markets are well outside of the Fed’s mandate. They are collateral damage, so to speak.

In his latest issue of Global Macro Investor, Raoul Pal estimates that the resulting carry trade has grown to roughly $3 trillion into major emerging economies (excluding China) and nearly $2 trillion into China alone. My friend Mark Hart comes up with similar numbers for “unexplained inflows” by backing the sum of foreign direct investment and trade out from the total growth in FX reserves, and he discusses the situation at length in a recent “Master Class” interview with Raoul Pal on Real Vision TV. These are staggering numbers, even compared to the massive Japanese yen carry trade that had grown to roughly $1 trillion by 2007; and they add up, quite simply, to the Mother of All Carry Trades… which can unwind VERY QUICKLY in the event of a major US dollar rally. Shades of 2008.

That’s the flip side to years of low rates, QE, and aggressive forward guidance. The Fed buys time for the US economy to find its footing at the expense of rampant misallocation across the rest of the world. Major developed economies can adjust their policies to offset the effects, but the emerging markets find themselves in a far more vulnerable position as easy money masks the urgent need for reforms. And once the Fed reverses its policy to reflect relative strength in the US economy, it’s a bloodbath for economies that cannot adjust easily, which in turn pushes the US dollar even higher and starts to take a serious toll on real economies… like China’s, where state-sanctioned data dramatically understates the extent of the world’s most dangerous debt bubble.

In the days leading up to All Hallows Eve, the prospect for a US dollar rally should inspire more fear than any campfire ghost story or voodoo curse. This is a realistic and increasingly probable outcome; and the last time the world saw a series of emerging-market crises (first in Mexico in 1994 and then in Southeast Asia in 1997) against the backdrop of a weak Japanese economy and a relatively stronger US economy, it pushed the US dollar to such heights that it triggered a 50% collapse in oil prices, pushed Russia’s economy over the edge in 1998, and blew a hole in the side of a highly levered hedge fund, Long Term Capital Management, that nearly brought down the global financial system.

The next round of policy divergence could be far more destructive than that, because this time the global financial system is far more levered; instability is far more widespread; and the amount of money required to backstop an accident will be greater than the Fed’s entire bloated balance sheet. These are the logical consequences of post-2008 financial repression, and they’re the reason why emerging-market central bankers like Raghuram Rajan are calling loudly for better coordination of global monetary policy.

It is indeed every central bank and country for itself, and that is a recipe for volatility and financial losses. If you think this story has a happy ending, you are not paying attention to history.
 
Geneva, Atlanta, and New York

I write this at the end of a very packed four days of constant mental stimulation. The Barefoot Summit at Kyle Bass’s ranch in East Texas was up to its usual high standards. And due to the rain we have had all summer, East Texas is about as pretty as I have ever seen it. And the weather was perfect. It was a great setting in which to sit and talk all things macro. Sen. Tom Coburn was in attendance (along with a few other political types), and I find him to be a thoroughly delightful and thoughtful man. I am sad to see his wisdom leave the Senate but understand the personal reasons. We need more men like him in government.

And while the weather in Boston was not initially welcoming, it has turned absolutely beautiful today. Niall Ferguson and his team at Greenmantle have put together a most thought-provoking conference. The gathering was held under strict Chatham House rules, so while I can share my thoughts about it, I can’t describe the actual conversations or the people involved without their permission. As you might expect of a man with Niall’s resources and connections, he was able to pull together fascinating panels and presentations of the highest quality. We were treated to in-depth analysis of almost every region of the world as well as to presentations of new ideas and technologies; and the forum was small enough to allow for very active debate.

Tomorrow I fly to Washington DC and then on to Geneva for a few days of meetings and some time to gather my thoughts before returning to Atlanta for a day before I finally head back to Dallas in time for Halloween.

I’m going to go ahead and hit the send button without my usual final comments, as I want to get to the gym and there is a full evening planned for tonight. You have a great week.

You’re more convinced about a dollar bull market than ever analyst,
John Mauldin
John Mauldin

Opinion

The Fed Rate Hike May Be a Mirage

Despite the central bank’s vows to increase interest rates, a variety of forces are working against the move.

By Romain Hatchuel

Oct. 26, 2014 7:18 p.m. ET

 
On Tuesday the Federal Open Market Committee will convene in Washington, D.C., as it does every six weeks or so. At that meeting, it is still widely expected that Federal Reserve Chair Janet Yellen and her colleagues from regional Federal Reserve banks will stop the Fed’s remaining $15 billion-a-month asset purchases, putting an end to the greatest monetary stimulus campaign in U.S. history.
 
For six years the Fed has bought trillions of dollars’ worth of U.S. Treasurys and mortgage-backed securities in an attempt to jump-start the U.S. economy. As a result, its balance sheet has increased to a record 25% of the nation’s gross domestic product—higher than at the end of World War II or at the heart of the Great Depression. Attention has already shifted to future interest-rate hikes, the next logical step in this dreaded tightening cycle, which the market believes will begin somewhere between the middle of next year and the beginning of 2016.
 
Those who have criticized what they consider a period of monetary lunacy will praise the normalization of Fed policy. Others will lament it and issue dire forecasts. Yet there is every reason to believe that this month’s highly anticipated end to so-called quantitative easing will be nothing more than a tactical retreat by the U.S. central bank, and that next year’s rate increase won’t materialize.
 
Federal Reserve Chairwoman Janet Yellen Associated Press
 
First, the U.S. economy remains stubbornly weak. In four of the past five years, the GDP growth forecast made by the Federal Open Market Committee at its November or December meetings for the following year has missed the mark by 0.5% to as much as 1.5%. That includes 2014, for which the middle of the Fed’s core projection range—known as “central tendency”—was cut to 2.1% last month, from 3% in December 2013. As much as Fed officials would like to revert to a more orthodox policy, such reversal is data-dependent, and when it comes to predicting data, their track record has been poor.
 
The minutes from September’s FOMC meeting, released on Oct. 8, showed that several members actually viewed the risks to real GDP growth as weighted to the downside. This isn’t surprising, considering the remaining slack in the U.S. labor market and the worryingly low inflation rate.
 
Some participants at the September FOMC meeting also expressed concern that weak foreign growth could slow down the U.S. economy. In particular, they cited the eurozone, for which the International Monetary Fund now sees a 40% chance of recession and a 30% risk of deflation by next year. Germany, Europe’s economic leader, recently released its worst industrial-output and export numbers since 2009, showing a respective 4% and 5.8% plunge in August.
 
Can the emerging world save the day? That seems unlikely. The Chinese economy keeps decelerating and is now expected by the IMF to grow by 7.4% this year, its lowest rate since 1990. Brazil fell back into recession in the first half of the year, while Russia’s economy is being severely hurt by the consequences of the Ukrainian conflict and should grow by a negligible 0.2% this year. Overall, the IMF now sees emerging market and developing economies growing by 4.4% in 2014, down from 5.1% back in January. Japan is still suffering from the impact of its April sales-tax hike, as well as the lack of structural reforms, which has led the IMF to also cut its growth outlook, from 1.7% in January to a meager 0.9%.
 
Another reason to doubt the Fed’s return-to-normalcy pledge is the recent appreciation of the U.S. dollar, which is now up 8.5% on average against major world currencies since its May lows. A strengthening greenback will hurt U.S. exports. It is also a drag on inflation which, so far, remains below the Fed’s 2% target. This could actually be one of the most compelling reasons for Ms. Yellen and her FOMC colleagues to reconsider their exit strategy. Faced with a European Central Bank that has finally decided to step up its support to eurozone economies, and a Bank of Japan  that continues to print trillions of yen every month, the Fed could have no choice but to resume its easing efforts to keep the dollar competitive in what already looks like a tacit currency war.
 
Then there is always the risk of a severe market correction that could be triggered by almost anything: a spreading of the Ebola epidemic, a geopolitical development (such as another Russian incursion), a financial event (such as a large bank or a country defaulting), or simply a spontaneous selloff caused by high valuations and an accumulation of bad news, as we have seen in recent weeks on Wall Street and abroad.
 
Since 1951, there have been only nine periods of more than a year during which U.S. equities didn’t experience a drawdown of 10% or more. Since the last such drawdown 1,120 days have passed, which puts the current correction-free episode in the top four in terms of length. The other three all happened in significantly stronger growth environments.
 
“Don’t fight the Fed” has become a sacred market mantra, and ignoring it has been a costly exercise for some. Trusting the Fed, as it vows to end monetary easing and raise interest rates, could prove an equally harmful strategy.
 
 
Mr. Hatchuel is managing partner of Square Advisors LLC, a New York-based asset-management firm.


miércoles, octubre 29, 2014

INSIDE SCHWAB / BARRON´S MAGAZINE COVER

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Barron's Cover

Inside Schwab

In his six years as head of brokerage Charles Schwab, Bettinger has doubled client assets to $2.4 trillion. He’s only getting started.

By Dyan Machan 

October 25, 2014


A lifelong Baltimore Orioles fan, Walter Bettinger II loves Cal Ripken Jr., who famously played 2,632 consecutive games over 16 seasons with the Os. But Bettinger stresses that people forget that the third baseman also had 3,184 hits and 431 home runs, and that’s what earned him a plaque at the Baseball Hall of Fame. “He was just a humble, hard-working man who never brought attention to himself,” says the CEO of Charles Schwab.  

You could almost say the same about Bettinger, 53. Born and raised in a small farm community in northwestern Ohio, he epitomizes the modest, Midwestern approach. “To me, leadership is all about serving other people, and the leader should be in the background, but yet strong and stable and consistent,” he says.

                                  
cat
Bettinger, a team player, says, ”If I wasn’t the CEO of Schwab, I might have been a basketball coach.” Photo: Andy Freeberg for Barron's

Bettinger is happy to let chairman and founder Chuck Schwab, 77, be the company’s public face in ads. “He’s not a grandstander,” says Schwab of Bettinger, “even though grandstanding can be useful.” Accordingly, it’s easy to overlook the sweeping change that Bettinger has spearheaded as Schwab’s exacting, behind-the-scenes boss.
 
In his six years as CEO, total client assets at Schwab (ticker: SCHW) have doubled to $2.4 trillion, surpassing Merrill Lynch Wealth Management, once the world’s largest retail broker. And he has steered the San Francisco–based company from itstransactional roots as a discount broker to offering fee-based financial advice and wealth management. Ironically, in Schwab’s early years, offering customers financial advice was a dismissible offense.
 
Transactional fees constitute just 13% of revenue today, down from 24% in 2009. That’s lower than rivals TD Ameritrade  (AMTD) and E*Trade Financial  (UBS) and Edward Jones. Bettinger now sees Schwab’s main competitors as the Morgan Stanleys, BlackRocks, and Well Fargos of the world—the mega asset handlers—in his mission to bring affordable investing to the mass affluent.
 
The company, which boasts 9.2 million brokerage accounts, believes that it has built the platform—both in product offerings and an expanding footprint of 325 retail offices—to push a lower-cost model. Typically earnest and precise, Bettinger turns into a flamethrower when he talks about the financial-services industry. Raising his voice a little, he says, “The business models of so many financial-services firms revolve around getting people to do what’s worst for them.”
 
AFTER ONE BOTCHED succession a decade ago, Schwab seems to be getting it right. Former CEO David Pottruck was fired in 2004 after 18 months on the job. Chuck Schwab, who started the company in 1973, returned to the helm. With remarkable timing, Schwab handed the keys to Bettinger in October 2008, when the financial world seemed headed off a cliff. But he kept a steady hand.
 
Schwab, which operates in two key segments—investor services, catering to individual investors, and advisor services, focused on registered investment advisors and employee retirement plans—didn’t suffer losses from exposure to mortgage-backed securities. Although some of its clients lost money through its short-term bond funds (it paid $319 million in total settlements), it increased client assets throughout. Postcrisis, from 2009 through 2013, Schwab grew net client assets by $826 billion—the same amount as E*Trade, TD Ameritrade, Bank of America Merrill Lynch, and Morgan Stanley Global Wealth Management combined.

Schwab has a long history of disrupting the securities industry. In 1974, when Wall Street was still charging investors hundreds of dollars per trade, Chuck Schwab placed a three-inch ad in The Wall Street Journal offering discounts of 70%. A year later, the brokerage industry deregulated commissions at the behest of the Securities and Exchange Commission, and the discount-brokerage industry was off to the races.
 
In 1984, the firm launched the first mutual fund supermarket, allowing its investors to buy and sell different mutual funds from one account instead of opening separate accounts at various mutual fund companies, a tedious process. The industry had no choice but to follow. Eight years later, Schwab eliminated transaction fees for mutual funds, and the brokerage industry again followed suit. “We were not making friends on Wall Street,” says Chuck Schwab, “We never have.”
 
Soon after, Schwab took on the big wire houses again, courting financial advisors at full-commission firms by offering clearing, custody, cash management, trading, and reporting. The firm now has 7,000 advisors on its platform managing $1.08 trillion, or 26% of the $4 trillion registered investment-advisor market, it says.
 
Advisors are leaving the big brokerages to gain control of a larger share of their clients’ 1% to 2% annual fees. And as they find the exit door, Schwab is adding $60 billion to $70 billion a year in net new money, Bettinger says.
                                  
cat
Schwab doesn’t share in their fees, but benefits in other ways from managers using its platform for trading. It also earns a tiny spread on its clients’ cash balances.
 
NOT ALL INDEPENDENT financial advisors like Schwab’s platform. Art Cohen, of A.M. Cohen & Co., a Chicago-based investment advisor with more than $500 million under management, uses Schwab’s platform for trading and administration for just a few of his clients and prefers it that way.
 
“I don’t want a custodian that’s going to try to lure my clients away,” he says, referring to Schwab’s aggressive campaign to give new customers $2,500 in cash for opening an account with more than $1 million. “It’s disturbing.”
 
Cohen keeps most of his clients at Pershing, owned by BNY Mellon  (BK), which doesn’t seek retail clients.
 
Now Schwab is pushing to expand its presence in the 401(k) market. The company has some work to do. Rival Fidelity Investments is the leader with $1.1 trillion in 401(k) assets under management, followed by AON Hewitt with $328 billion, and Vanguard with $305 billion. Schwab is a distant No. 13, with $115 billion in assets.
 
After the great migration from defined-benefit to defined-contribution plans ushered in by 401(k) plans, corporate plan sponsors left employees holding the bag, Bettinger says. “The 401(k) system works well for everyone—employers, service providers, money managers—everyone but investors,” he says.
 
When corporations were responsible for pension plans, they hired armies of actuaries and investment experts, he says. When the investment responsibility shifted to the plan participants, the corporations gave them an hour-long lecture, a flimsy cardboard retirement calculator, and a pat on the back.
 
BETTINGER IS INCENSED that 84% of the $3.7 trillion of defined-contribution assets are in actively managed mutual funds, which charge substantially higher fees than index funds. Statistically, he says, actively managed funds are unlikely to beat or even keep pace with lower-cost index funds over the long term. “This idea of beating the market does not need to be a part of 401(k) plans,” he says, though he’s quick to note that he’s not against actively managed funds—Schwab holds $770 billion of them on the books for its clients—just their overuse in retirement accounts.
 
Investment Company Institute economist Sarah Holden counters, “Plan sponsors want a broad lineup of funds for their participants.”
 
Says Bob Benish, executive director at the Plan Sponsor Council of America: “The problem is that many investors are too passive about their active funds. They are appropriate for the right person who pays attention.”
 
But Bettinger, who began his career 32 years ago calculating pension benefits, thinks Schwab has a better way. He says he anguished over a 2009 award he received from Plansponsor magazine at a dinner for his “contribution to the retirement security of working Americans,” as was inscribed on a crystal trophy. He felt the award was undeserved.
 
Riding in a taxi after the award ceremony, he says he felt sick and knew it wasn’t the chicken. The following day, Bettinger started changing the way Schwab managed companies’ 401(k) plans, leading to the 2012 introduction of what it calls the Schwab Index Advantage, which includes third-party advice from researchers Morningstar and GuidedChoice, giving plan participants objective advice and lower-cost investment choices like index and exchange-traded-fund portfolios.
 
The youngest of four children, Bettinger, the son of a college chemistry professor and a stay-at-home mom, grew up in Ada, Ohio. After a year at Delta State University, in Cleveland, Miss., on a golf scholarship, he returned to the Buckeye State to finish his studies at Ohio University. Graduating at the top of his class in 1982 with a degree in business administration, he went to work for nearby Westfield Insurance, which provided pension-plan administration to companies as a means to sell investment products. Eighteen months into it, he saw an opportunity to decouple the plan-servicing from the investing, and offer objective investing advice.
 
At 22, Bettinger founded the Hampton Company, dedicated to selling companies’ retirement-plan servicing along with objective investment advice. He called it Hampton because he thought potential clients would naturally picture a seasoned guy at the helm, not the still-boyish looking CEO who shaved once a week.
 
Starting out in 1983, he spent his life savings—a couple of thousand dollars—printing and hand-addressing brochures. He made cold calls relentlessly for more than a year without a single hit. “I knew I was failing,” Bettinger recalls. As a last resort, he attended night school to become a certified actuary, and that qualified him to start offering free investment seminars to accounting and law firms that would have him. Referrals rolled in. By early 1995, he had been vindicated and then some—having amassed nearly $1 billion in retirement-plan assets.
 
Schwab, which hired Hampton to handle record-keeping for its fledgling 401(k) business, bought the company that same year.
 
As a part of Schwab, its assets doubled to $2 billion in the first year. Chuck Schwab says he liked Bettinger’s Midwestern, straight-shooting ways. “He was an entrepreneurial guy, and I liked the tempo of his personality,” Schwab recalls. “We were compatible.”
 
He also notes that Bettinger merged his company seamlessly into Schwab’s businesses, something Schwab especially appreciates today, after the firm’s $2.73 billion acquisition of U.S. Trust in 2000. A painful culture clash ensued, leading to an eventual divorce and the sale of U.S. Trust to Bank of America (BAC) seven years later.
                                  
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SCHWAB COULD DO no wrong in the mid-to-late 1990s, helped by a rising stock market. Then the tech bubble burst in 2000, and Schwab, the company, could do no right. Competitors were offering $10 trades, beating Schwab’s $29 trades. Clients bolted, and by 2001, Schwab was laying off thousands of employees.
 
By 2004, Bettinger’s corporate retirement unit, run out of Akron, was the only bright light, so he was called to headquarters in San Francisco. Bettinger said OK, but rather than uproot his family, he commuted.
 
As head of the retail group, his first job was to stop the bleeding. In his first 100 days, he interviewed 50 clients and 50 employees, who left of their own will, and visited 120 branches. “It’s a little hard to even explain how dire things felt,” he says.
 
Meanwhile, Schwab had lost more than 80% of its stock market value, equivalent to $40 billion, as its shares plummeted to $7 from a split-adjusted 2000 high of $36. The stock recently traded at $26.01.
 
On one of his cross-continental flights, Bettinger wrote a white paper on what he saw was wrong, and what the company should do about it. He sent it to Chuck Schwab. Committed from his Hampton days to putting customers first, Bettinger perceived that they felt betrayed when zinged with nuisance fees, such as an extra $3 handling charge for equity trades, minimum-balance charges, and a $1 fee for ATM withdrawals. He also argued that the company had no future living off transactions, which were in decline and appealed to only a portion of the larger investment community. The firm had to broaden its appeal, he wrote, and become a full-service wealth manager, and yet still stand apart from the crowd.
 
Within 24 hours, Chuck Schwab called Bettinger and said, “Implement it all.” Chuck Schwab realized that Bettinger “had the skill level to be my partner.” Around the same time, David Pottruck, who had been named CEO in 2003, was caught having unauthorized discussions about divesting a securities firm that Schwab had bought the year before. Pottruck was out; Chuck Schwab rejoined as CEO; and Bettinger, he says, “was now a part of the team.”
 
Soon after, the company lowered commissions from $29 to $10, axed nickel-and-dime nuisance fees, and showed the door to six presidents in the retail group. It also started providing advice to individuals.
 
Schwab had taken baby steps toward managing assets in 2002, with its managed-portfolio initiative, a set portfolio of mutual funds. But Bettinger gave it a big push. Anyone with an account of more than $250,000 received a dedicated consultant, a fundamental shift for the firm. “He made it happen,” Chuck Schwab says.
 
Earnings began to return, and assets rolled in from other firms. Chuck Schwab named Bettinger CEO in 2008, even though the committed family man informed the board he wouldn’t move to headquarters until the youngest of his school-age kids graduated from high school in 2011. “I needed him to be close by,” says Schwab, “but I was willing to wait.”
 
TARGET-DATE RETIREMENT funds, which construct an asset-allocation mix based on an investor’s age, become more conservative as the targeted retirement date approaches. The target-date industry took off after the Pension Protection Act of 2006 allowed companies to automatically enroll employees in 401(k) plans and encouraged the use of target-date funds as the default option. They have amassed $670 billion, according to Morningstar.
 
Ask Bettinger about them, and he’ll set your hair on fire. “It’s a fascinating product developed to capture money in proprietary funds,” he says. “They may have been the best way at one time to get advice on a 401(k), but they’re not the right answer for today.” Schwab offers target-date funds, but it should be noted that so far they’ve attracted just $12.4 billion in assets, less than 2% of the total.
 
Bettinger illustrates: “Two people walk in to get advice. They’re both 40. One is single, no children, the other one’s married with five kids. The first individual has $1 million in liquid assets, the second has none. And what advice do we give them about a target-date fund? Buy the exact same thing. I mean, it makes no sense.”
 
Schwab’s mission for the retirement market, he says, is to offer third-party advice with low-cost index-fund and ETF portfolios. Schwab is offering its advice for 40 basis points (0.4% of assets), plus a 10 basis-point fee for an ETF index portfolio. That’s cheaper than 90% of all 401(k) plans that don’t include advice, Bettinger says.
 
But it’s a difficult sell getting corporate buyers to shake off a huge 401(k) provider such as Fidelity. And often there’s another layer of consultants such as Mercer managing the relationship, as well. Whether Schwab will succeed here is the hundred- billion-dollar question.
 
LOW INTEREST RATES have been devastating for the financial-services industry, and Schwab is no exception. The firm currently garners 35% to 40% of its revenue strictly from investing its balance sheet.
 
Historically, it has also earned a fee on its money-market, or cash reserves. But with rates so low, it currently waives the fee that amounts to $750 million a year.
 
If the Federal Reserve raises the overnight-lending rate, which is close to zero now, by 50 to 75 basis points, Jefferies analyst Daniel Fannon calculates that Schwab’s revenue would jump by $1.6 billion—half from the higher spread and half from lifting the fee waiver. That could boost earnings by $700 million, or 50 cents a share—not an insignificant sum, given that Schwab is expected to earn $1.3 billion, or 95 cents per share, on revenue of $6 billion this year, rising 19%, to $1.13 a share in 2015.
 
Fannon, who has a price target of $35 on the shares, notes that even in a sluggish economy, Bettinger has turned Schwab into an asset-gathering machine. He sees ongoing growth from new customers as well as a greater share of existing clients’ wallets. Among independent investment advisors, 80% of growth typically comes from existing clients. But getting to his price target, he says, will take a rate increase.
 
Within the next few weeks, Bettinger says Schwab will offer a Web-based advice platform for the general investing public, followed by a version for its independent investment advisors. This robo-investing product will design custom portfolios based on what will likely be at least a dozen variables, and at a bargain price of around 0.25% of assets, or less. Bettinger says the cost could go still lower with scale and technology improvements. The company hopes to get the word out on all its products by encouraging money managers to open Schwab franchises, a less expensive means of expanding its retail presence.
 
It is a bold plan, and it might be a long shot. But given Schwab’s history of disrupting the financial industry, it might not be something you want to bet against.