The Deadly Mediterranean Route

EU Seeks to Ward Off New Refugee Crisis

By Christiane Hoffmann, Walter Mayr, Peter Müller, Christoph Schult and Wolf Wiedmann-Schmidt

 Photo Gallery: A Deadly Route to Italy

The number of migrants crossing the dangerous Mediterranean route has risen significantly since the beginning of the year. European officials fear the situation could further deteriorate.

So far, though, Brussels hasn't been able to agree on a solution.

During a meeting with senior security officials in the Reichstag, Germany's parliament building, a week ago, Angela Merkel didn't mince words. While praising the Schengen zone for the border-free travel it has granted Europeans, the German chancellor also said that it could only work if the European Union's external borders were adequately protected. Schengen, she said, means that Germany's neighbors are no longer Austria or Poland, but Russia, Turkey and Libya.

The 2015 refugee crisis, Merkel said, taught us "fundamental lessons," such as the fact that EU external border protection wasn't good enough. The situation has since improved dramatically, Merkel said, "but we haven't yet achieved everything that we need."

The chancellor, unfortunately, is correct. Merkel has promised that the refugee crisis seen two years ago will not be repeated: Never again will Europe see an uncontrolled inflow of millions of people.

The refugee deal with Turkey is working, we are repeatedly told, and the crisis is over. That, though, could turn out to be wrong.

With German voters set to go to the polls on Sept. 24, Merkel's re-election campaign hinges on there not being a repeat of the refugee crisis, even if it's not as substantial as the 2015 influx. But west of the closed Balkan route, a new migrant stream has been growing since the beginning of the year.

From Jan. 1 to April 23, 36,851 migrants have followed the central Mediterranean route from North Africa to Italy. That represents a 45 percent increase over the same period last year, when a record 181,000 people crossed the Mediterranean on the route. "The situation is worrisome," says Izabella Cooper, spokeswoman for the European border control agency Frontex.

Even more concerning is the fact that summer hasn't even begun. Experience has shown that most migrants only climb into the boats once the Mediterranean grows calmer. Italian authorities estimate that a quarter million people will arrive on its shores this year. "There are challenges ahead," says a senior German security official.

Berlin is particularly concerned because it's not just Africans who are taking the Mediterranean route to Italy. An increasing number of South Asians are as well, which could mean that the route across the sea to Italy is now seen as a viable alternative to the defunct Balkan route. People from Bangladesh now represent the second largest group of migrants that have crossed over from Libya this year. From January to March 2016, by contrast, exactly one Bangladeshi was picked up on the route. Pakistanis have also chosen the Mediterranean route more often in recent months.

Officials in Berlin and Brussels have thus far sought to play down the numbers. "We can't yet say if it is a temporary upward tick or if it is a trend," says one EU diplomat.

Thus far, the majority of newcomers have remained in Italy. But German Interior Minister Thomas de Maizière, of Merkel's Christian Democrats (CDU), nevertheless applied with the European Commission for permission to extend German border controls on its border with Austria beyond the May expiration date. On Tuesday, that permission was granted, with the Commission saying that the controls must be lifted by the end of the year. German conservatives are likewise demanding that controls be established on the country's border with Switzerland.

Restrictive Interpretation

The EU is currently working on an emergency plan in case a "serious crisis situation" develops. The discussions are focusing on a scenario under which more than 200,000 refugees would have to be redistributed each year.

An unpublished report by Malta, which currently holds the rotating European Council presidency, calls for a more restrictive interpretation of asylum rights in such a case. In other words, should too many migrants begin arriving, the EU will increase efforts at deterrence. Controversial proposals for reception camps to be established in North Africa also remain under discussion.

Most of those currently fleeing from countries like Nigeria, Guinea and the Ivory Coast are doing so to escape grinding poverty and in the hopes of finding better opportunities in Europe. Very few of them have much chance of being granted asylum. That reality has made redistribution within the EU even more difficult. According to current law, those with no chance at asylum are supposed to be sent back home as quickly as possible and not sent to other European countries.

The key to Merkel's solution for the 2015/2016 refugee crisis was the EU-Turkey deal. The agreement called for Turkey to improve monitoring of its Aegean Sea coastline, which was the jumping-off point for the Balkan route via the Greek islands. At the same time, a more rigorous deportation policy, which meant that refugees who reached Greece would be sent back to Turkey, discouraged many from making the journey in the first place. That deal, in combination with border closures, has meant that the route has largely been abandoned.

That strategy, however, won't work for the Mediterranean route to Italy -- neither the increased coastal monitoring nor the rapid deportations. There is no country, after all, to which the migrants could be deported. Almost all of them depart from what was once Libya, today a failed state where the government, clans and other power-hungry groups are engaged in constant combat.

The country is widely viewed as a basket case with little prospect for a stable government in the foreseeable future. One German government official says that "no positive trends" can be observed.

The problem, though, is that there can be no solution to the current refugee influx without Libya.

Fully 90 percent of the migrants who have set off across the Mediterranean for Italy started their journeys from the Libyan coast.

Low Risk, High Earnings

Without a functioning state in Libya, however, there can be no effective border controls. The situation is completely chaotic, notes a late-January internal report from the EU Border Assistance Mission in Libya (EUBAM), which is currently working out of Tunis. Migrant smuggling, the report notes, is an income source for organized crime organizations "with extremely low risks and high earnings."

Nevertheless, the Libyan government has presented the EU with a list of needs for the upgrading of its coast guard, including 130 vessels, some of them armed, along with additional equipment. The EU border control agency Frontex is skeptical, saying that before any equipment is delivered, measures must be in place to prevent it from falling into the wrong hands.

Italian Prime Minister Paolo Gentiloni reached an agreement in February with Fayez Serraj, the prime minister of Libya's unity government, for millions in aid to strengthen the country's coast guard. But Serraj doesn't even have control of the entire capital, Tripolis. And the coast guard that Italy is supporting sometimes works together with migrant smugglers.

Because protecting the coast is unfeasible, the focus has shifted to returning migrants to North Africa. Months ago, the German government discussed the establishment of reception camps not in Libya, but in its neighboring countries of Tunisia and Egypt. But Tunis and Cairo demurred.

Might such camps, then, be built in Libya after all?

On a recent Monday afternoon, the Home Affairs Committee in European Parliament met to review the situation in Libya, a country that has become so dangerous that many government officials, NGO workers and politicians no longer feel safe traveling there. The committee had invited Annemarie Loof, operations manager for the aid organization Doctors without Borders, and the pictures she brought along to show to the parliamentarians were difficult to look at.

Left in the Lurch

They showed overcrowded internment camps, children sleeping on bare concrete and undernourished migrants with skin diseases and signs of having been tortured. "Refugees are big business in Libya," Loof says. "If you pump more money in, things will only get worse."

That, however, is exactly what the Italians are planning to do. The country feels as though it has been left in the lurch by Brussels and on the eve of the EU summit in Malta in early February, Rome reached an agreement with Libya on the establishment of "temporary reception camps" to which refugees can be deported. Initially, they are to be financed by Italy, but Libyan officials will be solely responsible for operating them. Loof's report focused on the conditions that might develop in such camps.

"It would be crucial for the Europeans to inspect the camps to guarantee humane conditions," says Martin Kobler, head of the United Nations Support Mission in Libya. But nobody is willing to do so. It is simply too dangerous.

An alternative to improving Libya's coast guard would be that of monitoring the country's southern border to prevent migrants from entering Libya in the first place. Recent media reports have indicated that some in Brussels have begun mooting the establishment of a mission to do so. But the idea has not found widespread favor in the EU capital and Berlin, too, is opposed. "I don't think a European police mission is realistic at the present time," says one German official.

One reason, to be sure, are the challenges associated with doing so. Libya's southern border runs for 1,500 kilometers through an extremely hot desert controlled largely by local clans. But Luxembourg Foreign Minister Jean Asselborn believes that, despite the difficulties, exactly that strategy should be pursued. "Europe has to help Libya control its southern border," he says.

"That is the gate for migration to Europe. It isn't just when the refugees head out to sea."

"The refugees must be stopped before they reach the Sahara," agrees Monika Hohlmeier, a member of European Parliament from the Christian Social Union, the Bavarian sister party to Merkel's CDU. "It's all a vicious circle: The more people we save in the Mediterranean, the more refugees end up in the migrant smuggling apparatus or die on the way." A strategy paper produced by the European Political Strategy Centre, a think tank under the authority of Commission President Jean-Claude Juncker, reaches the same conclusion. By limiting itself to merely saving migrants in maritime distress, Europe has "unintentionally encouraged smugglers to adopt new strategies enabling them to reap more benefits, while placing migrants even more at risk," the paper, published in early February, reads.

Brutal Treatment

Frontex has noted that migrant smugglers have recently become even more unscrupulous. They have, for example, begun packing up to 170 people onto inflatable rafts that can only safely transport 15 passengers at most. It isn't possible for such an overloaded vessel to make the entire trip across to Italy, nor is that the intention. The engines generally only have enough fuel to make it out of Libyan waters, with smugglers relying on the migrants being picked up by a passing ship. If not, well that's just bad luck. More than 1,000 migrants have already lost their lives trying to reach Italy this year.

Migrants who have been saved have told Frontex officials about the brutal treatment meted out by the smugglers. Those who refuse to board the overflowing boats in Libya are often forced to do so at gunpoint. Some are even shot or murdered. Frontex spokeswoman Cooper says that the border agency has repeatedly discovered migrants with gunshot wounds among those who have been saved from the Mediterranean.

It is a dilemma: The Europeans cannot simply stand by as increasing numbers of people drown in the Mediterranean. But the more active NGOs are in pulling people out of the water, the more cynically the smugglers take advantage of the help they provide. It has become something of a "taxi service to Europe" that has increased the incentive to risk the journey, complain high ranking German officials.

The Italian judiciary has gone a step further and accused some aid organizations of abetting human smuggling. "We have proof that individual NGOs maintain direct contact with migrant smugglers in Libya," claims Public Prosecutor Carmelo Zuccaro, based in Catania in Sicily.

"Telephone calls from Libya are made directly to these NGOs. The direction of travel to their ships are illuminated with spotlights."

For years, Italy has been among the European countries most affected by the refugee influx. The government in Rome, led by Paolo Gentiloni, is under extreme pressure. The hostels are overcrowded and there have been violent protests against newcomers in some Italian communities -- and populist politicians have been highlighting the issue ahead of upcoming mayoral elections. The head of the right-wing populist party Lega Nord says that "the invaders must be stopped and the illegals should be sent away." His party currently stands at around 13 percent in nationwide polls. Meanwhile, Senate Vice President Luigi di Maio, of the Five Star Movement, the strongest political party in the country, has been blasting away at the NGOs who save drowning refugees at sea.

Solidarity in Name Only

The Italian government has launched a variety of measures in an effort to regain control over the situation, but the number of new arrivals continues to climb. Shortly before Easter, Rome quickly issued a decree allowing for the more rapid deportation of asylum seekers whose applications have been rejected. In addition, Prime Minister Gentiloni and Foreign Minister Angelino Alfano are seeking to sign agreements with the most important countries of origin and transit countries in Africa. The president of Niger, for example, was recently promised 50 million euros during a visit to the Italian capital in exchange for tighter controls on the country's border with Libya.

The Italians do not believe that there will be a rapid breakthrough on the distribution of refugees throughout Europe. Recent years have shown repeatedly that solidarity exists in name only. In 2015, other EU members promised to take 160,000 refugees from Italy and Greece. Thus far, however, only 16,000 have been resettled.

During a breakfast meeting a week ago Wednesday, EU ambassadors from the 28 member states studied a six-page compromise paper presented by the Maltese council presidency: "The Solidarity Component of the Dublin System Reform." The paper envisions a system whereby Europe will classify immigration levels into three categories: normal refugee flows, strong increases and massive inflows in a crisis. Talks have focused primarily on the second category, with the third being classified as a "serious crisis situation."

Germany is insisting that as many European countries as possible accept refugees. To encourage countries like Hungary and Poland to accept such a plan, a compensation mechanism is under discussion which would include financial incentives for accepting refugees.

Countries that accept more than their quota would receive 60,000 euros per refugee within five years, whereas those who don't meet their quota would have to pay the same amount.

As a further concession, the proposal envisions the suspension of the distribution mechanism when more than a certain number of refugees per year need to be distributed -- the number 200,000 is currently under discussion. The measure, though, remains bracketed in the paper, which is EU diplomats' way of indicating that the debate has not yet been settled.

No Solution in Sight

In the case of a "serious crisis situation," the paper calls for "simplified legal procedures," which likely means that only the minimum standards laid out in the Geneva Refugee Convention would apply.

The proposals in the paper will not provide relief in the immediate future, which is why the Commission is urging EU member states to speed up deportations. Officials estimate that around 1 million people who sought asylum in 2015 and 2016 saw their applications rejected, meaning they were required to be sent home. But since 2015, not even half that number have been deported.

Repatriations to African countries are often unfeasible, says one EU diplomat. "Either the countries refuse to take their citizens back or the refugees who are to be deported have long since disappeared."

Meanwhile, demands are growing in Berlin for more intense monitoring of the German-Swiss border.

Germany's federal police force recorded 1,880 illegal entries through the border during the first three months of this year. It's not a huge number, but it has more than tripled relative to the same period in 2016 despite the lack of stationary border controls of the kind seen on the German-Austrian border. In other words, the true number of illegal entries is likely much higher.

"If the number of migrants coming across the Mediterranean continues to rise, we won't be able to avoid controls on the German-Swiss border," says Armin Schuster, a German parliamentarian with the CDU. Fellow conservative Stephan Mayer is demanding that the border be "tightly controlled, unilaterally if necessary, without EU permission."

Rigorous repatriations to source countries, border controls, measures to fight the causes of flight: Berlin and Brussels are deploying a broad variety of steps to prevent a new refugee crisis. The deepest crisis of Merkel's tenure taught the chancellor an important lesson: When a large influx of migrants begins pressuring Europe's external borders, Germany cannot look away. "We Germans," Merkel said in late August 2016, "ignored the problem for too long."

Today, government officials speak of the crisis as a "time when we weren't sufficiently aware of the problem." They say, however, that "we have learned our lesson." That seems to be the case. There is no lack of awareness for the problem this time around. But there is nevertheless no solution in sight.

 The Least Explicable Bubble

Of all the mini-bubbles now inflating out there, maybe the least explicable is the race among emerging market companies to borrow dollars. This has gotten them – and their governments — in huge trouble so many times in the past (see the Mexican default of 1982 and the the Asian contagion of 1997) that you’d think dollar debt would be kind of a hot stove thing for Brazilians and Mexicans. 
But no, they’re back at it:

Emerging-Market Companies Shrug Off Trump in U.S. Debt Binge
(Bloomberg) – Emerging-market companies are showing up to the U.S. debt market at the fastest pace ever, and finding plenty of appetite for their bonds.
Sales of dollar-denominated notes have climbed to about $160 billion this year, more than double offerings at this point in 2016 and the fastest annual start on record, according to data compiled by Bloomberg going back to 1999. Emerging-market assets tanked after Donald Trump’s surprise election in November, but they’ve quickly recovered, with bonds returning 4 percent this year and outperforming U.S. investment-grade and high-yield debt. 

The deluge of issuance began when companies anticipating a surge in borrowing costs amid economic stimulus from Trump rushed to sell notes before his inauguration Jan. 20. But the expected jump never materialized, extending the window for companies like Petroleo Brasileiro SA and Petroleos Mexicanos to pursue multi-billion-dollar deals.  
They found plenty of demand from investors keen to buy shorter-dated debt that’s better insulated against rising U.S. interest rates. 
Jean-Dominique Butikofer, the head of emerging markets for fixed income at Voya Investment Management in Atlanta, said he’s seen new interest in emerging markets from investors who already own U.S. high-yield bonds or emerging market sovereign debt that’s more vulnerable to rising interest rates. 
“You want to be less sensitive to U.S. rates, but you still want to diversify and you still want to play the EM catch-up growth story,” said Butikofer, whose firm manages $217 billion. “You’re going to gradually add emerging-market corporates.” 
The investable universe for emerging-market corporate debt is small, but growing quickly, with about $426 billion outstanding, according to Bloomberg Barclays Index data. That’s less than a tenth of the size of the U.S. investment-grade credit market. The notes have an average maturity of 6.3 years, compared with 10.8 years for investment-grade debt. 
Economic Shift 
Developing nations now rely less on exporting their goods to the U.S. and more on local consumption than in previous says, said Samy Muaddi, a Baltimore-based money manager at T. Rowe Price Group Inc., which oversees $862 billion. 
“The EM growth model has really shifted in the last 10 to 20 years,” Muaddi said.  
“Consumption has risen as a share of GDP in many of the countries we’re involved in.  
That growth driver is pretty durable irrespective of U.S. policy.” 
Debt from Indonesia, Argentina and Brazil is particularly attractive as those countries implement economic reforms, Muaddi said. While Trump’s trade policies may be bad news for Mexican companies if he scraps the North American Free Trade Agreement, he said many of the world’s biggest geopolitical risks are in developed markets — think Britain’s negotiations to leave the European Union or France’s election outcome. That’s upending the usual dynamic in which emerging markets are considered less stable. 

Risks still remain. A surge in the greenback could spell bad news for emerging-market companies with lots of dollar debt and revenue mostly in a local currency.  
The overseas debt binge has boosted their total foreign corporate debt due in the next five years to $1.58 trillion, according to the Institute of International Finance.  
About 80 percent of that is dollar denominated. 
‘Original Sin’ 
That could cause problems, according to Ricardo Hausmann, the director of the Center for International Development at Harvard University in Cambridge, Massachusetts. 
While developing nations and their companies aren’t as dependent on overseas debt as they were in the 1980s — when a similar pattern sparked a wave of defaults in Latin America — a rising dollar “will make it that much harder for companies and sovereigns with ‘original sin’ to pay,” Hausmann said. He coined the term in reference to developing countries’ reliance on overseas debt in an article for Foreign Policy magazine almost two decades ago. 
Investors seem unconcerned. They’ve poured $1.9 billion into mutual funds that purchase emerging-market debt denominated in dollars and other major currencies, according to data provider EPFR Global. The few exchange-traded funds that buy up the bonds have also had inflows of more than $200 million, Bloomberg data show. 
“There has been a lot of supply, but it’s been absorbed very well by the market,” said Daniel Senecal, a credit analyst at Newfleet Asset Management in Hartford, Connecticut, which manages $12 billion.

So…emerging market debt is a great way to diversify because these countries are no longer export-dependent, thus “insulating” them from the risk of rising US interest rates.

Furthermore, the developed world is where all the geopolitical risk now resides, so Brazil, Mexico (and Indonesia and Argentina!) have become safe havens.

If this seems to stretch the bounds of credulity, that’s because peak bubble rationales always do. In 1999 tech company earnings were “optional” and eyeballs were all that mattered. In 2006 home prices always went up so any price was a good price.

With today’s multiple bubbles such nonsense is everywhere. A college degree is worth millions over a lifetime so at a borrowed quarter-mil it’s a bargain. Modern cars will last decades so a 7-year auto mortgage is the best way to buy – especially if you have bad credit. Trump’s tax cuts will boost corporate profits without unduly increasing the deficit, so stocks at historically-high valuations are actually cheap.

But again, the craziest rationale has to be that since Latin American economies are now driven by local consumers, dollar-denominated debt is the best way for an Argentine copper miner to finance its expansion.

Here’s a quick scenario to ponder: The US blunders into another Middle-East war (or a stock market crash or unexpected slowdown when the auto, housing and student loan bubbles burst simultaneously) sending terrified capital pouring into Treasury bonds and pushing up the dollar.

That cheap emerging market dollar-denominated debt becomes 30% – 50% more expensive, causing a wave of borrowers to implode. And once again shell-shocked buyers of insanely-overvalued assets look back on their delusions and wonder what they were thinking.

The most consequential election of 2017

Even if defeated, Marine Le Pen has changed French politics

France is more divided than ever
AS FAMILY outings go, it was unorthodox. No fewer than 20 members of all ages travelled from Normandy to a soulless exhibition hall 20km (12 miles) north of Paris, to watch the nationalist Marine Le Pen take the stage for her last big campaign rally. The youngest in the troop was seven; there were several teenaged girls with pony-tails. But the family seemed thrilled. “For 30 years, politicians have ruined this country,” said Bernard, an uncle in the clan, who works in funeral insurance: “They tell us that we’re racist, but that’s nonsense. She’s the one who’s got concrete ideas to get us out of this chaos.”

Ahead of the run-off vote for the French presidential election on May 7th, Ms Le Pen trails her liberal opponent, Emmanuel Macron, by a hefty 20 points. But she has not given up the fight. On May 3rd she lashed out at Mr Macron in a televised debate against the 39-year-old one-time banker, casting the election as a referendum on globalisation and finance. She accused the former economy minister of being the candidate of “the system”, “Uberisation of society”, and “savage globalisation”.

In an echo of a campaign line used by François Hollande, the Socialist president, in 2012, Ms Le Pen told flag-waving supporters in Villepinte: “Today, the enemy of the French people is still the world of finance, but this time he has a name, he has a face, he has a party, he is presenting his candidacy and everyone dreams of him being elected: he is called Emmanuel Macron.”

It is a message that chimes with a big chunk of the electorate in a fractured country. Big cities and college-educated voters favour Mr Macron and his pro-European, business-friendly politics, while struggling smaller towns and rural parts lean to the protectionist, anti-immigration Eurosceptism of Ms Le Pen. Even some of those who recoil at her xenophobia turn out to loathe the world of finance even more. “Neither banker, nor racist” read a banner at a protest rally in Paris. Jean-Luc Mélenchon, a Communist-backed candidate who came a close fourth, refused to call for a vote for Mr Macron against Ms Le Pen. Fully 65% of his supporters said that they would abstain or spoil their ballot papers.
Ms Le Pen has made some gains. She secured the first national alliance in the 45-year history of her party, the National Front (FN), hooking up with Nicolas Dupont-Aignan, a right-wing Eurosceptic who scored nearly 5% of the vote in the first round. Ms Le Pen, who won 21%, has also tried to broaden her base by reaching out to the mainstream right (with its older voters) and the far left (with its younger ones). She lifted a stirring passage on regional identity from a speech by François Fillon, the defeated centre-right candidate, which her aides insisted was a “wink” at his electorate. Her team made an appeal on social media to Mr Mélenchon’s “unsubmissive” voters too, pointing to their shared positions such as distrust of NATO and desire for retirement at the age of 60.

Perhaps most striking, Ms Le Pen softened her position on the euro. Her vow to quit the single currency has long divided the FN: those around Florian Philippot, her lieutenant, consider it a centrepiece; those close to Marion Maréchal-Le Pen, her niece and an FN deputy, see it as a distraction. But it has turned into a liability for her run-off campaign. Older voters in particular worry that a currency devaluation could slash their pensions and savings. So Ms Le Pen has fudged the issue, with a muddled plan for parallel currencies instead. At a FN souvenir stand in Villepinte, offering such delights as pendants and earrings featuring Ms Le Pen’s blue-rose emblem, Anne-Claire, an off-duty police official, agrees: “The euro isn’t what matters; Marine is about defending the values of France.”

Nonetheless, it will be extremely difficult for Ms Le Pen to make up the gap between her and Mr Macron in the remaining days. No poll has put her remotely close to winning a majority.

She gets over 50% in only one region, Provence-Alpes-Côte d’Azur, the FN’s southern stronghold. In Brittany and greater Paris, her score drops to 31%. It would take a historic upset at this point for her to keep Mr Macron from the presidency. A loss for Ms Le Pen would be a symbolic defeat of the forces of nationalism and populism that have gained ground in parts of Europe. It could also put internal pressure on her leadership. “If she gets much less than 40%, the party will consider it a disappointment,” says Cas Mudde, a scholar of extremism.

Yet it would be a mistake all the same to understate Ms Le Pen’s achievement. With a first-round score of 7.7m votes, she has already set a historic record for the FN (see chart). In 2002, when her father, Jean-Marie Le Pen, also made it into the presidential run-off, there were demonstrations across the country and his opponent, Jacques Chirac, swept up 82% of the vote. This time, the streets have been mostly quiet, and she looks set to double his score. Mr Macron may well be safely elected on May 7th. But he will inherit a deeply divided country.

The Curious Case of Converging Yield Curves

The gap between two- and 10-year yields in the U.S. and Germany has converged

By Richard Barley

From one perspective, U.S. and European bond markets have diverged massively: the 10-year Treasury yield stands at 2.35% while 10-year German bonds yield just 0.39%. The Federal Reserve is raising rates; the European Central Bank is still deep in emergency-policy territory.

But from the perspective of the yield curve, the two sides are closer than you might expect.

The yield curve can help provide a window into the economic outlook. Yields on two-year debt tend to be affected most directly by central-bank actions, while 10-year yields paint a picture of longer-term expectations about growth and inflation. A steepening curve can be read as a sign of brighter economic prospects, and was one of the key signals last year that the market was embracing reflation.

A flatter curve could signal economic concerns.

Since the start of the year, the gap between two- and 10-year yields in the U.S. and Germany has converged, strategists at ING note, with both measures now just over 1 percentage point. That is unusual: the U.S. curve has been persistently steeper than its German peer since 2013.

But now the sands are shifting. The U.S. yield curve steepened sharply in the wake of President Donald Trump’s election victory but is now back close to levels seen before the vote, in part reflecting disappointing economic data. The German curve, by contrast, is still some 0.3 percentage point steeper than it was before the U.S. elections; it steepened again Thursday in response to another strong eurozone purchasing managers index Reading.

The factors behind the curves are different. In the U.S., the yield curve seems likely to respond most to Mr. Trump’s policy actions, and whether they are less underwhelming for investors than in his first 100 days. In Europe, it is economic data and monetary policy that are the bigger forces, with markets focused on even tiny shifts in the ECB’s dedication to ultraloose policy.

It is only one indicator of course. But the yield curve moves are another sign that it is Europe, not the U.S., with the stronger economic winds at its back.

Has U.S. Productivity Gone Hiding Overseas?

Companies’ shifting of profits overseas to avoid U.S. taxes may have artificially lowered U.S. productivity statistics

By Justin Lahart

Construction workers work on a high-rise condominium project on Biscayne Boulevard, in downtown Miami. Photo: Alan Diaz/Associated Press        

Where did America’s productivity go? Some of it may be hiding in Bermuda.

First-quarter productivity figures came out Thursday, and they weren’t good. With the economy faltering even as employers expanded payrolls, the Labor Department’s measure of how much a typical worker produced in a typical hour fell an annualized 0.6% from the fourth quarter. Versus a year earlier, productivity was up just 1.1%—a miserable number that is in keeping with the weak productivity growth that has taken hold over the past decade.

Productivity is a key driver of economic growth, and economists have struggled to explain the slowdown. Some argue it is a result of weak capital spending, some say innovations aren’t coming as fast as they used to. Still others say there is no slowdown and government data don’t capture the gains from new technologies and from the harder-to-measure service sector.

But provocative new research argues that some of America’s productivity gains are effectively being hidden offshore.

American companies have expanded their overseas operations in recent years. Commerce Department figures show that nonbank U.S. multinationals’ net income from overseas production came to about $1.2 trillion in 2014 versus $500 billion a decade earlier. Much of that was the result of companies stepping up their global operations, but some of it was a result of them moving intangible assets such as intellectual property overseas in order to shift income to low-tax countries.

Commerce Department figures tell the tale. In 2014 U.S. multinationals held about $1.8 million in assets overseas—anything from factories to patents—for each worker they employed overseas, but that varied a lot by country. In Canada, for example, they held $1.2 million in assets per employee, but in Ireland and Bermuda—popular destinations for their low tax rates—it was $10.3 million and $117 million, respectively.

The outsize asset-to-employment ratios of some countries are an indication that a lot of economic activity is being assigned there, argues University of Minnesota economist Fatih Guvenen. Because the activity isn’t being assigned to U.S. workers, they appear less productive.

That wouldn’t matter if, as appears to be the case in Canada, that economic activity is coming from workers doing their jobs. But Bermuda, where it looks as if assets such as intellectual property have been stashed, appears to be getting credit for productivity that really occurred in the U.S.

Mr. Guvenen and colleagues from Penn State and the Commerce Department calculate that from 2004 to 2008—the period when the U.S. productivity slowdown manifested itself—productivity growth would have been about 0.25 percentage points higher than the 1.5% annual rate shown in the official statistics. That doesn’t overturn the fact of the productivity slowdown, but it does mitigate it.

And it makes a difference in dollar terms. The economists’ productivity adjustments imply U.S. gross domestic product grew $250 billion a year more than the official numbers show since 2005. It doesn’t take long for that to really add up.

The Great Reset, Part Two

By John Mauldin

“Premature optimization is the root of all evil…”

– Donald Knuth, from his 1974 Turing Award lectura

This is the second of two letters that I think will be among the most important I’ve ever written.

These letters set out my philosophy about how we have to invest in the coming days and years.

They are the result of my years spent working with clients and money managers and thinking about the economic and particularly the macroeconomic world. Because of some of the developments I will be discussing, I think the future is likely to be extremely challenging for traditional portfolio allocation models. In these letters I also discuss some of the changes in my thinking about the new developments in markets that allow us to more quickly adapt to a changing environment – even when we don’t know in advance what that environment will be. I hope you today’s letter helpful. At the end I offer a link to a special report with more details.

Last week I discussed what I think will be the fallout from the Great Reset, when the massive amounts of global (and especially government) debt and the bubble in government promises will have to be dealt with. I think we’ll see a period of great volatility in the markets.

I offered a solution for dealing with this complexity and uncertainty in the markets by diversifying trading strategies. But that diversification must reflect a rethinking of Modern Portfolio Theory, including a significant reshaping of valuations in asset classes. We’ll deal with those topics today.

Modern Portfolio Theory 2.0

I think successful investing in the future will use a variation of Modern Portfolio Theory. MPT argues that you should diversify among noncorrelated asset classes to reduce overall portfolio volatility.

That strategy is wonderful when asset classes are truly noncorrelated – but we found out in 2009 that noncorrelation isn’t a reality anymore. Going forward, I think it will be more useful to diversify among noncorrelated trading strategies that are not committed to a buy-and-hold process for any particular asset classes. Call it MPT 2.0.

There’s a story here about how my thinking has changed on how we deal with Modern Portfolio Theory. About a decade ago, I gave the luncheon keynote speech at a major alternative investment (hedge fund) conference, on why I thought Modern Portfolio Theory no longer worked. My talk had to do with the rising correlation among asset classes and was an argument for active management and, yes, hedge funds (which of course the audience liked).

The next year the conference organizers invited Harry Markowitz, the Nobel Prize winner who developed the theory, to do the same luncheon keynote. That year, I was speaking at the conference later in the day.

Before Harry’s speech, I met him (for the first of what would be many times) out in the hall and began to question him, based on what I thought I understood about Modern Portfolio Theory. (Yes, there was hubris there – and worse.) Politely, with a smile as if he were lecturing a new student, Harry began to explain to me why I didn’t understand what he was saying, and he commenced drawing quadratic equations in the air with his fingers to explain his points.

What was so remarkable (I swear this is true) was that he was drawing the quadratic equations in reverse so that I could read them. Once I realized what he was doing, I was so stunned that someone could even do that I really didn’t hear much of anything else he said. We talked politely for about 10 minutes, and then he moved on. I don’t think I recovered for a week. But because I didn’t understand what he was saying, I still thought he was wrong.

A few years later, my friend Rob Arnott invited me to his annual Research Affiliates client program, where Harry was in attendance. I reminded him of our conversation and asked the same question I had before, and once more he began to try to get into my feeble brain what he was saying. I will admit he just wasn’t connecting. But Rob kept inviting me back; and as Harry was an advisor to his organization, we renewed our acquaintance annually and became what I like to think of as Friends.

Let me provide a little background on Harry. When his seminal paper was published in 1952, he had just left the University of Chicago to join the RAND Corporation, where he worked with George Dantzig on linear programming and the critical line algorithm that ultimately led to the concept of mean variance optimization. What I think is interesting is that the goal of linear programming at the time was to determine the best outcome in a model (i.e., to maximize profit subject to cost constraints or minimize costs subject to profit constraints/targets – typically applied to the allocation of resources in industrial companies or government agencies). In the 1940s, Dantzig had developed his ideas in work he did for the US Air Force, work he subsequently shared with John von Neumann, the father of game theory. Linear programming has been used to program models of transportation, energy, telecommunications, and manufacturing. The work Harry did in taking linear programming to the next level leads me to think of portfolio construction in terms of “engineering” a portfolio with whatever ingredients are available (stocks, bonds, asset classes, or trading strategies).

Interestingly, Markowitz’s work didn’t achieve importance until the early ’70s, when stocks and bonds got slammed at the same time. It had taken 20 years for his ideas to get a serious look. In addition to the movements in the stock and bond markets that were changing investors’ understanding of risk and its relationship to returns, the development of computing power and the founding of the Cowles Commission and CRSP (The Center for Research in Security Prices) at the University of Chicago gave Harry’s theories new life.

Back let’s turn back to engineering and the concept of utility. The math that is used to engineer a portfolio has been commoditized. We have computers that can do all the work no matter what asset classes we input. Pure robo-digital advisors are doing this task at low cost. The other important aspect of Markowitz’s work is the concept of utility and preference, which showed investors how to trade off risk and return on an “efficient frontier.” This is the act of determining one’s portfolio risk profile and deciding what level of risk is appropriate – where do I want to be on the efficient frontier?

Premature Optimization

The full quote at the beginning of this letter is from the renowned computer scientist Donald Knuth (Stanford) and is very applicable here: Programmers have spent far too much time worrying about efficiency in the wrong places and at the wrong times. Premature optimization is the root of all evil (or at least most of it) in programming.

Many investment advisors use Harry’s concept of the efficient frontier and diversification among asset classes to actually “overengineer” their client’s portfolios, giving them a false sense of security: “Look, here is what this cool program tells us your portfolio should look like. It’s all in the math, and that’s why you can trust it.”

This premature optimization leads people into accepting volatility in their portfolios because they think it’s required. A truer understanding of the efficient frontier is that the frontier is always moving; it’s not constant. So you can’t sit down and plan out your investment portfolio for the next 10 years in one afternoon and expect it to give you efficient, optimized results for years into the future – especially when that optimization is based on past performance and market history that is not going to be replicated in the future. Just my two cents.

This point brings to mind another great Donald Knuth quote: “Beware of bugs in the above code; I have only proved it correct, not tried it.” I can almost guarantee you that the software most investment advisors will use to show you how your portfolio should be allocated will be absolutely mathematically correct. But you will discover the bugs only as the future plays out.

Now back to my story about Harry and me.

Last year, I had an opportunity to sit outside with Harry on a fabulous California spring day, and I began again (hubris alert) to tell him why I thought Modern Portfolio Theory was going to lead investors astray, and I opined that what we needed to do was to diversify trading strategies among the various asset classes. He questioned me about how I wanted to go about doing that, and then he said, “But you are using Modern Portfolio Theory in the formulation of your strategy.” I was puzzled and was determined to figure out what he meant. He had said the same thing to me for several years, and I clearly wasn’t getting it. Our conversation continued, with me as the student and he as the very gracious and patient professor. And then the light dawned.

This is the key: I had clung to the simplistic understanding that Modern Portfolio Theory is about diversifying among noncorrelated asset classes. And it is. But I had a preconceived notion about the importance of particular asset classes. Moreover, with the correlation of all the asset classes that I understood to be in the toolbox “going to one” in times of crisis, it seemed to me that using MPT was simply diversifying your losses, not smoothing out your returns.

Harry patiently explained yet again that the key to MPT is in the words diversification and noncorrelation. The asset classes are just tools. They are interchangeable. Which was precisely what he was telling me when he was drawing those quadratic equations in the air 10 years earlier. I was just too dumb to understand. I hope that if I took his graduate course today, I could pass.

I think much of the investment industry shares my preconceived notion. Rather than opening our minds to a larger world with more potential, we assume we are limited to the asset classes most easily traded (stocks, bonds, real estate, international bonds, international real estate, large-cap, small-cap, etc.) If all you have is a hammer, everything looks like a nail.

I walked away from that conversation realizing – and have come to more firmly believe – that diversifying trading strategies is just another variant use of MPT. Call it MPT 2.0. I can still use all of the asset classes mentioned above (and, as we will see below, hundreds more), but I just don’t have to use all of them at the same time. Back in the early ’50s when Harry was writing his paper, there were numerous asset classes that didn’t correlate. International stocks and US stocks showed significantly different correlation structures and trends. Not so much anymore. Harry’s answer would be to simply change the asset classes in your toolbox and to continue to look for and find noncorrelating classes – or strategies.

Further, most “correlation studies” use past performance to predict future correlation. The sad truth is, that’s pretty much all we have available to us to determine correlation. In my study of correlation, I’ve come to understand that more is required than simply comparing historical return streams. You have to understand the underlying structure of the strategies and asset classes involved.

And that brings us to the third and final problem that will define future investing.

If You Don’t Have an Edge, There Is No Alpha

For investors, alpha is true north on the investing compass. It’s the direction you want to go.

Alpha is the positive return you get through some form of active investing, above and beyond what you would get with simple passive index investing. The theory behind active management, in most asset classes, is that managers can make a difference by using their superior analysis and systems and then putting only the best stocks (or whatever asset class they use) in their portfolios and possibly even shorting the bad ones. The theory says that the better stocks, whose earnings are rising, should go up in price more than the less profitable stocks go down.

The manager’s edge is the ability to differentiate between good companies with positive profit performance and those companies that have problems. And – this is key – for that expertise the manager gets to charge higher fees. If you were particularly good, beginning in the 1980s and through the first decade of the 2000s, you created a “long-short hedge fund” where you went “long” the stocks you thought were the better ones and “short” those you thought would fall in value. There were many different variations on this theme, but they all depended on the manager having an “edge” – some insight into true value differentiation.

But in the past few years that edge seems to have disappeared, and money has been flying out of many funds, and not just long-short funds. Active managers in the long-only space have been underperforming just as badly as their hedge fund brethren. Only about 10% of large-company mutual funds outperformed the Vanguard 500 Index Fund in the last five years.

So it’s no surprise that money is flying out of actively managed retail funds. According to CNBC, passive funds added a record $504.8 billion in 2016:

When it came to funds that focused on U.S. stocks, there was nearly a dollar-for-dollar switch:

Passive funds brought in a record $236.7 billion in investor cash, while their active counterparts saw $263.8 billion go out the door, worse even than the $208.4 billion in outflows during the height of the financial crisis in 2008. That doesn’t even count the more than $100 billion that left hedge funds during the year.

So why would that tectonic shift create problems in the valuation world? It’s simple when you think about it. Let’s take the small-cap world of the Russell 2000 as an example. My friend Paul Lyons at Tectonics went to his Bloomberg terminal and found that 30.7% of the 2000 stocks in that small-cap index had less than zero earnings for the previous 12 months, as of 3/22/17. A chart in the Wall Street Journal shows that the price-to-earnings ratio for the Russell 2000 was 81.46 as of May 26. That is not a typo.

There is $2.26 trillion in US small-cap stocks. Almost exactly 30% of that is in ETFs and mutual funds. My guess is that another 20% is in large pensions and in institutions that simply replicate the index. (Note: There are numerous small-cap indexes to choose from.)

When you buy a small index fund like the Russell 2000, even if the fees are cheap, you are buying stocks that aren’t making any money and are possibly shrinking in company size right along with those that are profitable and growing. In short, you’re buying the good and the bad indiscriminately.

And when everybody is buying every stock in the index in a massive way, there is no way for value-oriented active managers to fight that kind of buying action. They simply have no edge, or very little.

With the massive moves into passive index funds that we have seen in the past few years, shorting small-cap stocks is a prescription for pain. Yes, if a stock has seriously bad performance, it’s going to go down as stock pickers and investors sell; but finding enough such stocks to make a difference in an active fund is apparently difficult. And in the large-cap space?

Forget about it. (Note: If you have a highly concentrated portfolio, with just a few st ocks, it should be possible to outperform. But most people don’t want to take the risk of working with a manager with highly concentrated portfolios.)

So the Trump rally and the massive move into passive investing has pushed up US stocks in general (and to some extent global stocks as well). But what happens when we hit the next recession or loss of confidence? When investors start selling those passive funds, they’ll sell the good and the bad at the same time. In the case of the Russell 2000, they’ll sell all 2000 stocks. In the case of the S&P 500, all 500 stocks. And the move down has historically been much more precipitous than “climbing the wall of worry.”

How Should We Then Invest?

So let’s sum up. In my opinion, the entire world is getting ready to enter a period that I call the Great Reset, a period of enormous and unpredictable volatility in all asset classes. I believe that diversifying among asset classes will simply be diversifying your losses during the next global recession. And yet active management does not seem to be the answer because of the move by investors into passive investing. So what do we do?

I think that the answer lies in diversifying among noncorrelated trading strategies with managers who have a mandate to invest in any asset class their models tell them to. For a reasonably sophisticated investment professional, there are any number of ways to diversify trading strategies.

Up to this point in this letter, I’ve been talking philosophy rather than telling you how I actually intend to go about investing. In the coming paragraphs I’ll tell you how I’m going to diversify trading strategies and give you a link to the actual strategies, performance history, and managers that I will be using. Some of you will not agree with the philosophy I outlined above; some of you will think you can do a better job (or at least a different one) of diversifying trading strategies and managing money.

But, putting on my entrepreneurial business hat, my hope is that some of you will join me.

Back in the day, I allocated money to asset managers who traded mutual funds, before the rules were changed to make active trading of mutual funds either illegal or extremely difficult. But with the growth of money in exchange-traded funds (ETFs), that has changed. Globally, there is about $3.8 trillion in ETFs today. There are almost 2000 ETFs in the US alone, and according to ETFGI there are 4,874 ETFs globally, whose assets have skyrocketed from $807 billion in 2007 to $4 trillion today.

You know how somebody will talk about getting a time-consuming task done and then the next person says, “There’s an app for that”? No matter what asset you want, there’s now an ETF for that. I am constantly amazed how narrowly focused ETFs can be. There is now an ETF that focuses its investments just on companies in the ETF industry. It’s not all large-cap-index ETFs anymore. Some really small, niche-market ETFs have attracted significant capital.

Not surprisingly, a growing number of asset managers actively trade ETFs using their own proprietary systems. I began searching for the best of them some three years ago. I soon realized, for reasons I will explain in a white paper, that a combination of several managers is much better than just one. I have assembled a portfolio of four active ETF asset managers/traders with radically different styles. That approach theoretically gives me the potential for much less volatility than each manager’s system would face individually. The combination I’ve put together has been less volatile historically than the markets, over a full cycle.

Part of my edge is that I have been in the “manager of managers” business for more than 25 years, looking at hundreds of investment managers and strategies. That has actually been my day job when I’m not writing. So when a manager explains his system to me, I can “see” how it fits with those of other managers, understand whether it is truly different, and finally, determine whether it would add any benefit to my total mix. I’ve also learned that having more than the optimal number of managers doesn’t necessarily improve overall performance, but it does add complexity and increase trading costs.

You’re dealing with a few new puzzle pieces analyst,

John Mauldin

Wall Street's Best Minds

Grantham: Don’t Expect P/E Ratios to Collapse

Jeremy Grantham writes that era of high profit margins has contributed to stubbornly high multiples.

By Jeremy Grantham

Oh, the good old days!
When I started following the market in 1965 I could look back at what we might call the Ben Graham training period of 1935-1965. He noticed financial relationships and came to the conclusion that for patient investors the important ratios always went back to their old trends.

He unsurprisingly preferred larger safety margins to smaller ones and, most importantly, more assets per dollar of stock price to fewer because he believed margins would tend to mean revert and make underperforming assets more valuable.
You do not have to be an especially frugal Yorkshireman to think, “What’s not to like about that?”

So in my training period I adopted the same biases. And they worked! For the next 10 years, the out-of-favor cheap dogs beat the market as their low margins recovered. And the next 10 years, and the next! 1 Not exactly shooting fish in a barrel, but close. Similarly, a group of stocks or even the whole market would shoot up from time to time, but eventually – inconveniently, sometimes a couple of painful years longer than expected – they would come down. Crushed margins would in general recover, and for value managers the world was, for the most part, convenient, and even easy for decades. And then it changed.

Exhibit 1 shows what happened to the average P/E ratio of the S&P 500 after 1996. For a long and painful 20 years – for someone betting on a steady, unchanging world order – the P/E ratio stayed high by 1935-1995 standards. It still oscillated the same as before, but was now around a much higher mean, 65% to 70% higher! This is not a trivial difference to investors, and 20 years is long enough to test the apocryphal but suitable Keynesian quote that the market can stay irrational longer than the investor can stay solvent.

Along the way there were early signs that things had changed. First was the decline from the greatest bubble in US equity history, the 2000 tech bubble. Compared to the previous high of 21x earnings at the 1929 bubble high, this 2000 market shot up to 35x and when it finally broke, it fell only for a second to touch the old normal price trend. And then it quite quickly doubled.
Compare that experience to the classic bubbles breaking in the US in 1929 and 1972 (Exhibit 2) or Japan in 1989. All three crashed through the existing trend and stayed below for an investment generation, waiting for a new crop of more hopeful investors. The market stayed below trend from 1930 to 1956 and again from 1973 to 1987. And in Japan, the market stayed below trend for… you tell me. It is 28 years and counting! Indeed, a trend is by definition a level below which half the time is spent. Almost all the time spent below trend in the US was following the breaking of the two previous bubbles of 1929 and 1972. After the bursting of the tech bubble, the failure of the market in 2002 to go below trend even for a minute should have whispered that something was different. Although I noted the point at the time, I missed the full significance. Even in 2009, with the whole commercial world wobbling, the market went below trend for only six months. So, we have actually spent all of six months cumulatively below trend in the last 25 years! The behavior of the S&P 500 in 2002 might have been whispering in my ear, but surely this is now a shout? The market has been acting as if it is oscillating normally enough but around a much higher average P/E.

How about profit margins, the other input into the market level? Exhibit 3 shows the return on sales of the S&P 500 and Exhibit 4 shows the share of GDP held by corporate profits. Compared to the pre- 1997 era, the margins have risen by about 30%. This is a large and sustained change. And remember, it is double counting: above-average profit margins times above-average multiples will give you very much above-average price to book ratios or price to replacement cost. Counterintuitively, if we need to sell at replacement cost (most people’s view of fair value), then above-normal margins must be multiplied by a below-average P/E ratio and vice versa.

To this point, we have looked at two of the three most important inputs in markets and they are very different in the same direction, upwards. A third one – interest rates – is also very different. As is wellknown, short rates have never been at such low levels in history as they were last year. Come to think of it, the population growth rate is also very, very different. As is the aging profile of our population. And the degree of income inequality. So too the extent of globalization and indicators of monopoly in the US. Also the extended period of below-trend GDP growth and productivity almost everywhere but particularly in the developed world. And serious climate change issues that may be understated in countries like the US, the UK, and Australia, where the fossil fuel industries are powerful and engage in effective obfuscation, but pre-1997 the topic was not broadly appreciated at all. The price of oil in 1997 was more or less on its 80-year trend in real terms of around $18 a barrel in today’s currency. The trend price today, based on the cost of finding new oil, is about $65 a barrel with today’s price only slightly lower despite an unexpected surge in supply from US tight oil, or fracking. Three and a half times the old price is not an insignificant change when you realize that almost all serious economic declines have been associated with price surges in oil.

And, finally, my old bugbear – the modus operandi of the Federal Reserve and its allies is very different in its 22-year persistent effort to work the highs and lows of the rate cycle lower and lower. One might ask here: Is there anything that really matters in investing that is not different? (Actually, I have one, but will save it for another discussion: human behavior.)

We value investors have bored momentum investors for decades by trotting out the axiom that the four most dangerous words are, “This time is different.”2 For 2017 I would like, however, to add to this warning: Conversely, it can be very dangerous indeed to assume that things are never different.
Corporate profitability is the key difference in higher pricing  

Of all these many differences, the most important for understanding the stock market is, in my opinion, the much higher level of corporate profits. With higher margins, of course the market is going to sell at higher prices. So how permanent are these higher margins? I used to call profit margins the most dependably mean-reverting series in finance. And they were through 1997. So why did they stop mean reverting around the old trend? Or alternatively, why did they appear to jump to a much higher trend level of profits? It is unreasonable to expect to return to the old price trends – however measured – as long as profits stay at these higher levels.

So, what will it take to get corporate margins down in the US? Not to a temporary low, but to a level where they fluctuate, more or less permanently, around the earlier, lower average? Here are some of the influences on margins (in thinking about them, consider not only the possibilities for change back to the old conditions, but also the likely speed of such change):
• Increased globalization has no doubt increased the value of brands, and the US has much more than its fair share of both the old established brands of the Coca-Cola and J&J variety and the new ones like Apple,  Amazon, and Facebook. Even much more modest domestic brands – wakeboard distributors would be a suitable example – have allowed for returns on required capital to handsomely improve by moving the capitalintensive production to China and retaining only the brand management in the US. Impeding global trade today would decrease the advantages that have accrued to US corporations, but we can readily agree that any setback would be slow and reluctant, capitalism being what it is, compared to the steady gains of the last 20 years (particularly noticeable after China joined the WTO).
• Steadily increasing corporate power over the last 40 years has been, I think it’s fair to say, the defining feature of the US government and politics in general. This has probably been a slight but growing negative for GDP growth and job creation, but has been good for corporate profit margins. And not evenly so, but skewed toward the larger and more politically savvy corporations. So that as new regulations proliferated, they tended to protect the large, established companies and hinder new entrants. Exhibit 5 shows the steady drop of net new entrants into the US business world – they have plummeted since 1970! Increased regulations cost all corporations money, but the very large can better afford to deal with them. Thus regulations, however necessary to the well-being of ordinary people, are in aggregate anti-competitive. They form a protective moat for large, established firms. This produces the irony that the current ripping out of regulations willy-nilly will of course reduce short-term corporate costs and increase profits in the near future (other things being equal), but for the longer run, the corporate establishment’s enthusiasm for less regulation is misguided: Stripping out regulations is working to fill in its protective moat.

• Corporate power, however, really hinges on other things, especially the ease with which money can influence policy. In this, management was blessed by the Supreme Court, whose majority in the Citizens United decision put the seal of approval on corporate privilege and power over ordinary people. Maybe corporate power will weaken one day if it stimulates a broad pushback from the general public as Schumpeter predicted. But will it be quick enough to drag corporate margins back toward normal in the next 10 or 15 years? I suggest you don’t hold your breath.

• It is hard to know if the lack of action from the Justice Department is related to the increased political power of corporations, but its increased inertia is clearly evident. There seems to be no reason to expect this to change in a hurry.

• Previously, margins in what appeared to be very healthy economies were competed down to a remarkably stable return – economists used to be amazed by this stability – driven by waves of capital spending just as industry peak profits appeared. But now in a very different world to that described in Part 1,4 there is plenty of excess capacity and a reduced emphasis on growth relative to profitability. Consequently, there has been a slight decline in capital spending as a percentage of GDP. No speedy joy to be expected here.

• The general pattern described so far is entirely compatible with increased monopoly power for US corporations. Put this way, if they had materially more monopoly power, we would expect to see exactly what we do see: higher profit margins; increased reluctance to expand capacity; slight reductions in GDP growth and productivity; pressure on wages, unions, and labor negotiations; and fewer new entrants into the corporate world and a declining number of increasingly large corporations. And because these factors affect the US more than other developed countries, US margins should be higher than theirs. It is a global system and we out-brand them for one thing.

• The single largest input to higher margins, though, is likely to be the existence of much lower real interest rates since 1997 combined with higher leverage. Pre-1997 real rates averaged 200 bps higher than now and leverage was 25% lower. At the old average rate and leverage, profit margins on the S&P 500 would drop back 80% of the way to their previous much lower pre-1997 average, leaving them a mere 6% higher. (Turning up the rate dial just another 0.5% with a further modest reduction in leverage would push them to complete the round trip back to the old normal.)

This neat outcome tempted me to say, “well that’s it then, these new higher margins are simply and exclusively the outcome of lower rates and higher leverage,” leaving only the remaining 20% of increased margins to be explained by our almost embarrassingly large number of other very plausible reasons for higher margins such as monopoly and increased corporate power.

But then I realized that there is a conundrum: In a world of reasonable competitiveness, higher margins from long-term lower rates should have been competed away. (Corporate risk had not materially changed, for interest coverage was unchanged and rate volatility was fine.) But they were not, and I believe it was precisely these other factors – increased monopoly, political, and brand power – that had created this new stickiness in profits that allowed these new higher margin levels to be sustained for so long.
So, to summarize, stock prices are held up by abnormal profit margins, which in turn are produced mainly by lower real rates, the benefits of which are not competed away because of increased monopoly power, etc. What, we might ask, will it take to break this chain? Any answer, I think, must start with an increase in real rates.

Last fall, a hundred other commentators and I offered many reasons for the lower rates. The problem for explaining or predicting future higher rates is that all the influences on rates seem long term or even very long term. One of the most plausible reasons, for example, is the aging of the populations of the developed world and China, which produces more desperate 50-yearolds saving for retirement and fewer 30-year-olds spending everything they earn or can borrow. This results, on the margin, in a lowered demand for capital and hence lower real rates. We can probably agree that this reason will take a few decades to fade away, not the usual seven-year average regression period for financial ratios.
Any effect of lower population growth rates is likely to take even longer. No one seems sure what is causing lower productivity growth or what role it has in lower rates, but it would take some very unexpected good fortune to have productivity accelerate enough to drive rates upward in the near term. Income inequality that may be helping to keep growth and rates lower will, unfortunately, in my opinion, also take decades to move materially unless we have a very unexpected near revolution in politics.

Perhaps the best bet for higher rate equilibrium in the next few years is a change in the dominant central bank policy of using low rates to stimulate asset prices (which they clearly do) and stimulate growth (which, other than pushing growth back or forward a quarter or so, I believe they do not do). With 20 years of Fed support for this approach and loyal adherents in the ECB and The Banks of England and Japan, changing the policy is unlikely to be quick or easy. It is a deeply entrenched establishment view, or so it seems.

President Trump is admittedly a very, very wild card in this game, and he said a few anti-Fed things in the election phase, for whatever that is worth. He also gets to appoint five new members, including the chair, in the next 18 months. But in the end, will a real estate developer with plenty of assets and an apparent interest in being very rich really promote a materially higher-yield policy at the Fed? Possible, but quite improbable, I think. In short, I think lower rates than those in effect pre-1997 are likely to be with us for years, and the best we can hope for is several of the factors we’ve discussed moving slowly to push real rates higher.

In the meantime, while we wait for higher risk-free rates, investors – value mangers included – should brace themselves for continued higher multiples than those of the old days.

(Although with a very good chance that multiples will show a very slow decline.)

What does this mean for value investing? What it does not mean is that cheaper is not better. But price to book was never a measure of cheapness. The low price to book ratios reflect the market’s vote as to which companies have the least useful assets.

Only if the market gets carried away with pessimism or feels uncomfortable with the career risk of owning companies in temporary trouble will such ratios work. Sometimes they do and sometimes they don’t. A fully-fledged dividend discount model with strong quality adjustments and epic struggles to correct for accounting slippage is ideally what is needed. Alternatively, any analyst good enough to predict the future, whether for six months or six years, better than the market will win.

Unfortunately for us investors, the prediction business is not easy. The S&P has been selling at a much higher level of P/E for 20 years now and it has not meant that better stock pickers have not won. My personal belief and experience has been, though, that the greatest deviations from fair value occur at more macro levels – countries and asset classes – where career risk is higher than picking one insurance company over another and therefore the inefficiencies and opportunities for outperforming are greater.

What this argument probably does mean is that if you are expecting a quick or explosive market decline in the S&P 500 that will return us to pre-1997 ratios (perhaps because that is the kind of thing that happened in the past), then you should at least be prepared to be frustrated for some considerable further time: until you can feel the process of the real interest rate structure moving back up toward its old level.

All in all, from the many possibilities, I prefer my suggestion (from Part 1) of a 20-year limping regression that takes us two-thirds of the way back to the good old days pre-1997. What I fear is that if I am wrong, it is less likely to be because regression is more dramatic as some die-hard value managers believe (and I would dearly, dearly love to see!) than it is to be even slower. (The outlook I proposed for the S&P 500 last October of 2.8% real per year for 20 years – the whimper path – has fallen to 2.3% real at recent higher prices).
Outlook for corporate margins – and hence (probably) the market in 2017
There are three factors moving in favor of US profit margins this year. First, oil and resource prices appeared to have bottomed out last year and seem likely to have favorable comparisons for a few quarters.

Second, Trump is likely to settle for a moderate reduction in corporate tax rates this year after bouncing off the infinitely complex task of a full redo of the tax code. In a theoretical world, corporate taxes are a pass-through to consumers, but in the current, stickier, more monopolistic, more profit-fixated world, a corporate tax reduction will raise corporate profits for quite a while from where they otherwise would have been. Third, removing regulations here and there will, as mentioned, lower corporate costs in the short term.

Net-net, unless there are some substantial unexpected negatives, US corporate margins will be up this year, making for the likelihood, in my opinion, of an up year in the market at least until late in the year. This does seem to make the odds of a major decline in the near future quite low (famous last words?). Next year, though, is a different proposition. In conclusion, there are two important things to carry in your mind: First, the market now and in the past acts as if it believes the current higher levels of profitability are permanent; and second, a regular bear market of 15% to 20% can always occur for any one of many reasons. What I am interested in here is quite different: a more or less permanent move back to, or at least close to, the pre-1997 trends of profitability, interest rates, and pricing. And for that it seems likely that we will have a longer wait than any value manager would like (including me).

Jeremy Grantham is the co-founder of GMO, a Boston-based asset management firm. Grantham is the firm’s chief investment strategist.