Springtime Chart Fling

John Mauldin

Here in Texas you know spring is here when our state flower, the bluebonnet, pops up everywhere. I was at the Masters in Augusta last year, and the azaleas were beautiful. But they are cultivated and take a lot of work to bring out their beauty.

The bluebonnet is pure Texan. It is independent and can thrive anywhere. Anywhere else it would be called a weed. The state of Texas plants 30,000 pounds of bluebonnet seed along our highways every year. Last year was the 100th anniversary of the state’s planting program. And then of course there are the (deep red) Indian paintbrushes and other wildflowers that are planted. Additional oceans of bluebonnets are planted or reseed on private land. Bluebonnets, which need no fertilizer or anything other than sunlight and a little water, are cheap natural nitrogen fixation for hay fields. This time of year you can see the land carpeted here and there with bluebonnets if you fly over Texas.  

Photo: Getty Images

We see families taking pictures along the highways, telling their small children to smile and pose. Our family did it, just like everyone else. During bluebonnet season it is impossible to drive around the metroplex on the weekends without seeing people pulled over on the highways taking pictures of the bluebonnet explosions that seemingly erupt overnight.

The bluebonnets make spring a nice time of year – particularly this year, at least for me, because I see little beauty in the economic news.

On the other hand, there is a kind of beauty in seeing the economic indicators graphically, even when I don’t like what they show. So this week I’m going to dip – one last time –into the Strategic Investment Conference slide archives to show you what some of my favorite analysts shared in San Diego. These charts won’t be in any particular order, because they cover several different topics. And because it is Easter and/or Passover weekend, I will keep the word count down.

Just like the weather, the world economy and financial markets go through cycles. Most years, they don’t change suddenly. We get some transition time between the colder and warmer seasons. I fear we may be in an economic transition right now, and it may not be in the direction of the springtime or summer we would prefer. But let’s look at these charts and see what they tell us.

Velocity and Debt

We’ll begin with Lacy Hunt, chief economist at Hoisington Management and all-around monetary genius. He is one of the few who watch the velocity of money, which is continuing to fall, as it has for almost 20 years. This is not the stuff that GDP growth dreams are made of. The last decade saw an average of only 1.9% annual GDP growth. I think we can attribute that underwhelming performance partially to the ongoing fall in the velocity of money.

You may be asking, what exactly is the velocity of money? Essentially, it’s the frequency with which the same dollar changes hands because the holders of the dollar use it to buy something. Higher velocity means more economic activity, which usually means higher growth. So it is somewhat disturbing to see velocity now at its lowest point since 1949, and at levels associated with the Great Depression.

As you see, velocity has been falling for quite a few years now, so by itself this indicator doesn’t signal imminent doom. But the further below average it drops, the more likely problems become. Combine this trend with the late-cycle tax cut and the Fed’s tightening, albeit slowly, and this is an indicator to watch.

Velocity relates to inflation, by the way. If inflation is to accelerate beyond the current relatively benign level, the velocity of money needs pick up. It shows no sign of doing so, which is one reason Lacy sees little inflation risk.

Debt is another big issue for Lacy. People compare debt to addictive drugs, and as with some of those drugs, the dose needed to achieve the desired effect tends to rise over time. The next chart shows the additional economic output (GDP) generated by each additional dollar of business debt in the US.

As you can see, debt has become steadily less stimulative over the last several decades. But focus specifically on the lower right area. We saw the debt-growth effect rise, but only for a couple of years as the economy came out of recession. It began sliding again right about the time Ben Bernanke said the Fed would begin “tapering” its QE bond purchases. Now it’s almost back down where it was in the trough of the recession. That’s not encouraging.

Sidebar: The US is not the only country experiencing the dynamic of less growth per dollar borrowed. China in particular has been watching its return on debt drop far more than the US’s has. The Chinese are on a path to almost double their total debt in less than 10 years from 2008, to a level that is far above total US debt and the total debt of much of the rest of the world. There is a reason that Moody’s downgraded China’s debt last year. Just saying…
Missing Reflation

There was a lot of talk about inflation at the conference, and a few commenters openly worried about inflation’s becoming an issue; but in general there wasn’t much real concern about the return of an episode of 70s-style inflation. I am still skeptical that inflation will get to anything more than 2.5% in this cycle unless a trade war sends us spiraling into a deflationary recession. Mark Yusko presented this next chart, which shows that despite so many people’s expecting reflation in the US and Europe, it’s not really happening.

That said, let’s also note that inflation isn’t a one-size-fits-all matter. Much depends on your individual spending patterns. If your largest expenses are healthcare or housing, then your personal inflation rate is probably higher than the national average… for now. This can and probably will change if we get into a recession.

Generational Differences

At SIC my good friend Neil Howe and I talked about the differences in generations and especially with regard to income inequality. His data shows that when you were born makes a big difference. Those now 75 and older (what it is generally called the “Silent Generation”) began their economic lives in the 1950s–1960s when businesses were hiring lots of young people and the country was growing. Boomers mostly began their economic lives in the 1980s, just in time for the greatest bull market in history. This generational experience shows up in the distribution of wealth that we have today.

With apologies to Generation X, which followed the Boomers, the age-wealth disparity is even more apparent in the next chart. As older generations have prospered, Gen Xers have actually seen their median net worth go down in the last 20 years. Ugh. Basically, the young rule in terms of numbers, but the old rule in terms of dollars.

Income Disparity

At SIC I showed several charts on wage disparity, but I think the following is the one I find most poignant. (It was sent to me by Jonathan Tepper of Variant Perception.) Note that it is the 95th percentile of workers that has received the bulk of the increase in wages. The bottom 50% is either down or basically flat since 1979. Even the 70th percentile didn’t do all that well.

The average wage increase was boosted mostly by the gains that top wage earners made. This income-growth disparity is one of the key reasons for the increased frustration with “elites.” And this same gap is widening across much of Europe and the rest of the world.

We will talk about this trend more in future letters, but I’m afraid that the differentials in income and wealth are going to increase, not decrease, for a variety of reasons.

For one thing, that’s just where we are in the economic cycle, though with technological change and globalization are important factors, too, and not ones that politicians can readily control. Frustration will be on the increase, too.

Deficit Headache

Louis Gave, one of the Gavekal founders, is a human research machine and always a SIC favorite. This year he talked about differences between the US and China and where the world’s two largest economies are going. He has a fascinating thesis that defies summarizing, so I’ll just show you a couple of his US-focused charts.

First, we have this chart of the 30-year Treasury yield since 2010. Note the very consistent downward trendline. Note also what it did in early 2018.

It was no great surprise that long-term bond yields fell steadily as the Federal Reserve gorged itself on purchases of long-term bonds. Nor is it surprising that yields should rise now that the Fed is withdrawing from that market. But other things are happening, too, as Louis notes in the chart. If a US economy that is growing slowly at best, along with continued stimulus from Europe, China, and Japan, isn’t enough to keep US bond yields from rising, what will? And if yields rise a great deal more, recession odds will rise, too. And by definition, recessions are deflationary, and we will see interest rates decline in the developed world when recession comes again. That prospect is startling to contemplate, given how low rates already are.

Our growing government debt is part of the problem. Louis graphed it as a percentage of GDP going back to 1966.

Over the last half-century, higher deficits have been associated with recessions. After recessions end, the deficit shrinks, and occasionally (e.g., after Clinton and Gingrich cut their deal) we get a surplus. That’s not happening this time. Deficits are growing even without a recession.

On the positive side, today’s annual deficits are nowhere near 2009–2012 levels. That’s encouraging, but in the next recession tax revenues will fall, and spending will increase enough to not only swell the annual deficit but also to add north of $2 trillion to the national debt each year. We’re using up our breathing room, and that will be a problem – sooner or later.

Tech Trouble

This next chart comes from a wide-ranging presentation by Jeffrey Gundlach of DoubleLine Capital. It may be either good news or bad news, and even Gundlach wasn’t sure which.

The chart shows the XLK Technology ETF, which consists of the S&P 500 Index technology components. That dotted line shows that XLK only recently surpassed the high it set back in the year-2000 tech boom. If you are a technical analysis fan, this performance might seem bullish – we have a breakout from long-term resistance. But is it really?

For one thing, XLK is not now the same collection of stocks as XLK was then. Apple was a smaller component in 2000, while Facebook and others weren’t even public yet. Dell was a big player in that period but is now private and delisted. So is the comparison really valid? Maybe not. And even if it is, I’m not sure we can call this a convincing breakout yet. And given the last two weeks, it may not become one.

Gundlach also showed a chart for XLF, a financials ETF, and it has a similar pattern. If neither technology nor financials can keep rising from here, this bull market may be in for a long pause and possibly a breakdown. Take heed if you’re exposed to those types of stocks in particular.

Monetary Madness

Finally, let’s wrap with two charts from Grant Williams. He talked at length about US monetary policy and the way it has evolved over the years. Here’s a chart summarizing it.

The line colors denote each Fed chair’s tenure, and Grant has calculated their average federal funds rates. Younger readers will probably find those Volcker years incomprehensible. 20% overnight rates? Yes, it happened. I remember having a bank line from which I borrowed at 20%. And was happy to get it. And rates were 10% or close to it for more than five years. Hard to imagine now, even for us graybeards who lived through that time.

In any case, I suspect Jerome Powell will break the pattern of each chair’s delivering lower rates than the last. Yellen’s 0.5% average will be hard to beat – though if we get into a recession, he may well try.

Grant also showed this next one, which adds the 10-year bond yield to the chart above. It looks similar to Louis Gave’s 30-year yield chart but goes back further. Here again we see a nice downtrend that appears to be getting broken.

Ominously, you can see from Grant’s labels with arrows that peak yields tended to correspond with crises. If the current breakout persists, it is probably going to get its own label, and I bet we won’t like it.

We’ll conclude our spring chartfest there. If you want your own SIC Virtual Pass that includes the complete slide collections plus audio and video of all the presenters, click here.

Charlotte, Fort Lauderdale, Chicago, and Raleigh

You may have noticed in this week’s Outside the Box that I’m pondering some changes, along with my management team. I am finding myself busier and busier, mostly for good reasons, but my exploding to-do list is forcing me to re-examine priorities. My natural optimism makes me think I can do everything. The reality is, I can’t. I need to focus more energy on researching and writing, not to mention producing revenue, as well as thinking about portfolio construction; but I also want to keep bringing you free letters like this one. Somewhere in there is a happy medium. I’d like your feedback, so please take this short, anonymous survey.

I am home next week, but in April and May I travel to Charlotte, Fort Lauderdale, Chicago, and Raleigh for mostly private speaking engagements. The exception is a seminar open to financial advisors and brokers and sponsored by S&P, happening in Charlotte on April 11. The event is built around the theme of strategic and tactical ETF trading strategies.

The weather is beautiful this weekend in Dallas. The Mavericks are in a home stand, and I get to watch some pro hoops. As a side note, the new tax bill no longer allows companies to buy game tickets, give them away, and deduct the cost. I am wondering how that will impact revenue, especially for all those suites. My ticket partner used them to reward his best salesmen and now may not take his half. I will either find a new ticket partner or two, or I will have to let my tickets go back after 35 years, which is a shame because I have really good seats. But at some point you have to rationalize all those costs. Scalping a ticket or three or four a season would be a whole lot cheaper; but then again, if I find a partner…? We’ll see. Let me wish you a Happy Easter and/or Passover. Have a great week!

Your going to relax for the whole weekend for once analyst,

John Mauldin

Question Your Assumptions

I always thought I would learn more as I grew older. In fact, the opposite is happening: The older I get, the more I realize how much I don’t know. Maybe that’s why my search for answers seems to widen and intensify each year.

If you're looking for the 'next Bitcoin'... You're missing the bigger picture.

Our questions differ, but we’re all seeking answers. Our digital technologies, led by search, theoretically make it easy to find answers, too – but they aren’t necessarily the right ones. This is a growing problem. Whatever crazy thing you want to believe, a quick internet search will turn up some “expert” to confirm you’re right.

In Niall Ferguson’s latest book, The Tower and the Square, he spends a good part of one chapter documenting the high percentage of people, not just in the US but all over the world, who believe in one form of conspiracy theory or another. That would be funny if it weren’t so sad. One of the things Niall points out is that the dominance of Facebook and Twitter has tended to break us down further into tribes, where we increasingly talk just to our own kind, reinforcing our parochial beliefs and idiosyncrasies.

Worse, we are increasingly overconfident in our own beliefs, even without expert confirmation.

That’s no surprise to stock traders; they’ve long known that the crowd is often wrong. But they also know that the crowd can believe itself to be right a lot longer than skeptics think it can.

That’s how we get asset bubbles.

Today’s Outside the Box is a short Quartz article by Olivia Goldhill, discussing a new paper by social psychologist David Dunning. Extreme wonks might recognize the name because, with Justin Kruger, he defined the “Dunning-Kruger effect.” It says that people who lack knowledge on a particular topic tend not to recognize their lack. In other words, we don’t know enough to know how little we know.

In his latest research, Dunning says we often make bad decisions, not because other people trick us, but because we trick ourselves. “To fall prey to another person you have to fall prey to your belief that you’re a good judge of character, that you know the situation, that you’re on solid ground as opposed to shifty ground,” he says.

When we were all living in small bands on the savannah, this was actually a good behavioral trait to have. But then it was pretty easy to see who we could trust and who we couldn’t, because the decisions we were making were basically pretty simple. The world has gotten extraordinarily more complex, and we often end up relying on “experts” to make decisions for us, based on their training and knowledge, when in reality they bring their own biases, assumptions, and agendas –limitations that often they aren’t even aware of. As I write this, I can’t help but think of Fed economists, but the problem is pervasive.

We’re hit with such a constant tidal wave of information that no one person can stay on top of it anymore. So what we are “sure” about is no longer as sure as we once thought it was. In a world of social media, where we are breaking up into tribes that live in their own echo chambers (rather than as one big happy family, which is what the developers of social media thought we would become), it’s harder to know what is right and true, and thus the shout goes up, “Fake news!”

My Mauldin Economics colleague Patrick Watson has recently taken note of research similar to Dunning’s. In last week’s Connecting the Dots, he described a neuroscientific study showing that car dealers – experts on selling cars – have almost no idea what motivates car buyers. The researchers call this “expert blindness.” Our own knowledge can keep us from seeing what’s real.

That’s a pretty deep thought, but it’s an important one that we should all keep in mind. It tells me I should question my assumptions and do more research before I make important decisions.

As should we all. So read this Outside the Box and then resolve to question yourself.

On a related note, I’d like to ask your help. It is increasingly clear, given the multiple demands on my time, that I need to streamline my writing schedule. Producing both Thoughts from the Frontline and Outside the Box is not getting any easier, given the seemingly ever-increasing amount of research I have to do to stay on top of my game. And there’s just more – a lot more – going on in my business life than there was five or ten years ago.

We’re exploring some new ideas that will let me continue to deliver the quality information you deserve and even to improve it. I know change is hard (especially for me), and I also know some of you may have ideas I haven’t considered.

Your constantly questioning his assumptions analyst,

John Mauldin, Editor
Outside the Box

The Person Who’s Best at Lying to You Is You

By Olivia Goldhill

In 2008, the psychiatrist Stephen Greenspan published The Annals of Gullibility, a summary of his decades of research into how to avoid being gullible. Two days later, he discovered his financial advisor Bernie Madoff was a fraud, who had caused Greenspan to lose a third of his retirement savings.

This anecdote, from a presentation by University of Michigan social psychologist David Dunning, due to be presented at the 20th Sydney Symposium of Social Psychology in Visegrád, Hungary in July, highlights an unfortunate but inescapable truth: We are always most gullible to ourselves. As Dunning explains it, Greenspan – despite being the expert on gullibility – fell prey to Madoff’s fraudulent behavior not simply because Madoff was some master manipulator, but because Greenspan had, essentially, tricked himself.

“To fall prey to another person you have to fall prey to your belief that you’re a good judge of character, that you know the situation, that you’re on solid ground as opposed to shifty ground,” says Dunning. Greenspan, Dunning notes, failed to follow his own advice and take appropriate cautionary steps before trusting someone in a field he knew little about. Though he wrote the book on how not to be overly confident of your own judgments, Greenspan went against own advice when he handed over his savings without properly interrogating both Madoff’s confidence in himself, and his own sense of confidence in Madoff. Had he followed his own counsel, Greenspan would have recognized he knew little about financial investments, and would have done far more research before deciding to hand over his money to Madoff.

Dunning is an expert on the human tendency to overestimate confidence in our own knowledge and beliefs. In 1999, together with social psychologist Justin Kruger, Dunning identified the co-eponymous Dunning-Kruger effect: people who are incompetent and lack knowledge in a field tend to massively overestimate their abilities because, quite simply, they don’t know enough to recognize what they don’t know. So hugely unqualified people erroneously believe that they’re perfectly qualified. (This effect that has an unfortunate tendency to create the worst possible bosses. It’s also the opposite of imposter syndrome, which describes when qualified people worry that they aren’t qualified.)

In his latest presentation, Dunning highlights the studies that collectively show how we repeatedly and consistently fool ourselves into thinking we know more than we do, and so convince ourselves that our opinion or choice is right – even when there’s absolutely no evidence to support this. There are dozens of studies supporting this hypothesis, showing, for example, that British prisoners rate themselves as more ethical and moral than typical citizens, and that people mistakenly believe they’re better than others at reaching unbiased conclusions.

People tend to be just as confident in their false beliefs as their accurate ones. In one 2013 study, participants were asked a physics question about the trajectory of a ball after it was shot through a curved tube. Those who said the trajectory would be curved (wrong) were just as confident that their answer was correct as those who correctly stated the ball would have a straight trajectory.

A body of research has also established what scientists call “egocentric discounting”: If participants are asked to give an estimate of a particular fact, such as unemployment rate or city population, and then shown someone else’s estimate and asked if they’d like to revise their own, they consistently give greater weight to their own view than others’, even when they’re not remotely knowledgeable in these areas.

Our false confidence in our own beliefs also deters us from asking for advice when appropriate – or to even know to whom to turn. “To recognize superior expertise would require people to have already a surfeit of expertise themselves,” notes Dunning.

Gullibility to oneself is not a modern phenomenon. But the effects are exacerbated in the age of social media, when false information spreads rapidly. “We’re living in a world in which we’re awash with information and misinformation,” says Dunning. “We live in a post-truth world.”

The issue is that the current environment convinces people they’re more informed than they actually are. It might, says Dunning, actually be better for people to feel uninformed. “When people are uninformed, they know they don’t know the answer,” he says, and so they will be more open to hearing from others with real expertise. If we think they know enough, however, we’ll just “cobble together what seems to us to be the best response possible to someone asking us our opinion, or a policy, or what we think,” says Dunning. And, he adds, “unfortunately we’re programmed to know enough to cobble together an answer.”

There’s no quick fix to this, but there is a key step we could take to avoid being so willfully misinformed. We need to not only evaluate the evidence behind newly presented facts and stories, but evaluate our own capability of evaluating the evidence.

The same questions we consider when evaluating whether to trust another person should apply to ourselves: “Are you too invested in this thought or belief you have? Are you really giving the conclusions you’re reaching due diligence? Are you in over your head?”, says Dunning.

That said, constantly questioning ourselves would be impractical, leading to a constant state of self-doubt and uncertainty. Most effective, says Dunning, would be to focus on situations that are new to us, and where the stakes are high. “Normally those two situations go together,” says Dunning. “We only buy so many cars in our lives, we only invest large sums of money every so often, we only get married every so often.”

Of course, as that last example shows, at some point you have to give up being savvy and just trust your own judgment – both in yourself and others. Dunning quotes novelist Graham Greene: “It is impossible to go through life without trust…that would be to be imprisoned in the worst cell of all, oneself.”

We can though, learn to be a little more careful and wise. Just as we don’t blindly trust every person we meet, there’s no reason to be utterly trusting and gullible to ourselves.

So What Blows Up Next? Investor Psychology Shifts To The Dark Side  

Facebook is an epic growth story. It now has an astounding 2 billion active users and a stock that – from an already richly-valued level – rose by 53% in the previous year. In February its market cap peaked at $560 billion, a number that exceeds the GDP of many countries. Over 90 percent of Wall Street analysts covering it rated it a “buy.”

Everyone knew that it had data privacy issues but no one cared in the face of that massive subscriber growth.

Then, like flicking a light switch, everyone began to care after all. A data scandal that was simple enough for investors and politicians to understand broke out, and now high-profile users like Elon Musk (who deleted his Tesla and SpaceX Facebook accounts), big investors, and of course spotlight-seeking politicians around the world are all reacting.

Facebook’s market cap is down by $100 billion in the past week.

Before this month, investors were looking for the next Facebook. They still are, but with a completely different set of criteria. Where previously they were seeking companies with soaring popularity and addictive products, now they’re looking for malfeasance and other potential landmines. Does Google have data privacy issues that will come back to bite it?

Has Amazon antagonized the president enough to be slapped with a national sales tax? Did Apple over-price its latest phone to the point that customers don’t want it?

Virtually no one outside of a tiny, long-suffering group of short sellers had been asking these questions. Now everyone is.
And that, in a nutshell, is how markets morph from bull to bear. It’s not about fundamentals, but about which fundamentals are seen to matter. And generally it takes a high-profile object lesson to shift investor psychology from one extreme to the other. During the 2000s housing bubble, for instance, stock prices held up even as mortgage defaults were surging. Then Lehman Brothers collapsed and all anyone wanted to know was “which bank is next?” From CNN in 2008:
Lehman Brothers collapse stuns global markets
NEW YORK — Global markets were reeling Monday after a historic day on Wall Street that saw two famous names become the latest victims of the credit crunch. 

The leading U.S. investment bank Lehman Brothers filed for bankruptcy and brokerage Merrill Lynch was the subject of a $50 billion buyout by Bank of America. 
The fate of other big name financial institutions remained in doubt and stock prices plunged in Asia, Europe and the United States. In New York, the Dow Jones Industrial Average closed 504 points down, or about 4.4 percent. The Nasdaq composite lost 3.6 percent, its worst single-session percentage decline since March 24, 2003. It left the tech-fueled average at its lowest point since March 17 of this year.
In Europe, FTSE index in London declined 3.92 percent while the Paris CAC 40 was down 3.78 percent. It was the worst day for the index since the 9/11 terror attacks in 2001. Major Asian indexes were closed but India’s Sensex fell 5.4 percent, Taiwan’s benchmark dropped 4.1, Australia’s key index dropped 2 percent and Singapore fell 2.9. Check markets 
The turmoil at Merrill Lynch and Lehman is bound to mean job losses in the already hard-hit financial services industry, but so far neither company has indicated how many will be cut. “This crisis is clearly deeper than anybody had imagined only a short time ago,” Peter Stein, an associate editor at the Wall Street Journal in Asia, told CNN.

Of course the only way the markets could have been “stunned” in September 2008 is if they were willfully blind in August 2008.
Now fast forward to the current bull market, in which FANG companies put up massive growth numbers that convinced the world that growth would overcome all obstacles. But those companies (as big, fast-growing companies tend to do) have apparently cut some serious corners, and suddenly the consequences of those mistakes are what matter.

Now the question is whether a “Lehman moment” is coming that pushes the market’s mood from “anxiously watching” to full-on panic. That’s unknowable before-hand, but the potential candidates are numerous. Tesla, for instance, is an easy target, since it’s running out of cash just as its bonds are tanking, which means its next financing is going to be brutal (full disclosure: Members of the DollarCollapse staff are short this and several other Big Tech stocks).

Should the Big Four accountancy firms be split up?

Two experts debate how best to reform auditing

Natasha Landell-Mills and Jim Peterson

© Bill Butcher

Yes — Separating audit from consulting would prevent conflicts of interest

Auditors are failing investors. The situation has become so dire that last week the head of the UK’s accounting watchdog said it was time to consider forcing audit firms to divest their substantial and lucrative consulting work, writes Natasha Landell-Mills.

This shift from the Financial Reporting Council, which opposed the idea six years ago, is welcome. But breaking up the Big Four accountancy firms — PwC, KPMG, EY and Deloitte — can only be a first step. Lasting reform depends on auditors working for shareholders, not management.

Auditors are supposed to underpin trust in financial markets. Major stock markets require listed companies to hire auditors to verify their accounts, providing reassurance to shareholders that material matters have been inspected and their capital is protected. In the UK, auditors must certify that the published numbers give a “true and fair view” of circumstances and income; that they have been prepared in accordance with accounting standards; and that they comply with company law.

But audit is failing to meet investors’ expectations. The failure of Carillion, linked to aggressive accounting, is just the latest high profile example. And this is not just a UK phenomenon. The International Forum of Independent Audit Regulators found that 40 per cent of the audits it inspected were sub-standard.

Multiple market failures need to be addressed. The most obvious problem is that audit quality is invisible to those whom it is intended to benefit: the shareholders. It is difficult to differentiate good and bad audits. Even with the introduction of extended auditor reports in the UK (and starting in 2019 in the US), formulaic notes about audit risks often hide more than they convey.

Even when questions are raised about the quality of audits, shareholders almost always vote to retain auditors, with most receiving at least 95 per cent support. Last year, 97 per cent of Carillion shareholders voted to re-appoint KPMG. Lack of scrutiny creates space for conflicts of interest. Auditors who feel accountable to company executives rather than shareholders will be less likely to challenge them. These conflicts are exacerbated when audit firms also sell other services to management teams, particularly if that consultancy work is more profitable.

The dominance of the Big Four in large company audits is another concern: when large and powerful firms are able to crowd out high quality competitors, the damage is lasting.

Taken together, these failures have resulted in a dysfunctional audit market that needs a broad revamp. Splitting audit from consulting would prevent the most insidious conflict of interest. When non-audit work makes up around 80 per cent of fee income for the Big Four (and just over half of income from audit clients), the influence of this part of the business is huge.

Current limits on consulting work have not eliminated this problem. They are often set too high or can be gamed, while auditors can still be influenced by the hope of winning non-audit work after they relinquish the audit mandate.

There is quite simply no compelling reason why shareholders should accept these conflicts and the resulting risks to audit quality introduced by non-audit work. But other reforms are necessary.

Auditors should provide meaningful disclosures about the risks they uncover. They need to verify that company accounts do not overstate performance and capital and that unrealised profits are disclosed.

Engagement between shareholders and audit committees and auditors should become the norm, not the exception. Shareholders need to scrutinise accounting and audit performance, and use their votes to remove auditors or audit committee directors where performance is substandard.

Finally, the accounting watchdogs must be far more robust on audit quality and impose meaningful sanctions. Even the best intentioned will struggle against a broken system.

No — Lopping off advisory services would hurt performance

The recent spate of large-scale corporate accounting scandals is deeply worrying and raises a familiar question: “Where were the auditors?” But the correct answer does not involve breaking up the four professional services firms that dominate auditing, writes Jim Peterson.

Forcing Deloitte, EY, KPMG and PwC to shed their non-audit businesses would neither add competition nor boost smaller competitors. Lopping off the Big Four’s consulting and advisory services would degrade their performance, weaken them financially, and hamper their ability to meet the needs of their clients and the capital markets.

Although the UK regulator is raising competition concerns, the root problem is global. The growth of the Big Four, operating in more than 100 countries, reflects their multinational clients’ needs for breadth of geographic presence and specialised industry expertise.

The yawning gap in size between the Big Four and their smaller peers has long since grown beyond closure: even the smallest, KPMG, took in $26.4bn in 2017, three times as much as BDO, its next nearest competitor. If pressed, risk managers of the smaller firms admit to lacking the skills and the risk tolerance even to consider bidding to audit a far-flung multinational.

The suggestion that competition and choice would be increased by splitting up the Big Four is doubly unrealistic. Forcing them to spin off their non-auditing business would not create any new auditors.

We would continue to see dilemmas like the one faced by BT last year when it set out to replace PwC after a £530m discrepancy was uncovered in the accounts of its Italian division. The UK telecoms group ended up picking KPMG for want of alternatives, even though BT’s chairman had previously been global chairman of KPMG.

Similarly, Japan’s Toshiba tossed EY in favour of PwC in 2016, only to suffer disagreements with the second firm — this led to delays in its financial statements and an eventual qualified audit report. Wish as it might, Toshiba has no further choices, because of business-based conflicts on the part of Deloitte and KPMG.

A split by industry sector — say, assigning auditing of banking and technology to Firm A-1, while manufacturing and energy go to new Firm A-2 — would be no better. Each sector would still be served by just four big firms. If each firm were split in half, the two smaller firms would struggle to amass the expertise, personnel and capital necessary to provide the level of service that big companies expect.

Splitting auditing from advisory work is a solution in search of a problem. Many jurisdictions, including the UK, EU and US, restrict the ability of firms to cross-sell other services to their audit clients. Concerns about inherent conflicts of interest are overblown.

The enthusiasm for cutting up the Big Four also fails to recognise how the world is changing. The rise of artificial intelligence, blockchain and robotics is reshaping the way information is gathered and verified. Auditors will need more — rather than less — expertise.

Warehouse inventories, crop yields and wind farms will soon be surveyed rapidly and comprehensively in ways that could easily displace the tedious and partial sampling done for decades by squadrons of young audit staff. But to take advantage of these advances, auditors need to have the scale, the financial strength and the technical skills to develop and offer them.

These tools will also deliver data that management needs for operational and strategic decision making. If auditors are to be barred from providing this kind of advisory work, the legitimacy of methods that have prevailed since the Victorian era is under threat. Investors will require some sort of audit function, but who would provide it? Splitting up the Big Four will achieve nothing if they fail and are replaced by units of Amazon and Google.

Auditors should be held accountable for their mistakes, but these issues are too complex for simplistic solutions. Rather than a quick amputation, we need a full-scale re-engineering of the current model with all of its parts.

Natasha Landell-Mills is head of stewardship at asset manager Sarasin & Partners. Jim Peterson is author of ‘Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms’


Peru’s President Pedro Pablo the Brief

Lessons from another fallen leader

EVER since it began in July 2016 the presidency of Pedro Pablo Kuczynski in Peru looked like an accident waiting to happen. He squeaked into a run-off election only after his supporters in Peru’s media and business establishment helped to press the electoral authority to disqualify a more popular rival, Julio Guzmán. After he unexpectedly defeated Keiko Fujimori, a conservative populist, in the run-off by just 0.2% of the vote, she exercised her pique by using the congressional majority gained by her Popular Force (FP) party to harass Mr Kuczynski’s government. After narrowly surviving one impeachment attempt in December last year, PPK (as Peruvians know him) resigned on March 21st when defeat in another became inevitable. Having served just 20 months, he became the 19th elected president in Latin America in the past 30 years to fail to complete his term.

Many of these were victims of the instability inherent in Latin America’s unique combination of directly elected presidents and legislatures chosen by proportional representation. This arrangement means that presidents often lack congressional majorities. In PPK’s case, there were two aggravating factors. The presence of a host of small parties meant that the electoral system rewarded FP with 73 of the 130 seats in the unicameral congress, although it won just 36% of the vote. And Peru’s constitution, unusually for Latin America, contains parliamentary elements: congress can oust ministers and cabinets almost at will, and proceeded to do so.
Any president would have been tested by such a spiteful and powerful opponent as Ms Fujimori. But PPK played a big part in his own downfall. Although he had served in past governments, for most of his life he worked as an economist and businessman. He showed a disastrous disdain for politics. He appointed cabinets in his own image, stuffed with technocrats and business people. Friendship with the president outweighed knowledge of ministerial briefs or of a large and socially diverse country. A clearer political and communications strategy might have kept public opinion on his side and thwarted Ms Fujimori. As it was, his government soon seemed rudderless and impotent.

Faced with impeachment, his response was a caricature of political bargaining. He struck a secret deal with Kenji Fujimori, Keiko’s estranged brother, who was an FP congressman, to pardon their father, Alberto, a former president jailed for human-rights abuses. The pardon was controversial. PPK gained the votes of Kenji’s nine followers in congress, but he lost more: the backing of part of the left, of some of his own legislators and of many voters. Kenji was an ally of dubious worth. The release of clandestine videos of him and his allies offering FP legislators bribes in the form of public contracts made PPK’s defeat in a second impeachment certain.

It was PPK’s failure to distinguish between private business interests and public responsibility that had rendered him vulnerable to impeachment in the first place. Companies that he owned or to which he was linked earned $4.8m in fees from Odebrecht for consultancy work, some awarded when PPK was a minister in 2001-06 and signed a big public contract granted to the Brazilian construction company. This may have been legal, but it was unethical. That politics matters, that technocracy alone is not enough and that public servants must be seen to avoid conflicts of interest are lessons that appear to have been learned by two more successful businessmen-turned-presidents, Argentina’s Mauricio Macri and Sebastián Piñera of Chile, but not by PPK.

As for Peru, it may gain a respite under Martín Vizcarra, PPK’s vice-president, who has taken over the top job. A former provincial governor who belongs to no party, he has a record as a negotiator. FP may give him an easier ride, at least until after local elections in October. Ms Fujimori is facing an investigation over a claim by Odebrecht (which she denies) that it gave her campaign money in 2011.

For much of this century, Peru has been an economic success. But Peruvians are rightly disillusioned with their politicians. Four of the five living elected presidents have been accused of corruption. Growth has fallen to around 3% a year. Reviving it requires institutional reforms, especially of local government, education, the judiciary and the political system. The fujimoristas have blocked them. The fact that they are divided and in disarray offers an opportunity. Understandably, Mr Vizcarra’s instinct may be to play safe. But his best hope of surviving until 2021 is to be ambitious, and to set out a bold programme for a better country that Peruvians can rally around.

Lessons from the Iraq War After 15 Years

Javier Solana

US soldiers take oath to the US army on an Iraqi destroyed tank in Iraq

MADRID – It has been exactly 15 years since the start of one of the most fateful episodes of the early twenty-first century: the Iraq War. After the attacks of September 11, 2001, the French newspaper Le Monde famously declared, “Nous sommes tous Américains” (“We are all Americans”), and even predicted that Russia would become America’s main ally. But US President George W. Bush’s invasion of Iraq in March 2003 blew that prospect to smithereens.

We now know that the war, in addition to causing many of the Middle East’s current troubles, marked the beginning of the end of America’s post-Cold War hegemony. We also know that, though it was sold as part of the “war on terror,” the groundwork for the invasion had been laid well before 9/11.

As early as January 1998, the neoconservative Project for a New American Century (PNAC) sent a letter to then-President Bill Clinton urging him to topple Saddam Hussein. And, after winning the presidency in 2000, Bush declared Iraq one of his top two security priorities. Not coincidentally, Bush’s administration included ten of the 25 signatories of the PNAC founding statement of principles, including Dick Cheney as vice president and Donald Rumsfeld as secretary of defense.

Soon enough, the Bush administration became obsessed with promoting the idea that Iraq had weapons of mass destruction, despite the absence of any conclusive evidence. In September 2002, Rumsfeld received a now-declassified intelligence report stating that, “We don’t know with any precision how much we don’t know” about the “status of WMD programs” in Iraq. It made no difference.

In all likelihood, the Middle East would have been spared a great deal of suffering had the United States acted with more caution and rigor, as Hans Blix – the head of the United Nations Monitoring, Verification, and Inspection Commission – had advised. In May 2003, while aboard the aircraft carrier USS Abraham Lincoln, Bush delivered a speech in front of a banner declaring “Mission Accomplished.” But if the mission was to free Iraq from terror, reconstruct the country, and enhance security on all levels, it was an absolute failure.

It is generally agreed that the war in Iraq caused many more problems than it resolved.

Prominent US politicians who supported the 2003 invasion – including many Republicans – now admit that it was a mistake, as do a majority of Americans. But, while the 2003 invasion was a profoundly misguided policy, both in form and in substance, the chaos that consumed Iraq and the rest of the region stem from additional mistakes made by US policymakers after Saddam had been removed from power.

Above all, there was the Bush administration’s “de-Baathification” policy, which sought to eliminate every vestige of Saddam’s neo-Baathist regime. Iraq is a Shiite-majority country, but Saddam’s political apparatus was dominated by Sunnis, many of whom had acquired deep religious convictions during a period of Islamization in the 1990s. After being excluded from the reconstruction process, many Sunnis turned to militant sectarianism.

De-Baathification also led to the dismantling of the Iraqi army. Thousands of military personnel, suddenly deprived of income and status, found new hope in the incipient Salafist Sunni insurgency, led by Al Qaeda in Iraq, the precursor to the Islamic State (ISIS). The insurgents opposed not just the US occupation, but also its perceived beneficiaries: mainly the Shia majority.

Some ex-Baathists ended up in US detention centers, where abusive practices were widespread. While interned in centers like Camp Bucca in Southeastern Iraq, ex-Baathists and Salafists commingled, and the military experience of the former fused with the ideological extremism of the latter. By the time ISIS proclaimed its “caliphate” in 2014, an estimated 17 of its 25 principal commanders – including the group’s leader, Abu Bakr al-Baghdadi – had spent time in US detention centers between 2004 and 2011.

Meanwhile, sectarianism was creating havoc in Iraq’s Shia-led government. In 2010, the incumbent prime minister, Nouri al-Maliki, was re-elected, though his State of Law Coalition had won fewer seats than the more moderate Iraqi National Movement, led by Ayad Allawi. Barack Obama’s administration could have weighed in to help Allawi form a government, but instead enabled Maliki – Iran’s preferred choice – to hold onto power. Maliki’s policies became increasingly personalistic, clientelistic, and polarizing, fueling Salafist jihadism, which had sustained several blows prior to the 2010 election.

The Obama administration’s refusal to back Allawi was a precursor to its premature withdrawal from Iraq at the end of 2011. Both episodes cleared the way for the jihadist insurgency that was already moving into neighboring Syria. Less than three years later, the US was forced to return to Iraq; soon thereafter, it also launched an intervention in Syria.

Now, after a long and arduous campaign, ISIS has lost most of the territory it once held in Syria and Iraq. But the past 15 years have demonstrated that we cannot be complacent. Depriving ISIS of its territory does not eliminate the ideology that sustains it. In fact, it might radicalize it even further.

Looking ahead, the hope is that Iraq’s general election in May will deliver a government that is committed to ruling through consensus, maintaining stability, and defending the country’s institutions. Moreover, the next government will have to reach out to Iraq’s independence-minded Kurds and find a satisfactory way to integrate them into the political process.

For the US, in particular, one of the most important lessons of the past 15 years is that military interventions aimed at regime change will almost always lead to disaster, especially in the absence of a sensible plan for what comes next. The Iraq War showed that the cost of unilaterally forsaking diplomatic channels can be enormous.

One hopes that the Trump administration – particularly the incoming secretary of state, Mike Pompeo – will heed these lessons as tensions with Iran heat up. Iran’s growing regional influence owes much to America’s mistakes in Iraq, starting with the abandonment of diplomacy. A similar US approach to Iran would lead to another generation – or more – of turmoil in the Middle East.

Javier Solana was EU High Representative for Foreign and Security Policy, Secretary-General of NATO, and Foreign Minister of Spain. He is currently President of the ESADE Center for Global Economy and Geopolitics, Distinguished Fellow at the Brookings Institution, and a member of the World Economic Forum’s Global Agenda Council on Europe.

US-Saudi Relations and a Meeting in Washington

By George Friedman

The British statesman Ernest Bevin once said the kingdom of heaven runs on righteousness, but the kingdoms of the Earth run on oil. That might have been the motto that drove British foreign policy in the Middle East after World War I, and then U.S. policy after World War II.

But over the next two weeks, as the Saudi crown prince tours the United States, meeting with the president, other government officials and business leaders, the message will be decidedly different. Oil hasn’t lost its indispensability, but Saudi oil has.

No Effort too Great

Attention to the presence of oil in the Middle East grew as the industrial revolution shifted from coal to oil. When the Ottoman Empire was defeated in World War I, the British, French and Russians seized the opportunity to reshape the political structure of the region around its oil. Borders were imposed on the basis of oil, without regard for the nations themselves. Those areas that had oil were frequently those whose boundaries were the most difficult to draw.

Some of the most valuable oil fields were to be found on the eastern coast of the Arabian Peninsula. The British crafted a nation – ruled by a family, the Sauds – to maintain peace on the peninsula so that oil could be extracted peacefully. American policy in the region ultimately derived from British policy. The British sought to secure the production of oil, and so did the Americans. Both therefore maintained close relations with oil producers, and with the Saudis in particular.

Saudi Arabia had no qualms about weaponizing its oil supplies. In 1973, after a war between Israel and neighboring Arab states, the Saudis crafted an oil embargo targeting supporters of Israel, including the U.S. and its allies. The result was massive economic dislocation throughout the industrial world. The Saudis and other Arabs controlled enough of the world’s oil that they could not only control the price but also the tempo of life in the industrialized world. Whether the embargo was a result of concern for their Palestinian brethren or the desire to surge oil prices (or both) is debatable. What can’t be denied was that the Saudis controlled economic life in much of the world.

Washington got the message. It became fixed U.S. policy to maintain good relations with the Saudis and to protect them from political and military threats. The Americans’ commitment was put to the test in 1990, when Saddam Hussein’s Iraq invaded Kuwait, another significant oil producer. From Iraq’s new position, it was able to threaten the vital oil fields in eastern Saudi Arabia. By this point, the Soviets were far less of a threat than they had been, but U.S. policy was still shaped by the Cold War. Iraq was vaguely aligned with the Soviets, and the American nightmare was that if the Soviets seized the Saudi oil fields, they would have the United States and its alliance structure by the throat.

The U.S. massed an enormous military force in Saudi Arabia, first to protect the Saudi oil fields, and then to drive Saddam out of Kuwait. About half a million U.S. troops were used. No effort was too great for the protection of Saudi Arabia’s oil.

Reduced Importance

The U.S. commitment to the Saudis remains intact, but the meaning of the commitment has shifted for two reasons. First, the geopolitics of global oil has changed. A combination of events, particularly the surge in U.S. oil and shale gas production and the use of natural gas in place of oil in general, has reduced the importance of Saudi oil. Saudi supplies are still extremely important to the world, but the Saudis could not pull off an oil embargo today, and they no longer control the price of oil.

Second, in 1990 the U.S. was already the sole superpower, with a vast military force that for nearly two generations had been preparing for a war in Europe. That force and its allies overwhelmed the Iraqis. It was the greatest American military success since World War II. But hidden within it were dangerous flaws. It took about six months to build a force capable of retaking Kuwait. During that time, a more ambitious Saddam might have taken the Saudi oil fields. Moreover, the “desecration” of Saudi Arabia by the stationing of U.S. troops was one of the impulses behind the creation of al-Qaida. The flaws and consequences of the war exist still today.

And today, the U.S. is not coming off a peaceful triumph. American troops have been fighting in the Islamic world since 2001, with a consistently unsatisfactory outcome. Gone is the eagerness of the U.S. military to show its prowess. The force has been drained by a generation of warfare.

What this means is that, for a multitude of reasons, the political basis for the defense of Saudi Arabia has diminished. The American public is not excited about the prospect of another war.

Militarily, the same problem remains – the time to theater creates sizable openings for an aggressive power, Iran in this case. Instead of defending the oil fields, in the next war the U.S. might have to retake them.

Another large U.S. troop presence in parts of Saudi Arabia, however well-intentioned it would appear to the United States, could lead to unpleasant consequences in the Islamic world. Saudi oil no longer defines the global market. Even if Iran could seize Saudi Arabia’s oil – and Iran’s own military might is dubious – the only reason to seize oil now is to sell it. As far as the Americans and other consumers are concerned, whether it is Iran or the Saudis in control, the oil will flow.

The Reality of the Moment

The United States does not want Iran to dominate the Arabian Peninsula’s oil, and it will act within its means and interest to prevent it. But the U.S. means and interest aren’t what they were in 1990.

The kingdoms of Earth are still driven by oil (wind power notwithstanding), but the world is not short of oil right now. Britain imposed its power to control Middle Eastern oil, the United States inherited that power, and now that power is out of balance with the need. The global industrial base simply does not rely on Arabian oil fields anymore.

It is in this context that the Americans and the Saudis meet. They are still friends, whatever that means in the context of global politics. They have common enemies. But for the Americans, the commitment to the Saudis is shaped by the reality of this moment, not the last. Containing Iran is important, but it cannot be something the U.S. does alone. It is in the interest of Sunni powers like Turkey to deal with matters like Iran, backed to some extent by the United States.

But whatever the final communique of the meeting says, this is not 1990. Shifts in reality emerge at times of greatest stress and are the greatest surprise. They shouldn’t be.

How One Investor Turned a Bet on the Swiss Central Bank Into Millions

Theo Siegert’s stake doubled in value last year to nearly $25.3 million

By Brian Blackstone

The name of the Swiss National Bank is seen in German, French and Italian over the entrance of the bank’s headquarters in Zurich. Photo: arnd wiegmann/Reuters 

ZURICH—Meet the biggest winner of one of the past year’s best equity bets: a German investor who bought big into Switzerland’s central bank.

Düsseldorf, Germany-based businessman Theo Siegert’s stake in the Swiss National Bank SNBN 0.34%▲ soared in value over the past year as the central bank’s stock price gained over 250%. 
The SNB is a rarity among central banks—Japan and Belgium are others—in that it has listed shares. The SNB’s shares have more than tripled since the start of last year—even though analysts struggle to explain why—and traded at 5,860 Swiss francs early Thursday.

Only one stock on the Stoxx Europe 600 index gained by more: Belgian drugmaker Ablynx NV surged after being bought out by French rival Sanofi in January.

Mr. Siegert was the SNB’s second-largest shareholder last year, according to the SNB’s annual report released Thursday, ceding the top spot he held at the end of 2016 to the Swiss canton of Berne. Mr. Siegert reduced his stake by 650 shares last year, leaving him with 6,070 shares at year-end. Those 650 shares could have been worth well over two million francs, depending on when they were sold.

Even accounting for the lower number of shares, Mr. Siegert’s stake doubled in value last year, to nearly 24 million francs ($25.3 million), based on the year-end closing price. His 6,070 shares were worth 35 million francs on Thursday, assuming he has held on to them this year.

Mr. Siegert didn’t respond to requests for comment. He has previously declined to comment on his investments.

German investor Theo Siegert is the SwissNational Bank's largest private shareholder,and the value of his stake has soared alongwith the SNB's share price.

Stake in the Swiss National Bank owned by Mr. Siegert


Mr. Siegert, 70, isn’t a household name even in Germany, where he runs his family business, de Haen-Carstanjen & Söhne. It was originally set up as a trading business 200 years ago, dealing with goods for drugstores among other things. Today it is a family office, managing investments. He sits on the boards of several large German companies including E. ON SE , Henkel AG and Merck KGaA, according to his company’s website.

Still, the root of the gains for Mr. Siegert and the SNB’s other 2,191 private investors is a bit of a mystery. The SNB isn’t like other stocks and pays a tiny dividend. It is governed under laws for both public and private institutions, and owned primarily by individual Swiss states, known as cantons, and cantonal banks. Public-sector bodies own almost 80% of voting shares.

Shareholders have no say in the SNB’s monetary policy or how it manages its massive 790 billion franc war chest of foreign-currency stocks and bonds, built up through years of interventions to weaken the franc.

On the plus side, the SNB is ultrasafe. It prints its own currency—and the franc is among the world’s strongest—which it uses to buy assets. When the SNB loses money, it can always print more. Recently, its profit has been on a tear, aided by rising global stock markets, low bond yields and a weaker franc. The SNB earned a record 54 billion francs in profit last year.

Of that, two billion francs went to the federal government and cantons. A paltry 1.5 million francs was paid out as dividends, working out to 15 francs a share, which is capped by law. The rest went to the SNB’s own currency provisions and other reserves.

Among those who didn’t benefit from the SNB’s share-price surge last year: its own three-person governing board. According to the annual report, Chairman Thomas Jordan and the bank’s other two board members, Andrea Maechler and Fritz Zurbrügg didn’t own any SNB shares. The SNB said a “party related to” Mr. Jordan owned one share.

—Nina Adam contributed to this article.