domingo, noviembre 29, 2020



The money doctors

The asset-management industry is at last sorting the quacks from the true specialists, argues John O’Sullivan

In march 1868 a prospectus appeared for a new kind of money-market scheme. The Foreign & Colonial Government Trust would invest £1m ($5m at the time) in a selection of bonds. For £85 an investor could buy one of 11,765 certificates giving an equal share. 

The trust promised a 7% yield. Its aim was to give “the investor of moderate means the same advantages as the large capitalist in diminishing the risk of investing…by spreading the investment over a number of different stocks.” The modern asset-management industry was born.

A week later The Economist ran a leading article broadly welcoming the new trust. But—setting the tone for 150 years of financial punditry—it quibbled about the selected bonds. A chunk was allocated to Turkey and Egypt, countries that “will go on borrowing as long as they can, and when they cease to borrow, they will also cease to pay interest.” 

Fears were expressed that Europe was disintegrating. “In lending to Italy, you lend to an inchoate state; and in lending to Austria, you lend to a ‘dishevelled’ state; in both there is danger.”

The trust was the brainchild of Philip Rose, a lawyer and financial adviser to Benjamin Disraeli. His idea of a pooled investment fund for the middle class caught on. In 1873 Robert Fleming, a Dundee-based businessman, started his own investment trust, the First Scottish, modelled on Rose’s fund but with a bolder remit. It was largely invested in mortgage bonds of railroads listed in New York. 

The holdings were in dollars, not sterling. And whereas Rose’s trust was a buy-and-hold vehicle, the trustees of the First Scottish reserved the right to add or drop securities as they saw fit.

Rose’s trust survives to this day, but asset management is now a far bigger business. Over $100trn-worth of assets is held in pooled investments managed by professionals who charge fees. The industry is central to capitalism. 

Asset managers support jobs and growth by directing capital to businesses they judge to have the best prospects. The returns help ordinary savers to reach their financial goals—retirement, education and so on. 

So asset management also has a crucial social role, acting as guardian of savings and steward of firms those savings are entrusted to.

It is a business unlike any other. Managers charge a fixed fee on the assets they manage, but customers ultimately bear the full costs of investments that sour. Profit margins in asset management are high by the standards of other industries. 

For all the talk of pressure on fees, typical operating margins are well over 30%. Yet despite recent consolidation, asset management is a fragmented industry, with no obvious exploitation of market power by a few large firms and plenty of new entrants.

In many industries firms avoid price competition by offering a product distinct from their rivals—or, at least, that appears distinctive. Breakfast cereal is mostly grain and sugar, but makers offer a proliferation of branded cereals, with subtle variations on a theme. 

Asset management is not so different. Firms compete in marketing, in dreaming up new products and, above all, on their skill in selecting securities that will rise in value.

The industry has not performed well. Ever since a landmark paper by Michael Jensen in 1968, countless studies have shown that managers of equity mutual funds have failed to beat the market index. Arithmetic is against them. 

It is as impossible for all investors to have an above-average return as for everyone to be of above-average height or intelligence. In any year, some will do better than the index and some worse. 

But evidence of sustained outperformance is vanishingly rare. Where it exists, it suggests that bad performers stay bad. It is hard to find a positive link between high fees and performance. Quite the opposite: one study found that the worst-performing funds charge the most.

Why do investors put up with this? One explanation is that investment funds are more complex than breakfast cereals. At best they are an “experience good” whose quality can be judged only once consumed. 

But they are also like college education or medical practice: “credence goods” that buyers find hard to judge immediately. Even well-informed investors find it tricky to distinguish a good stockpicker from a lucky one. Savers are keen to invest in the latest “hot” funds. 

But studies by Erik Sirri and Peter Tufano in the 1990s show that, once fund managers have gathered assets, those assets tend to be sticky. They are lost only slowly through bad performance.

Firms have a fiduciary duty to act in the best interest of customers. Securities regulators (eg, the Financial Conduct Authority (fca) in Britain and the Securities and Exchange Commission (sec) in America) oversee asset managers. 

Unlike banks, which borrow from depositors and markets, asset managers are unleveraged and so not subject to intensive rules. 

The assets belong to beneficial investors; they are not held on a firm’s balance-sheet. 

The thrust of regulation is consumer protection from fraud and conflicts of interest. It does not prescribe investment strategies or fees. An investigation by the fca in 2016 found that investors make ill-informed choices, partly because charges are unclear. 

The problem of poor decision-making is most acute for retail investors. But even some institutional investors, notably those in charge of small pension schemes, are not very savvy. 

Around 30% of pension funds responding to a survey by the fca required no qualifications or experience for pension trustees. Investors are a long way from the all-knowing paragons of textbook finance theory.

Medical manners

A paper in 2015 by Nicola Gennaioli, Andrei Shleifer and Robert Vishny argued that fund managers act as “Money Doctors”. Most people have little idea how to invest, just as they have little idea how to treat health problems. 

A lot of advice doctors give is generic and self-serving, but patients still value it. The money doctors are in the same hand-holding business. Their job is to give people the confidence to take on investment risk.

In asset management, as in medicine, manner and confidence are as important as efficacy. “Just as many patients trust their doctor, and do not want to go to a random doctor even if equally qualified, investors trust their financial advisers and managers,” say Mr Shleifer and his co-authors. 

This may explain why investors stick with mutual-fund managers even in the face of only so-so performance. As long as asset prices go up, a rising tide lifts most boats in the asset-management industry—including a lot of leaky vessels.

But the seas are getting rougher. Over the past decade, investors have placed more capital with low-fee “passive” funds. These funds invest in publicly listed stocks or bonds that are liquid—that is, easy to buy or sell. The most popular are “index” funds, run by computers, that track benchmark stock and bond indices. 

The industry’s big winners have been indexing giants whose scale keeps costs down and fees low. The two largest, BlackRock and Vanguard, had combined assets under management of $13.5trn by the end of 2019. The losers were active managers that try to pick the best stocks.

High fees have not disappeared. The boom in passive investing has spawned its antithesis: niche firms, run by humans, in thinly traded assets charging high fees. A growing share of assets allocated by big pension funds, endowments and sovereign-wealth funds is going into privately traded assets such as private equity, property, infrastructure and venture capital. 

What has spurred this shift is a desperate search for higher returns. The management of private assets is an industry for boutiques rather than behemoths. 

But it has its own big names. A quartet of Wall Street firms—Apollo, Blackstone, Carlyle and kkr—have captured much of the growth in assets allocated to private markets.

The shake-up in asset management owes a lot to macroeconomics. The investors who snapped up certificates in Rose’s trust were dissatisfied with 2% interest in the money markets. Today investors would sell their grandmothers for such a yield. Interest rates in parts of the rich world are negative. 

In Germany and Switzerland, government-bond yields are below zero across the curve, from overnight to 30 years. Inflation is absent, so ultra-low interest rates are likely to persist. 

The expected returns on other assets—the yields on corporate bonds, the earnings yields on equities, the rental yield on commercial property—have accordingly been pulled down. The value of assets in general has been raised.

The steady decline of long-term rates is a nightmare for pension funds, because it increases the present value of future pension promises. Industry bigwigs often blame the Federal Reserve and other central banks. 

But interest rates have been falling steadily since the 1980s. There are deeper forces at work. The real rate of return is in theory decided by the balance of supply and demand for savings. 

The balance has shifted, creating a bonanza for asset managers, whose fees are based on asset values.

There are competing explanations for the savings glut. Demography is one: people are living longer, but average working life has not changed much. More money must be salted away to pay for retirement, with much of the saving taking place in the years of peak earnings in middle age. 

A bulge in the size of the middle-age cohort has pushed the supply of savings up. Another factor is the growth of China and other high-saving emerging markets. At the same time, the demand for savings has fallen. 

When Robert Fleming set up his investment trust, enterprises like railways were capital-intensive. Today the value of firms lies more in ideas than in fixed capital. Big companies are self-financing. 

Small ones need less capital to start and grow. The upshot is that more money is chasing fewer opportunities. Investors are responding by trying to keep fund-management costs down and putting more money into private markets in hopes of higher returns than in public markets. 

This response is reshaping the asset-management business.

This special report will consider the outlook for the industry and ask what it means for the economy, for the stewardship of firms, for capital allocation and for savers who place their trust in the money doctors. 

It will examine whether China’s untapped market can be a source of renewed growth. 

A good place to start is with the forces shaping the industry’s elite. 

Investors should take heed of the inflation chatter

Don’t be blindly addicted to free money and risk a shock when conditions change

Gillian Tett

© Ingram Pinn/Financial Times

There are two pieces of good news to celebrate in markets this week. The first is obvious: a fairly effective vaccine for Covid-19 is emerging from Pfizer and BioNTech. Anthony Fauci, the leading US infectious diseases expert, told the Financial Times he expects a second one soon, too.

This has unleashed hopes of an end to the coronavirus lockdowns in 2021. Investors have duly started positioning themselves for economic recovery: the 10-year Treasury yield has edge up towards 1 per cent and the share prices of value stocks have jumped, while those of many tech groups have declined (the latter were considered the primary beneficiaries of lockdowns).

However, the second piece of good news is not so self-evident, and many policymakers would not label it that way at all: there is rising market chatter about the idea that long-dormant inflation risks could return.

This week Goldman Sachs warned clients that a key theme of 2021 will be a sharp steepening of the yield curve, which charts the difference in short-term and long-term interest rates, amid inflation concerns. 

British asset managers Ruffer and Willis Owen are talking about this too. They cite charts of 20th-century financial history that show how prices usually jump after recessionary shocks, usually because of government reflation measures.

So are some government officials. “I do think investors need to start thinking about inflation again,” Wilbur Ross, US commerce secretary, told me this week. Mr Ross does not expect to see “runaway inflation”, but he does think that a zeitgeist shift around inflation is looming and it could spark market repricing. 

This could make investors more wary about bonds, particularly given how many of them the government must sell to cope with yawning deficits.

Officials at the Federal Reserve would beg to differ; indeed, many might deride this chatter as dangerous. After all, they say, the data does not show any price pressure now: the core consumer price index in the US fell sharply during the pandemic and is now running at about 1.6 per cent.

Thelatest US figure might be an understatement. This week economists at the IMF suggested that global inflation has been undercounted by about 0.23 percentage points during the pandemic because statisticians have not updated their consumption metrics to reflect how the lockdown has changed spending patterns.

However, even if “real” US inflation is nearer to 2 per cent, that remains within the Fed’s target range, particularly given that Jay Powell, Fed chair, said in August that 2 per cent is no longer a ceiling, but simply an average target over time.

Moreover, Fed officials do not see higher inflation on the horizon. That is partly because they expect demand to stay weak for some time: as Mr Powell explained last week, they think the spread of Covid-19 will suppress consumer activity for the foreseeable future. His British counterpart, Andrew Bailey, echoes this view.

The other reason that Fed officials think the 20th-century inflation patterns are unlikely to reappear is digitisation. Even before the lockdowns, consumers and corporate executives were becoming more adept at shopping online for services, goods and labour, stoking global competition. The pandemic has significantly intensified this. 

If digitisation suppresses labour costs in many sectors for the foreseeable future, it will keep inflation low.

They are probably quite right, unless, of course, a new outburst of protectionism causes digital integration to collapse. This does mean that the current inflation chatter might be overstated, but the sheer fact that investors are talking about these risks is actually a good, not bad, thing.

In the past few years markets have become dangerously addicted to a one-way bet. Inflation pressures had seemed so unexpectedly muted before the pandemic that investors started to act as if they would never return. 

Then Mr Powell promised in September to keep nominal interest rates at rock bottom levels until 2023. Since then, investors have become even more addicted to free money, or, more precisely, real interest rates that were in effect negative.

This has encouraged complacency around long-term risks in bond markets. It has also sparked the creation of some funky financial structures. Special purpose acquisition companies are a case in point: Spacs have boomed this year. 

Financiers tell me that investors like them because the structure not only offers a possible long-term equity market upside but also a short-term warrant with a yield slightly superior to T-bills. 

Many investors know perfectly well that zero-rate bets will suffer if interest rates suddenly rise. But they also know — to paraphrase the banker Chuck Prince right before the financial crisis — that financiers have to keep dancing if the free money music keeps playing.

That’s why this week’s inflation chatter is good news. It seems unlikely that rapid price growth will in itself pose a risk to the real economy any time soon. What could pose a risk is if the market remains blindly addicted to free money and then experiences a shock when conditions change.

If investors start shifting their portfolios now to embrace a less unbalanced vision of the future, this will help reduce that danger. Fed officials would be foolish to prevent this; whatever happens with a Covid-19 vaccine.

Giant jab

What a vaccine means for America’s economy

Although the coronavirus is spreading unchecked, there are grounds for optimism

On november 9th the end of the coronavirus pandemic came into tantalising sight. Pfizer and BioNTech announced that their vaccine was more effective than expected. 

Investors’ hopes for a stronger economy sent stockmarkets soaring. Ten-year Treasury yields neared 1%, levels last seen in March.

Even before the vaccine news broke, the speed of America’s economic bounceback was exceeding forecasts and surpassing others in the rich world. In April the imf reckoned that gdp would shrink by 6% in 2020. 

It now projects a decline of 4%. Unemployment peaked at 14.7% in April; in June the Federal Reserve had expected it to still be around 9% by the end of the year. It went on to fall below that rate only two months later. In October it stood at 6.9%.

Can a vaccine accelerate the economy’s return to its pre-covid state? The coronavirus is still spreading unchecked, with the burden often falling on the poorest. But many economists had also worried that the pandemic would leave broader economic scars that take time to heal. Here, a look at firms’ and households’ finances offers grounds for optimism.

The resurgence of the virus will put a dampener on the recovery in the months before a vaccine becomes widely available. Infections are rising so rapidly that, in the admittedly unlikely event that current trends were to continue, 1m Americans a day would be catching the disease by the end of the year. 

Renewed local restrictions on activity seem inevitable. That will lower some types of economic activity and could in turn increase the number of people who have lost their jobs permanently.

Still, it seems unlikely that America will enter a double-dip recession, as Europe is expected to. For one thing, it probably will not impose lockdowns as severe as those in Britain, France or Germany. 

High-frequency indicators, including The Economist’s analysis of Google mobility data, suggest that America’s recovery has slowed compared with the summer. But it has not gone into reverse, as it has in Europe. 

And the vaccine could boost the economy in some ways even before it becomes available. Torsten Slok of Apollo Global Management, an asset manager, argues that “households and firms are going to plan ahead, for example by booking travel [and] vacations”.

On the current growth path, at the turn of the year there will still be 10m fewer jobs than there would have been without the pandemic. Output will be some $700bn, or 4%, lower than otherwise. Most forecasters reckon that income per person will not exceed its pre-covid level until 2022, if not later. 

But growth will accelerate as jabs are administered. Everything from theatres to public transport will feel safer. That will further revive the labour market. Before the pandemic over a fifth of workers were in jobs involving close proximity to others.

There are other reasons to think America’s recovery may be faster than after previous recessions. History suggests that recoveries are sluggish when downturns leave deep economic scars. The financial crisis of 2007-09 cast a long shadow over subsequent years in part because of its chilling effect on bank lending, for instance. 

This time around, the effect of school closures on children’s education will be felt for decades to come. But in many other respects there is less evidence of lasting economic damage. 

A wave of bankruptcies and permanent closures has been avoided—especially of small firms, which employ half the workforce. And families’ finances have been resilient.

Start with small firms. At one point in April nearly half of them were closed, according to data from Opportunity Insights, a research team based at Harvard University, as shelter-in-place orders forced closures and fear of the virus prompted people to stay at home. Six months on, many firms are still struggling. 

In early October nearly a third of small firms reported that the pandemic had a large negative effect on business, according to the Census Bureau. One quarter of small businesses remain closed.

But these closures may not become permanent. Total commercial bankruptcy filings are running below their pre-pandemic trend, not to mention the levels of the last recession. 

Such data are not perfect, because not every firm that closes down files for bankruptcy. 

A new paper by economists at the Fed brings together many different measures of “business exit”, and finds “somewhat mixed” evidence that more businesses have gone bust in 2020.

But these unlucky outfits do not appear to represent a large share of employment. In addition, this bankruptcy ripple seems unlikely to turn into a wave. The share of small firms very late on their debt repayments is currently about half its level in 2009. 

Moreover, although the number of active businesses fell during the first wave of the pandemic, it has recovered almost all the lost ground, suggesting that new firms may have come up in place of exiting ones.

Firms’ resilience helps explain why unemployment has dropped much faster than expected. The share of unemployed Americans who say they have lost their job temporarily remains unusually high. Such workers expect to be recalled to their old employer, pointing to further declines in the unemployment rate.

What explains small firms’ surprising resilience? It seems hard to credit America’s business-focused stimulus measures. So far less than $4bn (or 0.02% of GDP) has been doled out by the Fed’s Main Street Lending Programme, which is supposed to channel funds to small and midsized enterprises. 

Economists are also underwhelmed by the Paycheck Protection Programme (ppp), which provided loans to small businesses that are turned into grants as long as recipients do not sack their employees. 

A paper by David Autor of the Massachusetts Institute of Technology and colleagues found that “each job supported by the ppp cost between $162,000 and $381,000 through May 2020”. But this money was poorly targeted: a lot of it was lapped up by firms that planned to continue operating, come what may.

Other factors are more important. Many small firms have managed to trim their outgoings. A recent paper from Goldman Sachs, a bank, finds that in May rent-collection rates fell to 10% or less for firms such as cinemas and gyms. A growing number of landlords now set rent as a percentage of tenants’ revenues, an arrangement that was uncommon before covid-19.

But perhaps the biggest reason for the lack of small-business carnage relates to consumer spending. In September retail sales were more than 5% up on the previous year. Americans appear to have tilted their spending towards small firms over large ones, on the premise that they are less likely to catch covid-19 in places with fewer people. 

The latest figures from JPMorgan Chase, a bank, show that credit-card spending in early November was only marginally lower than it was a year ago.

This relatively sturdy consumption in turn reflects the second factor behind the lack of scarring this time around: resilient household finances. Compared with other rich countries, America has directed more of its fiscal stimulus towards protecting household incomes. 

The federal government sent out cheques worth up to $1,200 per person and temporarily bumped up unemployment benefits by $600 a week. That is not to say that the disadvantaged have not been badly hit: some measures of deprivation have risen sharply. But viewed in aggregate, the financial security of households has proved remarkably stable.

A survey by the Federal Reserve found that 77% of adults were doing “at least OK” financially in July 2020, up from 75% in October 2019, before the pandemic struck. Between March and September households saved 19% of their gross income, up from 6% during the same period the year before, thereby accumulating $1.3trn (6% of gdp) in extra savings.

The stockpile gives consumers a buffer for the coming months, and should help support economic growth. In part for that reason, another blowout stimulus package may not be needed now that a vaccine is near. Lawmakers from the Democratic Party have pressed for spending of $3trn or more. Injecting money into the economy could well hasten the recovery. 

But another $1trn a year in stimulus may be enough to restore normality, assuming that by the start of next year the gap between America’s current and potential GDP may be around 4% of output, and that increases in government spending will translate somewhat less than one-to-one into extra gdp, as the evidence currently suggests.

A lot could still go wrong. Stringent lockdowns, European style, could still derail the recovery. Stimulus may not be passed at all. Either would worsen the economic scars that have so far been minimised, for instance by making it harder for the 3.6m Americans who have been unemployed for more than six months to find work. 

America’s many layers of government could delay the distribution of vaccines, just as they have botched the allocation of covid-19 tests. 

But households and businesses, at least, are in better shape than you might have feared. 

Mitch McConnell, the US Senate’s Republican roadblock

As majority leader, he would stand firmly in the way of Joe Biden’s more progressive plans

James Politi in Washington 

© Joe Cummings

Mitch McConnell took off his mask, cleared his throat, and barely smiled — even as he delivered a victory speech following his re-election last week as US senator from Kentucky.

“The greatest of all human powers is competition” Mr McConnell declared, quoting Henry Clay, his political hero and a Bluegrass state native who served as secretary of state in the 19th century.

That message clearly resonates with Mr McConnell. The 78-year old Republican Senate majority leader has emerged as one of America’s shrewdest political operators. He is a master of raw political battles for conservative goals and, through obstruction and opposition, the scourge of liberal legislative dreams.

Mr McConnell had a surprisingly happy election night. Not only did he retain his own seat, as expected, but many down-ballot Republicans outperformed the pre-election polls to hold office, unlike President Donald Trump. 

As long as GOP candidates prevail in at least one of two run-off contests in Georgia in January, the party will hang on to its majority in the Senate.

This means Democratic president-elect Joe Biden’s agenda would be hostage to Mr McConnell right from the start — sharply complicating his efforts to deal with the coronavirus pandemic and its economic fallout. 

“Biden is going to want a big stimulus package — Mitch is going to be very hesitant to deliver it,” says Heidi Heitkamp, a former Democratic senator from North Dakota.

Born in Alabama, Mr McConnell was struck by polio as a toddler while his father was fighting in the second world war. His mother took him to Warm Springs, the Georgia rehabilitation centre favoured by then president Franklin Roosevelt and the experience — which he still brings up — toughened him up for the rest of this life.

“From not being able to walk he went to being a little league baseball player. That all shows his early perseverance and discipline, which he certainly has in droves,” says Gary Gregg, the political scientist who directs McConnell Center at the University of Louisville.

Mr McConnell moved to Louisville — home of the Kentucky Derby — when he was 14 and got his first taste of politics when he successfully ran for president of his high school’s student council. 

A few years later, he attended the 1963 March on Washington where Martin Luther King Jr delivered his “I have a dream” speech. 

By 1974 he was working in the Department of Justice and, in 1984, he was elected to the Senate as a relatively moderate Republican.

As the party shifted to the right over the subsequent decades, Mr McConnell went along with it. After the 2006 midterm elections sent them into the minority, the Republicans chose him as their leader and he has been ever since.

When Barack Obama was elected, Mr McConnell stamped out hopes of bipartisan co-operation with the Democratic White House fairly quickly. “The single most important thing we want to achieve is for President Obama to be a one-term president,” he told the National Journal in 2010.

After Mr Obama was reelected in 2012, Mr McConnell compromised on a tax deal after negotiating it with Mr Biden. But the Kentuckian made himself notorious for his intransigence during Mr Obama’s last year in office. 

He refused to even hold a hearing on Merrick Garland, the president’s choice to fill the Supreme Court vacancy left open by the sudden death of conservative justice Antonin Scalia in February 2016.

Once Mr Trump was in office, Mr McConnell, with very limited Democratic support, shepherded through Neil Gorsuch, Brett Kavanaugh and, last month, Amy Coney Barrett on to the highest court. This cemented a conservative majority that could last for a generation — a long-term McConnell goal. 

“President Trump’s biggest success in office, frankly, has been his judicial nominees. And that is definitely the result of Senator McConnell’s ability to drive and marshal that process,” says Anne Cizmar, professor of government at Eastern Kentucky University.

After divorcing his first wife, with whom he had three children, Mr McConnell married Elaine Chao, now the transportation secretary. He has always preferred backroom deals to political showmanship. 

Dubbed “Moscow Mitch” by his critics, after he blocked legislation to tighten election security in the wake of Russia’s interference in the 2016 race, Mr McConnell not only brushed off those attacks, but seemed to revel in them — he liked to quip about his other nicknames, “Darth Vader” and “the Grim Reaper”.

He has recently embodied the Republican willingness to tolerate Mr Trump’s more controversial antics. Last week he refused to denounce Mr Trump’s unsubstantiated claims of voter fraud. “Suffice it to say, a few legal inquiries from the president do not exactly spell the end of the republic,” he said.

When he does take up arms, Mr McConnell’s colleagues point out, he gets results, over and over again. “Something I admire most about him is his constant willingness to stand up for conservative principles — even if that means taking the arrows for some of us on his team,” says Shelley Moore Capito, the Republican senator from West Virginia. 

“He’s very measured and keeps his cards close to his chest, but there’s always a method to his tactics.”

Mr McConnell will undoubtedly be a formidable opponent for Mr Biden. 

“He’s not an ideologue, his elixir is power. And his power comes from keeping his caucus together against all odds,” says Ms Heitkamp.