Commies, crooks and bloodshed

A massacre adds to Peru’s election woes

The government blames Marxist militants

As omens go, it was a bad one. 

On May 23rd, less than two weeks ahead of Peru’s presidential run-off election, 16 people were massacred in a remote village in an area known as “vraem”, the valley of the Apurímac, Ene and Mantaro rivers, where coca is grown. 

The area has been under a state of emergency since 2003.

The motive of the killers remains unclear. 

The authorities in Lima rushed to blame remnants of the Shining Path, a radical left-wing insurgency. 

Leaflets justifying the murders were left behind with the bodies. 

In the 1980s and 1990s the Shining Path was responsible for tens of thousands of deaths. 

However, the mayor of Vizcatán del Ene district, where the massacre took place, told reporters that he thought drug traffickers were more likely to be responsible (though both could be true). 

The violence throws a grenade into Peru’s already tumultuous election.

On one side is Pedro Castillo, a rural school teacher who briefly shot to fame in 2017 when he led a long teachers’ strike. 

He is the candidate of Free Peru, a hard-left party. 

On the other is Keiko Fujimori, the daughter of Alberto Fujimori, who as president in 1990-2000 defeated the Shining Path, but who has been serving a 25-year sentence for corruption and other abuses since 2009. 

Mr Castillo and Ms Fujimori were never expected to reach the run-off. 

Neither polled well in the first round campaign. 

But in a crowded field of 18 candidates on April 11th, they came top, with 19% and 13% respectively, putting them through to the final vote.

Ms Fujimori had already been making much of Mr Castillo’s supposed Marxism. 

Billboards across Lima encourage people to vote against communism. 

On May 25th, after the massacre, she accused him of having ties to the militants she considers responsible, and thereby of threatening her father’s legacy. 

Mr Castillo denies any such connections. 

His supporters say he is not a communist. 

But a newly elected congressman from Free Peru, Guillermo Bermejo, is on trial for terrorism for collaboration with the Shining Path 13 years ago. 

(He calls the accusations “pure fantasy”.) 

He has been taped saying that if his party takes power, “we’re not going to give it up...we prefer to stay to establish a revolutionary process in Peru.” 

Mr Castillo has not rebuked him.

Ms Fujimori has problems of her own. 

She has been arrested three times and spent more than a year in prison in pre-trial detention on charges of accepting illegal campaign donations. 

She was released a year ago as part of a scheme to curb the spread of covid-19 in jails. 

The Castillo campaign argues that Ms Fujimori would turn the state into a patronage machine to benefit the rich and well-connected. 

Ms Fujimori says that she is innocent and the victim of political persecution.

Whoever wins on June 6th will face a mistrustful population and a fractured Congress, with ten parties splitting the 130 seats in the unicameral legislature. 

Thanks to a series of scandals and political feuds, Peru has rattled through four presidents in the past five years. 

This election may not end the instability. 

The demise of the dollar? Reserve currencies in the era of ‘going big’

The extraordinary stimulus measures in the US could undermine confidence in the greenback if inflation takes off.

John Plender in London

Billionaire US fund manager Stanley Druckenmiller delivered an apocalyptic warning earlier this month that the dollar could cease to be the predominant global reserve currency within 15 years.

“I can’t find any period in history where monetary and fiscal policy were this out of step with the economic circumstances,” the chief executive of Duquesne Family Office declared.

He is not alone in expressing concerns about excess US demand, a more inflationary environment and accompanying dollar weakness. Such worries have been a contributory factor in the jittery equity markets of the past two weeks.

The dollar has survived at least four decades-worth of predictions of its demise. Yet Druckenmiller’s views on currencies should not be cavalierly dismissed. 

This is the man, after all, who with George Soros “broke” the Bank of England when he made a hugely profitable bet back in 1992 on sterling leaving the European exchange rate mechanism.

Druckenmiller’s warning comes against the background of a longstanding retreat from the dollar as the world has moved gradually towards a multiple reserve currency system. 

Even before the coronavirus pandemic and the extraordinary economic conditions it has generated, there were signs that the dollar’s dominance was slipping.

Billionaire Stanley Druckenmiller is predicting the dollar’s possible end as a reserve currency. His bets on sterling leaving the ERM, along with George Soros, ‘broke’ the Bank of England in 1992 © Christopher Goodney/Bloomberg

The IMF’s latest survey of official foreign exchange reserves shows that the share of US dollar reserves held by central banks fell to 59 per cent during the fourth quarter of 2020 — its lowest level in 25 years. 

This compares with a share of 71 per cent when the euro was launched in 1999.

That protracted trend is logical. 

As Barry Eichengreen of University of California, Berkeley has long argued, the US accounted for the majority of the industrial production of the non-Soviet world after the second world war. 

It thus made sense that the dollar was the principal unit in which exporters and importers invoiced and settled their trade, in which international loans were extended and in which central banks held their reserves.

Today, with the US accounting for less than a quarter of global gross domestic product it makes less sense and leads to the accusation, levelled by the then French finance minister Giscard d’Estaing in the 1960s, of the “exorbitant privilege” whereby the US government can borrow more cheaply because of the greater demand for its IOUs arising from the reserve currency role. 

Another aspect of the exorbitant privilege is that the Federal Reserve, with a mandate geared to purely domestic conditions, sets a monetary policy for the whole world which for many countries is less than optimal.

The latest IMF numbers confirm that the privilege is eroding as countries that trade with and borrow from the euro area increasingly seek to hold euro reserves. 

That process is now happening with China and the renminbi. 

Yet the erosion has been very gradual.

The question then is are there circumstances in which what still amounts to dollar dominance suddenly could turn into a dollar rout?

Anti-inflationary credibility at stake

When it comes to reserve currency status there are huge advantages deriving from incumbency, partly from inertia but also from network effects. 

The more people use the dollar, the more useful it is for everyone else. 

And as Dario Perkins, head of global macroeconomics of TSLombard, points out, the leadership of the global economy does not change hands often. 

Most previous regimes changes, he says, whether in 15th century Venice, Amsterdam in the late 1700s or the UK in the 1940s, happened because of political turmoil usually involving devastating military conflicts.

That said, there is general agreement that the biggest single peacetime threat to reserve currency status is economic and financial mismanagement. 

And with the Federal Reserve having abandoned its longstanding commitment to tightening policy in anticipation of inflation and President Joe Biden “going big” with fiscal policy, the fear that inflation could undermine the currency is mounting — at least in some circles.

Janet Yellen, US Treasury secretary. She and President Joe Biden have been criticised for ‘the least responsible fiscal macroeconomic policy we’ve have had for the last 40 years’ by former Treasury secretary Larry Summers © Tasos Katopodis/Bloomberg

Those concerns have been most forcefully expressed by former Treasury secretary and fellow Democrat Larry Summers, who has said the Biden administration is pursuing “the least responsible fiscal macroeconomic policy we’ve have had for the last 40 years”. 

In an interview with the FT last month he declared that “when it’s explained that the Fed has an entirely new paradigm . . . it’s a bit hard to understand why expectations should remain anchored.” 

He added: “We’re seeing an episode that I think differs both quantitatively and qualitatively from anything since Paul Volcker’s days at the Fed, and it stands to reason that would lead to significant changes in expectations.”

In other words the anti-inflationary credibility won at such high cost by the Fed over the past 40 years may now be in question, causing foreign investors to worry that the US will inflate away the value of their Treasury holdings.

One of the most fundamental requirements of a reserve currency is that it is backed by a state that can provide safe assets to global investors. 

The US has done that for more than 100 years, with the US Treasury market offering the safest haven in the world in times of crisis and the most liquid securities — that is, the easiest to trade.

Yet if the state pursues irresponsible policies those assets become less safe. 

The greatest potential threat to safety, as Summers implies, is inflation, which shrinks the real capital value of fixed interest investments.

Erosion of safety

The fears about potential inflation are not the only reason some investors are raising new questions about the role of the dollar in the international financial system. 

The pandemic-induced turbulence in the Treasury market in March 2020 has raised important questions about the market’s liquidity.

In early March, the Covid-19 scare sparked a typical, orderly flight to safety in US Treasuries. 

But from March 9 there was a disorderly flight from Treasury paper into cash. 

Analysis by the Basel-based Bank for International Settlements has shown that the dash for cash resulted substantially from forced selling by hedge funds that had borrowed heavily to profit from small differences in yield between cash Treasuries and the corresponding Treasury futures.

With the downward lunge in the market, the solvency of these highly leveraged funds was threatened and their lenders called in their loans, forcing the hedge funds to sell. 

In effect a feedback loop developed in which the inability of dealers to absorb sales led to further price declines, prompting more sales and leading to further price declines. 

Dealers responded by widening the bid-ask spreads they offered their clients on average by a factor of 13 in the first weeks of March. 

That should not have happened in what is usually termed the world’s deepest, most liquid government bond market.

Traders on Wall Street watch Donald Trump giving a speech at the start of the pandemic. Trump’s dysfunctional presidency and the protectionist policies he pursued — and which Biden has so far kept — were not good omens for a reserve currency © Spencer Platt/Getty

US Treasury data show that much of this turbulence was internationally driven. 

Global investors’ gross purchases of US Treasury bonds and notes reflected a classic flight to quality, jumping from $1.79tn in February 2020 to $2.67tn in March. 

Yet this was more than offset by foreign sales, which jumped from $1.79tn to $2.98tn, nearly a trillion higher than the previous peak over the decade.

This erosion of safety was a reflection of structural changes in the Treasury market. 

Darrell Duffie, a professor of finance at Stanford University Graduate School of Business, has pointed out that while growing federal deficits since the financial crisis of 2008 have caused the stock of marketable Treasuries to grow significantly, the balance sheets of the large banks that own the big primary dealers have not kept pace, partly because of tougher capital requirements introduced after the financial crisis.

 The gap has been filled by shadow banks such as hedge funds whose ability and readiness to provide liquidity in a crisis is limited.

In the event, the Fed rescued the Treasury market from extreme dysfunctionality by flooding it with liquidity and relaxing bank capital rules. 

Yet there remains a risk that the Fed’s morally hazardous interventions will ensure that bouts of illiquidity arrive with greater frequency and magnitude, given the historically high and growing ratio of federal debt to GDP and the ballooning stock of outstanding Treasury securities relative to the capacity of dealer balance sheets.

The other threat to the dollar’s reserve currency role is dysfunctional politics. 

Donald Trump exposed hitherto unsuspected weaknesses in the checks and balances of the US system. 

With many in the Republican party questioning the outcome of the election and the former president having incited the attempted insurrection at the US Capitol on January 6, the quality of American democracy is in question. 

And while Biden has moved to restore relations with traditional allies and return to the principle of international co-operation, he is not rowing back strongly from Trump-era protectionism.

These are not good omens for a reserve currency. 

Yet there is a case to be made for the extraordinary stimulus under way. 

In seeking to pursue a more aggressive fiscal policy than the US adopted after the financial crisis, the Biden administration hopes to facilitate higher growth, which could make for less poisonous domestic politics and provide a more stable underpinning for the dollar.

Meantime, international capital appears to be giving Biden the benefit of the doubt. 

Given their security dependence on the US, big holders of dollar reserves such as Japan and South Korea are unlikely to dump the dollar. 

As for China, US Treasury data show that from August 2017 to October 2020 China’s holdings of US Treasury securities declined from $1.2tn to $1.05tn. 

After Biden’s victory they rose in monthly progression to $1.1tn — this despite the new administration’s continuation of much of Trump’s hostile approach to China.

Video screens in Times Square, New York, show the debut of Coinbase, the cryptocurrency exchange, on the Nasdaq. In 2019, Mark Carney speculated that a new synthetic hegemonic currency could be provided through a network of digital currencies issued by central banks © Levine-Roberts/Sipa USA/Reuters

Alternative gains

If the dollar has retained its hegemonic role thus far it is because reserve currency status is about relative not absolute advantages. 

The question has always been, what are the alternatives? 

In terms of economic might the only realistic immediate challengers are the euro and the renminbi. 

Both are gaining, albeit slowly, in relative advantage.

The chief difficulty with the euro has always been the lack of a government bond market capable of providing safe assets on a scale comparable with the US. 

Yet the response to the pandemic has finally pushed the bloc into moves to create a European Union recovery fund financed by commonly issued EU debt. 

Those moves are as yet tentative, but they suggest that the euro, currently making up 20 per cent of global reserves, could play an increasing role.

In the case of the renminbi, Beijing is committed to challenging the dollar and has actively encouraged the use of the renminbi in bilateral trade transactions. 

The Belt and Road Initiative provides new financing opportunities for the digital renminbi currently under development. 

And Beijing has the advantage that China has recovered more strongly than the other big economies from the Covid-19 setback. 

Foreign capital has been flooding in too as China has progressively opened its financial markets.

Gita Gopinath, chief economist at the IMF, is sceptical that a digital currency could replace the dollar’s reserve role © Melissa Lyttle/Bloomberg

David Marsh, chair of OMFIF, the central banking think-tank, says the People’s Bank of China has recognised that renminbi appreciation will help control inflation as well as foster a shift of focus away from external to domestic demand. 

A stronger renminbi will thus help the currency’s internationalisation because foreign investors will be rewarded. 

Investors nonetheless have to include Chinese authoritarianism and a tradition of active state interventionism in markets in their calculations.

The wild card in this debate relates to digital currencies. 

Bitcoin, which moves several percentage points on a single tweet from Tesla chief executive Elon Musk, lacks credibility as a potential reserve currency. 

But Mark Carney, while governor of the Bank of England, suggested in 2019 that technology has the potential to disrupt the network externalities — the benefits of using a currency that many others are using- that prevent the incumbent global reserve currency from being displaced.

He speculated that a new synthetic hegemonic currency could be provided through a network of digital currencies issued by central banks. 

This would enable spillovers from shocks in the US through exchange rates and trade to become less synchronised across countries, while the dollar’s influence over global financial conditions might likewise decline.

Many are sceptical. 

Gita Gopinath, IMF chief economist, believes that technology has plenty to offer in providing cheaper and faster cross-border payments and improving financial inclusion. 

But her view of the development of the international reserve system focuses more on old-fashioned development of institutions to improve the eurozone’s architecture and resilience, and stronger domestic institutions and further liberalisation of markets in China.

History tells us that it took just 10 years for the dollar to remove sterling from its reserve currency role. 

That reflected the devastation wrought on British economic and financial might by the first world war. 

In the light of the extraordinary fiscal and monetary response to the pandemic it seems unlikely that the coronavirus will prove as economically potent as that military conflagration. 

But the threats to the dollar to watch are US fiscal profligacy and monetary debasement.

Twisted Democracies

In many democracies, particularly in Latin America, well-meaning reforms intended to enhance democracy have achieved just the opposite, with governments that are strong on paper but weak in practice. And with each election cycle, citizen rage is brought ever-closer to the boiling point.

Andrés Velasco

LONDON – Pedro Castillo is an authoritarian left-wing populist without the charm or charisma of most populists. 

Keiko Fujimori is a recently incarcerated right-wing populist, the daughter of a former dictator who is serving a 25-year sentence for murder, kidnapping, and corruption. 

Together, Castillo and Fujimori received fewer than one in three votes in the recent first round of Peru’s presidential election. 

Yet one of them will be the next president.

This much is certain: whoever wins the runoff will have a hard time governing. 

Castillo’s Perú Libre party has only 37 of the 130 congressional seats. 

Fujimori’s Fuerza Popular has just 24. 

She might just manage to assemble a majority because three other rightist parties have 45 seats among them. 

But compromise and coalition-building are not what Peruvian politics is about. 

Most parties are shells built around a single leader’s transient popularity. 

They spend their time and energy shooting down every other politician who tries to govern. 

That is what Fujimori and her party did to Pedro Pablo Kuczynski, who narrowly defeated her in 2016, and to Martín Vizcarra, who became president after Kuczynski resigned in 2018.

Ecuador, on Peru’s northern border, is in a similar bind. 

Guillermo Lasso, a conservative banker, will become president after a narrow runoff victory over Andrés Arauz, a left-leaning economist and close associate of Rafael Correa, the former president recently sentenced to eight years in jail for graft. 

But Lasso’s CREO party will have just 12 votes in the 137-seat congress, which could rise to 31 if he can count on the support of the center-right Social Christians. 

By contrast, Correa’s party has 48 seats, and Pachakutik, an indigenous people’s movement whose candidate came in a close third in the presidential race, has 27.

Lasso won not because he promised faster economic growth, but because a majority of voters did not want to relive the Correa years’ toxic mix of populism and strong-arm tactics. 

Like the next president of Peru, Lasso will face great difficulties governing. 

His plans for market-friendly reform will most likely gather dust.

It is not just that voters are becoming more fickle and politicians more feckless. 

The rules of South American democracy promote political fragmentation and divided government. 

But taking power from politicians has not delivered satisfaction to voters. 

On the contrary, weak governance has produced chaotic politics, mediocre policies, poor social and economic outcomes (the epic failure to control COVID-19 is only the latest example), and increasingly frustrated citizens.

The type of regime (presidential or parliamentary) and electoral system (majoritarian or proportional) define a country’s politics. 

The combination of parliamentary governance and proportional representation has yielded model democracies in Scandinavia. 

The parliamentary first-past-the-post formula of the Westminster system, copied by Canada and other Commonwealth countries, also works well. 

American exceptionalism shows up in the coupling of presidential and majoritarian arrangements (single-seat districts in the House, two seats per state in the Senate).

Former President Donald Trump notwithstanding, this combination has sustained nearly 250 years of stable democracy.

And then there is the oddball combination of presidentialism and proportional electoral systems, which exists only in Latin America. 

Presidents are elected for a fixed term of office and remain, regardless of whether they enjoy a parliamentary majority. 

And proportional systems, which allocate seats according to a party’s vote share, deliver the kinds of fragmented parliaments Peruvians and Ecuadorians have just elected and countries like Brazil, Colombia, and Chile have had to endure in recent years.

With two-round presidential elections now enshrined in most Latin American constitutions, the final winner can claim a vigorous mandate, from which all manner of deep and important reforms will follow. 

That vow, typically delivered in solemn tones on election night, vanishes under the harsh light of dawn. 

The strong majority of the runoff quickly turns into a weak minority in the legislature.

Some presidents, like Sebastián Piñera in Chile, end up caving in to the whims of ever-shifting parliamentary coalitions. 

Others, like Jair Bolsonaro in Brazil, are forced to rely on the votes of groups (the so-called Centrão) with which they share few if any ideas; the result is volatile and unpredictable policymaking. 

Others, like Fujimori’s father, Alberto, simply close down parliament and assume quasi-dictatorial powers – as Castillo has threatened to do if Peru’s legislature does not do his bidding.

The combination of a fixed-term executive presidency and a proportional electoral system was never a great idea. 

It has been made worse by the decline of another crucial democratic institution: political parties. 

Many Latin American countries never had strong and stable parties. 

In the few that did – Colombia, Costa Rica, Chile, and Uruguay – parties are a shadow of their former selves. 

For example, Chile today has 15 legally constituted parties and a half-dozen in the process of gaining legal recognition. 

No party or coalition commands a working legislative majority. 

In 2020, only 7% of Chileans expressed trust in parties, which have been described as “hydroponic”: floating above society with no roots in it.

The decline of parties throughout the region is partly the result of well-meaning reforms. 

It was thought that making the electoral system more proportional would better reflect society’s increasing diversity; instead, it produced myriad tiny parties that represent no one. 

Introducing primaries was supposed to make parties more democratic internally; it did, but at the risk of making them vulnerable to being taken over by media-savvy celebrities. 

The gain in transparency that came with campaign finance reform also caused a collapse in party discipline, as party bosses lost leverage over publicity-seeking parliamentarians. 

Greater use of plebiscites has allowed small groups of activists to hijack the policy agenda.

The problem is not uniquely Latin American. 

Yale political scientists Frances McCall Rosenbluth and Ian Shapiro argue that similar “decentralizing reforms” in the United States and Europe, meant to “return power to the people,” weakened parties and led to “policies that are self-defeating for most voters.” 

Paradoxically, the closer to the grassroots political power moves, the more disenchanted the grassroots become.

So, Peru and Ecuador, like Brazil and Chile before them, will have leaders that are strong on paper but weak in practice. 

They will promise much and be able to deliver little. Soon enough, voters will grow frustrated and vow to “throw the rascals out” and replace them with someone who truly takes popular interests to heart. 

Scholars and activists will propose further reforms meant to empower voters. And then the cycle will repeat, enraging citizens further. 

It is not a pattern that will end well.

Andrés Velasco, a former presidential candidate and finance minister of Chile, is Dean of the School of Public Policy at the London School of Economics and Political Science. He is the author of numerous books and papers on international economics and development, and has served on the faculty at Harvard, Columbia, and New York Universities. 

Honky Tonk Warren

Berkshire Hathaway’s questionable performance and governance

The world’s most famous conglomerate will struggle to outlast its feted founder in its current form

THE ANNUAL shareholders’ meeting of Berkshire Hathaway has been dubbed “Woodstock for capitalists”, so large is the throng it usually attracts. 

For the second year running, though, thanks to covid-19, the groupies have been denied their close-up love-in with Warren Buffett. 

The event on May 1st was online only, with Mr Buffett joined on screen by his longtime sidekick and fellow nonagenarian, Charlie Munger—a headline act that makes the Rolling Stones look like striplings. 

Nevertheless, Warren and Charlie outdid Mick and Keith for stamina, taking more than three hours of questions, covering everything from Berkshire’s first-quarter results, announced earlier that day, to the ways in which its subsidiaries do and don’t resemble children. 

For Buffettologists, the highlight was an apparent slip of the tongue by Mr Munger: “Greg will keep the culture”. 

The following day Mr Buffett, who had hitherto refused to publicly name an heir apparent, confirmed that the nod had gone to Greg Abel, the 58-year-old head of Berkshire’s non-insurance operations.

Mr Buffett has long held the stage as the world’s most celebrated investor, having turned a troubled textile firm purchased in the mid-1960s into a $630bn conglomerate spanning everything from railways and real estate to insurance and ice-cream parlours. 

Berkshire, which is essentially made up of two halves—a collection of owned or controlled businesses employing 360,000 people, and a $300bn portfolio of minority stakes in blue chips—has done long-term investors proud. 

Over the 56 years of Mr Buffett’s stewardship its stock has enjoyed a compounded annual gain of 20%, double that of the S&P 500 index (including dividends).

Berkshire’s more recent record looks less stellar, however—leaving some wondering if the company, like the Rolling Stones, is trading on its back catalogue, its greatest hits a thing of the distant past. 

That prompts another concern. 

At 90, Mr Buffett is still sharp and seemingly in good health. But no one lives forever. 

A change of front man, when it comes, will be a test of the endurance of Berkshire’s unique culture and its quirky (some would say anachronistic) governance.

It will also test whether the sprawling group can remain in one piece at a time when conglomerates are out of fashion. 

Berkshire has long enjoyed a sort of corporate exceptionalism, thanks to the halo over Mr Buffett. 

With disquiet growing over so-so returns, poor disclosure and more, that benefit of the doubt looks threatened.

You got the silver

Start with the financial performance. 

Operating profit—the number Mr Buffett urges shareholders to focus on—fell by 9% in 2020, to $22bn, after a flat 2019 (though it rebounded in the latest quarter, up 20% year on year). 

Berkshire’s shares badly underperformed the S&P 500 index in both years. 

Over the past ten years, its per-share market value has handily beaten the index just twice, while lagging far behind it four times. 

In truth, Berkshire’s performance relative to the S&P has been slipping for decades (see chart 1).

This loss of oomph is partly explained by the law of large numbers; the bigger Berkshire grows, the harder it is for any single successful investment to move the needle. 

Another factor is the dwindling of a past advantage. 

Berkshire has long used the float (premiums not paid out as claims) from its giant insurer, Geico, to funnel low-cost capital to its other operations. 

But these days capital is cheap for everyone.

Some wounds have been self-inflicted, however. 

Big bets on Occidental Petroleum and Kraft Heinz soured quickly. 

The consumer-goods giant, of which Berkshire owns 26.6%, is weighed down by $28bn of debt and bloated goodwill after a mispriced merger in 2015. 

Mr Buffett has admitted to overpaying for Precision Castparts, an industrial-parts maker that Berkshire bought in 2016, which subsequently triggered an $11bn write-down. 

Some of his timing has looks awry, too. 

Having built a big position in American airline stocks, Berkshire bulked up on more at the start of 2020, but lost its nerve as the pandemic spread, quickly dumping its holdings and crystallising a loss of perhaps $3bn-4bn. 

Within months the sector’s share prices had rebounded.

Indeed, the past year has given the lie to the received wisdom that Mr Buffett thrives in adversity. 

That was certainly true during the financial crisis of 2007-09, when Berkshire acted as an investor of last resort, striking highly lucrative deals to bail out GE and Goldman Sachs; the GE investment yielded a 50% return, most of it within three years. 

This time, though, with market liquidity less constrained, Berkshire has had less opportunity to pounce.

Nor has it been able to find an acquisition that is both good value and big enough to move that needle. 

Identifying “elephants” on which it could spend a sizeable part of its $145bn cash pile has become a parlour game in investment circles. 

When covid-19 first struck, many thought Mr Buffett would be spoilt for choice. 

But buoyant stockmarkets mean fewer bargains for value investors like him to snaffle up. 

And Mr Buffett eschews corporate auctions because they often involve paying big premiums.

Another turn-off is increased competition from private equity and SPACs. 

Berkshire’s biggest deal of 2020 was more bolt-on than blockbuster: the $10bn purchase of a gas-pipeline operator by its utility, Berkshire Hathaway Energy (BHE). 

That was less than half of what Berkshire spent over the year on buying back its own shares. (It has sharply increased buybacks over the past two years in response to calls for it to deploy more unspent capital, though the non-payment of a dividend remains a sacred cow.)

Perhaps the clearest sign that Berkshire may have lost its touch when it comes to finding attractive targets was the rapid in-and-out of Bill Ackman. 

The star hedge-fund manager, a lifelong Buffett fan, built a $1bn position in Berkshire in 2019 but had fully sold out by mid-2020, apparently after concluding he could find overlooked gems more effectively himself.

Berkshire has also taken flak for largely missing out on the tech boom of the past decade owing to Mr Buffett’s preference for mature businesses. 

There is one glaring exception, though: its 5.4% stake in Apple, which has produced a whopping $90bn gain over five years. 

Moreover, the economic pendulum may be swinging back towards the sort of industrial firms he favours: they should benefit from trillions of federal dollars earmarked for infrastructure upgrades as the economy recovers from the pandemic. 

BNSF, Berkshire’s railway network, can expect to profit as more heavy stuff needs shifting around for all these projects.

Some investors have grown increasingly vocal in pressing Berkshire to eke out more from its main divisions. 

Mr Buffett has described BNSF as one of the conglomerate’s four “jewels”, along with Geico, BHE and the Apple stake. 

But when Mr Ackman crunched the numbers in 2019, he found the railway’s operating margins to be five percentage points below the average of its peers. 

Geico has many virtues, including making a profit on its underwriting most years (unlike many rivals, which rely on investment gains to offset underwriting losses). 

But its margins, and its use of analytics, lag behind those of an arch-rival, Progressive.

Shine a light

The answer, says one large investor, is for Mr Buffett to be more hands-on with subsidiaries. 

That, though, would go against the grain of the idiosyncratic management structure and governance long in place. 

Division bosses are given almost total autonomy; it is not unheard of for them to go months without speaking to Mr Buffett. 

Berkshire’s head office is tiny, with just 26 people; subsidiaries have their own legal, accounting and human-resources departments. 

They report to head office, but it reports little to the outside world. 

Berkshire does not hold analyst calls or investor days. 

It gives out scant financial information beyond mandatory filings, says Meyer Shields, an analyst with KBW (who has long been shut out of Berkshire’s annual conclave because of his sceptical views).

Mr Buffett is proud of being different. 

Whereas other big companies have moved to a command-and-control approach, Berkshire’s remains rooted in trust: he trusts the divisions to get on with it, and shareholders are expected to trust that he will make more right calls than wrong ones.

This approach is increasingly at odds with corporate trends. 

At this year’s AGM, Berkshire faced shareholder proposals on its skimpy climate-risk disclosure and diversity policies (though both were defeated). 

It is also under fire over executive pay, which at Berkshire is heavily weighted to base salary, owing to Mr Buffett’s long-held suspicion that stock incentives encourage managers to manipulate the share price. 

Big proxy-advisory firms like ISS have backed some of these criticisms. 

Some have also taken aim at the board for being too old (four of its 14 members are 90 or over), too entrenched and too close to the boss. 

Berkshire has become a “very attractive lightning rod”, says Lawrence Cunningham of George Washington University, who has written several books about Mr Buffett.

Mr Buffett has little time for ESG metrics, diversity targets and the like. 

He has said he doesn’t want his managers to have to spend their time “responding to questionnaires or trying to score better with somebody that is working on that”. 

A lot of what is considered good governance today doesn’t fit with Berkshire’s heavily decentralised approach.

Even if so, pressure for change is growing, and is likely to intensify further once the founder no longer calls the shots. 

Moreover, the post-Buffett leadership is likely to be more diffuse, which those hoping to shake up Berkshire may see as an opportunity to apply more leverage. 

Mr Abel is the CEO-in-waiting, but Mr Buffett’s role as chairman is set to go to his son, Howard. 

His third role, as investment chief, will probably go to one of the group’s two top equity-portfolio managers, Todd Combs and Ted Weschler.

The most forceful efforts to impose change may come from those seeking to break up Berkshire. 

When he is gone, Mr Buffett conceded last year, “everybody in the world will come around and propose something, and say it’s wonderful for shareholders, and by the way it involves huge fees.” 

Some on Wall Street would see it as a coup to “release value” by, for instance, splitting the conglomerate into three bits, focused on insurance, industrial assets and consumer businesses.

Few doubt that Berkshire trades at less than the sum of its parts. 

But even the sceptical Mr Shields thinks the discount is only around 5%. 

Others think it may rise above 10% once its leader departs. 

Mr Buffett insists that a well-run conglomerate has enduring advantages. 

One is not being associated with a given industry, meaning it feels less pressure to maintain the status quo—“if horses had controlled investment decisions, there would have been no auto industry,” as he once put it.

A crunchier benefit relates to tax: Berkshire can move capital between businesses or into new ventures without incurring any. 

And taxable income at one subsidiary can help generate tax credits at another. 

Mr Buffett has claimed this gives BHE a “major advantage” over rivals in developing wind and solar projects.

On with the show

How vulnerable to centrifugal forces Berkshire proves to be will depend more than anything else on the composition of its shareholder base. 

Currently, it affords protection. 

The typical large American listed company is mostly owned by institutional investors. Berkshire is different. 

Mr Buffett has around 30% of the voting share; another 40% is held by an estimated 1m other individuals, many of them long-term loyalists (with whom he has spoken of having a “special kinship”); the rest is owned by institutions. 

If a vote were held today, it would overwhelmingly reject a break-up or wrenching strategic shift.

Mr Buffett and his retail kinsmen may not form such a powerful block for much longer, however. 

Many of the loyalists are getting on in years. 

The children who inherit their shares may show less zeal. 

Even some of the faithful may sell once the Oracle of Omaha has gone. 

Moreover, Mr Buffett’s stake will be sold into the market after his death, albeit over more than a decade: he has bequeathed it to various foundations on condition that they sell the shares and spend the proceeds on good causes. 

Posthumous shifts in the shareholder base are Berkshire’s “Achilles heel”, reckons Mr Cunningham.

As a keen student of corporate history, Mr Buffett will doubtless know that James J. Hill, a 19th-century railroad baron who led an operator that would later become part of BNSF, once declared that a company only has “permanent value” when it no longer depends on “the life or labour of any single individual”. 

Berkshire’s greatest challenges will come only after its grizzled rock star has left the stage.

Convertible debt sold by high-flying US groups falls back to Earth

Worries about inflation and a pullback in tech shares have weighed down on convertible bonds

Joe Rennison and Aziza Kasumov

Twitter, Peloton and Airbnb took advantage of hot demand to issue convertible bonds just before sentiment changed © Montage of Twitter, Peloton and Airbnb logos

Investors have been jolted by a slide in the price of convertible bonds issued at the top of the market this year, as fears of higher inflation have pushed interest rates upwards and dented the debt’s value.

Marquee tech groups like Twitter, Peloton and Airbnb took advantage of hot demand to issue convertible bonds just before sentiment shifted. 

Convertible bonds are sold as debt but can be switched to stock should a company’s value increase to a specified strike price, meaning these securities can be affected by fluctuations in stock or fixed income markets.

The drops sustained by these convertible bonds illustrate how Wall Street investors are grappling with both the risk of higher price growth and mounting concerns that the tech trade that has generated outsized returns since the market trough in March 2020 has run out of steam.

“It’s a double whammy,” said Peter Sheehan, a credit strategist at Loomis Sayles whose multisector income fund has more than 6 per cent of its cash in convertible bonds, including deals from Twitter and Peloton.

Sentiment was so strong earlier this year that several companies managed to sell bonds with a zero coupon, meaning they do not have to pay interest on the debt, as well as a high strike price that reduces the potential of existing shareholders becoming diluted.

However, as inflation fears have stirred as the economy has rebounded, the prices of the convertible bonds have sunk, with higher interest rates eroding the value of the debt and the tech companies’ stock prices. 

These concerns have triggered an exodus from convertible bond funds. In the week to May 12, the category sustained the biggest outflows since November, with investors globally pulling a net $530m, according to data by EPFR. 

“What happened? 

Rates went higher and converts got slammed,” said John McClain, a portfolio manager at Diamond Hill Capital Management, who said he has been buying up the debt now that prices have fallen.

Peloton’s zero per cent coupon bond sold in February traded as high as 110 cents on the dollar, but has since fallen to just 93.5 cents. 

Airbnb’s bond from the start of March has fallen to 92.5 cents and Twitter’s convert sold at a similar time dropped below 90 cents this month before retracing slightly. 

All three notes mature in 2026.

In turn, this has pushed the yield on the converts higher. 

Twitter’s convertible bond now yields more than 2 per cent.

Higher Treasury yields have also put the stock prices of some of Wall Street’s once high-flying growth stocks, seen as more sensitive to tightening financial conditions, under pressure. 

When a company’s stock price declines, the strike price that needs to be reached for a convertible bond to be turned into equity moves further out of the money, making it less attractive for investors to hold the note.

The stock prices of Airbnb, Twitter and Peloton have slid at least 20 per cent since the beginning of March.

Nonetheless, issuance of new convertible bonds has remained at record levels, with companies selling more than $95bn in convertible notes globally this year through May 25, the highest for that time of the year since Refinitiv started tracking the data. 

More than $60bn has been issued in the past three months alone, with Coinbase bringing the latest blockbuster deal, at $1.25bn, to market just last week.

All Inflation Is Transitory. The Fed Will Be Late Again

Lance Roberts


- While the "sell signal" remains intact, not surprisingly, the breakout above the consolidation on Thursday failed, with the selloff on Friday putting the market back where it started the week.

- There is a significant difference between a "recovery" and an "expansion." One is durable and sustainable; the other is not.

- The "frenzy" of investors to get into the market is unlike anything we have seen since 1999.

   Photo by photoMacgyver/iStock via Getty Images


Market Review & Update

Last week, we said:

"The market is trading well into 3-standard deviations above the 50-dma, and is overbought by just about every measure. Such suggests a short-term 'cooling-off' period is likely. With the weekly 'buy signals' intact, the markets should hold above key support levels during the next consolidation phase."

"As shown above, that is what is currently occurring. While the market remains in a very tight range, the "money flow" sell signal (middle panel) is reversing quickly. Importantly, note that the money flows (histogram) are rapidly declining on rallies which is a concern."

While the "sell signal" remains intact, not surprisingly, the breakout above the consolidation on Thursday failed, with the selloff on Friday putting the market back where it started the week. 

Furthermore, the MACD "sell signal" in the lower panel also suggests that prices may remain somewhat capped for the time being.

As noted, the concern remains of the decline in actual money flows. 

While the market is holding up near all-time highs, the support of positive money flows continues to deteriorate. 

Weakening money flows with the market remaining at more overbought conditions also suggest upside is limited over the next few weeks.

For now, the market trend remains bullish and doesn't suggest a sharp decrease of risk exposures is required. 

However, after reducing equity exposure previously, we are starting to look for the next short-term opportunity to increase risk. 

However, we aren't expecting much before we get into the summer months, where, as we will discuss, the risk begins to rise markedly.

All Inflation Is Transitory

On Wednesday, Jerome Powell commented that while he sees inflation, he believes it to be transitory. 

As my colleague Mish Shedlock noted:

"Inflation jumped as predicted, and so was the Fed comment about transitory."

As Mish discusses, inflation depends much on how you measure it and who it impacts. 

However, inflation is and remains an always "transient" factor in the economy. 

As shown, there is a high correlation between economic growth and inflation. 

As such, given the economy will quickly return to sub-2% growth over the next 24 months, inflation pressures will also subside.

Significantly, given the economy is roughly comprised of 70% consumption, sharp spikes in inflation slows consumption (higher prices lead to less quantity), thereby slowing economic growth. 

Such is particularly when inflation impacts things the bottom 80% of the population, which live paycheck-to-paycheck primarily, consume the most. 

The table below shows the current annual percentage change in the various categories.

As shown above, food and beverage prices make up 15.08% of the CPI calculation. 

The chart below from Brett Freeze breaks down how consumers spend their money based on income classes. 

The lowest income earners, making $15,000 to $29,999, pay almost 25% of their earnings on food. 

That compares to only 7.5% for families making more than $150,000.

Housing comprises 56.3% of spending for the lowest income class and only 20% for the highest. 

The CPI inflation calculation does not accurately portray how inflation affects a large percentage of the population. 

(This is also the group whose entire boost in income from the stimulus will get absorbed by higher prices)

The Fed May Be Right For The Wrong Reason

With double-digit rates of change in essential items like transportation (going back to work), food, goods and services, and energy, the impact on disposable incomes will come much quicker than expected. 

If we strip out "housing and healthcare," which are fixed budget items (mortgage and insurance payments), we see that "household" inflation is pushing 3.5% annualized.

Such is particularly problematic when wages aren't keeping up with inflation.

The Fed is probably right. Inflation will be transitory, but for all the wrong reasons.

Rates Tell The Same Story

As discussed in Friday's #MacroView, interest rates also tell us that economic growth will deteriorate markedly over the next few quarters.

"The correlation should be surprising given that lending rates get adjusted to future impacts on capital.

- Equity investors expect that as economic growth and inflationary pressures increase, the value of their invested capital will increase to compensate for higher costs.

- Bond investors have a fixed rate of return. Therefore, the fixed return rate is tied to forward expectations. Otherwise, capital is damaged due to inflation and lost opportunity costs.

As shown, the correlation between rates and the economic composite suggests that current expectations of sustained economic expansion and rising inflation are overly optimistic. At current rates, economic growth will likely very quickly return to sub-2% growth by 2022."

The problem for the Federal Reserve, and as quoted by Mish, is that the fiscal and monetary stimulus imputed into the economy is "dis-inflationary."

"Contrary to the conventional wisdom, disinflation is more likely than accelerating inflation. Since prices deflated in the second quarter of 2020, the annual inflation rate will move transitorily higher. Once these base effects are exhausted, cyclical, structural, and monetary considerations suggest that the inflation rate will moderate lower by year end and will undershoot the Fed Reserve's target of 2%. The inflationary psychosis that has gripped the bond market will fade away in the face of such persistent disinflation." - Dr. Lacy Hunt

The point here is that while economic growth may be booming momentarily, inflation, which is destructive when not paired with rising wages, will be transient. Given the massive surge in prices for homes, autos, and food, the reversal will cause a substantial disinflationary drag on economic growth.

The Fed Should Be Hiking And Tapering Now

There is a significant difference between a "recovery" and an "expansion." One is durable and sustainable; the other is not.

Following the financial crisis, the Federal Reserve cut rates and flooded the markets with liquidity. As discussed in "The Fed Continues To Make Policy Mistakes," the Fed should have acted sooner to prepare for the next economic downturn.

"The Fed should have started lifting rates as the spike in economic growth occurred in 2010-2011 as both the Fed and Government flooded the economy with liquidity. While hiking rates would have slowed the advance in the financial markets, the excess liquidity sloshing around the system would have offset tighter monetary policy."

The Fed is again suppressing rates but should be using the massive liquidity injections and economic recovery for hiking rates and taper bond purchases to prepare for the next downturn.

As Mohammed El-Erian noted:

"The majority of market participants are expecting an undramatic event including an upgraded economic outlook, a reiteration of uncertainties and signaling of no policy changes. Unfortunately, it's an outcome that kicks the policy can down the road when the central bank should be thinking now about scaling back extraordinary measures.

The longer it takes to do so, the harder it will be to pull off eventual normalization without risking both significant market volatility and damaging what should and must be a durable and inclusive economic recovery."

By not hiking rates now, they run the risk of being late once again.

Given the Fed waited too long to hike rates previously, such will be the same this time as they start hiking rates just as economic growth peaks due to the roll-off of stimulus.

There have been ZERO times in history when the Fed started a rate hiking campaign that did not lead to a negative outcome.

Something Is Going To Break

The "frenzy" of investors to get into the market is unlike anything we have seen since 1999.

The Fed's problem is that in 1999 there was a bubble in "" stocks but not in many other areas of the market. In 2007, it was a mortgage market bubble, but valuations were not extremely elevated in stocks.

Today, we are:

- Pushing the second-highest level of valuations in history

- Many other valuation measures such as Price-to-Sales, Tobin's-Q, and Market-Cap to GDP are at a record.

- Investors are rushing to buy the most speculative assets from various Cryptocurrencies, to Non-Fungible Tokens (NFTs), to highly speculative companies.

- Wall Street is rushing IPOs to market at the fastest pace on record.

- SPACs are the new asset class.

- A large portion of the Russell 2000 companies have no income.

- The bonds with the highest risk of default are trading at historically low rates.

- Individuals are rushing to pay the highest prices on records for housing and used cars.

- And, it's all done with the highest margin debt levels in history.

Of course, corporations are in on it as well, buying back their shares at a record pace (just after asking the government for a taxpayer-funded bail out in March 2020.)

Trapped With No Escape

In other words, it isn't just one bubble the Fed will have to deal with during the subsequent market melt-down. 

It will be all of them. 

The magnitude of the meltdown of multiple asset classes at one time will likely be larger than the Fed can bailout.

Importantly, I believe they know this already and hope that an inflationary push will help deflate some of the risks before the bubble bursts. 

As my colleague Doug Kass wrote on Thursday:

"From my perch, and in the end, of course, all violation of the fundamental laws of economic and financial common sense are paid for - but every Bull thinks he will unload before the break.

John Kenneth Galbraith once wrote that "What we do know is that speculative episodes never come gently to an end. The wise, though for most the improbable, course is to assume the worst."

I believe that there are numerous other bubbles or inflated values. Moreover, I see numerous headwinds that could reset broad valuations lower. Such includes higher corporate and individual tax rates, inflation, and inflated bullish investor sentiment.

It is easy enough to burst a bubble. To incise it with a needle so that it subsides gradually is an operation of undoubted delicacy."

I agree.

The bottom line is the Fed is trapped. 

If they hike rates, they bust the bubble and destroy economic growth. 

If they do nothing, the bubble inflates to a point it breaks under its weight.

In my opinion, not that it matters; it seems the risk of doing nothing far outweighs doing something. 

Taking small actions today to slowly deflate risk seems a much better alternative to the eventual bust.

Portfolio Update

As noted above, we will trigger the next short-term "buy signal," likely next week. 

As we have discussed regularly, given the daily "sell signal" was offset by a weekly "buy signal," there was little downside risk. 

Such turned out to be the case.

We can now start adding some additional exposure to areas that we need, but with equity holdings at near target weights, only minor adjustments need to get done. 

We still carry a very short-duration bond portfolio currently as interest rates continue to push towards our target of 1.8-1.9%. 

At that level, we will start accumulating long-duration bonds and increasing portfolio hedges.

Another reason we don't expect a lot of upside to markets because the recent "consolidation" failed to work off any of the overbought conditions. 

Notably, the market remains more than 5% above its 50-dma, which is historically extreme. 

Such gets corrected, usually through a price decline or a consolidation.

Over the last two weeks, we had suggested cleaning up portfolios and rebalancing risk. 

With that complete, portfolios should be in an excellent position to participate in whatever rally we get over the next couple of weeks.

As we head into summer, we will likely see our weekly and daily signals align with "sell signals" in late May or early June. 

Such will likely coincide with a realization of peak earnings and economic growth. 

While we don't expect a significant reversion at this juncture, given the ongoing liquidity support, a 7-10% correction is possible and well within annual norms.

Could it be more? Absolutely.

But that is something we will navigate once we get there.