Go with the Flow — Investing in Hydro

5 minute read
By John Heneghan and Annie Dysart • September 8, 2020

 

 

What is Hydropower?

 

Hydropower is a type of renewable energy that uses the force of flowing water to produce electricity. Its energy comes from the water cycle: the continuous movement of water on, above, and below earth’s surface. Hydropower is a renewable technology because it captures naturally occurring energy from the water cycle and produces electricity without reducing or using up water. The marginal cost of production for hydropower — and renewables like solar, wind, and geothermal energy —  is zero.

 

Check out this 3-minute video on hydropower.

 

The most common type of hydropower production is an impoundment facility. Impoundment uses a dam to hold river water until it is released through a turbine to activate a generator and produce electricity. The U.S. has over 90,000 dams, yet only 3% are active hydropower facilities. The majority of dams in the United States were originally built for irrigation or flood control purposes. 

 

In 2019, conventional hydroelectricity’s generation capacity in the United States was 79,746 megawatts (MW) — or about 80 million kilowatts. This is enough electricity to fuel 32 million homes a year.  The state of Washington produces the most energy from impoundment. It is home to the Grand Coulee Dam, the largest U.S. hydropower facility and the largest U.S. power plant in generation capacity.

 

Dams are controversial because of potential harmful environmental impact. They destroy carbon sinks in wetlands and oceans, deprive ecosystems of nutrients, reduce biodiversity, cause habitat fragmentation, and displace poor communities. Fish ladders —  a series of ascending pools that allow fish to circumvent a dam —  are a solution to impoundment facilities that would otherwise hinder the migration of species like salmon up and down rivers.

 

Another type of hydroelectric power is diversion, also known as a run-of-river facility. This method diverts part of a stream through a canal or penstock to spin a turbine and produce energy before the water rejoins the main river. The typical capacity of a diversion facility is less than 30 MW. 

 

Many run-of-river facilities across the nation are owned by small individual operators and very large scale utilities that view these facilities as low value assets burdened by old equipment, inefficient operations and often low power prices. 

 

Pumped storage facilities store energy for later use by pumping water uphill when electricity is cheap to a reservoir at higher elevation. When demand for electricity is high, water is released to a lower reservoir and through a turbine to generate electricity. 

 

Hydro operations can operate under federal, public, or private ownership. There can also be public-private and public-federal partnerships. Federal agencies operate about 49% of the total installed hydropower capacity in the U.S., public agencies operate about 24%, and private agencies operate about 25%. 

 

 

Hydropower accounts for around 6.6% of the electricity generated in the United States. Hydropower was the nation’s largest source of renewable energy until it was surpassed by wind power in 2019. According to the U.S. Energy Information Administration, total annual electricity generation from utility-scale non-hydro renewable sources (wind, solar, biomass, etc.) has been greater than hydropower generation since 2014.  

Total renewable energy resources represent 17% of U.S. electricity generation while dirty coal still represents 23% of generation and is a major contributor to greenhouse gases. Renewable energy sources, including hydro, are poised to take coal’s market share aided by technology advances in energy storage.

 

 

Advantages of Hydropower

 

Hydropower offers the lowest levelized cost of electricity across all major fossil fuel and renewable energy sources. Hydro is a reliable, cost-effective energy source due to low-maintenance equipment and longer facility lifespans that amortize significantly large upfront capital costs over time.

 

The total conversion efficiency of a hydropower plant ranges between 90-95%. Conversion efficiency is the useful energy output divided by the energy input —  for hydro, it is the hydroelectricity output divided by the kinetic energy of flowing water input. Hydropower’s conversion efficiency is greater than the conversion efficiency of both wind and solar, with wind at a rate of about 45% and solar at 25%.

 

Hydropower has high diversification potential with other renewable energies. A portfolio with hydro, wind, and solar energy that is diversified across energy sources and regions can have a stabilizing effect on asset portfolios.  Hydroelectric facilities provide baseload power; they run continuously to meet the minimum level of power demand. This consistency makes hydropower complementary to intermittent renewables like wind and solar that can only generate electricity when the sun is shining or the wind is blowing. Hydropower depends on the more reliable flow of water to help meet baseline electricity demands while other renewables can supply peak demands. 

 

Hydropower and Renewable Energy Storage

 

The push for decarbonization through renewables will require innovation in energy storage technologies that addresses the intermittencies of wind and solar energy. While pumped-storage hydropower accounts for 95% of U.S. utility-scale energy storage, lithium-ion battery storage has seen tremendous growth. The price of lithium-ion batteries has fallen by about 80% over the past five years, enabling the integration of storage into solar power systems. 

 

NREL’s Renewable Electricity Futures Study estimated that if 80% of the United States’ electricity is powered by renewables by 2050, 120 gigawatts of storage would be needed across the nation. The U.S. currently has 22 gigawatts of storage from pumped hydropower and 1 gigawatt from batteries.

 

Another opportunity looming on the hydro horizon is the potential coupling of hydropower and Bitcoin mining. Bitcoin mining lacks an eco-friendly reputation as an energy-intensive process with a large carbon footprint. However, this can change if miners use electricity from renewable sources. 

Much like energy storage utilizing lithium-ion batteries, Bitcoin and other cryptocurrencies are an energy storage technology. If energy is converted into bitcoins and stored for future purchases, it could contribute to the storage needed for the renewable energy revolution. 

 

Bitcoin miners can choose their location based on the cheapest cost of electricity, which happens to come from cleaner baseload energy sources like hydro, geothermal, and natural gas. More Bitcoin mining operations could be established proximate to renewable energy plants and have a positive environmental impact by reducing emissions and soaking up surplus energy that would otherwise go to waste.

 

Go with the Flow — Investing in Hydro 

 

Current trends show wind and solar energy assets are more frequently represented in institutional investors’ portfolios than hydropower assets. Hydropower facilities tend to have high upfront costs, complex installation processes, and absence from the market due to a history of public ownership and project sponsorship. These are some of the factors that create a scarcity of  hydroelectric investment opportunities.

 

Brookfield Renewable (BEPC: NYSE) is one of the world’s largest investors in renewable energy. Its strong ESG practices support global decarbonization and create long-term value for stakeholders.  It is geographically and technologically diversified, with 19,300 MW of renewable capacity located across North America, South America, Europe, India, and China. Hydro represents 7,900 MW (53% in U.S. & Canada), or 41% of capacity, followed by 4,700 MW of wind (52% in U.S. & Canada), 2,600 MW of solar, and 2,600 MW of energy storage and distribution assets. 

 

Brookfield has an investment grade, BBB+ balance sheet. Brookfield’s diverse and high-quality cash flows and strong financial position allow it to pursue growth opportunities and make distributions to shareholders. It targets annual equity deployment of $800 million in high-quality assets. Their investment strategy involves acquisition and development of high-quality renewable power assets and businesses below intrinsic value, recycling of capital from mature, de-risked assets, optimization of cash flows through operating expertise to enhance value, and financing businesses on an investment grade basis. 

 

Brookfield partners with governments and businesses to achieve their decarbonization goals. It has an 18,000 MW development pipeline diversified across multiple technologies and geographies, including approximately 2,400 MW under construction. 

 

Since 2012, Brookfield EPC has grown its annual distribution by 6% compound annual growth rate. Brookfield expects to continue distribution growth by 5% to 9% annually and deliver total returns of 12% to 15% to unitholders over the long-term. 

 

Brookfield is the best way to go with the flow on the decarbonization megatrend and invest in the inevitable transition to renewable hydro, wind and solar energy. 

Investing with Purpose

6 minute read

By John Heneghan and Annie Dysart • July 30, 2020

 

ESG and SRI Investing

Environmental, Social, and Governance (ESG) criteria are used by investors to guide more sustainable and socially responsible investment. ESG falls under the umbrella of socially responsible investing, or SRI. SRI is any investment strategy that considers both financial returns and social and environmental impacts when evaluating the suitability of investments. 

 

Incorporation of ESG criteria helps asset owners align investment decisions to their values and beliefs. It facilitates investing with purpose. ESG links health and wealth outcomes, highlighting the interdependence of healthy populations, environments, and economies. 

 

Environmental criteria address issues like climate change, pollution reduction, and sustainable utilization of natural resources. They increase pressure for regulations that establish environmental liability and steer markets towards sustainable products and services. Companies are evaluated for practices like greenhouse gas emissions, water usage, and waste disposal and encouraged to be transparent about these practices. 

 

Social criteria look at how a company interacts with employees, suppliers, customers, and communities. It addresses workplace health and safety, discriminatory practices, diversity, human rights issues, and again, transparency about these practices. 

 

Governance criteria assess company leadership, board structure and diversity, executive pay, audits, internal controls, and shareholder rights. It evaluates accounting and disclosure practices and controls to prevent corruption and bribery issues. 

 

The more sustainable a company, the higher its ESG score. Investment strategies that integrate ESG criteria into portfolios decrease the weight of companies with lower ESG scores and increase the weight of companies with higher ESG scores. Third parties evaluate company disclosures to subjectively generate these scores.

 

Several ESG ratings firms now exist to assess and score the ESG disclosures, such as Sustainalytics (with an ownership stake by Morningstar), Institutional Shareholder Services, and MSCI. Think of these as the Moody’s and Standard and Poor’s for sustainability. 

 

Types of Sustainable Investing

ESG integration is one of the most common types of sustainable investment strategies. Restriction screening is also very popular, commonly practiced through negative screens of industries like tobacco, weapons, or environmentally damaging operations. Morgan Stanley defined five types of sustainable investing or SRI:

• ESG Integration - Proactively considering ESG criteria alongside financial analysis. 
• Restriction Screening - Exclusionary, negative or values-based screening of investments.
• Impact Investing - Seeking to make investments that intentionally generate measurable positive social and/or environmental outcomes.
• Thematic Investing - Pursuing strategies that address sustainability trends such as clean energy, water, agriculture or community development.
• Shareholder Engagement - Direct company engagement or activist approaches.

 

The Rise of Socially Responsible Investing

Amy Domini is known as the godmother of socially responsible investing. She started the SRI movement in the 1990s and made the Time 100 list of the world’s most influential people in 2005. She said, “We must continue to stand together to demand that the search for monetary profits not come at the detriment of universal human dignity nor the undermining of ecological sustainability.”  

 

The emergence of the term “ESG” traces back to a 2004 report by the Global Compact titled “Who Cares Wins.” It was published in response to growing investor demand for more sustainable investment avenues and laid the foundations for a common understanding of ESG investment criteria. 

 

The report stated a belief that markets did not fully recognize the significance of emerging trends pressuring companies to improve corporate governance, transparency and accountability, nor the high stakes of reputational risks related to ESG issues. It emphasized the long-term importance of sustainable development, saying, “A better inclusion of environmental, social and corporate governance (ESG) factors in investment decisions will ultimately contribute to more stable and predictable markets, which is in the interest of all market actors.”

 

The incorporation of ESG principles and the practice of SRI have exploded in popularity. In 2017, 48% of retail and institutional investors worldwide applied ESG principles to at least a quarter of their portfolios. By 2019, that percentage surged to 75%. The European Union (“EU”) holds the most sustainable invested assets at $14.1 trillion US dollar (USD) equivalents. The United States follows with $12 trillion USD of sustainably invested assets. 

 

SRI now accounts for one out of every four dollars under professional management in the United States. In Europe, it accounts for one out of every two dollars. Sustainable investing is often a voluntary and strategic venture motivated by constituent demand, perceived potential for attractive financial performance, and evolving regulations driving greater disclosure on ESG factors.

 

Client demand from retail and institutional investors is the top reason for the incorporation of ESG factors in financial reporting disclosures. In the United States, corporations that provide ESG disclosures do so voluntarily. Unlike the EU, there is no definitive accounting or financial reporting framework in the U.S. under which ESG factors are measured and reported to stakeholders.

 

ESG is most popular among millenials, women, and high-net-worth individuals. 95% of millennials surveyed by Morgan Stanley in 2019 expressed interest in sustainable investing and 90% want to tailor their investments to their impact goals derived from personal values and beliefs. Millennials are poised to inherit over $68 trillion from their predecessors by 2030. Accordingly, the millennial ‘approach to investing’ will be an important determinant in the demand for ESG investments going forward.

 

The Deloitte Center for Financial Services (DCFS) projects client demand will accelerate ESG-mandated asset growth by three times that of non-ESG-mandated assets to comprise half of all professionally managed investments in the United States by 2025. Investment managers will likely respond to client demand for ESG by launching new ESG funds. 

 

 

The iShares ESG MSCI U.S.A. ETF (ESGU) launched in 2016 is the largest Socially Responsible ETF, with $7.8 billion in assets under management. ESGU tracks the MSCI USA Extended ESG Focus Index. This index is designed to maximize exposure to positive environmental, social and governance (ESG) factors as determined by MSCI’s ESG rating framework while exhibiting risk and return characteristics similar to those of the MSCI USA Index.  The index is sector-diversified and targets companies with high ESG ratings in each sector. It excludes tobacco and firearms manufacturers. iShares MSCI KLD 400 Social ETF (DSI) based on Domini’s groundbreaking work in socially responsible investing was the largest ETF prior to the launch of ESGU by BlackRock.

 

By February 2020, the number of ESG ETFs had skyrocketed to 293, with 805 listings globally. According to ETFGI, total assets invested globally in ESG ETFs reached a new record of $82 billion at the end of May 2020. There are currently 108 socially responsible ETFs traded in the U.S. markets, gathering total assets under management at a value of $37.2 billion and an average expense ratio of 0.39%. 

 

Several brand-name U.S. mega-cap companies are seizing opportunities to incorporate ESG into their governance frameworks and demonstrate to shareholders, stakeholders and customers that they are committed to sustainability. 

 

This year, Microsoft pledged to be carbon negative by 2030. By 2050, they aim to remove all the carbon emitted either directly or from electrical consumption since their founding in 1975. This carbon negative goal will be achieved through a $1 billion climate innovation fund to accelerate the global development of carbon reduction, capture, and removal technologies. 

 

By contrast, Starbucks has less ambitious (yet more attainable) sustainability goals. By 2030, the company aims to reduce carbon emissions by 50 percent; reduce waste sent to landfills from stores and manufacturing by 50 percent, and conserve or replenish 50 percent of the water currently being used for direct operations and coffee production. 

 

ESG Impact on Expected Returns 

Many investors express concern that ESG investing will limit their investment options and potentially lead to lower returns. Studies and analyses express varying conclusions regarding whether ESG investing helps or hurts overall portfolio performance. There is a lively theoretical and practical debate. 

 

In this video, Ben Felix from PWL Capital provides important insights to consider before committing to a sustainable portfolio, based on the assertion that sustainable portfolios provide lower expected returns. 

 

Felix discusses the impact of socially responsible investing on expected returns according to a December 2019 study written. After analyzing a global sample of 5,972 firms between 2004-2018, the authors concluded that companies with higher ESG scores tended to deliver lower average returns than companies with lower ESG scores. 

 

Investor tastes and preferences contribute to pricing effects on expected returns of sustainable and unsustainable companies. Investors with a strong preference for sustainable investments are less likely to invest in unsustainable companies that don’t reflect their core values and beliefs. They are more likely to invest in sustainable companies with lower returns for the tradeoff of aligning investment to their values. 

 

Another implication of this tradeoff is that sustainably-minded investors will require higher expected returns to consider investing in an unsustainable company; the opportunity for financial gain would have to overshadow their desire to uphold a socially responsible portfolio. 

 

At the other end of the spectrum, The Harvard Business School conducted a study in May 2019 that found companies adopting sustainability practices outperform their competitors. According to their analysis, a $1 investment over 20 years yielded $28 in return for companies focused on ESG factors versus a $14 yield for companies without focus on ESG factors.  So rather than sustainable portfolios providing lower returns, Harvard concluded that ESG factors enhanced returns.

 

Research Affiliates, a global investment research firm, recently weighed in on whether ESG integration contributed to portfolio performance in their report, “Is ESG a Factor?” Factors are stock characteristics associated with a long-term risk-adjusted return premium. In other words, factors can be systematically employed by investors to enhance portfolio returns. Factors must satisfy three critical requirements: they should be grounded in credible academic literature, consistent across definitions, and robust across geographies.

 

Research Affiliates concluded ESG was not a factor because there is little agreement in academic literature regarding its robustness in earning a return premium for investors, it lacks a common standard definition, and its performance results are not robust across geographies. They believe ESG is an important investing consideration despite dismissing it as a factor and lacking complete confidence in its ability to currently deliver as a theme. 

 

One of our core investment beliefs is that investor preferences are broader than risk and return. Nevertheless, ESG can be a very powerful theme in the portfolio management process in the years ahead.  However, as noted by Research Affiliates in their ESG factor analysis, one of the fundamental issues with ESG integration is that there is no common framework for evaluating companies’ ESG impacts. 

 

 

Call to Action

In his upcoming book, “Impact: Reshaping Capitalism To Drive Real Change”, Sir Ronald Cohen boldly addresses the obstacle of a lack of a common ESG impact measurement and assessment framework. He proposes the international adoption of “generally accepted impact principles” to transparently and consistently reflect the measurement of ESG impacts in financial statements to display “impact weighted profits.”

 

Cohen argues that today’s technology and big data allow us to reliably measure and assess impacts. He recommends that if governments force companies to publish impact weighted accounts, companies and stakeholders will develop a sharper focus on improving their impact and find creative solutions to social and environmental problems.  Cohen calls this novel approach impact capitalism.

 

Impact capitalism is the invisible heart of markets that drives the invisible hand of Adam Smith’s Wealth of Nations. Impact is the third essential dimension to consider alongside risk and return when considering possible investments. Connecting social initiatives to investment criteria in this manner will enable entrepreneurs to finance purpose-driven investment and charitable organizations. 

 

An investment is deemed attractive when its risk-reward potential is favorable . However, some investments have hidden costs that negatively impact employees, surrounding communities, or the environment. Many companies do not factor in the cost of mitigating social and environmental problems caused by their operations in their traditional investment analysis, such as a factory that emits air pollution and afflicts people in the area with respiratory problems. These unpaid costs, known as externalities, are often incurred by vulnerable populations that don’t have the means to fix the problem themselves. 

 

Impact investing presents an opportunity to take the pain out of profit. It creates a framework where financial success can be both self-interested and societally beneficial. When positive impact and profit coexist, everyone wins.  

 

We think impact capitalism has the potential to drive creative solutions for the many socioeconomic imbalances and environmental issues we face today. Watch for our upcoming digital series that will explore these critical matters in greater depth.

 

Wake Up to Bitcoin

8 min read

Wake Up to Bitcoin

By John Heneghan and Annie Dysart

Updated on June 2, 2020

 

What is Bitcoin and how does it work?

 

Bitcoin (BTC) is the most well-known and successful form of cryptocurrency with a market capitalization of about $170 billion at $9,300 per BTC and daily trading volume of $700 million.  It is especially popular among tech-savvy millennials who find it appealing for investment.  According to a nationwide survey by Bankrate in July 2019, millennials are three times more likely to invest in crypto than Generation X.  Bitcoin is the brand-name category killer and the Amazon of the digitally networked crypto world. 

 

Bitcoin is a digital and decentralized cryptocurrency built on blockchain technology. Blockchain architecture is designed to address concerns like decentralization, privacy, identity, trust and ownership of data. Blockchain’s democratized model uses distributed data storage, peer-to-peer transmission, consensus protocols, and digital encryption technology to validate transactions.  It is nearly impossible to counterfeit or double-spend cryptocurrency. 

 

Blockchain uses a public, digital ledger to create a fixed data chain of time-stamped transactions (blocks).  Blocks are chronologically strung together one after the other to form an immutable blockchain.  Transactions are cryptographically recorded and verified by a network of computers (consensus validation) that do not belong to any central authority. 

 

Every ten minutes, a set “block reward” of bitcoin is awarded to Bitcoin “miners.” Mining is the only way to “print” new Bitcoins into circulation. Miners use high power computers to solve complex math problems called hash functions to verify 1 megabyte, or 1 block, of Bitcoin transactions. 

 

Hash functions provide proof of work by processing data and generating another hash that matches the original data. Proof of work makes tampering with the blockchain very challenging; alteration of any kind would necessitate the re-mining of all subsequent blocks. 

 

Bitcoin’s supply issuance is strictly and algorithmically bound. The block reward is halved every 210,000 blocks, which takes about four years to mine. In 2009, the block reward was 50 Bitcoins every ten minutes, subsequently halving to 25 Bitcoins in 2013, 12.5 Bitcoins in 2016, and finally 6.25 Bitcoins in 2020. 

 

The supply of Bitcoin is capped by the blockchain code at 21 million. It would require network consensus to overwrite the coding language which is anathema to the value embedded in the Bitcoin network.  Currently, almost 18.5 million Bitcoins are in circulation, leaving approximately 2.5 million to be mined. The value of this “digital gold” will increase as its scarcity increases over time as fewer and fewer Bitcoins are “printed” with each successive halving until the supply is capped at 21 million.  The 21 millionth Bitcoin is expected to be mined in 2140. 

 

You can learn more about how Bitcoin and blockchains work in this 9 minute video from SciShow.

 

Blockchain and Fintech in China

 

China is the global leader in the use and development of blockchain technology.  China has by far the most blockchain patents in the world and more than 70% of the mining capacity.  Some of the biggest names in the crypto space are Chinese firms, including Binance, the world’s largest crypto exchange.  

 

Moreover, China is arguably the global leader in financial technology (fintech) solutions, particularly smart-phone based payment systems.  For example, the Chinese population has leapfrogged traditional credit card based payment rails with the dominance of mobile based Alipay and We Chat Pay.  Leveraging this fintech leadership, China has taken an early pole position in the development of an alternate global monetary and financial system by being the first country to issue a government backed digital currency. 

 

Why invest in Bitcoin? 

 

Bitcoin is a worthy investment for enhancement of portfolio diversification and improvement of expected returns without significant addition of portfolio risk.  

 

Although the price of Bitcoin has been highly volatile over time, historically investors that hold Bitcoin for the longer term, called “hodlers,” have been richly rewarded as Bitcoin’s historical return per unit of risk (Sharpe ratio) has been much greater than 1.0 with a five year annual return of 88% through May 31, 2020 on volatility of 66%.  

 

This compares to Research Affiliate’s forward-looking expected returns and risk for traditional asset classes wherein emerging market equities are viewed as the most attractive asset class.  Research Affiliates estimated EM equity’s Sharpe ratio at 0.42 today based on 10% nominal annual returns and 21% expected volatility.  A Sharpe ratio of 1.0 or better is unheard of in the traditional investment world.

 

A Bitwise investment study entitled, “The Case for Bitcoin in an Institutional Portfolio” concluded that “adding Bitcoin to a diversified portfolio of stocks and bonds would have consistently and significantly increased both cumulative and risk-adjusted returns of that portfolio over any meaningful time period in Bitcoin’s history, provided a rebalancing strategy is in place.” 

 

This positive portfolio impact endured even in periods in which the price of Bitcoin fell. The magnitude and consistency of Bitcoin’s contribution to portfolio efficiency when added to a traditional 60/40 portfolio were remarkable.  Bitwise’s study found that achieving these portfolio benefits only required a few critical practices:  

1. Hold Bitcoin for two years or more - the historical record of positive portfolio contributions quickly approached 100%
2. Disciplined quarterly rebalancing - sell your winners and buy your losing positions to get back to targeted allocation percentages
3. Well-thought out targeted allocation percentage - maximum drawdowns are the main limiting factor in deciding how much Bitcoin to add to investor portfolios.

 

Bitcoin and Investor Concerns

 

In March 2020, Fidelity Digital Assets released a study that surveyed nearly 800 European and American institutional investors. In general, institutional investors (hedge funds, pension plans, family offices and registered investment advisors) are keeping a keen eye on Bitcoin and other digital assets, and there are an increasing number of early-movers who have taken the crypto plunge. Key findings of the study include:

• 36% of respondents say they are currently invested in digital assets (adoption rate is much higher among hedge funds but in the low single digits for pension plans).
• 6 out of 10 respondents believe digital assets have a place in their investment portfolio.
• The three most appealing characteristics of digital assets to investors: they are uncorrelated to other asset classes, are an innovative technology play, and have high potential upside. 
• Investors’ perceived advantages of digital assets over traditional alternatives like hedge funds or private equity: higher liquidity, low transportation costs, low transaction costs, low storage costs, and unique return drivers.

Fidelity’s study also highlighted investor concerns regarding digital assets:

• Price volatility (53% of respondents) - (mitigated by well-thought out position sizing as suggested by above Bitwise study)
• Concerns about market manipulation (47%) - (this is a concern for all securities or currency markets.)  
• Lack of fundamentals to gauge appropriate value (45%) - (fundamental analysis has recently been published in Plan B stock to flow cross-asset analysis).

 

President of Fidelity Digital Assets Tom Jessop commented, “Investor concerns are largely focused on issues that will resolve themselves as the market infrastructure evolves. We’re proud to be one of many service providers actively driving that evolution for the benefit of the ecosystem and traditional investors alike.”  Fidelity Digital Assets envisions a future where all types of assets are issued natively on blockchains or represented in tokenized form.  In other words, Fidelity expects all traditional assets (stocks, bonds, currencies, etc.) will be issued and held on blockchain or in tokenized form.

 

Grayscale Bitcoin Trust

Grayscale Bitcoin Trust’s (GBTC) absorption of 25% of newly-mined Bitcoins in 2020 indicates higher demand for crypto exchange-traded instruments among retail investors.   With a market capitalization of $3.5 billion, GBTC is the investment vehicle of choice for investors, particularly smaller, retail investors.  

 

It is very difficult to buy Bitcoin right now through traditional investment brokerage accounts due to limited investment offerings.  GBTC is one of the few liquid, publicly listed exchange traded vehicles that invests in Bitcoin.  GBTC provides titled, auditable ownership through a traditional investment vehicle, can be held in tax advantaged accounts, and maintains robust security and storage protocols. 

 

In late June, Servant Financial initiated small, toehold positions in GBTC of 0.5% to 1.0% in client model portfolios, depending on investor risk profiles.  Our statistical analysis using historical data suggested that adding a 1% position in GBTC will increase expected returns by 1% annually while only increasing risk by 0.3 to 0.4% across all client risk models.  

 

In addition to enhancing portfolio efficiency, GBTC provides schmuck insurance in the event the global monetary and financial system were to fail (an event not represented in the historical data).  The more irresponsible and extreme the monetary and fiscal policy actions of the government become, the more Bitcoin will appreciate as an increasingly scarce store of value.  In extremis,  GBTC, Bitcoin, and gold would be expected to massively outperform traditional asset classes in the event of a total system crash.  With a maximum downside of 0.5% to 1.0%, GBTC provides a “bit or byte” of peace of mind with asymmetric upside for this fat tail risk. 

 

It’s Time to Wake Up to Bitcoin

 

Institutional investors are waking up to the unique characteristics of Bitcoin and crypto currencies, particularly after the legendary hedge fund manager Paul Tudor Jones recommended Bitcoin as “the fastest horse in the race” to beat the Great Monetary Inflation (GMI) - “unprecedented expansion of every form of money unlike anything the developed world has ever seen” - that we are presently experiencing.  

 

As Fidelity’s Jessop indicated, the infrastructure for large scale institutional investment in Bitcoin and crypto currencies is still under construction.  Today, there are only a few access points suitable for institutional investors’ large scale deployment.  For example, Jones’ hedge fund will take a “low single digit position” in Bitcoin through futures markets rather than direct holdings of Bitcoin.  His $40 billion fund already has existing connectivity with the major futures exchanges and well-established investment policies and procedures.

 

The developing nature of the market presents a distinct advantage for smaller, more nimble retail investors to get in front of the institutional money flows.  Recent investor surveys suggest that many retail investors are getting ahead of their investment advisors in knowledge and acceptance of Bitcoin as a suitable investment and are pushing their advisors to #getoffzero and make an initial portfolio allocation.

 

Extreme Financial Games

 

A hedge fund that I oversee for my family office client had the following energizing comment in the fund's most recent quarterly letter:

There is no secret sauce for successful investing beyond a proven process and humility.

Certainly a number of hedge fund managers have been humbled recently by persistent underperformance against the S&P 500 as this unmanaged index marches ever higher.  For example, the Dow Jones Credit Suisse Long-Short Hedge Fund Index has gained only 4.3% year-to-date through September 30, 2017 compared to a total return of 14.1% for the S&P 500.  Despite the generally exorbitant compensation in the industry, I have some empathy for hedge fund managers that have consistently underperformed the S&P 500 because they've employed a risk mitigation, hedging discipline of shorting richly valued stocks (a bet that a stock price will go down) with flawed or failing business models and/or inferior management.  You lose money shorting a stock if it rises in price for speculative, technical, or other reasons despite its rich valuation and perceived poor fundamentals.  This year a broad swath of hedge fund managers' egos have been left dazed and confused by the irrationality of today's markets.

I believe the hedge fund manager's reference above to a "proven process" is a reference to the proving grounds of a sustainable investment approach of performance measured over a full market cycle - both bull and bear phases.  The rigor and discipline of an investment process is only truly tested in a period of bearish market volatility and declining prices.  Like great women and men, it is in the trial that an investor is made.  Just like precious metals in a furnace it takes intense heat and pressure to reveal the inherent beauty and shine of an investment process.

Since its founding in 2005, Servant Financial's primary investment objective has been to take a risk aware approach to preserve client capital and maintain the real value of portfolios while growing capital over the long-term.  Our investment strategy provides for the essential tenets of a fiduciary driven approach by providing broad diversification, low transaction costs, low portfolio turnover, and tax efficiency.

We achieve these investment objectives through risk-based asset allocation and a core passive index strategy.  We overlay active management elements through a relative value discipline among asset classes and employing select active fund and stock selections.

As we've written about frequently in the past, investors have generally been penalized for taking a global, broadly diversified investment approach.  Simply stated, with the benefit of hindsight investors would have significantly outperformed by being solely long U.S. equities over the last eight years.  This issue was explored in a recent article from PIMCO entitled "Are Diversifying Assets Up Next In The Return-Seeking Cycle?".  The article cites some stark comparisons of performance across asset classes:

Since the lows of the global financial crisis in March 2009, U.S. stocks (proxied by the S&P 500) have returned 270%, or 16.8% annualized, outpacing every other major market over that period.  Contributing to that outperformance were highly differentiated returns among asset classes, particularly in the three calendar years following the “taper tantrum” sparked by comments from then-Fed Chairman Ben Bernanke.  Starting in 2013 and through 2015, the S&P 500 Index gained 52% cumulatively, whereas core bonds returned 4% (proxied by the Bloomberg Barclays U.S. Aggregate Bond Index) and an equally weighted basket of diversifying assets actually lost value, returning −12%.  In other words, diversifiers lagged U.S. stocks by 64% for the 2013–2015 period.

Futurist and inventor Elon Musk's statement that "There's a one in billions chance we're in base reality" immediately came to mind.  In summary, Elon took game theory to the next level when he stated that he believes we are living in some advanced civilization's computer simulation.  Essentially, the world in which we live is the ultimate in fake news and our markets are a form of entertainment called extreme financial games.  When one looks at this issue through the lens of valuation, I think there is something to be said for Musk's argument that U.S. equity markets are some form of computer simulated entertainment.  

Within this realm of extreme financial gaming, Servant's investment process has been dynamic and interactive and has consistently included forward-looking expected return inputs to supplement the longstanding investment advisory practice of using past returns to forecast future returns.  Research Affiliates recently posted an article entitled, "The Most Dangerous (and Ubiquitous) Shortcut in Financial Planning" - using historical returns to forecast the future is the shortcut methodology.  I'm unsure who is the puppet master in this extreme financial game, but I'd like to use the rest of this feature article to update investors on S&P 500 valuations and expected future returns by summarizing the work of three investment research firms that we religiously follow that use forwarding-looking return forecast models.

The first research firm expected return forecasts we'll look at are from GMO.  GMO is a global investment leader with expertise in managing multi-asset class strategies as well as focused strategies in a number of specific asset classes.  GMO's investment approach seeks to identify asset classes and securities where investors are paid to take risk and utilizes a long-term investment horizon, a belief in the power of mean reversion, discipline, conviction, and a commitment to research (emphasis added).  As we've covered in the past, mean reversion is a key assumption in GMO's asset class forecasts. GMO assumes asset class valuations will revert to their historical mean valuation levels over a 7 year forecast period.  For the S&P 500 this approach implies that GMO expects that the current Shiller price to earnings (PE) of ratio 31.3 times at the 100th percentile of its historical valuation range would revert to approximately the 50th percentile over the next 7 years.  In other words, the lower valuation multiple applied to the S&P 500 over time is expected to result in mark to market valuation losses by GMO.

GMO recently published their 7-year asset class real return forecasts as of September 30, 2017.  As you can see from the chart below, GMO expects that investors will lose money over the next 7 years on a real basis (after inflation) for all asset classes except emerging market equities (+2.4%), emerging market debt (+0.4%), and cash (+0.1%).  U.S. large cap (-4.1%) is expected to be the worst performer over this forecast period.

 

 

The next body of valuation research we will look at is from Research Affiliates.  Research Affiliates is a global leader in smart beta and asset allocation.  Dedicated to creating value for investors, Research Affiliates seeks to significantly impact the global investment community through their insights and product innovations.  The scatter plot below shows Research Affiliates' 10-Year expectations of risk and real return for portfolios and asset classes.  Follow this link above to Research Affiliates' website where you can click each of the individual dots, or make selections from portfolio and asset lists to get more information about each portfolio or asset class.  The portfolios connected by the dashed line below represent efficient, highest return per unit of risk, portfolios.  These efficient portfolios are governed by a set of diversification standards which can be seen by clicking the "Efficient" label in the portfolio list at their website.

These expected returns are based on a set of routines which model both expected cash flows and changes in asset prices (reversion to the mean), and not by extrapolating returns of the past (pervasive short-cut approach used by most financial advisors).  You can learn more about Research Affiliates methodology for valuing assets here.

In general, I would characterize Research Affiliates' methodology as a more robust version of GMO's basic methodology described above.  Note that Research Affiliates projection period is 10 years versus GMO's 7 year forecast period.  There are obviously other significant differences in assumptions and methodology as you'll note for example that Research Affiliates has projected a 10 year real return for emerging market equities of 6.3% with volatility of 22.9% compared to GMO's 7 year expected real return of 2.4%.

 

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The third and final research firm's work we'll look at is Hussman Funds.  Hussman Funds was founded by John Hussman, an economist, stock market analyst, and mutual fund owner.  He publishes a weekly market commentary and is broadly known for his public criticism of the U.S. Treasury and the Federal Reserve policies and for predicting the 2008-2009 U.S. Recession.  He has written extensively about the extreme valuations of the S&P 500 and other asset classes precipitated by Fed monetary policies and, not surprisingly, is predicting another market crash and financial crisis.  

Like GMO and Research Affiliates, Hussman has performed extensive investment research and valuation analysis. In his latest weekly commentary dated October 9, 2017 is entitled "Why Market Valuations are Not Justified by Low Interest Rates."  Hussman describes how his team has back tested some 15 different valuation approaches and determined the methodologies that have the highest correlation and predictive value for future expected returns.  One of his favorite methodologies is Margin-adjusted CAPE (cyclically adjusted price earnings/Shiller PE).  Hussman's introduction to this method is as follows:

The chart below is based on (Hussman's) margin-adjusted variant of Robert Shiller’s cyclically-adjusted PE (CAPE). Specifically, the CAPE (calculated here as the ratio of the S&P 500 to the 10-year smoothing of inflation-adjusted earnings) is multiplied at each point in time by a factor equal to the 10-year smoothing of corporate after-tax profits to GDP, divided by the historical norm of 5.4%. The resulting measure is similar to the S&P 500 price/revenue multiple, the ratio of market capitalization to corporate gross value-added, and other measures that share a correlation near 90% or higher with actual subsequent 10-12 year S&P 500 total returns in market cycles across history.

As expected, the (log) margin-adjusted CAPE acts as a “sufficient statistic” for actual subsequent S&P 500 total returns, particularly on horizons of 10-12 years (which is the point where deviations from historically normal valuations most reliably damp out). Also as expected, adding additional information about interest rates (green) does virtually nothing to improve the reliability of the resulting projections; a result that can be understood from our earlier valuation examples. If anything, low interest rates actually worsen expected future market returns here. If extreme valuations were not enough, depressed interest rates suggest the likelihood of below-average economic growth as well.

As you can tell by the green and blue lines in the bottom right corner, Hussman expects negative nominal returns for the S&P 500 over his 12 year forecast period.

 

 

The last and perhaps most telling chart on current extreme valuations below is Hussman's margin-adjusted Shiller PE.  Since the current profit margins of the S&P 500 are well above the historical norm of 5.4%, Hussman estimates the Margin-adjusted Shiller PE is something like 44 times today or significantly in excess of the 40 times for the 1929 market bubble, the dot.com bubble of 2000 at 41 times, and the current Shiller PE of 31.3 (without making an adjustment to normalize margins).

By these metrics, we are clearly in an extreme financial game simulation or some other artificially created financial and market situation.  The question is are these "fake" markets of an alien origin or do they emanate from Fed monetary policies as Hussman and other market historians would vehemently argue?  My intuition is that it is Fed induced rather than E.T., the Extra-Terrestrial, playing an advanced video game.

 

 

The Charm And The Unknown Of Emerging Markets

 

In last month's blog feature we ventured into new media with the introduction of audible.com to describe some thoughts on summer readings.  This month I'd like to explore the media frontier of Trusted Insight and share a video from their 2017 Alpha Investment Conference with you.

Trusted Insight (TI) is the world’s biggest network of institutional investors.  Think of it as the LinkedIn of institutional investors.  The TI network allows lead investors to syndicate investment opportunities to family offices, qualified institutional buyers, and other institutional investors across asset classes such as Venture Capital, Private Equity/Buy-out, Real Estate, Infrastructure and others.  TI also manages its own platform fund(s) and acts as syndicate lead in seed stage venture capital funds.

With over 140,000 members on the platform controlling over $18 Trillion in assets, TI is one of the fastest growing and most trusted alternative asset syndication platforms.  Each week 30,000 institutional investors engage on the TI platform.  These institutional investors are actively investing in alternative assets, primarily private equity, hedge funds, real estate and private companies.

Founded by Alex Bangash, TI started in 2010 and is venture-funded and revenue producing. Its investors were the first investors or founders of Facebook, LinkedIn, Mint, Match.com, and Blackstone, among others. The company has offices in NYC and San Francisco.

TI hosted its first annual Alpha Investment Conference in San Francisco in June.  I was fortunate enough to participate as a panel member on Reassessing The Golden Age Of Private Equity with Dale Hunt, Managing Director - Private Equity at Ascension Investment Management, Josh Stern, Director - Private Markets at Robert Wood Johnson Foundation, and Tristram Perkins, Managing Director - Neuberger Berman.  Please click on the image below to hyperlink to a 14 minute video from this panel discussion entitled The Charm and Unknown of Emerging Markets by TI.

Although the discussion is primarily targeted to institutional investors, I think it provides helpful perspectives for individual investors as well, particularly in the complex investment landscape that investors find themselves in. TI prefaced the discussion as follows: "Emerging markets take a sizable chunk of institutional capital from developed countries.  But as domestic private equity has been providing steady returns, is the risk of going into emerging markets still worthwhile?  While some warn that investors should be careful betting on emerging markets, others argue investors need a little patience and a “buy-and-build” approach.

In part three of TI’s private equity panel, investors discuss their experience and observations on emerging market investing. The panelists also answered questions from the audience."

 

 

In the video, I reference a new book from Sam Zell. Please click the image below to a hyperlink to the audible site to listen to the book read by Sam. Enjoy. 

 

 

We've also been busy over the past year or so contemplating the establishment and progression of Servant Financial over the past 12 years and going through a refresh of our branding and marketing materials to ensure proper reflection of our founding mission, values. and raison d'être.  This journey started with a new corporate logo which you see below.  Please note the heraldic shield that forms the V in Servant.  We believe investment and wealth management is a noble profession.  The assets that we manage for clients represent their dreams for the future whether it be a college education for a son or daughter, vacation home, secure retirement, or eldercare for aging parents.  At the center of the shield is a key which represents our vision of providing better client solutions through experience, passion, and integrity represented by the three rings at the bottom of the key.  The mustard plants coming forth from the key symbolize our mission to serve clients and communities with good and faithful financial advice and cultivate the growth and fulfillment of their dreams.

 

 

Summer Reading

 

The end of summer is upon us as we wind down the season over the long Labor Day weekend.  I thought it appropriate for this August newsletter to cover topics from my summer readings while vacationing in early August.  Consider it sort of like that book report we all had to prepare for the first week of school. We went to Saugatuk, MI for family vacation as we have every summer for more than a decade, but this time we took two consecutive weeks in this Cape Cod-like Midwestern retreat on Lake Michigan.  The extra week changed the pace of everything.  It was a magical trip of communing with nature, family and friends through running, kayaking, beaching, car racing, live music, dining, and, of course, reading, or in my case listening to a books on Audible.  (I found that I retain more information by hearing rather than reading.)  This is the tale of the experience as seen through the lens of my summer readings.

The odyssey began by climbing the 282 steps to the top of Mount Baldhead, or simply Mt. Baldy, above Oval Beach on Lake Michigan.  At the top of the mountain, I spied three tents of knowledge - one for Steve Case, one for Aldous Huxley, and one for Ben Bernanke.  I traveled from tent to tent soaking in each sage's wisdom.

The first tent was called Revolution after Steve Case's venture capital firm.  Steve is an American entrepreneur, investor, and businessman best known as the co-founder and former chief executive officer and chairman of America Online (AOL).  AOL was the leading company at the dawn of the consumer internet.  Steve wanted to talk to me about his new book "The Third Wave: An Entrepreneur's Vision of the Future."

Case predicts the future of the U.S. economy and describes what he calls the "Third Wave of the Internet."  AOL and other companies introduced early consumers to the Internet in the first wave.  Then search giants such as Google and companies such as Apple have led us into the second wave of the internet, the app economy.  The third wave that Steve envisions will be "the Internet of things", in which every experience, product, and service will be transacted online.  He imagines this Third Wave as being much less tech focused and more driven by centers of expertise in sector verticals.  He sees the tech geeks partnering with the industry experts to develop sector tailored tech enabled solutions.  He foresees partnerships developing in healthcare, agribusiness, manufacturing and production and other industries around existing, longstanding centers of excellence across every region of America.  These regions will have network density of expertise within sectors.  For example, in healthcare services we think of Mayo Clinic or in agribusiness with think of the Midwest and America's bread basket.  No longer will all the technological answers flow predominantly from Silicon Valley and the Bay area.  Other regions of the country will also prosper in what Steve refers to as the Rise of the Rest.  He foresees that skills around creativity and collaboration will be of critical importance in the Third Wave.  He punctuated this point with an African proverb that describes the requirements for success in the Third Wave - “If you want to go fast, go alone. If you want to go far, go together.”

 

 

I thanked Steve for sharing his wisdom and moved on to the second tent called "The Doors of Perception" hosted by Aldous Huxley.  Aldous was an English writer, novelist, and philosopher.  He is the author of nearly fifty books.  His best known work is his novel "Brave New World", set in a dystopian future while his non-fiction work "The Doors of Perception" recalls his experiences taking mescaline, a psychedelic drug.

Aldous relayed that Jim Morrison named his Los Angeles based band The Doors after Huxley's groundbreaking book.  The book itself was a reference to a quote made by poet William Blake, "If the doors of perception were cleansed, everything would appear to man as it is, infinite."  Huxley relayed that Morrison had developed an alcohol dependency that sadly led to his very early death at 27.

 

Aldous relayed that young Jimmy was unable to effectively process his feelings of indignation, fear and doubt.  Huxley believed that "when we bury our feelings of indignation, fear and doubt, we bury them alive."  He believes it is physically and psychologically unhealthy to bury disagreeable emotions.  We need to transform these hurts into something beautiful, virtuous, and personally fulfilling.  He says that is the way to open the doors of peace and prosperity.  He suggested that we need to practice mercy by never holding on to the bitterness.  We should be prone to forgiveness, and suppress the desire for revenge.  He recommended reading "The Paradoxical Commandments" by Dr. Kent Keith as a way to open the transformative doors of perception.  Huxley's favorite version of "The Paradoxical Commandments" was written on a wall in Saint Teresa of Calcutta's home for children entitled "Do It Anyway."

People are often unreasonable, illogical and self-centered; Forgive them anyway.

If you are kind, people may accuse you of selfish, ulterior motives; Be kind anyway.

If you are successful, you will win some false friends and some true enemies; Succeed anyway.

If you are honest and frank, people may cheat you; Be honest and frank anyway.

What you spend years building, someone could destroy overnight; Build anyway.

If you find serenity and happiness, they may be jealous; Be happy anyway.

The good you do today, people will often forget tomorrow; Do good anyway.

Give the world the best you have, and it may never be enough; Give the world the best you've got anyway.

You see, in the final analysis, it is between you and Your God. It was never between you and them anyway.

I bid Aldous adieu and headed on to the third and final tent hosted by former Fed Chairman Ben Bernanke.

 

 

Now I must tell you a few things before we relay the wisdom imparted by Bearded Ben.  First of all, Ben's tent was not a tent at all, but an orange Volkswagen vanagon.  Secondly, it was the most popular of the three sites, more popular than Case's Revolution tent, and Huxley's Doors of Perception.  There was a large crowd milling about the vanagon and the air was thick with anticipation like just before a Door's concert was about to begin.  I asked Ben what the story was with the massive crowd.  

 

 

Ben advised that he believed the people were attracted to the wisdom of his gray beard and proceeded to regale me with the history of the beard.  He advised that the Judeo-Christian tradition teaches us that God created man in His own image and that custom holds that God has a beard.  God’s beard, called Mazal, is seen as the source of all life and sustenance in creation. Mazal literally means “flow” and all fortune and goodness “flows” from God’s beard.  God's beard has thirteen knots and the untangling of these knots allows sustenance or God's mercy to flow, leading to good fortune, wisdom, and personal fulfillment.  

I was amazed at Ben's knowledge of facial hair, but had a Paul Harvey-like intuition that there was more to this story.  I commented to Ben that his gray beard was quite fashionable and perhaps "good fortune" and wisdom may flow from his beard, but surely that cannot be the sole reason for the large crowd around his VW.  I pressed him again and again until he finally confided to me that the VW vanagon came equipped with a printing press.  And, very shortly at a touch of a button "good fortune" would flow from his VW like manna from heaven.

 

And that is how I spent my summer vacation.

Mexico Private Equity Day

 

In early June I attended the Mexico Private Equity Day conference in New York hosted by AMEXCAP, the association of Mexican private equity firms. The mission of AMEXCAP is the dissemination of information on industry opportunities, challenges, and trends for private equity investment in the country. Given President Trump's often inflammatory rhetoric during the campaign and since his election about building a wall at the Mexican border and renegotiating the North American Free Trade Agreement (NAFTA), I thought it would be beneficial to provide you with the Mexican perspectives on these and other matters.

From a macro perspective, the Mexican economy is accelerating with first quarter of 2017 GDP at 2.8% compared to 2.1% for the fourth quarter of 2016. Mexican micro-economic reforms to open up the energy and telecom sectors to private investment are beginning to bear fruit, particularly in the energy sector.

Mexican production is not simply low cost manufacturing, but rather highly complex, value-added production. The three countries of NAFTA are highly interdependent and integrated from a production standpoint and each party understands and appreciates its role in the supply chain. Imports and exports within the NAFTA block are expected to increase rather than decrease despite Trump's rhetoric. Many conference speakers held the view that Trump's preferences for U.S. strategic direction had met with institutional constraints by the Federal government which would result in compromise. For example, the U.S. withdrew from the nascent Trans-Pacific Partnership (TPP) but longstanding NAFTA is still on the books and progressive renegotiations are expected. Conference panelists generally expected the news flow on NAFTA would be relatively quiet until the 2018 Mexican presidential election process picks up steam.

In a speech on macroeconomic conditions, Gerardo Rodriquez a BlackRock emerging markets portfolio manager forecasted upside to GDP growth for developed market economies as we enter the final years of this expansionary cycle. This trend in turn is accelerating the emerging market economic expansion led by the manufacturing sector based on improving purchasing manager indicators (PMIs). As the BlackRock chart below depicts, Mexico and its LaTam peer Brazil are two of several emerging economies with PMIs that are in positive territory and improving.

 

 

As the chart below depicts, emerging market analysts are beginning to revise GDP growth forecasts for emerging markets upward. After bottoming out in 2015 at about 4.25% annual growth, emerging market economic growth as a whole is expected to accelerate to approximately 5.0% for 2018. Similarly, after several years of downward revisions, GDP growth forecasts for Mexico are likely to be revised upward for this year and next. The consensus GDP growth forecast for Mexico for 2017 is presently at 1.8% and very much in line with U.S. growth forecasts.

 

 

BlackRock's Rodriquez cited a common issue with growth forecasts in that analysts were consistently revising GDP growth forecasts down over time in years just after the 2008/09 crisis. In hindsight, analysts had anticipated quicker economic recoveries than what actually happened. This issue was universal across developed and emerging markets. He theorized that perhaps analysts are now being too conservative with growth forecasts after this period of being too optimistic on economic growth.

 

 

The Mexican private equity business is a growing and vibrant part of Mexico's economic development. In some respects the Mexican private equity market has recently jumped into the fast lane. According to a recent report by Bain Consulting on global private equity, the once nascent industry in Mexico reached a number of milestones in 2016 as the industry invested around government privatizations in the energy and telecom sectors. In terms of number of transactions, firms, and broad ecosystem, private equity in Mexico has a low penetration rate compared to Brazil and other emerging market peers, but the industry is experiencing robust growth in Mexico. For example, there were more private equity deals in Mexico in 2016 than in Brazil.

One significantly positive secular trend that will drive the Mexican private equity industry is legislation in the past decade that opened private equity investments to Mexican pension plans. The age of the average Mexican worker is only 42. This is much lower than the average pensioner in the U.S. and other developed economies. From an investment perspective the longer term nature of these pension liabilities for the average Mexican worker makes private equity an attractive asset allocation alternative for these theoretically more risk tolerant and less liquidity sensitive investors.

Others acknowledged that in this globally competitive world private equity investment is an international play. The broad capital needs for Mexico for private investment are competing for investment dollars with other developing nations like Turkey, India, and Indonesia. Broadly speaking the private equity asset class in Mexico is uniquely positioned to back the best entrepreneurial firms, but this was viewed as both a blessing and a curse as there is a "scarcity of top managers who think like owners." At this stage in the development of Mexico's private equity ecosystem, there is a clear shortage of successful operators that have experience creating successful entrepreneurial enterprises. Mexico's entrepreneurial class is still in its development phase.

We can see the development of an entrepreneurial class manifested in economic statistics. As the chart below depicts, Mexico's productivity growth has been one of the lowest in the world. Mexico's productivity growth from 1980 to 2010 was 0.25%. This compares to the leaders in productivity growth of 1.5% to 2.0% for Ireland, South Korea, and China. Meanwhile, the developed U.S. experienced productivity growth at twice the pace of Mexico at 0.5%.

 

 

There were several speakers who touched on the underlying factors driving Mexico's low productivity growth. The two most often cited factors were rule of law and control of corruption. Enhancement of rule of law will be an important aspect to continued development of the private equity market in Mexico. For example the Mexican government is moving forward with its goal of privatizing the energy sector. The government has been holding auctions on exploration and production opportunities in Mexico that would previously have been solely the domain of the state-owned energy company Pemex.

Here are some noteworthy comments on this topic. One panelist shared a comment by a Houston-based energy CEO who indicated that she likes Mexican reservoirs but said that "it seemed like the Mexican government went around the world looking at energy concession contracts and picked the most complex and onerous provisions as requirements for the Mexican auction contracts." Another large energy investor raised questions about Mexican rule of law and the lack of separation of the judiciary branch of government.

BlackRock's Rodriquez stressed this issue as well. He indicated the rule of law and control of corruption continue to be the most significant challenges for LaTam. The World Bank ranks countries on these development factors as well as several other worldwide governance indicators.

The following table displays Mexico's percentile rank against all other countries on the World Bank's rule of law governance indicator as compared to Latin America & Caribbean region and Brazil for 2005, 2010 and 2015 rankings. Mexico lags Brazil and the region but perhaps even more telling its percentile rank in 2015 is below where it was in 2005.

 

 

This next table shows the World Bank's percentile rank of Mexico on its control of corruption governance indicator as compared to Latin America & Caribbean region and Brazil for 2005, 2010, and 2015 rankings. Once again Mexico's rankings lag the region and Brazil. Perhaps more disturbing is the precipitous drop in Mexico's ranking from 2005 to 2015.

 

 

BlackRock's Rodriquez noted that there are limited historical examples of emerging market countries piercing the ratio of 20% of U.S. GDP per capita. South Korea is one longer term example of a country that was able to continue on a steady path of wealth and prosperity for its people. China has just recently moved its GDP per capita to 25% of U.S. GDP per capita. Chile is a LaTam country that stands out as favorable player on this metric. Rodriquez cited that the reasons for the productivity lag in Latin America and the reason emerging market countries generally plateau around the ratio of 20% of U.S. GDP per capita is a) rule of law, b) control of corruption and c) failures in the education system. Research by Rodriquez indicates that GDP per capita is highly correlated to good scores on these three institutional development measures and the 20% ratio of U.S. GDP per capita threshold or ceiling reflects this dynamic.

This final chart below from Rodriquez's presentation depicts this phenomenon. The y-axis ranks countries on these three measures against the median percentile score represented at the zero horizontal line and the x-axis measures GDP per capita in U.S. dollar on a purchase price parity basis (PPP). Note that while Mexican GDP per capita has grown from 1996 (MEX'96) to 2015 (MEX'15), Mexico remains ranked below the median on these governance scores. Meanwhile, Chile (CHL) GDP per capita and governance rankings are both higher than Mexico and on par with South Korea (KOR). So in short, Mexico and other similarly situated developing countries could have higher GDP growth if they can meaningfully address their weak institutional oversight of rule of law and control of corruption.

 

 

In his recently published book "Am I Being Too Suble?: Straight Talk From A Business Rebel" billionaire and highly successful investor and entrepreneur Sam Zell wrote, "When you invest in emerging markets, you're trading rule of law for growth." Based on BlackRock's analysis by Rodriquez, the important corollary to this frictional cost of emerging market investing is that the leadership of emerging market countries, like Mexico, are sacrificing even higher GDP growth along with greater wealth and prosperity for their people by not addressing the meaningful productivity costs of weak institutional governance of rule of law and corruption.

Socially Responsible ETF Choices

 

Since the dawn of time, man has been given the gift of choice.  This concept is reflected in the ancient wisdom literature and the words of great philosophers.  The wisdom of Deutoronomy 11:26 written around 1400 BC imparts, "Look, today I am giving you the choice between a blessing and a curse!"  The classical Greek philosopher Plato pronounced around 400 BC, "Let each one of us leave every other kind of knowledge and seek and follow one thing only, if peradventure he may be able to learn and find some one who will make him able to learn and discern between good and evil, and so to choose always and everywhere the better life as he has the opportunity."

Every facet of life seemingly has this Platonic element of choosing the better life or the righteous path over the alternative.  In the investment realm, the element of doing good through investment choices is called socially responsible investing (SRI).  SRI is any investment strategy which seeks to consider both a financial return and the promotion of a social good through a combination of financial support and advocacy for social change.  As you would expect, religious organizations have generally taken the lead on this topic.  Perhaps the earliest modern day organization to formally encourage socially responsible investment policies was the United States Conference of Catholic Bishops.  In 1971, the Catholic Bishops openly challenged U.S. corporations on the issue of apartheid in South Africa.  In 1986, the USCCB issued its first formal set of guidelines for socially responsible investing.  USCCB ethical investment guidelines seek to: 1) do no harm (like the hippocratic oath) by avoiding participation in harmful activities, 2) to use its role as stockholder for social stewardship, and 3) to promote the common good and social justice.

These goals generally comport with today's evolving SRI mindset which broadly seeks to encourage corporate practices on environmental stewardship, consumer protection, human rights, and diversity.  For example, some common negative SRI screening criteria include avoiding businesses involved in alcohol, tobacco, fast food, gambling, pornography, weapons, contraception/abortion, fossil fuel production, and military products.  Areas of social advocacy recognized by SRI practitioners are often summarized under the alternative heading of ESG - environment, social justice, and corporate governance.

US-SIF - The Forum for Sustainable and Responsible Investing issued a Report on Sustainable and Responsible Investing Trends in the United States that identified $8.72 trillion in total assets under management at the end of 2015 that used one or more sustainable, responsible, or impact investing strategy.  This balance represents approximately 22% of the total assets under professional management in the United States as tracked by Cerulli Associates.  US-SIF reports that from 2014 to 2016, SRI enjoyed a growth rate of more than 33 percent, increasing from $6.57 trillion in 2014.  The chart below summarizes the scope of SRI activities in the United States (click chart for link to larger image).  

 

 

The vast majority of the foregoing assets are professionally managed for institutional investors.  Current assets under management for retail investors represent a much lower market share than the institutionally weighted 22% reported by US-SIF.  Within the ETF (exchange traded funds) market which is Servant Financial's investment vehicle of choice, there are 32 funds with social investment mandates with $2.4 billion of assets under management (AUM).  This compares to total AUM in ETFs of $3.4 trillion.  This suggests that SRI ETFs represent only about 1/10 of 1% of the ETF market.  Furthermore, total AUM of the more mature mutual fund industry is $15.7 trillion.  While AUM of $22 billion of the top 5 SRI focused mutual funds is more than 7 times larger than SRI ETF AUM at $22 billion, it still only represents around that same 1/10 of 1% of the mutual fund market.  

Despite these statistically low rates of market penetration, there may be some pent up demand for SRI investment solutions among retail investors.  A recent survey of retail investors' wealth management preferences by FactSet and Scorpio Partnership of over 1,000 high net worth individuals found that SRI was a particularly hot button for both millennials under 35 and Generation X adults between 35 and 54 years of age.  

When asked, "To what extent do you agree that your portfolio should be managed and allocated in a socially responsible manner?," sixty-one percent of respondents under age 35 said they expected their wealth managers to screen investments based on ESG factors.  Preferences for SRI were also high in the 35-54 age group with fifty-three percent of Generation X respondents in favor of some type of ESG screening. See the chart below (click chart for link to larger image).

 

 

When asked, "In the next five years, how do expect your allocations to socially responsible investments to change?," a whopping 90% of millennials said they expect their SRI allocations to increase either a little (45%) to a lot (45%).  Generation X individuals similarly expected SRI allocations to increase a little (46%) to a lot (26%).  See the chart below (click chart for link to larger image).

 

 

The two primary criticisms against SRI have historically been that 1) the screening processes (both negative and positive) required to identify qualified companies are costly to undertake and 2) the selection criteria in and of themselves will penalize investment performance.  The perception of this double whammy to net investment returns (after fund investment management fees) appears to be an artifact of history.  A decade or so earlier, the typical SRI mutual fund likely sported an expense ratio in excess of the average mutual fund expense ratio of 1.5%.  However, the construction of passive SRI indexes together with technological innovations that allow the broad sharing of screening methodologies from one to many have been driving these frictional costs lower for SRI conscious investors.  

A number of passive SRI indexes have been developed based on environmental and social criteria or religious-based criteria (Catholic and Islamic Indexes).  The oldest SRI Index is the Domini 400 Social Index, which started in 1990. The Calvert Social Index started in 2000, and the FTSE4Good Indexes dates from 2005. Currently index mutual funds and ETFs are available that track the Domini 400 Social Index, the FTSE4Good Select Index, and the MSCI US ESG Broad Market and ESG Select Social Indexes.  MSCI has created a series of social indexes which cover the entire US market and discrete segments of the market based upon market capitalization.

US-SIF publishes a list of over 200 SRI mutual funds.  Expense ratios for retail investor share classes among these funds range from 0.44% for a blended fixed income and equity product to 2.4% or more for global, emerging market focused or sector specific strategies.  SRI can be executed much more cheaply in more transparent and competitive domestic fixed income and large capitalization equity markets (S&P 500 or Russell 3000) than in international markets or global sector funds.

In 2016, TIAA Global Asset Management released Responsible Investing: Delivering Competitive Performance which argued against the misconception that responsible investment (RI) screens penalize investment performance.  In the report, TIAA concluded its "analysis of leading RI equity indexes over the long term found no statistical difference in returns compared to broad market benchmarks, suggesting the absence of any systematic performance penalty.  Moreover, incorporating environmental, social and governance (ESG) criteria in security selection did not entail additional risk. RI indexes and their broad market counterparts had similar risk profiles, based on Sharpe ratios and standard deviation measures."

The table below summarizes TIAA's findings (click table for link to larger image within research paper). Note: all of the index performance figures in the table are before (or gross of) fund management fees.

 

 

Servant Financial's preferred approach to build globally diversified portfolios for clients is to use low cost, tax efficient ETFs as much as possible.  The market development of SRI ETFs is still in its infancy.  Whereas there are over 200 SRI mutual funds with over $22 billion in AUM, there are only 32 SRI ETFs at about 10% of the size of the SRI mutual fund AUM.

The largest SRI ETF is iShares MSCI KLD 400 Social ETF (symbol DSI) with $748 million in AUM. This ETF has an expense ratio of 0.50%.  It was the second SRI ETF offering when it hit the market in November, 2006.  Launched in May 1990, the MSCI KLD 400 Social Index is one of the first SRI indexes.

The MSCI KLD 400 Social Index is designed to provide exposure to companies with high MSCI ESG Ratings while excluding companies whose products may have negative social or environmental impacts.  It consists of 400 companies selected from the MSCI USA IMI Index, which includes large-, mid- and small-cap US companies.  DSI aims to select companies with the highest ESG Ratings in each sector and maintain sector weights similar to those of the parent MSCI USA IMI index.  In addition, DSI excludes companies incompatible with a common set of values screens: alcohol, tobacco, gambling, civilian firearms, military weapons, nuclear power, adult entertainment and genetically modified organisms.  The following table summarizes some key facts and the top ten holdings of DSI (click chart for link to larger image).

 

 

The oldest SRI ETF is iShares MSCI USA ESG Select ETF (KLD) which was issued in January, 2005.  KLD is the second largest SRI ETF with $513 million in AUM.  This ETF has an expense ratio of 0.50%.  The MSCI USA ESG Select Index is designed to maximize exposure to positive environmental, social and governance (ESG) factors while exhibiting risk and return characteristics similar to those of the MSCI USA Index.  KLD is comprised of 100 or more large- and mid-cap stocks and is optimized to be sector diversified, targeting companies with high MSCI ESG ratings in each sector.  KLD uses far fewer negative screens than the MSCI KLD 400 Social Index as it only excludes tobacco.  Relative to the MSCI USA Index, the MSCI USA ESG Select Index tends to over-weight companies with high ESG ratings and under-weight companies with low ratings.  The Index is a benchmark for investors who seek an investment opportunity set with a very high ESG score and controlled risk.  Constituent selection is based on data from MSCI ESG Research.

The following table summarizes some key facts and the top ten holdings of KLD (click chart for link to larger image).  Note only two of the KLD top ten holdings are also included in DSI.

 

 

There are only two other ETFs with more than $250 million in AUM worth mentioning.  These ETFs have much more narrow social screens but interestingly both have lower expense ratios of 0.20%.  

The iShares MSCI ACWI Low Carbon Target ETF (symbol CRBN) seeks to track the investment results of an index composed of large and mid-capitalization developed and emerging market equities with a lower carbon exposure than that of the broad market.  CRBN has $314 million of AUM and seeks to support companies less dependent on fossil fuels by overweighting their stocks relative to higher carbon-emitting peers.  This ETF's holdings make it look like a quasi-financial, technology, and consumer focused fund as these three sectors represent 51% of the asset allocation.

The SPDR SSGA Gender Diversity Index ETF (symbol SHE) seeks to provide investment results that correspond generally to the total return performance of the SSGA Gender Diversity Index.  The SSGA Gender Diversity Index is designed to measure the performance of U.S. large capitalization companies that are "gender diverse," which are defined as companies that exhibit gender diversity in their senior leadership positions.  This ETF has $285 million in AUM and was seeded with $250 million by CalSTRS, the large California pension plan.  This ETF is much more diversified than CRBN. Further, academic research shows that firms run by women perform slightly better than their counterparts in return on equity.  Companies with strong female leadership sported 10.1% returns on equity compared to 7.4% for companies without a critical mass of woman at the top.  This explains SSGA's "Better Together" slogan.

Although the market share for SRI among retail investors appears rather low at less than 1% of mutual fund and ETF assets under management, surveys indicate that SRI is a clear aspirational goal among Millennials and Generation X investors.  The ETF industry appears to be in the early stages of developing low cost, tax efficient products around passive SRI indices to address these unmet retail investor needs.  Both parties are also operating under a certain set of economic criteria while they endeavor to find a better way or more righteous path to achieve their objectives.  We believe there is potentially a budding Platonic relationship here and will continue to monitor socially responsible ETF choices on behalf of our clients.

Entering The Inflation Labyrinth

 

A labyrinth is not a maze.  It is unicursal (one line) and has only one path to the center and back out.  The labyrinth has no dead ends or blind alleys like a maze.  It is a circular path to a sole destination. The path often twists and turns back on itself many times before reaching its center.  Once at the center, there is only one way back out. The same path in the opposite direction.

The labyrinth often symbolizes a journey to a predetermined destination such as a pilgrimage to a holy site.  For example, the best known labyrinth is the beautifully preserved pavement labyrinth in Chartres Cathedral, France (pictured below). The cathedral was constructed during the second decade of the 13th century.  The labyrinth is 12.9 meters (42.3 feet) in diameter and fills the width of the nave or center of the church.  While much has been written about the purpose of this labyrinth, little contemporary documentation has survived.  It is known that labyrinths in the French cathedrals were the scene of Easter dances carried out by clergy.  It is also popularly assumed that the labyrinth is a symbol of the long tortuous path that Medieval pilgrims endured to visit Chartres and other sacred places.

This month's feature article will focus on another labyrinth - the Federal Reserve's long torturous path to inflationary conditions.

 

A white paper from the Congressional Research Service entitled Monetary Policy and the Federal Reserve: Current Policy and Conditions by Marc Laborite, a specialist in macroeconomic policy, dated February 7, 2017, summarizes the current state of the Federal Open Market Committee's (FOMC or Fed) monetary policy conditions:

"The Fed anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”  Thus, although rates are being raised, the Fed plans to maintain an unusually stimulative monetary policy for the time being.  In terms of its mandate, the Fed believes that unemployment has reached the rate that it considers consistent with maximum employment (although other labor market indicators suggest some slack remains), but inflation has remained below the Fed’s 2% goal since 2013 by the Fed’s preferred measure.  Debate is currently focused on how quickly the Fed should raise rates. Some contend the greater risk is that raising rates too slowly will cause inflation to become too high or cause financial instability, whereas others contend that raising rates too quickly will cause inflation to remain too low and choke off the expansion."

Recent inflationary data suggests that inflation is on the rise across the globe particularly in the world's two largest economies.  According to Trading Economic's global macro models and analysts' expectations, the inflation rate in the United States is expected to be 2.50 percent by the end of the first quarter of 2017.  In January 2017, consumer price inflation (CPI) on a year over year basis (YoY) reached their forecasted level of 2.50 percent.  Core CPI YoY (excludes volatile energy and food prices) rose 2.3% in January.

Looking forward, Trading Economics estimates the inflation rate in the United States will remain at 2.50 percent for twelve months.  In the long-term, the U. S. inflation rate is projected to trend around 2.50 percent to 2020.  The chart below summarizes Trading Economic's inflation forecasts for the United States.  Note the nice upward sloping pattern indicative of rising inflation.

 

 

Trading Economics forecasts the inflation rate in the world's second largest economy of China to be 2.60 percent by the end of the first quarter of 2017.  China has also recently experienced a dramatic turn in inflationary metrics. China's January producer price index (PPI) posted a stronger-than-expected 6.9% YoY increase.  A year ago in January 2016, Chinese PPI was a negative (5.3%) YoY. China's remarkable one-year inflationary turnaround was not isolated to producer prices.  China's CPI has also increased 2.5 percent YoY up from a year ago CPI of 1.8 percent, well within earshot of Trading Economics forecast of 2.6 percent inflation by the end of the first quarter of 2017.  

Looking forward, Trading Economics estimates the inflation rate in China to stand at 3.00 percent in 12 months time.  In the long-term, the China inflation rate is projected to trend around 4.50 percent in 2020.  Again the chart for China shows a nice upward sloping inflationary pattern.

 

 

As outlined in the white paper Monetary Policy and the Federal Reserve: Current Policy and Conditions, the difficulty for the FOMC is properly timing their monetary actions to act soon enough to prevent incipient inflationary pressures from taking hold while not tightening monetary policy too quickly and choking off economic growth.  An additional policy wild card is the impact of Trump administration actions on economic activity.  Most experts view Trump's policies as favorable and expect his administration's policy initiatives to enhance overall economic growth prospects in the United States.  However, minutes from the Federal Reserve's January meeting released last week indicate that policymakers are highly uncertain about the impact of Trump's fiscal plan on the U.S. economy.  The following are some quotes from the Fed's January minutes addressing fiscal policy and inflation:

"Participants again emphasized their considerable uncertainty about the prospects for changes in fiscal and other government policies as well as about the timing and magnitude of the net effects of such changes on economic activity."

"Regarding the outlook for inflation, some participants continued to be concerned that faster-than-expected economic growth or a substantial undershooting of the longer-run normal unemployment rate posed upside risks to inflation."

The following chart from Advisor Perspectives summarizes the components of the consumer price index (CPI) to provide perspective on assessing inflation. Please note that the largest category is housing representing 42% of CPI followed by transportation and food and beverage components which both represent about 15% of CPI. These three components together represent approximately 72% of CPI.

 

 

Given the lengthy period of accommodative monetary policy since the Great Recession of 2008/9, it is not surprising that we are finally beginning to see an uptick of inflationary trends impact these three key components of CPI.  Most noteworthy is the rebound in commodity prices from the late 2014 to early 2016 correction which are essential inputs to the transportation and housing construction components.  West Texas Intermediate oil prices are up 63% year over year.  Industrial metal prices also saw large increases in 2016. Copper prices advanced 27% in 2016 and are up 10% so far in 2017.  Over the last twelve months, copper is up 28%, nickel is up 27%, silver is up 19%, and gold is up 2%.  Meanwhile indices of home prices show a continued inflationary trend as home prices rose 6.2% year over year in December 2016, as institutional/landlord ownership of single family homes increased to 37% in 2016, the highest percentage in over a decade.  These factors show how dynamic and resilient the U.S. economy has been as capital and supply have rapidly adjusted to aggregate demand and prices.

One of the more visible aspects of Trump's policies on economic growth and inflation is immigration.  Some experts suggest that less immigration would inhibit U.S. economic growth given poor underlying demographic trends.  U.S. fertility rates are falling, leading to a natural population growth rate of 0.4%, the lowest level since the founding of our nation.  Fertility is perhaps more of a longer term than immediate issue as relates to near term inflation monitoring.  Experts suggest that immigration - legal or unauthorized - is necessary to meet the economic growth requirements in the labor force and that absent robust immigration trends, particularly lower paying, less skilled employment, we would see a pick-up in inflationary pressures as wages are increased to attract needed productive labor capacity.

The following chart from Pew Research Center suggests that based upon the most recently available census data for the period from 2009 to 2014, that unauthorized immigration declined over this period and therefore was not a significant factor in the growth in the U.S. labor force during this time period.

 

 

In 2014, the nation’s civilian labor force of 160.4 million people consisted of about 132.8 million U.S.-born workers (83% of the total and up 1.6% from 2009), 19.5 million lawful immigrant workers (12% of total and up 7.8% from 2009 ) and 8.0 million unauthorized immigrant workers (5% of total and down 100K).  The numbers of U.S.-born members of the workforce and lawful immigrant members of the workforce both increased from 2009 to 2014, while the number of unauthorized immigrant workers did not.  As depicted in the chart below, the estimated number of unauthorized immigrants in the labor force plateaued in 2005 and has essentially flatlined since.

 

 

So while legal immigration has been a significant positive contributor to labor force growth over the relevant period, unauthorized immigration has not been a significant factor.  Arguably, a continuation of policies that promote legal immigration would have a continued positive effect on labor force growth and government tax revenues while policy actions to discourage unauthorized immigration would have negligible or minimal impact on the overall U.S. labor force and economy.  The table below sets forth the U.S. industries and occupations that employ the highest share of unauthorized immigrant workers.

 

 

Although unauthorized immigrants work throughout the U.S. economy, they are particularly concentrated in some sectors, according to the Pew Research Center analysis.  Compared with their 5% share of the civilian workforce, they were overrepresented in the agriculture (17%) and construction (13%) sectors, as well as in the leisure and hospitality industry (9%).  They were underrepresented in some sectors such as the educational and health services sector and the financial and information industries.

By occupation, unauthorized immigrants held a higher share of U.S. farming jobs (26%) in 2014 than would be expected given their share of the workforce.  They also held a disproportionate share of construction jobs (15%). By contrast, unauthorized immigrants held a lower share of maintenance, management, professional, sales and office support jobs than their share of the workforce overall.

Although the foregoing data suggests Trump immigration policies would likely have minimal overall impact on the U.S. labor force and economy, aggressive policy actions could result in labor force disruptions and spark inflationary pressures in specific sub-sectors such as agricultural/food and beverage and construction/housing sector where unauthorized immigration labor is a key production input.

Based upon the more hawkish tone of its policy statements, it would appear that the FOMC is much closer to the center of the inflation labyrinth than they would otherwise publicly admit for fear of being seen as behind the curve.  Even before the impacts of Trump fiscal policies, current CPI readings are running above the FOMC's 2% inflation target.  In addition, two key components of CPI - housing (42% of CPI) and transportation (15% of CPI) - are already on an uptrend.  Moreover, there is considerable data supporting the view that aggressive immigration policy actions could be highly disruptive to the labor cost inputs in the important agricultural and construction sectors of the U.S. economy.  As President Trump would say it could be "yuge." 

Bread of Presence

 

The new year of 2017 has started with incredible optimism and exuberant risk taking in liquid securities markets. Through January 24, 2017, the S&P 500 was up 2.4% on a total return basis while the technology heavy NASDAQ was up 4.8%. The four horseman of "gratification", better know as the FANGs, sped out of the starting gate with Facebook's (FB) price up 10.7%, Amazon (AMZN, +9.1%), Netflix (NFLX, +9.9%), and Google (GOOG, +4.8%). For the last twelve months through January 24th, the S&P 500 was up an astounding 24.9% and the NASDAQ up 26.6%.

Contrast the start of this year with January 2016 when fear held sway and we experienced the exact opposite market movements. Has all that much changed in one year's time? Certainly, we have a new administration ensconced in the White House and a Republican controlled House and Senate to boot, but will that in and of itself end Washington gridlock, particularly with a polarizing President Donald J. Trump with adolescent-like readiness to Tweet anything at anytime. With markets this ebullient, this is an opportune time to feast on the bread of presence, to ponder the current geopolicital situation, and to take stock of market fundamentals.

We mostly see the same yeast for loaves of instability we saw a year ago. First and foremost is the long fermenting yeast of monetary policy. Unprecedented monetary disorder of the past 8 plus years has been leavened by the global central bankers for so long that what were once considered "extraordinary" measures pass for normal and acceptable monetary policy. We have rising populism across the developed markets of Europe and America sowing the seeds of social and democratic instability. Our pugnacious President has no fear of publicly attacking his opposition as in his mind the ends justify the means. Those abhorred by his methods and beliefs tend to escalate the juvenile verbal warfare. For example, pop star Madonna had this to say at Women's March on Washington rally according to Business Insider, "Yes, I am outraged. Yes, I have thought an awful lot about blowing up the White House ... but I choose love," Madonna said from the main stage area near the National Mall. If you read the venomous words quoted in the linked article, it is quite clear that this pop star turned would be terrorist is speaking from a heart of stone. If there was any love in her words and actions, it was self-promotional love.

We also have calls for renegotiations of major trade agreements (BREXIT from the European Union and NAFTA), proposals for protectionist trade policies, and accusations of currency manipulation acting as a fungal culture for economic and market instability. No matter how you cut it the present moment in market history is not a time to be complacent. In fact perhaps it is time to be paranoid, very paranoid.

Andy Grove, founder and former Chairman and CEO of Intel, wrote a seminal book in 1996 that addressed this issue entitled, Only the Paranoid Survive: How to Exploit the Crisis Points That Challenge Every Company. Mr. Grove gave a speech in 1998 at the Intel Academy of Management, Annual Meeting that summarized his book and thoughts on how the paranoid survive Strategic Inflection Points.

He described Strategic Inflection Points as:

"...what happens to a business when a major change takes place in its competitive environment. A major change due to introduction of new technologies. A major change due to the introduction of a different regulatory environment. The major change can be simply a change in the customers' values, a change in what customers prefer. Almost always it hits the corporation in such a way that those of us in senior management are among the last ones to notice... But what is common to all of them and what is key is that they require a fundamental change in business strategy, and that's almost a definition of a strategic inflection point. A strategic inflection point is that which causes you to make a fundamental change in business strategy. Nothing less is sufficient. (emphasis added)"

Groves goes on to cite examples of Strategic Inflection Points in the telecom industry with the regulatory actions that broke up the Bell System in 1984 and more recently the Strategic Inflection Point in the bookseller industry with Barnes & Noble writing the final chapter on local booksellers followed shortly thereafter by Amazon.com shredding Border's and Barnes & Noble's business models.

He continues.

"One of the empirical observations with companies that are dealing with Strategic Inflection Points, or are in the middle of them, is that there is a growing divergence, a dissonance if you will, between the strategy statements of those companies and the strategy actions."

"It is extremely important to be able to listen to the people who bring you bad news and who are typically divided. In the system that I described to you, these people tend to be lower level people. They have to bring you bad news and be Cassandras against the senior management, against the fear of management of repercussions. Unless you deal with this fear, unless you live this fear you will never hear from those helpful Cassandras and you are going to be late in responding to the Strategic Inflection Points. (emphasis added)"

If you ponder the current geopolitical environment, don't the foregoing explanations and signs point to a Strategic Inflection Point in America that led to the populist ascendancy of Donald J. Trump to our Nation's 45th President? Haven't the Main Street and middle class voters assumed the role of the "helpful Cassandras" and brought the bad news of a Strategic Inflection Point to the senior management team in Washington? Didn't the voters just tell the Washington establishment that they are no longer "buying" the sub-standard institutional products and services the government is providing this Nation? And didn't the citizenry just fire the old CEO and management team and replace them a new CEO and leadership team who have the common sense to acknowledge that our Nation is at a Strategic Inflection Point that requires a fundamental change in strategy? Rather than the usual indifference of a kleptocratic politician, President Donald J. Trump is instead zealously paranoid about Making America Great Again and he is rapidly deploying plans to exploit crisis points in our Nation's resources of capital, industry and labor.

In his book, Only The Paranoid Survive, Groves opined that once a Strategic Inflection Point has been identified the next two phases that a business must go through is to first Let Chaos Reign (Chapter 7), "Resolution comes through experimentation. Only stepping out of the out old ruts will bring new insights." And so the Donald President Trump is now sifting through the wheat and chaff of government regulations, programs, and priorities and realigning the business of government to his strategic initiatives. In the first two days in office Trump has taken the following actions accordingly to PBS - 1) rollback Obamacare, aka Affordable Care Act, 2) freeze all in process regulation until it can be reviewed by him or his agency appointees, 3) no Federal money to support abortion, 4) United States withdrawal from the Trans-Pacific Partnership trade agreement, 5) Federal hiring freeze, 6) & 7) speed up approval for the Dakota Access and Keystone Oil Pipelines, 8) speed up environmental reviews for critical infrastructure projects, 9) direct Secretary of Commerce to draft regulations that provide that American steel is used for pipeline projects to the "maximum extent possible", 10) comprehensive review of American manufacturing regulations by the Secretary of Commerce, 11) deportations and sanctuary cities - speed up deportation process of criminals, hire more Immigration and Customs agents, and ordered the Attorney General and Secretary of Homeland Security to block Federal grants to sanctuary cities, and 12) build the Southern Border Wall.

There no longer seems to be cognitive dissonance between the strategic action of American leadership and the strategic statements of its new CEO Donald J. Trump. This speaks to Grove's next phase of fundamental strategic transformation Reign in Chaos (Chapter 8), "Clarity of direction, which includes describing what we are going after as well as well as what we will not be going after, is exceedingly important at the late stage of a strategic transformation." The Trump administration has compressed Grove's two phases into one potentially chaotic national transformation plan. These bold executive actions are wholly consistent with President Trump's strategic plan as most recently articulated in his inauguration address on January 20th. The following excerpts of Trump's inauguration address are consonant with the theory that Trump is using Grove's Only The Paranoid Survive playbook:

"We, the citizens of America, are now joined in a great national effort to rebuild our country and to restore its promise for all of our people."

"This is your day. This is your celebration. And this, the United States of America, is your country. What truly matters is not which party controls our government, but whether our government is controlled by the people."

"At the center of this movement is a crucial conviction: that a nation exists to serve its citizens."

"We will follow two simple rules: Buy American and Hire American. We will seek friendship and goodwill with the nations of the world – but we do so with the understanding that it is the right of all nations to put their own interests first."

"At the bedrock of our politics will be a total allegiance to the United States of America, and through our loyalty to our country, we will rediscover our loyalty to each other."

 

Moreover, Andy Grove's strategic spirit also seems to be influencing President Trump's policy on U.S. employment and job creation. Mr. Groves wrote a marvelous op ed in July 2010 for Bloomberg entitled "How America Can Create Jobs." Groves immigrated to America in 1956. He fled Soviet bloc Hungary where he "witnessed first hand the perils of both government overreach and a stratified population."

Groves felt strongly that employment growth depended on American companies' ability or willingness to scale up within the U.S. As Intel CEO, he worked to keep Intel's manufacturing in the U.S., with the company having 90,000 employees in 2010. He explained the causes and effects of many business's growth plans:

"Each company, ruggedly individualistic, does its best to expand efficiently and improve its own profitability. However, our pursuit of our individual businesses, which often involves transferring manufacturing and a great deal of engineering out of the country, has hindered our ability to bring innovations to scale at home. Without scaling, we don't just lose jobs—we lose our hold on new technologies. Losing the ability to scale will ultimately damage our capacity to innovate."

To remedy the problem, he strongly believed that "job creation" should become America's number 1 objective, much as it is in Asian nations. Among the methods he felt were worth considering was the imposition of a tax on imported products, a strategic tool now at the forefront of the Trump administration trade policies.

"The first task is to rebuild our industrial commons. We should develop a system of financial incentives: Levy an extra tax on the product of offshored labor. (If the result is a trade war, treat it like other wars—fight to win.) Keep that money separate. Deposit it in the coffers of what we might call the Scaling Bank of the U.S. and make these sums available to companies that will scale their American operations. Such a system would be a daily reminder that while pursuing our company goals, all of us in business have a responsibility to maintain the industrial base on which we depend and the society whose adaptability—and stability—we may have taken for granted."

In his closing sentence Grove clearly acknowledged back in 2010 his belief that our Nation was facing a Strategic Inflection Point, "If we want to remain a leading economy, we change on our own, or change will continue to be forced upon us."

Paradoxically, we see Trump's strategic initiatives as further fermenting short-term economic and market instability while advancing his long term strategic plan of allowing every American citizen the opportunity to put bread on their family table. Isn't this the same bread of presence or Promised Land that our Founding Fathers spoke of in the preamble to the U.S. Constitution?

We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defense, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America.