Going Negative?

Is Europe headed for negative interest rates?

The Euro-zone has been in recession since mid-2011. Their recovery from the Financial Crisis of ’08 and ’09 was tepid, and the currency crisis over there has severely damaged business and consumer confidence.

So ECB President Draghi is considering setting negative interest rates on bank reserves—charging banks for the privilege of stashing cash with the central repository. There’s precedent for such an action: Switzerland and Sweden have had such a policy in the past, and Denmark cut its deposit rate below zero in July of last year.

Negative rates are usually the response of a small economy to large capital in-flows—they discourage speculation. But they’ve never been used as a policy by in a major economic power. Nevertheless, when these smaller countries implemented them, they didn’t lead to major catastrophes. After all, we’ve had negative real interest rates over here for years. Negative nominal rates would be an annoyance, not an apocalypse.

But negative rates would be a distraction from Europe’s real problem—a disharmonious banking system and an anti-competitive labor market. Until they address those issues, Europe’s economy will hobbled.

Douglas R. Tengdin, CFA

Chief Investment Officer

Costs and Benefits

Is college worth it?

As millions graduate and face a sub-par job market, many are looking at their degree and their bills for student loans and wonder whether it all the time and effort and money are going to pay off.

There’s now a web site that tries to quantify this return on educational investment by school. The methodology of the return number is deeply flawed—it depends on self-reported surveys and eliminates anyone who later earns a graduate degree—but at least it’s a start. For the past several decades college costs have been released from the bonds of economic gravity—which is why now only about half of Americans see college as affordable.

Most of the information in the survey is fairly common-sense: top colleges cost more but return more; excessive costs lead to a lower ROI; low-rated colleges are less expensive, but often don’t enhance earnings all that much; and engineering -focused schools tend to have higher returns. But there are some surprises as well: a highly-rated four-year private school with tuition under $10 thousand per year; or many public universities that offer double-digit returns—to both in-state and out-of-state residents.

Cardinal Newman once wrote that you go to college to save your soul and enlarge your mind. But with prices so high, you’d be foolish not to look at the financial consequences as well.

Douglas R. Tengdin, CFA

Chief Investment Officer

Fracking Beer

The French have their wine, Russians have vodka, and Germans have beer.

Different countries are often characterized by their foods. Belgian chocolates, Swiss cheese—it makes your mouth water. In Germany it’s beer: over 1300 brewers produce some 5000 different beers employing about 25,000 workers—all governed by a 500-year old law, the “Reinheitsgeboot.” It’s a part of their national character.

Recently the Association of German Breweries sent an open letter voicing its concerns that hydro-fracking—the process of unlocking gas or oil deposits from shale by pumping in pressurized water and sand—could endanger purity of the water that Germany’s brewers use.

It’s not irrational. Fracking breaks up the structure of the bedrock and allows oil and gas to migrate towards a well where they can be extracted. It’s reasonable to be concerned that some gas might make its way into the water supply. And if that water is critical to a national icon, watch out.

The controversy shows how compromise and politics have to be part of any new technology. Cheaper energy may be good for business, but not if it threatens their beer.

Douglas R. Tengdin, CFA

Chief Investment Officer

The China Card (Part 4)

So what does China need to do?

The answer on everyone’s lips is growth: growth in output, growth in exports, growth in employment. If you have a growing economy, the additional economic output can cover a multitude of sins.

But that’s actually been a problem in China. They’ve grown so strongly that they haven’t needed to be efficient. So issues of pollution, congestion, moving millions of people from the interior to the coastal manufacturing clusters, and quality control, overcapacity, and bad debts are catching up with them. Government controls on interest rates, foreign exchange, and energy prices mean China now has a bunch of debt-laden, energy-hungry exporters that are struggling to remain competitive.

Prime Minister Li Keqiang noted in a recent speech, though, that the state is planning to reduce its role in economic matters in the hope of unleashing the nation’s creative energy. Whether this initiative moves from rhetoric to reality is an open question, but at least they’re talking about deregulation and reform.

And it can’t come too quickly. With Europe still in recession and US growth stuck in second gear, China’s exports have sagged. But there won’t be another major government stimulus package, as there was in 2008. The central government is worried about mounting local government debt and more bad loans.

China is at a crossroads: a return to cronyism or accelerating reform. The road to reform may be rocky, but at least it doesn’t end in a bureaucratic cul-de-sac.

Douglas R. Tengdin, CFA

Chief Investment Officer

The China Card (Part 3)

So what has gone wrong in China?

The slowdown in Chinese economic growth has led to a 4% market decline this year, even as other world equity markets are growing at a double-digit rate. It may even have contributed to the recent record drop in Japanese stock prices. But what’s causing their economy to sputter?

Some point to government capital controls: in prior years the banks have had capital requirements raised because of concerns about inflation. But a more likely candidate is capital misallocation. There’s a lot of central management of the Chinese economy—note, for example, their heavy subsidies of flat solar panels. This has led to rampant oversupply and the bankruptcy of several large solar-cell manufacturers—resulting in job losses.

Capital allocation is difficult in the best of circumstances, when price signals can rapidly adjust to new circumstances affecting supply and demand. In an administrative state where prices can be manipulated for political purposes, misallocation is inevitable, and you get overbuilding and underdevelopment, with an accompanying slowdown as the economy adjusts.

Booms and busts happen even in the most developed economies—don’t we know it! China may grow through its problems, but there will be some tough sledding ahead.

Douglas R. Tengdin, CFA

Chief Investment Officer

The China Card (Part 2)

Why has China grown so rapidly?

There are lots of low-wage countries. In the ‘90s the “Asian Tigers” of Singapore, South Korea, Taiwan, and Hong Kong specialized in finance or high-tech manufacturing and developed rapidly. Now they are fixtures in the global economy, hosting some world-class businesses.

China has become a manufacturing powerhouse not simply via low labor costs, but from its solid logistical performance. Companies only put facilities in places where they can be productive, and to be productive they need adequate infrastructure, efficient services, consistent border procedures, and reliable delivery performance. China has created manufacturing clusters in its coastal regions with eye towards these factors.

Other low-wage countries would have to put decades of effort and pour billions of dollars into their trade infrastructure to put even a minor dent into China’s trade advantage. So as world trade has grown, China has been able to leverage this.

China’s extraordinary growth has been a natural result of its focus on logistics. Its market pullback has come not from external competition, but from internal factors.

Douglas R. Tengdin, CFA

Chief Investment Officer

The China Card (Part 1)

Has China lost its mojo?

During the late ‘90s and early ‘00s the country became a manufacturing powerhouse, using inexpensive labor and managerial skill to surpass Japan, Germany, and the US in global exports. The value of its stock market soared, growing 5-fold between 1999 and 2007. China’s economy, and especially its coastal areas, have become boom-towns.

But since the Financial Crisis that market has been in decline. Stocks have fallen 60%, led by Chinese oil companies and banks. While other indices have gone on to reach new highs, The best the Chinese composite did was come to regain about a third of what it lost—back in 2009. Since then, the market has been in a steady down-trend.

Has China caught a Japanese flu? Back in the ‘80s Japan’s market was soaring, only to collapse under its own financial bubble. All their borrowing and spending couldn’t jump-start that economy, and their market has been on a 20-year slide.

But China is not Japan. Their economy is still expanding at a dramatic rate because they are a developing economy still building tangible and intangible infrastructure. There’s no evidence that their share of global trade is falling, and their entrepreneurial culture is intact.

China’s economy is still highly competitive. It’s market pullback will reverse, once they deal with some of the problems their growth has created.

Douglas R. Tengdin, CFA

Chief Investment Officer

Moving Mountains (Conclusion)

So how do you stay safe in the mountains?

One way to stay safe is not to go–to conclude that the risk is too great, that the weather is too poor and the opportunities too scanty. So it’s just more rational to stay home and water the garden.

But the mountains offer us vistas and light that we don’t get in the valley. It’s not just “because it is there.” Sometimes going over the mountains is the only way to get where we need to go. And sometimes we have to invest in risky markets in order to achieve our financial goals.

So the final lesson in risk management that the mountains teach us is knowing the right time. If you’re venturing out among the peaks, it’s essential to understand the regional and local weather—to know what’s coming and how it’s likely to be affected by the elevation and changing temperatures. In the same way, investors need to understand how global and national economic and financial conditions will affect their markets and investments. And sometimes the conditions are too sketchy—and we don’t head out when that’s the case.

Last week I started up Mount Washington for some spring skiing, but the conditions deteriorated and I turned back. Because the mountains will always be there. Waiting for the right conditions means we’ll be able to come back another day.

Douglas R. Tengdin, CFA

Chief Investment Officer

Moving Mountains (Part 4)

In spite of all you do, stuff happens.

In spite of all your preparation, all your planning, all your experience, mountains and markets can and will surprise you. Mountains are chaotic systems: they disrupt the airflow around them, and so they can create extreme situations, where the turbulent winds and a lack of cover transform a beautiful clear day into a massive maelstrom where there’s no shelter.

Markets are chaotic as well. That’s why the patterns we see, while perhaps reminiscent of previous market cycles, are always new. The most dangerous phrase in investing may be, “It’s different this time.” But in a very real sense, it’s always different. What makes that phrase so perilous is that it is often used to justify improper actions, that in “normal” times we would condemn as foolish.

So how do we adapt to market and mountain chaos? First, don’t panic. The surge of emotion that comes when things go wrong is rarely helpful. Second, follow the plan unless it’s obviously wrong. When the compass says to go one direction and your instincts say go the other way, follow the compass. Likewise, if the plan is to trim when a sector becomes 10% overweight, do it. It’s never easy to cut back on a winner. That’s why it’s a winner. Finally, don’t be afraid to turn back. Just because you’ve put money into a position doesn’t mean you should put more money there. Sunk costs are just that: sunk. We have to decide what to do based on current conditions, not based on what was done in the past.

Knowing that the best laid plans will have to be adapted as conditions change is important. It means you’ll be ready when things go wrong.

Douglas R. Tengdin, CFA

Chief Investment Officer

Moving Mountains (Part 3)

It’s been said that the difference between danger and disaster is preparation.

“Be prepared” is the motto of the Boy Scouts, and it’s good advice when you’re headed into the mountains. You need to be physically ready for challenge of the peaks—core body strength, cardio-vascular endurance, and mental energy. You need to have adequate clothing and emergency supplies, like a headlamp and compass. And you need to know the mountain and trails you’re going to. Maps, guides, and experienced friends help you understand where you are and what surprises might be around the next bend in the trail.

Investors need to be ready for what the markets might throw at them as well. Research, documentation, and mental preparation are critical to dealing with the surprises that markets inevitably send us. Researching investments can take time, but it’s worth it. If you understand what a business does and how it generates its cash, then the market’s gyrations are less likely to cause you to panic.

Documenting your decisions is also a great defense against second-guessing yourself. Going back to your files to see why you bought or sold what you did when you did will help you learn about both the markets and your own mind. And understanding ourselves is the real key to investment success. Recognizing how much risk you can tolerate and your other limitations is an ongoing process—and the way we prepare mentally for the markets.

With preparation, market volatility becomes opportunity. Without preparation, it can lead to permanent losses to a portfolio.

Douglas R. Tengdin, CFA

Chief Investment Officer