Something Old, Something New

What countries are the most innovative?

Source: Morguefile

It’s not an easy question. In addition to counting the number of patent applications, you need to examine the number of peer-reviewed articles, how widely that research is disseminated, new business formation, royalty and license fees, export revenues, even video uploads onto the internet. Innovation is important. Not only is it a key driver of economic success, but it also can improve our quality of life. In Africa, for example, access to clean water allows children to attend school, rather than spending up to 8 hours per day fetching water for their families.

An academic group ranked the innovation performance of 141 countries based on 79 indicators. The most innovative economies are not surprising: Switzerland, the UK, Sweden, Holland, and the US top the list. They’re wealthy, they invest a lot into research and development, and they protect intellectual property.

But there are some surprises as well. Although Vietnam is relatively poor, it punches well above its economic weight. It imports and exports a lot of high-tech and creative goods for a developing nation. On the other side, Qatar scores fairly poorly, for an oil-rich nation—about the same as Vietnam. They don’t invest as much in education, nor do they have much of a high-tech sector.

Source: The Economist

Efficient innovators are more effective at generating new ideas, given their investment in education and infrastructure. It’s notable how large China looms—given the size of its economy and its population. Clearly, their leaders have made creativity and research a national priority.

As many countries wrestle with the recent fall in oil and other commodity prices, it’s worth remembering: wealth isn’t extracted from the ground, it’s created by people. The ultimate economic resource is the human mind.

Douglas R. Tengdin, CFA

Chief Investment Officer

Known Unknowns

Known Unknowns

“I know something you don’t know.”

© MGM 1987. Source: IMDB

In The Princess Bride one of the characters smiles during an epic sword fight as he is forced back, step-by-step, towards the edge of a cliff. When his assailant asks why, he says that he knows something the other doesn’t: he’s not left-handed. As he changes hands, the tide of the fight turns.

As the market struggles with fears of a Chinese economic slowdown, concerns about energy stocks, and questions about Europe, many participants are quietly smiling: they know something many don’t: we’ve been here before.

Not at this specific point in history with these specific problems. But the problems that we are facing are fairly well understood. Developing nations with a bloated public sector needing economic restructuring? Latin America in the early ‘90s. A stagnant, jobless recovery and fears of deflation? The US in ’03-’04. Oversupply of a key economic component leading to structural issues? Oil in the late ‘80s—just like oil today.

The triple challenges of China, Europe, and oil are weighing on the market, but they are fairly well-understood, and the global economy has faced them before. There are lots of ways for policy-makers to address them. The more the market worries about these issues, the more opportunities there are to invest profitably.

It’s not the problems we know about that should worry us. It’s what we don’t know about.

Douglas R. Tengdin, CFA

Chief Investment Officer

Diversifying Our Lives

Diversification works.

“Fright of Astyanax” by Benjamin West (1797). Source: Getty Museum. This drawing was owned by Thomas Jefferson and exhibited in his parlor at Monticello.

That’s the secret to the success of many major products. Coca-Cola was created when someone accidentally added carbonation to medicinal syrup. Play-Doh was supposed to be a wallpaper cleaner. Toothpaste started as a homemade powder made from salt and burnt bread until someone noticed Parisian painters squeezing their pigments out of lead tubes and applied the lesson.

Steve Jobs told about how he created proportionally-spaced fonts for the original Macintosh. He had dropped out of college, but continued to audit courses that looked interesting. One of these was calligraphy. He was captivated by the beautiful, subtle way that great typography can subtly convey meaning and mood to a text. 10 years later he designed the Mac to have lovely typefaces.

It’s important to diversify not just our portfolios, but our lives, and not just to improve our returns. Being able to appreciate a beautiful sunrise or a passage from Shakespeare improves our outlook on everything. Thomas Jefferson had paintings and illustrations throughout his home; he was also an accomplished violinist. There’s no proof, but I believe that music and art helped him to be a better writer and more able administrator. They certainly aided his pursuit of happiness.

We can’t connect the dots in our lives looking forward; we can only see the pattern looking backwards. We have to balance our work, family, health, and spiritual pursuits. We may never get a lucky break. But if our lives are rich enough, we won’t need luck.

Douglas R. Tengdin, CFA

Chief Investment Officer

Cheaters Never Prosper?

People cheat.

Photo: Gerd Altman. Source: Pixabay

That’s the not-so-surprising conclusion from the VW’s “Dieselgate.” But before VW installed adaptive software to sense when their cars were being tested, there was a scam involving heavy trucks. 15 years ago Navistar, Renault, and Volvo paid over $1 billion in fines for installing devices to defeat exhaust tests on their vehicles. Last year Hyundai paid $300 million for overstating mileage claims on its cars. In 1996 GM recalled half a million Cadillacs that had a chip to shut off emissions controls when the air conditioner was on.

Lest you think it’s just auto makers who cheat, check out Google and YouTube. It’s easy to learn how to remove or punch holes in a car’s catalytic converter—improving mileage and power in a lot of cars. Then type “auto inspection cheats” to see how to fool the inspector. All the outrage about VW’s scandal reminds me of the scene from Casablanca, where Inspector Renault says he is shocked, shocked to find gambling going on in Rick’s café—just before an assistant hands him his winnings.

As long as there are audits and inspections, people will try to cheat and manipulate the score–whether it’s emissions testing or high school grades or football or investment management. This has been the case ever since Adam and Eve hacked their supervisor’s ethics-evaluation system–“knowing good and evil.” We’re born to trouble as the sparks fly upward.

For VW, it will take a while to reestablish trust after a scandal like this. But people need cars and companies to build them. The struggle between mileage and performance and emissions and costs will continue. Hopefully, we’ll just keep stumbling forward.

Douglas R. Tengdin, CFA

Chief Investment Officer

Portrait of an Innovator

How do we innovate?

Our economy runs on creativity and innovation. Innovation created light bulbs. It inspired the internet. It allows new ideas to flourish, like transistors, integrated circuits, and laser beams. But where does innovation come from?


Inventor Art Fry with Post-It note. Source: Wikipedia

Innovators often feel guilty, because they didn’t really do anything. They just connected a couple of ideas and saw something new. It seemed obvious at the time. A specific problem went searching for a solution—and that solution was adapted and generalized.

A great example is the post-it note. In 1968 a scientist at 3M—makers of Scotch Tape—was trying to develop a super-strong adhesive. Instead, he accidentally created a reusable, pressure-sensitive, low-tack bonding agent. The new product went practically undeveloped within the company for five years until another scientist—Art Fry—used it to anchor bookmarks in a hymnbook he used in the church choir. Now 3M sells over $1 billion of sticky notes per year in over 100 countries.

The best innovations are often staring us in the face. People just need the freedom to tinker, experiment, and fail—because a new recipe never comes out perfect the first time. Bill McKnight, an early leader at 3M, said that if you put fences around people you get sheep—and sheep never come up with new ideas. What innovators need is room.

Douglas R. Tengdin, CFA

Chief Investment Officer

Money for Nothing Forever?

Why are interest rates so low?

Source: Morguefile

It’s easy to see our ultra-low interest rates and blame the Fed. After all, they set short-term rates; they’re the ones managing the money supply; they’re the ones that oversee the banking system. But interest rates are low everywhere—not just in the US. And real interest rates—the difference between interest rates and inflation—have been falling for decades. Well before the financial crisis, long-term bond yields around the world began falling from 4% above inflation to roughly equal to inflation.

Source: Bank Underground

The low rates we see today would have been unimaginable a generation ago. I remember a friend in the early ‘80s who was thrilled to get a mortgage for only 8%: “We’ll never see that rate again,” her banker told her. Now, however, governments, corporations, and consumers around the world can get money for almost nothing. On the flip side, though, savers get almost nothing for their money. What’s causing this?

There are lots of possible culprits: technology, productivity, slower global growth. But the explanation that makes the most sense to me is one suggested by Ben Bernanke a decade ago: there’s a global savings glut: more people are setting more money aside and there aren’t enough productive ways to put that money to work.

What’s causing this? I see three major issues. First, demographics: people live longer but don’t necessarily work longer. Our life expectancy has risen, but our retirement age hasn’t gone up as much. That means more has to be set aside to pay for a longer retirement period. Second, global wealth: the rising middle class in emerging economies is generating significant amounts of new wealth. Rich and middle-class people save more than poor people. Finally, technology: the infrastructure of economic growth has changed. New industries don’t need as much capital as older industries. It takes more investment to produce concrete and steel than software and fiber optics. Also, code doesn’t pollute the environment—and doesn’t need to be cleaned up.

These are global, long-term trends. They aren’t likely to turn around any time soon—you can’t put the demographic, financial, and technological toothpaste back in the tube. Ultra-low real rates are going to be with us for a long, long time.

Douglas R. Tengdin, CFA

Chief Investment Officer

Topsy-Turvy Turnings

What’s going on? Did someone reverse the polarity?

Earth’s magnetic field, normal and reversed. Source: NASA

Everything is working backwards. In a normal world, Democrats run a free-for-all donnybrook during primary season, while Republicans are orderly and measured, choosing the next-person-in-line. In a normal world, German engineers build cars to be quietly dependable, instead of programming their autos to deceive US emissions tests. In a normal world, Greek voters change their government every couple years, instead of electing the same government to implement completely different policies.

Markets have always been a puzzle. Economist Adam Smith noted that when people pursue their self-interest, they appear to be guided by an invisible hand towards the common good—satisfying desires as efficiently as possible. Buddhist philosophy delights in paradoxical koans—contradictory questions that test one’s progress towards enlightenment—like, what is the sound of one hand clapping, or what did you look like before your mother was born. Apple’s Buddhist founder—Steve Jobs—was a ruthless competitor and an exacting boss. Is Apple a new koan?

Every million years or so, Earth’s magnetic field inverts, so the south pole becomes the north pole, and vice-versa. If that happened today, birds would fly north in the fall and extinct volcanoes would start erupting. The way things are changing, we should check which way the compass is pointing.

Douglas R. Tengdin, CFA

Chief Investment Officer

Central Banker to the World

What is the Fed’s role?

F15s and F16s over Kuwait, 1991. Photo: USAF. Source Wikipedia

Yesterday the Fed decided to keep interest rates near zero. It was a tough call. Employment has improved by more than the Fed expected, but inflation has moved away from the Fed’s target. Economists were evenly divided as to whether they would or even should raise rates this meeting.

In their statement, they comment that “recent global economic and financial issues may restrain economic activity.” Janet Yellen reinforced this in her press conference, where she said that they focused particularly on China and emerging markets. In other words, global markets spooked the Fed. They really are in a box: volatility rose and stocks fell because the Fed was expected to raise rates. With policy unchanged, volatility will fall and markets rise. And the next time the FOMC is ready to raise rates, markets will sell off again, spooking the central bank—lather, rinse, repeat.

VIX Volatility Index. Source: Bloomberg

It’s particularly notable that the FOMC chose to focus on global issues. The Fed is really acting as if they are central banker to the world. The market recent correction began in China, where concerns about their slowdown have led to a 40% pullback. China accounts for an increasing share of the world’s economy. But they have their own currency and their own central bank.

It’s hard for the Fed to be the world’s central banker. No one elected them; The UN didn’t appoint them; domestic citizens won’t understand; foreign folks will resent what seems like US hegemony. It’s a thankless task—like when King Arthur rides up to a peasant in Monty Python and the Holy Grail: she says, “You’re King? I didn’t vote for you.” But nature abhors a vacuum. Having stepped into the role, the Fed will find it hard to walk away.

It’s like being the world’s policeman—all you have is force, and there’s nothing to legitimize your power. But once you’ve begun, the alternative is chaos.

Douglas R. Tengdin, CFA

Chief Investment Officer

Endless War?

Are we in a clash of civilizations?

Clash of Civilizations Map. Artist: Kyle Cronan. Source: Wikipedia

It sure feels like it. In 1992 Harvard Professor Samuel Huntington gave a speech where he outlined this thesis. It was a heady time: the Berlin Wall had fallen; East and West Germany were reunifying; Operation Desert Storm had repelled Saddam Hussein’s invasion of Iraq. Some political theorists opined that we had reached the end—or goal—of history, that liberal democracy and free-market capitalism were the only reasonable way for societies to organize themselves. This was the “new world order.”

Huntington didn’t see it this way. He observed that there were still large cultural rifts in the world—and he observed eight major world civilizations: Western, Islamic, Russian, Chinese, Japanese, Hindu, Latin American, and African. The people in these groups are separated by history, language, culture, and most importantly, religion. The principal conflicts of the future, he thought, would occur along the cultural fault lines between these civilizations.

Source: Libya Diary and Huntington’s Clash of Civilizations

We certainly see a clash among the first four—China, Russia, Islam, and the West—and a lack of understanding. China sees itself as a great civilization that was oppressed and is now assuming its proper place in the world. Vladimir Putin justifies his aggression as a defense of the Russian people, language, and culture from Western decadence. And Islamic jihadis believe there are only two regions of the word: the dar al-Islam and the dar al-harb—the house of Islam and the house of war.

Ironically, there are many in the West who deny we are in a civilizational clash—that Iranians and Chinese and Russians are just like Westerners, only with different backgrounds. But that’s the whole point. Our different backgrounds lead to skirmishes that highlight our different cultures and values. We don’t all want the same thing. And the very self-criticism that characterizes Western culture has led many to believe that our civilization is fundamentally flawed. Hence the belief that most of the world’s problems come from the blind assertion of American power.

So we see conflict—hacking and cyber-war, guerilla war and terrorism, refugees, espionage, and other battles. We need to acknowledge this and prepare ourselves. As Leon Trotsky—the Communist revolutionary—is supposed to have said, “You may not be interested in war, but war is interested in you.”

Douglas R. Tengdin, CFA

Chief Investment Officer

Lehman Lessons

Should the Government have let Lehman fail?

Photo: David Shankbone. Source: Wikipedia CC BY-SA 3.0

Seven years ago Lehman Brothers filed for protection from creditors under Chapter 11 of the bankruptcy code. A last-minute deal to save the global investment bank had fallen through.

In the immediate aftermath, Lehman bonds traded at 60—then 30—cents on the dollar; Barclays and Nomura purchased Lehman’s North American and global franchises, respectively. Thousands of employees packed up their desks and started looking for work.

The plummeting value of Lehman debt had an immense ripple-effect. A large institutional money market fund was forced to “break the buck” and began redeeming shares at 97 cents. This led other institutional investors to shift their cash holdings from “prime” funds—which invested in corporate debt—to government funds, moving over a trillion dollars away from the private sector. This was the final domino of the financial crisis that led to the Great Recession.

Source: Bloomberg

In retrospect, should the Government have let Lehman fail? Bailouts and rescues were arranged for other systemically important financial companies: Bear Stearns and Fannie Mae before Lehman; Merrill, Citibank, and other major banks afterwards. Officials argue they had no authority to arrange a direct rescue, but so much was made up on the fly at that time that something probably could have been arranged.

In hindsight, letting Lehman fail was probably a mistake—for three important reasons:

1. The global financial system is far more integrated than we knew. Lehman’s bankruptcy immediately caused a crisis at AIG, the insurance giant. Their failure would have been even more momentous, and the Government did rescue them.

2. Our domestic economy is much more financially vulnerable than we knew. The run on prime money market funds led to millions of layoffs and trillions in economic losses.

3. Finally, when the establishment fails, anti-establishment groups will rise. We’ve seen huge growth in political radicalism both domestically and abroad. But radical solutions rarely add economic value. Instead, the uncertainty they create causes consumers and investors to be even more careful.

Letting Lehman fail has led to persistent underperformance economically and the emergence of political extremism. In theory, the Dodd-Frank legislation has procedures in place so that it doesn’t happen here again. Let’s hope that they work.

Douglas R. Tengdin, CFA

Chief Investment Officer