Chinese Fortunes

What’s happening in China?

Forbidden City in Beijing. Photo: Saad Aktar. Source: Wikimedia

Anyone who wants to understand the global economy needs to have a sense of what’s happening in China. China has the second largest economy in the world–almost 2/3rds the size of the US. Last year they grew more than the US and Europe combined. They’re essentially tied with Canada as our largest merchandise trading partner, providing 15% of our imports and exports–$300 billion worth.

So what happens in China affects the United States, and what happens in the US affects China. And for the past decade China has been restructuring their economy. They are shifting from an export-oriented development model to a service-based internal orientation. And it takes longer to ramp up service production than to build factories and export cheap goods, so China’s growth has down-shifted. For thirty years China had average 10% growth per year, but since 2010 they’ve grown just a little more than half that rate.

Chinese Real GDP Growth, 1979-2015. Source: China National Statistics Bureau, Bloomberg

This is disruptive. For three decades China has pursued a path of economic liberalization within a socialist framework. The economic reforms that began during Deng Xiaoping’s regime have increased the opportunities for hundreds of millions of Chinese peasants, who often leave their ancestral homes to relocate where they can find better jobs. But when the plan changes, people have to adapt. But it’s not that easy to change the expectations of hundreds of millions of people.

As a result, China’s market has been volatile. It’s had short bursts of dramatic growth, followed by years of contraction and stagnation. The central government wants to open up the economy without giving up political control. The economy and the market are experiencing growing pains, as China’s leaders struggle to get their institutions and incentives aligned properly.

Shanghai Composite Index, 2000-2016, Log scale. Source: Bloomberg

China is too big to ignore but too young to depend too much on. They’re trying to get the benefits of free markets without the cost of political turmoil. But it’s unclear if you can have one without the other. Not matter what happens in the immediate future, China’s role in the global capital markets will only grow.

Douglas R. Tengdin, CFA

Chief Investment Officer

Truth-Telling and Fools

Who tells you the truth?

King Lear and his Fool. Artist: Ary Scheffer. Source: Folger Library

No one wants to hear bad news. That’s why accountants and finance professionals are often so unpopular. A leader may have grand visions for the future filled with growth and opportunity—but his finance people tell him he doesn’t have the money to pay for it. Good leaders listen to counsel; bad leaders shoot the messenger, surrounding themselves with toadies and sycophants.

Eventually, these leaders overreach. They try to do something beyond their resources, and don’t learn of their errors until it’s too late. It’s important for companies to have systems in place where bad news can be safely conveyed to senior management before mistakes become so ingrained into the system that drastic steps are needed to correct them.

Wells Fargo reportedly had an ethics hotline where employees could report their concerns. But many employees were fired shortly after they spoke out about sending out debit cards or enrolling customers in online banking without their permission. Whistleblowers are supposed to be protected by law from retaliation. But Wells would then closely monitor the tipster and fire them for some other offense, like showing up late to work.

Now Wells is facing hundreds of millions in fines, and the stock has lost over $20 billion in market value. If the charges of retaliation prove to be true, senior executives could face criminal charges. And the brand has been seriously damaged. Why would anyone trust these people?

Many of Shakespeare’s lead characters attack those who bring them bad news—especially just before they fall. Cleopatra, Macbeth, Henry IV—they all threaten to kill the messenger. Ironically, it was the king’s “fool” who was often the most frank. Fools are the ones who have little to lose—and so they may be the only ones who are willing to tell the truth.

If we want to avoid becoming the main characters in our own tragedies, we need to have a culture that encourages people to speak the truth to those in power. A prophet may have no honor in his own country. But we have to see the world as it is—not how we’d like it to be.

Douglas R. Tengdin, CFA

Chief Investment Officer

Names, Brands, and Reputation

What’s in a name?


That’s what Juliet asks in the famous “balcony scene” in Romeo and Juliet. She had fallen in love with Romeo, but Romeo had the wrong family name. Tragically, they couldn’t escape their families’ heritage of violence and vendettas.

On the other side of the coin, companies put billions of dollars annually into creating names and brands that we can trust. Retailers like Amazon and Target, health care companies like Johnson & Johnson or Pfizer, and global firms like Rolex and Lego all live and die by their reputation.

34 years ago Johnson & Johnson faced a crisis after someone tampered with its Tylenol packages in order to commit a series of murders. Over seven people died in the Chicago area when they took pills that had been laced with cyanide. The company acted immediately and decisively, spending hundreds of millions of dollars to recall all of its over-the-counter pills, and compensated customers who threw away their bottles. They revamped their products to make them tamper-proof. This was costly. Tylenol sales represented 20% of J&J’s total revenues.

Photo: Roger Ressmeyer. Source: Time

A year later, Tylenol was once again the top-selling pain reliever, and J&J was one of the most trusted companies in America. Their response to the Tylenol murders is still discussed in business schools as a model of crisis management. Johnson & Johnson spent hundreds of millions, but preserving its global brand was worth hundreds of billions.

Brands matter. They convey quality and commitment. A brand is a promise that customers can expect long-term security—that a company is willing to put its reputation on the line every time someone uses their product or service. It’s a shame when firms forget this—or throw their good name away.

Douglas R. Tengdin, CFA

Chief Investment Officer

Investments, Risk, and Return

What is risk?

Base jumpers. Photo: Christophe Michot. Souce: Wikipedia

In 1952 Harry Markowitz changed the world. By combining different assets he proved that a diversified portfolio would have a lower variance. His mathematical formula used the variance of asset prices around an average as a proxy for risk. It made sense at the time: the more asset prices jump around, the more nervous people get.

Markowitz’s work was ground-breaking. Never before had risk been so clearly linked to return, nor had its reduction via diversification been so elegantly quantified. Modern Portfolio Theory was born. The biggest problem Markowitz faced with his idea was classifying it: it wasn’t math; it wasn’t corporate finance; it wasn’t classical economics. Of course he got a Ph.D. in economics, and later won the Nobel Prize for his work.

Risk and Return of possible portfolios. Source: Wikipedia

But Markowitz had another problem. He didn’t have anything but a slide rule to calculate his numbers. He had to do all his math by hand. Variance is fairly simple to calculate, but most investors don’t think of risk as variance. For them, risk is the chance of losing money. It comes in two flavors: short-term and long-term.

Short-term risk is the risk of 9/11 or the Financial Crisis or the Asian Contagion: major events that impact the market but that we also get over and move on from in a couple years or so. Unless you have to sell when the market is down, your portfolio will recover. Diversification reduces short-term risk, precisely because that’s the kind of risk Markowitz was calculating with his slide-rule.

But long-term risk is the risk of hyperinflation or asset seizure or devastation–by war or natural disaster. It’s the kind of loss that Shakespeare or Solomon worried about. And the solution is similar: spread your assets out, because you don’t know what disaster may be waiting around the corner. But it’s not enough just to buy stock in different companies if a revolution is headed your way. To hedge that sort of risk, you need to think differently.

Apple “Think Different” Ad. Public Domain. Source: Wikipedia

It’s a mistake just to look at short-term fluctuations. Long-term issues are real. Investors need to be ready, just in case.

Douglas R. Tengdin, CFA

Chief Investment Officer

Carbon Dreams

Are we bound to a “wheel of fire”?

Photo: Gerd Altman. Source: Pixabay

For millennia, people have burned things when they wanted or needed energy. Campfires and fireplaces give us heat; ovens and stoves cook our food; steam power, piston engines, and turbines help us get from place to place. Except for nuclear energy, most of our power comes from converting carbon into CO2.

But theories of climate change and global warming threaten to revise this. If increasing concentrations of CO2 in the atmosphere really are altering the weather, then every time we burn carbon for energy we’re taking a small step down a very long road. Carbon dioxide would create a cost—an externality—that needs to be incorporated into the price of energy.

This has happened before. A century ago, when Londoners used coal to heat their homes, a massive cloud of smoke and fog—smog—hung over that city. Fifty years ago Los Angeles struggled with ozone and nitrous oxide that came from people using cars for their daily commute. Sometimes we’ve regulated the externality, and sometimes we’ve grown out of it. But we’ve always adjusted—although sometimes it takes a little time to get it right.

Source: Wikipedia

For decades, energy companies have been researching the environmental effects of climate change. Part of the reason that the Saudis and Iranians and other OPEC nations are pumping oil as fast as they have—depressing nominal prices—is climate change and potential carbon taxes would depress the value of their reserves. At the end of 2015 one company—Exxon-Mobil—had 8.1 billion barrels of proven oil reserves, worth about $380 billion at current prices. Incidentally Exxon’s market cap is about $350 billion.

The way to address an externality is to factor its cost into the price of the commodity, often through a tax or fee. That makes alternatives more competitive. In classical mythology, the Wheel of Fire was a punishment meted out for a particularly egregious offense. If alternatives to carbon-based energy—like nuclear power, or wind, or electric cars—become much cheaper, we won’t be stuck on that wheel for very long.

Douglas R. Tengdin, CFA

Chief Investment Officer

Incomes and Outcomes

What can investors do about low rates?

Source: St. Louis Fed

Low interest rate around the world are challenging investors and savers everywhere. And it isn’t just households: state and local pension funds—once fully funded—are now underfunded by almost $2 trillion. With expected returns so low, governments and employees are being called upon to increase their contributions to make up for the shortfall. The resulting strain on public budgets has led to credit-rating cuts in places as diverse as New Jersey, Kentucky, and Chicago.

But individuals are struggling, too. Balanced portfolios that used to yield 4% now only yield 2%. A ladder of bank CDs only yields 1%. So lots of investors have shifted to high-dividend stocks to make up for lost income. The rationale is that AAA-rated Johnson & Johnson has a stable and growing dividend, and even lower-rated companies like Verizon and AT&T have strong business models. Why not use them as proxies for bonds, and enhance your income with equities?

Ratio of high-dividend stocks to S&P 500. Source: Business Insider

This unconventional thinking has become so widespread it’s almost conventional by now. Almost ten years of ultra-low interest rates have changed investor expectations. The yield spread between high-yielding stocks and the overall stock market has narrowed dramatically. We won’t know how this works out until we go through a full market cycle. Until then I have three observations.

First, equities are more volatile than bonds. This is because they have a junior claim on corporate cash flow. This was the case even when rates rose in the ‘70s. If investors aren’t psychologically prepared for greater variability in their portfolio values, they will be tempted to sell when the market falls, turning a temporary market fluctuation into a permanent loss of capital. And most people become more risk-averse when the market falls.

S&P 500 vs. Lehman Aggregate Bond Index, 1972-1982. Source: Bloomberg

Second, many of the vehicles that investors are now using to capture market returns haven’t been thoroughly tested in the courts. We haven’t had many bankruptcy cases or shareholder lawsuits that involve ETFs, MLPs, REITs, or other alphabet-soup investment vehicles. We’re flying in airframes that have been designed and constructed by computers, but haven’t hit a lot of turbulence yet. Make sure a good portion of your investments is in direct holdings of stocks and bonds.

Finally, it’s not always the case the reaching for yield ends in tears, but it’s happened enough times to worry about. Looking for more income by shifting investments from senior bonds to junk bonds to preferred stock to common dividends is moving down in the capital structure. Traditional asset allocation looks to stocks for growth and bonds for stability, but we may need to re-think this—especially in a slow-growth low inflation world.

Source: Alephblog

The indications are that long-term returns from all asset classes are going to be low for a while. Figuring out how to adapt is the biggest challenge this generation has faced. And what works for one investor probably won’t work for anyone else.

Douglas R. Tengdin, CFA

Chief Investment Officer

Dissent and Dysfunction?

Does the Federal Reserve need to do some team-building?

Federal Reserve “Dot Plot.” Source: Federal Reserve

As expected, the Fed did not increase their interest rate target. Instead, they decided to wait for further progress in the economy. In her prepared remarks, Janet Yellen emphasized that their decision doesn’t reflect a lack of confidence in the economy. Rather, she noted, the pace of hiring in the labor market seems to have slowed, and inflation is still running below 2%.

In their projections for economic growth, the Fed downgraded 2016 from 2.0% to 1.8%. That’s a nod to reality. So far this year we’ve grown at less than 1%. It’s not likely that the economy will boom in the second half of the year. Indeed, read GDP looks decidedly soft.

Source: Bureau of Economic Analysis

Despite our “blah” economy, three FOMC members dissented: Esther George–who always seems to want tighter money—along with Boston Fed President Eric Rosengren and Cleveland President Loretta Mester. Rosengren has been saying he’s concerned that the Fed will get behind the curve on inflation, and have to hike rates rapidly—as they did in 1994. That would be much more disruptive than a more gradual increase. Mester’s dissent is interesting: it reminds us that she’s generally hawkish, and would have voted to raise rates in June if not for the Brexit vote.

Despite Fed and press efforts to play down the disagreement, three dissents at a Fed meeting is a big deal. It’s the most that I’ve ever seen—and a far cry from the consensus-driven Fed that characterized the Greenspan era. All three dissenters wanted to raise rates. As one observer put it, this is as close the Fed could come to raising rates without raising them.

Source: St. Louis Fed

Looking at all the materials it’s clear that there are three hawks on the board—yesterday’s dissenters. But they’re balanced by three strong doves: Brainard, Powell, and Tarullo. That leaves only six FOMC members in the middle—not even a majority.

The Fed isn’t the Supreme Court: decisions aren’t just yes-or-no, and dissenters don’t have to explain their opinions. But Janet Yellen is leading the most contentious Fed in decades. She noted in her press conference that the Fed doesn’t suffer from group-think. That’s an understatement.

Douglas R. Tengdin, CFA

Chief Investment Officer

True Grit?

What makes an investor successful?

Photo: Paul Warrander. Source: Wikipedia

People can argue about whether success is due to luck or skill. But often it seems to come from somewhere else. Notably, a person’s performance in many areas come from a special blend of passion and persistence—grit.

Every year, Roxbury Preparatory Academy in Boston has a Pi Recitation Contest: 6th, 7th, and 8th-grade students stand at the front of the room and recite from memory as many digits of the number pi as they can. The winner gets to “pie” the school’s principal—usually after reciting well over 100 digits.

Source: Wikipedia

Pi-day is just one of dozens of ways the school—a public charter school comprised almost entirely of low-income minority students—encourages persistence and perseverance. The school wants its students to do hard things, to understand that effort determines success. And the approach seems to be working. Over 60% of students that attend the Dorchester, Massachusetts middle school go on to college.

Investors need grit. On any given day, the market can go up or down. Most years, the market will go down at least 10%. Sometimes this happens more than once a year. Chances are, we will see another 50% decline in the overall stock market at some point. What should we do? We can learn from students at Roxbury Prep, who have a Powerful Speaking Extravaganza every year where they perform a monologue from Shakespeare or other major works. If they forget something or get stuck, other students encourage them to restart a line and keep going.

Global Stock Market. Source: Bloomberg

Having a trauma-free life can be bad for our health, financially and otherwise. If we never taste the bitterness of defeat, we’re not ready when bad news arrives. Grit is the ability to get up again when something knocks us down.

Douglas R. Tengdin, CFA

Chief Investment Officer

World Wide Cash

Why do firms hold so much cash overseas?

Source: Capital Economics

As the global economy has grown, cash held overseas by US firms has grown at a rapid pace. US companies now hold over $2.5 trillion. The recent flap over Apple’s $14.5 billion fine by the European Commission brings into high relief the fact that the US has the highest corporate tax rates in the world, and claims a share of anything a US company does—if it brings those profits back home. So if Pfizer invents and tests a drug in Cambridge, England, manufactures it in Switzerland, and sells it in Africa, the US government wants a share of the profits.

Most of that cash is held by the biggest US companies. Microsoft and GE hold over $100 billion each. This vast pile of foreign money could provide a boost to GDP if it were ever brought home—a prospect that now doesn’t seem quite so remote. Both major party nominees for President have pledged to address this issue. Corporate inversions—where US companies change their domicile to a foreign address—have become increasingly common.

If companies repatriated their overseas cash, this probably wouldn’t lead to a surge in investment spending. After all, most of these companies have sterling credit ratings and face extremely low borrowing costs. If they had major projects to invest in, they could already do so. It’s more likely that the money would be returned to shareholders in some way—through dividends or stock buybacks. This could still provide an indirect boost to the economy, though, if shareholders spent part of their windfall.

It’s astounding that so many trillions of dollars are held overseas when our economy provides the best growth prospects anywhere. With the European Commission now setting its sights on McDonald’s and other US firms, finding a way to bring these dollars home—without paying a huge tax penalty—makes a lot of sense.

Douglas R. Tengdin, CFA

Chief Investment Officer

Getting Personal in the Gig Economy

Getting Personal in the Gig Economy



What is the “gig economy” doing to us?

Photo: Elisa Riva. Source: Pixabay

More and more people today are independent contractors—about a third of the US economy. Apps like Uber and Airbnb make it even easier to work for yourself. Uber makes it possible for folks with a set of wheels and some extra time to make money on their schedule, when they want to. Airbnb allows people to rent out their extra room or vacation home. Underutilized assets get monetized, and services become commodities.

But as the working world becomes more flexible, our relationships with each other break down. When we change jobs every few weeks, we don’t have as much incentive to be nice. The economy becomes depersonalized. It’s as if we all live in a big city, where we’re unlikely to run into the same folks again. Why invest the time and effort in developing a relationship of trust if the parties are going to change every other week?

Source: BLS

There’s no question that the gig economy is growing. And there are a lot of initiatives out there to help gig workers obtain benefits like health and disability insurance. But a bigger challenge may be what contract employment is doing to our relationships. As the economy becomes more efficient and more of our exchanges become one-shot interactions, investing in cooperative behavior becomes prohibitively expensive.

The same sort of concern was voiced over 100 years ago when assembly line manufacturing replaced artisanal production. Our cities grew, while small towns struggled. Output increased and society became richer, but at what cost? We all need long term relationships where they can trust other people and be trusted by them. The gig economy may be rational, but it may not be very healthy.

Douglas R. Tengdin, CFA

Chief Investment Officer