QE is the Federal Reserve buying long dated securities including MBS. The Fed pays the banks for these (and other long maturity securities such as Mortgage-Backed Securities ((MBS)) and Treasuries) and the payment is recorded as an accounting entry, by way of increasing the deposits banks hold with the Fed. The Fed pays the banks (sellers) a daily floating interest on this. This effectively means that by buying longer maturity Treasuries/MBS the Fed is reducing its long-term debt. Paying banks a daily rate of interest, which floats, is economic equivalent to issuing short term floating rate debt. So, if the Fed were a homeowner, this translates to the equivalent of a homeowner trading long term fixed rate mortgage (at very low rates) for (changing rates) short term floating rate mortgage. In the case of the Fed, it was around $ 40 billion/month.
Why is this not sensible?
First it does not make sense to replace very long-term low interest date with uncertain interest, daily priced, short term debt.
Second, it is not sensible for the Fed to buy mortgages when the housing market is booming. Few people own financial assets, especially MBS. So, purchasing financial assets helps just a few people for by buying MBS the Fed is propping up value.
Third, borrowing short to buy long term financial assets is both misguided and unsustainable in the long ter. The Fed should recognize inflation, problematic aspects of QE.
VCs picks winners but the actual work of building companies is done by entrepreneurs. VC firms have become platforms that conceive, create, and launch companies. For companies to be formed we need many things ; an innovative breakthrough idea, managerial skills to initiate, build, execute, and grow. We need capital. And to ensure that product, pricing, and execution works. All of these come with huge uncertainty and lots of friction which makes success elusive. Some firms are creating platforms which raise their own funds and invest in their own seeded ideas, in their own innovation capacity, in attracting talent – the idea being all factors are co-deployed in pursuit of a risky idea which comes from same source. Critics say things are impossible, improbable, undesirable. But entrepreneurship is not for the faint of heart. What an entrepreneur needs is for everything to work after she has taken the plunge. To have capital, confidence, community to get to critical mass. Entrepreneurship is not about sequential incremental. One has an obligation to jump into the unknown. In typical companies, incremental advances happen given decision making is driven by always questioning and organized skepticism. For an entrepreneur who doesn’t have all the pieces together people will be skeptical. But herein lies the challenge. Since creating is about making something that does not already exist, since innovation is not connected to current reality people tasked with investing in it don’t quite know what to do with it. This creates natural resistance and a nay sayer attitude. It is always easy to say no than say yes. The riskiest of ideas begin with basic research, which when done right becomes enabling research and is followed by applied research. To encourage entrepreneurship to flower at large scale we need to be systematic in creating conditions which allow new things to happen. This needs the exercise of leadership, patience, money. The only way new breaking ideas will see the light of day is when we are willing to embrace unreasonable propositions, accept people who have potential, but we do not judge them solely by past success or failure. For it is only when we have major breaks-throughs does incrementalism stop, and extraordinary advances and leaps happen.
It is for these and many other reasons we need to encourage and protect leaps into the unknown, nurture a special culture, create systematic ways, and build on learning that comes with it. We in the U.S. are fortunate to live in a country that attracts immigrants who constantly refresh and reconstitute our culture. We have roots and a rich history. We have world class institutions, and a can do attitude that says anything’s possible. Our innovative ecosystem has emerged from a sequence of events over the past five decades. It cannot be constructed overnight and is hard to reproduce. The entrepreneurial mindset is one that is anchored in future rather than in the present. It has few boundaries and is willing to imagine anything. And in the third decade of this century with increased knowledge, multiple paths, new tools, digital transformation, abundant capital anything is possible. The future is limitless.
The increasing demand for food products from developing economies has triggered the need for rapid improvements in agricultural productivity all the way to final consumption. This creates a variety of investment opportunities in agriculture-related sectors in both the short and long run. The present food system cannot be defined as ‘sustainable’ (a sustainable system being one that ensures the present and future quality of all aspects of life). On the contrary it seems that current food consumption trends are moving very quickly in the opposite direction.
The cyclical component of price is the delivery premium or discount determined largely by fluctuations in short-term fundamentals as captured by inventory levels. Long-dated prices have rarely moved, reflecting the relatively stable cost of bringing new supply into the market (marginal cost). Volatility in prices is driven by the cyclical component of price (demand changes).
Sentiment and policies that suppressed the Shale revolution exhausted spare capacity, and a multi-decade secular decline in old economy fossil fuels, and lack of storage together create conditions for oil price volatility in the U.S.
The data charted below speaks volumes!
And if we now increase imports I expect a larger global trade imbalance, which increases the supply of Dollars against other currencies, particularly the Euro, if oil prices rise further. This will affect other oil importing countries too. Although, with greater supply of the Dollar, theoretically a weakening in the Dollar should make Dollar denominated oil more affordable to consumers buying in other currencies, the empirical evidence shows no such relationship as the demand elasticities are extremely small and the volatility of oil price is usually four to five times that of the currency, completely overwhelming any currency effect.
U.S. Department of Energy announced the release of 50 million barrels of crude oil from the Strategic Petroleum Reserve. Many other countries including India and China have followed suit.
This move, while good for political optics, is not going to solve the problem. In the chart below I show that it is a fundamental characteristic that (i) Commodities that are more difficult to store are more volatile and Oil ranks high up there; (ii) Over the years lower oil storage capacity has led to higher oil price volatility – the data speaketh !
I have been examining the proxy voting and engagement policies and practices of SWFs and am particularly concerned with U.A.E ADIA, China CIC, Kuwait KIA, Qatar QIA & Saudi PIF . I tend to think of their capital as dumb money, for despite their often-significant equity stakes and associated voting power, they bring zero value add to matters related to governance, corporate actions, ESG and shareholder proposals to U.S. companies.
These SWFs no doubt hold huge amounts of U.S. equity through funds, indexed vehicles, private placements but tend to act as passive investors in U.S. equity markets. This is not necessarily a good thing. These SWFs do not publish data on their proxy votes, have no published proxy voting guidelines, do not report on their private engagement with management, don’t take board seats. Treading carefully the intersect of politics and finance, to clear of controversy, they often do not vote, do not file 13 Fs and have little economic incentive to engage in shareholder activism – and are therefore derelict in contributing to improving corporate governance. They avoid the costs of engagement and are free riders on others who exercise activist governance. They are bad stewards of corporate governance and shareholder rights, have little to say on child labor, risk management, climate change, board competence, exec compensation. These funds do not clearly explain their true objectives and relationship with citizens, little is known about their internal governance and decision-making process, their internal operations and how exactly do they implement their investment strategies or performance, AUM risk profile etc. They keep their holding below thresholds that trigger tax liability. To avoid headline risk they make use of CFIUS safe harbor provisions. More crucial given their inert holdings they take up a seat which could belong to vigilant engaged shareholders which exercise control over company boards and reign in principal agency problems. In short, their behavior is very different from responsible large investment funds, such as pension funds, endowment funds, or mutual funds.
The Santiago Principles GAPP 21 addresses participation in corporate governance to the extent it recommends return maximization, commercial, non-strategic investing but is largely silent on specifics. It is of little help. Only Norway’s Government Pension Fund Global and Singapore’s Temasek Holdings meet standards expected. Their process is designed to improve transparency and enable fund shareholders to monitor their funds’ involvement in the governance activities of portfolio companies.
We need legislation and rules that require SWFs report their proxy votes. These funds do have voting power when they have the ability to vote the security, including the ability to determine whether to vote the security at all, or to recall a loaned security before a vote. Not voting too is a form of voting after all!
The $5 trillion insurance industry finances (insurance premiums are being used to fund climate damaging investments) and in turn is exposed to, risks from climate change. Insurance firms are exposed to climate risks in their underwriting and investments in physical properties, in fossil fuel projects, in emissions intensive industries and projects as well as in multiple other areas. Given low yields on junk bonds, to meet liability obligations it is increasingly teaming up with private equity which finance dirty high emission projects. The insurance industry and banks are big investors in companies that contribute to climate change. They are now a significant portion of Blackstone’s assets for which it even has a dedicated Blackstone Insurance Solutions group. To earn the float, many firms have been acquiring insurance companies e.g., KKR – Global Atlantic, Carlyle Group – Fortitude Re, Apollo Global Management – Athene Holding, Blackstone managing parts of AIG portfolios etc. Private equity investments are opaque and long term, and little is known about their private fossil fuel assets financed by insurance money.
Also, since rating agencies have woefully categorized climate impacts on portfolios many insurance firms are grossly under capitalized against potential future climate related losses. There is very little data from insurers on property claims payouts, claim rates, premium rate increases, rates of non-renewals, claims denial, and systematic regional exits of property insurance markets in climate-impacted areas.
I recommend that insurance companies now beef up their capital structures, optimize their capital and most importantly adjust for potential liabilities.
Insurance companies need capital to absorb losses from expected events, unexpected but foreseeable events and unexpected unforeseen events in order to meet their obligations to policyholders and other stakeholders
Insurers protect their policyholders from financial losses associated with risk, including:
Insurance risk – property damage, bodily injury, legal liability, early death, disability, illness and longevity Volatility risk – the volatility of financial markets and/or the incidence of insurance risk – i.e.,, the unexpected occurrence of foreseeable loss events
Capital Management Involves Four Basic Steps:
Determining Required Capital – how much capital does the company need to survive the risks it has assumed at a selected probability Optimizing Required Capital – minimize the capital needed to absorb those risks Funding Required Capital at Optimal Cost – obtain capital at the lowest effective cost to owners Maintaining Financial Flexibility for Foreseen and Unforeseen Events – have a margin for error that provides the company: Incremental capital for error in its risk models Capacity to raise additional capital at reasonable terms when needed
CyrusOne provides mission-critical data center facilities for approximately 1000 customers. Over the last five years revenue has grown annually by 20%, earnings every year by 20%, and funds from operation too have grown by almost 12% annually . They have a strong presence in US markets where they have created a national footprint & they’ve also gone into Europe. They received an investment grade rating on their debt and the long-term outlook is pretty good – largely because one expects the usage of data to grow, the trend towards enterprise outsourcing, increased reliance on technology, as well as newer things are happening such as data hungry artificial intelligence and in the future the arrival of autonomous vehicles. Most enterprises are now outsourcing their data centers – it is expected that almost 80% of enterprises will have shut down the traditional data centers by 2025. There is a lot of reliance now on technology and e-commerce, on remote work, in collaboration platforms, technologies such as video over Internet are mainstream, growth in mobile traffic and connected devices all of which drive a lot more consumption of data.
They have a high-quality portfolio of primarily owned assets and most of their customers are in the fortune 1000. In Europe they have a presence across most key markets. They’ve exhibited development and operational expertise and have a good track record. While it is true, they have scaled but they’re not huge – still small enough to generate meaningful growth. With investment grade risk and a customer centric focus they are going to be well-positioned for profitable growth in coming years. The portfolio of assets is good : almost 92% of their operating income comes from the assets that they own, 80% of their customers are in Fortune 1000, and the average credit rating of their large customers is almost 80%. Their leases have rent escalation clauses, the weighted remaining lease term is over four years . When it comes to Europe they have an attractive set of assets across key markets with an emphasis on Frankfort and London. Importantly they have a new data center in the portfolio and long standing relationship with the fast growing customers . With a track record of on time delivery, they also have capacity to significant increase their footprint to support growth in short time. They have capacity and access to land across key markets to support growth. All this is expected to produce attractive equity for they have access to capital which is critical in a capital intensive business to ensure continued growth, especially where there is market volatility. What speaks volumes is that their customers have entrusted them with mission critical assets, partnered with them they’re going to grow with them.
This said, there are certain things one needs to look out for. For example, demand is concentrated with large customers which is a disproportionate part of their portfolio. They therefore need to diversify this portfolio and execute long-term leases. Another issue of concern is prices in this segment have continue to decrease so they do need to build efficiencies to protect returns against pricing decrease. And of course they are development challenges that come from resource scarcity, local regulations and public sentiment – so they will have to be very deeply local to secure line, water, power permits and leverage their global platform for environmental, safety and regulatory, considerations. They will need to secure long-term capacity pipelines in markets that are going to grow, so this injection of capital will help them to continue to invest in global digital gateway markets to support growth. They ought to emphasize their development and operational expertise story, maintain their strong balance sheet, strive for low cost of capital and grow their funds from operations.
The ability to arrive at an optimum capital structure can be source of significant differentiator.
Conundrum: Since REITs do not benefit from interest tax shield the question is why have any debt at all? Spread between low cost financing and acquisition at high cap rates do increase earnings, but that also makes the REIT riskier , raises the cost of distress. The enterprise value of the REIT cannot change by taking on cheaper debt, so why take it? More debt also reduces flexibility to invest more opportunistically when property values fall etc. Having a zero debt REIT can be a very unique differentiator.
This month I reflected on the many public to private equity transactions I worked on over the last 20 years and gleaned some lessons. I collated the gestalt of my take-aways into a deck. The essential issues to wrap one’s hands around include:
Going Private Considerations; Should Companies Go Private?; Is a Company Better Off Being Private?; Going Private Considerations; Board Considerations; Director Responsibilities; Board Considerations; Pre-Signing vs. Post-Signing Market Check; Going Private Transactions; Going Private Transaction Process Alternatives; Transaction Timing Alternatives; Role of the Special Committee in Negotiated Transaction; Special Committee Obligations in Negotiated Transactions; Leverage Considerations for Going Private Transaction; Comparable Credit Analysis; Indicative Timeline; Legal and Governance Considerations
Why Am I Ok With Consortium or Club Private Equity Deals?
Some Limited Partners are averse to club deals for it concentrates deal risk for them. However, I see many advantages to such arrangements, especially during mega multi billion $ transactions. We see around 20-25 such deals a year, and whilst not the norm, they do occur. These do bring up unique consortium dynamics, which I will separately touch upon.
‘Hostile’ M&A Public Escalation Analytical Framework– I have participated in as well as examined over three dozen M&A’s over the years. What I find is an absence of a common analytical framework applicable across historical experiences of the United Kingdom, the United States, and Japan. Much has to do with differences in takeover regulation I suspect. Still, distilling my experience, I have attempted to create a general approach applicable to the public escalation phase. I present this below.
2020 had around $16 billion of catastrophe bond and insurance linked-securities issuance. Around $47 billion capital remains outstanding. And No, there were no Covid-19 Cat bonds issued prior to the pandemic! I have concluded that these instruments indeterminate payouts have huge optionality which cannot be correctly modelled and therefore this security is not amenable to purposive inclusion – despite their non correlated characteristics – with the strategic asset allocation process. Certain other insurance linked securities may be, but even those are a stretch and should reside within the realm of tactical and opportunistic play.
What role can the financial system play in improving post pandemic global supply chains?
The pandemic has distorted and disrupted global supply chains. Shelves stand empty and inventory to sales ratios plummet. Manufacturing, construction, retail and wholesale trade are especially hit. Business activity is likely to reduce and prices are increasing in lumber, in consumer goods and other sectors. Scarcity in semiconductors and the auto sector is now very evident.
I have been dabbling off and on trying to properly frame and then answer a perplexing question : What role can the financial system, and in particular global banks, play in improving post pandemic global supply chains? I conclude that the biggest opportunity lies in capital structuring opportunities.
To support my conclusion I explain how i went about it.
UNCTAD has excellent reports and statistics on global and regional trade flows which provided a wonderful sense of magnitude and context. I also examined literature suggesting that supply chains have become global, fragile and sophisticated ever since China joined the WTO. The basic economics literature and bargaining theory outlines conflicts of interest in trade.
With this background, I now am able to demonstrate that there is a huge opportunity for capital structuring & cost of capital arbitrage within international trade. I explain this with a customer view and financing cost of supply chain perspective and then conjecture on the value-add a global bank (or financing institution) can bring. This value-add can be through participating in supply chain financing cost of capital arbitrage, providing as yet undiscovered financial solutions, creating new mechanisms for driving working capital, driving down cost of goods sold, as well as providing the lubricant to immunize supply chains – which in turn will drive more sales and promote global trade growth.
Managing taxes are clearly an important part of any investment strategy for taxable investors. Harvesting losses, timing decisions, deferring gains can certainly add value to a portfolio. But what impact, if any, do taxes have on arriving at long term strategic asset allocation?
Our conclusion: Having tested over 100,000 randomly generated unbiased portfolios with unbiased tax rates, we discovered that taxes have an impact not only on return, but also on risk. This fact mediates the impact of taxes on asset weights, as the relative efficiency of assets is roughly the same before and after tax. Tax optimization is important and adds value to tactical asset allocation, to asset location, but is largely irrelevant for determining ex- ante long term strategic asset allocation. On a risk-adjusted return basis taxes do not matter.
It has long been and remains my view that the US Treasury will not default upon its debt obligations- not even for a very brief period of time. Yet markets have been on edge for the past month as the date (October 18) by which the Treasury would have exhausted all extraordinary measures approached. Senate Majority Leader Chuck Schumer just announced a temporary agreement reached on increasing the debt ceiling through December. This is good for unless a political compromise was reached, the US Treasury would have been forced to switch to cash-only management in order to continue operations i.e. after October 18 the Treasury would have to operate on a cash-only basis.
The market implications from a technical Treasury default – a default in which bondholders would be paid in full but with some type of delay – are both wide-ranging and hard to anticipate. There are, however, two potential developments that would most seriously threaten the stability of financial markets: (i) a credit freeze in the short-term repurchase agreement (repos) market where Treasuries are used as collateral to secure short-term borrowing; and (ii) severe disruptions to the money markets since most money market funds (MMFs) invest heavily in US Treasury securities. The credit markets would freeze, if a handful of MMFs were to “break the buck” (where the net asset value (NAV) per share falls below USD 1. Even if the immediate impact was not dramatic, if a short-term default led investors to question the willingness of the US government to honor its obligations in a timely manner, then the impact could be both more far reaching and long lasting.
When the $480 billion debt hike is exhausted, the political gamesmanship from both parties will renew. Negotiations in Congress will likely heat up again towards the end of the year, as they renew attempts to forge a long-term deal. I think that the negotiations will continue and bleed into 2022 with rigidity on both sides to prove to their respective constituents that they stood their ground and boost their reelections chances at the next primaries. Congressional representatives have a strong incentive to fight until the last minute. Therefore, I again expect a last-minute deal to emerge, possibly as late as in late February or early March, when the Treasury will once again cease to be able to use book-keeping measures to operate under the ceiling. However, I don’t expect a drastic government shutdown.
In the U.S., the debt ceiling is once again making headline news. Government shutdowns and the thought of U.S. defaulting on its debt could have devastating consequences both for the U.S. and for the global economy. Meanwhile, India is a completely different story.
The Covid-19 pandemic after effects will test how much debt developing countries can bear. The attitude within OECD of course has been “don’t worry about government deficits so much and continue to spend”. Last year the U.S. Federal Reserve and other counterparts moved aggressively with sweeping emergency rate cuts and offers of cheap dollars, to help combat the pandemic. Emergency policy easing by central banks in UK, New Zealand, Japan and South Korea, Australia, too had provided further stabilization. But can non-OECD or developing countries pump ample liquidity into the markets too, and support fiscal stimulus?
Which brings me to India. India has around $540 billion FX reserves.
India’s overall fiscal deficit- the gap between expenditure and revenue for 2020-21 was 9.3 per cent GDP, a very high number which complicates the task of monetary policy. A fully discretionary fiscal policy framework will likely worsen this. India has had the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 which sets a target for the government to establish financial discipline in the economy, improve the management of public funds and reduce fiscal deficit. The FRBM has in the past incentivized the government to reduce the fiscal deficit by a percent of GDP each year, and gradually move to a position where current spending matched current revenues. The government would need to explain to Parliament any breaches of the Act. The discipline of this law was in part responsible for a significant improvement in government finances in the first decade but after the 2008 GFC, the general government’s deficit rose sharply from 4% of GDP to 8.3%. A pause in the FRBM and an expansionary budget thereafter contributed to the large increase in the deficit. Once the discipline of the FRBM was obviated, the urgency of imposing fiscal limits was no longer clear. After the stimulus, the economy did recover from April 2009 onwards, but the fiscal stimulus was not rolled back, and deficits remained high. Ever since, the government has continued to borrow. The lack of a rules-based system due to escape clauses in the FRBM has come alongside a sharp deterioration in government finances. A fiscal rule spending rule would increase the accountability and transparency of fiscal policy. A rule could be a variant of an “Expenditure Rule, or Revenue Rule, or Budget Balance Rule or a limit on Debt Rule”.
Of course, implementing any such fiscal rule would be much more difficult, as it involves the government and opposition coming together on spending issues.
But shouldn’t India have fiscal rules that outline its fiscal policy?