A turn in the credit cycle

This is interesting and worth keeping an eye on: US C&I (Commercial and Industrial) loan delinquencies have started to turn up, signalling the turn in the credit cycle. A rise in delinquencies implies a tightening in bank loan terms with about a one-year lag. We would expect lending to be weakening from here on out …


It also has implications for Equities, of course:

VIX volatility (the volatility index for the implied volatility on the S&P500 equity index, and a generally accepted barometer of market sentiment / risk appetite) tends to follow a similar cycle: volatility tends to increase with a modest lag from delinquencies (hardly surprising that equities dislike tightening credit conditions).


Unsurprisingly, the equity index itself moves with volatility in a lag from credit conditions:


These are just interesting credit developments worth watching, in our opinion.

This fits together with the pressure on European banks, and impending credit contraction, that we have previously highlighted.

And with conditions outside China tightening – Singapore and Hong Kong are prime examples of the credit crunch enveloping S East Asia – it leaves China’s 25% y/y credit growth looking quite anomalous, apart from being entirely unsustainable.


Bear markets… less bearish

Looking back at the S&P 500 bear markets over the last fifty years or so, an interesting observation springs out of the data:

We looked at the % of up days versus the % of down days in each bull and bear market: the chart shows the difference (% up less % down days).


  1. Each cycle has seen a greater bias towards up days and away from down days (that applies for bull and bear markets).
  2. Bull markets have become increasingly bullish and bear markets decreasingly bearish. So much that, in fact, in the 2007/9 bear market (the biggest since the 1930s) there were “just” 49% down days (versus 47% up days) – a brutal bear market and the market fell less than half the time.
  3. Bear markets with, on balance, fewer down days increase the anxiety and pain of not being in the market, particularly so if the market is flat/up more than it is down.



Just a useful reminder that bear markets increasingly come in “batch form” i.e. with sudden, large declines interspersed with modest gains/stability rather than in a continuous and even process of declines outnumbering gains…. bear markets seem to be progressively less bearish.



Emerging markets… is it time to go back in?

Following our recent blog note on the level of implied returns in the major developed markets, a look at emerging market equities might be appropriate, especially after a sustained period of underperformance. Could it be time to buy back into the dream? What does valuation imply for long run returns?

To recap:

  • The MSCI Emerging Markets Equity (EME) Index (local currency) has returned 10.8% annualised since March 2009 and 2.7% annualised in the last five years.
  • The MSCI EAFE (developed non-US) Equity Index (local currency) has returned 12.9% and 9.5% respectively.
  • The MSCI US Equity Market Index (local currency) has returned 18.2% and 14.3%.

The underperformance of emerging markets in the last five years is striking. 7 – 12% annualised underperformance versus developed non-US equities and the US Index.

The underperformance is clear when you look at the relative price/book ratio for the MSCI Emerging Markets Index versus the MSCI World Index. Emerging markets have gone from a 16% premium to a 35% discount since 2010.

Call us old-fashioned, but we still adhere to the view that emerging markets, with their relative institutional, social, political and economic frailties should trade at a discount. So, at least we are back on the right side of the axis and about half way to the relative valuation at the trough after the Asian crisis in the 1990s.


The question then becomes “Is the current discount sufficient to deliver an attractive, relative implied return premium for emerging markets versus developed markets?”

Here is the relative valuation of emerging market equities versus the EAFE Index (developed non-US markets) and the UK Equity Index:

  • EME at a 14% discount versus EAFE from a near 40% premium in 2010.
  • EME at a 21% discount versus the UK from a near 20% premium in 2010.



As we showed in a previous blog piece on expected market returns, the arithmetic of equity returns is very simple – implied returns are a function of four simple numbers:

  1. The starting valuation ratio.
  2. The ending valuation ratio.
  3. The growth rate in earnings per share over the holding period.
  4. The dividend yield.

Of course, returns can be made to look as attractive as you want if you make outlandish, non-evidence based and obviously biased forecasts for variables 2, 3 and 4 (assuming that we can agree on an appropriate measure of valuation to start from). All one must do is make up a sales story and fix the numbers to fit.

We prefer to let the data speak and on that basis we make the following assumptions:

  1. The starting valuation is the current MSCI Index price/book ratio.
  2. The ending valuation is the long run trailing median price/book ratio i.e. we assume that ten years forward the P/B ratio has reverted back simply to its run trailing median level. What could be more conservative?
  3. The growth rate of earnings per share (and the per share bit is important, especially in emerging markets where vast amounts of equity dilution takes place from net new issuance necessary to finance the growth in earnings) is assumed to be the long run trailing annualised rate of earnings per share.
  4. The dividend yield is what it is and easily observable.

Now, we can turn to calculating the implied ten year holding period annualised return for EAFE, EME and UK equity indices on the basis of those parameters (it should be noted that earnings per share growth, for example, is staggeringly stable across markets over long time spans).

  • The first chart shows the annualised implied return for emerging equities less the annualised implied return for EAFE (developed non-US equities) at monthly points over the last fifteen years.

A number of thoughts spring to mind: (a) investors in the 2007 – 12 period were actually prepared to accept a meaningfully lower implied annualised return in EME equities than in EAFE equities; they believed in the dream of perpetual motion in emerging markets that is at odds with all of the historical data set with the cross sectional correlation between equity returns and growth being negative; (b) investors today seem willing to accept a 1.5% annualised return premium in emerging markets.


  • The second chart shows the annualised implied return for emerging equities less the annualised implied return for UK equities at monthly points over the last fifteen years.

Again, UK investors appeared happy to forgo 3% annualised return in 2008 – 10 to chase the emerging markets growth dream and are happy to accept a 1.8% premium today to move from UK equities to the emerging markets.


Of course, besides valuation and long run expected returns under conservative, empirically-validated assumptions, there are other considerations:

  • Emerging markets have a higher downmarket beta than developed markets. That is to say, when the US market falls sharply the emerging markets fall far more substantially. Emerging markets offer no downmarket diversification at all.
  • We also need to consider other identifiable known factors in returns since, at the end of October, emerging markets had negative absolute momentum and negative relative momentum (versus the UK, US or EAFE). We would want to see positive absolute and relative momentum before we commit to emerging markets.

So, all things considered, the modest implied return premium in emerging markets, the greater drawdown beta, and the negative absolute and relative momentum versus the developed markets all suggest to us that there will come a better opportunity to move back into emerging markets. As Aristotle said “patience is bitter, but its fruit is sweet”.



What is the expected market return?

Often we get asked what our view is of expected returns and, although our investment process is not conditional upon a set of expected asset class returns, we thought it might be interesting to see what a passive balanced portfolio might be expected to return over the course of the next ten years.

We have set an investment horizon of ten years simply because over this time period there is a clear and statistically significant relationship between valuation and returns that is not seen at short horizon dates, certainly not at a one year horizon.

Our analysis is just to give a baseline for what the expected passive return on a balanced portfolio might look like over the next decade.

Starting with Equities: the total return you earn over any period is comprised of capital gain (growth in earnings and the change in the Price/Earnings ratio) and income (dividends).

Without showing some lengthy arithmetic, take it from us (for those of a more nerdy nature we can provide details of the equations and a spreadsheet should you wish) that the Expected Equity index Return (ER) can be closely approximated (from The Gordon Growth Model) as,

ER = (1 + g) * (End PE ratio/Start PE ratio) ^ (1/t) – 1 + Dividend Yield * (Start PE ratio/ End PE ratio + 1)/2

Capital gain and Income are separated.


g = the growth rate of earnings per share over our time horizon, in our case ten years

End PE ratio = the Price/Earnings ratio at the 10 year horizon date, we use the Price/Trailing 10 year average reported earnings

Start PE ratio = the Price/Earnings ratio today, we use the Price/Trailing 10 year average reported earnings

t = the time horizon, in our case this is ten years

Dividend Yield = today’s dividend yield

Now, you might say “if I knew the PE ratio in ten years’ time and I knew how much earnings per share would grow over the next ten years I would be a genius with perfect foresight and life would be easy!”. In fact, you would be correct in thinking that, so we obviously need to make some assumptions/forecasts.

As anyone who has spent time in our company knows, we don’t like forecasts and we have next to no time for forecasters.

(For a fantastic demolition of the futility of forecasting and the witchcraft of forecasters see the following wonderful papers by Dr. Kesten Green and Professor J Scott Armstrong, University of South Australia: “Simple versus Complex Forecasting: The Evidence” and “The Seer-sucker Theory: The Value of Experts in Forecasting

So, rather than forecast the inputs, let’s set them at “normalized” or long run trend levels,

We assume earnings per share growth is at its long run trailing rate over the next ten years, we assume the PE ratio in ten years simply reverts back to its long run historical median level. No forecasts to manipulate, no exaggerated claims, just more of the same we saw over the last 5 decades and more…

Moreover, we proxy expected inflation, needed to convert nominal into real returns, with trailing 3 year average inflation.

So, taking those inputs, we calculate the implied ten year annualized return for the equity indices in the US, UK, Germany and Japan and plot them with real cash yields and real ten year bond yields in each case to give you an “implied return curve”:

In all cases the real implied cash and bond returns are pretty much zero – that is what QE does for you (it drives them to zero to force you out along the curve seeking returns in equities, it drives the curve to the horizontal axis as it has done in the US).

The implied real equity index return in the USA is a measly 2.5%. It is far more attractive elsewhere but we should never forget the down-market sensitivity of non-US markets to the US.


What of a balanced portfolio? Well if we look at a 50/50 Equity/Bonds mix in each case, and a weighted average for a portfolio of all four markets, this is what we get:

A US balanced portfolio has an implied return of 2% – the standard annualized return assumption for most big US pension funds is 7-8% – with the implied real return below 5% in all cases. Interestingly, a weighted average (using equity index weights) is just 2.5%


Of course, it is possible to get more, but that implies that earnings per share growth  (from the starting point of record profit margins) exceeds its long run, and highly stable, trend growth rate and/or valuation multiples go significantly higher.

That would be the best case scenario and, like everyone we like to hope for the best, but a prudent investor always plans for the worst (the event that earnings per share growth is slower than trend or the valuation multiple falls below the long run median level at any point over the next ten years) and that is exactly how we approach portfolio construction.

In the best case our fund should produce solid returns and in the worst case it should substantially lessen portfolio drawdown.



The Dr. Fox lecture

As investors in our Fund and regular readers of our blogs well understand, we are firm believers in the “elegance of simplicity”. In accordance with Occam’s Razor, why make things more complex if the complexity adds little or no incremental marginal value and only means that there are more things that can, and will, go wrong?

We have had people say to us, ‘if you added a few bells and whistles, your strategy would be even more appealing’, ‘it all seems too simple’ or ‘why if things can be made so simple and understandable do others not do the same?’.

To that end, we thought you might find the following brief clip – “The Dr. Fox Lecture” – extremely illuminating. Just 5 minutes of your time will show you just how the desire for complexity and opacity is a trap for the foolish.

Back in 1970, a group of psychologists wanted to test the response of intelligent people to the machinations of a so-called “expert”, the fabled “Dr. Fox”. As you will see from the lecture clip, an actor was put in place to deliver a highly complicated lecture full of opaque jargon, contradictions and made up facts. He appeared smart, well informed and a master of his topic, in fact an expert. Unfortunately, what the audience did not know is that he was delivering a lecture of meaningless nonsense wrapped in pseudo-scientific jargon.

Despite the dense, complicated and absurd content, the audience ratings for the lecture were fantastic. The audience lapped up the complexity and pseudo-science; they couldn’t get enough of it.

That study, and others that have followed, shows that people actually value complexity, even when they cannot untangle it and do not understand it. In short complexity creates exclusivity (there are only so many of us smart enough to understand, of course) and exclusivity creates desirability (as an advertising and marketing executive well understands).

So, the next time you see a portfolio manager with a complex, multi-faceted, opaque portfolio with lots of moving parts just think of the fabulous Dr. Fox.



Is Austerity to blame? …We think so

July 7, 2015

“Why can’t Greece be more like Ireland?” has been cried over and over again in recent days. After all, they went through imposed austerity and yet have grown 1.9% annualised since the end of 2009 (in real terms) while Greece has contracted at a 4.9% annualised rate.

The following charts offer an explanation and illustrate why more austerity – in the form of the demand for large structural budget surpluses in Greece – may not be the answer.

Chart 1 shows the change in the Cyclically Adjusted Primary Budget Balance (this is the part of the budget that is structural and thus cannot be explained by strong/weak growth – it cannot be grown out of) and excludes debt interest repayments versus Annualised Real GDO growth over the last 5 years.

The line runs right through the data the correct way – a strong correlation between the degree of fiscal tightening (approaching 20% points of GDP in Greece) and realised Growth.

Austerity policies do appear to depress growth rates.


It is import to note that Ireland sits a little off the line. It has done slightly better than one would have expected given an 8% points of GDP swing in the primary structural balance.

If we exclude Ireland, the relationship is much stronger; austerity and growth are exceptionally linked.


Then what is so special about Ireland?

Take a look at Exports of Goods and Services as a % of GDP for those countries above. At the end of 2009 Greek Exports were just 18% of GDP, the lowest in the bloc. Going forward to today, exports now account for 33% of GDP (GDP has dropped by 25% and exports have held up with a weaker Euro).

But… look at Ireland. Irish Exports at the end of 2009 were almost 100% of GDP.


With the Euro declining (20% in broad, real, trade weighted terms from the end of 2009) and Unit Labour costs also declining, it is little surprise that Ireland has fared better. Especially when it has also experienced less than half the cumulative austerity that Greece has been subjected to. Austerity has been smoothly/steadily applied most everywhere, with Greece given a more front-loaded and larger dose than anyone else.


There is a message in this for the UK as well. Austerity, to date, has been comparatively modest, with virtually no tightening in the structural budget balance since 2011. A more aggressive stance would suggest that the much lauded performance of the UK economy could look a lot less exciting without some Sterling weakness to offset the impact.



UK Current Account Statistics explains UK growth profile

July 3, 2015

Currently, there is an interesting picture in the UK Current Account Statistics and one which explains the comparatively better UK growth profile

The Current Account Balance = Government Balance + Private Sector Balance (where Private Sector Balance = Household Sector Balance + Business Sector Balance). The Current Account Balance measures the difference between Gross Investment and Gross Savings in the economy (and that difference can be allocated between sectors).

The 4-Quarter Moving Average of the UK Current Account Balance as a % of GDP is at its worst ever – a deficit of 6.2% of GDP. The UK has a Current Account Deficit on an alarming scale. The deficit says that the UK needs to attract a capital inflow, from foreigners, of just over £110 billion.

Large current account deficits have been shown, repeatedly, to lie at the heart of many a financial crisis. With a large, external financing requirement, you are very vulnerable to rising risk premia and sharply diminishing market sentiment. (Many excuses can be wheeled out including incorrect accounting for foreign property investment, poor returns on UK overseas assets, etc. The simple fact is, the UK is accumulating Net Foreign Liabilities at an alarming rate).


If we break the Current Account Deficit down and look at the Private Sector Balance (as a % of GDP), the Private Sector in the UK is back to accumulating Net Liabilities (Debt) – a deficit of 1.5% of GDP.

The late 1980s boom and the late 1990s boom were the last time we saw this (we skirted the deficit line in the 2006/7 period). No wonder the UK is doing comparatively well, the growth is underpinned by Private Sector liability accumulation and a record current account deficit – not a good structural sign.

The other side of the sharp deterioration in the UK deficit is the sharp improvement in the Eurozone deficit.


In conclusion, currently we have a record current account deficit and a private sector deficit again (alongside a sizeable public sector deficit). The UK does it again – builds a recovery on debt and asset inflation and not productivity.


Greek Update

June 29, 2015

“You shouldn’t commit suicide because you’re afraid of death”  European Commission President, Jean-Claude Juncker

Last week, European markets rallied strongly on rumours that the “Troika” (the IMF, the ECB and the European Commission) and the Greek government were close to an agreement to at least postpone the funding issues facing the country. Ahead of tomorrow’s looming debt repayment to the IMF (the Greeks are trying to borrow money from one creditor, its Eurozone counterparts, to repay the debt of another creditor, the IMF! The phrase “rearranging the deckchairs…” springs to mind in this case) a deal appeared to be in place, subject to last details being clarified. The loan sum under discussion is just Euro15bn, with a “gap” in the agreement between both parties amounting to just 0.5% of Greek GDP (or about Euro800mn) in a broader Eurozone of Euro10.5trn. A tiny, almost irrelevant, amount of money within the compositional nature of the proposals from the Troika has been enough to throw the situation into apparent chaos. Very simply, Syriza wants the rich to bear more of the burden in tax increases whilst the Troika seeks a commitment to enforcing prior agreements, firstly, and a blend of tax increases and spending cuts alongside real institutional reform. Unfortunately, previous failure to enforce rigorously much needed structural changes, for example in the area of tax collection, weakens the tolerance of the Troika and lessens the credibility of the Greek negotiators.

The Greek negotiators in Brussels appear to have learned of the intention to call a referendum to allow the Greek people to accept or reject the “final” Troika proposals from the media, whilst Finance Minister Varoufakis stated in his regular Twitter updates that “Capital controls within a monetary union are a contradiction in terms. The Greek government opposes the very concept”. Just hours later banks are closed, deposit withdrawals are limited and the Prime Minister proposes Capital Controls. To say that Greek policy appears uncoordinated would be polite. Furthermore, Varoufakis also said “Democracy deserved a boost in euro-related matters. We just delivered it. Let the people decide. (Funny how radical this concept sounds!)”. The proposition that the Eurozone as a whole answers to the expressed wishes of Greek voters is fanciful in the extreme. No! The Greek government answers to the Greek voters and it appears, when faced with the end-game in the negotiations, to have blinked first and asked the Greek people to take the decision it seems incapable itself of taking. The Greek government expects its negotiating position to be strengthened by a “no” vote in favour rejecting the Troika proposals. We doubt that to be the case.

Local polling in recent days suggests that approximately 70% of Greeks want the country to remain within the Eurozone and, given a brief experience of the uncertainty and fear generated by capital controls and bank closures, we would expect that to be reflected in a clear “yes” vote in favour of compromise and agreement with the Troika. Whilst avoiding an imminent “Grexit” (this would, in any event, take many months in transition and not be an immediate event) it would certainly lead to Greek elections and another period of political uncertainty in the country. Another interim technocrat government may be necessary to manage the country in the intervening period.

Greek anger is understandable, the economy has shrunk 25% and the structural budget balance has swung by an entirely unprecedented 20% of GDP, but “root and branch” institutional reform, which is desperately needed, cannot be avoided and would not be addressed by default, denial and devaluation. The inflation that would, we think inevitably, eventually follow from the reissue and devaluation of a “New Drachma” would represent the most indiscriminate and insidious tax on the poor, since inflation always hurts harder those with the least assets and redistributes wealth and income from the poor to the rich.

We highlighted the geo-political implications of Grexit in our last monthly letter – Greece increasing its economic and political ties to Russia (giving the Russians the possibility of a naval base in the Mediterranean) and a worsening of the European migrant crisis (Greece is already a significant point of entry – 61,000 migrants have arrived by sea so far this year – and a deepening economic crisis would dramatically increase the porosity of European borders). Both parties, the Greek government and the Troika, have little to gain and much to lose from the impasse, so let’s not throw in the towel just yet as European officials have demonstrated over the years their uncanny ability to find ways to postpone making difficult decisions and take advantage of improbable loopholes as well as coming up with questionable legal interpretations to temporarily patch apparently unsolvable situations.

The ECB, as part of its commitment to QE, increased its balance sheet by Euro 207bn in the 4 weeks through April 10th, driving bond yields sharply lower and boosting equity markets, but then took its foot off the pedal and in the last 4 weeks has increased its asset base by just Euro 35bn. In response to the current situation, we would expect the ECB to accelerate the QE process from the recent anaemic pace. The maintenance of systemic liquidity is paramount and the ECB has the scope to prevent contagion.

Our portfolio, given its substantial exposure to US Government bonds, which have rallied sharply on safe haven flows and the lower likelihood in these circumstances of a Fed rate hike, is proving quite resilient in the face of this volatility and uncertainty despite the equity sell-off that is negatively affecting our pro-cyclical exposure.


MONOGRAM Capital Management, LLP is authorised and regulated by the Financial Conduct Authority. Any investment is speculative in nature and involves the risk of capital loss. The above data is provided strictly for information only and this is not an offer to sell shares in any collective investment scheme. Recipients who may be considering making an investment should seek their own independent advice. Recipients should appreciate that the value of any investment, and any income from any investment, may go down as well as up and that the capital of an investor in the Fund is at risk and that the investor may not receive back, on redemption or withdrawal of his investment, the amount which he invested. Opinions expressed are MONOGRAM’s present opinions only, reflecting the prevailing market conditions and certain assumptions. The information and opinions contained in this document are non-­‐binding and do not purport to be full or complete.

Gold as an inflation hedge? …Think again!

June 26, 2015

In 1971, the US government decided to unilaterally suspend the convertibility of the US dollar into Gold, opening a totally new monetary era where the value of money became purely based on faith. Whether this was a mistake or not remains to be seen, but since then, Gold has not behaved like a currency, being rather perceived as a store of value or an investment opportunity- although some money managers would dispute the very notion that Gold qualifies as an investment. This is because Gold is not very useful in any industrial or chemical process and offers no yield to its owner. Warren Buffett puts it quite clearly:

“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what it’s worth at current gold prices, you could buy — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”

While the above is factually correct, it is also true that Gold has performed well (+10.4% per annum over the last 15 years) and that Gold is widespread as an investment. However, the basis for successful investments is to understand the conditions under which they work.

The financial conventional wisdom holds Gold as a good inflation hedge and a decent enough store of value. On paper, this makes sense, because Gold is a real asset. It is also largely inert, which means that it does not decay. Therefore, all other things being equal, the real price of Gold should be stable over time.

The empirical evidences however, directly contradict this proposition. The figure 1 below shows the impact of inflation over the price of Gold over four different time windows: 5, 10, 20, and 40 years. In none of these four periods has inflation explained more than 5.2% of the movement in Gold prices.

Figure 1: Impact of monthly change in OECD G7 inflation over the price of Gold.

Gold as an inflation hedge ...Think again! graph

Further, Gold cannot be considered a good store of value. This is because in the last 40 years, the price of Gold has changed over a year by an average of 19.3%. Its maximum peak-to-through loss has reached 61.6% (sept-99). In our view, such volatility disqualifies Gold as an appropriate store of value.

In the soon-to-be-published second part of this blogpost, we will discuss what, in our view, are possible drivers of the price of gold.