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Sam Wylie's finance newsletter
Dr Sam Wylie is a director of Windlestone Education and a Principal Fellow of the Melbourne Business School. Sam consults and teaches finance programs for corporate and government clients.
s.wylie@mbs.edu or 0428 103 859
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Inflation is the only way out: Part I
Many economists believe that an extended period of inflation is ultimately the only way out of the low growth aftermath of the GFC. Moreover, the measures needed to stimulate inflation, such as: quantitative easing, negative interest rates, higher inflation targets and commitments to 'do whatever it takes', are blunt instruments. Therefore, a degree of overshooting - inflation that is too high -- should be expected. Deflation is the immediate danger but investors need to plan today for inflation in the medium to long term.
I never talk about the GFC in the past tense because it is obvious, in the following ways, that we are still living through it:
- GDP growth remains a long way below long term trend growth in developed countries, despite the stimulus of $25 trillion of extra government debt and $10 trillion of quantitative easing.
- Inflation fell rapidly in every major economy in 2014 and early 2015, including China and India. Consumer price inflation settled at close to zero in the US, UK, Europe and Japan in early 2015 and has not changed much since.
- Central bank balance sheets are grotesquely distorted by quantitative easing, as shown below, and total QE continues to grow rapidly.
- Asset prices are in bubble territory in many markets, with prices at historically high multiples of cash flows -- especially stocks, bonds and commercial real estate.
Figure 1: Projected growth of major central bank balance sheets
Why the world economy has not recovered from the GFC, and how to escape the GFC are the 64 trillion dollar questions. On the first question of why we are still stuck in the GFC, there are two dominant competing explanations - 'secular stagnation' and 'debt overhang'. These are competing explanations but they both point to a burst of inflation being one way out of the GFC, and perhaps the only way.
Secular stagnation One group of economists, led by Larry Summers, believes that the GFC and its aftermath should be seen in the context of a long term trend that began in the 1970s or earlier - Secular Stagnation. The meaning of 'secular' in this context is that the trend is permanent and not cyclical. 'Stagnation' refers to the lack of demand relative to supply of goods and services.
Summers and Co believe that without higher inflation real interest rates cannot fall low enough to stimulate the demand needed for healthy economic growth and full employment. Summers has repeatedly warned the US Fed against raising interest rates before inflation rises, and thereby pushing real interest rates higher. I think Summers is spot on. Janet Yellen's intention to continue raising rates in 2016, in the absence of USD inflation, is fraught with danger - reckless, really.
Higher inflation would allow real interest rates to go lower which would make monetary policy more effective. With inflation of 5%, real interest rates could fall to minus 2% for an indefinite period.
Debt overhang Another group, influenced by the research of Carmen Rheinhart and Ken Rogoff, point to the history of economic crises that have resulted from a failure of the banking system - just as the GFC did. History shows that such crises follow a clear pattern of: first, many years of high growth in borrowing by firms and households, followed by a banking crisis, followed by a deep recession, followed by 7 to 15 years of slow growth during which households, firms and governments deleverage their balance sheets. Finally, after the long period of deleveraging, normal growth is resumed.
Unfortunately the GFC is following the first part of this historical pattern (massive credit growth in the two decades before, banking failure, economic crisis, low GDP growth) but not the second part (deleveraging). Far from deleveraging, global debt levels have continued to grow faster than GDP. I
n the Rogoff and Rheinhart framework, economic growth will not return to pre-crisis levels u
ntil debt levels fall.
With inflation of 5% or more the real value of global debt, as a percentage of GDP, will begin to fall. A real reduction in overall debt levels would stimulate the global economy because households, firms and governments that have lower debt have a higher propensity to spend on consumption and investment. If households, corporations and governments do not save their way to a debt reduction then only a burst of inflation can achieve the same effect.
Whatever has to happen will happen
Whether Summer's 'secular stagnation' or Rogoff and Rheinhart's 'debt overhang' better explains the aftermath of the GFC - in either case inflation levels of 5% or more offer a way out. For secular stagnation it offers lower real interest rates and for debt overhang it offers lower real debt levels.
Central banks have already employed the extraordinary measures of massive quantitative easing and more recently negative interest rates in their efforts to fight deflation. The European Central Bank recently moved to negative interest rates of minus 0.3% on balances held by commercial banks at the ECB, to get the money out of the ECB and circulating in the economy.
Those measures have only managed to stop inflation falling below zero.
But, if inflation of 5% or more is the only way out, then eventually a burst of global inflation is what we will have. If even more extraordinary measures to stimulate inflation are needed then those measures will be taken. That will especially mean 'talking up' inflation by central bankers and moving to higher inflation targets to change the expectations of households and firms about future inflation.
Overshooting
The key to defeating deflation and inducing substantial inflation is shifting the expectations of households and firms about future levels of inflation. That is because expectations about inflation are partially self fulfilling. Households will only demand higher wages and firms will only demand higher prices if they expect prices to rise.
Unfortunately inflation expectations have been falling in developed economies since the beginning of the GFC. To turn those expectations around - to move them up by 3 or 4% -- will take truly extraordinary measures. But those measures are blunt instruments. There is no way to induce inflation with these blunt instruments and to fine tune levels of inflation to avoid overshooting. So, a degree of overshooting should be expected.
What should investors do?
To summarise, many economists believe that inflation of 5% or more in the major developed economies will be needed to escape the GFC. Inducing that inflation will require an application of blunt instruments that means that a degree of overshooting is likely - perhaps quite a lot of overshooting and high levels of inflation in the medium to long term.
In the next newsletter I am going to write about the conundrum faced by investors of navigating short term global deflationary dangers followed by long term inflation. In addition, the likelihood that long term global inflation will be imported into Australia, and what investors should do to prepare.
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Academic & Industry Conference,
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Join keynote speakers Prof David Yermack (Stern School at NYU) and Prof Stephen Brown (NYU and Monash), as they address the challenges to the financial industry posed by cryptocurrencies, and the block chain technology behind them.
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Nadia Massoud
Ian Potter Professor
of Finance, MBS
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Robo-financial advice is an idea that is as old as the web itself.
Vanguard had plans for a robo-advice product in 1999. Now there is a new surge of energy in this space with a large group of fintech startups going after the opportunity. Imagine that you were building a robo-advice product, then what would your business model look like? What service would you provide? What market segment would you go after? What would your revenue model be?
The product Most of the robo-advisors that are up and running, such Betterment or WealthFront in the US, or InvestSmart or Stockspot in Australia, are trying to emulate traditional financial advisers. You go to their website and they ask you a lot of questions - just as if you had gone to the office of a financial planner.
- They try to understand your current situation: your goals, age, income, responsibilities, risk aversion, current investments, etc.
- They then recommend choices: How much to save; how much to invest in each asset class (stocks, real estate, bonds, cash, etc.); how much to borrow; how much insurance you need; etc.
- Finally, they implement each choice for you: Choosing investment products in each asset class; purchasing insurance, arranging loans, etc. They are not very sophisticated at this stage - but these are early days.
More doctor and less architect I would describe this approach as the 'design and implement approach'. It is conceptually the same type of service as offered by architects - understanding of your situation, design and implementation.
I think this is the wrong approach for do-it-yourself (DIY) investors who are the natural clientele of robo-advisers. Those investors have already made investment choices and implemented them. Robo-advisors should be working with the client to examine those choices and find improvements.
That is, robo-advisers should be using a 'diagnostic approach'. When you go to the doctor you don't need design and implementation. You just need to know what is wrong with the body you already have, and how to fix it.
Successful robo-advisors will be more diagnostic. They will not start from scratch with the goal of implementing choices for investors, but instead ask investors why they have made the current choices and suggest changes. Questions like:
- Why are you 25% invested in cash, when your situation (young, few responsibilities, safe employment) suggests that you should take a relatively large amount of risk?
- Why do you have an SMSF? How is that helping you? Here is a list of ways in which self managed super adds value for investors. Which of these apply to you? None of them? Ok, why don't you switch to a low cost industry fund, like AustralianSuper or UniSuper?
- Why do you have growth assets (high capital gain, low income) in your family trust and income assets (low capital gains, high income) in your SMSF? Here are two reasons why that might be best practice. Does either apply to you?
- Why do you have a fixed rate loan for that investment property instead of a floating rate loan? Here are three reasons why that would make sense. Does one apply to you?
Revenue model How to charge for the robo-financial advice? Ideally all financial advisers would charge a fee for service. For instance, $350 per hour x 24 hours = $8,400 per year. But, in reality they almost always charge a fraction of funds under advice (FUA). For instance, $840,000 x 1% = $8,400.
Even advisers who claim to charge an hourly fee usually want to know how much of your money they will have under their advice before they quote the number of hours they expect to charge. That allows them to charge their 1% and then work backwards to the ostensible number of hours.
So it is with robo-advisers. They charge a percentage of FUA - typically between 25 and 75 basis points (0.25 to 0.75%). This is partly why they emulate financial advisers rather than providing a purely diagnostic service. Unless they are providing ongoing advice and administration it is very difficult to charge an ongoing fee.
This is the challenge for a diagnostic robo-advice service -- how to charge ongoing rather than one-off, or episodic, fees. There are two approaches that could be taken. First, a diagnostic robo-adviser could be embedded in a wider service. It might be bundled with the services of an SMSF administration provider. Secondly, the diagnostic service could be provided at low cost by a private wealth management firm, private bank or even an industry fund as a way of establishing contact with wealthy investors.
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Going defensive: Option strategies
A combination of bank shares plus put options to protect against a fall in the value of those shares looks attractive at the moment. Grossed-up dividend yields are very high and the price of options on banks shares are relatively low. That is a happy combination, especially for SMSF investors.
Say that an investor thinks that ANZ shares have plenty of upside because the global search for yield will eventually bring investors back to all the major Australian banks, and especially to ANZ which is priced 25% lower than its high point of $36.80 in April 2015.
But, the investor is concerned about the downside risk of bank shares in this period of greater economic uncertainty -- there are many credible scenarios in which bank shares fall steeply over the next 6 months. Our investor wants to participate in any upside in ANZ shares, but for the next six months the downside risk is too much.
What can be done?
A simple strategy for participating in the potential upside, but limiting the downside risk for a fixed period, is to own ANZ shares but protect them with put options.
Put option example Sophie, owns 1000 ANZ shares which are currently priced at $27.25. She wants to hedge against a fall in the share price below $27.00 between today (early January 2016) and the end of June 2016. Sophie is investing through her self managed superannuation fund (SMSF) which is in the pension phase (rather than the accumulation phase), so we can ignore tax.
Sophie can buy 1000 put options on ANZ shares with an exercise price of $27.00 and a maturity date of June 2016. The price of these $27, June 2016 ANZ put options is $1.68 today.
Each put option allows her to put one ANZ share to the ASX (the seller of the options) and receive $27 in exchange. The option can be exercised (at Sophie's discretion) any time up to the expiry date of 23 June 2016 (the Thursday before the last Friday in the month).
Figure 2: Pay-off to hedged and unhedged ANZ shares
The graph above shows what the value of Sophie's investment in ANZ shares will be on 23 June 2016 (y axis) as a function of the price of ANZ shares on that date (x axis). The blue line is the value of shares that are left unhedged and the red line is the value of the shares plus puts (including the original cost of buying the puts).
The red line shows that once Sophie has purchased a $27, June 2016 ANZ put option for each of her 1000 shares, then her investment in ANZ shares cannot fall below 27.00 - 1.88 = $25.12 in value. If instead of falling the share price rises, then Sophie doesn't need protection and will ignore the puts (which will expire unexercised). But if the share price is below $27 on 23 June then she will exercise the put and receive $27.
Buying puts v 'going to cash'
Many investors have eliminated their exposure to the downside risk of ANZ shares by selling; that is, exchanging bank equity for a bank deposit. That acheives perfect capital preservation and locks in a six month return of about 1.4% (2.80% per annum for 6 month term deposits).
The ANZ share and put combination does not provide full capital preservation but it does participate in the upside if ANZ shares rise, and it limits the damage to a return of no lower than -2.4% if the ANZ share price falls.
I am assuming here that ANZ's dividend, due in mid-May, will be 90 cents per share - a rise of 4.7% from the 86 cent dividend paid 12 months earlier. The dividend could, of course, be cut (as it was in 2009), or even reduced to zero, in which case the return to the share plus put would be -7.1%. However, if ANZ is forced to cut its dividend then Sophie will be very glad that she protected her shares with a put.
Cheap put options? Above I said that put options on bank shares are currently relatively low cost - but low cost compared to what?
A crucial driver of option prices is the expectation that investors have about the future volatility of the price of underlying shares. Volatility is an option owner's friend. For instance, after Sophie buys ANZ put options, then higher volatility in the ANZ share price can only help her. If the volatility expresses itself as a big increase in the share price then Sophie will benefit from that increase through ownership of the share. If volatility appears as a big price fall then no matter, Sophie has the put option to protect her. The higher the expected volatility, the more investors are prepared to pay for options that allow them to participate in the upside but be protected from the downside of large price movements.
Implied volatility
The relationship between expected volatility and the price of options is direct. If we know the expected volatility then the famous Black-Scholes equation gives us the price of an option. Likewise, if we know the price we can work backwards to the expected volatility. This is the implied volatility of the option (the vol implied by the price). The implied volatility provides a means of comparing the price of options across different stocks. And, a means to compare the price of options on a single stock, like ANZ, from day to day to say whether they are 'expensive' or not.
For instance, lets compare the cost of protecting ANZ shares with options to the cost of protecting BHP shares. It cost Sophie 6.2% of the price of the ANZ share ($1.68/$27.25) to buy protection at close to the current price ($27.25) for six months. To achieve the same protection of a BHP share would currently cost her 13.1% of the BHP share price.
Protecting BHP shares is currently more expensive than protecting ANZ shares. We could just as easily see that in the difference in the implied volatilities of the shares. The implied volatility of BHP shares is currently about 40%. For ANZ shares it is only about 20%.
That 20% is not a historically low implied volatility for ANZ shares, but it is low when we consider how much uncertainty hangs over the global banking sector. If you think that more volatility is coming than the market is building into the put price (as I do) then you believe put options are currently selling at low prices.
Benefits of put option protection
Note that to participate in the upside but limit downside risk investors could use call options instead of put options. In that strategy the investor puts their money in the bank (instead of buying the share) and buys a call option (instead of a put option). In this strategy, if the share price fell then Sophie would have the money in the bank. If the share price rises, then Sophie can use the money in the bank to 'call' the share to her; that is she can exercise the option to buy (not sell) an ANZ share for $27 (the strike price of the call option).
The equivalence of these alternative put and call strategies for eliminating downside risk creates a very tight relationship between the prices of put and call options, which is known as put-call parity.
Note that SMSFs
are
permitted to buy options. The fund's investment strategy and trust deed must allow the purchase of options. The fund must also have a derivative risk statement that sets out how options are being used to hedge risk.
Protecting shares with options for a short period of time can be a very helpful strategy for investors. There is a lot to know about option strategies, so I will write about them in future newsletters.
Cheers, Sam
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