On Target Newsletter

In this issue:

  • Investment risks
  • Safe storage
  • The dollar
  • Renewables
  • World economy
  • Clash over giant dam
  • Where to invest
  • Frontier markets

Judging the Risks in an Investment

Risk assessment should be the first step when choosing any investment.

You cannot avoid risk entirely, nor should you – it’s the price you pay for the prospect of higher returns. Equities generally deliver higher total returns over the long term than bonds because they’re riskier. Similarly, bonds – which carry some risk, but much less than shares — deliver more than a savings account at a bank.

Sometimes the type or scale of risk you’re taking on is not obvious. In Britain more than a million people suddenly discovered their savings – held through with-profit policies and pension plans – were at risk in Equitable Life, a giant mutual life insurer that was long regarded as one of the most secure. Equitable got into trouble because it misjudged its risk in guaranteeing future investment returns – an expensive mistake for most of its policyholders.

On the other hand, most investors are too frightened of risk.

Investing in equities can be less risky than it seems, as the longer you hold them, the lower the risk. The US stock market has lost as much as 30 per cent in a single day, yet over 20-year periods has never failed to deliver a positive real return.

Hedge funds have the reputation of being high-risk, and many are — yet some are particularly low-risk. They can be effective instruments for reducing the average risk in a portfolio.

There are many different kinds of investment risk. Here are the more important ones:

Specific. The risk that a company or sector will lose value because of circumstances which only or mainly affect them. Examples would be the loss of a contract accounting for most of a company’s earnings, or the catastrophic impact of the 9/11 terrorist attacks on airlines.

Market. The values of a whole category of assets, such as shares, may plunge because of changing conditions or perceptions not specific to the particular asset in which you’re invested. An obvious example would be the bear market in global equities that struck us in March.

Default. You lose your money through fraud, a suddenly adverse business environment or managerial incompetence that devastate the entity you’ve invested in. Some years ago there was the highly publicised case of Enron, for instance investment asset and the income from it are denominated falls in terms of your own monetary unit.

Interest rate. Unexpected increases in rates hit the value of many investments for several reasons. One little-understood but important one is that it tends to boost the rate used to discount the future returns from an asset, which has the mathematical effect of cutting the present value of that asset.

Political. Unwelcome surprises such as riots, a terrorist incident, the outbreak of an epidemic or the election of a radical government can have a sudden adverse impact on the value of assets directly or indirectly linked to the country concerned.

Management. The risk that your company investment loses value because the managers have lost focus or drive, perhaps because of the unexpected loss of an outstanding chief executive, leading to loss of market share, erosion of profit margins and balance-sheet deterioration.

Liquidity. The danger that you won’t be able to sell your investment with ease, without sustaining significant loss. This is greatest when investing in a “narrowly-traded” market – there are few buyers and sellers at any time – such as the shares of small companies.

Purchasing power. The risk that the return on a “locked-in” investment – one that can only be cashed after a set or minimum holding period — will be poor after adjusting for inflation.

Choosing who’s to manage your capital: a hazard oft-overlooked

Some risks are less well-known, or only apply to specific assets:

Opportunity cost. The risk that you’ll lose out from failing to invest in a fast-rising asset because you don’t have the cash or the nerves to do so.

Last-day or critical-day. Where much of the redemption value of your asset depends on asset prices on the last day of its term, or where there is no certainty about the date when it will accrue, such as on the death of the investor.

Manager selection. The risk that the performance of the management to whom you have committed long-term savings, as in a pension fund, turns out to be far worse than the past record on which you based your choice. There can be many reasons for this, such as focus on sectors that go out of favour or loss of a talented manager.

Individual investors often base their strategies on fallacious perceptions of risk. For example, they are worried about the risk of a 5 per cent loss of original capital but ignore the risk of failing to get a 5 per cent gain when the market moves up. Professionals judge both as similar levels of investment risk.

An American study showed that the risks of primary concern to mutual fund investors were the chances of loss of original capital; of fluctuations in the value of their investment; of loss of real value because of inflation; and of not having enough money to achieve set goals (such as paying for a child’s university education at a future date).

There are several ways in which the risk in a security can be measured:

Volatility. This encompasses all the factors which have contributed to movements in price in the past such as interest or exchange rate fluctuations, profits, tax rates and changes in market perceptions.

The metric most used by professionals to gauge this is standard deviation (SD), which measures the ratio of average upward and downward movements in the price of an asset in relation to its mean or average price or return, typically over the past 36 months.

By comparing the SD of a fund, for example, with its peers’, you can determine whether or not greater, or even undue, risks have been taken to achieve a higher return. However, SDs share with other ratios based on historical experience, the deficiency that they may not be a good guide to the future.

Volatility over the period considered may have been unduly high due to special factors, as happened with American bonds in the mid-1990s when the US Federal Reserve unexpectedly raised interest rates and there was a financial crisis in neighbouring Mexico.

Correlation. A portfolio invested in a greater number of securities will nearly always have a lower risk than one invested in a smaller number, even if all the securities are high-risk.

Diversification is a basic strategy for reducing investment risk. Good managers ensure that any strategic move into higher-risk assets is accompanied by greater diversification.

The benefits of spreading risk in this way are enhanced by selecting assets which do not have a close correlation with one another – that is, their values do not move in the same direction, or at least not simultaneously.

A share listed in Turkey, for example, is likely to have a very low or even a negative correlation with one listed on Wall Street, as the forces moving its price are likely to be location-specific, such as consumer demand, political instability, or changes in the exchange rates of the national currency, interest rates or tax.

A company depending entirely on export sales is likely to do well precisely when a firm depending on imported products or components is suffering from a weak national currency. Putting one in your portfolio would neutralize the risk in the other. 

The metric used to gauge this kind of risk is the correlation coefficient (CC), which shows the extent to which changes in the value of one asset have been linked to changes in the value of another.

A ratio of one shows a complete positive correlation (the values of both securities have in the past moved in the same direction, to the same extent, at the same time). A CC of 0.40 would show only a weak linkage, while a negative one of 0.80 would indicate a strong tendency for values to move in opposite directions.

For practical purposes, any CC above 0.70 is regarded as strongly positive; in the range down to 0.40 only moderately positive; figures below that show little linkage.

By careful selection of assets in different markets, managers seek what is known as the “efficient frontier” – the point at which return of the portfolio as a whole is likely to be highest relative to overall risk.

Managers of indexed or “tracker” funds, however, actively seek a perfect positive correlation with the benchmark they are committed to tracking.

Performance. Several measures are commonly used to gauge whether a fund manager has been taking on undue risk relative to the return he has delivered, and relative to his peers’.

The most popular is the Sharpe ratio. It’s the extent to which there has been return in excess of a notional risk-free rate, such as the yield on 90-day US Treasury bills, divided by the fund’s standard deviation. A simpler modified form, commonly used, ignores the deduction of a risk-free return.

A deficiency of this ratio is that it can be very high for completely different reasons – because of aggressive, relatively high-risk fund management, or because of very cautious, low-risk management.

The Treynor ratio is similar to the Sharpe, but instead of the return in excess of risk-free rate being divided by the standard deviation, it’s divided by the Beta – which is a measure of how a fund has performed relative to a benchmark, usually a sector average or an index.

Another measure of performance-related risk is maximum drawdown. This shows the maximum amount an investor could have lost had he or she bought or sold a share or fund unit at the worst times. It is expressed as a percentage of purchase capital, and is a kind of worst-case scenario based on historical experience.

Consistency measures the risk that a fund is likely to underperform relative to its peers in any one period, such as a year. It is based on the frequency that a fund manages to achieve outperformance, such as appearing in the top quartile, quintile or even decile (25, 20 or 10 per cent).

Funds’ “star” ratings are often based on a combination of Sharpe and consistency measures.

Your views may differ considerably from others’

There are other aspects of risk to be considered, such as exposure to exchange rate or interest rate changes.

However, all standard measures of investment risk suffer from the limitations of being based on history (the future may not mirror the past), and of not taking into account the situations and attitudes of the individual investor.

Not only will different investors have different views on what constitutes risk, but also their capacity to accept risk will differ. Clearly a retired couple with little income and a small amount of assets will be less able to risk fluctuations in their investments than a young couple years away from retirement.

Assessment of individual sensitivity to risk should be the starting-point of planning any investor’s portfolio.

Keeping Your Precious Metals in Safety

Investing in and holding physical precious metals, especially when kept outside the banking system in private high-security storage facilities, requires trust, security, risk diversification and hedging against the vulnerabilities and worst-case scenarios of the monetary system, say Ronald-Peter Stoeferle and Mark Valek, managing partners at Incrementum, the precious metals investment specialists.

Choice of storage location is critical. The main factors to be considered are the level of protection of individual financial freedom and of private property rights, political and economic stability, and the government’s predictability, restraint and historical track record.

According to these measures, three countries stand out from the rest: Switzerland, Liechtenstein and Singapore.

Switzerland can be relied upon as a safe haven as there are strict limits placed on government powers and a long track record of the government’s staying well within those limits. That makes confiscation of precious metals stored under Swiss law very improbable.

Its longstanding neutrality position (avoiding involvement in both world wars), its solid non-interventionist foreign policy record, and the fact that more than 50 per cent of households are armed, “create a safe environment and provide peace of mind both for its citizens and for investors.”

In stark contrast to its European Union neighbours, the Alpine nation is much more prudent in managing its finances. For example, according to latest figures, the federal budget achieves significant surpluses. Its total government debt is less than 200 billion francs — stable in absolute terms, and in a declining tendency relative to GDP.

Liechtenstein (where Incrementum is based) is an independent principality bordering Switzerland that has focused on development as a financial hub.

The monarch is a fierce proponent of limited government, free trade and free speech. The state has strong ties with Switzerland, which provides any military defence that might be needed. It has been running budget surpluses for years.

It has gone to some lengths to provide an attractive and welcoming environment for entrepreneurs, investors and start-ups, embracing cryptocurrencies, for example, very early in its adoption curve.

Singapore, the island state in Southeast Asia, has moved beyond its spectacular success as a miracle economy to challenge Switzerland as a global business and financial hub.

It has no capital gains tax, no sales taxes on investment-grade precious metals, and a strong record of respect for private property rights. Its tax regime and regulatory framework are simple and investor-friendly. Business owners and investors have comparatively very little red tape to contend with. The country regularly leads global rankings for speed and efficiency in registering new businesses.

Ultra-high-net-worth individuals (those with at least $30 million) are flooding in to establish residence.

Stoefele and Valek say: “When selecting a location to store your wealth in physical precious metals, you should look at the political system as well as the government’s track record through thick and thin. It is also important to consider the country’s gold culture and relevant tradition. In nations with a long history of widespread private gold ownership, governments face formidable obstacles and serious opposition against aggressive legislation such as ownership restrictions, seizures or confiscation orders targeting precious metals.”

Why the Greenback Will Remain Top Dollar

One of the classical arguments favouring gold is that it’s the anti-dollar. When the greenback is weak, gold is strong. But among the gold bulls there are many who argue that the metal can prosper even when the US currency is strong. One of these is Brent Johnson of Californian gold investment specialist Santiago Capital, who puts forward the following arguments (among others) for a significantly firmer greenback:

► As the global reserve currency, there is global demand for the US dollar. There isn’t global demand for the Euro, Yen, Ruble, Lira, Real, Peso.

► There is currently no clear alternative to the US dollar payment system. In the year of its existence the INSTEX European non-dollar system has done just one transaction of less than $500,000 and was largely political in nature.

► While bilateral trade agreements between non-US countries continue to rise, they pale in comparison to the clear dominance of global trade taking place in dollars.

► Despite the massive stimulus provide by the Federal Reserve, the central banks of the rest of the world will also be forced to dramatically increase money supply. Without global demand to backstop their stimulus, these efforts will help to weaken their currencies.

► The US has the deepest and most liquid capital markets. Due to global demand for dollars, its capital markets will outperform those of the rest of the world.

► This outperformance will create a vicious cycle leading to further upward pressure on the US dollar and downward pressure on other fiat currencies. After the 2008 global financial crisis the US recapitalized its banking system. Much of the rest of the world did not. As foreign banking systems come under increasing pressure, this will be another factor making the US an attractive alternative.

► Much of the non-US global economy transacts on Eurodollars (dollars outside the US banking system) — but they do not have the ability to print them. This makes the Fed the de-facto central bank to the rest of the world.

► The US will use dollar liquidity (repo and swap lines) as a weapon to shore up and enact its new foreign policies. Friends will be rewarded with access to liquidity, while competitors will be punished by the withdrawal of liquidity.

► The US military will continue to enforce the dollar’s use as the global reserve currency.

Expect a Comeback Play about Renewables

Although the collapse in the prices of fossil fuels has undermined the case for renewables – most of which suddenly look outrageously expensive compared to oil and gas – it won’t undermine carbonatics’ roller-coaster campaign to win the favour of policymakers and corporate decisionmakers as and when the oil market recovers.

A signal of what’s coming was the surprising decision of Royal Dutch Shell to abandon its longstanding policy of never cutting its dividend. One reason was the need to build the enormous resources going forward that are going to be needed to finance the switch away from fossil fuels to which the company has allocated priority.

Despite the massive propaganda to promote renewables, for now they deliver only about 2 per cent of the world’s energy needs.

They are hobbled by intermittency – when it’s night (in the case of solar) or there’s no wind, there has to be backup power available from other sources (usually gas, oil or coal-fired) or hugely expensive battery farms.

And they cannot compete without big subsidies and/or government guarantees which the politicians are under increasing pressure to reduce or even scrap. According to consultants Rystad Energy the internal rates of return in the US are currently only 4 per cent for wind farms, 6½ per cent for solar projects.

Allen Brooks, the well-known energy commentator, says that corporate chief executives responsible for allocating their companies’ capital know they can get returns two to three times those available from renewables by investing in traditional oil and gas projects. For them it’s a hard sell to get shareholders to accept lower returns, and possibly lower dividend payments, for shuffling investment in favour of renewables over oil and gas.

The only new point I’ve seen in favour of renewables is that the wild swings in prices of oil will influence support for them – oil has been as low as $10 a barrel, and could easily soar to as much as $100 in a surprise bull market – as their supply is largely at stable, fixed prices. But so would energy coming from new nuclear plants. Without the volatility of sun or wind.

Outlook for the World Economy

Near-term, unlike other pandemics, Covid-19 is a disinflationary shock to the global economy because of high spare production capacity and high unemployment, says Credit Suisse. But longer-term, it will turn out to be an inflationary shock.

Fiscal policy will remain expansionary until unemployment falls to politically acceptable levels. There will be higher minimum wages. Deglobalization will raise costs. The dollar will weaken. The downtrend in oil prices has ended. A lot of the disinflationary impact of disruptive technology has been seen. Most central banks will allow inflation to overshoot.

The problem of excessively high debt – the IMF says US debt will reach 146 per cent of GDP by the end of next year – will have to be addressed. The most politically, socially and economically pragmatic solution is to pursue money printing until unemployment falls to low levels, allowing inflation to rise and capping bond yields.

The US and the UK are countries most likely to resort to high inflation. However. “we do not believe in hyper-inflation as the wage/price link of the 1970s has disappeared with acute de-unionization.”

Equities are an inflation hedge, so the S&P 500 index, now below 3200, could easily get to 3500 by the end of next year; gold (now $1,800) to $2,200.

Cyclical shares outperform as inflation expectations rise. The sectors most sensitive are construction, mining, paper and real estate. Worst performing is healthcare. Credit Suisse likes real asset stocks that are cheap and not technically disrupted such as UK homebuilders, packaging/trees, German residential real estate and cement. This includes names such as Bellway, Stora Enso, Anglo American and LafargeHolcim.

The bank lifts its recommendation for investment in global real estate – preferably companies with a residential focus – to overweight.

Recent numbers such as those for car sales in America, soaring restaurant reservations and hotel bookings in Britain, and a significant pick-up in social and economic activity in Germany, suggest the release of pent-up demand, says MoneyWeek’s Merryn Somerset Webb.

“It’s tempting, given today’s bias to misery, to assume that this is just a temporary blip that will burn itself out as trade tensions and unemployment rise and new lockdowns loom amid a second wave of virus hell. “But that is not a given… Fiscal and monetary support has been stunning. We are in a whole new world of state support.”

Economies also have relatively healthy financial systems. There is no reason to expect deleveraging or bad loan losses anything like those that came in 2008 in the wake of the global financial crisis. Good firms have used the Covid-19 crisis to get better. The lockdowns might even trigger a wave of digitalization and productivity gains.

Escalating Tension Over Huge New Dam

This month the Ethiopian dam set to be Africa’s biggest hydroelectric plant, and the seventh largest in the world, will start to fill with water. And perhaps to trigger war.

The Grand Ethiopian Renaissance Dam (GERD) sits on the main branch of the Nile river. The $5 billion project is fiercely opposed by Egypt, which sits downstream. It claims the dam will eventually cut off water essential to tens of millions of its small farmers and turn into desert up to a third of its agricultural land.

Ethiopia needs the dam to become a major exporter of electricity, mainly to neighbouring Sudan. It denies that Egypt will lose much water and claims it will benefit from controlled flows.

The two countries have failed to reach agreement after years of negotiations. Faced with the prospect of the enormous dam – designed to hold 74 billion cubic metres of water – starting to fill, Egypt has now taken the dispute to the UN Security Council.

That’s unlikely to resolve the conflict. In which case Egypt’s ruling generals may resort to war. A land attack doesn’t look feasible – two countries, Sudan and South Sudan, intervene. But a large-scale air attack via the Red Sea would be.

Where to Invest

Governments are broke and the spending plans under way to combat the lockdown-induced recessions are going to push deficits to even greater heights, Eoin Treacy says in FullerTreacyMoney. To pay down the debt, interest rates will be kept low, the purchasing power of currencies will be degraded, and savers will be robbed of returns,

The only solution is to seek profits from speculation. That’s why the mega-cap technology sector is now in the third psychological stage of its bull market. With zero interest rates and abundant liquidity, capturing market share is the only business model that makes sense.

“Meanwhile, gold is at the other end of the spectrum, and as a result is the only hard asset that is also a value play at current levels.”

With the 30-year Treasury real yield – adjusted for inflation – sitting below zero, bond markets are signalling a grim outlook for economic growth… and profits.

So it’s no surprise that investors are focusing on companies and sectors with robust cash flows and good chances of increasing revenues, says the FT’s  Michael Mackenzie. But can the premium enjoyed by technology, as well as communication services and healthcare companies, be sustained?

One reason it might be is that lawmakers are considering industrial policy that bolsters research and development, boosting companies in sectors such as medical devices, biotech and robotics.


Frontier markets: Notwithstanding the damage the pandemic has done to emerging economies, some are well-positioned to bounce back strongly because of the resilience of their banks and foreign exchanges reserves argues Matthew Vogel of FIM Partners in Dubai.

► The Philippines has huge forex buffers, a low fiscal deficit and sound banks. Its ratio of external debt to GDP is only 24 per cent, its forex reserves are enough to cover 12 months of imports, and fiscal and monetary policies have been substantial without threatening macroeconomic stability.

► Peru, similarly, has been implementing strong initiatives to combat the virus. It has freedom to act because of years of sound policy management. Deficit and debt ratios are low, funding resources are abundant.

► Vietnam’s handling of Covid-19 has been short and sharp, keeping infections and deaths low. Already the economy has resumed close-to-normal activity.

The countries offer investors the best opportunities, but “frontier markets across the board will probably outperform developed markets in the short to medium term.”

Stay-at-home index: The pandemic lockdowns have accelerated trends already under way such as the apocalypse in traditional retailing. The evolution of the subscription business model, cloud computing, video conferencing, remote work and learning have been evident for years. Lockdowns have amplified those trends.

Solactive, a German information provider, has compiled a Stay At Home index of companies benefiting such as Netflix, Amazon, Pelaton, DocuSign and Wayfair.

Coal: China is approving plans for new coal-fuelled power plants on a bigger scale than for five years, adding more than 40 gigawatts to capacity this year. The country, the world’s largest producer and user of coal, uses it to generate half its electricity. It has promised to stop adding to carbon emissions by 2030, but now seems to have abandoned efforts to reach that target.

Japan, similarly, gives lip-service to “green” targets while sticking with the dirtiest fossil fuel. It has approved plans to build 22 new coal-fired power plants over the next five years, increasing coal’s share of electricity supplies.

Century bonds: Austria has issued another government bond maturing in a hundred years to take advantage of the very low interest rates international investors are willing to accept because of the avalanche of paper from global central banks. In 2017 Austria offered its first century bond with a yield of more than 2.1 per cent. It went down so well that Vienna now offers just 0.88 per cent for a hundred-year lock-up. It has raised €2 billion.

Value stocks: Globally they are relatively cheaper than they’ve almost ever been says the GMO fund management group. That cheapness “buys a lot of margin of safety” if things turn out bad economically, “while still providing an expected return higher than developed stock markets.

“A combination of that spread and a long position in emerging-market value stocks – the cheapest stocks in the world – provides a far better risk/reward trade-off than a traditional equity position.”

When sex is OK: Britain eased its lockdown rules which originally made it illegal to have sex with a person from another household, Jonathan Sumption reported, allowing it “provided that it happens in the daytime and not at night, and in the garden not it in the house. Unless… a sex worker in involved, in which case it will be ‘necessary for work purposes’ and okay even at night.

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