Distinguished Speaker Series: James Bullard, President and CEO of the St. Louis Federal Reserve Bank

On September 12th, CFA Society Chicago welcomed James Bullard, president and CEO of the St. Louis Federal Reserve Bank. Members and guests heard Bullard’s remarks over breakfast at The University Club.

The focus of the discussion explored a possible strategy to extend the U.S. economic expansion. Bullard noted that historical signals used by monetary policy makers have broken down, specifically the empirical Phillips curve relationship. As a result Bullard suggested putting more weight on financial market signals, such as the slope of the yield curve and market -based inflation expectations. Handled properly, these signals could help the Federal Open Market Committee (FOMC) better identify the neutral policy rate and possibly extend the U.S. economic expansion.

Following are excerpts from Bullard’s presentation “What Is the Best Strategy for Extending the U.S. Economy’s Expansion?

The Disappearing Phillips Curve

Prior to 1995 inflation expectations were not well anchored. Around 1995, the U.S. inflation rate reached 2 percent, and U.S inflation expectations stabilized near that value. Bullard interpreted this as the U.S. having an implicit inflation target of 2 percent after 1995, calling it the inflation-targeting era. The FOMC named an explicit inflation target of 2 percent in January 2012, but Bullard said he believes that the Committee behaved as if it had a 2 percent target well before that date. The post 1995 period in the U.S. coincided with a global movement among central banks toward inflation targeting beginning in the early 1990s. During this period, the 2 percent inflation target became an international standard.

Once inflation expectations stabilized around this international standard, the empirical relationship between inflation and unemployment– the so called “Phillips curve”–began to disappear. Bullard provided a chart showing the slope of the Phillips curve has been drifting toward zero since the 1990’s and has been close to zero for the past several years.

Current monetary policy strategy

The conventional wisdom in current U.S. monetary policy is based on the Phillips curve and suggests that the policy rate should continue to rise in order to contain any increase in inflationary pressures. However, in the current era of inflation targeting, neither low unemployment nor faster real GDP growth gives a reliable signal of inflationary pressure because those empirical relationships have broken down. Continuing to raise the policy rate in such an environment could cause the FOMC to go too far, raising recession risk unnecessarily.

Given that, Bullard suggested using financial market signals such as the yield curve as an alternative to the Phillips curve. The slope of the yield curve is considered a good predictor of future real economic activity in the U.S. This is true both in empirical academic research and in more casual assessments. Generally speaking, financial market information suggests that current monetary policy is neutral or even somewhat restrictive today. Specifically, the yield curve is quite flat, and market based inflation expectations, adjusted to a personal consumption expenditures basis, remain somewhat below the FOMC’s 2 percent target. Financial market information also suggests the policy rate path in the June 2018 summary of Economic Projections (SEP) is too hawkish for the current macroeconomic environment.

A forward-looking strategy

More directly emphasizing financial market information naturally constitutes a forward looking monetary policy strategy. One of the great strengths of financial market information is that markets are forward looking and have taken into account all available information when determining prices. Thus, markets have made a judgment on the effects of the fiscal package in the U.S., ongoing trade discussions, developments in emerging markets, and a myriad of other factors in determining current prices.

Financial markets and the Fed

Financial markets price in future Fed policy, which creates some feedback to actual Fed policy if policymakers are taking signals from financial markets. This has to be handled carefully. Ideally, there would be a fixed point between Fed communications and market based expectations of future Fed policy, i.e., the two would be close to each other. Bullard said that generally speaking, markets have currently priced in a more dovish policy than indicated by the FOMC’s SEP – they expect the Committee to be more dovish than announced but still not enough to achieve the inflation target.

Caveats on financial market signals

Financial market information is not infallible, and markets can only do so much in attempting to predict future macroeconomic performance. The empirical evidence on yield curve inversion in the U.S. is relatively strong, and TIPS -based inflation expectations have generally been correct in predicting subdued inflationary pressures in recent years. Therefore, both policymakers and market professionals need to take these financial market signals seriously.

Risks 

Bullard suggested that yield curve inversion would likely increase the vulnerability of the economy to recession. An inflation outbreak is possible but seems unlikely at this point. By closely monitoring market based inflation expectations, the FOMC can keep inflationary pressure under close surveillance. In addition, financial stability risk is generally considered moderate at this juncture. Arguably, these are being addressed through Dodd-Frank and related initiatives, including stress testing.

Opportunities

The current expansion dating from the 2007-2009 recession has been long and subdued on average. The slow pace of growth suggests the expansion could have much further to go. The strong performance of current labor markets could entice marginally attached workers back to work, increasing skills and enhancing resiliency before the next downturn.

Uncertainty

Another long standing issue in macroeconomics is how to think about parameter uncertainty, or more broadly, model uncertainty. Bullard pointed to two studies: Brainard (1967) suggested that when model parameters are in doubt, policy should be more cautious than otherwise and, Hansen and Sargent (2008) suggested that, in some cases, policymakers might want to be more aggressive than otherwise. This is an unresolved issue, but how to handle parameter uncertainty has been a concern for the FOMC for years.

Conclusion

Bullard re-iterated his position stressing that U.S. monetary policymakers should put more weight than usual on financial market signals in the current macroeconomic environment due to the breakdown of the empirical Phillips curve. Handled properly, current financial market information can provide the basis for a better forward-looking monetary policy strategy. The flattening yield curve and subdued market-based inflation expectations suggest that the current monetary policy stance is already neutral or possibly somewhat restrictive.

A Taste of Latin America

CFA Society Chicago held its latest social event on Marth 13th at the Mexican restaurant Pueblo. Pueblo specializes in traditional Mexican fare with a “contemporary twist”, and is located inside of Latinicity on the third floor of Block 37 (northwest corner of State and Washington). Latinicity features eight innovative kitchens, the sit down restaurant Pueblo, a coffee café, full bar, and lounge.

The program for the evening was simple; participants were to watch and learn how to make a three course Latin dinner with hands on instruction from Pueblo’s kitchen staff. The dinner menu included a side dish that each participant would make, while Pueblo’s chef, Marcos Flores would show the group how to make a soup and entrée.

Chef Marcos began the program explaining to the group how to make the first course, Aquachile Ceviche. Aquachile Ceviche is a Mexican seafood dish that includes shrimp, pineapple, cucumber, avocado, celery, tomatillo, serrano, and cilantro. Chef Marcos provided some basic guidance on how to properly use a cutting knife, and then provided specific instructions on how to assemble the dish. Each person made their Aquachile at their station, which were close enough together so that acquaintances could be made and tips could be shared. I found out from sampling my station mates Ceviche that the smaller diced the ingredients, the better the dish.  It is suggested the dish be served with avocado and tostadas, and if you like, beer and tequila.

Once everyone had finished creating their Aquachile, Chef Marcos explained the steps required to make a large batch of Aquachile Sauce to accompany the dish. In a large blender he combined; garlic, white onion, chopped celery, fresh grated ginger, 2 limes, cilantro with stems, 1 whole serrano, 2 ice cubes, 3 small whole tomatillos, and kosher salt. Once those ingredients were blended olive oil was slowly added to complete the sauce. Chef Marcos advised that the sauce should sit for several minutes before serving, chilled.

We relocated to the kitchen where preparations began for Ajiaco Soup – a creamy chicken and potato soup, and Lomo Saltado – a traditional Peruvian dish. The group gathered around Chef Marcos as he prepared the soup. He diced potatoes, and brought them to a boil. Next, he cut raw chicken into strips and browned them in a skillet. Potatoes, chicken, corn, cilantro, green onions, and other spices were then combined into a large pot and let simmer. Chef Marcos explained that Lom Saltado is a stir-fry dish that includes strips of sirloin, sliced onions, and whole tomatoes. Over a medium skillet with hot oil, sirloin was browned, onions and tomatoes were added and sautéed until they were soft. Chef Marcos advised that the dish is traditionally served over fries or rice.

Once those dishes were complete, the group headed to the bar where Pueblo’s head bartender had been making a batch of Pisco Sours, which is made of Pisco brandy, egg whites, fresh lime, simple syrup, and bitters. The Pisco Sour originated from Peru or Chile, and is considered a South American classic. The drink’s name comes from pisco, which is its base liquor, and the term sour is in reference to sour citrus juice and sweetener. One of our group asked the reason for using egg whites. The bartender explained it adds a soft, element to the texture of the drink, and egg whites produce a layer that floats on top of the drink, which is ideal for decorating with drops of bitters or highlighting a garnish.

With drinks in hand we moved to the dining area to enjoy the fruits of our and Chef Marcos’ labor.  Pueblo staff had assembled a large table with the dishes of the evening; the Lomo Saltado, Ajiaco Soup, each participant’s Aquachile Ceviche, the chilled Aquachile sauce, and tortilla chips.

Over dinner we discussed a number of topics from, the reasons that brought us to the event, to economic growth expectations given the passage of the tax bill coupled the general uncertainty that is endemic to the current administration. Several of the participants noted they wanted to take a cooking class but not invest in a full cooking course. A couple of those people remarked that their experience at Latinicity would motivate them to enroll in a cooking class and another couple advised that they had been to Pueblo before and enjoyed the food so much that they wanted to replicate some of the dishes. Our group agreed that the soup was the hands down winner of the best dish of the night. Regarding economic growth expectations? We decided it was more fun to discuss the events of the evening over another Pisco Sour with new found friends.

Distinguished Speaker Series: Rupal Bhansali, Ariel Investments

Rupal Bhansali was the featured guest speaker at CFA Society Chicago’s March Distinguished Speaker Series luncheon held at the Chicago Club. Bhansali is chief investment officer and portfolio manager of Ariel Capital Management’s international and global equity strategies. Her presentation was called The Power of Non-Consensus Investing.

Bhansali began with two examples of non-consensus thinking: the micro-lending phenomenon that has helped eradicate poverty in places like India and the rise of Silicon Valley business model that was radically different from what was conventionally accepted. These examples highlighted that non-consensus thinking can be applied to a variety of situations and disciplines, including investment management. Also, this type of non-consensus thinking can drive alpha in investment portfolios. Considering the non-consensus aspect of your research is a great way to determine if there may be alpha.

The aim of institutional asset management is to be correct – correct in your assumptions, correct on your earnings estimates, correct with rates of growth. The problem with being correct is that it gets you to the same place as other good investors. A research analyst that is correct along with the rest of the institutional market is not necessarily rewarded. Fundamental research is about finding alpha, which in most cases is akin to proving everyone else wrong. Being correct and non-consensus provides rewards. The question then is how to be behaviorally different but remain analytically sound?

Bhansali provided an example of applying non-consensus thinking to the investment prospects of a global tire company. The consensus view of this company (and tire industry) was that tires were a conventional part of a car, low tech in terms of manufacture (it is just rubber and steel bands right?), and that the market is driven by new car sales. That view seemed reasonable, certainly a consensus view at the time. She then offered a non-consensus view. Is the manufacture of a tire a simple process that can be copied by a competitor? Turns out no, tire manufacturing is an involved process that cannot be easily reverse engineered. Do consumers consider tires interchangeable? No – they have brand affiliation. The consumer also cares about safety, fuel economy, and performance, which provides the company a value proposition. What drives this market is miles driven, not new car sales. A sector and business that was consensus branded as a low tech, interchangeable auto part, turned out to be a high tech, branded, mission critical good. If you had a non-consensus view on this market/brand, outsized returns were made.

A second example of a non-consensus investment view was provided on the mobile phone market. There was a time when BlackBerry and Nokia were market darlings. In part, these views were based on advanced technology, great user experience, superior growth, and competitive product advantage. The market took those factors to be insurmountable barriers. In fact these companies suffered from an eroding advantage where their products were surpassed by other brands. Apple seized the opportunity to displace these companies with a better product and user experience, offering the market exceptional growth of its own – for a time. Bhansali remarked that the consensus view on Apple has been positive for too long. Apple also suffers from many of the factors that doomed Blackberry and Nokia: alternative options and equivalent user experience for a cheaper price. She also noted that the iPhone is the dominate driver of revenue for Apple. If iPhone sales falter, Apple returns will suffer.

Bhansali’s last example of consensus/non-consensus thinking was particularly pertinent to the audience. Currently passive management is the go to option for investors. It is consensus – low entry cost, simple, easy, a no-brainer decision, while active management exhibits high costs, might have hidden risks, and is an active decision. Seems like there is no hope for active management given this view. Passive management and ETFs are winning and the outlook for active management is bleak. However, what would a non-consensus view of this subject consider? Although passive management is low cost, it is not low risk. Passive management has come of age in a prolonged bull market. It has not been stressed in a recessionary, or bear market. What might occur when large passive funds try to liquidate at the same time? For starters, the bid/ask spread will widen – a crowded trade is a risky trade. The scale that helps keep the cost of passive management low also exposes it to be too big to liquidate. A non-consensus view of active management might consider that the ease of ETF investing doesn’t equal being right, that real active management pays for itself when true active management is identified with active share, fundamental research, and management that has skin in the game.

The audience then offered some questions to Bhansali:

Q: If you believe that alpha is everywhere then the universe of securities is huge, how do you screen down to a manageable amount of securities?
A: Start from a rejection perspective not a selection perspective. Good securities will be the residual.

Q: In your portfolio what type of downside protection do you use or recommend?
A: I do not use derivatives as they are too short term in nature, and one must get the timing and thesis right for them to be effective. Protection can be obtained via investment ideas – using securities that have low correlation with the portfolio.

Q: What makes a great research analyst?
A: Bhansali noted that although it less common today, that being a generalist was helpful to her evolution as a research analyst. She also advised that a good analyst should follow multiple sectors, and always examine the counterfactual – understand what will cause a company to underperform as much as you understand the factors of outperformance.

Corporate Governance in an era of Clawbacks, ESG, Mega-Managers, and Zombie Investors

Two expert panels came together at the Conference Center at UBS Tower on November 29th to provide insights to various aspects of board related corporate governance. The first panel, moderated by Eileen Kamerick, focused on Management and Directors. Kamerick is a current and previous board member of several financial and industrial companies and is an adjunct professor. The panel included Thames Fulton, managing director at RSR Partners (executive recruiting); Frank Jaehnert, member of the board of directors of Briggs & Stratton, Itron, Inc., and Nordson Corporation; and Todd Henderson, professor of law at the University of Chicago Law School.

Kamerick started with a question about board diversity – should investors care about diversity? Henderson believes board diversity is a top issue and gave the following example of why boards lack diversity. When adding board members it is typical to get one or two women and / or a minority on a board, and then the board stops diversifying. Boards go through a ‘we are diversified enough’ type of thinking. Boards also suffer from a bias by what traits they look for in a new board member, which is usually for a former CEO or an operating exec type skill set. The pool of women or minorities coming from this group is already small, so the odds of getting a diverse board pick is reduced. The lack of diversity in the C-suite carries forward to the board. To combat the small pool of current/former women CEO’s corporate boards should look for a skill set other than a CEO, looking at other non-corporate entities such as universities, foundation/endowments or the private equity world. While the panel was in favor of board diversification, they were against legislation for mandatory board seats for women – legislation of behavior is not usually effective.

The panel then considered the topic of executive compensation, which is under the prevue of a corporate board. How should the board determine reasonable compensation? Jaehnert advised that the alignment of executive compensation with that of the shareholders is crucial, and that compensation should not be mandated but it should be provided in a defined and appropriate manner. Henderson considered that boards and investors spend too much time on CEO pay, because CEO’s are underpaid relative to revenues.

Kamerick asked the panelists to elaborate on how to set executive compensation. The panel advised that even if peer compensation or quasi government mandated compensation is used as a guide, the compensation committee is still responsible for setting executive compensation. However, most of these committees lack the training or background that is typically required. To obtain the appropriate skill set a board should have a current or former head of HR as a board member. In practice a board is more likely to rely on the job training, gathering executive compensation skills in a disjointed manner. One area that should be considered to obtain expertise on management compensation is the private equity world, which is better suited to choose compensation packages.

Kamerick brought up claw back policies – should they be used, are they effective. The panel as a whole was in favor of claw backs for a variety of instances including fraud, and for reputational damage as a result of executive actions. The panel advised a downside of claw backs; provisions of this sort would increase CEO pay. If a CEO understands that he/she will continue to be responsible for claims against them, the CEO will mitigate that by asking for more compensation. To combat this behavior the panel suggested using disgorgement of earnings, which would work better than claw backs.

The last topic the panel discussed was that of board services. An example why board services make sense was provided; when a corporation needs financial or legal help, the corporation hires a CPA or law firm to get the needed expertise. However, when a corporation needs governance (via a board) they hire individuals who do not have the collective depth of governance knowledge required. Hiring for board services should be allowed, but is illegal in Delaware (which exclude corporations) as well as in the Investment Company Act of 1940 (which exclude investment companies). An area in which there examples of professional boards could be found in the LLC space.

The panel provided some final thoughts based on audience questions;

  • If you have been on a board for a lengthy period of time, you are probably no longer independent.
  • Search firms are not favored by boards when looking for new board members. The board will seek out people they know or have had a history with.

 

The second panel focused on topics related to investors and asset managers. The moderator was Bob Browne, CFA, executive vice president and CIO at Northern Trust. The members of this panel included Gillian Glasspoole, CFA, senior associate of Thematic Investing for the Canada Pension Plan Investment Board; James Hamilton, CFA, director at BlackRock; and Kevin Ranney, director of product strategy and development at Sustainalytics.

Browne started with a question about analysis of a corporate board governance – is good or bad governance worthy of investor analysis? Hamilton advised that as an investor engagement of a board is process oriented, meeting with the board as well as senior management. It is through these meetings where one can get a sense of if the board is adding value. Depending on the size of the corporation, some education of the board regarding governance can occur. Larger cap companies have ESG processes in place, whereas the middle and small cap corporations are more open to having institutional investors provide guidance on ESG good practices.

Browne then asked the panel to consider difference between corporate governance in Europe versus the United States. Europe is more tuned in to ESG and looks to meet or exceed international standards. In Europe board diversity and executive compensation are linked to ESG targets. From the asset owner perspective Europeans are more inclined to think about ESG and have specific goals to address them. However, Europeans do not try to link alpha to ESG as much as it is done in the United States and Europe considers ESG value unto itself, without the need to have a positive correlation to alpha.

Another cultural board difference between Europe and the United States is the holding of CEO and chairman role by the same person (common in the United States, frowned upon in Europe). Hamilton considered that holding the CEO and chairman position is an acceptable practice, but other strong independent voices are needed in the boardroom to offset that dynamic.

The panel closed the program with a discussion regarding board transparency. How does an investor know if a board is doing the job they were hired for, and they are acting in the best interest of stakeholders? The panel noted in practice it is hard to determine if a board is engaged, but there are ways to get an overall idea. Do all the board members go to all committee meetings, do they have onsite visits to offices other than the headquarters? Learn to ask the correct questions and then you will uncover issues that will impact the value of the company.

Oak Brook Progressive Networking Dinner

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On May 23rd, CFA Society Chicago held a progressive networking dinner at Maggiano’s Little Italy in Oak Brook.

A progressive networking dinner allows participants to meet people in a casual environment over good food and drinks. Dinner is split into three rounds; salad/appetizer, main course, and desert. Each participant is assigned a specific table for each round / course. Then over that course, each person has the opportunity to provide an introduction and background to their table mates. After each course the participants reassemble at different tables and sit with a new group. The setup allowed me to meet 15 people during the event.

Conversation at the various tables went quickly from introductions to a wide variety of topics. I shared my first course with a quant from a prop trading firm, a member of an independent financial advisory firm, and a credit underwriter. Conversation ranged from the potential effects of the Department of Labor’s Fiduciary Rule, while another table mate explained how and where to attract funds for a hedge fund that he was starting.

My second and third courses allowed me to meet a new set of individuals including an ETF portfolio manager, wealth manager, institutional asset allocation manager, and financial consultant. These conversations also went in a variety of directions; the nature and constraints that must be followed to build and run a completion fund, the rationale behind currency hedging global trading in the current market, and the Bears trade for the second pick in the recent draft. Consensus on the trade was that it was rich.

My straw poll as to the effectiveness of the event was overwhelmingly positive. The participants I spoke with appreciated the setting, which allowed for more in depth conversation, as well as discussions that involved all of their tablemates.

This event was one of several CFA Society Chicago events that are held in the suburbs each year. The central Oak Brook location allowed 25 people to attend from a variety of suburban locations.

Distinguished Speaker Series: Will McLean, CFA, Northwestern University

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The Endowment Model in a Low Return World

On January 24th the Distinguished Speaker Series held its first luncheon of the year welcoming one of our own, Will McLean, CFA. Mr. McLean is Vice President and Chief Investment Officer at Northwestern University, and is responsible for managing the University’s $9.7 billion endowment portfolio. Mr. McLean gave an engaging presentation to a sold out crowd over lunch at the W City Center.

Mr. McLean’s presentation centered on the challenges endowments face given the low expected return environment. McLean explained that Northwestern University follows the Yale Model of endowment investing. The Yale Model is an investment philosophy developed by David Swensen, the Yale University Chief Investment Officer. This model deviates from the traditional asset classes (stocks, bonds, and cash) and uses modern portfolio theory to invest in alternative and non-liquid assets in the form of private equity and hedge funds.

Mr. McLean laid out five principles used to manage the University’s portfolio:

  1. Diversification – this concept is straightforward. As a portfolio becomes more diversified there is typically less correlation, and the risk of the portfolio is reduced. McLean advised issues could arise if a portfolio becomes overly diversified. Excessive diversification spreads capital thinly and causes an excellent investment to impart a marginal influence on the total value of the portfolio. Over diversification could also cause investment standards to be lowered – when anything can be added to the portfolio, standards are more likely to loosened.
  2. Equity oriented portfolios need to provide a higher than average return. Given the makeup of the portfolio and the annual needs of the University, the expected return of the portfolio is in the 7-8% range.
  3. Take advantage of the illiquidity premium. The time horizon of the University’s portfolio is near perpetuity. Therefore, it is reasonable to invest in illiquid / inefficient markets.
  4. Use active managers – invest in stock pickers in the right markets. Northwestern’s investment management team and board of trustees believe active management adds value, and more uncertainty should be good for active management. Different asset classes offer different dispersions. It makes little sense to invest in the large cap equity space when the difference between the top and bottom quartile manager is not significant. Seek out alternative asset classes with bigger dispersions of returns.
  5. Ensure that your manager’s interests aligned with your own. When engaging in manager selection find out who owns the investment management firm that is under consideration. What is the owner’s motivation? McLean advised that it had been his experience that when a manager takes their firm public with an IPO, the manager’s performance underperforms. Their motivation changes from client enrichment to self-enrichment.

Due diligence should also take into account other aspects besides the manager’s performance record. Consider the internal split of management fees; do they flow to a select few individuals? How much career advancement is available to junior employees at the investment firm?  Are employees likely to be nurtured and grow or leave the firm? Negative answers to any of these questions the long-term viability of the manager to produce alpha.

DSC_3299Once his prepared remarks were concluded, Mr. McLean took a number of questions from the audience.

How do you manage board expectations of returns?

Many board members are former money managers, thus they are well versed in the risk vs. return dynamic, and they have rational market expectations.

How do you manage spending over bad returns?

There is a spending policy, which is a board level decision. The portion of the University budget funded by the endowment does not vary much from year to year.

Does Northwestern University take a view on asset allocation?

The University does not believe in market timing or tactical investing.

What is the thought process of the allocating AUM to the hedge fund asset class?

The University’s current allocation is for a 20% weighting to hedge funds. In general, 1/3 goes to long/short, and 2/3 goes to uncorrelated macro and market neutral strategies. Overall Northwestern University views hedge funds as an uncorrelated piece of the portfolio.

How does one incorporate human phycology / behavior into choosing an investment manager?

The University has a standardized approach for manager selection. Behavioral patterns at the manager firm are collected and evaluated. The manager selection team has been trained (by outside sources) to ask the right questions during the interview process, and to evaluate the manager’s non-verbal answers. Current and former employees are also interviewed for their points of view. Overall, you must train yourself to consider the all aspects of the manager’s answers and behavior.

Distinguished Speaker Series: Dr. David Kelly, CFA, J.P. Morgan Global Investment Management

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Dr. David, Kelly, CFA

Dr. David Kelly, CFA, the Chief Global strategist for J.P. Morgan Global Investment Management, provided his thoughts and views on investing in the current low/no rate environment.

Starting with a review of the U.S. economy Kelly noted that real GDP has grown just over 2% on average over the past five years. Under normal circumstances this level of growth is considered anemic, but the current slow and steady expansion is acceptable from Kelly’s point of view. Consumers are benefiting from low mortgages and gas prices, overall demand is growing, and banks are issuing more credit. Kelly considers this economy analogous to a healthy tortoise – it does not move swiftly, but it is steady. It is unrealistic for the U.S. economy to grow at historical levels (+3%) given the low unemployment rate, which from Kelly’s point of view is the biggest impediment to continued growth of the economy. Kelly believes that the sliding unemployment and labor participation rates are due to the aging population. Baby boomers comprise a large segment of the working population, the oldest of which became eligible for retirement in 2011. Boomers will of course will continue to retire, constraining the labor market, and helping the unemployment and participation rates to fall further. To combat the coming labor shortage Kelly suggested comprehensive immigration reform, bringing more people (workers) in to the U.S.  If immigration reform is not successful the unemployment rate could fall into the 3% range, constricting the economy to a growth rate under 2%.

Kelly believes that the Federal Reserve needs to raise rates in September. If this window were missed then the Fed would likely have to wait until December to not affect the November election. Further delays in raising the Fed Funds rate will make raising rates harder to do in the future – the Fed will be provided with more reasons for not raising rates, which will further undermine its credibility.

dsc_3084As of April 2016, 35% of all developed world government bonds had a yield below zero. Low global rates have helped lower U.S. interest rates. Global bond buyers looking for better yields have moved to U.S. denominated securities driving down domestic yields. However, Kelly suggested that rising rates in the U.S. could act a balloon to world bond rates. Given the current and projected fixed income market, Kelly suggested underweighting domestic and global fixed income until real rates reach a normalized range.

Turning to the equity markets Kelly believes the current equity market is still relatively cheap. Do to the expected rising rate environment the financial sector should be overweighed while the utility sector is expected to underperform. However, there is more upside outside of the U.S. equity market in Europe and the emerging market space.  These areas should outperform in the medium term based on stronger relative earnings. The current forward P/E of the S&P 500 is around 17x earnings, over the long-term average of 16x, while the MSCI EAFE forward P/E is at its long-term average.

Kelly took questions at the end of the presentation from several members from the audience. One individual asked “How best should a government sustain a countries economic growth?” Kelly’s answer was a bit surprising in that he focused on income inequality – the more there is, the less sustainable economic growth becomes. Kelly noted that most problems that create income inequality start with single parent families (SPF). In the 1980’s, 18% of households were SPF. As of this past year the SPF households number 42%, which from any number of perspectives is an alarming statistic.

CFA Society Chicago Euchre Tournament

20160303_180851_resizedOn March 3, more than 40 investment professionals joined CFA Society Chicago at Exchequer Restaurant and Pub for its first card tournament.

The evening brought out a diverse group including:

  • Over confident card players (after all, over confidence is a trademark of our profession isn’t it?).
  • Novices wanting to learn a new game while networking with peers.
  • Deal stealers? Yes, that’s part of the game.
  • Deck stackers? Probably were, but none were caught.

DSC_2623Throw in an open bar along with pizza and chicken wings (included in the price of admission) and what do you get? The CFA Chicago’s first Euchre tournament.

What exactly is Euchre? Euchre is a trick-taking card game most commonly played with four people in two partnerships with a deck of 24 standard playing cards. Euchre appears to have been introduced into the United States by the early German settlers in the Midwest. DSC_2621It has been more recently theorized that the game and its name derives from an eighteenth-century Alsatian card game named Juckerspiel. (From Wikipedia).

Euchre retains a strong following in some parts of the Midwest; especially in  Indiana, Iowa, Illinois, Ohio, Michigan, and Wisconsin. A survey of several players confirmed where they learned the game – typically from parents or relatives, or in college.

There were 19 teams that took part in a single elimination style tournament. The winners of the tournament were Hans Stege and Ankit Bhutada!DSC_2630

Looking to play? You can find bar sponsored leagues especially in the northern suburbs. Several players mentioned that they would partake in a periodic (semi-annual) Euchre tournament, so stay tuned for future tournaments.

Distinguished Speakers Series: Jason DeSena Trennert

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Jason Trennert – Strategas Research Partners LLC

Jason DeSena Trennert provided his thoughts, observations, and market predictions for 2016 to a sold out audience at the Standard Club on January 13th.

Trennert first addressed the drop in the market that coincided with the start of the year. He noted that historically the first weeks of January are generally a poor predictor of total year performance. He then addressed recent market commentary suggesting the United States is headed for a recession. There are three things that can create or cause a recession:

  • Inflation
  • Policy errors (think of the Japanese government raising taxes in 1988)
  • Exogenous events (oil embargo)

While not agreeing with current fiscal/monetary policy, Trennert did not consider the current policies so bad that they would push the country into recession, and with a current inflation rate around 5%, he found no reasonable catalyst for a 2016 recession. Trennert asked rhetorically why do people feel lousy and think the outlook in the near term is for a recession when we have; a continuing fall in unemployment, wage growth acceleration, and lower oil prices? The short answer is the 24 hour news cycle that focuses on the negative and unlikely (such as 2016 recession) instead of the longer-term view of expected growth.

Expanding his point of view on monetary and fiscal policy, Trennert pointed out an inefficient policy mix. Over the past eight years the Fed has used an easy monetary policy, while fiscal policy has been that of tight regulation brought on in large part by Dodd/Frank legislation. This combination has favored financial risk taking over economic risk taking or capital investment. In this period companies have received more credit for uses of cash that were more accretive (share repurchases and M&A) than they have for long-term investments like capex. Frequently changing government policies make long-term planning difficult.

Trennert 1Trennert also provided his thoughts on why the stock market will likely go up in the next few years. The number of companies listed on U.S exchanges has fallen from over 8,800 in 1997 to 5,300 in 2015. Simple supply and demand could provide the continuation of the rally of high-quality stocks. Today there are simply fewer stocks being chased by more dollars. Why aren’t more companies going public? Regulatory costs of being a public company along with the growth of the private equity industry could account for the relatively small number of companies deciding to go public.

The audience was given the opportunity to ask several, wide-ranging questions including; what is the best catalyst for continued growth? Trennert – Tax reform (an overall reduction in the tax code) would provide the biggest, most effective impact to growth in the economy. Tax code simplification would provide companies certainty with regard to long term investments which would help spur economic growth.

Distinguished Speaker Series: Dmitry Balyasny

Dmitry Balyasny, Managing Partner and Chief Investment Officer, provided an outline of his firm, Balyasny Asset Management (BAM), as well as thoughts on how a well-functioning hedge fund should be structured at a luncheon presentation hosted by CFA Society Chicago on September 10th, 2015.

Balyasny provided a summary of how he got his start in the business; beginning with trading short-term equity and futures, and later in a fund of funds analyst role. After a number of years of trading and fundamental analysis under his belt, Balyasny set up BAM in 2001. He happily advised BAM Atlas Global fund has never had a negative return since its inception (2002) and also noted that Atlas Global has a correlation with the S&P 500 since inception of .04.

Balyasny provided several tips on what it takes to build a good hedge fund complex, from returns to the overall culture, and include the following:

  1. Ensure that you have a low correlation index – Balyasny Dmitry headshot with tie 1consistently looks for uncorrelated managers; people that are doing different things (that add Sharpe).
  1. Promote a collaborative, partnership culture, and attract and retain talent through a culture of excellence.

According to Balyasny a good hedge fund is small to medium in size and has robust risk management separate from portfolio management, emphasizing sector specialization, and dynamic capital allocation.

How does BAM produce for their clients? Their source of alpha is primarily drawn from ideas – bottom up bets (big bets do not work). BAM generates alpha primarily from ideas, 87%, while sizing of the bet only accounts for 13% of alpha. Thus it is critical to have numerous good ideas.

Balyasny also noted that since the market is mostly efficient, alpha is typically acquired over a short period of time. Approximately 70% of BAM’s alpha is generated within four months of purchase; 44% in less than one month, and 26% in one to three months. Thus BAM turns over their portfolios frequently in an effort to generate alpha. The BAM model focuses on the short-term as they believe it is difficult to look out years into the future and have expectations hold.

Balyasny finished the discussion by answering several questions including an interesting question regarding fee compression in the hedge fund market. Balyasny thought it strange that nearly all hedge fund products are priced the same, the 2 and 20 model. “Either they are too expensive, they are not providing alpha, or they are too cheap.” Balyasny noted that BAM’s pricing structure pushes past the 2 and 20 to a higher level because of their delivery of alpha and in an effort to remain small.