ESG: A Material Information Advantage

Does your ESG integration program have an edge? If not, read on. Everyone knows that it’s difficult to produce alpha—an abnormal excess return over the market—due to skill rather than luck. And yet, by looking deeply, and at the right factors, one can find investment opportunities (and market inefficiencies) that are overlooked by others.

Howard Marks, Co-Chairman of Oaktree Capital Management, refers to this process as “second-level thinking” in his incredible book The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor (46). Marks goes on to explain:

 Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both” (78).

Sustainable investing is all about second-level thinking. First, we need to gain an informational advantage by identifying material environmental, social and governance (ESG) factors. Then, we need to understand how that information drives intrinsic value, and cash flow, to design investment strategies that appropriately meet the client’s risk and return objectives over an appropriate time horizon.

 

Corporate Sustainability: First Evidence on Materiality

The good news is that Harvard researchers have found new evidence linking performance on sustainability issues to financial performance. Importantly, the research differentiates between material and immaterial sustainability factors—addressing a significant gap in prior research.

Authors Mozaffar Khan, George Serafeim and Aaron Yoon from Harvard Business School present their findings in Corporate Sustainability: First Evidence on Materiality (Working Paper 15-0703). A major finding is that firms with high performance on material sustainability issues and concurrently low immateriality  scores have the best future stock performance—generating an annualized alpha of 6.01%.

Using calendar-time portfolio stock return regressions we find that firms with good performance on material sustainability issues significantly outperform firms with poor performance on these issues, suggesting that investments in sustainability issues are shareholder-value enhancing” (1).

In addition, firms with good performance on material sustainability factors also  outperformed those with good performance on immaterial sustainability factors by an annualized alpha of 1.96%. So, again good performance on the right (material) ESG factors adds value. The results are summarized below.

Source: Sustainability Accounting Standards Board (SASB) Industry-based Standards to Guide Disclosure and Action on Material Sustainability Information Slide 22 (2015).

Even good performance on immaterial sustainability factors added .6% annualized alpha. At a minimum, this means that sustainability investments are not shareholder value-destroying (3). However, firms with poor performance on sustainability factors (both material and immaterial) underperformed by an annualized alpha of -2.90%.

What’s the big idea? Access to material sustainability information can give your ESG integration program an edge.

 

Material ESG Information Access

In the Harvard study cited above, the data collection process was driven based on materiality guidance on sustainability issues from SASB. The SASB website provides a sector-level materiality map that identifies sustainability issues by level of materiality at http://materiality.sasb.org. In short, this map is a great starting point for identifying which issues are likely to be material for more than 50% of the industries in the sector. Then, the Harvard researchers used MSCI KLD as the source of their sustainability data—which is the most widely used dataset by past studies (7).

SASB sustainability issues are organized under the following five categories: Environmental, Social Capital, Human Capital, Business Model and Innovation and Leadership and Governance. For example, the environmental category contains issues like greenhouse gas (GHG) emissions, air quality, energy management, fuel management, water and wastewater management, waste and hazardous materials management and biodiversity impact.

After identifying the material issues, the SASB Standards Navigatorhttps://navigator.sasb.org/ can be used to research specific “evidence-based metrics” that are known to impact business value in the areas of revenues, costs, assets, liabilities and cost of capital. Bottom line, it’s all about analyzing the right non-financial ESG metrics that can have a material impact on financial performance.

For illustrative purposes, a few SASB environmental accounting metrics applicable to the Oil and Gas Exploration and Production industry are shown below. As you can see, each metric in the SASB Standards has a unique reference number, description and a clearly defined unit of measurement.

Sector: Non-renewable Resources, Industry: Oil & Gas Exploration and Production

  • Greenhouse Gas Emissions – Accounting Metric NR0101-01 – Gross global Scope 1 emissions, percentage covered under a regulatory program, percentage by hydrocarbon resource. Unit = Metric tons (t) CO2-e, Percentage (%). The registrant shall disclose gross global Scope 1 greenhouse gas (GHG) emissions to the atmosphere of the six greenhouse gases covered under the Kyoto Protocol: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride
  • Air Quality – Accounting Metric NR0101-04 – Air emissions for the following pollutants: NOx (excluding N2O ), SOx, volatile organic compounds (VOCs), and particulate matter (PM) Unit = Metric Tons (t)
  • Water Management – Accounting Metric NR0101-06 – Volume of produced water and blowback generated; percentage (1) discharged, (2) injected, (3) recycled; hydrocarbon content in discharged water. Unit = Cubic meters (m3), Percentage (%), Metric tons (t)
  • Reserves Valuation & Capital Expenditures – Accounting Metric NR0101-22 – Sensitivity of hydrocarbon reserve levels to future price projection scenarios that account for a price on carbon emissions. Unit = Million barrels (MMbbls), Million standard cubic feet (MMscf).

Importantly, SASB standards are drawing wide interest across the globe and have been downloaded over 27,392 times by more than 4,640 users in over 65 countries in top capital markets including the U.S. ($25.9B), E.U. ($10.4B), Japan ($4.6B), China (3.9B) and Hong Kong ($3.1 B) (Slide 24).

SASB standards can be downloaded, at no charge, for a variety of sectors and industries at: http://www.sasb.org/standards/download/. Additionally, MSCI ESG Research sells a comprehensive suite of ESG data, ratings and research products.  See https://www.msci.com/resources/factsheets/MSCI_ESG_Research.pdf

 

A Vision of the Future

As noted at the outset, after gaining an informational advantage one must then be able to efficiently analyze the data in order to design investment strategies that appropriately meet the client’s risk and return objectives. Given the wealth of new ESG information that will be coming down the pike through the SASB Standards, there will be exciting opportunities to develop new investment strategies and analysis.

For example, financial analysts will enjoy creating new multi-factor regression models that incorporate material ESG factors in an attempt to forecast sources of performance and risk. And there will be even more ways to conduct peer comparisons with a complete data set—using consistent ESG units—while benchmarking against the industry average.

SASB provides a vision of this future in the illustration below. It shows a hypothetical peer comparison using sustainability fundamentals in the pharmaceutical industry.

Source: SASB: Industry-based Standards to Guide Disclosure and Action on Material Sustainability Information Slide 19 (2015).

It’s my hope that more access to high-quality, material ESG information will improve the investment decision making-process, increase business competition and lead us to a more sustainable future.

Leadership: Managing Talent and Comp in the New Era

Exhibiting investment leadership, establishing a winning culture, building high performing investment teams – are all intertwined.

On Wed., May 27th at the Hotel Allegro, Jim Ware, CFA presented from the new white paper from Focus Group Consulting “”Investment Challenges: Remaining Relevant through Compelling Value”. The 35 people in attendance were given terrific insights into what it will take for investment management firms to be successful in the post-financial crisis era.

Unlike many talks and studies of the success criteria in the investment industry, Jim’s material did not dwell on a benchmark beating strategy or how to become better at marketing. Rather, through the right kind of investment leadership, winning firms will be successful at hiring the right people and developing a strong culture. Improved talent retention and decision making will directly lead to the success of the firm.

Strengths, weaknesses, and inattention to blind spots were discussed. Leadership in the investment industry has tended to fall onto driven, smart individuals with exceptional technical skills. However, developing talent, collaboration and self-awareness tend to be not so strong in traditional investment leaders, yet these areas are most important for creating success in the new environment.

Through audience polling attendees were able to directly provide feedback based on observations within their own firms, and the results were compared to averages compiled by Focus Consulting Group in similar talks both within and outside the U.S.

Regarding leadership, Mr. Ware made an observation that only perhaps 50% of an investment management firms success relates to performance. The other 50% is based on relationship, thus the intangibles that were at the heart of the discussion. He cited a firm that had 7 consecutive years of relative outperformance yet had not grown assets under management due to neglect for the culture and leadership concerns.

A few best practices that were highlighted include that good leaders will get curious about a weakness, not defensive. This requires creating a good feedback channel. Modeling good behaviors, and considering culture and values in employment decisions were also of importance.

In conclusion Jim left everyone with a Checklist for the New Era which is a scorecard of 10 important factors that should be assessed by all senior members of a management team and evaluated on a strongly agree – strongly disagree scale. For more information on this please contact the CFA Society Chicago office.

 

CFA Chicago: Investing in Latin America

CFA Chicago: Investing in Latin America

¡Que fantástico! ¡Que increíble!  The CFA Society of Chicago recently celebrated its 90th anniversary by welcoming investment professionals from across Latin America to the Midwest for its 2015 Annual Conference: Emerging Opportunities in Latin America!

Christopher Vincent, CFA, Chairman CFA Chicago and Partner at William Blair, cast the vision for the conference that enabled participants to gain deep market insights on Latin America and foster new relationships across Latin American CFA Societies. On the Society’s 90th anniversary, Chris pointed out that CFA Chicago is the oldest investment analysts society in the world. It was founded in 1925—with a membership of 4—and today is the 6th largest society in the world with more than 4,300 members.

Chris gave a special thanks to Marie Winters, CFA, SVP Northern Trust, Larry Cook, CFA, Executive Director UBS Global Asset Management and Garrett Glawe, CFA, Vice President MSCI, who did a fantastic job as co-chairs for the 2015 Annual Meeting. Garrett Glawe served as an outstanding Master of Ceremonies (and is now available to MC other events…The Academy Awards, Music Awards, Emmys, etc.). Chris gave special thanks to Northern Trust, Aberdeen Asset Management, BNY Mellon and FitchRatings for their support and generous corporate sponsorships which made the event possible.

On a brief housekeeping note, the information flow at the conference was designed like a funnel. We started at the macro / geo-political level and gradually worked our way down through broad Latin American business issues and investment industry trends to more specific regional and industry investment risks and opportunities. Please keep this in mind as you look for information relevant to your needs in the report below.

It should also be noted that the panelists did not provide specific recommendations to buy or sell particular securities or provide investment advice.

The Politics of Economic Reform

Christopher Garman, Head of Country Analysis at eurasia group, opened the conference with a broad overview of how the  Latin American political environment may impact your investment portfolio. Although each country has different political issues, Garman emphasized, “For the first time in a long time, emerging markets are at a political turning point which investors need to appreciate.” In short, today there really is a unifying theme in emerging markets that are at a political inflection point.

For the first time in a long time, emerging markets are at a political turning point which investors need to appreciate.” Chris Garmen, eurasia group

Specifically, Garmen observes that Latin America is at the end of a “political super-cycle.” Back in 2002, commodity prices were low and political incumbents only held office for 3 years on average. Then, commodity prices increased, there was a period of rapid economic growth and incumbents remained in office for 7.2 years on average. In short, it was a very good time to be a politician but not many economic reforms took place.

Source: eurasia group, May 2015 Latin America Outlook (Slide 2)

Today, Garman indicates that Latin America is facing slower economic growth and a “messy” end to its super-cycle. Incumbents barely win re-election and weak second-termers hold office while facing high fiscal demands from a rapidly growing middle class. Garman explains that the problem is particularly acute in Latin America where economies are highly dependent on commodity exports and the growing middle class makes up a larger share of the population than in other emerging markets.

Source: eurasia group, May 2015 Latin America Outlook (Slide 3)

As shown above, there has been extraordinary growth in the emerging middle class across Latin America which now represents 30% to 80% of the population in some countries. These new middle class families demand more security, education, health care and other public services from overwhelmed governments that are rapidly losing public support as shown below.

Source: eurasia group, May 2015 Latin America Outlook (Slide 3)

Garmen then presented a detailed analysis and outlook for a number of Latin American countries. The highlights are summarized below.

Brazil: Short-term Trajectory: Neutral, Long-term Trajectory: Neutral

Garman is cautiously optimistic on Brazil. In the wake of the state-controlled oil company scandal at Petrobras, Garman feels President Dilma Rousseff’s administration is seeing a meaningful course correction. He feels Brazil is moving towards a more market-friendly equilibrium and a constructive response to the political pressure. The government can increase taxes without congressional approval and has already done so to avoid losing investment grade status on its debt. In the oil and gas E&P sector, Garman expects an open pre-salt costal shelf framework will allow others to get involved in production. In addition, watch for aggressive selling of assets to improve Brazil’s financial position and new rules to attract investors to infrastructure projects like airports, highways and railroad projects.

Garmen estimates a 60% probability that Brazil “muddles through” and a very large fat tail risk of 40% that the course correction could be undermined if the corruption probe (Operation Carwash) spreads to other sectors of the economy with knock-on effects. There is significant risk the investigation grows because the federal prosecutors office, federal police and judiciary all have a high degree of independence (normally a very good thing) in Brazil. The bad news is that if it grows to the scale of the Italy’s Mani Pulte (“clean hands”) operation—which reached 5,000 executives and politicians—then Garman points out we could see a 3% to 4% contraction in GDP.

Mexico: Short-term Trajectory: Positive, Long-term Trajectory: Positive

Garmen notes that Mexico is the inverse of Brazil. Although President Pena Nieto has lost popularity amidst scandals it shouldn’t influence his ability to execute reforms. Importantly, President Nieto made significant constitutional reforms in energy, education and other areas all within his first year in office and the June 2015 mid-term elections shouldn’t change this dynamic. Garman expects that quick implementation of energy and telecom reforms are still likely. Longer-term, the big risk is that slower growth and discontent produce a leftist candidate in 2018.

Colombia: Short-term Trajectory: Neutral, Long-term Trajectory: Neutral

Colombia is facing strong external headwinds due to lower oil prices. Garman believes that President Santos’ second-term success will be tied to his ability to deal with the Revolutionary Armed Forces of Colombia (FARC) but expects that a deal remains likely within a year and will be a boon for the oil sector. Lower oil production will add pressure to the fiscal accounts increasing risks for higher taxes and short-term pain but Garman has a constructive muddle-through view.

Argentina: Short-term Trajectory: Negative, Long-term Trajectory: Positive

Garmen expects the October elections to be very competitive between Daniel Scioli (FPV), Sergio Massa (FR) and Mauricio Macri (PRO) but notes that there are no major differences between the candidates. In short, he feels that there will be constructive policy adjustments after the election regardless of whoever wins. However, successful implementation of the adjustments will be very challenging for any administration due to significant macroeconomic events. Watch for a lifting of foreign exchange (FX) controls, increased debt issuance and a possible settlement with holdouts.

Venezuela: Short-term Trajectory: Negative, Long-term Trajectory: Negative

In Venezuela, Garman estimates the probability of a credit event in 2016 at 60%. He reports that it’s likely the government will make the necessary adjustments to service its debt in 2015 but will enter 2016 with very little in the bank. The government is willing to dramatically cut imports and liquidate assets. Garman feels President Maduro will maintain power through the election. However, if Maduro is unable to finish his term, with 70% disapproval ratings, then Garman suggests a social/political crisis could develop where the military steps in to put a damper on it. Complicating matters further, there are no strong alternative candidates within the chavismo.

Chile: Short-term Trajectory: Negative, Long-term Trajectory: Negative

In Chile, Garman reports that the risk to investors will be high as costly reforms advance and economic growth remains subdued. Tax and electoral reforms have been approved and education and labor reforms are advancing. Chile had enjoyed more than two decades of successful economic policies and political stability but today there are high demands for additional spending and regulation.

Peru: Short-term Trajectory: Neutral, Long-term Trajectory: Neutral

In Peru, Garman feels that the political risk is high but it remains one of Latin America’s best performing economies. He believes that its economic and investment polices are unlikely to change before the end of President Humala’s term in 2016. However, it’s likely that a populist candidate could emerge and reverse policy in 2016.

Click here for a link to Chris Garman’s full presentation.

Navigating Business Challenges in Latin America

The first panel discussion of the day was moderated by Ignacio Campos, Director of Strategy & Business Development, Fortune Brands Home and Security, and revealed key insights on navigating business challenges in Latin America. This panel of corporate executives provided interesting perspectives across the pharmaceuticals, lighting and food service industries.

Anil G. D’Souza, Corporate Vice President – Japan and Emerging Markets, Hospira, Inc., sees the best opportunities for Hospira’s infusion and pharamcutical services in Brazil and Mexico due to the size of the markets and low per capita spending on healthcare. D’Souza explains, “Healthcare is not a want but a need—and that’s a huge advantage.” He believes it’s essential to develop your strategy and then stick with—only changing tactics—until a fundamental change occurs.

Hospira’s strategy works with governments and industry associations to stay ahead of the game and influence results. D’Souze capitalizes on acquisitions and joint ventures as a means to gain access to public tender participation bids. His biggest challenges involve import restrictions. In Brazil, public-private partnerships are utilized to transfer technology over a five to ten year period which D’Souze reports works well if the technology will be obsolete after 5 years.

Dave Riesmeyer, Executive Vice President of Panasonic Lighting Americas, Inc.believes it takes two things to win in Latin America. First, a well-postioned entry strategy with a strong brand and technology that’s recognized. Second, a strong local partner. He observes that the customer is no less demanding in Latin America and you need the proper logistics, import and legal support to get the product delivered on time. Like D’Souza, Riesmeyer looks for joint venture opportunities to reduce investment costs and provide an off ramp if things go wrong.

Reismeyer stresses that security issues are the biggest risk of doing business in Latin America. He believes security is worse in Mexico today than it was ten years ago—especially near the US border. Reismeyer said, “It’s statistically more dangerous to travel in Latin America than it is in Africa.” In addition, he points out that all of the Latin American countries have old infrastructure (roads, bridges, etc.) which significantly impact traffic and logistics.

It’s statistically more dangerous to travel in Latin America than it is in Africa.” Dave Riesmeyer, Panasonic Lighting Americas, Inc.

John Naoum, Sr. Marketing Manager, Global Business Development, Brinker International (owner of Chili’s Bar & Grille and Maggiano’s Little Italy) covered the food service industry. About 30% of Brinker’s fleet of restaurants are in Mexico and the  Andean States where there is a mature market and steady growth. He sees huge potential for growth in Peru and Colombia where Brinker still needs to build infrastructure.

In regards to strategy, Naoum agrees that finding a strong local partner is the most important factor for success. If the market accepts American brands and views the United States in an aspirational manner then it’s a positive sign. However, significant tax and import challenges exist. Naoum explained that it can take six months to launch a new menu item in Latin America as compared to only 3 to 4 weeks in Asia and the Middle East. Furthermore, some import taxes are as high as 45% and make some products, such as ribs in Ecuador, cost prohibitive. Overall, it’s easy to trade and import goods in Mexico, due to NAFTA, but taxes can be high.

Luncheon Keynote Speaker: Ambassador Luis Miguel Castilla

Luis Miguel Castilla, Ambassador of Peru in the US, presented the luncheon keynote address. Ambassador Castilla believes  we are at the end of a structural super cycle in commodities across Latin America. Approximately 81% of Peru’s exports are currently in commodities like copper (which has declined in price for the past 15 quarters), oil and gold. So Peru wants to diversify its export basket and transition to a knowledge-based economy. To that end, Ambassador Castilla stressed the importance of the US-Peru Free Trade Agreement (FTA), the Trans Pacific Partnership (TPP) and Pacific Alliance to Peru’s future.

Ambassador Castilla explained that its FTA with the US is comprehensive and goes well beyond basic goods to include labor, services, investment, intellectual property, government procurement, legal and institutional issues, human rights and democratic principals. In addition, the TPP represents a potential market of over 800 million people and 40% of the world’s GDP. Since interregional trade in Latin America is still less than 10%, due to physical and sanitary barriers, it’s critical for Peru to get to the other side of the Pacific. Peru currently operates the busiest shipping port in South America and ultimately wants to become a hub in the global supply chains through the TPP.

In addition, Peru formed an alliance with Mexico, Chile and Colombia to pursue deep financial integration (e.g. by viewing investments in pension funds in Colombia as domestic investments), liberalization of trade, infrastructure improvements and sharing public finance resources such as disaster risk management. This block of countries represents over 200 million people and a combined GDP of $2.1 trillion USD.

Source: Estimates WEO-FMI (2013), Peru – Development Challenges in a Global Setting, Luis Miguel Castilla (May 2015).

In closing, Ambassador Castilla was asked what advice he would give US Presidents and he replied, “A lack of active US presence in the region is being filled by other big countries.” He went on to point out that the US is the fifth largest investor in Peru after a number of European and Asian countries so he asked, “Why is the US so far down the list?”

A lack of active US presence in the region is being filled by other big countries.” Ambassador of Peru in the US, Luis Castilla

Click here for a link to Ambassador Castilla’s full presentation.

Asset Managers: Opportunities & Challenges in Latin America

Raman Aylur Subramanian, CFA, Managing Director & Head of Index Applied Research for the Americas, MSCI, moderated the next panel discussion on the asset management industry in Latin America. According to Boston Consulting Group, Latin America accounted for only 2.5 % of global assets under management (AuM) in 2013. And this represents a very low proportion relative to GDP. Therefore, Subramanian points out that the nascent industry has significant opportunities for growth. Further supporting this hypothesis, the PwC analysis shown below estimates that AuM in Latin America will grow at a 12.5% CAGR between 2012 and 2020.

Ned Burmeister, SVP & COO, Principal International (US $519 bn AuM, $97.2 bn AuM in Mexico, Brazil and Chile) started off with Principal’s Latin American business strategy. Specifically, Principal seeks to leverage its high-quality pension and mutual fund expertise, within developed pension markets of sufficient size, then springboard into the voluntary mutual fund space.

Burmeister sees great opportunity in the Latin American pension and retirement space because he feels the mandatory contribution programs, in and of themselves, will never provide the kind of replacement income that’s necessary for retirement. As shown on the left, pension assets as a percentage of GDP in Latin America significantly lag those in the US and Europe.

In Brazil, Burmeister says, “The first and only person investors call is the bank.” Banks have had an aggressive and closed architecture directing  clients to their own investments. Hence, Principal sources mostly through Banco do Brasil. Finally, Burmeister believes emerging markets are going to leapfrog from plain vanilla equity or fixed income funds to lifestyle and solutions funds.

Lucas Ramirez, CFA, Head of Research, Sura Asset Management (US $114 bn AuM) also observed that the mutual fund industry in Latin America is dominated by the banks. Ramirez says, “You don’t see Vanguard, Fidelity or Blackrock—but local banks that protect their distribution channels by closing them to others, like Sura.”  Yet, Ramirez points to the expected growth in Latin American AuM, in the BCG forecast provided above, and is optimistic that Sura has the right strategy.

Sura is the largest pension fund manager in Latin America with over 17 million clients and a 23.3% market share in AuM across six countries (Mexico, Colombia, El Salvador, Peru, Chile and Uruguay.) Ramirez explained that Sura’s strategy is to  build a regional sales force of financial advisors offering different solutions (real estate, infrastructure funds, etc.) to increasingly more sophisticated clients in Latin America. Sura then relies on third-party investment teams to pick the stocks.

Manuel E. Mejía-Aoun, Founder, Managing Partner, and Chief Investment Officer of Alpha4x Asset Management, says he launched a hedge fund rather than compete with Principal and Sura. Alpha4x manages two global macro hedge funds: Cayman and Brazil. Their strategy is to focus on interest rates, currencies, sovereign credit and equity indices rather than picking stocks. Overall, Alpha4x tries to create low to slightly negative correlations to major indices, produce consistent risk-adjusted returns and maintain disciplined risk management processes.

Mejia-Aoun explains that a global middle class is developing in Latin American that has more more in common with a lawyer in New York City. When asked about his views on Brazil, Mejia-Aoun joked, “The optimist says Brazil is the country of the future. The pessimist says it will always be.”

The optimist says Brazil is the country of the future. The pessimist says it will always be.” Manuel E. Mejia-Aoun

Click here for a link to Session 3: Asset Managers in Latin America

Investment Opportunities & Risks in Latin America

Dan Kastholm, CFA, Managing Director, Latin America Corporate Finance, FitchRatings, moderated the last panel discussion of the day and successfully brought us from 30,000 feet down to ground level. I had the pleasure of working with Dan to organize this last panel of experts and can tell you that we were fortunate to have Kastholm’s more than twenty years of experience in Latin American markets at our disposal. Kastholm noted that FitchRatings has more than 200 people in Chicago with 60 analysts covering Latin America and following 550 credits. FitchRatings also rates 97% of all cross-boarder issues placed globally. Dan led an interesting discussion with the panel across a variety of asset classes and sectors including equity, fixed income, real estate, energy and infrastructure.

Michael Reynal, Senior Portfolio Manager, Head of Emerging Markets; RS Investments; specializes in Latin American equity investments and markets. Reynal bluntly described the current situation in Latin America as dire with earnings growth crushed the last couple of years and I/B/E/S consensus estimates at -2% in 2015. However, he is a professional stock picker and says, “We are often too negative and don’t capture the turn in the markets.” Reynal tries to look past the political drama and be positioned to avoid the risk of underperformance.

Reynal likes finding promising second and third-tier corporates in Latin America and says, “You have to get on a plane and check them out.” Without providing  specific investment advice, Reynal noted Volaris as an example of a growing low-cost Mexican airline carrier and Ferreyros, a successful Caterpillar distributor, headquartered in Lima, Peru. He also noted M.Dias Branco, a Brazilian cracker and pasta company, which has a large market share in the unbranded cracker market and Gruma—the largest manufacturer of corn flour and tortillas in the world—headquartered in San Pedro Garza García and Nuevo León Mexico. Reynal is optimistic on the energy and transportation sectors in Mexico but is more speculative about prospects in Brazil.

Elizabeth Bell, Investment Manager, Aberdeen Asset Management, is responsible for real estate investment activities throughout the Americas on behalf of both separate accounts and fund-of-funds managed by Aberdeen. Bell sees positive opportunities for local, residential real estate developers in Mexico. She reports that the drop in oil prices has been good for the US consumer and is driving manufacturing in Mexico—which in turn drives demand for industrial warehouse space and housing. She also points to a slowdown of residential demand in Brazil. And she worries that if lending dries up Brazilian developers won’t be able to refinance their working capital and become distressed.

Despite the fact that three large Mexican public home builders filed for bankruptcy in 2014 (Urbi, Homex and Corporación Geo SAB), Bell points to pent up demand for residential housing and says, “There are housing deficits of 10 million units across the residential segment in Mexico.” Furthermore, she explains that one-third of the deficit is in the middle-income segment which is doing well. Bell says, “The problem is that banks are not lending to the sector and equity investors have been too timid to put their capital at risk.”

The problem is that banks are not lending to the sector and equity investors have been too timid to put their capital at risk.” Elizabeth Bell, Aberdeen Asset Management

Bell sees Mexican housing as a bright spot for those who want to step in and fill the liquidity gap by lending to small developers who need capital. Bell has seen 18% to 20% returns on senior debt and 20% to 25% on mezzanine debt. She explains that you have to get past the headline risk and fear of bankruptcy because  many local developers are still earning profits and are willing to take on expensive debt in order to achieve their returns. Also, there is good support for low to middle income buyers who can get loans. Finally, Bell cautions that real estate is high risk and you need to find best-in-class partners to do business in Latin America.

Juan Bosch, Senior Investment Strategist (Argentina) and Independent Director of Compass Group; highlighted the favorable total debt-to-GDP ratios in Latin America provided by aMcKinsey & Company study (below). After the 2008 financial crisis, debt-to-GDP ratios in developed countries increased significantly more than in Argentina, Peru, Mexico, Colombia, Brazil and Chile which are still below 150%. Bosch points out that interest rates in Argentina are near 9% to 10% while other areas of Latin America are at 5%.

Source: McKinsey & Company

Bosch is focusing on more liquid asset classes right now and feels that corporate bond yields are good and is long in the financial sector. He emphasizes the need to  take advantage of growth in the Latin American middle class which is just below Eastern Europe and Central Asia (shown below.) Bosch feels that pursuing alternative investments like real estate and infrastructure is an effective way to tap this demand.

Source: BCA Research 2014

Uwe Schillhorn, CFA, Head of Emerging Market Debt, UBS, views Latin America as many different markets rather than just one. Yet, Shillhorn finds the common denominator to be their heavy reliance on extractive industries and commodities.  In fact, he notes that oil and other commodities have been correlated and this has been a big disappointment for countries like Peru. He’s seen currencies weaken (but says they were fundamentally expensive before) and large nominal devaluations but expects currencies will appreciate once commodity prices stabilize. Schillhorn sees Mexico as a glimmer of hope that’s now in need of a second generation of reforms.

In the bond market, Schillhorn warns that it could be very bad for Latin America when US interest rates start to go up. Schillhorn says, “If rates go up in an orderly fashion then the risk premium won’t go up. But if the market moves quickly then risk premia will widen. And if it’s a violent change then credit spreads will blow out.”

“If rates go up in an orderly fashion then the risk premium won’t go up. But if the market moves quickly then risk premia will widen. And if it’s a violent change then credit spreads will blow out.” Uwe Schillhorn, UBS

Closing Keynote Address

Ernesto Zedillo, President of Mexico (1994-2000), Director of theYale Center for the Study of Globalization, was introduced by Chris Vincent, CFA, to provide the closing keynote address at the 2015 CFA Chicago Annual Conference. Vincent noted that Mr. Zedillo’s life story is truly amazing. Rising from humble working-class beginnings, with a public school education, Zedillo’s drive for self-improvement and public service earned him a masters degree and PhD in economics at Yale University and brought him to the presidency of Mexico.

Zedillo argued that CFA Chicago’s discussion about investing in Latin America was vitally important for two reasons. First, investors simply cannot ignore such an important middle-class region of the world with per capital income at $16,000 USD, over 600 million people and a combined GDP of over $6 trillion USD. Second, Zedillo says Latin America is going through a “special moment.” He explains that about four to five years ago there was widespread optimism and it was easy to invest in Latin America. Today, Zedillo asserts that you must exercise greater caution and use more sophisticated analysis to find the opportunities.

Zedillo argues that we must first understand the history of the region. He believes that most Latin American countries overestimated the resilience of their domestic policies and falsely attributed the results to skillful policy rather. Correspondingly, they underestimated the significant role external events would have on their economies—for good or bad. In retrospect, he points out that there was a systematic underestimation of the impact of the super cycle—which can now be declared as over—and other significant structural challenges (e.g. demographic changes, etc.) now lie ahead. Zedillo warns, “The day of reckoning for becoming complacent is not tomorrow—it’s today”

The day of reckoning for becoming complacent is not tomorrow—it’s today.” Ernesto Zedillo

Zedillo emphasized that Latin America is at a “fork in the road” and the urgency for change in each country is even more critical. He says the “homework” ahead of the region is very complex and cannot be oversimplified. Yet, Zedillo says that with gains in productivity the region can make gains in alleviating poverty, inequality and low per capita income.

Zedillo closed with a few observations on regional challenges. He calls Venezuela’s situation “catastrophic” since its GDP fell 4% last year and is estimated to fall another 7% this year and in 2016. He feels that Argentina, though in recession, is “fixable.” In regards to Brazil, the Latin American giant in terms of size and complexity, Zedillo feels the economy will contract by 1% this year and  be in recession. On a positive note, Zedillo says Mexico is lucky to be more “interdependent” with the US (e.g. NAFTA) than other Latin American countries. Therefore, he believes Mexico will consistently do better after a crisis given its strong connection to the US economy.

CFA Society Chicago Book Club:

How Latin America Weathered the Global Financial Crisis by Jose De Gregorio

Following the CFA Society Chicago 2015 Annual Conference held on May 7th which focused on emerging opportunities in Latin America, the CFA Society Chicago book club met on May 19th to discuss “How Latin America Weathered the Global Financial Crisis” by Jose De Gregorio.  The author was the governor of the central bank of Chile during the global financial crisis.

When analyzing Latin America, economists tend to focus on LA-7 which represent 90% of the output of Latin America.  LA-7 represents the countries with greater than $100B in GDP including Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.  Brazil and Mexico represent 2/3rds of the output of Latin America.

Leading up to the global financial crisis and depending on country until the 80s and 90s, growth was rather weak due to high inequality, low openness to trade, weak institutions, high inflation, and unsustainable fiscal policies.  Though in the 80s and 90s, structural reforms began to take place and the benefits were seen about a decade later.  Chile for example was one of the first to benefit after the structural shift to an independent central bank and a flexible FX policy.

Latin America was surprisingly resilient during the global financial crisis given the many shocks there have been over the 70s, 80s, and 90s.  Part of the resilience came from sound macroeconomic management and strong financial systems.  Structural reforms that took place prior to the global financial crisis such as floating FX rates acted as shock absorbers.  Other structural reforms included a more open economy and inflation targeting to help lower volatility.  It has been found that the greater the credibility of the central bank, the lower the volatility of inflation.  The commodity super-cycle of the early 2000s drove an expansionary boom in Latin America given the large dependence on commodity exports.  What also helped Latin America was China’s double-digit growth leading to higher demand of copper from Chile, soybeans from Argentina, or oil from Venezuela.  The commodity boom provided a nice cushion of wealth for the times that lay ahead.  The large build-up of financial reserves resulting from the commodity super-cycle were initially expected to be used as insurance against rising FX rates but the reserves ended up providing a cushion during the global crisis.  Some countries diversified their economies away from being dependent on a main commodity export which further provided downside protection.  Chile for example was able to diversify away from copper and keep it from being a driver of the business cycle.  Latin American countries also were less levered than the advanced economies.  Mexico on the other hand was the worst performer during the financial crisis due to the proximity to the US and large trade agreements.  Unlike during the Asian Financial Crisis, the terms of trade improved for Latin America helping to lead to a more resilient economy over the 08-09 period.

In summary, key drivers that helped Latin America weather the global financial crisis were a terms of trade boom, inflation control, the commodity super-cycle, structural reforms, credible central banks and financial systems, less leverage, sound macroeconomic management, and diversifying their economies away from being dependent on a single export.  Major risks to Latin American countries include falling commodity prices, continued populism, hyperinflation, poor infrastructure, a weak educational system, high inequality, and not doing enough on the reform front.

 

Upcoming Schedule:

June 16, 2015: The Billion Dollar Mistake: Learning the Art of Investing through the missteps of Legendary Investors by Stephen Weiss

July 21, 2015: On Saudi Arabia: Its People, Past, Religion, Fault Lines – and Future by Karen Elliott House

*(NOTE: Those who attend the July Book Club meeting will receive a free copy of “Superpower: Three Choices for America’s Role in the World” by Ian Bremmer)

August 18, 2015: Superpower: Three Choices for America’s Role in the World” by Ian Bremmer

September 15, 2015: The New Cold War? Religious Nationalism Confronts the Secular State by Mark Juergensmeyer

October 20, 2015: TBD

Five Hobbit Lessons for Sustainable Investing

In Devin Brown’s Hobbit Lessons: A Map for Life’s Unexpected Journeys, we learn five key lessons drawn from J.R.R. Tolkien’s timeless story The Hobbit. These lessons are well worth remembering and, in fact, may even help add meaning and value to your investment portfolio. And when it comes to sustainable investing, the lessons are particularly fitting because sustainability, by definition, causes us to think even more deeply about the long-term—how we earn our wealth, what we do with it and the implications our investments have on the environment and society.

Hobbit Lesson #1 – When adventure comes knocking, let it in—even if it makes you late for dinner, even if part of you says not to, despite what the neighbors might say. Saying yes to adventure will be good for you, and profitable too—though not in the way you might think” (32).

Developing a sustainable investment program is like embarking on a new adventure. The global sustainable investment market is growing rapidly and there are numerous strategies to help you achieve your goals. Although it may take a little longer to identify and analyze these material non-financial factors (and even make you late for dinner)—I believe that incorporating sustainable environmental, social and governance (ESG) analysis can reduce portfolio risk and generate long-term returns.

Global Growth in SRI Assets

According to the Global Sustainable Investment Review 2014, the world market for sustainable investing (SRI) has grown from (USD) $13.3 trillion in 2012 to $21.4 trillion in assets by 2014 (3). That’s a 26.9% compound annual growth rate (CAGR) in just the past two years. And, sustainable investment assets in Asia have grown at a 15.1% CAGR—from $40 billion to $53 billion over the same timeframe (4).

In my view, this remarkable growth in assets illustrates both the value of a more robust investment decision-making process and the dawn of a new era in sustainable investing.

Sustainable Investment Strategies

Hobbit Lesson #2 – Have your friends’ backs – someone has yours” (58).

As with any great adventure, there are a number of paths to choose from. The paths (or strategies) can demonstrate both your commitment to protect others from harm (e.g. having your friends’ backs) and lead you to opportunities where others can protect you from risk. GSIA reports that seven key sustainable investment strategies have emerged across the globe:

  1. “Negative/exclusionary screening: the exclusion from a fund or portfolio of certain sectors, companies or practices based on specific ESG criteria;
  2. Positive/best-in-class screening: investment in sectors, companies or projects selected for positive ESG performance relative to industry peers;
  3. Norms-based screening: screening of investments against minimum standards of business practice based on international norms;
  4. Integration of ESG factors: the systematic and explicit inclusion by investment managers of environmental, social and governance factors into traditional financial analysis;
  5. Sustainability themed investing: investment in themes or assets specifically related to sustainability (for example clean energy, green technology or sustainable agriculture);
  6. Impact/community investing: targeted investments, typically made in private markets, aimed at solving social or environmental problems, and including community investing, where capital is specifically directed to traditionally underserved individuals or communities, as well as financing that is provided to businesses with a clear social or environmental purpose; and
  7. Corporate engagement and shareholder action: the use of shareholder power to influence corporate behavior, including through direct corporate engagement (i.e., communicating with senior management and/or boards of companies), filing or co-filing shareholder proposals, and proxy voting that is guided by comprehensive ESG guidelines” (6).

Across these investment strategies, GSIA reports that the largest strategy globally is negative screening/exclusions ($14.4 trillion), followed by ESG integration ($12.9 trillion) and corporate engagement/shareholder action ($7.0 trillion). Negative screening is the largest strategy in Europe and ESG integration dominates in the United States, Australia/New Zealand and Asia.

The Association for Sustainable & Responsible Investment in Asia (ASrIA) reports that the top three investment strategies in Asia (ex-Japan) are ESG integration ($23.4 million), negative/exclusionary screening ($16.5 million) and sustainably themed investing ($2.0 million) in their 2014 Asia Sustainable Investment Review(10).

Importantly, Asian investors cite fiduciary duty, financial opportunity and risk management as their primary motivations for sustainable investing (20). Which brings us to Brown’s third lesson:

Hobbit Lesson #3 – Be fond of waistcoats, pocket handkerchiefs and even Arkenstones (just don’t let them become too precious)” (82).

In short, it’s okay to seek financial opportunity and enjoy “fancy” or valuable things. However, Brown draws out Tolkien’s theme and warns us that, “…if we let our possessions become too important, if we let them become too precious, they will eventually come to possess us and bring about our downfall” (81).

Emerging Themes in Asia

Interestingly, the data show that sustainability-themed investment strategies have had the highest asset growth rates—both globally and in Asia. ASrIA reports that game-changing issues like climate change mitigation are driving many countries in Asia to implement more supportive regulatory landscapes for environmentally focused investments like clean tech and renewable energy (14). The four key themes emerging in Asia include new opportunities for clean energy, green bonds, conservation finance and impact investing.

Clean Energy

Bloomberg New Energy Finance expects that over US $250 billion per year will be invested in Asia’s clean energy infrastructure through 2030. Although renewable power is expected to produce a third of the region’s electrical power by 2030, even more coal and oil-fired electric generation can be expected to be used to meet the region’s growing energy needs—and that will lead to a significant rise in emissions as well (21).

China is already the world’s largest energy consumer and it’s expected to increase its energy use by 60% by 2030. Therefore, investment opportunities should abound across Asia as the region attempts to transition to a more sustainable, and environmentally friendly, low-carbon future. In the Philippines, the National Renewable Energy Program (2011-2013) plans to triple renewable capacity to 15.3 GW by 2030. In India, multiple policies have been deployed to increase renewable power such as Renewable Purchase Obligations, Renewable Energy Certificates (“RECs”) and favorable State Electricity Regulatory Commission (SERC) tariffs for mainly private-investment driven renewable generation—though coal will still be a major fuel over the next five years. In Thailand, renewable energy makes up 12.2% of capacity and the Alternative Energy Development Plan (ADEP) (2012 – 2021) has set an ambitious 25% target (22).

Green Bonds

KEXIM Bank in South Korea issued the first green bonds in Asia in 2013. Although the market is still in its infancy, first movers like the Asian Development Bank (ADB), the Development Bank of Japan and Taiwan’s Advanced Semiconductor Engineering have also issued green bonds. And the Chinese government has decided that green bonds will be an important part China’s financial market reform (23).

Hopefully, proceeds from green bonds will help the region finance large-scale energy and environmental projects that will support its transition to a low-carbon growth model. However, investors will need to be cautious and seek full disclosure, transparency and an independent evaluation of these new financing vehicles to ensure that investor expectations can be met (23).

Conservation Finance

The scale of Asia’s economic growth is creating incredible financial wealth but inevitably depletes natural resources and increases the risk of pollution. Globally, we’ve lost 50% of the world’s mammals, birds, amphibians and reptiles over the past 40 years due to human activities that destroy habitat or over-exploit fishing and hunting. Examples in Asia include degradation of natural forest in Indonesia and Cambodia and threats to coral reefs in Southeast Asia by overfishing (24). So, it’s imperative that we protect these truly irreplaceable and invaluable treasures.

 Hobbit Lesson #4 – Remember not all that is gold glitters (in fact, life’s real treasures are quite ordinary looking)” (100).

Conservation finance is a form of impact investing in which part of the investment remains in the ecosystem to enable its conservation (the ‘impact’) and part of it is returned to investors. While more government and regulatory intervention is expected, there remains a US $200 bn – $300 bn funding gap to satisfy global conservation needs. Therefore, asset managers and banks have the opportunity to develop new products and advisory services for private, philanthropic and institutional investors with an appetite for conservation finance (24).

Impact Investing

Impact investing takes an ownership stake in equities, bonds or other instruments to generate social, health and environmental benefits with the expectation of subsequently exiting the investment. ASrIA surveyed Asian investors and found that they recognize financial opportunity, contribution to community and fiduciary duty as primary motivations of impact investing (26). I’d also note that Michael E. Porter and Mark R. Kramer argue that creating societal value is a powerful way to create economic value while meeting the vast unmet needs in the world in their article, “Creating Shared Value,” in the January 2011 issue of Harvard Business Review.

J.P. Morgan estimates that the global impact investment market could absorb between US $400 billion and US $1 trillion over the next decade. And the Rockefeller Foundation forecasts that Southeast Asia will be the next hub for impact investing. However, currently a shortage of viable investment products and limited access to qualified professional advice is reportedly holding impact investing back in Asia (25).

Putting it in Perspective

Part of the adventure of sustainable investing is the opportunity to generate both financial and social returns while addressing the world’s most significant challenges. At times, it might seem hard to believe that your investments can make a global difference but remember this final Hobbit lesson:

 Hobbit Lesson #5 – Recognize you are only a little fellow in a wide world (but still an important part of a larger story)” (122).

ASrIA reports that Malaysia, Hong Kong, South Korea and Singapore are the largest Asian markets for sustainable investments. In addition, Indonesia, Singapore and Hong Kong were the fastest growing markets since 2011 (11). As global and Asian SRI markets continue to grow there will undoubtedly be new risks but there will also be exciting new opportunities for investors!

https://www.linkedin.com/pulse/five-hobbit-lessons-sustainable-investing-robert-r-mudra-cfa?trk=prof-post

CFA Society Chicago Book Club Discussion:

The Forgotten Depression: 1921: The Crash That Cured Itself by James Grant

The CFA Society Chicago Book Club met for their monthly meeting on April 21, 2015 to discuss The Forgotten Depression, by James Grant.  We went around the room and shared our backgrounds and kicked off our discussion on the 1920-1921 “Forgotten Depression”.  About a decade before the Great Depression of 1929-1933, there was a volatile economic downturn that lasted from January 1920 to July 1921.  It could be said to be the last governmentally unmedicated depression with the hero being the one and only invisible hand.

A surprise to many was when the war ended in November 1918, the postwar depression and deflation most expected didn’t immediately happen.  Inflation was in the double digits during the war and continued into 1919.  When peace didn’t immediately yield deflation, many thought the inflated war time wages and prices were here to stay.  Increased prices invited speculation and the speculators were lured by the low and easy money.  Businesses that should have gone under stayed afloat due to the easy money and ability to refinance.  Investors, farmers, and businesses expected the double digit inflation to continue into the 20s.  It didn’t happen.  The auto industry ended up collapsing in 1920 as Ford and GM both invested based on their forecast of rising prices.  Farmers had it worse than autos as farmers borrowed heavily to plant fencepost to fencepost in anticipation of rising prices.  In NYC, National City Bank lent unwisely against the collateral of sugar in Cuba.  By 1921, prices collapsed to 1913 levels.  Finally people began to see that the speculative nature following the war had collapsed.  NYSE stock prices fell 40%, unemployment which was not yet measured was certainly in the double digits, corporate profits collapsed, exports halted, demand dried up, and there was a run on the banks.    Benjamin Strong who was governor of the Fed at the time was a believer in the classical approach to money and banking.  When Benjamin Strong reflected on what was to come, he advised that there will be heightened unemployment, there will be deflation, there will be hard times, but the bad times will end and the economy will move forward.

By 1922, we saw a liquidation of labor that turned out to be what launched the roaring 20s.  The period can also be described as the Great Inflation followed by the Great Deflation with the volatile recession lasting a short 1.5 yrs peak to trough.

 

Upcoming Schedule:

May 19, 2015: How Latin America Weathered the Global Financial Crisis by Jose De Gregorio

June 16, 2015: The Billion Dollar Mistake: Learning the Art of Investing through the missteps of Legendary Investors by Stephen Weiss

July 21, 2015: On Saudi Arabia: Its People, Past, Religion, Fault Lines – and Future by Karen Elliott House

*(NOTE: Those who attend the July Book Club meeting will receive a free copy of “Superpower: Three Choices for America’s Role in the World” by Ian Bremmer)

August 18, 2015: Superpower: Three Choices for America’s Role in the World” by Ian Bremmer

September 15, 2015: TBD

 

To sign up for a future book club event, please click here:

http://www.cfachicago.org/apps/eve_events.asp

CFA Society Chicago Book Club Discusses

Bust; Greece, the Euro, and the Sovereign Debt Crisis by Matthew Lynn

The CFA Society Chicago Book Club met on March 17 to discuss Greece and how the debt crisis came to be and the outlook going forward.  Matthew Lynn’s 2011 book, Bust; Greece, the Euro, and the Sovereign Debt Crisis was a fantastic read and encouraged a very in depth discussion.

Just two short years after the collapse of Lehman Brothers, Greece faced mounting debts resulting from easy borrowing driven by cheaper rates after arguably fiddling its way into the Euro in 2001.  The Euro was created in 1999 to promote three key components.  1) Promote open trade across European borders minimizing FX risk, 2) Initiate a more dynamic, prosperous, and innovative Europe, and 3) Provide price stability with the intention of competing with the USD as a global safe haven currency.  Interestingly, countries like Portugal and Greece with much poorer credit quality were able to borrow Euros as easy as Europe’s strongest country, or Germany.  By becoming part of the Euro, countries resulted in a loss of national sovereignty and could no longer devalue their way out of debt as they did in the past.  Nor could they target a lower currency to export their way to growth.

Understanding Greece involves taking a look at the country’s history.  There have been predominantly two Greek families in power post WWII.  Post WWII, Greece never modernized while the North became industrial powerhouses.  Greece has had to rely on shipping, tourism, and agriculture.  They never heavily targeted investing in manufacturing like the North.  Greece has defaulted on numerous occasions including 1826, 1843, 1860, and 1893.  In 1997, the Greek Central Bank had to raise rates from 10% to 150% to stop the currency from going into freefall.  When evaluating whether Greece was suitable for the Euro, Greece was initially denied in 1999 but by July 2000, supposedly inflation was down to 5% and the budget deficit was only 1% of GDP gaining Greece entrance into the Euro effective 1/1/2001.  Once Greece switched to the Euro, we saw the Greek economy create strong growth but rising trade and budget deficits.  With low rates and the ability to borrow, Greece was riding an illusion of prosperity.  The 2004 Olympics held in Athens was a giant cost to the country.  Millions were spent on new stadiums that unfortunately tend to collect dust once the games are over.  In September 2004, it was reported by the Greek government that the accounting was incorrect and the country should never have been in the Euro.  The EU did nothing about it.  Greece continued to not play by the rules running up a higher and higher budget deficit to GDP.  Tax evasion and bribery has been common corruption we have seen in the country.  The Greek Pension system certainly doesn’t help the deficit as the retirement age is significantly lower than that of countries in the North.  Unmarried woman for example receive their parents pension if they are unmarried which discourages employment.  The Euro was not meant to be a currency you joined to become a stronger country, it was meant to only include the strongest countries to ensure price stability.

It was not only Greece that was incentivized to borrow at the ultra low rates once joining the Euro.  We saw very similar issues in Portugal.  Spain’s borrowing fueled a real estate boom that resulted in high growth but with relatively low productive growth making Spain less competitive.  Ireland cut its corporate tax rate luring corporations from all over driving the per capita income to one of the highest in the world.  The lower ECB rates resulted in Ireland’s excessive borrowing and an artificial property boom.

Germany on the other hand was running a surplus while the Club Med countries were running deficits.  Postwar Germany is said to be an economic miracle.  West Germany had strong growth driven by a stable currency, low inflation, hard work, brilliant engineering, and a frugal mindset.  Germany was not in favor of the Euro given their strong stable currency.  Germans tend to live within their means and avoid borrowing and credit cards.  The culture of Germany includes saving, living within their means, manufacturing, and frugality.  This all seems to diverge from the cultures of the Club Med countries which has led to where we are today.

After just under a decade, once 2009 hit following the credit crisis, we began to see the negative impacts of the excessive borrowing of peripheral Europe.  We saw downgrades from S&P and Fitch in late 2009.  Stocks in Greece began to fall, yields spiked, and bailout discussions began.  Germany did not want to bailout Greece.  The No Bailout Treaty of the EU also stated that each member state was responsible for its own public finances which was a precondition for long term growth in Europe.  From the end of 09 through May 2010, much debate and meetings took place to resolve the European sovereign debt crisis.  To protect the Euro, Merkel ended up compromising breaking the No Bailout Treaty and coming together with the IMF to bailout Greece, Portugal, and Spain among others in the trillion Euro bailout.  This resulted in the ECB for the first time buying government bonds helping to lower rates and increase prices to stabilize the Club Med countries.  Austerity programs across the Club Med countries were initiated and confidence was restored in the Euro.  Government salaries were frozen and social programs were cut.  Italy was forced to cut wages or suffer stagnation.  The question remaining was, did the EU and IMF provide a cure, a short term fix, or poison to the region?

It seems as though Greece has tended to follow the script of new government and new spending program, then falling GDP, austerity, and another EU bailout.  Excessive borrowing without investing in manufacturing led Greece to where it is today.  The author believes that once the moral hazard of providing bailout funds was initiated, the Euro was destined to fail.  He believes it was a major policy mistake to put politics in front of economics by creating a single European state.  He argues that bringing together the very strong economies of Germany and France with that of Greece, Ireland, and Portugal was a major mistake.  He argues that the markets should decide the outcome and it would have been better long term to let Greece go bust rather than provide a bail out.

Upcoming Book Club Schedule:

April 21, 2015: The Forgotten Depression: 1921: The Crash That Cured Itself by James Grant

May 19, 2015: How Latin America Weathered the Global Financial Crisis by Jose De Gregorio

June 16, 2015: TBD

July 2015: TBD

Aug. 2015: TBD (NOTE: Those who attend the Aug Book Club meeting will receive a free copy of Superpower: Three Choices for America’s Role in the World by Ian Bremmer. This is his new book and was released May 2015.)

Sept. 2015: Superpower: Three Choices for America’s Role in the World by Ian Bremmer

Sign up for a future book club event.

 

Climate and Energy Policy: What do Americans Want?

Consider, for example, the fact that President Barak Obama’s Administration has been reviewing Transcanda’s Keystone XL Pipeline project for more than six years. And, Amy Harder of The Wall Street Journal recently reported that this delay has emboldened resistance to at least 10 other oil and natural gas pipeline projects across North America representing $40 billion of investment. (See “Protests Slow Pipeline Projects Across U.S., Canada – Anti-Keystone XL Fight Emboldens Resistance to At Least 10 Other Projects.” The Wall Street Journal 9 Dec. 2014)

In addition, opposition to the Yucca Mountain Nuclear Waste Repository in Nevada and to the proposed Cape Wind generation facility off the coast Massachusetts illustrate how very long and costly delays to energy infrastructure projects can be. Some refer to this process of building public support for energy infrastructure projects as gaining “social license.” (Read more about social license and energy infrastructure here: Energy Investing: US-Canada Energy Summit).

In this environment, it’s essential for energy producers, developers, utilities, regulators and legislators to have a clear understanding of how consumers, and voters, actually think about difficult energy choices.

Fortunately, new research by Dr. Stephen Ansolabehere, Professor of Government at Harvard University, and Dr. David M. Konisky, Associate Professor of Public Policy at Georgetown University, provides rich insights into how—and how not—to develop energy, environmental and climate policy in their book Cheap and Clean: How Americans think about Energy in the Age of Global Warming.

Hats off to EPIC

Before we begin, I’d like to thank Dr. Michael Greenstone, Director – Energy Policy Institute at Chicago (EPIC), Milton Friedman Professor of Economics at the University of Chicago, for bringing Dr. Ansolabehere to Chicago recently for an engaging presentation on his research—rife with audience participation and discussion. I’d also like to thank Dr. Ansolabehere for the use of several slides and exhibits below.

EPIC is a collaborative energy institute of the University of Chicago’s Social Sciences Division, Harris School of Public Policy and Booth School of Business. I’ve found the EPIC Seminar Series of lectures and Symposia to be remarkable opportunities to gain direct access to some of the world’s leading thinkers on energy, economics and the environment.

About the Research

Ansolabehere and Konisky explain that, for decades, public opinion research on energy has been highly fragmented and episodic. The prior research often focused on the latest crisis—highlighting short-term events like oil spills, nuclear accidents and gas price spikes. As a result, “the emphasis on such episodes has made public opinion about energy seem fleeting, fractured and lacking in any rationale” (363). Furthermore, prior research typically asked about only one form of energy in isolation from other choices. The authors explain that pollsters and analysts must instead think systematically to really understand public opinion about energy in a meaningful way. Systematic thinking about energy asks questions like:

“What are the main sources of energy, and what are the public’s attitudes toward each one? What are the key attributes of each energy source, how do people view each energy source according to those attributes, and how important are each of the attributes in explaining what people want?” (578).

In my opinion, the really exciting thing about Ansolabehere and Konisky’s new research is that it has tracked these types of questions for more than a decade to see what the public wants the energy sector to look like and how public preferences have changed (578).

Their methodology utilized the MIT/Harvard Energy Surveys to gather information from 2002 to 2013 and then, based on the data, identified, quantified and explained the factors that really drive public opinion for various fuels such as coal, natural gas, nuclear, oil, hydro, solar and wind by developing a variety of multiple regression models. In addition, they also evaluated public opinion on different climate policies including regulatory caps, cap and trade and carbon taxes.

The regression models are fully described in the book and the appendix contains the summary statistics of the models including the coefficients, standard errors, significance levels and correlations.

Energy Choices

The first thing to understand is that we consume electricity, transportation, and heat, not coal, nuclear or solar power. In short, the authors explain that people value the qualities or attributes of the power they use and not the fuel itself. This means that people really want energy that is inexpensive, dependable, and safe—and it’s these attributes that really drive public opinion (62).

Having said that, the authors paint a picture of US public opinion about the energy sources used to generate electricity. As shown in the graph below, Americans want less reliance on coal and oil as illustrated by the large portions of pink (reduce use of fuel) and red (not use at all) throughout the time series (2002 to 2013). Second, Americans want to keep natural gas and nuclear power as they are, or increase them somewhat—with natural gas having the edge between the two.Third, Americans want to substantially increase the use of “alternative fuels” such as solar and wind as illustrated by the large portions of green (increase use) across the series (171).

In addition, Ansolabehere and Konisky report that very few American’s are pure conservationists who want to use less of every energy source (582). And very few want an “all of the above” energy strategy as often cited by the Obama administration (173).

So what’s the big idea?

“People have clear, stable opinions about the energy future that they would like to see in the United States. They know what sort of power plants they would like to see developed, and they know why. There is a simple, unifying structure to public opinion about energy, and that is the desire to have an energy system that simultaneously reduces environmental harms and economic costs” (363).

Economic Costs and Environmental Harms

Well, we’ve just seen what people want. But why do they want what they want? And are their perceptions about energy supported by accurate information? Ansolabehere and Konisky conclude that a “Consumer Model” best describes what people want from energy and energy policy. In short, people think about energy like they would any other consumer good.

The authors explain that in the Consumer Model, “an individual’s opinion about the use of various fuels and the direction of public policy depends on two key factors or attributes of energy—the economic cost (the private good) and the environmental cost (the public good)” (580). In fact, they found that between 75 and 80 percent of the variation in support for different fuels was explained by these two factors and while there can be other factors—they are of secondary importance (362). Survey respondents were then asked how expensive they thought electricity from each of these different fuels sources is and how harmful each method of generating electricity is to the environment.

In terms of costs (above), people generally got the cost of coal and natural gas as less expensive than nuclear and oil correct. However, the public incorrectly believes that solar and wind power are much less expensive than coal, natural gas, nuclear power and oil (246).

When informed of the true costs of electricity from solar and wind power, they found significant decreases in support for these fuels and increases in support for fossil fuels (411). Americans still wanted to significantly expand use of these fuels but their support was more tempered. So, Ansolabehere and Konisky remind us that public support for a fuel source does not mean that people ignore economic costs of the fuel in judging a public policy to increase the use of that fuel (389).

In terms of environmental harm, Ansolabehere and Konisky note that people have the relative harms about right. They correctly see coal and oil as having the most adverse environmental effects. Natural gas is seen as less harmful than these fuels but more harmful than hydro. Solar and wind power are correctly perceived to pose few environmental harms (259).

Importantly, people gave greater weight to environmental harm than to economic considerations in evaluating energy choices and policies. In fact, environmental harms were more than twice as important than economic costs as evidenced by larger coefficients in the regression models (290). So environmental harm is a strong predictor of energy preference. The policy implication of this finding suggests that the government should put, for example, $2 into clean coal for every $1 into research on cheap solar to be in line with the public’s relative preferences (361).

The public’s reaction to nuclear power appears strong and perhaps exaggerated (258). The authors conducted further research into nuclear power and found that two-thirds of the sample indicated they would support significant expansion of nuclear power “if there were a safe and effective way to deal with nuclear waste” (264).

Providing more information on environmental harms decreased support for coal, natural gas and oil and increased support for nuclear power (422). In addition, there was a substantial decrease in support for coal and an increase in support for alternative fuels, especially wind (432).

Interestingly, the research dispels conjecture that public perceptions about energy are explained by political or demographic differences among people. The authors found that it’s not political party or ideology, education, age or religion that really matters. Those factors are secondary. Rather, people think about energy through a common lens of cost and harms and then fit particular fuels into that framework. Then, the particular fuel defines the terms of the political debate (276).

Finally, economic cost and environmental harm were also found to be the most important factors that explain why people oppose the location of some sorts of power plants near their homes but not others—the not in my backyard (NIMBY) attitude (354).

Understanding the Trade-Offs

In order to effectively move climate and energy policy forward, we must recognize that there are real trade-offs between the economic costs and environmental harms of energy production. Today, no fuel exists that is both cheap and clean (593).

Based on data from Dr. Michael Greenstone and Dr. Adam Looney, the authors illustrate a “technology frontier” for new electric generation sources by plotting the “levelized” cost of generation against the social cost (environmental harm) for each fuel. The levelized cost is the present value, in real dollars, of the total costs of building and operating an electric generation plant over its financial life and duty cycle—presented in cents/Kwh (125).

Social costs are the hidden costs that consumers do not see on their electric bills. They arise from pollution caused by energy production that causes increased health care costs. For example, burning coal produces sulfur oxides, nitrogen oxides and particulates that contribute to the formation of smog (ground level ozone), acid rain and other pollution (lead, mercury, etc.). High levels of smog increase risk of cardiovascular disease, lung cancer, bronchitis, and asthma (110). Greenstone and Looney also estimate that the true social costs of fossil fuels (ignoring global warming) is about 75% more than we currently pay for energy (609).

As illustrated below, Ansolabehere and Konisky use existing coal-fired generation plants as the reference point since they are the least expensive (about 3 cents/kWh) but have the highest social costs from pollution and carbon emissions. New pulverized coal plants provide only a marginal reduction in social costs and are more expensive than new natural gas plants that provide significantly greater reductions in social costs. Solar, wind and nuclear power have significantly lower social costs. However, solar power costs about 17 cents/kWh more than coal while wind and nuclear are about 5 cents/kWh to 7 cents/kWh more respectively.

Bottom line, cleaner energy will cost more.

Global Warming

Today, the risks associated with global climate change (flooding in major cities, expansion of deserts, droughts, disruption of food supplies, etc.) are widely discussed by almost every national government in the world. The authors explain, “energy is back on the national agenda not because we have an energy crisis but because there is a risk of a looming global environmental disaster” (450).

The conundrum for public policy makers who realize the long-term implications of today’s energy choices is that although most Americans are concerned about global warming they don’t see it as the most important problem (“MIP”) facing the nation and have a low willingness to pay (“WTP”) to solve the problem. In short, the authors did not find climate concern to be a major driver of public opinion about energy (443).

For example, in Gallup’s January 2012 poll, “two-thirds of Americans identified the economy as the nation’s most important problem, followed in order by dissatisfaction with government (15 percent), healthcare (6 percent), immigration (3 percent), education (3 percent)”. Typically, energy and environment do not rank highly compared to the economy and other problems (467).

Ansolabehere and Konisky found that the median amount people were willing to pay to “solve” global warming was only $5 per month ($60 per year) or about 5% of the typical monthly electric bill. And two dozen other studies, assessed by Johnson and Nemet, found the median amount to be $135 per year. In short, “most Americans don’t appear willing to make the trade off that many policy experts feel is required: substantially higher energy prices in order to substantially reduce carbon emissions” (483). The authors sense that Americans don’t want to pay more now to solve a future problem with no immediate health or environmental benefits for people living today (e.g. pay more, get nothing) (445).

Although nuclear power is widely recognized by climate scientists, economists, and others as a potentially important way to significantly reduce carbon emissions to address global warming the public doesn’t yet make that connection (334). Despite the fact that nuclear power has virtually no carbon emissions and offers the capacity to offset significant amounts of greenhouse gas. In addition, nuclear power provides more reliable electricity at a far lower price than solar or wind (286).

Ansolabehere and Konisky explain, “Nuclear power is the one non–fossil fuel that can be deployed quickly at an industrial scale to bend the carbon curve in our energy sector. Unlike wind and solar power, nuclear power does not suffer from either the intermittency or the transmissions problems that currently limit these sources, making it a useful way to generate baseload capacity” (335).

Surprisingly, Ansoblahere and Konisky found that people who were concerned about global warming were less, not more, likely to support nuclear power than those who were not concerned. And nuclear power was not alone. Except for solar power, they found no relationship between concern about climate change and support or opposition to the fuel (312). However, providing information about global warming seems to increase support for nuclear power (373). And what’s really interesting is that public attitudes for every fuel were local rather than global.

“Americans are more concerned about local pollution issues, including pollution of rivers, lakes, and reservoirs, air pollution, pollution of drinking water, and toxic waste contamination of soil and water. Even other global issues, such as ozone depletion and loss of tropical rain forests, weigh more heavily on the minds of most Americans than global warming” (470).

In other words, people mentally connect with perceived local environmental harms from air and water pollution and economic cost more than they do to global warming. Given these findings, how can climate and energy policy move forward?

Climate Policy

Ansolabehere and Konisky explain that the problem with our highly competitive electricity market is that it exerts strong downward pressure on prices but that the social costs associated with different fuels are not reflected in prices. As a result, the market fails to deliver cleaner energy.

“The electricity market fails, then, to allow people to “buy” cleaner water or cleaner air. There is pent-up demand for these attributes for fuels, and, hence, people give even greater weight to those attributes in public opinion polls, because that is the unmet demand in the market” (508).

Certain government policies, like environmental regulations and fuel taxes, are designed to force firms to “internalize” the social costs that would otherwise not be seen on the consumers monthly electric or gas bill (17). Ansolabehere and Konisky reviewed numerous public opinion polls, from 2007 to 2012, on three commonly discussed policies designed to address climate change. These three polices are:

  1. Regulate carbon emissions (Regulatory Cap) – Either directly through a cap or limit on carbon emissions from manufacturing, industry and consumers or indirectly through renewable fuel standards that require a minimum amount of electricity come from noncarbon emitting sources. Notably, 30 state legislatures and electorates have adopted renewable portfolio standards (576).
  2. Create a market for emissions (Cap and Trade) – A system of tradable carbon emission permits issued by the government up to a total limit on all emissions (a cap). Generally thought to be more economically efficient than a “one-size fits all” regulatory cap because firms with a low marginal cost of reducing carbon emissions would have an incentive to further reduce emissions and trade them while firms with a high marginal cost to reduce emissions could efficiently buy permits instead of facing costly restrictions. (See Regional Greenhouse Gas Initiative (RGGI) of 9 Northeast and Mid-Atlantic states)
  3. Tax emissions (Carbon Tax) – A direct tax on the production or consumption of coal, natural gas and oil in order to discourage use of fuels that emit carbon into the atmoshpere and to encourage use of fuels that do not. A simple and direct method of adjusting the price of each energy source to reflect its social costs (524).

These polls found dramatically more public support for a regulatory approach to limit emissions than for the other policies. First, there was about 75% to 80% support for a regulatory cap on carbon. Notably, the public wants a regulatory approach to limit emissions even though many economists believe that cap and trade would be a more efficient policy. Second, cap and trade received between 45% to 55% support. Third, carbon taxes were supported by only 25% to 45% of respondents depending on the level of the tax. Although taxes are efficient they can be politically unpleasant (528). However, public support rose to 40% for “revenue-neutral” carbon taxes which are tied to an equivalent reduction in federal income and payroll taxes (564).

Seeking to further explain this phenomenon, Ansolabehere and Konisky identified the correlations between the three regulatory policies, concern for global warming and the environmental and economic attributes of energy as shown below.

Global Warming Concern (Green) – The green portion of each bar explains the amount of predicted support for each climate policy that’s associated with a concern for global warming. Notice that the baseline support associated with a concern for global warming is relatively high–about 30% for Regulatory Caps and Cap and Trade and about 22% for a Carbon Tax.

Environmental and Economic Attributes – The purple, red, blue and yellow components illustrate how the predicted support for each policy is influenced by those who also see the connection with the environmental harms (purple) and economic costs (red) of traditional fuels as well as the environmental benefits (blue) and economic costs (yellow) of alternative fuels. Notice that these attributes of energy production dramatically added 50% of support for Regulatory Caps (now at 80%) but only about 20% to Cap and Trade.

The political implications of these findings are huge. In short, concern for global warming alone is not enough to drive climate legislation. Furthermore, a simple regulatory approach appears to be the politically expedient solution. The authors go on to illustrate the nexus between their research and two key pieces of legislation.

First, The American Clean Energy and Security Act (Waxman-Markey bill), which passed the House in 2009 but failed to pass the Senate, proposed a national system of tradable carbon allowances (cap and trade). It was almost entirely viewed as about global warming and this may have been the political error. The sponsors failed to make a connection between reductions in local environmental harms and climate policy. However, their opponents successfully emphasized the economic cost of the legislation (603). Case in point, concern for global warming alone was not enough to carry the day.

Second, California passed the Global Warming Solutions Act in 2006, also known as AB (Assembly Bill) 32, which created a cap and trade system. Subsequently, Proposition 23 was put forth to postpone implementation of AB 32. However, opponents of Proposition 23 successfully emphasized the environmental and health damages of coal and oil, which the voters understood, and it was defeated. They rarely even mentioned global warming (606). Today, AB 32 is regarded as the most aggressive piece of climate legislation ever adopted by an American legislature (494). Here, climate legislation was driven by local environmental concerns.

“It takes more than just concern about global warming to win support of a majority of the public for climate policy. The political fate of various climate policies depends primarily on the other half of the equation—how the public thinks about energy” (567).

Environmental Policy + Energy Policy = Climate Policy

Ansolabehere and Konisky conclude that we should stop thinking narrowly about climate policy as just climate policy. Instead, they suggest that climate issues should be viewed more broadly from the perspective of energy and the environment.This strategy would seek to develop policies that simultaneously achieve immediate environmental and energy goals and long-term climate goals (573).

For example, the authors suggest aggressively targeting the co-pollutants of carbon such as particulates, sulfur and mercury that present immediate and localized health risks. By reducing the use of fuels with the highest concentrations of these pollutants progress can be made on immediate health risks (573). In this way, progress is made on the local pollution issues as well as on the long-term climate issue. Dr. Ansolabehere goes on to suggest, “mercury and soot regulations might do more to help the US meet its climate goals than a 25 cent gas tax and would be politically easier to sustain.”

This appears to be a very logical strategy based on the research findings. Ansolabehere and Konisky have found considerable public support for regulatory policies like U.S. EPA caps on carbon emissions and renewable portfolio standards. And they’ve found that on questions of immediate environmental regulation public opinion approaches a consensus (or at least a majority) large enough for the government to act (575).

Pragmatism and Policy

I highly recommend Cheap and Clean: How Americans Think about Energy in the Age of Global Warming by Dr. Stephen Ansolabehere and Dr. David M. Konisky for their holistic and systematic analysis of how Americans really think about energy, environmental and climate policy.

It’s amazing to know that there is a basic consumer model that aptly describes public opinion on energy. It’s rational and apolitical. It weighs the trade-offs between economic costs and environmental harm and is primarily concerned about local issues.

After that, climate policy can be highly partisan. But this research should help policymakers in both government and industry develop the pragmatic solutions Americans want while simultaneously addressing long-term climate issues.

Ansolabehere and Konisky summarize their findings best by saying:

“Americans need to hear pragmatic solutions that fit with our approach to energy generally. We think about energy as consumers. We are motivated by the economic costs and local environmental harms, things we can see and feel and name. We need to think and act locally” (493).

Gaffney Signals End of Era; Provides Alternative Strategies for Fixed Income Investors

During a frigid Chicago lunch-hour in late February, Kathleen Gaffney, CFA, spoke to a room of CFA Chicago Society members and their guests at the Willis Tower’s Metropolitan Club about the prospects of fixed income investing and potential income generating strategies during the eventual rise in interest rates. Her overriding message was one of reassurance; “We’ve been here before.”

Gaffney, the lead portfolio manager for Eaton Vance’s multi-sector bond strategies, began her presentation by discussing today’s current ultra-low interest rate environment and the risks associated with a Fed decision to increase short-term rates in 2015, which she expects in June, lest the Fed risk being behind the curve. However, she was quick to give the Fed credit for current policies and actions, which Gaffney labeled “bridge-financing” until the private sector can provide the momentum to move the economy forward. As the U.S. leads the world into economic recovery, while other world economies toddle, Gaffney is not concerned about inflation or rising long-term rates. Her forecast for the yield on the 10-year Treasury bond is 4% by the end of 2015, although she admits her forecasts for the 10-year have been incorrect in the recent past.

Besides the obvious risks to bond values in a rising rate environment, Gaffney also noted that nearly none of the fixed income practitioners operating today have experienced the magnitude of the long-term rise in interest rates that preceded the cycle’s peak in 1984. Additionally, regulatory changes have reduced Wall Street’s ability to put their own capital to work, resulting in decreased valuation support, reduced liquidity and very swift corrections in high yield, emerging and equity markets.   The end of the era will require careful asset allocation and alternative strategies that seek to mimic fixed income returns, while minimizing interest rate risk.

Gaffney encouraged the audience of investors and advisors to enhance portfolio flexibility by thinking broadly about the various “levers” that can be pulled to generate investment returns, i.e. credit, country and currency. She likened taking interest rate risk in today’s rate environment to driving down a dead-end road at 80 mph.  Rather, with her expectation of a secular bull market in equities, fixed income investors may consider “high-quality” equities with good dividend yields that will provide additional return on positive market movements, according to Gaffney. She also suggested that investors consider equity sensitive convertible bonds to mimic the returns of high yield bonds, while minimizing interest rate risks. Floating rate bonds were also offered as a reasonable alternative. However, Gaffney noted that floating rate notes introduce an additional element of repayment risk if rates rise too high or too fast, which she does not expect. The current strong dollar also provides opportunities to benefit from the potential growth from product importers to the U.S. Additionally, Gaffney proffered an idea that countries working to implement long-term positive structural reforms, including Brazil and India, have the potential for enhancing portfolio returns. However, she cautioned investors regarding new issuances encouraging investors to increase due diligence levels for new market entrants.

Gaffney finished the luncheon session with a question and answer session that included audience inquiries regarding duration assignments, the potential for negative deposits rates and, among other things, the performance of the her managed portfolios if the 10-year yield does reach 4% in 2015.

Distinguished Speaker Series: Kathleen Gaffney, CFA, Co-Director of Diversified Fixed Income, Eaton Vance

The Distinguished Speaker Series featured Kathleen Gaffney, CFA, and Co-Director at Eaton Vance who focuses on fixed income. Eaton Vance is one of the oldest and most distinguished investment management firms in the United States.  Gaffney warned that the “end of the era” of low interest rates is at hand and that more volatility will be the result.

The increase in volatility is due to more than just the expected rise in interest rates.  Gaffney warns that the broker/dealer community has been hard hit by new capital rules that prevent them from holding large inventories of bonds.  Due to the global financial crisis of 2008-2009, this “shock absorber” has been taken away.  Gaffney stressed that moving capital will be difficult, leaving the market vulnerable to sharp corrections.

Gaffney stated that she is convinced that the credit markets are ripe for correction.  The FED’s actions will most likely impact short and intermediate term bonds the most.  If the FED does not begin to tighten in June, it will be accused of being behind the curve. She believes that the fundamentals in the United States are good and that once rate hikes begin; the resulting yield curve will resemble a “bear flattener” as short rates will rise faster than longer term rates.  Inflation will result when economies outside the US continue their economic recovery.

Gaffney is convinced that duration risk is the greatest risk facing the US bond market.  It is her position that US interest rates are too low and that the 10-year treasury yield will approach 4% by year-end.  She also believes that high-yield and investment grade corporate bonds are currently expensive. In this environment, as part of a multi-sector strategy, Gaffney utilizes dividend paying equity substitutes in her fixed income portfolio.

Gaffney purchases equities that yield between 1.5% and 3.0% at prices that are more reasonable than current bond prices.  These equities have yields that currently compare favorably to the 10-year treasury.  The equities market at this time also offers more liquidity than fixed income markets, and she is able to use up to 20% of her portfolio for equities.

In the brief question and answer period that followed Gaffney stated that she is an optimist and that strong GDP numbers which she expects in the near future will be a catalyst for rising interest rates.  She assigns a 0 duration to the equity positions she holds in her portfolio. It was interesting to hear how a multi-sector strategy allows her to include equities in the search for yield.