Weekend Reading
Comment of the Day

March 07 2014

Commentary by Eoin Treacy

Weekend Reading

Thanks to a subscriber for this list of mostly academic reports which it is reasonable to assume constitute the reading material of policy makers globally. This week we have an additional entry in the form of a new offering from Deutsche Bank who has just hired the former editor of the Financial Times’ Lex column.  “Insights in 140 Words” is posted below.

Eurozone inflation - The debate divides like Marmite yet is complex like a fine Bordeaux. Amidst warnings about Japan-style deflation headline prices have held steady for the last five months and excluding energy inflation is up. Regional differences add to the confusion. In Greece and Cyprus prices are actually falling. Meanwhile overall inflation in the periphery (0.3 per cent) is lower than the core (1.1 per cent). Indeed this is the first sustained period of lower relative inflation in peripheral countries since 1999. Yes this helps their competitiveness. Trouble is lower inflation versus, say, a year ago means real interest rates are down less than headlines suggest - a problem for an indebted periphery. For example 5-year Italian bond yields are 100 basis points lower since January 2013 but reduced inflation expectations account for 80 basis points of that. Tricky times for the ECB. 

Russian stocks - Pity the emerging markets investor reeling from the relentless march of a foreign power with designs on overseas expansion. Yes, being underweight Tencent must be a nightmare these days. China’s internet juggernaut has advanced another 30 per cent this year and is now the third largest company in the MSCI emerging markets index - bigger than China Mobile and ICBC. Indeed for managers running funds against this commonly used benchmark the Ukraine crisis is almost a sideshow in comparison. Russia only has four stocks in the top 50 names and 22 in the index overall - half as many as Malaysia. That explains why the index has not fallen since Crimea was overrun last week. Hence too why fund managers worry less about whether, say, Sberbank is cheap ($50bn market value, 5 times price/earnings) than whether Tencent is expensive ($150bn, 60 times). 

Politics matters - Thanks mostly to German energy policy shares in power producer RWE have collapsed 70 per cent since 2007. Thanks mostly to Russian energy policy shares in gas producer Gazprom are also down 70 per cent over the same period. Yet the latter is a monopoly while the former has been thrown to the competitive wolves by its government - indeed this week RWE reported its first loss in 60 years as Germany’s rush into renewables weighs on prices. How can such different situations result in identical underperformance? It helps that neither company generates a return above its cost of capital. Gazprom’s problem (Ukraine aside) is sloth: revenues per unit of capital invested have almost halved since 2007. RWE’s is simple pain: cashflow margins have fallen versus investment. But the common factor is unfavourable politics against which most companies are defenseless. 

Bank earnings - Few industries post record earnings after five years of stagnant revenues and rising costs. But American banks managed to do just that in 2013. Their operating revenue of $670bn was unchanged versus the year before and broadly flat over the previous five years. And a record $190bn wage bill helped push non-interest expenses close to peak levels and 15 per cent higher than 2007. Luckily, however, US banks squirreled away too much money in the bad times and since then loan loss provisions have dropped to 13-year lows. Hence the highest net income ever. In contrast, profits at European banks have dropped by a quarter over three years as revenues fell and bad debt expenses at 1 per cent of loans are twice the level of US lenders. Europe’s banks will be hoping for some help from their pasts too. 

Skin in the game - European legislators want portfolio managers to receive half their bonuses in units of their own funds. Meanwhile employee money makes up at least a tenth of assets under management at 70 per cent of all hedge funds. Clearly, this skin-in-the-game idea is popular. But it is also often misguided. Take a Japanese equity manager. For most of the last two decades his stocks traded lower, but clients probably had an allocation to Japan for risk purposes. It would be wrong to force an 80 per cent loss on the manager without regard to his overall investment position. Sure it is comforting to know that passengers interests are aligned with an airline pilot’s. But chefs love fast food and fashion designers wear scruffy clothes. Such incongruities are why money remains the best way of rewarding people for a hard day’s work.

Fed: “Banks as Patient Fixed Income Investors” 


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