Kitchen Table Economics & Investing

Damian Lillicrap is the Head of Investment Strategy for QSuper. He invests $38 billion in global portfolios for 550,000 fund members. He arrived in the world of finance after a stint in the real world. He studied chemical engineering then worked as an engineer for 5 years. He fell into finance via a working holiday in London. His roles evolved from photocopying and distributing reports for traders, to generating return and risk analysis before managing portfolios. He has now been in finance for over twenty years, first working for Credit Suisse in London, later the Commonwealth and Macquarie Banks in Sydney, then to the Queensland Investment Corporation before his current role with QSuper. He lives in Brisbane. For more information, visit his website: www.barenakedeconomist.com

Contents

List of figures (graphs and diagrams)

Introduction

Part 1 The current state of play

1 A short tour of a troubled world

2 Fixing structural issues is hard – not fixing them is worse

Part 2 Debt and money – what they should teach you at school

3 The money-multiplier effect – lending creates lenders

4 Debt, money and inflation – down and dirty

5 The business cycle and the super debt cycle

Part 3 Field work – bringing theory to the real world

6 Can printing money hold the key?

7 Jobs, currency, exports, politics and internal focus

8 Why over-building matters

Part 4 The road ahead

9 Eliminating housing bubbles

10 Don’t overrate globalisation

11 GDP isn’t the only thing

Part 5 Investing – putting your savings to work

12 Investing overview

13 Cash and inflation

14 Bills and bonds – like a forward-dated cheque

15 Equities – higher risks, higher returns

16 Real estate – levelling your expectations

17 Gold and currency – be aware!

18 Portfolio construction

19 Dynamic asset allocation – changing risk and reward

20 Efficient markets – the what and how

21 Saving for retirement is underrated

Over to you!

Acknowledgements

Glossary

Index

List of figures

(graphs and diagrams)

Figure 1 Size of Japanese government debt

Figure 2 Structural issues in the United States

Figure 3 Debt to GDP ratio in the United States

Figure 4 Structural issues in European peripheral countries

Figure 5 The kitchen table money-multiplier perspective

Figure 6 Different measures of the money supply

Figure 7 Business cycle with asset-price inflation flowing to CPI

Figure 8 Relationships between asset price inflation and CPI

Figure 9 Bill and bond investment yield

Figure 10 Yield on paper as rates reduce

Figure 11 A breakdown of bond yields

Figure 12 A ‘normal’ yield curve over time

Figure 13 Plotting of long-term interest rates

Figure 14 Comparative return on cash, bonds and equities

Figure 15 Plotting of earnings per share

Figure 16 Raw P/E compared to CAPE

Figure 17 P/E as of October 2012

Figure 18 Normal vs low cash environment

Figure 19 Earnings yield, interest rates and five-year average inflation

Figure 20 Normal monetary policy vs impact of QE

Figure 21 US and Australian house prices over 120 years

Figure 22 Trade-offs for portfolio positioning with changing misvaluation signals

Figure 23 Portfolio positioning for different levels of misvaluation

Introduction

Economics has been referred to as the dismal science – we really didn’t want to know much about it. Recessions came; recessions went. We didn’t like them, but we believed they were relatively fleeting. Well, that was the way of things. Now, something seems broken, and we want someone to fix it.

‘They’re not trying hard enough!’ we shout. Believe me, they are trying but there are no easy answers. The problems around the globe are worse than most people understand. We are seeing manifestations of the crisis, such as slow growth and higher unemployment. Unfortunately, many of these problems are likely to get worse before they get better. We are being barraged with economic numbers and sound bites – unemployment is ‘X’, the market has gone up ‘Y’, this economist says ‘improving’, that economist says it’s ‘deteriorating’ – when what we really need is to understand how the broader picture works. It is important that people without financial expertise understand what is happening because:

they are exposed to risks

they impact the policies that politicians follow

in a chaotic world they need to take charge of their finances or risk losing them.

One European politician famously said, ‘We all know what to do, we just don’t know how to get re-elected after we’ve done it,’ and this quote could apply across many countries at the moment. When I first heard it, I thought it reflected badly on politicians; later I thought it reflected badly on us, the voters. But how can voters make good decisions if the problem hasn’t been explained in terms they can understand? Perhaps this quote reflects badly on me for not writing a book like this sooner.

I started life as a chemical engineer, and ended up in markets by chance. I have been in finance for about 20 years and am now responsible for investing tens of billions of dollars. As an engineer, if you make a mistake, if you don’t understand something, people can get hurt, or worse. In engineering there is a tight set of beliefs about what is an acceptable approach to building something. From such an environment, I found much of economics and investment theory quite inconsistent when I first started. Sadly, based on what we see around us, most of us would agree that the profession that guides us on how to manage our financial system has been found wanting over the last few years.

That said, there are many wise economists and investors. I have been privileged to have worked with and met some of the most respected economists and investors in the world, and many of these individuals have been incredibly generous with their time and knowledge.

Some people suggest that the rules of economics need to be rewritten since the global financial crisis (GFC). My perspective is that there are no rules for economics or, conversely, that there are too many rules, too many views. While in science there tends to be a dominant paradigm (set of beliefs), which tends to be quite tightly specified, in economics there are competing schools of belief about how markets work and what should be done to fix them. It is less a science and more of a collection of churches of beliefs.

I have been something of a magpie in this world, happy to borrow from any school in the search for an overall, consistent set of understandings that make sense and that help make good investment decisions. Sometimes an academic paper captures the essence of an idea perfectly, sometimes an old market cliché contains wisdom that can’t be escaped, and I often consider ‘reflexivity’ – the circular relationship between cause and effect in markets – as described by George Soros. I’ve mined all of these different areas looking for the gems.

My fund has got most of the big investment decisions right (within the discretion we’ve had) over the course of the GFC, so these views, these ideas, have been road tested in the toughest environment. People try to do the best that they can in finance, commerce and industry. Some label it greed, but we should acknowledge that if they gave their best on a running track or football field we would respect them. There has been some market behaviour that was unconscionable. I don’t condone this. However, I’m not convinced that a desire to make a profit was the core reason for today’s problems. I believe today’s problems stem from a failure to really understand what was driving the economy during the good times, and the long-term consequences of what was going on.

This book examines how things that looked so right, when examined via a disciplined, almost scientific, approach, were indeed flawed. In economies, imbalances can build slowly, sometimes for decades, and outcomes can look great as they build, but can then unwind dramatically. We can’t rely on correlations here. Instead we need understand the building blocks of the economy to see how things play out.

Economic problems cause social problems, and social problems result in hardship. As debt balances build, we are creating intergenerational issues – supporting lifestyles at the expense of future generations. While we hear a lot about growth and austerity, the real choice, though, appears to be less about these two and more about the pain today versus more pain for the next generation.

An unfortunate reality is that, as nations, many of us have lived beyond our means for a number of years. This will be painful to rectify. Blaming other countries for our woes won’t help; all of us were drawn into believing that we were doing the right thing. Blaming others and aggressive behaviour can be detrimental – wars have been incubated in environments of blame. With perspective we can get through this, and the greater the perspective and the greater the generosity to others, the sooner we will be through it and the better the journey will be.

This book focusses on the basics of economics and investing. While the two are related, they are not the same. I believe you need to understand economics when investing, but this is just an input to an investment decision. The biggest investment opportunities seem to occur when a false paradigm is held widely, and there is money to be made when this fallacy is exposed. It happens surprisingly often – tech bubble, credit bubble, and so on. I think there is a subtle misalignment of interest that leads to housing bubbles, which we have seen too regularly over recent decades, and I suggest a mechanism to improve the situation.

There is a lot about money (money supply) and debt in the following chapters. This is what you need to understand the economic crisis of our time, and how things will play out over the next decade or two. Increasingly, people are being made responsible for their own retirement outcomes. Unless they take an interest in this they are probably going to end up with less than they expect. They are likely to be disappointed when they realise this, and will need to decide between a number of compromises. The sooner they work this out the more flexibility they will have in their choices.

I will talk about the fundamentals of the major asset classes – equities, bonds, cash, and property – and why gold and currency are fundamentally difficult assets to invest in and probably best avoided. Also discussed is borrowing and leverage in investing; for example, margin lending for shares, or borrowing to finance an investment property. I will look at why the standard investment approaches followed by many large firms effectively tie the firm’s arms behind its back, so that it can’t defend itself as well as possible when the bad times come.

The title of the book comes from a conversation with a family friend not long after I moved into the financial world.

‘Look,’ he said, ‘at the end of the day, the government is like a family, they have to balance the budget sometime. A family can’t go on spending above its income indefinitely; it’s just kitchen table economics!’ Households understand they have to balance a budget, and at its core the world of finance boils down to such homespun truths. I have used that commonsense kitchen table analogy as a filter on every economic and market conversation ever since.

Where concepts are well established, the book doesn’t aim to reference these; for instance, the principles of supply and demand – if demand for a good or service increases, the price of this product tends to increase; similarly, if the supply of a product increases, then the price is likely to fall, and vice versa. If you haven’t covered supply/demand principles before, not to worry, that sentence is all that you really need to know! In this internet-savvy world, references and further reading for common economic concepts can be accessed easily.

Where I discuss thinking or beliefs that are not widely held, or if I present theories that I have developed, I will endeavour to make this clear so you know these views are in the minority. You might discount such views, or see them as a chance to invest when the opportunity for returns is greatest. I don’t believe in all the concepts in this book equally. If there is a weakness in economics, it is that there are too many schools of thought. If I’m only partially convinced on any subject, I’ll aim to let you know. It’s a weakness in any field when a widely held view is embraced dogmatically without enough scepticism.

Wiser people than I have suggested that you can’t be taught anything, you can be presented with information, but it is you who chooses what you learn from it. If you haven’t thought much about economics and markets before and are in the process of trying to understand them (perhaps because you are concerned about your investments), what I would suggest is that you become familiar with a frame of reference as a starting point against which you can compare things.

There is a spectrum of views out there. Generally, in the media we get sound bites, or perhaps a page or two of research focussed on a very small part of the overall picture. Having a broader framework allows you to understand what a snippet of information implies about the rest of the picture. Here I am giving you a framework, and I’d encourage you to think about this as a starting point. Then, as you absorb other bits of information, you can create your own view. Before I had such a framework, I found it hard to position and use the pieces of information that I was getting. I hope my framework similarly helps you.

PART 1

The current state of play

First up, let me take you on trip around the globe. We’ll look at different countries to understand the range of challenges and the subtle differences between similar problems in different regions. Although a lot of the issues look different at first blush, there are some basic structural factors that are common across locations.

1

A short tour of a troubled world

The world is in turmoil. There are concerns about sovereign default and financial system stability. The authorities have been working feverishly for years. We seem to have dodged some bullets, but we really don’t seem to be moving forward. Part of the problem is that there are losses in the system that no one wants to accept, so they are getting shunted around the system.

Ireland – shell gaming ain’t solving

What’s a shell game? It’s when a trickster moves around three coconut shells with a pea hidden underneath one of them, and you have to work out where the pea is! Ireland presents a useful case study in economic shell gaming.

Ireland had a housing bubble. Houses are generally purchased with an element of debt. When house prices rise, household debt levels also tend to rise. While the buyers of houses are taking on increasing levels of debt, the sellers of houses are benefiting from the higher prices that they have received from these houses. By selling, they increase their spending money and that stimulates the economy. A fast-growing economy means people have more money to pay off even larger mortgages. This is a positive feedback cycle, and the reason why a housing price bubble feels like such a great thing for the economy while it is growing – but we all know this now! We also know that housing was misprised.

When the prices of housing fell in Ireland the country entered a deep recession and many people defaulted on their mortgages. This caused losses for the banks. Even a conservative bank has about 10 times as many loans as it has capital. This means that if it loses 10 per cent on its loan book, it will lose all of its capital and become bankrupt. If it loses more than 10 per cent on its loan book, then the losses go beyond the providers of equity (the shareholders) to the people or institutions that have loaned money to the bank – the bondholders, and possibly even depositors.

Following the collapse of Lehman Brothers and the flow-on consequences around the world financial system, authorities have been particularly concerned about the flow-on effects of such losses to bondholders. These concerns led the Irish government to guarantee the losses on Irish banks, so that the Irish government effectively took the losses on to their books.

The pain associated with these losses hasn’t gone away. If bondholders took the hit, they would have borne the pain, and it could be argued that was a fair result. After all, bondholders take a risk by lending to (buying bonds from) these banks, and the risk here was a bad one. However, they are not bearing the pain. Instead the Irish government picked up the losses. As such, the Irish people are shouldering the pain while the debt is paid down.

The size of this debt means the Irish people may never pay it down. It is therefore highly possible that the Irish government will default on or restructure its obligations. This could hurt people that invested in its debt (Irish government bonds), or the debt of the banks it guaranteed, so this pain may not yet have found its final home.

The crisis we are facing across the globe arose because we’ve had paper profits on assets, often paid for by real loans. The paper value of the assets has declined but the loans (an asset to the lender) have not been marked down. It’s a shell game with the pain not being realised but being pushed around, often to end up on the balance sheet of governments. Recognising that the losses haven’t been realised is important. If the people of Ireland don’t understand the problem, then they won’t do the right thing by themselves. These losses must find a home and there are several potential paths it can travel:

the government takes on the losses and they are paid off over a number of years via increased taxes

the losses flow on until they are realised; for example, if the banks in Ireland are allowed to fail, both the equity holders and bondholders will take the hit.

The concern the authorities have had is that losses to bond and equity holders will result in a cascade of losses, causing a string of other banks to fail. This was real risk to the global economy at the time.

A current risk is that people know these losses exist (and are yet to find their final home), so they are cautious about investing until they are more certain that they won’t be exposed to the losses. It is tough to buy a bond, for example, if there is a sword hanging over the bank that issued it.

The size of the problem is so large it can push governments into a debt death spiral (such that they can never pay it down), so even the prospect of governments absorbing the losses doesn’t bring closure to the issue. As long as