The cart before the horse

Back in March of 2009, in a CNBC interview, investor Warren Buffett suggested that President Obama should prioritize reviving the economy which “had fallen off a cliff…and put other problems on the back-burner”.  Buffett, a life-long Democrat, had made it clear that he supported President Obama so that there was every reason to believe that he was offering his best advice. 

As we know, the White House chose “not to let a good crisis go to waste”[1] and, instead, focused on launching Obamacare and on other policies aimed at income redistribution.  In the rush to complete its critical piece of legislation while Democrats controlled the Congress, the White House didn’t spend much political capital trying to reach a consensus with their political opponents[2].

So far, Obamacare has had very mixed results, with both increases and decreases in insurance coverage as well as very large rises in premia for middle class enrollees, particularly at Medicare.  The economy itself has been lackluster, although performing better than its European counterparts.  Sadly, the country is much more divided today than it was in 2008.

A similar situation has developed in Chile, long the best performing economy in South America.  For years, it consistently outpaced its neighbors both in terms of GDP growth and growth in the ranks of its middle class.  In 2014, President Michelle Bachelet started her second mandate with much more radical political, social and economic objectives than in 2006-2010. 

The gist of these was to step back from the liberal economic system, increase state participation in such areas as pensions, increase union power, effectively increase corporate taxation (even at the cost of new investments) and generally engage in income redistribution.  Crucially, the government rushed these far-reaching reforms in Congress with the intent of steamrolling the opposition.  So far, it has been an embarrassing failure.

This new orientation, plus a number of political scandals[3], has resulted in a sharp drop in GDP growth, from 4.1% in 2013 to 1.8% in 2014, 2.1% in 2015 and probably 1.7% or so this year.  Worse, growth in GDP per capita on a PPP basis was only half as much over the same 2013-2015 period.

As in the US, the rush to impose income redistribution measures without spending substantial political capital in search of a broad consensus[4] and without setting the base for strong economic growth has proven ineffective and divisive.

Lest we forget, in 1999 newly elected President Chavez started a far greater redistribution effort which was financed initially by booming oil prices, then price freezes, and finally via nationalizations and expropriations.  No serious effort was made to boost or diversify the economy; every effort was made to replace private initiative with bureaucratic state control.

With the passing of time and the drop in oil prices, any social gain[5] obtained was reversed and turned into massive losses.  Today, Venezuela is on the brink of economic and social implosion.

Critics will object that this post is about promoting selfish capitalism and rejecting socially progressive policies and governments.  They would be wrong.

Case in point, the Socialist President of Chile, Ricardo Lagos.  During his term (2000-2006), he reached a consensus to create a number of major social programs to benefit the less affluent among the population, including unemployment insurance, an anti-poverty program extending into many areas deemed essential[6], healthcare and others.  At the same time, he expanded Chile’s foreign trade potential by signing trade agreements with the EU, the US and others. 

President Lagos clearly understood that to finance income transfers without being socially divisive, you needed to create more revenues by growing the economic pie, via free-markets and prudent fiscal policies.  By the end of his term, GDP per capita on a PPP basis had grown at a rate of 6.5% p.a[7].

It is quite possible that the social programs of President Lagos slowed real economic growth from the 7%+ p.a. of the 1990s down to 5% p.a.[8]  But the purpose of government is not to maximize economic growth but to improve the overall well-being of the population, and 5% in real terms isn’t bad when it also brings social harmony. 

I recall a meeting I attended back then between US investors and the President in which he very bluntly told Wall Streeters that if they wanted to continue enjoying the fruits of Chile’s growth, the less affluent could not be left behind.  He was right.  Mr. Lagos has announced that he is considering running for a second term in 2017.  If he does and wins, I expect him to succeed where many current political leaders are struggling: healing national divisions.

The global economy has been slowing down for almost a decade.  The Great Recession of 2008, excessive reliance on debt to sustain growth and the end of the Chinese investment boom have been as many headwinds.  As Ringo Starr would say, economic growth don’t come easy. 

So far, many governments have taken the easy route: borrow more, inflate financial asset prices, avoid reforms and pit the haves against the have nots.  The dividends of such choices are currently zero.

A wiser, more difficult but more rewarding, course is to recognize that people will accept some necessary hardship if the burden sharing is viewed as fair.  In that same vein, income redistribution in a democracy, unless it is accompanied by (the prospects of) real economic growth is inherently destabilizing.

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[1]  Famous quote attributed to then White House Chief of Staff Rahm Emanuel.

[2]  Conservative Republicans but also the Roman Catholic Church and unions and others opposed Obamacare as drafted but often for different reasons.

[3]  Some but not all involving people in the President’s entourage or political party.

[4]  Even if it meant less ambitious reforms.

[5]  Such gains are highly suspect.  Poverty rates were calculated by the government National Statistics Institute and changes were made to the basic food cost index (canasta familiar) so that it was not comparable with data from before 1999.  So while the apparent purchasing power of the poor was raised, that of the ones better off was reduced as a result of a failing economy.

[6]  Such as health, children education, housing, family, income.

[7]  Despite a difficult first two year period due to external shocks.

[8]

The harder they fall

The revelation that Wells Fargo employees had opened millions of accounts without the knowledge of their customers has come like thunder in a bright blue sky.

Here was the most respected of the big US banks seemingly behaving as the reviled Wall Streeters, after it had touted its plain vanilla business and earned Warren Buffett’s confidence and admiration[1]!

Of course, not everybody cried, as Congressional critics were quick to point out that they had been right all along: big banks were out to trick their customers rather than serve them, and their staff would stop at nothing to earn fat bonuses.  It also provided a timely boost to the controversial Consumer Financial Protection Bureau which uncovered the problem.

Still, the bank has given them ample ammunition:

-         The scope of the fraud, close to two million accounts and credit cards,

-         That some 5,300 employees and managers were fired, hardly “a few isolated bad apples”,

-         That the leader of the unit where the shenanigans had taken place chose that time to retire with US$125 million in stocks, options and retirement benefits, a large chunk of which had been accumulated during her stewardship of the consumer banking unit,

-         Finally, that the bank CEO squarely blamed employees but didn’t name any high ranking executives among those responsible and was vague as to his own accountability.

At the same time, it should be noted that the actual financial damage inflicted on the bank customers was light: some 14,000 accounts incurred an average of US$28 each, and, in total, US$5 million was refunded which works out to less than US$5 per client[2].  This explains why, by today’s standards, the fine was a very modest US$185 million.

Nevertheless, I expect that the final cost to the bank will be much higher.

To begin with, the bad publicity will bite all the more so that Wells Fargo had such a good reputation.  Negative sentiment will weigh on the stock price.

The bank will need to spend hundreds of millions on better internal controls and training.  The decision-making will likely be slowed down as transactions will need to go through lengthier and slower approval processes.  Risk taking will probably diminish, and with it profits as staff will be wary of making career-ending decisions.

This scandal will likely take a bigger toll on top management than we have seen to-date.  Let’s face it, when thousands of employees feel so pressured to reach their goals that they resort to fraud, either (1) they were poorly trained and/or of uncommonly bad character, or (2) the top down pressure was so intense and widespread that it was no accident.  Either way, management is at fault.

Having worked for a large bank, I for one believe that corporate culture determines how business is conducted; it is critical in guiding managers’ and employees’ behavior and decision making.  In this instance, and from anecdotic evidence, I believe that there was a corporate cultural problem.  Setting the appropriate culture IS the responsibility of top management, under the supervision of the board of directors.

A key Wells Fargo strategy toward growth and profitability has also been called into question: the much advertised effort to deepen and broaden the relationship with customers by selling them ever more products.  Yet in recent years, while the goal had been set at 8, they had plateaued just north of 6.  If 6 rather than 8 is the effective ceiling, how will the bank make up for this setback, especially since cross-selling will be under closer scrutiny?

Some have compared this crisis to the JP Morgan “London Whale”.  JPM was punished much more harshly, even though its victims were its own shareholders rather than its customers.  With its “fortress balance sheet”, JPM recovered relatively quickly although it is likely that its future profitability suffered because of rising compliance expenses and lower risk tolerance.

Wells Fargo has in my view a bigger problem: besides incurring greater compliance expenses and dialing back risk-taking, it faces a greater strategic challenge and it may suffer from upheaval in its top management ranks.

For all these reasons, I wouldn’t be surprised if its stock price were to drift down toward book value, i.e. US$36 vs. US$47 today, reflecting a loss of premium valuation and lower future earnings.

Although it is no excuse, I think that the current financial context of quasi-zero interest rates keeps exerting ever stronger pressure on banks’ net interest margins, and Wells Fargo is the latest but by no means last victim.

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[1]  Buffett’s Berkshire Hathaway owns 9.7% of Wells Fargo, a stake worth US$21 billion.

[2]  In the absence of further details, such average number is difficult to interpret.  My own hunch is that some customers were charged fees of about US$30 while others incurred no charges.

On the Cliffs of Marble

When I left France for the US in 1972, as it turned out never to come back, I packed a poster of the north wall of the Eiger and a copy of my favorite book of all times: Ernst Jünger “ Sur les Falaises de Marbre”[1].

This extraordinary book recalls the last days in an imaginary land before its invasion and destruction at the hands of the Great Forester, a cunning and ruthless tyrant who lived in the vast forests nearby.  Jünger started his book while staying in a small town on the shore of Lake Constance.  Years later while on a vacation, I visited picturesque Meersburg and Lindau, drove through the rolling hills behind Hagnau and watched the sun set over the snowy peaks of the Alps beyond the shimmering lake, and memories of the book and its magic rushed back to my mind.

Some have said it was a criticism of Stalinism, others of Nazism.  It certainly was a paean to freedom, to what makes life in harmony with friends, neighbors and nature so precious, and how quickly we can lose these and how painful it then is.

I don’t believe that we are living on the banks of Jünger’s vast Marina.  But I do feel that we are in danger of slipping into a period of greater tension, greater division and failure to address our most pressing problems.  Before too long, and unless we regain our senses, the time for a Great Forester could arrive.

For many reasons, we are left with four candidates to the presidency: a populist and demagogue and Forester apprentice, an aging career politician with truth telling issues, an ex pot entrepreneur, and an activist who spray-paints bulldozers of companies she disapproves of (sadly, the Democrat, Republican and Green VP candidates are probably better than the top of their tickets).

It is difficult to imagine how any of these candidates could unite the country.  Hillary Clinton is probably the one more likely to try and build consensus because she is the one who most lacks a committed base, but can she bridge the trust gap?

Meanwhile, Americans are more divided than they have been in decades.  It is both ironic and sad that they were most united when President Obama took office in 2008.  Responsibility for this can be spread wide, and because of that, redemption will be hard to reach: Tea Party extremists unwilling to compromise, main stream Republicans unable to deal with them and the opposition, Democrats in Congress and the White House enamored with diktat and income redistribution without GDP growth; most of all, politicians deaf to popular angst and aspirations.

Against this dreary political background, the economy and the financial markets have been operating with a high degree of wariness, where extreme monetary policies have attempted to offset the absence of fiscal reforms and pro-growth policies.  The fix has carried increasing risks: financial assets are overpriced, public pension funds are hugely under water, the insurance industry is at risk and even consumption is threatened by the need for households to save more when 10 year Treasurys yield a meager 1.7% p.a.  

So we have a divided political class, a divided nation, a subpar economy and stretched financial markets.  I might add that the same combination of slow growth and excessive indebtedness is pressuring governments and traditional parties and giving openings to populists of all kinds around the world.

As an investor, I would think that prudence is in order.  Sure, stocks are not as expensive as bonds, but does that make them attractive, as a class?  Not really.  There is nothing wrong in keeping stocks of steady performing companies, or in buying into carefully chosen turnarounds.  But if one keeps a large exposure to equities, buying some protection seems advisable to me.

Alternatively, cash does look like a good temporary alternative.  Another one is real estate.

History shows that people and countries don’t change until they have to.  In America, I don’t think we have reached that point, nor do I see anyone able to mobilize the nation.  History has also shown that it takes time for a large country or economy to change direction.       

Caveat emptor!

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[1] On the Marble Cliffs.