January 18, 2011

Stagflation and the Brownian Motion to Mean Labor Costs

Today's spread between "countries who can (do it cheaply)" and "countries who can't (compete on cost)" is closing, and this is closing as consumers increasingly make price based choices.

So what does this mean? My guess is that G7 "stagflation" is the pull of localized wage deflation (stagnation at best) versus the push of exported emerging market wage inflation. Maybe we can blame the free flow of capital, perhaps the free flow of information, or even the encouragement of global democracy. In any case the cheap labor of the world has finally got the means to take notice of their lot in life and they are and will continue to demand more.

Compounding this may well be consumers tightening their belts by consuming cheaper instead of less. This puts upward pressure on cheap G7 external labor while simultaneously putting unemployment pressure on G7 internal labor. This translates into a higher cost of cheap goods independent of G7 wage or employment growth, and that sounds like stagflation to me.

Will this change the price of a Monet? Doubtful. But it will continue to effect high end retailers the more expensive end of the non durable consumer cycle.

November 17, 2010

November 10, 2010

ReInsurance and Discounted Book Value - The New Normal?

ReInsurance executives are painfully aware of their discounted valuations as measured by enterprise book values. With an excess of underwriting liquidity and a soft market for short tailed liabilities, Reinsurance executives point to "the cycle" as the culprit, implying better days ahead. Many believe that capacity destruction through reduced capital (either via buybacks, special distributions or industry loss) will create a tighter market, hence bankable premiums and an expansion in enterprise values.

With real interest rates zero to negative and nominal rates near zero, it makes sense that the short tailed trade (CAT) has become flooded with capital (pun intended). These near zero investment rates mean that Reinsurers are completely reliant on underwriting returns in the short tail.

Reinsurance price to books have typical ranged from 0.85 to 1.6 with the current idiosyncratic environment driving books in a lower 0.7 to 1.0 range.The industry assumption is that the soft market, low combined ratios, and historically weak returns on capital have collectively caused investors to discount Reinsuance enterprise values.

But every actuary knows that correlation does not imply causality. The discounted book state that the industry finds itself in could be the aggregate result of some emerging factors that may lead to a new normal in valuations.

Consider the alternative: The ISL ILW secularized market is gaining traction as the returns (having shown uncorrelated to credit) are reinforcing alternative asset investor's view that insurance exposure is an asset class. The long awaited adoption of securitized reinsurance is no doubt catalyzed by an extremely favorable comparison to near zero investment yields. It is important to understand that this short tailed exposure can be accessed at par. This means that an investor can gain access to short tailed reinsurance exposure at or near the equivalent enterprise value of book.

Another factor that may influence discounting is the market's fear of financial non transparency, driven by the events and subsequent disclosures of 2008. Reinsurance accounting allows for some flexibility in loss reserves that make the tangible nature of book difficult to grasp. It seems reasonable for a rational investor to discount this uncertainty, particularly in light of the existence of a fully transparent alternative means of access.

And finally, as underwriting returns in the short tail should be more volatile than investment returns in the short tail, and the mix of return contribution shifts to 100% liability returns, it would be logical for investors to factor in the volatility of the enterprise returns when considering valuation.

Dismissing the impact and persistence of these emerging factors in explaining the current state of reinsurance price to book valuations, may prove wishful thinking. Of course future book premiums may be in the offing, but these new headwinds certainly won't facilitate that scenario. Alternative access will most likely keep a tight lid on book values for short tail predominated businesses, while the uncertainty in the meaning of reinsurance book value will weigh heavily on valuations.

Of course there are actions Reinsurers can undertake, given the current valuation and interest rates environment. Reinsurers capital structure can be adjusted by swapping equity for debt on the balance sheets. Accretive buybacks of equity and access to cheap financing make for a compelling argument.

Regardless of the course of action existing Reinsurers take, new entrants will find capital formation difficult in an environment where sub book investment alternatives persist. In turn, alternatives will continue to gain traction. Paradoxically, discounted book itself may help facilitate a further adoption of alternative structures at the cost of traditional company capital formation, thereby reinforcing the persistence of discounted book.

September 15, 2010

Japan Inc. vs the Speculators

Here we have a classic matchup.
A Sovereign bank vs market speculators. If you recall the classic match up of the early 1990's (Market led by George Soros vs Bank of England)

The UK's prime minister and cabinet members tried vehemently to prop up a sinking pound and withdrawal from the monetary system the country had joined two years prior was the last resort. Prime Minister Major raised interest rates from 10 to 12 percent, then to 15, and he authorised the spending of billions of pounds to buy up the sterling being frantically sold on the currency markets however the measures failed to prevent the pound falling lower than its minimum level in the ERM.

The Treasury took the decision to defend Sterling's position, believing that to devalue would be to promote inflation.[5] On 16 September the British government announced a rise in the base interest rate from an already high 10 to 12 percent in order to tempt speculators to buy pounds. Despite this and a promise later the same day to raise base rates again to 15 percent, dealers kept selling pounds, convinced that the government would not stick with its promise. By 19:00 that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would remain at the new level of 12 percent (however, on the next day interest rate was back on 10%). It was later revealed that the decision to withdraw had been agreed at an emergency meeting during the day between Norman Lamont, Prime Minister John Major, Foreign Secretary Douglas Hurd, President of the Board of Trade Michael Heseltine and Home Secretary Kenneth Clarke (the latter three all being strong pro-Europeans as well as senior Cabinet Ministers), and that the interest rate hike to 15 percent had only been a temporary measure to prevent a rout in the pound that afternoon.

the Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM) after they were unable to keep sterling above its agreed lower limit. George Soros, the most high profile of the currency market investors, made over US$1 billion profit by short selling sterling.
Source Wikipedia

By contrast, Todays matchup is altogether different. Speculators are buying Yen as a safe haven currency as they regard the BOJ's lack of will to print yen, and it's position as the second largest investable economy (China is not there yet) as the only credible safe haven from dollar and euro risks. So there is no end game, just a parking spot.

Given Japan's deflationary domestic economy and it's fundamental need to export to survive, BOJ should be printing with reckless abandon. Building up foreign reserves would not be inflationary, and it would give Japan some global clout to defend against an economic collapse of it's own.

Unlike, Black Wednesday, the speculators have no capitulation trigger to press on.
Additionally, the is nothing to stop Japan's MOF from printing ad nauseam.

Sempre Fiat!

August 18, 2010

Here's a Link to my Newly Published Paper in All About Alpha

Many thanks to Christopher Holt and Staff at All About Alpha