JACK BOGLE LIVES TO 114: PART 1 ASSET ALLOCATION

Jack Bogle is 86. He is an absolute legend, founder of Vanguard Investments and #1 proponent of passive index investing. It was disclosed today that Bogle-san personally has a higher weighting in bonds than equities for the first time (53% bonds/47 equities).  Let’s take a stab at calculating the duration of Jack’s portfolio. The duration of the US bond market is 8 years, hence the bond component estimate is a modest 4.24 year (0.53 * 8). Equities are a great inflation hedge, primarily  because they have a very long duration. For the US stock market, as a whole, is it approximately 50 (price/ dividend ratio, 100/2), contributing 23.50 year of duration to the portfolio, for a 28 duration aggregate. Math geeks can rightly protest this is too simplified, and it is (higher level math and many assumptions are required to fine tune) but the real # is higher, not lower, so simmer down.

This investment mix, assuming Jack is planning for his purposes solely (wait for PART II – Estate Taxes) takes his investment portfolio, from a duration perspective, to his 114th birthday. Not to burst anyone’s bubble, but Japan is the master of the supercentenarian lotto and women make up 87%+ of the 60,000 Japanese >100 years old. The oldest Japanese man presently is Yasutaro Koide (112) who resides in Nagoya, Japan.

Asset allocation has been shown to be more important that security selection over long periods of time. Bonds, as an asset class, are not “easy”, as anyone even brushing up against the high yield component this month can attest, but it is worth the effort. The merit of municipal bonds for US taxpayers can not be downplayed as “It is not what you make, but what you keep.”  Power to you Jack Bogle, we are rooting for you! JCG

Note(s):

i) Duration, in bond land, is the 1st derivative of the price/yield relationship (ratio of price/yield). The 2nd derivative, to be profiled in an upcoming post, is convexity (positive convexity is an awesome security feature). Generically, across asset classes, duration can be defined as the elasticity of the security price with respect to changes in the gross rate of return.

ii) If you found this post of interest, follow me on twitter @firehorsecaper as my 11 year old pointed out it is not cool to be following more people than follow me.

Tough week to have to raise rates, but I think Yellen will hike. It has been 9.5 years since the last hike in June 2006.  The FOMC (Papa Gruff) has broad shoulders and can afford to get rates officially off the zero bound. As others have pointed out, much of the initial move is already factored into Fed Fund futures (approx. 75% at time of writing). The ECB (Baby Gruff), despite their most recent disappointment (bridge overload), remains in QE infinity mode, as does the BOJ (Mama Gruff). 12-18 months out EUR/USD at 0.95 and USD/JPY 140.00 are not out of the realm of possibility if both goats were to sit out an entire monetary cycle.

Much of the what has been playing out in the markets since the 2013 Taper Tantrum is grounded in divergent central bank policies. The DXY is near its highs. As fellow peanut gallery member dyer440 noted in his most recent “oil gambler” piece, oil has a very high statistical inverse correlation to the USD (75% over the last decade). All former lottery winner countries are getting taken to the mat quicker than a UFC featherweight title fight. The currencies moves have been extreme to the downside; BRL, ZAR, MYR, NOK, CAD, and AUD, all cannon fodder until further notice.

PBoC (Troll) has been under the bridge for a long time. The Chinese troll is not scary just because of his size in terms of dwindling appetite for iron ore and other base metals. Monetary policy could not be effectively managed in a fully closed system, but things are changing rapidly. I wrote a brief note Nov. 30th on  the most recent decision by the IMF to include China’s Renminbi as a component in the Special Drawing Rights (SDR) basket. China is joining the easing party. Having guided the Yuan to a 4 1/2 year low (spending nearly $700bln of their reserves to keep the pace “measured”), bigger moves are afoot. PBoC signalled its intent last Friday to change the way it manages the Yuan’s value and feel it is better measured against a baskets of currencies (much like the SDR they just got added to/ qualified for). The timetable is unclear with respect to implementation. This news falls well short of abandoning the loose peg to the Greenback, but all should take note, the Troll is not slumbering. JCG

BTG Pactual, the once darling of the emerging market investment banking scene, appears to be in its death throws. Andre Esteves, ex-CEO, is wearing much wider pin stripes than he would like in Brazilian prison, with no day passes for Carnival. The arrest came on Nov. 25th (formal charges, accusing Esteves and Brazil Senator Delcidio do Amaral of obstructing a criminal investigation were laid Dec. 7th) as a result of the on-going Operation Lara Jato (Operation Car Wash), Brazil’s largest ever corruption case. Twelve + private companies, involving upwards of 100 individuals are accused of paying bribes to secure contracts with Petrobras, a publicly listed (incl. a US listing importantly, subject to the Foreign Corrupt Practices Act) company which Brazil owns a controlling stake.

Sete Brazil is a private company which was co-founded in 2010 by BTG Pactual, Brazilian banks and Petrobras (9%). Sete had 28 charter agreement with Petrobras, representing over $89bln (total backlog) with a 14.5 year duration. The total investment to build the 29 ultra deepwater rigs (with 5 different shipyards in Brazil) was $26.4bln.  We have all seen what has transpired in oil & gas land over the past year. A group of five Brazilian lender extended $5bln to Sete Brazil in June 2015 in an effort to stave off bankruptcy. The Sete rig plan has been cut to 18 (14 underway) with $3.6bln of the aforementioned loan still o/s with repayment pushed to 2016.

Others have pointed to the Andre Esteves arrest as  being the equivalent of Lloyd Blankfein, Goldman’s CEO being arrested, perp walked down Wall Street and thrown in Leavenworth. On some metrics, the scale of this story is bigger. It was most recently reported that Mr. Blankfein’s net worth is estimated at $1.1bln. Andre Esteves is also a self-made billionaire, recently reported to be worth $2.2bln (2 Lloyds), #13 in Brazil and #628 of Forbes 2015. Esteves owned approx. 23% of BTG Pactual equity and the all important Golden Share that gave him largely unfettered management control. Subsequent to Mr. Esteves’s arrest the “top 7”, as they are affectionately referred, have taken control of BTG Pactual. The Golden Ticket was shredded and Esteves’s common exchanged for preferred shares (exact terms not disclosed, but note pref shares rank ahead of common in a wind up). Challenges lie ahead. Both major rating agencies have stripped BTG Pactual of their former investment grade rating (now BB-/Ba2, both with negative outlook). Moody’s is a press release on Nov. 25th stated, “BTG Pactual CEO’s absence could hurt credit rating.” Over 1/2 of BTG Pactual’s BRL30bln (US$8bln equiv.) in funding comes form wholesale sources. A finger has been placed in the dike, as BRL6bln has been provided to BTG Pactual by Fundo Garantidor de Creditos, a private deposit insurance plan funded by the Brazilian Banks. Non-core assets are being sold to further bolster liquidity, with some success. Singapore’s sovereign wealth fund GIC purchased BTG Pactual’s 25.6% stake in Brazilian hospital chain Rede D’Or BRL2.38bln (US$618mm). BTG is also looking to sell BSI, the Swiss private bank they bought less than 6 months back, with CS and Julius Baer said to be potential bidders. BTG Pactual’s USD bonds, BTGPBZ 4% 01/16/20 have lost about 44% of their value in recent weeks, falling from $90.00 to $50.00 (dipping into the $40’s). BTG Pactual equity also fell by 50% over the same period but appeared to have a floor at BRL15.00, until today. The stock is down another 12% to BRL13.22 in early trade today.

A billion here, a billion there, and pretty soon you’re talking real money. 12/09/15 Moody’s placed Brazil’s Baa3 issuer, bond rating for review downgrade. Moody’s does not see a turnaround likely in 2016 for Brazil. Investment grade ratings are hard to achieve, and it appears even harder to maintain. JCG

Note: USD/BRL (US Dollar / Brazilian Real) exchange rate stands at 3.75 at the time of writing, down 44% over the last year (2.60 on 12/09/14).

Obama has kept to his 1st term campaign promise with respect to coal, that is for certain. Coal has had a tough run since 2008. Twenty-seven coal companies have filed for bankruptcy since 2012. The Clean Power Plan has since assisted in kicking  up the pace of the coal steamroller.

$KOL, the ETF for the coal sector (tracks the Stowe Coal Index of global listed names with revenues from coal >50%) hit an all time low last Friday, December 4, 2015. The index is down 54% in the last year and a full 87% from the 2008 peak. The 2nd largest constituent in KOL is China’s Shenhua with a 9% weighting. Shenhua, China’s largest coal player is expected to produce and sell in excess of 500 million tonnes of coal in 2015 (215,000 employees versus 80,000 for the entire coal mining industry in the US). In total, China produces almost 4bln tonnes (3.87 rounded up).

There is no value or “mean reversion” strategy that will save the day for the macro coal outlook at this juncture, in my view. Clever exit strategies are likely more appropriate. Those with equity exposure might want to vet the 1st lien bond portion of the capital structure and flip their long equity position to a short (to estimated recovery rate) as a hedge. Senior unsecured recovery rates in some of the recent coal cadavers, such as Walter Energy (r.i.p. 07/15/2015) has been <5%, a feat hard to match in non-technology names.

China both produces and consumes more than 50% of global coal production. Coal demand is set to plateau with China’s coal-fired power plant moderization plans, but from a standing start 40% of China’s overall energy draw and 66% of their power is coal derived. US electricity is 39% coal generated at present (alas the Tesla Model S is not powered by dried Unicorn dung, its’ power is more coal derived, upon further investigation, than a Denali Hybrid).

Looking to fossil fuel c02 emissions from power production globally, currently 73% are from Thermal Coal, 20% from Nat Gas and 7% from Oil. At current coal prices 1/2 of known coal reserves should stay in the ground. To meet global climate change goals 80% should. Nat gas produces 50% of the co2 of coal per BTU.  It may not seem so right now, but Nat Gas appears to be the prettiest girl at the dance. JCG

Note: Proven coal reserves currently stand at 893 billion tonnes globally (110 years worth at current production levels).

Much of the press on Myanmar has been on the most recent election. 90 parties were in the running, 88 D. Trump’s and 2 real contenders with the ruling USDP (Union Solidarity & Development Party) handily unseated by Aung San Suu Kyi’s NLD (National League for Democracy) party.  Yangon (formerly Rangoon) remains the centre of power. Myanmar (formerly Burma) is the largest country in SE Asia (1.6x CA) with a population of 60 million (France has 66mm for reference). While the population of Myanmar is 68% Burman (incl. Suu Kyi, the new leader) there are 100 distinct ethnic groups within Myanmar. It is like a Benetton commercial, except with more tears.

This post is not about the Myanmar elections but about what developed nations like the USA could do to further the plight of this poor country (#149/186 on the UN list of poorest countries), namely lifting long standing trade sanctions. Per capita GDP in Myanmar is $1,200 with 15mm making only $1.25 a day. Trenton, NJ’s (“Trenton Makes and the World Takes”) per capita GDP is $17,400 ($48/day).

As China finally gets real progress underway on “One Belt, One Road” (OBOR, 21st Century Silk Road), an initiative all should get up the curve on (trade flows, fx, infrastructure, commodities), the US would be well served by having an ear to the ground . The Greater Mekong Subregion (GMS), which includes Myanmar, Thailand, Cambodia, Laos, Viet Nam and the Yunnan Province – PRC has a population of > 325mm. The East-West corridor of the OBOR project runs a full 1,450 km from Myanmar to Viet Nam.

Myanmar is the 6th largest producer of rice with over 20mm acres in production. Agriculture makes up 36% of Myanmar’s $64bln economy.

A full 90% of the fine Jade on planet Earth originates from Myanmar (Kachin Province in the North). The strongest bid has always been from China where > $10bln worth of Jade was imported in the last year. Jade, with a 2014 value estimated at $31bln (16mm kg) makes up almost 50% of Myanmar’s GDP (tax receipts a scant 2% of production). Burmese Jadeite export to China has been a lucrative trade since the 3rd century AD. The November 22, 2015 landslide at a typical Myanmar jade mine which took the lives of >100 souls was a stark reminder of the typical harsh conditions.

The time to try and influence a more equitable sharing of the jade mining spoils is now. Some recent market intel estimates that upwards of 2/3 of global high-end earth moving equipment is deployed in Myanmar jade mines (financed by Chinese interests). As one would guess, the “efficiency” gains are considerable, mines with a former life of 3 years have been compressed to a couple of months. They will make a movie about it someday. We should try and write an alternate ending.

As a frontier market, Myanmar is not green lighted by many global institutional investors yet. Accredited investors on the private lending side can achieve 15% returns in US$ on 2-3 year term deals, documented under Singapore Law. Telecom is a hot sector (highest growth rates globally, incl. Africa) as is Yangon real estate. JCG

The tobacco space, from an investment perspective, is fraught with peril.  That said, Tobacco Bonds are some of the most liquid and highest yielding segments of the US municipal bond market.

Smoking rates in the Developed World have plummeted (less than 20% of Americans currently smoke versus peak levels of 30% when 53% of men smoked, in the “Mad Men” era). Smoking rates in the US have declined, on average 3.3% per annum from 2000. US cigarette shipment are set to print their first positive growth print since 2006 in 2015, which has resulted in a rally (9% return ytd) in high yield tobacco bonds, after a stonking 19% rally in 2014. Most see this uptick as an outlier, with the downward consumption trend firmly in place.

Perhaps the largest Structured Settlement case study ever is the “Tobacco Bond” segment of the municipal market where US States (17 of those States eligible to do so) securitised a portion of the approx. $206bln Master Settlement Agreement (MSA) made with the major tobacco companies in 1998. Over $90bln of Tobacco Bonds have been issued. There are $32bln in senior lien (par amount) outstanding with $19bln rated below investment grade. Phillip Morris, Lorillard and Reynolds American agreed to make annual payments to US States to resolve liabilities for health care costs related to smoking. The bonds were largely issued on a non-recourse basis, hence the bond investors have their repayment prospects tied to on-going cigarette shipment volumes. Many of the bond structures underestimated the pace of smoking cessation and the rating agencies estimate upward of 80% of the o/s bonds will result in a partial loss of principal (extension of maturity dates in most cases). Plenty of clever muni houses troll in this space which is likely the best way to gain exposure given the inherent complexities in selecting specific bonds. Most funds limit their exposure to the space to 15-20% of fund AUM. One of my favourite bonds in the space when still on US soil, in the top Federal tax bracket, was Illinois $1.5bln “Railsplitter” deal of 2010 which was structurally superior to all before it in that with a 17.5 year maturity (many deals had 30+ year final maturities) and it was able cover debt service even with smoking rates declining by 10% per annum (levels still never seen).

Asia tobacco sidebar: Recent cigarette stats out of China are beyond comprehension, where it was recently reported that  68% of males > 15 year old currently  smoke cigarettes. The “normal ratio” of male to female smokers is 5:1 but in China is approaches 20:1 with a scant of women 3.2% partaking. A full 1/3 of all cigarettes sold globally are sold in China (versus their 17% population weighting). Nobody to sue here, as China Tobacco runs the show. Tobacco related revenues account for upwards of 7% of China government revenues presently. A full 30% of Chinese males are projected to eventually perish from smoking related illness at current consumption levels. Next to be sorted will be the price elasticity equation, as these heady revenue numbers are achievable with a pack of Yellow Crane Tower smokes selling for US$0.40 equivalent! With the near nationwide ban on smoking in US prisons (the US has 5% of the world’s population but incarcerates 20% of the world’s prisoners) there are reported cases of single prison cigarettes selling for US$30.00. Odd that the US would push for such a government sponsored longevity study when the cost per inmate is so high, but that is a topic for another day. In India, over 75% of cigarette consumption is in single cigarette (aka loose) format, a practice Modi would like to ban but enforcement will be all but impossible. ITC controls 80% of the tobacco trade in India and they are sold through 7mm+ establishments (sole proprietor corner stores primarily).

Phillip Morris (PM) equity trades at a PE of 19x with a dividend yield of 4.67%. Reynolds-Lorillard (RAI) merged in mid 2015 and sports a PE of 17% and a dividend of 3.11% (Reynolds bought the 4th signatory to the MSA is 2004). For those willing to put in the work there could be compelling “hedged high yield” trades worth considering where you buy the tax exempt tobacco bond (most effective for those in the highest 38.6% Federal tax bracket)  and hedge via shorting PM and RAI stock to your deemed recovery value. Higher order analysis is required as the Tobacco Bond coupon is tax exempt (muni interest is not subject to 3.8% Obamacare investment tax either) and you would be cross hedged in a taxable instrument with a high dividend which you would be on the hook for. If you think big tobacco equity is fully valued + and that there is too much pessimism built into the high yield Tobacco Bonds, this strategy certainly reduces the funding cost of the position. JCG

Natural Gas is now trading at levels not seen since 2002. We stand today at $2.10 per MMBTU (one million British Thermal Units, aka BTUs). The January 2016 contract traded in the past week at all time contract lows. For reference, when Brian Hunter of Amaranth fame tried to divine a nat gas price spike over the Winter of 2006/2007, price were at $5.11 per MMBTU. A massive inventory build in the USA and unseasonably warm temperatures (New York enjoyed temps in the 70’s through much of November) have been given credit for the plunge. I officially call codswallop on this natural gas swoon.

New York is not Singapore.

Latitude (an internationally sanctioned measure of the distance from the equator):

Singapore 1.3 degrees N

Beijing 39.92 degrees N

New York 40.71 degrees N

Beijing just endured the coldest November it has experienced in 6 decades (not 6 year, or 16, 60 years). The Chinese government (smart lads, reference the IMF’s SDR announcement of yesterday) wants to promote the use of natural gas in China. Coal still makes up a full 40% of China’s energy needs (Mad Max poor air quality this week exasperated by El Nino, apparently). Airborne particulate from NG is 1/10 that of coal. China cut NG prices by 30% for non-resi customers as recently as October 2015 to spur demand which was running at a growth rate of 5%. China shortages of NG are now running at 40% versus ramped demand, due largely to the November cold snap. This market can turn quickly. January 2016, I see a 3 handle. JCG

Disclosure: Long NG

Note: BTU = heat required to heat 1 pint (16 oz.) of water by 1 degree Fahrenheit. 3,412 BTU = 1 kWh

A pivotal week in the world financial markets lies ahead. We kick off today with the IMF’s decision on giving the Chinese Yuan the “Fisher Price” (safe to play with) stamp of approval on inclusion as a component in the Special Drawing Rights (SDR) basket (aka reserve currency status). The delta is high on a yes result, given previous carping by Legarde et al, with the most likely weighting being 14% (USD is 41.9%). On the trade importance metric, China get a large check mark, with 12% of global trade. The qualification metric of being “freely usable” has been cut with an unknown substance to read “widely traded in the principal exchange market”. It appears China will get a participation trophy reflecting its’ size (2nd largest economy at US$ 10.4 tln. equiv. vs. $17.4 tln for the USA) and economic reforms made to date (i.e. partial elimination of capital controls).

While this pivotal decision could attract upwards of US$1 tln to the Renminbi (people’s currency) over time, China macro is a tad cray cray at present, leading some leading houses to estimate near term inflows as low as +US$40bln on a yes vote.

Even the CNY (onshore Yuan) bulls thinks it depreciates by 3-6% vs. USD over the coming year. The bears see CNY off by 17% from current levels by the end of 2016 (7.50 vs. 6.3944 as at 30/11/15). Plenty of information on the interweb about CNH (offshore Yuan), but suffice it to say CNH is on its’ back foot for the foreseeable future.  It trades 570 pips back of CNY at 6.4515 and is presently looked at as the canary in the coal mine wrt further PBoC easing measures when it trades >450 pips cheap to CNY. CNH was a popular carry + appreciation trade for several years running but those days are over. The Dim Sum bond market stands at US$500bln equiv. remains small in relation to the onshore bond market in China (120% of GDP). Rates in China are at 4% with inflation running at 2%, hence the scope for further easing is world leading (assuming negative rates in Europe lose steam at -0.65%).

Less than 5% of Chinese nationals hold a passport, versus 40% in the US. 15-20mm more Chinese passports are issued every year. The stories of global real estate being Dysoned up by Chinese investors will likely continue unabated  (NYC, London, Paris, Vancouver, Sydney & Christchurch). UHNW Chinese want lower beta investment strategies in currencies other than CNY. The impetus is likely not purely on an asset allocation metric, based on return profiles, but rather on the near term risk of wealth confiscation. The on-going anti-corruption, anti-graft investigations are far reaching.

A betting man would wager that, at least in the near term, the “I Yuan out” camp wins out. JCG

Malaysia is getting a lot of press these days, and not much of it favourable.  Obama is fresh back from his trip to Malaysia where last week be attended the ASEAN-USA Summit in Kuala Lumpur (KL), the Capital of Malaysia. Some expected Supreme Leader to at least figuratively box the ears of Malaysia’s leaders over the on-going 1 Malaysia Development Berhad (1MDB)  scandal which had been well covered in the popular press (WSJ and other venerable publications). No such calamity ensued, perhaps given the tender stage of TPP discussions where President Obama needs all the allies he can muster, which could give Najib near term immunity (at least until the next challenge).

Tomfoolery has prompted foreigners to pull US$7bln of assets out of Malaysia in 2015. At this stage, it might be helpful to put all this in context. Malaysia is a big country. KL lies 9,400 miles from New York City. California is 1.3 times bigger,in terms of land mass, than Malaysia. CA’s GDP is US$2 trillion versus Malaysia’s $315bln. California’s population is 39 million versus Malaysia’s 30mm. In per capita GDP terms, California is $51,300 to Malaysia’s $10,500. The economy of Malaysia is the 3rd largest in SE Asia after Indonesia and Thailand. Malaysia is the 3rd richest, as measured by per capita GDP after Singapore and Brunei (Singapore at $55,200, Brunei at $38,500 with the USA at $53,000, for reference).

Not all the news is bad. For the first half of 2015 Malaysia’s GDP grew at 5.4% and is projected to grow 4.5-5.0% for the full year. Malaysia is growing at a pace well ahead of developed market economies (6% in 14′) despite headwinds. Malaysia has a sizeable ($100 bln+) and well funded pension plan, the Employees Provident Fund (EPF) which has upwards of 23% invested internationally (capped at that level near term, but up from < 10% less than a decade ago). Government debt as a % GDP stood at 53.9% as of the end of 2014. Federal explicit guarantees at the end of 2014 totalled 16% of GDP.

Within SE Asia, Malaysia is the most exposed to falling commodity prices (in terms of net exports and the government’s fiscal position). Global petrochemical prices have followed crude lower. Nat gas and palm oil make up 7.7% of exports in Malaysia. The famous Petronas Twin Towers were completed in 96′ at a cost of $5.6bln and held the record as the tallest towers in the world for 6 years through 04′. MYR, is the ticker for the Malaysian Ringgit which stands at 4.27 per USD and is down 27% from a year ago. Only the Brazilian Real has fared worse, down 57%. Other oil weighted economies have seen their currencies bruised as well; Norwegian Krone down 27%, Canadian Dollar down 17%, South African Rand down 27% and the Aussie Dollar with its’ iron ore derived umbilical cord to China, down 17% year-over-year.

1MDB is a “strategic development company”, wholly owned and controlled by the Federation of Malaysia (A3/A-). With approx. US$9bln in debt, 1MDB represents Malaysia’s largest contingent liability. A nearly perfectly timed (pre-Obama would have been ideal) lifeline has arrived with the inking of a deal to sell 1MDB’s prime Edra energy assets to China General Nuclear Power for MYR 9.83bln (US$2.3bln), plus the assumption of related debt the deal could be worth MYR18bln (US$3.9bln). Clearly the debt reduction was welcome, as some foretold something closer the magic beans under all that 1MDB debt. Malaysian CDS (5 year) has rallied to 176bp (in 56bp from October 5, 2015 when it stood at 232). 1MDB’s US$ debt has rallied smartly as well ($10.00+), OGIMK 4.4% 03/23 isin XS0906085179,(A- rated) yield 6.31% (+406 CT10), asset swapping (par/par basis) to 3 mth USD L+443. When Malay 5 year CDS was at 232 1MDB debt was yielding 9.44% eclipsing B rated Mongolia (Mongol 5.125% 12/22) which was yielding 8.53% (L+600).

There are more layers to this onion that I have time to write or you have time to read. Scaling the size of the problem can be useful. Pre-paydown from the recent Edra energy asset sale the 1MDB debt at $9bln was <3% of Malaysian GDP. Troublesome yes, lethal no. Perhaps the better question is why is a country endowed with relatively rich natural resources is languishing at 10k per capita GDP after gaining independence 55+ years ago. JCG