Scotland as a Sovereign Credit: A Preliminary Glance

A year from now, Scotland will vote on independence. The Scottish National Party has published its 667-page blueprint for “Scotland’s Future”. I have looked at the document and have read some critiques of it. It is a bit daunting to try to read the whole thing at one sitting. It’s not a light read.

The SNP’s white paper raises many interesting questions, such as:

1. The legal status of UK nationals residing in Scotland, and vice-versa.

2. The formula for dividing up the national debt.

3. Relationship with the EU.

4. Currency arrangements.

5. Security arrangements: neutrality, or alliance with the UK and NATO?

6. Immigration policy.

7. Form of government: kingdom or republic?

8. If a kingdom, which royal house?

9. A written constitution?

The white paper purports to answer these questions, but the UK government has agreed to nothing whatsoever. The document represents a Scottish wishlist, nothing more. Scotland cannot propose a Confederate-style secession on unilateral terms. Rather, she will have to secede as the result of a mutually negotiated settlement with the UK. In such a negotiation, she holds very few cards. The UK government can say nyet to to everything, if it wants.

What I would like to do is to look at an independent Scotland as a sovereign credit. Unfortunately, the white paper does not resemble a rating package or even an offering circular. It is a political manifesto with the occasional nugget of useful information.

There is already quite a bit of literature about the fiscal outlook for an independent Scotland. This is a contentious subject in which my expertise is limited. I would prefer to look, today, at Scotland’s external position.

The SNP’s plan provides for the Bank of England to act as Scotland’s central bank. Instead of adopting the euro or a new currency, Scotland would keep the British pound.

I will dispense with the problematic question of British consent to such an arrangement. After all, any country can adopt any foreign currency as its domestic currency, just as a number of countries use the dollar without permission. I will also ignore the question as to how Brussels would feel about a candidate member opting out of the common currency.

My question, as a credit analyst, is: How would Scotland’s external position look?  Independence does not mean escaping the UK debt-free, given that the parting would be by mutually negotiated agreement. Scotland would have to accept a pro-rata share of the UK national debt. Thus, Scotland would sail forth burdened with a substantial debt load (perhaps ~75% of GDP) denominated in foreign currency, and would perforce continue to borrow in foreign currency. I say foreign, because I cannot see a Tory-led government agreeing to cede any degree of political control over the BofE to a socialist foreign country. (I say Tory-led since Labour would be the loser without Scotland.) Countries such as the Bahamas, El Salvador, Panama and Ecuador can adopt the dollar if they choose, but that only allows their central bankers to gaze at the Eccles Building from Constitution Avenue. It doesn’t give them a seat on the FOMC.

Should Scotland adopt sterling as its currency, it would be committing mortal sin at birth: owing a lot of debt in a currency it can’t print, just like the PIIGS on the continent. The Scottish financial system will be 100% “sterlingized”. Needless to say, this would be a very interesting country and banking system to analyze and rate. I can predict this much without having seen any official numbers: Scotland is not AAA. The Scots will point to Norway, but Norway has no debt, a great track record, and a large sovereign wealth fund. I would point to Ireland.

Because Scotland must command continuing access to the international debt market, she would have to be quite self-disciplined in her fiscal policies. No Troika rescue for her (unless she joined the eurozone). The UK has been allowed by the market to run big fiscal and current account deficits because she prints her own currency. Had the UK joined the eurozone, her rating would be lower today, and she might very well have become a PIIG herself: the UK has had some very bad numbers since the Crash. An SNP-ruled Scotland, with its leftist social-welfare agenda, would not be permitted to run a large fiscal deficit, because she will have to continually roll her debt, just like Ireland and the other PIIGS.

What kind of an economy is Scotland? I would say volatile, due to dependence on oil exports and related economic activity. What kind of a credit would Scotland be with Brent crude at $50? One would like to know the oil price below which the government runs a deficit, and then run  oil-price simulations to suss out the probabilities. Given that we’re talking about expensive North Sea oil, my guess is that the breakeven is a pretty high price: far above the Gulf states’ breakeven. In other words, a somewhat fragile credit given its debt load. Not Norway.

Another potential roadblock: How do you separate one sovereign obligor into two, without the original obligor guaranteeing the other? There is no provision in the UK’s bonds for credit substitution, and there is implicit protection against such an event.  Is the UK is going to call its debt and replace it with a securities package, as in a distressed exchange, or would the swap be voluntary? Is any of this legal under English law? What recourse would gilt-holders have? You can bet that the hedge funds would bring suit, since Scottish bonds are likely to trade below par. Will the UK have to guarantee the bonds that are assumed by Scotland? That would work, but would be politically unpopular down south, because the UK can’t force Scotland to honor its debts.

And what are we to make of the bonds that the UK is selling today? Do they have the risk of an involuntary conversion into the debt of an inferior credit? If there is no such risk, then how will the national debt be divided? You may recall that Russia solved this problem by keeping all of the Soviet Union’s debt (and then defaulting on some of it). The UK will never agree to this, and if it did, it wouldn’t be AAA given its recalculated debt ratios.

Chinese Monetary Propaganda

“The People’s Bank of China said the country does not benefit any more from increases in its foreign-currency holdings, adding to signs policy makers will rein in dollar purchases that limit the yuan’s appreciation. ‘It’s no longer in China’s favor to accumulate foreign-exchange reserves,’ a deputy governor at the central bank said in a speech yesterday. The monetary authority will end normal intervention in the currency market and broaden the yuan’s daily trading range, Governor Zhou Xiaochuan wrote in an article.

--Bloomberg, Nov. 20, 2013

Bloomberg quotes PBoC officials (above) saying that the PBoC will stop mopping up FX inflows, and will let the yuan appreciate. This already has the metallic community atwitter over the coming Fall of the Dollar and the Bursting of the Treasury Bubble.

This kind of thinking fits into the larger theory that the dollar and the Treasury bond are supported by a Ponzi scheme funded by witting and unwitting central bankers at home and abroad. China buys Treasuries so that she can “control” us, while the Fed buys Treasuries to “finance Obama’s deficits” with hyperinflation. Sooner or later, the music will stop and the Ponzi will collapse, enriching the metallic community and other doubters of America’s benighted currency.

Personally, I am very uncomfortable with China’s mercantilism, and I would like to see the yuan appreciate enough to bring our trade with China into better balance. I don’t like the idea of hollowing out our manufacturing base in exchange for cheap consumer goods. A stronger yuan would reduce unemployment among the young and unskilled, and help us to revive manufacturing.  I think that threatening China with punishment for “currency manipulation” is an excellent idea, especially if there is real policy follow-through, which has never occurred. Romney was pushing for that during the election, and was accused of “China bashing”. It's unsporting to bash one’s enemy!

The Ministry of Propaganda can say whatever it chooses about ending FX intervention, all of which is purely for foreign consumption, and meant to head off Congressional action such as the Schumer-Graham punitive tariff bill. But the hard fact is that China needs to add millions of new jobs every year as its peasants migrate eastward, and that requires a cheap yuan.

China needs to keep the yuan cheap enough that Americans will buy more flatscreens and laptops, not less. Pretty soon it will be cars and airplanes. There is no chance that the yuan will ever float. China cannot build enough dams, bridges and power plants to create adequate internal demand; she must export in exchange for our paper money. Hence her writhing around on the subject of the exchange rate, a topic about which she cannot afford to be frank. Instead she pretends that she is unpegging, which we are supposed to believe.

The metallic community is wrong, as usual. The dollar, bonds and stocks are safe. Gold and silver will continue their downward drift.

The Fed’s October Minutes: Embracing Defeat

[Note to readers: I have been a bit preoccupied with healthcare policy lately, such that I took my eye off of the economy for the past two months. I may write something about the ACA, although there has already been a tidal wave of ink on the subject. And having said that, I return to my regular beat.]
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“Although the incoming data suggested that growth in the second half  might prove somewhat weaker than many of them had previously anticipated, participants broadly continued to project the pace of economic activity to pick up.

“Participants generally expected that the data would prove consistent with the Committee's outlook for ongoing improvement in labor market conditions and would thus warrant trimming the pace of purchases in coming months.

--FOMC minutes from 10/29-30/13 meeting

The Fed has concluded that, despite the fact that it has failed to achieve either of its dual mandates, conditions will nonetheless improve and it can begin to reduce monetary stimulus. Although none of the Fed’s prior forecasts with respect to unemployment and inflation have proved remotely accurate, its current optimistic forecast is sufficient reason to take away the punch bowl with 7.2% unemployment, a low labor-force participation rate, and inflation running at 50% below target.

The Fed has congratulated itself on the success of its policies, despite the fact that the zero funds rate and massive growth in the Fed’s balance sheet have had no  impact on money growth, inflation or unemployment.

In my view slowing QE is an economically meaningless event, since QE itself proved economically meaningless. Instead of using the proceeds of the Fed’s purchases to make loans, banks have instead left it on deposit at the Fed as an interest-bearing, zero-risk asset, doing nobody any good. Money growth has remained sluggish despite “massive monetary stimulus”.

The economy’s #1 problem today is not the sequester, the deficit or Obamacare. It is the abysmal nominal growth rate, now hovering just above 3%. Historically, 3% nominal growth has been recessionary; luckily for us it is only near-recessionary. If the Holy Grail is 4% real growth, we will never achieve it with 3% nominal growth: there isn’t room.  We will need 6-7% nominal growth if we ever hope to see pre-crash unemployment levels.

It has not entirely escaped the Fed’s notice that the rate of inflation has been steadily falling since 2011, and is now at 1%,  50% below a target that was already too low. The failure of QE to influence money growth has resulted in  disinflation that threatens to become deflation.

Monetary policy can be challenging in the context of “stagflation”, when inflation is high and real growth is low.  That challenge, however, is completely absent today. Today, both inflation and growth are very low. If some version of the Phillip’s Curve still operates, the Fed has plenty of room for both higher inflation and higher growth. Expressed differently, money growth today is below NAIRU, the lowest achievable rate of unemployment that does not cause inflation to accelerate. Instead, we have high unemployment and falling inflation, also known as a pre-recessionary condition.

It is ironic that the hawks (on and off the FOMC) criticize the Fed when it experiments with new ways to achieve its mandates. They say that by changing policy instruments or guideposts, the Fed will “lose credibility” because any change is inconsistent with prior guidance. They desire a foolish consistency, and fail to understand that the best way for the Fed to lose credibility is to consistently miss its mandates, as it has been doing for the past five years.

The Fed’s employment and inflation targets have no credibility because they seem to have no influence on policy. When inflation expectations are “firmly anchored” at a rate below your target, you should know that your policy has no credibility. Instead of committing to “do what it takes” to achieve its mandates, the Fed instead commits to continue doing what it has been doing: policy continuity for the sake of policy continuity. And now, to further reinforce its credibility, it will do a bit less of what it has been doing.

The key question going forward is whether the FOMC’s dynamics will be affected by the change in leadership. Will Yellen’s dovish views be given greater deference than Bernanke’s were, or will the War of the Angry Birds continue unabated? Let us pray that, once Janet is seated in the driver’s seat, things will change. The mention in the minutes of possibly reducing interest on reserves provides a glimmer of hope.

The Dollar Survives Ted Cruz

Some twenty years ago, Moody's published an investor comment entitled "Southeast Banks Survive Hugo". A number of us (who hadn’t written the comment) found it pretty funny since banks typically survive hurricanes and other natural phenomena (e.g., “Russian Banks Survive Cold Winter”).

I am honoring that ground-breaking piece of research with today's post: "The Dollar Survives Ted Cruz".

The financial media (especially in Europe, and especially at the FT*) have been rife with commentary about America's sad decline as an economic superpower as a result of the latest government shutdown and the latest debt ceiling kerfuffle.  “Can These People Govern Themselves?”,  “Are Tea Party Crazies Running America?”, etc.

It is solemnly agreed by saddened commentators that global investors have lost confidence in the US as a result of the recent dustup. This most recent discrediting of the US follows many previous discreditings when foreign investors lost confidence in the United States, its currency and its debt: the “Constitutional crisis” of Watergate, the double-digit inflation of the Carter era, the "massive deficits" of the Reagan years, the fiscal profligacy of the Bush tax cuts and, most recently, Obama's "massive" stimulus and trillion-dollar deficits.

Global investors must be exhausted by the experience of repeatedly losing confidence in the United States. You'd think by now that Treasury bonds would be be used as toilet paper like the Zimbabwe trillion dollar note.

Isn't it odd then, that Treasury yields have steadily fallen throughout the "crisis", and that this banana republic can borrow money for 30 years at 3.6%? And isn't it odder still  that the worthless dollar and the dodgy Treasury Bond continue to constitute the majority of foreign central banks' international reserves? Perhaps these central banks didn't get the memo that they were supposed to flee the dollar and buy Yuan or bullion or pork bellies. The Dallas Fed got the memo.

What the FT and other serious commentators forget is that the US Treasury bond is a monopoly product because it is the only security denominated in US dollars issued by an entity that can print US dollars. Like Porsche, there is no substitute.

Let's look at the T-bond’s competitors: eurozone government bonds, Japanese JGBs, British gilts, and not much else. What about the yuan, every journalist’s favorite currency these days? Like the North Korean won, the Cuban peso and the Venezuelan Bolivar, the yuan is nonconvertible, and thus useless as a reserve asset.

Eurozone government bonds? Too small a float to be liquid in an emergency, not denominated in any country’s domestic currency, and most eurozone governments are far from AAA. Japanese JGBs? A huge market, but not as liquid as one would think, in the wrong time-zone, and nowhere near AAA. Not a good substitute for the greenback.

Central banks must be able to provide dollar liquidity to their members at all times because the business of international finance is conducted in dollars. Thus, whenever there is a market convulsion, banks require dollars from their central banks to meet dollar claims, which is why the Fed is asked to establish dollar swap lines during financial crises. The alternative would be for central banks to fire-sale their own currencies in the middle of a crisis.

There are no credible threats to the global dominance of the dollar and the T-bond. Treasury yields have never been lower, despite trillion-dollar deficits and deteriorating debt ratios. A dollar-zone crisis is much less likely than a eurozone crisis; Japan’s debt-trajectory is asymptotic; and the UK's credit was wounded by the financial crisis.

The US is not a pretty credit, like Estonia or Botswana (no debt), but it will remain the #1 credit for the rest of this century, no matter what Fitch and S&P have to say about it.

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*“Washington’s flirtation with a voluntary default has shaken confidence in American political institutions…the world is now monitoring the US to see when it will recover its senses."--FT: A Superpower At Risk Of Slippage”, Oct. 25th, 2013

How To Invest In The Stock Market

Presentation to the Episcopal High School Investment Club, Alexandria, VA. 17 Oct. 2013

What Is A Stock?

1. One element of a corporation’s capital structure.

2. Corporate capital structure ranked by declining priority of claim:

Secured debt

Senior unsecured debt

Subordinated debt

Preferred stock

Common stock

3. Common stock is the only security that participates in the financial performance of the firm: no fixed interest or dividend, no claim in bankruptcy.

4. Stocks are the only asset class that offers the opportunity to “strike it rich”, or to lose it all.

What Makes Stocks Special?

1. Stocks permit an small investor to participate in the ownership of a large company.

2. The smallest investors can own shares in the biggest companies.

3. Stocks are a much better hedge against inflation than bonds.

4. In the postwar era, stocks have outperformed bonds by a wide margin: Dow was at 160 on V-J Day; at 1000 30 years ago; is now at 15000. I expect it to go to 20000 over the next two years.

Ways To Invest In Stocks

1. Stock-picking based on fundamentals

2. Market-timing based on valuation

3. Market-timing based on patterns

4. Mutual funds and ETFs

>Stock-Picking Based On Fundamental Analysis

1. Revenue and earnings growth (growth): GOOG, AMZN, AAPL

2. Low PE ratio, undervaluation (value): out-of favor sectors

3. High dividend yield (income): utilities, cyclicals

4. Long-term stability (blue chip): JNJ, KO, PEP, GE

5. Strong free cash flow (value): tend to be unsexy

6. Return of capital (stewardship): management that works for the shareholder

7. Strength of franchise (moat): brand names

8. Financial fundamentals: capitalization, profitability, cash generation, cash disposal policies, accounting conservatism, management risk tolerance.

>Market-Timing Based On Valuation

1. Analyzes the market like an individual stock

2. Values the market based on expectations of earnings and PE ratio.

3. Some look at overall dividend yield, some look at PE and some look at the equity risk premium over bonds [market earnings yield vs bond yields].

4. Buy cheap (March 2009), sell dear (now?)

>Market Timing Based On Patterns

This is called “Technical Analysis” and looks for patterns in the prices of individual stocks or of the overall market that are believed to provide information about future price movements. While many respected market gurus use technical analysis, economists consider it to be pure voodoo.

>Mutual Funds And ETFs

1. Mutual funds and ETFs are an efficient way for the small investor to diversify his equity portfolio.

2. Managed funds offer the style, sector, objective and expertise of the portfolio manager.

3. Style: e.g., large cap growth; sector: e.g., financials; objective: e.g., long-term capital gains; expertise: e.g., technology.

3. Passive funds seek to efficiently replicate the performance of an index with minimal overhead.

3. ETFs offer a somewhat static portfolio, with a stated style, sector, and objective, with periodic rebalancing.

4. Indexed ETFs, like passive mutual funds, seek to replicate the performance of an index. The most popular market index is SPY, which replicates the S&P 500.

5. Some good performers: PKW, RPV, RPG, CSD, USMV, PFM, FPX, CSM, VIG, SPHQ, HDV, SDY, DVY.

Beta and Alpha

1. Beta measures the degree to which a stock or portfolio matches the performance of the overall market (SPY). A low beta means low correlation, while a high beta means high correlation or a super-charged correlation (more volatile than the market but in the direction of the market).

2. Alpha measures the ability of a portfolio to produce returns in excess of the market average. Indexed funds have low alpha (= to market), while managed funds may have high or low alpha. The goal in active investing is to outperform the market, i.e., to generate alpha. Most managed funds lack alpha. Some indexed ETFs have alpha (e.g., PKW).

Understanding Corporate Cashflow

Revenue

-Operating Expense

=Operating profit

-Taxes

=Net income

-Capital expenditures

-Acquisitions

+ Noncash expenses (e.g., depreciation)

=Free cashflow

-retained cash

= cash returned to shareholders (dividends, buybacks)

Should You Invest In Individual Stocks?

1. Are you a full-time professional equity analyst?

2. Do you have access to proprietary valuation models for each industry in which you invest?

3. Are you an expert in the relevant industries?

4. Do you listen to quarterly earnings calls and attend the annual Investor Day? Can you call the CFO with questions?

4. How well do you understand the financial dynamics of technology stocks, or pharmaceuticals?

5. Do you possess information not shared by the wider market?

If you answered no to these questions, then don’t buy individual stocks.  Invest in mutual funds or ETFs.

How Can I Know When It’s A Good Time To Buy Stocks?

1.You will need to work on yardsticks for estimating the intrinsic value of the stock market in order to compare your estimates with the current market price.

2. Typical yardsticks are: PE ratio (looking both backward and forward, which requires forward earnings estimates), dividend yield, market-to-book, market to FCF.

3. The problem with such yardsticks is that they only compare the market to itself, not to interest rates. High interest rates lower the value of the corporate earnings yield (E/P), while low interest rates raise the value of corporate earnings (lower discount rate).

4. The best measure for market valuation is the Equity Risk Premium which can be crudely be described as the market earnings yield minus the risk-free rate.  

5. Today's ERP is almost 6%, which is high by historical standards.

6.If we calculate the ratio of ERP to the risk-free rate, we get a multiple of 3.3x, which is extremely high by historical standards. If you accept the premises of this analysis, then you must conclude that stock prices today are very cheap, and that you should buy stocks right now.

7. Why are stocks so cheap? Because it is only five years since the Crash, and investors remain highly risk-averse. They think they are “safe” and “conservative” holding 3% bonds.

8. What could derail this view? Either (i) higher interest rates, which I do not expect; or (ii) lower corporate earnings due to another recession, which I also do not expect. What I expect is that stock prices will continue to rise until the ERP and the EY/RFR normalize. That would imply that stocks could double over the next few years, as greed replaces fear.

Bearish Scenarios Lack Credibility

On October 8th, I wrote that equity investors should ignore the “budget crisis” because stock prices were low (“Forget The Debt Ceiling: Stock Prices Are Very Low”). That was the point at which the pundits were telling us to stock up on canned goods (“worse than 2008”). The day I wrote that post, the Dow closed at 14,773. 

On Friday (10/18), the Dow closed at 15,400--a gain of over 600 points in 10 days. Once again, we have relearned the lesson that there is very little actionable information in the A section of the paper, and not much more in the business section. Actionable investing information is found in the calculation of market valuation, not in the blathersphere.

On October 1st, Damodaran* calculated the Equity Risk Premium at almost 6%. It has been hovering in this vicinity since the Crash. The ERP had not been this high in absolute terms since the inflationary Carter years; it has historically trended around 3%. As a multiple of the risk-free rate, the ERP has never been this high (3.3x). Over the past 50 years the multiple has remained below 1x, generally in the .5 to .7 range. Today, the multiple is about five times its historical average. Hence, the compelling imperative to remain heavily exposed to the stock market.

Should the ERP and the ERP multiple revert to their historical levels (of 3% and .6x), the stock market would be perhaps 2-3x its current level, without factoring in future earnings growth. I would also point out that corporate earnings do not need to grow for market eps to grow. Many companies today have excess free cashflow, and are using it to reduce their float (the denominator for the calculation of eps) and thus increase earnings per share.

It is true that higher bond yields would also reduce the ERP. That is a risk to the rosy scenario. But given the fact that inflation remains at extremely low levels, and that the Fed is unlikely to adopt a radical reflationary policy, the prospects for higher inflation are bleak.

Many market analysts are focused on the fact that today’s market PE ratio (18.2x) appears quite high in an historical context. This might be a useful factoid if today’s interest rates were anywhere near their historical norms. But interest rates are at levels never seen before, not even under the gold standard. Therefore historical PE comparisons are meaningless. The market is very cheap.       

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*http://pages.stern.nyu.edu/~adamodar/               

Yellen Can't Change Fed Policy

First the good news: Yellen is a monetarist, a dove and an activist. She believes that monetary policy plays an important role in achieving good economic growth, and that the Fed should respect its employment mandate . She is more dovish than Bernanke, and more forceful. She is, in my view, an improvement over Bernanke who placed too much emphasis on consensus.

Now for the bad news: Like Bernanke, Yellen will be faced with the hawkish faction which is likely to tie her hands and prevent her from doing what she believes is right. Were Yellen to advocate more radical policies, such as price-level targeting or nominal growth targeting, she would invite discord and vocal dissent. She would injure the Fed’s “institutional credibility”, and invite Congressional interference, which is anathema.

So here is the bottom line: Yellen will fail as Bernanke has failed. Only radical policies can move the dial on money growth, and radical policies are precluded by the hawks. Indeed, the hawks want to return to orthodoxy as soon as possible. She will have her hands full fighting against this tendency.

Thus, the outlook for the US economy is grim: low money growth, low inflation, low growth, high unemployment, weak fiscal revenue and an ever-growing output gap. That suggests that the bond market should not react to her appointment: she can’t raise the inflation rate any more than Bernanke could.