Shelter Island Capital Management

It is customary for money managers and other such financial advisors to state their views on the market for the year ahead. Some even provide a list of surprises that are not in the consensus but could have an outsize impact. These thoughts are usually interesting but fraught with the implicit dangers of divination, as “it is very difficult to make predictions, especially about the future.” We are going to take a different approach, rather than trying to evaluate possible scenarios for the next twelve months, we will remind you of three things that should be top of mind for investors and savers at all times.

The three enemies of wealth accumulation

Taxes, inflation, and management fees are the three horsemen of the Apocalypse for investors. The best strategy to maximise long-term investment returns necessarily starts with the optimization of your portfolio for taxes. We do not provide tax advice but you should carefully explore the tax implications of different investment products.

Protecting your portfolio from inflation is more complex. Generally, but not always, fixed income does not perform well in an inflationary environment. Some believe that real assets such as real estate should perform better, as leases and rental contracts generally have annual inflation adjustments. But this is helpful only up to the point where an inflationary environment starts impacting economic activity negatively and thus vacancy rates. In addition, higher refinancing costs will impact the bottom line and higher discount rates will dent valuations. Some industries perform better than others in an inflationary environment, thus certain industries will also perform better in the stock market. Commodities may be a source of protection. Over long periods, US broad equity indices have beaten inflation. That is not the case in other stock markets.

Fees and expenses is the problem area where it is easier to make good progress. Investors pay management fees in the belief that the manager they have selected has an especial ability to beat a benchmark over long periods. If only life worked like that! Academic and industry research conclude unassailably that most portfolio managers in liquid markets, such as large capitalization US stocks, are unable to beat their benchmark over time, after fees. For most, the underperformance is largely explained by the fees and expenses of their funds.

Even if a few managers outperform, it would be very lucky to choose the right manager for the next 5 or 10 years, especially if you keep in mind that past performance is not only not a guarantee of future success but more likely is a guarantee of future underperformance, as most index outperformance may be attributed to the prevalence of the manager’s style.

When you’re hot, you’re hot, and when you’re not….

When a particular style is hot, let’s say Value, then Value biased managers outperform Quality or Growth managers as well as the broad market. Those same managers may underperform for long periods when the leadership in the market changes to another category. Thus over very long periods very few managers beat the S&P 500. There are other reasons that make the Index a formidable opponent, such as survivor bias and the winner takes all outcomes in technology categories. Some managers will outperform, but determining who those managers will be is a very complex problem to solve ex ante. Therefore most people are better off investing in very low cost indexed funds or ETFs.

The savings in fees over time make a huge difference. If you were to save $10,000 per year during your working life of forty years and the S&P500 were to return its 50 year Compound Annual Growth Rate of 10.61%, you would start your retirement with $5,227,570. A slight underperformance of just 61 basis points per year would leave you with just $4,425,952 or 15% worse off.

There are more reasons to pay for ability in fixed income markets, especially in high yield. New issue access is far more important for returns in this market. Duration and credit exposure choices will also make a difference. Choosing a manager with all the necessary resources may justify paying their fees going forward, as has been the case historically.

Alternative investment fund managers typically charge significantly higher fees. There are two broad categories: liquid and illiquid strategies. Hedge funds are included in the former category while buy-out, growth, private credit, real estate or infrastructure funds comprise the latter.

Academic research suggest that long-term hedge fund returns are not compelling, as they are close to LIBOR for the industry as a group. This is perhaps not surprising as investing in financial markets is a zero-sum game. Research on buy-out funds’ returns concludes that they have similar returns to the S&P500, although with far less volatility, which is a much desired feature. Clearly, the choice of managers is the key to success in these asset classes and one of the few areas where financial advisors could add a lot of value were they not conflicted because of access to capacity or distribution agreements.

How to cut the pie

Asset allocation is one of the most important investment decisions, thus many people pay their bankers an advisory fee. Banks have complex asset allocation models that usually reach very similar conclusions, which are then overlaid on the risk tolerance and financial objectives of individual customers. All their computations can be summarised with a simple rule of thumb, for most people the allocation to equities should be 100 minus their current age. For very wealthy people who often think about their legacy to heirs, foundations, and charities allocations close to 100% in equities may be optimal.

One thing one should always keep in mind is that the interests of financial advisors and their customers are often misaligned. Did your advisor tell you to go into cash in the fourth quarter of 2021 or at least to sell all your fixed-income exposure? If the answer is no, your advisor is probably not telling you today to reduce your deposit balances to a minimum either and use the proceeds to buy T-bills or a money market fund. At much lower rates, it did not matter much where you parked your liquidity, at current rates it is crucial to get remunerated on cash balances.

How to make your banker very happy

In spite of several rounds of rate hikes, most financial institutions are getting away with not paying anything for deposits. Once again they are exploiting the asymmetry of information with their customer. While your liquidity makes no money your bank is printing money, financing its loan portfolio priced at current market rates at zero-cost. Your banker is laughing all the way to the bank. Oh wait! She is at the bank already. Don’t be a chump.
In the euro zone some banks are selling principal-protected funds and held to maturity fixed-income funds. The former is a source of high fees to build a simple portfolio consisting of a zero coupon strip of a bond and a call option on an index. The latter is disingenuous to say the least as you may also buy bonds and hold them to maturity and not pay management fees. These are some of the pitfalls you must avoid on the road to financial success.

It’s Back to the Future in Economics

The “All In” podcast may be used as a gauge of the zeitgeist. The opinions expressed by some of the panellists in the latest episode are very much aligned with current thinking on the urgency and manifold benefits of reversing recent globalization trends. The analysis is that rising inequality of income, wealth, and opportunity may only be reversed with strict controls on immigration and rebuilding manufacturing in the US. Welcome to 1984!

One panellist’s top priorities is to stop Trump’s populist movement. A second panellist states that US citizens are very concerned about chaos at the southern border with Mexico. Only one podcaster addressed the issue of consumer choice and the benefits of trade. None of them seem to understand that there was no good alternative to opening up to trade with China twenty years ago. An underdeveloped and very poor China would have been a much bigger threat to world order and peace. Think North Korea with viable nukes and 60 times the population.

Awash in a sea of euphemism

We are awash in a sea of euphemism. We say on-shoring when we mean protectionism. Thus, the US Inflation Reduction Act and the retaliatory EU copycat will generate more inflation with their subsidies and tariffs. These costly and ultimately self-defeating policies obviously have the support of businesses who benefit directly, but also from the regulatory industry which includes both civil servants and the consultancy class. The public’s support is divided along the political fracture lines between the dominant populists of the left and the right on the one hand, who find common ground in isolationism, and the dwindling number of free-trade supporters on the other.

The tide has turned, the future is bleak. Many forget that peace is often one of the outcomes of free-trade. The US government is in contempt of a recent ruling from the World Trade Organization (WTO), which declares that there were no grounds for the Trump era tariffs. The Biden Administration disagrees. Traditionally pro-trade advocates such as Paul Krugman will justify the upending of the US-sponsored world economic order because, “The General Agreement on Tariffs and Tarde (GATT) is important, but not more important than protecting democracy and saving the planet.”

The Tariff Act of 1930 sponsored by Senator Reed Smoot and Representative Willis C. Hawley raised US tariffs on over 20,000 imported goods against the recommendation of the League of Nations World Economic Conference of 1927, which had instead recommended to eliminate tariffs to help Germany and other countries pay WWI reparations. We all know how the ensuing trade wars helped put an end to the Depression and boosted democracy the world over. Certainly, Wall Street did not take protectionism well in the 1930s.

Renewable energy and the new caste system

Renewable energy is a euphemism for government industrial policy. Electrification of transportation is a euphemism for the rationing of automobile ownership and use. At Davos, the private-jet-set made clear their wish to impose a similar class system on all transportation modes. The enormous capital investments needed for energy transition are unaffordable in most of the world’s populous countries. Energy transition is eroding the competitiveness of manufacturing in the EU and elsewhere with nothing to show for in terms of CO2 reduction. The EU IRA Act will pit the EU against China as well as the US in a lose-lose confrontation.

In any case, all the investments made to date in wind and solar renewable energy sources have reduced the reliance on fossil fuels for the world’s energy needs by just 1 percentage point, according to some sources. Energy return on energy invested (EROI) refers to the ratio of the usable energy returned during a system’s lifetime, to all the invested energy needed to make this energy usable. The EROI of some of the renewable energy technologies such as wind is below 1. If CO2 and other greenhouse gases emissions are such a real threat, we should be building reliable and safe nuclear power plants as does China, because the intermittence of other renewable energy sources is a major problem. Additionally, we are still far from having cost efficient storage besides pumped hydro.

Volume auto manufacturers have rationally taken advantage of the recent and temporary shortage of microprocessors to reduce drastically the production of their entry level models and to raise all prices. All original equipment manufacturers (OEMs) are hopeful that their competitors will remain “rational” going forward. Experience would suggest it is more wishful thinking than anything else. Yet, CO2 tariffs on imported electric vehicles from China may become a very effective protection for the US and EU auto industries at a huge cost to consumers.

Inflation is a tax on the less affluent

Immigration controls, or introducing a “points system,” is another source of inflation and is self-defeating in a rapidly ageing developed world. While the Chairman of the Fed worries about a shortage of labour, some on Wall Street are trading on a quick pivot in monetary policy. Some people take comfort that the recent lay-offs at Big Tech will ease wage pressures, yet Walmart announced yesterday a 17% increase in hourly wages for entry level employees to $14, nearly twice the US minimum wage.

Paradoxically, inflation is the form of taxation that most exacerbates inequality, which allegedly is the top of mind concern for the advocates of the reversal of the post-World War II global economic order. So what is it that the supporters of such policies really want?

We live in a world where consensus opinions may not be challenged. Any criticism, no matter how well informed, is derided as conspiratorial, uninformed, politically motivated or all of the above. Those who listen to Al Gore in rapture wilfully ignore Peter Lindzen, currently Professor Emeritus and former Alfred P. Sloan Professor of Meteorology at the Massachusetts Institute of Technology. Others will go to Davos to meet a Swedish teenager but refuse to read the essay on Climate Change data by New York University Professor Steven Koomin. Dr Koomin is the former Undersecretary for Science at the U.S. Department of Energy under the Obama Administration and a former professor of Physics at Caltech. He is often dismissed because he worked for five year as Chief Scientist at BP researching renewable energy to move the company “beyond petroleum.”

It was this unhealthy obeisance to a belief system that doomed the inhabitants of Easter Island to extinction.

While sanctions on Russian oil and natural gas exports and declining rig counts in the US shale basins are the proximate reasons for the spike in oil prices, most industry analysts believe we will have higher oil prices forever because oil companies have been reducing investments in exploration and production for several years as they invest in renewable energy to meet CO2 neutrality and ESG targets.

The Davos crowd’s own goals

One would think that as liberal democracy is on the wane, we should try to make our democracies stronger, not weaker. Yet the cognoscenti who convene at the World Economic Forum have largely embraced the progressive agenda on scant evidence that this regression to 1960s and 70s policies would have a higher chance of success today than it did then. Trade is a win-win situation. So is immigration. So is energy security.

Many people are revolted by the prescriptions for the hoi polloi that bear down from these pulpits of woke religion from people who likely do not remember flying commercial. Their “do as I say, not as I do” sanctimonious recommendations are easily exploited to their political gain by the very same right-wing populists they wish to neutralize. The peace dividend has come and gone. A new Cold War is emerging between the US and China in which Russia’s leadership has found room to pursue its imperial ambitions.

We can ill afford the cost of rearming the West while simultaneously devoting trillions to very low return investments and subsidies to energy transition. It might be more practical and far less onerous to stop building cities in flood areas. While the Davos crowd pursues its agenda, the German government has eased the permitting of regasification facilities, bringing forward their completion by several years, upending the “expert” timelines of just a few months ago. Germany is also reverting to coal for electricity generation, as we expected at the outset of the war in Ukraine. We hope this realpolitik approach wins the day.

Clever Keynes

There are few books on economics, if any, that are more informative or more pleasurable reading than John Maynard Keynes ‘The Economic Consequences of the Peace’ (1919). His analysis and prognosis were spot on. Some of the paragraphs in the Introduction describe the decline in the quality of life in England as WWI put an end to the second age of globalization.

“What an extraordinary episode in the economic progress of man that age was which came to an end in August, 1914!…The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could despatch his servant to the neighbouring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable. The projects and politics of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion, which were to play the serpent to this paradise, were little more than the amusements of his daily newspaper, and appeared to exercise almost no influence at all on the ordinary course of social and economic life, the internationalization of which was nearly complete in practice.”

Keynes’s observations have not aged. Should we not counteract the current isolationist trends, we will find ourselves on a road to rising general impoverishment which will in turn inevitably lead to more conflict. And keep in mind that corruption is the first derivative of protectionism and government-directed industrial policy.