Inefficient Capital Allocation

In my last Russia Reading List I bemoaned Putin dictating how banks should operate and their lending policies. There are a number of problems with this sort of state meddling, but one I did not touch on in this post was the resulting inefficient capital allocation. Over at SA, Peter Fuhrman has authored a cut-to-the-chase post on how state meddling in banks' lending policies can skew the efficiencies of the free market - in a China context. Now obviously Russia and China are different beasts - but there is an uncanny correlation in how state authorities in both countries apply pressure to banks resulting in how debt is deployed to who for how much. I misquote Peter Fuhrman: Capital is not a problem in Russia. Capital allocation is.

Hitler Misses the Bottom

This is fantastic. And probably the best of the series these guys have done. We might have seen the bottom. But I'm not sure we won't yet see the lows again. The second dip is nigh. (HT MGJ)

Russia Reading List

After almost a month, I am back online.

Much has happened with Russia the last few weeks. . . .

Back on the 25th of July Joe Bidden, US VP, was interviewed by the WSJ. Biden said that “Russia has to make some very difficult, calculated decisions. They have a shrinking population base, they have a withering economy, they have a banking sector and structure that is not likely to be able to withstand the next 15 years, they’re in a situation where the world is changing before them and they’re clinging to something in the past that is not sustainable”. Whether this eventuates will remain to be seen. But Biden echoes what has been written on this blog in the past - that the Russian Federation has a serious and perhaps terminal population problem. Obviously for such a xenophobic and anti-immigration government and society, immigration isn't going to provide a solution without a structural shift in attitudes. And the secondary problems that arise from a shrinking and horridly aging population trickle down to become territorial, fiscal and economic growth based too. It's difficult to have a sustainable growth economy without a growing or at least stable population base and all that comes with it. The long run outlook could be better. Much better. But we don't live in the long run. Can Russia (read: Putin) turn this party around? Watch this space. Giving an opposing view, there is a good piece over at Seeking Alpha on why Biden is wrong. Seeking Alpha also curiously points out that the state of California is a more risky investment proposition than the Russian Federation - at least measured by CDS pricing. And Time points out Medvedev's latest initiative to reverse the shrinking Russian population - stop them boozing. Obviously Mr Medvedev has not come across the Borg or he would already know that with such matters resistance is futile.

Two Russian Akula class fast-attack hunter-killer submarines have been tracked on patrol off the Eastern seaboard of the USA. The NYT reports that such activity has not been reported for about 15 years. Writing on matter, STRATFOR stated (05.AUG.2009) "These are the most modern and capable attack submarines in the Russian fleet, often compared to the U.S. Los Angeles class". Russia continues to ensure its power projection efforts are not missed. But as STRATFOR has more recently noted (10.AUG.2009), this was an interesting event and perhaps part of some form of wider Maskirovka strategy, but ultimately of little importance.

STRATFOR also wrote (10.AUG.2009) that most of Russia's other sabre rattling was ultimately of little consequence to the US too. However, two potential events present potential global geopolitical structural breaks of the highest order. Firstly, if Germany were to ally itself with Russia, rather than the Europe/ US. This is not entirely out of the question considering the increasing cosiness of the Merkel government with that of Putin's, largely and at least initially predicated on energy trade. Secondly, if tensions with Iran escalated to a serious level. STRATFOR on this second scenario states "If the Iranians were to successfully mine these waters [Strait of Hormuz], the disruption to 40 percent of the world’s oil flow would be immediate and dramatic. The nastiest part of the equation would be that in mine warfare, it is very hard to know when all the mines have been cleared. It is the risk, not the explosions, which causes insurance companies to withdraw insurance on vastly expensive tankers and their loads. It is insurance that allows the oil to flow". This reference to the importance insurance plays in the movement of petroleum products cannot be understated. The piracy situation off the coast of Somalia in the last 12 months has shown on a smaller scale how insurance and re-routing costs can rapidly spiral upwards and perhaps affect the end cost of the shipped goods. Interestingly this is a key reason encouraging Israel not to bomb Iran's nuclear facilities unilaterally - Iran would immediately respond by mining the Strait of Hormuz using small water craft, rendering the blame for the resultant global oil crisis firmly at Israel's feet.

It appears that Russia is also facing the possible beginnings of a grain crisis. Put in the context of the global financial problems, Russia's dramatic recent slowdown in mineral/ petroleum based revenue, the deepening of the global food shortages, and the slump in Russia's federal reserves, this is a real concern to the Kremlin. Circumstances have not yet begun to approach the fictional scenario laid out in Frederick Forsyth's "The Devil's Alternative", where almost all of the Soviet grain crop is decimated. But the butterfly effect can take hold and go the distance swiftly and without warning. Stranger things have happened. STRATFOR wrote (18.AUG.2009) "Several Russian grain-producing regions have suffered serious problems during the winter harvest, the period from June to August when grain crops planted during the previous winter are harvested. Severe drought and scorching hot temperatures have caused fires that have reduced the year’s wheat output, particularly in southern Siberia east of the Ural Mountains, on the eastern frontier of Russia’s grain belt. In particular, Chelyabinsk oblast (or district) has reported that 80 percent of its grain harvest has been burned away, Sverdlovsk oblast has lost 40 percent and Tyumen oblast 30 percent". Because of this, Russia faces at least an 12% grain deficit on this year's harvest. Historically Russia has exported 20% of its grain harvest to Europe on average, which constitutes a considerable 17% of global grain production. This will probably result in two things to varying degrees. Firstly, Russia will likely become, at least temporarily, a net importer of grain this year. This has implications for an already troubled Ruble. Secondly, if supply of grain for sale on world markets is reduced, all things being equal, equilibrium price will move North. Of course all things aren't equal - despite the general trend for demand across the board having decreased contemporaneously with the recent global economic downturn, demand-supply drivers are very firmly in place to fuel the soft commodity super cycle.

Last week the Russian Federal Statistics Service reported that foreign direct investment (FDI) into the Russian Federation for H109 had decreased year-on-year a whopping 45%. Obviously the massive capital flight following the Russian invasion of Georgia last year has not reversed. Interestingly in Q209 the RTS index recovered considerably from tumbling values of the previous 9 months. Prima facie it would appear that there is a weak correlation between the RTS and FDI. Certainly a number of prominent investors have recently opined that the Russian investment proposition is merely a beta-tracking play on oil & gas. Clearly such comments refer to investment in the Russian stock market and even the most superficial of analyses will reveal that (on a cap-weighted basis) this market is significantly driven by the fortunes of its oil & gas constituents, giving the thesis immediate merit. Seeking Alpha has yet another article on the Russian authorities bullying foreign investors. Not the smartest way to encourage fresh FDI and engender faith in the Rule of Law. The article states ". . . another cautionary tale for investors: what’s theirs is theirs, and what’s yours is theirs–if they want it. Given Russia’s dependence on foreign capital flows, this is a counterproductive attitude that will impede Russian progress for years to come". And if you thought that Medvedev was the vanguard of corruption fighting in Russia, a detailed article on the Medvedev-Putin show over at Seeking Alpha might change your mind.

Last week Business Week published an interesting article on Putin's statist and increasingly centralist moves to control how commercial banks lend to their customers. Namely he was dictating how interest rate levels were set. Hardly free price equilibrium and certainly not a mechanism central bankers/ democratic governments would use in influencing interest rates. The article states "In economic terms, this was an extremely debatable decision. Banks had been keeping interest rates high not only out of greed, but because the crisis makes it very difficult to distinguish between good and bad borrowers, i.e. those who are able to pay back their loans and those who will soon go bankrupt. So if the interest rate on loans is kept high, the inevitable losses from unpaid debts are to some extent covered". Putin's actions actively detract from any free market policy and at best muddy the waters of an efficient finance market. It will be interesting to see how this affects the interest rate swap market for longer dated terms vis-a-vis property debt. Sure, the big Russian banks are backed by one government hand while being told how to conduct commercial enterprise with the other. This set of affairs will continue to deliver as long as the government is a willing donor with its reserves and can garner international credit. The article goes on to discuss the congenital weakness of the Ruble, the lack of faith all parties have in the national currency and what it means for Russia. Well worth a read. (HT Mister Gupta).

The August edition of the McKinsey Quarterly has an excellent piece on the state of Eastern European banking. This is a must read for anyone involved in any way in the CEE/ Russia/ CIS market space. Especially those in an asset-backed capacity. The whole article is worth quoting, though some choice bits are "Over the longer term. . . a reemphasis on careful [cost of debt] pricing, brought about by a higher cost of capital and liquidity, will actually help reinflate [banking] margins. We expect that banks will successfully pass on to customers their higher cost of funds; margins correlate well with funding costs". This is followed by an insightful graphic showing the uptrend in the risk free rate. Obviously this has ramifications for asset values. The article goes on to state "To reflect the higher cost of funding and the risk their clients face, banks must adopt a new pricing discipline. . . Many have already begun efforts to improve pricing but are stumbling because they lack capabilities. Specifically, they need to react quickly to market changes in funding costs. They will need the ability to calculate, in real time, a target credit margin for each customer, taking into account the up-to-the-minute cost of financing, the client’s business climate (its size, macroeconomic conditions prevalent in its geography and industry, and so on), and its risk exposure". Clearly there are opportunities for those with the expertise and market insight to position themselves to proactively provide this information to banks in the region. Perhaps even more so for asset-backed lending. Moving from solely a client instructed position providing the end product to the banks, to creating a true go-to/ supplier-partner of choice for the banks. For additional reading and for those who can't get MQ access, Seeking Alpha has a brief article with links to not so brief reports on the fast approach of the death spiral of CEE heavy lending banks.

Finally, two last articles from Seeking Alpha on the state of the Russian economy, consumer spending, consumer lending, inflation and the Ruble, here and here. Both well worth a sobering read - as the second article states "Russia faces extreme difficulties. Its political brittleness, and the rigidity of its labor market (due in large part to the monocities, the legal and institutional nihilism and state capitalism that stifle small business and encourage large, cumbersome enterprise, and other Soviet inheritances) make it very difficult to adjust to large economic shocks; in this system, large enterprises serve as welfare agencies. But this threatens to turn them into zombies–and take the rest of the Russian economy with it". Clearly, those who will make money in/ from Russia in the years to come will have true connectedness to those who can/ will pay for their offering and a clear understanding of why it will be demanded. Naturally for real assets, these factors will be key in ultimately driving income yield.

mulletover

It's been a frenetic couple of weeks and will be at least another one or so to come. . . . Hence the dearth of posts.

So until then I leave you with the trusty sounds of mulletover (hat tip MGJ).

Eats the F430. . .

The new Ferrari 458. You can see more pics here.

Jim Rogers on Radio 4 - Update

Last week on the 14th Jim Rogers was interviewed on the BBC's Radio 4 Today show. I mentioned it that day in a post. Anyway, for those of you interested in listening to the interview, you can do here. For those of you familiar with the Rogers Shtick, he's not saying much he doesn't usually say. For those of you who are not, it's worth the four minutes.

The Draw of Dubai

The British expats I spoke to believed, without exception, that the Emiratis are utterly useless, corrupt and indolent, and, according to several, some British managers are leaving rather than abide by a new law that requires them to employ a certain percentage of Arabs on every job. They’re simply not up to it, they say. As it is, the locals make up less than one-fifth of the total UAE population, the westerners roughly half that amount. The majority population in Dubai is the criminally low-paid, enchained, abused, dispossessed peasantry from south Asia.

The full article over at The Times. Rather amusing and well worth a read at work.

Reading List

Skin in the game and pain money. SA has a brief post on why this is so important and the principal-agent dilemma. I'd extend the concept from new venture development to active fund managers - co-investing can be a solid interest aligner. The post also touches on stock options generating alignment of interest - though there are inherent issues with this thesis as Whitney Tilson and Chalie Munger have amply discussed here.

I'm a bit late to the party on this one - SA has another solid post on the 'free' business model and the back-and-forth between Malcolm Gladwell, Chris Anderson and Mark Cuban. Well worth reading if like me you haven't been following this. Not surprised to see Chris Anderson gunning for the pro-Free team - a very clever chap, though I've always suspected he's overly idealistic.

Another post from SA on the outlook for investing in Russia and the Russian economy. If the material in the dedicated "Russia's Future" reading list below didn't give Russian investors cause for concern, this detailed post should. The drop in retail sales and GDP is quite something.

For those interested in NZ - there's a good post from Bernard Hickey reporting the review of NZ's tax system and the possible imposition of CGT to target house price inflation. I've written more than once in this blog about the idiocy of NZ retail investors and their unstoppable addiction to investing in housing. Quite pragmatically PM Key is opposed to a CGT regime. Also quite pragmatically he is looking to roll back the Helengrad grip of the Resource Management Act and the Building Act on housing supply. Regulation-driven housing constraint has long been one part of the equation in the rapid house price inflation of the last decade. Those investing in NZ residential real estate have again been warned.

Lundeen's Bear Market Race to the Bottom continues with his latest issue. Though his "Bear's Eye View" chart that tracks the '29 crash seems to have an err.... upticking kink in it. I bet Lundeen has his fingers crossed that this is only temporary with this bear rally's last puff.

Infectious Greed has a repost of an Economist graph detailing car parking rates around the world. These sorts of figures often have suspect accuracy and sources. Perhaps the concept was a PPP spin on the Big Mac Index. I know for sure (from co-authoring a detailed car parking development report) that at least the Moscow rates are way too low for anywhere you would want to park near or in central Moscow.

A great chart from Flowing Data showing why cheap airlines can afford to be so cheap.

Fabrice Grinda has posted an interesting autopsy of a failed NYC fractional art ownership startup. Just goes to show how much long-trending systematic market movements can tip the balance of success or failure.

An interesting article from the Telegraph on an interview with oligarch Alex Lebedev, who he is, whether he's really dying of mercury poisoning, his deal with the Kremlin and his intentions on disrupting British media.

And finally, what may become a landmark case on division of assets in NZ divorce cases. It looks like NZ has just gone one better than the British courts awarding a portion of future earnings. The Cactus has a link to the original story and some frank commentary - well worth a click and read - here's a taste:

The Supreme Court (read Supreme) has decided in favour of a wife not just for value during her marriage, but BEFORE she was even married to the man. . . . . This woman will now be enriched in a lump sum to the tune that most working women would never independently earn in their lifetime. Why be a teacher, cleaner, policewoman, nurse, receptionist or middle manager when you can just do housework? . . . . Housework is now deemed contribution to convert separate property into relationship property. . . . The rot will now set in under New Zealand law and expand on this dramatic break through through obvious judicial activism. Look over time for more stupid decisions, less marriage and relationships, more contracting out and ultimately more poverty stricken women as men hunker down to protect their assets from not just the IRD, but the worst enemy created by the Supreme Court - a housewife.

Reading List: Russia's Future

To anyone who follows Russia's plight, the country faces an increasing number of immediate and longer term economic, financial, geopolitical and social problems.

Two of the more serious longer term problems are demographic (which I mentioned in a recent post) and territorial. Both are becoming more of a threat to Russia's survival as time passes. And while both do not keep the average Russian from sleeping, both are at the forefront of worry for Prime Minister Putin. Both must also be a concern for any longer term investor in Russian capital assets. Especially of the illiquid sort.

Russia's demographic time bomb has been written about for many years. SA published an article last week putting this in an investment context. The article is sobering reading for anyone considering investing outside of St. Petersburg, Moscow or the larger/ more prosperous of the Millioniki. As investors become more aware of the depth of this problem, it will further swell an already bloated country risk premium.

For centuries Russia has faced the monumental task retaining territorial control and integrity. This task is becoming more difficult as both first and second derivative negative population growth increases, and the population centralises to core cities. Territorial threats from the West and the Caucasus have been widely reported in the media for some time. Not so widely reported is the threat posed by China to the East. The Telegraph has a good piece detailing this. It would appear that the population creep across the border has already begun.

New Hotel Projects

Who said luxury consumer spending was dead? And here I was thinking that high-beta, high-octane hotel developers had all crawled back under their rocks. Even the petro-dollar fueled crazies. Looks like I was wrong. The RICS monthly rag has this little spread of hotels due to come online soon. I especially like the Cairo one, by Zaha, pictured above.

Tom Cruise on Jonathan Ross

Jonathan Ross interviewed Tom Cruise on his chat show early this year. It was Ross' come back show after being banished from the BBC.

And what a come back. He ripped Cruise apart. The whole thing is worth watching if you can find it on the web. But this part is especially good. The two other guests seen out the back are Stephen Fry and Lee Evans (who for once doesn't appear to be sweating).

Correlations Continued. . .

Great article posted on SA about the recent evolution of correlations between asset classes. Furthers the theme of the Felix Salmon article in yesterday's Reading List.

Like Salmon, this article posits that as more people diversify into other asset classes, correlation risk increases.

The increase in correlation between asset classes over the last decade has been huge. The article says:

Between 1991 and 1994 the correlations between the S&P 500 and high-yield bonds was ~0.2-0.3; international stocks ~0.3-0.4; REITs ~0.3 and was negligible in commodities.

By early 2008 those numbers looked like: ~0.7-0.8 for high yield bonds; ~0.7-0.8 for international stocks; ~0.6-0.7 for REITs and slightly negative ~-0.2 to -0.3 for commodities.

An Uneven Recovery

Peter Zeihan of STRATFOR gives a good summary of the current global economy and the outlook. Skip the preamble if you wish and head straight to 90 seconds in.

Reading List

Prolific poster Felix Salmon has a good piece here on asset allocation. He also talks about correlation risk and the difficulties of correlation measurement. He writes: Ultimately, I suspect that any investment strategy more sophisticated than “buy low, sell high” is doomed to fail eventually. Good to see that the Margin of Safety thesis is still popular.

Robert Shiller (of Yale, who else?) is interviewed here. Well worth a watch - too many themes to list here.

Lundeen's Bear Market Race to the Bottom continues with his latest release. If you're starting to feel bullish, Lundeen will cool you off.

And for those interested in NZ, it looks like the PM is intending to streamline the tax system. It also looks like there will be a policy shift ahead to encourage productive investment - this should help kill NZ retail investors' addiction to buy-to-let housing.