For important disclosures please refer to page 21. · Treasury bond yield, CLSA’s technical analyst Laurence Balanco’s view is that it is on the cusp of confirming a top in yield

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Christopher Wood [email protected] +852 2600 8516

Thursday, 30 August 2018 Page 1

For important disclosures please refer to page 21.

Japan, India and turning onTokyoJerome Powell made a politically astute speech at Jackson Hole last Friday which was interpreted by markets as dovish, primarily because he stated that “we have seen no clear sign of an acceleration (in inflation) above 2%”. Still there has been minimal impact in terms of any change in monetary tightening expectations from what was discussed here recently (see GREED & fear – The dollar as a weapon, 16 August 2018), with the Fed funds futures still discounting 75bp of rate hikes by the end of 2019.

But what has happened of late is that the yield curve has continued to flatten. The spread between the 10-year and the 2-year Treasury bond yields has declined from 33bp at the start of August to 19bp last Friday, the lowest level since July 2007, and is now 21bp (see Figure 1). As for the 10-year Treasury bond yield, CLSA’s technical analyst Laurence Balanco’s view is that it is on the cusp of confirming a top in yield terms and a break below the 200-day moving average, which coincides with the 30 May lows at the 2.75-2.78% area (see CLSA research Price Action Global – Upside/downside exhaustion, 24 August 2018).

Figure 1US yield curve (10Y-2Y and 30Y-10Y Treasury bond yield spreads)

Source: CLSA, Bloomberg

Figure 2US 10-year Treasury bond yield

Source: Bloomberg

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Meanwhile, the S&P500 finally made a new high for the year on 24 August, breaking the previous one in late January (see Figure 3). This demolishes GREED & fear’s previous working hypothesis,namely that January was the high for this cycle. It has also served to highlight further the contrasting performance year to date between America and the rest of the world, most particularly since the start of the second quarter when the dollar rally hit Asia and emerging markets. The S&P500 has risen by 9% year-to-date and is up 12.9% since 2 April. By contrast, the MSCI AC World ex-US Index has declined by 4.3% in US dollar terms so far this year and is down 2.5% since 2 April(see Figure 3). Meanwhile, the MSCI Emerging Markets Index and the MSCI AC Asia ex-Japan Index have fallen by 7.6% and 5.6% respectively in US dollar terms year-to-date and are down 8.5% and 6% since the start of April (see Figure 4).

Figure 3S&P500 relative to MSCI AC World ex-US Index

Source: CLSA, Datastream

Figure 4S&P500, MSCI AC World ex-US, Emerging Markets and Asia ex-Japan 2018 year-to-date performance in US dollar terms


The US equity rally has been driven primarily by the boost to earnings from tax reform and the related phenomenon of surging share buybacks. S&P500 actual reported share buybacks rose by 42% YoY to a record US$189bn in 1Q18 (see Figure 5). While there were another US$410bn worth of buyback announcements in 2Q18, according to Bloomberg. This buyback frenzy has revived attention of late on the shrinking nature of America’s equity market, and the related and ongoing boom in private equity. The number of listed domestic companies in the US has declined from a

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peak of 8,090 in 1996 to 4,336 in 2017 (see Figure 6). This focus has also been encouraged by Donald Trump’s recent comment about moving away from quarterly earnings, and the short-termism quarterly reporting encourages. GREED & fear has a certain sympathy with this view. The “earnings guidance” game and the related phenomena of buying back shares on credit are clearly not healthy. But GREED & fear could have said that many years ago, and did. What is evident is that this year promises to be a record year for share buybacks, breaking the previous annual record of US$589bn in 2007, just prior to the global financial crisis.

Figure 5S&P500 actual reported share buybacks

Note: Data up to 1Q18. Source: S&P Dow Jones Indices

Figure 6Number of listed domestic companies in the US

Source: World Bank, World Federation of Exchanges

Meanwhile, as to the question of whether America continues to outperform Asia and emerging markets, it will in GREED & fear’s view rest primarily on the action in the US dollar. As previously written here (see GREED & fear - The dollar as a weapon, 16 August 2018), this will depend primarily on whether the combination of fiscal easing and monetary tightening continues. Fiscal easing seems a certainty with the Donald which means monetary policy will be the key variable. This is why the action in the US yield curve represents the best hope for Asia and emerging market investors looking for renewed outperformance. For the yield curve is the best signal that the Fed is unlikely to raise rates as much as anticipated. Implicit in the above view is GREED & fear’s assumption that the main reason for Asian and emerging market underperformance is US dollar strength rather than any

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systemic crisis. As previously discussed here (see GREED & fear - The dollar as a weapon, 16 August 2018), Turkey is not viewed as systemic by GREED & fear while China is not seen as in crisis.

GREED & fear has just arrived in Tokyo for the first time in six months. The main message gleaned so far in initial meetings is that the Bank of Japan remains unconvinced that wage growth has really gained traction despite the ever greater tightening witnessed in the labour market. True, there has been a seemingly encouraging pickup this year in the base wages of full-time workers. Average monthly scheduled cash earnings for full-time employee rose by 1.1% YoY in 2Q18, up from 0.3%YoY in 4Q17 (see Figure 7). Still the view is that this statistic has been distorted or exaggerated by the change in the sample category used by the Ministry of Health, Labour and Welfare in its monthly statistics. Thus, full-time workers’ scheduled earnings growth on a same-sample basis is running at 0.6% YoY in 2Q18, according to the Labour Ministry (see Figure 8).

Figure 7Japan wage growth for full-time and part-time employees

Source: CLSA, Ministry of Health, Labour and Welfare

Figure 8Japan wage growth for full-time workers (usual reported figures vs same-sample basis estimates)


The result is that permanent wages are still thought to be growing at only the 0.5-0.7% YoY range by the central bank, which is well below what the Shinzo Abe government or indeed the Bank of Japan would like to see. As a result, they are still running well below the 2% YoY hourly wage growth temporary workers are enjoying (see Figure 7), though the problem remains that temporary

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workers’ average hourly wages in absolute terms are still 43% below what is earned by permanent employees (see Figure 9). In this respect, labour reform remains the missing link in Abenomics, in terms of ending the unhealthy divide between temporary and permanent labour with temporary workers still accounting for 38% of the workforce (see Figure 10). Indeed, such labour reform that has happened of late has made the market even more rigid since there was a law passed in late June which limits the number of hours employees can work to prevent so-called “overwork”. Thus, employees are limited to a cap of 100 hours of overtime work a month and 720 hours of overtime a year. This law will be effective from April 2019 for large companies and a year later for smaller firms.

Figure 9Japan average hourly wage: Full-time workers / part-time workers ratio


Figure 10Japan number of employees by type of employment

Source: CLSA, Japan Statistics Bureau

This legislation, drafted to counter suicides and other social ills, did not exempt white-collar workerscontrary to efforts by the Abe administration, save for those highly paid employees with annual incomes of more than ¥10.75m (US$97,000) such as financial traders and bankers!

The conclusion from all of the above remains a lack of conviction that inflation is gaining traction, which is why of course the Bank of Japan in late July revised down its fiscal 2020 inflation target, excluding consumption tax hike effects, from 1.8% to 1.6%. Remember the sales tax is due to be raised from 8% to 10% in October next year. But even the latter inflation target looks optimistic against core-core CPI inflation (excluding fresh food and energy) of 0.3%YoY for July (see Figure 11).

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Figure 11Japan core CPI inflation (adjusted for sales tax hike effects)

Source: Statistics Bureau, Bank of Japan

Still, this does not mean there is total despair or that Abenomics is a total failure since it has been evident for some time that labour compensation is improving. The best way of showing this, given the increasing participation rate of both females and elderly people, remains aggregate compensation paid in the economy. This has risen by a total of ¥29tn over the past five years of Abenomics. Thus, total compensation of employees rose by 4.3% YoY in 2Q18 and is up 14% since bottoming in 4Q09 to a record annualised ¥285tn in 2Q18 (see Figure 12).

Figure 12Japan nominal compensation of employees

Source: CLSA, Japan Cabinet Office

This fact is probably the main reason why Prime Minster Abe continues to remain popular after more than five consecutive years as prime minister, with his popularity recently rebounding from what appears to have been a pseudo scandal. The latest Nikkei poll conducted over the past weekend shows that Abe’s approval rating rose from 45% in July to 48% in August and up from a recent low of 42% in May (see Figure 13). The improvement in the job market can also be seen, for example, in the ease with which graduates can now get jobs. Thus, the employment rate of job-seeking new university graduates rose by 0.4ppt YoY to a record 98% at the beginning of April, the seventh consecutive year of increases, according to an annual survey conducted by the labour and education ministries (see Figure 14). Meanwhile, the perennial concerns about Japanese demographics, and related lack of immigration, are being defied to a significant extent by the

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continuing rise in the participation rate. The total labour force participation rate has increased from a low of 59% in 4Q12 to 61.5% in 2Q18 (see Figure 15).

Figure 13Approval rating for Prime Minister Shinzo Abe’s Cabinet

Note: Latest poll conducted on 24-26 August 2018. Source: Nikkei polls

Figure 14Japan employment rate of job-seeking new university graduates (as of 1 April)

Source: Ministry of Health, Labour and Welfare

Figure 15Japan labour force participation rate

Source: Statistics Bureau

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The above also explains, as discussed here the last time GREED & fear was in Tokyo (see GREED & fear - Lower beta Asean and Kuroda semantics, 8 March 2018), why the Abe administration, and therefore also the Bank of Japan, given that BoJ Governor Haruhiko Kuroda is a political appointee, is no longer obsessed about meeting the 2% inflation target. This is also why what the market, if not the central bank, calls “stealth tapering” has commenced in terms of the BoJ decision on 31 July to abandon its commitment to fix the 10-year JGB “around zero” for a new undertaking to let the yield move in a range of 20bp above or below zero.

Still, while this move would seem to amount to a form of tapering, the effect has been to some extent undermined by a BoJ attempt at “forward guidance” with the BoJ pledging at the same July policy meeting to maintain “current extremely low levels of short- and long-term interest rates for an extended period of time”. GREED & fear would not get too hung up in the confusion stemming from these seemingly contradictory actions. The simple reality is that Kuroda is coming under political pressure to start to normalise monetary policy, not least as a result of lobbying from the financial services sector which has been a major casualty from negative or zero interest rates. In this respect, the mixed message is best explained by Kuroda’s need to save face since he remains so far below the 2% inflation target he first committed to back in early 2013 at the launch of Abenomics.

Meanwhile, the two main current concerns of the Japanese central bank are the lack of greater traction in wages given the tight labour market and the risk that another bout of US dollar strength, triggered either by events in Europe or emerging markets or worse case both, precipitates another wave of “risk off” in markets which would likely send the yen higher against the dollar as well as other currencies. This to GREED & fear remains a real risk given that, on a real effective exchange rate basis, the yen remains undervalued (see Figure 16) while the market is now of the view that the BoJ has commenced “stealth tapering” which should be yen positive.

Figure 16Japan real effective exchange rate

Source: BIS, Bank of Japan

Meanwhile, from a stock market standpoint, it is of note that foreign investors are on course to sell more Japanese stocks year to date in US dollar in net terms than in any year since 1987 (see Bloomberg article: “A US$35 billion selloff is pulling down Japan’s stock market”, 29 August 2018). Thus, foreigners sold a net ¥3.9tn worth of Japanese stocks so far in 2018, according to Japan Exchange Group data through the week ended 24 August. This has already exceeded the previous annual record net selling of ¥3.7tn reached in 2008 and 2016 since the weekly data series began in late 1993 (see Figure 17).

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This foreign exit seems somewhat strange to GREED & fear since Japanese fundamentals are hardly disastrous from an equity market standpoint though “trade war” concerns are an obvious negative. Earnings growth remains satisfactory while share buybacks continue to rise. It is also the case that Japan has so far outperformed Europe and emerging markets year to date, if not the American market, in US dollar terms. The MSCI Japan Index is down 2.8% in US dollar terms year-to-date, compared with a 7.6% decline in the MSCI Emerging Markets and a 3.9% decline in the MSCI AC Europe Index, while the S&P500 is up 9% year-to-date (see Figure 18).

Figure 17Foreign net buying of Japanese stocks

Note: Data up to the week ended 24 August 2018. Source: Japan Exchange Group, Bloomberg

Figure 18MSCI Japan, Emerging Markets, Europe and S&P500 year-to-date performance in US dollar terms


So why the foreign exodus out of Japan? This is not an easy one to answer. But in the absence of a better explanation, GREED & fear would cite the growing loss of credibility of the Japanese stock market as a result of the BoJ’s ongoing buying of equities via the purchase of ETFs. Unfortunately, despite the commencement of stealth tapering, the Japanese central bank continues to persist with this unwise policy. It has now bought a total of ¥23tn worth of equities and is committed to buying another ¥6tn this year (see Figure 19). Yet the longer this policy persists, the greater the overhang and the greater the distortion to the functioning of the equity market, just as the BoJ’s massive ownership of JGBs has undoubtedly distorted if not killed the JGB market.

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Figure 19Bank of Japan holdings of Japanese equities

Note: Data up to 20 August 2018. Source: Bank of Japan

As previously discussed here (see GREED & fear – Revisionism, 2 August 2018), the best way to reverse out of this ridiculous policy would be to transfer the BoJ equity holding to the Government Pension Investment Fund (GPIF) off market. That would increase the equity weighting of the government pension fund from 26% to 37%. Now would be as good a time as any to do this since the GPIF is currently showing a positive return from its increased allocation to equities, a policy which is one of the most positive outcomes of Abenomics. The GPIF’s asset allocation to domestic equities has risen from 9.7% in March 2009 to 25.6% at the end of June 2018 (see Figure 20), while the GPIF made ¥2.6tn of capital gains in the quarter ended 30 June and ¥10tn in FY17.

Figure 20GPIF’s asset allocation in domestic equities

Source: Japan Government Pension Investment Fund (GPIF)

Still, for now Abe will not be focused on such a technical issue since he is concentrating on his campaign for the LDP presidential election on 20 September, a vote which he is expected to win in a landslide. Still, the issue of how the BoJ reverses out of its equity buying strategy will need to be addressed sooner or later.

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A word is due on India this week. Just as GREED & fear has been surprised by the extent of US equity outperformance this year, in the context of ongoing Fed tightening, so GREED & fear is surprised by the extent of Indian outperformance year-to-date in an Asia and emerging market context in US dollar terms. So, GREED & fear suspects, are many fund managers.

Figure 21MSCI India relative to MSCI AC Asia Pacific ex-Japan Index in US dollar terms


The Indian outperformance has become quiet marked. The MSCI India Index has declined by only 1.3% in US dollar terms year-to-date, while the MSCI AC Asia Pacific ex-Japan Index and the MSCI Emerging Markets Index are down 5.1% and 7.6% respectively over the same period. The MSCI India has also risen by 10.2% since bottoming in late May, while the Asia Pacific ex-Japan and emerging markets benchmark indices are down 4.1% and 5.5% over the same period (see Figure 21). This is all the more impressive given that the rupee is down 9.5% year to date.

Unlike America, where GREED & fear has been recommending an Underweight for global investors, GREED & fear has been positioned for an Overweight in India. Still, this is primarily on a structural view since GREED & fear will admit to having had no conviction at the start of 2018 that India would outperform this year which is why the triple overweight in the Asia Pacific ex-Japan relative-return portfolio was cut to a double overweight in February. Still, GREED & fear’s double overweight has been a lot higher than the positioning of most investors.

Why has India been so resilient and defied bearish expectations? One reason why is that India, as primarily a domestic-driven economy, is clearly much less exposed to Trump-driven trade concerns. But in GREED & fear’s view the stock market’s resilience may also be a sign that India is contra cyclical in the sense that the economy is accelerating at a time when many other markets in Asia could be near their cyclical peak. In this respect, it needs to be remembered that it is 10 years since the last investment cycle peaked. The gross fixed capital formation to nominal GDP ratio has declined from an estimated 36% in FY08 to 28.5% in the past three fiscal years (see Figure 22). When that new investment cycle commences it will be very bullish for the stock market. This is the main reason why GREED & fear has been less concerned about the undoubtedly high valuations in India. This is because, as has been pointed out by CLSA’s Indian strategist Mahesh Nandurkar for some time, in macro terms, the level of corporate profits in India relative to GDP is depressed, reflecting the lack of an investment cycle. Thus, corporate profits as a percentage of GDP havedeclined from 7.1% in FY08 to 3.1% in FY18 ended 31 March (see Figure 23).

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Figure 22India gross fixed capital formation as % of nominal GDP

Note: Data prior to FY12 estimated based on the historical Source: CLSA, MOSPI, CEIC Data

Figure 23India corporate profits as % of GDP

Source: CMIE, ACE Equity, MOSPI, CLSA

Is there any evidence of a new investment cycle? The data is reasonably encouraging. Real gross fixed capital formation rose by 14.4% YoY in 1Q18, while manufacturing sector capacity utilisation rose from 74.1% in 4Q17 to 75.2% in 1Q18, the highest level since 1Q16 (see Figure 24). The industrial production index for capital goods also increased by 9.6% YoY in June and was up 8.4%YoY in 1H18 (see Figure 25).

Still the difficulty with Indian macro data of late is the undoubted distortion created by the two ”shocks” of demonetisation in November 2016 and the introduction of the Goods and Services Tax (GST) in July 2017. That said, at a time when fund managers had at the start of this year given up on a capex cycle ever happening again in India, the equity market’s resilience may be a signal that it is nearer at hand than the consensus thinks. This would also mean that the stock market will be much more resilient to monetary tightening and a higher oil price than currently assumed. It would also mean that any correction, caused by the inevitable concerns that Prime Minister Narendra Modi will not be re-elected in next April-May’s general election, will be a buying opportunity. GREED & fear continues to believe that Modi will be re-elected.

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Figure 24India capacity utilisation rate

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Figure 25India industrial production growth for capital goods

Source: MOSPI

Meanwhile, if GREED & fear cut the overweight in India from a triple to double in the relative-return portfolio, fortunately the same did not happen in the long-only portfolio which remains 48% invested in India. Still, the portfolio remains heavily geared into housing finance and related property plays which have not been the main drivers of performance this year unlike last year in the Indianstock market. The Nifty Index has risen by 11% in rupee terms year-to-date and is up 17% from its 23 March low, while the Nifty Realty Index has declined by 20% year-to-date and is down 6% since late March (see Figure 26).

Still, GREED & fear continues to believe that the property cycle is turning up in India, as does CLSA’s Indian office. And the data supports this view. CLSA’s Indian property analyst Abhinav Sinha notesin a new report that pre-sales for listed developers and the industry in general are up in the 25-30% range in 1HCY18 (see Figure 27 and CLSA research India Property – Residential recovery broadening, 23 August 2018). So, while pricing is still lagging volume, the trend is clearly improving (see Figure 28). Meanwhile rising mortgage rates, up 30bp from a 12-year low of 8.4% in 1Q18 (see Figure 29), are less of a concern than they might be because of affordability running at the best level in more than 10 years (see Figure 30).

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Figure 26Nifty Realty Index relative to Nifty Index

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Figure 27India combined quarterly residential pre-sales of 12 listed developers

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Figure 28India average residential property price trend in prime locations of key cities

Source: CLSA, Cushman & Wakefield. *Mumbai, Delhi, Gurgaon, Bengaluru, Pune, Chennai, Hyderabad.

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Figure 29India mortgage rates

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Figure 30India housing affordability

Note: Mortgage payment to post-tax income ratio of a Rs6m mid-income apartment. Source: CLSA

Figure 31Net inflows into Indian equity mutual funds adjusted for Arbitrage funds

Note: Include 65% of flows into balanced funds. Source: CLSA, AMFI, Bloomberg

Finally, on India, it is also worth noting again the continuing resilience of inflows into domestic equity mutual funds, which is another reason for the stock market’s resilience this year. Net inflows into domestic equity mutual funds, excluding arbitrage funds, totalled US$16bn in the first seven

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months of this year, compared with US$12.4bn in January-July 2017 (see Figure 31). This increasingly looks like it is a secular, not a cyclical phenomenon, in which case it is extremely bullish.

On another topic, millennials are primarily known for spending their time fondling tiny computers called “smartphones” and providing the cannon fodder for the “sharing economy”. But in the investment area there has so far been one area which has aroused their interest. This has been, of course, the crypto currency boom and the related search for the best applications to implement blockchain technology.

Still, a second area of interest is now emerging in the area of cannabis investing as legalisation momentum gathers pace resulting in the opportunity to invest in a brand new consumer market. On this point, GREED & fear was interested to read about a deal announced earlier this month where Constellation Brands, a seller of liquor brands such as Corona beer and Svedka Vodka, will increase its stake in Canopy Growth, Canada’s largest publicly traded diversified cannabis company, from 10% to 38%. Apart from the obvious desire of Constellation to secure a presence in a burgeoning new market, the interesting point was the valuation with the deal done at a 51% premium to the previous closing price valuing Canopy at 103x trailing 12-month sales. The company was not profitable last year. Canopy’s share price has since risen to C$59.8 or 127x trailing sales, according to Bloomberg (see Figure 32).

Similarly, GREED & fear was also interested to read that UK alcohol giant Diageo is also pursuing a deal with a Canadian cannabis company (see BNN Bloomberg article: “UK alcohol giant Diageo circling Canada for cannabis deals” by David George-Cosh, 24 August 2018). Diageo has reportedly met with several Canadian companies in the past month to gauge their interest in a deal for a potential investment or collaboration to create new cannabis-infused beverages.

Figure 32Canopy Growth share price and price to sales ratio

Source: Bloomberg

Certainly, Canadian quoted cannabis companies enjoy lofty valuations even though they are down 45% from their peak (see Figure 33). All of the large licensed producers are not yet making any money. The reason that Canada is the epicentre of the cannabis story from an investment standpoint is because full-scale legalisation is due to be implemented on 17 October. When that historic event occurs, it is likely in GREED & fear’s view to act as a catalyst for pressure for legalisation to grow elsewhere, most particularly in America. At present 30 states in America have some form of a legalised cannabis programme if medicinal applications are included, while nine of

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these states have legalised recreational use. But if a person buys a cannabis product in, say, Denver and then flies with it to Los Angeles, he or she is breaking federal government laws even though recreational use is allowed in both Colorado and California.

Figure 33Bloomberg Canada Cannabis Competitive Peers Index

Source: Bloomberg

Figure 34Poll: Support for legalising marijuana use in the US

Note: The latest figures are based on a 5-11 October 2017 poll. Source: Gallup Polls

Why is legalisation coming? First and foremost, unlike most areas of contention in divisive American politics, cannabis legalisation does not appear to be a partisan issue. GREED & fear read recently, for example, that more than 50% of Republicans support legalisation (see Figure 34). GREED & fear also doubts that The Donald has huge problems with the issue though the American president will certainly be aware, as are the cashed up tobacco and liquor industries, of the commercial opportunities. GREED & fear recently saw an estimate from the Marijuana Business Daily that the US cannabis market is forecast to reach US$20bn by 2022, up from US$6bn in 2017, while the legaland illicit cannabis market is currently estimated at more than US$50bn. This puts it around the same size as other consumer goods industries such as smartphones and wine though, for now at least, still below cigarettes and beer which are running at around US$80bn and US$110bn.

There are two other reasons why the call for cannabis legalisation is gaining momentum in America. The first is the growing awareness of the reduced collateral damage from use of cannabis compared with alcohol, both for the individual concerned and for society at large since “stoned” people do not

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tend to be violent. But the second reason is more powerful. That is the dramatically increased awareness in America during the past two years of the country’s opioid addiction crisis in terms of the growing numbers of Americans addicted to “pain killing” prescription drugs such as OxyContin. Thus, Alan Krueger, former chairman of the President’s Council of Economic Advisers released a study in October 2016 that showed that nearly half of all prime working-age male dropouts from the workforce, comprising then nearly 7m people, were on daily “pain killer” medication (see Boston Fed Economic Conference paper: “Where Have All the Workers Gone?”, 4 October 2016). In practice this costly medication is often paid for primarily by Medicaid, America’s means-tested health benefits programme. Yes, America does have a form of socialised medicine, however basic.

America’s opioid crisis has existed for some time, as have the rise of the non-participation rate in the labour force and the related stagnant level of household incomes. The US labour force participation rate has declined from a peak of 67.3% in April 2000 to 62.9% in July 2018, while the number of Americans not in the labour force rose to a record 95.9m in May and was 95.6m in July (see Figure 35). But it only became a topic of media focus amongst East Coast and West Coast elites after the November 2016 election as explanations were sought as to how the people in the middle of the country, known as the flyover zone, could have elected such a person as Donald Trump. See, for example, a lengthy article on the opioid issue (Commentary Magazine: “Our Miserable 21st Century”,by Nicholas Eberstadt, 15 February 2017).

Figure 35US labour force participation rate and Americans not in the labour force

Source: US Bureau of Labour Statistics

Faced with the choice between Americans being addicted to opioids which are ultimately heroin derivatives, or having open access to cannabis, it is not hard to see which would be a better alternative in a society where there is now much greater focus on the fallout from ever greater wealth inequality, as indeed there is in the Western world at large, most particularly as “artificial intelligence” threatens more and more lower paying jobs. In this respect, Aldous Huxley’s vision in Brave New World (Chatto & Windus, 1932) of a future society where the masses are living on somamight turn out to be a more accurate vision of the future than George Orwell’s 1984 (Nineteen Eighty-Four, Secker & Warburg, 1949).

Certainly, no one should underestimate the ability of a legalised cannabis market to stimulate consumption by coming up with an attractive and diversified range of products. On this point, when last in America earlier this year, GREED & fear visited for the first time a cannabis store in Denver, and was struck by the clever merchandising in terms of the many different cannabis-related

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https://www.commentarymagazine.com/articles/our-miserable-21st-century/



products on offer. In this respect, where bottled water and premium coffee brands have gone, cannabis is likely to follow. But this is an area where Asia will definitely not be leading.

Meanwhile, it is too premature to assume that wealth inequality in America has peaked despite the revision to US data discussed here recently which has resulted in a significant increase in the household savings rate from 3.2% to 6.8% for May (see GREED & fear – Revisionism, 2 August 2018). The reason why is that the increase in the savings rate is primarily driven by upward revisions in the proprietors' income and investment income categories rather by an increase in the compensation of employees. Thus, US personal savings in 1Q18 were revised up from an annualised US$481bn to US$1.09tn, with disposable income revised up by US$516bn or 3.5% to US$15.3tn. Within this aggregate, proprietors’ income and investment income (interest and dividend income) were revised up by US$129bn and US$215bn (or 9.1% and 8.6%) respectively to US$1.55tn and US$2.72tn. By contrast, compensation of employees was revised up by only US$101bn or 1% to US$10.7tn (see Figure 36-38).

Figure 36Revision in 1Q18 US personal income and savings

Source: CLSA, US Bureau of Economic Analysis

Figure 37Revision in US proprietors’ income


Data for 1Q18 New Old change %chg New Old

Personal income 17,319 16,851 469 2.8% 76% 100% 4.3% 3.7%

Compensation of employees 10,710 10,609 101 1.0% 17% 22% 4.5% 4.4%

Proprietors' income 1,550 1,421 129 9.1% 21% 28% 5.1% 2.9%

Rental income of persons 749 762 -13 -1.7% -2% -3% 4.2% 4.3%

Income receipts on assets 2,720 2,504 215 8.6% 35% 46% 4.3% 3.5%

Personal current transfer receipts 2,934 2,911 23 0.8% 4% 5% 3.5% 2.8%

Less: Contrib. for govt social ins 1,344 1,356 -12 -0.9% 2% 3% 4.9% 5.6%

Less: Personal current taxes 2,030 2,078 -48 -2.3% 8% -- 1.3% 2.9%

Equals: Disposable personal income 15,289 14,773 516 3.5% 84% -- 4.7% 3.8%

Less: Personal outlays 14,195 14,292 -98 -0.7% 16% -- 4.5% 4.5%

Equals: Personal savings 1,094 481 614 128% 100% -- 7.8% -13.3%

Personal savings rate % 7.2 3.3 3.9 118% -- -- -- --

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Figure 38Revision in US personal investment income (interest income and dividend income)


As a result, proprietors’ income and investment income contributed to 74% of the revision in total personal income, compared with only 22% contributed by compensation of employees. The other point, of course, as regards compensation for labour is that the pickup in average hourly earnings growth in the past two years looks even less impressive when viewed in real rather than nominal terms. Thus, US real average hourly earnings declined by 0.2% YoY in July and are up only an annualised 0.2% over the past two years (see Figure 39).

Figure 39US real average hourly earnings growth

Source: US Bureau of Labour Statistics

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50 Master Moves That ShapedBerkshire Hathaway

AP

50 Master Moves That Shaped Berkshire Hathaway

The defining decisions that Warren Buffett has taken in the 50 yearsthat he has been leading Berkshire Hathaway

N Mahalakshmi & Rajesh Padmashali

While he has always wanted to win and still does, Warren Buffetthimself might not have visualised that he would end up creating theBerkshire Hathaway of today. He wrote in the 2014 annual report,“Berkshire now owns nine-and-a-half companies that would belisted on the Fortune 500 were they independent.” Last year, his

https://www.outlookbusiness.com/specials/50-master-move…way/50-master-moves-that-shaped-berkshire-hathaway-900 26/08/18, 10C43 AMPage 1 of 35

partner, Charlie Munger, had mused, “How the hell does this thingend up blowing past GE?” At last count, Berkshire had a market capof $360 billion versus GEʼs $280 billion.

Though Munger explained what he thought were the reasons forBerkshireʼs phenomenal success, he did also write, “Berkshireʼsbetter outcome was so astoundingly large that I believe that Buffettwould now fail to recreate it if he returned to a small base whileretaining his smarts and regaining his youth.” When this waspointed out at the 50th-year annual meeting, Buffett recalled thetrifecta that was unlikely to happen again. The first was LorimerDavidson spending four hours to explain the insurance industry tohim when he was a 20-year-old. The second was Jack Ringwaltselling National Indemnity to him and the final one was Ajit Jainwalking into his office in 1985.

Left to Buffett, his list of master moves would only be thesefortuitous three. But if one were to believe Munger, “If peoplewerenʼt so often wrong, we wouldnʼt be so rich.” The fortuitoustrifecta and Mungerʼs wisecrack aside, what they have achievedthrough Berkshire is the stuff of legend and the 50 master movesthat you will read below is only in hindsight.

1 Choosing to stay at OmahaThe key to thinking independently is to shut out noise and not getcarried away by it. Independent thinking and rationality has beencentral to Buffett s̓ success and being away from Wall Street hashelped.After graduating from Columbia and being turned down byBen Graham for a job at his investment firm Graham and Newman,he returned to Omaha to become a stockbroker. Buffett didnʼt quite


enjoy the brokerage business and pursued Graham, sending himstock ideas continuously till he relented. Buffett moved to New Yorkfor the love of the job in 1954, but returned to Omaha once Grahamdissolved his partnership firm in 1956.Buffett ran his investmentpartnership firm in Omaha with extreme success till 1969. His nextstint at New York was only when he stepped in at Salomon Brotherswhen it was embroiled in a crisis

2 Winding up Buffett PartnershipIn the investment industry, it s̓ not common for fund managers towind down operations and return capital to clients if they have runout of ideas or are circumspect. Buffett did exactly that early in hiscareer.After an extremely successful stint at the Buffett Partnership,delivering return of 29.5% compounded between 1956 and 1969,Buffett decided to close down the partnership and return the moneyto investors in 1969. Despite his fabulous performance, he took thisbold decision, citing “inability to find bargains in the current market”.He liquidated all shares held by the partnership except BerkshireHathaway, a textile company he had whimsically taken control of.


3 Turning Berkshire into an investment companyBuffett qualifies his Berkshire purchase as the "dumbest" stock hebought but then turned it into his famed investment vehicle. Whenhe first bought into Berkshire, its textile business was ailing but herevived the company under CEO Ken Chace. Besides Chace'sefforts to reduce inventory, sweat and sell assets, a temporarycyclical upturn generated substantial cash in the initial years. Buffettread correctly the winds of change affecting the textiles business,so he changed direction and invested its cash flows into morelucrative businesses. This decision forms the foundation forBerkshire's future. "Burlington Industries, the largest company in thetextiles business (then and now) chose a different path, deployingall available capital into its existing business between 1965 and1985. Over the 20-year period, Burlington's stock appreciated at apaltry annual rate of 0.6 percent; Berkshire's compunded return wasa remarkable 27 percent", notes William Thorndike in his book TheOutsiders.

4 Focusing on capital allocationBuffett figured out in his late 20s that investing had become hispassion and that s̓ what he excelled at. His enormous reading list


and legwork had led to a deep understanding of varied businessesand their economics, unlike most CEOs, who are constrained andblinkered because of the business they operate in. Whatdifferentiates Buffett from other successful CEOs is that he turnedBerkshire into an investment company where he would take allinvestment decisions and let the operating managers take care ofthose businesses. Despite their phenomenal operating experience,the managers of Berkshire companies send their profits back toOmaha and Buffett decides on the allocation based on everybusinessʼ investment worthiness. There is no question of sinkingmoney in declining businesses (textiles was shut down) but nothingstops him from allocating extraordinary capital to businesses thatmay hold outsized return potential. In recent history, capitalintensive businesses such as BH Energy and Burlington Northernhave received a bulk of the funding for acquisitions and expansion.

5 Investment flexibilityThrough his career, he has dabbled in every financial instrument inthe universe. Buffett has been asset-class agnostic, though now heis constrained by size. He still wants to own the best and says, “AtBerkshire, we prefer owning a non-controlling but substantialportion of a wonderful company to owning 100% of a so-sobusiness; it s̓ better to have a partial interest in the Hope Diamondthan to own all of a rhinestone. Our flexibility in capital allocation —our willingness to invest large sums passively in non-controlledbusinesses — gives us significant advantage over companies thatlimit themselves to acquisitions they can operate. Our appetite foreither operating businesses or passive investments doubles ourchances of finding sensible uses for Berkshire s̓ endless gusher ofcash.”


6 Investing in long-term relationshipsBuffett s̓ investment prowess apart, one of his greatest strengths ishis ability to gauge character and competence in people, andcultivate them. Right from choosing Charlie Munger as his partner,to his close association with the chairperson of Washington PostCompany, Katherine Graham, who aided in understanding the mediabusiness, where he made some remarkable bets, to the currentpartnership with 3G Capital. Buffett s̓ secret to great long-termrelationships is to first have a high entry barrier in terms of trust.Buffett works with trust and talk rather than confront and mock. Hisapproach of “praise by name, criticise by category” also ends upwinning him more friends than enemies.

7 National Indemnity Buffett s̓ likeability also resulted in many a great deal. Jack Ringwalt,the controlling shareholder of National Indemnity Insurance, cameto Buffett in 1967 saying he would like to sell. Buffett did not ask foran audit, as he knew Ringwalt was honest but quirky, and wouldwalk away if the deal became complicated.Buffett used a bulk ofBerkshire s̓ cash to acquire National Indemnity and sister companyNational Fire and Marine for $8.6 million. “Though that purchase


had monumental consequences for Berkshire,” Buffett reveals in the2014 annual letter, “its execution was simplicity itself.” Moreimportantly, it became an important pillar of the Berkshire structure.

8 The power of floatUsing the insurance business to fuel his investment vehicle wasBuffett s̓ masterstroke, as it provided an implicit leverage withoutthe firm having to actually borrow any money but bolstering overallreturn. This “float” is estimated to have added nearly a third toBerkshire s̓ annual return. Buffett explains the power of float lucidlyin his 2014 letter. “Property-casualty insurers receive premiums upfront and pay claims later. This collect-now pay-later model leavesP/C companies holding large sums — money we call ‘float.̓Meanwhile, insurers get to invest this float for their benefit.Consequently, as our business grows, so does our float.” Besides,Buffett adds, the nature of Berkshire s̓ insurance contracts is suchthat “we can never be subject to immediate demands for sums thatare large compared to our cash resources. This strength is a keypillar in Berkshire s̓ economic fortress”.

9 Underwriting disciplineNormally, insurance companies register an underwriting profit ifpremiums exceed the total of expenses and eventual losses thatadds to the investment income the float produces. Buffett says thelure of this profit creates such intense competition that the industryactually ends up with a significant underwriting loss.But Berkshire isan exception, operating at an underwriting profit for 12 consecutiveyears, with pre-tax gain for the period having totalled $24 billion.The whole strategy of profitable underwriting and focus on floatcreation, as opposed to simply focusing on premium revenue, has


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meant that Berkshire companies would avoid underwriting insurancewhen prices were unattractive, while underwriting large amountswhen the prices were attractive.“In 1984, National Indemnity wrote$62.2 million in premium. Two years later, premium volumes grew anextraordinary six-fold to $366.2 million. By 1989, they had fallenback 73 percent to $98.4 million and did not return to the $100million level for 12 years. Three years later, in 2004, the companywrote over $600 million in premiums. Over this period, NationalIndemnity averaged an annual underwriting profit of 6.5 percent as apercentage of premiums compared with an average loss of 7percent for a typical property and casualty insurer,” points outThorndike in The Outsiders. As for re-insurance, almost all big-ticket underwriting lands up at Berkshire. “When major insurershave needed an unquestionable promise that payments of this type(where contracts entail substantial payments 50 years hence ormore) will be made, Berkshire has been the party — the only party— to call,” says Buffett, adding that there have been only eight P/Cpolicies in history that had single premium exceeding $1 billion andall eight were written by Berkshire; the highest ever was atransaction with Lloyd s̓ in 2007, where the premium was $7 billion.

10 GeicoBuffett bought into Geico when the firm lost more than 95% of its


value because of serious underwriting losses, but a new CEO wastrying to revive the company, bringing back the underwritingdiscipline it was once known for. Between 1975 and 1980, Buffettinvested about $45 million into Geico, raising his stake to 33%, ashe knew the company had a low-cost structure (it directly soldinsurance to customers and, hence, its operating cost was 15 centsa dollar compared with 24 cents for competition) and with the newmanagement, it could do better.Over the next 15 years, by 1995,Buffett s̓ investment had grown to $2.4 billion, a 51% stake, as thecompany also bought back shares. Berkshire finally bought theremaining 49% in January 1996 for $2.3 billion. In the 2014 annualletter, Buffett wrote, “It was clear to me that Geico would succeedbecause it deserved to succeed. No one likes to buy auto insurance.Almost everyone, though, likes to drive. The insurance consequentlyneeded a major expenditure for most families. Savings matter tothem — and only a low-cost operation can deliver these. Geico s̓ lowcosts create a moat — an enduring one — that competitors areunable to cross.”

11 Conglomerate structureCharlie Munger loves spin-offs as a strategy and Buffett himselfmay feel that Berkshire is subject to a holding company discount,but they have favoured the conglomerate structure rather than splitthe company for a short-term pop. The conglomerate structure isabhorred by the market, usually because of the discretion it allowsmanagement to allocate — or misallocate — capital. With Buffettand Munger at the helm, the structure works beautifully, as theyhave perfected capital allocation. The biggest advantage is taxefficiency. Buffett has often advocated more taxes for the rich buthas worked toward minimising tax outgo via deal structuring and


deferrals. “Thanks to its long-time horizon, Berkshire holds manyassets acquired decades ago, resulting in deferred taxes nowtotalling $60 billion. These amount to interest-free governmentloans without conditions,” says Buffett watcher LawrenceCunningham.

12 Lean operationFor a company of Berkshire s̓ size and complexity with a turnover ofnearly $200 billion and 340,000 employees, its headquarters isthinly staffed — and that s̓ an understatement. Berkshire s̓ office atFarnam Street in Omaha houses 25 people, including Buffett. AddsCunningham, “Most sizable American corporations use centralisedprocedures and departments, middle managers meeting regularly,along with consultants, directives, supervision and second-guessing. Berkshire has none of that — no centralised accounting,personnel, legal or technology departments; no hierarchies forreporting or budgeting; no middle managers or consultants. All suchfunctions are handled in the individual units.” That cuts costs and


eliminates bureaucracy.

13 Buying forever as centerpiece As Buffett graduated from Graham s̓ cigar butts strategy to one thatemphasised quality stocks and fair prices, “buying forever” wasprobably a natural corollary. Implicit in the philosophy of buying forkeeps are three considerations: 1) the power of compounding cando magic over long time periods, 2) there is cost associated withmoving in and out of stocks, which erodes value over time, and 3)the reinvestment risk associated with winding down an existingholding. Barring IBM, which was purchased in 2011, his top fourpositions have been in his portfolio for over 20 years.

14 See's CandiesSee s̓, a California-based candy company, was the landmarkinvestment that marked the departure of Buffett from a purequantitative process that Graham advocated to a quality-focusedapproach — the concept of ‘moatʼ in Buffett parlance. Buffettbought the company on Munger s̓ recommendation, at a price farhigher than what he had paid for any stock till then. He paid $25


million, or 6X operating income, in 1972. To date, See s̓ Candies hasbrought in pre-tax earnings of $1.9 billion, with its growth funded byinvestments of $40 million. See s̓ competitive advantage wasunleashed after Buffett initiated a more aggressive pricing strategycommensurate with its quality of products. Buffett has said, “If therewas no See s̓, there would have been no Coke,” highlighting thesignificance of this investment.

15 Coca-ColaBuffett s̓ big bet on Coke had many tittering as they could not figureout why Buffett had taken such a massive bet on a century-oldcompany. But the cold war was thawing and coupled with a massivedistribution moat, Buffett could not see anything but a windfall ofsugary profits from across the globe. The presence of one-timeneighbour, the very competent Donald Keough, at the helmreinforced the comfort. Berkshire is now sitting on more than atwenty-fold gain on its investment, with the dividend fountainunlikely to run out of concentrate anytime soon. Coke is one ofthose dream investments for Buffett, high not only on nostalgia butalso on return.


16 Washington PostThis was one of those bargains of the century. Not only did he run apaper route as a teen, Buffett had also been buying regionalnewspapers and realised that sooner or later, the bulk of theadvertising ends up with the market leader. The WashingtonPost was as strong as one could get in its market and given what itwas trading at, Buffett loaded up enough to become the second-largest shareholder in the holding company. If anything comes closeto Coke, Washington Post Company must be it. The only differenceis that he let go of it, but in a tax-effective manner that only Buffettcould have envisaged.

17 Capital CitiesIf The Washington Post was Buffett s̓ initiation to national


newspapers, then Capital Cities and getting to know Tom Murphywas his gateway to national broadcasting. His earlier experience ofinvesting in ad agencies and the template of advertising leadershipwas transplanted to a television network. Buffett financing CapitalCitiesʼ acquisition of ABC resulted in a network that ran across thecountry, and then the eventual buyout by Disney. Again, like Keoughat Coke, the formidable tag team of Tom Murphy and Dan Burke atCap Cities made a big difference to how the return shaped up.

18 Concentration as opposed to diversificationBuffett and Munger have held the view that diversification does notreduce risk. “Diversification is protection against ignorance. Itmakes little sense if you know what you are doing,” Buffett hasfamously said. In the end, investing is about recognising everythingthat could go wrong and still being convinced about the upside.What this means is that your chances of striking it rich are higher ifyou bet on a few high-conviction ideas than across many whereyour conviction isnʼt as high. Currently, the top four positions inBerkshire s̓ investment portfolio account for 60% of the total value.There have even been occasions when a single stock hasaccounted for more than 15% of the total value.

19 American ExpressDuring his partnership days, Buffett made a big bet on AmericanExpress in 1965, when the company was battling the salad-oil crisis.He loaded up on Amex, building it to about 40% of his total portfolio— that amounted to more than 5% ownership in Amex at a cost of$13 million. That affection continues and Berkshire today holdsnearly 15% in Amex, and that stake was worth $14 billion in end-December 2014.American Express' credit card business focuses on


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encouraging higher spending by creating great reward schemes.While Amex has consistently widened its basket of offerings, it hasbeen facing the heat recently because of a host of businesschallenges, including the end of its partnership with Costco, thelargest US wholesaler. Buffett is unfazed, but his portfolio managershave already built positions in MasterCard and Visa, although thatexposure is significantly smaller.

20 Wells FargoBuffett s̓ traditional dislike of financial institutions was overcome bythe valuation at play. During the collapse in banking stocks in 1990,Buffett reckoned that Wells Fargo s̓ balance sheet had the depth towithstand the rot lending it had done. It was too good anopportunity to pass up and pretty soon, he was laughing all the wayto the bank to buy more of its stock. So much so, that today,Berkshire holds about 10% of the bank in its investment portfolio.Given his earlier affirmation about “loading up on things that he likesbest”, expect him to add more to the single-biggest holding in hisportfolio.

21 Moody'sWhile he does make general statements, Buffett never goes to town


with his investment thesis on any of his holdings. However, many intown went after him for Berkshire s̓ holding in Moody s̓ after the2008 crisis. Buffett, who was one of the ardent critics of thoseinvolved in the sub-prime crisis, always had a fat holding inMoody s̓, one of the credit rating agencies, that was asleep at thewheel. Moody s̓ enviable regulatory moat aside, Buffett has reducedhis holding over the years but the remainder is still worth over $2billion. This is probably one of the few stocks which has made himmoney but not given him much cause for cheer.

22 Contrarian approachAt the heart of investing are the emotions of greed and fear. Themore depressed and fearful the market, the greater the potential forgains. And vice versa. While Buffett has bought into greatbusinesses run by able managements, he timed his entry on severaloccasions when the stock was hit by a major scandal or crisis,which, in Buffett s̓ assessment, did not damage the intrinsic value ofthe business to the extent that the market was reacting. Thorndikenotes, “The majority of Berkshire s̓ public market investmentsoriginated in some sort of industry or company crisis that obscuredthe value of a strong underlying business.”

23 Strike only when coldConventional fund managers say “time in the market is moreimportant than timing the market.” While that statement may have


some merit, steering clear of a major catastrophe can result in veryvaluable dry powder. Buffett did so famously on two occasions —the first time in the late ʼ60s when he dissolved the BuffettPartnership and returned money to investors saying the marketswere overvalued; and he did a repeat in 1987 ahead of the Octobermarket crash, when he sold all his stocks barring his core positions.Buffett s̓ comfort with long periods of inactivity and spurts of peakactivity is legendary and helps seize opportunities that offersuperlative return.

24 Smart acquisitions led by intrinsic value The key to maximising return is to buy businesses when the price issubstantially lower than the intrinsic value. Buffett s̓ acquisitions arenot led by size or synergies but by the addition to intrinsic worth.Deeply cognisant of the intrinsic worth of Berkshire, barring the oddmisstep with Dexter Shoes, he has largely abstained from makinglarge acquisitions (BNSF is an exception) using shares. “Theintrinsic value of the shares you give in an acquisition should not bemore than the intrinsic value of the business you receive. Tradingshare of a wonderful business which Berkshire most certainly is forownership of a so-so business irreparably destroys value,” saidBuffett in his 2014 letter, adding that “Iʼve yet to see an investmentbanker quantify this all-important math when he is presenting astock-for-stock deal to the board of the potential acquirer.”


25 Positioning BRK as a great place to sellBerkshire has, over time, earned itself a reputation of an ideal homefor family businesses wanting to sell out. Firstly, it s̓ easy to sell toBerkshire. No prolonged discussions or negotiations. Buffett hasbeen listing his “acquisition criteria” in the Berkshire annual reportfor over three decades now, and any business-owner can approachBuffett directly if the acquisition criteria are met. Buffett is quickwith deals and assures to give an answer usually in five minutes orless. But more than the ease of transaction itself is what comesafter. Says Barnett Helzberg, who sold off his business HelzbergDiamonds to Berkshire Hathaway in 1995, “Promoters know Buffettis not going to change it, he is not going to sell it and he is not goingto take it public. That is why he is the best person in the world to sellout to. That is also why Warren gets the opportunity to buy somevery good family businesses.”

26 Hire well, manage littleBuffett may have said, “I try to buy stock in businesses that are sowonderful that an idiot can run them. Because sooner or later, onewill,” but that grossly underplays the emphasis he lays on smartmanagers. His model of extreme de-centralisation would not workunless the operating managers delivered. A notable fact is thatnobody at Berkshire is awarded stock options. Having hired well,


Buffett limits his interactions with his CEOs to the minimal, only toget involved in capex decisions. He allows 100% operating freedomto his managers, with full expectation that they will beconscientious. This tightrope walk has ensured that Berkshire hasnever lost a CEO to competition in all these years. It alsodemonstrates the fiduciary responsibility that is ingrained in theBerkshire culture.

27 Trust-based model In May 2009, when the world was emerging out of the credit crisis,Buffett s̓ partner Charlie Munger said something fundamental aboutBerkshire Hathaway that resonated with the 35,000 people presentat the annual meeting: “Our model is a seamless web of trust that s̓deserved on both sides. That s̓ what weʼre aiming for. TheHollywood model, where everyone has a contract and no trust isdeserved on either side, is not what we want at all.” To which Buffetthad added, “We donʼt want relationships that are based oncontracts.” It is this seamless web of deserved trust that is unique toBerkshire.

28 Steering clear of institutional imperativeHuman beings and, by extension, companies find great comfort inherding. Hence, anything popular or even downright financiallyfoolish gets copied if there are enough people doing it. That appliesto sub-prime lending or the rush to underwrite insurance at lowpremium. It is then left to independent-minded contrarian leaders toensure that their institution doesnʼt succumb to mindless fads orindulge in collective behaviour that borders on grey. Buffett wasclear from the onset about doing the right thing both in letter andspirit and this was forcefully put forward when he stepped in to fixthe breakdown at Salomon Brothers. All his operating companiesare expected to toe the line.


29 No banker for dealsIn the earlier days, Buffett, unlike most CEOs, relied on his ownresearch. And he didnʼt rely on investment bankers to do dealseither. Bankers and brokers are driven by self-interest and for thehefty fees they charge, their advice often ends up being counter-productive. “Donʼt ask the barber if you need a haircut,” saysBuffett. Apart from the deals that knock on his door, he relies on hisnetwork and previous sellers of businesses for deals. That has notdeterred Wall Street from calling every now and then as Berkshiresubsidiaries do a lot of bolt-on acquisitions through the year.

30 Governance structureIf Berkshire were some middling company, its board could havepassed off as a coterie. Most of them have known Buffett for a longperiod of time but there is a big difference. The directors arepersonally invested in Berkshire and those shares have been boughtwith their personal money. Buffett champions the idea that directors


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will be able custodians of shareholder interest when they have skinin the game. Unlike other American directors who are well-paid,Berkshire directors get paid almost nothing. They probably end upspending more attending the board meetings and are also notprovided liability insurance cover.

31 Direct communication with shareholdersIn line with the belief of not pandering to Wall Street, he does notgive earnings guidance, spends no time on analyst calls orinvestment conferences but spends a full day answering questionsat his legendary annual shareholder meetings in Omaha. Hisshareholder letters are a detailed account of all the major operatingbusinesses of Berkshire, besides his take on important economicconcepts and issues. Buffett and Munger have maintained that allshareholders should have access to new information that Berkshirereleases simultaneously and should also have adequate time toanalyse it. All financial data is thus released late on Fridays or earlyon Saturdays. The annual meeting is also always held on the firstSaturday in May. Buffett and Munger do not talk one-on-one tolarge institutional investors or analysts, treating them as they do allother shareholders.


32 Not splitting shares and creating another classManagements often engineer stock splits to make the stock appearoptically cheap and to create greater liquidity. Slicing a pizza doesnot make it any bigger, so Buffett has refrained from splitting theshares of Berkshire. Higher ticket size investments are often morethought through by investors and they tend to take a more long-term view. Still, Buffett created a new Class B, with fractionaleconomic and voting rights, back in 1996 when two New Yorkmoney managers designed a unit trust that would buy the stock andthen issue fractional units designed to trade at a low price for a fee.“To knock out these meddling middlemen, Berkshire amended itscharter to rename its existing common stock Class A and add aClass B, with fractional economic and voting rights. It vowed to offeras many shares as necessary to fill demand, which it did, thus killingoff demand for the unit trust,” says Cunningham.

33 No dividend policy


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Over the past nearly 50 years, Berkshire has not paid a single dollaras dividend. In addition to its cash pile, Berkshire earned $20 billionin 2014 but all of that is retained for reinvestment. In his 1984 letterto shareholders, Buffett wrote, “Unrestricted earnings should beretained only when there is a reasonable prospect — backedpreferably by historical evidence or, when appropriate, by athoughtful analysis of the future — that for every dollar retained bythe corporation, at least one dollar of market value will be createdfor owners. This will happen only if the capital retained producesincremental earnings equal to, or above, those generally available toinvestors…”For investors who are in need of cash, he suggestsselling shares instead. “The sell-off policy lets each shareholdermake his own choice between cash receipts and capital build-up.”The other advantage is that dividends attract a higher rate of taxcompared with capital gains. The recent clamour for dividends fromcertain pockets was voted down overwhelmingly by the majority ofshareholders.

34 Integrity at all costsBuffett s̓ values of integrity and humility were ingrained at an earlyage from his father Howard Buffett, a stockbroker who later ransuccessfully for Congress. Warren has carried that forward andcarefully built Berkshire with trust and integrity as core values.


Breach of trust and integrity issues fall in the zero-tolerance zonefor Buffett and Munger. After the Salomon Brothers episode, thiswas again apparent when Buffett took the tough decision to let goof David Sokol, after it came to light that he had bought shares ofLubrizol in his personal account ahead of Berkshire s̓ acquisition ofthe company. David Sokol was one of his smartest managers, atrusted lieutenant and potential heir apparent. Despite that, orperhaps because of that, Buffett took the hard call.

35 Surfing big trendsAlthough Buffett underplays how much he looks at macros, hisstock selection reveals a strong underpinning of the prevailingeconomic environment. Whether it be companies having pricingpower when inflation was hurting or playing the private equity gameat a time of near-zero interest rates or even investing in a businesslike wind energy because of the tax advantages it offers, Buffett hasintelligently played macro trends as is visible in his portfolio. Thebeauty of his strategy is to pick stocks by quickly identifyingstructural trends but, at the same time, not lose sight of anopportunistic move that could hold significant gains.


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36 Betting on management changeAnother strategy is betting on a new management and strategicchange. Managements tend to destroy value when they diversifyinto businesses that promise lower returns than the existing“franchise-type” business that delivers high returns. A capable newmanagement can add value by simply returning to the core businessand doing away with mediocre businesses, and that s̓ a goodopportunity to exploit. Thorndike presents evidence in his book TheOutsiders.

37 Saying no to dotcom darlingsEven at the peak of the internet boom, when Buffett wasunderperforming and there was pressure and criticism about hisabstaining from technology, he stuck to his circle of competence.


Although Buffett says he does not understand technology, the truthis that the pace of technology change makes predicting future cashflows next to impossible. Often, the longevity of the company alsobecomes questionable. Even though Buffett has largely refrainedfrom technology, he bought into IBM in 2012 and has added to hisposition amid much cynicism.

38 Widening circle of competenceSticking to his circle of competence has been Buffett s̓ pet theorybut the best part of Buffett and Munger is that they turnedthemselves into a life-long learning machine which has resulted inan ever-expanding circle of competence. The continuous learning— besides being intense readers, both devour balance sheets like atabloid — ensures that they know what to look at and where not towaste time. In the recent annual meeting, Munger said, “We werealways dissatisfied with what we already knew, and we wanted toknow more. If Warren and I had stayed frozen in time, Berkshirewould have been a terrible place.”


39 Cultivating China as an allyOutside the US, UK and Germany, the country with the mostBerkshire fanatics has to be China, where he is looked upon as agod of investing. About 3,000 shareholders were in attendance fromChina for the 50th-year annual meeting, and so were variousChinese media agencies. Buffett and Munger, too, are impressed bythe way China has emerged as an economic power. And being thekind to have always looked around bends, they both believe that it isimperative for the US to nurture a cordial economic and politicalrelationship with China. While there has been nothing recent,Berkshire s̓ earlier investment in PetroChina was handsomelyrewarding.

40 PetroChinaThis was Buffett s̓ first major investment in the Chinese market andseemed timed to cash in on a bottoming crude market and potentialeconomic recovery in 2002. Buffett, until then, had not venturedoutside the US market in such a major way, with a close to $500-million investment. The recovery in the world economy resulted in ahigher crude price and Buffett exited the largest Chinese oilproducer making seven times his original investment. In an earlier


interview, he had mentioned, “We bought it at a $35-billion marketcap, but I thought the company was worth at least $100 billion.When we sold the stock, it was valued at probably $250 billion-275billion.”

41 BYDMunger may have discussed and suggested a zillion investmentideas after See s̓ Candies to Buffett, but it is the BYD investmentthat most recall as the recent one influenced by him. The BYDinvestment was suggested by Himalaya Capital s̓ Li Lu — whomanages Munger s̓ money — and then became a part of theBerkshire portfolio. BYD is essentially a bet on the adoption ofelectric cars in China, and possibly around the world. The companyis working on an efficiently rechargeable car battery and if it getsthere before anybody else, there is another windfall awaitingBerkshire. That happening, BYD will indeed mean Build YourDreams.


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42 Berkshire Hathaway EnergyEarlier known as MidAmerican, Berkshire Hathaway Energy supplieselectricity and natural gas to about 12 million customers andgenerated $1.9 billion in net earnings in 2014. Buffett hastraditionally stayed away from utilities, as they are capital-intensivebusinesses. The aggressive stance at BH Energy is not only drivenby tax incentives but also the assurance of a steady return. In a way,it seems to be insurance against a turn in the current benign marketenvironment. There is also a potential successor in the form of GregAbel, who also sits on the board of Heinz.

43 Impeccable deal structuring Buffett is great at identifying investment opportunities, as his buyingspree during the 2008 crisis showed, but his prowess extends far


beyond in smartly structuring deals. Buffett invested in the late ʼ80sin convertible preferred securities of Salomon Brothers, Gillette, USAirways, and Champion Industries, wherein the dividends came withtax relief, which meant that not only could he earn higher post-taxyields but also benefit from any potential appreciation in stock price.In the deal struck with Bank of America post the crisis, Berkshirehas the option of buying 700 million shares by 2021 at $5 billion.The market value of that stake today is $12 billion. Buffett is stillsitting on the position and says he will “exercise the option closer toexpiry”, even as he holds on to the cash. He has also frequentlyused a “cash-rich split-off” to maximise return. This play involves anexchange of cash and assets for stock and Buffett has used thistax-efficient mechanism very effectively in the case of the Duracellacquisition and to exit the Washington Post Company.

44 Burlington NorthernIf there was a direct vote on the future of the US economy, this $44-billion deal was it. It is now in Buffett s̓ words “Berkshire s̓ mostimportant noninsurance subsidiary”. Berkshire will spend $6 billionon capital expenditure to improve capacity and its network. This isone quarter of revenues, but this capex as well as that at BH Energyshould lead to more deferred taxes and hence quasi float. Given thefear of mishaps, half the capex will be for improvement andmaintenance of tracks.

45 IscarIf PetroChina was the first major listed equity that Berkshire boughtoutside the US, then metalworks company Iscar was the first major


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buyout of a private company outside the US for Berkshire. Thisbuyout, again, reinforced Berkshire s̓ position as a prized home evenfor private companies outside the US. The $6-billion transactionwas done in two parts over 2006 and 2013, and the fact thatBerkshire paid $2 billion for the last 20% implied that it was prettysatisfied with the way Iscar had grown since the acquisition. Giventhis favourable experience, it is likely that Berkshire could do moreacquisitions in Israel.

46 IBMThe world takes its own time to come around and grasp the wisdomin Buffett s̓ decisions. His call to invest in IBM might be another suchcase. It could well be that Buffett has not bought IBM for itstechnology. After having dissected it well over his lifetime, he mighthave bought it as a digital concrete company for its corporate moat,regular cash flows, share buy-backs and its capacity to pay regulardividends. Buy-backs are a regular theme wherever Buffett isinvolved, and so are dividends. Buffett likes dividends, it is just thathe doesnʼt like to pay them. Then, given its legacy and standing inthe corporate world, IBM is not something that will just go away. Itcan marshal enough resources to do an acquisition and tilt theplaying field in services.


47 Partnering with 3GIn a world of low interest rates, to juice up return, you need leverage.Debt has been anathema to Berkshire since its inception. So, thenext best alternative in a 1%-interest-rate world is to do privateequity with a partner that you are comfortable with. 3G Capital isthat partner for Berkshire Hathaway and Jorge Paulo Lemann seemsto be someone who Buffett is comfortable with. Getting intoBerkshire s̓ inner circle is a tough act, and that Buffett is taking theflak for 3G s̓ tough-love tactics is a reflection of the belief that hehas in its capabilities. Look forward to more big elephant co-hunting.

48 Cash hoard


Buffett has been averse to leverage and loves cash because itcomes handy when the best opportunities arise. That belief has onlybeen strengthened over time, especially after the 2008 crisis, whenthere was great opportunity in the market and Buffett himself endedup buying early in the plunge. He considers cash a strategicadvantage, and that was very evident in 2008. And even thoughBuffett may deliberately deemphasise macro fundamentals in hisinvestment approach, his acute sense of timing has helped himmake profitable decisions. That s̓ probably the reason he is beingjudicious with his cash in the current times.

49 Succession structure

This has been the subject of endless speculation, and almosteverybody associated with Berkshire was unusually tight-lipped thistime around at the annual meeting. Buffett had earlier written, “Boththe board and I believe we now have the right person to succeed meas CEO — a successor ready to assume the job the day after I die orstep down. In certain important respects, this person will do a betterjob than I am doing.” Even Charlie Munger, who knows how much tospeak and where, had everyone chattering after mentioning GregAbel and Ajit Jain. The only hitch is that outside of Buffett andMunger, despite Berkshire s̓ culture, very few seem assured that hissuccessor will measure up. Given the tone of finality in the 2014letter, it is likely that a successor will be announced much soonerthan is expected.


50 Giving through Berkshire

Over the years, Warren and Charlie have transferred planeloads ofwisdom through their writing and annual meetings at Omaha andLos Angeles. They have not only been generous with theirknowledge but also with their wealth. Like with most things, bothBuffett and Munger are in sync here. “Those of us who have beenvery fortunate have a duty to give back. Whether one gives a lot asone goes along as I do, or a little and then a lot (when one dies) asWarren does, is a matter of personal preference,” says Munger.Buffett, on his part, has outsourced his giving to the Bill and MelindaGates Foundation. He has been systematically giving Berkshirestock away and continues to nudge other billionaires to sign theGiving Pledge. The impact of this collective largesse will be felt afterthose who left it behind are long gone.

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A DECADE AFTER THE GLOBAL FINANCIAL CRISIS: WHAT HAS (AND HASN’T) CHANGED? BRIEFING NOTESEPTEMBER 2018

It all started with debt.

In the early 2000s, US real estate seemed irresistible, and a heady run-up in

prices led consumers, banks, and investors alike to load up on debt. Exotic

financial instruments designed to diffuse the risks instead magnified and

obscured them as they attracted investors from around the globe. Cracks

appeared in 2007 when US home prices began to decline, eventually causing

the collapse of two large hedge funds loaded up with subprime mortgage

securities. Yet as the summer of 2008 waned, few imagined that Lehman

Brothers was about to go under—let alone that it would set off a global liquidity

crisis. The damage ultimately set off the first global recession since World War

II and planted the seeds of a sovereign debt crisis in the eurozone.1 Millions

lost their jobs, their homes, and their savings.

The road to recovery has been a long one since those white-knuckle days of

September 2008. Historically, it has taken an average of eight years to recover

from debt crises, a pattern that held true in this case.2 The world economy

has recently regained momentum, although the past decade of anemic and

uneven growth speaks to the magnitude of the fallout.

Central banks, regulators, and policy makers were forced to take extraordinary

measures after the 2008 crisis. As a result, banks are more highly capitalized

today, and less money is sloshing around the global financial system. But

some familiar risks are creeping back, and new ones have emerged. In this

article, we build on a decade of research on financial markets to look at how

the landscape has changed.3

A decade after the global financial crisis: What has (and hasn’t) changed? 2 McKinsey Global Institute

GLOBAL DEBT CONTINUES TO GROW, FUELED BY NEW BORROWERS

As the Great Recession receded, many expected to see a wave of

deleveraging. But it never came. Confounding expectations, the combined

global debt of governments, nonfinancial corporations, and households has

grown by $72 trillion since the end of 2007 (Exhibit 1). The increase is smaller

but still pronounced when measured relative to GDP.

Underneath that headline number are important differences in who has

borrowed and the sources and types of debt outstanding. Governments in

advanced economies have borrowed heavily, as have nonfinancial companies

around the world. China alone accounts for more than one-third of global

debt growth since the crisis. Its total debt has increased by more than five

times over the past decade to reach $29.6 trillion by mid-2017. Its debt

has gone from 145 percent of GDP in 2007, in line with other developing

countries, to 256 percent in 2017. This puts China’s debt on a par with that of

advanced economies.

Exhibit 1

SOURCE: Bank for International Settlements (BIS); McKinsey Country Debt Database; McKinsey Global Institute analysis

1 Includes household, nonfinancial corporate, and government debt; excludes debt of the financial sector. Estimated bottom up using data for 43 countries from Bank for International Settlements (BIS) and data for eight countries from McKinsey’s Country Debt Database.

NOTE: Figures may not sum to 100% because of rounding.

31

2000

Households 18

54

07

25

41

21

37

29

32

32

110

08

33

42

66

5936Government

33

09

43

4060

10

3936

15

52

43

50

13

64

38

148

56

157

14

61

56

42

65

16

Nonfinancialcorporates

97105

169166

117

139

Change, 2007–H1 2017Percentage points

Total debt to GDP1

%

198 207 224 234 227 213 226 232 236 237

+31

+29

+11

Global debt has continued to swell since the crisis but has remained stable relative to world GDP since 2014.

Total debt outstanding1

$ trillion, constant H1 2017 exchange rate

Financial crisis anniversaryBriefing notemc 0824

H1 2017

3McKinsey Global Institute A decade after the global financial crisis: What has (and hasn’t) changed?

Growing government debt

Public debt was mounting in many advanced economies even before 2008,

and it swelled even further as the Great Recession caused a drop in tax

revenues and a rise in social-welfare payments. Some countries, including

China and the United States, enacted fiscal-stimulus packages, and some

recapitalized their banks and critical industries. Consistent with history, a debt

crisis that began in the private sector shifted to governments in the aftermath

(Exhibit 2). From 2008 to mid-2017, global government debt more than

doubled, reaching $60 trillion.

Among Organisation for Economic Co-operation and Development countries,

government debt now exceeds annual GDP in Japan, Greece, Italy, Portugal,

Belgium, France, Spain, and the United Kingdom. Rumblings of potential

sovereign defaults and anti-EU political movements have periodically strained

the eurozone. High levels of government debt have set the stage for pitched

battles over spending priorities well into the future.

Exhibit 2

130

110

100

160

150

120

140

2017 1H

20152000 2007 2009 2012

Public

Private2

Public debt increased rapidly after the crisis in advanced economies.

SOURCE: BIS; McKinsey Country Debt Database; McKinsey Global Institute analysis

1 Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Luxembourg, Netherlands, New Zealand, Norway, Portugal, Singapore, South Korea, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

2 Includes household and nonfinancial corporate sector debt. NOTE: Debt as percent of GDP is indexed to 100 in 2000; numbers here are not actual figures.

Debt by sector in advanced economies1

% of GDP (Index: 100 = 2000)

+20

+2

0

+35

2000–07

Change in debt-to-GDP ratioPercentage points

2007–H1 2017Pre-crisis Post-crisis

Actual debt-to-GDP ratio%

Public

Private

69

164

105

164


In emerging economies, growing sovereign debt reflects the sheer scale of

the investment needed to industrialize and urbanize, although some countries

are also funding large public administrations and inefficient state-owned

enterprises. Even so, public debt across all emerging economies is more

modest, at 46 percent of GDP on average compared with 105 percent in

advanced economies. Yet there are pockets of concern. Countries including

Argentina, Ghana, Indonesia, Pakistan, Turkey, and Ukraine have recently

come under pressure as the combination of large debts in foreign currencies

and weakening local currencies becomes harder to sustain. The International

Monetary Fund assesses that about 40 percent of low-income countries

in sub-Saharan Africa are already in debt distress or at high risk of slipping

into it.4 Sri Lanka recently ceded control of the port of Hambantota to China

Harbour Engineering, a large state-owned enterprise, after after falling into

arrears on the loan used to build it.

Corporate borrowing in the era of ultra-low interest rates

An extended period of historically low interest rates has enabled companies

around the world to take on cheap debt. Global nonfinancial corporate debt,

including bonds and loans, has more than doubled over the past decade to hit

$66 trillion in mid-2017. This nearly matches the increase in government debt

over the same period.

In a departure from the past, two-thirds of the growth in corporate debt has

come from developing countries. This poses a potential risk, particularly when

that debt is in foreign currencies. Turkey’s corporate debt has doubled in the

past ten years, with many loans denominated in US dollars. Chile and Vietnam

have also seen large increases in corporate borrowing.

China has been the biggest driver of this growth. From 2007 to 2017, Chinese

companies added $15 trillion in debt. At 163 percent of GDP, China now has

one of the highest corporate-debt ratios in the world. We have estimated

that roughly a third of China’s corporate debt is related to the booming

construction and real-estate sectors.5

Companies in advanced economies have borrowed more as well. Although

these economies are rebalancing away from manufacturing and capital-

intensive industries toward more asset-light sectors, such as health,

education, technology, and media, their economic systems appear to run on

ever-larger amounts of debt.

In another shift, corporate lending from banks has been nearly flat since the

crisis, while corporate bond issuance has soared (Exhibit 3). The diversification

of corporate funding should improve financial stability, and it reflects

deepening capital markets around the world. Nonbank lenders, including

private-equity funds and hedge funds, have also become major sources of

credit as banks have repaired their balance sheets.

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Exhibit 3

Nonfinancial corporate bonds outstanding have increased 2.7 times over the past decade to $11.7 trillion.

Global nonfinancial corporate bonds outstanding by region1

$ trillion, nominal exchange rate

SOURCE: Dealogic; McKinsey Global Institute analysis

1 Bond nationality is based on the location of the headquarters of the parent company of the company issuing bonds.2 Data as of December 4, 2017.3 Other advanced economies include Australia, Canada, Hong Kong, Japan, New Zealand, Singapore, South Korea, and Taiwan.4 Other developing economies include Argentina, Brazil, Chile, Colombia, Czech Republic, India, Indonesia, Israel, Kazakhstan, Malaysia,

Mexico, Peru, the Philippines, Poland, Russia, South Africa, Thailand, and the United Arab Emirates. NOTE: Figures may not sum to 100% because of rounding.

Global nonfinancial corporate bonds out-standing/GDP%

1.31.8 2.3 2.8

3.64.8

0.6

0.91.1

1.6

2.1

2.61.1

2.0

0.6

0.9

1.2

0.7

1.1

1.2

2013

Otheradvancedeconomies3

20032000 2007 2010 20172

Otherdevelopingeconomies4

China

WesternEurope

UnitedStates

2.4

3.4

4.3

6.1

8.8

11.7

0.4

+7.8

+8.6

+39.9

+14.0

+7.9

Compound annual growth rate (CAGR)%

+2.6

+1.5

+1.9

+0.9

+0.6

Change$ trillion

8 9 8 10 13 16

2007–17

+10.5 +7.4


HOUSEHOLDS HAVE REDUCED DEBT, BUT MANY ARE FAR FROM FINANCIALLY WELL

Unsustainable household debt in advanced economies was at the core of the

2008 financial crisis. It also made the subsequent recession deeper, since

households were forced to reduce consumption to pay down debt.

Mortgage debt

Before the crisis, rapidly rising home prices, low interest rates, and lax

underwriting standards encouraged millions of Americans to take out bigger

mortgages than they could safely afford. From 2000 to 2007, US household

debt relative to GDP rose by 28 percentage points.

Housing bubbles were not confined to the United States. Several European

countries experienced similar run-ups—and similar growth in household debt.

In the United Kingdom, for instance, household debt rose by 30 percentage

points from 2000 to reach 93 percent of GDP. Irish household debt climbed

even higher.

US home prices eventually plunged back to earth starting in 2007, leaving

many homeowners with mortgages that exceeded the reduced value of

their homes and could not be refinanced. Defaults rose to a peak of more

than 11 percent of all mortgages in 2010. The US housing collapse was soon

mirrored in the most overheated European markets.

Having slogged through a painful period of repayment, foreclosures, and

tighter standards for new lending, US households have reduced their debt

by 19 percentage points of GDP over the past decade (Exhibit 4). But the

homeownership rate has dropped from its 2007 high of 68 percent to

64 percent in 2018—and while mortgage debt has remained relatively flat,

student debt and auto loans are up sharply.

Exhibit 4

While households in the hard-hit countries have deleveraged, household debt has continued to grow in other advanced economies.

SOURCE: BIS; McKinsey Global Institute analysis

Household debt to GDP%

25

75

0

50

100

125

United States

201720072000

Germany

United Kingdom

Ireland

SpainPortugal

100

0

125

25

50

75

2007

France

Canada

Australia

2000

Norway

2017

FinlandSwedenSouth Korea

Greece

Change in household debt to GDP ratio, 2007–17Percentage points

-6

-19

-18

-20

-8-50

+14+28+22+23+23+16+12+6

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Household debt is similarly down in the European countries at the core of

the crisis. Irish households saw the most dramatic growth in debt but also

the most dramatic decline as a share of GDP. The share of mortgages in

arrears rose dramatically when home prices fell, but Ireland instituted a large-

scale mortgage-restructuring program for households that were unable to

meet their payments, and net new lending to households was negative for

many years after the crisis. Spain’s household debt has been lowered by

21 percentage points of GDP from its peak in 2009—a drop achieved through

repayments and sharp cuts in new lending. In the United Kingdom, household

debt has drifted downward by just nine percentage points of GDP over the

same period.

In countries such as Australia, Canada, South Korea, and Switzerland,

household debt is now substantially higher than it was prior to the crisis.

Canada, which weathered the 2008 turmoil relatively well, has had a real-

estate bubble of its own in recent years. Home prices have risen sharply in its

major cities, and adjustable mortgages expose home buyers to rising interest

rates. Today, household debt as a share of GDP is higher in Canada than it

was in the United States in 2007.

Other types of household debt

Looking beyond mortgage debt, broader measures of household financial

wellness remain worrying. In the United States, 40 percent of adults

surveyed by the Federal Reserve System said they would struggle to cover

an unexpected expense of $400.6 One-quarter of nonretired adults have no

pension or retirement savings. Outstanding student loans now top $1.4 trillion,

exceeding credit-card debt—and unlike nearly all other forms of debt, they

cannot be discharged in bankruptcy. This cycle seems likely to continue, as

workers increasingly need to upgrade their skills to remain relevant. Auto loans

(including subprime auto loans) have also grown rapidly in the United States.

Although overall household indebtedness is lower since the crisis, many

households will be vulnerable in future downturns.

BANKS ARE SAFER BUT LESS PROFITABLE

After the crisis, policy makers and regulators worldwide took steps to

strengthen banks against future shocks. The Tier 1 capital ratio has risen

from less than 4 percent on average for US and European banks in 2007 to

more than 15 percent in 2017.7 The largest systemically important financial

institutions must hold an additional capital buffer, and all banks now hold a

minimum amount of liquid assets.

Scaled-back risk and returns

In the past decade, most of the largest global banks have reduced the scale

and scope of their trading activities (including proprietary trading for their

own accounts), thereby lessening exposure to risk. But many banks based in

advanced economies have not found profitable new business models in an era

of ultra-low interest rates and new regulatory regimes.

Return on equity (ROE) for banks in advanced economies has fallen by

more than half since the crisis (Exhibit 5). The pressure has been greatest

for European banks. Their average ROE over the past five years stood at

4.4 percent, compared with 7.9 percent for US banks.

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Investors have a dim view of growth prospects, valuing banks at only slightly

above the book value of their assets. Prior to the crisis, the price-to-book

ratio of banks in advanced economies was at or just under 2.0, reflecting

expectations of strong growth. But in every year since 2008, most advanced

economy banks have had average price-to-book ratios of less than one

(including 75 percent of EU banks, 62 percent of Japanese banks, and

86 percent of UK banks).

In some emerging economies, nonperforming loans are a drag on the banking

system. In India, more than 9 percent of all loans are nonperforming. Turkey’s

recent currency depreciation could cause defaults to climb.

The best-performing banks in the post-crisis era are those that have

dramatically cut operational costs even while building up risk-management

and compliance staff. In general, US banks have made sharper cuts than

those in Europe. But banking could become a commoditized, low-margin

business unless the industry revitalizes revenue growth. From 2012 to 2017,

the industry’s annual global revenue growth averaged only 2.4 percent,

considerably down from 12.3 percent in the heady pre-crisis days.

Exhibit 5

%

Banks have posted weaker financial performance since the crisis.

SOURCE: SNL; McKinsey Panorama; McKinsey Global Institute analysis

NOTE: Analysis includes ~1,000 banks in 70 countries, each with total assets exceeding $2 billion. They account for ~75 percent of global bank assets.

Return on equity Price-to-book ratio

20

0

10

5

30

25

15

2002 05 10 15 2017

3.0

0

1.0

2.0

4.0

1.5

0.5

2.5

3.5

052002 10 15 2017

Total developed country banks Total emerging economy banks

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Digital disruptions

Traditional banks, like incumbents in every other sector, are being challenged

by new digital players. Platform companies such as Alibaba, Amazon,

Facebook, and Tencent threaten to take some business lines, a story that

is already playing out in mobile and digital payments. McKinsey’s Banking

Practice projects that as interest rates recover and other tailwinds come

into play, the banking industry’s ROE could reach 9.3 percent in 2025. But if

retail and corporate customers switch their banking to digital companies at

the same rate that people have adopted new technologies in the past, the

industry’s ROE could fall even further.8

Yet technology is not just a threat to banks. It could also provide the

productivity boost they need. Many institutions are already digitizing their

back-office and consumer-facing operations for efficiency. But they can also

hone their use of big data, analytics, and artificial intelligence in risk modeling

and underwriting—potentially avoiding the kind of bets that turned sour during

the 2008 crisis and raising profitability.

THE GLOBAL FINANCIAL SYSTEM IS LESS INTERCONNECTED—AND LESS VULNERABLE TO CONTAGION

One of the biggest changes in the financial landscape is sharply curtailed

international activity. Simply put, with less money flowing across borders, the

risk of a 2008-style crisis ricocheting around the world has been reduced.

Since 2007, gross cross-border capital flows have fallen by half in absolute

terms (Exhibit 6).

Exhibit 6

Global cross-border capital flows have declined 53 percent since the 2007 peak.

SOURCE: IMF Balance of Payments; McKinsey Global Institute analysis

1 Gross capital inflows, including foreign direct investment (FDI), debt securities, equity, and lending and other investment.

Global cross-border capital flows1

$ trillion

% of global GDP

1990–20005.3

2000–1011.3

2010–177.1

0

2

6

4

8

10

12

14

2000

12.7

1990 10 1495 97 03 07

5.9

2017

-53%


Global banks retrench

Eurozone banks have led this retreat from international activity, becoming

more local and less global. Their total foreign loans and other claims have

dropped by $6.1 trillion, or 38 percent, since 2007 (Exhibit 7). Nearly half of the

decline reflects reduced intra-eurozone borrowing (and especially interbank

lending). Two-thirds of the assets of German banks, for instance, were outside

of Germany in 2007, but that is now down to one-third.

Exhibit 7

4.4

3.6

1.2

0.8

1.11.7

1.9

2000

3.8

7.8

3.7

07

2.5

3.5

4.9

2.2

2.8

2017

6.6

23.4

15.8

-7.6

European banks have reduced foreign claims.

SOURCE: BIS; McKinsey Global Institute analysis

1 Foreign claims include cross-border claims and local claims of foreign affiliates. Claims include loans, deposits, securities, derivatives, guarantees, and credit commitments.

NOTE: Figures may not sum to 100% because of rounding.

8

62

29

4623

17

14

Decline in foreign claims of Eurozone banks, 2007–17%100% = $6.1 trillion

FranceUnited Kingdom

Other Western Europe

Other Eurozone

Germany

Non-Eurozone-1.5

Eurozone-6.1

Foreign claims1

$ trillion, annual nominal exchange rates

By type

By region

Interbankcross-borderclaims

Nonbankcross-borderclaims

Local claimsof foreignsubsidiaries

Intra-Eurozone

To UnitedKingdom

To UnitedStates

Rest ofworld

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Swiss, UK, and some US banks have reduced their international business.

Globally, banks have sold more than $2 trillion of assets since the crisis. The

retrenchment of global banks reflects several factors: a reappraisal of country

risk, the recognition that foreign business was often less profitable than

domestic business, national policies promoting domestic lending, and new

regulations on capital and liquidity.

The world’s largest global banks have also curtailed correspondent

relationships with local banks in other countries, particularly developing

countries. These relationships enable banks to make cross-border payments

and other transactions in countries where they do not have their own

branch operations. These services have been essential for trade-financing

flows and remittances and for giving developing countries access to key

currencies. But global banks have been applying a stricter cost-benefit

analysis to these relationships, largely due to a new assessment of risks and

regulatory complexity.

Some banks—notably those from Canada, China, and Japan—are expanding

abroad but in different ways. Canadian banks have moved into the United

States and other markets in the Americas, as their home market is saturated.

Japanese banks have stepped up syndicated lending to US companies,

although as minority investors, and are growing their presence in Southeast

Asia. China’s banks have ramping up lending abroad. They now have more

than $1 trillion in foreign assets, up from virtually nil a decade ago. Most of

China’s lending is in support of outward foreign direct investment (FDI) by

Chinese companies.

Foreign direct investment is now a larger share of capital flows, a trend that promotes stability

Global FDI has fallen from a peak of $3.2 trillion in 2007 to $1.6 trillion in 2017,

but this drop is smaller than the decrease in cross-border lending. It partly

reflects a decline in corporations using low-tax financial centers, but it also

reflects a sharp pullback in cross-border investment in the eurozone.

However, post-crisis FDI accounts for half of cross-border capital flows, up

from the average of one-quarter before the crisis. Unlike short-term lending,

FDI reflects companies pursuing long-term strategies to expand their

businesses. It is, by far, the least volatile type of capital flow.

Global imbalances between nations have declined

Ben Bernanke pointed to the “global savings glut” generated by China and

other countries with large current account surpluses as a factor driving interest

rates lower and fueling the real-estate bubble.9 Because much of this capital

surplus was invested in US Treasuries and other government bonds, it put

downward pressure on interest rates. This led to portfolio reallocation and,

ultimately, a credit bubble. Today, this pressure has subsided—and with it, the

risk that countries will be hit with crises if foreign capital suddenly pulls out.


The most striking changes are the declines in China’s current account surplus

and the US deficit. China’s surplus reached 9.9 percent of GDP at its peak in

2007 but is now down to just 1.4 percent of GDP. The US deficit hit 5.9 percent

of GDP at its peak in 2006 but had declined to 2.4 percent by 2017. Large

deficits in Spain and the United Kingdom have similarly eased.

Still, some imbalances remain. Germany has maintained a large surplus

throughout the past decade, and some emerging markets (including Argentina

and Turkey) have deficits that make them vulnerable.

NEW RISKS BEAR WATCHING

Many of the changes in the global financial system have been positive. Better-

capitalized banks are more resilient and less exposed to global financial

contagion. Volatile short-term lending across borders has been cut sharply.

The complex and opaque securitization products that led to the crisis have

fallen out of favor. Yet some new risks have emerged.

Corporate-debt dangers

The growth of corporate debt in developing countries poses a risk, particularly

as interest rates rise and when that debt is denominated in foreign currencies.

If the local currency depreciates, companies might be caught in a vicious cycle

that makes repaying or refinancing their debt difficult. At the time of this writing,

a large decline in the Turkish lira is sending tremors through markets, leaving

EU and other foreign banks exposed.

As the corporate-bond market has grown, credit quality has declined.

There has been notable growth in noninvestment-grade “junk” bonds. Even

investment-grade quality has deteriorated. Of corporate bonds outstanding in

the United States, 40 percent have BBB ratings, one notch above junk status.

We calculate that one-quarter of corporate issuers in emerging markets are at

risk of default today—and that share could rise to 40 percent if interest rates

rise by 200 basis points.

Over the next five years, a record amount of corporate bonds worldwide will

come due, and annual refinancing needs will hit $1.6 trillion to $2.1 trillion.

Given that interest rates are rising and some borrowers already have shaky

finances, it is reasonable to expect more defaults in the years ahead.

Another development worth watching carefully is the strong growth of

collateralized loan obligations. A cousin of the collateralized debt obligations

that were common prior to the crisis, these vehicles use loans to companies

with low credit ratings as collateral.

Real-estate bubbles and mortgage risk

One of the lessons of 2008 is just how difficult it is to recognize a bubble while

it is inflating. Since the crisis, real-estate prices have soared to new heights in

sought-after property markets, from San Francisco to Shanghai to Sydney.

Unlike in 2007, however, these run-ups tend to be localized, and crashes are

less likely to cause global collateral damage. But sky-high urban housing

prices are contributing to other issues, including shortages of affordable

housing options, strains on household budgets, reduced mobility, and

growing inequality of wealth.


In the United States, another new form of risk comes from nonbank lenders.

New research shows that these lenders accounted for more than half of

new US mortgage originations in 2016.10 While banks have tightened their

underwriting standards, these lenders disproportionately serve lower-income

borrowers with weaker credit scores—and their loans account for more

than half of the mortgages securitized by Ginnie Mae and one-third of those

securitized by Fannie Mae and Freddie Mac.

China’s rapid growth in debt

While China is currently managing its debt burden, there are three areas to

watch. First, roughly half of the debt of households, nonfinancial corporations,

and government is associated, either directly or indirectly, with real estate.11

Second, local government financing vehicles have borrowed heavily to fund

low-return infrastructure and social-housing projects. In 2016, 42 percent

of bonds issued by local governments were to pay old debts. This year, one

of these local vehicles missed a loan payment, signaling that the central

government might not bail out profligate local governments. Third, around

a quarter of outstanding debt in China is provided by an opaque “shadow”

banking system.

The combination of an overextended property sector and the unsustainable

finances of local governments could eventually combust. A wave of loan

defaults could damage the regular banking system and create losses for

investors and companies that have put money into shadow banking vehicles.

Yet China’s government has the capacity to bail out the financial sector if

default rates reach crisis levels—if it chooses to do so. Because China’s

capital account has not been fully liberalized, spillovers to the global economy

would likely be felt through a slowdown in China’s GDP growth rather than

financial contagion.

Additional risks

The world is full of other unknowns. High-speed trading by algorithms can

cause “flash crashes.” Over the past decade, investors have poured almost

$3 trillion into passive exchange-traded products. But their outsized popularity

might create volatility and make capital markets less efficient, as there are

fewer investors examining the fundamentals of companies and industries.

Cryptocurrencies are growing in popularity, reaching bubble-like conditions

in the case of Bitcoin, and their implications for monetary policy and financial

stability is unclear. And looming over everything are heightened geopolitical

tensions, with potential flash points now spanning the globe and nationalist

movements questioning institutions, long-standing relationships, and the

concept of free trade.


•••

The good news is that most of the world’s pockets of debt are unlikely to pose

systemic risk. If any one of these potential bubbles bursts, it would cause

pain for a set of investors and lenders, but none seems poised to produce a

2008-style meltdown. The likelihood of contagion has been greatly reduced by

the fact that the market for complex securitizations, credit-default swaps, and

the like has largely evaporated (although the growth of the collateralized-loan-

obligation market is an exception to this trend).

But one thing we know from history is that the next crisis will not look like the

latest one. If 2008 taught us anything, it is the importance of being vigilant

when times are still good.

This briefing note was authored by MGI partner Susan Lund; MGI chairman

and director James Manyika; Asheet Mehta, a senior partner with McKinsey

& Company’s financial services practice; and Diana Goldshtein, a McKinsey &

Company knowledge specialist.

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Endnotes1 Raghuram G. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy,

Princeton University Press, 2010.2 Carmen M. Reinhardt and Kenneth S. Rogoff, “Recovery from financial crises: Evidence

from 100 episodes,” American Economic Review: Papers & Proceedings 2014, Volume 104, Number 5. See also Reinhardt and Rogoff, Is this time different? Eight centuries of financial folly, 2009.

3 MGI’s body of research includes Debt and (not much) deleveraging, February 2015; The new dynamics of financial globalization, August 2017; and Rising corporate debt: Promise or peril? June 2018.

4 International Monetary Fund, Regional economic outlook: Sub-Saharan Africa, April 2018.5 Debt and (not much) deleveraging, McKinsey Global Institute, February 2015.6 Board of Governors of the Federal Reserve System, Report on the economic well-being of

households in 2017, May 2018.7 The Tier 1 capital ratio, a measure of financial health, is calculated by dividing a bank’s core

capital by its risk-weighted assets.8 McKinsey & Company Financial Services practice, Remaking the bank for an ecosystem

world, October 2017.9 “The global savings glue and the US current account deficit,” remarks by Ben S. Bernanke at

the Sandridge Lecture, Virginia Association of Economists, March 10, 2005.10 Liquidity risks in nonbank mortgages, Brookings Papers on Economic Activity, March 2018.11 Debt and (not much) deleveraging, McKinsey Global Institute, February 2015.

Further reading

Bank for International Settlements, International capital flows and financial

vulnerabilities in emerging market economies: Analysis and data gaps, August

2016; and Economic resilience: A financial perspective, December 2016.

International Monetary Fund, Global financial stability report: A bumpy road

ahead, April 2018.

Mian, Atif, and Amir Sufi, House of Debt: How They (and You) Caused

the Great Recession, and How we Can Prevent it from Happening Again,

University of Chicago Press, 2015.

Rajan, Raghuram G., Fault Lines: How Hidden Fractures Still Threaten the

World Economy, Princeton University Press, 2010.

Reinhart, Carmen M. and Kenneth S. Rogoff, This Time is Different: Eight

Centuries of Financial Folly, Princeton University Press, 2009.

Turner, Adair, Between Debt and the Devil: Money, Credit, and Fixing Global

Finance, Princeton University Press, 2016.

McKinsey Global Institute | Copyright © McKinsey & Company 2018www.mckinsey.com/mgi @McKinsey_MGI McKinseyGlobalInstitute

www.mckinsey.com/mgi

Aug 2018

GMO White Paper

1

Introduction 1It was always going to be difficult for us – Homo sapiens – to deal with the long-term, slow-burning problems that threaten us today: climate change, population growth, increasing environmental toxicity, and the impact of all these three on the future ability to feed the 11 billion people projected for 2100.

Our main disadvantage is that our species has developed over the last few hundred thousand years not to address this kind of long-term, slow-burning issue, but to stay alive and well-fed today and perhaps tomorrow. Beyond that we have a history of responding well only to more immediate and tangible threats like war.

Ten thousand years ago, or even a hundred years ago, these problems were either mild or non-existent. Today they are accelerating to a crisis. And at just this time, when of all times we could use a lucky break, our luck has deserted us. We face a form of capitalism that has hardened its focus to short-term profit maximization with little or no apparent interest in social good just as its power to influence government and its own fate has grown so strong that only the biggest most powerful corporations and the very richest individuals have any real say in government. To make matters worse, we have an anti-science administration that overtly takes the side of large corporations against public well-being, even if that means denying climate change and stripping the country of the very regulations designed to protect us. The timing could not be worse. It is likely we in the US will lose – indeed, we are losing already – the stable and reasonable society that we have enjoyed since The Great Depression. Beyond the US, the risks may be even greater, with the worst effects in Africa – threatening the failure of an entire continent.

Our one material advantage is in the accelerating burst of green technologies, which has been better than anyone expected 10 or even 5 years ago and that may in the future be able to offset much of the accelerating damage from climate change and other problems. Yet despite these surprising technological advances, we have been losing ground for the last few decades, particularly in the last few years. Somehow or other we must find a way to do better. We must expand on our strengths in technology while fighting our predisposition toward wishful thinking, procrastination, and denial of

1 This paper uses much of the same material presented at this year’s Morningstar Investment Conference in Chicago in June and at London School of Economics in April 2018. Please make allowances for its conversational style. I have attempted to adapt and expand this version for the general public. And please remember you don’t have to read this in one sitting. The original “Race of Our Lives” is part of the GMO Quarterly Letter from April 26, 2013 and can be read at www.gmo.com.

The Race of Our Lives Revisited1

Jeremy Grantham

2 The Race of Our Lives RevisitedAug 2018

inconvenient long-term problems. We must also find inspirational leadership, for without it this race, possibly the most important struggle in the history of our species, may not be winnable. It is about our very existence as a viable civilization. We will need all the leadership, all the science and engineering, all the effort, and all the luck we can muster to win this race. It really is the race of our lives.

Part I: Summary of the Argument I’m going to give you a broad overview of this topic first, then follow with considerable back-up data and supporting exhibits.

You could call this the story of carbon dioxide and Homo sapiens. You may not know, but if we had no carbon dioxide at all, the temperature of the Earth would be minus 25ºC – a frozen ball with no life with the possible exception of bacteria. That crucial 200 to 300 parts per million of carbon dioxide has taken us from that frozen state to the pretty agreeable world we have today. CO2 is therefore, thank heavens, a remarkably effective greenhouse gas. The burning of fossil fuels, which is the main cause for increasing CO2 and warming the world, has played a very central role in the development of civilization. The Industrial Revolution was not really based on the steam engine – it was based on the coal that ran the steam engine. In a world without coal, we would have very quickly run through all our timber supplies, and we would have ended up with what I imagine as the great timber wars of the late 19th century. The demand for wood would have quickly denuded all of the great forests of the world, and we would have returned to where we were at the time of Malthus, living at the edge of our capability, enduring recurrent waves of famine along with every other creature on the planet. A few good years, the population expands; a few bad years, we die off.

A gallon of gasoline can do work equivalent to 400 hours of manual labor. This extraordinary advance meant that the ordinary middle class had the power that only kings had in the distant past. And what it did, this incredible gift of accumulated power from the sun over millions of years, was to create an enormous economic surplus that catapulted civilization forward in terms of culture and science. Above all, agriculture has benefited, allowing our population to surge forward.

The sting in this tale, however, is that this has left us with 7.5 billion people today, going on a predicted 11 or so billion by 2100. Such a large population can only be sustained by continued heavy, heavy use of energy. Fossil fuels will run out, destroy the planet, or do both. The only possible way to avoid this outcome is rapid and complete decarbonization of our economy. Needless to say, this will be an extremely difficult thing to pull off. It requires the best of our talents and innovation, which miraculously, it may be getting. It also needs much better than normal long-term planning and leadership, which it most decidedly is not getting yet. In theory, Homo sapiens can easily handle this problem; in practice, it will be a very closely run race. We should never underestimate technology but also never underestimate the ability of us humans to really mess it up.

If the outcome depended on our good sense, if we had, for example, to decide in our long-term interest to take 5% or 10% of our GDP – the kind of amount that you would need in a medium-sized war – we would of course decide that the price was too high until it would be too late. It is hard for voters, and therefore politicians too, to give up rewards now to take away pain in the distant future, particularly when the pain is deliberately confused by distorted data. It is also hard for corporations to volunteer to reduce profits in order to be greener. Given today’s single-minded drive to maximize profits, it is nearly impossible.

But technology, particularly the technology of decarbonization, has come surging in to help us. This is the central race. Technology, in my opinion, will in one sense win. If we were able to look ahead

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40 years, I’m confident that there would be a decent sufficiency of cheap green energy on the planet. In 80 years perhaps it’s likely we would have full decarbonization. Lack of green energy will not be the issue that brings us down. If only that were the end of the story. The truth is we’ve wasted 40 or 50 years since the basic fact about manmade serious climate damage became known. We’re moving so slowly that by the time we’ve fully decarbonized our economy, the world will have heated up by 2.5ºC to 3ºC, and a great deal of damage will have been done. A lot more will happen in the deeper future due to the inertia in the environmental system: if we no longer produce even a single carbon dioxide molecule, ice caps, for example, will melt over centuries and ocean levels will continue to rise by several feet.

I don’t worry too much about Miami or Boston being under water – that’s just the kind of thing that capitalism tends to handle pretty well. The more serious problem posed by ocean level rise will be the loss of the great rice-producing deltas: the Nile, the Mekong, the Ganges, and others, which produce about a fifth of all the rice grown in the world. Agriculture is in fact the real underlying problem produced by climate change. Even without climate change, it would be somewhere between hard and impossible to feed 11.2 billion people, which is the median UN forecast for 2100. It will be especially difficult for Africa.

With climate change, there are two separate effects on agriculture. One is immediate: the increased droughts, the increased floods, and the increased temperature reduce quite measurably the productivity of a year’s harvest. Then there’s the long-term, permanent effect: the most dependable outcome of increased temperature is increased water vapor in the atmosphere, currently up over 4% from the old normal. This has led to a substantial increase in heavy downpours. It is precisely the heavy downpours that cause soil erosion. In regular rain, even heavy rain, farmers lose very little soil. It is the one or two great downpours every few years that cause the trouble. We’re losing perhaps 1% of our collective global soil a year.2 We are losing about a half a percent of our arable land a year.3 Fortunately, it is the least productive half a percent. It is calculated that there are only 30 to 70 good harvest years left, depending on your location.4 In 80 years, current agriculture will be simply infeasible for lack of good soil. We must change our system completely to make it sustainable, which, critically, involves reducing erosion to almost zero by using no-till or low-till farming combined with cover crops. Because these are significant changes for a conservative community, it will take decades and we’ve barely started.

Happily, there are impressive advances in new technology in agriculture too. From intensive data management that tells us square meter by square meter exactly what is going on, where the nutrients are lacking and where more water is needed; to the isolation of every single micro-organism that relates to a plant. This race, too, is finely balanced.

A separate thread also closely related to fossil fuels is that we’ve apparently created a toxic environment, not conducive to life, from insects to humans as we will see. We must respond by a massive and urgent move away from the use of complicated chemicals that saturate our daily life.

A subtext to all of what I have to say here is that capitalism and mainstream economics simply cannot deal with these problems. Mainstream economics ignores natural capital. A true Hicksian5 profit requires that the capital base be left completely intact and only the excess is a true profit. Of course, we have not left our natural capital base intact or anything like it. The replacement cost of the copper,

2 D.R. Montgomery, Dirt: The Erosion of Civilizations, University of California Press, 2007.3 Pimentel and Burgess, “Soil Erosion Threatens Food Production,” Agriculture, August 2013.4 2015 International Year of Soil Conference, UN Food and Agriculture Organization.5 Sir John Richard Hicks is considered one of the most important and influential economists of the 20th century.


phosphate, oil, and soil – and so on – that we use is not even considered. If it were, it’s likely that the last 10 or 20 years (for the developed world, anyway) has seen no true profit at all, no increase in income, but the reverse.

Capitalism also has a severe problem with the very long term because of the tyranny of the discount rate. Anything that happens to a corporation over 25 years out doesn’t really matter to them.6 Therefore, in that logic, grandchildren have no value. Corporations also handle externalities very badly. Even the expression “handle badly” is flattering, for corporations typically don’t handle them at all, they’re just completely ignored. When they are not ignored it is usually because of direct or implied pressure from customers collectively. We deforest the land, we degrade our soils, we pollute and overuse our water, and we treat our air like an open sewer. All of this is off the balance sheet and off the income statement. Worse, any sensible response is deliberately slowed down by skillful programs of obfuscation, well-funded by fossil fuel interests and their allies. These deliberate obfuscators were known as the merchants of doubt when the problem was tobacco. (One of those merchants, MIT professor Richard Lindzen, actually went seamlessly from defending tobacco – where he famously puffed cigarettes through his TV interviews – to denying most of the problems of climate change.) This does not happen in China, India, Germany, or Argentina. This is unique to the English-speaking, oily countries – the US, the UK, and Australia – where the power of the fossil fuel interests is used to influence both politics and public opinion.

I think I understand the capitalist argument. Milton Friedman, a patron saint of today’s brand of capitalism, famously said “There is only one social responsibility of business…to increase its profits (so long as it…engages in open and free competition without deception or fraud).” It makes for a simple enough world. But it is very different from the US I came to in 1964, which (except civil rights) was with hindsight perhaps at the sweet spot of the social contract. CEOs were content with 40 times the income of their average workers (as Japan still is) and not today’s 300 times. Corporations acted as if they really had obligations to the cities and states in which they operated. And, of course, to their country. This is true to a much smaller degree today. Corporations also acted as if they had real responsibility to their workers: to prove it they set about designing generous, i.e., expensive, well-managed defined benefit pension funds. Which they did not have to do. Today they claim, despite much higher profit margins, that they cannot afford them. The US as a whole also projected an idea of a global social contract – whenever the cold war would allow it – to promote the idea that ethical behavior had value (there were some miserable exceptions, but mostly it tried). It was always the US leading the way in promoting cooperative international trade, to enormous beneficial effect globally.

Today both of these contracts appear to have been torn up and climate change is the epitome of what those who did the tearing up really hate: it occurs everywhere and very slowly. It is the ultimate Tragedy of the Commons: so it can only be dealt with by government leadership and regulation. All this is anathema to the new regime of maximizing an individual country’s advantage and short-term corporate profits. Yet however much libertarians may hate regulation – and in general I am sympathetic – when it comes to climate change it is simple. There is no other way.

As a footnote to the data provided, I will also examine the long and widely held view that any form of divestment is guaranteed to ruin performance. And together we will discover this view is completely inaccurate.

6 At a corporate discount rate of 15%, a common enough hurdle for new investments – today’s value of $1 earned 26 years from now is two and a half cents.

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Part II: Back-up Data

Climate Change Damage Is AcceleratingExhibit 1 is the famous chart you might have seen used by Al Gore. It shows that for hundreds of thousands of years, the Earth’s atmosphere has had 180 to 300 parts per million of carbon dioxide. At 180 parts per million, we had ice ages (in the popular parlance) where, for example, 20,000 years ago New York was over a thousand feet deep in ice: enough to cover any building there today. At the previous highs of 280 parts per million, we had the interglacials, four of them, where our species benefited from the temperate and relatively stable environment we have enjoyed for the last few thousand years: a remission from cold that allowed for and facilitated the growth of civilization in the last 12,000 years. (Just for the record, 75% to 80% of the last 400 thousand years were spent in the “ice ages” and only 20% to 25% were in the warmer interglacials.)

In 1950, carbon dioxide levels were pretty much at the top of this historical range, and we were perhaps ready to slide into a new ice age in the next few thousand years. Then, bang, we added another 120 parts per million in the blink of an eye! We have added the same amount that separates the bottom of glacial phases from interglacials, and we’ve added it in just 70 years. It is a dramatic and reckless experiment. The best word to describe it is feckless. We are going to add another 120 parts per million, I give you my personal guarantee. By the time we finish, we will have tripled the difference between an ice age and an interglacial. We must sincerely hope it is not worse than that.

Exhibit 1: Historical CO2 Levels (Reconstruction from Ice Cores)

Source: NOAA

I’m proud to say I did Exhibit 2 about four and a half years ago because back then the scientists would not use the word “accelerate.” Scientists can be pretty chicken: not unreasonably given they are anxious to protect the dignity of science; they also desperately don’t want to be caught out exaggerating. With climate change they tend to underestimate and then are surprised by accelerating data. I sympathize with them – in science, overstatement is often dangerous – but in climate change work understatement can be very, very dangerous if it leads politicians to underreact in their policies. 1

JG_Morningstar_Race of our Lives_6-18

Proprietary information – not for distribution. For Institutional Use Only. Copyright © 2018 by GMO LLC. All rights reserved.

Exhibit 1: Historical CO2 Levels (Reconstruction from Ice Cores)

Source: NOAA


Exhibit 2: Global Surface Temperature Compared to 1951-1980 Average

As of 8/31/16 Source: NASA Goddard Institute for Space Studies, GMO

I have kept an informal check on the number of peer-reviewed articles where the conclusion is a change in the climate outlook – with much help from the “Carbon Brief ” and many others. My informal count is that about 80% conclude that, from the specialized work they have just done, the climate outlook is likely to be worse than consensus. The remaining 20% is either compatible with existing consensus or predicts a mitigating factor, a recent example of which would be that accelerating ice melting in Antarctica leads to an unexpectedly rapid rise in the bedrock from the reduced weight of the ice, which slows the rate of ice cap melting. But an 80-20 ratio in peer-reviewed science is pretty scary in itself. In stock market work – even economics – when a trend is systematically underestimated time after time models usually change to catch up. Climate science to date has been content to lag. What I must concede, though, is that since the US presidential election and the declaration of open war not just on climate science but science and research in general, the tone of climate research has toughened up considerably and become more realistic, and the term “acceleration,” almost overnight (and considerably overdue), has become commonplace.

Still, the data in Exhibit 2 is clear. The trendline through the first 50 years of the last century is an increase of 0.007ºC per year. In the second half, the trend had doubled to 0.015ºC per year. Then between the two El Niños – climate events that cause a temporary surge in global heat – of 1998 and 2016 (like lining up the top of bull markets), the temperature increased at an average of 0.025ºC per year.

Exhibit 3 shows what that looks like in color coded form from 1850 to 2017. Deep red goes up to +0.6ºC above long-term average and dark blue goes down to –0.6ºC below. This is an exceptionally clear way of showing data. Yes, there’s a little variability, but my, oh my, the dark red is all on the right.

2JG_Morningstar_Race of our Lives_6-18


Exhibit 2: Global Surface Temperature Compared to 1951‐1980 Average

As of 8/31/16Source: NASA Goddard Institute for Space Studies

‐1.0

‐0.5

0.0

0.5

1.0

1.5

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Tem

pera

ture A

nom

aly

(°C)

1958

+.007°C per year

+.025°C per year from peak to peak

+.015°C per year


Exhibit 3: Global Annual Temperatures, 1850-2017 – Color-Coded

Source: Ed Hawkins, Climate Lab Book

This exhibit reminds me of all the talk about pauses – the claim that 1998 was supposedly the top of the warming, which had then stopped, a favorite refrain of both deniers and “don’t worry-ers.” This argument was still remarkably in full force as late as 2013 and is repeated even now. Indeed, a famous British politician, former Chancellor of the Exchequer, Lord Lawson, said on BBC Radio 4 this past April that the previous 10 years had not had any warming. He was not just wrong. The last 10 years were 10 of the hottest 11 years in history and contained the 3 hottest years ever. Please explain to me, if anyone knows, why these people say stuff like that. I have no idea. Perhaps they hate their grandchildren.

Exhibit 4 shows ocean temperature, which is accelerating even more than air temperature. The oceans absorb 93% of all the heat, with the rest spread between dry land and the air.7

Exhibit 4: Ocean Heat Content (in Joules)

Source: “Improved Estimates of Ocean Heat Content from 1960 to 2015,” Cheng et al, Science Advances, March 10, 2017

7 D. Laffoley and J.M. Baxter (editors), “Explaining ocean warming: Causes, scale, effects and consequences,” IUCN, September 5, 2016.



Exhibit 3: Global Annual Temperatures, 1850‐2017 – Color‐Coded

Source: Ed Hawkins, Climate Lab Book



Exhibit 4: Ocean Heat Content (in Joules)

Source: “Improved Estimates of Ocean Heat Content from 1960 to 2015,” Cheng et al, Science Advances, March 10, 2017.

GER GBR

0‐2000 Meters

1950 ‐ 1990 = 37 units/year

1990 ‐ 2016 = 99 units/year


The black line from the bottom left to the top right shows the heat energy of the ocean from the surface to 2,000 meters deep. From 1950 to 1990 it warmed at 37 heat units a year. From 1990 to 2016, the warming almost tripled to 99 units. Acceleration in something this dangerous should make the hair at the back of your neck prickle a bit. It does mine.

Ice is melting even faster. Exhibit 5 is a view of a famous glacier valley in Alaska at the same time of year in each picture. It has just vaporized in 63 years.

Exhibit 5: Muir Glacier, 1941 and 2004

Source: USGS

The most dependable effect of climate change, as I mentioned, is downpours. Exhibit 6 shows the annual number of three inches per day downpours in the US.

Exhibit 6: Annual 3”+ Rainfall Days in the US

Source: Climate Central



Exhibit 5: Muir Glacier, 1941 and 2004

August 1941 August 2004

Source: USGS



Exhibit 6: Annual 3”+ Rainfall Days in the US

Source: Climate Central


Last year in Houston, Hurricane Harvey dumped 10 inches of rain in a day, followed by 10 inches, followed by 10 inches. If you try to put a probability on that it just does not compute. Perhaps a 1-in-1,000-year event, perhaps almost impossible. It turns out that within the prior 18 months, Houston had already had a 1-in-200-year event. Within 18 months before that, a 50- to a 100-year event. In a terrible update from Japan just this month (July), almost 200 lives were lost and 2 million were asked to evacuate because of a downpour that was so far off the scale that it made Harvey look like a drizzle: 23 inches of rain in 1 single day.

Exhibit 7 is a quick survey of this kind of damage: the number of floods is up by 15 times from 1950, the deaths from droughts up by 10 times, wildfires by 7 times, and extreme temperature events by 20 times.

Exhibit 7: Extreme Weather Events on the Rise

Source: EM-DAT database

Part III: Decarbonizing the EconomyThe good news is that greener technologies are also accelerating. This puts me in a very interesting position. I deal with green technologists and they have no idea how bad the situation is for the environment. Then I deal with environmentalists, who I must say are a gloomy lot, and they have no idea how rapidly the science is advancing in this area. Exhibit 8 is a bit dry, but it is absolutely vital. This is from the boss of one of the three largest utility companies in America, not one of our greens. This is a guy from the dark side, you might say, who is just telling it like it is.



Exhibit 7: Extreme Weather Events on the Rise

Source: EM‐DAT database

Floods Drought Mortality

Wildfires Extreme Temperature Events

0500

10001500200025003000

1950‐1966 1967‐1983 1984‐2000 2001‐2017

No. of F

lood

s

0

5000

10000

15000

20000

25000

1996‐2005 2006‐2015

x15 x10

No. of D

eaths in Droug

hts

0

100

200

300

400

1950‐1983 1984‐2017

No. of W

ildfires

x7

0

100

200

300

400

500

1950‐1972 1973‐1995 1996‐2017

No. of E

xtreme

Tempe

rature Eve

nts

x20


Exhibit 8: From the Horse’s Mouth

NextEra Energy controls Florida Power & Light, as well as the world’s largest trading unit for wind and solar. So he really should know what he’s talking about. And he says that without incentives, wind will be $0.02 to $0.03 per kilowatt-hour early in the next decade. Including a few hours of battery storage to carry that power into the evening surge will add another penny. What that means is that wind and solar are going to be cheaper than the operating costs of coal and nuclear, even the best coal and the best nuclear.

Once again: you can receive a gift of a nuclear plant and just the cost of operating it is higher than the cost of building and operating a modern solar plant or a modern wind farm. This economic contest is therefore a done deal. Six months after that comment from Mr. Robo, Xcel Energy in Colorado wanted to close a couple of coal plants early and asked for bids for renewable energy. They were swamped by an amazing 850 bids. The median bid, the one in the middle, below which half were cheaper, was 2.1 cents per kilowatt-hour for wind including storage. The median bids they received for solar and wind power are shown in Exhibit 9.

Exhibit 9: Xcel Energy 2023 Solicitation – Median Levelized Cost per MWh

Source: Xcel Energy, Lazard, EIA *Operating cost for new coal plants includes 30% CCS to comply with EIA New Source Performance Standards

In June, we were all shocked when the Florida Power & Light boss said it would be 2 to 3 cents plus a penny for storage. Six months later, it was 2.1 cents including storage. These bids had median storage costs at only 0.3 cents / kilowatt-hour for wind, and 0.7 for solar, compared to the 1 cent from Mr. Robo’s estimate. Even solar, which was unexpectedly dearer than wind, came in at 3.7 cents with storage, which is similar to the operating costs of a new coal plant and well below the levelized cost, including capital, of a coal plant.

8GMO_Template


Exhibit 8: From the Horse’s Mouth

“Without incentives, wind is going to be a $0.02 or $0.03 product early in the next decade. Battery storage will be $0.01 on top of that. And when you look at (...) coal and nuclear, today, operating costs are around $0.03. New wind and new solar, without incentives and combined with storage, are going to be cheaper than the operating cost of coal and nuclear in the next decade. That is going to totally transform this industry.

— James Robo, 06/22/2017CEO of NextEra Energy

9GMO_Template


Exhibit 9: Xcel Energy 2023 Solicitation –Median Levelized Cost per MWh

Source: Xcel Energy, Lazard, EIA*Operating cost for new coal plants includes 30% CCS, to comply with EIA New Source Performance Standards

0

10

20

30

40

50

60

70

Solar WindWith Storage Without

New coal plants ‐ operating cost only*

Coal LCOE

$/MWh


Exhibit 10 shows the rate at which wind and solar prices have declined since 2009. Look at that – solar, from $400/MWh, screaming down to $55 in 2016 and soon to $25 or $30. The median coal plant has been completely outflanked. No one had this even as a gleam in their eye 10 years ago.

Exhibit 10: Unsubsidized Levelized Cost of Renewable Energy over Time

As of 12/31/16 Source: Lazard

An important word about wind. A two-megawatt wind tower is about the biggest wind tower you will have bumped into in your daily life. If you’re cycling through Holland, you will typically see two-megawatt wind towers. That’s the size of the Statue of Liberty. In Exhibit 11 I refer to that two-megawatt wind tower as a toy. The real monster is coming: since this exhibit was drawn up, GE actually offered for delivery in 2022 a 12-megawatt wind tower.

Exhibit 11: Giant Wind Turbines Illustrate the Speed of Change

Source: Reuters, GMO



Exhibit 10: Unsubsidized Levelized Cost of Renewable Energyover Time

As of 12/31/16Source: Lazard

$/MWh (Log

Scale)

$400

$100

$50

2009 2010 2011 2012 2013 2014 2015 2016

Onshore Wind

Utility Scale SolarCoal



Exhibit 11: Giant Wind Turbines Illustrate the Speed of Change

Source: Reuters, GMO

MONSTER

Eiffel TowerParis

12MWturbine

2022 (est)

7MWturbinePlanned

St Paul’sCathedralLondon

MHI Vestas8MW turbineoff Liverpool2016

2MWturbine

Several locations2000

Statue of LibertyNew York

260 m

195 m

TOY

324 meters

155 m

111 m93 m 90 m

Newest version


Let me tell you about their 12-megawatt wind tower. It will stand 260 meters, or 284 yards, high. A single blade will measure 107 meters long. On its upswing, the blade would be nearly as high as the Eiffel Tower, where my wife and I had lunch last fall. It is almost impossible to imagine looking across at a wind tower from high up the Eiffel Tower. Let me tell you something else about windmills. The power generated goes up by the swept area, which means Pi R squared. When you take a 10-foot blade and make it 20, you do not get twice as much power, you get 4 times as much. As you go up near the top of the Eiffel Tower, you pick up more wind. Actually, it’s a rather disappointing fraction, but you pick up about 20% more wind. But this is the key: the wind factor is cubed. A hurricane with wind speeds of 140 miles per hour does not have a modestly more damaging effect than one at 120. You cube 14 versus cubing 12. It is 60% more powerful. And that is why everyone dreads the 140-miles-per-hour hurricane.

It is the same here – that 20% higher wind speed at the top of the Eiffel Tower will generate 60% more power (less a few percent from mechanical inefficiencies), and the increased length of the blades will be squared. When 20- and 25-megawatt wind towers with new lightweight materials are built in the North Sea and the North Atlantic, possibly in the next 20 or 30 years, they may well generate the cheapest electricity on the planet. (Solar in deserts would likely be an honorable second.)

The disappointing factor for green energy enthusiasts has always been battery costs. Indeed, batteries had been falling in cost for the 20 years prior to 2010 at less than half the rate of progress in solar.8 But just as the idea of that disappointment had become a cliché, Exhibit 12 happened.

Exhibit 12: Lithium-ion Battery Pack Prices and Annual Decline

Source: Bloomberg New Energy Finance, GMO Low end of 2025 estimate range, at $40/kWh, assumes adoption of next-generation solid-state battery technology.

In 2010, Tesla was looking at $1,000 per kilowatt-hour for battery storage. This year, the insiders say it’s down to nearly $150; we will use $165. It has dropped 85% in 8 years, faster than solar panels, wind, or anything else. Quite remarkable. This, though, is not the end of the game. When we’re building 30 million electric cars globally, engineering and sheer scale will very likely cut the $165 in half to $80-odd by 2025 for current lithium ion batteries. When the next generation of solid-state battery technology is introduced, it will likely halve again.

8 N. Kittner, F. Lill, and D.M. Kamen, “Energy storage deployment and innovation for the clean energy transition,” Nature Energy, July 2017.



Exhibit 12: Lithium‐ion Battery Pack Prices and Annual Decline

Source: Bloomberg New Energy Finance, GMOLow end of 2025 estimate range, at $40/kWh, assumes adoption of next‐generation solid‐state battery technology.

1000800

642 599 540350 273 209 165

0100200300400500600700800900

1000

2010 2011 2012 2013 2014 2015 2016 2017 2018E … 2025E

Pric

e ($

/kW

h)

‐20% ‐20% ‐7% ‐10% ‐35% ‐22% ‐23% ‐21% ‐52% to ‐76%

4080


I’m very pleased to say the Grantham Foundation is investing in a solid-state lithium-ion cell, which was delivered for testing to a major European car factory two months ago. It is half the weight, half the volume, half the materials, and, at scale, potentially half the price. It does not burst into flame, and it charges in five minutes. If we don’t get there first, there is a hotshot group at Tufts and another at MIT (go Boston, by the way) who are closing in, claiming similar properties for their new batteries. In addition, Mr. Dyson of hand dryer and vacuum cleaner fame, is also making progress – or at least investing heavily – on this in the UK. Solid-state will happen. It is only a question of whether we save a year or two in development time. Solid-state batteries will make electric cars much cheaper to build than gasoline-driven ones, and they are today already much cheaper to run and maintain with only 15% of the moving parts of an internal combustion vehicle. Rapid charging will also largely remove range anxiety, with electric charging being similar to filling up at a gas station.

So, you take all this optimism, all this progress in green technology, and where does it get us? Regrettably, it only gets us to Exhibit 13.

Exhibit 13: World Annual Primary Energy Consumption by Source, 1900-2050

As of 9/30/17 Source: OurWorldinData.org, Vaclav Smil, GMO Data from 2015-2050 is estimated or forecast.

The bad news is that although the renewables in green are surging, by 2050 over 50% of energy consumption is projected to still be driven by fossil fuels. What that means is even if fossil fuels were to peak in a couple of years, and I believe they certainly will peak by 2030 or 2035, the carbon dioxide in the atmosphere will continue to rise and rise. Climate change will not have been stopped. It will barely be slowing down, as shown in Exhibit 14. Bear in mind that the year with the single largest increase in CO2 levels was last year! 13

JG_Morningstar_Race of our Lives_6-18


Exhibit 13: World Annual Primary Energy Consumption by Source, 1900‐2050

As of 9/30/17Source: OurWorldinData.org, Vaclav Smil, GMOData from 2015‐2050 is estimated or forecast.

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Exhibit 14: Annual Energy Supplied by Fossil Fuels, and Cumulative CO2 Emissions

As of 9/30/17 Source: OurWorldinData.org, Vaclav Smil, Carbon Dioxide Information Analysis Centre, GMO Data from 2015-2050 is estimated or forecast.

This guarantees that we have no hope of limiting the world’s temperature increase to 1.5ºC. In all probability we will reach our 2ºC target by 2050, and we will be fighting tooth and nail – with any luck, with carbon taxes and an improved attitude – to keep it below 3ºC by 2100. We really will need luck, in technology and above all in political leadership: the need to stand up to the influence of the fossil fuel industry and manage the widely held dislike of the necessary regulations. The outlook for the world temperature to 2050, even in this optimistic scenario with accelerating progress in renewable energy and green technology, is shown in Exhibit 15.

Exhibit 15: Atmospheric CO2 and Temperature Increase since Pre-Industrial Era

As of 9/30/17 Source: National Oceanic and Atmospheric Administration, GMO Data from 2016-2050 is estimated or forecast.



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Cumulative Anthropogenic CO2 Emissions, GT (right axis)

Exhibit 14: Annual Energy Supplied by Fossil Fuels, and Cumulative CO2 Emissions

As of 9/30/17Source: OurWorldinData.org, Vaclav Smil, Carbon Dioxide Information Analysis Centre, GMOData from 2015‐2050 is estimated or forecast.



Exhibit 15: Atmospheric CO2 and Temperature Increase since Pre‐Industrial Era

As of 9/30/17Source: National Oceanic and Atmospheric Administration, GMOData from 2016‐2050 is estimated or forecast.

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The necessary investment in decarbonizing the economy will be epic and is already well over $300 billion a year. That’s the amount of money the world is spending annually to build out renewable energy. To put that in very relevant perspective, $300 billion is less than the amount of losses in the United States alone from weather and climate disasters in the single year of 2017: Hurricane Harvey, Hurricane Maria, wildfires, and so on, all exacerbated by climate change. Exhibit 16 shows forecast annual global renewable energy capex out to 2050. We will need, by 2050, $2 trillion per year in today’s money, to put in the transmission lines, the power plants, the storage facilities, the reengineered steel and cement factories, and everything else that is needed to completely decarbonize our society. Decarbonizing the economy is arguably the most important industrial change since the wholesale introduction of oil in the early 20th century.

Exhibit 16: Annual Global Renewable Energy Capex

As of 9/30/17 Source: DNV GL Data from 2015-2050 is estimated or forecast.

Part IV: Climate Change and Feeding the 11.2 BillionSo far we have at least had a balance between good technological surprises and the disheartening acceleration of climate damage. It is time now for the terrible news. Sorry about this. I tell you, it’s hard to live with for me, too. The issue is food sufficiency. Population growth and increasing wealth are driving up food demand, while climate change, soil erosion, and many other factors are impacting food supply. Exhibit 17 shows what the world population looks like since 1500. For the first few hundred years, it was stable. When Malthus wrote, it was only one billion. When I was born, it was up to about 2.3 billion. Today, just in my lifetime, the global population has tripled. (Whenever you see an exponential chart like this in investing, you know what to do: go short.)



Exhibit 16: Annual Global Renewable Energy Capex

As of 9/30/17Source: DNV GLData from 2015‐2050 is estimated or forecast.

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Exhibit 17: World Population and Projections to 2100

As of 1/25/18 Source: UN World Population Prospects

The good news that Malthus never dreamt about, our last best hope really, is declining fertility. In developed countries we’re all below replacement level, shown by the black dotted line across Exhibit 18. The irony here is it’s probably because we’ve discovered how incredibly expensive and inconvenient children are. This is my scientific reason. There are other more serious reasons, which we’ll get to, including waiting longer to have children and a side effect of toxicity.

Exhibit 18: Fertility Rates in the “Western World”

As of 12/31/17 Source: World Bank

Fertility rates are dropping fast for many poorer countries too, as seen in Exhibit 19. Iran is my hero. It used to have seven children for each woman in 1960, and now it’s down to 1.6. My other hero is Bangladesh, dirt-poor then and now – unlike Iran, this country has no oil. It also had seven children, but today that number has dropped to 2.2.



Exhibit 17: World Population and Projections to 2100

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Exhibit 18: Fertility Rates in the “Western World”

FranceUnited StatesUnited KingdomCanadaGermanyItaly


Exhibit 19: Fertility Rates Decline in Emerging Countries


It really is amazing. And all they’ve done is had a persistent program with some education and a little bit of training for the women involved. These women go out into the rural villages over and over again, and try very hard. It really can be done with limited resources and persistence.

Exhibit 20 shows the real problem with population. In a word, Africa, where such persistent policies are sadly lacking. In most of Africa fertility rates are declining, but not rapidly, nor are they forecast to decline rapidly. Indeed, in several countries rapid population growth seems to be encouraged either overtly or by inference – the obvious lack of governmental interest in reducing it. The exhibit shows the midrange world population forecasts from the UN. The rest of the world, in dark blue, goes from 6.2 billion today up to 7.2 in 2050 and then peaks out and drops back to 6.7 by 2100. The rest of the world is not the problem. Given a couple of hundred more years, that 6.7 may fall back down to 2. A fertility rate of 1.6, which is above Japan today, would take the whole rest of the world back to 2 billion in a few generations (six or seven generations would do it, about 200 years).

Exhibit 20: World Population to 2100 – Medium UN Estimate

As of 9/30/17 Source: UN World Population Prospects



Exhibit 19: Fertility Rates Decline in Emerging Countries

As of 12/31/17Source: World Bank

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Other Africa3.7 Bn

Nigeria0.8 Bn

Rest of World6.7 Bn

Other Africa2.1 Bn

Nigeria0.4 Bn

Rest of World7.2 Bn

Other Africa 1.0 Bn Nigeria

0.2 BnRest of World6.2 Bn

Exhibit 20: World Population to 2100 – Medium UN Estimate

As of 9/30/17Source: UN World Population Prospects

2015 Population: 7.4 Billion 2050 Population: 9.8 Billion2100 Population: 11.2 Billion

Other Africa Nigeria Rest of World


The problem, as you can see clearly, is Africa. Nigeria, the biggest country in Africa by population, is a perfect case. When I was born, there were 28 million Nigerians. Today, there are about 190 million: the precise number is not known. The midrange forecast for 2100 is 780 million! In recent surveys Nigerians say that seven children is the desired family size, so they are disappointed by their actual six.9 Only 15% use contraception and 54% consider it immoral.10 In a recent poll, 74% of Nigerians said they would love to emigrate if they could, and 38% said they actually plan to try to emigrate in the next 5 years, mostly to the US or Europe.11 38% of 780 million – that’s 300 million who would love to go to the US and Europe, particularly the UK, which today can feed just half of its current 66 million people – the rest of its food is imported. (The only worse country is Japan, which feeds one-third. Everyone says how economically ludicrous it is for Japan to accept a declining population, but come serious, global food troubles, and they will come, the only way for Japan to even approach internal food sufficiency is to have a much smaller population.) Nigeria is just an example; the rest of Africa is forecast to nearly quadruple its population, or try to, to 3.7 billion people by 2100. When the UN makes these forecasts, we tend to assume they are on top of agricultural issues, but based on their conclusions I strongly doubt it. Another major problem is the sensitivity of the population issue. Not nearly enough time and thought and money is spent on population growth because it’s so politically sensitive.

To get to the heart of the food problem, grain productivity, shown in Exhibit 21, is now barely keeping up with population. There is no safety margin. In the Green Revolution it was growing at 3.5% per year, and now on average since 1995 it’s come down to about 1.2%, with the world’s population growth also at 1.2%. A dead heat. We are producing as much grain as we produce people. There is simply no room for them to eat meat that takes 8 or 10 times the grain per calorie as eating bread directly. And yet, they intend to. This is going to be a very uncomfortable situation for the poor people who can’t afford to buy grain. (The population curve is, unsurprisingly, much less volatile than grain productivity, which is still influenced by the natural vagaries of annual weather. After three years of terrible grain-growing weather, we have had four excellent years through last season.)

Exhibit 21: Grain Productivity and Population Growth: No Safety Margin!

As of 12/31/17 Source: Food and Agriculture Organization of the United Nations, GMO *For world’s three major staple crops: wheat, rice, and corn

9 National Demographic and Health Survey, Nigeria National Population Commission and ICF International, 2014; World Bank.10 Pew Research Center, Spring 2013 Global Attitudes Survey.11 Pew Research Center, Spring 2017 Global Attitudes Survey.



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Exhibit 21: Grain Productivity and Population Growth:No Safety Margin!

10‐Year AverageGrowth in Crop Yields*

10‐Year AverageGrowth in Population

As of 9/17/17Source: Food and Agriculture Organization of the United Nations, GMO*For world's three major staple crops: wheat, rice, and corn.


Part of this grain productivity problem is the inconvenient fact that as we progress in productivity we increasingly face diminishing returns. Every species has its limits. Humans will never be 12 feet tall. Let me point out they’ve been breeding race horses for thousands of years – the chief of the tribe always wanted to have the fastest horse – and they’re still breeding them today. Yet Secretariat still has the record for one and a half miles on dirt. Horses haven’t gotten materially faster for 45 years and they were barely getting faster for years before that. You can’t get blood out of a stone. You can get the horses to break more legs, but you can’t get them to run much faster because they are already close to their limit. Now grain, too, has diminishing returns. When looking for diminishing returns, go to the best grain producers on the planet per acre. (Not the US. The US is the best per person, say, a 62-year-old farmer and his son and 6,000 acres.) If you want the best per acre, you go to rice in Japan and wheat in Germany, France, and the UK, as shown in Exhibit 22. Their grain yields were growing brilliantly forever – until the last 20 years, when their progress became very slow and erratic. It is what you expect. And in the US, the USDA’s data on multi-factor productivity shows little or no gain from corn in the last 12 years.

Exhibit 22: 5-Year Moving Average of Crop Yields in Leading Countries

As of 12/31/17 Source: Food and Agriculture Organization of the United Nations

One of the reasons for this is that increased fertilizer use, the backbone of the Green Revolution, is also peaking out. You can use more in poor parts of the world, but the US and China, the two biggest users, already officially use too much – so much, it begins to be counter-productive as well as damaging to the health of waterways from excessive run-off of phosphorus and nitrogen.

Exhibit 23 summarizes all of this, showing the growth in agricultural productivity in the US all the way back to 1930. Back then we were chugging along at a nice 1.5% a year. In the Green Revolution of the 50s and 60s, we accelerated for 20 years to 3.5% a year. Quite remarkable – every 3 years there was a 10% increase in the amount of crops grown on the same land. After that, not surprisingly, productivity growth dropped back then started to drop to new modern lows. Our 2010-2030 estimate, based on talking to scientists, is that productivity per acre would still continue to grow, other things being even, but at a slowly diminishing rate as we approach limits.



Exhibit 22: 5‐Year Moving Average of Crop Yields in Leading Countries

As of 12/31/17Source: Food and Agriculture Organization of the United Nations

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Exhibit 23: Diminishing Returns for Grain Productivity

As of 1/31/18 Source: USDA NASS *GMO projection excluding future effects of erosion and climate change

It turns out, however, that in the future of grain growing, other things will not be even. We face two increasing problems that seem likely to push productivity backwards: soil erosion and climate change. As we dug into these two problems, we quickly discovered a third: the giant seams that can run between different branches of science. Starting with erosion, we spoke to several soil scientists who specialized in erosion who were not aware that future climate change would materially affect erosion even though, as previously mentioned, the single most dependable feature of climate change is an increase in the very heavy downpours that do almost all the erosion damage – with 5- to 10-foot gullies sometimes appearing overnight in the great storms in Iowa and Kansas. Exhibit 24 shows the damage that more routine heavy rains can cause.

Exhibit 24: Gully Erosion

Source: Katharina Helming, CC BY-SA 1.0, https://commons.wikimedia.org/w/index.php?curid=42387941



Exhibit 23: Diminishing Returns for Grain Productivity

Average Annual Agricultural Productivity Growth in the United States, by 20‐year blockAverage of yield growth for corn, wheat, and rice

As of 1/31/18Source: USDA NASS*GMO projection excluding future effects of erosion and climate change.

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Exhibit 24: Gully Erosion

Source: Katharina Helming, CC BY‐SA 1.0, https://commons.wikimedia.org/w/index.php?curid=42387941


Exhibit 25 shows the effect of erosion on grain production going forward, according to the latest science. And what we did here is make a very, very modest assumption that the 10% damage to productivity that the erosion experts calculated we would get over the next few decades would increase to 13% because of the increase in heavy downpours. (We estimated this ourselves because, at least as far as we could find, no one else was doing it.)

Exhibit 25: Effect of Erosion on Grain Production

As of 4/30/18 Source: USDA NASS; “Soil Erosion, Climate Change and Global Food Security: Challenges and Strategies,” Rhodes, Science Progress, 2014, GMO *GMO estimate

Exhibit 26 is one of my horror show graphics actually. Pictured is an installation describing the topsoil of a particular farming county in Iowa. In 1850, this county had 14 inches of wonderful Midwestern topsoil. Ideally, you need only 4 inches and 3 will get you by. Fourteen inches is a luxury beyond belief for the rest of the world. But by 1900, it was 11.5”; by 1950, 9.5”; by 1975, 7”; by 2000, 5.5”.



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Exhibit 25: Effect of Erosion on Grain Production

‐13%

As of 4/30/18Source: USDA NASS; “Soil Erosion, Climate Change and Global Food Security: Challenges and Strategies,” Rhodes, Science Progress, 2014; GMO*GMO estimate.

US Grain Yields, Historical and Projected Index averaging corn, wheat, soy, and rice yields, 2017 = 1


Exhibit 26: Soil Depth in Iowa Has Halved Since Intensive Cultivation Began

Source: Iowa Public Radio, “The Greatest Story Never Told,” installation in Adair County, Iowa, by David B. Dahlquist and RDG Planning & Design

At considerable difficulty, we found the experts on soil in Iowa responsible for the data in this exhibit. We called them and asked what the number was for 2017. And they said, “Yes, erosion is recognized now as a major problem. People are trying much harder; the rate of erosion has come down by a lot, by nearly half.” But now, it’s 4.8”. Just think about that: 14” down to 4.8”. Our safety margin has gone from 11 inches to 1 or 2 inches. Yet there are still no signs of panic that reach the public or, apparently, the politicians. That may not scare you, but it certainly scares me.

Now, we get to another disheartening finding from the last 12 months. This is a report from the journal Proceedings of the National Academy of Sciences. When you get bad news, you don’t want it to come from one of the most prestigious scientific journals. This was a study done by a large team of a dozen or so top scientists, as usual for important studies these days, led by Dr. Liang. As I understand it, they studied what effect actual downpours, droughts, and increasing temperatures had on agricultural productivity in America over the last 50 years and they calculated the effect by each specific grain in each specific area. They put all that data into their model so that they captured the increasing incidence of floods and droughts from climate change. They then extrapolated the midrange of climate models into the future, building in the expected increases in heavy floods and severe droughts out to 2040, where the temperature increases also begin to really hurt (having had little effect up to now, with some areas gaining and some losing from temperature). They concluded



Exhibit 26: Soil Depth in Iowa Has Halved Since IntensiveCultivation Began

Source: Iowa Public Radio, “The Greatest Story Never Told,” installation in Adair County, Iowa, by David B. Dahlquist and RDG Planning & Design.

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Although all the soil used for agriculture in the US is privately owned, it is in a real sense – an existential sense – a commons like the air and water, for without it none of us survive. We soil owners are all completely free to destroy our common good. Or as two former US Presidents put it:

“While the farmer holds the title to the land, actually it belongs to all the people because civilization itself rests upon the soil.” - Thomas Jefferson

“The nation that destroys its soil destroys itself.” - F.D. Roosevelt


that by 2040, if nothing else changed, the impact of climate change would be to take grain productivity all the way back to where it was in 1980, which is Exhibit 27. If this is true, it is incredibly bad news. This is the kind of data where your best hope is that the scientists have made a major error.

Exhibit 27: Effect of Climate Change on Grain Production

As of 4/30/18 Source: USDA NASS; “Determining Climate Effects on US Total Agricultural Productivity”, Liang et al, Proceedings of the National Academy of Sciences, GMO

When we called Dr. Liang to ask him some questions, he seemed unaware that erosion had any important impact on the future of agriculture. It does seem to be a problem: climate scientists like him in one box and erosion scientists, with mud on their boots, in another, with very little communication or attempt to coordinate. It is a problem for most specialists – and one we can sympathize with – that to be on top of their fields they have to have a very tight focus. So the scary thing is that our crude attempt to put all these factors together is the first that you, dear reader, have ever seen!

Exhibit 28 is, therefore, distinctly homemade. The lines show the various projections including all these factors one-by-one. At the top is the simple extrapolation of the historic productivity gains. The next line down shows what happens when you build in the diminishing marginal returns that we have seen in Japan, Germany, France, and the UK. Next is the effect of erosion, and the effect of more erosion from increased downpours. Then there’s the coup de grace from the climate change study.



Exhibit 27: Effect of Climate Change on Grain Production

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As of 4/30/18Source: USDA NASS; “Determining Climate Effects on US Total Agricultural Productivity”, Liang et al, Proceedings of the National Academy of Sciences; GMO

user

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Exhibit 28: Combined Effect of Climate Change and Soil Erosion

As of 4/30/18 Source: USDA NASS, Rhodes 2014, Liang et al 2017, GMO

We decided to give a one-third credit for adaptation to climate change: that farmers will be clever; they will change the crops they grow; they will work on building in more drought resistance or flood resistance. (By the way, you have to pick. You can’t do both drought and flood resistance at the same time.) Even with adaptation, grain productivity will fall a lot. Maybe in real life farmers will excel and deliver a two-thirds credit for adaptation. What we really need here is improved policy, very productive research, and an unusual willingness to change. But unfortunately, even with substantial adaptation, productivity will still be way down from the historic trend and very likely even down from where we are today.

We also have bug and pathogen immunities to consider. Do you know we lose as much of our crop to weeds, bugs, and pathogens



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Exhibit 28: Combined Effect of Climate Change and Soil Erosion

As of 4/30/18Source: USDA NASS, Rhodes 2014, Liang et al 2017, GMO

‐56%

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GMOs and Super WeedsAs a semi technical aside, during the last few million years a few plants have stumbled by mutation into much more efficient ways of processing water, sun, and CO2 and produce up to twice the mass of vegetation. They are called C4 and comprise a lowly 3% of all plants but account for around 25% of plant biomass thanks to their efficiency. In agriculture C4 plants include corn and sugar cane that compared to lowly wheat, barley, rice, and other C3 grains, are monsters of productivity. Well the good news is that one day we may torture the C3 grains into having more of the C4 characteristics to positive output effect. It is a difficult job that has been likened in complexity to nuclear fusion. The bad news is that 14 of the 18 most troublesome weeds are now C4 (from 3% in nature to over three-quarters in modern US farming!). The whole point of genetically modified organism research – or 90% of the point – is to produce seeds that can withstand much-increased doses of specific pesticides, most commonly glyphosate. And which weeds do you think are going to better withstand this chemical onslaught, C3 or C4? We have in fact designed a system to produce C4 super weeds that now compete with our lowly C3 crops like wheat and rice. Whoops!


today, as a percentage, as we did in 1945 before we declared chemical war on these organisms?12 If we pull back from the chemicals now, the bugs and weeds, which have turned into super bugs and super weeds, will eat our lunch, breakfast, and dinner. Had we never done it, we would be losing approximately the same amount as we are now, but saving impressive amounts of money – approximately as much as for feed or fertilizer.

Before we finish on farming, I’d like to touch on the global distribution of phosphate reserves. We cannot grow any living thing without potassium (potash) and phosphorus (phosphate). We mine these elements, which are very, very finite. We dig these essential fertilizers out and we scatter them in excess around our farms because they are cheap (where the heavy rains often carry them off and pollute the streams and rivers and the Gulf). Exhibit 29 is the problem: 75% of all the high-grade phosphorus reserves in the world are in Morocco and Western Sahara (which Morocco controls).

Exhibit 29: Global Distribution of Phosphate Reserves

As of 12/31/10 Source: USGS

This share of reserves makes OPEC and Saudi Arabia look like absolute pikers, and phosphate is much more important even than oil. Phosphorus, the key ingredient in phosphate, is an element and cannot be made or substituted for. If ISIS takes over Morocco, I give you my second personal guarantee that within a week the military of China or the US or both will have intervened. We simply cannot manage for long under currently configured agriculture without Morocco’s reserves – perhaps 35 to 40 years.

This section began with the premise that food sufficiency will prove to be our civilization’s greatest future challenge. If the UN population forecast presented in Exhibit 17 actually happens – even if we stay on that flight path for another decade or two – we will be looking at a failing continent, in my opinion, with some of the damage caused by the need to maintain political correctness. The process may well have started already. Five countries, in my view, have failed already in Africa, five more or so are possibly in the process of failing. Food problems there will put incredible pressure on Europe through immigration, and the scale will be far too great for Europe to handle well. I wrote five years ago that the first casualty of this African (and near Eastern) problem would be the liberal traditions of Europe. Well, it happened a whole lot faster than I feared! Just an accumulated couple of million refugees are already providing political propaganda that is empowering right-wing groups everywhere in Europe. Imagine if Europe were to try and take 100 million, and 100 million isn’t even a down payment on the billion and a half or so that will want to emigrate if the population keeps growing like this. Europe will need to get its act together and form a joint policy that is as gentle and as firm and as reasonable as it can possibly be. It simply will not be able to take and absorb nearly as many food and climate refugees as would be required to solve the problem. (I am not speaking as someone with fascist tendencies – on income equality for example, I am left of the Scandinavian countries. Sometimes the truth is politically very incorrect indeed.)

12 M. Yudelman, A. Ratta, and D. Nygaard, “Pest Management and Food Production: Looking to the Future,” International Food Policy Research Institute, 1998.



Annual Production and Reserves (millions of metric tons)

Production (2010) Reserves

Morocco and Western Sahara 26.0 50,000

World 176.0 65,000

Exhibit 29: Global Distribution of Phosphate Reserves

As of 12/31/10Source: USGS


We have a growing population who want to eat meat, diminishing agricultural returns, and worldwide erosion taking 1% a year of the global soil and half a percent of our arable land. Then there is urban expansion, which is nearly always in fertile river plains, taking the best arable land and concreting it over – calculated to be about two and a half million acres a year.13 Plus, there are water availability problems from hell that I could spend half an hour on, or an expert could spend a week on. Reservoirs in South Africa, in Morocco, in Spain, in Nevada, are all shrinking, all suffering from the increased heat. We’re depleting our aquifers: in heavily irrigated areas such as Las Vegas or the Central Valley of California, well water levels have fallen by hundreds of feet. In China, parts of Beijing are sinking by four inches a year – that’s how fast they’re pumping out the water.14 Over half a billion people globally totally depend on underground, very finite aquifers for their water and food.

For all these many reasons, agriculture is the key to our future success or failure. It is also where climate change has its most consequential effects. But, sadly, it is not the only problem:

Part V: Toxicity, Biodiversity, and the Deficiency of CapitalismNow, we come to the next piece of very bad news: the 75% loss of flying insects. This was from a report done by German insect fanatics, amateurs who love insects.15 They went out every year to a different selection from 63 forest preserves. They put out the same nets in the same places at the same time of year. They took all the bugs that they caught, and they laid them out and they counted them. Germans are unbeatable at this type of thing! And to everyone’s shock and horror, over 27 years there has been more than a 75% decline in the total quantity of flying insects. These are our pollinators. They have just gone missing. Why isn’t this a dramatic item in our news? One-third of all the food plants that we eat need pollination, every flower needs a pollinator. What we’ve done is created a toxic world, which is apparently not conducive to life as we know it.

This toxicity together with climate change and population pressure form an unprecedented threat to biodiversity. We are, as you probably know by now, in the sixth great extinction. The first five were caused by meteorites and by great shifts in the climate caused by the sun. This sixth one is caused by us, the people. And we, too, are part of the biodiversity that is threatened: the last piece of very bad news science has for us (at least in this paper) is that in the developed world there’s been over a 50% loss of sperm count. This is from a recent meta-study16 of almost 200 individual sperm count studies from different parts of the world: it’s hard to imagine how they could get the data that badly wrong. Although I hope they have. One Danish study said that healthy young men in Copenhagen today have lower sperm quality than men visiting infertility clinics 70 years ago!17 In China, coming from way behind us, they have a 25% loss in the last 15 years.18 And no one is concerned! Will we worry at 75%? How about 87%? This very well may be contributing already to the declining fertility rate of the Western world, along with delayed marriage. (So, oddly, we may face the problem of low fertility in the long term in the developed world while we face the problem of too-high a fertility rate in Africa.)

13 Bren d’Amour et al., “Future urban land expansion and implications for global croplands,” Proceedings of the National Academy of Sciences, August 2017.14 M. Chen et al, “Imaging Land Subsidence Induced by Groundwater Extraction in Beijing (China) Using Satellite Radar Interferometry,” Remote Sensing, 2016, 8(6) 468.15 C. Hallmann et al., “More than 75 percent decline over 27 years in total flying insect biomass in protected areas,” PLOS One, October 2017.16 H. Levine et al., “Temporal trends in sperm count: a systematic review and meta-regression analysis,” Human Reproduction Update, November 2017. 17 N. Jørgensen et al., “Human semen quality in the new millennium: a prospective cross-sectional population-based study of 4867 men,” BMJ Open, Volume 2, Issue 4, 2012.18 C. Huang et al., “Decline in semen quality among 30,636 young Chinese men from 2001 to 2015,” Fertility and Sterility, January 2017.


I think toxicity and the chemicals causing it will turn out to be a hotter button than climate change. Climate change is regrettably a bit like the story of boiling the frog in the pot. (Speaking of which, frogs are going extinct too – scientists say the total amphibian population is falling 4% every year.19) Toxicity, sperm counts, insects going missing, and birds and frogs going with them is something that I think can excite people to action. Europe has turned unexpectedly serious, for example, on the risks of plastics in the last year, banning some single-use plastics. The EU has also banned three incredibly important neonicotinoids that are alleged to kill bees. And very probably do, along with all other flying insects that come near them. This is the problem though: in the EU, if regulators have some doubt, a company must prove its chemical is clean. But in the US, if there’s doubt, how could anyone interfere with the capital rights of a chemical company to its chemicals? We will take the side, at least for the next few years, of the chemical companies because there is a lot of doubt. This is a complicated soup we are dealing with – it is hard to impossible to positively prove which chemical is contributing precisely what damage. Have we in the US, inadvertently or otherwise, adopted an ultra-corporate-friendly standard that will produce so toxic an environment before we act that the consequences – totally avoidable on paper – will be extreme?

In any case in the US, the chemical companies will get the benefit of the doubt – not our sperm count, or flying insects, or life in general. At least until we are more obviously on the ropes. An interesting choice to make.

Exhibits 30 and 31 show some of the apparent effects of toxicity. Healthwise in the West, things are going so well in many areas, but autoimmune diseases are just exploding. They have to do with chemicals – endocrine disruptors – in all probability, especially exposure to them during pregnancy. There’s the same rise with certain cancers, for which there is no other obvious explanation.

Exhibit 30: Prevalence of Autoimmune Disorders in Western World (1940-2012)

Source: Boström et al 2012, Rubio-Tapia et al 2009, Autism Speaks, National Center for Health Statistics, Gale 2002

19 M.J. Adams et al., “Trends in Amphibian Occupancy in the United States,” PLOS One, May 2013.



0

5

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20

25

0

2

4

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8

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12

1940 1950 1960 1970 1980 1990 2000 2010

Exhibit 30: Prevalence of Autoimmune Disorders in Western World (1940‐2012)

Source: Boström et al 2012, Rubio‐Tapia et al 2009, Autism Speaks, National Center for Health Statistics, Gale 2002

Inci

denc

e Ra

te

Inci

denc

e Ra

te

Multiple Sclerosis per 100,000 Autism

per 1,000

Type 1 Diabetesper 100,000

(RHS)

Celiac Diseaseper 1,000

Asthma per 100


Exhibit 31: Age-Standardized Incidence Rate of Cancers in Scandinavia*

As of December 2007 Source: World Health Organization International Agency for Research on Cancer *Average of Denmark, Finland, and Norway. (Countries chosen for having longest available data.)

There’s a cheerful professor at Harvard, Dr. Steven Pinker, who’s come out with a couple of books saying how wonderful things are. On the data he uses, he’s absolutely accurate. Yes, we do live longer. Yes, we have fewer wars, fewer murders, and fewer this and fewer that. But what it doesn’t account for is sustainability and toxicity: that we’re using up our resources and threatening our biosphere. It’s a bit like the guy who falls off the top of the Empire State Building, and as he passes each floor on the way down he is heard to say, “So far, so good.” “14 inches of soil, life expectancy increases, so far so good.” “12 inches of soil, 8 inches, 4 inches, so far so good.” “80% of our sperm count, 50%, so far so good.” “80% of our flying insects, 50%, 25%, so far so good.” We’re simply not accounting for the real underlying damage. Without that accounting, things can indeed be construed as looking pretty good. It’s seductive. Right up to the edge of the cliff most of the numbers look better and better and just a few look worse and worse. But how super critical those few worse numbers are.

The greatest deficiency of capitalism is its complete inability to deal with any of these things that we are talking about even though it can handle the millions of more mundane factors that go into producing a workable economy, far better than planned economies. Let me tell you my story once again of the devil and the farmer. The devil goes to a Midwestern farmer and he says, “OK, if you sign this contract and give me your soul, I will triple your profits, your meager profits that have always been a struggle for you. And I will do it for 100 years for you and your descendants.” The farmer is desperate, so he signs. The profits are tripled and all is well.

Now footnote 21 of the contract – there are always footnotes with the devil – says the farmer will lose 1% of his soil every year. Because that’s what farmers are all losing anyway, big deal. So he signs, and 100 years later there’s no soil at all left for his great-great-grandchildren. He has given up soil as well as his soul. Exhibit 32 shows what happened. The expected value of the deal with the devil was $5.5 million. The no-deal farmer up the road who stuck it out the hard way had a present value of only $2 million.



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1953 1962 1971 1980 1989 1998 2007

Exhibit 31: Age‐Standardized Incidence Rate of Cancers in Scandinavia*

As of December 2007Source: World Health Organization International Agency for Research on Cancer*Average of Denmark, Finland, and Norway. (Countries chosen for having longest available data.)

Breast (RHS)

Melanoma (LHS)

Testis (LHS)

Age‐

Stan

dard

ized

Inci

denc

e pe

r 100

,000

Age‐

Stan

dard

ized

Inci

denc

e pe

r 100

,000


Exhibit 32: The Devil’s Deal: Your Soil and Your Soul!

Source: GMO

As I’ve noted before, at least when the starving crowds arrive from Chicago, the farmer dies rich. As currently configured, every MBA ever produced would sign that contract, or fail the course. That is capitalism. Ask Milton Friedman once again. A corporation’s responsibility is to maximize profits, not to waste money attempting to guess how to save our soil. There’s simply no machinery in today’s world, which has gone all Milton Friedman on us, to get this job done: to reach a sustainable agriculture system, and a stable temperature that we can live with – ideally close to the one we have enjoyed for the last few thousand years.

Part VI: Investing and the EnvironmentExhibit 33 is our portfolio at GMO of climate change opportunities, which has been around for a year. What we’re trying to do is understand, a little ahead of the market, these powerful and complicated new crosswinds as we decarbonize. I hope we are helped in this task by the deliberate propaganda that has been aimed at downplaying the current speed and long-term importance of climate change. Unsurprisingly, the portfolio has lots of clean energy stocks, copper (which is 5 times more heavily used by electric cars than conventional cars), masses of energy efficiency opportunities, and around 20% in agriculture. I can say that I have a very high-confidence belief that these industries collectively will have higher top-line revenue growth than the balance of the economy.



Exhibit 32: The Devil’s Deal: Your Soil and Your Soul!

Profits per year under deal and no deal

Source: GMO

0

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150,000

200,000

250,000

300,000

350,000

0 20 40 60 80 100

Annu

al P

rofit

s

Year

"No deal" present value (5% discount rate): $2,000,000

"Deal" present value (5% discount rate): $5,583,000!

user

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Exhibit 33: Illustrative Climate Change Portfolio (Global Equities)

Source: GMO

Part VII: The Alleged Perils of Divestment It should be pretty clear from this discussion that if you’re messing around with oil stocks, you’re taking the serious risk of ending up with stranded assets, and if you’re messing with chemical companies of the toxic kind, you are taking some risks also. Oil companies are being sued everywhere because they’ve been caught red-handed. They were writing for peer-reviewed journals in the late 1970s, proving that carbon dioxide was dangerous and that the ocean levels would rise. They took advantage of their knowledge: they took it into account to drill in the Arctic and to site their refineries. And they have misrepresented the damage they knew their products would cause. They are vulnerable and face many legal battles as we speak. Yet investment committees, the most conservative groups on the planet as we know – I have spoken to perhaps 3,000 or so of them – maintain that if they divest from oil it will ruin their performance. And that in any case, ethics, à la Friedman, should not come into it. If they accept any constraint at all, they feel, it will ruin their performance. I’m sympathetic up to a point: you don’t want everyone with a bee in his bonnet to come marching in. But this issue – climate change – is the mother and father of all exceptions. It is about our survival. Exhibit 34 shows what we did to test this long-held divestment hypothesis. We took out each of the 10 major groups in the market for 30 years, leaving only 9 of the 10 groups in each portfolio, and what we found was



Exhibit 33: Illustrative Climate Change Portfolio (Global Equities)

Segment Exposure

Clean Energy 39.4%Solar 9.7%Wind 8.5%Other Clean Energy 1.3%Clean Power Generation 6.1%Batteries & Storage 14.0%

Smart Grid 6.2%Copper 8.4%Energy Efficiency 16.8%

Transportation 6.6%Buildings 0.4%Diversified Efficiency 6.0%Technology 1.9%Lighting 1.4%Recycling 0.5%

Agriculture 19.1%Farming 3.8%Farm Machinery 1.6%Timber 0.7%Eco‐Chemicals/Seeds 1.5%Fertil izer 5.5%Fish Farming 5.9%

Water 4.4%Cash 5.6%

Source: GMO


that it didn’t make any difference. The entire range from best to worst was only 50 basis points. The return you get without Energy is highlighted – you make 3 bps more without Energy. Look at the graph. Taken together, other than IT in the 2000 bubble, they look like a single series. Even the 2000 deviation settled back as if the bubble had never occurred.

Exhibit 34: You Can Divest from Oil – or Anything Else – Without Consequence

As of 9/30/17 Source: S&P, GMO

After I first showed this exhibit I had a suspicion that we had picked a lucky time period. My conscience nagged me for a while. So, we went back in history, first to 1957, and then with some considerable effort all the way back to 1925, as shown in Exhibit 35. Look at 1925: the range between missing the best group and the worst has soared from plus or minus 50 basis points to plus or minus 56 basis points. When you divest from oil or chemicals, the starting assumption must be that it will cost you a few tiny basis points of deviation, and it’s just as likely to be positive deviation as negative. These are the facts – not the hearsay of investment committees that have managed to maintain an erroneous, but perhaps convenient, consistency over decades on this issue.



‐0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Sep‐90 Mar‐95 Sep‐99 Mar‐04 Sep‐08 Mar‐13 Sep‐17

Exhibit 34: You Can Divest from Oil – or Anything Else – Without Consequence

Annualized Absolute Returns (Nominal Terms): 1989‐2017 – Range: 50 bps

Abso

lute R

etur

ns

(Nom

inal T

erm

s, L

ogar

ithm

ic S

cale

)

As of 9/30/17Source: S&P, GMO

9.44% 9.54% 9.56% 9.66% 9.71% 9.74% 9.75% 9.77% 9.84% 9.90% 9.94%

0%

4%

8%

12%

Ex HealthCare

Ex ConsumerStaples

Ex IT Ex Industrials S&P 500 Ex Energy Ex ConsumerDiscretionary

Ex Utilities Ex Materials Ex Telecom Ex Financials

Ex Cons. Discr.Ex Cons. StaplesEx EnergyEx FinancialsEx HealthEx IndustrialsEx ITEx MaterialsEx TelecomEx UtilitiesS&P 500


Exhibit 35: Divestment Back to 1925

As of 9/30/17 Source: S&P, GMO Prior to March 1957 the S&P 500 is represented by the S&P 90 Index.

There are two quick points to be made before we leave this exhibit. The first is on the power of compounding. In the 92 years since 1925 the S&P 500 would have turned a single dollar – not allowing for inflation and taxes – into $22,911! Not bad is it? (Without Energy you would have had 4.3% less, or $21,984.) The second point is to admire how well the market mechanism did this particular job. I have always made a lot of fuss at how incompetent the market mechanism has been in dealing with bubbles, allowing through momentum and career risk for crazy overvaluations followed by dangerous collapses. But here the market has been amazingly efficient at pegging the long-term prospects of these 10 major groups. It has taken away any possible free lunches from buying, say, appealing high-growth technology and selling dopey utilities by pricing technology higher and utilities lower to compensate. Impressive. Who knew? Not me anyway.

Now we can put a more accurate price on divestment and ethics. For example, if you were to consider it unethical to own these oil companies whose scientists wrote, as mentioned, about the serious dangers of climate change in the 1970s only to have management later ignore it all and fund deniers and obfuscators, you can believe the cost of your ethics is about +/- 20 basis points!

There is, however, one more economic argument in favor of divestment: that the Energy sector will be the first example of much more significant mispricing than any sector in the past due to oil companies not bending with the economic winds but fighting them all the way. And why would the market not do its usual remarkable job of forecasting this? Because this is the first time in history, I believe, where a significant chunk of the US investment community does not believe in the most important factor that will affect this sector – climate change. Why? Because we have had a 30-year, well-funded program to make the problem of climate change seem vague, distant, and problematic, the end result of which



Exhibit 35: Divestment Back to 1925

As of 9/30/17Source: S&P, GMOPrior to March 1957 the S&P 500 is represented by the S&P 90 Index.

9.44% 9.54% 9.56% 9.66% 9.71% 9.74% 9.75% 9.77% 9.84% 9.90% 9.94%

0%

4%

8%

12%

Ex HealthCare

Ex ConsumerStaples

Ex IT Ex Industrials S&P 500 Ex Energy Ex ConsumerDiscretionary

Ex Utilities Ex Materials Ex Telecom Ex Financials

1989‐2017 Range: 50bps

10.04% 10.12% 10.18% 10.25% 10.28% 10.28% 10.34% 10.34% 10.34% 10.39% 10.65%

0%

4%

8%

12%

Ex ConsumerStaples

Ex HealthCare

Ex Energy S&P 500 Ex ConsumerDiscretionary

Ex IT Ex Industrials Ex Telecom Ex Utilities Ex Financials Ex Materials

1957‐2017 Range: 61bps

11.37% 11.39% 11.44% 11.48% 11.51% 11.51% 11.51% 11.53% 11.54% 11.57% 11.91%

0%

4%

8%

12%

Ex ConsumerStaples

Ex HealthCare

Ex ConsumerDiscretionary

Ex Energy Ex IT Ex Telecom Ex Utilities S&P Index Ex Financials Ex Materials Ex Industrials

1925‐2017 Range: 54bps


is that we have a Republican Party wherein 60% of the people don’t believe a word of the facts I have showed you. Some of them, presumably, are in the stock market. How many of these deniers does it take to distort the price? How can this not affect the market’s probabilities of carbon taxes, energy regulations, and other important factors? There certainly should be more mispricing than normal and that might just allow for unexpected long-term underperformance of Energy (and perhaps some chemicals). Certainly the governor of the Bank of England, Mark Carney, has been telling everyone that they are bitterly underestimating the future troubles facing the oil industry and I agree.

(The short-term prospect for oil, however, is a very different story and there exists a probability, in my opinion, of a near-term squeeze on oil prices before the electric cars kick in fully.)

Part VIII: What Should Investors Do About Climate Change? Let me finish this with some recommendations. What I’m hoping you will do, first of all, is vote for green politicians. I don’t care what party they belong to. It might surprise you to learn that all the great environmental law of the past 100 years came from Republicans. Second, lobby your investment firms to be a bit greener and encourage them to lean on their portfolio companies to do the same. Push them hard. Cash in some of your career risk units. You will at least be able to look your children in the eye. You may even feel better. And your firms may be able to attract more of the best kind of young recruits who are beginning to care very much more about these issues than we older folk collectively do.

We’re racing to protect more than our portfolios from stranded assets and other climate change impact. That I believe is easy enough. But for those portfolio managers who happen to be human, we have a much more important job. We’re racing to protect not just our portfolios, not just our grandchildren, but our species. So get to it.

Postscript 1: What Should We All Do?Of course, the first recommendation is the same: vote for green politicians. Especially support those who are pushing for a carbon tax, or a “cap and trade” program that sets limits for total CO2 production but allows for trading and therefore more directly encourages efficiency and promotes CO2 sequestration – reforestation, improved soil management, and direct CO2 recovery from the air – that in a pure tax would probably be missed. Be aware that a direct carbon tax must be high to change consumer behavior enough to reach our goal of holding to less than 2ºC warming – one estimate is $200-$300/ton by 2050.20 I would point out, though, that economic sensitivities are much higher for electricity generation than for gasoline. Taxes on gasoline in European countries average over $300/ton and they certainly have not made London or Paris free of traffic! Nor have these taxes crashed their respective economies. What they have done is created a market for energy-efficient cars that on average get almost twice the miles per gallon as do US vehicles.

In contrast to transportation, $40/ton is more than enough to get rid of all coal-fired electricity generation in a couple of decades. A ton of coal for generation costs about $40/ton and generates 2.8 tons of CO2. In addition, as discussed above, the costs of wind and solar plus a few hours’ storage are already substantially cheaper. A $40/ton tax on coal and natural gas would be an enormous incentive to design new generations of larger scale and cheaper storage.

One thing to watch out for is that the major oil companies are all in favor of a modest carbon tax if it comes with immunity to the damage they have caused. That would indeed be a great bargain for them, for they know through their European subsidiaries that gas taxes are simple “pass-throughs.” They

20 Environment Canada, 2018.


act as tax collectors and pass on the several dollars per gallon tax immediately to the government. It absolutely does not affect their return on equity.

But should they get immunity? In a world in which we all benefited from using fossil fuels – which we certainly did – and all were ignorant of the damage CO2 caused, there would be no unethical behavior, in my opinion, by oil companies or others, nor any possible breaking of consumer disclosure laws. But this is not the case. The oil companies did know of future damage. Better than all but a handful of scientists. And they deliberately hid this data, as mentioned above, after about 1982, having previously reported it in detail. Worse, they funded propaganda that has delayed our progress on decarbonization, perhaps by several years, and recklessly endangered us. For this part there should be no immunity any more than for any other dangerous activity.

So let us all lobby as best we can for taxes high enough to be effective or equivalent programs that encourage sequestration and give immunity only for behavior that represents ignorance, acted on in good faith.

Other than this main agenda item, what should we do? There are several small household improvements we can make, many of which, like LED lighting, high-efficiency furnaces, washing machines, refrigerators, and insulation, actually save money. At a larger scale, we can buy electric vehicles as their price comes down: the full lifetime costs, including much cheaper maintenance and running costs, are already cheaper for a $45,000 vehicle and, as mentioned, will be much cheaper yet in the next 10 years. At an even larger scale we can take fewer jet flights and do more video conferencing. One or two fewer flights a year will dwarf all the other savings. But at the highest level of savings of all we should consider having one less child, which is several times more effective than all the above added together as it represents one complete lifetime of carbon footprint plus that person’s descendants forever, or at least until we reach a zero net carbon equilibrium. Tough, but true.

Postscript 2: Just Heat Waves or Climate Change?The current heat wave covers most of the Northern hemisphere so I swelter in Boston along with my sisters in London – who have less air conditioning. But in places as varied as Canada, Greece, India, and Japan it is far more serious as people are dying from the heat directly and the unprecedented fires they cause – including, remarkably, fires inside the Arctic Circle. Of course, global climate is far too complicated for any single incident to be explained with certainty, but these occurrences have in general been predicted for several decades: that we would have more long and dangerous heat waves than normal along with more prolonged heavy downpours. (Pity Japan that had both within a month.) And the accumulating number of new record high temperatures leaves new record lows in the literal dust: as of July 25th, weather stations around the world have reported 122 record highs in the last month, versus only 2 record lows. The hottest overnight minimum temperature ever recorded anywhere – 108.7ºF in Quriyat, Oman – was on June 26, 2018. Imagine surviving that without air conditioning! Not only is the base temperature of the planet 1ºC or 1.7ºF hotter than it used to be, added on to both peaks and troughs, but some climate scientists have predicted21 that the flow of weather has been changed so that longer spells of heat and rain should be expected. And both of these are exactly what we have been getting. Outside the US and the UK this new work is discussed and it is taken for granted that climate change is part of it. The discussion is only about which part and how much. Here in the US, as a testimonial to the effectiveness over the years of the denialist propaganda, there is hardly a peep. When people make up their minds based on politics and the clan they belong to, there is perhaps no weather extreme enough to convince them of the obvious.

21 J.A. Francis and S.J. Vavrus, “Evidence linking Arctic amplification to extreme weather in mid-latitudes,” Geophysical Research Letters, March 2012.


Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending August 2018, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

Copyright © 2018 by GMO LLC. All rights reserved.

Jeremy Grantham. Mr. Grantham co-founded GMO in 1977 and is a member of GMO’s Asset Allocation team, serving as the firm’s chief investment strategist. He is a member of the GMO Board of Directors and has also served on the investment boards of several non-profit organizations. Prior to GMO’s founding, Mr. Grantham was co-founder of Batterymarch Financial Management in 1969 where he recommended commercial indexing in 1971, one of several claims to being first. He began his investment career as an economist with Royal Dutch Shell. Mr. Grantham earned his undergraduate degree from the University of Sheffield (U.K.) and an M.B.A. from Harvard Business School. He is a member of the Academy of Arts and Sciences, holds a CBE from the UK and is a recipient of the Carnegie Medal for Philanthropy.

Thirty years ago the dire predictions of leading climate scientists were laughed at. Now we watch these predictions coming true and ignore the data or pretend to. So, as the world starts to burn up, we twiddle our thumbs and talk about “just another heat wave!” God help us. For we appear incapable of, or are at least unwilling to, help ourselves, and our great scientific skills increasingly appear insufficient on their own.

8/20/2018 The Case for a 50-Year Bull Market - Barron's

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https://www.barrons.com/articles/the-case-for-a-50-year-bull-market-1534550401

ADVISOR GUIDE

The Case for a 50-Year Bull Market

As head of Merrill Lynch Wealth Management, Andy Sieg oversees the so-called thundering herd of

14,820 financial advisors, the second-largest workforce among the big brokers.

Barron’s: What advice would you give investors to get the most out of an advisor?

Andy Sieg: We encourage clients to be very specific about what success means to them, and even more

specifically what their intent for their wealth is. In many cases, clients have thought about this, but may not

have articulated it. When we encourage clients to be more specific about their intentions for their wealth,

it produces clarifying conversations—not just with the advisor but also between the members of a couple,

or across generations in a family.

Deep into this bull market, where does Merrill see investment opportunities?

It’s very easy right now to talk yourself into a sense that we’re in the late innings of the bull market. We

think a much better perspective is to take a step back and say that we’re probably only 10 years into

another 50-year bull-market cycle.

The drivers of this bull market are a very powerful extension of the baby boomers’ productive lives, the

silver economy, which is powering a lot of economic activity in the U.S. and around the world, and the rise

of the millennial generation, which is a larger and even more economically powerful cohort than the

boomers. The growth of the middle class in emerging markets around the world will be a lasting,

sustained growth engine. And supercharging all of this is the technology innovation cycle, which we see

Andy Sieg, Head of Merrill Lynch Wealth Management PHOTO: JARED SOARES

By Steve Garmhausen Aug. 17, 2018 8:00 p.m. ET

user

Highlight



year after year.

Over the last 50-year bull cycle, almost every year

there was a reason that people worried. The big

risk for individuals is that they become paralyzed by

the bears and the negative news at the moment. By

not being in the equity market, they’re not

participating in the global economic expansion.

That’s the real risk that families have.

What is your advice for graduates entering the

workforce this fall?

My first advice is to take a careful look at the wealth

management industry. It’s a growth industry, and it

promises tremendous careers for those who have

what it takes. For grads entering wealth

management, my most important advice is to remember that this business begins and ends with clients—

everyone’s success in the financial industry broadly comes from their ability to serve clients well. The

combination of a tremendous work ethic, rock-solid integrity, and an ability to build relationships with

people around you are the three ingredients to long and successful careers.

The industry is graying. Are there going to be enough financial advisors to go around 20 years

from now?

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Yes is the short answer. There’s an awareness that we are in a golden age for wealth management or, as

we like to say, a bull market for advice. With boomers moving into retirement, there’s a need for sound,

long-term financial planning at a scale we’ve never seen before, and it’s causing ever-greater interest in

wealth management as a career path.

We’re sensing much more interest on campus around careers in wealth management, and more

universities with degree programs around financial planning. And when people predict a shortfall of

advisors, I think they’re very much underestimating how many advisors are eager to extend their careers.

There is no such thing as 65 as the normal retirement age for our advisors. I think that is going to help

ensure that we have the ranks of advisors we need.

What should investors make of the unusual climate

in Washington, D.C.?

You need to avoid getting wrapped up in the day-to-day

noise and focus on fundamentals. The fundamentals

are that U.S. economic growth is strong. This is a more

pro-business climate than we’ve seen in quite some

time. The benefits of last year’s tax bill are real and

lasting. Our midsize- and small-business-owner clients

are very optimistic about what they’re seeing in their

local markets. The eternal risk to investors is to be

distracted from fundamentals by the day’s headlines or

the day’s tweets. My strong advice is to focus on the

long term. A bullish perspective has been the right

perspective for a long time in America, and I don’t thing

that’s changing anytime soon.

Thanks, Andy.

Email: [email protected]

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In-Line

MORGAN STANLEY & CO. INTERNATIONAL PLC+

Adedapo O Oguntade, CFAEQUITY ANALYST

+44 20 7677-9026

Anil Sharma, CFAEQUITY ANALYST

+44 20 7425-8828

Jacqueline W HoRESEARCH ASSOCIATE

+44 20 7677-7412

MORGAN STANLEY & CO. LLC

James E FaucetteEQUITY ANALYST

+1 212 296-5771

Betsy L. Graseck, CFAEQUITY ANALYST

+1 212 761-8473

MORGAN STANLEY & CO. INTERNATIONAL PLC+

Sheena ShahSTRATEGIST

+44 20 7677-6457

Diversified Financials

EuropeIndustryView

Diversified FinancialsDiversified Financials

Exploring global cryptocurrencyregulationsEU regulators are increasingly concerned about retail clientexposure to cryptocurrency trading. Whilst so far, there is noexplicit ban on trading of these products, warnings and limitshave been imposed. Our latest thoughts highlight the keyevolution in the sector.

Rising regulatory spotlight on cryptocurrency trading in Europe. The European

Securities and Markets Authority (ESMA) amongst other EU regulators have

expressed strong concerns on the exposure of unsophisticated retail clients to

the trading of cryptocurrencies (Bitcoin, Ripple, Ether) and cryptocurrency

contracts for difference (CFDs). In fulfilling their mandate on investor protection,

we have seen a number of warnings, restrictions on trading and in some cases

bans imposed on the advertising of such products. New EU CFD regulations are

in force from August 1, 2018 where leverage on retail client crypto CFD trades

has been capped at 2:1. We expect negative impact on total cryptocurrency CFD

volumes in Europe as a result. However, we are yet to see any explicit ban on

trading these products.

Global cryptocurrency regulations. The regulatory environment continues to

evolve as countries assess the benefits and risks of permitting/promoting

cryptocurrencies domestically. International bodies like the International

Monetary Fund have called for increased collaboration as countries assess both

the potential benefits of improved market efficiency with the risks if used with

leverage and without appropriate safeguards. Increased lobbying efforts and

significant investor losses are likely to keep regulation top of mind, given the

large amounts of capital at stake.

Crypto regulations are increasing at a measured pace in the US. The fragmented

structure of the US financial regulatory system has led to a patchwork of crypto

regulations, making it harder for market participants to navigate. 3 federal

agencies are leading the charge - the SEC, CFTC and FinCEN. There has been a

push for a more coordinated response among regulators. The Financial Stability

Oversight Council (FSOC), headed by Treasury Secretary Mnuchin, has set up a

working group. A more coordinated response should lead to more rule clarity

and less duplication, a positive for crypto markets in the long run.

Limited exposure to crypto trading in our European coverage. CMC Markets is

the only stock under our EU coverage with a direct exposure to cryptocurrency

trading, though this is nascent having launched CFD trading (of crypto) in March

2018. As such, the product's share of revenues is currently immaterial. Other

players such as IG Group and Plus 500 (both uncovered) have launched similar

offerings with Plus 500 having the largest exposure, we believe.

Morgan Stanley does and seeks to do business withcompanies covered in Morgan Stanley Research. As aresult, investors should be aware that the firm may have aconflict of interest that could affect the objectivity ofMorgan Stanley Research. Investors should considerMorgan Stanley Research as only a single factor in makingtheir investment decision.For analyst certification and other important disclosures,refer to the Disclosure Section, located at the end of thisreport.+= Analysts employed by non-U.S. affiliates are not registered withFINRA, may not be associated persons of the member and may notbe subject to NASD/NYSE restrictions on communications with asubject company, public appearances and trading securities held bya research analyst account.

1

August 21, 2018 04:11 AM GMT







http://www.imf.org/en/Publications/GFSR/Issues/2018/04/02/Global-Financial-Stability-Report-April-2018

Regulatory position on cryptocurrency trading and distribution inEurope

Adedapo Oguntade, Anil Sharma

We have published a number of reports assessing ESMA's CFD regulations in Europe,

including:

CMC markets is currently the only stock under our EU coverage with a direct exposure

to cryptocurrency trading. ‘Currency Management Corporation’ (CMC Markets) is a

contract for difference (CFD) and spread betting firm specialising in financial products

(e.g. shares, FX, and indices). Revenues are generated predominantly from the bid-offer

spread, with the bulk coming from CFD transactions. The firm has a global footprint

with >50k customers in 70 countries.

CMC launched its cryptocurrency CFD offering in March 2018 and as such this currently

accounts for an immaterial portion of revenues. Other players such as Plus 500

(uncovered) have realised greater benefits as early industry movers - Plus 500 indicated

cryptocurrency CFDs trading represented less than 15% of 2017 revenues.

We have received a number of enquiries / investor questions on the position of EU

regulators on cryptocurrency CFDs and similar derivative products with a focus on

which European countries have banned cryptocurrency CFDs, if any. We explore this in

the light of the various regulatory pronouncements we have seen thus far. To be clear,

CMC's exposure here is not material and we do not make any changes to our forecasts

on the back of this note.

Investor protection concerns at the top of regulatory focus. Consumer protection is a

growing concern for regulators, particularly as complaints have increased and poor

practices have been uncovered in the retail CFD & spread betting industry. Over the last

two to three years, we have seen intense regulatory scrutiny on the distribution of CFD

products in Europe. In Dec 2016, the UK regulator (FCA) proposed introducing leverage

limits, enhancing disclosure and prohibition on bonus payments, which arguably

heralded the start of greater pan European legislation. In June 2018, the European

Securities and Markets Authority (ESMA) published wide ranging temporary measures to

address these concerns with a focus on: (i) prohibiting the marketing, distribution or sale

of binary options to retail clients; and (ii) lower leverage limits and defining the nature of

trading accounts that can be offered to retail clients (see note). These measures took

ESMA update on CFDs and binary options, 18th December, 2017

ESMA publish measures on CFDs and binary options, March 27, 2018

CMC Markets: Risk reward less appealing; downgrade to Equal-weight, May 1,2018

ESMA adopts final product intervention measures on CFDs, June 1, 2018

ESMA publishes update on upcoming measures, July 12, 2018

2

https://ny.matrix.ms.com/eqr/article/webapp/73c49930-e3d6-11e7-84cf-8d07e0586637?ch=rpint&sch=cc

https://ny.matrix.ms.com/eqr/article/webapp/5f3fe0bc-318a-11e8-ba27-fba2371fa2b6?ch=rpint&sch=cc

https://ny.matrix.ms.com/eqr/article/webapp/1ce2ebe8-4255-11e8-9695-5e5c95fbb3b1?ch=rpint&sch=cc

https://ny.matrix.ms.com/eqr/article/webapp/cd18dbea-659f-11e8-83fe-a692b3e66a6b?ch=rpint&sch=cc

https://ny.matrix.ms.com/eqr/article/webapp/d5d51374-85c6-11e8-8ff8-a076c615a16b?ch=rpint&sch=cc

https://www.esma.europa.eu/press-news/esma-news/esma-adopts-final-product-intervention-measures-cfds-and-binary-options

https://ny.matrix.ms.com/eqr/article/webapp/5f3fe0bc-318a-11e8-ba27-fba2371fa2b6?ch=rpint&sch=cr

effect from 2 July/1 August 2018.

We see rising regulatory spotlight on cryptocurrency trading. Given the surging

popularity of cryptocurrencies (i.e Bitcoin, Litecoin, Ethereum) over the last 18 -24

months, ESMA and a number of National Competent Authorities (NCAs) have expressed

concerns on the exposure of unsophisticated retail investors to trading these products.

Several examples:

Notably, three key European regulators - The European Securities and Markets

Authority (ESMA), the European Banking Authority (EBA) and the European Insurance

and Occupational Pensions Authority (EIOPA) - issued a joint warning statement on

cryptocurrencies highlighting why they were risky for consumers including amongst

others: (i) extreme volatility (ii) absence of protection (iii) lack of exit options (iv) lack of

price transparency and (v) operational disruptions. Following on from the warning,

ESMA restricted the leverage limit on cryptocurrency CFDs to 2:1 for retail clients as

part of its temporary CFD industry measures.

Which EU countries have banned cryptocurrencies? Amongst the NCAs, Belgium placed

a ban on the distribution of OTC Forex, CFDs and binary options in August 2016 on firms

authorised in Belgium. This ban affects all CFDs including crypto CFDs; This does not

extend to other variations of cryptocurrencies such as spot, futures or options contracts.

In France, the AMF has determined that cash-settled cryptocurrency contracts qualify as

a derivative, irrespective of the legal qualification of a cryptocurrency. In line with

provisions under Safin II legislation, the AMF has banned the electronic adverts of

derivatives such as binary options and forex contracts with cryptocurrency as

underlying. Adverts of cryptocurrency CFDs to retail clients where there is no negative

balance protection are also banned.

FCA issue warning on trading cryptocurrency CFDs. Cryptocurrencies do not fall under

the regulatory scope of the FCA (See link). However firms that offer cryptocurrency

derivatives need to be authorised by the FCA. In November 2017, the FCA issued a

warning to consumers highlighting the risks in investing in cryptocurrency CFDs. The

body noted these products were extremely high-risk speculative products and expressed

1. The French regulator, Autotite des marches Financiers (AMF), has also published a

release on cryptocurrency derivatives advertising while in the UK, the FCA issued

warnings on the product.

2. Belgium, the Financial Services and Markets Authority (FSMA) warned on

fraudulent cryptocurrency trading platforms publishing a list of firms where

indications of fraud were established.

3. The German regulator, Bafin, published an advisory note on the regulation of Initial

Coin Offerings (ICO) identifying which laws could be triggered in an ICO and on a

case by case basis, when such ICOs can be regarded as financial securities. In terms

of trading, the Bafin has focused on identifying and banning cryptocurrency

exchanges which have not been properly authorised.

4. In Cyprus, the Cyprus Securities and Exchange (CYSEC) in a 2017 release permitted

trading in these products when certain conditions are satisfied. Subsequently,

CYSEC has published new rules governing derivatives on virtual currencies which

are in line with ESMA measures.

3

https://www.amf-france.org/en_US/Actualites/Communiques-de-presse/AMF/annee-2018?docId=workspace://SpacesStore/a225bf1d-de35-4f58-89e3-f03cb7e9e551

https://www.fsma.be/en/warnings/cryptocurrency-trading-platforms-beware-fraud

https://www.bafin.de/SharedDocs/Downloads/EN/Merkblatt/WA/dl_hinweisschreiben_einordnung_ICOs_en.pdf;jsessionid=F0CDE6238E8C71FEA03B1052171B479E.1_cid381?__blob=publicationFile&v=2

https://www.cysec.gov.cy/CMSPages/GetFile.aspx?guid=68916d74-fd47-40a4-a848-1f6bacb8aea3

https://www.cysec.gov.cy/CMSPages/GetFile.aspx?guid=2cd4bb96-9cf7-476d-abce-7f7583406c80

https://www.esma.europa.eu/sites/default/files/library/esma50-164-1284_joint_esas_warning_on_virtual_currenciesl.pdf

https://www.fsma.be/en/news/fsma-regulation-establishes-framework-distribution-otc-derivatives-binary-options-cfds

https://www.amf-france.org/en_US/Actualites/Communiques-de-presse/AMF/annee-2018?docId=workspace://SpacesStore/a225bf1d-de35-4f58-89e3-f03cb7e9e551

https://www.fca.org.uk/news/statements/cryptocurrency-derivatives

https://www.fca.org.uk/news/news-stories/consumer-warning-about-risks-investing-cryptocurrency-cfds

the following concerns:

The FCA has not issued any bans on cryptocurrencies with no indication of any plans to

carry out additional studies on the product.

Cryptocurrency adverts are banned on major social media platforms. Major social media

networks like Google and Twitter have placed bans on all cryptocurrency and initial coin

offering (ICO) adverts on their platforms in an effort to enhance consumer protection.

In similar fashion, Google has indicated advertisers offering online trading of

instruments such as CFDs and financial spread bets will need to be both licensed by

national regulators in the countries they are targeting and certified by Google to make

use of the company's advertising service. Facebook initially instituted a ban earlier in the

year but this has now been rescinded.

1. Price volatility - vulnerability to sharp movement in price with the possibility for

>20% movement in value in a single day.

2. Leverage: The possibility for leverage to multiple losses with some firms offering

leverage of up to 50:1

3. Charges and funding costs: Spread fees, funding charges and commissions on

cryptocurrencies tend to be higher than other products.

4. Price transparency: There is greater risk that consumers will not receive a fair and

accurate price for the underlying cryptocurrency when trading.

4

Global trading of cryptocurrency

Sheena Shah

It is well known that the retail investor has been a participant in cryptocurrency

markets. The volatility in prices and the ever increasing number of tokens to trade has

caught the attention of regulators and central banks. Overall, the thinking has been that

cryptocurrencies are not a financial stability risk because the volume of flows are low vs

the broader financial market. We have written in more detail in prior notes, below we

summarise the key ideas.

- Why a Country May Be Interested in Digital Currency (8 May 2018)

- Where Are Exchanges Based? (25 Apr 2018)

-Features of a Bitcoin Bear Market (19 Mar 2018).

Changing regulation has caused cryptocurrency exchanges to reconsider which country

they are located in. In April when we ran our analysis, the largest cryptocurrency

volumes were traded via one exchange called Binance, which had announced that it will

move operations from Hong Kong to Malta. From around 200 other exchanges we

analysed, the next favoured locations are South Korea, Belize and Seychelles (Exhibit 1).

The United Kingdom ranked particularly highly on the number of exchanges located

there, but only saw 1% of trading volume.

Defined but also attractive regulation makes an exchange decide to choose one country

over another – a set of laws for companies to follow when handling digital tokens,

customer assets, AML policies, taxes, etc. Regulatory certainty is part of the

attractiveness for the companies so they can plan for the future as they know what to

expect. Low taxes are a benefit.

The country where bitcoin is traded is unknown but the fiat currency that is exchanged

for bitcoin can be used as a proxy. The major trading currency on exchanges has changed

over time (Exhibit 3). Exhibit 2 shows that most recently, most trading is still versus the

Japanese Yen (36%) but a crypto-token USD Tether (USDT) is still taking an increasing

share of volumes. That has occurred because the biggest exchanges only allow trading

Exhibit 1: Where are exchanges located?

0

200

400

600

800

1,000

1,200

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Britis

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USA

Sout

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Esto

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Finl

and

Cryptocurrency trading volume by legal location of exchange (USDmn)

Allocations as of April 2018Volumes as of August 2018

Source: CoinMarketCap.com, company websites, Morgan Stanley Research. Originally published here.

Exhibit 2: Bitcoin major trading currencies

JPY, 35.7%

USDT,33.3%

USD,13.9%

DASH,5.0%

XMR, 2.8%EUR, 2.2%

Others,7.2%

Bitcoin trading by currency (14-Aug-18, 1m av)

Source: CryptoCompare, Morgan Stanley Research

5

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https://ny.matrix.ms.com/eqr/article/webapp/21b6e6e0-f62b-11e7-a199-e952e118a8a5?ch=rpint&sch=cm

https://ny.matrix.ms.com/eqr/article/webapp/6d6a1952-125c-11e8-b486-4f602178b9fa?ch=rpint&sch=cm

https://ny.matrix.ms.com/eqr/article/webapp/e1115b70-47ab-11e8-adef-6a0a1ce82510?ch=rpint&sch=cm

https://www.cryptocompare.com/

between cryptocurrencies. As cryptocurrency prices have been falling correlations

between coins stayed high so traders looked for a way to come out of the market, with

USDT being relatively stable around 1 USD, providing that avenue. Cryptocurrencies

make up about 60% of all trading vs bitcoin, while fiat currencies around 40%.

Exhibit 3: Bitcoin Trading by Currency

Source: CryptoCompare, Morgan Stanley Research

6

Global Cryptocurrencies Regulation

James Faucette

The degree of regulation varies widely. Governments have taken multiple approaches

to regulating cryptocurrencies. Some jurisdictions have kept the space less regulated, in

part to attract crypto investment (e.g. Malta), and others are using it as part of a push

for improved efficiency for their financial services industries. Others countries, like the

US, have a wide range of regulatory reviews underway regarding cryptocurrencies. In the

US, financial regulators have their own unique and evolving views on crypto. For

example, the IRS' opinion is that cryptocurrencies are assets and therefore investors

need to disclose gains for short and long term capital gains taxes, the SEC recently

stated that initial coin offerings (ICOs) can be construed as securities and can be subject

to securities law, several Federal Reserve Governors have highlighted that

cryptocurrency is not legal tender. Reviews are ongoing and we should expect the

regulatory regime to continue to firm up.

Meanwhile, large sums of money raised from ICOs are funding lobbying efforts.

Associations are engaging with investors (e.g. venture capital firms) who have invested

heavily in ICOs and cryptocurrency technology to push pro-cryptocurrency legislation.

Coinbase, the largest US-based cryptocurrency exchange platform, recently formed a

PAC (political action committee) in the US, and Fidelity is lobbying on behalf of bitcoin

and other digital assets, according to the FEC and Politico. Associations like ACCESS in

Singapore and Bitcoin Association Switzerland are also said to be lobbying and

educating interested parties. We expect lobbying to increase in countries that are moving

toward stricter regulations, given the large amounts of capital at stake.

Significant investor losses may lead to regulation. ICOs have raised over $5bn in capital

YTD, nearly as much as the total for 2017. However, as we highlighted in our note,

Update: Bitcoin, Cryptocurrencies and Blockchain, 2/3 of potential ICOs in 2017 failed

before/after their ICOs, a much higher failure rate vs. startups in their first year. Reports

Exhibit 4: Degrees Regulation of ICOs and Cryptocurrencies Globally

Note: Green area represents country where government has provided limited guidance on regulation. Red area indicates that country has prohibitedcryptocurrencies in some capacity. Yellow indicates progressing toward greater regulation. This is intended to offer a visual representation of varyinglevels of regulation at a point in time and may not accurately reflect more recent developments. Source: Business Insider, Morgan Stanley Research

rd

7

http://docquery.fec.gov/cgi-bin/forms/C00680355/1243300

https://www.politico.com/story/2018/05/22/washington-cryptocurrencies-bitcoin-lobbyists-549994

https://www.nasdaq.com/article/op-ed-lobbying-efforts-promote-the-blockchain-industry-around-the-world-cm929256

https://ny.matrix.ms.com/eqr/article/webapp/8809f448-65f5-11e8-83fe-a692b3e66a6b?ch=rpint&sch=sr

of fraudulent ICOs have also surfaced, with the WSJ reporting that some active ICOs,

currently raising over $1bn, have missing/fake executive teams and are using plagiarized

investment documents. Cryptocurrency exchange hacks have also hurt investors, with

$801mn in coin losses resulting from just 5 hacks in 2018 (Exhibit 5). Earlier this year, the

South Korean government inspected 21 cryptocurrency exchanges and found that no

firm met all 85 inspection standards, according to the WSJ. Meaningful losses with no

recourse may spur tighter regulation. If it increases, we believe cryptocurrency

transactions will migrate to less-regulated jurisdictions. As an example, when China

increased its restriction on bitcoin mining in 2017 and then banned trading, we saw

global bitcoin trading move away from the CNY (Exhibit 3).

Exhibit 5: Some of the Largest Hacks on Cryptocurrency Exchanges/PlatformsExchange/Platform Date of Hack Value in Coin Loss ($mn)Bancor (Israel) Jul-18 24Coinrail (South Korea) Jun-18 40Bithumb (South Korea) Jun-18 32BitGrail (Italy) Feb-18 170Coincheck (Japan) Jan-18 535NiceHash (Slovenia) Dec-17 70Parity (UK) Jul-17 32Youbit (South Korea) Apr-17 35Bitfinex (Hong Kong) Aug-16 77DAO (Germany) Apr-16 55Mt. Gox (Japan) Jan-14 450

$24mn$40mn

$32mn$170mn

$535mn$70mn

$32mn$35mn

$77mn$55mn

$450mn

Value in Coin Losses

Source: WSJ, Morgan Stanley Research

8

Exhibit 6: Regulators Globally are Watching Cryptocurrencies Closely

Regulator/Event Comments

Jay Clayton, SEC Chairman(USA)

“ (I am) very optimistic that developments in financial technology will help facilitate capitalformation,” but “many promoters of ICOs and cryptocurrencies are not complying with oursecurities laws and, as a result, the risks are significant.” SEC staff has been instructed “to beon high alert for approaches to ICOs that may be contrary to the spirit of our securitieslaws.” (Jan/Feb 2018)

Brian Bussey, Director of CFTC’sClearing and Risk division(USA)

The CFTC has issued new guidance to exchanges and other trading platforms that areinterested in listing bitcoin futures and other cryptocurrency derivatives products. “CFTCstaff is providing this information, in part, to aid market participants in their efforts to designrisk management programs that address the new risks imposed by virtual currencyproducts.” (May 2018)

Raphael Bostic, President, FederalReserve Bank of Atlanta(USA)

“They (cryptocurrencies) are speculative markets. They are not a currency. If you havemoney you really need, do not put it in these markets.” (March 2018)

Valdis Dombrovskis, the EU’s FinancialChief(Europe)

“This (cryptocurrency) is a global phenomenon and it’s important there is an internationalfollow-up at the global level. We do not exclude the possibility to move ahead (by regulatingcryptocurrencies) at the EU level if we see, for example, risks emerging but no clearinternational response emerging.” (Feb 2018)

Mike Carney, Bank of EnglandGovernor(Europe)

Cryptocurrencies do not threaten “financial stability” at the moment, but they could aftermore consumers get involved. It is time to incorporate the cryptocurrency ecosystem intothe rest of the financial system, applying to it the same regulatory approach and the same“rigorous standards.” (Mar 2018)

Andrea Enria, Chairperson, EuropeanBanking Authority(Europe)

Suggested it could be more efficient to prohibit banks and other financial institutions fromholding and selling cryptocurrencies, than to directly regulate crypto, according to FT. (Mar2018)

Ashley Alder, Chief Executive,Securities and Futures Commission,Hong Kong(Asia)

“Some complainants claimed that cryptocurrency exchanges had misappropriated theirassets or manipulated the market, or that technical breakdowns of the exchanges’ platformshad caused them significant losses. Several complaints against ICO issuers alleged unlicensedor fraudulent activities. We will continue to police the market and enforce when necessary. ”(Feb 2018)

The Monetary Authority of Singapore(Asia)

“When it comes to money laundering or terrorism financing, Singapore’s laws do not makeany distinction between transactions effected using fiat currency, virtual currency or othernovel ways of transmitting value. ” MAS will seek to impose anti-money laundering and anti-terrorist financing requirements on intermediaries that exchange fiat for virtual currencies –such as exchanges and brokers. (Jan 2018)

Jose J. Kattoor, Reserve Bank of IndiaChief General Manager(Asia)

“Virtual Currencies (VCs)... raise concerns of consumer protection, market integrity andmoney laundering, among others. Reserve Bank has repeatedly cautioned users, holders andtraders of virtual currencies, including Bitcoins, regarding various risks associated in dealingwith such virtual currencies.” Entities regulated by RBI shall not deal with or provide servicesto any individual or business entities dealing with or settling VCs. Regulated entities whichalready provide such services shall exit the relationship within a specified time. (Apr 2018)

Source: Morgan Stanley Research

9

Regulatory landscape in the US

Betsy Graseck

Different agencies, different jurisdictions, different rules...The fragmentation in the US

financial regulatory system has led to a patchwork of crypto regulations, making it

tougher for market participants to navigate. 3 federal agencies are currently leading the

efforts, in our view. The Securities and Exchange Commission (SEC) has been focused on

the ICO market, looking for any potential fraud or other misconduct. The Commodity

Futures Trading Commission (CFTC) has oversight of the crypto futures market.

Meanwhile, the Financial Crimes Enforcement Network (FinCEN) has said that any

businesses exchanging virtual currencies are "money transmitters" meaning that they

have to register with FinCEN and are subject to AML/BSA compliance. While the three

agencies focus on different aspects of crypto, they shared the same goal of providing

more investor protection, in particular for retail investors.

What does the SEC care about? ICOs. The SEC has said that certain ICO tokens are

securities and therefore fall under its jurisdiction. Whether or not a token is deemed a

security depends on the specific facts and circumstances of the offerings, as determined

by the Howey test. Those that are securities will need to be registered with the SEC

unless exempted. The SEC is also looking to apply securities law to exchanges and

digital asset storage companies that deal with securities token. In 2018 YTD, the SEC has

brought 7 enforcement actions against ICOs that allegedly violated federal securities

law. Note that the SEC has previously said that bitcoin and ethereum are not considered

securities.

Another area that has been gaining attention is crypto ETFs. The SEC has not to date

approved for listing and trading any ETFs holding cryptocurrencies or other related

assets. The SEC has recently rejected a second attempt by Cameron and Tyler

Winklevoss, founders of crypto exchange Gemini, to list the first crypto ETF on a

regulated exchange, citing issues with high volatility and funds' liquidity. The market is

now watching for the SEC's decision whether to approve for listing the VanEck/SolidX

bitcoin ETF proposal. The SEC has set a deadline for September 30 to make a decision.

Crypto derivatives fall under the purview of the CFTC. The CFTC has designated crypto

as a commodity, giving it oversight of the crypto derivatives markets. In late 2017, the

CFTC has allowed the CBOE and CME to launch bitcoin futures products on their

exchanges. The CFTC believes that the bitcoin futures markets will provide them with

greater visibility into the underlying spot markets that they would not otherwise have. It

is worth highlighting that the two bitcoin futures products are cash-settled contracts,

which means that buyers do not have to hold bitcoin itself. Additionally, clearing

members have the ability to impose trading or exposure limits on their clients, as well as

increase margin requirements.

Cryptocurrencies are assets for federal tax purposes, as per the IRS. This means that

crypto is subject to capital gain taxes, just like stocks, bonds or other investment

properties. Further, the IRS has recently launched the Joint Chiefs of Global Tax

Enforcement (J5) with four other countries, namely Australia, Canada, the Netherlands

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https://www.sec.gov/news/press-release/2017-131

https://www.irs.gov/compliance/joint-chiefs-of-global-tax-enforcement

and the UK, to investigate cryptocurrency crimes like tax fraud and money laundering.

What about the Fed? Former Fed Chair Janet Yellen has called crypto a "highly

speculative asset" that "doesn't constitute legal tender." While the Fed does not have a

direct jurisdiction over cryptocurrencies, it is responsible for ensuring that the banking

organizations under its supervision are appropriately managing their risk exposure to

crypto market participants.

Building a more coordinated regulatory response to crypto. The Financial Stability

Oversight Council (FSOC) has formed a cryptocurrency working group comprising the

SEC, CFTC, the Fed and the FinCEN. Further, the SEC and CFTC have issued a

memorandum of understanding in June to ensure a continued coordination and

information sharing between the two agencies, in particular on cryptocurrencies. We

think that a more concerted effort to regulate crypto will lead to more rule clarity and

less duplications, a positive for the development of crypto markets in the long run.

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For important disclosures please refer to page 21. · Treasury bond yield, CLSA’s technical analyst Laurence Balanco’s view is that it is on the cusp of confirming a top in yield

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