The Objective
Luis Arenzana


«Markets today are generally priced to perfection and as illiquid as we can remember»



There are so many interesting stories going on at this time, that it is hard to choose. SWMBO will soon leave office; she has been the Chancellor of Germany for sixteen years. Expect myriad paeans on her steadfast leadership of Germany and the EU, her moderating influence on international relations, and her cerebral approach to decision making. Glasgow is hosting the United Nations Climate Change Conference. World leaders will outdo each other in frenzied proclamations and frantic statements on the extreme urgency of meeting zero net greenhouse gases emissions targets no matter the cost or the lack of supporting data to justify such alarmism. In the financial markets, the talk of the town is inflation. It has finally reared its ugly head. Two lawyers, Jerome Powell and Christine Lagarde, will have the final say in terms of immediate monetary policy decisions on whether this spike is transitory or of a more permanent nature. Finally, earnings season is well underway. Markets today are generally priced to perfection and as illiquid as we can remember. It is not just intraday volatility of Government bonds; the lack of liquidity in equity markets reminds us of the period between Bear Sterns hedge funds’ problems in the summer of 2007 and the Volkswagen squeeze following Lehman Brothers’s bankruptcy filing. As a result, earnings misses receive harsh punishment, luckily, beats are finally rewarded.

SWMBO may be remembered fondly by many, but not by us. We will not forget her presiding over the clumsy, divisive, and openly xenophobic approach to the euro area sovereign and debt crisis. Her initial reluctance to present her electorate with the harsh reality that you may not have your cake and eat it too, resulted in wanton misery for millions of innocent bystanders in the periphery of the euro zone. Millions of families suffered austerity policies to fix a crisis that resulted from politicians’ very poor design of single currency area for a non-optimal set of countries. Widespread unemployment and misery upended the political landscape in Greece, Italy, Spain and Portugal in conjunction with adverse domestic political developments.

The story line of the lazy and therefore low productivity periphery labour force sank in from the get go as it resonated with deeply held stereotypes going back to the Wars of Religion that afflicted this God forsaken Asian subcontinent for centuries. Economics were never part of the political discussion once the twin Sovereign and Banking crises got underway. Yet, a country cannot run a current account surplus of 9% of GDP without its trading partners necessarily running current account deficits. In other words, the surplus country needs to lend money to the deficit countries in order to run that surplus. Keynes already suggested in the 1930s that for the gold standard to work well, countries running large current account surpluses should be fined just as much as countries running large deficits. The rules of the euro currency board absurdly, yet most conveniently for Germany, only set limits on deficits.

SWMBO has also played an important role in advancing energy policies targeting lower CO2 emissions. Unfortunately, her policies, including the early retirement of Germany’s nuclear facilities (a knee jerk reaction to the Fukushima accident) and coal thermal plants are proving very costly for millions of much less affluent non-German EU citizens. In addition, as has become quite clear in recent weeks, Europe is increasingly beholden to the whims of Vladimir Putin. It is inconceivable to US policy makers that Germany would not have a single regasification facility and is happy to depend on Gazprom for most of its non-renewable energy sources going forward. Some say that Merkel’s upbringing in the GDR informs her distrust of the US and her comfort with Russia. Perhaps there is some truth to that statement; what’s more important though, is that most Europeans do not feel represented by such policies.

Finally, Brexit might be her biggest failure. As the EU has grown eastwards taking-in countries that have given up a historic opportunity, following decades of subjugation to the Soviet Union, to embrace the liberal politics and culture of the West, it is a tragedy to part ways with the United Kingdom. SWMBO is as much to blame as her French counterparts for this historic mistake. Not engaging with David Cameron when he came to them to negotiate a deal that would had ratified the UK’s special status in the EU was irresponsible. As it turns out, the EU can live with the demise of the rule of law in Poland or in Spain. The European Council twists and turns to accommodate the rising authoritarianism of the Hungarian government. The European Commission ignores the descent of Bulgaria towards failed state status. Yet, SWMBO could not reach a compromise with the British PM that just required accepting the reality that the UK is “not committed to further political integration into the European Union” and move on. In the interim, the EU has not moved one inch towards further political union in spite of all of Macron’s efforts unless you count the conditionality that comes with the NextGenerationEU as a closer union because there are no spaces between the words.

The UN Climate Change Conference is an interesting and lonely example of near universal consensus. The question is not so much, whether the IPCC’s observations are accurate, but rather whether the modelling is robust enough to drive trillions of dollars of investments. The environmental movement has supported a number of self-defeating energy policies before. Some of their members are honest enough to recognize some of their past mistakes. Dr Patrick Moore, a co-founder of Greenpeace, is today co-chairman of the Nuclear Energy Institute’s new Clean and Safe Energy Coalition. Felipe González, the former Socialist PM of Spain and “no-nukes” campaigner and enforcer, has also turned around to see nuclear power generation as a solution to the world’s growing energy needs. Before you crucify us for heresy, may we suggest that you read “Unsettled” by Dr Steven E. Koonin.

Unlike Al Gore, the inventor of the Internet who later pivoted to becoming the lay prophet of the anthropogenic global warming doom movement, Dr Koonin is an actual scientist. A former Undersecretary for Science in the US Department of Energy under the Obama Administration, he has published 200 peer-reviewed papers in physics and astrophysics, scientific computation (i.e. modelling), energy technology and policy on climate science. Dr Koonin was a professor of Theoretical Physics and a university provost at Caltech. He is currently a professor at New York University. He is a member of the US National Academy of Science and the JASON group of scientists who solve technical problems for the US government. He is currently an independent governor for the Lawrence Livermore National Laboratory and has served in similar roles for the Los Alamos, Sandia, Brookhaven, and Argone National Laboratories.

No sooner was this book published that some reviewers accused the author of delivering many of the same type of fallacies that he points out in others. His critics are fierce and usually start their argument with the statement that Dr Koonin is not a climate science expert. They also like to point out that in the IPCC AR6 report the scientific community unequivocally asserts “that the increase in of CO2, methane, and nitrous oxide in the atmosphere over the industrial era is the result of human activities and that human influence is the principal driver of many changes observed across the atmosphere, ocean, cryosphere and biosphere”. The most recent report published in August concludes, “Human influence on the climate system is now an established fact”. This sounds truly definitive, does it not?

However, what does “fact” mean to a scientist? Actually, not what you might think it does. Whereas an observation that has been repeatedly confirmed and for all practical purposes is accepted as “true”, truth in science, however, is never final. What is accepted as a fact today may be modified or even discarded tomorrow. Contemporary epistemology embraces this scientific process. Scientist posit tentative statements about the natural world leading to deductions that can be tested. The process of verification leads to a better understanding of natural phenomena over time. Nevertheless, the one thing that scientists do not do is to consider a subject permanently settled. This is reason enough to be sceptical of the IPCC’s blind faith in their conclusions.

The inflation question is far from settled as well. One of the most interesting observations on this hot subject comes from John Greenwood, Chief Economist at Invesco: “In the current environment it is revealing to contrast the price changes in the US or UK with those in Switzerland or Japan. Since supply chain disruptions, electronic chip shortages, problems in auto manufacturing or the more recent surge in energy prices are global in nature, it should be the case that prices in the US, the UK, Switzerland and Japan should all be rising at roughly the same rate. But that is not what we find. Consumer prices in the US are rising the fastest (by 5.25% year-on-year in August), followed those in the UK (3.2% in August), but in Switzerland (0.9% in September) they are barely rising at all, while in Japan (-0.4% in August) they are still falling”.

Since Bernanke pointed out that the risk of deflation outweighs the risk of rising inflation because central banks are far less well equipped to deal with the former than with the later problem, Central Bankers would rather err on the side of inflation, at least this matter seems to have been settled for now.

Finally, we will turn to financial markets. Indices have been moving monotonously up since the trough of March 2020. Underneath, there is significant dispersion. The average stock is certainly not up anywhere as much as the broad indices would lead you to believe. Stock picking has been a challenge to those who do not own the mega caps and even to some of those who do own them, viz. Ark’s surprisingly poor year to date returns. We observe a lack of liquidity in Government bond markets, which may be explained by central banks’ purchases. The stock market may not be as liquid as the trading volume suggests either, as news seem to have a very large impact on share prices. Nowhere is this phenomenon more evident than in the demise of the Chinese technology giants as the Government there implemented policies that had been flagged for months.

Finally, fundamentals seem to be increasingly irrelevant. Take for instance the current love affair with European banks. Last week BBVA, a multi-country lender domiciled in Spain, reported earnings. The stock price surged 7.4% as earnings were a beat and management confirmed a large stock buyback program that had been already announced when the stock was 50% lower. In their glowing reviews, not a single analyst seemed to notice that the book value per share (BVPS) had barely changed for the year going up just €0.04 to €6.74. This is surprising since the bank reported a cumulative EPS of €0.46 for the first 9 months of 2021 and has only distributed €0.139 per share in dividends. Perhaps this lack of interest in such important details stems from the banality of this disconnect between earnings and book value. Since 2011, BBVA has reported a cumulative EPS of €5.86, has paid out €3.53 in cumulative dividends per share, and yet the Book Value per Share has declined from €8 to €6.74 instead of going up to €10.33. This in spite of selling their US banking subsidiary for 1.34x tangible book value in a deal that reportedly has a positive impact on CET1 of 300 bps.

We have chosen BBVA as just an example but the problem is common to many other banks in the euro zone including their local rival Banco Santander, not to speak of capital destruction champions such as Commerzbank or Deutsche Bank. Even Intesa San Paolo, often an example of best in class, has failed to grow its BVPS over the past decade and currently ekes out a paltry 6.7% return on equity (ROE). Yet some investors cannot get enough of these stocks which some would think present a clearly asymmetric risk to the downside. These newcomers, for most are newcomers, trust that higher interest rates and inflation will make these banks more profitable. This is in spite of much evidence that rates are not going higher any time soon in the euro zone. Additionally, there is no evidence that if and when they do these banks will actually be more profitable because we cannot make apples to apples comparisons as current, much higher, capital requirements are a recent development and are not even fully phased in.

The mystery of the missing Book Value likely may come from mark to market losses in the portfolio of securities held at amortized cost and other securities portfolios, the mark to market of certain derivatives, and the impact of foreign exchange variations. Our point is that while we may live in the Age of Information, the truth has never been harder to detect. Whether we are trying to understand SWMBO’s legacy, Climate Change, the root causes of inflation or the real profitability of a public company, there is an industry that specializes in not spoiling a good story with the facts. The information is usually there, right in front of us, but we are persuaded to look elsewhere. It takes some practice to remain inure to the narrative of those who conform these consensus views. Such are the demands of our profession. Our job is to try to find the facts that underlie the PR machines’ alternative reality and come to our own conclusions. It is getting increasingly more complicated to understand what is really going on as the disinformation industry is at the top of their game and can count on large resources as well as the most credible spokespeople.

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