This week, I shared a warm interaction I had with Ira Gluskin, and received a superb report by Geordie Young, one of our portfolio managers. Not only were they pleasant surprises, but they highlight the thinking of our Investment team. I wanted to share them with all of you.
Earlier this week, I showed Geordie Young, who helps manage our credit funds among other things, a copy of an op-ed piece from the FT that had to do with behavioural shifts that are still occurring in this post-bubble-bust-recovery- financial repression cycle. Geordie’s role on the Investment Team is one of portfolio manager, but he is also a big picture macro guy and what I like about him is that he is an out-of-the-box thinker. He passed on this original piece of work he wrote recently titled Time Asymmetry on the possible range of outcomes in terms of which part of society will end up bearing the costs and benefits from this era of massive fiscal deficits and ultra-low interest rates, and I just thought it was too good to just sit here on the shelf.
Let’s take a stylised example of a society with two groups: Generation Old and Generation Young. Generation Old owns the vast majority of the risky productive assets (i.e. capital stock, like private businesses and public equities). However Generation Old no longer has the risk tolerance or time horizon to continue to optimally hold these assets and wait for future uncertain cash flows. Generation Old needs the present value (PV) in cash today and can’t wait around until the future. Generation Old doesn’t need any more capital appreciation, it needs certainty; it wants to lock in the current PV level of wealth. So it wants to sell risky assets for cash or guaranteed cash streams.
Generation Young has no money to buy the risky productive assets. So one outcome is the outright cost of risky productive assets will fall to a level where Generation Young can afford them (e.g. the case the San Fran Fed is implying when it forecasts zero real return in equities for five years). But what might end up happening is that risky productive assets have to trade down through intrinsic value just to get to a clearing level Generation Young can afford. This can lead to stunted capital formation and sub-optimal risk taking in the economy, producing subpar economic growth in the meantime and damaging long term potential growth going forward.
However, there is another option. While lacking money today, Generation Young does have an asset — time. Another outcome is the spread between the cost of time and risky assets gets attractive enough for Generation Young to do the spread trade. What is the cost of time: interest rates. Borrowing and lending is simply the process of moving cash flows in time. So Generation Young borrows money from a third party, uses that money to buy risky assets from Generation Old, and uses time to pay off the borrowings. Generation Young thereby pockets the positive carry and accumulates wealth. The third party turns around and gives Generation Old a safe place to park the cash proceeds of the risky asset sale. The third party doesn’t need to offer Generation Old much in terms of compensation, just security.
Who is this natural third party: the government. When risk assets are not cheap on an outright basis, but are cheap on a relative basis compared to the cost of time, then the government should be encouraging the levered long trade. It accomplishes all the social goals a government wants: Generation Old gets their money, the generational transfer of assets happens near fair value — not at distressed levels — with the capital stock continuing to be maintained and upgraded, and Generation Young gets to build wealth. The problem is a time asymmetry problem between when Generation Old wants the money and when Generation Young will be able to accumulate the money.
This positive carry between risk assets and time will be captured by someone. The problem right now is that the system is set up such that only a select few investor classes can access this type of trade. Professional investor classes like private equity and hedge funds have preferred access to this. The irony is that the government encourages average households to lever up unproductive assets like houses at preferred borrowing rates, but makes it punitive for these same households to lever up productive assets (i.e. high margin rates, low leverage ratios and tight mark-to-market requirements). To make matters worse, the investor class that should be households’ advocates in this trade (insurance companies and pension funds) are being forced by the regulatory environment to do the opposite. The focus on mark to market solvency, managing duration gaps, and asset risk weighting instituted by regulators is conspiring to force these investors to sell equities and buy (low-yielding) bonds.
We need to make the discussion about borrowing levels more nuanced. Debt is neither good nor bad, it just is. The real question is what the borrowing is used for. Money borrowed for consumption is rarely a good idea, as the integrated sum of spending over a lifetime is a constant, so borrowing to consume is sum zero; a surfeit of spending today is offset by deficit of spending in the future. On the other hand, borrowing to invest in productive assets does not have to be sum zero. Obviously good investment decisions need to be made, and the rate of risk adjusted return needs to exceed the cost of borrowing, specifically where the return comes from generated cash flows, not valuation gains. But if these criteria are met then borrowing should be encouraged.
We discussed a stylised generational example, but the situation in the U.S. is not that far off. The elder generational cohort — the Boomers — are no longer capitalists, but have aged into risk adverse rentiers. They no longer have the appetite or time horizon to make large scale investments and bet on growth; they are more interested in “dividending” out the capital stock to themselves. As such, the country’s capital stock is being treated like it is in “run-off” mode, without the necessary maintenance and investments for the future being made.
The younger generational cohort — the Echo Generation — has the demographic numbers, but doesn’t have the accumulated savings yet to afford the assets. Given the largest inter-generational asset transfer in history is about to go down, it would seem the government has a keen incentive to make sure it happens smoothly, with minimal disruption to the productive capacity of the economy. If debt levels within the system are elevated for a period of time, then so what, as long as the debt is used to procure productive assets at fair prices.
There are three implicit assumptions being made in this argument that can be used as a route of critique. First is the assumption that the risky productive assets are at fair value. If one doesn’t believe risky assets are at fair value, it is akin to saying the risk premium in market prices needs to be even higher. That is a fine debate to have, and ultimately one the market needs to decide, and settle. It is not the place for government to get involved in this.
Second assumption is that Generation Young will use this surplus of time in a productive manner. If Generation Young is not able to maintain (or grow) the cash flow generating properties of the risky productive assets, then the whole analysis collapses and it devolves into a Ponzi scheme. This is where government involvement should be focused. The government has the responsibility to insure the productive capacity of Generation Young is optimised. This may involve the government getting involved, or getting out of the way, as the situation warrants. Regardless, this should be the prime focus of all elected officials and regulators. If the system doesn’t unlock the potential in Generation Young then the system is doomed.
The third assumption is that during the time it takes for Generation Young to pay off the financed purchase of the risky assets, that none of the parties involved (specifically Generation Young or the Third Party) are “stopped out”. Effectively since there is leverage involved, the problem involves an element of path dependency. However, this is where the government needs to think rationally about risk. As long as the government believes in the capabilities of Generation Young, and in its institutions’ ability to unleash these capabilities, then the government should reduce or mitigate the path dependency aspect. In essence, the government needs to not allow society to get caught up in “mark to market” as a measurement of risk but focus solely on the probability of permanent drawdown of productive capacity as the appropriate measure of risk. That is the proper metric of risk for society, and a metric too few people are looking at today.
ODE TO IRA
If you ever told me in years gone by that I would have my office beside that of Ira Gluskin, I never would have believed it (maybe because until we moved location to the Bay Adelaide Centre in the Fall of 2011, Ira never had an office).
Yesterday, Ira walked into my office to wish me a happy new year. And he asked me how my father was … very touching. I told him that for an 86-year old with advanced Parkinson’s and now wheelchair-bound for the most part (but mental acuity intact) that he was not doing too badly at all, and that I visited dad this past weekend and he was actually in pretty good humour.
I told Ira “we have you to thank that we can afford to have him in the posh Four Elms Retirement Home up there in Thornhill”.
Ira asked why that was the case.
I told him that my dad followed his advice on the Income Trust space a decade ago. Ira looked at me quizzically.
So I reminded Ira that back in 2003, the two of us shared the podium at the annual forecaster gala dinner to the Toronto Society of Financial Analysts at the Sheraton Centre ballroom. This was my first full year in New York with Mother Merrill and I was back home with the honour of delivering the macro forecast along with Ira’s market musings. We sat at the head table together and Ira didn’t say a word to me — he poured over his written text and penned in changes and comments at the margins through the entire dinner. I don’t even think he ate (if I recall, he didn’t miss anything special). He delivered his speech after me, but left his prepared text that he had agonized over for much of the dinner on the table. And then he went on to deliver a phenomenal speech in front of 1,300 people over the outlook for Income Trusts with no notes at all. It was an incredible performance.
The following weekend, I visited my parents at their condo and my dad asked me what Ira Gluskin had to say at the dinner event. I told him that Ira discussed the outlook for Income Trusts, which at that point in time was a market largely ignored and yet about to embark on years of impressive returns. Dad was a very active investor (savvy too) and asked me to get a copy of Ira’s speech for him to peruse, and I told him that I would give the folks at Gluskin Sheff a call and see if they would forward me a copy. Patricia Maguire, Ira’s executive assistant (then and now) happily emailed me a copy of the prepared text (the one Ira never gave, but he is always best when he talks off the cuff anyways) and I in turn handed a copy to my father. And he was very pleased.
Dad sat down at the dining room table, I remember this like yesterday, devouring Ira’s speech at the same time that he was devouring my mother’s (may she rest in peace) famous cheese blintzes. I asked dad if he was at all interested (ahem) in what I had to say at the forecast dinner.
Pause. Then dad asked me … “will it make me any money?”
I said “probably not, but it’s still interesting.”
Dad replied “thanks son. I think I’ll just stick to what Ira has to say.”
Like I said, listening to Ira and building exposure in the Income Trust arena and accumulating all those cash flows played a key role in dad’s current stay at the Four Elms retirement residence. So when I thanked Ira the other day and he asked me why I was thanking him and I recounted this story to him, well, I have to admit … I don’t think I have heard Ira laugh that hard in my four years at the firm. It’s a rather infectious laugh.
And get this — Patricia still has that speech on file! And while the Income Trust theme has morphed into a more broadly diversified Premium Income Strategy, the sermon he gave on that fateful night back in 2003 is still very much worth a read. In fact, I’m getting her to print another copy off for dad … whoever said that nostalgia ain’t what it used to be? There’s actually few things better than a fond memory, especially one that helped pay for dad’s retirement!
Thanks again, Ira.