The Brexit Negotiations: A Game Plan from Game Theory

The Prime Minister’s Brexit speech on January 17th marked the opening move in the negotiation process that will lead to the UK’s departure from European Union. The UK’s best strategy through these negotiations will depend upon how the other side responds. However, clues are offered by Game Theory, defined as “the study of models of conflict and co-operation between intelligent rational decision makers.”

1. The opening move. Game Theory suggests that the person making the opening move should propose co-operation to arrive at a mutually beneficial solution. The PM’s offer of a “bold and ambitious free-trade agreement” between the UK and her EU partners meets this criterion. Under her proposals, the UK would leave the Single Market, and so regain control over her borders, laws and finances, but continue to offer all EU Member States tariff-free access to British markets, provided they do the same.

2. The response. As demonstrated by The Prisoner’s Dilemma, the EU’s optimal response would be to co-operate. In their initial responses to the PM’s speech, some EU leaders did make positive noises, welcoming the clarity of her approach. However, Game Theory suggests that, unless trust between two parties is high, one party may believe it has more to gain by ending co-operation and pursuing a “beggar my neighbour” policy, advancing their own interests at the expense of the other party. In his Brexit speech on October 7th 2016, President Hollande of France declared that “There must be a threat, there must be a risk, there must be a price.”

3. The principle of reciprocity. Happily for the long-suffering citizens of France, they will shortly be shot of the most incompetent and unpopular President in history of the Fifth Republic. So what he has to say on the subject is irrelevant. What is more worrying is that certain EU leaders have strongly criticised British Ministers for suggesting that Hollande’s approach is not helpful, while refraining from any comment on what he said back in October – suggesting that they agree with his position. Which begs the question – who on earth wants to be a member of any club that threatens to punish them should they decide to leave? However, should the EU adopt Hollande’s policy of vindictive retribution, then Game Theory gives clear guidance on the UK’s response. The very worst response would be to continue to co-operate. Game Theory indicates that the best strategy in the face of threats from the other side is “tit-for-tat”, or “do unto others as they do unto you.” Comments over the past week by the Prime Minister, the Chancellor of the Exchequer and the Foreign Secretary have made it clear that the UK will retaliate against any attempt to “punish” the UK for its temerity in exiting the EU. So, for example, should the EU impose a 10% tariff on UK exports to the single market, the UK should reciprocate by imposing a 10% tariff on any EU imports to the UK.

4. Know your BATNA. The Prime Minister spelt out her BATNA – Best Alternative To a Negotiated Agreement – on January 17th when she stated that “no deal is better than a poor deal”. This is the strongest possible BATNA as it signals that the UK is prepared to walk away, so cannot be held to ransom by the EU. Under this scenario, UK–EU trading relationships would be governed by World Trade Organisation rules, with the UK free to pursue trade deals with the rest of the world on a bilateral basis.

5. Apply leverage and be prepared to “divide and rule”. By referring to security issues in her speech, the PM subtly alluded to the possibility that the UK’s military support to other EU Member States might be compromised if they seek to pursue a punitive policy against the UK during Brexit negotiations. While this has provoked predictable criticism from europhiles, it seems to me to be simple common sense. I can’t think of a single example of a nation giving military support to another nation that is attacking it economically. As the Prime Minister stated, such an approach could not be regarded as that of a friend. And interestingly, after her speech, the President of the EU Council, Donald Tusk of Poland, adopted a notably more conciliatory tone than in some of his earlier statements, or indeed than the views expressed by some of his colleagues from Western European Member States. Could his more moderate approach by any chance have anything to do with anxiety in his native land and the Baltic States about potential threats from the East?

The PM and her Ministers have played their hand well in the first move of the Brexit Game. How it progresses from here depends upon the response of the EU. It is to be hoped that the EU will also enter into co-operative mode, leading to a mutually beneficial Clean Brexit and UK-EU Free Trade Agreement in 2019. However, there is a real risk that negotiations could break down, not because of disagreements between the EU and the UK, but because of fractures within the EU itself. Eastern Members like Poland and the Baltic States may wish to pursue a co-operative strategy but be frustrated by Western Members foolishly seeking to “make an example” of the UK in a misguided attempt to dissuade other Member States from leaving. In that case, the UK’s second best strategy is clear – to leave the negotiating table, cancel subscriptions to the EU, and continue to trade with EU Member States under WTO rules.

In either event, the Prime Minister’s January 17th speech may in time come to be regarded as a case study in the successful application of Game Theory.

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Solving the Mystery of the Brexit Bounce

In the run-up to the EU referendum on June 23rd, you could hardly move without hearing prophecies of doom from the Great and Good of the terrible consequences should Britain vote to leave.

IMF Chief Christine Lagarde predicted the impact on the UK economy would range from “bad to very, very bad”. George Osborne, then Chancellor of the Exchequer, forecast a severe recession which would oblige him to add 2p to the basic rate of income tax to save Britain’s public finances. Mark Carney, Governor of the Bank of England, warned of a “material impact” on growth if Britain voted to leave the EU, adding for good measure that it could lead to a 3% hike in mortgage interest rates. Not to be outdone, Scotland’s very own Cassandra, Nicola Sturgeon, predicted after the Brexit vote “a lost decade” with “deep and severe consequences”, no doubt only restraining herself from foreseeing plagues of frogs and locusts and darkness across the land by a wholly statesmanlike concern not to trigger panic.

And in case anyone should – heaven forfend – suspect for a moment that these forecasts might possibly be driven by a self-serving agenda on the part of these estimable individuals, they could find reassurance from a supposedly neutral third party. For were they not supported by very thorough and detailed technocratic forecasts prepared by high powered economists at that most august of all British institutions – Her Majesty’s Treasury? And no-one could possibly question their impartiality and political independence, could they?

Well, yes they could – and did.

Writing to the Financial Times on April 19th in a letter reproduced on this site, I cautioned that the Treasury’s warning of the “permanent economic damage” that a vote to leave the EU would cause the UK “continues a worrying trend, first seen in last year’s referendum on Scottish independence, towards the politicisation of the Treasury.” I cautioned that this threatened to undermine the fundamental principle of the civil service’s political neutrality. “Instead,” I wrote then, “the Treasury is slowly metamorphosing into an instrument of pro-government propaganda supporting the established order.”

Nine months on, my concerns were echoed last week by the Bank of England’s Chief Economist, Andrew Haldane. He raised the question of whether there needs to be a fundamental reassessment of conventional forecasting assumptions and methodologies. For his pains, he suffered the outrage of certain members of the UK’s political and economic establishment.

In my judgement, this criticism is wholly unfair. Mr Haldane deserves credit for having the courage to go against a complacent consensus which has clearly been undermined by the robust performance of the UK economy since the Brexit vote, contrary to the overwhelming weight of opinion from those who now criticise him.

So why were their forecasts so badly wrong?

Firstly, it seems almost tautologous to state that, if most UK electors voted to leave the EU, it was because, on balance, they believed that they personally would be better off if the UK was no longer constrained by the EU’s rules and regulations. This in turn could be expected to feed through to an increase in their confidence once Britain voted to leave, not to a collapse in confidence as assumed in the Remainers’ doom-laden forecasts. So there was a fundamental inconsistency at the heart of the Remainers’ forecasting assumptions.

The more arrogant proponents of the Remain case (of whom there seem to be quite a few) seem to imply that those who voted to leave were either too stupid, or too ignorant, or quite possibly both, to appreciate the dire consequences of their actions.

The problem for the Remainers is that their narrow opinion of the EU’s merits is contrary to the conclusion of every great economist, from Adam Smith to John Maynard Keynes, that a move away from protectionism towards free trade will improve economic welfare. Their conclusion has been borne out by experience in all places, at all times. I can’t think of a single leading economist of the past who had a contrary view – not David Ricardo, not John Stuart Mill, not even the iconoclastic Joseph Schumpeter. And if they’re right, then any threats associated with leaving the EU will be hugely outweighed by the opportunities created by an open, freely trading structure, hopefully with zero tariffs, achieved by new British agreements with rapidly growing nations in Asia, Africa and Latin America, as well as our old friends in the Commonwealth and North America.

So the increased confidence seen since the Brexit vote is entirely consistent with the Rational Expectations Hypothesis, as consumers and investors alike anticipate better times ahead outside the EU.

January 11th 2017

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What happened to the UK Treasury’s neutrality?

The Treasury’s warning of the “permanent economic damage” that a vote to
leave the EU would cause the UK reported in the lead article of today’s
Financial Times continues a worrying trend, first seen in last year’s
referendum on Scottish independence, towards the politicisation of the

Whatever one’s views on these referenda, it is a matter of concern that the
principle of civil service neutrality is gradually being undermined.
Instead, the Treasury is slowly metamorphosing into an instrument of
pro-government propaganda supporting the established order. No reputable
City or academic economic research agency would attempt to do what the
Treasury now claims to have done, of giving “objective” forecasts for the
British economy as far out as 2030. It is impossible to anticipate what
impact the UK’s trading relationships might have 15 years in the future on
factors that are inherently uncertain, such as the rate of innovation and
new business formation. Yet the Treasury has endeavoured to do precisely
that on the basis of a series of highly tendentious assumptions.

Michael Nevin
Financial Times, April 19 2016

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Do high yield bonds outperform other asset classes? The race begins….

Over the course of the current (2015/16) financial year, I have built up a portfolio of 12 of the highest yielding Sterling fixed-income securities generally available to a retail investor. These securities are held in an individual savings account (Isa). This is important, as it means that all interest accrues free of tax. As at last night (March 14th), the portfolio offered a running yield of 9%, and a yield to maturity of 11%.

The 12 securities that make up the portfolio are as follows, in alphabetical order:

1. Balfour Beatty 10.5p convertible preference shares maturing 1/7/2020 (EPIC code: BBYB) with a yield to maturity (YTM) of 5.6% and running yield (RY) of 8.4% at the current offer price of 115.5
2. Co-operative Bank 11% subordinated loan notes maturing 20/12/2023 (42RQ): YTM of 8.4% and RY of 9.6% at current offer price of 114.75
3. Enquest Plc 5.5% senior bonds maturing 15/2/2022 (ENQ1): YTM 26.7% and RY 14.2% at current offer price of 38.65
4. Enterprise Inns 6.375% senior bonds maturing 26/09/2031 (AK44): YTM 6.6% and RY 6.5% at current offer price of 97.5
5. Eros International 6.5% senior bonds maturing 15/10/2021 (ERO1): YTM 18.8% and RY 11.1% at current offer price of 58.5
6. International Personal Finance 6.125% senior bonds maturing 8/05/2020 (IPF1): YTM 8.5% and RY 6.7% at current offer price of 92
7. Newcastle Building Society 12.625% PIBS (NBSR): YTM and RY both 7.25% at current offer price of 174
8. OneSavings Bank 7.875% Perpetual Subordinated Bonds (1SBB): YTM and RY both 8.75% at current offer price of 90
9. Premier Oil 5% senior bonds maturing 11/12/2020 (PMO1): YTM 15.8% and RY 7.7% at current offer price of 65
10. Raven Russia 12% cumulative redeemable preference shares (RUSP): YTM and RY both 9.7% at current offer price of 124
11. R.E.A. Holdings 9% cumulative preference shares (RE.B): YTM and RY both 10.1% at current offer price of 89
12. Skipton Building Society 6.875% PIBS (SBSB): YTM and RY both 7.1% at current offer price of 97.

The reason why these securities offer such tempting yields is because “the market” – that amorphous mass of buyers, sellers, speculators and investors – collectively believes there is a high chance that any of them might default. Their current yields thus price in a distinct possibility of capital loss.

The central proposition of High Yield Hypothesis being tested here is that, while individual high yield securities may indeed default at some point, the probability of loss for a diversified portfolio of such securities, over time, is likely to be less than implied by their market prices. Consequently, the returns that an investor can secure from high yield bonds should exceed that of other major asset classes.

The 12 securities listed above have been purchased in monthly intervals over the past 12 months at a total cost of £14,682, as described in monthly posts on this website. Alternatively, this investment of £14,682 could have been deployed into other assets:

1. Gilts, issued by the UK Government to fund its borrowing programme. The gilt that will be used in this test is the benchmark ten-year gilt, UK Treasury 4.25% maturing in 2027 (EPIC TR27). It is currently offered for sale at 127.38, giving the investor a running yield of 3.3%. That may not sound too bad for a security deemed to be “as good as gold”. However, at that price its yield to maturity is -1.8% because the investor will lose 27.38 when it is repaid at 100 on maturity. Public spritied though I try to be, I must confess that the prospect of being charged 1.8% per annum (i.e. the running yield less the annual capital loss through to maturity) does not fill me with any great joy. Yet gilts have actually been among the best performing of all asset classes during the 2015/16. Such is the crazy world that Central Bank policies of Quantitative Easing and financial repression has produced. The £14,682 investment could have been used to by £11,826 (nominal) stock in TR27 over the same period as the High Yield Portfolio was built up. At today’s prices, that stock would be worth £15,234, giving the gilt investor a 4% profit to date. We will see if the gilt investor is still in profit in five years’ time….

2. Gold. John Maynard Keynes may have described it as no more than a “barbarous relic”, but for many investors gold remains the ultimate store of value, accepted as such throughout the world, easily converted into cash, and a safe haven during periods of crisis and instability. In 2015/16, an investment of £14,682, committed on the same dates as the investments in high yield bonds, would have been sufficient to buy 19.42 troy ounces of gold, which would have risen in value to £16,876 as at today’s date. So gold bugs could feel quietly content at its performance this year. But gold generates no income, so its price would have to rise year by year by more than the yield on other assets in order to outperform them. The question is whether it can do so consistently.

3. The FTSE 100. Individual shares may rise or fall. Individual companies may collapse into insolvency. But the FTSE 100, the weighted index of the 100 largest companies by capitalisation quoted on the London Stock Exchange, will never default unless the entire economic system disintegrates. In which case we’d all have rather more important things to worry about. Moreover, the yield on a FTSE 100 index tracker, currently standing at 4.15% with the FTSE at 6150, is reasonably attractive in historical terms, particularly with inflation close to zero. It is a lot more appealing than the yield on gilts. An investment of £14,682 would have acquired 225 units in a FTSE 100 tracker at an average price of £65.25 over the course of 2015/16. This investment would currently be showing a loss, as some of the units were purchased when the FTSE was above 6900 in the quarter between April and June 2015. But over time, most investment analysts would predict on the basis of historical performance that equities will generate a higher return than either gilts or gold. My counter proposition is that, during a period of economic downswing such as we are currently experiencing, fixed-income securities may generate a higher and more stable return than equities.

4. Residential property. For many people in the UK, residential property is easily their single most important investment. To assess how it compares with the other asset classes, we will measure a synthetic index which assumes that an amount of £14,682 was invested in units of the Halifax House Price Index in 2015/16, when it averaged approximately 655. In addition, it is estimated that a net yield of 3% can be secured from rents on residential property, after all costs are met.

These then are the five runners in this particular race: high yield bonds, gilts, gold, equity and residential property. How they fluctuate over any short period will not tell us very much. Therefore, their performance will be measured over the five year period to March 31 2021 to determine the winner.

The starting cost of all five investments is £14,682. Gold is the current leader in terms of its value as at today’s date, followed by gilts. The question is how much each investment will generate in annual income between now and the end of March 2021, and what the terminal capital value of each investment will be on March 31 2021.

I will report the results here on that date, and also aim to provide an annual update in March of each year between now and 2021 on how each of the five asset classes is performing.

Let the race begin!

March 15th 2016

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Who’s afraid of the big bad bear?

An air of despondency hangs over the City of London, with security markets in steady decline, dragged down by the collapse in international commodity prices. In Aberdeen, Britain’s oil capital, the atmosphere is closer to panic. Property prices are tumbling, and many who want to sell are finding no buyers at all. In late January, the Financial Times reported that “oil rigs stand idle in the Cromarty Firth near Inverness, where freezing waters have been a gauge for the chilling effects of the big fall in oil prices.” The FTSE is officially in bear territory, having fallen more than a fifth from its peak of 7,100 last April to less than 5,500 at one point in February.

This is further confirmatory evidence, if such is needed, that the UK economy, along with most of the OECD, is in a long economic downswing. As I wrote in The Golden Guinea in 2012, “the weak stock market recovery between 2009 and 2011 was a secondary reaction within a prolonged bear market, rather than the harbinger of a sustained recovery” (p. 202).

Does this mean that now is the time to liquidate holdings of all financial securities? I would say not: if one listens to the advice of successful investors through the ages, bear markets represent an excellent opportunity to build up security holdings. Baron Rothschild advised that, “the time to buy is when there is blood on the street, even if the blood is your own.” Sir John Templeton recommended that an investor should “buy at the point of maximum pessimism.” I don’t know whether we are at the point of maximum pessimism now, but we are certainly not at the point of maximum optimism. And Warren Buffett advised, “keep things simple, by accumulating securities over a long period, and never sell when the news is bad and their prices are well off their highs.”

But the question is – what securities to buy? It is my contention, as set out in previous comments on this website, that during a long economic downswing bonds represent a superior investment to equities.

Within the entire class of fixed-income securities, I am testing a further hypothesis. This is the hypothesis that fallen angels – bonds which have lost their investment-grade rating, whose prices have fallen and yields have risen – represent, as an asset class, better value than gilts or investment-grade corporate bonds.

This hypothesis is being tested by building up a portfolio of 12 sub investment-grade fixed-income securities, buying one in each month of the 2015/16 financial year. There are currently 11 securities in the portfolio, with the final security purchased today. This is the convertible preference share issued by Balfour Beatty, paying a gross dividend of 10.75 pence per share, which equates to a net dividend of 9.675 pence per share after a 10% tax is deducted at source.

The yield to maturity, at just under 6%, is the lowest on any of the 12 securities in the high yield portfolio. Against this, the preference shares offer potential upside as they carry the right to convert into Balfour Beatty ordinary shares at a conversion ratio of 0.2469136 ordinary shares per preference share.

In my quieter moments, I do wonder how many hours of billable time was spent by some financial wizard to come up with this exact conversion ratio, as opposed to, say, a ratio of 0.25 ordinary shares per preference share. But of course that would have been too easy and no fun at all. Even worse, such a simple conversion ratio would doubtless have generated far lower advisory fees and, horror of horrors, been readily understandable to the ordinary investor.

Be that as it may, it can be calculated that it would be worth converting the preference shares into ordinary shares on maturity in July 2020 if the price of the ordinary shares exceeds £4.05 on that date. Admittedly, this doesn’t look very likely at the moment, with Balfour Beatty shares trading at a price of just £2.30, but given the volatility of stock market prices it is by no means impossible that the price of the ordinary shares rises by more than £1.75 over the next four years.

So the Balfour Beatty convertibles become the 12th and final security acquired for the Experimental High Yield Portfolio.

Issuer: Balfor Beatty Plc
Coupon: 10.75% gross, equating to 9.675% net after a 10% tax deduction
Maturity Date: July 1st 2020
Conversion Rights: 0.2469136 Ordinary Shares per 1 Preference Share up to the date of maturity
Payment Dates: 6-monthly on January 1st and July 1st
Offer Price: 114.35
Running Yield: (at Offer Price) 8.5%
Yield to maturity (at Offer Price): 5.9%
Nominal Amount: £1,000
Cost £1,143.50 + £13.67 commission and stamp duty = £1,157.17

February 16th 2016

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Charles Smith Remembered

I was saddened to learn of the sudden death earlier this week of Charles Smith following a suspected heart attack. Charles, a partner in Brodies LLP, was widely acknowledged as one of the foremost environmental and energy lawyers in Scotland, at a time when the regulatory framework applying to both was in a state of rapid flux, requiring careful interpretation and application.

We worked together on the modern equivalent of alchemy – an ambitious attempt to turn mixed garbage, if not into gold, then at least into the equivalent of oil – a reliable and sustainable source of renewable energy. The technical advisers must determine whether this will work; the financial advisers (myself, in this instance) must assess whether it is affordable; but it is the lawyers who arguably have the most challenging and essential task of giving commercial reality to a project through a robust contractual structure. Some of Charles’ most important work must, of necessity, remain commercially confidential; but his published guidance on energy supply companies provides an enduring template of how such projects can be structured. It will remain one of my key references for as long as I advise on renewable energy projects.

Blessed with a first-class intellect, an ability to explain complex legal provisions in clear and understandable English, an encyclopaedic memory and the forensic ability to identify and correct any areas of potential inconsistency or ambiguity in legal drafting, he was an essential member of a team at the leading edge of innovative renewable energy technology. His passing, at the peak of his powers, leaves a gap that will not easily be filled.

I salute a man of many qualities, and mourn the loss of a respected colleague and valued friend.

Michael Nevin
January 30th 2016

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A Land Value Tax for Scotland

The devolution of greater financial powers to Scotland presents both a threat and an opportunity.

The threat is that growth and productivity in the Scottish economy could be adversely affected if taxes are poorly designed or applied at higher rates than in England. This risk was highlighted by the Government’s proposals in late 2014 to introduce a Land and Buildings Transactions Tax (LBTT) at a significantly higher rate than in England, at 10% on residential transactions between £250,000 and £1 million, compared to 3% in the rest of the UK up to £0.5 million, and 4% between £0.5 million and £1 million. Unsurprisingly, these proposals provoked a sharp backlash and forced the Finance Secretary into an embarrassing climbdown.

On a more positive note, greater tax powers present an opportunity for The Scottish Government to rationalise and streamline the tax structure inherited from the rest of the UK to promote growth and jobs in Scotland.

At the moment, three taxes account for around 80% of all fiscal revenues raised at UK level – income tax and National Insurance contributions; VAT; and corporation tax. These are likely to remain the principal sources of revenue for The Scottish Government, and are broadly viewed as “good taxes” by economists – being reasonably easy to assess and collect, regarded as fair by those upon whom they are levied (within limits), and efficient in that they do not unduly distort the workings of the free market.

The same cannot be said for the 10% of fiscal revenues accounted for by three property taxes – LBTT, expected to raise approximately £0.5 billion annually for The Scottish Government, Council Tax (frozen since 2008), which raises £1.8 billion annually in Scotland, and national non-domestic rates levied on businesses, which raise approximately £2.6 billion annually.

My proposal is that these three taxes should be replaced by a single Land Value Tax (LVT), levied on the unimproved value of land, introduced on a fiscally neutral basis. In other words, the rate of LVT would be set to raise approximately the same amount as the combined total of LBTT, Council Tax and national non-domestic rates, or around £5 billion annually. On a rudimentary analysis, this would imply that a land value tax would be levied at a rate of approximately 0.5%, or £500 per £100,000 of unimproved land value annually.

A Land Value Tax would offer a number of advantages, including the following:
1. It would be cheap and easy to administer.
2. It is impossible to evade, as land cannot be hidden.
3. It is efficient, in that it does not discourage enterprise, effort or productivity. Since the taxation base is the unimproved value land, families who chose to improve their homes and thus enhance their market value would not be penalised by a higher tax rate – unlike the poorly conceived proposals for a Mansion Tax (which now, happily, seem to have died a death).
4. The taxation base would be easy to assess and update. Unimproved site values could be independently calculated by the RICS Scotland on a quinquennial basis, using data provided by completed market transactions.
5. Landowners who chose to leave their land in an unimproved condition would pay exactly the same rate per acre or per square metre as landowners who have invested in the development of their estates. For this reason, it would eliminate the need for regulations, such as those proposed by The Scottish Government, intended to force landowners to enhance their estates – and, even worse, threaten them with expropriation if they fail to do so. This regulatory approach owes more to the ideology of Joseph Stalin or Mao Tse-tung than the philosophy of Adam Smith, and, unsurprisingly, has provoked strong criticism. It doesn’t take Nostradamus to predict that, were such regulations ever to be implemented, they would almost certainly have a significant negative impact on the Scottish economy, undermining confidence and private sector investment. By contrast, in the words of Henry George, “land value tax prevents private investors from profiting from the mere possession of land, while allowing the value of all improvements to land to remain with the investors whose efforts secure it.”
6. Unlike LBTT, receipts from the tax would not go up and down with the economic cycle, but remain stable through time, because the taxation base would be the underlying land value rather than the number of property transactions.
7. As the experience of other domiciles demonstrates, LVT can be applied at State level within a Federal system, for example in New South Wales in Australia and Pennsylvania in the USA.

Because of these advantages, Land Value Tax has been advocated by a wide range of economists, including Henry George, William Vickrey and Milton Friedman, who stated in Economica in 1980 that “in my opinion, the least bad tax is a property tax on the unimproved value of land.” More recently, Scottish economist James Mirrlees, a Nobel Prize winner, advocated the use of a land value tax in his report to the Institute of Fiscal Studies on The Dimensions of Tax Design: The Mirrlees Review in 2010.

Finally, the introduction of a land value tax, set and collected at local authority level, could help cut through the growing tensions between central government and local authorities, who are complaining (in my view, with some justification) that the national freeze on Council Tax that has applied since 2008 is making it increasingly difficult for them to fund essential local services.

To date, The Scottish Government has, perhaps understandably, pursued a broadly cautious approach in applying the greater taxation powers at its disposal. However, a more radical approach is required to address growing tensions in the local taxation system, and the politically sensitive issue of land reform. A Land Value Tax would address both issues, in a way that is economically efficient and would promote productivity, growth and job creation in Scotland.


This article was originally published on the Wealthy Nation Institute website, on January 26th

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The Kondratieff Wave and the Bond Market

Following commentary over the past three months on the Kondratieff cycle, the question has been raised as to how an investor can tell whether financial markets are in the upswing or downswing phase of a long wave.

During the upswing, private sector investment is strong and rising; share prices increase over time in real terms; and, reflecting buoyant economic activity, there is upward pressure on real interest rates.

By contrast, during the downswing, private sector investment is weak, equity indices are static or falling in real terms, and there is downward pressure on real interest rates.

It is relatively straightforward to identify whether financial markets are in a secular upswing or downswing by drawing time series charts of the annual average values of these three variables.

During an upswing, equities outperform bonds. This doesn’t mean that bear markets never occur in equity markets during an upswing – they can and do, but they will be relatively brief interludes in the upward march of equity prices. George Ross-Goobey, the pension fund manager of Imperial Tobacco, was therefore right to shift their funds out of bonds and into equities in the 1950s, during the early stages of the post-war upswing. He did so because dividend yields were higher than bond yields, and because he accurately foresaw that dividends would rise over time in line with the underlying growth of the British economy.

He was also right to shift out of equities back into government bonds (gilts) at the tail end of the post-war upswing. His obituary in the Telegraph in 1999 reported that, “By the end of the 1960s, Ross-Goobey perceived that the price of shares had risen perhaps too far with the emergence of the “reverse yield gap”, i.e. the yield on gilts was higher than that on shares, buying gilts heavily in 1974 when yields rose to over 15 per cent.”

This was at the beginning of a long wave downswing, and his timing was impeccable.

Though Ross-Goobey is long gone, the tactics he deployed through the long wave of his career remain valid today. The upswing of the Internet long wave broke on the international financial crisis of 2007-09 and we are now in a downswing. In such an economic environment, bonds represent a safer investment than equities and offer the prospect of superior returns over time. As noted in earlier comments, equity prices as measured by the FTSE 100 (and I suspect other international indices such as the Dow-Jones) have fallen significantly since the financial crisis, while bond prices have risen.

There is of course the risk that a distressed company could default on its bond payments, and the financial markets are pricing in this risk for the securities held in the Golden Guinea High Yield Portfolio. All 10 securities currently held in the portfolio are offering yields that indicate market participants believe they carry a significant default risk.

So too does the 11th security purchased this month, the senior bonds issued by International Personal Finance (IPF), currently quoted on ORB at less than 90 pence in the £.

IPF was spun out of the overseas loans arm of home credit company Provident Financial in 2007, since when it has pursued an active growth strategy particularly in eastern Europe and Russia. It operates through a network of 30,000 part-time agents, who advance loans to borrowers unable to access credit from the banks. This is reflected in high default rates, with IPF accepting that between 25% and 30% of the loans it advances will not be repaid, and the interest rates it charges reflect this risk. However, its business model is threatened by efforts by regulators, particularly in eastern Europe, to restrict high-cost credit. IPF announced in December 2015 that proposed legislation in Slovakia “will have a material adverse financial impact on its existing Slovak business”, following similar legislation in Poland.

These restrictions have led to a downgrading of IPF’s corporate debt. Equally, an earlier announcement accompanying the company’s third quarter results stated that “We expect to deliver continued strong growth in Mexico and through our digital businesses….Notwithstanding the challenges in growing the top line in our European home credit business, we are confident that the result for the year as a whole will be broadly in line with consensus,.”

This suggests that IPF’s operations are sufficiently diversified, both geographically and operationally, to ride out temporary turbulence in particular markets.

At current prices, IPF’s bonds offer a running yield of 7% and a yield to maturity in excess of 9.5%. If the High Yield Hypothesis (HYH) is valid, then financial markets tend to overreact to temporary bad news, driving security prices below their true value. The IPF bonds represent a test of this hypothesis.

Issuer: International Personal Finance Plc
Coupon: 6.125%
Maturity Date: May 8th 2020
Payment Dates: 6-monthly on May 8th and November 8th
Offer Price: 87.975
Running Yield (at Offer Price): 7.0%
Yield to maturity (at Offer Price): 9.6%
Nominal Amount: £1,000
Cost: £879.75 + £7.95 commission = £887.70

January 12th 2016

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Pricing Anomalies in the Fixed Income Market

By comparison with the market for equities, the London corporate bond market remains illiquid and imperfect. The LSE has done its best to improve matters by introducing the Order Book for Retail Bonds (ORB), publishing up-to-the-minute information on its platform on the volume and price of bonds traded, breaking news and financial results. But there are structural barriers mitigating against a smooth, perfectly competitive and liquid market. Prime among these is a paucity of market-makers. Banks are increasingly wary of holding large amounts of bonds on their balance sheet or are constrained from doing so by regulatory and capital requirements. Consequently, even quite small trades can cause sharp and discontinuous price movements, and there remain apparent anomalies in the pricing of different securities issued by the same company.

One example that caught my eye relates to the different classes of Permanent Interest-Bearing Shares (PIBS) issued by the Skipton Building Society. The Skipton is a small building society with total assets at its most recent balance sheet date of just under £16 billion, and total equity of just under £1.1 billion. It has three PIBS currently quoted on the LSE, in alphabetical order by EPIC code as follows:

SBSA: 8.5% PIBS quoted at an Bid price of 128 on December 14th 2015, and an Offer price of 138, implying a yield of 6.15% (= 8.5%/138) at the Offer price.

SBSB: 6.875% PIBS quoted at a Bid price of 91.5 and an Offer price of 97 on December 14th, implying a yield of 7.09% at the Offer price.

SKIP: 12.875% PIBS quoted at a Bid price of 193 and an Offer price of 203 on December 14th, implying yield of 6.32% at the offer price.

The notes to the building society’s accounts state that “all PIBS are unsecured and rank pari passu with each other.”

There is a wide spread between the Bid and Offer prices of all three issues, in excess of 5%. The value of all three issues is small, ranging from £16 million in the case of the 8.5% securities to £47.3 million in the case of the 6.875% issue. LSE data indicates that they trade only in small amounts and relatively infrequently. Their price charts on the LSE website reveal sharp discontinuous price movements, with occasional spikes upwards or downwards, followed by long periods when the price doesn’t change at all. These are all indicators of a very narrow and illiquid market.

Anyone investing in such a market would be well advised to “buy and hold”, as the capital of active traders would be rapidly eaten up by the wide Bid / Offer spread. In the event of any downturn in security prices, the only viable strategy is to sit tight and ride out temporary turbulence. This is true of all the bonds held in the Sterling High Yield Portfolio.

The question is this: how can it make sense for three securities, issued by the same firm and ranking equally for payment, to offer yields that are 1% apart? The yield on the 8.5% issue stands at 6.15%, while the yield on the 6.875% issue stands at 7.09%.

This is not a rhetorical question – if anyone can offer an explanation, I would be delighted to know what it is.

My final observation is that, in an economically deflationary environment – the downswing of the long wave (as discussed in my comment last month) – a yield in excess of 7% on a fixed income security issued by what appears to be a stable, prudently run and profitable financial institution is a good return. So the Skipton 6.875% issue becomes the 10th investment within the High Yield Bond Portfolio.

Issuer: Skipton Building Society
Coupon: 6.875%
Maturity Date: Undated
Payment Dates: 6-monthly on April 15th and October 15th
Offer Price: 95.75
RY at Offer Price: 7.2%
YTM at Offer Price: 7.2%
Nominal Amount: £1,000
Cost: £957.50 + £7.95 commission = £965.45

December 14th 2015

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Schumpeter, Minsky and me: Long waves in British financial markets – Part 2

My analysis indicates that we are now in the downswing of the fifth long wave in British financial markets since the Industrial Revolution. The upswing ended with the international financial crisis of 2007–09, and one would expect that the downswing will endure for between 20 and 25 years and evolve in two phases, each lasting approximately a decade: a recessionary phase which is now coming to an end, when the bad debts built up to fund speculative investments during the final bubble of the upswing are progressively liquidated; followed by a recovery. The recovery is likely to be characterised by consolidation, defensive mergers and the emergence of innovations that will drive the next upswing. As Kondratieff observed, “during the long wave downswing, a large number of important discoveries and inventions are made, which however are usually applied on a large scale only at the beginning of the next long upswing.”

The inflection point of each of the five long waves was marked by a major financial crisis, which is now sometimes termed as a Minsky Moment, after Hyman Minsky (1919-1996). Minsky was a student of Schumpeter at Harvard University during the 1940s, and like Schumpeter and Keynes, he recognised that capitalist economies do not converge to a stable general equilibrium in the way set out in conventional textbooks, but rather progress in a cyclical fashion. He also recognised that credit-financed speculation drives economies far above their natural rates of growth towards the end of the long wave upswing, leading inevitably to a financial crisis. These crises are the economic equivalent of a heart attack, when the entire financial system seizes up and there are widespread banking failures.

Individual banking failures can occur at any time. What is different about Minsky Moments is that they go beyond the failure of one or two individual banks in isolation, to a wider systemic collapse which ripples from one institution to another causing severe credit contraction and choking off the normal flow of funds from savers to borrowers.

Such moments occur once in a generation, and mark the inflection point from upswing to downswing. They are clearly identifiable in each of the five long waves since Industrial Revolution:

1. The Industrial Revolution
Upswing: 1785–1814
Inflection point: 1814–15
Downswing: 1815–1844

2. The Railway Revolution
Upswing: 1844–1873
Inflection point: The Panic of 1873
Downswing: 1873–1896, aka the Long Depression

3. The Automobile Revolution
Upswing: 1896–1929
Inflection point: The Crash of 1929 followed by banking crises and collapse of the Gold Standard in 1929–1932
Downswing: 1929–1948: The Great Depression followed by the Second World War

4. The Aerospace Revolution
Upswing: 1948–1971
Inflection point: The Secondary Banking Crisis of 1972–1974
Downswing: 1972–1992: The collapse of the Bretton Woods system followed by Stagflation during the 1970s and Recovery during the 1980s

5. The Internet Revolution
Upswing: 1992–2007
Inflection point: The International Financial Crisis of 2007–2009
Downswing: 2007 –

After each inflection point, the British Government of the day responded by introducing reforms to restore confidence in the banking system.

Paradoxically, my observation is that the safest time historically to invest in bank securities is in the aftermath of a Minsky Moment. It is such a cathartic event that the last thing survivors are likely to do is to repeat the mistakes that brought down their competitors. Gone are the reckless lending practices of the upswing’s final bubble. Gradually, bad and doubtful debts within the banking system are written down. The capital base of surviving banks is rebuilt to more prudent levels, often at the behest of the regulatory authorities. The priority of Bank Directors is to ensure their own survival. Above all, they seek to avoid the scandals and imprudent lending practices that destroyed the reputations and careers of their predecessors.

At the same time, new banking institutions emerge. Today they are called Challenger Banks, which are building up their loan books and market share at the expense of long established incumbents – banks like Virgin, Metro, Aldermore, First Direct and OneSavings.

During the period that follows a Minsky Moment, yields on bank bonds are likely to be exceptionally high, coming down only gradually as a fragile confidence returns.

Thus, somewhat to my surprise, running the numbers through my spreadsheets, I find that, today, the highest yielding security yet to be included in the Experimental High Yield Portfolio are a class of perpetual subordinated bonds issued by OneSavings Bank. This is despite the fact that the bank has reported excellent financial results, with new loans and advances of £986 million in the first 9 months of 2015 increasing its total loan book by 25% to £4.9 billion, accompanied by strong margins, a sound capital base and upward re-ratings by most analysts tracking the stock.

So the Perpetual Subordinated Bonds issued by the bank become the ninth security to be added to the portfolio.

Issuer OneSavings Bank plc
Coupon 6.591%
Maturity Date Undated, but callable on March 7th 2016
Payment Dates Half yearly on March 7th and September 7th
Offer Price 95.7
Running Yield (at Offer Price) 6.9%
Yield if called (at Offer Price) 16.3%
Nominal Amount £1,000
Cost £968.95 (inclusive of £11.95 accrued interest) + £5.75 commission = £974.70

November 10th 2015

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