Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Sunday, 30 September 2018

Responding to disruption

Really liked reading 'The Disruption Dilemma' by Joshua Gans. Quite relevant to what I’m doing currently. The logical framework presented resonated, especially Gans’ distaste for the current hype that 'every start-up is disruptive and disruption is everywhere'. He has also outlined well the strategic choices which firms need to make.

The book defines disruption as the failure of successful firms because they continue to make the choices that drove their success. Using several examples, Gans shows that firms are rarely blindsided by technology. However, they fail to counter new competitive threats by continuing to follow what seems to be a rational course. Citing the popular Blockbuster / Netflix case, he talks about how Blockbuster’s customers were happy going to stores when Netflix started its postal delivery model which initially only appealed to a niche segment. Blockbuster emulated the mailing model but decided to stick to its tried-and-tested approach. Its decision making was guided by available knowledge and its existing operating model. Blockbuster arguably made the “right” choices for an incumbent, as they would have looked without the benefit of hindsight. However, Netflix moved so fast in improving its offering and broadening its appeal that Blockbuster was never able to catch-up and compete. This is quintessential disruption.

The dilemma for incumbents is the need to make choices under uncertainty about the impact of emergent business models and new technology. Ex ante it is hard to know whether an innovation is disruptive. Making it harder is organisational inertia of moving away from a tried and tested course. (As an aside, ‘Essence of Decision’ by Graham Allison on the Cuban missile crisis is a great read to understand decision making inertia and challenges).

Firms need to counter two different types of disruption:
1. Demand side disruption where new entrants initially target underserved or unserved customer niches and use them to grow and eventually win.
2. Supply side disruption where new technology leads to changes in the way components of a product or service are combined to serve customer needs making incumbents' existing products uncompetitive as customer preferences change (e.g. iPhone)

Demand side disruption is more familiar and responses are well known based on likelihood of change. If a firm assesses likelihood to be low, it pays to focus on core strengths and continue with incremental improvements to the business model. All this requires is the ability to “keep your head while all about you are losing theirs”. However, if disruption appears likely, firms should aggressively invest in new technology or product and move away from the old model. In this instance, the value of the old model should be discounted far more than what a traditional approach might dictate because demand shifts are large and quick. This creates conflict as it requires firms to move away from the tried-and-tested approach of leveraging what exists to building what is needed in the future. A middle way is to create an option by monitoring developments and later acquiring new entrants when disruption appears likely. However, it requires the firm to be ready to pay a premium since valuations will reflect the higher likelihood of change. Interestingly, Blockbuster had the opportunity to buy Netflix for $50 million in 2000 which it passed on.

Responding to supply-side disruption is harder since it requires a change in the way an organisation structures itself and collaborates. In most firms, division of labour and areas of expertise create a narrow focus on parts at the expense of the whole. Also, ways of collaboration are embedded making it harder for innovative ideas to flow from one part to the other. There is a great anecdote in the book about the creation of Blackberry Messenger, the 'killer app' of its time. It was developed by three engineers taking the initiative on their own despite active resistance from the organisation. In fact, the manager of one of the developers gave him a bad performance review for spending time to develop what would be used by 50 million users and be a much-loved feature of Blackberry!

The book is less detailed on how to effectively respond to supply-side disruption. It makes the general point on creating organisations where different areas / divisions are able to collaborate easily and gives examples of organisations like Canon which have done this successfully. To my mind, this is where cross-functional Agile teams become critical. Countering supply-side disruption requires awareness of the overall system, the changes impacting it and how the various components should fit together. Isolated areas of expertise with well-defined hierarchies and formalised communication channels will fail.

In my opinion, banking is undergoing supply side disruption as technology enables parts of the value chain to be done independently (i.e. modularisation) and combined based on customer preference. For example Monzo takes standard bank products and provides them in an innovative way e.g. a deposit facility, a cashless payment service, an information service and a marketplace for financial products. For incumbents, countering the disruptive threat is not about optimising components by making the deposit account better or digitising loan decisions but requires coming up with an overall experience and proposition which delights the customer and is built around them. This requires a fundamental shift in culture and organisation for most.

Wednesday, 7 June 2017

The great election gamble

Theresa May’s great gamble looks to be going awry as polls have tightened with Labour pulling almost even from a staggering Tory majority at the time of announcement. Although the reliability of publicly available polls is usually low given underlying assumptions (see here for FT Alphaville’s great exposition), the momentum towards Labour is still breathtaking. Corbyn may be forgiven for having the air of Lenin in 1917.
The election was May’s to lose given the shambolic opposition. However, the general anger against the establishment seems to have turned against her. Corbyn, simply by mouthing platitudes promising socialist utopia, has become an effective channel for this anger. Moreover, the toxic legacy of Cameron and Osborne’s austerity is now being hung like an albatross around May’s neck as police and public service cuts have become an issue in the aftermath of terror events. Whether she falls is going to be mainly decided by Scotland and the youth vote. If the anti-Tory vote tactically swings en-masse towards Labour from SNP, Corbyn has a chance. Together with the millennial / under 35 vote, which has shown itself to be more susceptible to Corbyn’s snake oil, it may push him into Number 10 on the the 9th (the massive voter registration amongst the 18-24 year olds does point to a Corbyn surge).  
For a trader, given all the uncertainty, shorting Gilts seems to offer good risk-reward. If Corbyn wins, Gilts are likely to sink as investors re-rate the risk premium for a potential Venezuela-of-the-West. A May win is not going to make Gilts rally much especially given current low 10-year yield of 1%. In fact, yields seem to have already outperformed recently compared to USTs (chart below). Moreover, given the impending nastiness which will be unleashed as Brexit negotiations get underway, the hit to government finances from the slowing economy and continuing inflationary pressures due to Sterling weakness, Gilt yields are likely to rise in the short to medium term from historic lows. Strong and stable, Gilts are not. 
(Disclaimer - This is merely my opinion and NOT investing advice. You should do your own analysis before putting on any position)
 Source: St. Louis Fed, FRED database, Bank of England, Author's calculations

Monday, 6 March 2017

Brexit and mortar – the UK housing market revisited

The UK housing market has continued to astound, scaling new heights oblivious to the surrounding economic environment. Brexit notwithstanding, house prices rose to a new peak in December 2016, up 16% above the pre-crisis peak. Unfortunately affordability has continuously declined because household incomes have not risen as quickly and dramatically. In the last decade, median household income rose about 4%. As a result, house price to median income ratio of ~7.75 is at a new high. (Figure 1 below). An example to translate these statistics into the real world: It’ll take a median household approximately 12 years to save for an 80% LTV mortgage assuming it saves an eighth (12.5%) of its income (i.e. more than double the current UK household savings rate of around 6%).

The increase in house prices has been driven by increasing household leverage given that incomes haven’t kept pace. Total net mortgage lending to households has increased by 12% since the crisis to £1.3 trillion (roughly 70% of 2016 GDP). Average lending per household increased 7% and stood at 180% of median income at the end of 2015 (latest available data), which was about 10 percentage points higher than the pre-crisis peak. (Figure 2 below). Fortunately, the resumption of income growth since 2012 has helped reduce the loan to income ratio from its high of 189% in 2012.

Increased household leverage, which has outpaced increases in income, has only been possible due to rock bottom interest rates. Bank of England cut rates to 0.5% in March 2009 and remained there until the fear of Brexit led to another cut to 0.25% in August 2016. Alongside quantitative easing (QE), this has pushed mortgage rates to the lowest levels ever (or at least from the time BoE has data). (Figure 3 below).
All the elements to make a classic Minsky mix are here, i.e. (non productive) asset price increases based on increasing leverage which is provided on the assumption of further price increases (based on FCA’s data, LTVs for new mortgages have consistently increased since the crisis with a third of loans made in 2016 above 75% LTV compared to only a quarter in the immediate aftermath of the crisis in Q2 2009). Moreover, extraordinary monetary policy has provided temporary stability and ensured that cost of leverage falls even as leverage increases.

However, Brexit is now going to test the seeming invulnerability of the UK housing market. Sterling depreciation (~20% since referendum announcement) has already contributed to inflation with the latest CPI figure edging ever closer to BoE’s 2% target (Figure 4). While the BoE could earlier be safely relied on to shift the inflation goalposts (i.e. confirming Minsky’s regulatory bailout hypothesis), it now faces a dilemma. The Brexit war with EU is likely to be long and acrimonious. During this, any hint of capital flight may require using the conventional defensive measure of rate hikes. Similar to 1991-92 when interest rates were raised to defend the Sterling in the ERM, this is likely to have a devastating effect on mortgagees. For example, raising rates by 1 percentage point now will lead to a 37% increase in mortgage interest costs. Unfortunately standing pat and not raising rates now poses a greater risk of an inflationary squeeze on household incomes. On top of this is the very real possibility of a Brexit-induced slowdown in incomes as job creation slows and some jobs migrate to the EU (potentially in areas such as finance). This implies affordability is set to fall further even if BoE keeps its easy money stance. Moreover, an environment with heightened risks is likely to make banks more circumspect about lending irrespective of low rates (i.e. liquidity trap), putting a brake on leverage-enabled house buying.
While UK housing’s Minsky moment seems to be at hand, it has been predicted many times before without materialising (mea culpa as well). With the triggering of Article 50 imminent, we will know soon enough whether the UK housing market manages to dodge the Brexit bullet too. Despite the risk of sounding like a perma-bear on UK housing, I believe the denouement is near. Given high valuations and stretched affordability, risk-reward is skewed against being long.

Sunday, 23 October 2016

Who's winning the Brexit game?

My latest article on Brexit published in Mint this Sunday which takes a slightly contrarian tack to the reports and opinion pieces grabbing the headlines.

Only the opening moves have been made on the Brexit chessboard but judging by the reaction from spectators, the UK is inexorably heading towards checkmate by the EU. The Bremoaners have seized on the less than sterling performance of the British pound as proof that the armageddon they predicted is not going to be long in coming.

The post-Brexit fall of nearly 19% in the pound and forecasts of another ~10% decline have been spun as evidence of a weak position. The recent wild swings have added to the sense of unease and have led to calls for Prime Minister Theresa May and her government to sue for an honourable draw.

However, focusing on the gyrations of the pound is akin to looking at the clock in a chess game. Screaming that it is running down is factually correct but completely useless. Moreover, it detracts from focusing on the board and coming up with a winning strategy.

As with any price, that of a free floating currency in forex markets depends on demand and supply. Simply put, demand for the pound comes from exporters, tourists, UK residents earning foreign income and foreign investors. Supply comes from importers, UK citizens going abroad, repatriation of earnings by foreigners and UK investors investing abroad. While speculators tend to weigh in on one side or the other based on their beliefs about future demand and supply, over time the price is determined by non-speculative flows.

Therefore confusing a weakness in the currency with a weak position on the Brexit chessboard is a mistake for three reasons.

First, rather than being the “de-facto opposition” to the government signalling wrong policy choices, a falling pound is a great ally by making the UK economy more competitive and allowing it to rebalance.

The strength of the pound over the past decade and a half was primarily due to capital inflows into the UK as foreigners bought UK assets (e.g. property) and London took on a central role in the increasing financialization of the global economy. (As Ashoka Mody, a former IMF deputy director, points out, a strong pound actually made the British economy more fragile. By encouraging the FIRE sectors—finance, insurance and real estate—and discouraging manufacturing it inflated a “finance-property bubble”.)

The share of finance and insurance in gross value added (GVA = GDP - taxes + subsidies) for the UK went up more than 4 percentage points between 2001-09 and at 9.7% in 2009 was significantly more than the other G7 economies (figure 1).

Figure 1: Share of finance and insurance in nominal GVA
This acute dependence on finance was catastrophically exposed during the credit crisis. Further, the post-crisis reversal in global economic financialization was bound to affect the pound negatively. In fact it stayed ~25% lower from its pre-crisis levels, reflecting the new reality of a more constrained financial sector.

By injecting greater uncertainty on the continued role of the UK in the global financial sector and on trade and economy in general, Brexit has caused a short-term decline in demand as foreign investors reassess the situation. The consequent repricing has been exacerbated as speculators lean against the pound, anticipating prolonged low demand and increased supply as some investors rush to exit.
However, the fall in the pound has not only made British exports cheaper, services of British lawyers, consultants and other professionals have also became more competitively priced. For example, the call-centre labour arbitrage just reduced 15-20%. Are firms going to go to India, or set up shop in the Midlands?

Moreover, following through on threats to relocate post Brexit became more expensive for firms. Yes, the flipside is that imports are more expensive but in a deflationary global environment this is likely to be contained. Moreover, the expected inflationary dose is what every developed market central bank is trying its hardest to deliver without much success so far.

By curtailing import demand and spurring exports, the falling pound reduces the current account deficit, which reached 5.4% in 2015, the highest since records began in 1948.
It will further help by redirecting UK domestic tourism within the country and attracting foreign tourists. All of these effects are likely to create jobs in the non-financial sector and will directly benefit the Brexit-voting constituency. In the side game, grandmaster May has checkmated opposition leader Corbyn even as his party flails around screaming at the clock.

Second, spinning the pound’s weakness as a consequence of poor government policy is an error and obfuscates the UK’s true position in Brexit negotiations. Here, May has made all the right moves.
In the age of Twitter, the British government has stuck to its guns on providing only appropriate disclosures rather than a detailed running commentary. This not only prevents the European Union (EU) from being forewarned and devising a counter, it also allows a smoother process without every small detail being blown into a major bone of contention.

Moreover, it gives greater room to negotiate compromises without fear of screaming headlines about backtracking, losing face, etc. Of course, parliamentary disclosure is essential, but parliament is not expected to co-draft legislation, nor is it expected to be party to every government decision.
May’s announcement to trigger Article 50 by end-March 2017 was an inevitable and essential defensive move given pressure for clarity from the EU and within her own party. Triggering the article will give the EU the advantage since negotiations must complete in two years and the EU can wait it out.

However, May and the government’s publicly stated willingness to prioritize border control over access to the single market has neutralized this advantage even before the event. The move has generated huge controversy and has not been helped by some exceedingly idiotic proposals by May’s team. To paraphrase Lord Acton, by tilting towards populist xenophobia, the Tories are giving opponents just grounds for opposition and kindling dispute within the country. This is illustrated by Nicola Sturgeon’s renewed call for Scottish independence, which latched on to the real and imagined stream of xenophobia running across the Tory conference. 

However, rather than being bogged down in an unending argument on immigration or the grandiose dreams of going it alone in trade, we should focus on the move as a great negotiating ploy. Since Brexit, every EU leader (e.g. Francois HollandeAngela MerkelJean-Claude Juncker) has hectored on curtailing single-market access unless the UK does what the EU wants.

By deprioritizing single market access, May has publicly destroyed the union’s single-point strategy. Of course, to be effective, the statement needs to be credible. However, credibility in negotiations is not based on rational economic arguments, but on making the opponent believe that one is prepared to carry out the stated action. Here, credibility is ensured by the Brexiteers’ triumvirate of Liam Fox, David Davis and Boris Johnson standing behind May.

Third, the mainstream narrative around the pound’s weakness may inadvertently help the UK by providing false comfort to the EU. So far, the EU players' plan seems to be clamouring for Article 50 and making sure UK “pays a price” that dissuades other potential exits.

They are playing a defensive waiting game in the hope of a British capitulation. As discussed above, while a plunging pound may look like an implosion, it actually leads to the opposite and strengthens the UK’s position over time. Moreover recent UK economic statistics give no cause for concern yet, with consumer confidence back to pre-Brexit levels in September and retail sales continuing to rise.
Playing a waiting game also assumes that the European elite can quell the anti-EU movements gaining ground across countries which threaten to tear it apart. Without an implosion of the British economy which shows the dangers of life outside EU, they are left with the much harder challenge of delivering growth.

The IMF forecasts euro area growth to be below the pre-crisis rate and only ~1.5% per annum over the next five years. The EU’s own forecast shows unemployment to fall only gradually and likely to be still above pre-crisis levels by the end of 2017.
While the British pieces have moved to take the best advantage of the situation, Europe is withdrawing into a defensive shell, with Juncker passing a “presidential order” to ensure there are no informal discussions with British representatives.

This speaks to the very real fear that Europe is an amalgamation of differing viewpoints and strategies which UK can use to its benefit. The inability of the EU to offer a united and coherent strategy was cruelly exposed during the European debt crisis and is likely to show up again in Brexit negotiations. While UK has substantial challenges ahead, based on the opening game, betting on grandmaster May to win is a smart move. 

Sunday, 17 July 2016

Theresa May’s Brexit gambit

A grandmaster has entered the Brexit game. Theresa May’s first set of moves as PM have confounded opponents and onlookers alike. Her cabinet appointments have raised eyebrows with Boris Johnson as Foreign Secretary also raising many a laugh. She has indicated a decisive break from the failed pro-elite austerity strategy of Cameron-Osborne. And she has swiftly moved to shore up the union by meeting with Nicola Sturgeon and acknowledging that the UK is more than just England. Importantly, triggering Article 50 to leave the EU will only be done once there is a “UK approach”. This also provides a legitimate reason to prolong the triggering, which is UK’s best strategy in Brexit negotiations. May’s strategy is masterful to watch in an era of Camerons and Goves where bland smiles and glib words hide an intellectual deficit of epic proportions and shameless short term opportunism trumps long-term sense.

The choice of appointing Brexiteers, David Davis, Liam Fox and Boris Johnson, achieves three crucial objectives. First, it cements May’s position by assuaging the Eurosceptic right flank of the Tory party and heading off potential future challengers. It allows her time and space to plan Brexit rather than rush headlong into it. Second, it places the Brexit brigade on the spot to deliver on the dream they promised. If they succeed, she wins by being the PM who calmly steered the nation away from the EU whirlpool. If they fail, she wins again by exposing the mendacity of their pre-Brexit claims and changing course (another reason why deferring invocation of Article 50 is sound strategy). Third, it channels their right-wing energies outwards towards achieving the national interest by competing with other nations. Also, given their fierce ambition (all three having coveted the Tory leadership at various points), they are likely to put in an extra effort to succeed in their brief to distinguish themselves. Moreover, having the right-wingers in international portfolios allows May to pursue a softer domestic economic policy and improve social cohesion.

In addition, May has placed the people quite appropriately. The important international trade and Brexit portfolios where a serious approach and detail orientation are critical have been given to David Davis and Liam Fox. The foreign secretary’s brief requires a candidate able to charm, persuade foreign leaders and raise Britain’s profile in the world. It also requires an ability to be flexible with the truth. Grasp of detail is irrelevant (it is the civil service which takes care of detail). Ergo Boris. He has demonstrated all these capabilities as Mayor of London and successful Brexiteer. Moreover, the clownish persona disarms opponents to the steely machinations of a first rate political brain as evidenced by his rise to the top echelons of the party. It also takes the edge off the insults and nonsense he spouts on occasion as it is usually ascribed to buffoonery. Any other “serious” politician would have been sunk had they even said half of these things. He is exactly the foreign secretary needed to put one over the foreigner. While a “serious” candidate might make us feel good, international relations require a mastery of realpolitik which Boris Johnson has demonstrated. Would you rather have a straight shooter who comes back waving a document signed by an autocrat believing in the eternal friendship being proclaimed?

The other well thought Theresa May move which has surprised is to break from the Osbornian cult of austerity and send its architect packing. Given current conventional wisdom, even considering a fiscal expansion and not falling back on opening the monetary spigot to deal with a crisis is quite revolutionary (notably the Bank of England did not reduce interest rates last Thursday as was widely expected). Austerity along with easy monetary policy has contributed to increasing wealth inequality and created a perception of the system not working for the common person. It has given rise to populists across UK and other countries and was probably a decisive factor in the Brexit vote. In addition to breaking from current economic dogma, May has done well to appoint Philip Hammond. Deficit spending, when the nation has cut itself away from the EU, requires market credibility to prevent soaring Gilt yields. The new Chancellor, being an established fiscal hawk provides it.

Alongside positioning her pieces, May has sharpened offense and strengthened defence. She has kept UK on the front foot by ignoring the European voices clamouring for a swift invocation of Article 50. It pushes significant Brexit uncertainty onto a crisis-ridden EU and constricts its ability to formulate an effective response (evidence the considerable gnashing of teeth from various European capitals). It may make it easier to obtain pre-negotiation concessions. The ambiguity also provides hope to markets stopping them from freaking out, thus containing the short-term economic fallout. Delaying Article 50 triggering also buys time to set a clear strategy and implement it while the country continues to benefit from the single market. In addition, May’s meeting with Nicola Sturgeon to reassure that Scots that they would have a say in Brexit reduces the threat to UK disintegration.

It is early days yet and much can change, however Theresa May seems to have set her eyes on winning the Brexit game. She has rapidly reconfigured the board to put UK at an advantage. She has astutely positioned people, forced EU on the back foot on Article 50 and mitigated potential vulnerabilities by acting to shore up the Union. As the game unfolds, Jean-Claude Juncker and team may find themselves in the position of an amateur playing Judith Polgar.