Product and Strategy Notes: Another Look at Avian Flu, Mervyn King's Speech (Governor Bank of England), New US Commodity ETF (DBC) and and Yale/Harvard

Another Look at Avian Flu

In our December 2005 issue, we summarizes a study by the U.S. Congressional Budget Office on the potential impact of H5N1 avian influenza pandemic. Based on assumptions of a 30% infection rate, and, of those, a 2.5% mortality rate, it concluded that the economic impact of an influenza pandemic would be approximately equal to an average post-World War Two recession. In theory, these assumptions reflect the CBO's estimate of the historical trade-off between how easy it is to transmit an influenza strain from one human to another, and how deadly it is. Historically, as transmissibility increased, mortality declined.

To check the sensitivity of the CBO's economic forecast to its assumption about H5N1's mortality rate, we turned to another source, the International Futures Model developed for the United States National Intelligence Council as part of its “2020” future scenarios project. IFS is a global economic and political forecasting model, which can be accessed on www.ifsmodel.org. Absent any influenza pandemic, the IFS Model's baseline forecast is that real world gross domestic product should grow at a compound annual rate of 3.38% between 2006 and 2010. We adjusted its mortality assumptions upward as far as the model allowed, beginning in 2006, peaking in 2007 and 2008, and returning to normal thereafter. By our calculations, this is equivalent to increasing the death rate from H5N1 from the 2.50% assumed by the CBO to 12.66% (assuming no change in the 30% infection rate, which may well be conservative). This reduced real global GDP growth between 2006 and 2010 to a compound annual rate of just 1.66% , which included a two- year global recession in 2008 and 2009. While all the caveats mentioned in this month's article on forecasting clearly apply to this estimate, it is a worrying one nonetheless. Any increase in the human-to-human transmissibility of H5N1 without evidence of a sharp reduction in its mortality rate (which, by some estimates, is still between 33% and 50% of those infected) should be a cause for serious concern.

Mervyn King's Fascinating Speech

On January 16, Mervyn King, Governor of the Bank of England, gave a fascinating speech to a business dinner in Kent. Its principal focus was the substantial fall in real interest rates seen around the world in recent years. Recall that in theory, the real rate of interest on government bonds is the price that balances the supply of and demand for risk free savings. In principle, three factors should interact to determine its level. The first is the growth rate of total factor productivity in the economy. As it increases, a dollar of investment produces more output than before. Assuming no change in the division of this increased output between labor, capital, government (taxes) and consumers (in the form of lower prices), an increase in TFP increases the profitability of investment. Assuming no increase in the supply of savings, this leads to a rise in real interest rates.

The second factor that affects the real interest rate is consumers' time preference - that is, the rate of return they require in order to put off a dollar of consumption today until tomorrow. Impatient consumers - who want it all, right now - lead to higher real interest rates. On the other hand, consumers with a high time preference have more patience, and lead to lower real rates.

The third factor affecting real interest rates is consumers' risk aversion. The less risk averse they are, the less they will save. Assuming no change in the desired level of investment, this will cause an increase in the real rate of interest.

In his speech, Dr. King noted that there were “broadly two types of explanation for the fall in long-term real rates around the world.” The first “explains low real rates as the outcome of an increased propensity to save and lower willingness to invest in the world as a whole.” He noted that the past few years have seen an increased propensity to save in the world, particularly in Asia. Whether this reflects a high willingness to delay consumption or a high degree of risk aversion is an unresolved issue. The permanence of this situation is also open to question. Dr. King speculated “as their people become more prosperous, domestic demand in China and elsewhere in Asia will become the primary driver of those countries' growth, so they may want to save less.” On the other hand, he also noted that “the growing recognition that increasing longevity will mean we need to save more for retirement may sustain or even lift world savings rates.”

On the investment side of the equation, Dr. King noted “business investment in developed economies has been weak in recent years for reasons we do not fully understand.” He went on to note that “although there are signs of a pick-up in business investment in the U.S. and Euro area, investment remains weak in the U.K. and a recovery of world investment spending is not assured.” It is interesting, in the context of our theoretical model, to speculate on the possible reasons for the observed weakness in global investment spending. Logically, it should be related to either expectations of a decline in total factor productivity growth, or a reduction in the share of output going to capital, and an increase in the share going to some combination of labor, taxes, and lower prices for consumers.

Frankly, you could make an argument for any and all of these. Total factor productivity growth could slow if we are approaching the point where it is constrained by the increasingly poor performance of public school systems in many countries. A severe influenza pandemic that reduced the supply of labor, or simply the affect of declining fertility rates in developed countries could lead to labor receiving a higher share of total output. Given the size of the unfunded liabilities for state pensions and national health insurance benefits facing many developed countries (and, as usual, we commend Australia for having addressed these issues better than most), it is reasonable to assume that taxes as a share of total output could increase in the future (which might well have a knock on negative effect on total factor productivity growth). Finally, the entry of Chinese (and, increasingly, Indian) production into world markets has put downward pressure on prices in multiple industries, reducing the increase in returns to capital caused by rising total factor productivity. This only confirms Dr. King's point that the decline of global investment spending is a phenomenon “we do not fully understand.” However, he also went on to state in his speech that “there is another, very different, explanation for recent low long-term interest rates.”
Dr. King noted that “rapid growth of money - as central banks have kept official interest rates very low - has helped to push up asset prices as investors 'search for yield.' Data from the IMF suggest that world broad money in 2003 and 2004 was growing at its fastest rate since the late 1980s. Across the world, the prices of all kinds of assets have risen - not just of government bonds, but also of equities, houses, and other real estate, commodities, gold and other precious metals. Moreover, risk premiums have become unusually compressed and the expansion of money and credit may have encouraged investors to take on more risk than hitherto without demanding a higher return.”

Dr. King pointedly noted, “it is questionable whether such behavior can persist. At some point, the ratio of asset prices to the prices of goods and services will revert to more normal levels. That could come about in one of two ways: either the prices of goods and services rise to 'catch up' with asset prices as the increased money leads to higher inflation, or asset prices fall back as markets reassess the appropriate levels of risk premia. In neither case would it be easy to keep inflation close to the 2% target.”

He closed his speech with appropriate words of caution. “I do not pretend to know whether…low long-term interest rates are primarily related to underlying preferences for savings and investment, or to the global growth of money and a possible under-pricing of risk, or, in all probability, to some combination of the two. Nor, since we do not know the causes of low long-term rates, can we be sure for how long they will persist.”

New U.S. Commodity ETF (DBC)

After much delay, the United States finally has an exchange traded fund that tracks a commodity index. The new DB Commodity Index Tracking Fund (ticker DBC) is keyed to the Deutsche Bank Liquid Commodities Index. The DBLCI includes fewer commodities than either the Goldman Sachs Commodities Index or the Dow Jones AIG Commodities Index. Its weighting of major commodity groups lies in between the GSCI and DJAIG, as shown in the following table:

As a practical matter, this difference in weightings turns out to be somewhat less than this table would suggest; between 1992 and 2004, the correlation between the GSCI and DBLCI was an impressive .91; their respective correlations with the DJAIG were .89 and .86. Moreover, the standard deviation of the returns on the GSCI and DBLCI were indistinguishable over this period, at, respectively, 17.60% and 17.63%, compared to 11.88% on the DJAIG.

The annual expense charge on the new ETF initially will be about 1.45% per year; as initial offering expenses are amortized over three years, this should decline to something closer to 1%.

For tax purposes, it is critical to note that, as described in the DBC prospectus, and unlike other Exchange Traded Funds, it is expected that DBC will be treated as a pass through entity, and the shareholders in DBC will be deemed to own a portion of the underlying Master partnership that actually trades the commodity futures contracts. This means that taxable investors will have to report their pro-rata share of the Master Fund's gains and losses, even if they do not correspond to the cash flows the investors have received. Moreover, because the Master Fund is a partnership, cash flows received will become taxable once they exceed the investor's initial cost basis in the DBC shares.

While we plan to run a longer review article next month on the valuation of commodity, timber, and property funds, our initial take on DBC is that, while it makes sense for investors committed to using ETFs, to implement their asset allocation strategy, there is no compelling case for investors in PCRDX or QRAAX to switch to it.

Yale and Harvard

Along with Stanford, Yale and Harvard are the giants in the world of university endowment investing. Over the past month, both of them have made some interesting news. At a recent meeting of the National Association of College and University Business Officers, David Swensen, who runs Yale's endowment, strongly urged his peers, particularly those running smaller endowment funds, to index their holdings. He stressed that actively managed funds were rarely worth the fees they charged, and “absolute return [hedge funds] don't belong in your portfolio unless you can identify the top 25% or top 10% [of managers].” He went on to note that while Yale and other very large endowments can spend the time and money required to identify top quality active managers, smaller funds lack the necessary resources. In this regard, “the distinction between institutional investors and individual investors is overrated.”

Meanwhile, Jack Meyer, the former manager of Harvard's endowment, has left to start his own hedge fund, Convexity Capital. What we find most admirable about Mr. Meyer's new fund is the fee structure he has chosen to use. While the typical hedge fund charges “2 and 20” (2% of the assets under management, plus 20% of all profits), Meyer will charge a base fee of only 1.25%, and peg his 20% incentive fee to returns above a relevant index - that is, to real alpha. As we move towards a world in which alpha and beta investing are increasingly separated, we applaud this step towards more rational pricing.

| A Note from the Publisher | This Month's Issue: Key Points | This Month's Letters to the Editor:Volatility (Difference Between Futures Contracts and Realized Volatility) and How to Position Portfolios Under Different Crisis Situations | Global Asset Class Returns | Equity Market Valuation Update | Forecasting | Product and Strategy Notes: Another Look at Avian Flu, Mervyn King's Speech (Governor Bank of England), New US Commodity ETF (DBC) and and Yale/Harvard | 2006-2007 Model Portfolios Update |